Chapter 1 Notes: Economics and Economic Reasoning
What Economics Is
Alfred Marshall quote: studying Political Economy by visiting poor quarters to understand real-world economies.
After reading this chapter, you should be able to:
Define economics and list three coordination problems economies must solve.
Explain decision-making by comparing marginal costs and marginal benefits.
Define opportunity cost and explain its relation to economic reasoning.
Explain real-world events in terms of economic forces, social forces, and political forces.
Differentiate microeconomics from macroeconomics.
Distinguish positive economics, normative economics, and the art of economics.
A metaphor: economists see a "symphony of costs and benefits" in the world, emphasizing practicality and decision-making.
Economics defined
Economics is the study of how human beings coordinate their wants and desires, given the society’s decision-making mechanisms, social customs, and political realities.
A key word in economics is coordination.
The author’s voice: textbooks have quirks; this book embraces a human, sometimes playful, voice to stay engaging.
The Coordination Problems in an Economy
Coordination refers to how the three central problems facing any economy are solved:
What, and how much, to produce.
How to produce it.
For whom to produce it.
Scarcity: resources are limited relative to wants. Two elements:
Our wants.
Our means of fulfilling those wants.
Wants are changeable and partly determined by society; the way we fulfill wants can affect future wants.
Scarcity is dynamic: technology and human action underlie production; future technologies could expand supply (e.g., nanotechnology that could revolutionize production) but new wants would still develop.
How societies deal with scarcity: coercion—limiting wants and increasing the amount people are willing to work.
An alternative, humorous definition: economics can be seen as getting people to do things they don’t want to do (e.g., studying) and not to do things they do want (e.g., eating lobster) so that others’ wants align with society’s constraints.
Economic Reasoning: The Cost-Benefit Mindset
Economists think critically, compare costs and benefits, and base decisions on those comparisons.
Example: evaluating a policy to eliminate terrorist attacks via costs and benefits, including the costs of security measures and the benefits of reduced attacks.
The core method: create a simple model that captures the essence of the issue, test the model with empirical evidence to see if predictions fit reality.
Freakonomics example: Steve Levitt’s cost/benefit reasoning explains why many drug dealers live with their mothers—expected income from illegal activity can be higher than legal minimum wage given backgrounds and U.S. institutions; coupled with empirical data, this supports a simple economic model: people do what’s best financially given constraints.
Economic reasoning is broad: it can influence decisions about dating, class attendance, marriage, and post-graduation work choices.
Important caveat: real-world questions are complex; economics provides a framework rather than all the answers.
Marginal Costs and Marginal Benefits
Core idea: decisions are based on marginal (incremental) costs and marginal benefits.
Marginal cost (MC): the additional cost incurred by an additional unit of activity, excluding sunk costs.
Sunk costs are already incurred and cannot be recovered (e.g., tuition).
Marginal benefit (MB): the additional benefit from an additional unit of activity.
If MB > MC, the extra activity adds value; if MC > MB, it is not worth it.
Example: attending class—tuition is sunk; marginal cost is the value of the next hour you could spend elsewhere; marginal benefit is the knowledge or preparedness gained from the class.
Simple rule: MC and MB guide decisions. The marginal framework helps avoid counting sunk costs.
Opportunity Cost
Definition: the benefit you might have gained from choosing the next-best alternative.
You obtain a benefit from one choice only by giving up another alternative.
Examples:
Dating choices: the opportunity cost of going out with Natalie is the benefit you would have gained from dating someone else (e.g., Margo or Mike).
Environmental policy: cleaning up the environment might reduce funds available for helping the homeless.
Family decisions: having a child could forego two boats, three cars, and a two-week vacation each year for five years.
Two concrete life-course examples:
Course selection: taking one course precludes another (trade-off with theater).
Study time: limited time to study economics, other subjects, sleep, or party.
Opportunity cost is not limited to individuals: it applies to government decisions (guns vs butter).
Example: spending more on health care reduces funds for other programs (e.g., homeless aid, debt reduction, or national defense).
Opportunity costs have practical implications for public policy and everyday choices.
The concept also implies that there is a cost to being reasonable: even thinking about alternatives takes time.
Key idea: opportunity costs convert the value of all other options into a cost of the present decision.
Economic and Market Forces
When goods are scarce, they must be rationed by some mechanism.
Examples: dorm room lotteries; first-come, first-registered classes; food rationing by price.
Every society must decide whether to let market (economic) forces operate freely or to rein them in; market forces operate via price changes that ration scarce goods.
The invisible hand is the price mechanism; it guides actions and resource allocation when market forces predominate.
Societal choice exists: economic reality is a contest among economic forces, social/cultural forces, and political/legal forces.
Three controlling forces always present:
1) Economic forces (the invisible hand)
2) Social and cultural forces
3) Political and legal forces
Economic Terminology and the Need to Understand Institutions
The textbook treats economic terminology as something to learn through context.
Terms introduced: opportunity cost, invisible hand, market, etc.
Real-world institutions matter for applying theory; differences in banks, unions, laws, and cultural norms explain why pure theory may not always predict outcomes.
Theories, Models, and Principles
Theorizing and modeling:
Theories tie terminology and institutions together; models provide a contextual framework; principles are commonly held insights stated as laws.
Theories/models are empirically tested, though economics is observational (not experimental) and natural experiments are used.
Example natural experiment: New Jersey's minimum wage increase vs Pennsylvania (no increase).
The Invisible Hand Theory:
Key insights: prices adjust to balance supply and demand; when quantity supplied > quantity demanded, price tends to fall; when quantity demanded > quantity supplied, price tends to rise.
Under certain conditions, markets are efficient: the price mechanism coordinates decisions and allocates resources to their best use.
Theories and models are abstract and need to account for simplifying assumptions; understanding those assumptions is crucial for applying theory properly.
Economic theory often told as stories; theories are made concrete with stories to convey insights.
Economic theory must be balanced with attention to institutions and real-world constraints.
The Invisible Hand: Assumptions and Limits
Central assumption: individuals behave rationally; choices maximize happiness given constraints.
If the rationality assumption fails, the invisible hand may not function as predicted.
The chapter emphasizes understanding the assumptions behind the theories and recognizing their limits.
Microeconomics vs Macroeconomics
Microeconomics: study of how individual choices are shaped by economic forces; examines households, firms, markets, and prices; examples include pricing policies, buying decisions, and resource allocation among alternatives.
Macroeconomics: study of the economy as a whole; examines inflation, unemployment, business cycles, and growth; focuses on aggregate relationships (e.g., consumption and income, government policy effects).
Analogy: micro looks at cells of the body; macro looks at the body as a whole and its components.
Interrelation: macro outcomes arise from micro decisions; micro decisions depend on macro conditions; the subjects are taught separately but are interdependent.
Economic Institutions
Institutions include laws, practices, and organizations that affect the economy.
Institutions span social, political, and religious dimensions; e.g., family as an economic institution; banks in different countries.
Institutional differences explain cross-country variation in economic outcomes (e.g., Germany vs USA banking rules, Netherlands unions).
To apply theory, you must understand economic institutions that shape decisions.
Economic Policy Options
Policy options include:
Restricting firm mergers
Running budget deficits
Addressing international trade deficits
Adjusting tax policies
Economic policy requires understanding how institutions might change due to policy changes and how policies interact with political and social forces.
The aim is to select policies that align with goals while recognizing constraints and institutional responses.
Objective Policy Analysis: Positive, Normative, and the Art of Economics
Objective policy analysis separates value judgments from analysis:
Positive economics: what is and how the economy works.
Normative economics: what the goals of the economy should be.
The art of economics (political economy): applying knowledge to achieve chosen goals within the economy’s structure.
The three-part distinction was introduced by John Neville Keynes; reinforced by Friedman and Lipsey in the 1950s.
Policy discussions often fall into the art of economics, combining positive analysis with normative goals.
There is always some value judgments involved in policy discussions; analysts must strive for objectivity while recognizing their own value perspectives.
The role of institutions: institutions can be integral to policy success or failure; policies can alter institutions, which in turn alter outcomes.
Summary of Key Concepts and Takeaways
Economics is about coordination under scarcity and decision-making by comparing costs and benefits.
The three central coordination problems are what/how much to produce, how to produce, and for whom to produce.
Scarcity creates trade-offs; opportunity cost captures the value of the next-best alternative.
Marginal analysis (MC vs MB) drives rational decision-making; sunk costs are ignored in marginal decisions.
TANSTAAFL emphasizes that every choice has a cost; there is no free lunch.
Market forces, price mechanisms, and the invisible hand coordinate individual decisions under certain conditions; social and political forces can constrain or shape market outcomes.
Microeconomics studies individual/firm decisions; macroeconomics studies the economy as a whole.
Institutions influence how economics operates; differences across countries affect economic outcomes.
Economic theory relies on simplifying assumptions; understanding these assumptions is crucial for applying theory to real-world issues.
Policy analysis combines positive economics with normative goals; the art of economics applies theory within institutional and political contexts to design policy.
Real-world examples (pollution regulation, climate policy) illustrate how economists design incentive-based solutions to reduce costs and improve welfare.