M01 Miller554844 16 Econ C01

Chapter 1
The Nature
of Economics
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Introduction
Today, the U.S. government is part owner of some

major U.S. banks.
What greater government control means for decision
making about what and how much to produce, how to
organize production, and who obtains the items
produced?
You will learn the answer to this question in this
chapter.

1-2
Learning Objectives
• Discuss the difference between

microeconomics and macroeconomics
• Evaluate the role that rational self-interest
plays in economic analysis
• Explain why the study of economics
is a science
• Distinguish between positive and
normative economics

1-3
Chapter Outline
• The Power of Economic Analysis

• Defining Economics
• The Three Basic Economic Questions and
Two Opposing Answers
• The Economic Approach: Systematic
Decisions
• Economics as a Science
• Positive versus Normative Economics

1-4
Did You Know That ...
• Economics is one of the fastest-growing

college majors?
• During the past 10 years, the number of
students majoring in economics at U.S.
colleges has increased by 40%?
• Economics majors typically land higher
paying jobs than other majors?

1-5
The Power of Economic Analysis
• Incentives
– Rewards for engaging in a particular activity
– The nature of individuals’ self-interested
responses to incentives is the starting point for
economic analysis

1-6
The Power of Economic
Analysis (cont'd)
• The economic way of thinking is a
framework to analyze solutions to
economic problems.
– How much time to study
– Choosing which courses to take
– Whether the U.S. government should
encourage or discourage immigration

1-7
Analysis (cont'd)
• The economic way of thinking gives you
the power—the power to reach informed
conclusions about what is happening in the
world.
• Economic analysis helps you make better
decisions, and increases your
understanding when watching or reading
the news on the Web.

1-8
Analysis (cont'd)
• Economic analysis is a way of thinking
about all decisions.
– Your education, career, financing your home,
family
– Your involvement in the business world, or in
politics as a voter

1-9
Defining Economics
• Economics
– The study of how people allocate their limited
resources to satisfy their unlimited wants
– The study of how people make choices

1-10
Defining Economics (cont'd)
• Resources
– Things used to produce other things to satisfy
people’s wants
• Wants
– What people would buy if their incomes were
unlimited

1-11
• With limited income (resources), people

must make choices to satisfy their wants.
• We never have enough of everything,
including time, to satisfy our every desire.

1-12
• Individuals, businesses, and nations face

alternatives, and choices must be made.
• Economics studies how these choices are
made.

1-13
Microeconomics
versus Macroeconomics
• Microeconomics
– The study of decision making undertaken by
individuals (or households) and by firms
– Like looking though a microscope to focus on
the smaller parts of the economy
• The effects of changes in gasoline prices
• A family’s choice of having a baby
• An individual firm’s decision to advertise

1-14
Microeconomics
versus Macroeconomics (cont'd)
• Macroeconomics
– The study of the behavior of the economy as a
whole
– Deals with economywide phenomena
• The national unemployment rate
• The rate of inflation
• The yearly output of goods and services in a nation

1-15
Microeconomics
versus Macroeconomics (cont'd)
• Macroeconomics deals with aggregates, or
totals—such as total output in an
economy.
• Modern economic theory blends micro and
macro concepts.

1-16
The Three Basic Economic Questions and
Two Opposing Answers
• Economic System
– The institutional mechanism through which
resources are utilized to satisfy human wants

1-17
Two Opposing Answers (cont’d)
• Three economic questions:

1. What and how much will be produced?
2. How will items be produced?
3. For whom will items be produced?

1-18
• Two opposing answers in the form of

economic systems:
– Centralized command and control (central
planning): Authority that makes all economic
decisions
– Price system (market system): Decentralized
decision making process in which prices are
terms (signals) under which people agree to
make exchanges

1-19
• Economic systems of the world’s nations

(e.g., U.S.) are mixed systems that
incorporate aspects of both centralized
command and control and a decentralized
price system

1-20
The Economic Approach:
Systematic Decisions
• Economists assume that individuals act as
if motivated by self-interest and respond
predictably to opportunities for gain.

1-21
Systematic Decisions (cont’d)
“It is not from the benevolence of the
butcher, the brewer, or the baker that we
expect our dinner, but from their regard to
their own interest.”
—Adam Smith, An Inquiry into the Nature and
Causes of the Wealth of Nations, 1776

1-22
International Example: Indian Men Living in the
United States Become Ineligible Bachelors
• For Indian men working in the United States,

finding a bride back in India has become more
difficult.
• Today an increasing number of Indian women opt
for married life in India, where jobs are plentiful,
instead of marrying to a man in the United States,
where the unemployment rate has exceeded 10
percent.

1-23
• Rationality Assumption
– The assumption that people do not intentionally
make decisions that would leave them worse
off

1-24
• Questions
– Does the fact that some people make
apparently irrational choices invalidate the
rationality assumption in economics?
– Can economic models be applied to situations
in which behavior is at odds with what we
expect from rational people?

1-25
• Responding to incentives
– Rationality and the use of incentives
• Positive incentives
• Negative incentives
– Making choices
• Balancing cost and benefits

1-26
• Some examples of incentives
– Responding to positive incentives
• Schoolchildren getting gold stars, working to have a
“better life” for yourself
– Responding to negative incentives

• Penalties, punishments, using credit cards to avoid
check overdrafts

1-27
Policy Example: The Government Gives Everyone
an Incentive to Own a Golf Cart
• The U.S. government and some state

governments offer tax credits to people buying
electric vehicles, including golf carts.
• Golf carts sales have soared as many people have
found that these tax credits were sufficient to
fund more than two-thirds of the price of a
qualifying golf cart.

1-28
• Defining self-interest
– The pursuit of one’s goals, does not always
mean increasing one’s wealth
• Prestige
• Friendship
• Love

1-29
Example: The Perceived Value of Gifts
• Often the recipient of the gift places a

value on it far less than the market value.
• Should we substitute gift certificates for
physical gifts?

1-30
Economics as a Science (cont’d)
• Economics is a social science that employs

the same kinds of methods used in other
sciences, such as biology.
• Economics uses models.

1-31
Economics as a Science
• Models or Theories
– Simplified representations of the real world
used as the basis for predictions or
explanations
– Should capture only the essential relationships
that are sufficient to analyze a problem
– Cannot be faulted as unrealistic simply because
it does not represent every detail of the real
world
• A map is the quintessential model

1-32
Economics as a Science (cont'd)
• Assumptions
– The set of circumstances in which a model is
applicable
– Every model, or theory, must be based on a set
of assumptions.

1-33
Example: Getting Directions
• A map is a simplifying model of reality.

• The degree of simplification varies across maps;
some contain more detail than others.
• Economic models attempt to focus on what is
relevant to the problem at hand and omit what is
not.

1-34
• Ceteris Paribus Assumption

[KAY-ter-us PEAR-uh-bus]
– Nothing changes except the factor or factors
being studied.
– “Other things constant”
– “Other things equal”

1-35
• Economics is an empirical science.

– Real-world data is used to evaluate the
usefulness of a model.
– Models are useful if they predict economic
phenomena.
– Economic models predict how people react, not
how they think.

1-36
• Behavioral Economics
– Approach to the study of consumer behavior
• Emphasizes psychological limitations and
complications which may interfere with rational
decision making
– Proponents believe that it is “unrealistic” to
assume:
• Unbounded selfishness
• Unbounded willpower
• Unbounded rationality

1-37
• Bounded Rationality
– Hypothesis that people are nearly, not fully,
rational
• They cannot examine every choice available to them
• They appear to use rules of thumb to sort alternatives

1-38
Why Not … try to increase blood donations by
offering small payments to donors?
• To encourage more people to give blood, some

governments now provide small payments to
blood donors.
• But some people who have previously donated
blood may become less likely to respond to blood
drives because they believe the financial
payments might make them look “greedy” by
selling blood instead of making a sacrifice.

1-39
Positive versus
Normative Economics
• Positive Economics
– Purely descriptive statements or scientific
predictions; “If A, then B,” a statement of what
is
• Normative Economics
– Analysis involving value judgments; relates to
whether things are good or bad, a statement of
what ought to be

1-40
You Are There: A Movie Producer Responds to
Incentives
• Initially, movie producer Ingo Volkammer planned

to film the action movie Velocity in North America.
• Later the Spanish and German governments
offered him subsidies to cover much of the firm’s
production cost.
• But still later changes in the euro’s value raised
the dollar-denominated cost of filming in Europe,
so that Volkammer eventually returned the
climactic scenes to North America.

1-41
Issues & Applications: In Many U.S. Industries,
Command and Control Rules
• In 2008, the U.S. government required a number

of U.S. banks to accept taxpayer-funded
purchases of ownership shares in those banks.
• Even though banks, including JPMorgan Chase
and Bank of America, have bought back the
government’s shares, the government will likely
remain a large shareholders at Citigroup and
some other major banks.
• In 2009 and 2010, government command and
control also spread to the auto and health care
industries.

1-42
Figure 1-1 Banks Receiving the Largest
Amounts of U.S. Government Funding

1-43
Summary Discussion
of Learning Objectives
• Microeconomics versus macroeconomics
– Economics is the study of how individuals make
choices to satisfy wants
– Microeconomics is the study of decision making
by individual households and individual firms
– Macroeconomics is the study of nationwide
phenomena, such as inflation and
unemployment levels

1-44
Summary Discussion
of Learning Objectives (cont'd)
• Self-interest in economic analysis
– Rational self-interest is the assumption that
individuals behave in a reasonable (rational)
way in making choices to further their interests

1-45
Summary Discussion
• Economics as a science
– Economists use models, or theories, that are
simplified representations of the real world to
analyze and make predictions about the real
world

1-46
Summary Discussion
• The difference between positive and
normative economics
– Positive economics deals with what is, whereas
normative economics deals with what ought to
be
– Positive statements are of the “if…then”
variety, while normative ask what “should, or
could” be

1-47
Appendix A: Reading and Working with
Graphs
• Independent Variable
– A variable whose value is determined independently of,
or outside, the equation under study
• Dependent Variable
– A variable whose value changes according to changes in
the value of one or more independent variable

1-48
Appendix A: Direct and Inverse
Relationship
• Direct Relationship
– A relationship between two variables that is positive,
meaning that an increase in one variable is associated
with an increase in the other and a decrease in one
variable is associated with a decrease in the other
• Inverse Relationship
– A relationship between two variables that is negative,
meaning that an increase in one variable is associated
with a decrease in the other and a decrease in one
variable is associated with an increase in the other

1-49
Table A-1 Gas Mileage as a Function of
Driving Speed

1-50
Figure A-1 Direct and Inverse Relationships

1-51
Appendix A: Constructing a Graph
• Number Line
– A line that can be divided into segments of equal length,
each associated with a number
• y Axis
– The vertical axis in a graph
• x Axis
– The horizontal axis in a graph
• Origin
– The intersection of the y axis and the x axis in a graph

1-52
Figure A-2 Horizontal Number Line

1-53
Figure A-3 Vertical
Number Line

1-54
Figure A-4 A Set of Coordinate Axes

1-55
Table A-2 T-Shirts Purchased

1-56
Figure A-5 Graphing the Relationship
Between T-Shirts Purchased and Price

1-57
Figure A-6 Connecting the Observation
Points

1-58
Figure A-7 A Positively Sloped Curve

1-59
Appendix A: The Slope of a Line (A Linear
Curve)
• Slope
– The change in the y value divided by the corresponding
change in the x value of a curve
– The “incline” of the curve
– “Rise” over “run”

1-60
Figure A-8 Figuring Positive Slope

1-61
Figure A-9 Figuring Negative Slope

1-62
Figure A-10 The Slope of a Nonlinear Curve

1-63

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Chapter 1

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Today, the U.S. government is part owner of some

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

• Discuss the difference between

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

• The Power of Economic Analysis

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

• Economics is one of the fastest-growing

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

• With limited income (resources), people

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

• Individuals, businesses, and nations face

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

• Three economic questions:

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

• Two opposing answers in the form of

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

• Economic systems of the world’s nations

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

• For Indian men working in the United States,

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

– Responding to negative incentives

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

• The U.S. government and some state

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

• Often the recipient of the gift places a

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

• Economics is a social science that employs

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

• A map is a simplifying model of reality.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

• Ceteris Paribus Assumption

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

• Economics is an empirical science.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

• To encourage more people to give blood, some

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

• Initially, movie producer Ingo Volkammer planned

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

• In 2008, the U.S. government required a number

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.