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Unformatted text preview: coL75888_ch01_001-024.indd coL75888_ch01_001-024.indd Page 4 6/22/09 11:20:00 PM user-f501 /Users/user-f501/Desktop CHAPTER 1 Economics and Economic Reasoning In my vacations, I visited the poorest quarters of several cities and walked through one street after another, looking at the faces of the poorest people. Next I resolved to make as thorough a study as I could of Political Economy. —Alfred Marshall AFTER READING THIS CHAPTER, YOU SHOULD BE ABLE TO: 1. Define economics and explain how economists develop models. 2. Explain how to make decisions by comparing marginal costs and marginal benefits. 3. Define opportunity cost and explain its relationship to economic reasoning. 4. Explain real-world events in terms of economic forces, social forces, and political forces. 5. Differentiate between microeconomics and macroeconomics. 6. Distinguish among positive economics, normative economics, and the art of economics. hen an artist looks at the world, he sees color. When a musician looks at the world, she hears music. When an economist looks at the world, she sees a symphony of costs and benefits. The economist’s world might not be as colorful or as melodic as the others’ worlds, but it’s more practical. If you want to understand what’s going on in the world that’s really out there, you need to know economics. I hardly have to convince you of this fact if you keep up with the news. Unemployment is down; the price of gas is up; interest rates are down; businesses are going bankrupt . . . The list is endless. So let’s say you grant me that economics is important. That still doesn’t mean that it’s worth studying. The real question then is: How much will you learn? Most of what you learn depends on you, but part depends on the teacher and another part depends on the textbook. On both these counts, you’re in luck; since your teacher chose this book for your course, you must have a super teacher.1 W What Economics Is Economics is the study of how human beings coordinate their wants and desires, given the decision-making mechanisms, social customs, and political realities of the society. One of the key words in the definition of the term “economics” is coordination. Coordination 1 This book is written by a person, not a machine. That means that I have my quirks, my odd sense of humor, and my biases. All textbook writers do. Most textbooks have the quirks and eccentricities edited out so that all the books read and sound alike—professional but dull. I choose to sound like me—sometimes professional, sometimes playful, and sometimes stubborn. In my view, that makes the book more human and less dull. So forgive me my quirks—don’t always take me too seriously—and I’ll try to keep you awake when you’re reading this book at 3 a.m. the day of the exam. If you think it’s a killer to read a book this long, you ought to try writing one. coL75888_ch01_001-024.indd coL75888_ch01_001-024.indd Page 5 6/22/09 11:20:03 PM user-f501 /Users/user-f501/Desktop Chapter 1 ■ Economics and Economic Reasoning 5 can mean many things. In the study of economics, coordination refers to how the three central problems facing any economy are solved. These central problems are 1. What, and how much, to produce. 2. How to produce it. 3. For whom to produce it. How hard is it to make the three decisions? Imagine for a moment the problem of living in a family: the fights, arguments, and questions that come up. “Do I have to do the dishes?” “Why can’t I have piano lessons?” “Bobby got a new sweater. How come I didn’t?” “Mom likes you best.” Now multiply the size of the family by millions. The same fights, the same arguments, the same questions—only for society the questions are millions of times more complicated. In answering these questions, economies find that inevitably individuals want more than is available, given how much they’re willing to work. That means that in our economy there is a problem of scarcity—the goods available are too few to satisfy individuals’ desires. Three central coordination problems any economy must solve are what to produce, how to produce it, and for whom to produce it. The coordination questions faced by society are complicated. Scarcity Scarcity has two elements: our wants and our means of fulfilling those wants. These can be interrelated since wants are changeable and partially determined by society. The way we fulfill wants can affect those wants. For example, if you work on Wall Street, you will probably want upscale and trendy clothes. Up here in Vermont, I am quite happy wearing Levi’s and flannel. The degree of scarcity is constantly changing. The quantity of goods, services, and usable resources depends on technology and human action, which underlie production. Individuals’ imagination, innovativeness, and willingness to do what needs to be done can greatly increase available goods and resources. Who knows what technologies are in our future—nannites or micromachines that change atoms into whatever we want could conceivably eliminate scarcity of goods we currently consume. But they would not eliminate scarcity entirely since new wants are constantly developing. So, how does an economy deal with scarcity? The answer is coercion. In all known economies, coordination has involved some type of coercion—limiting people’s wants and increasing the amount of work individuals are willing to do to fulfill those wants. The reality is that many people would rather play than help solve society’s problems. So the basic economic problem involves inspiring people to do things that other people want them to do, and not to do things that other people don’t want them to do. Thus, an alternative definition of economics is that it is the study of how to get people to do things they’re not wild about doing (such as studying) and not to do things they are wild about doing (such as eating all the lobster they like), so that the things some people want to do are consistent with the things other people want to do. The quantity of goods, services, and usable resources depends on technology and human action. Modern Economics Economics, like any field of study, evolves and changes. As technology and analytic techniques change and as new evidence is discovered, the approach that economists use to study problems changes. In early times, economics was primarily based on deduction—a method of reasoning in which one deduces a theory based on a set of almost self-evident principles. Theory consists of logical deductions based on those principles. The traditional principles upon which economic theories were built are the assumptions that people are rational and self-interested. There were, of course, enormous debates about how to interpret rationality and self-interest, but these remained theoretical debates since economists had no good way to test which interpretation was more accurate. coL75888_ch01_001-024.indd coL75888_ch01_001-024.indd Page 6 6/22/09 11:20:03 PM user-f501 /Users/user-f501/Desktop 6 Introduction ■ Thinking Like an Economist Modern economics is no longer solely a deductive science. Modern economics is based on both deduction and induction—a method of reasoning in which one develops general principles by looking for patterns in the data. Modern behavioral economists, for example, will do a lab experiment to see how people behave, and then build their models on the behavior that they observe. One of the reasons induction has become more important in modern economics is that computing technology has improved, lowering the cost of using inductive methods. Economists can now analyze large data sets and find patterns through the use of statistical methods. Such analysis was impossible 50 years ago and was much more difficult to do even 10 or 20 years ago. In Chapter 6 we explore these changes in more detail. A Guide to Economic Reasoning People trained in economics think in a certain way. They analyze everything critically; they compare the costs and the benefits of every issue and make decisions based on those costs and benefits. For example, say you’re trying to decide whether a policy to eliminate terrorist attacks on airlines is a good idea. Economists are trained to put their emotions aside and ask: What are the costs of the policy, and what are the benefits? Thus, they are open to the argument that security measures, such as conducting body searches of every passenger or scanning all baggage with bomb-detecting machinery, might not be the appropriate policy because the costs might exceed the benefits. To think like an economist involves addressing almost all issues using a cost/ benefit approach. Economic reasoning also involves abstracting from the “unimportant” elements of a question and focusing on the “important” ones by creating a simple model that captures the essence of the issue or problem. How do you know whether the model has captured the important elements? By collecting empirical evidence and “testing” the model—matching the predictions of the model with the empirical evidence—to see if it fits. Economic reasoning—how to think like a modern economist, making decisions on the basis of costs and benefits—is the most important lesson you’ll learn from this book. The book Freakonomics gives examples of the economist’s approach. It describes a number of studies by University of Chicago economist Steve Levitt that unlock seemingly mysterious observations with basic economic reasoning. For example, Levitt asks the question: Why do drug dealers on the street tend to live with their mothers? The answer he arrives at is that it is because they can’t afford to live on their own; most earn less than $5 an hour. Why, then, are they dealing drugs and not working a legal job that, even for a minimum-wage job, pays over $7.00 an hour? The answer to that is determined through cost/benefit analysis. While their current income is low, their potential income as a drug dealer is much higher since, given their background and current U.S. institutions, they are more likely to move up to a high position in the local drug business (and Freakonomics describes how it is a business) and earn a six-figure income than they are to move up from working as a Taco Bell technician to an executive earning a six-figure income in corporate America. Levitt’s model is a very simple one—people do what is in their best interest financially—and it assumes that people rely on a cost/benefit analysis to make decisions. Finally, he supports his argument through careful empirical work, collecting and organizing the data to see if they fit the model. His work is a good example of “thinking like a modern economist” in action. Economic reasoning, once learned, is infectious. If you’re susceptible, being exposed to it will change your life. It will influence your analysis of everything, including issues normally considered outside the scope of economics. For example, you will likely use economic reasoning to decide the possibility of getting a date for Saturday night, and Economic reasoning is making decisions on the basis of costs and benefits. coL75888_ch01_001-024.indd Page 7 6/22/09 11:20:03 PM user-f501 /Users/user-f501/Desktop ADDED DIMENSION Economic Knowledge in One Sentence: TANSTAAFL Once upon a time, Tanstaafl was made king of all the lands. His first act was to call his economic advisers and tell them to write up all the economic knowledge the society possessed. After years of work, they presented their monumental effort: 25 volumes, each about 400 pages long. But in the interim, King Tanstaafl had become a very busy man, what with running a kingdom of all the lands and all. Looking at the lengthy volumes, he told his advisers to summarize their findings in one volume. Despondently, the economists returned to their desks, wondering how they could summarize what they’d been so careful to spell out. After many more years of rewriting, they were finally satisfied with their one-volume effort, and tried to make an appointment to see the king. Unfortunately, affairs of state had become even more pressing than before, and the king couldn’t take the time to see them. Instead he sent word to them that he couldn’t be bothered with a whole volume, and ordered them, under threat of death (for he had become a tyrant), to reduce the work to one sentence. The economists returned to their desks, shivering in their sandals and pondering their impossible task. Thinking about their fate if they were not successful, they decided to send out for one last meal. Unfortunately, when they were collecting money to pay for the meal, they discovered they were broke. The disgusted delivery man took the last meal back to the restaurant, and the economists started down the path to the beheading station. On the way, the delivery man’s parting words echoed in their ears. They looked at each other and suddenly they realized the truth. “We’re saved!” they screamed. “That’s it! That’s economic knowledge in one sentence!” They wrote the sentence down and presented it to the king, who thereafter fully understood all economic problems. (He also gave them a good meal.) The sentence? T h ere A i n’t N o S u ch T h ing A s A F r ee L u nch— TANSTAAFL who will pay for dinner. You will likely use it to decide whether to read this book, whether to attend class, whom to marry, and what kind of work to go into after you graduate. This is not to say that economic reasoning will provide all the answers. As you will see throughout this book, real-world questions are inevitably complicated, and economic reasoning simply provides a framework within which to approach a question. In the economic way of thinking, every choice has costs and benefits, and decisions are made by comparing them. Marginal Costs and Marginal Benefits The relevant costs and relevant benefits to economic reasoning are the expected incremental, or additional, costs incurred and the expected incremental benefits that result from a decision. Economists use the term marginal when referring to additional or incremental. Marginal costs and marginal benefits are key concepts. A marginal cost is the additional cost to you over and above the costs you have already incurred. That means not counting sunk costs—costs that have already been incurred and cannot be recovered—in the relevant costs when making a decision. Consider, for example, attending class. You’ve already paid your tuition; it is a sunk cost. So the marginal (or additional) cost of going to class does not include tuition. Similarly with marginal benefit. A marginal benefit is the additional benefit above what you’ve already derived. The marginal benefit of reading this chapter is the additional knowledge you get from reading it. If you already knew everything in this chapter before you picked up the book, the marginal benefit of reading it now is zero. The marginal benefit is not zero if by reading the chapter you learn that you are prepared for class; before, you might only have suspected you were prepared. www Web Note 1.1 Costs and Benefits Marginal Cost and Marginal Benefit 7 coL75888_ch01_001-024.indd Page 8 6/22/09 11:20:04 PM user-f501 /Users/user-f501/Desktop 8 Introduction ■ Thinking Like an Economist If the marginal benefits of doing something exceed the marginal costs, do it. If the marginal costs of doing something exceed the marginal benefits, don’t do it. Comparing marginal (additional) costs with marginal (additional) benefits will often tell you how you should adjust your activities to be as well off as possible. Just follow the economic decision rule: If the marginal benefits of doing something exceed the marginal costs, do it. If the marginal costs of doing something exceed the marginal benefits, don’t do it. As an example, let’s consider a discussion I might have with a student who tells me that she is too busy to attend my classes. I respond, “Think about the tuition you’ve spent for this class—it works out to about $40 a lecture.” She answers that the book she reads for class is a book that I wrote, and that I wrote it so clearly she fully understands everything. She goes on: I’ve already paid the tuition and whether I go to class or not, I can’t get any of the tuition back, so the tuition is a sunk cost and doesn’t enter into my decision. The marginal cost to me is what I could be doing with the hour instead of spending it in class. I value my time at $75 an hour [people who understand everything value their time highly], and even though I’ve heard that your lectures are super, I estimate that the marginal benefit of your class is only $50. The marginal cost, $75, exceeds the marginal benefit, $50, so I don’t attend class. I congratulate her on her diplomacy and her economic reasoning, but tell her that I give a quiz every week, that students who miss a quiz fail the quiz, that those who fail all the quizzes fail the course, and that those who fail the course do not graduate. In short, she is underestimating the marginal benefits of attending my classes. Correctly estimated, the marginal benefits of attending my class exceed the marginal costs. So she should attend my class. Q-1 Say you bought a share of Sun Microsystems for $100 and a share of Cisco for $10. The price of each is currently $15. Assuming taxes are not an issue, which would you sell if you need $15? Economics and Passion www Web Note 1.2 Blogonomics Economic reasoning is based on the premise that everything has a cost. Q-2 Can you think of a reason why a cost/benefit approach to a problem might be inappropriate? Can you give an example? Recognizing that everything has a cost is reasonable, but it’s a reasonableness that many people don’t like. It takes some of the passion out of life. It leads you to consider possibilities like these: • Saving some people’s lives with liver transplants might not be worth the additional cost. The money might be better spent on nutritional programs that would save 20 lives for every 2 lives you might save with transplants. • Maybe we shouldn’t try to eliminate all pollution because the additional cost of doing so may be too high. To eliminate all pollution might be to forgo too much of some other worthwhile activity. • Providing a guaranteed job for every person who wants one might not be a worthwhile policy goal if it means that doing so will reduce the ability of an economy to adapt to new technologies. • It might make sense for the automobile industry to save $12 per car by not installing a safety device, even though without the safety device some people will be killed. You get the idea. This kind of reasonableness is often criticized for being coldhearted. But, not surprisingly, economists disagree; they argue that their reasoning leads to a better society for the majority of people. Economists’ reasonableness isn’t universally appreciated. Businesses love the result; others aren’t so sure, as I discovered some years back when my then-girlfriend told me she was leaving me. “Why?” I asked. “Because,” she responded, “you’re so, so . . . reasonable.” It took me many years after she left to learn what she already knew: There are many types of reasonableness, and not everyone thinks an coL75888_ch01_001-024.indd Page 9 6/22/09 11:20:05 PM user-f501 /Users/user-f501/Desktop Chapter 1 ■ Economics and Economic Reasoning 9 economist’s reasonableness is a virtue. I’ll discuss such issues later; for now, let me simply warn you that, for better or worse, studying economics will lead you to view questions in a cost/benefit framework. Opportunity Cost Putting economists’ cost/benefit rules into practice isn’t easy. To do so, you have to be able to choose and measure the costs and benefits correctly. Economists have devised the concept of opportunity cost to help you do that. Opportunity cost is the benefit that you might have gained from choosing the next-best alternative. To obtain the benefit of something, you must give up (forgo) something else—namely, the next-best alternative. The opportunity cost is the value of that nextbest alternative; that is a cost because in choosing one thing, you are precluding an alternative choice. The TANSTAAFL Opportunity costs have always made choice difficult, as we see in the story in the box on page 7 embodies the opportunity cost early-19th-century engraving, “One or the Other.” concept because it tells us that there is a cost to everything; Opportunity cost is the basis of that cost is the next-best forgone alternative. Let’s consider some examples. The opportunity cost of going out once with Natalie cost/benefit economic reasoning; it that you (or Nathaniel), the most beautiful woman (attractive man) in the world, is the benefit is the benefit choosing might have gained from the next-best you’d get from going out with your solid steady, Margo (Mike). The opportunity cost of alternative. cleaning up the environment might be a reduction in the money available to assist lowincome individuals. The opportunity cost of having a child might be two boats, three cars, and a two-week vacation each year for five years, which are what you could have had if you hadn’t had the child. (Kids really are this expensive.) Examples are endless, but let’s consider two that are particularly relevant to you: Opportunity Cost what courses to take and how much to study. Let’s say you’re a full-time student and at the beginning of the term you had to choose five courses. Taking one precludes taking some other, and the opportunity cost of taking an economics course may well be not taking a course on theater. Similarly with studying: You have a limited amount of time to spend studying economics, studying some other subject, sleeping, or partying. The more time you spend on one activity, the less time you have for another. That’s opportunity cost. Notice how neatly the opportunity cost concept takes into account costs and benWeb Note 1.3 efits of all other options, and converts these alternative benefits into costs of the deciOpportunity Cost sion you’re now making. The relevance of opportunity cost isn’t limited to your individual decisions. Opportunity costs are also relevant to government’s decisions, which affect everyone in society. A common example is what is called the guns-versus-butter debate. The resources that a society has are limited; therefore, its decision to use those resources to have more guns (more weapons) means that it will have less butter (fewer consumer goods). Thus, when society decides to spend $50 billion more on an improved health care system, the opportunity cost of that decision is $50 billion not spent on helping the homeless, paying off some of the national debt, or providing for national defense. The opportunity cost concept has endless implications. It can even be turned upon Q-3 John, your study partner, has itself. For instance, it takes time to think about alternatives; that means that there’s a just said that the opportunity cost of cost to being reasonable, so it’s only reasonable to be somewhat unreasonable. If you studying this chapter is about 1/38 the price you paid for this book, followed that argument, you’ve caught the economic bug. If you didn’t, don’t worry. Just since the chapter is about 1/38 of remember the opportunity cost concept for now; I’ll infect you with economic thinking the book. Is he right? Why or why not? in the rest of the book. www coL75888_ch01_001-024.indd Page 10 6/22/09 11:20:05 PM user-f501 /Users/user-f501/Desktop ADDED DIMENSION Economics in Perspective All too often, students study economics out of context. They’re presented with sterile analysis and boring facts to memorize, and are never shown how economics fits into the larger scheme of things. That’s bad; it makes economics seem boring—but economics is not boring. Every so often throughout this book, sometimes in the appendixes and sometimes in these boxes, I’ll step back and put the analysis in perspective, giving you an idea from whence the analysis sprang and its historical context. In educational jargon, this is called enrichment. I begin here with economics itself. First, its history: In the 1500s there were few universities. Those that existed taught religion, Latin, Greek, philosophy, history, and mathematics. No economics. Then came the Enlightenment (about 1700), in which reasoning replaced God as the explanation of why things were the way they were. Pre-Enlightenment thinkers would answer the question “Why am I poor?” with “Because God wills it.” Enlightenment scholars looked for a different explanation. “Because of the nature of land ownership” is one answer they found. Such reasoned explanations required more knowledge of the way things were, and the amount of information expanded so rapidly that it had to be divided or categorized for an individual to have hope of knowing a subject. Soon philosophy was subdivided into science and philosophy. In the 1700s, the sciences were split into natural sciences and social sciences. The amount of knowledge kept increasing, and in the late 1800s and early 1900s social science itself split into subdivisions: economics, political science, history, geography, sociology, anthropology, and psychology. Many of the insights about how the economic system worked were codified in Adam Smith’s The Wealth of Nations, written in 1776. Notice that this is before economics as a subdiscipline developed, and Adam Smith could also be classified as an anthropologist, a sociologist, a political scientist, and a social philosopher. Throughout the 18th and 19th centuries, economists such as Adam Smith, Thomas Malthus, John Stuart Mill, David Ricardo, and Karl Marx were more than economists; they were social philosophers who covered all aspects of social science. These writers were subsequently called classical economists. Alfred Marshall continued in that classical tradition, and his book, Principles of Economics, published in the late 1800s, was written with the other social sciences much in evidence. But Marshall also changed the questions economists ask; he focused on those questions that could be asked in a graphical supply/demand framework. This book falls solidly in the Marshallian tradition. It presents economics as a way of thinking—as an engine of analysis used to understand real-world phenomena. But it goes beyond Marshall, and introduces you to a wider variety of models and thinking than the supply and demand models that Marshall used. Marshallian economics is primarily about policy, not theory. It sees institutions as well as political and social dimensions of reality as important, and it shows you how economics ties in to those dimensions. Economic and Market Forces Q-4 Ali, your study partner, states that rationing health care is immoral—that health care should be freely available to all individuals in society. How would you respond? When an economic force operates through the market, it becomes a market force. 10 The opportunity cost concept applies to all aspects of life and is fundamental to understanding how society reacts to scarcity. When goods are scarce, those goods must be rationed. That is, a mechanism must be chosen to determine who gets what. Let’s consider some specific real-world rationing mechanisms. Dormitory rooms are often rationed by lottery, and permission to register in popular classes is often rationed by a first-come, first-registered rule. Food in the United States, however, is generally rationed by price. If price did not ration food, there wouldn’t be enough food to go around. All scarce goods must be rationed in some fashion. These rationing mechanisms are examples of economic forces, the necessary reactions to scarcity. One of the important choices that a society must make is whether to allow these economic forces to operate freely and openly or to try to rein them in. A market force is an economic force that is given relatively free rein by society to work through the market. Market forces ration by changing prices. When there’s a shortage, the price goes up. When there’s a surplus, the price goes down. Much of this book will be devoted to coL75888_ch01_001-024.indd coL75888_ch01_001-024.indd Page 11 6/22/09 11:20:06 PM user-f501 /Users/user-f501/Desktop Chapter 1 ■ Economics and Economic Reasoning 11 analyzing how the market works like an invisible hand, guiding economic forces to coordinate individual actions and allocate scarce resources. The invisible hand is the price mechanism, the rise and fall of prices that guides our actions in a market. Societies can’t choose whether or not to allow economic forces to operate—economic forces are always operating. However, societies can choose whether to allow market forces to predominate. Social, cultural, and political forces play a major role in deciding whether to let market forces operate. Economic reality is determined by a contest among these various forces. Let’s consider an example in which social forces prevent an economic force from becoming a market force: the problem of getting a date for Saturday night. If a school (or a society) has significantly more people of one gender than the other (let’s say more men than women), some men may well find themselves without a date—that is, men will be in excess supply—and will have to find something else to do, say study or go to a movie by themselves. An “excess supply” person could solve the problem by paying someone to go out with him or her, but that would probably change the nature of the date in unacceptable ways. It would be revolting to the person who offered payment and to the person who was offered payment. That unacceptability is an example of the complex social and cultural norms that guide and limit our activities. People don’t try to buy dates because social forces prevent them from doing so. Now let’s consider another example in which political and legal influences stop economic forces from becoming market forces. Say you decide that you can make some money delivering mail in your neighborhood. You try to establish a small business, but suddenly you are confronted with the law. The U.S. Postal Service has a legal exclusive right to deliver regular mail, so you’ll be prohibited from delivering regular mail in competition with the post office. Economic forces—the desire to make money—led you to want to enter the business, but in this case political forces squash the invisible hand. Often political and social forces work together against the invisible hand. For example, in the United States there aren’t enough babies to satisfy all the couples who desire them. Babies born to particular sets of parents are rationed—by luck. Consider a group of parents, all of whom want babies. Those who can, have a baby; those who can’t have one, but want one, try to adopt. Adoption agencies ration the available babies. Who gets a baby depends on whom people know at the adoption agency and on the desires of the birth mother, who can often specify the socioeconomic background (and many other characteristics) of the family in which she wants her baby to grow up. That’s the economic force in action; it gives more power to the supplier of something that’s in short supply. If our society allowed individuals to buy and sell babies, that economic force would be translated into a market force. The invisible hand would see to it that the quantity of babies supplied would equal the quantity of babies demanded at some price. The market, not the adoption agencies, would do the rationing.2 Most people, including me, find the idea of selling babies repugnant. But why? It’s the strength of social forces reinforced by political forces. What is and isn’t allowable differs from one society to another. For example, in Cuba and North Korea, many private businesses are against the law, so not many people start their own businesses. In the United States, until the 1970s, it was against the law 2 Economic Economic reality is controlled by three forces: 1. Economic forces (the invisible hand). 2. Social and cultural forces. 3. Political and legal forces. Social, cultural, and political forces can play a significant role in the economy. Q-5 Your study partner, Joan, states that market forces are always operative. Is she right? Why or why not? Even though it’s against the law, some babies are nonetheless “sold” on a semilegal market, also called a gray market. At the turn of the century, the “market price” for a healthy baby was about $30,000. If it were legal to sell babies (and if people didn’t find it morally repugnant to have babies in order to sell them), the price would be much lower because there would be a larger supply of babies. (It was not against the law to sell human eggs in the early 2000s, and one human egg was sold for $50,000. The average price was much lower; it varied with donor characteristics such as SAT scores and athletic accomplishments.) coL75888_ch01_001-024.indd coL75888_ch01_001-024.indd Page 12 6/22/09 11:20:07 PM user-f501 /Users/user-f501/Desktop 12 Introduction ■ Thinking Like an Economist Economic forces are always Economic operative; society may allow market forces to operate. What happens in society can be seen as a reaction to, and interaction of, economic forces with other forces. to hold gold except in jewelry and for certain limited uses such as dental supplies, so most people refrained from holding gold. Ultimately a country’s laws and social norms determine whether the invisible hand will be allowed to work. Social and political forces are active in all parts of your life. You don’t practice medicine without a license; you don’t sell body parts or certain addictive drugs. These actions are against the law. But many people do sell alcohol; that’s not against the law if you have a permit. You don’t charge your friends interest to borrow money (you’d lose friends); you don’t charge your children for their food (parents are supposed to feed their children); many sports and media stars don’t sell their autographs (some do, but many consider the practice tacky); you don’t lower the wage you’ll accept in order to take a job away from someone else (you’re no scab). The list is long. You cannot understand economics without understanding the limitations that political and social forces place on economic actions. In summary, what happens in a society can be seen as the reaction to, and interaction of, these three forces: economic forces, political and legal forces, and social and historical forces. Economics has a role to play in sociology, history, and politics, just as sociology, history, and politics have roles to play in economics. Economic Terminology www Web Note 1.4 Hip Hop Economics Economic terminology needs little discussion. It simply needs learning. As terms come up, you’ll begin to recognize them. Soon you’ll begin to understand them, and finally you’ll begin to feel comfortable using them. In this book, I’m trying to describe how economics works in the real world, so I introduce you to many of the terms that occur in business and in discussions of the economy. Whenever possible I’ll integrate the introduction of new terms into the discussion so that learning them will seem painless. In fact I’ve already introduced you to a number of economic terms: opportunity cost, the invisible hand, market forces, economic forces, just to name a few. By the end of the book, I’ll have introduced you to hundreds more. Economic Insights Economists have thought about the economy for a long time, so it’s not surprising that they’ve developed some insights into the way it works. As I stated above, modern economists use a combination of both induction and deduction in arriving at insights. That combination is called abduction. Abduction is a method of analysis that uses a combination of inductive methods and deductive methods. Modern economics is an abductive science. In this book I will introduce you to economic theories and models. Theories and models tie together economists’ terminology and knowledge about economic institutions. Theories are inevitably too abstract to apply in specific cases, and thus a theory is often embodied in an economic model—a framework that places the generalized insights of the theory in a more specific contextual setting—or in an economic principle—a commonly held economic insight stated as a law or general assumption. To see the importance of principles, think back to when you learned to add. You didn’t memorize the sum of 147 and 138; instead, you learned a principle of addition. The principle says that when adding 147 and 138, you first add 7 1 8, which you memorized was 15. You write down the 5 and carry the 1, which you add to 4 1 3 to get 8. Then add 1 1 1 5 2. So the answer is 285. When you know just one principle, you know how to add millions of combinations of numbers. Theories, models, and principles are continually “brought to the data” to see if the predictions of the model match the data. Increases in computing power and new statistical techniques have given modern economists a far more rigorous set of procedures to coL75888_ch01_001-024.indd coL75888_ch01_001-024.indd Page 13 6/22/09 11:20:07 PM user-f501 /Users/user-f501/Desktop Chapter 1 ■ Economics and Economic Reasoning 13 determine how well the predictions fit the data than was the case for earlier economists. This has led to a greater emphasis on inductive methods, and modern economics is characterized by its strong reliance on quantitative empirical methods. Modern empirical work takes a variety of forms. In certain instances, economists study questions by running controlled laboratory experiments. That branch of economics is called experimental economics—a branch of economics that studies the economy through controlled laboratory experiments. Where laboratory experiments are not possible, economists carefully observe the economy and try to figure out what is affecting what. To do so they look for natural experiments—naturally occurring events that approximate a controlled experiment where something has changed in one place but has not changed somewhere else. Economists can then compare the results in the two cases. An example of a natural experiment was when New Jersey raised its minimum wage and neighboring state Pennsylvania did not. Economists Alan Kruger and David Card compared the effects on unemployment in both states and found that increases in the minimum wage in New Jersey did not significantly affect employment. This led to a debate about what the empirical evidence was telling us. The reason is that in such natural experiments, it is impossible to hold “other things constant,” as is done in laboratory experiments, and thus the empirical results in economics are often subject to dispute. As I stated above, modern economics uses a combination of inductive and deductive methods to gain insight into the economy in a method called abduction. Abduction recognizes our inability to determine a final Truth with a capital T, meaning that it is true beyond any doubt, and instead looks for truth with a lowercase t. It’s the best truth we have at the moment. That’s the extent of truth that we will be striving for in this book. While economic models are less general than theories, they are still usually too general to apply in specific cases. Models lead to theorems (propositions that are logically true based on the assumptions in a model). To arrive at policy precepts (policy rules that conclude that a particular course of action is preferable), these theorems must be combined with knowledge of real-world economic institutions and value judgments determining the goals for which one is striving. In discussing policy implications of theories and models, it is important to distinguish precepts from theorems. Theories, models, and principles Theories, must be combined with a knowledge of real-world economic institutions to arrive at specific policy recommendations. The Invisible Hand Theorem Knowing a theory gives you insight into a wide variety of economic phenomena even though you don’t know the particulars of each phenomenon. For example, much of economic theory deals with the pricing mechanism and how the market operates to coordinate individuals’ decisions. Economists have come to the following theorems: When the quantity supplied is greater than the quantity demanded, price has a tendency to fall. When the quantity demanded is greater than the quantity supplied, price has a tendency to rise. Using these generalized theorems, economists have developed a theory of markets that leads to the further theorem that, under certain conditions, markets are efficient. That is, the market will coordinate individuals’ decisions, allocating scarce resources to their best possible use. Efficiency means achieving a goal as cheaply as possible. Economists call this theorem the invisible hand theorem—a market economy, through the price mechanism, will tend to allocate resources efficiently. Theories, and the models used to represent them, are enormously efficient methods of conveying information, but they’re also necessarily abstract. They rely on simplifying assumptions, and if you don’t know the assumptions, you don’t know the theory. The result of forgetting assumptions could be similar to what happens if you forget that you’re Q-6 There has been a superb growing season and the quantity of tomatoes supplied exceeds the quantity demanded. What is likely to happen to the price of tomatoes? coL75888_ch01_001-024.indd coL75888_ch01_001-024.indd Page 14 6/22/09 11:20:07 PM user-f501 /Users/user-f501/Desktop REAL-WORLD APPLICATION Winston Churchill and Lady Astor There are many stories about Nancy Astor, the first woman elected to Britain’s Parliament. A vivacious, fearless American woman, she married into the English aristocracy and, during the 1930s and 1940s, became a bright light on the English social and political scenes, which were already quite bright. One story told about Lady Astor is that she and Winston Churchill, the unorthodox genius who had a long and distinguished political career and who was Britain’s prime minister during World War II, were sitting in a pub having a theoretical discussion about morality. Lady Astor Churchill suggested that as a thought experiment Lady Astor ponder the following question: If a man were to promise her a huge amount of money—say a million pounds—for the privilege, would she sleep with him? Lady Astor did ponder the question for a while and finally answered, yes, she would, if the money were guaranteed. Churchill then asked her if she would sleep with him for five pounds. Her response was sharp: “Of course not. What do you think I am—a prostitute?” Churchill responded, “We have already established that fact; we are now simply negotiating about price.” One moral that economists might draw from this story is that economic incentives, if high enough, can have a powerful influence on behavior. But an equally important moral of the story is that noneconomic incentives also can be very strong. Why do most people feel it’s wrong to sell sex for money, even if they might be willing to do so if the price were high enough? Keeping this second moral in mind will significantly increase your economic understanding of real-world events. supposed to add numbers in columns. Forgetting that, yet remembering all the steps, can lead to a wildly incorrect answer. For example, 147 1 138 1,608 is wrong. Knowing the assumptions of theories and models allows you to progress beyond gut reaction and better understand the strengths and weaknesses of various economic theories and models. Let’s consider a central economic assumption: the assumption that individuals behave rationally—that what they choose reflects what makes them happiest, given the constraints. If that assumption doesn’t hold, the invisible hand theorem doesn’t hold. I find it useful to distinguish two types of modern economists: modern traditional economists and modern behavioral economists. Modern traditional economists use models that focus on traditional assumptions of rationality and self-interest; modern behavioral economists modify these assumptions, and are working on models that incorporate some predictably irrational behavior. Yet another group of modern economists deemphasizes deductive models almost completely and develops empirical models that are primarily based on statistical patterns they discover in data. Presenting the invisible hand theorem in its full beauty is an important part of any economics course. Presenting the assumptions on which it is based and the limitations of the invisible hand is likewise an important part of the course. I’ll do both throughout the book. Economic Theory and Stories Theory Theory is a shorthand way of telling a story. 14 Economic theory, and the models in which that theory is presented, often developed as a shorthand way of telling a story. These stories are important; they make the theory come alive and convey the insights that give economic theory its power. In this book I coL75888_ch01_001-024.indd coL75888_ch01_001-024.indd Page 15 6/22/09 11:20:09 PM user-f501 /Users/user-f501/Desktop Chapter 1 ■ Economics and Economic Reasoning 15 present plenty of theories and models, but they’re accompanied by stories that provide the context that makes them relevant. At times, because there are many new terms, discussing theories takes up much of the presentation time and becomes a bit oppressive. That’s the nature of the beast. As Albert Einstein said, “Theories should be as simple as possible, but not more so.” When a theory becomes oppressive, pause and think about the underlying story that the theory is meant to convey. That story should make sense and be concrete. If you can’t translate the theory into a story, you don’t understand the theory. Microeconomics and Macroeconomics Economic theory is divided into two parts: microeconomic theory and macroeconomic theory. Microeconomic theory considers economic reasoning from the viewpoint of individuals and firms and builds up to an analysis of the whole economy. Microeconomics is the study of individual choice, and how that choice is influenced by economic forces. Microeconomics studies such things as the pricing policies of firms, households’ decisions on what to buy, and how markets allocate resources among alternative ends. Our discussion of opportunity cost was based on microeconomic theory. The invisible hand theorem comes from microeconomics. As we build up from microeconomic analysis to an analysis of the entire economy, everything gets rather complicated. Many economists try to uncomplicate matters by taking a different approach—a macroeconomic approach—first looking at the aggregate, or whole, and then breaking it down into components. Macroeconomics is the study of the economy as a whole. It considers the problems of inflation, unemployment, business cycles, and growth. Macroeconomics focuses on aggregate relationships such as how household consumption is related to income and how government policies can affect growth. Consider an analogy to the human body. A micro approach analyzes a person by looking first at each individual cell and then builds up. A macro approach starts with the person and then goes on to his or her components—arms, legs, fingernails, feelings, and so on. Put simply, microeconomics analyzes from the parts to the whole; macroeconomics analyzes from the whole to the parts. Microeconomics and macroeconomics are very much interrelated. What happens in the economy as a whole is based on individual decisions, but individual decisions are made within an economy and can be understood only within that context. For example, whether a firm decides to expand production capacity will depend on what the owners expect will happen to the demand for their products. Those expectations are determined by macroeconomic conditions. Because microeconomics focuses on the individual and macroeconomics focuses on the whole economy, traditionally microeconomics and macroeconomics are taught separately, even though they are interrelated. Microeconomics is the study of how individual choice is influenced by economic forces. Macroeconomics is the study of the economy as a whole. It considers the problems of inflation, unemployment, business cycles, and growth. Q-7 Classify the following topics as macroeconomic or microeconomic: 1. The impact of a tax increase on aggregate output. 2. The relationship between two competing firms’ pricing behavior. 3. A farmer’s decision to plant soy or wheat. 4. The effect of trade on economic growth. Economic Institutions To know whether you can apply economic theory to reality, you must know about economic institutions—laws, common practices, and organizations in a society that affect the economy. Corporations, governments, and cultural norms are all examples of economic institutions. Many economic institutions have social, political, and religious dimensions. For example, your job often influences your social standing. In addition, many social institutions, such as the family, have economic functions. I include any institution that significantly affects economic decisions as an economic institution because you must understand that institution if you are to understand how the economy functions. Economic institutions differ significantly among countries. For example, in Germany banks are allowed to own companies; in the United States they cannot. This helps To apply economic theory to reality, you’ve got to have a sense of economic institutions. coL75888_ch01_001-024.indd coL75888_ch01_001-024.indd Page 16 6/22/09 11:20:09 PM user-f501 /Users/user-f501/Desktop REAL-WORLD APPLICATION Economists and Market Solutions Economic reasoning is playing an increasing role in government policy. Consider the regulation of pollution. Pollution became a policy concern in the 1960s as books such as Rachel Carson’s Silent Spring were published. In 1970, in response to concerns about the environment, the Clean Air Act was passed. It capped the amount of pollutants (such as sulfur dioxide, carbon monoxide, nitrogen dioxides, lead, and hydrocarbons) that firms could emit. This was a “command-and-control” approach to regulation, which brought about a reduction in pollution, but also brought about lots of complaints by firms that either found the limits costly to meet or couldn’t afford to meet them and were forced to close. Enter economists. They proposed an alternative approach, called cap-and-trade, that achieved the same overall reduction in pollution but at a lower overall cost. In the plan they proposed, government still set a pollution cap that firms had to meet, but it gave individual firms some flexibility. Firms that reduced emissions by less than the required limit could buy pollution permits from other firms that reduced their emissions by more than their limit. The price of the permits would be determined in an “emissions permit market.” Thus, firms that had a low cost of reducing pollution would have a strong incentive to reduce pollution by more than their limit in order to sell these permits, or rights to pollute, to firms that had a high cost of reducing pollution and therefore reduced their pollution by less than what was required. The net reduction was the same, but the reduction was achieved at a lower cost. In 1990 Congress adopted economists’ proposal and the Clean Air Act was amended to include tradable emissions permits. An active market in emissions permits developed and it is estimated that the tradable permit program has lowered the cost of reducing sulfur dioxide emissions by $1 billion a year. Economists used this same argument to promote an incentive-based solution to world pollution in an agreement among some countries to reduce world pollution known as the Kyoto Protocol. In 2008 this became the central idea in a policy proposal to reduce carbon emissions, with the U.S. government creating a law that would require firms to keep carbon emissions at some initial level but allow firms that reduce carbon emissions to “sell” their reduced emissions to other firms that could then increase their emissions by an offsetting amount. You can read more about the current state of tradable emissions at epa.gov/airmarkets. 16 explain why investment decisions are made differently in Germany as compared to the United States. Alternatively, in the Netherlands workers are highly unionized, while in the United States they are not. Unions in the Netherlands therefore have the power to agree to keep wages lower in exchange for more jobs. This means that government policies to control inflation might differ in these two countries. Economic institutions sometimes seem to operate in ways quite different than economic theory predicts. For example, economic theory says that prices are determined by supply and demand. However, businesses say that they set prices by rules of thumb— often by what are called cost-plus-markup rules. That is, a firm determines what its costs are, multiplies by 1.4 or 1.5, and the result is the price it sets. Economic theory says that supply and demand determine who’s hired; experience suggests that hiring is often done on the basis of whom you know, not by market forces. These apparent contradictions have two complementary explanations. First, economic theory abstracts from many issues. These issues may account for the differences. Second, there’s no contradiction; economic principles often affect decisions from behind the scenes. For instance, supply and demand pressures determine what the price markup over cost will be. In all cases, however, to apply economic theory to reality—to gain the full value of economic insights—you’ve got to have a sense of economic institutions. coL75888_ch01_001-024.indd coL75888_ch01_001-024.indd Page 17 6/22/09 11:20:10 PM user-f501 /Users/user-f501/Desktop Chapter 1 ■ Economics and Economic Reasoning 17 Economic Policy Options Economic policies are actions (or inaction) taken by government to influence economic actions. The final goal of the course is to present the economic policy options facing our society today. For example, should the government restrict mergers between firms? Should it run a budget deficit? Should it do something about the international trade deficit? Should it decrease taxes? I saved this discussion for last because there’s no sense talking about policy options unless you know some economic terminology, some economic theory, and something about economic institutions. Once you know something about them, you’re in a position to consider the policy options available for dealing with the economic problems our society faces. Policies operate within institutions, but policies also can influence the institutions within which they operate. Let’s consider an example: welfare policy and the institution of the two-parent family. In the 1960s, the United States developed a variety of policy initiatives designed to eliminate poverty. These initiatives provided income to single parents with children, and assumed that family structure would be unchanged by these policies. But family structure changed substantially, and, very likely, these policies played a role in increasing the number of single-parent families. The result was the programs failed to eliminate poverty. Now this is not to say that we should not have programs to eliminate poverty, nor that two-parent families are always preferable to one-parent families; it is only to say that we must build into our policies their effect on institutions. Some policies are designed to change institutions directly. While these policies are much more difficult to implement than policies that don’t, they also offer the largest potential for gain. Let’s consider an example. In the 1990s, a number of Eastern European countries replaced central planning with market economies and private ownership. The result: Output in those countries fell enormously as the old institutions fell apart. While most Eastern European economies have rebounded from their initial losses, some countries of the former Soviet Union have yet to do so. The hardships these countries continue to experience show the enormous difficulty of implementing policies involving major institutional changes. To carry out economic policy To effectively, one must understand how institutions might change as a result of the economic policy. Q-8 True or false? Economists should focus their policy analysis on institutional changes because such policies offer the largest gains. Objective Policy Analysis Good economic policy analysis is objective; that is, it keeps the analyst’s value judgments separate from the analysis. Objective analysis does not say, “This is the way things should be,” reflecting a goal established by the analyst. That would be subjective analysis because it would reflect the analyst’s view of how things should be. Instead, objective analysis says, “This is the way the economy works, and if society (or the individual or firm for whom you’re doing the analysis) wants to achieve a particular goal, this is how it might go about doing so.” Objective analysis keeps, or at least tries to keep, subjective views—value judgments—separate. To make clear the distinction between objective and subjective analysis, economists have divided economics into three categories: positive economics, normative economics, and the art of economics. Positive economics is the study of what is, and how the economy works. It explores the pure theory of economics, and it discovers agreed-upon empirical regularities. These empirical regularities are often called empirical facts—for example, large price fluctuations in financial markets tend to be followed by additional large price fluctuations. Economic theorists then relate their theories to those facts. Positive economics asks such questions as: How does the market for hog bellies work? How do price restrictions affect market forces? These questions fall under the heading of economic theory. Q-9 John, your study partner, is a free market advocate. He argues that the invisible hand theorem tells us that the government should not interfere with the economy. Do you agree? Why or why not? Positive economics is the study of what is, and how the economy works. coL75888_ch01_001-024.indd coL75888_ch01_001-024.indd Page 18 6/22/09 11:20:10 PM user-f501 /Users/user-f501/Desktop 18 Introduction ■ Thinking Like an Economist Normative economics is the study Normative of what the goals of the economy should be. The art of economics is the application of the knowledge learned in positive economics to the achievement of the goals determined in normative economics. Q-10 Tell whether the following five statements belong in positive economics, normative economics, or the art of economics. 1. We should support the market because it is efficient. 2. Given certain conditions, the market achieves efficient results. 3. Based on past experience and our understanding of markets, if one wants a reasonably efficient result, markets should probably be relied on. 4. The distribution of income should be left to markets. 5. Markets allocate income according to contributions of factors of production. As I stated above, economic theory does not provide definitive policy recommendations. It is too abstract and makes too many assumptions that don’t match observed behavior. In positive economic theory, one looks for empirical facts and develops theorems—propositions that logically follow from the assumptions of one’s model. Theorems and agreed-upon empirical facts are almost by definition beyond dispute and serve as the foundation for economic science. But these theorems don’t tell us what policies should be followed. Policies are built on two other branches of economics: normative economics and political economy or the art of economics. Normative economics is the study of what the goals of the economy should be. Normative economics asks such questions as: What should the distribution of income be? What should tax policy be designed to achieve? In discussing such questions, economists must carefully delineate whose goals they are discussing. One cannot simply assume that one’s own goals for society are society’s goals. For example, let’s consider a debate that is currently ongoing in economics. Some economists are worried about global warming; they believe that high consumption in rich societies is causing global warming and that the high consumption is a result of interdependent wants—people want something only because other people have it—but having it isn’t necessarily making people happier. These economists argue that society’s normative goal should include a much greater focus on the implications of economic activities for global warming, and the distribution of income, than is currently the case. Discussion of these goals falls under the category of normative economics. The art of economics, also called political economy, is the application of the knowledge learned in positive economics to the achievement of the goals one has determined in normative economics. It looks at such questions as: To achieve the goals that society wants to achieve, how would you go about it, given the way the economy works?3 Most policy discussions fall under the art of economics. The art of economics branch is specifically about policy; it is designed to arrive at precepts or guides for policy. Precepts are based on theorems and empirical facts developed in positive economics and goals developed in normative economics. The art of economics requires economists to assess the appropriateness of theorems to achieving the normative goals in the real world. Whereas once the assumptions are agreed upon, theorems derived from models are not debatable, precepts are debatable, and economists that use the same theorems can hold different precepts. For example, a model may tell us that rent controls will cause a shortage of housing. That does not mean that rent controls are necessarily bad policies since rent controls may also have some desirable effects. The precept that rent controls are bad policy is based upon a judgment about the importance of those other effects, and one’s normative judgments about the benefits and costs of the policy. In this book, when I say that economists tend to favor a policy, I am talking about precepts, which means that alternative perspectives are possible even among economists. In each of these three branches of economics, economists separate their own value judgments from their objective analysis as much as possible. The qualifier “as much as possible” is important, since some value judgments inevitably sneak in. We are products of our environment, and the questions we ask, the framework we use, and the way we interpret the evidence all involve value judgments and reflect our backgrounds. Maintaining objectivity is easiest in positive economics, where you are working with abstract models to understand how the economy works. Maintaining objectivity 3 This three-part distinction was made back in 1891 by a famous economist, John Neville Keynes, father of John Maynard Keynes, the economist who developed macroeconomics. This distinction was instilled into modern economics by Milton Friedman and Richard Lipsey in the 1950s. They, however, downplayed the art of economics, which J. N. Keynes had seen as central to understanding the economist’s role in policy. In his discussion of the scope and method of economics, Lionel Robbins used the term “political economy” rather than Keynes’ term “the art of economics.” coL75888_ch01_001-024.indd Page 19 6/22/09 11:20:10 PM user-f501 /Users/user-f501/Desktop REAL-WORLD APPLICATION Economics and Global Warming A good example of the central role that economics plays in policy debates is the debate about global warming. Almost all scientists are now convinced that global warming is occurring and that human activity such as the burning of fossil fuel is the cause. The policy question is what to do about it. To answer that question, most governments have turned to economists. The first part of the question that economists have considered is whether it is worth doing anything, and in a well-publicized report commissioned by the British government, economist Nicholas Stern argued that, based upon his cost/benefit analysis, yes it is worth doing something. The reason: because the costs of not doing anything would likely reduce output by 20 percent in the future, and that those costs (appropriately weighted for when they occur) are less than the benefits of policies that can be implemented. The second part of the question is: what policies to implement? The policies he recommended were policies that changed incentives—specifically, policies that raised the costs of emitting greenhouse gases and decreased the cost of other forms of production. Those recommended policies reflected the economist’s opportunity cost framework in action: if you want to change the result, change the incentives that individuals face. There is considerable debate about Stern’s analysis—both with the way he conducted the cost/benefit analysis and with his policy recommendations. Such debates are inevitable when the data are incomplete and numerous judgments need to be made. I suspect that these debates will continue over the coming years with economists on various sides of the debate. Economists are generally not united in their views about complicated policy issues since they differ in their normative views and in their assessment of the problem and of what politically can be achieved; that’s because policy is part of the art of economics, not part of positive economics. But the framework of the policy debate about global warming is the economic framework. Thus, even though political forces will ultimately choose what policy is followed, you must understand the economic framework to take part in the debate. is harder in normative economics. You must always be objective about whose normative values you are using. It’s easy to assume that all of society shares your values, but that assumption is often wrong. It’s hardest to maintain objectivity in the art of economics because it can suffer from the problems of both positive and normative economics. Because noneconomic forces affect policy, to practice the art of economics we must make judgments about how these noneconomic forces work. These judgments are likely to reflect our own value judgments. So we must be exceedingly careful to be as objective as possible in practicing the art of economics. www Web Note 1.5 The Art of Economics Policy and Social and Political Forces When you think about the policy options facing society, you’ll quickly discover that the choice of policy options depends on much more than economic theory. Politicians, not economists, determine economic policy. To understand what policies are chosen, you must take into account historical precedent plus social, cultural, and political forces. In an economics course, I don’t have time to analyze these forces in as much depth as I’d like. That’s one reason there are separate history, political science, sociology, and anthropology courses. While it is true that these other forces play significant roles in policy decisions, specialization is necessary. In economics, we focus the analysis on the invisible hand, and much of economic theory is devoted to considering how the economy would operate if the invisible hand were the only force operating. But as soon as we apply theory to reality and policy, we must take into account political and social forces as well. 19 coL75888_ch01_001-024.indd coL75888_ch01_001-024.indd Page 20 6/22/09 11:20:19 PM user-f501 /Users/user-f501/Desktop 20 Introduction ■ Thinking Like an Economist An example will make my point more concrete. Most economists agree that holding down or eliminating tariffs (taxes on imports) and quotas (numerical limitations on imports) makes good economic sense. They strongly advise governments to follow a policy of free trade. Do governments follow free trade policies? Almost invariably they do not. Politics leads society in a different direction. If you’re advising a policy maker, you need to point out that these other forces must be taken into account, and how other forces should (if they should) and can (if they can) be integrated with your recommendations. Conclusion There are tons more that could be said by way of introducing you to economics, but an introduction must remain an introduction. As it is, this chapter should have 1. Introduced you to economic reasoning. 2. Surveyed what we’re going to cover in this book. 3. Given you an idea of my writing style and approach. We’ll be spending long hours together over the coming term, and before entering into such a commitment it’s best to know your partner. While I won’t know you, by the end of this book you’ll know me. Maybe you won’t love me as my mother does, but you’ll know me. This introduction was my opening line. I hope it also conveyed the importance and relevance that belong to economics. If it did, it has served its intended purpose. Economics is tough, but tough can be fun. Summary • The three coordination problems any economy must solve are what to produce, how to produce it, and for whom to produce it. In solving these problems, societies have found that there is a problem of scarcity. • Deduction begins with almost self-evident principles and develops models and conclusions based on those principles. Induction looks at empirical evidence first and infers principles from those observations. Abduction is a combination of deduction and induction. • Economic reasoning structures all questions in a cost/ benefit framework: If the marginal benefits of doing something exceed the marginal costs, do it. If the marginal costs exceed the marginal benefits, don’t do it. • Sunk costs are not relevant in the economic decision rule. • The opportunity cost of undertaking an activity is the benefit you might have gained from choosing the next-best alternative. • “There ain’t no such thing as a free lunch” (TANSTAAFL) embodies the opportunity cost concept. • Economic forces, the forces of scarcity, are always working. Market forces, which ration by changing prices, are not always allowed to work. • Economic reality is controlled and directed by three types of forces: economic forces, political forces, and social forces. • Under certain conditions, the market, through its price mechanism, will allocate scarce resources efficiently. • Economics can be divided into microeconomics and macroeconomics. Microeconomics is the study of individual choice and how that choice is influenced by economic forces. Macroeconomics is the study of the economy as a whole. It considers problems such as inflation, unemployment, business cycles, and growth. coL75888_ch01_001-024.indd coL75888_ch01_001-024.indd Page 21 6/22/09 11:20:19 PM user-f501 /Users/user-f501/Desktop Chapter 1 ■ Economics and Economic Reasoning 21 • Economics can be subdivided into positive economics, normative economics, and the art of economics. Positive economics is the study of what is, normative economics is the study of what should be, and the art of economics relates positive to normative economics. • Theorems are propositions that follow from the assumptions of a model; precepts are the guides for policies based on theorems, normative judgments, and empirical observations about how the real world differs from the model. Key Terms abduction (12) art of economics (18) deduction (5) economic decision rule (8) economic force (10) economic model (12) economic policy (17) economic principle (12) economics (4) efficiency (13) experimental economics (13) induction (6) invisible hand (11) invisible hand theorem (13) macroeconomics (15) marginal benefit (7) marginal cost (7) market force (10) microeconomics (15) natural experiment (13) normative economics (18) opportunity cost (9) positive economics (17) precepts (13) scarcity (5) sunk cost (7) theorem (13) Questions and Exercises 1. Why does the textbook author focus on coordination rather than on scarcity when defining economics? LO1 2. Define deduction and give an example of deductive reasoning. LO1 3. Define induction and give an example of inductive reasoning. LO1 4. Your study partner has suggested that deductive reasoning is much more accurate than inductive reasoning. How would you respond? LO1 5. State whether the following is an example of deductive, inductive, or abductive reasoning: a. The number of rings inside a tree is the age of a tree. This tree has 10 rings. Conclusion: This tree is 10 years old. b. People spend 80 percent of their income. Susan will earn $60,000 this year. Conclusion: Susan will spend $48,000. c. Ten college students are standing in a line to choose either an economics course or an English course. The first student chooses economics. The second student chooses economics and so does the third. Conclusion: All college students prefer economics over English. d. Ten college students are standing in a line to choose either an economics course or an English course. The first student chooses economics. The second student chooses economics and so does the third. Conclusion: All college students prefer economics over English. The fourth student in line chooses English. The first three students were women; the fourth was a man. Revised conclusion: Male college students prefer English. Female college students prefer economics. LO1 6. List one recent choice you made and explain why you made the choice in terms of marginal benefits and marginal costs. LO2 7. You rent a car for $29.95. The first 150 miles are free, but each mile thereafter costs 15 cents. You plan to drive it 200 miles. What is the marginal cost of driving the car? LO2 8. Economists Henry Saffer of Kean University, Frank J. Chaloupka of the University of Illinois at Chicago, and Dhaval Dave of Bentley College estimated that the government must spend $4,170 on drug control to deter one person from using drugs and the cost that one drug user imposes on society is $897. Based on this information alone, should the government spend the money on drug control? LO2 9. What is the opportunity cost of buying a $20,000 car? LO3 10. Suppose you currently earn $30,000 a year. You are considering a job that will increase your lifetime earnings by $300,000 but that requires an MBA. The job will mean also attending business school for two years at an annual cost of $25,000. You already have a bachelor’s degree, for which you spent $80,000 in tuition and books. Which of the above information is relevant to your decision whether to take the job? LO3 11. Suppose your college has been given $5 million. You have been asked to decide how to spend it to improve your college. Explain how you would use the economic decision rule and the concept of opportunity costs to decide how to spend it. LO2, LO3 coL75888_ch01_001-024.indd Page 22 6/22/09 11:20:20 PM user-f501 /Users/user-f501/Desktop 22 Part I ■ Introduction: Thinking Like an Economist 12. Calculate, using the best estimates you can: a. Your opportunity cost of attending college. b. Your opportunity cost of taking this course. c. Your opportunity cost of attending yesterday’s lecture in this course. LO3 13. In 1999 Royal Philips Electronics paid $180 million to buy 20-year naming rights of the Atlanta, Georgia, stadium, home of NBA’s Atlanta Hawks. University of Massachusetts Professor Timothy D. DeSchriver and Drexel University Professor Paul E. Jensen analyzed naming rights. In their study, what was the likely impact of each of the following on a corporation’s willingness to pay to name a stadium? (Difficult) a. An existing team is relocating to the stadium. b. The stadium is in a highly populated area. c. The stadium’s current name is the Staples Center and has had that name for 20 years. LO3 14. Give two examples of social forces and explain how they keep economic forces from becoming market forces. LO4 15. Give two examples of political or legal forces and explain how they might interact with economic forces. LO4 16. Individuals have two kidneys, but most of us need only one. People who have lost both kidneys through accident or disease must be hooked up to a dialysis machine, which cleanses waste from their bodies. Say a person who has two good kidneys offers to sell one of them to someone whose kidney function has been totally destroyed. The seller asks $30,000 for the kidney, and the person who has lost both kidneys accepts the offer. a. Who benefits from the deal? b. Who is hurt? c. Should a society allow such market transactions? Why? LO4 17. State whether the following are primarily microeconomic or macroeconomic policy issues: a. Should U.S. interest rates be lowered to decrease the amount of unemployment? 18. 19. 20. 21. 22. b. Will the fact that more and more doctors are selling their practices to managed care networks increase the efficiency of medical providers? c. Should the current federal income tax be lowered to reduce unemployment? d. Should the federal minimum wage be raised? e. Should Sprint and Verizon both be allowed to build local phone networks? f. Should commercial banks be required to provide loans in all areas of the territory from which they accept deposits? LO5 List two microeconomic and two macroeconomic problems. LO5 What is an economic model? What besides a model do economists need to make policy recommendations? LO6 Does economic theory prove that the free market system is best? Why? (Difficult) LO6 State whether the following statements belong in positive economics, normative economics, or the art of economics. a. In a market, when quantity supplied exceeds quantity demanded, price tends to fall. b. When determining tax rates, the government should take into account the income needs of individuals. c. What society feels is fair is determined largely by cultural norms. d. When deciding which rationing mechanism is best (lottery, price, first-come/first-served), one must take into account the goals of society. e. California currently rations water to farmers at subsidized prices. Once California allows the trading of water rights, it will allow economic forces to be a market force. LO6 Distinguish between theorems and precepts. Is it possible for two economists to agree about theorems but disagree about precepts? Why or why not? LO6 Questions from Alternative Perspectives 1. Is it possible to use objective economic analysis as a basis for government planning? (Austrian) 2. In “Rational Choice with Passion: Virtue in a Model of Rational Addiction,” Andrew M. Yuengert of Pepperdine University argues that there is a conflict between reason and passion. a. What might that conflict be? b. What implications does it have for applying the economic model? (Religious) 3. Economic institutions are “habits of thought” that organize society. a. In what way might patriarchy be an institution and how might it influence the labor market? b. Does the free market or patriarchy better explain why 98 percent of secretaries are women and 98 percent of automobile mechanics are men? (Feminist) 4. In October of 2004, the supply of flu vaccine fell by over 50 percent. The result was that the vaccine had to be coL75888_ch01_001-024.indd coL75888_ch01_001-024.indd Page 23 6/22/09 11:20:20 PM user-f501 /Users/user-f501/Desktop Chapter 1 ■ Economics and Economic Reasoning 23 rationed, with a priority schedule established: young children, people with weakened immunity, those over 65, etc., taking priority. a. Compare and contrast this allocation outcome with a free market outcome. b. Which alternative is more just? (Institutionalist) 5. The textbook model assumes that individuals have enough knowledge to follow the economic decision rule. a. How did you decide what college you would attend? b. Did you have enough knowledge to follow the economic decision rule? c. For what type of decisions do you not use the economic decision rule? d. What are the implications for economic analysis if most people don’t follow the economic decision rule in many aspects of their decisions? (Post-Keynesian) 6. Radical economists believe that all of economics, like all theorizing or storytelling, is value-laden. Theories and stories reflect the values of those who compose them and tell them. For instance, Radicals offer a different analysis than most economists of how capitalism works and what ought to be done about its most plaguing problems: inequality, periodic economic crises with large-scale unemployment, and the alienation of the workers. a. What does the radical position imply about the distinction between positive economics and normative economics that the text makes? b. Is economics value-laden or objective and is the distinction between positive and normative economics tenable or untenable? (Radical) Issues to Ponder 1. At times we all regret decisions. Does this necessarily mean we did not use the economic decision rule when making the decision? (Difficult) LO2 2. Economist Steven Landsburg argues that if one believes in the death penalty for murderers because of its deterrent effect, using cost/benefit analysis we should execute computer hackers—the creators of worms and viruses—because the deterrent effect in cost saving would be greater than the deterrent effect in saving lives. Estimates are that each execution deters eight murders, which, if one valued each life at about $7 million, saves about $56 million; he estimates that executing hackers would save more than that per execution, and thus would be the economic thing to do. (Difficult) a. Do you agree or disagree with Landsburg’s argument? Why? b. Can you extend cost/benefit analysis to other areas? LO2 3. Adam Smith, who wrote The Wealth of Nations, and who is seen as the father of modern economics, also wrote The Theory of Moral Sentiments. In it he argued that society would be better off if people weren’t so selfish and were more considerate of others. How does this view fit with the discussion of economic reasoning presented in the chapter? LO3 4. A Wall Street Journal article recently asked readers the following questions. What’s your answer? a. An accident has caused deadly fumes to enter the school ventilation system where it will kill five children. You can stop it by throwing a switch, but doing so will kill one child in another room. Do you throw the switch? b. Say that a doctor can save five patients with an organ transplant that would end the life of a patient who is sick, but not yet dead. Does she do it? c. What is the difference between the two situations described in a and b? d. How important are opportunity costs in your decisions? LO3 5. Economics is about strategic thinking, and the strategies can get very complicated. Suppose you kiss someone and ask whether the person liked it. You’d like the person to answer “yes” and you’d like that answer to be truthful. But they know that, and if they like you, they may well say that they liked the kiss even if they didn’t. But you know that, and thus might not really believe that they liked the kiss; they’re just saying “yes” because that’s what you want to hear. But they know that you know that, so sometimes they have to convey a sense that they didn’t like it, so that you will believe them when they say that they did like it. But you know that . . . You get the picture. Economists have studied such issues; you can find a discussion of similar issues on George Mason University Economist Tyler Cowen’s Web site (www.gmu.edu/jbc/ Tyler). (Difficult) a. Should you always be honest, even when it hurts someone? b. What strategies can you figure out to avoid the problem of not believing the other person? LO3 6. Go to two stores: a supermarket and a convenience store. a. Write down the cost of a gallon of milk in each. b. The prices are most likely different. Using the terminology used in this chapter, explain why that is coL75888_ch01_001-024.indd coL75888_ch01_001-024.indd Page 24 6/22/09 11:20:21 PM user-f501 /Users/user-f501/Desktop 24 Introduction ■ Thinking Like an Economist the case and why anyone would buy milk in the store with the higher price. c. Do the same exercise with shirts or dresses in Wal-Mart (or its equivalent) and Saks (or its equivalent). LO4 7. About 90,000 individuals in the United States are waiting for organ transplants, and at an appropriate price many individuals would be willing to supply organs. Given those facts, should human organs be allowed to be bought and sold? LO4 8. Name an economic institution and explain how it affects economic decision making or how its actions reflect economic principles. LO4 9. Tyler Cowen, an economist at George Mason University, presents an interesting case that pits the market against legal and social forces. The case involves payola—the payment of money to disk jockeys for playing a songwriter’s songs. He reports that Chuck Berry was having a hard time getting his music played because of racism. To counter this, he offered a well-known disk jockey, Alan Freed, partial songwriting credits, along with partial royalties, on any Chuck Berry song of his choice. He chose Maybellene, which he played and promoted. It went on to be a hit, Chuck Berry went on to be a star, and Freed’s estate continues to receive royalties. a. Should such payments be allowed? Why? b. How did Freed’s incentives from the royalty payment differ from Freed’s incentives if Chuck Berry had just offered him a flat payment? c. Name two other examples of similar activities—one that is legal and one that is not. LO4 10. Name three ways a limited number of dormitory rooms could be rationed. How would economic forces determine individual behavior in each? How would social or legal forces determine whether those economic forces become market forces? LO4 11. Prospect theory suggests that people are hurt more by losses than they are uplifted by gains of a corresponding size. If that is true, what implications would it have for economic policy? (Difficult) LO6 12. Is a good economist always objective? Why? LO6 Answers to Margin Questions The numbers in parentheses refer to the page number of each margin question. 1. Since the price of both stocks is now $15, it doesn’t matter which one you sell (assuming no differential capital gains taxation). The price you bought them for doesn’t matter; it’s a sunk cost. Marginal analysis refers to the future gain, so what you expect to happen to future prices of the stocks—not past prices—should determine which stock you decide to sell. (8) 2. A cost/benefit analysis requires that you put a value on a good, and placing a value on a good can be seen as demeaning it. Consider love. Try telling an acquaintance that you’d like to buy his or her spiritual love, and see what response you get. (8) 3. John is wrong. The opportunity cost of reading the chapter is primarily the time you spend reading it. Reading the book prevents you from doing other things. Assuming that you already paid for the book, the original price is no longer part of the opportunity cost; it is a sunk cost. Bygones are bygones. (9) 4. Whenever there is scarcity, the scarce good must be rationed by some means. Free health care has an opportunity cost in other resources. So if health care is not rationed, to get the resources to supply that care, other goods would have to be more tightly rationed than they currently are. It is likely that the opportunity cost of supplying free health care would be larger than most societies would be willing to pay. (10) Joan is wrong. Economic forces are always operative; market forces are not. (11) According to the invisible hand theorem, the price of tomatoes will likely fall. (13) (1) Macroeconomics; (2) Microeconomics; (3) Microeconomics; (4) Macroeconomics. (15) False. While such changes have the largest gain, they also may have the largest cost. The policies economists should focus on are those that offer the largest net gain—benefits minus costs—to society. (17) He is wrong. The invisible hand theorem is a positive theorem and does not tell us anything about policy. To do so would be to violate Hume’s dictum that a “should” cannot be derived from an “is.” This is not to say that government should or should not interfere; whether government should interfere is a very difficult question. (17) (1) Normative; (2) Positive; (3) Art; (4) Normative; (5) Positive. (18) 5. 6. 7. 8. 9. 10. ...
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