Introduction Chapter 1 Slides by Pamela L Hall
Introduction Chapter 1 Slides by Pamela L. Hall Western Washington University © 2005, Southwestern
Introduction n Knowledge of economic theory provides a road map for § Understanding how economy operates § How individuals interact as groups of consumers and producers Road map describes how a decentralized system of resource allocation § Can result in efficiently allocating limited resources Ability to understand economic theory and apply it to everyday choices § Will provide you with power to make correct choices and understand choices made by others n Road map can aid us in addressing practical, realistic problems such as § Environmental degradation § Cartels § Dishonest used car salespeople § Discrimination 2
Introduction n Epistemology § Field of philosophy that critically investigates nature, grounds, limits, § n and criteria or validity of human knowledge A theory of cognition • Act or process of knowing Economic theory contains a great deal of epistemology § Theory for examining how human behavior affects economic decisions • For example, economists have worked to specify minimal number of assumptions required for characterizing an individual consumer’s preferences n Applied economist § Combines economic theory with knowledge of institutions and environment to address practical problems 3
Economics Defined n n Riches in terms of fewness of wants are what economics is all about Unfortunately we are unable to satisfy all of our wants— there are limits § For a society these limits take form of scarce resources • For example, land, water, labor, and physical capital n n Economics is study of how to allocate these limited resources to satisfy unlimited wants Economics is a social science, in contrast to a natural science § Deals with human society or its characteristic elements, such as individual, family, or state n Scarcity means there are not enough resources to satisfy every possible demand 4
Economics Defined n Economics § Social science concerned with allocation of scarce resources for satisfying unlimited wants • E. g. , with a federal budget surplus, do we pay down national debt, cut taxes, maintain social programs, or fly to Mars? n Society § Interaction of individuals within an environment • E. g. , United States and other countries n Social welfare § Happiness for society as a whole • E. g. , economists have suggested modifications to a country’s gross national product as a surrogate measure for social welfare 5
Economics Defined n Local bliss § Social welfare is maximized for a given resource constraint • E. g. , a time of peace and prosperity n Global bliss (or bliss) § There are no resource constraints and all wants are satisfied • E. g. , our dreams n Agent § Household or firm within an economy • E. g. , you n Economy § Group of agents interacting to improve their individual and joint satisfaction • E. g. , interaction of buyers and sellers in a free society 6
Economics Defined n Using resources in one way has an opportunity cost of not being able to use them in another way § For example, opportunity cost of allocating time for studying is lost enjoyment of seeing a movie instead n Scarce resources are continuously changing through time § Nonrenewable resources are declining § Renewable resources may increase or decline over time § Capital, both human and physical, will depreciate over time • Must be augmented to maintain or increase present levels n Change in resources is a constraint (limitation) that prevents complete satisfaction § Assuming individuals’ wants are insatiable 7
Economics Defined n n Individuals’ wants are also continuously changing § Depending on age, location, and even time of day Economics is concerned with way society chooses to allocate a continuously changing set of limited resources § Among a continuously changing set of unlimited wants Would you be sorry if all your wants were satisfied? § Yes, because tomorrow these current wants will change Economics is a philosophical inquiry into process of resource allocation § Outlines how a society allocates its scarce resources to achieve § prosperity and well-being for its citizens Objective of economics • Maximize happiness for society as a whole (social welfare) subject to limited resources 8
Economics Defined n n Economics provides a theory for determining § § What commodities to produce When to produce them How to produce them For whom to produce them Theory describes economic environment in which agents (households and firms) interact § Knowledge of this environment provides an understanding of how an § economy operates Economic theory offers both an explanation for and predicts how agents within an economy operate • Must understand this operation of an economy to make efficient decisions on how to allocate resources n With understanding of economic theory, ability to explain, predict, and control economy is possible § Economic theory could be used as a basis for • Design of policies by governments wishing to control outcome of a program or • As a critique of control actions governments might take 9
Economics Defined n For example, economic theory can describe § How price of oil affects auto production § Why a large increase in gasoline price results in little § § n n reduction in demand for gasoline Why a cattle rancher will stay in business even if she is losing money Why a firm with monopoly power can charge a higher price for its commodity than a competitive firm Economic theory is a very nonlinear use of language § Full implications are more than just sum of parts § Makes it a very powerful and exciting field of study Why study economics? § Microeconomic theory offers solutions to practical problems 10
Taxonomy of Economics n Economics may be classified into a number of divisions § Economic philosophy • Positive and normative § Major fields • Micro and macro n Economists tend to specialize in one of the major fields § In their applications they will generally employ both positive and normative economic philosophies 11
Microeconomics and Macroeconomics n Microeconomics § Concerned mainly with economic activities of individual consumers and producers or groups of consumers and producers, known as markets • Examples include ¨ ¨ ¨ n Consumers’ demand for food Cost to a firm for a particular volume of production Per-unit price a firm charges for a specific volume of its output Macroeconomics § Concerned with behavior of economic aggregates or economy as a whole • Examples include ¨ ¨ ¨ Total volume of output for a nation General level of prices and employment Total level of income and expenditures 12
Microeconomics and Macroeconomics n n n Complement each other Microeconomics deals with efficient allocation of resources within an economy Macroeconomics deals with maintaining a stable economic environment resulting in full employment with stable prices § If macroeconomists are unable to maintain full employment of resources • Microeconomists need not worry about efficiently allocating these resources ¨ ¨ Since unemployed resources are not scarce or limited Microeconomics is of limited use unless resources are fully employed § Reverse is also true—if microeconomists are unable to efficiently allocate resources • Even with fully employed resources social welfare will not be maximized 13
Microeconomics and Macroeconomics n Fallacy of composition states § What is true of parts is not necessarily true of whole § In terms of economics, generalizations made at microeconomics level may not always be true at macroeconomics level n For example, rising unemployment may result in workers’ increasing their savings § Microeconomics would predict an increase in individual savings § However, unemployed may decrease their savings to maintain their § living standards Macroeconomic effect of combining workers’ and unemployed’s savings levels may result in a decrease in savings • Called Paradox of Thrift 14
Microeconomics and Macroeconomics n Converse of fallacy of composition is fallacy of division § What is true of whole is not necessarily true of the parts § Generalizations made at macroeconomic level may not always be true at microeconomic level n n For example, in aggregate (macro), level of prices may be stable § Specifically, there is no inflation, defined as a general rise in prices § However, in a particular market (micro), prices may be rising rapidly Micro- and macroeconomics are not distinct areas of study § Both can be used to investigate same policy action § For example, an increase in government taxes affects consumers and producers can be analyzed with • Microeconomic tools ¨ Investigate effect on markets for specific commodities, such as housing or automobiles • Macroeconomic tools ¨ Analyze effect on aggregate employment, inflation, and national income 15
Positive and Normative Economics n Positive economics § Concerned with what is, was, or will be § Considers actual conditions that have occurred or will occur in an economy § If two people disagree over positive statements in economics • Should be able to settle their controversy by logical thinking and appealing to • facts For example, the statement “A 10% increase in the price of gasoline will have no effect on the number of vacationers going skiing, ” is a positive statement ¨ n Can be tested by empirical research § Number of skiers before price hike can be compared with number of skiers after Normative economics § Concerned with what ought to be § Involves value judgments—statements about what is good and what is bad, § what ought to have occurred, or what ought to occur in an economy If two people disagree over normative statements • They are disagreeing over value judgments and may not be able to reach an agreement ¨ For example, “Only Bohemian residents should be allowed to vacation in Bohemia, ” is a value judgment that cannot be tested § Empirical evidence cannot be used to destroy one’s belief about the issue 16
Applied Economics n n Applied Economics is closely related to normative and positive economics Belongs to neither category but to a category called art of economics § Distinction dates back to father of John Maynard Keynes, John Neville Keynes n Positive economics is study of what is and the way the economy works n Normative economics is study of what should be n Art of economics is applied economics that accepts some set of goals determined in normative economics § Pure science, not applied economics § It is also not applied economics § Discusses how to achieve those goals in reality, given insights of positive § economics Relates conclusions derived in positive economics to goals determined in normative economics 17
Applied Economics n Positive economics is abstract thinking about abstract problems § Immediate or even future relevance is of little or no concern to a positive economics researcher n Methodology for art of economics is broader, more inclusive, and less technical than methodology for positive economics § Requires a knowledge of institutions and of social, political, and historical phenomena n n Mechanisms for using available data in addressing current economic problems are developed as economic art Applied economics relies on all other disciplines to support positive economics § Engineering, biology, and ecology are improving technology • Helps produce more desirable commodities from limited resources § Mathematics, computer science, and statistics are developing new tools for § advancing both applied economics and positive economic theory Applied economics incorporates theories from political science, sociology, and psychology 18
Models n Economics is based on belief that most behavior can be explained § By assuming agents have stable, well-defined preferences • Make rational market choices consistent with these preferences n Economics is distinguished from other social sciences by its general acceptance of this belief § Paradigm in economics • Foundation for building economic models n n Models are basic tool used by scientists to increase our understanding of real world § Simplified representations of reality Reality is simplified in different ways in a model § Depending on objectives of model and particular situation • For example, a map is a simplified model of world, but not all information about world can be placed on one map 19
Assumptions n A model is used to simplify reality from which conclusions are logically deduced about some system § A system is a group of units interacting to form a whole • For example, consumers and producers interact to form a market system n Assumptions are assertions about system properties that are observable in real world § Can be evaluated for their degree of realism n n Properties are traits and attributes of a system A model describes essential features of a system, based on theory, in a way that is simple enough to understand manipulate § Close enough to reality to yield meaningful results n Consider a model of consumer behavior with following assumptions § Consumer is rational and attempts to maximize satisfaction (utility) • Consumer has a fixed level of income § Commodities (goods and services) vary continuously, and utility consumer derives from them is measurable • Consumer has a given set of preferences for these commodities § Commodity prices are constant 20
Assumptions n Based on this set of assumptions, can conclude that a consumer will maximize utility § By equating marginal (additional) utility per dollar for all the commodities he purchases n In this model, variables—commodity prices, income, and consumer preferences—are assumed to influence consumer’s purchases of commodities § Called exogenous variables n Based on economic theory, we can develop a model where these exogenous variables cause change in other variables § Called endogenous variables (in this case, consumer’s purchases) n Assumptions characterize type of world for which a model is intended, but model is not an exact representation of reality § For example, when at supermarket you do not count level of utility you receive per unit of commodity • However, a model provides a reasonable abstraction 21
Assumptions n Abstracting from reality is part of scientific method § Minimizes influences of personal and cultural beliefs in explaining reality n n n Economists employ scientific method to develop and test models that are accurate representations of reality Hypothetical models are important in any science § Even if these models are artificial, they are useful Real test of such models is whether they lead to conclusions that help to further scientific objectives § Explanation, prediction, and control 22
Analysis n Value of economic models is not in how realistic are their assumptions n As illustrated in Figure 1. 1, economists employ scientific method for analyzing these models Considering reality (the real world) as a starting point, an economist reduces the complexities of reality to manageable proportions n § But in how useful are conclusions derived from them § By developing a model of a real-world system based on economic theory • Results in a logical model suited to explain system observed n By logical argument (deduction), logical or model conclusions can be derived § Hypotheses of relationship among variables • Hypotheses are then transformed into conclusions about real world n Economists may also employ econometrics (application of statistics to economics) to analyze reality n For developing an econometric model, economists use experimental abstraction based on economic theory, which leads to experimental design § Model is then useful in testing hypotheses derived from economic theory n Theoretical and econometric models complement each other in developing realworld conclusions 23
Figure 1. 1 Scientific method 24
Analysis n Relative emphasis on theoretical versus statistical models has changed over time § Greek tradition proves things with abstract principles (theoretical models) • For example, proof of Pythagorean Theorem does not depend on particular size of a right triangle § Babylonian tradition discovers things by computation • Such as fact that a million different right triangles all have same relation among squares of their sides n Greek tradition prevailed in works of past Nobel laureates such as Paul A. Samuelson and Kenneth J. Arrow § Applied mathematical reasoning to a minimum of data n Ever-decreasing cost of computation due to advanced technology has increased cost of Greek science (theoretical modeling) relative to Babylonian science (econometric modeling) § Elegant analysis still costs as much time and effort as it ever did, but number crunching becomes ever cheaper n The kinds of practical questions consumers, firms, governmental policymakers, and economists are asking are more amenable to answers from Babylonian economics § For example, an econometric model can show magnitude of a reduction in pollution § from a change in a pollution standard In contrast, a theoretical model will generally only provide an indication of direction of change and not magnitude 25
Tools n Tools employed for developing theoretical models and deriving conclusions are prose, geometry, mathematics, and computer programming § Prose is ordinary language of people in speaking or writing • Disadvantage of prose was that key features of a model were lost as it was verbally transmitted or imitated among individuals ¨ Written communication solved this problem § For relatively detailed models a great deal of writing was required § Geometry alleviated this limitation—“a picture is worth a thousand words" • Geometric illustrations that complement writing allow a model to be • communicated and conclusions to be developed with greater efficiency Geometry is an excellent tool for describing a model with two variables, such as price and quantity ¨ ¨ Unfortunately, geometry is limited by its dimensions Geometry is not able to represent fourth, fifth, or any higher dimension § Required of a model with more than three variables § Mathematics allows us to enter worlds of higher dimensions and explore their vast areas with models designed to provide insights into their workings • If a picture is worth a thousand words, mathematics is worth the universe 26
Tools n A model can always be communicated without mathematics § But mathematics greatly reduces a model’s description and expresses it in a very concise manner n As mathematical models become more complex § Analytical solutions to models become difficult or impossible n However, advancement of computer programming provides numerical solutions to these complex models § Computer programs have provided solutions to some models that previously could not be solved 27
Models in Scientific Explanation, Prediction, and Control n n An educated person is someone who is able to explain relationships among facts Neither a list of facts nor a compilation of summary statistics from a survey are explanations § Facts and statistics are generally called data § An explanation is general relation underlying data • Data are interpreted or explained by applying theory to account for relationships among variables n If a model does well in explaining relationships, it can be used for prediction § Deriving some conclusion before it is observed n Distinction between explanation and prediction § Explanation is a conclusion observed first, with a model in support of the § conclusion provided afterward Prediction is a conclusion deduced from a model before conclusion is observed 28
Models in Scientific Explanation, Prediction, and Control n Control is altering of one or more exogenous variables in a model to predict a particular outcome § Examples include • Changing price of a commodity to predict change in a consumer’s purchases • Changing pollution standard in a model to predict change in pollution n For purposes of control, a model that provides valid explanations as well as accurate predictions is required n Based on models developed in following chapters, we investigate changes in (control of ) exogenous variables—such as prices, wages, and income § By comparing one equilibrium position to another • Called comparative statics analysis n Table 1. 1 lists a collection of optimization models along with comparative statics analysis developed and discussed in following chapters § All optimization models involve either maximizing or minimizing an objective function § Given a fixed level for exogenous variables, endogenous variables are varied to determine optimal level of objective function • Generally, objective function is subject to some constraint ¨ Such as limited income or a given level of technology 29
Table 1. 1 Collection of optimization models developed in this text 30
Development of Microeconomics n Marshallian-cross analysis n Figure 1. 2 shows an illustration of Marshallian cross § Developed in 1880 by English economist Alfred Marshall § Per-unit price of a commodity, p, is measured on vertical axis and quantity of § commodity, Q, is measured on horizontal axis Marshallian cross is represented by market demand supply curves • As price decreases, quantity demanded for a commodity by consumers is expected to increase ¨ Results in a downward or negatively sloping demand curve ¨ Decreasing supply of commodity § Results in an upward or positively sloping supply curve • Firms supplying this commodity are expected to react to this price decline by • Point of intersection (crossing) represents market equilibrium level of price and quantity ¨ n n Quantity Supplied = Quantity Demanded § No incentive for consumers or firms to change their market behavior Market-clearing price (pe) is most efficient mechanism for allocating scarce resources among unlimited wants Marshallian-cross analysis has been applied to a wide range of social behavior 31
Figure 1. 2 Marshallian Cross 32
Partial-Equilibrium Versus General. Equilibrium Models n Marshallian cross is only a partial-equilibrium model § Only considers one market at a time rather than all markets in an economy § For some questions, this narrowing of perspective gives valuable insights § n and analytical simplicity However, for broader questions about efficiency and welfare implications of economic activities • Narrow viewpoint may prevent discovery of important interrelations For answering broader questions, a general-equilibrium model is required § Models whole economy or some major subset n French economist Leon Walras created basis for such an investigation by representing economy with a number of simultaneous equations § Created model that permits effects of a change in one market to be carried through into other markets n In a sense, current macroeconomics is simply an example of applied general equilibrium analysis 33
- Slides: 33