Introduction

Chapter 1

Slides by Pamela L. Hall

Western Washington University
©2005, Southwestern
 Introduction
 Knowledge of economic theory provides a road map for
 Understanding how economy operates
 How individuals interact as groups of consumers and producers
 Road map describes how a decentralized system of
resource allocation
 Can result in efficiently allocating limited resources
 Ability to understand economic theory and apply it to
everyday choices
 Will provide you with power to make correct choices and understand
choices made by others
 Road map can aid us in addressing practical, realistic
problems such as
 Environmental degradation
 Cartels
 Dishonest used car salespeople
 Discrimination 2
 Introduction
 Epistemology
 Field of philosophy that critically investigates nature, grounds, limits,
and criteria or validity of human knowledge
 A theory of cognition
• Act or process of knowing
 Economic theory contains a great deal of epistemology
 Theory for examining how human behavior affects economic
decisions
• For example, economists have worked to specify minimal number of
assumptions required for characterizing an individual consumer’s
preferences
 Applied economist
 Combines economic theory with knowledge of institutions and
environment to address practical problems

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 Economics Defined
 Riches in terms of fewness of wants are what economics is
all about
 Unfortunately we are unable to satisfy all of our wants—
there are limits
 For a society these limits take form of scarce resources
• For example, land, water, labor, and physical capital
 Economics is study of how to allocate these limited
resources to satisfy unlimited wants
 Economics is a social science, in contrast to a natural
science
 Deals with human society or its characteristic elements, such as
individual, family, or state
 Scarcity means there are not enough resources to satisfy
every possible demand

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 Economics Defined
 Economics
 Social science concerned with allocation of scarce
resources for satisfying unlimited wants
• E.g., with a federal budget surplus, do we pay down national
debt, cut taxes, maintain social programs, or fly to Mars?
 Society
 Interaction of individuals within an environment
• E.g., United States and other countries
 Social welfare
 Happiness for society as a whole
• E.g., economists have suggested modifications to a country’s
gross national product as a surrogate measure for social welfare

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 Economics Defined
 Local bliss
 Social welfare is maximized for a given resource
constraint
• E.g., a time of peace and prosperity
 Global bliss (or bliss)
 There are no resource constraints and all wants are
satisfied
• E.g., our dreams
 Agent
 Household or firm within an economy
• E.g., you
 Economy
 Group of agents interacting to improve their individual
and joint satisfaction
• E.g., interaction of buyers and sellers in a free society 6
 Economics Defined
 Using resources in one way has an opportunity cost
of not being able to use them in another way
 For example, opportunity cost of allocating time for
studying is lost enjoyment of seeing a movie instead
 Scarce resources are continuously changing
through time
 Nonrenewable resources are declining
 Renewable resources may increase or decline over time
 Capital, both human and physical, will depreciate over
time
• Must be augmented to maintain or increase present levels
 Change in resources is a constraint (limitation) that
prevents complete satisfaction
 Assuming individuals’ wants are insatiable
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 Economics Defined
 Individuals’ wants are also continuously changing
 Depending on age, location, and even time of day
 Economics is concerned with way society chooses to
allocate a continuously changing set of limited resources
 Among a continuously changing set of unlimited wants
 Would you be sorry if all your wants were satisfied?
 Yes, because tomorrow these current wants will change
 Economics is a philosophical inquiry into process of
resource allocation
 Outlines how a society allocates its scarce resources to achieve
prosperity and well-being for its citizens
 Objective of economics
• Maximize happiness for society as a whole (social welfare) subject to
limited resources

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 Economics Defined
 Economics provides a theory for determining
 What commodities to produce
 When to produce them
 How to produce them
 For whom to produce them
 Theory describes economic environment in which agents (households
and firms) interact
 Knowledge of this environment provides an understanding of how an
economy operates
 Economic theory offers both an explanation for and predicts how agents
within an economy operate
• Must understand this operation of an economy to make efficient decisions on how
to allocate resources
 With understanding of economic theory, ability to explain, predict, and
control economy is possible
 Economic theory could be used as a basis for
• Design of policies by governments wishing to control outcome of a program or
• As a critique of control actions governments might take

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 Economics Defined
 For example, economic theory can describe
 How price of oil affects auto production
 Why a large increase in gasoline price results in little
reduction in demand for gasoline
 Why a cattle rancher will stay in business even if she is
losing money
 Why a firm with monopoly power can charge a higher
price for its commodity than a competitive firm
 Economic theory is a very nonlinear use of
language
 Full implications are more than just sum of parts
 Makes it a very powerful and exciting field of study
 Why study economics?
 Microeconomic theory offers solutions to practical
problems 10
 Taxonomy of Economics
 Economics may be classified into a number of
divisions
 Economic philosophy
• Positive and normative
 Major fields
• Micro and macro
 Economists tend to specialize in one of the major
fields
 In their applications they will generally employ both
positive and normative economic philosophies

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 Microeconomics and
Macroeconomics
 Microeconomics
 Concerned mainly with economic activities of individual consumers
and producers or groups of consumers and producers, known as
markets
• Examples include
 Consumers’ demand for food
 Cost to a firm for a particular volume of production
 Per-unit price a firm charges for a specific volume of its output
 Macroeconomics
 Concerned with behavior of economic aggregates or economy as a
whole
• Examples include
 Total volume of output for a nation
 General level of prices and employment
 Total level of income and expenditures

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 Microeconomics and
Macroeconomics
 Complement each other
 Microeconomics deals with efficient allocation of resources
within an economy
 Macroeconomics deals with maintaining a stable economic
environment resulting in full employment with stable prices
 If macroeconomists are unable to maintain full employment of
resources
• Microeconomists need not worry about efficiently allocating these
resources
 Since unemployed resources are not scarce or limited
 Microeconomics is of limited use unless resources are fully employed
 Reverse is also true—if microeconomists are unable to efficiently
allocate resources
• Even with fully employed resources social welfare will not be maximized

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 Microeconomics and
Macroeconomics
 Fallacy of composition states
 What is true of parts is not necessarily true of whole
 In terms of economics, generalizations made at microeconomics
level may not always be true at macroeconomics level
 For example, rising unemployment may result in workers’
increasing their savings
 Microeconomics would predict an increase in individual savings
 However, unemployed may decrease their savings to maintain their
living standards
 Macroeconomic effect of combining workers’ and unemployed’s
savings levels may result in a decrease in savings
• Called Paradox of Thrift

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 Microeconomics and
Macroeconomics
 Converse of fallacy of composition is fallacy of division
 What is true of whole is not necessarily true of the parts
 Generalizations made at macroeconomic level may not always be
true at microeconomic level
 For example, in aggregate (macro), level of prices may be
stable
 Specifically, there is no inflation, defined as a general rise in prices
 However, in a particular market (micro), prices may be rising rapidly
 Micro- and macroeconomics are not distinct areas of study
 Both can be used to investigate same policy action
 For example, an increase in government taxes affects consumers
and producers can be analyzed with
• Microeconomic tools
 Investigate effect on markets for specific commodities, such as housing or
automobiles
• Macroeconomic tools
 Analyze effect on aggregate employment, inflation, and national income
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Positive and Normative Economics
 Positive economics
 Concerned with what is, was, or will be
 Considers actual conditions that have occurred or will occur in an economy
 If two people disagree over positive statements in economics
• Should be able to settle their controversy by logical thinking and appealing to
facts
• For example, the statement “A 10% increase in the price of gasoline will have no
effect on the number of vacationers going skiing,” is a positive statement
 Can be tested by empirical research
 Number of skiers before price hike can be compared with number of skiers after
 Normative economics
 Concerned with what ought to be
 Involves value judgments—statements about what is good and what is bad,
what ought to have occurred, or what ought to occur in an economy
 If two people disagree over normative statements
• They are disagreeing over value judgments and may not be able to reach an
agreement
 For example, “Only Bohemian residents should be allowed to vacation in Bohemia,” is a
value judgment that cannot be tested
 Empirical evidence cannot be used to destroy one’s belief about the issue

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 Applied Economics
 Applied Economics is closely related to normative and positive
economics
 Belongs to neither category but to a category called art of economics
 Distinction dates back to father of John Maynard Keynes, John Neville
Keynes
 Positive economics is study of what is and the way the economy works
 Pure science, not applied economics
 Normative economics is study of what should be
 It is also not applied economics
 Art of economics is applied economics that accepts some set of goals
determined in normative economics
 Discusses how to achieve those goals in reality, given insights of positive
economics
 Relates conclusions derived in positive economics to goals determined in
normative economics

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 Applied Economics
 Positive economics is abstract thinking about abstract problems
 Immediate or even future relevance is of little or no concern to a positive
economics researcher
 Methodology for art of economics is broader, more inclusive, and less
technical than methodology for positive economics
 Requires a knowledge of institutions and of social, political, and historical
phenomena
 Mechanisms for using available data in addressing current economic
problems are developed as economic art
 Applied economics relies on all other disciplines to support positive
economics
 Engineering, biology, and ecology are improving technology
• Helps produce more desirable commodities from limited resources
 Mathematics, computer science, and statistics are developing new tools for
advancing both applied economics and positive economic theory
 Applied economics incorporates theories from political science, sociology,
and psychology

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 Models
 Economics is based on belief that most behavior can be
explained
 By assuming agents have stable, well-defined preferences
• Make rational market choices consistent with these preferences
 Economics is distinguished from other social sciences by its
general acceptance of this belief
 Paradigm in economics
• Foundation for building economic models
 Models are basic tool used by scientists to increase our
understanding of real world
 Simplified representations of reality
 Reality is simplified in different ways in a model
 Depending on objectives of model and particular situation
• For example, a map is a simplified model of world, but not all information
about world can be placed on one map

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 Assumptions
 A model is used to simplify reality from which conclusions are logically deduced
about some system
 A system is a group of units interacting to form a whole
• For example, consumers and producers interact to form a market system
 Assumptions are assertions about system properties that are observable in real
world
 Can be evaluated for their degree of realism
 Properties are traits and attributes of a system
 A model describes essential features of a system, based on theory, in a way that
is simple enough to understand and manipulate
 Close enough to reality to yield meaningful results
 Consider a model of consumer behavior with following assumptions
 Consumer is rational and attempts to maximize satisfaction (utility)
• Consumer has a fixed level of income
 Commodities (goods and services) vary continuously, and utility consumer derives
from them is measurable
• Consumer has a given set of preferences for these commodities
 Commodity prices are constant

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 Assumptions
 Based on this set of assumptions, can conclude that a consumer will
maximize utility
 By equating marginal (additional) utility per dollar for all the commodities he
purchases
 In this model, variables—commodity prices, income, and consumer
preferences—are assumed to influence consumer’s purchases of
commodities
 Called exogenous variables
 Based on economic theory, we can develop a model where these
exogenous variables cause change in other variables
 Called endogenous variables (in this case, consumer’s purchases)
 Assumptions characterize type of world for which a model is intended,
but model is not an exact representation of reality
 For example, when at supermarket you do not count level of utility you
receive per unit of commodity
• However, a model provides a reasonable abstraction

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 Assumptions
 Abstracting from reality is part of scientific method
 Minimizes influences of personal and cultural beliefs in
explaining reality
 Economists employ scientific method to develop
and test models that are accurate representations
of reality
 Hypothetical models are important in any science
 Even if these models are artificial, they are useful
 Real test of such models is whether they lead to
conclusions that help to further scientific objectives
 Explanation, prediction, and control

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 Analysis
 Value of economic models is not in how realistic are their assumptions
 But in how useful are conclusions derived from them
 As illustrated in Figure 1.1, economists employ scientific method for analyzing
these models
 Considering reality (the real world) as a starting point, an economist reduces the
complexities of reality to manageable proportions
 By developing a model of a real-world system based on economic theory
• Results in a logical model suited to explain system observed
 By logical argument (deduction), logical or model conclusions can be derived
 Hypotheses of relationship among variables
• Hypotheses are then transformed into conclusions about real world
 Economists may also employ econometrics (application of statistics to
economics) to analyze reality
 For developing an econometric model, economists use experimental abstraction
based on economic theory, which leads to experimental design
 Model is then useful in testing hypotheses derived from economic theory
 Theoretical and econometric models complement each other in developing real-
world conclusions

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Figure 1.1 Scientific
method

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 Analysis
 Relative emphasis on theoretical versus statistical models has changed over
time
 Greek tradition proves things with abstract principles (theoretical models)
• For example, proof of Pythagorean Theorem does not depend on particular size of a right
triangle
 Babylonian tradition discovers things by computation
• Such as fact that a million different right triangles all have same relation among squares of
their sides
 Greek tradition prevailed in works of past Nobel laureates such as Paul A.
Samuelson and Kenneth J. Arrow
 Applied mathematical reasoning to a minimum of data
 Ever-decreasing cost of computation due to advanced technology has increased
cost of Greek science (theoretical modeling) relative to Babylonian science
(econometric modeling)
 Elegant analysis still costs as much time and effort as it ever did, but number
crunching becomes ever cheaper
 The kinds of practical questions consumers, firms, governmental policymakers,
and economists are asking are more amenable to answers from Babylonian
economics
 For example, an econometric model can show magnitude of a reduction in pollution
from a change in a pollution standard
 In contrast, a theoretical model will generally only provide an indication of direction of
change and not magnitude 25
 Tools
 Tools employed for developing theoretical models and deriving
conclusions are prose, geometry, mathematics, and computer
programming
 Prose is ordinary language of people in speaking or writing
• Disadvantage of prose was that key features of a model were lost as it was
verbally transmitted or imitated among individuals
 Written communication solved this problem
 For relatively detailed models a great deal of writing was required
 Geometry alleviated this limitation—“a picture is worth a thousand words"
• Geometric illustrations that complement writing allow a model to be
communicated and conclusions to be developed with greater efficiency
• Geometry is an excellent tool for describing a model with two variables, such as
price and quantity
 Unfortunately, geometry is limited by its dimensions
 Geometry is not able to represent fourth, fifth, or any higher dimension
 Required of a model with more than three variables
 Mathematics allows us to enter worlds of higher dimensions and explore
their vast areas with models designed to provide insights into their workings
• If a picture is worth a thousand words, mathematics is worth the universe

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 Tools
 A model can always be communicated without
mathematics
 But mathematics greatly reduces a model’s description
and expresses it in a very concise manner
 As mathematical models become more complex
 Analytical solutions to models become difficult or
impossible
 However, advancement of computer programming
provides numerical solutions to these complex
models
 Computer programs have provided solutions to some
models that previously could not be solved

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 Models in Scientific Explanation,
Prediction, and Control
 An educated person is someone who is able to explain relationships
among facts
 Neither a list of facts nor a compilation of summary statistics from a
survey are explanations
 Facts and statistics are generally called data
 An explanation is general relation underlying data
• Data are interpreted or explained by applying theory to account for relationships
among variables
 If a model does well in explaining relationships, it can be used for
prediction
 Deriving some conclusion before it is observed
 Distinction between explanation and prediction
 Explanation is a conclusion observed first, with a model in support of the
conclusion provided afterward
 Prediction is a conclusion deduced from a model before conclusion is
observed

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 Models in Scientific Explanation,
Prediction, and Control
 Control is altering of one or more exogenous variables in a model to predict a
particular outcome
 Examples include
• Changing price of a commodity to predict change in a consumer’s purchases
• Changing pollution standard in a model to predict change in pollution
 For purposes of control, a model that provides valid explanations as well as
accurate predictions is required
 Based on models developed in following chapters, we investigate changes in
(control of ) exogenous variables—such as prices, wages, and income
 By comparing one equilibrium position to another
• Called comparative statics analysis
 Table 1.1 lists a collection of optimization models along with comparative statics
analysis developed and discussed in following chapters
 All optimization models involve either maximizing or minimizing an objective function
 Given a fixed level for exogenous variables, endogenous variables are varied to
determine optimal level of objective function
• Generally, objective function is subject to some constraint
 Such as limited income or a given level of technology

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Table 1.1 Collection of optimization
models developed in this text

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Development of Microeconomics
 Marshallian-cross analysis
 Developed in 1880 by English economist Alfred Marshall
 Figure 1.2 shows an illustration of Marshallian cross
 Per-unit price of a commodity, p, is measured on vertical axis and quantity of
commodity, Q, is measured on horizontal axis
 Marshallian cross is represented by market demand and supply curves
• As price decreases, quantity demanded for a commodity by consumers is
expected to increase
 Results in a downward or negatively sloping demand curve
• Firms supplying this commodity are expected to react to this price decline by
 Decreasing supply of commodity
 Results in an upward or positively sloping supply curve
• Point of intersection (crossing) represents market equilibrium level of price and
quantity
 Quantity Supplied = Quantity Demanded
 No incentive for consumers or firms to change their market behavior
 Market-clearing price (pe) is most efficient mechanism for allocating
scarce resources among unlimited wants
 Marshallian-cross analysis has been applied to a wide range of social
behavior
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 Figure 1.2
Marshallian Cross

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Partial-Equilibrium Versus General-
Equilibrium Models
 Marshallian cross is only a partial-equilibrium model
 Only considers one market at a time rather than all markets in an economy
 For some questions, this narrowing of perspective gives valuable insights
and analytical simplicity
 However, for broader questions about efficiency and welfare implications of
economic activities
• Narrow viewpoint may prevent discovery of important interrelations
 For answering broader questions, a general-equilibrium model is
required
 Models whole economy or some major subset
 French economist Leon Walras created basis for such an investigation
by representing economy with a number of simultaneous equations
 Created model that permits effects of a change in one market to be carried
through into other markets
 In a sense, current macroeconomics is simply an example of applied
general equilibrium analysis

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