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1 Economics, Economic Methods, and Economic Policy

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Learning Outcomes

After reading this chapter, you should be able to

• Define economics and recognize the value of studying economics.

• Explain the relationship between scarcity and choice and the role of opportunity costs.

• Understand how the production possibilities curve is used to help understand an economic system.

• Understand and follow the steps to proper policy analysis.

Section 1.1 Economics

Introduction In the spring of 2007, the Houston Astros were holding an open tryout in Maracay, Venezuela, and a 16-year-old, 5' 5" kid named José was just trying to get on the field. The Astros thought he was too short and that he was lying about his age, so they rejected him. The next day he came back with his birth certificate and convinced the Astros to give him an evaluation. They liked what they saw, so they gave a young José Altuve $15,000 and put him into their minor league system. Over the next 11 years, José became an MLB All-Star, a Gold Glove second base- man, the first person in the history of major league baseball to lead his league in hits for four years in a row, and the league MVP when the Astros won the World Series for the first time in history.

So what would you pay a player like José Altuve? Well, on March 19, 2018, the Astros signed a contract with him for $151 million over five years, the largest contract in Astros history. What principles of economics could possibly justify this? Ask yourself, how many people can sup- ply the skills that professional sports players can? Well, actually, start by asking yourself how many people can supply the skills that college graduates can. One of the advantages of educa- tion is that the supply of people who are as well-educated as you are narrows as you reach higher levels of education. This scarcity—paired with the demand for well-educated people in the market—is why people with a college degree earn an estimated one million dollars more over their lifetime than people without.

But, getting back to José, how many people can play great defense at second base, lead the league in batting, and lead their team to their first World Series championship? The supply is literally one, making José Altuve a very limited resource. Facing such scarcity, what do you pay to keep José Altuve? Everything you’ve got.

1.1 Economics

What Is Economics? Economics is the study of how people, individually and through institutions, make decisions about producing and consuming goods and services and about how they face the problem of scarcity. Scarcity, or the inability to satisfy everyone’s wants, is a fundamental economic problem in a world with limited resources. The study of economics is divided into microeco- nomics and macroeconomics.

Microeconomics focuses on the choices made by individuals and businesses. It describes the interactions of producers and consumers in individual markets, such as the market for cars, smartphones, and everyday items. It also examines interactions between such markets; for example, the impact of changes in the demand for steel on the price of aluminum or the deci- sion of Lyft to offer free rides to political events.

Section 1.1 Economics

In microeconomics, the most important tools are demand and supply. Demand and supply help explain prices and outputs in individual markets. These tools also explain the relation- ship between prices and outputs in different markets. In microeconomics, you may look at the demand for the output of a single industry, such as bicycle manufacturing. In macroeco- nomics, you look at the level of prices and output for the economy as a whole, using aggregate demand and aggregate supply as the main tools. Even though microeconomics and macroeco- nomics are often studied separately, they are closely related.

Economics is a social science. This classification makes economics an academic relative of political science, sociology, psychology, and anthropology. All of these fields look at the behav- ior of human beings, both individually and in groups. They study different subsets of the actions and interactions of human beings. (For this reason, they are also sometimes termed behavioral sciences.)

Economics focuses on the consumption, production, and use of scarce resources by individu- als and groups. It is also concerned with the processes by which households and firms make decisions about the use of scarce resources.

The study of the economy as a whole is called macroeconomics. Macroeconomics is concerned with the aggregate or total effect, determined by adding across many markets. Macroeconom- ics studies the behavior of variables that describe the whole economy, such as the value of the total output in goods and services that the economy produces in a given time period, which is called gross domestic product (GDP). Macroeconomics also examines the behavior of aggregates such as the price level and unemployment.

Вадим Черенко/iStock/Thinkstock Jupiterimages/Stockbyte/Thinkstock The study of microeconomics focuses on a micro level, while the study of macroeconomics focuses on the aggregate level. This is like analyzing all the components of a single snowflake versus analyzing the combined impact of all the snow in the Sierra Nevada.

Section 1.1 Economics

Why Study Economics? Economics is a required course for many different majors, from international relations to engineering. You may be wondering why this is so. One reason is that economics interacts with almost all other academic subjects because it is, at its core, the study of decision making. It affects and is affected by current events. Also, it has a major effect on politics, both domestic and international.

A second reason for studying economics is the impact that economic ideas and theories have on world leaders. Much of what political decision makers do is based on economic theory, or the belief about what guides behavior. As John Maynard Keynes, an economist who has had great influence on macroeconomic policy in this century, wrote:

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.

Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. (Keynes, 1936, p. 383)

Keynes was saying that if you want to understand what politicians, great or mad, are trying to do, you must understand the economic theories on which they are acting.

A third reason for studying economics is that it provides a better understanding of how soci- ety functions. Economic theory is very useful in understanding behavior because it allows the development of theoretical models with predictive power. As Alfred Marshall (1890), another influential economist, wrote, “Economics is the study of mankind in the ordinary business of life” (p. 323).

Key Ideas: Microeconomics Versus Macroeconomics

• Microeconomics focuses on the choices made by individuals and businesses. ∘ The primary tools are demand and supply.

• Macroeconomics is the study of the economy as a whole. ∘ The primary tools are aggregate demand and aggregate supply.

Economics in Action: What Is Economics?

Economics is not just the study of finance; in fact, economics is another form of social studies. Economics studies people’s desires in a world of limited resources. Find out more with Dr. Mary J. McGlasson’s video at http://www.youtube.com/watch?v=yoVc_S_gd_0.

http://www.youtube.com/watch?v=yoVc_S_gd_0

Section 1.1 Economics

Finally, economics is incredibly useful. People who are trained in economics find rewarding jobs in a wide range of careers, including musicians Mick Jagger and Lionel Richie; actors Cate Blanchett, Danny Glover, and Bob Barker; financier Warren Buffet; astronaut Eileen Collins; and fashion designer Diane von Fürstenberg. If you like to think in a logical way, you will enjoy studying economics.

Key Ideas: The Direction of Macroeconomics

The study of economics

• interacts with almost all other academic subjects, • impacts ideas and theories of world leaders, and • is useful in understanding behavior.

Global Outlook: The Internationalization of Studying Economics

This Global Outlook box represents a feature that you will find throughout the book. In Global Outlook boxes, we will examine how an institution, culture, product, policy, or way of doing business in another country differs from its counterpart in the United States. This chapter is devoted to concepts and ideas that are universal because scarcity exists in all countries and in all times. Many of the examples in this book are drawn from experiences of people living in the United States. As you read Global Outlook boxes, you will see that some differences in the ways things are done in other countries can be explained by economic incentives.

For example, if you travel to Italy, you will be struck by the fact that houses have significantly fewer closets than comparable houses in the United States. Is this because Italians prefer fewer closets than Americans? What if we went into predominately Italian neighborhoods in New York City? Would we find fewer closets in these neighborhoods than we would in an Asian neighborhood in New York City? This is a ceteris paribus experiment. So the question is, all things being equal, do Italians prefer fewer closets than Americans? If we looked around in the United States, we would conclude that, at least in the United States, Italians don’t exhibit any different behavior in building homes with closets than other ethnic groups.

We could then ask if Italians in the United States are different from Italians in Italy. This is something a psychologist might do. An economist would expect that there is some government policy driving these choices. The economist would therefore look deeper. What the economist would find is that the Italian government (in part) determines the property tax on a home on the basis of the number of closets it has. Therefore, if you do not build closets but instead buy armoires (an armoire is a piece of furniture that is a stand-alone closet), you can avoid paying taxes—a better explanation than a difference in tastes!

As you study economics and as you read these Global Outlook boxes, look for examples of your own. When you learn how to see these economic forces at work, you will be amazed at the analytical power of economic theory.

Section 1.2 Scarcity: Limited Resources but Unlimited Wants

1.2 Scarcity: Limited Resources but Unlimited Wants Whether you are just taking one course or planning a career in economics, the single most important problem you will address is that of scarcity. There are simply not enough resources to produce all the goods and services that people would like to consume. As the world’s popu- lation continues to grow, from 6.3 billion people in 2000 to more than 7.6 billion in 2018 (Worldometers, 2018), more stress will be placed on our already limited resources. The first tool we will develop is an economic model that is used to explain how any economic system deals with the basic problem of scarcity. Human wants and desires are vast, relative to the resources available to satisfy them. Thus, in every economic system there has to be some method for making choices among alternative actions.

Resources are inputs, such as land, labor, capital, or enterprise, that can be used to produce goods and services for human consumption. We live in a world of limited resources. Some resources, such as oil and coal, are converted to energy and used up in the course of produc- tion or consumption. Others are not used up in that sense but are virtually fixed in quantity, like land, diamonds, and copper. At any given time, even the quantity of resources created by people—roads, factories, machines, and skilled labor—cannot be changed quickly or cheaply.

Limited resources conflict with unlimited wants. Human wants are said to be unlimited because no matter how much people have, they always want more of something. You may know people who seem perfectly content with what they have. If you ques- tioned them carefully, however, you would probably find that they would like cleaner air, more time to play tennis or golf, or more shelters for the home- less. Since not all wants can be satisfied, individuals have to choose which ones to satisfy with limited available resources. In fact, every society is faced with the problem of scarcity and choice. Without the threat of scarce resources, there would be no need to make choices about which desires or needs to satisfy—and thus no need to study economics.

Opportunity Cost Every decision to produce or consume something means sacrificing the production or con- sumption of something else. Economists use the term opportunity cost to denote the full value of the best alternative that is given up, or forgone. For example, the cost of going to a football game includes the value of what is given up in order to attend. Part of the cost of attending the game is the price of the ticket; this price represents the other goods and ser- vices you could have purchased with that money instead. However, there is another impor- tant part of the cost. This second part is the most valuable alternative use of those 3 hours. The opportunity cost of attending the game consists of both the price of the ticket and the difference in your test grade that 3 more hours of studying would have produced. Even if the ticket were free, going to the game would still have an opportunity cost.

danielvfung/iStock/Thinkstock In 2018 China was the largest country by population in the world with more than 1.4 billion residents. It is inter- esting to consider how many people would be living in China today in the absence of its one-child policy.

Section 1.2 Scarcity: Limited Resources but Unlimited Wants

Many people have problems grasping the concept of opportunity cost because they are used to thinking of cost only as the amount of money spent on an item or an activity. In economics, however, the concept of cost is much broader. It includes not only the dollar outlay (the other goods you could have purchased) but also the value of the next best choice you could have selected. These alternatives include the cost of time (the earnings or satisfaction you could have produced for yourself in some other activity) and other sacrifices you may have made. For example, let’s say you have $5,000, and your choice is either to buy shares of Apple or to stash the money in a savings account that earns only 3% per year. If you invest in Apple, then the opportunity cost is the value of the earnings from the savings account. If the Apple stock returns 6%, you’ve benefited because the alternative would have been less profitable. How- ever, if the Apple stock only returns 1% when you could have had 3%, then your opportunity cost is 3% – 1% = 2%. Another example would be the decision to learn more about econom- ics, which has the opportunity cost of the time and materials, as well as the value of the topic that does not get studied as a result. Sometimes it is difficult to place a dollar value on these other costs, but they still play an important role in economic decisions.

Some Applications of Opportunity Cost Your everyday life provides many illustrations of the concept of opportunity cost. For exam- ple, what is the opportunity cost of attaining a college degree? It is not simply the dollar fig- ure. Money spent on books and tuition is certainly one part of the opportunity cost; however, the expense of your room, meals, and clothing is not, because you would have incurred those costs even if you were not in college. Economists do not count them, because they are not opportunity costs.

One important opportunity cost is the income you could have earned working during the years you spent in classes. For most students, that lost income will eventually be surpassed by higher future earnings. In 2018 the monetary value of a college graduate was 73% higher than that of people who hold only a high school diploma (Caplan, 2018). However, right now the lost income from working is an opportunity cost that should be included. Even if you can earn only $10 per hour, if you have to cut your working hours by 20 hours a week during the 32 weeks a year you are in school, the lost earnings represent a cost of $6,400 a year, plus the lost opportunities to invest and grow savings as a result.

For some students, the opportunity cost of going to college is even higher. Suppose you are a talented athlete who could play professionally right after high school, as many baseball and tennis players do. Your college education may cost as much as $200,000 (or more) a year in lost earnings. After 2 or 3 years of college, many football and basketball players face this dilemma. Even if they are straight-A students, the opportunity cost of completing a degree in terms of lost income is very high. It is not surprising that many of them choose to turn pro and postpone or abandon getting a degree. Kevin Love of the NBA Cleveland Cavaliers played just one season of basketball at the University of California–Los Angeles before forgoing his remaining 3 years of eligibility to participate in the 2008 draft. Love earned more than $22 million in his 2017–2018 season—would an economist say that he made the right choice?

Section 1.2 Scarcity: Limited Resources but Unlimited Wants

Of course, all combinations in the shaded area of Figure 1.1 are also attainable. However, these combinations would not exhaust your entire budget of $60. We have ruled out the pos- sibility of saving part of the $60, because we are assuming only two alternative choices: cola and pizza. Combinations above and to the right of the line are not attainable, because they cost more than $60.

Opportunity Cost and the Choice Curve We can illustrate the concept of opportunity cost and its relationship to choice using a very simple example. Assume that you have $60 to spend, and you have two choices: pizza and cola. Pizzas cost $15 each, and a 20-ounce bottle of cola costs $2.50. To keep things simple, we assume that you wish to spend the whole $60. Figure 1.1 shows the various combinations of pizza and cola that you can buy with $60. If you spend the entire $60 on pizza, you can purchase four pizzas and no cola (point P at the y-intercept). On the other hand, you can buy 24 bottles of cola and no pizza (as shown by point R at the x-intercept). Other possibilities lie along the line that connects these two intercepts. The line represents all possible combina- tions of pizza and cola that total $60. It is easy to see that points A and B represent attainable combinations because both contain whole numbers of colas and pizzas (for example, point A represents the combination of three pizzas and six colas). Connecting all these points with a continuous line implies that you can purchase fractional units of cola and pizza. This is merely a convenient assumption.

Figure 1.1: Choice among alternatives

If a 20-ounce bottle of cola costs $2.50 and a pizza costs $15, a person with $60 to spend has many attainable combinations of cola and pizza. The line PR represents the boundary between attainable and unattainable combinations; the opportunity cost of one pizza is six bottles of cola.

4 8 12 16 20 Cola (20 oz. bottles)

Pizzas

Unattainable combinations

Attainable combinations

Section 1.3 Society’s Choices: The Production Possibilities Curve

Figure 1.1 illustrates the array of choices and the concept of opportunity cost. The price of one pizza is the same as the price of six colas. The decision to purchase a pizza means the sacrifice of those colas that could have been purchased. Opportunity cost is measured by the slope of the choice line.

Key Ideas: Summarizing Opportunity Cost

• The opportunity cost of a decision is the full value of the best alternative that is given up, or forgone.

• The opportunity cost of consumption or production includes the cost in dollars and the value of the next best alternative.

• Opportunity cost is measured by the slope of the choice line.

1.3 Society’s Choices: The Production Possibilities Curve From the perspective of the economy as a whole, the choice is not how to spend income between alternative purchases but how to allocate available productive resources between alternative goods that could be produced. This problem is illustrated by a close relative of the choice curve in Figure 1.1. Society’s choice curve is called a production possibilities curve. This curve shows the various output combinations of two goods or groups of goods that can be produced in an economy with the available resources. This economic model is based on a few simplifying assumptions that make the problem tractable:

1. All of the economy’s productive resources are fully employed. This means that every- one who wants a job has one. Also, factories, land, and other resources are being used to full capacity.

2. There are only two goods (or two types of goods) in the economy. 3. The resources used in production are interchangeable. One worker is the same as

another, one machine can be substituted for another, and all land is equally useful for producing the two goods.

4. We are looking at the economy at a specific period of time (the short run). During this time period, both the quantity and quality of resources are fixed, and the technology does not change.

Given these four assumptions, we can look at an example of a production possibilities curve. These assumptions allow us to consider a simplified model of an economic system. Table 1.1 lists combinations of levees and soybeans that an economy can produce. (Here, levees are used as an example of government-built infrastructure, and soybeans represent food sup- plies.) Figure 1.2 plots the numbers of Table 1.1 on a graph. Line PR in Figure 1.2 is a produc- tion possibilities curve. It represents all the combinations of levees and soybeans that can be produced in this economy when the available resources are fully employed.

Section 1.3 Society’s Choices: The Production Possibilities Curve

In Figure 1.2 points A and B represent two different combinations of levees and soybeans that lie on the production possibilities curve. They are both output combinations that can be attained in this economy with the available resources. Point C is also attainable. Since it lies inside of line PR, however, production at point C means that some resources are unemployed. There are points on line PR that have to be better than C because they represent either more levees, more soybeans, or more of both. The economy can do better—that is, can produce more. Therefore, the combination at point C is inferior to all points on the production pos- sibilities curve from P to R.

Table 1.1: Production possibilities curve

Soybeans (tons) Levees

20 0

16 1

12 2

8 3

4 4

0 5

Figure 1.2: Production possibilities curve

A production possibilities curve shows combinations of two goods that can be produced in an economy, with fixed resources and technology points on the curve representing the full employment of sources.

4 8 12 16 20 Soybeans (tons)

Levees

Unattainable

Attainable

combinations

Section 1.3 Society’s Choices: The Production Possibilities Curve

Line PR in Figure 1.2 can also be used to measure opportunity cost for the economy. It is a straight line; this fact implies that the opportunity cost of one product in terms of the other is constant. That is, the number of levees given up to get another ton of soybeans does not change along line PR. Each time the production of soybeans is increased by 1 ton, one quarter of a levee is sacrificed. The opportunity cost of one more ton of soybeans is one quarter of a levee. Conversely, the opportunity cost of one more levee is 4 tons of soybeans.

Opportunity cost of one good in terms of another is constant along line PR in Figure 1.2 because we assume here that all resources are alike for production purposes. That is, any unit of resources is just as good as any other unit in producing either soybeans or levees. This assumption produces a straight-line production possibilities curve.

After an economist has constructed a model, the next step is to go back and relax some of the assumptions to see what difference they make. Consider what happens when we drop the third assumption stated earlier—that productive resources are interchangeable. That is, we no longer assume that one unit of labor or land is just as productive as another for producing either good. Table 1.2 shows a different set of combinations of levees and soybeans that can be produced in this economy. These combinations are plotted on the graph in Figure 1.3. At point A in Figure 1.3, output is 10 levees and 200 tons of soybeans. At point B, output consists of more levees, 100, but fewer soybeans, only 100 tons.

Table 1.2: Hypothetical scenario of increasing opportunity cost

Soybeans (tons) Levees

205 0

200 (point A) 10

195 (point C) 20

187 30

179 40

169 50

158 60

146 70

133 80

117 90

100 (point B) 100

77 (point D) 110

50 120

0 130

} –5 } +10

} –23 } +10

Section 1.3 Society’s Choices: The Production Possibilities Curve

The production possibilities curve in Figure 1.3 is bowed, or curved, instead of being a straight line. This new shape reflects the change in the assumption that resources are alike. Here we are being more realistic and assuming that some resources are better suited to the production of levees and others to the production of soybeans. This change in assumptions produces a model that differs from the first one in what it implies about opportunity cost.

Increasing Opportunity Costs If the economy is at point A in Figure 1.3, we can get another 10 levees by shifting resources from soybean production to levee production. In moving from point A to point C, we must give up only a small amount of soybeans: 5 tons. But to move from point B to point D, producing another 10 levees requires a larger sacrifice of soybeans, 23 tons instead of 5. This production possibilities curve illustrates the very important principle of increasing opportunity cost. That is, the more levees that are already being produced, the larger the sacrifice of soybeans that is required to build additional levees. Table 1.2 shows that between points A and C, 10 more levees cost 5 tons of soybeans. Between points B and D, however, 10 more levees cost 23 tons of soybeans.

Increasing opportunity costs are frequently observed in wartime, for example. As more war goods are demanded, civilian sacrifices increase. Initially, as military production expands, additional labor and other resources are used that are relatively more productive for making weapons, like missiles, and relatively less productive for producing other goods. As the switch to missiles continues, however, military production takes resources that are relatively less

Figure 1.3: Production possibilities and increasing opportunity costs

On this production possibilities curve, the opportunity cost of additional units of soybeans increases as the economy becomes more specialized in soybeans: Producing each additional unit of soybeans requires a larger sacrifice of levees than before (increasing opportunity cost). If the economy is inside the production possibilities curve at some point, such as E, more of both goods could be produced.

77 100 195 200 205

130

110

100

0 Soybeans (tons)

Levees P

E C

Section 1.3 Society’s Choices: The Production Possibilities Curve

productive for making missiles, although they were highly productive for growing soybeans. Soybean production falls by larger and larger amounts, therefore, because more resources are stripped away from soybeans for every extra missile produced. These resources are increas- ingly best suited to producing soybeans and least adaptable to missile production.

Unemployment The production possibilities curve can also illustrate unemployment and the positive impact of reducing the amount of unused resources. Suppose the economy is at point E in Figure 1.3. This point is inside the production possibilities curve because some workers, factories, land, and machines are unemployed. If the economy could move from point E to point C, it would be possible to have more soybeans (195 tons instead of 100) with no sacrifice of levees. Moving from point E to point B would mean producing the same amount of soybeans (100 tons) but more levees (100 instead of 20). Finally, at point E more of both levees and soybeans could be produced. At point E the opportunity cost of both soybeans and levees is zero because none of either good has to be sacrificed to increase production of the other.

From a macroeconomic perspective, unemployed resources are wasteful. They represent extra production that could be attained simply by putting them to work. The opportunity cost of the goods gained is zero. Thus, economists believe that full employment is an important goal. It is important not just for the individual who needs to work to earn income but also for the aggregate economy. For example, according to the Bureau of Labor Statistics (2018a), approximately 4.1% of American would-be workers were unemployed in January 2018. What kinds of projects could these individuals have completed had they been productively employed? Compare that to the 10% unemployed workers in October 2009. How much more is the United States able to produce when the number of unemployed workers is less than half of what it has been in previous years? These are real losses in the form of the opportunity cost of having unemployed resources, in this case labor resources, when more goods and services could be created, bought, and sold with full employment.

One of the main concerns of macroeconomics is explaining how an economy can find itself inside the production possibilities curve at a point such as E in Figure 1.3. How can an eco- nomic system avoid the idleness and waste of unemployed resources? If an economy finds itself at a point such as E, what policies can be implemented to get back on the production possibilities curve? These are important questions in the study of macroeconomics, and the production possibilities curve is a useful technique for identifying them.

Economic Growth Another macroeconomic issue that can be illustrated by the production possibilities model is economic growth. If technology can improve or the quantity of resources can increase, then output can grow beyond the limits of the production possibilities curve. Better technology or more resources means a change in the fourth assumption stated earlier—that both resources and technology are fixed. As labor becomes more skilled and productive, and as producers acquire new machines and plants embodying the latest technology, the production possibili- ties curve shifts outward.

Section 1.3 Society’s Choices: The Production Possibilities Curve

An outward shift of a production possibilities curve is shown in Figure 1.4. If the economy is at point A on PR, production consists of D1 tons of soybeans and C1 units of levees. With the shift of the curve to P1R1, it is possible to reach some point, such as point B, that includes more of both soybeans (D2 tons) and levees (C2 units). Other possible combinations on the new pro- duction possibilities curve include the same amount of one good and more of the other (such as point E or F) and less of one good and more of the other (such as point H or J). No matter which combination is produced, the important thing about an outward shift of a production possibilities curve is that it increases the economy’s capacity to respond to human wants and, in some countries, deliver the resources that people need to survive.

Figure 1.4: Shift of the production possibilities curve

An outward shift of the production possibilities curve from PR to P1R1 means that the economy can produce more of both goods (economic growth).

Added resources, usually labor or capital, are sources of economic growth. New technology can also shift a production possibilities curve outward and account for economic growth. Invention, innovation, discovery of resources, and improvements in productivity all contrib- ute to economic growth and allow us to produce and consume beyond point A.

Key Ideas: The Production Possibilities Curve

The production possibilities curve shows

• attainable combinations (points on the curve), • opportunity cost (the slope of the curve), • unemployment of resources (points below or inside the curve), and • economic growth (a shift of the curve outward).

0 R

Soybeans (tons)

Levees

C2 C1

D2D1 R1

Attainable region

Section 1.3 Society’s Choices: The Production Possibilities Curve

Holding All Else Constant Unlike physical scientists, social scientists have fewer opportunities to conduct controlled experiments to validate their models. Thus, economists most often test hypotheses by look- ing at actual experiences in markets. Such experiments are often referred to by economists as ceteris paribus experiments. Ceteris paribus is a Latin phrase that means “all else being equal,” or “holding all else constant.” An economist changes one variable in a theoretical model (for example, the technology for producing levees in the production possibilities model). The economist then predicts what would happen ceteris paribus, or if everything else remained constant. The ceteris paribus assumption is the most common and most important assump- tion in economic models. If the technology of soybean production improved, but there was no change in the technology of producing levees, the production possibilities curve would shift out, as from PR to PR1 in Figure 1.5. The economist would predict an increase in output of both commodities but a relatively larger increase in the output of soybeans. The economist must then untangle the effects of the change in soybean technology on the mix of output (levees and soybeans) from anything else that changed in the real world in the time period when this model was being tested.

Figure 1.5: Technological change and the production possibilities curve

A change in the technology of producing soybeans shifts the production possibilities curve from PR to PR1. This shows that if all resources were devoted to soybeans, more could be produced. If all resources were devoted to levees, however, no increase in output could occur. Increases in both are also possible.

In addition to the ceteris paribus assumption, one other assumption is a basic part of most economic models. This assumption is that most people behave in a self-interested way. In general, self-interested behavior consists of people trying to get the most of something they want (to maximize some goal) out of available resources. For consumers, self-interested behavior means maximizing their satisfaction. For owners of productive resources, self- interest is expressed by seeking to maximize income. For business firms, self-interest means maximizing profits. In the production possibilities model, self-interested behavior will direct

0 R

Soybeans (tons)

Levees

Section 1.4 The Basic Elements of the Economic Approach

the decision as to which combination to produce out of all possible combinations. That com- bination is the one that maximizes the welfare or satisfaction of consumers.

However, self-interest is often confused with selfishness, although they are quite different in practice. Critics of market economies argue that encouraging and rewarding self-interested behavior is a basic flaw in such systems. In fact, concern for others and for the community as a whole is not incompatible with self-interest, because individuals define their own self- interest in terms of what is satisfying to them. Some individuals derive their greatest satisfac- tion from material possessions, others from leisure or enjoyment of the arts, and still others from helping people and building better communities. Some people may derive satisfaction from all of these simultaneously! Then self-interested behavior is not inconsistent with vol- unteer work or charitable contributions. Such unselfish activities are not, by our definition, un-self-interested. This definition of self-interest is broad enough to cover the actions of the Kardashians and Mother Teresa.

When economists use the self-interest assumption in developing a theory, they are simply saying that they expect behavior to be influenced by costs and benefits. If the cost of a course of action declines or the benefits rise, relative to alternatives, more people will choose that course of action. For example, if the price of soybeans rises relative to that of corn, some farm- ers will switch production from corn to soybeans, attracted by the higher price. If salaries for public school teachers rise relative to those of accountants, more people are likely to prepare for a teaching career, and fewer will study accounting. If the penalty for speeding falls, ceteris paribus, more people are likely to drive faster than the posted speed limit. If the cost of giving to charity rises because it is no longer tax deductible, less will be given to charity.

Furthermore, economists do not use the concept of self-interest to predict any one person’s or firm’s behavior but rather average or group behavior. Such predictions are similar to the use of attributes of certain groups by insurance companies to predict how often certain events will occur. Insurance companies develop norms for various groups—life expectancies, acci- dent rates, or numbers of house fires—and use them to set prices for policies. These norms say nothing about how likely any particular member of a group is to live past age 80, run a car off the road, or have a house burn to the ground.

1.4 The Basic Elements of the Economic Approach This discussion of theories and models suggests that economics is much like other sciences in its methods. What is unique or different about the economic approach? There are a few emphases and ideas that help set economics apart.

The Core Values of Economics 1. Like the natural sciences, economic theory is positive, or nonnormative. Positive

statements are if–then propositions about what is. In contrast, normative statements describe what ought to be. In other words, economic theory strives to be scientific. However, when economists try to apply economic theory to policy questions, they often find it difficult to keep their work positive. Economic theory

Section 1.4 The Basic Elements of the Economic Approach

is value free, but appliers of the theory are often tempted to mix in their values in order to favor a preferred outcome or policy. It is a positive statement to say that production of more levees will require increasing sacrifices of soybeans. It is a nor- mative statement to say that more levees and fewer soybeans should be produced. One easy way to separate the two is to look for words like should or ought to, which identify a normative statement.

2. Economic theory cannot predict the future. It can only explain the effects of certain events. Economic theory consists of statements of the if-A-then-B type. The predic- tion that B will occur depends on whether A happens. (Note that theory does not predict the occurrence of A; economists do not have a crystal ball.) In the production possibilities model, an increase in resources will result in economic growth, ceteris paribus. In this case, part of the ceteris paribus assumption is that the increased resources will be put to work and not left unemployed. There is, however, some dif- ference between what economics is and what many economists actually do. Many economists, especially macroeconomists, spend a great deal of time forecasting future conditions. To do this, they make use of economic theory. In forecasting, an economist guesses the likelihood that A will occur and then uses economic theory to predict the occurrence of B. Sometimes, however, forecasts are wrong. This does not necessarily mean that the theory is incorrect: The forecaster may have been wrong in expecting A to occur.

3. Most economists look first to market processes for solutions to social problems. This market bias reflects a preference for the freedom and efficiency arising from decen- tralized processes. However, most economic theory is applicable to nonmarket sys- tems as well, even though the legal and political institutions differ. Economists can apply tools developed for analyzing market economies to the workings of socialist economies and to a wide variety of nonmarket behavior.

4. Economists pay a great deal of attention to cost. The emphasis on opportunity cost, scarcity, and choice is fundamental to economics. Nobel Prize winner Milton Fried- man underscored the importance of opportunity cost when he remarked: “There is no such thing as a free lunch.” Focusing on the subject of cost often puts economists in conflict with policy makers. Environmentalists do not like to hear economists talk about the opportunity cost of environmental purity in terms of forgone output. Col- lege admissions officers seeking students do not like economists reminding students that the opportunity cost of a college education includes income not earned while in college.

5. Economists are very interested in chances to substitute among alternatives. Substitu- tion and cost are closely related because the decision to substitute is based on the costs of the various alternatives. Sometimes substitutes are obvious, such as plastic for aluminum or electric heat for gas. Other substitutes are less apparent. A tree, for example, can substitute for gas or oil as heat or for aluminum siding on houses. Trees can also substitute for air-conditioning or awnings by providing shade. An important task of economic analysis is identifying alternatives that can serve as sub- stitutes and evaluating the costs of substituting one for another.

6. Economists think in terms of marginal analysis. The marginal approach means look- ing at the effects on other variables of small increases or decreases in one important variable. Should we produce one more levee? If we do, what will be the (marginal) cost in terms of soybeans not produced? Most decisions in economics are not all-or- nothing choices but are made at the margin. Decisions about how to spend the next hour, whether to eat another slice of pizza, and whether to hire an extra worker are all marginal decisions.

Section 1.4 The Basic Elements of the Economic Approach

7. Economists take the individual, rather than the group, the industry, or the commu- nity, as the basic decision-making unit. They regard the behavior of individuals as an important influence on public policy and on decisions made in the private sector. The emphasis on individuals rather than groups reflects the importance of incentives in economics. Changes in prices, costs, profits, wages, substitutes, and opportunities are the driving forces behind individual economic decisions. It is the individual, not the group or community, that responds to incentives.

Key Ideas: Core Values of Economics

• Economic theory is positive. • Economic theory cannot predict the future. • Economists look to markets for solutions to social problems. • Economists emphasize opportunity cost, scarcity, and choice. • Economists evaluate the costs of substituting one good or service for another. • Economists think on the margin. • Economics considers the individual to be the basic decision-making unit.

Using Economics to Dictate Public Policy One of the most important uses of economics is to help analyze possible solutions to public policy problems and to develop recommendations. Some of the most famous economists in history—Adam Smith, David Ricardo, John Maynard Keynes, Milton Friedman, and Paul Sam- uelson—became interested in economics because it offered tools with which to develop solu- tions to policy issues. When economic models are applied to public policy issues, it is difficult to decide when the economist’s task ends and the policy maker takes over. When economic methods are used for policy analysis, there is a five-step process.

1. State the problem. The choice of what problem to consider and how to state it is the task of the policy maker. How a problem is stated often determines what tools the economist applies and what solutions are considered. For example, suppose the problem is illegal parking, like parking without a permit or in a space not designated for parking. Let us follow that problem through the next four steps.

2. Apply the relevant economic model. The economist turns to the tool kit to select the most useful theoretical model. In this case there is a fairly simple technique called cost–benefit analysis. This technique simply assumes that people are self-interested, that they are aware of the opportunity costs and benefits of their actions, and that they will choose the course of action that maximizes the excess of benefits over opportunity costs. This simple model predicts that an increase in the opportunity cost of illegal parking or a reduction in benefits will reduce the amount of such parking.

Section 1.4 The Basic Elements of the Economic Approach

3. Identify possible solutions. The most common error at this stage is to leave out some alternative solutions. Cost-based solutions to illegal parking might include higher fines. Do you think a person would be less likely to park without a permit if the fine were $500 instead of $50? More police officers would raise the cost by increasing the probability of being caught. The city could reduce the benefits of illegal parking by providing more bicycle racks or free bus transportation to and from commuter parking lots.

4. Evaluate solutions. This is the stage where economists are most useful, pointing to costs, substitutes, and incentives. A good economic model predicts how various alternative solutions will affect the amount of illegal parking, who will gain and who will lose, and which solution costs the least to implement. For example, more police officers would be more expensive than higher fines. Bicycle racks are cheaper than shuttle buses. However, racks are not as helpful as buses would be for commuters, unless the commuters live very close to the city center.

5. Choose and implement one or more solutions. This step is not the task of the econo- mist, although it is hard to stop after carrying the process this far. The policy maker (who may have been trained as an economist) takes the economist’s list of possible solutions and the evaluation and makes a policy choice.

Most arguments among economists occur when they overstep the boundaries of scientific analysis and advocate a particular solution to an economic problem. Newspapers and tele- vision news programs often quote economists who disagree. However, economists agree far more often than they disagree. Disagreements make headlines; agreement is not news. Throughout this book, we will point out where most economists agree and also where and why they disagree. The models we describe represent a broad range of agreement among most economists on how markets work and how individuals respond to incentives.

Key Ideas: Using Economics to Dictate Policy

• Economics offers tools with which to develop solutions to policy issues. • Economics can be used to develop policy recommendations. • It is up to the policy maker to take the economist’s list of possible solutions and

make a policy choice.

Section 1.4 The Basic Elements of the Economic Approach

Policy Focus: Economists as Policy Advisors

Paul Samuelson (1915–2009) and Milton Friedman (1912–2006) were two of the best known American economists. They were both very active in the major macro and micro policy debates of the past four decades. Both were winners of the Nobel Prize in Economics. However, the two men represented polar extremes with respect to economic policy. Samuelson saw an important role for government in modern industrial society. Friedman argued that the market economy operates very well and that the interventions supported by Samuelson do more harm than good. Samuelson was a leader of the liberal (policy) school of economics. Friedman represented the conservative or free-market school, which is sometimes called the Chicago school.

Samuelson, once a professor at the Massachusetts Institute of Technology, had an undergraduate degree from the University of Chicago and master’s and doctoral degrees in economics from Harvard University. His PhD dissertation—Foundations of Economic Analysis, written when he was only 23 years old—was published as a book. It still ranks as a monumental work in the application of mathematics to economics, and graduate students still study it. Many of today’s economists were introduced to economics with Samuelson’s textbook Economics. Samuelson is largely responsible for making the economics department at the Massachusetts Institute of Technology one of the best in the country.

Friedman was a professor at the University of Chicago, where he taught for 30 years. He was also a senior research fellow at the Hoover Institution at Stanford University. Friedman received an undergraduate degree from Rutgers, an MA degree from the University of Chicago, and a PhD from Columbia University. He made notable contributions to economic theory. His policy ideas are readily available in three books: Essays in Positive Economics (1953), Capitalism and Freedom (1962), and Free to Choose (1980). Before his passing, Friedman angered some of the conservatives who usually agreed with him by arguing that illegal drugs should be legalized. He argued that legalizing such drugs would reduce both the profits in selling them and the crime and violence among sellers and users.

Economics may very well be the only field in which two people can get a Nobel Prize for taking opposite viewpoints.

Kyodo/Associated Press

Paul Samuelson (L) and Milton Friedman (R) were both Nobel Prize–winning economists.

Associated Press

Conclusion

Conclusion By now you should know why you cannot have everything that you want all of the time. We live in a world of scarcity. You must make choices, managers of firms must make choices, and leaders of countries must make choices. As we proceed, you will become more adept at understanding the trade-offs involved in making choices—whether for personal consump- tion, business decisions, or public policy. The policy focus in each chapter will remind you that one of the important functions of economics is to help you understand and improve public policy.

As you begin to understand the economic way of thinking, you will gain insights into an end- less array of interesting policy questions. We will explore these in subsequent chapters.

Key Ideas

1. Economics is the study of how decisions about producing and consuming goods and services are made and how individuals and groups face the problem of scarcity. Microeconomics looks at the interactions of producers and consumers in individual markets. Macroeconomics is the study of the economy as a whole and is concerned with aggregates, numbers that are determined by adding across many markets.

2. Social or behavioral sciences look at the behavior of human beings, individually and in groups. They study different subsets of the actions and interactions of human beings. Together, macroeconomics and microeconomics make up one of the social sciences.

3. Economics interacts with almost all other academic subjects, and much of what both domestic and international political decision makers do is based on economic theory. Economics also provides an understanding of how society functions. Economics is useful; people who are trained in economics find rewarding jobs and careers.

4. Resources are limited, but human wants are unlimited. This conflict is the basic economic problem of scarcity. People cannot have everything they want, and they must make choices. In order to have more of one good, people must settle for less of another. The cost of extra units of one good is the number of units of the other sacri- ficed, or the opportunity cost. The principle of increasing opportunity cost says that the more of one good people have, the greater the amount of other goods they must sacrifice to obtain one more unit of that good.

5. The production possibilities curve illustrates the problem of scarcity. The curve shows the various output combinations of two goods or groups of goods that can be produced in an economy with the available resources. Unemployment of resources is shown by a point inside the curve; economic growth is indicated by a shift of the curve to the right.

6. The economic approach is positive and marginal and cannot be used to predict the future. Economists tend to look to the market for solutions, pay a great deal of atten- tion to cost, are interested in substitution among alternatives, and look at the indi- vidual as the decision-making unit.

7. One of the most important uses of economic theory is to develop models that can be used for policy analysis. An issue is analyzed in five steps: State the problem, apply the relevant economic model, identify solutions, evaluate solutions, and choose and implement solutions.

Conclusion

Critical-Thinking Questions

1. Do you think people exhibit behavior patterns that confirm the self-interest assump- tion? Does your own behavior confirm this assumption? Is a contribution to charity or volunteer work a contradiction of the self-interest assumption?

2. Why do economists theorize rather than attempt to describe reality exactly? 3. Do assumptions have to be realistic in order for a theory to work? 4. What is the difference between using theory to predict and forecasting? 5. Consider the following simple predictive model: If the speed limit is reduced, fewer

highway deaths will occur. What assumptions are being made? What ceteris paribus conditions could change and make this prediction invalid?

6. Which of the following quantities are microeconomic and which are macroeco- nomic? Which might fall between the two? a. price of shoes b. number of 18- to 24-year-olds in the U.S. labor force c. level of interest rates d. unemployment in Tulsa, Oklahoma e. production of agricultural products f. average level of prices g. production of butter h. average price of imported goods i. unemployment in the United States j. total output k. unemployment of carpenters l. number of nurses in the U.S. labor force m. unemployment in the northeastern states

7. What is the opportunity cost of working 10 hours a week driving for DoorDash while in college? If you worked more hours per week, would you experience increasing or constant opportunity cost? That is, would the extra hours require giving up alterna- tive uses of your time that have the same value or an increasing value?

8. Try developing a simple economic model to predict how students will respond to an increase in dormitory rents. What are your assumptions? What will happen to the number of dormitory spaces rented? What will happen to the number of off-campus apartments rented and their prices?

Conclusion

Key Terms ceteris paribus assumption The assump- tion that everything else will remain con- stant, used for most economic models. (Ceteris paribus is Latin for “all else being equal.”)

gross domestic product (GDP) The total market value of all final products produced by a country’s residents in a given year.

increasing opportunity cost The principle that as production of one good rises, larger and larger sacrifices of another are required.

normative statements A set of proposi- tions about what ought to be (also called value judgments).

opportunity cost The full value of the best alternative that is given up when a decision is made.

positive statements A set of propositions about what is, rather than what ought to be.

production possibilities curve A graph that depicts the various combinations of two goods that can be produced in an economy with the available resources.

resources The inputs of land, labor, capital, and enterprise that a firm uses to produce outputs.

scarcity The central economic problem that there are not enough resources to produce everything that individuals want.

self-interested behavior A basic assump- tion of economic theory that individual deci- sion makers do what is best for themselves.

unlimited wants The needs and desires of human beings, which can never be com- pletely satisfied.