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Date: Mon, 12 Jan 1998 09:05:19 +0800
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   Unit 1: The Scope and Method of Economics [INLINE] UNDER CONSTRUCTION
   
   Read "Case and Fair": Chapter 1 - pages 1-20.
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     A. Definition of Economics
     
     Economics is the study of how individuals and societies choose to
     use the scarce resources that nature and previous generations have
     provided.
     
     The key word in this definition is "choose".
     
     Economics is a behavioral science.
     
     In large measure it is the study of how people make choices.
     
   
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     B. Why study economics?
     
     1. To learn a way of thinking: This summer we are going to learn to
     think like economists - to use tools that will help us analyze
     complex situations in the real world of economics.
     
     2. To understand society: Past and present economic decisions have
     an influence on the character of life in a society.
     
     3. To understand global affairs: Understanding international
     relations begins with knowledge of the economic links among
     countries.
     
     4. To be an informed voter: When you participate in the political
     process, you are voting on issues that require a basic understanding
     of economics.
     
   
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     C. The difference between micro and macro economics
     
     Microeconomics deals with the functioning of individual industries
     and the behavior of individual economic decision-making units -
     business firms and households. It explores the decisions that
     individual businesses and consumers make - firms' choices about what
     to produce and how much to charge, and households' choices about
     what and how much to buy.
     
     Macro economics looks at the economy as a whole. Instead of trying
     to understand what determines the output of a single firm or
     industry, or the consumption patterns of a single household or group
     of house holds, it examines the factors that determine national
     output and income.
     
     While micro economics focuses on individual product prices, macro
     economics looks at the overall price level and its behavior over
     time.
     
     Micro economics questions how many people will be hired or laid off
     in a particular industry and the factors that determine how much
     labor a firm or industry will hire. Macro economics deals with
     aggregate employment and unemployment: how many jobs exist in the
     economy as a whole, and how many people are willing to work but
     unable to find jobs..
     
     We are going to be using this word "aggregate" a lot. It refers to
     the behavior of firms and households taken together. For example,
     aggregate consumption refers to the consumption of all the
     households in the economy; aggregate investment refers to the total
     investment made by all firms in the economy.
     
     There are some topics which micro and macro economics share.
     
     For example, the study of how government policy affects the economy.
     
     However, again micro economics looks at these effects on the level
     of the individual firm or household, macro economics considers the
     effects of policy on the economy as a whole..
     
     The micro economic foundations of macro economics.
     
     There is also another important relationship between the two
     branches of economics and this is what is called the micro economic
     foundations of macro economics. This is a fairly new development and
     one which is trying to reconcile the assumptions and principles of
     micro economic analysis with efforts to understand the economy as a
     whole.
     For example, in efforts to understand inflation, macro economists
     are now trying to include micro economic ideas about the way that
     prices adjust to changes in supply and demand..
     
   
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     D. The relationship between economics and social philosophy. One of
     the first economists was an Englishman by the name of Adam Smith.
     (Some would say he was the first economist.)
     Born in the early part of the 18th century, Smith developed the idea
     of the "invisible hand" and was the first to describe the
     relationship between supply and demand in a free market economy. He
     described himself as a "social philosopher".
     
     Social philosophy is concerned with fairness. It deals with
     questions such as:
     Why are some people rich and others poor?
     Is it fair that 90% of the country's wealth is controlled by 5% of
     the population?
     Is the progressive income tax, which taxes a higher proportion of
     the income of the wealthy, fair?
     These questions are still relevant and are the subject of economic
     policy.
     
   
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     E. Economic Policy
     
     A policy is a plan that guides action.
     
     An example of an economic policy would be the Federal government's
     plan to keep the economy working at full employment.
     Anyone can recommend macro economic policies but it is up to
     governments to implement them.
     
     In general we judge the outcomes of any policy according to four
     criteria:
     
     1. Efficiency: In economics we say that a policy is efficient if it
     leads to outcomes that help the economy produce what people want at
     the least possible cost.
     
     2. Equity or fairness: This is obviously hard to define because
     fairness like beauty depends on who's looking, but in general terms
     we could say that an economic policy is fair if it leads to outcomes
     in which the costs and benefits are shared in a way that is
     proportional to a person's participation.
     
     3. Growth: At the present time economic policies are also judged
     according to whether or not they lead to increases in output. I say
     "at present" because some economists are beginning to question the
     assumption that economic growth is always a good thing.
     
     4. Stability: In economics stability is defined as the condition of
     the economy in which output is growing at a steady rate, with low
     inflation and full employment. Currently, the Federal Reserve is
     defining stability as a growth rate of about 3%, with inflation
     between 2% and 3% and unemployment between 5% and 6%.
     
   
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     F. What economists do. In addition to making policy recommendations,
     economists spend a lot of time formulating theories and developing
     models. These two words have more or less the same meaning in
     economics that they do in other academic disciplines.
     
     A theory is a coherent set of hypotheses which make statements about
     the way the world works.
     
     To illustrate this idea of theory, the text refers to what is known
     as "the law of demand". This so-called law is really just a
     well-tested hypothesis which states that when prices fall, people
     tend to buy more, and vice versa.
     
     A theory is said to be "good" if its hypotheses turn out to valid
     statements about the real world and if it has predictive power.
     
     I should say at this point that very few economic theories,
     particularly in macro economics, have predictive power.
     
     A model is just a formal statement of the theory, usually a
     mathematical statement.
     
     Several institutions have built huge models of the US economy and
     how it works that have hundreds of equations linked together. These
     big models usually run on computers. When we visit the Federal
     Reserve in San Francisco we will see one of these models in action.
     We will also be working with a number of smaller models and a large
     number of pictures of models.
     
     
     
     The text points out two common errors that are made when people
     develop theories or build models. These are:
     
     1. The post hoc fallacy: This mistake is made when someone mistakes
     an association between two variables for a cause and effect
     relationship. My favorite example of this is taken from a study done
     in Holland at the end of WWII which showed a positive relationship
     between the number of storks inhabiting a certain city and the
     number of babies born.
     
     2. The fallacy of composition: This has to do with the belief that
     what is true for the part is also true for the whole. There are many
     examples of this kind of thinking in economics. For example, we have
     seen over a very long period of time the benefits of free markets -
     the efficiencies in individual markets that are created whenever
     people are free to pursue their own self-interest. However, it might
     be a mistake to assume that pursuit of one's own self interest was
     the best thing for society as a whole.
     
     You cannot prove a theory.
     
     It is important to note that neither theories nor models can ever be
     proved beyond the shadow of a doubt. The best we can say of a theory
     is that it is consistent with the facts as currently observed and
     that it is seems to have predictive power.
     
     Another fact about theories is that they are always based on certain
     assumptions which have to be accepted for the theory to work.
     
     For example, in economic theory two of the most important
     assumptions are (1) that people make rational choices based on
     analyzing costs and benefits and (2) that people try to maximize
     utility.
     
     Another important assumption that is rarely discussed is that the
     world of economics can be understood by understanding the behavior
     of discrete variables.
     
     All of these assumptions are now under attack.
     
   
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     G. Other Important Concepts Introduced in Chapter 1
     
     1. Opportunity Cost: This can be understood as the cost of lost
     opportunities. An example would be the opportunity cost of coming to
     Skyline this summer. This cost is measured by the wages I could have
     been earning if I had decided to work instead.
     
     The reason that opportunity costs exist is because resources are
     scarce; it is an especially important concept in economics where we
     are often trying to measure the costs and benefits of different
     economic choices, policies, etc.
     
     2. Marginal: This refers to the "last unit" and is also an important
     factor in making economic choices.
     
     For example, suppose the publisher of our textbook is trying to
     calculate the costs of producing more books. In making this
     calculation, Prentice Hall would only consider the marginal or
     additional costs of just these new books. The money they have
     already spent would be irrelevant. These are the sunk costs and even
     though they would be included in a calculation of average costs,
     they wouldn't influence the decision to produce additional books.
     
     3. Markets - free and regulated, efficient and inefficient:
     
     Markets can be free or regulated, efficient or inefficient. Most
     markets in the real economy represent some combination of these
     qualities.
     
     A market is said to be free if buyers and sellers are free to come
     together and make deals without government interference.
     
     A regulated market is one where the government sets at least some of
     the rules.
     
     For example, the stock market is relatively free - people can buy
     and sell shares of stock without much interference from the
     government. However, the Securities and Exchange Commission
     establishes many rules in this market, particularly for companies
     who wish to sell their stock.
     
     An efficient market is one in which there is a very rapid
     circulation of information and in which profit opportunities are
     grabbed up almost as soon as they appear. Inefficiencies arise
     wherever the flow of information is restricted and where people are
     not free to take advantage of profit opportunities.
     
     4. Ceteris Paribus: This is a Latin phrase which mean "all else
     equal" and refers to the difficulty of analyzing more than two
     variables at a time. It is trotted out by economists when they want
     to emphasize the fact that they are looking at a single
     relationship, holding everything else constant. For example, "The
     amount of a good or service that people want is inversely related to
     the price, ceteris paribus."
     
     The things that are held constant in this example are the tastes and
     preferences of consumers, the availability of substitutes etc.
     
   
   
   
   
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