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Lecture 01:
The Scope and Method of Economics

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 The Scope And Method Of Economics
•economics The study of how
individuals and societies choose to use
the scarce resources that nature and
previous generations have provided.

Economics is the study of how individuals and societies choose

to use the scarce resources that nature and previous
generations have provided. The key word in this definition is
choose. Economics is a behavioral, or social, science. In large
measure it is the study of how people make choices. The
choices that people make, when added up, translate into
societal choices.

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 Is Economics a Science
• Science is the systematic body
of knowledge about a certain
field of study. Economics is a
social science concerned with
the study of individuals, acting
alone or in groups.
Economics and Development
Economic development – is the process of change that takes
place in a country over time, affecting its capacity to improve
its standard of living.

Economic analysis – systematic way of thinking.

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 Why Study Economics?
• To Learn A Way Of Thinking
•Three fundamental concepts:
• Opportunity cost
• Marginalism, and
• Efficient markets

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 Why Study Economics?
To Learn A Way Of Thinking

Opportunity Cost

•opportunity cost The best

alternative that we forgo, or give up,
when we make a choice or a decision.

scarce Limited.

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 Why Study Economics?
To Learn A Way Of Thinking

Marginalism and Sunk Costs

•marginalism The process of

analyzing the additional or
incremental costs or benefits arising
from a choice or decision.

sunk costs Costs that cannot

be avoided, regardless of what is
done in the future, because they
have already been incurred.

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 Why Study Economics?
To Learn A Way Of Thinking

Efficient Markets—No Free Lunch

•efficient market A market

•in which profit opportunities are
•eliminated almost instantaneously.

The study of economics teaches us a way of

thinking and helps us make decisions.

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 Why Study Economics?
To Understand Society

•Industrial Revolution The period in

England during the late eighteenth and
early nineteenth centuries in which new
manufacturing technologies and improved
transportation gave rise to the modern
factory system and a massive movement
of the population from the countryside to
the cities.

The study of economics is an essential part of the study of

society.
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 Why Study Economics?
To Understand Global Affairs

An understanding of economics is essential to an

understanding of global affairs.

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 Why Study Economics?
To Be An Informed Citizen

A knowledge of economics is
essential to be an informed
citizen.

When we participate in the political process, we are

voting on issues that require a basic understanding
of economics.

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 HOW PEOPLE MAKE DECISIONS
• Decision making is at
the heart of economics.
• The first four principles
deal with how people
make decisions.

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 HOW PEOPLE MAKE DECISIONS
• Decision making is at
the heart of economics.
• The first four principles
deal with how people
make decisions.

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 HOW PEOPLE MAKE DECISIONS
Principle #1: People Face Tradeoffs

All decisions involve tradeoffs. Examples:

• Going to a party the night before your midterm leaves
less time for studying.
• Having more money to buy stuff requires working
longer hours, which leaves less time for leisure.
• Protecting the environment requires resources that
might otherwise be used to produce consumer goods.

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 HOW PEOPLE MAKE DECISIONS
Principle #1: People Face Tradeoffs
• Society faces an important tradeoff:
efficiency vs. equity
• efficiency: getting the most out of scarce resources
• equity: distributing prosperity fairly among society’s
members
• Tradeoff: To increase equity, can redistribute income
from the well-off to the poor.
But this reduces the incentive to work and produce, and
shrinks the size of the economic “pie.”

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 HOW PEOPLE MAKE DECISIONS
Principle #2: The Cost of Something Is
What You Give Up to Get It
• Making decisions requires comparing the costs and
benefits of alternative choices.
• The opportunity cost of any item is whatever must be
given up to obtain it.
• It is the relevant cost for decision making.

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 HOW PEOPLE MAKE DECISIONS
Principle #2: The Cost of Something Is
What You Give Up to Get It

Examples:
The opportunity cost of…
…going to college for a year is not just the tuition,
books, and fees, but also the foregone wages.
…seeing a movie is not just the price of the ticket, but
the value of the time you spend in the theater.

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 HOW PEOPLE MAKE DECISIONS

Principle #3: Rational People Think at the

Margin
• A person is rational if he/she systematically and
purposefully does the best he/she can to achieve
his/her objectives.
• 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.

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 HOW PEOPLE MAKE DECISIONS
Principle #3: Rational People Think at the
Margin
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.

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 HOW PEOPLE MAKE DECISIONS
Principle #4: People Respond to Incentives
• incentive: something that induces a person to act, i.e.
the prospect of a reward or punishment.
• 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 (e.g., Toyota Prius) rise.
• In response to higher cigarette taxes,
teen smoking falls.

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 HOW PEOPLE INTERACT
• An “economy” is just a
group of people
interacting with
each other.
• The next
three principles
deal with how people
interact.

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 HOW PEOPLE INTERACT
Principle #5: Trade Can Make Everyone
Better Off
• Rather than being self-sufficient, people can specialize
in producing one good or service
and exchange it for other goods.
• Countries also benefit from trade & specialization:
• get a better price abroad for goods they produce
• buy other goods more cheaply from abroad than
could be produced at home

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 HOW PEOPLE INTERACT
Principle #6: Markets Are Usually A Good
Way to Organize Economic Activity

• A market is a group of buyers and sellers.

(They need not be in a single location.)
• “Organize economic activity” means determining
• what goods to produce
• how to produce them
• how much of each to produce
• who gets them

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 HOW PEOPLE INTERACT
Principle #6: Markets Are Usually A Good
Way to Organize Economic Activity

• In a market economy, these decisions result from the

interactions of many households and firms.
• Famous insight by Adam Smith in
The Wealth of Nations (1776):
Each of these households and firms
acts as if “led by an invisible hand”
to promote general economic well-being.

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 HOW PEOPLE INTERACT
Principle #6: Markets Are Usually A Good
Way to Organize Economic Activity
• The invisible hand works through the price system:
• The interaction of buyers and sellers
determines prices of goods and services.
• Each price reflects the good’s value to buyers and
the cost of producing the good.
• Prices guide self-interested households and firms to
make decisions that, in many cases, maximize
society’s economic well-being.
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 HOW PEOPLE INTERACT
Principle #7: Governments Can Sometimes
Improve Market Outcomes
• Important role for govt: enforce property rights
(with police, courts)
• People are less inclined to work, produce, invest, or
purchase if large risk of their property being stolen.
• A restaurant won’t serve meals if customers
do not pay before they leave.
• A music company won’t produce CDs if too many people
avoid paying by making illegal copies.

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 HOW PEOPLE INTERACT
Principle #7: Governments Can Sometimes
Improve Market Outcomes
• Govt may alter market outcome to promote efficiency
• market failure, when the market fails to allocate society’s
resources efficiently. Causes:
• externalities, when the production or consumption
of a good affects bystanders (e.g. pollution)
• market power, a single buyer or seller has substantial
influence on market price (e.g. monopoly)
• In such cases, public policy may increase efficiency.

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 HOW PEOPLE INTERACT
Principle #7: Governments Can Sometimes
Improve Market Outcomes

• Govt may alter market outcome to promote equity

• If the market’s distribution of economic well-being
is not desirable, tax or welfare policies can change how
the economic “pie” is divided.

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 HOW THE ECONOMY AS A WHOLE WORKS

• The last three principles

deal with the economy
as a whole.

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 HOW THE ECONOMY AS A WHOLE WORKS
Principle #8: A country’s standard of living
depends on its ability to produce goods &
services.

• Huge variation in living standards across countries and

over time:
• Average income in rich countries is more than ten
times average income in poor countries.
• The U.S. standard of living today is about eight
times larger than 100 years ago.

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 HOW THE ECONOMY AS A WHOLE WORKS
Principle #8: A country’s standard of living
depends on its ability to produce goods &
services.
• The most important determinant of living standards:
productivity, the amount of goods and services produced
per unit of labor.
• Productivity depends on the equipment, skills, and
technology available to workers.
• Other factors (e.g., labor unions, competition from
abroad) have far less impact on living standards.

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 HOW THE ECONOMY AS A WHOLE WORKS
Principle #9: Prices rise when the
government prints too much money.

• Inflation: increases in the general level of prices.

• In the long run, inflation is almost always caused by
excessive growth in the quantity of money, which
causes the value of money to fall.
• The faster the govt creates money,
the greater the inflation rate.

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 HOW THE ECONOMY AS A WHOLE WORKS
Principle #10: Society faces a short-run
tradeoff between inflation and
unemployment
• In the short-run (1 – 2 years),
many economic policies push inflation and
unemployment in opposite directions.
• Other factors can make this tradeoff more or less
favorable, but the tradeoff is always present.

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 The Scope of Economics
Microeconomics and Macroeconomics
microeconomics The branch of economics that
examines the functioning of individual industries and the
behavior of individual decision-making units—that is,
business firms and households.

macroeconomics The branch of economics that

examines the economic behavior of aggregates—
income, employment, output, and so on—on a
national scale.
Microeconomics looks at the individual unit—the household, the firm,
the industry. It sees and examines the “trees.” Macroeconomics
looks at the whole, the aggregate. It sees and analyzes the “forest.”

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 The Scope of Economics
Microeconomics and Macroeconomics
TABLE 1.1 Examples of Microeconomic and Macroeconomic Concerns

Divisions
of Economics Production Prices Income Employment

Microeconomics Production/output in Price of individual Distribution of Employment by

individual industries and goods and services income and individual businesses
businesses wealth and industries

How much steel Price of medical care Wages in the auto Jobs in the steel
How much office Price of gasoline industry industry
space Food prices Minimum wage Number of employees
How many cars Apartment rents Executive salaries in a firm
Poverty Number of
accountants

Macroeconomics National Aggregate price level National income Employment and

production/output unemployment in
the economy

Total industrial output Consumer prices Total wages and Total number of jobs
Gross domestic Producer prices salaries Unemployment rate
product Rate of inflation Total corporate
Growth of output profits

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 The Scope of Economics
The Diverse Fields of Economics
TABLE 1.2 The Fields of Economics
Comparative economic examines the ways alternative economic systems function. What are the advantages and
systems disadvantages of different systems?
Econometrics applies statistical techniques and data to economic problems in an effort to test hypotheses
and theories. Most schools require economics majors to take at least one course in statistics
or econometrics.
Economic development focuses on the problems of low-income countries. What can be done to promote
development in these nations? Important concerns of development economists include
population growth and control, provision for basic needs, and strategies for international
trade.
Economic history traces the development of the modern economy. What economic and political events and
scientific advances caused the Industrial Revolution? What explains the tremendous growth
and progress of post—World War II Japan? What caused the Great Depression of the
1930s?
Economics of race and examines the role of race and gender in economic theory, in economic life, and in
gender policymaking. How has discrimination by race or gender affected the well-being of
households and the distribution of income and wealth?
Environmental economics studies the potential failure of the market system to account fully for the impacts of
production and consumption on the environment and on natural resource depletion. Have
alternative public policies and new economic institutions been effective in correcting these
potential failures?
Finance examines the ways in which households and firms actually pay for, or finance, their
purchases. It involves the study of capital markets (including the stock and bond markets),
futures and options, capital budgeting, and asset valuation.
Continued...
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 The Scope of Economics
The Diverse Fields of Economics
TABLE 1.2 The Fields of Economics (continued)
The history of economic which is grounded in philosophy, studies the development of economic ideas and theories
thought, over time, from Adam Smith in the eighteenth century to the works of economists such as
Thomas Malthus, Karl Marx, and John Maynard Keynes. Because economic theory is
constantly developing and changing, studying the history of ideas helps give meaning to
modern theory and puts it in perspective.
Industrial organization looks carefully at the structure and performance of industries and firms within an economy.
How do businesses compete? Who gains and who loses?
International economics studies trade flows among countries and international financial institutions. What are the
advantages and disadvantages for a country that allows its citizens to buy and sell freely in
world markets? Why is the dollar strong or weak?
Labor economics deals with the factors that determine wage rates, employment, and unemployment. How do
people decide whether to work, how much to work, and at what kind of job? How have the
roles of unions and management changed in recent years?
Law and economics analyzes the economic function of legal rules and institutions. How does the law change the
behavior of individuals and businesses? Do different liability rules make accidents and
injuries more or less likely? What are the economic costs of crime?
Public economics examines the role of government in the economy. What are the economic functions of
government, and what should they be? How should the government finance the services
that it provides? What kinds of government programs should confront the problems of
poverty, unemployment, and pollution? What problems does government involvement
create?
Urban and regional studies the spatial arrangement of economic activity. Why do we have cities? Why are
economics manufacturing firms locating farther and farther from the center of urban areas?

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 The Method of Economics
Descriptive Economics and Economic Theory

descriptive economics The compilation of

data that describe phenomena and facts.

economic theory A statement or set of

related statements about cause and effect,
action and reaction.

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 The Method of Economics
Theories and Models

model A formal statement of a theory, usually

a mathematical statement of a presumed
relationship between two or more variables.
variable A measure that can change from
time to time or from observation to
observation.

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 The Method of Economics
Theories and Models

All Else Equal: Ceteris Paribus

ceteris paribus, or all else equal A device

used to analyze the relationship between two
variables while the values of other variables
are held unchanged.
Using the device of ceteris paribus is one part
of the process of abstraction. In formulating
an economic theory, the concept helps us
simplify reality to focus on the relationships
that interest us.
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 The Method of Economics
Theories and Models

Expressing Models in Words, Graphs, and Equations

The most common method of expressing

the quantitative relationship between two
variables is graphing that relationship on a
two-dimensional plane.

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 The Method of Economics
Theories and Models

Testing Theories and Models: Empirical Economics

empirical economics The collection and

use of data to test economic theories.

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 The Method of Economics
Economic Policy

Criteria for judging economic outcomes:

1. Efficiency
2. Equity
3. Growth
4. Stability

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 The Method of Economics
Economic Policy

Efficiency

efficiency In economics, allocative

efficiency. An efficient economy is one
that produces what people want at the
least possible cost.
Equity

equity Fairness.

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 The Method of Economics
Economic Policy

Growth
economic growth An increase in the total
output of an economy.

Stability

stability A condition in which

national output is growing steadily, with
low inflation and full employment of
resources.
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 Thank you…

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