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Econ272 Foundations of Economic Analysis Text:
An Economic Way of Thinking
4th Edition
Chapter 1: An Economic Way of Thinking
Economists and Normal People Economists are weird. They don’t think like normal people. Because you are most likely a normal person, and you will encounter a great deal of abnormal thinking in this text, I’d like to start by confronting this issue directly, rather than letting it lie dormant for a few important chapters. The weirdness of economic thinking often makes economics hard to understand, and I want you to understand basic economics. You don’t have to like it. You don’t even have to think like an economist after the final exam, but I hope in this text to show you that it might be a good idea once in awhile. Let’s now look at a few characteristics of their thinking that make economists a little different, a little strange, a little abnormal.
Some Keys to Understanding the Way Economists Think Economists assume people try to do the best they can with the resources they have. We call this rational behavior. Our definition of “best they can” usually means they do the best they can for themselves. This doesn’t mean that people aren’t concerned about the welfare of others. Take poverty for example. In economics we would assume that an individual could want fewer poor people because it would make him or her feel better to have less poverty. It’s the well being of the individual thinking about poverty that is important in a definition of rationality, not the level of poverty per se. Economists focus on individuals rather than groups of individuals. Even though we study groups of individuals such as businesses, governments, and families, we always realize that individuals make up these groups, and that these individuals have a paramount interest in their own well being. The idea of a “society” or “community” wanting something is foreign to the economist. Societies and communities do not choose and act. People do. Economists don’t question the validity of individual preferences. Economists are not normative in an “in your face” sort of way. A normal person might question the ethics of driving a gas-guzzler in an energy crisis, or drinking alcohol, smoking tobacco, or viewing internet pornography. An economist would consider
these actions simply the choices of a rational individual. “Different strokes for different folks” could be an economist’s anthem. Economists emphasize making the economic pie bigger and worry less about the relative size of an individual’s piece of it. This is sometimes referred to as a concern for efficiency over equity. Or like the character Peekay in Bryce Courtney’s Power of One, economists think first with the head, then with the heart. Normal people think first with the heart, then with the head. Economists love abstraction, theory and models. In order to understand how the economic world works, economists form theories and use models to represent these theories. Take crime for example. Why does someone rob a liquor store? A normal person might posit that a criminal is the product of a broken poverty-stricken home, a person raised without instruction in proper values and modes of social conduct. Not an economist. To an economist, one robs a liquor store if the expected benefits exceed the expected costs. Irrespective of one’s background, one has to choose to commit the robbery. Likewise, an economist would model marriage as an exchange between two rational individuals each trying to maximize the expected present value of a lifetime stream of benefits and costs. Because they assume people act rationally in their own interest, economists often point out the self- interest in seemingly lofty human behavior. Need-based financial aid at colleges is price discrimination. The NCAA is a successful buyers cartel, exploiting college athletes for the good of the institution. Bureaucrats are not just passive conduits through which legislative decisions are channeled into our lives. Bureaucrats have their own agenda. Churches can best be understood as profit maximizing institutions, and so on. Normal people see this as cynicism and avoid associating with economists. Economists have a strong commitment to the market economy as a way of addressing the basic economic problem. To the economist, trade is mutually beneficial. Normal people distrust markets, and often think that trade is a way for the powerful to take advantage of the weak. Economists see the benefit to others from self-interested behavior. This is the famous invisible hand principle. In 1776 Adam Smith wrote a book inquiring into the causes of wealth and prosperity. One of his conclusions was that self-interested pursuit of profit by the farmer, the rancher, butcher and baker puts food on
consume to provide our well being. Individuals have their own capital goods such as houses, refrigerators, stoves and lawnmowers, and can own a portion of other capital goods by purchasing shares of a company’s stock through a stock market. We also own collectively capital goods through governments, such as roads, parks, fighter jets and school buildings. Human capital is the resource people create by augmenting the productivity of their labor time by acquiring skill and technique. Economists are interested mostly in the enhanced productivity that people sell in the marketplace, what we call marketable human capital. Most college students understand that acquiring human capital requires that we forego want satisfaction today in exchange for more want satisfaction in the future. Learning about Asian history, French impressionist painting, and the 20th^ century American novel all create human capital as well, albeit usually a less marketable form. Natural resources are gifts from nature, such as land to grow food and trees on, to dig minerals out of, to build on, or to dispose of waste on. Oceans, lakes and rivers provide sources of food, energy, transportation and recreation. While the physical resource base is limited, the value of that resource base in terms of want satisfaction is determined by the amount of labor, capital and human capital we have to use with natural resources. We also receive other life support services from natural resources, such as the protection from ultraviolet radiation by the ozone layer, a hospitable climate, and a rich and diverse biota. The implications of the basic economic problem are illustrated in Figure 1-1. The fundamental conflict between wants and resources is shown buy the two solid arrows running into each other. This conflict results in scarcity, the most fundamental economic fact of life. Our wants exceed our ability to satisfy them with our resources. Sometimes economists assume unlimited wants, and this might be a correct empirical observation, but unlimited wants are not necessary for scarcity. As long as wants exceed what resources can provide we have scarcity.
Wants Resources Scarcity Choice Cost The Basic Economic ProblemFigure 1-
The fact of scarcity leads to the next implication shown in Figure 1-1, choice. Because we cannot satisfy all wants with our resources we have to choose among wants, and choose how to use our resources in satisfying them. Choice is such a fundamental concept that economics is sometimes called the science of choice. Individuals certainly have to choose. Do I go to a movie or study economics? Do I buy a new computer or new ski equipment? Do I forego a better car today to invest in human capital by going to college? Any organized group of people also faces scarcity and is forced to choose. A family chooses how many of its members work outside the home, and who cooks or does the dishes or mows the lawn. Campus organizations choose among alternative party and public service projects. Businesses choose which goods and services to produce and how much of each resource to use in the production process. Local, state and national governments face wants of constituents that exceed what limited tax revenues can provide. They, too, have to choose. Finally, we see the most unfortunate implication of the basic economic problem at the bottom of Figure 1-1, cost. When we choose one use of resources, we give up another. The cost of that choice is the value of the best foregone alternative. If you can buy only a computer or new ski equipment, the cost of choosing the computer is the ski equipment you didn’t buy. Because choice satisfies a particular want and foregoes the opportunity to satisfy others, we often refer to cost as opportunity cost in economics. Please note that we have found the source of cost in economics without talking about money or prices at all. Cost can result from spending choices in a marketplace, but it doesn’t have to. Every spring students understand opportunity cost when they are confronted with the choice of going to class or playing in the warm sunshine. The foregone value of tossing a Frisbee is the cost of attending a history class. No market transaction arises, but cost occurs just the same.
Alternative Approaches to the Basic Economic Problem We will be studying the standard economic approach to the basic economic problem in this text. In standard economics we examine ways to maximize the value of human wants satisfied. Using more and more
people in an economy have to answer three basic economic questions. What will we produce? How will we produce it? And for whom will the goods and services be produced, i.e., who gets to consume what portion of the national economic output? When these decisions are answered economists say the economy has allocated its resources. One way to classify economic systems is illustrated in Figure 1-2. We use only two characteristics of an economic system here, and both have to do with resources. Across the top of the figure we find resource allocation, with two possible subcategories, market and command. Down the side of the figure we have two categories of resource ownership, private and government. The words collective, public, and state often are substituted for the word government. The two possible forms of resource allocation and two possible forms of resource ownership give four combinations that describe four types of economic systems. But before we address these economic systems, let’s discuss the two characteristics of economic systems in more detail. Market allocation is something we will spend a lot of time on in this book. With market allocation an economy uses the decentralized process of people interacting in markets to answer the three fundamental economic questions. People answer the WHAT question by deciding what they want to consume and by their willingness to buy it in a market. If sellers can produce and sell something at a price that people are willing to pay, it gets produced. If not, the good is not produced. For example, take platinum lawn sprinklers. At the price a producer would have to receive to make platinum lawn sprinklers profitable, no one would buy them. Platinum lawn sprinklers don’t get produced. By contrast, people are willing to pay $20,000 – $40,000 for sport utility vehicles in the U.S. We can find them for sale almost everywhere. Market resource allocation addresses the HOW question in a similar decentralized manner. Producers want to produce goods at the lowest possible cost, because if they keep costs down there will be more profit for the owners of the company. Producers have an incentive to use just the right amount of labor, human capital,
Figure 1-
A Classification of Economic Systems
Resource Allocation
OwnershipResource
Market Command Private
Government
CapitalismMarket CapitalismCommand
SocialismMarket CommandSocialism
capital and natural resources. Owners of resources wish to sell them at a price that yields the highest amount of income. With market allocation buyers of resources and sellers of resources come together in the market, and in the process of buying and selling prices are established that guide both buying and selling behavior. In market allocation the FOR WHOM question is answered by market processes as well. People receive income from selling resources in the market. If you have a lot of resources to sell, or if you just get a high price for what you do sell, you have a high income and can buy lots of goods and services in the marketplace. If you don’t own many resources, or if you receive a low price for what you do sell, you can’t buy as much in the marketplace. Your portion of national economic output is much smaller. In market allocation your portion of national output depends on the value of the resources you sell in the marketplace. Command resource allocation relies on centralized political decisions about resource use rather than individual decisions coordinated by markets. The government decides what will be produced, how it will be produced, and the incomes of people in the economy. Political incentives rather than price incentives guide the allocation of resources. No economy relies totally on either market or command allocation. Some form of markets exists even in the most extreme command economies. Likewise, some government involvement in resource allocation exists in all market-oriented economies, usually in the form of regulation of product and resource markets or in the form of income redistribution programs, such as food and housing subsidies for low-income people. Governments might restrict certain market transactions in prostitution, pornography, drugs, and gambling. Liquor stores are closed on Election Day many places in the U.S. Businesses often need to obtain licenses even in market economies. Zoning laws restrict the type of business you can have in a certain area. Child labor, hazardous working conditions, uncontrolled air and water pollution and misleading financial statements might be illegal. And, of course, we are all familiar with taxes, part of our income that we are not allowed to buy goods and services with. The meaning of private resource ownership is pretty straightforward. Individuals or voluntary associations of them in businesses own resources. And if you own a resource you have a right not to use that resource in the economy. If you don’t want to work, you don’t have to. Private ownership of capital can be
Later in this book we will be discussing the political economy of economic policy. Political economy is the interaction of politics and economics. When we make a meal from these two ingredients, politics and economics, not all will find the dishes to their liking. In fact, a great many political issues around the world today have much to do with our two ways of classifying economic systems, the methods of resource allocation, market or command, and the modes of ownership, private or government.
The Science of Economics: Observation, Theory and Models Just as chemists, physicists and geologists wish to explain the natural world, economists wish to explain individual behavior, social relationships and the causes of economic well being. In observing the economic world, we see all kinds of economic phenomena. Prices of goods and services rise and fall, and when they do people change how much of them they buy and sell. For some goods lines of buyers form where the good is sold. For other goods, chronic surpluses develop. New products come on the market and others vanish. Some people are rich, others are poor. Economies grow, but they also decline, sometimes by a large amount like in the Great Depression from 1929-1933. In some economies, people become more and more well off over time, while in others they remain locked in poverty. Some businesses have the power to set prices at whatever level they want to, while others appear to have little pricing power. Some businesses succeed and some businesses fail. Democratic governments seem always to spend more than they collect in taxes, resulting in chronic budget deficits. Goods like national defense, wildlife species, and clean air and water are under produced in an economy unless the government is involved. This is only a sampling from the list of economic phenomena. Why do these events happen? How does the economic world work? One common method of explaining real world phenomena is the use of theory and observation. Economics is not unique here. The theory of relativity, the gas laws, and the laws of thermodynamics are examples of theory from the natural sciences. After observing phenomena in the real world, we develop possible reasons for their occurrence. These speculations take the form of cause and effect relationships called theories. If A happens, then B results. For example, we will study in Chapter 3 a very important economic
theory, the theory of demand, which posits an inverse relationship between the price of a good and the amount buyers will buy, other things held constant. But is this a good theory? Sometimes we evaluate a theory according to its logic and internal consistency, but more often in modern science we have to test theories to see if they work. Is the pudding tasty? Try it and see if you like it. “The proof of the pudding is in the eating.” Theories are harder to test in economics than in the natural sciences, because laboratory experiments are difficult to arrange. If a chemist wants to test the theory about the pressure in a closed container with a given volume of a gas when she turns up the heat, she can go to the laboratory and do a controlled experiment. She holds the volume of gas constant in a closed container, turns up the heat and measures the pressure change. In economics it’s much more difficult to do controlled experiments. Can you imagine the national outcry if an economist received a grant to test what would happen if a government rapidly and dramatically increased the amount of money in the economy. The rapid increase in the average level of prices would explain an interesting cause and effect relationship, something we’ll call inflation in Chapter 11, but that would be the last economics experiment performed. One way of exploring the implications of theories about reality is the use of models. The U.S. Army Corps of Engineers, a government agency actively involved in flood control and river transportation, has a scale model of the Mississippi River system. By running a large flow of water through the scale model, they can get an idea of how floods will affect natural and human activities along the banks of the Mississippi without actually flooding out the folks who live there. Probably better than testing the theory in the real world, don’t you think? The important thing about this hypothetical flood in the model of the Mississippi is that Corps of Engineers can control what they want to do with the model. They have the power to control the uncontrollable and see implications they would have missed by just staring out the window at reality. Models are very useful. Scale models are rare in economics. We mainly use mathematical models in economics, and representations of them with graphs. For some beginning students of economics abstraction is difficult and the models we use to explore theories are a barrier to learning. But the simplification of reality is absolutely necessary if we are going to understand it.
(point labeled D). These two combinations of goods are two possible points on the economy’s ppf, but only two of the possible points. In an extremist society of either butter crazies or gun nuts we would be finished with the model at this point. But in most economies people would want to produce some of both goods, because they would want to consume some of each. Points B and C on the graph represent two additional combinations of guns and butter produced by the economy. At point B we produce G 1 guns and B 1 butter. Note that we have now represented a theory about the implications of scarcity in the model. If we are using all of our limited resources at point A, producing only guns, and we want some positive amount of butter, we must transfer some of the resources from gun production to butter production. At point B we have B 1 – 0 more butter production than we had at point A, but Gmax – G 1 less gun production. The only way we can produce (and consume) more butter is to choose to produce fewer guns. We also can say that the cost of choosing B 1 butter is the Gmax – G 1 guns given up. Fewer guns is the opportunity cost of more butter. If scarcity exists, then people choose and incur cost. Point C is another possible combination of guns and butter production for the economy, G 2 guns and B 2 butter. Again, to produce more butter we have to give up more guns. Now the cost of B 2 – B 1 butter is G 2 – G 1 guns. Note that the model has been constructed such that butter has become more costly as we have more and more of it. We can see this in the model because the two increments of butter, B 1 – 0 and B 2 – B 1 are equal. The costs of the two equal amounts of butter, however, are not equal, as G 2 – G 1 > G 1 – Gmax. We call this the law of increasing cost, our first encounter with what economists call diminishing returns. One way to understand the law of increasing cost is to realize that all resources are not equally suited for the production of both goods. In the U.S., for example, Wisconsin would be a much better place to produce butter than guns. In Wisconsin, we have abundant good pastureland and many pacifists who study at the University of Wisconsin. Utah, however, would be a much better place for military operations, as the mountain and desert terrain are much better for bombing ranges than for cows, and students at Brigham Young University are more likely to support a strong national defense. At point A, with only gun production, we’re producing guns in both Utah and Wisconsin. As we transfer land and labor from gun production to butter production, we don’t do it in Utah, but rather we expand butter production in Wisconsin. We leave Utah land (mountains and
desert) and labor (BYU students) in gun production and convert Wisconsin bombing ranges to pasture, and make dairy farmers out of reluctant soldiers. We get a big increase in butter, B 1 – 0, for a small cost in guns, G 1
- Gmax. But as we convert more and more land and labor from guns to butter, we eventually have to start making dairy farmers out of BYU graduates and start milking cows in the desert of the Great Basin. Note that the final increment of butter, Bmax – B 2 , requires a much greater opportunity cost in guns. G 2 – 0. Points A, B, C, and D are just four possible combinations of guns and butter available in the economy. We can imagine an almost infinite number of points between A and B and between B and C and C and D. If we connected all these points we would have the production possibility frontier ABCD of Figure 1-3. The concavity to the origin, (it’s bowed outward) represents the law of increasing cost Scarcity requires that people in the economy choose points on or inside the production possibility frontier. We would like to be farther to the upper right in Figure 1-3, because we assume more is preferred to less, but we have to label points in this area not attainable (N.A.), because of limited resources and the ensuing scarcity they generate. One point inside the ppf is point U. Here the economy is not using all its resources, or it is using them inefficiently. Because we assume people in the economy prefer more to less of each of the goods in our model, we can safely say that the combination of goods represented by point U is a bad one. Any point within the approximate triangular area UBC is preferable to point U, because we can have more of one good without sacrificing any of the other. At many points we could have more of both goods. In Chapter 9 we will have more to say about moves like the one from point U to a point on the ppf. We can see here what economists find objectionable about an economy with unemployed resources or inefficient uses of them. When resources are unemployed people in the economy forego the satisfaction of valuable wants. That can’t be good when more is preferred to less.
