PART I INTRODUCTION TO ECONOMICS The Scope and Method of Economics The study of economics should begin with a sense of wonder. Pause for a moment and consider a typi- cal day in your life. It might start with a bagel made in a local bakery with flour produced in Minnesota from wheat grown in Kansas and bacon from pigs raised in Ohio packaged in plastic made in New Jersey. You spill coffee from Colombia on your shirt made in Texas from textiles shipped from South Carolina. After class you drive with a friend on an interstate highway that is part of a system that took 20 years and billions of dollars to build. You stop for gasoline refined in Louisiana from Saudi Arabian crude oil brought to the United States on a supertanker that took 3 years to build at a shipyard in Maine. Later you log onto the Web with a laptop computer assembled in Indonesia from parts made in China and send an e-mail to your brother in Mexico City, and you call a buddy on a cell phone made by a company in Finland. Your call is picked up by a microwave dish hidden in a church steeple rented from the church by a cellular company that was just bought by a European conglomerate. You use or consume tens of thousands of things, both tangible and intangible, every day: buildings, rock music, iPods, telephone services, staples, paper, toothpaste, tweezers, pizza, soap, digital watches, fire protection, banks, electricity, eggs, insurance, football fields, computers, buses, rugs, subways, health services, sidewalks, and so forth. Somebody made all these things. Somebody organized men and women and materials to produce and distribute them. Thousands of decisions went into their completion. Somehow they got to you. In the United States, over 146 million people—almost half the total population—work at hundreds of thousands of different jobs producing over $14 trillion worth of goods and services every year. Some cannot find work; some choose not to work. Some are rich; others are poor. The United States imports over $257 billion worth of automobiles and parts and about $229 billion worth of petroleum and petroleum products each year; it exports around $62 billion worth of agricultural products, including food. High-rise office buildings go up in central cities. Condominiums and homes are built in the suburbs. In other places, homes are abandoned and boarded up. Some countries are wealthy. Others are impoverished. Some are growing. Some are not. Some businesses are doing well. Others are going bankrupt. At any moment in time, every society faces constraints imposed by nature and by previous generations. Some societies are handsomely endowed by nature with fertile land, water, sunshine, and natural resources. Others have deserts and few mineral resources. Some societies receive much from previous generations—art, music, technical knowledge, beautiful buildings, and pro- ductive factories. Others are left with overgrazed, eroded land, cities leveled by war, or polluted natural environments. All societies face limits. CHAPTER OUTLINE Why Study Economics? p. 2 To Learn a Way of Thinking To Understand Society To Understand Global Affairs To Be an Informed Citizen The Scope of Economics p. 7 Microeconomics and Macroeconomics The Diverse Fields of Economics The Method of Economics p. 10 Descriptive Economics and Economic Theory Theories and Models Economic Policy An Invitation p. 15 Appendix: How to Read and Understand Graphs p. 18 1 2 PART I Introduction to Economics economics The study o f how individuals and societies choose to use the scarce resources that nature and previous generations have provided. Economics is the study of how individuals and societies choose to use the scarce resources that nature and previous generations have provided. The key word in this definition is choose. Economics is a behavioral, or social, science. In large measure, it is the study of how people make choices. The choices that people make, when added up, translate into societal choices. The purpose of this chapter and the next is to elaborate on this definition and to introduce the subject matter of economics. What is produced? How is it produced? Who gets it? Why? Is the result good or bad? Can it be improved? Why Study Economics? There are four main reasons to study economics: to learn a way of thinking, to understand soci- ety, to understand global affairs, and to be an informed citizen. To Learn a Way of Thinking Probably the most important reason for studying economics is to learn a way of thinking. Economics has three fundamental concepts that, once absorbed, can change the way you look at everyday choices: opportunity cost, marginalism, and the working of efficient markets. opportunity cost The best alternative that we forgo, or give up, when we make a choice or a decision. scarce Limited. Opportunity Cost What happens in an economy is the outcome of thousands of individ- ual decisions. People must decide how to divide their incomes among all the goods and services available in the marketplace. They must decide whether to work, whether to go to school, and how much to save. Businesses must decide what to produce, how much to produce, how much to charge, and where to locate. It is not surprising that economic analysis focuses on the process of decision making. Nearly all decisions involve trade-offs. A key concept that recurs in analyzing the decision- making process is the notion of opportunity cost. The full "cost" of making a specific choice includes what we give up by not making the alternative choice. The best alternative that we forgo, or give up, when we make a choice or a decision is called the opportunity cost of that decision. When asked how much a movie costs, most people cite the ticket price. For an economist, this is only part of the answer: to see a movie takes not only a ticket but also time. The opportu- nity cost of going to a movie is the value of the other things you could have done with the same money and time. If you decide to take time off from work, the opportunity cost of your leisure is the pay that you would have earned had you worked. Part of the cost of a college education is the income you could have earned by working full-time instead of going to school. If a firm pur- chases a new piece of equipment for $3,000, it does so because it expects that equipment to gen- erate more profit. There is an opportunity cost, however, because that $3,000 could have been deposited in an interest-earning account. To a society, the opportunity cost of using resources to launch astronauts on a space shuttle is the value of the private/civilian or other government goods that could have been produced with the same resources. Opportunity costs arise because resources are scarce. Scarce simply means limited. Consider one of our most important resources—time. There are only 24 hours in a day, and we must live our lives under this constraint. A farmer in rural Brazil must decide whether it is better to con- tinue to farm or to go to the city and look for a job. A hockey player at the University of Vermont must decide whether to play on the varsity team or spend more time studying. marginalism The process of analyzing the additional or incremental costs or benefits arising from a choice or decision. Marginalism A second key concept used in analyzing choices is the notion of marginalism. In weighing the costs and benefits of a decision, it is important to weigh only the costs and benefits that arise from the decision. Suppose, for example, that you live in New Orleans and that you are weighing the costs and benefits of visiting your mother in Iowa. If business required that you travel to Kansas City, the cost of visiting Mom would be only the additional, or marginal, time and money cost of getting to Iowa from Kansas City. CHAPTER 1 The Scope and Method of Economics 3 Consider the music business. To produce a typical CD, music labels spend approximately $300,000 on recording the music and music video, developing marketing materials, and distrib- uting the album. Once the label has made this investment, physically producing another copy of the CD for sale typically costs about $2. When the music label is deciding whether to sign a new artist and produce a CD, the $300,000 investment is important. Companies such as EMI and Columbia Records spend a great deal of time thinking about whether a new CD by a newly dis- covered artist will sell enough copies to make a profit. But once an artist is signed and the invest- ment is made and the music label is trying to decide whether to manufacture the 100,001st copy of a new CD, the key cost number is $2. Every new copy costs only $2, and as long as EMI can sell that copy for more than $2, it is better off making the copy. The original investment made to cre- ate the music is irrelevant—a sunk cost. Sunk costs are costs that cannot be avoided because they have already been incurred. Technically, we call the incremental cost of producing one more unit of a good or service the marginal cost. One of the interesting changes in the music business is what has happened to the marginal cost of producing another copy of a CD given the introduction of iTunes as an alterna- tive to the physical CD. While it is not always easy to figure out what the marginal cost is (and we will spend some time in this text honing your skills in this area), understanding the idea of mar- ginalism when thinking about choices is critical. There are numerous examples in which the concept of marginal cost is useful. For an air- plane that is about to take off with empty seats, the marginal cost of an extra passenger is essen- tially zero; the total cost of the trip is roughly unchanged by the addition of an extra passenger. Thus, setting aside a few seats to be sold at big discounts through www.priceline.com or other Web sites can be profitable even if the fare for those seats is far below the average cost per seat of making the trip. As long as the airline succeeds in filling seats that would otherwise have been empty, doing so is profitable. sunk costs Costs that cannot be avoided because they have already been incurred. Efficient Markets—No Free Lunch Suppose you are ready to check out of a busy grocery store on the day before a storm and seven checkout registers are open with several people in each line. Which line should you choose? Usually, the waiting time is approximately the same no matter which register you choose (assuming you have more than 12 items). If one line is much shorter than the others, people will quickly move into it until the lines are equal- ized again. As you will see later, the term profit in economics has a very precise meaning. Economists, however, often loosely refer to "good deals" or risk-free ventures as profit opportunities. Using the term loosely, a profit opportunity exists at the checkout lines when one line is shorter than the others. In general, such profit opportunities are rare. At any time, many people are search- ing for them; as a consequence, few exist. Markets like this, where any profit opportunities are eliminated almost instantaneously, are said to be efficient markets. (We discuss markets, the institutions through which buyers and sellers interact and engage in exchange, in detail in Chapter 2.) The common way of expressing the efficient markets concept is "there's no such thing as a free lunch." How should you react when a stockbroker calls with a hot tip on the stock market? With skepticism. Thousands of individuals each day are looking for hot tips in the market. If a particular tip about a stock is valid, there will be an immediate rush to buy the stock, which will quickly drive up its price. This view that very few profit opportunities exist can, of course, be carried too far. There is a story about two people walking along, one an economist and one not. The noneconomist sees a $20 bill on the sidewalk and says, "There's a $20 bill on the sidewalk." The economist replies, "That is not possible. If there were, somebody would already have picked it up." There are clearly times when profit opportunities exist. Someone has to be first to get the news, and some people have quicker insights than others. Nevertheless, news travels fast and there are thousands of people with quick insights. The general view that large profit opportuni- ties are rare is close to the mark. efficient market A market in which profit opportunities are eliminated almost instantaneously. The study of economics teaches us a way of thinking and helps us make decisions. 4 PART I Introduction to Economics To Understand Society Industrial Revolution The period in England during the late eighteenth and early nineteenth centuries in which new manufacturing technologies and improved transportation gave rise to the modern factory system and a massive movement of the population from the countryside to the cities. Another reason for studying economics is to understand society better. Past and present eco- nomic decisions have an enormous influence on the character of life in a society. The current state of the physical environment, the level of material well-being, and the nature and number of jobs are all products of the economic system. To get a sense of the ways in which economic decisions have shaped our environment, imag- ine looking out a top-floor window of an office tower in any large city. The workday is about to begin. All around you are other tall glass and steel buildings full of workers. In the distance, you see the smoke of factories. Looking down, you see thousands of commuters pouring off trains and buses and cars backed up on freeway exit ramps. You see trucks carrying goods from one place to another. You also see the face of urban poverty: Just beyond the freeway is a large public housing project and, beyond that, burned-out and boarded-up buildings. What you see before you is the product of millions of economic decisions made over hundreds of years. People at some point decided to spend time and money building those buildings and fac- tories. Somebody cleared the land, laid the tracks, built the roads, and produced the cars and buses. Economic decisions not only have shaped the physical environment but also have deter- mined the character of society. At no time has the impact of economic change on a society been more evident than in England during the late eighteenth and early nineteenth centuries, a period that we now call the Industrial Revolution. Increases in the productivity of agricul- ture, new manufacturing technologies, and development of more efficient forms of transporta- tion led to a massive movement of the British population from the countryside to the city. At the beginning of the eighteenth century, approximately 2 out of 3 people in Great Britain worked in agriculture. By 1812, only 1 in 3 remained in agriculture; by 1900, the figure was fewer than 1 in 10. People jammed into overcrowded cities and worked long hours in factories. England had changed completely in two centuries—a period that in the run of history was nothing more than the blink of an eye. It is not surprising that the discipline of economics began to take shape during this period. Social critics and philosophers looked around and knew that their philosophies must expand to accommodate the changes. Adam Smith's Wealth of Nations appeared in 1776. It was followed by the writings of David Ricardo, Karl Marx, Thomas Malthus, and others. Each tried to make sense out of what was happening. Who was building the factories? Why? What determined the level of wages paid to workers or the price of food? What would happen in the future, and what should happen? The people who asked these questions were the first economists. Similar changes continue to affect the character of life in more recent times. In fact, many argue that the late 1990s marked the beginning of a new Industrial Revolution. As we turned the corner into the new millennium, the "e" revolution was clearly having an impact on virtually every aspect of our lives: the way we buy and sell products, the way we get news, the way we plan vacations, the way we communicate with each other, the way we teach and take classes, and on and on. These changes have had and will clearly continue to have profound impacts on societies across the globe, from Beijing to Calcutta to New York. These changes have been driven by economics. Although the government was involved in the early years of the World Wide Web, private firms that exist to make a profit (such as Facebook, YouTube, Yahoo!, Microsoft, Google, Monster.com, Amazon.com, and E-Trade) created almost all the new innovations and products. How does one make sense of all this? What will the effects of these innovations be on the number of jobs, the character of those jobs, the family incomes, the structure of our cities, and the political process both in the United States and in other countries? During the last days of August 2005, Hurricane Katrina slammed into the coasts of Louisiana and Mississippi, causing widespread devastation, killing thousands, and leaving hundreds of thousands homeless. The economic impact of this catastrophic storm was huge. Thinking about various markets involved helps frame the problem. For example, the labor market was massively affected. By some estimates, over 400,000 jobs were lost as the storm hit. Hotels, restaurants, small businesses, and oil refineries, to name just a few, were destroyed. All the people who worked in those establishments instantaneously lost their jobs and their incomes. The cleanup and rebuilding process took time to organize, and it eventu- ally created a great deal of employment. The storm created a major disruption in world oil markets. Loss of refinery capacity sent gasoline prices up immediately, nearly 40 percent to over $4 per gallon in some locations. The CHAPTER 1 The Scope and Method of Economics 5 price per gallon of crude oil rose to over $70 per barrel. Local governments found their tax bases destroyed, with no resources to pay teachers and local officials. Hundreds of hospitals were destroyed, and colleges and universities were forced to close their doors, causing tens of thou- sands of students to change their plans. While the horror of the storm hit all kinds of people, the worst hit were the very poor, who could not get out of the way because they had no cars or other means of escape. The storm raised fundamental issues of fairness, which we will be discussing for years to come. The study of economics is an essential part of the study of society. To Understand Global Affairs A third reason for studying economics is to understand global affairs. News headlines are filled with economic stories. International events often have enormous economic consequences. The destruction of the World Trade Center towers in New York City in 2001 and the subsequent war on terror in Afghanistan and elsewhere led to a huge decline in both tourism and business travel. Several major airlines, including U.S. Airways and Swissair, went bankrupt. Hotel operators worldwide suffered huge losses. The war in Iraq and a strike in Venezuela, a major oil exporter, in 2003 sent oil markets gyrating dramatically, initially increasing the cost of energy across the globe. The rapid spread of HIV and AIDS across Africa will continue to have terrible economic consequences for the continent and ultimately for the world. Some claim that economic considerations dominate international relations. Certainly, politi- cians place the economic well-being of their citizens near the top of their priority lists. It would be surprising if that were not so. Thus, the economic consequences of things such as environmental policy, free trade, and immigration play a huge role in international negotiations and policies. Great Britain and the other countries of the European Union have struggled with the agreement among most members to adopt a common currency, the euro. In 2005, France and the Netherlands rejected a proposed European constitution that would have gone a long way toward a completely open economy in Europe. The nations of the former Soviet Union are wrestling with a growing phe- nomenon that clouds their efforts to "privatize" formerly state-owned industries: organized crime. Another important issue in today's world is the widening gap between rich and poor nations. In 2007, world population was over 6.5 billion. Of that number, over 2.4 billion lived in low- income (less than $900 annually per capita) countries and just over 1 billion lived in high-income (over $11,000 per capita per year) countries. The 37 percent of the world's population that lives in the low-income countries receives less than 3.3 percent of the world's income. In dozens of countries, per capita income is only a few hundred dollars a year. The 15 percent of the popula- tion in high-income countries earn 75 percent of the world's income. An understanding of economics is essential to an understanding of global affairs. To Be an Informed Citizen A knowledge of economics is essential to being an informed citizen. During the last 35 years, the U.S. economy has been on a roller coaster. In 1973-1974, the Organization of Petroleum Exporting Countries (OPEC) succeeded in raising the price of crude oil by 400 percent. Simultaneously, a sequence of events in the world food market drove food prices up by 25 per- cent. By mid-1974, prices in the United States were rising across the board at a very rapid rate. Partially as a result of government policy to fight runaway inflation, the economy went into a recession in 1975. (An inflation is an increase in the overall price level in the economy; a recession is a period of decreasing output and rising unemployment.) The recession succeeded in slowing price increases, but in the process, millions found themselves unemployed. From 1979 through 1983, it happened all over again. Prices rose rapidly, the government reacted with more policies designed to stop prices from rising, and the United States ended up with an even worse recession in 1982. By the end of that year, 10.8 percent of the work force was unemployed. Then, in mid-1990—after almost 8 years of strong economic performance—the 6 PART I Introduction to Economics iPod and the World It is impossible to understand the workings of an economy without first understanding the ways in which economies are connected across borders. The United States was importing goods and services at a rate of over $2 trillion per year in 2007 and was exporting at a rate of over $1.5 trillion per year. For literally hundreds of years, the virtues of free trade have been the subject of heated debate. Opponents have argued that buying foreign-produced goods costs Americans jobs and hurts American producers. Proponents argue that there are gains from trade—that all countries can gain from specializing in the pro- duction of the goods and services that they produce best. But in today's global economy, it is often unclear what is an import and what is an export. Consider the following column in The New York Times in 2007: An iPod Has Global Value. Ask the (Many) Countries That Make It. The New York Times Who makes the Apple iPod? Here's a hint: It is not Apple. The company outsources the entire manufacture of the device to a number of Asian enterprises, among them Asustek, Inventec Appliances, and Foxconn. But this list of companies isn't a satisfactory answer either: They only do final assem- bly. What about the 451 parts that go into the iPod? Where are they made and by whom? Three researchers at the University of California, Irvine—Greg Linden, Kenneth L. Kraemer, and Jason Dedrick—applied some investigative cost accounting to this question, using a report from Portelligent Inc. that examined all the parts that went into the iPod. Their study, sponsored by the Sloan Foundation, offers a fascinating illustration of the complexity of the global economy, and how difficult it is to understand that com- plexity by using only conventional trade statistics. The retail value of the 30-gigabyte video iPod that the authors examined was $299. The most expensive component in it was the hard drive, which was manufac- tured by Toshiba and costs about $73. The next most costly components were the display module (about $20), the video/multimedia processor chip ($8), and the controller chip ($5). They estimated that the final assembly, done in China, cost only about $4 a unit. The researchers estimated that $163 of the iPod's $299 retail value in the United States was captured by American companies and workers, breaking it down to $75 for distribution and retail costs, $80 to Apple, and $8 to various domestic component makers. Japan contributed about $26 to the value added (mostly via the Toshiba disk drive), while Korea contributed less than $1. The real value of the iPod doesn't lie in its parts or even in putting those parts together. The bulk of the iPod's value is in the conception and design of the iPod. That is why Apple gets $80 for each of these video iPods it sells, which is by far the largest piece of value added in the entire supply chain. Those clever folks at Apple figured out how to combine 451 mostly generic parts into a valuable product. They may not make the iPod, but they created it. In the end, that's what really matters. Source: HalR. Varian, Published: June 28, 2007, The New York Times, reprinted with permission. CHAPTER 1 The Scope and Method of Economics 7 U.S. economy went into another recession. During the third and fourth quarters of 1990 and the first quarter of 1991, gross domestic product (GDP, a measure of the total output of the U.S. econ- omy) fell and unemployment again increased sharply. The election of Bill Clinton late in 1992 was no doubt in part influenced by the so-called "jobless recovery." From the second quarter of 1991 through the early part of the new millennium, the U.S. economy experienced the longest expansion in its history. More than 24 million new jobs were created, pushing unemployment below 4 percent by the year 2000. The stock market boomed to historic levels, and the biggest worry facing the American economy was that things were too good! The presidential election of 2000 was close, to say the least, with the outcome not known until early December. In mid-December, President-elect George W. Bush and his economic advis- ers began to worry about the possibility of a recession occurring in 2001. The stock market was below its highs for the year, corporate profits were not coming in as well as expected, and there were some signs that demand for goods was slowing. Indeed, following the election, the economy slipped into a recession and economic conditions were made worse by the September 11, 2001, attacks on the World Trade Center and on the Pentagon. The stock market, which suffered losses as early as 2000, fell for 3 consecutive years, reducing people's wealth by trillions of dollars. Total employment dropped by nearly 2.7 million. But by 2002, the economy began to grow again, slowly, and by 2005, nearly 3.5 million jobs had been created. The war in Iraq and the threat of international terrorism following the 9/11 attacks increased military expenditures in the United States substantially. At the same time, tax cuts proposed by President Bush and passed by Congress led to large deficits in the federal budget. The housing market began to boom in 2001. Fueled by lower interest rates that made bor- rowing less expensive, foreign demand, and a highly competitive mortgage market that made mortgage credit available to virtually any applicant, house prices rose substantially around the country. Housing starts, the number of new housing units begun each period, rose steadily to a record high by 2005 of over 2 million annually. Sales of existing homes at the same time rose above 7 million per year. In addition, as house values rose, home owners had higher wealth and increased their spending. Much spending was driven by borrowing against the house. When you add all the services surrounding house sales, the huge spending on new units, and the purchases at stores such as Home Depot that go with new house sales, the economy was strongly stimulated by the housing market until the middle of 2006, when housing began to slow. One of the key factors that fueled the housing boom was the expansion of mortgage credit to borrowers who in earlier years would have not have qualified. Some borrowers had bad credit histories, low incomes, or other substantial debts. These mortgages came to be called subprime loans. In addition, mortgage loans that carried low monthly payments for a few years that were later followed by substantially higher payments became prevalent. In the summer of 2007, the housing market stalled, prices began to fall, and the huge amount of mortgage debt outstanding (over $10 trillion by 2007) experienced rising delinquency and default. Losses were huge and sent financial markets, including the stock market, into a sharp decline. The question at the start of 2008 was whether the sharp slowdown of the housing market combined with the problems of the credit markets would lead the economy as a whole into a recession. To be an informed citizen requires a basic understanding of economics. The Scope of Economics Most students taking economics for the first time are surprised by the breadth of what they study. Some think that economics will teach them about the stock market or what to do with their money. Others think that economics deals exclusively with problems such as inflation and unem- ployment. In fact, it deals with all those subjects, but they are pieces of a much larger puzzle. Economics has deep roots in and close ties to social philosophy. An issue of great importance to philosophers, for example, is distributional justice. Why are some people rich and others poor? And whatever the answer, is this fair? A number of nineteenth-century social philosophers wres- ded with these questions, and out of their musings, economics as a separate discipline was born. 8 PART I Introduction to Economics The easiest way to get a feel for the breadth and depth of what you will be studying is to explore briefly the way economics is organized. First of all, there are two major divisions of eco- nomics: microeconomics and macroeconomics. microeconomics The branch of economics that examines the functioning of individual industries and the behavior of individual decision- making units—that is, firms and households. macroeconomics The branch of economics that examines the economic behavior of aggregates- income, employment, output, and so on—on a national scale. Microeconomics and Macroeconomics Microeconomics deals with the functioning of individual industries and the behavior of indi- vidual economic decision-making units: firms and households. Firms' choices about what to pro- duce and how much to charge and households' choices about what and how much to buy help to explain why the economy produces the goods and services it does. Another big question addressed by microeconomics is who gets the goods and services that are produced. Wealthy households get more than poor households, and the forces that determine this distribution of output are the province of microeconomics. Why does poverty exist? Who is poor? Why do some jobs pay more than others? Think again about what you consume in a day and then think back to that view over a big city. Somebody decided to build those factories. Somebody decided to construct the roads, build the hous- ing, produce the cars, and smoke the bacon. Why? What is going on in all those buildings? It is easy to see that understanding individual microdecisions is very important to any understanding of society. Macroeconomics looks at the economy as a whole. Instead of trying to understand what determines the output of a single firm or industry or what the consumption patterns are of a sin- gle household or group of households, macroeconomics examines the factors that determine national output, or national product. Microeconomics is concerned with household income; macroeconomics deals with national income. Whereas microeconomics focuses on individual product prices and relative prices, macro- economics looks at the overall price level and how quickly (or slowly) it is rising (or falling). Microeconomics questions how many people will be hired (or fired) this year in a particular industry or in a certain geographic area and focuses on the factors that determine how much labor a firm or an industry will hire. Macroeconomics deals with aggregate employment and unemployment: how many jobs exist in the economy as a whole and how many people who are willing to work are not able to find work. To summarize: Microeconomics looks at the individual unit—the household, the firm, the industry. It sees and examines the "trees." Macroeconomics looks at the whole, the aggregate. It sees and analyzes the "forest." Table 1.1 summarizes these divisions of economics and some of the subjects with which they are concerned. CHAPTER 1 The Scope and Method of Economics 9 The Diverse Fields of Economics Individual economists focus their research and study in many diverse areas. Many of these specialized fields are reflected in the advanced courses offered at most colleges and universities. Some are con- cerned with economic history or the history of economic thought. Others focus on international eco- nomics or growth in less developed countries. Still others study the economics of cities (urban economics) or the relationship between economics and law. These fields are summarized in Table 1.2. Economists also differ in the emphasis they place on theory. Some economists specialize in developing new theories, whereas other economists spend their time testing the theories of oth- ers. Some economists hope to expand the frontiers of knowledge, whereas other economists are more interested in applying what is already known to the formulation of public policies. 10 PART I Introduction to Economics positive economics An approach to economics that seeks to understand behavior and the operation of systems without making judgments. It describes what exists and how it works. normative economics An approach to economics that analyzes outcomes of economic behavior, evaluates them as good or bad, and may prescribe courses of action. Also called policy economics. descriptive economics The compilation of data that describe phenomena and facts. economic theory A statement or set of related statements about cause and effect, action and reaction. As you begin your study of economics, look through your school's course catalog and talk to the faculty about their interests. You will discover that economics encompasses a broad range of inquiry and is linked to many other disciplines. Economics asks and attempts to answer two kinds of questions: positive and normative. Positive economics attempts to understand behavior and the operation of economic systems without making judgments about whether the outcomes are good or bad. It strives to describe what exists and how it works. What determines the wage rate for unskilled workers? What would happen if we abolished the corporate income tax? The answers to such questions are the subject of positive economics. In contrast, normative economics looks at the outcomes of economic behavior and asks whether they are good or bad and whether they can be made better. Normative econom- ics involves judgments and prescriptions for courses of action. Should the government subsi- dize or regulate the cost of higher education? Should medical benefits to the elderly under Medicare be available only to those with incomes below some threshold? Should the United States allow importers to sell foreign-produced goods that compete with U.S.-produced prod- ucts? Should we reduce or eliminate inheritance taxes? Normative economics is often called policy economics. Of course, most normative questions involve positive questions. To know whether the gov- ernment should take a particular action, we must know first if it can and second what the conse- quences are likely to be. (For example, if we lower import fees, will there be more competition and lower prices?) Some claim that positive, value-free economic analysis is impossible. They argue that ana- lysts come to problems with biases that cannot help but influence their work. Furthermore, even in choosing what questions to ask or what problems to analyze, economists are influenced by political, ideological, and moral views. Although this argument has some merit, it is nevertheless important to distinguish between analyses that attempt to be positive and those that are intentionally and explicitly normative. Economists who ask explicitly normative questions should be forced to specify their grounds for judging one outcome superior to another. Positive economics is often divided into descriptive economics and economic theory. Descriptive economics is simply the compilation of data that describe phenomena and facts. Examples of such data appear in the Statistical Abstract of the United States, a large volume of data published by the Department of Commerce every year that describes many features of the U.S. economy. Massive volumes of data can now be found on the World Wide Web. As an example, look at www.bls.gov (Bureau of Labor Statistics). Where do all these data come from? The Census Bureau collects an enormous amount of raw data every year, as do the Bureau of Labor Statistics, the Bureau of Economic Analysis, and non- government agencies such as the University of Michigan Survey Research Center. One important study now published annually is the Survey of Consumer Expenditure, which asks individuals to keep careful records of all their expenditures over a long period of time. Another is the National Longitudinal Survey of Labor Force Behavior, conducted over many years by the Center for Human Resource Development at The Ohio State University. Economic theory attempts to generalize about data and interpret them. An economic theory is a statement or set of related statements about cause and effect, action and reaction. One of the first theories you will encounter in this text is the law of demand, which was most clearly stated by Alfred Marshall in 1890: When the price of a product rises, people tend to buy less of it; when the price of a product falls, people tend to buy more. Theories do not always arise out of formal numerical data. All of us have been collecting observations of people's behavior and their responses to economic stimuli for most of our The Method of Economics Descriptive Economics and Economic Theory CHAPTER 1 The Scope and Method of Economics 11 lives. We may have observed our parents' reaction to a sudden increase—or decrease—in income or to the loss of a job or the acquisition of a new one. We all have seen people standing in line waiting for a bargain. Of course, our own actions and reactions are another important source of data. Theories and Models In many disciplines, including physics, chemistry, meteorology, political science, and economics, theorists build formal models of behavior. A model is a formal statement of a theory. It is usually a mathematical statement of a presumed relationship between two or more variables. A variable is a measure that can change from time to time or from observation to observa- tion. Income is a variable—it has different values for different people and different values for the same person at different times. The rental price of a movie on a DVD is a variable; it has different values at different stores and at different times. There are countless other examples. Because all models simplify reality by stripping part of it away, they are abstractions. Critics of economics often point to abstraction as a weakness. Most economists, however, see abstraction as a real strength. The easiest way to see how abstraction can be helpful is to think of a map. A map is a repre- sentation of reality that is simplified and abstract. A city or state appears on a piece of paper as a series of lines and colors. The amount of reality that the mapmaker can strip away before the map loses something essential depends on what the map will be used for. If you want to drive from St. Louis to Phoenix, you need to know only the major interstate highways and roads. You lose absolutely nothing and gain clarity by cutting out the local streets and roads. However, if you need to get around Phoenix, you may need to see every street and alley. Most maps are two-dimensional representations of a three-dimensional world; they show where roads and highways go but do not show hills and valleys along the way. Trail maps for hikers, however, have "contour lines" that represent changes in elevation. When you are in a car, changes in elevation matter very little; they would make a map needlessly complex and more difficult to read. However, if you are on foot carrying a 50-pound pack, a knowledge of eleva- tion is crucial. Like maps, economic models are abstractions that strip away detail to expose only those aspects of behavior that are important to the question being asked. The principle that irrelevant detail should be cut away is called the principle of Ockham's razor after the fourteenth-century philosopher William of Ockham. Be careful—although abstraction is a powerful tool for exposing and analyzing specific aspects of behavior, it is possible to oversimplify. Economic models often strip away a good deal of social and political reality to get at underlying concepts. When an economic theory is used to help formulate actual government or institutional policy, political and social reality must often be reintroduced if the policy is to have a chance of working. The key here is that the appropriate amount of simplification and abstraction depends on the use to which the model will be put. To return to the map example: you do not want to walk around San Francisco with a map made for drivers—there are too many very steep hills. All Else Equal: Ceteris Paribus It is usually true that whatever you want to explain with a model depends on more than one factor. Suppose, for example, that you want to explain the total number of miles driven by automobile owners in the United States. The number of miles driven will change from year to year or month to month; it is a variable. The issue, if we want to under- stand and explain changes that occur, is what factors cause those changes. Obviously, many things might affect total miles driven. First, more or fewer people may be driving. This number, in turn, can be affected by changes in the driving age, by population growth, or by changes in state laws. Other factors might include the price of gasoline, the house- hold's income, the number and age of children in the household, the distance from home to work, the location of shopping facilities, and the availability and quality of public transport. When any of these variables change, the members of the household may drive more or less. If changes in any of these variables affect large numbers of households across the country, the total number of miles driven will change. model A formal statement of a theory, usually a mathematical statement of a presumed relationship between two or more variables. variable A measure that can change from time to time or from observation to observation. Ockham's razor The principle that irrelevant detail should be cut away. 12 PART I Introduction to Economics ceteris paribus, or all else equal A device used to analyze the relationship between two variables while the values of other variables are held unchanged. Very often we need to isolate or separate these effects. For example, suppose we want to know the impact on driving of a higher tax on gasoline. This change would raise the price of gasoline at the pump but would not (at least in the short run) affect income, workplace location, number of children, and so on. To isolate the impact of one single factor, we use the device of ceteris paribus, or all else equal. We ask: What is the impact of a change in gasoline price on driving behavior, ceteris paribus, or assuming that nothing else changes? If gasoline prices rise by 10 percent, how much less driving will there be, assuming no simultaneous change in anything else—that is, assuming that income, number of children, population, laws, and so on, all remain constant? Using the device of ceteris paribus is one part of the process of abstraction. In formulating economic theory, the concept helps us simplify reality to focus on the relationships that interest us. Expressing Models in Words, Graphs, and Equations Consider the following statements: Lower airline ticket prices cause people to fly more frequently. Higher interest rates slow the rate of home sales. When firms produce more output, employment increases. Higher gasoline prices cause people to drive less and to buy more fuel-efficient cars. Each of those statements expresses a relationship between two variables that can be quanti- fied. In each case, there is a stimulus and a response, a cause and an effect. Quantitative relation- ships can be expressed in a variety of ways. Sometimes words are sufficient to express the essence of a theory, but often it is necessary to be more specific about the nature of a relationship or about the size of a response. The most common method of expressing the quantitative relation- ship between two variables is graphing that relationship on a two-dimensional plane. In fact, we will use graphic analysis extensively in Chapter 2 and beyond. Because it is essential that you be familiar with the basics of graphing, the Appendix to this chapter presents a careful review of graphing techniques. Quantitative relationships between variables can also be presented through equations. For example, suppose we discovered that over time, U.S. households collectively spend, or consume, 90 percent of their income and save 10 percent of their income. We could then write: C = .90 Y and S = .10Y post hoc, ergo propter hoc Literally, "after this (in time), therefore because of this." A common error made in thinking about causation If Event A happens before Event B, it is not necessarily true that A caused B. where C is consumption spending, Y is income, and S is saving. Writing explicit algebraic expressions like these helps us understand the nature of the underlying process of decision making. Understanding this process is what economics is all about. Cautions and Pitfalls In formulating theories and models, it is especially important to avoid two pitfalls: the post hoc fallacy and the fallacy of composition. The Post Hoc Fallacy Theories often make statements or sets of statements about cause and effect. It can be quite tempting to look at two events that happen in sequence and assume that the first caused the second to happen. This is not always the case. This common error is called the post hoc, ergo propter hoc (or "after this, therefore because of this") fallacy. There are thousands of examples. The Colorado Rockies have won seven games in a row. Last night you went to the game and they lost. You must have jinxed them. They lost because you went to the game. Stock market analysts indulge in what is perhaps the most striking example of the post hoc fallacy in action. Every day the stock market goes up or down, and every day some analyst on some national news program singles out one or two of the day's events as the cause of some change in the market: "Today the Dow Jones industrial average rose 5 points on heavy trading; analysts say that the increase was due to progress in talks between Israel and Syria." Research has shown that daily changes in stock market averages are very largely random. Although major news events clearly have a direct influence on certain stock prices, most daily changes cannot be linked directly to specific news stories. Very closely related to the post hoc fallacy is the often erroneous link between correlation and causation. Two variables are said to be correlated if one variable changes when the other variable changes. However, correlation does not imply causation. Cities that have high crime rates also have many automobiles, so there is a very high degree of correlation between number CHAPTER 1 The Scope and Method of Economics 13 of cars and crime rates. Can we argue, then, that cars cause crime? No. The reason for the cor- relation may have nothing to do with cause and effect. Big cities have many people, many peo- ple have many cars; therefore, big cities have many cars. Big cities also have high crime rates for many reasons—crowding, poverty, anonymity, unequal distribution of wealth, and readily available drugs, to mention only a few. However, the presence of cars is probably not one of them. This caution must also be viewed in reverse. Sometimes events that seem entirely uncon- nected actual...