what economics is about 1 - dr. asad karim khan...

1

WHAT ECONOMICS IS ABOUT

I. IntroductionA Definition of Economics

Economics is a social science that deals with efficient

and “equitable” (?) allocation of scarce resources

Economics is the social science that studies the

choices that individuals, businesses, governments,

and societies make as they cope with scarcity and the

incentives that influence and reconcile those choices.

Definition of Economics

Scarcity

All economic questions arise because we are unable to

satisfy all our wants—because we face scarcity.

Society’s wants exceed the resources available to satisfy

them.

Rich and poor alike are faced with scarcity.


Incentives

Everyone responds to incentives. In general there is some

sort of incentive behind everything an individual does.

Without proper incentives in place, it’s hard to motivate

anyone to do anything: Market economy vs. Planned

economy

To solve any problem, policymakers should think hard

before making an incentive design – otherwise, it may

backfire.


Microeconomics

Microeconomics is the study of choices made by individuals and businesses, and the influence of government on those choices.

Micro = small

Macroeconomics

Macroeconomics is the study of the effects on the national and global economy of the choices that individuals, businesses, and governments make.

Macro = big

Three Big Microeconomic Questions

Microeconomics seeks to understand what determines:

What goods and services are produced – which and how

much of each;

How goods and services are produced;

For whom goods and services are produced;

Goods and services are the things that people value so

produce to satisfy wants – their own and others’.


What Goods and Services

are Produced?

Agriculture accounts for less

than 1 percent of total U.S.

production, manufactured

goods for 22 percent, and

services for 77 percent.

In China, agriculture

accounts for 11 percent of

total production,

manufactured goods for 47

percent, and services for 43

percent.

What Goods and Services are Produced?


Share of Agricultural and Industrial sectors in GDP of Bangladesh


The facts about what we

produce raise the deeper

question: What

determines the

quantities of, say, realtor

services, new homes,

DVD players, or corn

that we produce?

Microeconomics

provides some answers

to these questions.


How are Goods and Services Produced?

Factors of production are the resources, or “primary

inputs” that we use to produce goods and services.

They are grouped into four categories:

Land

Labor

Capital

Entrepreneurship


The “gifts of nature,” i.e. all natural resources, that we use

to produce goods and services are land.

The work time and effort that people devote to producing

goods and services is labor.

The quality of labor depends on human capital, which is

the knowledge and skill that people obtain from education,

on-the-job training, and work experience.


The tools, instruments, machines, buildings, and other

man-made durable, physical, things that are used to

produce goods and services are capital.

The human resource that organizes land, labor, and

capital, and bears the risks involved, is entrepreneurship.

The reward for organization and risk-bearing is profit [or

loss!]


This Figure shows a

measure of the growth of

human capital in the

United States over the

last century—the

percentage of the

population that has

completed different

levels of education.


The facts about how we

produce raise the deeper

question: What determines

the quantities of capital,

labor, and other inputs that

get used to produce each

good or service?

Microeconomics provides

some answers to this

question.


For Whom are Goods and Services Produced?

Who gets the goods and services depends on the incomes

that people earn, and what they want.

Land earns rent.

Labor earns wages.

Capital earns interest.

Entrepreneurship earns profit.


This Figure shows the distribution of income in Bangladesh during 2004-05.

The richest 5% earn almost 84 times more than the poorest 5%. Putting it in

another way, the poorest 5% earn only about 1.2% of what the richest 5%

earn.


The facts about for whom raise the deeper question:

What determines earnings and the distribution of income that in turn

determine who gets the goods and services produced?

Microeconomics provides some answers to this question.

Three Big Macroeconomic Questions

Macroeconomics focuses on three big questions:

What determines the standard of living?

What determines the cost of living?

Why and how does our economy fluctuate?


What Determines the Standard of Living?

The standard of living is the level of consumption that people enjoy

on average. It is usually measured by average income per person.

In a paper published in the Journal of Monetary Economics in 2008,

Restuccia, Yang and Zhu report: In 1985, the average income per

worker (PPP-adjusted, yearly) in the richest 5% of the countries in the

world was 34 times that of the poorest 5%. In their sample of 86

countries:

–The richest 5%: U.S.A., Canada, Switzerland, and Australia

–The poorest 5%: Burundi, Tanzania, Burkina Faso, and Ethiopia.

PWT 6.3 Data (for 155 countries): In 2005, the average income per worker

(PPP-adjusted, yearly) in the richest 5% of the countries in the world was 58

times that of the poorest 5%.

The richest country: Luxembourg, Income per worker: $103,569 / year

The Poorest country: Dem. Rep. of Congo, Income per worker: $967 / year

Position of Bangladesh:

130-th, Income per worker: $4,661 / year

Income per person: $2,166 / year

≈ BDT 14,000 / month

Without PPP-adjustment, average income per person:

Around BDT 3,500/month


Macroeconomics seeks to explain differences in the

standard of living across countries.

Macroeconomics also seeks to explain the rate at which

the standard of living changes.



What Determines the Cost of Living?

The cost of living is the amount of money it takes to buy

the goods and services that a typical family consumes.

The cost of living in the United States is the number of

dollars it takes to buy the goods and services that a typical

family consumes.

The cost of living in Bangladesh is the number of takas it

takes to buy the goods and services that a typical family

consumes.

What matters mostly is the rate at which prices change.


A rising cost of living is called inflation.

A falling cost of living is called deflation.

Inflation brings a shrinking value of taka and deflation

brings a rising value of taka.

Macroeconomics seeks to explain the forces that

determine the cost of living and the inflation (or deflation)

rate.


Why Does Our Economy Fluctuate?

The business cycle is the periodic but irregular up-and-

down movement in production and jobs in an economy.

During 2007-08, the U.S. economy entered a recession—

production and jobs shrank.

During the 1990s, the U.S. economy enjoyed a prolonged

expansion—production and jobs increased.

The Figure on the next slide illustrates the stylized phases

and turning points of a business cycle.


Data source: U.S. Department of Commerce Bureau of Economic Analysis

0

2000

4000

6000

8000

10000

12000

14000

16000

2000 2002 2004 2006 2008 2010 2012

U.S. GDP (Quarterly, Billion 2005 USD)


Data source: U.S. Department of Commerce Bureau of Economic Analysis

U.S. GDP (Quarterly, Billion 2005 USD)

0

2000

4000

6000

8000

10000

12000

14000

16000

2000 2002 2004 2006 2008 2010 2012

GDP Trend GDP


-500

-400

-300

-200

-100

0

100

200

300

400

2000 2002 2004 2006 2008 2010 2012

The U.S. Business Cycle (2000-2012)


Why Does Our Economy Fluctuate?

Economists remain unsure about the sources of economic

fluctuations and about the actions that might be taken to

smooth the economy.

But in your study of macroeconomics, you will learn some

of what economists have discovered about economic

fluctuations.

The Economic Way of Thinking

Choices and Tradeoffs

The economic way of thinking places scarcity and its

implication, choice, at center stage.

You can think about every choice as a tradeoff—an

exchange—giving up one thing to get something else.

A classic tradeoff is “guns versus butter.”

“Guns” and “butter” stand for any two objects of value.


Microeconomic Tradeoffs

The three microeconomic questions become sharper

when we think in terms of tradeoffs.

“What?” Tradeoffs arise when people choose on what to

spend their incomes, when governments choose on what

to spend their tax revenues, and when businesses choose

what to produce.


Microeconomic Tradeoffs

“How?” Tradeoffs arise when businesses choose among

alternative production technologies.

“For Whom?” Tradeoffs arise when choices change the

distribution of buying power across individuals.

Government redistribution of income from the rich to the

poor creates the big tradeoff—the tradeoff between

equality and efficiency. Equity [fairness] and efficiency

are two classic ways to judge economic decisions.


Macroeconomic Tradeoffs

Standard of Living Tradeoffs arise when we choose

between current consumption and activities that we hope

will increase our standard of living in the future.

Activities such as saving and investing, education, and

research should increase future production and

consumption possibilities, which permit increases in the

standard of living.


Macroeconomic Tradeoffs

An Output-Inflation Tradeoff arises when policymakers

choose how much inflation to endure in order to maintain a

high level of production.

An output-inflation tradeoff arises if a policy action that

lowers inflation also lowers output, or a policy action that

boosts output increases inflation. Unfortunately, this is

often the case.


Opportunity Cost

Thinking about a choice as a tradeoff emphasizes cost as

an opportunity forgone.

The highest-valued alternative that we give up to get

something is the opportunity cost of the activity chosen.

There Is No Such Thing As A Free Lunch.


Opportunity Cost

Consider people who speak about free housing, free

bridges (“no charge to cross it”), and free parks. None of

these things are actually free. The resources that provide

housing, bridges, and parks could have been used in

other ways.

If it is not qualified by anything else, in economics “cost”

always means opportunity cost. This is an example of

jargon.

JARGON

Economics uses jargon a lot

Jargon means a special vocabulary

Economics jargon can be confusing

because it often gives special meaning to

ordinary, every day words, that have a

different meaning in normal usage

Why jargon?

Jargon allows precision

Jargon allows shorter statements

Jargon permits more efficient

communication

It’s standard in economics, so we have to

know it to understand economics

Quote: Joan Robinson[Professor of Economics at U. of Cambridge]

“You study economics in

order to avoid being fooled by

economists”

Bad aspects of Jargon

Jargon can be used to make things ambiguous

Jargon can be confusing to those who are unsure of it

Unnecessary jargon hinders efficient communication

rather than helping it

Economics as a Foreign Language

ALL economics and economists use jargon to

some extent

MOST of economics is common sense

Except for a very few non-intuitive ideas,

learning economics amounts to learning how

to express what you know in the right jargon,

i.e. it is like learning a new language


Margins and Incentives

People make choices at the margin, which means that

they evaluate the consequences of making small

incremental changes in the use of their resources.

The benefit from pursuing an incremental increase in an

activity is its marginal benefit.

The opportunity cost of pursuing an incremental increase

in an activity is its marginal cost.

These are both best thought of as rates – how much

benefit or cost for a one-unit change.


Margins and Incentives

Marginal benefit and marginal cost act as incentives —

inducements to take a particular action or not.

For any activity, if marginal benefit exceeds marginal cost,

people have an incentive to do more of that activity

If marginal cost exceeds marginal benefit, people have an

incentive to do less of that activity.

Economists seek to predict choices by looking at changes

in incentives, that is, in marginal cost and benefit.

Economics: A Social Science

Social Science

Economics is a social science.

Economists distinguish between two types of statements:

What is — positive statements

What ought to be — normative statements

A positive statement can be tested by checking it against

facts – if it is false, data will show it to be false.

A normative statement cannot be tested – it involves

opinion or value judgments.


Model Building

An economic model is a description of some aspect of

the economic world that includes only those features of

the world that are needed for the purpose at hand.


Obstacles and Pitfalls in Economics

Economists cannot easily do experiments and most

economic behavior has many simultaneous causes.

To isolate the effect of interest, economists use the logical

device called ceteris paribus or “other things being equal”

Economists try to isolate cause-and-effect relationships by

changing only one variable at a time, holding all other

relevant factors unchanged.


Obstacles and Pitfalls in Economics

Three common fallacies that economists try to avoid are:

1. The fallacy of composition, which is the false statement that

what is true for the parts is true for the whole or what is true for

the whole is true for the parts.

2. The post hoc fallacy from the Latin term “post hoc, ergo

propter hoc”—means “after this, therefore because of this,”

which is the error of reasoning that a first event causes a

second event because the first occurs before the second. The

Rooster crowing does not make the sun rise.


3. The cum hoc fallacy from the Latin term “cum hoc, ergo propter

hoc”—means “with this, therefore because of this,” which is the

error of reasoning that correlation proves causation.

Examples of the cum hoc fallacy

Example 1:

The faster windmills are observed to rotate, the more wind is observed to be.

Therefore wind is caused by the rotation of windmills.

Example 2:

Sleeping with one's shoes on is strongly correlated with waking up with a

headache. Therefore, sleeping with one's shoes on causes headache.

what economics is about 1 - dr. asad karim khan...

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