Explanation of Economics 1

A definition for economics:

· All economic questions arise because we want more than we can get.

· What each one of us can get is limited by time, by the income we earn and by the prices we must pay.

· Our inability to satisfy all of our wants is called scarcity.

· We face scarcity as a society. We want to provide better healthcare and better education and a cleaner environment and so on.

· Faced with scarcity, we must choose among the available alternatives.

· The choices we make depend on the incentives that we face. An incentive is a reward that encourages or a penalty that discourages and action.

Economics is the social science that studies the choices that individuals, businesses, governments and entire societies make as they cope with scarcity and the incentives that influence and reconcile those choices.

Economics is divided into 2 main parts:

· Microeconomics

o Microeconomics is the study of the choices that individuals and businesses make, the way these choices interact in the markets and the influence of governments.

· Macroeconomics

o Macroeconomics is the study of the performances of the national economy and the global economy.

Two Big Economic Questions:

· How do choices end up determining what, how and for whom goods and services get produced?

· When do choices made in the pursuit of self-interest also promote the social-interest?

What, How and For Whom?

Goods and services are the objects that people value and produce to satisfy wants.

· Goods are physical

· Services are actions performed

What? (What gets produced)

· What we produce changes over time.

· New technologies allow us to produce more objects.

· Technological advancements make us more productive at producing more food and manufactures.

How? (How it gets produced)

· Goods and services get produced by using productive resource that economists call the factors of production.

· Factors of production are grouped into 4 categories:

o Land

o Labour

o Capital

o Entrepreneurship

Land:

· Natural Resources

· Included land in every day sense.

· Also metal ores, oil, gas and coal, water, air, wind and sunshine.

· Our lands surface and water resources and renewable.

· Some of our mineral resources are recyclable.

· The resources that we use to create energy are non-renewable. (can only be used once).

Labour:

· The work time and work effort that people devote to producing goods and services.

· Labour includes the physical and metal efforts of all the people who work on farms and construction sites and in factories, shops and offices.

· The quality of labour depends on human capital, which is the knowledge and skill people obtain from education, on-job training and work experience.

Capital:

· The tools, instruments, machines, buildings and other constructions that businesses now use to produce goods and services are called capital.

· We talk about money, shares and bonds as Financial Capital. Financial capital plays an important role in enabling businesses to borrow the funds that they use to buy capital.

Financial capital is not used to produce goods and services, it is not a factor of production!

Entrepreneurship:

· The human resource that organizes labour, land and capital is called entrepreneurship.

· Entrepreneurs come up with new ideas about what and how to produce, make business decisions and bear risks that arise from these decisions.

For Whom?

Who gets the goods and services that are produced depends on the income that people earn. A large income enables a person to buy large quantities of goods and services. A small income leaves a person with few options and small quantities of goods and services.

People earn their incomes by selling the services of the factors of production they own:

1. Land earns rent.

2. Labour earns wages.

3. Capital earns interest.

4. Entrepreneurship earns profit.

Which factor of production earns the most income?

Labour – Wages and fringe benefits are around 70% of total income. Land, capital and entrepreneurship shares the rest.

When is the Pursuit of Self-Interest in the Social Interest?

Self-Interest:

· Your own choices are the best ones for you.

· One does not always think how their choices affect other people.

· You make choices that are in your self-interest.

Social Interest:

· Could it be possible that when each one of us makes choices that are in our best interest, it turns out that these choices are also best for society as a whole?

· Choices that are best for society as a whole are said to be in the social interest.

· Economists have been trying to find an answer to this question since 1776, the year of the American Revolution.

· Also the year of Adam Smith’s book, The Nature and Causes of the wealth of Nations.

The Economic way of Thinking

Choices and Trade-Offs

· Because we face scarcity, we must make choices. And when we make choices we must select from a range of alternates.

· You can think about your choice as a trade-off. A trade-off is an exchange – giving up one thing to get something else.

What, How and For Whom Trade-offs

What Trade-Offs:

· What goods and services get produced depends on choices made by each one of us, by our government and by the businesses that produce the things we buy.

· Each one of us faces a trade-off when we choose how to spend our income.

· The government faces a trade-off when it decided how to spend our tax money.

· Businesses face a what trade-off when they decided what goods to produce and in what quantities.

How Trade-Offs:

· How goods and services get produced depends on choices made by the businesses that produce the things we buy.

· EG; Blockbuster Video Rentals opens a new store with automated vending machines and closes a traditional store with manual service.

· Blockbuster trades-off labour for capital.

For Whom Trade-offs

· For whom goods and services get produced for depends on the distribution of buying power. Buying power can be redistributed – transferred from one person to another –in three ways:

o By voluntary payments

o By theft

o Through taxes and benefits organized by government.

· Redistribution brings a trade-off.

· Each one of us faces a for whom trade-off when we choose how much to contribute to an Oxfam appeal.

· You donate; you trade-off your own spending for a small increase in economic equality.

· We face a for whom trade-off when we vote to make theft illegal and devote resources to law enforcement; we trade-off goods and services for an increase in the security of our property.

· We also face a for whom trade-off when we vote taxes and welfare arrangements that redistribute buying power from the rich to the poor. Government redistribution confronts society with what we call the big trade-off – the trade-off between equality and efficiency. Taxing the rich and making transfers to the poor bring greater economic equality. But taxing productive activities such as running a business, working hard and saving and investing in capital discourages these activities.

· So taxing productive activities means producing less.

· A more equal distribution means there is less to share.

Choices bring Change

· What, How and For Whom goods and services get produced changes over time.

· And choices bring change.

· The quantity and range of goods and services found in Europe is much greater than that found in Africa.

· And the economic condition of Europeans today is much better than it was a generation ago.

· But the quality of economic life (and its rate of improvement) does not depend purely on nature and luck.

· It depends on the choice made by each one of us, by governments and by businesses.

· And these choices involve trade-offs.

· One choice is that of how much of our income to consume and how much to save.

· The more we save and invest, the more goods and services we will be able to produce in the future.

· A second choice is how much effort to devote to education and training.

· By becoming better educated and more highly skilled, we become more productive and are able to produce more goods and services.

· If everyone become better educated, production increases and income per person rises.

· A third choice, usually made by businesses, is how much to effort to devote to research and development of new products and production methods.

Opportunity Cost

· Every choice involves a cost.

· The Opportunity Cost of something is the value of the next best alternative that we give up to get it.

· The opportunity cost of more goods and services in the future is less today.

Choosing at the Margin

· Choices are not all or nothing.

· You decide how many minutes to dedicate to each activity.

· To make this choice you compare the benefit with the cost.

· You make a choice at the Margin.

· The benefit that arise from an increase in activity is called the Marginal Benefit.

· The cost of an increase in activity is called the Marginal Cost.

Responding to Cost

· A change in marginal cost or marginal benefit changes the incentives that we face and leads us to change our choices.

· A central idea in economics is that we can predict how choices will change by looking at the change in incentives.

· More of an activity occurs when the marginal cost falls or its marginal benefit rises.

· Incentives are also the key to reconciling self-interest and the social interest.

· When our choices are not in the social interest, it is because of the incentives we face.

· One of the challenges for economists is to discover the incentive systems that result in self-interested choices leading to social interest.

Human Nature, Incentives and Institutions

· Economists take human nature as a given and view people as acting in their self-interest.

· All people- consumers, producers, politicians, and civil servants – pursue their self-interest.

· Self-interested actions are not necessarily selfish.

· A self-interested act gets the most value for you based on your view about value.

Economics: A Social Science

Economics is a social science and, like all scientists, economists distinguish between two type of statements:

· What is

· What ough to be

· Statements about what is are called positive statements and they might be right or wrong. We test a positive statement by checking it against a fact.

· Statements about what ough to be are called normative statements and they cannot be tested.

The task of economic science is to break is to discover positive statements that are consistent with what we observe in the economic world.

This task breaks up into three steps:

1. Observation and measurement

2. Model Building

3. Testing Models

Observation and Measurement:

· Economists observer and measure data on such things as the quantities of natural and human resources, wages and work hours, the prices and quantities of the goods and services, taxes and government spending and the items bought from and sold to other countries.

Model Building:

· An Economic Model is a description of some aspect of the economic world that included only those features of the world that are needed for the purpose at hand.

· A model is simpler than the reality is represents.

Testing Models:

· A model’s prediction may correspond or be in conflict with the facts. By comparing the models prediction with the facts, we are able to test a model and develop and economic theory.

· An Economic Theory is a generalization that summarizes what we think we understand about the economic choices that people make and the performance of industries and entire economies.

Obstacles and Pitfalls in Economics

· We cannot easily do economic experiments and most economic behavior has many simultaneous causes. For these two reasons, it is difficult to unscramble cause and effect in economics.

Unscrambling cause and effect

· The logical device which all scientists use to identify cause and effect, is called ceteris paribus.

· Ceteris paribus is a Latin term which means “other things being equal”.

Fallacies

Fallacy of Composition

The fallacy of composition is the (false) statement that what is true of the parts is true of the whole or what is true of the whole is true of the parts.

EG; 1 . “Stand up at the football match to get a better view.” If one person stands up and the rest remain seated, the statement is true. If everyone stands up the statement is false.

EG; 2. For an economic example, suppose a business fires some workers to cut costs and improve profitability. If all businesses take similar actions, people have less money to spend, businesses sell less and profits don’t improve.

Post Hoc Fallacy

Another Latin phrase – post hoc ergo propter hoc –means “after this, therefore because of this”. This post hoc fallacy is the error of reasoning that a first event causes a second event because the first occurred before the second.

EG; 1. Suppose you are a visitor from a far-off world. You observe people shopping in early December and then you see them opening gifts and partying on Christmas Day. ”Does the shopping cause Christmas?” After deeper analysis you discover that Christmas causes the shopping.

Agreement and Disagreement

Economists agree on a wide range of questions. And often the agreed-upon view of economists disagrees with the popular and sometimes politically correct view.