Chapter 1: Economics and the Economic Way of Thinking

1.1 Definition and Questions

• Scarcity: The condition that arises because wants exceed the ability of resources to satisfy them. Faced with scarcity, we must make choices among available alternatives. The choices we make depend on the incentives we face.
• Economics Defined: Economics is the social science that studies the choices that individuals, businesses, governments, and entire societies make as they cope with scarcity, the incentives that influence those choices, and the arrangements that coordinate them.
• Macroeconomics vs Microeconomics:
  • Macroeconomics: The study of the aggregate (or total) effects on the national economy and the global economy of the choices that individuals, businesses, and governments make.
  • Microeconomics: The study of the choices that individuals and businesses make and the way these choices interact and are influenced by governments.
• Two Big Economic Questions:
  1) How do choices determine What, How, and For Whom goods and services get produced?
  2) When do choices made in self-interest also promote the social interest?
• What, How, and For Whom?
  • Goods and Services: goods are the objects people value and produce; services are the actions people value and produce to satisfy human wants.
  • Questions:
    1) What goods and services get produced and in what quantities?
    2) How are goods and services produced?
    3) For Whom are the various goods and services produced?
• Can the Pursuit of Self-Interest Be in the Social Interest?
  • Self-Interest: the choices that are best for the individual who makes them.
  • Social Interest: the choices that are best for society as a whole.
  • Inquiry into whether self-interested choices can serve social goals (illustrated with examples).
• Topics illustrating the link between self-interest and social interest:
  • Globalization: the expansion of international trade and multinational production; pace accelerated by cheaper communication (microchips, satellites, fiber optics).
  • Information Age: innovations by chipmakers and software developers; self-interest vs social benefit.
  • Climate Change: energy production/usage decisions made in self-interest; implications for social welfare.

1.2 The Economic Way of Thinking

• Six Economic Ideas that Define the Economic Way of Thinking:
  1) Choice is a tradeoff.
  2) Cost is what you must give up to get something.
  3) Benefit is what you gain from something.
  4) People make rational choices by comparing benefits and costs.
  5) Most choices are “how much” choices made at the margin.
  6) Choices respond to incentives.

• A Choice Is a Tradeoff:

  • Scarcity forces us to choose among alternatives.
  • Whatever choice you make, you could have chosen something else.
  • We can view choices as tradeoffs: giving up one thing to obtain another.

• Cost and Benefit:

  • Cost: what you must give up to get something.
  • Opportunity Cost: the best thing you must give up to get something—the highest-valued alternative forgone.
  • Benefit: what you gain from something; measured by what you are willing to give up.

• Rational Choice and How Much:

  • A rational choice uses available resources to best achieve the chooser’s objective.
  • Marginal Thinking: choosing at the margin by comparing all relevant alternatives incrementally.

• Making a Rational Choice:

  • A rational choice occurs when marginal benefit equals or exceeds marginal cost: $ext{MB} \ge ext{MC}$ (often written as MB > MC for optimal incremental decisions).

• Marginal Cost and Marginal Benefit:

  • Marginal Cost (MC): the opportunity cost of a one-unit increase in an activity.
  • Marginal Benefit (MB): the gain from one more unit of something; measured by what you are willing to give up to obtain that unit.
  • Relationship: MB - MC guides decisions at the margin.

• Choices Respond to Incentives:

  • Incentive: a reward or penalty that encourages or discourages an action (a “carrot” or a “stick”).
  • Positive Incentives: e.g., tax refunds, pay raises, awards, extra credit.
  • Negative Incentives: e.g., taxes, jail, fines, getting fired.
  • Direct Incentives: explicit promises of rewards.
  • Indirect Incentives: secondary effects that influence behavior (e.g., cheating as a side effect of certain rewards).
  • Patents and Copyrights as incentives to innovate.

• Economics as a Social Science (the scientific method):
  1) Start with a question or puzzle about cause and effect from observed facts.
  2) Build a model that describes essential features needed to explain the observed facts (an Economic Model).

  • An Economic Model is a description including only necessary features to explain the observed facts.
    3) Check the model against facts.

• Economic Models: a concrete example

  • Example question: What determines a person’s wage rate (W)?
  • Possible factors: Education, Age, Experience, Skills, Pleasant Conditions, Female.
  • Represented as: $W = f( ext{Education}, ext{Age}, ext{Experience}, ext{Skills}, ext{Pleasant Conditions}, ext{Female})$

• Disagreement: Normative vs Positive Economics

  • Positive Economics: statements that can be tested as true or false (what is).
  • Normative Economics: statements about what ought to be (value judgments).
  • Some disagreements can be settled by facts; others cannot.
  • The distinction helps in evaluating policy debates.

• Positive vs Normative Analysis (quick reference):

  • Positive Statement: a testable claim (true/false when examined with evidence).
  • Normative Statement: an opinion about what ought to be.
  • General guidance: positive claims are preferred when testing against data.

• Practice What You Know—Positive or Normative?

  • The moon is made of green cheese. → Positive (testable fact, though false).
  • Rich people should be taxed more. → Normative.
  • More taxes on the rich will increase tax revenues. → Positive.
  • Everyone should donate to charity. → Normative.
  • Government intervention in markets is bad. → Normative.
  • Economics majors earn more on average than sociology majors. → Positive.
  • Everyone should take Economics I: ECO2013. → Normative.

• Economics as Policy Tool:

  • Economics offers a framework for approaching problems in various spheres:
  • Personal: e.g., Should you take out a student loan?
  • Business: e.g., Is a star athlete worth a high salary?
  • Government: e.g., How should the government balance its budget?

• Does school provide a big enough benefit to justify its cost?

  • Benefits of school: present enjoyment of student life; higher future income.
  • Costs: tuition, books, other study costs, forgone earnings.
  • Net benefit for most people tends to be large because benefits accrue over a working lifetime.
  • “Eye on the BENEFIT and COST of SCHOOL.”

• Notable real-world contrasts:

  • Some individuals (e.g., Bill Gates, Mick Jagger, Clayton Kershaw) quit or turn down opportunities because they weighed the benefits differently; illustrates that the decision depends on perceived benefits and costs.

• Appendix Getting Started (Appendix Checklist)

  • After studying this appendix you should be able to:
  • Interpret graphs that display data.
  • Interpret graphs used in economic models.
  • Define and calculate slope.
  • Graph relationships among more than two variables.

Appendix: MAKING AND USING GRAPHS

• Basic Idea: A graph visualizes the relationship between two variables.
  • Axes: Horizontal axis (x-axis), Vertical axis (y-axis); origin as the intersection.
• Making and reading graphs:
  • Horizontal axis measures the first variable (e.g., temperature).
  • Vertical axis measures the second variable (e.g., ice cream consumption).
  • Example points:
  • Point A: at temperature 40°F, ice cream consumption = 5 gallons/day.
  • Point B: at temperature 80°F, ice cream consumption = 20 gallons/day.
• Interpreting Data Graphs:
  • Scatter Diagram: value of one variable against another (e.g., income vs expenditure).
  • Time-series Graph: time on x-axis, variable(s) on y-axis (e.g., price over time).
  • Trend: general tendency over time.
  • Cross-section Graph: values for different groups in a population at a point in time.
• Positive (Direct) Relationship:
  • As one variable increases, the other increases; graphically a straight line or curve with positive slope.
  • Example: As speed increases, distance traveled in a fixed time increases.
• Negative (Inverse) Relationship:
  • As one variable increases, the other decreases; graphically a downward-sloping line or curve.
  • Examples: As leisure time increases, problems solved decreases; as journey length increases, cost per mile falls (reach a minimum).
• Unrelated Relationships:
  • No systematic relationship: the graph is horizontal (no change in y with x) or vertical (no change in x with y).
• The Slope of a Relationship:
  • Definition: ext{Slope} = rac{
    abla y}{
    abla x} (change in y over change in x).
  • Positive slope example: If ∆x = 4 and ∆y = 3, then slope = $rac{3}{4}$.
  • Negative slope example: If ∆x = 4 and ∆y = -3, then slope = $rac{-3}{4}$.
  • Slope of a curve at a point equals the slope of the tangent line at that point.
• Relationship Among More Than Two Variables (ceteris paribus):
  • Use the ceteris paribus assumption: other things being equal.
  • Example figure: price and consumption with temperature held constant.
• Interpreting Graphs Used in Economic Models:
  • Positive Relationship (Direct): X↑ → Y↑; X↓ → Y↓.
  • Linear Relationship: graphs as straight lines.
• Figures (illustrative):
  • A1.2(a) Scatter diagram: as income increases, expenditure increases.
  • A1.2(b) Scatter diagram: higher cell-phone bills associated with more subscribers.
  • A1.2(c) Time-series: price of coffee over time; show rising/falling trends.
  • A1.2(d) Cross-section: participation in sporting activities across groups.
• Area, Slope, and Shape Calculations (Appendix CALCULATING AREA):
  • Triangle: $ext{Area} = frac{1}{2} imes b imes h$
  • Rectangle: $ext{Area} = w imes h$
  • Square: $ext{Area} = a^2$
  • Parallelogram: $ext{Area} = b imes h$
  • Trapezoid: $ext{Area} = frac{1}{2} (a + b) imes h$
  • Circle: $ext{Area} = <br /> \pi r^2$; Circumference: $C = 2 \pi r$
  • Sector: $ext{Area} = frac{1}{2} r^2 heta \ ( heta ext{ in radians})$
  • Ellipse: $ext{Area} = \pi a b$
• Note: In the figure of sectors and sectors, angles can be in radians for area calculations.

Appendix: PRACTICE WHAT YOU KNOW

• Question: What can be said about Scarcity?
  • Options:
  • Scarcity forces us to make choices. (Correct)
  • Scarcity doesn’t affect the super-wealthy. (Incorrect)
  • Scarcity only affects commodities such as oil. (Incorrect)
  • Scarcity generally doesn’t affect our day-to-day living. (Incorrect)
• Question: Which situation illustrates an Incentive?
  • Options:
  • Dave snacks all afternoon and isn’t hungry for dinner. (Not an incentive change)
  • Dirk’s children misbehave during dinner. (Not an incentive)
  • Lee gives his children candy if they behave during dinner. (Incentive)
  • Jaime goes to a restaurant for dinner. (Not an incentive)
• Question: The Opportunity Cost of buying a good is:
  • Options:
  • The sum of values of all other goods you could have purchased. (Incorrect)
  • The value of the next-best alternative you could have purchased. (Correct)
  • Irrelevant since you will purchase your highest-valued good. (Incorrect)
  • The average of values of all other goods you could have purchased. (Incorrect)
• Question: With regards to Marginal Thinking, an individual will do an action if:
  • Options:
  • The probability of success is greater than 50%. (Incorrect)
  • The action has positive benefits. (Partially correct but incomplete)
  • The costs of the action are small. (Incorrect)
  • Marginal Benefits > Marginal Costs. (Correct)
• Question: The governor increases funding for education but decreases funding for infrastructure. This illustrates:
  • Options: Trade-offs; Comparative Advantage; Incentives; Markets.
  • Correct: Trade-offs.

Appendix: Calculating and Interpreting Areas, Slope, and Multi-variable Graphs

• Area formulas recap (for quick reference):
  • Triangle: $A = frac{1}{2} b h$
  • Rectangle: $A = w h$
  • Square: $A = a^2$
  • Parallelogram: $A = b h$
  • Trapezoid: $A = frac{1}{2} (a + b) h$
  • Circle: $A = \pi r^2$; Circumference: $C = 2 \\pi r$
  • Sector: $A = frac{1}{2} r^2 heta \ ( heta ext{ in radians})$
  • Ellipse: $A = \pi a b$
• The slope concept revisited:
  • Slopes indicate how one variable changes with another:
  • Positive slope: y increases as x increases.
  • Negative slope: y decreases as x increases.
  • General formula: ext{Slope} = rac{\Delta y}{\Delta x}
  • Examples:
  • If $\Delta x = 4$ and $\Delta y = 3$, slope = $\frac{3}{4}$ (positive).
  • If $\Delta x = 4$ and $\Delta y = -3$, slope = $-\frac{3}{4}$ (negative).
  • Slope of a curve at a point equals the slope of the tangent line at that point.
• Multi-variable relationships (ceteris paribus):
  • When relating ice cream consumption, price, and temperature, hold other factors constant to isolate how one variable affects another.

Connections to Foundational Principles and Real-World Relevance

• The core of economic reasoning rests on choosing under scarcity, evaluating tradeoffs, and using marginal analysis to inform decisions.
• Incentives shape behavior in everyday life: tax policy, wages, price changes, and policy design.
• The scientific method in economics helps test theories against real-world data and refine models.
• Distinguishing positive and normative analysis improves clarity in policy debates.
• Graphs and data interpretation are essential tools for understanding economic relationships and communicating conclusions.
• Understanding area, slope, and multi-variable graphs underpins data analysis across economics and related disciplines.

Note on structure and use for exam preparation

• Use these notes to recall core definitions, distinctions, and the logical flow from scarcity to marginal analysis to policy implications.
• Practice questions included (from the Practice sections) to test understanding of positive vs normative reasoning and tradeoffs.
• Be comfortable with the symbolized forms: $ext{MB}, \text{MC}, \text{W} = f(\,)$, and standard area/slope formulas in LaTeX.