The study of economics provides the student with a key to understanding aspects of the world around us. Each day on television and in the newspapers, major public policy issues are discussed, each one having an economic impact on society. Other issues affect us personally. Why am I being laid off from my job? Why has the price of gas increased so fast? Why do jobs in some degree programs pay more than others? Economics is a social science which attempts to explain how the economic choices we make have an impact on our everyday lives. Economics is about choices. In its simplest form, economics studies the allocation of scarce resources in response to unlimited wants. In other words, economics is the study of how people deal with scarcity. Take for example, the notion of time. Time is limited. Each individual has to ask him/herself the question, what is the best use of my time? Should I work or should I play? Should I be a part-time student or a full-time student? Decision making involves weighing and balancing the benefits and costs of alternatives.
Over the years I have encountered many people, who having discovered that I teach economics, have made statements such as, “I took economics once before- and hated it!”, “It was the most confusing and boring class I have ever taken!” or “All they ever talk about is depressing topics such as unemployment and inflation.” Statements such as these have given the field of economics a derogatory nickname, “the dismal science” (although its original meaning has a connection to slavery). I hope the information below and throughout the rest of the course will help to demonstrate the relevance of economics to understanding the society around them.
The Connection of Economics to Students
As a student of economics, you will begin to notice that your approach to thinking about choices and problems will be different than before you enrolled in an economics course. Below is a brief description of how economics will be useful to you as an individual:
In Your Daily Life. Economics is about the study of choice. You will ask yourself questions such as, how should I spend my time on the weekend, should I pay cash or use a credit card, and finally how to evaluate a financial investment, such as purchasing a house.
As a College Student. Economics is beneficial to you as a student by helping to ask yourself questions such as, should I attend as a part-time or full-time student, should I buy textbooks from the bookstore or online, and what field of study to pursue.
In Your Career. Economics will assist you in making career decisions, such as, should you stay at your current job or seek another, should you switch careers, or move to another city with better job opportunities.
In Your Political Life. As you learn more about economics, you will begin to see the connection between economics and politics. Economics and politics and intertwined. Every economic decision has political ramifications, and every political decision has economic ramifications. Economic principles should give you insights into taking positions on issues such as should the minimum wage be increased, should there be tax breaks for corporations, or should the United States pursue trade agreements such as NAFTA?
Economists see two different ways to view the economic landscape. The first is microeconomics. Microeconomics looks at the small picture. Its focus is on the individual’s relationship to the economy. It explores the interaction of consumers and producers in markets. A student can use microeconomics to understand how markets, work, to make personal decisions, and to analyze the impact of government decisions. The following are questions that microeconomics would help answer:
1) How would a higher tax on cigarettes affect consumption by teenagers?
2) Should I put my savings in a bank account or invest them in the stock market?
3) Would an increase in the federal minimum wage help the working poor?
Macroeconomics, on the other hand, looks at the big picture. It concentrates on the economy as a whole. An student of economics could use macroeconomics to answer such questions as:
1) Why do some economies grow faster than others?
2) How can an increase in interest rates affect the housing market?
3) Should the government pursue trade agreements such as NAFTA?
The study of economics often calls for the analysis of complex issues. Economists often differ on their analysis of the issues. How can we then make sense of the varied opinions offered to us? We can start by sorting unsupported opinions from thoughtful, supported analysis. In the field of economics there are positive and normative economic statements. Positive statements rely on facts and describe the economy the way it is. Normative statements are value judgments. These statements emphasize what “should” or “ought” to be. Notice the difference in the two statements below.
Positive Statement: The unemployment rate is rising.
Normative Statement: The unemployment rate is too high.
The first statement can be verified. One could look at the unemployment rate from the previous month to check for accuracy. The second statement is an opinion.
Research in Economics
Positive and normative economic statements help steer the direction of research in the field of economics. Economists develop theories to explain economic behavior. Theory and research go hand in hand. Economists, like other social scientists, rely on the research model.
The research model assists economists in developing economic theories. A theory is created by a process of testing research. Good research involves observation and measurement. Economists will keep track of a wide variety of economic data such as prices, wages, and hours worked. Economics is a young discipline. Although many useful theories have been discovered over the past two centuries, there are still many areas where economists are looking for answers.
In conducting good research, economists will want to isolate the factor of interest and investigate its effects. By changing only one factor, and keeping the rest constant, economists are better able to arrive at accurate conclusions. This process is known as “ceteris paribus“, a Latin term which means, “other things being equal”. Holding other factors equal is crucial in determining which factor is responsible for creating change. The concept of ceteris paribus can be found in how some economic concepts are explained through the use of graphs.
Economic models are explanations of how the economy or part of the economy works. Economic models take complicated occurrences in the real world, and simplify them. Economic models are always based on assumed conditions that are simpler than those of the real world. Economic models differ from those in the hard sciences such as physics, because they deal with unpredictable human behavior. Economic models can be described with text, tables, or graphs. Examples of economic models would be the laws of supply and demand, which we will explore in more detail in unit three.
Because not everyone interprets data the same way, there are competing models in the field of economics. This can be a source of frustration for students. Which theory should I believe in? If you feel uneasy about all the competing economic theories and models, don’t feel alone. President Truman, in his frustration with economists, famously said: “I want a one-armed economist. That way he can not say ‘on the other hand’. ” The comic strip below pokes fun at economic theories.
The Problem of Scarcity
Scarcity involves making choices. Scarcity means individuals, businesses and governments have to deal with the problem of unlimited wants, but limited resources. Every economic system, from capitalism to socialism, has to deal with the problem of scarcity. Which goods and services are scarce in a society is determined by the geography, culture, and political system of that society. The concept of scarcity is the foundation for the field of economics. The value of baseball cards are determined in large part by their scarcity. The Mickey Mantle baseball card pictured above sold for $486,100 in November 2015.
Individuals, businesses and government all need to concerned with scarcity. A college student with a few hundred dollars to spend can opt to spend that money on a variety of items, from a stereo system to a computer. Or the student can choose not to spend the money at all. Whatever choice is made, there will be advantages and disadvantages associated with it.
Businesses are also faced with making choices. If a business has surplus funds available, it needs to decide if it should hire an additional worker or instead purchase a new computer system. Governments too, need to make choices. If a government has a surplus, it can choose to either build new roads or to provide additional health care coverage to its senior citizens.
To better understand the concept of scarcity, the field of economics relies on the phrase, “there is no such thing as a free lunch”. There is a price and a cost to everything, even if those prices and costs are hidden. For example, suppose a local tavern advertises that a “free lunch” will be served from noon until one o’clock. Is the food that a patron eats really free? The field of economics would say no for a number of reasons. First, there is an expectation that a person entering the tavern will first have to order a drink before they will be able to eat the food. Secondly, there were “costs” associated with the purchase of the food by the tavern owner. Third, there were opportunity costs ( a concept described below) in purchasing the food. The money used to purchase the food could have been used for other business decisions (advertising, replacing outdated machinery, wage increases to employees).
Essential Economic Questions
Because of scarcity, all economic choices can be summarized in big questions about the goods and services a society should produce. These questions are: (1) What to produce? (2) how to produce, and (3) for whom to produce? Each of these questions will be explored in greater detail below.
What to Produce?
The first question every society faces is what to produce. Should a society build more roads or schools? Because of scarcity, society can not build everything it wants. Choices have to be made. Once a society determines what to produce it then needs to decide how much should be produced. In a market economy the “what” question is answered in large part by the demand of consumers.
How to Produce?
The next question a society needs to decide after what to produce is how to produce the desired goods and services. Each society must combine available technology with scarce resources to produce desired goods and services. The education and skill levels of the citizens of a society will determine what methods can be used to produce goods and services. For example, does a nation possess the technology and skills to pick grapes with a mechanized harvester, or does it have to pick the grapes by hand?
For Whom to Produce?
The final question each society needs to ask is for whom to produce. Who is to receive and consume the goods and services produced? Some workers have higher incomes than others. This means more goods and services in a society will be consumed by these wealthy individuals, and less by the poor. Different groups will benefit from the different ways that we choose to spend our money.
All of us make many decisions each day that require looking at the costs and benefits that we incur because of those decisions. The field of economics relies heavily on marginal analysis to explain economic concepts. This essential concept is discussed in greater detail below.
What is marginal analysis? Marginal analysis involves considering the effects of small changes (additions or subtractions) to a current situation. For example, students have scarce leisure time. If an hour becomes available the student needs to ask him/herself how that hour should best be spent. Should the student spend that hour reading a book on economics, or sleeping, or hanging out with friends? If a greater benefit is believed to come from reading an economics book than by sleeping an extra hour, then the student will choose reading the book. This would be a marginal analysis decision.
Efficiently using our resources to maximize our benefits is an essential economics concern. For example, a business owner might debate if bringing on an additional worker would be beneficial to the company. An additional worker would cost $15 per hour. But that additional worker would increase profits by $20 per hour. The business owner would hire the new worker because of the increase in value of $5 per hour. Decisions made by individuals and institutions are usually very close to the decisions predicted by marginal analysis.
In an earlier discussion about scarcity, the claim was made that economics is about making choices because of the problem of scarcity. In economic terms, these choices are referred to as opportunity costs. The discussion below will explore in more detail the concept of opportunity cost.
The best definition for opportunity costs is that it refers to the next best alternative given up in order to obtain a good or service. If this definition doesn’t make sense to you, then the term “trade off” can be substituted in its place. Opportunity cost decisions exist because of scarcity. Scarcity forces us into making choices. The well known phrase, “There is no such thing as a free lunch” (described above), is another way of describing the concept of opportunity cost.
The following example should illustrate the concept. You are a college student working a part-time job. Your place of employment asks you to work an additional two hours. You were planning on watching television with some friends before you were asked to work longer. What do you do? There is a measurable cost for each decision. If you decide to work you miss seeing the television show as well as the good company of your friends. On the other hand, if you decide to watch television and not work, you are giving up the possibility of making extra money. Suppose you are paid $10 per hour. The opportunity cost of watching television with your friends could then be measured at $20. The $20 would represent the next best alternative that was given up.
Individuals, businesses, and government all make opportunity cost decisions. At the individual level, the choices a person makes can affect their personal economic situation. At the business level, the choices made can affect the profitability of the business. At the government level, choices have political ramifications.
Production Possibility Frontier
In an earlier discussion we talked about how an economy’s scarce resources limits its options. The field of economics provides us a model to help us understand the choices that each economy must make. The Production Possibilities Frontier is a model that shows the various combinations of two goods the economy is capable of producing, given the factors of production and the technology it has available.
The Production Possibilities Curve is designed to illustrate the concept of opportunity cost. Each point on the curve illustrates the trade off that must be made. It is important to note that the production possibilities curve does not tell a society the combination of goods and services it should produce. It only demonstrates what happens when a society moves from one level of production to another. In other words, to get more of one thing (money from work) you will get less of another (time to study). Points outside the curve are unobtainable. For example, in the graph below, point “G” in unobtainable. An economy would have to have more resources or better technology to obtain them. Full production means that there can be no increase in output of one product without a reduction in the output for the other product. It means that the four factors of production discussed below (land, labor, capital, entrepreneurship) should contribute to the maximum satisfaction of society’s needs. Full production means a society is trying to produce an item in the most efficient and least costly way. This means that every point on the production possibilities curve represents an efficient outcome.
Points inside the curve represent unemployment or underutilization of resources. For the graph below, point “F” would represent unemployment or inefficiency. Points A, B, C, D, and E are all obtainable and demonstrate full employment and efficiency. Because resources are scarce, not every outcome is possible. For example, no matter how resources are allocated between automobiles and wooden chairs in the graph below, the economy cannot produce the amount of cars and wooden chairs represented by point “G”. Full employment is the condition that exists when all available resources are engaged in the production of goods and services. Full employment exists at every point ON the production possibilities curve. With respect to the production possibilities curve and opportunity costs, the law of increasing costs is a principle that states that once all factors of production (land, labor, capital) are at maximum output and efficiency, producing more will cost more than average. As production increases, the opportunity cost does as well.
Economic growth for an economy, such as an advancement in technology or an increase in supply of resources, is represented by an upward and right shift of the curve. This is demonstrated in the second graph below. The opportunity cost, or trade off, is demonstrated when you move from one point to another. For the example below, if you move from point “B” to point “C”, the opportunity cost in chairs, is approximately 20 chairs.
To sum up the production possibilities curve, if you want to have more of “x”, you will have to give up some of “Y”. The production possibilities frontier (curve) is an economic model that illustrates the trade-off or opportunity cost decisions economies have to make in their attempt to be efficient and to grow. The PPF graph shows how resources must be shared among goods during the production process.
Economic growth for an economy, such as an advancement in technology or an increase in supply of resources, is represented by an upward and right shift of the curve. Economic growth is demonstrated in the graph above by the blue curve. Society can move production from a point on the old “frontier” (red curve above) to a point on a new “frontier” (blue curve above).
For the concept of production possibility curves to work, four assumptions have to be in place. Because the production possibilities frontier (curve) is an economic model, these assumptions have to be in place in order to force a society to make choices. The four assumptions are:
1) There is a limited supply of resources. This means that existing resources (machinery, supplies, etc…) can only be transferred from the production of one good to the production of another good.
2) The technology is also limited. Existing technology is held fixed with no new innovations or inventions taking place.
3) The economy is running efficiently. Everyone who wants a job has one and all other resources are being used. This refers to the concepts of full employment and full production discussed above.
4) There exists only a “two-good” world. There are no other choices.
If any on these conditions were not present, a society would not be forced to make a choice between two levels of production.
Factors of Production
Factors of production refer to the resources used to produce goods and services in a society. Economists divide these resources into the four categories described below.
As was mentioned above, the factors of production are usually divided into four categories.
Land refers to all natural resources. Such things as the physical land itself, water, soil, timber are all examples of land. The economic return on land is called rent. For example, a person could own land and rent it to a farmer who could use it to grow crops. A second resource is labor.
Labor refers to the human effort to produce goods and services. The economic return on labor is called wages. Anyone who has worked for a business and collected a paycheck for the work done, understands wages. A third factor of production is capital.
Capital is anything that is produced in order to increase productivity in the future. Tools, machines and factories can be used to produce other goods. The field of economics differs from the field of finance and does not consider money to be capital. The economic return on capital is called interest.
Finally, the fourth factor of production is called entrepreneurship. Entrepreneurship refers to the management skills, or the personal initiative used to combine resources in productive ways. Entrepreneurship involves the taking of risks. The economic return on entrepreneurship is profits.
Factors of Production and Their Relationship to the Circular Flow Model
The Circular Flow Model describes the flow of money and products throughout the economy. The model divides markets into two markets: 1) markets for goods and services, and 2) markets for factors of production (factor markets). In the goods and services market, households purchase goods and services from firms who produced them. In this relationship, money flows from households to businesses. In the factors of production market, firms use any of the factors of production (land, labor, etc…) to produce goods and services. This is where households provide (supply) their labor to firms. Firms provide money to workers in the form of wages for their work, which they then use to purchase goods and services. When the factors of production market is combined with the goods and services market, a closed loop is formed with the flow of money creating sustained economic activity. The diagram below illustrates this model.
It should be noted that the circular flow model represents a capitalistic economy with no role for government. The circular flow model is useful because it sets the stage for understanding the concepts of supply and demand in unit three, where households represent the demand side and businesses/firms represent the supply side.
Every discipline has its own tools that it uses to help understand difficult concepts. Economics is no exception. Economists use graphs to further clarify concepts and to show relationships in a way that can be more easily understood. Graphs are simply a tool used to illustrate numeric data in economics and many other sciences. The information below should help the student to better understand how graphs are used in economics.
In economics, graphs that present economic concepts are often drawn as line graphs, bar charts, and pie charts. Some of the more frequently used economic models are presented using curves. The production possibilities curve, demand curves, and supply curves are such examples. When working with curves, it is important to pay attention to the labels on the axes and to the content. Curves that slope upward to the right show a direct or positive relationship. When one variable increases, the other variable also increases. For example, durable goods purchases increase as income increases. The Lorenz Curve, which you will learn about in unit 6, is one such example. Curves that slope downward and to the right show an inverse or negative relationship. When one variable increases, the other decreases and vice versa. For example, the law of demand shows an inverse relationship between price and quantity demanded.
To summarize, a graph is a pictorial representation of the relationship between two or more variables.
To many, economics is considered a social science. That means it is a discipline that helps us to understand human behavior. It is a relatively new field of economics that puts it a bit at odds with traditional economics. Why would it be at odds with traditional economics? Traditional economics sees people as calculating, unemotional maximizers. The standard economic model of human behavior includes three unrealistic traits which are:
1) unbounded rationality
2) unbounded willpower and
3) unbounded selfishness
All three of the above behavioral economics modifies.
Behavioral economics considers human decision making to be more complex. People have limitations in knowledge and cognitive ability, and rationality may be considered bounded by such constraints. Behavioral economics which borrows heavily from the field of psychology is the study of how thinking and emotions affect individual economic decisions and the behavior of markets. Behavioral economics tries to increase the realism of economic analysis by introducing psychological factors that influence decision making. Let’s see how behavioral economics affects the three traits stated above.
1. Unbound rationality. Departures from rationality emerge both in judgments (beliefs) and in choices. The ways in which judgment diverges from rationality are extensive. Some illustrative examples include overconfidence, optimism, and extrapolation. Traditional economics believes people are robotic in their behavior, that they are always rational, selfish individuals who make calculated, stable, and predictable decisions. This is referred to as “homo economicus”. Behavioral economists believe that because of limitations of knowledge and processing information, the human brain will not always choose the best option. Because human behavior varies across time and space, decisions are affected by cognitive biases, emotions, and social influences.
An example would be a mid-1990s study of New York City taxicab drivers (Camerer et al. 1997). These drivers pay a fixed fee to rent their cabs for twelve hours and then keep all their revenues. They must decide how long to drive each day. The profit-maximizing strategy is to work longer hours on good days—rainy days or days with a big convention in town—and to quit early on bad days. Suppose, however, that cabbies set a target earnings level for each day and treat shortfalls relative to that target as a loss. Then they will end up quitting early on good days and working longer on bad days. The authors of the study found that this is precisely what they do.
2. Unbounded willpower. Classical economics assumes people have complete self-control. Humans, even when we know what is best, sometimes lack self-control. Most of us, at some point, have eaten, drunk, or spent too much, and exercised, saved, or worked too little. Though people have these self-control problems, they are at least somewhat aware of them: they join diet plans and buy cigarettes by the pack (because having an entire carton around is too tempting). They also pay more withholding taxes than they need to in order to assure themselves a refund.
3. Unbounded selfishness. Classical economists believe people are boundedly selfish. Although economic theory does not rule out altruism, as a practical matter economists stress self-interest as people’s primary motive. For example, the free-rider problems widely discussed in economics are predicted to occur because individuals cannot be expected to contribute to the public good unless their private welfare is thus improved. But people do, in fact, often act selflessly. Millions of people donate to charities. Similar selfless behavior has been observed in controlled laboratory experiments. People often cooperate in Prisoners’ Dilemma games and turn down unfair offers in “ultimatum” games.
A concept found to both classical and behavioral economics is the role of incentives and disincentives. If you recall from your Intro to Psychology classes, that people respond predictably to positive and negative incentives (remember B.F. Skinner and Behaviorism?) Rewards are positive incentives that make people better off. Penalties are negative incentives that make people worse off. How much of economic behavior can be explained through incentives and disincentives? For example, how might you explain China’s attempt to reduce its population through its “One Child” policy through incentives and disincentives? How might the three factors listed above influence China’s birth rate? How can we use behavioral economics to understand organ and blood donation?
Behavioral economists do not rely as heavily on mathematical models to predict outcomes. Instead, they collect real world data on past consumer behavior and conduct experiments involving real transactions to gauge how consumers might behave in future situations. The goal in collecting such data is to eliminate unlikely outcomes so that likely ones come into focus. Although not as exact of a science compared to using mathematical equations, behavioral economists often manage to make startlingly accurate economic predictions. Economists have found that making realistic assumptions about human nature generally leads to a more precise result.
Criticism of the Field of Economics
As economies around the world struggle to meet the needs of citizens, many people have become critical of the field of economics. Many people accuse the discipline of having been hijacked by the business and corporate communities. Others have complained that economists have been wrong so much that we should stop listening to them. Has economics becoming a discipline that allows the rich and powerful in society to hide behind charts, graphs, and algebraic equations? No other discipline dominates political theory and practice as much as economics.
Recently the field of economics has said that the purpose of economics is to focus on growing an economy so as to produce more wealth. But is that the only or best answer? Perhaps the goal of an economy should be increasing the welfare of the majority of its citizens, instead of on wealth creation. Most of economics focuses on what the economy “does” , but spends very little time on what its goal “is” our “ought” to be. Perhaps this is where a change of thinking is needed in the field of economics. Many people believe that economics has gotten away from a discussion of ethics and morality that Adam Smith emphasized in his book, “The Theory of Moral Sentiments” to a discipline that focus solely on the acquisition of wealth. Below is a quote I came across on the internet that looks at how economic professors may play a role in promoting a misunderstanding of economics:
“The main trick used by professors of economics is to draw their pupils into a make-believe world and then convince them that [this] is a good approximation to the real world, enough so that the [reality] in which we live can be studied effectively by analyzing the fantasy world.”
Below are a list of books that exhibit economic concepts learned in this unit.
Parkin, Michael 2000 Economics (5th Edition) New York: Addison- Wesley
Slavin, Stephen L. 1999 Economics (5th Edition) New York: Irwin McGraw-Hill
Taylor, John B.
2001 Economics. Boston: Houghton Mifflin Company
2000 Economics (2nd Edition) New York: Worth Publishers
Tucker, Irvin B. 1995 Survey of Economics New York: West Publishing Company
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