CHAPTER 1

Economics and
Economic
Reasoning
 Chapter Objectives:
• Define economics and list three coordination problems that
an economy must solve.
• Explain how to make decisions by comparing marginal costs
and marginal benefits.
• Define opportunity cost and explain its relationship to
economic reasoning.
• Explain real-world events in terms of economic forces, social
forces and political forces.
• Differentiate bet. Microeconomics and macroeconomics
• Distinguish among positive economics , normative economics
and the art of economics.
 What is Economics?
It is the study of how human beings
coordinate their wants and desires,
given the decision-making
mechanisms, social customs and
political realities of the society.
Three Central Problems facing an
economy
• What and how much to produce.
• How to produce it.
• For whom to produce it.
 To understand an
economy we/you need to
learn:
• Economic reasoning
• Economic terminology
• Economic insights
• Economic institutions
• Economic analysis
• Economic policy options
 Economic Reasoning (ER)
ER will simply provides a framework within
which to approach a question, thus, in
economic way of thinking, every choice
has costs and benefits, and decisions are
made by comparing them.
 Marginal Costs and Marginal Benefits

Marginal Cost – is the additional cost to you

over and above the costs you have already
incurred. (not counting sunk costs – costs that
have already been incurred and cannot be
recovered)
Marginal Benefit – is the additional benefit
above what you already derived.
 Economic Decision Rule
• If the marginal benefits of doing something
exceed the marginal costs, do it.
• If the marginal costs of doing something
exceed the marginal benefits, don’t do it.

(Opportunity Cost of undertaking an activity is

the benefit foregone by undertaking that
activity)
 Economic Terminology (ET)
ET needs little discussion. It simply needs
learning. (opportunity cost, the invisible hand,
market forces, economic forces, etc.)
• Invisible Hand Theory – is the price
mechanism, the rise and fall of prices that
guides our action in the market.(people tend to
allocate resources efficiently)
• Economic Forces – are rationing mechanisms
that are necessary reactions to scarcity.
• Market Force – is an economic force that is
given relatively free rein by society to work
through the market. (Ex. Shortage & surplus to
price)
• Game Theory
 Economic Insight (EI)
Are theories often based on generalizations about
the workings of an abstract economy. Since
theories are inevitably too abstract to apply in
specific cases, thus, it is embodied in an economic
model.
Economic model – is a framework that places the
generalized insights of the theory in a more
specific contextual setting or an economic
principle (a commonly held economic insight
stated as a law or general assumption).
 Economic Institution (EI)
Are laws, common practices and organizations in
a society that affect the economy. (Banks in
Germany vis-à-vis US banks and Netherland’s
workers vs. workers of US)
 Economic Policies (EP)
Are actions or inaction taken by the
government to influence economic
activities and actions.(Examples: should
the government restrict mergers
between firms? Should it decrease the
taxes? Should it run a budget deficit?)
 Economic Analysis
is the process of directing economic
relationship by examining economic behavior
and events, and determining the causal
relationships among the data and activities
observed.
 Purposes of economic analysis
1. Economic analysis is an aid in
understanding how economy operates because
it explains how economic variables are related
to one another.

2. It permits prediction of the results of

changes in the economic variables.

3.It serves as basis of policy formulation.

MICROECONOMICS – is the study of
how individual choice is influenced
by economic forces.

MACROECONOMICS – is the study of

the economy as a whole. It considers
the problems of inflation,
unemployment, business cycles and
growth.
 Classify the following topics as
macroeconomics or microeconomics:
• The impact of a tax increase on
aggregate output.
• The relationship between two competing
firm’s pricing behavior.
• A farmer’s decision to plant soy or
wheat.
• The effect of trade on economic growth.
Positive economics – is the study of what is
and how economy works. It ask question such
as how do price restrictions affect market
forces which fall under the heading of
economic theory.
Normative economics – is the study of what
the goals of the economy should be. It ask
question what should the distribution of
income be.
 Art of Economics
Is the application of the knowledge learned
in positive economics to the achievement
of the goals one has determined in
normative economics.