Econ 201Lecture 1.3

Economic Way of Thinking

1-7-2009

Overview

• What is Economics– Trying to define it

• The scientific method

• The economic way of thinking– “organizing your facts”– Applying the scientific method to a problem– Narrow versus broad economics– Fundamental basis for economic theory

What is Economics?

• “Theory of Economics does not furnish a body of settled conclusions inevitably applicable to policy. It is a method … a way of thinking ..to draw correct conclusions.” – John Maynard Keynes

• It is both descriptive of what has happened as well as predictive

What is Economics?

• A Science?– Consists of theories that help us understand

and make valid predictions about the real world (J. Hirschliefer, UCLA)

• Test, validate and accept/reject theories – subjecting theories to empirical analysis

• What does it seek to explain?– How a market societies organizes and

coordinates itself to:• Produce and allocate goods and services

What is Economics?

• Social/Market Coordination– For individuals:

• How individuals make choices among various goods, how to allocate time, with a scarcity constraint (e.g., income, time)

– For firms:• How firms decide to enter which markets• How firms decide how much and what to produce in

response to the market’s price signal

– For the market• How does the market’s price get determined?

Who are the Principal Actors?

• Consumers– Supply labor to the market to earn income– Purchase goods from firms

• Firms– Which goods are produced in response to consumer

demand– What technology and which inputs are used

• Government– Establishes the “rules” of the game, e.g. property

rights and illegal behavior– Provide incentives (taxes, subsidies), guarantees

property and legal rights

Scientific Method

What is the Study of Economics?

• The study of economics involves learning how to organize facts the way economists do. – Or what Paul calls – learning the economic way of

thinking

• An alternative way of thinking– good-versus-bad" model (conspiracy theories)

• two conflicting groups: good people and bad people. • zero-sum game: one person's gain is another's loss. • evil motives, possessed by the bad people, lead to bad

results unless these people are in some way controlled. Good motives lead to good results.

An Example

• Looking at the recent history of gas/oil prices

Testing Economic Hypotheses

• Explaining the past increase to $4/gal (~50%)– A demand-side hypothesis

• Increase in consumption from newly industrialized nations increased (shifted) the demand for gasoline

– A supply-side hypothesis• Reduced refinery capacity reduced the supply of gas (refined oil)

– Good/Bad Guy Model (Mike Mays, 5/08 before Congress)• Increase in demand from speculators who buy and sell promises to

deliver oil at a later date is almost equal to the increase in demand from China

• Empirical evidence– World-wide consumption increased by only 3-4%

• Insufficient to account for most of the increase in price– Increase in demand by speculators even less

• Refinery capacity did diminish by ~30-40%

Broad versus Narrow Economics

• Narrow economics– Theory of behavior based on “incentives” is restricted

to analysis of human behavior in the marketplace• E.g., impact of the “cow gas” tax

• Broad economics– Incentives are not limited to economic incentives,

such as prices, taxes or income– Behavior based on incentives is not restricted to only

markets• E.g., CIA and Afghan warlords

Narrow Economics

• ANPR (Notification of Proposed Rule Making),– Give EPA authority to regulate greenhouse gas

• not only greenhouse gas from manmade sources like transportation and industry,

• also “stationary” sources which would include livestock.

• New York Farm Bureau estimates:– Basic facts:

• $175 per cow, and $87.50 per head of beef cattle• $20 per hog,” • Apply to >= 25 dairy cows, 50 beef cattle or 200 hogs

– Impact: add between 7 and 8 cents per gallon of milk costs to farmers

Broad Economics

• Afghan warlords and Viagra (http://www.telegraph.co.uk/)– Whatever it takes to make friends and influence

people – whether it's building a school or handing out Viagra," one veteran CIA officer told The Washington Post.

– According to the newspaper, pills to boost the libidos of Afghan tribal patriarchs are the latest in a long line of inducements including medicine or operations for family, toys and school equipment, tooth extractions and visas

– The trick was to identify a means of pleasing the CIA source enough to guarantee his loyalty without making it obvious to others that he's being rewarded.

What is Economic Theory Based On?

• “all social phenomena emerge from the actions and interactions of individuals who are choosing in response to expected benefits and costs” (Heyne)– Focus on choice under constraint

• Constraint scarcity– Scarcity: can’t have all of the things you want

» Even if unlimited income and no natural resource constraints => time

• In reality – all are limited and choices must be made about how to use them – or there would be no economic problem

So What is Economics?

• Economics is the study of the:– Choices we make– Constraints that we face– Tradeoffs that are made because of scarcity

Basic Behavioral Postulates1. For each person some goods are scarce

- have to make choices (core of the economic problem)2. Each person desires many goods and services

- tradeoffs3. Each person is willing to forsake some of an economic good to

get more of other economic goods- Opportunity costs

4. More one has of any good, the lower it personal marginal value- Diminishing marginal value

5. Not all people have the same tastes and preferences6. People are innovative and rational

- Does not mean we know everything and don’t make mistakes, but we do learn from them and don’t repeat them

Scarcity

• Past Examples– Malthus

• Hypothesized that continued high rate of population growth would outstrip world’s ability to produce food

– Mayan and Eastern Island examples

• Current issues– Climate Change

• Affecting human health, ecosystem, moral dimension and requiring international coordination

– Water Accessibility• Increasing water stress from both supply and sanitation

– Meeting the Challenges• Economic activities and environmental problems• International cooperation

Overview: Welcome to Economics!

• http://ingrimayne.com/econ/Introduction/Overview1.html

• After you finish this unit, you should be able to: – Explain what the term "invisible hand" means and

who first used it. – Give at least one common definition of economics. – State what Malthus thought about population growth. – Explain how Popper defines scientific statements. – Distinguish between positive and normative

statements. – Explain what scarcity, choice, and self-interest have

to do with economics.