Transcript The Art and Science of Economic Analysis  What is the economic problem?  What is the “art” of economic analysis?  What is.

1
The Art and Science of
Economic Analysis
 What is the economic problem?
 What is the “art” of economic analysis?
 What is the “science” of economic
analysis?
What Economics Is All About
 Scarcity refers to the limited nature of society’s
resources.
 Economics examines how people use their
scarce resources to satisfy their unlimited wants.
• How many hours should a student work or
study?
• How do firms decide how many works to hire
and what skill levels those workers need?
• How should a local government decide where
stoplights are needed?
1
Scarce Resources, Unlimited Wants
 Resources are the inputs used to produce the
goods and services that people want.
• Labor
• Capital
• Natural resources
• Entrepreneurial ability
 Because resources are scarce, we must make
choices.
2
How People Make Decisions
 Decision making is
at the heart of
economics.
 Understanding the
forces that shape
these choices is the
first step to
mastering the art of
economics.
3
How People Make Decisions
Rational Self-Interest
 By rational, economists mean that people try to
make the best choices they can, given the
available information.
 Individuals are assumed to be self-interested.
4
"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 self-interest.
We address ourselves, not to their
humanity but to their self-love, and
never talk to them of our own
necessities but of their advantages."
-- Adam Smith, The Wealth of Nations (1776)
5
How People Make Decisions
Choice Requires Time and Information
 Time and information are scarce and valuable.
 Information is costly to acquire.
• How do we decide how much?
6
How People Make Decisions
Economic Analysis is Marginal Analysis
 Many decisions are not “all or nothing,”
but involve marginal changes – incremental
adjustments to an existing plan.
 Evaluating the costs and benefits of marginal
changes is an important part of decision making.
7
How People Make Decisions
Economic Analysis is Marginal Analysis
Examples:
 A student considers whether to go to college
for an additional year, comparing the fees &
foregone wages to the extra income he could
earn with an extra year of education.
 A firm considers whether to increase output,
comparing the cost of the needed labor and
materials to the extra revenue.
8
How People Make Decisions
Economic Analysis is Marginal Analysis
 Rational people respond to incentives because
they make decisions by comparing costs and
benefits. Examples:
• In response to higher gas prices, sales of
“hybrid” cars rise.
• In response to higher potential fines, drivers are
less likely to speed in work zones.
9
ACTIVE LEARNING
Exercise
1:
You are selling your 1996 Mustang. You have
already spent $1,000 on repairs.
At the last minute, the transmission dies. You can
pay $600 to have it repaired or sell the car “as is.”
In each of the following scenarios, should you have
the transmission repaired?
A. The blue book value is $6,500 if the transmission
works; $5,700 if it doesn’t
B. The blue book value is $6,000 if the transmission
works; $5,500 if it doesn’t
10
Microeconomics and Macroeconomics
 Microeconomics is the study of how
households and firms make decisions
and how they interact in markets.
 Macroeconomics is the study of the economy
as a whole
 These two branches of economics are closely
intertwined, yet distinct: they address different
questions.
11
The Science of Economic Analysis
 Economists employ the scientific method,
which is the dispassionate development and
testing of theories about how the world works.
 This means the economist uses models, which
are simplifications of reality so that predictions
can be made.
 Models incorporate assumptions which may
seem unrealistic but allow us to focus on what is
important.
12
Some Familiar Models
A road map
13
Some Familiar Models
A model of human
anatomy from high
school biology
class
14
Some Familiar Models
A model airplane
15
Some Familiar Models
Don’t forget
to floss!
The model
teeth at the
dentist’s office
16
Normative Versus Positive
 A positive statement is one that can be proved or
disproved by reference to facts.
 A normative statement is one that represents an
opinion and cannot be proved or disproved.
17
2:
Identifying positive vs. normative
ACTIVE LEARNING
Which of these statements are “positive” and which
are “normative”? How can you tell the difference?
a. Prices rise when the government increases the
quantity of money.
b. The government should print less money.
c. A tax cut is needed to stimulate the economy.
d. An increase in the price of gasoline will cause an
increase in the consumer demand for video
rentals.
18
Pitfalls to Avoid
 The fallacy that association is causation
 The fallacy of composition
 The mistake of ignoring secondary effects
19
ACTIVE LEARNING
A Brain Teaser:
4:
In 1995, the federally-mandated 55-miles-per-hour
speed limit was repealed. At that time, the National
Highway Traffic Safety Administration predicted that
highway deaths would rise by 6,400 per year.
In 1998, the same organization announced that
annual traffic deaths declined from 41,817 (in 1995)
to 41,480 (in 1996).
How did this happen?
20