Chapter 1: Economics and Economic Reasoning (Vocabulary Flashcards)
Economics and Economic Reasoning
Learning Objectives (from Page 2):
Define economics and identify its components.
Discuss various ways in which economists use economic reasoning.
Explain real-world events in terms of economic forces, social forces, and political forces.
Explain how economic insights are developed and used.
Distinguish among positive economics, normative economics, and the art of economics.
What Economics Is
Economics is the study of how human beings coordinate their wants and desires, given the decision-making mechanisms, social customs, and political realities of the society.
The three central coordination problems any economy must solve:
What to produce
How to produce it
For whom to produce it
Scarcity
Scarcity exists because individuals want more than can be produced.
Scarcity means the goods available are too few to satisfy individuals’ desires.
The degree of scarcity is constantly changing.
The quantity of goods, services and usable resources depends on technology and human action.
Microeconomics and Macroeconomics
Microeconomics: the study of individual choice, and how that choice is influenced by economic forces.
Macroeconomics: the study of the economy as a whole.
Microeconomics and Macroeconomics (Examples)
Microeconomics studies:
The pricing of firms
Household decisions on what to buy
How markets allocate resources among alternative ends
Macroeconomics studies:
Inflation
Unemployment
Economic growth
A Guide to Economic Reasoning
Economic reasoning or “thinking like an economist” involves:
Analyzing issues and comparing costs and benefits of a decision
Abstracting from the unimportant elements of a question and focusing on the important ones
Freakonomics and Thinking Like an Economist
Steve Levitt’s Freakonomics contains examples of “thinking like an economist.”
Example: Levitt uses economic reasoning to explain why people become drug dealers — the potential financial benefit of selling drugs is much higher than the cost of giving up a minimum wage job.
Marginal Costs and Marginal Benefits
Decisions are often made by comparing marginal costs and marginal benefits.
Marginal cost (MC): the additional cost over and above costs already incurred.
Marginal benefit (MB): the additional benefit above what has already derived.
A fundamental premise: everything has a cost.
Economic reasoning hinges on MB and MC being compared for incremental decisions.
The Economic Decision Rule
If the marginal benefits of doing something exceed the marginal costs, do it: MB > MC \Rightarrow \text{Do it}.
If the marginal costs of doing something exceed the marginal benefits, don’t do it: MC > MB \Rightarrow \text{Don’t do it}.
Opportunity Cost
Opportunity cost: the benefit that you might have gained from choosing the next-best alternative.
Opportunity cost should always be less than the benefit of what you have chosen.
OC is the basis of cost/benefit economic reasoning.
Formula-friendly takeaway: OC < B_chosen.
Examples of Opportunity Cost
Individual decisions:
The opportunity cost of college includes items you could have purchased with the money spent for tuition and books.
Loss of the income from a full-time job.
Government decisions:
The opportunity cost of money spent on the war on terrorism is less spending on health care or education.
Opportunity Cost: Types of Costs
Implicit costs: costs associated with a decision that often are not included in normal accounting costs.
Illusionary sunk costs: costs that show up in financial accounts that are already spent.
Implicit costs should be included in opportunity costs but illusionary sunk costs should not be included.
Costs relevant to decisions are often different from the measured costs.
Economic Knowledge in One Sentence
This one sentence embodies the concept of opportunity cost: "There ain’t no such thing as a free lunch." Abbreviated as TANSTAAFL.
Economic and Market Forces
Economic forces: the necessary reactions to scarcity.
A market force is an economic force that is given relatively free rein by society to work through the market.
The invisible hand is the price mechanism that guides our actions in a market. The invisible hand is an example of a market force.
If there is a shortage, prices rise.
If there is a surplus, prices fall.
Social and Political Forces
What happens in society can be seen as a reaction to, and interaction of:
Economic forces
Social forces
Political forces
Social and political forces influence market forces.
Social and political forces often work together against the invisible hand.
Using Economic Insights
Theories tie together economists’ terminology and knowledge about economic institutions.
Theories are too abstract to apply in specific cases and are often embodied in economic models and principles.
An economic model is a framework that places the generalized insights of the theory in a more specific contextual setting.
An economic principle is a commonly held insight stated as a law or general assumption.
Theories and Precepts
Theories, models, and principles are continually tested to see if the predictions of the model match the data.
Models lead to:
Theorems (propositions that are logically true based on the assumptions of the model)
Arrive at policy precepts (policy rules that conclude that a particular course of action is preferable)
These theorems must be combined with knowledge of real-world economic institutions and value judgments to determine economic goals for society.
The Invisible Hand Theorem
According to the invisible hand theorem, a market economy, through the price mechanism, will allocate resources efficiently.
Price tends to fall when quantity supplied is greater than quantity demanded.
Price tends to rise when the quantity demanded is greater than the quantity supplied.
Efficiency: achieving a goal as cheaply as possible.
Economic Institutions
Economic institutions are laws, common practices, and organizations in a society that affect the economy.
To apply economic theory to reality, you’ve got to have a sense of economic institutions.
Economic institutions differ significantly among nations.
They sometimes seem to operate differently than economic theory predicts.
Objective and Subjective Economic Policy
Economic policies are actions (or inaction) taken by the government to influence economic actions.
There are two types of policy analysis:
Objective policy analysis keeps value judgments separate from the analysis.
Subjective policy analysis reflects the analyst’s views of how things should be.
Economic Policy Options
To distinguish between objective and subjective analysis, economics is divided into three categories:
Positive economics: the study of what is and how the economy works.
Normative economics: the study of what the goals of the economy should be.
The art of economics: using the knowledge of positive economics to achieve the goals determined in normative economics.
Examples of Categories of Economics
Positive economics questions: "How does the market for hog bellies work?"
Normative economics questions: "What should tax policy be designated to achieve?"
Art of economics: "To achieve the goals that society wants to achieve, how would you go about it, given the way that the economy works?"