C H A P T E R 1
The Art and Science of
Economic Analysis
I.INTRODUCTION
This chapter presents an overview of economics and explains how economic analysis is performed.In particular, it introduces the concept of the economic problem and an important type of economic analysis: marginal analysis. There is also an appendix that discusses how graphs are used. Other tools of economic analysis are presented in the next chapter.
II.OUTLINE
1.The Economic Problem. Because resources are scarce and human wants are unlimited, people cannot have everything they want. Economics is the study of how individuals choose to use their scarce resources in an attempt to satisfy their unlimited wants.
1.1Resources
a. Labor (physical and mental effort). Payments to labor are called wages.
b.Capital. Payments to capital are called interest.
(1)Physical capital (manufactured items used in the production of goods)
(2)Human capital (knowledge and skills people acquire to enhance their ability to produce)
c.Natural resources (land, bodies of water, minerals, etc.) Payments to natural resources are called rent.
d.Entrepreneurial ability (the talent of a person who tries to discover and exploit profit-able activities). Payments for entrepreneurial ability are called profit.
1.2Goods and Services
a.Goods and services are produced to satisfy human wants.
b.Goods are tangible; services are intangible.
c.Both goods and services require scarce resources and are therefore themselves scarce.
d.Without scarcity there would be no economic problem.
1.3Economic Decision Makers
a.There are four types of decision makers in the economy: households, firms, governments, and the rest of the world.
b.Markets are the means by which buyers and sellers carry out exchanges.
1.4A Simple Circular-Flow Model
- The circular-flow model describes the flow of resources, products, income, and revenue among households, firms, government, and the rest of the world.
b. The flows of resources in one direction are offset by flows of money in the other
direction.
1
2.The Art of Economic Analysis
2.1Rational Self-Interest
a.Economists assume that individuals act in their own best interests.
b.Economists also assume that individuals are rational, which means that people try to make the best choices possible under the circumstances.
2.2Choice Requires Time and Information
2.3Economic Analysis Is Marginal Analysis
a.Marginal means “incremental” or “extra.”
b.An individual changes his or her behavior whenever the expected marginal benefit from doing so is greater than the expected marginal cost.
2.4Microeconomics and Macroeconomics
a.Microeconomics is the study of how individual economic agents make decisions and how the choices of various decision makers are coordinated.
b.Macroeconomics is the study of the economy as a whole.
3.The Science of Economic Analysis
3.1The Role of Theory
a.A theory, or model, is a simplification of reality that focuses on the most important features of a relationship.
b.Theory is needed to determine which facts are relevant in a relationship.
c.Theory is also used to make predictions about the real world.
3.2The Scientific Method
a.Step One: Identify the question and define the relevant variables. (A variable is a quantity that can take on different possible values.)
b.Step Two: State the assumptions that specify the conditions under which the theory is to apply.
(1)Ceteris paribus: other things are held constant
(2)Behavioral assumption: a notion concerning individual behavior that is taken to be true; for example, rational self-interest
c.Step Three: Formulate hypotheses about relations among the key variables.
d.Step Four: Test the theory.
3.3Normative Versus Positive Analysis
- A positive statement is one that can be verified by referring to the facts.
- A normative statement is a statement representing someone's opinion or values; it cannot be proved or disproved.
3.4Economists Tell Stories
3.5Case Study: A Yen for Vending Machines
3.6Predicting Average Behavior
a.Economic theories do not permit an economist to predict the behavior of individuals because any individual may behave in unpredictable ways.
- The random behaviors of individuals tend to cancel each other, so the average behavior of a large group can be predicted.
3.7Some Pitfalls of Faulty Economic Analysis
a.Fallacy That Association Is Causation. It is a mistake in analysis to think that one event caused another simply because the first event preceded the second.
b.Fallacy of Composition. It is erroneous to believe that what is true for the individual is true for the group.
c.Mistake of Ignoring the Secondary Effects. Economic analysis should not ignore secondary effects, which develop slowly over time as people react to events.
3.8If Economists Are So Smart, Why Aren't They Rich? The economics profession thrives because its models usually do a better job of explaining the real world than do alternative approaches.
3.9Case Study: College Major and Career Earnings
4.Appendix: Understanding Graphs. Graphs are a way of compressing information.
4.1Drawing Graphs. Graphs can express three types of relations between two variables:
a.Positive (direct) relation: as one variable increases, the other variable increases.
b.Negative (inverse) relation: as one variable increases, the other variable decreases.
c.Independent relation: as one variable increases, the other remains constant; the variables are unrelated.
4.2The Slopes of Straight Lines. Slope is the change in the vertical distance between two points divided by the corresponding change in the horizontal distance between the points.
4.3The Slope, Units of Measurement, and Marginal Analysis
a.The mathematical value of the slope depends on the units of measurement on the graph; e.g., the slope of a line relating price and output will be different if output is measured in feet than if it is measured in yards.
b.The slope measures the marginal effects, so it is important in economic analysis.
4.4The Slopes of Curved Lines
a.Slope of a curved line is different for each point on the curve.
b.Slope of a curved line at a point is found by measuring the slope of a straight line tangent to the curve at the point.
4.5Line Shifts. A line can shift when a variable not measured on the horizontal or vertical axis changes.
III.DISCUSSION
The Economic Problem
Two facts of life create the economic problem: scarce resources and unlimited human wants. Resources are combined to produce goods and services. Since resources are scarce, not all goods and services that people desire can be produced; that is, goods and services are also scarce. Consequently, individuals must make choices. Even though we cannot have everything we want, we can have some of the things we want.
Households, firms, governments, and the rest of the world are the four economic actors in the economy. Households act both as consumers who demand the goods and services produced and as resource owners who supply resources to firms and government. Everybody owns at least one productive resource: his or her own labor. Firms supply goods and services to consumers by hiring resources to produce them. The government provides some goods and services, such as national defense, that tend not to be produced by private firms. The government also makes and enforces rules to be followed by other economic actors. The rest of the world includes foreign households, firms, and governments. The circular-flow model shows the flow of resources, products, incomes, and revenues among the economic actors—households, firms, government, and the rest of the world.
Buyers and sellers come together to carry out exchange in markets. Some markets—farmers' markets, for example—are physical places with specific geographic locations. Other markets are less concrete and consist of communications by individuals thousands of miles apart. For example, people can order books from a book club through the mail.
The Art of Economic Analysis
Economists assume that people are motivated by self-interest. This does not mean that they act selfishly; it means that they make choices that will make them better off, as they themselves define “better off.” Religious or political zealots who risk their lives for a cause presumably do so because they believe they will be better off for doing so. Self-interest, by itself, does not allow us to make predictions or to explain human behavior adequately. However, when the assumption of rationality is added, we can begin to analyze and explain human behavior. By “rational” we mean consistent and reasonable. If we assume that people behave consistently, then we can predict how they will change their behavior when they face different economic environments.
Rational choice takes time and information. A choice can be a poor one if a decision maker lacks good information. The collection and assimilation of information take time and use up resources. Rational individuals collect information from a variety of sources as long as the expected marginal benefit of doing so exceeds the expected marginal cost.
It is very rare for people to have to make all-or-nothing decisions. Instead, decisions usually involve choices between the status quo and something else. One chooses among having apple pie for dessert, cake for dessert, or no dessert at all. A decision is made on the basis of a comparison of the extra (marginal) benefits and the extra (marginal) costs of the contemplated change. When marginal benefits exceed marginal costs, the individual makes the change.
Economics is broken down into two parts: microeconomics and macroeconomics. Microeconomics concerns the economic behavior of individual decision makers, such as the consumer, the worker, and the manager of a firm. Macroeconomics examines the economic system as a whole and tries to explain unemployment, inflation, and economic growth.
The Science of Economic Analysis
An economy as large, diverse, and interrelated as the U.S. economy is too complex for any individual to understand. There is so much economic data that people cannot understand the reason for every transaction. A theory is used to reduce the complexity of an economic system to manageable limits. Consequently, a theory does not contain all relevant details and facts. A theory attempts to simplify economic reality by capturing the essential features of economic relations.
Economic analysis follows the scientific method, which can be broken down into four steps. First, the specific economic question must be identified and the relevant variables must be defined. Second, the assumptions that specify the conditions under which the theory applies must be identified. In economics, it is common to employ the assumption of ceteris paribus, which means “other things held constant.” For example, when we say that a higher price for a good causes fewer units of the good to be sold, we hold income and tastes, among other things, constant. Third, hypotheses about the relations among variables are stated. These generally take the form of if-then statements. Fourth, the hypotheses are tested.
Economists distinguish between positive economic statements and normative economic statements. Positive economic statements are associated with economic theory and involve facts or predictions that are testable. Normative economic statements involve value judgments and opinions. The statement “Tariffs on imported steel will increase employment in the U.S. steel industry” is an example of a positive statement. “Higher tariffs should be placed on imported steel” is an example of a normative statement.
Economics is a social science that attempts to explain economic behavior. But human beings are complex and individuals are unique in many ways. Economists try to explain and predict the average behavior of people. Specific individuals may not behave as expected even though the average behavior of people is predicted well.
It is easy to fall into several traps that lead to incorrect economic thinking. The association-causation fallacy is common. It is especially easy to fall into this trap when one event precedes another in time. It can even be the case that the second event caused the first event. For example, if one observed that many people at the race track were betting on a particular horse and then observed that that particular horse won the race, it would be erroneous to conclude that the horse won because many people bet on it. Rather, people expected the horse to win so they bet on the horse. Another common error is the fallacy of composition, which is the mistaken belief that what is true for the individual is also true for the group. One person can see a football game better by standing up, but if everyone stands nobody has a better view. Mistakes are also made when people ignore the secondary effects of an economic activity or policy.
Appendix: Understanding Graphs
If this is your first course in economics, read the appendix to this chapter in the textbook carefully. Economists often use graphs to represent relations. Graphs generally reflect a relation between two variables, such as price and quantity, money supply and interest rates, or wages and hours worked. An independent variable is one that has a causal effect on another variable. The other variable is called the dependent variable because its value depends on the value of the first variable.
A question that is often of interest in economics is whether one variable has a positive, or direct, effect on another variable or an inverse, or negative, effect. Exhibit 1 shows a line that represents a consumption function. The independent variable is income and the dependent variable is consumption expenditures. The graph represents the assumption that as a family's income increases, its consumption spending also increases. Hence, there is a direct, or positive, relation between a family's income and the amount the family spends.
A negative, or inverse, relation is illustrated in Exhibit 2. Here the independent variable is hours of practice and the dependent variable is one's golf score. The more one practices, the lower the golf score will be.
The slope of a line is the amount the vertical variable changes for a given increase in the horizontal variable. The slope of an upward-sloping line is positive; the slope of a downward-sloping line is negative. The slope of a straight line is constant, but the slope of a curved line changes at every point. To find the slope of a curved line at a point, draw a straight line tangent to the point. The slope of this line is the slope of the curved line at that point. Make sure that you understand the graphs that are used in the appendix in the textbook.
IV.LAGNIAPPE
The Consumption Function
The theory of the consumption function can be used to illustrate the scientific method as it is applied in economics. John Maynard Keynes developed the theory of the consumption function during the Great Depression. He identified two key variables—consumption spending and income—and hypothesized that people spend some percentage of any increase in income on goods and save the rest. Hence, consumption is a function of income. After World War II, many economists forecasted a recession on the basis of the consumption function theory. They argued that incomes would fall after the war; this would lead to reduced consumption spending, which would reduce the incomes of even more people. However, the recession did not materialize. This caused some economists to reexamine the consumption function. Milton Friedman altered the theory by pointing out that people do not respond to temporary fluctuations in their incomes by altering consumption spending greatly. Instead, they make consumption spending decisions on the basis of their expected long-term average, or permanent, income. Once the theory was modified to include longer-term considerations, it was used more successfully in making predictions.
Question to Think About: Does the percentage of income spent on consumption goods vary with age?
Heroic Self-Interest
As stated before, the assumption of self-interest does not imply that people always behave in a selfish manner. Each person defines his or her own self-interest in a different way. Most of us probably would not consider actions that are likely to lead to our death as being in our self-interest. Yet it is possible for people to believe that. The ancient Greeks wrote of heroes who valued fame more than life and who were willing to die to gain this fame. In the story of the Trojan War, the gods had foretold that the first Greek who landed on Trojan soil would die. A young man named Protesilaos jumped ashore first so that his name would go down in history. The greatest Greek hero, Achilles, faced the option of going to Troy, where he would gain great fame and die, or staying at home, where he would live a long life and remain unknown. He chose to go to Troy. Evidently, he perceived it to be in his self-interest to gain fame rather than to die an unknown.
Question to Think About: Do you think all ancient Greeks would have made the same decision that Achilles made?
The Art and Science of Economic Analysis1
V.KEY TERMS
Scarce resourcesMarginal
EconomicsEconomic theory, or economic model
Behavioral assumptionVariable
Natural resources Other-things-constant assumption
Renewable resource Hypothesis
Exhaustible resourceBehavior assumptions
LaborPositive economic statement
CapitalNormative economic statement
Human capitalAssociation-causation fallacy
Entrepreneurial abilityFallacy of composition
RentSecondary effects
WagesOrigin
ProfitHorizontal axis
InterestVertical axis
GoodGraph
ServiceTime-series graph
ScarceFunctional relation
MarketDependent variable
Product marketIndependent variable
Resource marketPositive, or direct, relation
Circular-flow modelNegative, or inverse, relation
MicroeconomicsSlope
MacroeconomicsTangent
Rational self-interest
VI.QUESTIONS