ECN104 Lecture 1

What is Economics?

Definition and Core Principles

Economics is the study of incentives and how these incentives influence the choices made by individuals and groups. The discipline is grounded in three foundational principles:

• Optimization: People strive to choose the best available option, given their information and constraints.

• Equilibrium: Economic systems tend to reach a state where no individual can benefit by changing their own behavior unilaterally.

• Empiricism: Economists use data and empirical analysis to test theories and understand real-world phenomena.

The Principles and Practice of Economics

Focus on Human Behavior and Choice

Economists primarily study human behaviour, with choice—not money—serving as the unifying feature of all economic analysis. Every aspect of life involving decision-making can be examined through an economic lens.

• Economic Agent: Any individual or group that makes choices, such as consumers, firms, parents, or politicians.

The Scope of Economics

Scarcity and Resource Allocation

Economics investigates how agents make choices among scarce resources and how these choices impact society. Scarce resources are items that people desire, but the available quantity is less than what is wanted.

• Scarcity: The fundamental economic problem of having limited resources to meet unlimited wants.

Why is economics called the "Dismal Science"? This term reflects the discipline's focus on trade-offs and constraints, often highlighting difficult choices and limitations.

Normative and Positive Economics

Descriptive vs. Prescriptive Analysis

• Positive Economics: Describes and explains economic phenomena as they are. For example, observing that some people took more than one piece of candy and not everyone received a piece.

• Normative Economics: Prescribes what ought to happen, often based on value judgments. For example, suggesting that each student should take only one piece so everyone gets some, or proposing alternative rules for distribution.

Example: In a classroom experiment with a bowl of candies, positive economics would record the actual distribution, while normative economics would debate the fairest or most efficient way to distribute the candies.

Microeconomics vs. Macroeconomics

Levels of Economic Analysis

• Microeconomics: The study of incentives and choices facing individuals, firms, and governments.

• Macroeconomics: The study of the entire economy, including how monetary and fiscal policy affect microeconomic incentives and choices.

The Three Principles of Economics

Optimization, Equilibrium, and Empiricism

• Optimization: Making the best possible choice with the available information.

• Equilibrium: A state where everyone is optimizing and no one can be better off by making a different choice.

• Empiricism: Using data to answer interesting and important economic questions.

The First Principle: Optimization, Trade-offs, and Budget Constraints

Making Choices Under Constraints

• Optimization: Individuals aim to make the best possible decisions, though they may not always succeed due to imperfect information or cognitive limitations.

• Trade-offs: All optimization problems involve trade-offs, where gaining some benefits requires giving up others.

• Budget Constraint: The set of options available to an individual without exceeding their budget. Economists use budget constraints to model trade-offs.

• Opportunity Cost: The value of the best alternative forgone when making a choice.

• Cost-Benefit Analysis: Weighs all opportunity costs and benefits to guide decision-making. Both individuals and policymakers should consider all opportunity costs, though these may sometimes be overlooked or exaggerated.

Example: Deciding whether to drive 3 miles to save 20 book versus a $1,000 computer illustrates how the context of a decision affects perceived value and opportunity cost.

Historical Example: Dwight D. Eisenhower's 1953 speech highlighted the opportunity cost of military spending in terms of schools, hospitals, and infrastructure that could have been built instead.

The Second Principle: Equilibrium

Understanding Economic Stability

• Equilibrium: A situation where no agent can benefit by changing their behavior, given the choices of others.

• Optimality: Equilibrium is not always optimal, especially in the presence of externalities or free-rider problems.

• Externalities: When the actions of one agent affect others (e.g., pollution as a negative externality, public art as a positive externality), equilibrium may not be socially optimal.

• Free Rider Problem: Occurs when individuals or groups benefit from resources or services without paying for them, leading to under-provision of public goods (e.g., national defense, public roads).

The Third Principle: Empiricism

Role of Data and Causality in Economics

• Empiricism: Economists use data to test theories and understand causality in real-world situations.

• Correlation vs. Causation: Correlation between two variables does not necessarily imply that one causes the other.

• Econometrics: The application of statistical methods to economic data to test hypotheses and evaluate theories. Econometrics can refute or fail to refute a theory, but cannot definitively prove it.

Example: Observing that crowded beaches and high temperatures are correlated does not mean that reducing beach attendance will lower temperatures.

Additional info: Similar statistical approaches are used in other fields, such as biostatistics and psychometrics, to analyze data and test theories.