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Introduction:Thinking Like an Economist 1
Economics and Economic Reasoning
In my vacations, I visited the poorest quarters of severalcities and walked through one street after another, looking
at the faces of the poorest people. Next I resolved to make
as thorough a study as I could of Political Economy .
Alfred Marshall
CHAPTER1
Copyri ght 2010 by the McGraw-Hi ll Companies, Inc. All ri ghts reserved.McGraw-Hill/Irwin
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What Economics Is
Economics is the study of how human beings coordinate their
wants and desires, given the decision-making mechanism,
social customs, and political realities of the society
McGraw-Hill/Irwin
The three central coordination problems any economy
must solve:
1. What, and how much, to produce
2. How to produce it
3. For whom to produce it
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Scarcity
Scarcity exists because individuals want more than can
be produced
McGraw-Hill/Irwin
The degree of scarcity is constantly changing
The quantity of goods, services and usable resources
depends on technology and human action
Scarcity means the goods available are too few
to satisfy individuals desires
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Modern Economics
Economics, like any field of study, evolves and changes
McGraw-Hill/Irwin
Modern economics is based both on deduction and
induction
Abductionis the combination of deduction and induction
Inductionis a method of reasoning in which
one develops general principles by looking forpatterns in the data
Deductionis a method of reasoning in whichone deduces a theory based on a set of almost
self-evident principles
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Marginal costs and marginal benefits
McGraw-Hill/Irwin
Using economic reasoning, decisions are often made by
comparing marginal costs and marginal benefits
Marginal cost is the additional cost over and
above costs already incurred
Marginal benefit is the additional benefit above
and beyond what has already accrued
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The economic decision rule:
McGraw-Hill/Irwin
If the marginal benefits of doing something exceed the
marginal costs, do it.
If the marginal costs of doing something exceed the
marginal benefits, dont do it.
MB > MC Do it!
MC > MBDont do it!
Marginal costs and marginal benefits
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Opportunity Cost
McGraw-Hill/Irwin
Opportunity cost is the basis of cost/benefit economic
reasoning
Opportunity cost should always be less than the benefitof what you have chosen
Opportunity cost is the benefit forgone of the next-best
alternative to the activity you have chosen
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Economic and Market Forces
McGraw-Hill/Irwin
The invisible hand is the price mechanism that guides
our actions in a market. The invisible hand is an example
of a market force.
A market force is an economic force that is given
relatively free rein by society to work through the market
Economic forces are mechanisms that ration scarce goods
If there is a shortage, prices rise
If there is a surplus, prices fall
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Economic and Market Forces
McGraw-Hill/Irwin
Political and social forces often work together against
the invisible hand
Social, cultural, and political forces influence market
forces
What happens in society can be seen as a reaction to,
and interaction of:
Economic forces
Social forces Historical forces
d i
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Economic Insights
McGraw-Hill/Irwin
Theories are too abstract to apply in specific cases and
are often embodied in economic models and principles
Theories tie together economists terminology and
knowledge about economic institutions
An economic principle is a commonly held
insight stated as a law or general assumption
An economic model is a framework that places
the generalized insights of the theory in a more
specific contextual setting
I d i
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Economic Insights
McGraw-Hill/Irwin
Models lead to
theorems (propositions that are logically truebased on the assumptions of the model)
to arrive at policy precepts (policy rules that
conclude that a particular course of action is
preferable)
Theories, models, and principles are continually tested
to see of the predictions of the model match the data
These theorems must be combined with knowledge of
real-world economic institutions and value judgments
to determine economic goals for society
I d i
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The Invisible Hand Theory
McGraw-Hill/Irwin
Prices fallwhen quantity supplied is greater thanquantity demanded
Prices rise when the quantity demanded is greater
than the quantity supplied
According to the invisible hand theory, a market
economy, through the price mechanism, will allocate
resources efficiently
Efficiency means achieving a goal as cheaply as possible
I d i 1
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Economic Institutions
McGraw-Hill/Irwin
Economic institutions are laws, common practices,
and organizations in a society that affect the economy
Economic institutions differ significantly among nations
They sometimes seem to operate differently than
economic theory predicts
To apply economic theory to reality, you've got to have
a sense of economic institutions
I t d ti 1
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Economic Policy Options
McGraw-Hill/Irwin
To distinguish between objective and subjective analysis,
economics is divided into three categories
1. Positive economics is the study of what is
2. Normative economics is the study of what
should be
3. Art of economics is using the knowledgeof positive economics to achieve the goals
determined in normative economics
Objective Policy Analysis