Miller 14e 447476_01

Chapter 1

The Nature of Economics

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 1-2

Introduction

Rhesus monkeys are willing to forgo 10% of their “income” of cherry juice to examine photos of leading and attractive members of their group.

This behavior mirrors our willingness to purchase celebrity magazines.

Nevertheless, economists who study making choices in response to rewards or inducements, propose some are willing to pay to be viewed by others as leading and attractive members of our society.

What can economists tell us about why people purchase items that attract attention such as flashy sports cars or designer clothing?


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


Chapter Outline

• The Power of Economic Analysis

• Defining Economics

• Microeconomics versus Macroeconomics

• The Economic Person: Rational Self-Interest

• Economics as a Science

• Positive versus Normative Economics


Did You Know That ...

• Six of seven main U.S. railroad lines meet in Chicago?

• The bottlenecks these lines caused created incentives to lay more track?

• Incentives are the underpinnings for all the decisions you and others make?


The Power of Economic Analysis

• Incentives Rewards for engaging in a

particular activity


• 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 troops should be sent abroad

The Power of Economic 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.



• 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


Defining Economics

• Economics

The study of how people allocate their limited resources to satisfy their unlimited wants

The study of how people make choices


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



• 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.



• Individuals, businesses, and nations face alternatives, and choices must be made.

• Economics studies how these choices are made.


Microeconomicsversus 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 economyDecision of a worker to work overtime or not

A family’s choice of having a baby

An individual firm advertising


Microeconomicsversus Macroeconomics (cont'd)

• Macroeconomics

The study of the behavior of the economy as a whole

Deals with economywide phenomenaThe national unemployment rate

The rate of growth in the money supply

The national government’s budget deficit


Microeconomicsversus Macroeconomics (cont'd)

• Macroeconomics deals with aggregates, or totals—such as total output in an economy.

• Modern economic theory blends micro and macro concepts.


The Economic Person:Rational Self-Interest

• Economists assume that individuals act as if motivated by self-interest and respond predictably to opportunities for gain.


The Economic Person:Rational Self-Interest (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



• Rationality Assumption

The assumption that people do not intentionally make decisions that would leave them worse off


Example: “Neuroeconomics” Explores the Rationality Assumption

• Economists want to know which parts of the brain play the greatest role in determining an individual’s choices.

• Brain scans reveal considerable coordination between the limbic system (governing emotions) and the prefrontal cortex (associated with reason and calculation).

• There is evidence the brain attempts to factor in reasoned calculations aimed at making a choice consistent with the “best” overall outcome.



• 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?



• Responding to incentives

Rationality and the use of incentivesPositive incentives

Negative incentives

Making choicesBalancing cost and benefits



• Some examples of incentives

Responding to positive incentivesSchoolchildren getting gold stars, working to

have a “better life” for yourself

Responding to negative incentivesPenalties, punishments, using credit cards to

avoid check overdrafts


E-Commerce Example: Playing the Float with Plastic Instead of Checks

• Checks used to take up to several days to clear.

• People would rush to make deposits to avoid overdraft charges.

• Technological developments enhanced digital imaging, and banks have reduced check float.

• This has provided incentives for more credit card purchases—as they allow for deferred payment.

• How might high interest rates influence incentives to use credit cards?



• Defining self-interest

The pursuit of one’s goals, does not always mean increasing one’s wealthPrestige

Friendship

Love


Example: The Perceived Value of Gifts

• 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?


Economics as a Science

• Models or Theories

Simplified representations of the real world used as the basis for predictions or explanationsA map is the quintessential model


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.


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.



• Ceteris Paribus Assumption[KAY-ter-us PEAR-uh-bus]

Nothing changes except the factor or factors being studied.

“Other things constant”

“Other things equal”



• 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.



• Behavioral Economics

Approach to the study of consumer behavior Emphasizes psychological limitations

and complications which may interfere with rational decision making



• Bounded Rationality

Hypothesis that people are nearly, not fully, rational They cannot examine every choice available

to them

Use simple rules of thumb to sort alternatives


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


Issues and Applications: Do People Engage in Conspicuous Consumption?

• In 1902, economist Thorstein Veblin coined the phrase conspicuous consumption.

• Ori Heffetz of Princeton University looked for empirical evidence to support Veblin’s idea.

• Evidence showed higher-income people buy visible items.


Issues and Applications: Do People Engage in Conspicuous Consumption? (cont'd)

• Is conspicuous consumption for real or just a rational response to higher income?


Summary Discussionof 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.


Summary Discussionof 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.



• 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.



• 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.

End of Chapter 1

The Nature of Economics

Education

Miller 14e 447476_01