Chapter 1

Introducing the economic way of

thinking
Chapter summary
Scarcity is an economic problem faced by everyone. It is a situation in which we are unable to
have as much as we would like to have. While society has unlimited wants, it faces limited
means. In essence, society has insufficient resources or factors of production (i.e. land, labour
and capital) to produce all goods and services to meet everyone’s needs. As a result of scarcity,
society has to make choices. These choices are made at the ‘micro’ and ‘macro’ level.
Microeconomics is the branch of economics that studies decision-making by a single individual,
household, firm or industry, while macroeconomics is the branch of economics that studies
decision-making for the economy as a whole.
Economics can be further subdivided into positive (‘what is’) and normative (‘what
ought to be’) economics. We would all be well advised to first have a firm grasp of ‘what is’
before we argue ‘what ought to be’. This leads us to a look at how economists derive economic
theories. Economic theories are developed in much the same way as scientific theories, both are
based on induction and deduction. These theories can be expressed:
• verbally, or in written form
• as a numerical table
• graphically
• mathematically.
From these theories, models are formed that help explain the relationship between
economic variables. However, models should be used with caution. Two common pitfalls to
clear thinking are the failure to understand the ceteris paribus assumption and confusing
association and causation.
The appendix to this chapter focuses on how theories can be expressed graphically.
Graphs are visual aids that help us see the direct or inverse relationship between two or more
sets of data or variables.

New concepts introduced

• scarcity • entrepreneurship
• labour • macroeconomics
• economics • microeconomics
• model • ceteris paribus
• normative economics • land
• positive economics • capital
• resources • economics and ethics

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2 Economics for Today Instructor’s Manual

Instructional objectives
After completing this chapter, students should be able to:
• understand that if there was no scarcity there would be no such thing as economics.
Economics is the study of scarcity and how we deal with it
• understand that scarcity exists because we are unable to produce as much as we would like
(our wants are unlimited, but our means of production are limited)
• understand that we try to do the best we can with what we have – to maximise our
production with our limited resources. This leads to producers producing for a market to
efficiently allocate resources in terms of what to, how to, and for whom to produce.
• list the factors of production: land, labour, and capital
• distinguish between ‘macro’ and ‘micro’
• distinguish between positive and normative economic analysis
• explain why economists are interested in relationships between economic variables
• explain why theories enable us to discern relationships between economic variables
• know how theories can be expressed
• explain the limitations to the use of theories
• understand the ethical foundations of market economies.

Chapter 1 outline
Introduction
The problem of scarcity
Scarce resources and production
Exhibit 1.1 Three categories of resources
Land
Labour
Capital
Economics: the study of scarcity and choice
Microeconomics
Macroeconomics
You make the call: Can the free market eliminate scarcity?
The methodology of economics
Exhibit 1.2 The steps in the model-building process
Identifying the problem
Developing a model
Testing the model
Hazards of the economic way of thinking
The ceteris paribus assumption
Association versus causation
You make the call: Can simple models explain stock market movements?
International focus: A prominent American economist explains why economists
disagree
Why do economists disagree?

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 Chapter 1: Introducing the economic way of thinking 3

Positive economics
Normative economics
Economics and ethics
Analyse the issue: Tim Costello on Adam Smith and business ethics?
Key concepts
Summary
Study questions and problems
Online exercises
Answers to ‘You make the call’
Multiple-choice solutions

Hints for effective teaching

1 Try to use this chapter to generate as much interest in economics as possible. Don’t feel too
pressed for time. Treat this chapter thoroughly – especially, ‘theories’. It will be time well
spent. (Some additional comments with respect to theories are found below in
point 5.)
You may want to start the class by asking students what they want to get out of the class –
what they always wanted to know and were afraid to ask. Let them know that there is no
such thing as a ‘silly’ question. (Establishing a rapport with your students at the first
opportunity will pay off.) Get your students to identify some economic issues and establish
that these issues stem from the fact that we are faced with scarcity. It is important to stress
the difference between ‘positive’ and ‘normative’ economic analysis – the difference
between ‘fact’ and ‘opinion.’
2 Indicate that in economics, capital is not money. It is defined as ‘plant and equipment’.
Students often get ‘capital’ and ‘money’ confused.
3 Point out that scarcity is not a synonym for poverty. Even ‘rich’ nations like Australia (and
rich people) are faced with scarcity because they are unable to have as much as they would
like to have.
4 Give some examples of economic investigations and ask students to distinguish between
whether they relate to ‘micro’ or ‘macro’ issues. Being the first chapter, it is essential that
while economics is comprised of microeconomics and macroeconomics, they should not
integrate the two together when studying them.
5 Indicate that theories are realistic because they are based on facts. Theories are practical
because they avoid unnecessary detail and enhance our understanding of relationships
among economic variables. Theories (general statements about the causal relationship
between variables based on facts) are extremely useful in developing workable policies to
address a real-world problem. In sum, stress that economists derive economic theories
because they are useful in the development of economic policies designed to solve real-
world economic problems.
6 Indicate that there are really three forces at play in the real world in which we all live:
economic, social and political. These three forces are often in conflict. Sound or rational
economic reasoning doesn’t always prevail – especially when it comes to developing
economic policy in a political environment.

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4 Economics for Today Instructor’s Manual

Solutions to text problems

International focus
A prominent American economist explains why economists disagree (pp 12–13)
Normative issues lead to most disagreements between economists. This is because normative
analysis deals ‘with the way things ought to be, and unavoidably involves the noneconomic
value judgements of the analyst’ (p13). On the other hand, positive analysis is ‘the application
economic postulates and principles to a question – in other words, finding out about the way
things are and why the world behaves as it does’ (p 13). There are many other examples of
normative and positive analysis on p 12 and also in the text.

Analyse the issue

Tim Costello on Adam Smith and business ethics (pp 16–18)

1 Two positive statements relating to business ethics are:

a this doctrine emphasises that business is part of the community
b the increasing transparency of business affairs

Two normative statements relating to business ethics are:

a based on this doctrine, there is no need for business to give wealth directly to the
community
b maximise profit instead, so shareholders could bestow it wherever they wished
in the community.

2 Positive argument –Taking up the challenge will increase profits in the long run.
Normative argument – Taking up the challenge is desirable for society’s sake.

3 Students may provide answers, such as the following: businesses should be ethically
responsible because humans (labour) are involved in generating profits. Furthermore,
certain business decisions, for instance, impact negatively on humans (society) and the
environment.
a A positive reason for the decision – impacts on society and the environment
b A normative reason for the decision – Businesses should be ethically responsible

There are alternative ways to ensure that businesses are good citizens. Appropriate regulations,
incentives and penalties are some of the alternatives that can be employed to make businesses
good citizens.

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 Chapter 1: Introducing the economic way of thinking 5

Study questions and problems solutions

(p 20)
1 Nations with high-living standards and nations with low-living standards face the problem
of scarcity because society’s wants are unlimited, while the resources available are finite.
For this reason, only a certain level of society’s wants can be satisfied. Note that the wants
between rich and poor nations may differ and yet the problem of scarcity remains because
human wants are forever greater than the available supply. This applies to time, goods,
services and resources. As stated in the book because scarcity is pervasive, you really can’t
‘have it all’ (p. 2).
Therefore, because our wants are unlimited even if you win $1 million in a lottery, you
would not escape the problem of scarcity.
2 Money is not considered as capital because it cannot physically be used to produce goods or
services. Capital is a factor of production, while money is not. Money is only a means to
purchase factors of production, such as capital or labour, which can actually produce goods
and services. Note that the term capital as it is used in the study of economics can be
confusing (p. 5).
3 a The answer is capital. The reason for this is that computer software, like physical plant,
machinery and equipment contributes to making goods and services.
4 Macroeconomics applies an overview perspective of an economy by examining economy-
wide variables such as inflation, unemployment and growth of the economy.
Microeconomics examines individual economic units such as the market for corn, petrol or
ostrich eggs.
5 a microeconomics. This issue will be discussed in more detail in Chapter 5.
b macroeconomics. This issue will be discussed in more detail in Chapter 13.
c microeconomics. This issue will be discussed in more detail in Chapter 18.
d macroeconomics. This issue will be discussed in more detail in Chapter 17.
6 c simplified description of reality used to understand the way variables are related.
7 An economic model is a simplified description of the real world, as it aims to analyse and
predict the relationship between variables and to make the events more comprehensible.
8 People are complicated and their economic choices are usually influenced by many
variables. In order to focus only on the most important variables that influence choices, the
ceteris paribus assumption rules out changes in certain variables that might affect the model.
9 We are probably observing an association between events but if the decline in building
activity caused the recession it would be a cause of causation.
10 c only.
11 d statement of normative economics.
12 No, economists argue that individuals should pursue their own self-interest interest, subject
to an underlying set of moral principles, such as those espoused by mainstream religions.
13 A positive argument in the text is that ‘airbags are estimated to add up to $1,000 to the cost
of a car’. This argument can be tested by data collected from drivers using airbags versus
drivers using only seat belts. A normative argument is that the government should leave the
decision of whether to spend the extra $1000 or so, for an airbag to the consumer. This
policy question involves people’s opinions on the appropriate role of government in the
automobile market. Students can research this issue on the Internet and share their findings
with the class.

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6 Economics for Today Instructor’s Manual

Multiple-choice solutions
(pp 21–22)
1c in all countries of the world
2d none of the above, because scarcity cannot be eliminated
3c a financial asset
4c people making choices because of the problem of scarcity
5a individual, or specific markets
6a macroeconomics
7a other relevant factors, like consumer incomes must be held constant
8a confused association and causation
9a the income tax system collects a lower percentage of the income of the poor
10c if the overall unemployment rate is 7 per cent, youth unemployment rates will
average 20 per cent
11a the minimum wage is good because it raises wages for low-income earners
12b workers will gain their rightful share of total income.

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 Chapter 1: Introducing the economic way of thinking 7

Appendix to chapter 1
Applying graphs to economics
Appendix summary
In economics, graphs are used as visual aids to illustrate relationships between economic
variables. If a relationship exists between two variables, then the relationship is either direct
(also known as a positive relationship) or inverse (also known as a negative relationship).
A direct relationship between two variables means that as one variable (the independent
variable) increases this causes the other variable (the dependent variable) to also increase in
value; and vice versa. A direct relationship is illustrated graphically as an upward sloping, or
positively sloped line or curve.
An inverse relationship between two variables means that as one variable increases (the
independent variable) this causes the other variable (the dependent variable) to decrease in
value; and vice versa. An inverse relationship is illustrated graphically as a downward sloping,
or negatively sloped line or curve.
An independent relationship means there is no relationship between two variables. This
is expressed graphically as a horizontal line.
A shift in a curve (or line), occurs when the ceteris paribus assumption is relaxed and a
third variable, which is not on either axis of the graph, is allowed to change.

New concepts introduced

• direct relationship • inverse relationship
• slope • independent relationship

Instructional objectives
After completing this appendix, students should be able to:
• know what a direct relationship is and how it is reflected graphically
• know what an inverse relationship is and how it is reflected graphically.

Appendix to chapter 1 outline

Introduction
A direct relationship
Exhibit A1.1 A direct relationship between variables
An inverse relationship
Exhibit A1.2 An inverse relationship between variables
The slope of a straight line
The slope of a curve
Exhibit A1.3 An independent relationship between variables
Exhibit A1.4 The slope of an upward-sloping, non-linear curve
Introducing a third variable to the graph
Exhibit A1.5 The slope of a downward-sloping, non-linear curve
Exhibit A1.6 Changes in price, quantity, and income in two dimensions

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8 Economics for Today Instructor’s Manual

A helpful study hint using graphs

Key concepts
Summary
Study questions and problems
Multiple-choice solutions

Hints for effective teaching

1 Stress the limitations of theory – especially association versus causation. Just because
two things happen to occur together doesn’t mean one necessarily causes the other. For
example, the rooster may think his crowing is causing the sun to rise but we know better.
2 Providing a solid understanding of graphs will avoid many problems later. Point out that
the dependent variable goes on the ‘Y’ or vertical axis. The independent variable goes
on the ‘X’ or horizontal axis. A direct (also known as a positive), relationship is always
expressed as a positively sloped line or curve. An inverse (negative) relationship always
has a negative slope. (Question 1 of ‘Study questions and problems’ gives some
examples.)

Solutions to text problems

Study questions and problems
(p 33)
1 a inverse, (assumption: income held constant)
Life
Expectancy

Age

b direct, (assumption: parents income and education held constant)

Annual
Income

Years of Education

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 Chapter 1: Introducing the economic way of thinking 9

c direct

Sales
of Umbrellas

Rainfall

d inverse, (assumption: altitude held constant)

Mean Summer
Temperature

Distance from Equator

2 a the relevant relationship is that there is an inverse relationship between the price per
hamburger and the quantity consumers will purchase at each alternative price.
b The numerical table is:
Price per Quantity of
hamburger hamburgers
$ demanded
per year
4.00 20,000
3.00 40,000
2.00 60,000
1.00 80,000

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10 Economics for Today Instructor’s Manual

c Most students will prefer the graphical model because of its clarity. See Figure 1A-1
below.

Figure 1A-1

Multiple-choice solutions
(p 33)
1d all of the above are true
2d ½
3a positive
4d all of the above are true
5d remains constant with changes in X
6c –1
7c a third variable that is not on either axis.

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