Economics Notes

1.0 The Nature of Economics

1.1 Define Economics and Discuss the Difference Between Microeconomics and Macroeconomics

  • Learning Objectives:

    • Define economics and differentiate between microeconomics and macroeconomics.
    • Identify the three basic economic questions and the two opposing sets of answers.
    • Evaluate the role of rational self-interest in economic analysis.
    • Explain why economics is a science.
    • Distinguish between positive and normative economics.

  • Economics Defined: Economics is the study of how people allocate their limited resources to satisfy their unlimited wants.

    • It is a social science that seeks explanations of real events.
    • Social sciences analyze human behavior, unlike physical sciences which analyze non-human phenomena.

  • Resources: Things used to produce goods and services to satisfy people's wants. They have value.

  • Wants: What people would buy if their incomes were unlimited.

  • Choices: Economics helps study how individuals, businesses, and nations make choices when facing alternatives.

  • Microeconomics:

    • Studies decision-making by individuals, households, and firms.
    • Focuses on the small parts of the economy, like the effects of gasoline price changes or new healthcare regulations.

  • Macroeconomics:

    • Studies the behavior of the economy as a whole.
    • Deals with economy-wide phenomena like unemployment, price levels, and national income.
    • Deals with aggregates or totals such as total output in an economy.

  • Blending of Micro and Macro: Modern economists increasingly use microeconomic analysis as the basis for macroeconomic analysis, recognizing that aggregates result from individual and firm choices.

  • AI Technologies: Artificial intelligence (AI) technologies involve the use of automated data analytics techniques, machine learning, or virtual or augmented reality techniques to examine and evaluate information to help consumers, businesses, and governments make decisions.

  • Microeconomic and Macroeconomic Applications of AI:

    • Micro: Data analytics applied to information on prices, quality, features, and quantities purchased.
    • Macro: Central banks using automated data analytics to evaluate price levels, outputs, and employment levels across many economies.

  • Aggregates: Total amounts or quantities. For example, aggregate demand is total planned expenditures throughout the nation.

1.2 Identify the Three Basic Economic Questions and the Two Opposing Sets of Answers

  • Economic System: A society's institutional mechanism for determining how scarce resources are used to satisfy human desires.

  • Three Basic Economic Questions: Every nation must address these, regardless of its government or economic system:

    1. What and How Much Will Be Produced? A mechanism must determine which items are made.
    2. How Will Items Be Produced? Decisions on the mix of resources used in production (labor vs. machines).
    3. For Whom Will Items Be Produced? A mechanism for distributing produced items is crucial.

  • Two Opposing Sets of Answers:

    • These questions are answered based on the nation's economic system.

    • Centralized Command and Control:

      • A centralized authority (e.g., government) decides what and how many items to produce, how resources will be organized, and who gets the items.

    • The Price System (Market System):

      • Answers the three basic economic questions via decentralized decision-making.
      • Individuals and families own scarce resources and make choices about production and income allocation.
      • Prices signal resource scarcity and abundance.

    • Mixed Economic Systems:

      • Most nations have mixed systems that incorporate aspects of both centralized command and control and a decentralized price system.

1.3 Evaluate the Role That Rational Self Interest Plays in Economic Analysis

  • Rationality Assumption:

    • Economists assume individuals act as if they systematically pursue self-motivated interests.
    • Individuals do not intentionally make decisions that would leave them worse off.
    • Economics focuses on what people do with their limited resources, not on analyzing thought processes.

  • Responding to Incentives:

    • Individuals respond to changes in incentives (rewards or penalties for engaging in a particular activity).
    • Human behavior can be explained by how individuals respond to changing incentives.

  • Altered Incentives Example- Earnings based incentive of college degree:

    • College earnings incentive (1975): $20,000\$20,000 annually.
    • Incentive Increase (Feb): $33,000\$33,000 annually.
    • Current Incentive: $29,500\$29,500 annually.
    • The anticipation of annual earnings steadily increased from 13 percent to 33 percent today.
    • Decline in college earnings payoff over time = 11%11\%.
    • Increase in fees during same time period = 75%75\%.
    • Todays dollars and cents incentives to pursue a college degree are much weaker than was true a generation ago.

  • Defining Self-Interest:

    • Includes goals relating to prestige, friendship, love, power, helping others, creating works of art, and many other matters, not measured in monetary terms.

    • Individuals want the ability to further their goals by making decisions about how items around them are used.

  • Enlightened self-interest: Individuals, in the pursuit of what makes them better off, also achieve the betterment of others around them.

  • Behavioral Example: Charitable Donations

    • Motivations: Desire to help others and benefiting from government incentives (tax deductions).
    • Study in Japan after earthquake: Taxpayers directed more taxes and donations to municipalities that suffered.
      • Where governments offered reciprocal gifts, directed taxes and donations were six times larger.

1.4 Explain Why Economics is a Science

  • Economics as a Science:

    • Economics is a social science using similar methods to biology, physics, and chemistry.
    • It uses models or theories - simplified representations of the real world.

  • Models or Theories: Simplified representations of the real world used as the basis for predictions or explanations.

  • Variables: Choices that people make or other human outcomes that are subject to change.

  • Models and Realism:

    • No model is complete or captures every detail.
    • A model is an abstraction from reality.
    • Models should capture essential relationships to analyze a problem or answer a question.

  • Assumptions:

    • Every model or theory is based on assumptions that define the circumstances in which the model is applicable.

  • The assumption ceteris paribus:

    • Ceteris paribus means other things constant or other things equal.
    • Similar to other sciences, economics uses the ceteris paribus assumption.
    • Economists focus on the the relationship between changes in prices and changes in how much of a given product people will purchase. Other factors remain constant.

  • Deciding on the usefulness of the model:

    • The test of a model is its ability to predict accurately.
    • Economists use data to test their models (empirical science).

  • Models of Behavior, Not Thought Processes:

    • Economic models predict how people act and what they do with limited resources.
    • Economists predict behavior, not how people will think.

  • Behavioral Economics and Bounded Rationality:

  • Alternative approach, examines consumer behavior in the face of psychological limitations and complications that may interfere with rational decision making.

  • bounded rationality, the hypothesis that people are nearly, but not fully, rational so that they cannot examine every possible choice available to them but instead use simple rules of thumb to sort among the alternatives that happen to occur to them.

  • Positive vs. Normative Economics:

    • Positive Economics:
      • A value-free approach to inquiry.
      • Relates to statements like "if A, then B."
      • Deals with what is.
    • Normative Economics:
      • Involves value judgments about economic policies.
      • Statements of what ought to be.
      • Based on personal values and preferences.

1.5 Distinguish Between Positive and Normative Economics

  • Positive Economics:

    • Analysis strictly limited to descriptive statements or scientific predictions (if A, then B).
    • Deals with "what is."

  • Normative Economics:

    • Analysis involving value judgments about economic policies.
    • Deals with "what ought to be."

1.6 Other terms

  • Empirical: Relying on real world data in evaluating the usefulness of the model.
  • Behavioral economics: An approach to the study of consumer behavior that emphasizes psychological limitations and complications that potentially interfere with rational decision making.
  • Bounded rationality: The hypothesis that people are nearly, but not fully, rational so that they cannot examine every possible choice available to them but instead use simple rules of thumb to sort among the alternatives that happen to occur to them.