Study Guide
Chapter 1: The Art and Science of Economic Analysis

  1. Introduction
  2. Outline
  3. Discussion
  4. Lagniappe
  5. Key Terms
  6. Questions
  7. Answers

I. Introduction

This chapter presents an overview of economics and tells how economic analysis is performed. In particular, it introduces the concept of the economic problem and an important type of economic analysis: marginal analysis. There is also an appendix that discusses how graphs are used. Other tools of economic analysis are presented in the next chapter.

II. Outline

  1. The Economic Problem.
  2. Because resources are scarce and human wants are unlimited, people cannot have everything they want. Economics is the study of how individuals choose to use their scarce resources in an attempt to satisfy their unlimited wants.

    1.1 Resources
    1. Land (includes all natural resources). Payments to land are called rent.
    2. Labor (physical and mental effort). Payments to labor are called wages.
    3. Capital. Payments to capital are called interest.
      1. Physical capital (manufactured items used in the production of goods)
      2. Human capital (knowledge and skills people acquire to enhance their ability to produce)
    4. Entrepreneurial ability (the talent of a person who tries to discover and exploit profit-able activities). Payments for entrepreneurial ability are called profit.

    1.2 Goods and Services
    1. Goods and services are produced to satisfy human wants.
    2. Goods are tangible; services are intangible.
    3. Both goods and services require scarce resources and are therefore themselves scarce.
    4. Without scarcity there would be no economic problem.

    1.3 Economic Actors
    1. There are four types of actors in the economy: households, firms, governments, and the rest of the world.
    2. Markets are the means by which buyers and sellers carry out exchanges.

    1.4 Microeconomics and Macroeconomics
    1. Microeconomics is the study of how individual economic agents make decisions and how the choices of various decision makers are coordinated.
    2. Macroeconomics is the study of the economy as a whole.

  3. The Art of Economic Analysis
  4. 2.1 Rational Self-Interest
    1. Economists assume that individuals act in their own best interests.
    2. Economists also assume that individuals are rational, which means that people try to make the best choices possible under the circumstances.

    2.2 Economic Analysis Is Marginal Analysis
    1. Marginal means "incremental" or "decremental."
    2. An individual changes his or her behavior whenever the expected marginal benefit from doing so is greater than the expected marginal cost.

    2.3 CASE STUDY: Marginal Analysis in the Computer Industry

    2.4 Choice Requires Time and Information

  5. The Science of Economic Analysis
  6. 3.1 The Role of Theory
    1. A theory, or model, is a simplification of reality that focuses on only the most important features of a relationship.
    2. Theory is needed to determine which facts are relevant to an analysis of a relationship.
    3. Theory is also used to make predictions about the real world.

    3.2 The Scientific Method
    1. Step One: Identify and define the relevant variables. (A variable is a quantity that can take on different possible values.)
    2. Step Two: State the assumptions that specify the conditions under which the theory is to apply.
      1. Ceteris paribus: other things are held constant
      2. Behavioral assumption: a notion concerning individual behavior that is taken to be true; for example, rational self-interest
    3. Step Three: Formulate hypotheses about relations among the key variables.
    4. Step Four: Test the theory.

    3.3 Economists Tell Stories

    3.4 CASE STUDY: A Yen for Vending Machines

    3.5 Predicting Average Behavior
    1. Economic theories do not permit an economist to predict the behavior of individuals because any individual may behave in unpredictable ways.
    2. The random behaviors of individuals tend to cancel each other, so the average behavior of a large group can be predicted.

    3.6 Normative Versus Positive Analysis
    1. A positive statement is one that can be verified by referring to the facts.
    2. A normative statement is a statement representing someone's opinion or values; it cannot be proved or disproved.

    3.7 Some Pitfalls of Faulty Economic Analysis
    1. Fallacy That Association Is Causation. It is a mistake in analysis to think that one event caused another simply because the first event preceded the second.
    2. Fallacy of Composition. It is erroneous to believe that what is true for the individual is true for the group.
    3. Mistake of Ignoring the Secondary Effects. Economic analysis should not ignore secondary effects, which develop slowly over time as people react to events.

    3.8 If Economists Are So Smart, Why Aren't They Rich? The economics profession thrives because its models usually do a better job of explaining the real world than do alternative approaches.

  7. Appendix: Understanding Graphs. Graphs are a way of compressing information.
  8. 4.1 Drawing Graphs. Graphs can express three types of relations between two variables:
    1. Positive (direct) relation: as one variable increases, the other variable increases.
    2. Negative (inverse) relation: as one variable increases, the other variable decreases.
    3. Independent relation: as one variable increases, the other remains constant; the variables are unrelated.

    4.2 The Slopes of Straight Lines. Slope is the change in the vertical distance between two points divided by the corresponding change in the horizontal distance between the points.

    4.3 The Slope Depends on How Units Are Measured
    1. The mathematical value of the slope depends on the units of measurement on the graph; e.g., the slope of a line relating price and output will be different if output is measured in feet than if it is measured in yards.
    2. The slope measures the marginal effects, so it is important in economic analysis.

    4.4 The Slopes of Curved Lines
    1. Slope of a curved line varies at every point.
    2. Slope of a curved line at a point is found by measuring the slope of a straight line tangent to the curve at the point.

    4.5 Curve Shifts. A curve can shift when a variable not measured on the horizontal or vertical axis changes.

    4.6 Of Mice and Fleas: The 45-Degree Ray from the Origin. Every point on the 45-degree line is of equal distance from both axes.

III. Discussion

The Economic Problem

Two facts of life create the economic problem: scarce resources and unlimited human wants. Resources are combined to produce goods and services. Since resources are scarce, not all goods and services that people desire can be produced; that is, goods and services are also scarce. Consequently, individuals must make choices. Even though we cannot have everything we want, we can have some of the things we want.

Households, firms, governments, and the rest of the world are the four economic actors in the economy. Households act both as consumers who demand the goods and services produced and as resource owners who supply resources to firms and government. Everybody owns at least one productive resource: his or her own labor. Firms supply goods and services to consumers by hiring resources to produce them. The government provides some goods and services, such as national defense, that tend not to be produced by private firms. The government also makes and enforces rules to be followed by other economic actors. The rest of the world includes foreign households, firms, and governments.

Buyers and sellers come together to carry out exchange in markets. Some markets -- farmers' markets, for example -- are physical places with specific geographic locations. Other markets are less concrete and consist of communications by individuals thousands of miles apart. For example, people can order books from a book club through the mail.

Economics is broken down into two parts: microeconomics and macroeconomics. Microeconomics concerns the economic behavior of individual decision makers, such as the consumer, the worker, and the manager of a firm. Macroeconomics examines the economic system as a whole and tries to explain unemployment, inflation, and economic growth.

The Art of Economic Analysis

Economists assume that people are motivated by self-interest. This means that they not only act selfishly, but that they also make choices that will make them better off, as they themselves define "better off." Religious or political zealots who risk their lives for a cause presumably do so because they believe they will be better off for doing so. Self-interest, by itself, does not allow us to make predictions or to explain human behavior adequately. However, when the assumption of rationality is added, we can begin to analyze and explain human behavior. By "rational" we mean consistent and reasonable. If we assume that people behave consistently, then we can predict how they will change their behavior when they face different economic environments.

It is very rare for people to have to make all-or-nothing decisions. Instead, decisions usually involve choices between the status quo and something else. One chooses among having apple pie for dessert, cake for dessert, or no dessert at all. A decision is made on the basis of a comparison of the extra (marginal) benefits and the extra (marginal) costs of the contemplated change. When marginal benefits exceed marginal costs, the individual makes the change.

Rational choice takes time and information. A choice can be a poor one if a decision maker lacks good information. The collection and assimilation of information take time and use up resources. Rational individuals collect information from a variety of sources as long as the expected marginal benefit of doing so exceeds the expected marginal cost.

The Science of Economic Analysis

An economy as large, diverse, and interrelated as the U.S. economy is too complex for any individual to understand. There is so much economic data that people cannot understand the reason for every transaction. A theory is used to reduce the complexity of an economic system to manageable limits. Consequently, a theory does not contain all relevant details and facts. A theory attempts to simplify economic reality by capturing the essential features of economic relations.

Economic analysis follows the scientific method, which can be broken down into four steps. First, the relevant variables must be identified and defined. Second, the assumptions that specify the conditions under which the theory applies must be identified. In economics, it is common to employ the assumption of ceteris paribus, which means "other things held constant." For example, when we say that a higher price for a good causes fewer units of the good to be sold, we hold income and tastes, among other things, constant. Third, hypotheses about the relations among variables are stated. These generally take the form of if-then statements. Fourth, the hypotheses are tested.

Economists distinguish between positive economic statements and normative economic statements. Positive economic statements are associated with economic theory and involve facts or predictions that are testable. Normative economic statements involve value judgments and opinions. The statement "Tariffs on imported steel will increase employment in the U.S. steel industry" is an example of a positive statement. "Higher tariffs should be placed on imported steel" is an example of a normative statement.

Some Pitfalls of Economic Thinking

It is easy to fall into several traps that lead to incorrect economic thinking. The association-causation fallacy is common. It is especially easy to fall into this trap when one event precedes another in time. It can even be the case that the second event caused the first event. For example, if one observed that many people at the race track were betting on a particular horse and then observed that that particular horse won the race, it would be erroneous to conclude that the horse won because many people bet on it. Rather, people expected the horse to win so they bet on the horse. Another common error is the fallacy of composition, which is the mistaken belief that what is true for the individual is also true for the group. One person can see a football game better by standing up, but if everyone stands nobody has a better view. Mistakes are also made when people ignore the secondary effects of an economic activity or policy.

Appendix: Understanding Graphs

If this is your first course in economics, read the appendix to this chapter in the textbook carefully. Economists often use graphs to represent relations. Graphs generally reflect a relation between two variables, such as price and quantity, money supply and interest rates, or wages and hours worked. An independent variable is one that has a causal effect on another variable. The other variable is called the dependent variable because its value depends on the value of the first variable.

A question that is often of interest in economics is whether one variable has a positive, or direct, effect on another variable or an inverse, or negative, effect. Exhibit 1 shows a line that represents a consumption function. The independent variable is income and the dependent variable is consumption expenditures. The graph represents the assumption that as a family's income increases, its consumption spending also increases. Hence, there is a direct, or positive, relation between a family's income and the amount the family spends.

Exhibit 1

A negative, or inverse, relation is illustrated in Exhibit 2. Here the independent variable is hours of practice and the dependent variable is one's golf score. The more one practices, the lower the golf score will be.

Exhibit 2

The slope of a line is the amount the vertical variable changes for a given increase in the horizontal variable. The slope of an upward-sloping line is positive; the slope of a downward-sloping line is negative. The slope of a straight line is constant, but the slope of a curved line changes at every point. To find the slope of a curved line at a point, draw a straight line tangent to the point. The slope of this line is the slope of the curved line at that point. Make sure that you understand the graphs that are used in the appendix in the textbook.

IV. Lagniappe

The Consumption Function

The theory of the consumption function can be used to illustrate the scientific method as it is applied in economics. John Maynard Keynes developed the theory of the consumption function during the Great Depression. He identified two key variables -- consumption spending and income -- and hypothesized that people spend some percentage of any increase in income on goods and save the rest. Hence, consumption is a function of income. After World War II, many economists forecast a recession on the basis of the consumption function theory. They argued that incomes would fall after the war; this would lead to reduced consumption spending, which would reduce the incomes of even more people. However, the recession did not materialize. This caused some economists to reexamine the consumption function. Milton Friedman altered the theory by pointing out that people do not respond to temporary fluctuations in their incomes by altering consumption spending greatly. Instead, they make consumption spending decisions on the basis of their expected long-term average, or permanent, income. Once the theory was modified to include longer-term considerations, it was used more successfully in making predictions.

Question to Think About: Does the percentage of income spent on consumption goods vary with age?

Heroic Self-Interest

As stated before, the assumption of self-interest does not imply that people always behave in a selfish manner. Each person defines his or her own self-interest in a different way. Most of us probably would not consider actions that are likely to lead to our death as being in our self-interest. Yet it is possible for people to believe that. The ancient Greeks wrote of heroes who valued fame more than life and who were willing to die to gain this fame. In the story of the Trojan War, the gods had foretold that the first Greek who landed on Trojan soil would die. A young man named Protesilaos jumped ashore first so that his name would go down in history. The greatest Greek hero, Achilles, faced the option of going to Troy, where he would gain great fame and die, or staying at home, where he would live a long life and remain unknown. He chose to go to Troy. Evidently, he perceived it to be in his self-interest to gain fame rather than to die an unknown.

Question to Think About: Do you think all ancient Greeks would have made the same decision that Achilles made?

V. Key Terms

Scarce resources Other-things-constant assumption
Economics Behavioral assumption
Land Hypothesis
Labor Positive economic statement
Capital Normative economic statement
Human capital Association-causation fallacy
Entrepreneurial ability Fallacy of composition
Rent Secondary effects
Wages Origin
Interest Horizontal axis
Profit Vertical axis
Good Graph
Service Time-series graph
Scarce Functional relation
Market Dependent variable
Product market Independent variable
Resource market Positive, or direct, relation
Microeconomics Negative, or inverse, relation
Macroeconomics Slope
Rational self-interest Tangent
Economic theory, or economic modelRay

VI. Questions

A. Completion

  1. ___________________ is the study of how individuals use their ___________________ resources to satisfy their ___________________ wants.
  2. The ultimate raw material associated with labor is ___________________.
  3. There are two kinds of capital, ___________________ capital and ___________________ capital.
  4. ___________________ includes management and organizational skills, combined with a willingness to take risks.
  5. The entrepreneur is the ___________________ claimant.
  6. An automobile is a ___________________; an airplane ride is a ___________________.
  7. Exchange is carried out in ___________________.
  8. A key behavioral assumption concerning human economic behavior is that of ___________________.
  9. Economic choice usually involves a comparison of ___________________ benefits and costs.
  10. A ___________________ is a simplification of economic reality that tries to capture the most important elements of the relation under consideration.
  11. A __________________ is a quantity that can take on different possible values.
  12. ___________________ are conditional statements of the if-then variety.
  13. A ___________________ economic statement represents an opinion.
  14. Unintended consequences that develop slowly over time as people respond to circumstances are called ___________________ effects.
  15. The relation between income and consumption is ___________________ because increases in income lead to increases in consumption.

B. True/False

  1. _____ The economic problem results from the fact that resources are scarce but human wants tend to be limitless.
  2. _____ A student's knowledge of computer programming is an example of human capital.
  3. _____ Profit goes to the owners of capital.
  4. _____ All goods are scarce but not all services are scarce.
  5. _____ Product markets refer to specific geographic locations.
  6. _____ Microeconomics is the study of the economy as a whole.
  7. _____ People who give to charity cannot be motivated by rational self-interest.
  8. _____ A decision to go to one college instead of another is an example of a marginal decision.
  9. _____ Time is a scarce resource.
  10. _____ Rational self-interest directs people to make any choice for which the total benefits exceed the total costs.
  11. _____ Good theories contain as many details as possible.
  12. _____ Assumptions are used to simplify theories by eliminating areas that are not expected to have important effects on the analysis.
  13. _____ A theory is not good if it cannot predict accurately all the time.
  14. _____ A positive statement is one that can be verified by reference to facts.
  15. _____ If one event follows another, then the first event necessarily caused the second event.
  16. _____Policymakers generally pay close attention to both the primary and the secondary effects of policies.
  17. *_____Two variables are independent if increases in one leave the second unchanged.
  18. *_____The slope of a vertical line is zero.

C. Multiple Choice

  1. Which of the following is an example of a scarce resource?
    1. coal
    2. water
    3. unskilled labor
    4. time
    5. all of the above

  2. Crude oil is considered which kind of resource?
    1. land
    2. labor
    3. physical capital
    4. human capital
    5. none of the above

  3. Since goods are scarce,
    1. we always have to pay money for the goods we get.
    2. we never can get what we want.
    3. everybody wants some of each good that exists.
    4. we must choose among them.
    5. a and d

  4. Services differ from goods in that services
    1. do not always use scarce resources.
    2. do not always satisfy wants.
    3. often do not have a price.
    4. are intangible.
    5. are provided by the government.

  5. Markets include
    1. shopping malls.
    2. arrangements by which buyers and sellers communicate their intentions.
    3. union hiring halls.
    4. all of the above
    5. a and b only.

  6. Which of the following decisions is not consistent with rational self-interest?
    1. giving money to charity
    2. choosing to work for the Peace Corps instead of for a large corporation
    3. buying a car without knowing everything about it
    4. becoming a bullfighter
    5. All are consistent with rational self-interest.

  7. Economic choices are made by comparing
    1. total benefits and total costs.
    2. marginal benefits and marginal costs.
    3. average benefits and average costs.
    4. the behavior of rational people with that of irrational people.
    5. any of the above except d.

  8. People are rational if they
    1. have perfect information about the future.
    2. know and understand philosophy.
    3. are selfish.
    4. make the best choices they can given their circumstances.
    5. none of the above

  9. If consumers must collect information to make rational decisions, then they should collect additional information as long as
    1. it helps them make good decisions.
    2. they learn something from the additional information.
    3. the marginal cost of the information is less than the expected marginal benefit from the information.
    4. there is anything they do not know about the good.
    5. all of the above

  10. A good theory is one that
    1. best replicates reality.
    2. uses the fewest assumptions.
    3. predicts more accurately than other theories.
    4. cannot be proven wrong.
    5. all of the above

  11. The validity of a theory is determined by
    1. testing the reasonableness of its assumptions.
    2. testing its predictions with evidence.
    3. making sure its variables are well defined.
    4. none of the above.
    5. all of the above.

  12. Ceteris paribus means
    1. economic man.
    2. other things constant.
    3. the fallacy of composition.
    4. secondary effects.
    5. positive economics.

  13. A positive statement is one that
    1. can be supported or rejected with reference to the facts.
    2. states how things ought to be.
    3. is true.
    4. cannot be refuted.
    5. all economists agree on.

  14. Which of the following is an example of a normative statement?
    1. The rate of inflation is lower today than it was ten years ago.
    2. High interest rates cause lower economic growth.
    3. Since price controls cause shortages, the government should not use price controls to combat inflation.
    4. Per capita income is higher in the Soviet Union than in the United States.
    5. Tariffs result in higher prices to consumers.

  15. Suppose that some individual decision makers in Los Angeles decide that removing the pollution control equipment on their cars will not have a noticeable effect on pollution in the area. Several months later pollution levels are higher than ever. The decision makers have fallen into
    1. ignoring the secondary effects.
    2. the fallacy that association is causation.
    3. the fallacy of composition.
    4. irrational self-interest.
    5. none of the above.

  16. It has been found that minimum wage laws increase unemployment among teenagers. This is an example of
    1. ignoring the secondary effects.
    2. the fallacy that association is causation.
    3. the fallacy of composition.
    4. irrational self-interest.
    5. none of the above.

    Exhibit 3

  17. *In Exhibit 3, the relationship between price and quantity depicted by line ab is
    1. positive, with slope 0.4.
    2. positive, with slope -0.4.
    3. inverse, with slope -2.5.
    4. inverse, with slope -0.4.
    5. positive, with slope 2.5.

  18. *The value of a dependent variable is determined by
    1. the value of the independent variable.
    2. the values of other dependent variables.
    3. the assumptions of the model.
    4. the reliability of the theory.
    5. b and d.

  19. *A straight line is tangent to a curve at point A. If the slope of the straight line is +3, the slope of the curve at A
    1. is between 0 and +3.
    2. is equal to +3.
    3. is equal to -3.
    4. is more than +3.
    5. The slope cannot be determined without more information.

  20. *If consumption is on the vertical axis and income is on the horizontal axis, a 45-degree line represents
    1. the expected relation between income and consumption.
    2. the marginal benefit from another dollar of income.
    3. the marginal cost of another dollar of income.
    4. the best combination of income and consumption for a rational consumer.
    5. the combination of points where consumption equals income.

D. Discussion Questions

  1. Explain how scarcity and choice are related.

  2. How are human capital and entrepreneurial ability different from labor?

  3. The text says that a study of economic aggregates must begin with an understanding of individual choice. Why is this so?

  4. Explain the concept of rational decision making. Can decisions a student makes about what to take to college be said to involve rational decision making? Explain.

  5. "People don't really act rationally. If they did, there would never be any mistakes." Evaluate this statement.

  6. The number of people volunteering to serve in the Peace Corps increased greatly during the late 1960s. Can you offer an explanation for this?

  7. Sales of automobiles increased in December 1986 and fell in January 1987. The deductibility of sales taxes ended on December 31, 1986. Did the change in the tax laws affect sales of autos in December and January? Explain.

  8. The text says that a company's decision to build a plant in Taiwan can be an example of a marginal decision. Explain how such a large investment can be described as marginal.

  9. People usually spend more time deciding which car to buy than they do choosing a brand of toothpaste. Can you offer an explanation for this observation?

  10. Economic theory says that a rise in the price of a good will cause people to buy less of it. If the price of meat increases and John Doe buys more meat, has the theory been refuted? Explain.

  11. How are economic theory and positive statements related?

  12. Discuss the four steps of the scientific method.

  13. How do predictions and forecasts differ?

  14. If association is not the same as causation, then how can we determine when one variable affects another?

  15. *Use the following information to answer the question below:

    x=02 4 6 8 10 12 14 16 18 20
    y=01 2 3 4 5 6 7 8 9 10

    Exhibit 4

    1. Graph the relation between x and y on Exhibit 4.
    2. Is this a positive or a negative relation? How do you know?
    3. What is the slope of the line?

  16. *You are given the following information regarding the price of eggs and the quantity purchased.

    Price: $1.00 0.90 0.80 0.70 0.60 0.50 0.40
    Quantity (dozens): 1 2 3 4 5 6 7

    Exhibit 5

    1. Graph the relation between price and quantity purchased on Exhibit 5.
    2. What is the slope of the line?

  17. *In Exhibit 6, what is the slope of the curve at point a? point b? point c? point d?

    Exhibit 6

  18. *
    1. Draw a curve whose slope increases with distance from the origin.
    2. Draw a curve illustrating a direct relation whose slope decreases as the distance from the origin increases.
    3. Draw a curve illustrating an inverse relation whose slope increases as the distance from the origin increases.
    4. Draw a curve illustrating an inverse relation whose slope decreases as the distance from the origin increases.

*Throughout this study guide, asterisks next to question numbers indicate that the material is discussed in an appendix.

VII. Answers

A. Completion

1. Economics; scarce; unlimited 9. marginal
2. time 10. theory (model)
3. human; physical 11. variable
4. Entrepreneurial ability 12. Predictions
5. residual 13. normative
6. good; service 14. secondary
7. markets 15. direct (positive)
8. rational self-interest

B. True/False

1. True 10. False
2. True 11. False
3. False 12. True
4. False 13. False
5. False 14. True
6. False 15. False
7. False 16. False
8. True 17. True
9. True 18. False

10. False: Decisions are based on marginal benefits and marginal costs.
12. True: A theory is good not because it predicts accurately all the time but because it predicts better than other theories.

C. Multiple Choice

1. e 6.   e 11. b 16. a
2. a 7.   b 12. b 17. d
3. d 8.   d 13. a 18. a
4. d 9.   c 14. c 19. b
5. d 10. c 15. c 20. e

D. Discussion Questions

  1. Scarcity implies that we cannot have everything that we want. Our resources are limited, so we must choose which of the many possible goods and services we will have. This applies to society as well as to any individual.

  2. Human capital differs from labor in that human capital involves knowledge that people acquire to increase their ability to produce, whereas labor refers to the human time spent in production. Entrepreneurial ability is the special talent of bringing other resources together to produce goods in new and more profitable ways.

  3. All choices are made by individuals. Consequently, to understand how the choices of many individuals affect the economy, it helps to know how the individual choices were made and how they interact to determine the aggregate performance.

  4. Rational decision making involves comparing the status quo with the marginal benefits and marginal costs of alternative situations. The rational individual chooses so as to make him-self or herself as well off as possible, given the constraints the individual faces. A college student cannot take everything to the dorm, so the student must choose which items to take. The things that are most likely to be used at college will go; those that are less likely to be used will not go. The larger the dorm room and the larger the vehicle taking the things, the more the student will take to college.

  5. People do not know all possible effects of every decision. Therefore, people sometimes make mistakes. If individuals had better information, they would choose differently.

  6. One explanation is that the military was drafting eligible young men in the late 1960s to fight in the Vietnam War. The Peace Corps was an alternative to the military, so many chose to join the Peace Corps.

  7. Yes. People who were considering the purchase of a new car were spurred to act before the end of December to avoid the tax penalty. On the margin, it was more attractive to buy a new car in December 1986 than in January 1987.

  8. A new plant increases the productive capacity of a firm. If the firm wants to increase capacity, it must either build a new plant or expand an existing plant. The decision is a marginal decision since it involves a change from the status quo rather than an all-or-nothing decision.

  9. People make decisions on the basis of expected marginal benefits and expected marginal costs. Since the marginal costs of buying a new car are greater than those of buying a new tube of toothpaste, we expect people to inquire more about the expected benefits of the automobile.

  10. No. Theory applies to people on average, not to specific individuals. There are many possible factors that could explain John Doe's behavior-he may have just quit being a vegetarian, he may have inherited a lot of money, or he may be getting ready to have a big dinner party.

  11. The predictions of economic theory are positive statements, since they are capable of being tested and either upheld or refuted. Theory does not involve opinion or value judgments.

  12. The first step is to identify and define the key economic variables. The second step is to state the assumptions, including behavioral assumptions, that specify the conditions under which the theory is to apply. Basically, this involves identifying the variables or conditions that would cause the theory not to predict as well as expected. The third step is to develop testable hypotheses about the relations among the variables. The last step is to test the theory.

  13. Predictions are based on the implications of a theory and generally take the form of if-then statements. There is no expectation that the prediction will occur if the conditions are not met. A forecast is an educated guess that a certain event will actually occur.

  14. One of the roles of theory is to identify likely causal relations. However, there will be occasions when we cannot ascertain causality.

    1. Discussion Question 15a Graph
    2. The relation is positive because when x goes up, y goes up.
    3. 0.5

    1. Discussion Question 16a Graph
    2. -.1

  15. Slope at point a: -1; at point b: 0; at point c: 1; at point d: infinite

  16. Discussion Question 18 Graph