Lesson Two
Chapter One – Thinking Like an Economist
Or Becoming an Economic Naturalist
Macro and Micro Economics Introduction
by Economics Founder ~ Adam Smith
What Does it Mean to Be a Naturalist?
A naturalist economist has a systematic way of examining his or her world. The closest approach I can come to this approach is how a Buddhist approaches life. He or she approaches life as a way of thinking rather than from pure emotion which is how most of us humans live our everyday lives. Take for example the concept that less is more. To a Buddhist less is more in terms of simplifying his or her life. To an economist less is more because the costs associated with taking on more could create present or future problems.
Here is a further example of how an economist thinks. Let’s discuss for a moment SUNK COSTS which is on page 10 of your text. An economist would suggest that a sunk cost is a cost beyond recovery at the moment a decision must be made. Do we think this way as humans? No most of us live our lives by pure adrenaline rather than from our minds.
Just like buying a Japanese lemon at a used car lot. So you decide never to buy another Japanese car ever again. Well, that is how many people make their purchasing decisions. They are not thinking in terms of SUNK COSTS but they are examining their purchases on an emotional level. To a Buddhist he or she would call this negative Karma. Or if something negative happens from ones past he or she is to "Let it Go". Let Go of the negative experience or Karma so they can get on with their present and future lives. However, the average person will do just the opposite. The average person will instead allow a past negative experience dictate his or her present or future experience.
In fact, the real scenario could have been one where the Japanese firm sold a perfectly good car 5 years earlier to a unreliable customer. Maybe the guy drove it into the ground, plus he never changed the oil. Some people turn their cars over every 2 to 4 years and let someone else pick up the pieces. So after you took it over it began to fall apart. So you exclaim because I bought a lemon I will never ever purchase another Japanese car. This way of thinking is purely on emotion and one that most of us will make.
However, in understanding SUNK COSTS or how a Naturalist thinks, I want to discuss two scenarios A: one businessman who is not examining SUNK Costs another B: businessman who does examine SUNK COSTS making a decision.
Background: For example the firm lost money making a past decision to purchase a piece of equipment that broke down shortly after its warranty was up.
Businessman A (Not a Naturalist): This manager because the machine still hasn’t been depreciated decides to fix up the old machine instead of taking the time to investigate and repurchase a newer machine decides to take any chances that the old machine might break down again. This boss is allowing a past decision to decide on his present and future situation. He doesn’t consider the fact that the assembly line may go down again if the machine has another future breakdown.
Businessman B (A Naturalist): So instead of fixing it a wise manager might have decided that it would be better to buy a new machine rather than repair the old machine because of its future liability. He believes that the past cost of the purchasing of that bad piece of equipment is irrelevant so he or she decides to purchase a new replacement (even if the replacement has to be made much earlier on the accounting books than was expected). So the manager instead of keeping the old machine because it still hasn’t been depreciated and instead of fixing it up decides to let the old machine go and purchase another newer machine with less chance of future break downs and problems of the assembly line losing time.
The job of this class is simply to get you to think as the authors suggest like you are a Naturalist in an Adam Smith genre. I know that if you keep this Naturalist ideal in mind that it will make this class come alive and much easier.
The Smith Everyone "Knows"
Everyone knows Adam Smith. Well, Smith was an Economic Naturalist. Even most non-economists, know his great treatise, The Wealth of Nations. They know him to be the philosopher of "self-interest" who put avarice at the core of his values positing a mystical "invisible hand" which will take care of everybody so long as everybody takes care of themselves. They know him to be the philosophical mainstay of industrial capitalism in which the ever-greater "division of labor" reduces the worker to a mere "servo-mechanism" of the machine. They know him as the prophet of unrestricted free trade and the champion of "laissez-faire", "get the government off the backs of business" polity. Indeed, the ideas of Smith are the very ground of the economic and political life that we lead; hence, we absorb Smith in the very air that we breath, and know him so well that it is hardly necessary to read him at all; indeed, there are few who take the trouble to do so.
The only problem with this view is that, like so many things that everybody "knows", what they know does not happen to be so. In fact, there is no possible reading of Smith that will support the "readings" that Smith is usually given. In nearly every area that Smith is commonly cited, he expresses strong opinions against what has become the "common view" of Smith: Instead of praising greed, he warns against its pernicious effects; instead of denigrating labor, he puts it at the heart of all economic values; instead of supporting "capitalism" (a term he never uses), he warns that the mercantile class has interests which oppose the good of society. So then, was he not a supporter of laissez- faire (another term he never uses)? Yes, but a laissez-faire that means the opposite of what the term has come to mean. Was he not a supporter of our great manufacturing enterprises? Not really; such things were in the future, and Smith places not manufacturing, but farming and the well-being of the farm at the heart of the Wealth of Nations. And with that in mind, he deserves a re-reading, especially on those very points for which he is most praised or blamed, but only rarely understood.
Adam Smith and Labor
At the heart of all economic values praised by Smith is the worker. Labor is the original foundation of all property and therefore the most sacred. (Wealth of Nations, p.129 *) Indeed, in the original state of affairs, "which precedes both the appropriation of land and the accumulation of stock, the whole produce of labor belongs to the laborer." However, as land was divided into private property, "the landlord demands a share of almost all the produce with the laborer can either raise or collect from it." Labor is also "the real measure of the exchangeable value of all commodities", and "the only accurate measure of value".
For Smith, the "liberal reward of labor" is crucial to the success of society: But what improves the circumstances of the greater part can never be regarded as inconveniency to the whole. No society can surely be flourishing and happy; of which, the far greater part of the members are poor and miserable. It is but equity, besides, that they who feed, clothe and lodge the whole body of the people, should have such a share of the produce of their own labor as to be themselves tolerably well fed, clothed and lodged.(83)
Indeed, better wages improve the industry of the worker because that industry, "like every other human quality, improves in proportion to the encouragement it receives."(86) Thus, "If masters would always listen to the dictates of reason and humanity, they have frequently occasion rather to moderate, then to animate the application of many of their workmen."(87) Further, it is not high wages that are the cause of high prices, but high profits; wages have only an arithmetic affect on prices, but profits act geometrically (103), in a fashion similar to compound interest. (104) Our merchants and master-manufacturers complain much of the bad affects of high wages in raising the price...They say nothing concerning the bad effects of high profits. They are silent with regard to the pernicious effects of their own gains. They complain only of those of other people. (104)
However, in the negotiation of wages, the worker is at a distinct disadvantage. In the first place, the law prevented him from joining with his follows to bargain; that is to say, unions were outlawed. Further, the law always favors the masters over the workers. Workers were prevented from joining in unions to raise wages, but the masters were not forbidden to unite to lower them; indeed, the law encouraged them to do so. This legal inequality particularly angered Smith, who noted that, "People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices." "But when the worker’s attempt to meet it" it generally end[s] in nothing, but the punishment or ruin of the ringleaders." Smith, that by supporting the "division of labor" as the key to the improvement of productivity, he supports a system which results in a mind-numbing alienation of the worker from his work.
Adam Smith and the Capitalists
The introduction to the Prometheus edition of The Wealth of Nations states the common view that the book "still stands as the best statement and defense of capitalist economics."Yet it is difficult to see to what, exactly, the introduction refers. Smith never uses the term "capitalist;" He is familiar with only two forms of "political economy": mercantilism and agricultural systems. The majority of the book is an attack on the former, and the later is the only system to which he can give his considerable intellectual support. It is likely that what the editor had in mind is the first section of the book, where Smith lays out such principles as supply and demand, the law of rents, the division of labor, etc. However, it is not clear to what extent such principles are exclusively "capitalist"; Supply and Demand is a law which applies apart from any system of politics; the distribution owner, the agrarian, even the socialist recognize such laws. So it is not so much a matter of Smith "defending" capitalism (which he never does), as it is of capitalists appropriating Smith, and often against his expressed wishes. Smith does however, comment at great length on the interests of the mercantile class. We have already seen how much he resents the privileges they possess in opposition to their workers and the influence they have in this regard with the legislature. We have also already seen that Smith realizes that it is profit, rather than wages, which drives high prices. But Smith goes much further. In fact, Smith states that the interests of this class run exactly counter to the interests of society as a whole. This conflict between the interests of society and the interests of the "capitalists" (to use the modern term) works in two ways: the first is the tendency to seek, often with the connivance of the legislature, a "monopoly" price for their goods; and the second is that a rising economy actually lowers the return on capital. Each of these ought to be carefully examined. The first of these conflicts can be seen in the pricing of goods.
Pricing operates between two poles:
The price of monopoly is upon every occasion the highest that can be got. The natural price, or the price of free competition, on the contrary, is the lowest which can be taken, not upon every occasion indeed, but for any considerable time together. The one is...the highest which can be squeezed out of the buyers... The other is the lowest which the sellers can commonly afford to take...
The monopoly price is most often sustained by "the exclusive privileges of corporations" and by the host of subsidies, tariffs, drawbacks, and exclusive charters discussed in excruciating detail in 8 chapters of Book IV. Thus legislative power, and the privilege it may confer, is essential to improving the profits of the capitalist. But even this is not the most pernicious divergence of interest between the capitalists and the public. For that, we must look at the "natural interests" of the various classes of society.
Introduction
The chapter opens with a game/example regarding class size. You students know that as class size increases, the opportunity to interact with the teacher diminishes. As interaction diminishes, so does the ability (or opportunity) to learn. Note the noise and distraction level in a lecture hall compared to the relative quite in a small class setting. This relationship can be turned around to suggest that as class size increases, it becomes ever harder for a student to stay enthused and to grasp the major points in the lessons. Graph this as follows:
The positive slope of the red line shows that learning becomes more difficult as class size increases. A similar diagram can be used to show that the cost per student decreases as class size increases. The instructor’s salary, upkeep for the lecture hall, heat and lights, and janitorial services all cost less per student when the costs are spread over 50 or 100 or 300 students rather than being paid by 10 or 20 students. The following graph shows this.
A more complete story emerges when the two curves – the "discomfort curve" and the cost per pupil curve are shown on the same diagram:
If the two forces – cost per student and discomfort associated with class size – can be measured in the same terms (most likely in some dollar or monetary terms), the "best" size of class is shown by the intersection of the two curves. To the left of the intersection the costs are very high. In fact, they are much higher than the "cost" of the discomfort. A student will be glad to put up with a few more students in order to drive the cost down. To the right of the intersection, the discomfort has become extremely high (costly). The student will be happy to pay more in order to improve the learning environment. The best combination of class size and cost is designated by the intersection of the two curves.
Economics: Studying Choice in a World of Scarcity (pages 4-5)
This section describes a circumstance that is often overlooked. Scarcity requires choices. If it were not for scarcity, choices would not be needed, and no one would make them. This seems to be a ridiculous statement because something is always scarce. Tell your students that almost every choice that they make is made because something is scarce. Some students will challenge this, but challenges can be refuted.
Such examples can come up in open discussion. Most suggestions will relate, directly or indirectly, to scarce time or scarce money. One possible situation concerns a very wealthy person who simply does not want to choose between the BMW and the top-of-the-line Cadillac,, so he buys both. No choice is made because there is no scarcity involved. The wealthy person has no need to consider the choice. This line of argument actually reinforces the point that choices are made because of scarcity.
The scarcity principle says that for ordinary people, life is made up of "either/or" situations. I can have this or that. I can take biology or botany. I can buy a Honda or a Toyota. I can eat beef or fish. I can go to the football game or to the basketball game. But in none of these cases can I have both of the objects. Either time or money will prevent having both. These comparisons lead to the notion of a trade-off, and like it or not, students as well as instructors must constantly be choosing between this and that; between Plan A and Plan B (and Plans C, D, E, and F). After the discussions related to scarcity, you can come back to the fundamental notion that economics is the discipline that is designed to help make appropriate choices. Return to the time-honored definition:
Economics is the study of allocating scarce resources among alternative and competing ends.
The process of choosing is aided by the cost-benefit principle. This principle is highlighted (along with scarcity) on page four. It is easiest to think of this principle in terms of a dichotomous choice: the chooser is selecting from a group of two opportunities. Apples or oranges. Study or play. Chevrolet or Ford. State College or Community College. The choice process involves comparing benefits and costs. In order to be chosen, extra benefits must have a value greater than the cost required to obtain them. You should put more beans on your plate if, and only if, the benefit that you receive from the added beans is greater than the cost of obtaining them.
Costs and Benefits
Comparing benefits and costs has been a part of economic reasoning and economic literature since the discipline first appeared many decades ago. The principle is as frequently called benefit-cost analysis as it is called the cost-benefit principle. Make sure that your students understand that the hyphen separating the two words "cost" and "benefit" is just a hyphen and not a minus sign. While subtracting benefits from costs may be useful in some contexts, the principle is based on a broader understanding of a comparison.
The authors continue with the class size example. The example works very well in pointing out that different people will have different ideas about appropriate class size. The educational psychologist, talking as a person with interests only in learning, says that one pupil per teacher is best (Why not two teachers per pupil?). The school trustees, thinking as much about money as about the educational experience, argue in favor of large classes in order to reduce costs per pupil. Individual students will have different ideas about what is the best size. The interested learner will want small classes while the socially oriented student might want the opportunity to hide from view or not attend a large and impersonal class.
Regardless of orientation or desire, the individuals making the choices are guided by the same principle. If they want small classes, they must be sure that the cost of the move to this class size will be at least offset by benefits accruing to the change.
Bill Gates, reportedly the richest man in the world, is mentioned on page five. The implication regarding his unwillingness to pick up a $100 bill (of course he would pick it up. All of us stoop to pick up even almost-worthless pennies!!) detracts from the fact that he and his spouse have given close to $9.0 billion to charities in the past few years. Most of the donated money has gone for health care and for general education.
Applying the Cost-Benefit Principle
Rationality is an important notion in all of economics. It requires every economic unit (person, family, firm, or government) to have a definable goal and to act on opportunities that further that goal. The following are possible goals:
Rationality assumes that a person (family, firm, or government) will seek to gather more and more of the qualities that contribute to the satisfaction of its goal or goals. In most cases, the goals must be stated in qualitative terms, but economists frequently use dollars as a convenient numeraire or metric for one several goals taken in combination. Here are two extensions associated with the notion of rationality:
Example 1.1 can be complicated, but it is based on a very real problem. It also becomes an important part of the explanations later in the chapter. Ask your students to read the example, and then go over it in class to insure that all students understand it and are moving ahead with this essential background. You may want to restructure the example and present it a second time.
One very important aspect of the example appears in the second paragraph where the authors say" "The cost of taking any action is the dollar value of everything you giveup by taking [that action]."
The example is based on the idea that the $10 saving has a real cost. It takes time to make the trip downtown, and if the trip itself costs $10 or more, the prospective buyer should buy at the store near the campus. The "auction" sounds too unreal, but it is likely that all prospective purchasers in a situation similar to this will go through some unconscious auction to determine the amount of cost saving required to trigger the trip downtown. Use a simple example to make the point. Put the following table on the screen or on the chalk board and ask the students to indicate when they would buy at the nearby store and when they would buy downtown:
|
Cost of making the trip to town |
Benefit from the trip |
Make the trip to town? |
|
$12 |
$10 |
No |
|
$11 |
$10 |
No |
|
$10 |
$10 |
Possibly |
|
$9 |
$10 |
Yes |
|
$8 |
$10 |
Yes |
Economic Surplus
Surplus is a familiar concept, but the students will have to be told that the real surplus is not the $10 saving from the purchase of the computer game., but the difference between the $10 and the implied cost of making the trip downtown. If the trip to town "costs" $5, the surplus is $10 - $5 = $5. If the cost of the trip is $9.50, the surplus is $10.00 - $9.50 = $0.50.
Opportunity Cost
The true cost of something is what you give up to get it.
Opportunity cost is one of the most important concepts in all of microeconomics. Even so, students frequently miss the idea and misunderstand what is at issue. This section is very brief. You will likely want to expand the explanation as well as provide additional examples. Present opportunity cost in several ways:
Opportunity cost is not easily demonstrated by a graph or a flow diagram or any other common visual. The "fork in the road" can be used as can a series of either/or choices such as Spanish/German, baseball/football, or teaching/accounting. The term and the concept come back again and again in the study of economics. Students will appreciate being reminded from time to time that the opportunity cost of any activity is represented by the value of the activities that have been given up.
The Role of Economic Models
All models are abstractions. A model train abstracts from the size of the real thing. It captures the essential points of a train, but it will not run on real tracks and it will not carry freight because it lacks the size and the complexity. A playhouse is a model, and models of proposed commercial buildings are often seen in the open areas in retail malls. These models are all built to show essentials without important details – size being a major detail. Economic models are much the same. They are constructs made of words, mathematical symbols, graphs, and flow diagrams that show how some complex relationship from the real world actually works.
The following simple model shows how retail activity works:
This model is so highly oversimplified that it cannot convey a great deal of information. Nonetheless, it identifies three major actors in the chain that moves products from producer to consumer. Adding detail will add understanding. Other models can be similarly described.
Models are used throughout the study of microeconomics. They are used to introduce comparative advantage, supply and demand, production possibilities, and elasticity in just the first four chapters of the book. Many more models follow in later chapters.
The paragraphs make a necessary point with respect to models. A prospective purchaser does not need an elaborate computer in his/her head in order to make the decision about going to town to save $10. The prospective buyer has likely made hundreds of similar decisions in earlier days and months. The experience kicks in to help make the present decision.
Most decisions use this kind of experience-based implied modeling. It takes only seconds to make the yes or no decision regarding the purchase of an ice cream cone. On the other hand, the decision to purchase a home in the suburbs may require weeks of agonizing over models that include such variables as interest rates, number in the family, years until the mortgage is paid off, distance to a school, as well as the more common concern over price and family income. Even in this complex case, the model may not be written out or drawn. It is, however, studied very carefully by those who are contemplating the purchase.
The Recap provides a useful quick glimpse of the concepts that have been covered to this point. It can be expanded slightly to show that an action should not be taken if the cost-benefit principle shows that the economic surplus is negative (cost > benefit).
Four Important Decision Pitfalls
These pitfalls play two roles. They offer useful insights into the construction and use of economic models and they provide useful everyday lessons for students who might still be wondering why they are taking economics.
Pitfall 1: Measuring the Costs and Benefits as Proportions Rather than Absolute Dollar Amounts
This pitfall takes you back to the problems that surrounded the choice between buying a computer game at a nearby store and walking to town in order to save $10. The issue is complicated by a second problem. Should the student buy a $2,020 computer in a nearby store or should he/she walk downtown in order to purchase the same computer for $2,010? The correct response is that $10 is $10. If the walk to town is taken for the $10 saved on the game, the walk should also be taken to save the $10 on the computer.
Again, $10 is $10 no matter how it is saved.
Exercise 1.2 provides a second example of the pitfall. Saving $100 is always better than saving $90. The proportion is not a realistic issue. Note that Exercise 1.2 holds true only if a potential buyer can realistically consider going to Tokyo or going to Chicago. If going to Tokyo is some idealized figment, the example doesn’t work.
Pitfall 2: Ignoring Opportunity Costs
(Try to count how many times the authors refer – directly or indirectly – to the opportunity cost concept in the section on Pitfall 2). What if Deion Sanders had decided to play baseball without checking his football options? He would have taken home $3.6 million, but he would not have known that he was giving up a $7.8 million opportunity. Sanders could not afford to ignore the opportunity cost that went with the baseball contract. The same is true of the student who decides to teach rather than pursue a career as an accountant. The opportunities must be examined. The final sentence before Example 1.3 (page nine) helps make the point. Students, and all others, should be told to think in terms of "Should I do (PLAN A) or should I do (PLAN B)? Thinking using an either/or format helps decision makers to focus on opportunity costs – the cost attached to closing an option.
Example 1.3 can become quite complex. It helps to work it out on the chalkboard. The key issue is the $1350 total benefit that the hypothetical student will get by making the trip to Ft. Lauderdale. Start with this. Once the $1350 benefit is well understood, the costs can be developed as follows:
Non-transportation costs are $1000
Opportunity cost of using the coupon (what the
coupon is worth if used for a trip to Boston) $400
Total costs for the trip to Florida $1400
The $1400 total cost exceeds the $1350 level of benefits, so the trip should not be taken. The opportunity cost of the coupon is the amount that the student will have to pay for the ticket to Boston. If the coupon is used for the Ft. Lauderdale trip, all of the anticipated expenses of the Boston trip will become real dollars that will have to come from somewhere.
Exercise 1.3 changes the entire problem. If the coupon expires in a week, the trip to Ft. Lauderdale becomes the best "reasonable use" because the coupon has no opportunity cost after one week. Use it or lose it.
Pitfall 3: Failure to Ignore Sunk Costs
Students often find this to be the most difficult to understand of the four pitfalls listed here. Think of an automobile – the second most expensive capital item owned by most U.S. families. Students know about depreciation on the automobile and that the depreciation continues regardless of how much the car is driven.
Note: This supposition must be qualified. A car owner who drives 35,000 miles per year will surely depreciate the car more quickly than an elderly couple who drive only 4,000 miles per year. These are exceptions to the general practice of driving about 8,000 to 15,000 miles per year. The vast majority of car-owners drive within this range, and these same drivers have little or no control over the depreciation that they must "pay."
The question becomes how should an "average driver" respond to the "average level" of depreciation? The answer is that no response is warranted because regardless of whether the car is driven more miles of fewer miles, the depreciation costs continue to mount. These depreciation costs are "sunk costs" so they should not be a part of the driver’s decision criteria.
The authors list non-refundable airline tickets as a familiar sunk cost. Most any ticket or advance purchase becomes a sunk cost. If a student purchases expensive tickets for a rock concert then finds that it is impossible to attend, the original cost must be ignored. Resale would be nice, but the tickets may have to be given away. In either case the purchase price does not matter.
Example 1.4 provides an interesting discussion point. Most students have been in settings somewhat similar to those created by the $5 all-you-can-eat restaurant. You may wish to point out that this example is based on empirical evidence (see footnote #1). When the patron pays – even the rather modest $5 for all you can eat – there is a temptation or a hidden need to eat as much as possible even if you go away feeling over-full. If you behave this way, you have likely taken the $5.00 cost into consideration and have tried to maximize the quantity of food that you eat. This is faulty reasoning. The $5 is a sunk cost. It should be ignored once the money has been handed to the cashier. Pay your money and eat what you want to eat and no more than that.
The italicized sentence at the beginning of the section tells the story about sunk costs: The only costs that should influence a decision about whether to take an action are those that we can avoid by not taking the action. Sunk costs cannot be avoided or changed, so they should be ignored.
Pitfall 4: Failure to Understand the Average-Marginal Distinction Margins and averages are extremely important in studying and using microeconomics. Your students have an intuitive feeling regarding what averages are and how they can be used, but marginals will be new to some of them. Define the two terms using terms from economics or from everyday life rather than the terms that are used in a math book:
Marginal: The difference made by adding or subtracting one extra unit of something.
Average: A number that is calculated to summarize a group of numbers.
Use a seemingly random series to elaborate the point. Given the following numbers, 2, 7, 4, 9, 9, 3, 6, 1, and 5, the last number that appears (5) is the marginal number simply because it appears at the end of the series. If the 5 were not here, the "1" would be the marginal number. It is the difference that it makes simply by appearing in the group. An average can be used to summarize the series of numbers. The average is the total of the series divided by the number of integers in the series or 46/9 = 5.1. Of all available numbers, 5.1 comes closest to summarizing the nine numbers in this series.
A student's grades can often help teach the difference between average and marginal. Let’s assume t he following table has developed information that I keep in my gradebook:
Suzie’s last semester grades:
|
Week of class |
Test Grade |
Marginal Test grade |
Calculating Average |
Average |
|
Week 2 |
78 |
78 |
78/1 |
78.0 |
|
Week 3 |
82 |
82 |
160/2 |
80.0 |
|
Week 4 |
54 |
54 |
214/3 |
71.3 |
|
Week 5 |
91 |
91 |
305/4 |
76.3 |
|
Week 6 |
79 |
79 |
384/5 |
76.8 |
|
Week 7 |
73 |
73 |
457/6 |
76.2 |
|
Week 8 |
81 |
81 |
538/7 |
76.9 |
Note that the number in the upper cell of the marginal column is frequently omitted from tables such as this one. Including it or omitting it does not change the message. You may want to reduce the size of the table. The points can all be made using only the data from weeks 2, 3, and 4. Use the table as follows:
The relationship between average and marginal is further explained in Examples 1.5 and 1.6. If you students want you can read the examples with some care and to combine the information in Table 1.1 and Table 1.2 to solve the problem relating to the appropriate number of shuttles to send up. Exercise 1.4 will help you understand the concepts relating to average and marginal.
Exercise 1.5 requires some knowledge of basketball. It is not self-evident or intuitive that allowing the star to take one more shot requires that the others on the team take one less shot. Use this exercise only in conjunction with the "solution." The critical issue is that the star’s marginal shot, like Suzie’s third week test score, may not be successful, and the contribution to the average score may be well below average.
Recap
The summary is quite good. It can be used as an introduction to the study of the four pitfalls. You may want to use it as an introduction to this section. If so, be sure to mention the large number of definitions that appear here.
Normative Economics vs. Positive Economics
The box makes the point. In the end, you students want to think of economics as a normative study – it should tell us (individuals, firms, and governments) what we should do. For example, the marginal principle tells us to add more of an activity until the marginal cost is just offset by the marginal benefit. Students will ask about the origin of the data that provides the information that helps us to make that decision. The information comes from positive economics, the study of factual situations. Put another way, positive economics is based on facts that come from the real world; normative economics tells about actions and decisions that should come in the future. Some examples may help.
Strawberries respond to applications of nitrogen fertilizer. Farm records show that applying 50 pounds of nitrogen per acre will be followed by a yield of 5 tons of strawberries (positive). If the fertilizer application is increased to 100 pounds per acre, the yield goes to 15 tons per acre. The farmer should therefore apply the added nitrogen (normative).
AT the present time, about 13 percent of the U.S. population lives on incomes below the poverty level (positive). Congress should pass legislation to reduce that to eight percent (normative).
The incentive principle reinforces many of the lessons presented in this chapter: marginal reasoning, positive/normative economics, the cost-benefit principle, and many others.
Economic Terminology
Economic Perspective- An economic way of thinking of life's decisions.
Scarcity - Because resources of land labor and capital are scarce, this sets limits to our choices.
Choice - Due to scarce resources, we need to make choices. How do we optimize our choices?
Rational Behavior - People, businesses and institutions apply self-interest to all their choices.
Marginal Benefits - The extra benefit we receive by making one choice over another.
Marginal Cost - The extra cost we obtain by assuming one choice over another.
Economic Methodology - We apply the following scientific hypothesis testing procedure:
1) observe,
2) create hypothesis,
3) test, and
4) either accept or reject our original hypothesis.
Theoretical Economics - The role of economics theorizing is to arrange facts, interpret them, and then generalize by stating what we have learned from those facts. Often we apply statistics to this process.
Economic Principles - These are statements about economic behavior or the economy that enables production and the probable effects of certain actions.
Generalizations - Economic principles are expressed as the actions of consumers, workers, or firms.
Other-Things- Equal Assumption - Assuming that all other variables, except the ones we are considering (usually two like X and Y) remain constant. Then we make inference about X variable and its effect on Y.
Policy Economics - We analyze data and then build assumptions or policies to put them in place. Economic policy normally reviews problems as they arise but economic analysis examines events that will transpire if a policy was or was not implemented.
Economic Policy Procedures -
1) State goal - make a clear statement about the goal you want to achieve i.e. (Full Employment at 4%).
2) Determine Policy Options - i.e. should government employ more civil servants or have businesses add more labor to employ more people to bring employment to 4%.
3) Implement government hiring or business hiring decision and
4) Evaluate whether it worked and what to do next time of which of the two decisions was the better decision to maintain a 4% unemployment rate.
Macro Economics - We examine the spending of the whole economy. We examine how consumers, businesses, and governments spend while maximizing their benefits and minimizing their costs. Also the study of aggregate demand and supply, of Gross Domestic Product, Money and money supply etc.
Micro Economics - We look at specific economic units or products or factors (land, labor), demand and supply for individuals and businesses. We examine the marginal returns in relation to marginal costs, as well as how prices affect individuals and business.
Biases - Most people are biased because they assume a false sense of reality. Economics tries to get people to apply logic and economic reasoning using facts rather than fables.
Loaded Terminology - The newspapers are full of loaded terminology where their writers use words that are larger than life. For i.e. A writer may say obscene profits instead of high profits to exaggerate his or her case.
Fallacy of Composition
What is true for one person is not necessarily true for the nation. If one person gets a raise it benefits that person; however, if everyone gets a raise no one is better off. That's what happens when the Fed increases the money supply and causes inflation. We are only paying higher prices at the store so no one was better off when everyone gets a raise.
Post Hoc Fallacy
You can't say that event A preceded B. Before Galileo, people saw the sun go up and the sun go down so they assumed that the sun orbited around the earth. There are many 'Old Wives Tales' similar to this type of reasoning that are causation distortions.
Correlation and Causation
Just because X rises and Y rises too doesn't mean that X's rises caused Y to rise. There's an assumption that more education is better, but that's not necessarily true. Today, there are many unemployed Ph. D's who hold degrees in many unemployable disciplines. For i.e. History Professor which are too numerous to find employment.
Economic Goals
1) Economic Growth - The more goods and services produced, the higher is our standard of living.
2) Full Employment - Provide citizens with suitable jobs so they are willing and able to work.
3) Economic Efficiency - Achieve maximum fulfillment of wants as our available resources increase.
4) Price Stability - Keep prices constant without large rises (by inflation) and falls (by deflation).
5) Economic Freedom - Guarantee, businesses, workers, and consumers a high degree of freedom to make their own economic choices.
6) Equitable Income Distribution - Ensure that most citizens won't face poverty while a few will enjoy much.
7) Economic Scarcity - Provide for those who are ill, disabled, laid of and aged to earn their maximum level of employment. Getting people employed in jobs they enjoy, rather than working at jobs they don't like.
8) Balance of Trade - Seek a balance between all of our trading partners so it's as equitable as possible.
9) Tradeoffs - To achieve one thing we need to sacrifice another.
Why Do We Study Economics
1) So we citizens can vote intelligently both politically and
2) In the market place (with our dollar votes). Being rational we try to maximize benefits and reduce costs
Key Concepts:
Economics is the study of how people make choices under conditions of scarcity and of the results of those choices for society. Economic analysis of human behavior begins with the assumption that people are rational—that they have well-defined goals and try to achieve them as best they can. In trying to achieve their goals, people normally face trade-offs: Because material and human resources are limited, having more of one good thing means making do with less of some other good thing.
Our focus in this chapter has been on how rational people make choices among alternative courses of action. Our basic tool for analyzing these decisions is cost-benefit analysis. The cost-benefit principle says that a person should take an action if, and only if, the benefit of that action is at least as great as its cost. The benefit of an action is defined as the largest dollar amount the person would be willing to pay in order to take the action. The cost of an action is defined as the dollar value of everything the person must give up in order to take the action.
Often the question is not whether to pursue an activity but rather how many units of it to pursue. In these cases, the rational person pursues additional units as long as the marginal benefit of the activity (the benefit from pursuing an additional unit of it) exceeds its marginal cost (the cost of pursuing an additional unit of it).
In using the cost-benefit framework, we need not presume that people choose rationally all the time. Indeed, we identified four common pitfalls that plague decision makers in all walks of life: a tendency to treat small proportional changes as insignificant, a tendency to ignore opportunity costs, a tendency not to ignore sunk costs, and a tendency to confuse average and marginal costs and benefits.
Positive economics deals with "what is" or facts. Positive statements predict how people will behave and therefore are testable. Normative economics deals with "what ought to be"—that is, with value judgments and opinions about how people should behave.
The Incentive Principle states that incentives matter. That is, a person is more likely to take an action if benefits rise and less likely to take an action if costs rise.
Microeconomics is the study of individual choices and of group behavior in individual markets, while macroeconomics is the study of the performance of national economies and of the policies that governments use to try to improve economic performance.
Chapter 1- The Economic Perspective -- Homework
Email Assignment #2
What does it mean to begin to think like an economic naturalist?
Now that you are becoming an economic naturalist from this point on,, discuss the key variables economists use to view their world and tell what each one represents?
According to the author, what Four Pitfalls do most non economists mismanage as they attempt to make important lifetime decisions?
Discussion Question #2
In your book it was suggested that a rational person is someone who has well-defined goals who tries to fulfill those as best he or she can. Explain, if you saw Bill Gates leave a $100 bill lying on the sidewalk and wouldn’t pick it up, would Bill Gates be acting irresponsibly?
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