Chapter 1: What Is Economics? & Appendix: Graphs in Economics – Study Notes

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What Is Economics?

Definition of Economics

Economics is the social science that studies how individuals, businesses, governments, and societies make choices to cope with scarcity and the incentives that influence and reconcile those choices.

Scarcity: Our inability to satisfy all our wants due to limited resources.
Choices: Because of scarcity, we must make decisions about what to do with our limited resources.
Incentives: Rewards or penalties that influence choices.

Microeconomics focuses on the choices of individuals and businesses, their interactions in markets, and the influence of governments.

Microeconomics vs. Macroeconomics

Microeconomics: Studies individual and business decisions, market interactions, and government influence.
Macroeconomics: Studies the economy as a whole, including inflation, unemployment, and economic growth. (Additional info: Macroeconomics is covered in other chapters.)

The Two Big Economic Questions

1. How do choices determine what, how, and for whom goods and services are produced?

What? The types and quantities of goods and services produced vary by country and depend on choices made by individuals, businesses, and governments.
How? Goods and services are produced using factors of production:
- Land: Natural resources ('gifts of nature').
- Labor: Human effort, including the quality determined by human capital (education, training, experience).
- Capital: Tools, machines, buildings, and other constructions used in production.
- Entrepreneurship: The human resource that organizes land, labor, and capital.
For Whom? Distribution depends on income:
- Land earns rent.
- Labor earns wages.
- Capital earns interest.
- Entrepreneurship earns profit.

2. Do choices made in pursuit of self-interest also promote the social interest?

Self-interest: Choices that are best for the individual.
Social interest: Choices that are best for society as a whole, involving efficiency (no one can be made better off without making someone else worse off) and fair shares (equitable distribution).
Key issues illustrating the tension between self-interest and social interest:
- Globalization
- Information-age monopolies
- Climate change
- The COVID-19 pandemic

Key Ideas in the Economic Way of Thinking

Six Key Ideas

A choice is a tradeoff: Choosing one thing means giving up something else.
People make rational choices by comparing benefits and costs: Rational choices maximize benefit over cost for the decision-maker.
Benefit is what you gain from something: Determined by preferences (likes, dislikes, and their intensity).
Cost is what you must give up: The opportunity cost is the highest-valued alternative forgone.
Most choices are "how-much" choices made at the margin: Decisions are made by comparing marginal benefit and marginal cost.
Choices respond to incentives: Changes in marginal benefit or cost alter incentives and thus choices.

Marginal Analysis

Marginal benefit: The additional gain from an incremental increase in an activity.
Marginal cost: The additional opportunity cost from an incremental increase in an activity.
Rational choice: If marginal benefit exceeds marginal cost, do more; if not, do less.

Economics as a Social Science and Policy Tool

Positive vs. Normative Statements

Positive statement: Can be tested against facts (describes 'what is').
Normative statement: Expresses an opinion; cannot be tested (describes 'what ought to be').

Economic Models and Reasoning

Economic model: A simplified description of reality used to understand and predict economic events.
Models are tested by comparing predictions with facts, using:
- Natural experiments
- Statistical investigations
- Economic experiments
Common reasoning errors:
- Fallacy of composition: Assuming what is true for one is true for all.
- Post hoc, ergo propter hoc: Assuming that because one event follows another, the first caused the second.

Economist as Policy Adviser

Economics provides tools for evaluating alternative solutions to policy questions by comparing marginal benefits and marginal costs.
Normative goals are set outside economics; economics helps assess how to achieve them.

Appendix: Graphs in Economics

Graphing Data

Graphs are visual tools that reveal relationships between variables in economics.

Axes: The horizontal axis is the x-axis; the vertical axis is the y-axis. The origin is where they meet.
Variables: Common variables include quantities produced and prices.
Scatter diagram: Plots values of two variables for different observations to reveal relationships.

Types of Relationships in Graphs

Positive (direct) relationship: Both variables move in the same direction; shown by an upward-sloping line.
Negative (inverse) relationship: Variables move in opposite directions; shown by a downward-sloping line.
Maximum or minimum: Relationship is positive over part of the range and negative over another.
No relationship: Variables are unrelated; graph shows no pattern.

Slope of a Relationship

Slope formula:

Positive slope: Upward sloping line.
Negative slope: Downward sloping line.
Slope of a curved line: Varies at different points; can be calculated at a point (tangent) or across an arc (average slope).

Graphing Relationships Among More Than Two Variables

When more than two variables are involved, economists use ceteris paribus ("all other things equal") to isolate the relationship between two variables.
Example: The quantity of ice cream consumed depends on both price and temperature. By holding temperature constant, we can graph the relationship between price and quantity.
When the held variable changes (e.g., temperature rises), the entire curve shifts.

Sample Table: Factors of Production and Their Incomes

Factor of Production	Definition	Income Earned
Land	Natural resources used in production	Rent
Labor	Human effort (physical and mental)	Wages
Capital	Tools, machinery, buildings	Interest
Entrepreneurship	Organization of other factors, innovation	Profit

Key Concepts for Review

Economics addresses: What, how, and for whom goods and services are produced; whether self-interest promotes social interest.
Key definitions: Scarcity, opportunity cost, marginal analysis, incentives, positive vs. normative statements.
Marginal analysis: Comparing marginal benefit and marginal cost to make rational choices.
Economic models: Simplified representations used for analysis and prediction; be aware of reasoning errors.