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What is Economics? • Scarcity – a basic human dilemma – Limited resources vs. unlimited wants – The human condition requires making choices • Definitions of Economics – Mankiw’s definition • …is the study of how society manages its scarce resources – Hedrick’s definition • …is how society chooses to allocate its scarce resources among competing demands to improve human welfare – Alternative definitions • … what economists do. • … is the study of choice. • Fundamental Questions of Economics - Scarcity requires all societies to answer the following questions: – What is to be produced? – How is to be produced? – For whom will it be produced WHFM Questions How Do Economists Study Human Behavior? • Economics as a Science – The scientific method • Observation→Theory→Data→Testing – Rational Behavior • Weighing benefits and costs and maximizing total net benefits • Marginal vs. Total Thinking – Economic Theory and Models • Simplification by assumption • Ceteris Paribus – Holding other factors constant • Prediction vs. realism – Microeconomic versus Macroeconomics – Bias towards use of natural rather than controlled experiments – The specialized language of economics (e.g. “He has lots of money.”) • Money – medium of exchange • Wealth – accumulated financial and non-financial assets • Income – the purchasing power earned during a given period Why do Economists Study Human Behavior? • Scientists versus policy makers • Positive Economics – Descriptive - what the world is like. – Objective- value judgments need not be made – Positive statements can theoretically be tested by appealing to the facts • Normative Economics – Prescriptive - what the world ought to be like – Subjective – value judgments must be made – Normative statements cannot be tested appealing to facts. Categories of Basic Principles of Economics • How do people make decisions? • How do people interact? • How does the economy work overall? How Do People Make Decisions? • Principle #1 - People face tradeoffs – Time allocation – an example of tradeoffs – Efficiency versus equity – Production Possibilities Frontier • Principle #2 - The cost of something is what you have to give up to get it – Opportunity costs come from Von Weiser, a German economist late 1800s – Opportunity costs are independent of monetary units – TINSTAAFL – The real costs of going to college • Principle #3 - Rational people think at the margin – Rational or irrational decision-making – Marginal benefits and costs versus total benefits and costs – Weighing marginal costs and benefits leads to maximizing net benefits (total welfare) – The boxes example . • Principle #4 –People respond to incentives – Reactions to changes in marginal benefits and costs – Increases (decreases) in marginal benefits mean more (less) of an activity – Increases (decreases) in marginal costs mean less (more) of an activity – Example of seat belts leading to increased speeds – Example of SUV (with child car seat) in Issaquah How Do People Interact? • Principle #5 - Trade can make everybody better off – Adam Smith author of the “An Inquiry into the Causes and Consequences of the Wealth of Nations” 1776 – Gains from the division of labor and specialization – Mercantilists perspectives – Example of why Ellensburg • Principle #6 - Markets are usually a good way of organizing economic activity – feudal times where feudal states were self-supporting, also haciendas in the new world – the benefits of trade are so powerful that people began to trade – markets for economists are more abstract than the notion of a middle eastern bazaar or a flea market and simply determine the prices and quantities traded of different goods and services – the “failure” of centrally planned economies and the movement towards markets for the WHFM questions Markets – Principles 1-5 combine with markets to turn the pursuit of self-interest into promoting the interests of society – Adam Smith and the “invisible hand” – creativity and productivity are stimulated by the pursuit of self-interest into improving resource allocations – “set it and forget it” becomes “compete or be obsolete” – in some cases markets fail to allocate resources effectively so, • Principle #7 Governments can sometimes improve interaction that occurs in markets – there are circumstances when market signals fail to allocate resources efficiently or equitably – Public Goods, Externalities and Income Distribution – Some goods or services that people desire will not be produced by markets (e.g. lighthouses). – Some goods or services will either be underproduced (vaccines) or overproduced (pollution) because markets fails to register certain benefits or costs. – markets may also fail to provide an equitable or fair distribution of resources – government intervention with its ability to coerce (the opposite of voluntary) can regulate, tax and subsidize to change market outcomes – efficiency and equity: the pie analogy – if government intervention always the proper solution? How Does the Economy Work as a Whole? • Principle # 8 – A country’s standard of living depends upon its ability to produce goods and services – Adam Smith’s “An Inquiry into the Nature and the Consequences of the Wealth of Nations” – Materialism – more toys mean more welfare – wealth: a necessary or sufficient condition for happiness (are rich people happier, children with lots of toys) – leisure time and productivity – the factors of production: land or natural resources, labor, capital, entrepreneurship – technology and productivity – the rule of 72 for growth rates • Principle #9 – The general level of prices rises when the government prints and distributes too much money – definition of money, the concept of snow to Inuits, and economic language – inflation is an increase in the general or average level of prices in an economy – “not worth a continental” and recent example in Argentina – the establish of the Federal Reserve and the introduction of sustained inflation in the US • Principle #10 – Society faces a short-run tradeoff between inflation and unemployment – Short-run and the long-run – demand and supply shocks – short-run increases (decreases) in output above (below) long-run potential output lead to adjustments – countercyclical stabilization versus pro-cyclical destabilization – political business cycles