Chapter 1 The Nature of Economics Introduction Rhesus monkeys are willing to forgo 10% of their income of cherry juice to examine photos of leading and attractive members of their group. This behavior mirrors our willingness to purchase celebrity magazines. Nevertheless, economists who study making choices in response to rewards or inducements, propose some are willing to pay to be viewed by others as leading and attractive members of our society. What can economists tell us about why people purchase items that attract attention such as flashy sports cars or designer clothing? Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-2 Learning Objectives Discuss the difference between microeconomics and macroeconomics Evaluate the role that rational selfinterest plays in economic analysis Explain why the study of economics is a science Distinguish between positive and normative economics Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-3 1
Chapter Outline The Power of Economic Analysis Defining Economics Microeconomics versus Macroeconomics The Economic Person: Rational Self-Interest Economics as a Science Positive versus Normative Economics Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-4 Did You Know That... Six of seven main U.S. railroad lines meet in Chicago? The bottlenecks these lines caused created incentives to lay more track? Incentives are the underpinnings for all the decisions you and others make? Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-5 The Power of Economic Analysis Incentives Rewards for engaging in a particular activity Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-6 2
The Power of Economic Analysis (cont'd) The economic way of thinking is a framework to analyze solutions to economic problems. How much time to study Choosing which courses to take Whether troops should be sent abroad Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-7 The Power of Economic Analysis (cont'd) The economic way of thinking gives you the power the power to reach informed conclusions about what is happening in the world. Economic analysis helps you make better decisions, and increases your understanding when watching or reading the news on the Web. Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-8 The Power of Economic Analysis (cont'd) Economic analysis is a way of thinking about all decisions. Your education, career, financing your home, family Your involvement in the business world, or in politics as a voter Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-9 3
Defining Economics Economics The study of how people allocate their limited resources to satisfy their unlimited wants The study of how people make choices Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-10 Defining Economics (cont'd) Resources Things used to produce other things to satisfy people s wants Wants What people would buy if their incomes were unlimited Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-11 Defining Economics (cont'd) With limited income (resources), people must make choices to satisfy their wants. We never have enough of everything, including time, to satisfy our every desire. Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-12 4
Defining Economics (cont'd) Individuals, businesses, and nations face alternatives, and choices must be made. Economics studies how these choices are made. Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-13 Microeconomics versus Macroeconomics Microeconomics The study of decision making undertaken by individuals (or households) and by firms Like looking though a microscope to focus on the smaller parts of the economy Decision of a worker to work overtime or not A family s choice of having a baby An individual firm advertising Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-14 Microeconomics versus Macroeconomics (cont'd) Macroeconomics The study of the behavior of the economy as a whole Deals with economywide phenomena The national unemployment rate The rate of growth in the money supply The national government s budget deficit Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-15 5
Microeconomics versus Macroeconomics (cont'd) Macroeconomics deals with aggregates, or totals such as total output in an economy. Modern economic theory blends micro and macro concepts. Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-16 The Economic Person: Rational Self-Interest Economists assume that individuals act as if motivated by self-interest and respond predictably to opportunities for gain. Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-17 The Economic Person: Rational Self-Interest (cont'd) It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, 1776 Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-18 6
The Economic Person: Rational Self-Interest (cont'd) Rationality Assumption The assumption that people do not intentionally make decisions that would leave them worse off Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-19 Example: Neuroeconomics Explores the Rationality Assumption Economists want to know which parts of the brain play the greatest role in determining an individual s choices. Brain scans reveal considerable coordination between the limbic system (governing emotions) and the prefrontal cortex (associated with reason and calculation). There is evidence the brain attempts to factor in reasoned calculations aimed at making a choice consistent with the best overall outcome. Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-20 The Economic Person: Rational Self-Interest (cont'd) Questions Does the fact that some people make apparently irrational choices invalidate the rationality assumption in economics? Can economic models be applied to situations in which behavior is at odds with what we expect from rational people? Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-21 7
The Economic Person: Rational Self-Interest (cont'd) Responding to incentives Rationality and the use of incentives Positive incentives Negative incentives Making choices Balancing cost and benefits Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-22 The Economic Person: Rational Self-Interest (cont'd) Some examples of incentives Responding to positive incentives Schoolchildren getting gold stars, working to have a better life for yourself Responding to negative incentives Penalties, punishments, using credit cards to avoid check overdrafts Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-23 E-Commerce Example: Playing the Float with Plastic Instead of Checks Checks used to take up to several days to clear. People would rush to make deposits to avoid overdraft charges. Technological developments enhanced digital imaging, and banks have reduced check float. This has provided incentives for more credit card purchases as they allow for deferred payment. How might high interest rates influence incentives to use credit cards? Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-24 8
The Economic Person: Rational Self-Interest (cont'd) Defining self-interest The pursuit of one s goals, does not always mean increasing one s wealth Prestige Friendship Love Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-25 Example: The Perceived Value of Gifts The perceived value of gifts Often, the recipient of the gift places a value on it far less than the market value. Should we substitute gift certificates for physical gifts? Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-26 Economics as a Science Models or Theories Simplified representations of the real world used as the basis for predictions or explanations A map is the quintessential model Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-27 9
Economics as a Science (cont'd) Assumptions The set of circumstances in which a model is applicable Every model, or theory, must be based on a set of assumptions. Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-28 Example: Getting Directions A map is a simplifying model of reality. The degree of simplification varies across maps; some contain more detail than others. Economic models attempt to focus on what is relevant to the problem at hand and omit what is not. Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-29 Economics as a Science (cont'd) Ceteris Paribus Assumption [KAY-ter-us PEAR-uh-bus] Nothing changes except the factor or factors being studied. Other things constant Other things equal Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-30 10
Economics as a Science (cont'd) Economics is an empirical science. Real-world data is used to evaluate the usefulness of a model. Models are useful if they predict economic phenomena. Economic models predict how people react, not how they think. Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-31 Economics as a Science (cont'd) Behavioral Economics Approach to the study of consumer behavior Emphasizes psychological limitations and complications which may interfere with rational decision making Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-32 Economics as a Science (cont'd) Bounded Rationality Hypothesis that people are nearly, not fully, rational They cannot examine every choice available to them Use simple rules of thumb to sort alternatives Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-33 11
Positive versus Normative Economics Positive Economics Purely descriptive statements or scientific predictions; If A, then B, a statement of what is Normative Economics Analysis involving value judgments; relates to whether things are good or bad, a statement of what ought to be Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-34 Issues and Applications: Do People Engage in Conspicuous Consumption? In 1902, economist Thorstein Veblin coined the phrase conspicuous consumption. Ori Heffetz of Princeton University looked for empirical evidence to support Veblin s idea. Evidence showed higher-income people buy visible items. Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-35 Issues and Applications: Do People Engage in Conspicuous Consumption? (cont'd) Is conspicuous consumption for real or just a rational response to higher income? Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-36 12
Summary Discussion of Learning Objectives Microeconomics versus macroeconomics Economics is the study of how individuals make choices to satisfy wants. Microeconomics is the study of decision making by individual households and individual firms. Macroeconomics is the study of nationwide phenomena, such as inflation and unemployment levels. Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-37 Summary Discussion of Learning Objectives (cont'd) Self-interest in economic analysis Rational self-interest is the assumption that individuals behave in a reasonable (rational) way in making choices to further their interests. Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-38 Summary Discussion of Learning Objectives (cont'd) Economics as a science Economists use models, or theories, that are simplified representations of the real world to analyze and make predictions about the real world. Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-39 13
Summary Discussion of Learning Objectives (cont'd) The difference between positive and normative economics Positive economics deals with what is, whereas normative economics deals with what ought to be. Positive statements are of the if then variety, while normative ask what should, or could be. Copyright 2008 Pearson Addison Wesley. All rights reserved. 1-40 End of Chapter 1 The Nature of Economics 14