The Nature of Economics

Defining Economics

Economics – The study of how people allocate their limited resources to satisfy their unlimited wants. Also phrased as: The study of the use of scarce resources which have alternative uses. (Slide 1-2)
Resources – Things used to produce other things to satisfy people’s wants. (Slide 1-3)
Wants – What people would buy if their incomes were unlimited. (Slide 1-3)

With limited income (resources), people must make choices to satisfy their wants. We never have enough of everything, including time, to satisfy every desire. (Slide 1-4)

Individuals, businesses, and nations face alternatives, and choices must be made. Economics studies how these choices are made. (Slide 1-5)

Economic Analysis – The economic way of thinking to analyze solutions to economic problems. Examples include:
- How much time to study
- Choosing which courses to take
- Whether troops should be sent abroad (Slide 1-6)
The economic way of thinking gives you the power—the power to reach informed conclusions about what is happening in the world. Example: Bailout. Economic analysis helps you make better decisions and increases your understanding when watching or reading the news on the Web. (Slide 1-7)

An extremely important part of Economic Analysis is incentives: rewards/punishments for engaging in a particular activity. How do coaches use incentives? How do teachers use incentives? (Slide 1-8)

Responding to incentives involves rationality and the use of incentives.
Positive incentives – Rewards for engaging in a behavior (e.g., schoolchildren getting gold stars). (Slide 1-9)
Negative incentives – Penalties or punishments to deter behavior. (Slide 1-9)
Making choices involves balancing costs and benefits; punishment has to be enough to deter the crime. Example: Don’t let players perform a cost-benefit analysis by withholding knowledge of the punishment for getting caught. (Slide 1-9)

Microeconomics – The study of decision making undertaken by individuals (or households) and by firms. Like looking through a microscope to focus on smaller parts of the economy. Examples:
- The decision of a worker to work overtime or not
- A family’s choice of having a baby
- An individual firm advertising (Slide 1-10)
Macroeconomics – The study of the behavior of the economy as a whole; deals with economy-wide phenomena. Examples:
- The national unemployment rate
- The rate of growth in the money supply
- The national government’s budget deficit (Slide 1-11)

Models or Theories – Simplified representations of the real world used as the basis for predictions or explanations. A map is the quintessential model (Slide 1-12)

A map is a simplifying model of reality for getting to a destination (e.g., Houston).
Your answer focused on what was relevant to the problem at hand and omitted the rest.
The model was based on a set of assumptions (e.g., speed limit, stop signs, etc.).
Economic models attempt to focus on what is relevant to the problem at hand and omit what is not. Models are based on a set of assumptions. (Slide 1-13)

Rationality Assumption – The assumption that people do not intentionally make decisions that would leave them worse off.
Example: Do individuals in prison not fall under the rationality assumption? They might not believe they would be caught. (Slide 1-15)

Economists assume that individuals act as if motivated by self-interest and respond predictably to opportunities for gain. (Slide 1-16)

Defining self-interest – The pursuit of one’s goals; it does not always mean increasing one’s wealth.
Example: How much is the President paid? Consider Bill Gates and a $1000 bill example; the President must be responding to other goals besides money, such as prestige, friendship, love. (Slide 1-17)

Ceteris Paribus Assumption [KAY-ter-us PEAR-uh-bus] – Nothing changes except the factor or factors being studied; “Other things equal.”
Example: Students earn higher grades when they write with pen instead of pencil. You have to hold everything constant for students using pen and pencil. Consider what would happen if those who used pen studied more. Use this same assumption when you get to supply/demand analysis. (Slide 1-18)

Economics is an empirical science – empirical knowledge that is closely related to evidence, especially experiments. Real-world data is used to evaluate the usefulness of a model.
Models are useful if they predict actual occurrences. (Slide 1-19)

Positive Economics – Purely descriptive statements or scientific predictions; “If A, then B,” a statement of what is (Slide 1-20)
Normative Economics – Analysis involving value judgments; relates to whether things are good or bad, a statement of what ought to be (Slide 1-20)