Chapter 1 Vocabulary: The Art and Science of Economic Analysis (McEachern Economics 11e, Ch. 1)
The Economic Problem
The economic problem arises from a conflict between unlimited wants and scarce resources.
Our wants and desires are virtually unlimited.
Resources are scarce, not freely available, and have a positive price.
The core scarcity condition: unlimited wants vs scarce resources with a positive price.
Consequence: you must choose among many possible wants and must forgo satisfying some others.
Definition: Economics is the study of how people use their scarce resources to satisfy their unlimited wants.
Resources
Resources are inputs or factors of production used to produce goods and services.
Major resource categories:
Labor: physical and mental effort used to produce goods and services.
Capital: buildings, equipment, and human skills used to produce goods and services; associated payment is
Interest for the use of capital.
Natural resources: all gifts of nature used to produce goods and services; can be Renewable or Exhaustible; payment to resource owners is Rent.
Entrepreneurial ability: talent to dream up a new product or find a better way to produce; profit arises as reward for entrepreneurial ability.
Distinctions:
Physical capital vs. Human capital (human capital = knowledge and skills that increase productivity).
Renewable vs. Exhaustible resources.
Economic definitions:
Labor: effort used to produce goods and services; wages are the payment for labor.
Capital: inputs other than labor that contribute to production; interest is the payment for capital use.
Rent: payment to resource owners for the use of natural resources.
Goods and Services
Good: tangible product satisfying a human want.
Service: an activity or intangible product satisfying a human want.
Scarcity of a good or service exists if the quantity desired exceeds the quantity available at a zero price.
Scarcity and Choice
Making choices in a world of scarcity means forgoing some goods and services.
The best things in life are not free; most goods and services are scarce.
The phrase "There is no such thing as a free lunch" means that even allegedly free goods involve costs (scarce resources) borne by someone, often with an expectation of something in return.
Economic Decision Makers
Decision makers in the economy include:
Households
Firms
Governments
Rest of the world
Their interactions determine how resources are allocated in the economy.
Households: as consumers demand goods/services and as resource owners supply resources to markets.
Firms, Governments, Rest of the World: demand resources and produce goods/services.
Markets
Market: set of arrangements by which buyers and sellers carry out exchange at mutually agreeable terms.
Product market: where goods/services are bought and sold.
Resource market: where resources (labor, capital, etc.) are bought and sold.
A Simple Circular-Flow Model
Circular-flow model: diagram tracing the flow of resources, products, income, and revenue among decision makers.
Simple model focuses on interactions between Households and Firms.
Mechanism:
Households earn income by supplying resources to resource markets.
Firms demand resources to produce goods/services and supply them to product markets.
Households spend income to demand goods/services.
Spending flows through product markets as revenue to firms.
Rational Self-Interest (Behavioral Foundations)
Individuals are rational:
They make the best choice given available information.
They maximize expected benefits given costs; minimize expected costs to achieve a given benefit.
The lower the personal cost of helping others, the more help we offer.
Time & Information in Choice
Rational choice requires time and information.
Time and information are scarce and valuable.
Rational decision makers are willing to pay for information if the expected benefits exceed costs.
Steps to rational decision making:
Acquire information if additional benefits exceed additional costs.
Marginal Analysis
Economic analysis is marginal analysis:
Compare expected marginal benefit (MB) to expected marginal cost (MC).
Decision rule: act if MB > MC; otherwise, do not.
Marginal means incremental, additional, or extra.
Microeconomics vs Macroeconomics
Microeconomics: study of economic behavior in particular markets; individual economic choices; how markets coordinate choices; the pieces of the puzzle.
Macroeconomics: study of the economic behavior of entire economies; overall performance; business cycles (rises and falls of economic activity) relative to long-term growth.
The Science of Economic Analysis
Economic theory or economic model: a simplification of economic reality used to predict cause-and-effect in the real world.
A good theory: helps understand a messy world, provides a guide to sorting, saving, and understanding information.
The Role of Theory
Many people misunderstand the role of theory; they substitute their own theory for a theory they don’t believe or understand.
All of us employ theories, even if imperfect, as illustrated by the Pepsi-machine example (pounding on a vending device).
The Scientific Method (Steps 1–4)
Step 1: Identify the question and define relevant variables.
Variable: a measure that can take on different values at different times.
Step 2: Specify assumptions (e.g., Other-things-constant assumption, or ceteris paribus; describe expected behavior).
Step 3: Formulate the hypothesis (how key variables relate to each other).
Step 4: Test the hypothesis by comparing predictions with evidence; either reject or use the hypothesis; adopt or modify as needed when a better theory emerges.
Exhibit 3 summarizes the process: develop a theory that predicts outcomes more accurately than alternatives; reject if inferior; modify if possible.
Normative vs Positive
Positive economic statements: provable or disprovable by reference to facts; describe what is (what is happening).
Normative economic statements: reflect opinions about what should be; cannot be proven or disproven by facts alone.
Economists Tell Stories
Economic analysis blends art and science.
Economists explain theories by telling stories: case studies, anecdotes, parables, personal experiences, and data.
Predicting Average Behavior
Individual behavior is hard to predict because individuals act randomly and can offset one another.
Average behavior of groups is predicted more accurately than individual behavior.
Focus is on typical or average behavior of people in a group.
Pitfalls of Faulty Economic Analysis
Fallacy: association is causation – just because two variables are associated does not imply one causes the other.
Fallacy of composition – what is true for an individual or part is not necessarily true for the whole.
Ignoring secondary effects – unintended consequences of economic actions that may develop slowly as people react.
Why Aren’t Economists Rich (In General)
Some economists earn substantial income in various roles (e.g., appearances, consulting, expert testimony).
Economists hold influential positions in government and central banks (e.g., heads of major departments; Federal Reserve).
Economics is the only social science and business discipline to receive the Nobel Prize; economists’ pronouncements are widely reported in the media; models often explain economic phenomena better than alternatives.
College Major and Annual Earnings
Earnings depend on several factors: general ability, effort, occupation, college attended, college major, highest degree earned.
Economics major (bachelor’s):
Rank: #6 of 20 majors (Exhibit 4).
Median wage for 0–5 years experience: 51{,}400.
Median wage for 10–20 years experience: 97{,}700.
Rank among top 10% of 207 majors.
Understanding Graphs
Graph terminology:
Origin: point of departure.
Horizontal axis (x-axis): starts at the origin and is a straight horizontal line.
Vertical axis (y-axis): starts at the origin and is a straight vertical line.
Graphs convey information in a compact form; types include time-series and functional relationships.
Time-series graph: shows the value of a variable over time.
Functional relation: the value of the dependent variable depends on the value of the independent variable, i.e., Y is a function of X: Y = f(X).
Exhibit 6 and Graphs: Time Series and Functional Relations
Exhibit 6: U.S. unemployment rate since 1900; a time-series graph depicts the behavior of unemployment over time.
Exhibit 5: Basics of a graph – any point on a graph represents a combination of values of two variables (e.g., 5 units of x and 15 units of y at point a; 10 units of x and 5 units of y at point b).
Exhibit 7: Schedule relating distance traveled to hours driven (distance = speed × time for a given speed).
Exhibit 8: Graph corresponding to Exhibit 7; points a–e depict different hour-distance pairs; connecting points yields the relation.
Drawing Graphs: Relationships Between Variables
Types of relationships:
Positive (direct) relation: as one variable increases, the other increases.
Negative (inverse) relation: as one variable increases, the other decreases.
Independent (unrelated) variables: one variable changes while the other remains unchanged.
Slopes and Curves
The slope of a straight line:
Definition: m = rac{ ext{change in vertical variable}}{ ext{change in horizontal variable}} = rac{Δy}{Δx}.
A straight line has a constant slope along its length.
Exhibit 9: (a) positive slope (0.5); (b) negative slope (-0.7).
Slopes of curved lines:
Slope varies along the curve.
The slope at a point equals the slope of the tangent line at that point.
Exhibit 11 demonstrates slopes at different points on a curved line with tangent lines at points a and b.
Exhibit 12 shows curves with both positive and negative slopes (hill-shaped and U-shaped curves).
Slopes and Units of Measure
Slope depends on units of measure; different units produce different slopes for the same total cost.
Exhibit 10 shows two panels:
Panel (a): output measured in feet; total cost is the same ($1 per foot), slope = 1.
Panel (b): output measured in yards; total cost is still $1 per foot, but slope = 3 because 1 yard = 3 feet.
Slopes for curved lines vary by point (Exhibit 11).
Shifts in the Line (Change in Assumptions)
Line shifts occur when an underlying assumption changes, altering the relationship between variables.
A shift represents a different relationship; it is not a movement along the original line.
Exhibit 13: If average speed changes from 50 mph to 40 mph in the distance-vs-hours relation, the entire line shifts right from T to T′, indicating more hours are needed for the same distance.
Example interpretation: 200 miles at 50 mph takes 4 hours; at 40 mph, 5 hours.
Emphasizes that changes in assumptions (e.g., speeds, costs, technology) shift the entire relationship.
Exhibit 2: The Simple Circular-Flow Model (Households and Firms)
Households earn income by supplying resources to resource markets (labor, capital, etc.).
Firms demand these resources to produce goods and services and supply them to product markets.
Households spend income to demand goods and services; this spending flows through product markets as revenue to firms.
This flow illustrates resource markets, product markets, and the interaction between decision makers that allocates resources.
The Rational Decision Maker and Information
Rational decision makers evaluate costs and benefits and adjust behavior when marginal benefits exceed marginal costs.
Willingness to pay for information increases when the expected benefit exceeds the cost.
The role of information: more information can improve decisions if its benefits exceed its costs.
Summary of Key Concepts to Remember
Economic problem: unlimited wants vs scarce resources; scarcity necessitates choice and trade-offs.
Resources (factors of production): labor, capital, natural resources, and entrepreneurial ability; associated payments: wages, interest, rent, profit.
Types of resources: physical capital vs. human capital; renewable vs. exhaustible resources.
Goods vs. services; scarcity and zero price assumption implications.
Decision makers: households, firms, governments, and the rest of the world; markets and circular-flow dynamics.
Market types: product markets and resource markets.
Graphical literacy: understanding graphs, time-series, functional relationships, and slopes.
Marginal analysis and the criterion MB > MC for action.
Positive vs normative analysis; the role of theory in economics; economists as storytellers.
The scientific method: questions, assumptions (ceteris paribus), hypotheses, testing, and refinement.
Common pitfalls: correlation vs causation, composition, and secondary effects.
Economics earnings and the value of majors; relevance of economic modeling in real-world contexts.
The importance of units in measuring slope and the impact on interpretation when units change.
Key Formulas and Definitions (LaTeX)
Slope of a straight line: m = rac{Δy}{Δx}
Slope is constant along a straight line: m = ext{constant}
Dependence in a function: Y = f(X)
Marginal concepts: marginal benefit (MB) and marginal cost (MC)
Time-series relation concept: a variable changing over time, Y_t as a function of time t
Ceteris paribus (Other-things-constant) assumption: used to isolate the effect of key variables
Positive statement: can be tested with facts; normative statement: expresses what should be
Profit in resources context: ext{Profit} = ext{Sales revenue} - ext{Resource costs}
In economics notation, price and cost relationships can be represented in forms such as revenue minus cost or MB vs MC decisions.
Exhibit Highlights (Quick References)
Exhibit 2: Simple circular-flow model explanation: households offer resources; firms demand resources; households spend income; firms earn revenue.
Exhibit 4: Median annual pay by major (Economics major): 0–5 years: 51{,}400; 10–20 years: 97{,}700; economics major typically ranks 6th among 20.
Exhibit 5: Basics of a graph – points on a graph represent combinations of two variables (e.g., 5 x and 15 y at point a; 10 x and 5 y at point b).
Exhibit 7–8: Distance vs. hours driven schedule and its graph; demonstrates how to read a table and convert to a graphical relation.
Exhibit 9: Alternative slopes for straight lines – panels (a) and (b) show positive and negative slopes with values (e.g., 0.5 and -0.7).
Exhibit 10: Slope depends on units of measure; two panels with same total cost but different unit measures yield different slopes.
Exhibit 11: Slopes at different points on a curved line; slope equals tangent slope at that point.
Exhibit 12: Curves with both positive and negative slopes (hill-shaped and U-shaped curves).
Exhibit 13: Shift in a line due to a change in assumptions (e.g., average speed affects the hours for a given distance).
End-of-Chapter Connections
Connects scarcity to decision-making, market structure, and the role of information in shaping outcomes.
Prepares for microeconomic analysis of how individuals and firms interact in markets and how policies may affect resource allocation.
Lays groundwork for understanding how to interpret graphs, models, and empirical data in economics.