I. Introduction

II. Outline

The Economic Problem.

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.

The Art of Economic Analysis

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

The Science of Economic Analysis

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.

Appendix: Understanding Graphs. Graphs are a way of compressing information.

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

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

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

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

Appendix: Understanding Graphs

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.

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.

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

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

Heroic Self-Interest

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

V. Key Terms

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

VII. Answers

A. Completion

B. True/False

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.

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

16. 1. 
       
    2. -.1

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

18.