Chapter 1

The Power of Economics

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What will you learn in this chapter?
• Concepts of:
– Scarcity.
– Opportunity cost and marginal decision
making.
– Incentives.
– Efficiency.
• How to distinguish between:
– Correlation and causation.
– Positive and normative analysis.
• Characteristics of good economic
modeling.
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 What is economics?
• Economics is the study of how people
manage resources.
• Decisions made by individuals and also by
groups.
• Resources are both physical objects and
intangibles such as time.
• Economics is divided into two broad fields:
– Microeconomics: Study of individuals and
firms.
– Macroeconomics: Study of the economy on a
regional, national, or international scale.

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 Choices and rational behavior
• Economists assume that people
– Compare all available choices.
– Purposefully behave in the way that will best
achieve their goals, called rational behavior.
• Peoples’ decisions can be studied using
four main questions:
1. What are their wants and constraints? -
scarcity
2. What are their trade-offs? – opportunity cost
3. How will others respond? - incentives
4. Why isn’t everyone doing it? - efficiency
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 Scarcity
• People make decisions aimed at
getting the things they want.
• People want a lot of things, but they
are constrained by limited resources.
• Scarcity is the condition of peoples’
wants being greater than available
resources.
– Individuals’ resources: time and money.
– Societies’ resources: factors of production,
such as labor and technology.
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 Opportunity cost
• Every decision in life involves weighing the
trade-off between costs and benefits.
– Rational behavior dictates that when people choose
between two things, the one with the greatest net
benefit (benefits minus costs) is chosen.
• The benefits are often easily calculated.
• The costs include both the direct cost and
opportunity cost.
– The direct cost includes all associated costs.
– The opportunity cost includes the value of the next
best alternative.
– Opportunity cost is based on people’s valuation of
the best alternative.
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 Active Learning: Opportunity cost
Suppose that you are studying for your
economics final and you are confronted with the
choice to go to the movies with your friends.
• What is the opportunity cost of going to the
movies?
– How does this change if you are borderline failing?
• What is the opportunity cost of studying
economics?
– How does this change depending on the movie?
• What is the rule of thumb in deciding which
activity to chose?

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 Active Learning: Opportunity cost
• What is the opportunity cost of going
to the movies?
– The opportunity cost of going to the
movies is the value placed on studying.
This could be valued at the change in
grade from study or forgone future
earnings.
• How does this change if you are
borderline failing?
– The costs of possibly retaking the class
are now considered.
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 Active Learning: Opportunity cost
• What is the opportunity cost of studying
economics?
– The opportunity cost of studying economics is the
value of going to see the movie. It could be valued
at the ticket price.
• How does this change depending on the
movie?
– If the individual has a big desire to see the movie,
this will increase the opportunity cost.
• What is the rule of thumb in deciding which
activity to choose?
– Choose the activity with the lowest opportunity
cost.
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 Opportunity cost
• Rational behavior suggests that people
compare the additional benefits of a
choice against the additional costs.
– Referred to as marginal decision making.
– No consideration of past benefits or costs,
both referred to as sunk.
• Opportunity cost helps understand
adages such as “the mechanic’s car is
the worst one on the block.”

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 Incentives
• Rational behavior suggests that people
respond to incentives.
• An incentive is something that causes a
change in the tradeoffs that people face.
– Positive incentives: Makes people more likely to
do something by lowering their opportunity cost.
– Negative incentive (disincentive): Makes people
less likely to do something by raising their
opportunity cost.
• When an incentive is provided on a large
scale, the consequences can be extremely
large.
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 Active Learning: Incentives
• Suppose your higher education institution
permits your final exam score to replace a
midterm exam score in a course.
– How does this affect your opportunity cost of
going to the movies?

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 Active Learning: Incentives
• Suppose your higher education institution
permits your final exam score to replace
a midterm exam score in a course.
– How does this affect your opportunity cost of
going to the movies?

• The opportunity cost of going to the

movies increases.
• The institution has given students an
incentive to engage in non-school related
activities.
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 Efficiency
• Rational behavior suggests that
people seek opportunities to get what
they want.
– Given this behavior, individuals and firms
will act to provide the things people want.
• If a profit-making opportunity exists, someone
will provide the good or service.
• This leads to efficiency: resources are
used to produce goods and services
with the greatest economic value.

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 Efficiency
Sometimes economies do not operate efficiently.
• Innovation: Yet to be discovered
innovations/ideas increase efficiency.
• Market failure: People and firms may be
prevented from capturing the benefits of the
opportunity or incur additional costs.
• Intervention: Interventions in the economy
cause transactions to not take place.
– Most often government policies.
• Goals other than profit: Individuals and
governments have goals other than profit.

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 Problem-solving toolbox
• Accurately spotting the fundamental
economic concepts at work in the world
is sometimes difficult.
• Economic analysis requires:
– Theory to be combined with observations.
– Scrutiny of both theory and observations
before drawing conclusions.
• These analyses distinguish between:
– Positive analysis: The way things are.
– Normative analysis: The way things should
be.
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Active Learning: Positive and normative statements

For each of the following, categorize as

either a positive or normative
statement.
– GDP fell by 0.5% during last quarter.
– Given an inflation rate of 2%, no one
should be concerned with higher costs
of living.
– The DOW rose above 15,000 on May 3,
2013.

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Active Learning: Positive and normative statements

For each of the following, categorize as

either a positive or normative statement.
– GDP fell by .5% during last quarter.
• Positive statement.
– Given an inflation rate of 2%, no one
should be concerned with higher costs of
living.
• Normative statement.
– The DOW rose above 15,000 on May 3,
2013.
• Positive statement.

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 Correlation and causation
• When two events occur together, there is a
tendency to assume that one causes the
other.
• Economists differentiate between two
relationships.
– Correlation: A consistently-observed relationship
between two events.
• Positive correlation: Increase in A and B.
• Negative correlation: Increase in A and a decrease in B.
– Causation: A relationship between two events in
which one brings about the other.
• A causes B.
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 Correlation and causation
There are three reasons why an assumed
causal relationship may be false:
• Correlation without causation: Two events
may be extremely correlated, making it
appear that a causal relationship exists.
• Omitted variables: Two events may be
extremely correlated due to a third event
causing the two.
• Reverse causation: Sometimes it is unclear
whether Event A causes Event B or if Event B
causes Event A.
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Active Learning: Correlation and causation
For each of the following statements,
classify whether it is false due to
correlation without causation, an
omitted variable, or reverse causation.
• Education and future earnings is
positively correlated.
• Shoe size and reading comprehension
scores are positively correlated.
• Baby booms are caused by higher
quality minivans.
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Active Learning: Correlation and causation
For each of the following statements, classify
whether it is false due to correlation without
causation, an omitted variable, or reverse
causation.
• Education and future earnings is positively
correlated.
– Omitted variable bias: ability.
• Shoe size and reading comprehension scores are
positively correlated.
– Correlation without causation.
• Baby booms are caused by higher-quality
minivans.
– Reverse causation.
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 Models
Economic models show how people, firms, and
governments make decisions about managing
resources, and how their decisions interact.
• Models are a simplification of complex
problems.
• Models include:
– Groups of individuals and their choices.
– Markets to study.
• What makes a model useful?
– Makes clear assumptions.
– Describes the real world accurately.
– Predicts cause and effect.
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 Summary
• Four concepts of economics are discussed
– Scarcity: Constraints on obtaining everything
wanted.
– Opportunity cost: Given scarcity, people face trade-
offs.
– Incentives: Economic agents can alter people’s
trade-offs by providing incentives/disincentives.
– Efficiency: Markets typically provide the highest
value of goods/services.
• The differences between correlation and
causation are analyzed.
• Economists utilize models to understand
decision making.
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