The Role and Method of Economics
1 c h a p t e r
WHY STUDY ECONOMICS?
As you begin your first course in economics, you may be asking yourself why you’re here. What does economics have to do with your life? Although there are many good reasons to study economics, perhaps the most compelling is that many of the questions you face every day are at least partly economic in character: Why do 10 AM classes fill up more quickly than 8 AM classes during registration? Why is it nearly impossible to catch a taxi after a play on a rainy night in New York City? Why is it hard to find an apartment in San Francisco, Berkeley, or New York? Why is teenage unemployment always higher than adult unemployment? Why are the prices of prescription drugs so high? Will higher taxes on cigarettes reduce the number of people who smoke, and if so, by how much? Why are male basketball players paid more than their female counterparts? Why do female models make more money than male models do? Studying economics will help you answer questions like these and many others.
Another reason to study economics is that it can teach you how to “think better” by helping you develop a disciplined method of analyzing problems —the economic way of thinking. The problem solving tools you develop by studying economics will prove valuable to you, both personally and professionally, regardless of your career choice. A student of economics becomes aware that, at a basic level, much of economic life involves choosing among alternative courses of action—making choices between our conflicting wants and desires in a world of limited resources. Economics provides some clues as to how to intelligently evaluate these options and determine the most appropriate choices in given situations.
ECONOMICS—A WORD WITH MANY DIFFERENT MEANINGS
Some individuals think economics involves the study of the stock market and corporate finance, and it does—in part. Others think that economics is concerned with the wise use of money and other matters of personal finance, and it is—in part. Still others think that economics involves forecasting or predicting what business conditions will be in the future, and again, it does—in part.
A Unique Way of Looking at Human Behavior
Economics is a unique way of analyzing many areas of human behavior. Indeed, the range of topics to which economic analysis is applied is quite broad.
Many researchers have discovered that the economic approach to human behavior sheds light on social issues that have been with us for a long time: discrimination, education, crime, divorce, political favoritism, and many more. In fact, your daily newspaper is filled with economics. You can find economics on the domestic page, the international page, the sports page, the entertainment page, the comics, and even the weather.
Growing Wants and Scarce Resources
Precisely defined, economics is the study of the allocation of our limited resources to satisfy our unlimited wants. Resources are inputs—land, human effort and skills, and machines and factories, for instance—used to produce goods and services. The problem is that our unlimited wants exceed our limited resources, a fact that we call scarcity.
Scarcity forces us to decide how best to use our limited resources.
This is the economic problem:
Scarcity forces us to choose, and choices are costly because we must give up other opportunities that we value. The economic problem is evident in every aspect of our lives. You may find that the choice between shopping for groceries and browsing at the mall, or between finishing a research paper and going to a movie, is easier to understand when you have a good handle on the “economic way of thinking.”
Economics: A Brief Introduction
s e c t i o n 1.1
· Why study economics?
· What is economics?
· What is scarcity?
ECONOMICS IS ALL AROUND US
Although you might think that much of what you desire in life is “non-economic,” economics concerns everything an individual might consider worthwhile, including things that you might consider “priceless.” For instance, although we may long for love, sexual fulfillment, or spiritual enlightenment, few of us would be able to set a price for them. But even these matters have an economic dimension. Consider spirituality, for example. Concern for spiritual matters has led to the development of institutions such as churches, synagogues, and temples that conduct religious and spiritual services. In economic terms, these services are goods that many people desire. Love and sex likewise have received economists’ scrutiny. One product of love, the institution of the family, is an important economic decision-making unit. And sexual activity results in the birth of children, one of the most important “goods” that humans desire.
Even time has an economic dimension. In fact, in modern culture, time has become perhaps the single most precious resource we have. Everyone has the same limited amount of time per day, and how we divide our time between work and leisure (including study, sleep, exercise, and so on) is a distinctly economic matter. If we choose more work, we must sacrifice leisure. If we choose to study, we must sacrifice time with friends, or time spent sleeping or watching TV. Virtually everything we decide to do, then, has an economic dimension.
Living in a world of scarcity involves trade-offs— and when we know what the trade-offs are, we can make better choices from the options all around us, every day.
Economics: A Brief Introduction 5 The front pages of our daily newspapers are filled with articles related to economics—either directly or indirectly. News headlines might read: Fuel Prices Soar; Should Social Security Be Revamped?; Stocks Rise; Stocks Fall; President Vows to Increase National Defense Spending; Health Costs Continue to Rise.
By Lynn Brenner
AVERAGE AMERICAN GRADE: F
The National Council of Economic Education tested 1,010 adults and 1,085 high school students on their knowledge of basic economic principles.
· On average, adults got a grade of 57 percent on a test on the basics of economics. Among high school students, the average grade was 48 percent.
· Almost two-thirds of those tested did not know that in times of inflation, money does not hold its value.
· Only 58 percent of the students understood that when the demand for a product goes up but the supply doesn’t, its price is likely to increase.
· Half of the adults and about two-thirds of the students didn’t know that the stock market brings people who want to buy stocks together with those who want to sell them.
· Just over one in three Americans realize that society must make choices about how to use resources.
SOURCE: Lynn Brenner, “What We Need to Know About Money,” Parade Magazine, April 18, 1999, pp. 4–7. Reprinted with permission from Parade, copyright © 1999.
AMERICANS SCORE POORLY ON ECONOMIC LITERACY
In The NEWS
Among Adults Among High School Grade (percent) Students (percent)
A 6 3 B 10 7 C 15 11 D 20 13 F 49 66
6 CHAPTER ONE | The Role and Method of Economics
1. Economics is a problem-solving science.
2. Economics is the study of the allocation of our limited resources to satisfy our unlimited wants.
3. Resources are inputs used to produce goods and services.
4. Our unlimited wants exceed our limited resources, so we must make choices.
1. Why is economics worth studying?
2. What is the definition of economics?
3. Why does scarcity force us to make choices?
4. Why are choices costly?
5. Why do even “non-economic” issues have an economic dimension?
s e c t i o n c h e c k
ECONOMICS IS A SOCIAL SCIENCE
Like psychology, sociology, anthropology, and political science, economics is considered a social science.
And like the other social sciences, economics is concerned with reaching generalizations about human behavior. Economics is the study of people.
It is the social science that studies the choices people make in a world of limited resources.
Economics and the other social sciences often complement one another. For example, a political scientist might examine the process that led to the adoption of a certain tax policy, while an economist might analyze the impact of that tax policy. Or while a psychologist might try to figure out what makes the criminal mind work, an economist might study the factors causing a change in the crime rate.
Social scientists, then, often study the same issues but from different perspectives.
MACROECONOMICS AND MICROECONOMICS
Conventionally, we distinguish two main branches of economics, macroeconomics and microeconomics.
Macroeconomics deals with the aggregate, or total economy; it looks at economic problems as they influence the whole of society. Topics covered in macroeconomics include discussions of inflation, unemployment, business cycles, and economic growth.
Microeconomics, by contrast, deals with the smaller units within the economy, attempting to understand the decision-making behavior of firms and households and their interaction in markets for particular goods or services. Microeconomic topics include discussions of health care, agricultural subsidies, the price of everyday items such as running shoes, the distribution of income, and the impact of labor unions on wages. To put it simply, microeconomics looks at the trees while macroeconomics looks at the forest.
Economics as a Science
s e c t i o n 1.2
· How is economics similar to other social sciences?
· What are macroeconomics and microeconomics?
http://sextonxtra.swlearning.com
To work more with this Chapter’s concepts, log on to Sexton Xtra! now.
SELF-INTEREST
Economists assume that individuals act as if they are motivated by self-interest and respond in predictable ways to changing circumstances. In other words, self-interest is a good predictor of human behavior in most situations. For example, to a worker, self-interest means pursuing a higher paying job and/or better working conditions. To a consumer, it means gaining a higher level of satisfaction from limited income and time.
There is no question that self-interest is a powerful force that motivates people to produce goods and services. But self-interest can include benevolence.
Think of the late Mother Teresa, who spent her life caring for others. One could say that her work was in her self-interest, but who would consider her actions selfish? Similarly, workers may be pursuing self-interest when they choose to work harder and longer to increase their charitable giving or saving for their children’s education. So don’t confuse self-interest with selfishness.
ACTION AND INACTION HAVE CONSEQUENCES
Most economists believe that it is rational for people to anticipate the likely consequences of their behavior.
For example, if a man with a suspended driver’s license chooses to drive his car illegally, he presumably considered the possible consequences of this action before he made that decision. Just because he has thought about what might happen to him if he drives without a license—perhaps a serious jail sentence or an impounded car—those considerations will not necessarily prevent him from choosing to drive. Or if a woman decides to take up smoking, she presumably thought about the consequences of that action. She may still decide to smoke, but she will have at least considered the potential results of that action. Just as every action has a consequence, so too does every inaction —the act of deciding not do something or not to make a change: If you choose not to study, you could fail an exam; if you choose not to pay your income taxes, you could go to jail; if you are diagnosed with high blood pressure and choose not to change your diet, you could have a stroke.
Economic Behavior 7
s e c t i o n 1.3
· What is self-interest?
· Why is self-interest not the same as selfishness?
1. Economics is concerned with reaching generalizations about human behavior.
2. Economics provides tools to intelligently evaluate and decide our choices.
3. Macroeconomics deals with the aggregate, or total, economy.
4. Microeconomics focuses on smaller units within the economy—firms and households, and how they interact in the marketplace.
1. What makes economics a social science?
2. What distinguishes macroeconomics from microeconomics?
3. Why is the market for running shoes considered a microeconomic topic?
4. Why is inflation considered a macroeconomic topic?
Most individuals try to anticipate the likely consequences of their behavior or actions. This does not mean that individuals will always make the right choices, but it does imply that they have at least thought about the possible consequences. In choosing to drive recklessly, for example, you could become or cause one of the over 40,000 fatalities a year reported by the National Highway Traffic Safety Administration.
ON COURAGE
By Dan Millman
Many years ago when I worked as a volunteer at Stanford Hospital, I got to know a little girl named Liza who was suffering from a rare and serious disease. Her only chance of recovery appeared to be a blood transfusion from her 5-yearold brother, who had miraculously survived the same disease and had developed the antibodies needed to combat the illness.
The doctor explained the situation to her little brother and asked the boy if he would be willing to give his blood to his sister. I saw him hesitate for only a moment before taking a deep breath and saying, “Yes, I will do it if it will save Liza.” As the transfusion progressed, he lay in a bed next to his sister and smiled, as we all did, seeing the color return to her cheeks. Then his face grew pale and his smile faded. He looked up at the doctor and asked with a trembling voice, “Will I start to die right away?” Being young, the boy had misunderstood the doctor; he thought he was going to have to give her all his blood.
SOURCE: Dan Millman, “On Courage,” Sacred Journey of the Peaceful Warrior.© 1991, H. J. Kramer, Inc.
CONSIDER THIS:
Some people will help others even when the costs are extraordinarily high. But more often than not, these cases of pure selflessness involve close friends or relatives. For example, we seldom observe employees asking employers to cut their wages and increase their workload to increase a company’s profits.
Or how often do you think customers walk into a supermarket demanding to pay more for their groceries? In short, a great deal of human behavior can be explained and predicted by assuming people act as if they are motivated by their own self-interest.
© O’Brian & Mayor Photography/FPG International/Getty Images
Economic Behavior 9
How can economists expect to be taken seriously, noneconomists are given to complain, when their model of man is so patently inadequate? Mainstream economics assumes that people are driven by the rational pursuit of self-interest.
But, as everybody knows, people are not rational and they often act selflessly. Where in this view of man as desiccated calculating-machine is there recognition of the centrality of love, duty and self-sacrifice in human conduct? What use is a purported science of social behavior that is blind to the necessary conditions for social behavior?
These questions would be telling if “rational” and “selfinterest” meant what these critics take them to mean. But they do not. In mainstream economics, to say that people are rational is not to assume that they never make mistakes, as critics usually suppose. It is merely to say that they do not
make systematic mistakes—ie, that they do not keep making the same mistake over and over again. And when economists talk of self-interest, they are referring not just to satisfaction of material wants, but to a broader idea of “preferences” that can easily encompass, among other things, the welfare of others.
Even when the terms are properly understood, “rational pursuit of self-interest” is a simplifying assumption. But the right question is whether this simplification is fruitful, or so gross that it hides what needs to be examined. Human behavior is far too complicated to be analyzed—to yield patterns and suggest generalizations —without employing some such simplification. And in nearly every branch of economics, rationality has proved a useful one . . .
Turning from means to ends, what about self-interest? Here the issues are subtler. If economics supposed, at one extreme, that people seek only to maximize their material consumption, then it would be plain wrong, and that would be that. If, at the other extreme, it assumed that people seek to satisfy their preferences (or some such formula), then it would be true merely by virtue of the meaning of the words—and it would not tell you anything. The assumption built into mainstream economics is much closer to the second of these than the first . . .
However, the assumption of self-interest is not entirely tautological.
Many kinds of apparently selfless behavior may in fact be self-interested in the way economics proposes . . .
People show consideration for others in the hope or expectation that the favor will be returned. Behavior that establishes a reputation for honesty, or that signals a willingness to enter into commitments, is also, as a rule, self-interested in this sense. That makes it no less conducive to a flourishing society, no less to be praised and encouraged . . . it is self-interest, not love, that holds society together . . .
Adam Smith, one of the greatest economic thinkers and author of The Wealth of Nations published in 1776, pointed out that if people want dinner, they look not to the benevolence of the butcher, brewer or baker, but to their regard for their own interest, his aim was not to portray social interaction as mean and narrow. Rather it was to draw attention to the extraordinary and improbable power of self-interest: this stunted, inward- looking trait is transformed, through spontaneous social co-operation, into a force for the common good.
Smith regarded this as almost miraculous. So it is. The main task of economics has been to understand this astonishing process. And by and large, thanks to its simplifying assumptions, it has succeeded. That’s not so dismal, is it?
SOURCE: Dec. 10th 1998. From The Economist print edition.
THE BENEVOLENCE OF SELF-INTEREST
USING WHAT YOU'VE LEARNED
A Q
1. Economists assume that people act as if they are motivated by self-interest and respond predictably to changing circumstances.
2. People try to anticipate the possible consequences of their actions.
1. What do economists mean by self-interest?
2. What does rational self-interest involve?
3. How are self-interest and selfishness different?
ECONOMIC THEORIES
A theory is an established explanation that accounts for known facts or phenomena. Specifically, economic theories are statements or propositions about patterns of human behavior that occur expectedly under certain circumstances. These theories help us sort out and understand the complexities of economic behavior and guide our analysis.
We expect a good theory to explain and predict well. A good economic theory, then, should help us better understand and, ideally, predict human economic behavior.
ABSTRACTION IS IMPORTANT
Economic theories cannot realistically include every event that has ever occurred. A theory weeds out the irrelevant facts from the relevant ones. We must abstract. A road map of the United States may not include every creek, ridge, and gully between Los Angeles and Chicago; indeed, such an all-inclusive map would be too large to be of value. But a small road map with major details will provide enough information to travel by car from Los Angeles to Chicago. Likewise, an economic theory provides a broad view, not a detailed examination, of human economic behavior.
DEVELOPING A TESTABLE PROPOSITION
The beginning of any theory is a hypothesis, a testable proposition that makes some type of prediction about behavior in response to certain changes in conditions. In economic theory, a hypothesis is a testable prediction about how people will behave or react to a change in economic circumstances.
For example, if we notice that the price of compact discs (CDs) has increased, we might hypothesize that sales of CDs will drop, or if the price of CDs has decreased, our hypothesis might be that CD sales will rise. Once we state our hypothesis, we test it by comparing what it predicts will happen to what actually happens.
Using Empirical Analysis
To determine if our hypothesis is valid, we must engage in empirical analysis. That is, we must examine the data to see if our hypothesis fits well with the facts. If the hypothesis is consistent with realworld observations, we can accept it; if it does not fit well with the facts, we must go “back to the drawing board.” Determining whether a hypothesis is acceptable is more difficult in economics than it is in the natural or physical sciences. Chemists, for example,
10 CHAPTER ONE | The Role and Method of Economics
Economic Theory
s e c t i o n
1.4
_ What are economic theories?
_ What can we expect from theories?
_ Why do we need to abstract?
_ What is a hypothesis?
_ What is empirical analysis?
How is economic theory like a map? Because of the complexity of human behavior, economists must abstract to focus on the most important components of a particular problem. This is similar to maps that highlight the important information (and assume away many minor details) to help people get from here to there.
© Ryan McVay/PhotoDisc/Getty One Images
In our discussion of economic theory, we have not yet mentioned that there are certain problems that may hinder scientific and logical thinking. In this section, we discuss several potential problems to avoid in economic thinking: violation of the ceteris paribus assumption, confusing correlation and causation, and the fallacy of composition.
can observe chemical reactions under laboratory conditions. They can alter the environment to meet the assumptions of the hypothesis and can readily manipulate the variables (chemicals, temperatures, and so on) crucial to the proposed relationship.
...
Januszek66