Ch 1: The Nature of Economics

Introduction & Context

• Average marriage age for women increased from 20 (1950) ➔ 27 (today); more women choose never to marry
  • Economic factors (e.g., men’s earning power, manufacturing-job decline) will be tied back to this observation in later slides (see “Issues & Applications”)
• “Did You Know?” Russian dashboard cameras
  • >25 % of cars use dash-cams due to: icy roads, police corruption, staged accidents
  • Illustrates self-interested responses to incentives

1.1 The Power of Economic Analysis

• Incentives: rewards or penalties that alter behavior
  • Starting point for economic analysis; assume self-interested responses
• Economic way of thinking provides a framework to analyze any decision
  • Personal: time spent studying, course selection
  • Policy: immigration, voting
• Goals of economic analysis
  • Reach informed conclusions about world events
  • Improve individual decision making (education, career, home finance, voting)
• Economics – definitions
  • Study of how people allocate limited resources to satisfy unlimited wants; the science of choice
• Key terms
  • Resources: anything of value used to produce goods/services
  • Wants: desires individuals would fulfill with unlimited income
• Scarcity ⇒ choice
  • Limited income/time vs. unlimited wants ⇒ trade-offs for individuals, firms, nations
• Microeconomics
  • Focus on individual units (households, firms)
  • Examples: impact of gasoline prices, family fertility decision, firm’s advertising budget
• Macroeconomics
  • Economy-wide aggregates: \text{GDP}, unemployment, inflation
  • Modern theory blends micro foundations with macro conclusions
• Artificial Intelligence (AI) & Big Data
  • Automated analytics, machine learning, VR/AR to aid decisions
  • Micro use: firm-level price & purchase data
  • Macro use: central-bank analysis of price levels, output, employment

1.2 Three Basic Economic Questions & Two Opposing Answers

• Economic system: institutional mechanism allocating scarce resources
• Three universal questions
  1. What goods/services & how much?
  2. How will they be produced?
  3. For whom (distribution)?
• Opposing systems
  • Centralized command & control (planning)
  • Price (market) system: decentralized exchange based on price signals
• Reality: Most nations (e.g., U.S.) operate mixed systems containing elements of both

1.3 The Economic Approach: Systematic Decisions

• Fundamental assumption: individuals act as if motivated by rational self-interest
  • Classic quote (Adam Smith 1776): dinner due to butcher/baker pursuing their own interest
• Rationality assumption
  • People do not intentionally choose actions that make them worse off
• Key questions about rationality
  • Do irrational choices invalidate models? → Models can still predict average/aggregate behavior even with anomalies
• Incentives & Choice
  • Positive incentives: rewards (gold stars, higher income)
  • Negative incentives: penalties (fines, late fees)
  • Decision rule: choose option where \text{Marginal Benefit} \ge \text{Marginal Cost}
• Example: College payoff
  • Real annual earnings premium \uparrow from \$20{,}000 (1975) ➔ \$33{,}000 (2000), then ↓ to \$29{,}500 post-2000
  • Explains rise in degree attainment from 13 % ➔ 33 % (1975-2000), slower growth afterward
• Self-interest ≠ selfishness
  • Goals may include prestige, friendship, love, charity
• Behavioral evidence on charity
  • Post-earthquake Japan: donations 6× higher to regions offering reciprocal gifts ⇒ donors respond to personal benefit (tax deduction, gifts) as well as altruism

1.4 Economics as a Science

• Economics = social science using scientific method
• Models/Theories
  • Simplified representations for prediction/explanation (maps as analogy)
  • Must capture essential relationships; rely on assumptions
• Ceteris paribus: hold other factors constant while examining one change
• Empirical discipline
  • Use real-world data to test models; adjust theory when facts disagree
• Models concern observable behavior, not internal thought
  • Stated preferences in surveys often differ from revealed preferences
• Behavioral Economics
  • Integrates psychology; recognizes bounded rationality
  • Humans cannot process all information; use rules of thumb
  • Rejects assumptions of unbounded selfishness, willpower, rationality
  • Rules of thumb simplify decision making under complexity

1.5 Positive vs. Normative Economics

• Positive economics: descriptive, testable statements
  • Form: “If A, then B”
  • Example: “An increase in the minimum wage will raise teen unemployment.”
• Normative economics: prescriptive, value-laden statements
  • Form: “should/ought”
  • Example: “The minimum wage should be increased to ensure a living wage.”

Real-World Applications

• Everyday skills: career planning, managerial decisions, household budgeting, voting choices
• Housing finance example (Freddie Mac)
  • Government support allows below-market interest rates on 10-yr loans
  • Borrowers must cap rents: creates affordable housing supply via private firms
• Marriage & labor markets
  • 25 % decline in high-paying manufacturing jobs for non-college men since 2000
  • Women’s marriage decisions respond to reduced economic contributions of potential spouses

Appendix A – Working With Graphs

• Variables
  • Independent: determined outside equation
  • Dependent: changes in response
• Relationships
  • Direct (positive): \Delta x > 0 \;\Rightarrow\; \Delta y > 0
  • Inverse (negative): \Delta x > 0 \;\Rightarrow\; \Delta y < 0
• Table A-1: Fuel efficiency vs. speed (inverse relationship)
  • E.g., at 45 mph ⇒ 25 mpg; at 75 mph ⇒ 13 mpg
• Graph construction basics
  • Number line, axes, origin
  • Coordinate pair (x,y) from data table (e.g., point I = (20,10))
• Slope of linear curve
  • \text{Slope} = \dfrac{\text{rise}}{\text{run}} = \dfrac{\Delta y}{\Delta x}
  • Positive slope ⇒ upward line; negative slope ⇒ downward
• Nonlinear curves
  • Slope varies along curve; can be positive, zero (peak), negative
• Summary objectives from appendix
  • Graphing ➔ apply ceteris paribus
  • Identify slope changes; understand direct/inverse links

Summary of Learning Objectives

• 1.1 Economics definition; micro vs. macro distinctions
• 1.2 Three basic questions; planning vs. price systems
• 1.3 Rational self-interest & incentives guide choices
• 1.4 Economics as scientific modeling (assumptions, empirical tests)
• 1.5 Positive (what is) vs. normative (what ought) statements

Ethical & Philosophical Implications

• Recognition of self-interest in altruistic acts (e.g., charity) prompts debate on motives
• Mixed economies reflect pragmatic blend of efficiency (markets) and equity (government intervention)
• Behavioral economics challenges pure rationality, suggesting policies may need to account for heuristics and biases