Assignment:
The Nature of Economics
Overview:
This chapter introduces economics as a science. Economics is defined, and its subareas, macroeconomics and microeconomics, are introduced. The chapter also discusses the three fundamental questions faced by every nation of what to produce, how to produce, and for whom to produce.
The chapter then presents the two types of economic systems, command and control or the price system, used to answer the three fundamental questions.
Economic rationality and self-interest are discussed along with their implications for decision making and economic model building. The concept of behavioral economics is introduced.
Economics as a science is closely associated with the development of models. To aid understanding, a significant section on the methodology of economics discusses model construction, the role of assumptions, and determining the usefulness of a model. Finally, the difference between positive and normative economics is presented. There is a discussion of why it is important to separate these two areas of analysis clearly.
Learning Objectives:
After studying this chapter, students should be able to:
1 Define economics and discuss the difference between microeconomics and macroeconomics
2 Identify the three basic economic questions and the two opposing sets of answers
3 Evaluate the role that rational self-interest plays in economic analysis
4 Explain why economics is a science
5 Distinguish between positive and normative economics
Outline
I. The Power of Economic Analysis: The analytical framework of the course is the economic way of thinking. The economic way of thinking permits the student to reach informed conclusions about what is happening in the world.
A. Defining Economics:
The study of how people allocate their limited resources to satisfy their unlimited wants. The ultimate purpose of economics is to explain how people make choices.
B. Microeconomics versus Macroeconomics:
Economics is divided into two types of analysis: macroeconomics and microeconomics.
1. Microeconomics:
The part of economic analysis that studies individual decision making undertaken by individuals (or households) and by firms.
2 Miller • Economics Today, Eighteenth Edition
©2016 Pearson Education, Inc.
2. Macroeconomics:
The part of economic analysis that studies the behavior of the economy as a whole. It deals with economywide phenomena such as changes in unemployment, the general price level, and national income.
II. The Three Basic Economic Questions and Two Opposing Sets of Answers:
Every nation must address three fundamental questions that concern the problem of how an economic system allocates a society’s scarce resources.
A. The Three Basic Questions:
(1) What will be produced?
(2) How will items be produced?
(3) For whom will it be produced?
B. Two Opposing Sets of Answers
1. Centralized Command and Control:
Also called a command and control system, this system has a centralized authority that decides what items to produce and how many of
each, determines how the scarce resources will be organized in the items’ production, and identifies who will be able to obtain the items.
2. The Price System:
Also called a market system, a price system is an economic system that answers the three basic questions using decentralized decision making. In a pure price system, individuals own all of the scarce resources used in production. This means those choices about what and how many of each item to produce are made by private parties on their own initiative, as are the decisions about how to produce those items.
Finally, individuals and families choose how to allocate their incomes to obtain those items at prices established by privately organized mechanisms. Those prices in turn signal everyone in a price system relative scarcity of different resources, which in turn provides information about what and how many items to produce, how to produce each, and who will choose to
buy the items.
3. Mixed Economic Systems:
The economic systems of the world incorporate aspects of both centralized command and control and the decentralized price systems.
III. The Economic Approach:
Systematic Decisions:
Economists assume that individuals act as if they pursue self-motivated interests and respond predictably to perceived opportunities to obtain those interests.
A. The Rationality Assumption: The assumption that individuals will not intentionally make decisions that would leave them worse off.
B. Responding to Incentives:
An incentive is the reward for engaging in a given activity. People react to an incentive by making a rough comparison of costs and benefits. A negative incentive raises the cost of doing something. If benefits of a given choice do not change, then a higher cost (negative incentive) will decrease or perhaps eliminate a particular choice.
C. Defining Self-Interest:
The pursuit of goals that make the individual feel better off. In economic analysis, these goals are often those which can be measured in monetary terms, although the pursuit of other goals such as prestige, love, or power can be analyzed using this
concept.
IV. Economics as a Science:
Economics is a social science that utilizes the same types of methods used in biology, chemistry, and physics. Economic models or theories, which are simplified representations of the real world, are developed and used as aids in understanding, explaining, and
predicting economic phenomena in the real world.
A. Models and Realism:
A model should capture the essential relationships that are sufficient to analyze the specific problem or answer the specific question being asked. No economic model is complete in the sense of capturing every detail and relationship that exists in the real world.
A model is by definition an abstraction from reality. This does not mean that models are deficient simply because they are unrealistic and use simplified assumptions. Every model in every science requires simplification compared to the real world.
B. Assumptions:
Assumptions define the set of circumstances in which a model is most likely to be applicable. Every model, therefore, must be based on a set of assumptions.
1. The Ceteris Paribus Assumption:
All Other Things Being Equal:
The assumption that nothing changes except the factors being studied. It is used to isolate the effect of a change in one variable on another one by assuming that all other variables do not change.
C. Deciding on the Usefulness of a Model:
A model is useful if it yields usable predictions supported by real-world observations. If a model makes a prediction and factual evidence
supports the prediction, then the model is useful. Thus economics is an empirical science; that is, it relies on real-world data in evaluating the usefulness of a model.
D. Models of Behavior, Not Thought Processes:
Models relate to the way people act in using limited resources and not to the way they think. Models normally generalize people’s behavior. Economists are interested in what people actually do, i.e., revealed preferences, rather than what they think they will do, ( declared preferences).
E. Behavioral Economics and Bounded Rationality:
An approach to consumer behavior that emphasizes psychological limitations and complications that potentially interfere with rational
decision making.
1. Bounded Rationality:
The idea that people are nearly, but not fully, rational so that they cannot examine every choice available to them but instead use simple rules of thumb to sort among the alternative available to them.
2. Rules of Thumb:
A behavioral implication of bounded rationality is that people will use rules of thumb; that is, a simplified method of decision making. An important issue is that persons who appear to use rules of thumb may behave as if they are fully rational.
3. Behavioral Economics:
A Work in Progress: So far, proponents of behavioral economics have not conclusively demonstrated that paying closer attention to psychological thought processes can improve economic predictions.
V. Positive versus Normative Economics:
Positive economics deals with what is. Positive economic statements are “if-then” statements. Normative economics deals with what some person thinks ought to be. Normative economic statements involve value judgments and normally have the words “ought” or “should” in them.
Because positive economics predicts consequences of actions, it can be used to predict the effects of various policies to see if the policies aid in achieving desired goals. Positive economics cannot provide criteria for choosing which outcomes or goals are preferable.
A. Distinguishing between Positive and Normative Economics: Positive economics is analysis that is strictly limited to making either purely descriptive statements or scientific predictions. Normative economics is analysis involving value judgments about economic policies, a statement about what ought to be.
B. A Warning: Recognize Normative Analysis:
Although it is easy to define positive economics, it is often difficult to identify unlabeled normative statements, even in a textbook.