Carlos A Rodriguez Herrera 2 1 23 Principles of Macroeconomics ECON 2002 01 Chapter 1 The Nature of Economics Introduction Nearly half of the babies born in Hong Kong Hospitals today have mothers who are classified as tourists visiting from the Chinese mainland How can fundamental principles of economics explain patterns of social behavior such as this You will explore this question in Chapter One Learning Objectives Discuss the difference between microeconomics and macroeconomics Evaluate the role that rational self interest plays in economic analysis Explain why economics is a science Distinguish between positive and normative economics Chapter Outline The Power of Economic Analysis Defining Economics The Three Basic Economic Questions and Two Opposing Answers The Economic Approach Systematic Decisions Economics as a Science Positive versus Normative Economics The Power of Economic Analysis Incentives Rewards for engaging in a particular activity The nature of self interested responses to incentives is the starting point for economic analysis The economic way of thinking is a framework to analyze solutions to economic problems How much time to study Choosing which courses to take Whether the U S government should encourage or discourage immigration The economic way of thinking gives you the power to reach informed conclusions about what is happening in the world Economic analysis helps you make better decisions and increases your understanding when watching or reading the news on the Web Economic analysis is a way of thinking about all decisions These decisions could be about Your education career or financing your home Your involvement in the business world How you cast your ballot as a voter Defining Economics Economics The Ohio State University 1 Carlos A Rodriguez Herrera 2 1 23 The study of how people allocate their limited resources to satisfy their unlimited wants The study of how people make choices Things used to produce other things to satisfy people s wants Resources Wants What people would buy if their incomes were unlimited With limited income resources people must make choices to satisfy their wants We never have enough of everything including time to satisfy our every desire Individual businesses and nations face alternatives and choices must be made Economics studies how these choices are made Microeconomics versus Macroeconomics Microeconomics The study of decision making undertaken by individuals or households and by firms Like looking though a microscope to focus on the smaller parts of the economy a The effects of changes in gasoline prices b A family s choice of having a baby c An individual firm s decision to advertise Macroeconomics The study of the behavior of the economy as a whole Deals with economy wide phenomena a The national unemployment rate b The rate of inflation c The yearly output of goods and services in a nation Macroeconomics deals with aggregates or totals such as total output in an economy Modern economic theory blends micro and macro concepts The Three Basic Economic Questions and Two Opposing Answer Economic System The institutional mechanism through which resources are utilized to satisfy human wants Three economic questions 1 What and how much will be produced 2 How will items be produced 3 For whom will items be produced Two opposing answers in the form of economic systems 1 Centralized command and control economic decisions prices are terms signals under which people agree to make exchanges market system decentralized decision making process in which central planning authority that makes all 2 Price system Economic systems of the world s nations are mixed systems that incorporate aspects of both centralized command and control and a decentralized price system The Economic Approach Systematic Decisions Economists assume that individuals act as if motivated by self interest and respond predictably to opportunities for gain It is not from the benevolence of the butcher the brewer or the baker that we expect our dinner but from their regard to their own interest Adam Smith An Inquiry into the Nature and Causes of the Wealth of Nations 1776 Rationality Assumption The Ohio State University 2 Carlos A Rodriguez Herrera 2 1 23 Questions The assumption that people do not intentionally make decisions that would leave them worse off Does the fact that some people make apparently irrational choices invalidate the rationality assumption in economics Can economic models be applied to situations in which behavior is at odds with what we expect from rational people Responding to incentives Rationality and the use of incentives a Positive incentives b Negative incentives Making choices a Balancing cost and benefits Some examples of incentives Responding to positive incentives a Schoolchildren getting gold stars working to have a better life for yourself Responding to negative incentives a Penalties punishments using credit cards to avoid check overdrafts The pursuit of one s goals does not always mean increasing one s wealth Defining self interest a Prestige b Friendship c Love Economics as a Science Economics is a social science that employs the same kinds of methods used in other sciences such as biology Economics uses models to explain economic phenomena in the real world Models or Theories Simplified representations of the real world used as the basis for predictions or explanations Should capture only the essential relationships that are sufficient to analyze a problem Cannot be faulted as unrealistic simply because they do not capture all details of the real world a A map is the quintessential model Assumptions The set of circumstances in which a model is applicable Every model or theory must be based on a set of assumptions Ceteris Paribus Assumption Nothing changes except the factor or factors being studied Other things constant Other things equal Economics is an empirical science Real world data is used to evaluate the usefulness of a model Models are useful if they predict economic phenomena Economic models predict how people react not how they think Economists seek to predict what people will do when faced with certain incentives When surveyed for a poll many people will say that tax breaks have no effect on their charitable donations Yet we find that charitable giving does respond to tax incentives In this instance an accurate prediction would need to be based on what people actually do Behavioral Economics The Ohio State University 3