Econ 100 Lecture 1.3

1. Econ 100Lecture 1.3 Ch. 1 Economic Way of Thinking 1-7-2009

2. Overview • What is Economics • Trying to define it • The scientific method • The economic way of thinking • “organizing your facts” • Applying the scientific method to a problem • Narrow versus broad economics • Fundamental basis for economic theory

3. What is Economics? • “Theory of Economics does not furnish a body of settled conclusions inevitably applicable to policy. It is a method … a way of thinking ..to draw correct conclusions.” • John Maynard Keynes • It is both descriptive of what has happened as well as predictive

4. What is Economics? • A Science? • Consists of theories that help us understand and make valid predictions about the real world (J. Hirschliefer, UCLA) • Test, validate and accept/reject theories • subjecting theories to empirical analysis • What does it seek to explain? • How a market societies organizes and coordinates itself to: • Produce and allocate goods and services

5. What is Economics? • Social/Market Coordination • For individuals: • How individuals make choices among various goods, how to allocate time, with a scarcity constraint (e.g., income, time) • For firms: • How firms decide to enter which markets • How firms decide how much and what to produce in response to the market’s price signal • For the market • How does the market’s price get determined?

6. Who are the Principal Actors? • Consumers • Supply labor to the market to earn income • Purchase goods from firms • Firms • Which goods are produced in response to consumer demand • What technology and which inputs are used • Government • Establishes the “rules” of the game, e.g. property rights and illegal behavior • Provide incentives (taxes, subsidies), guarantees property and legal rights

7. Scientific Method

8. What is the Study of Economics? • The study of economics involves learning how to organize facts the way economists do. • Or what Paul calls – learning the economic way of thinking • An alternative way of thinking • good-versus-bad" model (conspiracy theories) • two conflicting groups: good people and bad people. • zero-sum game: one person's gain is another's loss. • evil motives, possessed by the bad people, lead to bad results unless these people are in some way controlled. Good motives lead to good results.

9. An Example • Looking at the recent history of gas/oil prices

10. Testing Economic Hypotheses • Explaining the past increase to $4/gal (~50%) • A demand-side hypothesis • Increase in consumption from newly industrialized nations increased (shifted) the demand for gasoline • A supply-side hypothesis • Reduced refinery capacity reduced the supply of gas (refined oil) • Good/Bad Guy Model (Mike Mays, 5/08 before Congress) • Increase in demand from speculators who buy and sell promises to deliver oil at a later date is almost equal to the increase in demand from China • Empirical evidence • World-wide consumption increased by only 3-4% • Insufficient to account for most of the increase in price • Increase in demand by speculators even less • Refinery capacity did diminish by ~30-40%

11. Broad versus Narrow Economics • Narrow economics • Theory of behavior based on “incentives” is restricted to analysis of human behavior in the marketplace • E.g., impact of the “cow gas” tax • Broad economics • Incentives are not limited to economic incentives, such as prices, taxes or income • Behavior based on incentives is not restricted to only markets • E.g., CIA and Afghan warlords

12. Narrow Economics • ANPR (Notification of Proposed Rule Making), • Give EPA authority to regulate greenhouse gas • not only greenhouse gas from manmade sources like transportation and industry, • also “stationary” sources which would include livestock. • New York Farm Bureau estimates: • Basic facts: • $175 per cow, and $87.50 per head of beef cattle • $20 per hog,” • Apply to >= 25 dairy cows, 50 beef cattle or 200 hogs • Impact: add between 7 and 8 cents per gallon of milk costs to farmers

13. Broad Economics • Afghan warlords and Viagra (http://www.telegraph.co.uk/) • Whatever it takes to make friends and influence people – whether it's building a school or handing out Viagra," one veteran CIA officer told The Washington Post. • According to the newspaper, pills to boost the libidos of Afghan tribal patriarchs are the latest in a long line of inducements including medicine or operations for family, toys and school equipment, tooth extractions and visas • The trick was to identify a means of pleasing the CIA source enough to guarantee his loyalty without making it obvious to others that he's being rewarded.

14. What is Economic Theory Based On? • “all social phenomena emerge from the actions and interactions of individuals who are choosing in response to expected benefits and costs” (Heyne) • Focus on choice under constraint • Constraint  scarcity • Scarcity: can’t have all of the things you want • Even if unlimited income and no natural resource constraints => time • In reality – all are limited and choices must be made about how to use them – or there would be no economic problem

15. So What is Economics? • Economics is the study of the: • Choices we make • Constraints that we face • Tradeoffs that are made because of scarcity

16. Basic Behavioral Postulates • For each person some goods are scarce - have to make choices (core of the economic problem) • Each person desires many goods and services - tradeoffs • Each person is willing to forsake some of an economic good to get more of other economic goods - Opportunity costs • More one has of any good, the lower it personal marginal value - Diminishing marginal value • Not all people have the same tastes and preferences • People are innovative and rational - Does not mean we know everything and don’t make mistakes, but we do learn from them and don’t repeat them

17. Overview: Welcome to Economics! • http://ingrimayne.com/econ/Introduction/Overview1.html • After you finish this unit, you should be able to: • Explain what the term "invisible hand" means and who first used it. • Give at least one common definition of economics. • State what Malthus thought about population growth. • Explain how Popper defines scientific statements. • Distinguish between positive and normative statements. • Explain what scarcity, choice, and self-interest have to do with economics.