Chapter 1

Chapter 1
The Nature
of Economics

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-2
Introduction
Nearly half of the babies born in Hong Kong Hospitals
today have mothers who are classified as tourists
visiting from the Chinese mainland.
How can fundamental principles of economics explain
patterns of social behavior such as this?
You will explore this question in Chapter One.

Learning Objectives
• Discuss the difference between
microeconomics and macroeconomics
• Evaluate the role that rational self-interest
plays in economic analysis
• Explain why economics is a science
• Distinguish between positive and normative
economics

Chapter Outline
• The Power of Economic Analysis
• Defining Economics
• The Three Basic Economic Questions and
Two Opposing Answers
• The Economic Approach: Systematic
Decisions
• Economics as a Science
• Positive versus Normative Economics

Did You Know That ...
– Economics is a rapidly growing college major?
– During the past 10 years, the number of
students majoring in economics at U.S. colleges
has increased by 40%?
– Economics majors typically earn more than
students who major in management, chemistry,
or psychology?

The Power of Economic Analysis
• Incentives
– Rewards for engaging in a particular activity
– The nature of self-interested responses to
incentives is the starting point for economic
analysis

The Power of Economic
Analysis (cont'd)
• The economic way of thinking is a
framework to analyze solutions to
economic problems
– How much time to study
– Choosing which courses to take
– Whether the U.S. government should encourage
or discourage immigration

Analysis (cont'd)
• The economic way of thinking gives you the
power to reach informed conclusions about
what is happening in the world
• Economic analysis helps you make better
decisions, and increases your understanding
when watching or reading the news on the
Web

Analysis (cont'd)
• Economic analysis is a way of thinking
about all decisions
• These decisions could be about:
– Your education, career, or financing your home
– Your involvement in the business world
– How you cast your ballot as a voter

Defining Economics
• Economics
– The study of how people allocate their limited
resources to satisfy their unlimited wants
– The study of how people make choices

Defining Economics (cont'd)
• Resources
– Things used to produce other things to satisfy
people’s wants
• Wants
– What people would buy if their incomes were
unlimited

• With limited income (resources), people
must make choices to satisfy their wants
• We never have enough of everything,
including time, to satisfy our every desire

• Individuals, businesses, and nations face
alternatives, and choices must be made
• Economics studies how these choices are
made

Microeconomics
versus Macroeconomics
• Microeconomics
– The study of decision making undertaken by
individuals (or households) and by firms
– Like looking though a microscope to focus on the
smaller parts of the economy
• The effects of changes in gasoline prices
• A family’s choice of having a baby
• An individual firm’s decision to advertise

Microeconomics
versus Macroeconomics (cont'd)
• Macroeconomics
– The study of the behavior of the economy as a
whole
– Deals with economywide phenomena
• The national unemployment rate
• The rate of inflation
• The yearly output of goods and services in a nation

Microeconomics
versus Macroeconomics (cont'd)
• Macroeconomics deals with aggregates, or
totals—such as total output in an economy
• Modern economic theory blends micro and
macro concepts

The Three Basic Economic Questions and
Two Opposing Answers
• Economic System
– The institutional mechanism through which
resources are utilized to satisfy human wants

Two Opposing Answers (cont’d)
• Three economic questions:
1. What and how much will be produced?
2. How will items be produced?
3. For whom will items be produced?

• Two opposing answers in the form of
economic systems:
– Centralized command and control (central
planning): Authority that makes all economic
decisions
– Price system (market system): Decentralized
decision making process in which prices are
terms (signals) under which people agree to
make exchanges

Policy Example: The Federal Government
Directs New California Train Tracks
• Centralized command and control was used
to make decisions regarding a
high-speed rail project in California.
• Railway construction began in the least-
populated areas, in order to provide service
immediately for areas that were considered
to be “underserved”.

• Economic systems of the world’s nations
(e.g., U.S.) are mixed systems that
incorporate aspects of both centralized
command and control and a decentralized
price system

International Policy Example:
Cuba Experiments with Mixing It Up
• Cuba is undergoing a transition in which
600,000 former employees of the public
sector will now be employed in the private
sector.
• These workers will be paid wages
determined by the price system.

The Economic Approach:
Systematic Decisions
• Economists assume that individuals act as if
motivated by self-interest and respond
predictably to opportunities for gain

Systematic Decisions (cont’d)
“It is not from the benevolence of the
butcher, the brewer, or the baker that we
expect our dinner, but from their regard to
their own interest.”
—Adam Smith, An Inquiry into the Nature and
Causes of the Wealth of Nations, 1776

• Rationality Assumption
– The assumption that people do not intentionally
make decisions that would leave themselves
worse off

• Questions
– Does the fact that some people make apparently
irrational choices invalidate the rationality
assumption in economics?
– Can economic models be applied to situations in
which behavior is at odds with what we expect
from rational people?

Example: Hello, Bank Robber, I’ll
Remember You
• How can the rationality assumption help
prevent bank robberies?
– Some banks now follow a policy of having a
teller, guard, or branch manager greet every
person entering the bank.
– A high probability of being recognized and
remembered should deter potential bank
robbers.

• Responding to incentives
– Rationality and the use of incentives
• Positive incentives
• Negative incentives
– Making choices
• Balancing cost and benefits

• Some examples of incentives
– Responding to positive incentives
• Schoolchildren getting gold stars, working to have a
“better life” for yourself
– Responding to negative incentives
• Penalties, punishments, using credit cards to avoid
check overdrafts

• Defining self-interest
– The pursuit of one’s goals, does not always
mean increasing one’s wealth
• Prestige
• Friendship
• Love

Example: The Perceived Value of Gifts
• Often the recipient of the gift places a value
on it far less than the market value.
• Should we substitute gift certificates for
physical gifts?

Economics as a Science (cont’d)
• Economics is a social science that employs
the same kinds of methods used in other
sciences, such as biology
• Economics uses models to explain economic
phenomena in the real world

Economics as a Science (cont'd)
• Models or Theories
– Simplified representations of the real world used
as the basis for predictions or explanations
– Should capture only the essential relationships
that are sufficient to analyze a problem
– Cannot be faulted as unrealistic simply because
they do not capture all details of the real world
• A map is the quintessential model

• Assumptions
– The set of circumstances in which a model is
applicable
– Every model, or theory, must be based on a set
of assumptions

Example: Getting Directions
• A map is a simplifying model of reality.
• The degree of simplification varies across maps;
some contain more detail than others.
• Economic models attempt to focus on what is
relevant to the problem at hand and omit what is
not.

• Ceteris Paribus Assumption
[KAY-ter-us PEAR-uh-bus]
– Nothing changes except the factor or factors
being studied.
– “Other things constant”
– “Other things equal”

• Economics is an empirical science
– Real-world data is used to evaluate the
usefulness of a model
– Models are useful if they predict economic
phenomena
– Economic models predict how people react,
not how they think

What if economic theories were based on what
people say they would do, rather than on what
they actually do?
• Economists seek to predict what people will
do when faced with certain incentives
– When surveyed for a poll, many people will say
that tax breaks have no effect on their charitable
donations
– Yet, we find that charitable giving does respond
to tax incentives
– In this instance, an accurate prediction would
need to be based on what people actually do

• Behavioral Economics
– Approach to the study of consumer behavior
• Emphasizes psychological limitations and complications
which may interfere with rational decision making
– Proponents believe that it is “unrealistic” to
assume:
• Unbounded selfishness
• Unbounded willpower
• Unbounded rationality

• Bounded Rationality
– Hypothesis that people are nearly, not fully,
rational
• They cannot examine every choice available to them
• They appear to use rules of thumb to sort alternatives

Positive versus
Normative Economics
• Positive Economics
– Purely descriptive statements or scientific
predictions, such as: “If A, then B.”
– A statement of what is
• Normative Economics
– Analysis involving value judgments; relates to
whether things are good or bad.
– A statement of what ought to be

You Are There: Why So Many Firms Are
Incorporating Outside the United States
• In recent years, an increasing number of U.S.
family-owned companies or partnerships have
chosen to incorporate in other countries.
• The fact that the U.S. corporate tax rate is the
second highest in the world has given firms an
incentive to establish their corporate identity
outside U.S. borders.

Issues & Applications: Why So Many Tourists
Have Been Giving Birth in Hong Kong (cont’d)
• The increase in “tourist births” is consistent with
the rationality assumption.
• Mothers from mainland China are responding to
incentives:
– The quality of care is better in Hong Kong.
– A child born in Hong Kong receives the benefit of 12 years
of publicly provided education and subsidized health care.
– Mothers who give birth in Hong Kong are exempt from
China’s one-child policy.

Issues & Applications: Why So Many Tourists
Have Been Giving Birth in Hong Kong (cont’d)
• How does Hong Kong benefit from providing these
benefits for tourist mothers?
– There has been a decline in the birth rate among Hong
Kong residents.
– Without immigration, the population would begin to
decline.
– By allowing mothers to give birth and then to remain in
Hong Kong, the government pursues a policy of rational
self-interest.

Summary Discussion
of Learning Objectives
• Microeconomics versus macroeconomics
– Economics is the study of how individuals make
choices to satisfy wants
– Microeconomics is the study of decision making
by individual households and individual firms
– Macroeconomics is the study of nationwide
phenomena, such as inflation and
unemployment levels

Summary Discussion
of Learning Objectives (cont'd)
• Self-interest in economic analysis
– Rational self-interest is the assumption that
individuals behave in a reasonable (rational) way
in making choices to further their interests

Summary Discussion
• Economics as a science
– Economists use models, or theories, that are
simplified representations of the real world to
analyze and make predictions about the real
world

Summary Discussion
• The difference between positive and
normative economics
– Positive economics deals with what is, whereas
normative economics deals with what ought to
be
– Positive statements are of the “if…then” variety,
while normative ask what “should, or could” be

Appendix A: Reading and Working with
Graphs
• Independent Variable
– A variable whose value is determined independently of, or
outside, the equation under study
• Dependent Variable
– A variable whose value changes according to changes in
the value of one or more independent variable

Appendix A: Direct and Inverse
Relationship
• Direct Relationship
– A relationship between two variables that is positive,
meaning that an increase in one variable is associated
with an increase in the other and a decrease in one
variable is associated with a decrease in the other
• Inverse Relationship
– A relationship between two variables that is negative,
meaning that an increase in one variable is associated
with a decrease in the other and a decrease in one
variable is associated with an increase in the other

Table A-1 Gas Mileage as a Function of
Driving Speed

Figure A-1 Direct and Inverse Relationships

Appendix A: Constructing a Graph
• Number Line
– A line that can be divided into segments of equal length,
each associated with a number
• y Axis
– The vertical axis in a graph
• x Axis
– The horizontal axis in a graph
• Origin
– The intersection of the y axis and the x axis in a graph

Figure A-2 Horizontal Number Line

Figure A-3 Vertical
Number Line

Figure A-4 A Set of Coordinate Axes

Table A-2 T-Shirts Purchased

Figure A-5 Graphing the Relationship
Between T-Shirts Purchased and Price

Figure A-6 Connecting the Observation Points

Figure A-7 A Positively Sloped Curve

Appendix A: The Slope of a Line (A Linear
Curve)
• Slope
– The change in the y value divided by the
corresponding change in the x value of a curve
– The “incline” of the curve
– “Rise” over “run”

Figure A-8 Figuring Positive Slope

Figure A-9 Figuring Negative Slope

Figure A-10 The Slope of a Nonlinear Curve

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