Second Day Lesson: A Review/Overview of EconomicsSource: Introduction to Economics by Marc Lieberman and Robert Hall

Words of Wisdom: “Man as an objective, sensuous being is therefore a suffering being—and because he feels what he suffers, a passionate being.” –Karl Marx, “The Economic and Philosophic Manuscripts”

Why study economics?

1. To understand the world better. Economics has the power to help us understand phenomena (global and cataclysmic, local and personal) because they result, in large part, from the choices we make under conditions of scarcity. It is hard to find any aspect of life about which economics does not have something important to say.

2. To gain self-confidence. Understanding basic economic principles will expand your grasp of world events and increase your confidence as you face the future. You need no longer feel that there is a mysterious, inexplicable forces shaping your life. When you master economics, you gain a sense of mastery over the world, and thus over your own life as well.

3. To achieve social change. To make the world a better place, economics is indispensable. Economics can help us understand the origins of serious social problems (e.g. unemployment, hunger, poverty, disease, child abuse, drug addiction, violent crime), explain why previous efforts to solve them have failed, and enable us to design new, more effective solutions.

4. To help prepare for other careers. Practitioners in various field (business, politics, international relations, law, medicine, engineering, psychology, etc.) often find themselves confronting economic issues and so economics has become a popular college course.

5. To become an economist. If you decide to pursue a career as an economist—obtaining a master’s degree or even a Ph.D.—you will find many possibilities for employment: teaching at colleges or universities, engagement in variety of activities both in the private sector and the government. Work includes assessing the risk of investing abroad for banks, determining new methods of producing, marketing, and pricing products for manufacturing companies; helping design policies to fight crime, disease, poverty, and pollution for government agencies; helping create programs for less developed counties for international organizations; helping the public interpret global, national, and local events in media; providing advice on controlling costs and raising funds more effectively for nonprofit organizations.

What is the method of economics?

Economics relies heavily on models. This discipline goes beyond any other social science in its insistence that every theory be represented by an explicit, carefully constructed model. A model is an abstract representation of reality. It is made up of words, diagrams, and mathematical statements. A model is not supposed to be exactly like reality. Rather, it represents the real world by abstracting, or taking from it, that which will help us understand it. There is much in the real world that a model must leave out.

What is the guiding principle in building a model?

A model should be as simple as possible to accomplish its purpose. A model should contain all necessary details—but no unnecessary ones (e.g. a map).

What are the assumptions and conclusions on every economic model?

Every economic model begins with assumptions about the way decision makers in the economy behave. There are two types of assumptions in a model: simplifying assumptions and critical assumptions.

1. Simplifying assumption- a way of making a model simpler, without affecting may of its important conclusions. The purpose of this is to rid a model of extraneous detail, so its essential features can stand out more clearly. We make assumptions not because they are true, but because they make a model easier to follow and do not change any of the important insights we can get from it.

2. Critical assumption- any assumption that affects the conclusions of a model in an important way. In an economic model, there is always one or more critical assumptions, economists like to make these assumptions explicit from the very beginning. By stating the conclusion up front, we see immediately where the model’s conclusions spring from.

How does an economist make sense of the complexity of an economy?

In two steps:

1. The decision makers in the economy are divided into three broad groups: households, business firms, and government agencies.

a. Microeconomic models- focus on the behavior of individual households, firms, and government agencies and how they interact with each other

b. Macroeconomic models- group decision makers together into sectors—the household sector, the business sector, the government sector, and the foreign sector—and study how each sector interacts with the others.

2. Make two critical assumptions about decision makers:a. “Every economic decision maker tries to make the best out of any situation.” This means

maximizing some quantity (e.g. households maximize utility—their well-being or satisfaction; firms maximize profits; managers maximize power, prestige, job security). There may be a disagreement about what is being maximized, but there is virtually a unanimous agreement that any economic model should begin with the assumption that someone is maximizing something.

i. Implication 1- we are all engaged in a relentless, conscious pursuit of narrow goals—an implication contradicted by much of human behavior. How do we maximize our own being?

Why do economists assume that people make decisions consciously, when, in reality, they often don’t? The ultimate purpose of building an economic model is to understand and predict behavior—the behavior of households, firms, government, and the overall economy. As long as people behave as if they are maximizing something, then we can build a good model by assuming that they are. Whether they actually, consciously maximize anything or not.

ii. Implication 2- it does not imply that people are selfish or that economists think they are. On the contrary, economists are very interested in cases where people take the interests of others into account (e.g. family context, friendship, neighborhood, etc.)

b. “Every economic decision maker faces constraints.” Households are constrained by limited incomes, business firms are constrained by requirements that they pay for all of the inputs they use, and government agencies are constrained by limited budgets.

What are the three questions that serve as the beginning for any economic analysis and planning?

1. Who are the individual decision makers?2. What are they maximizing?3. What constraints do they face?

What are the basic principles of economics?

The basic principles of economics are ideas that are used again and again to analyze economic problems. They form the foundation upon which economic theory is built. Here are the Eight Basic Principles of Economics:

Basic Principle #1—Maximization Subject to Constraints: The economic approach to understanding a problem is to identify the decision makers, and then determine what they are maximizing and the constraints that they face.

Basic Principle #2—Opportunity Cost: All economic decisions made by individuals or society are costly. The correct way to measure the cost of a choice is its opportunity cost—that which is given up to make the choice.

Basic Principle #3 –Specialization and Exchange: Specialization and exchange enable us to enjoy greater production and higher living standards than would otherwise be possible. As a result, all economies exhibit high degrees of specialization and exchange.

Basic Principle #4 –Markets and Equilibrium: To understand how the economy behaves, economists organize the world into separate markets and then examine the equilibrium in each of those markets.

Basic Principle #5 –Policy Tradeoffs: Government policy is constrained by the reactions of private decision makers. As a result, policy makers face tradeoffs: Making progress toward one goal often require some sacrifice of another goal.

Basic Principle #6 –Marginal Decision Making: To understand and predict the behavior of individual decision makers, we focus on the incremental or marginal effects of their actions.

Basic Principle #7 –Short-Run versus Long-Run Outcomes: Markets behave differently in the short run than in the long run. In solving a problem, we must always know which of these time horizons we are analyzing.

Basic Principle #8 –The Importance of Real Values: Since our economic well-being depends, in part, on the goods and services we can buy, it is important to translate from nominal values—which are measured in current dollars (peso)—to real values—which are measured in purchasing power.

Next Lesson: Part 4: Macroeconomics: Basic Concepts

What are the concerns of macroeconomics? What is its approach? pp.297-304 (Haque)What is GDP? Pp.309-324 (Adolfo and Damos)What are employment and unemployment concerns in macroeconomics? pp.325-334 (Debuque)How do we measure price level and inflation? pp.342-352 (Maruya)