Lecture 1

What is Economics?

Definition and Core Principles

Economics is the study of incentives and how these incentives influence people's choices. The discipline is built upon three foundational principles that guide economic analysis and understanding.

• Principle 1: Optimization – Individuals strive to choose the best available option, given their information and constraints. Example: Consumers compare prices and features to select the most suitable product within their budget.

• Principle 2: Equilibrium – Economic systems tend toward equilibrium, a state in which no individual can benefit by changing their own behavior. Example: In a competitive market, prices adjust so that supply equals demand, and no buyer or seller has an incentive to change their actions.

• Principle 3: Empiricism – Economists use data and empirical analysis to test theories and understand real-world phenomena. Example: Researchers analyze historical data to determine the impact of minimum wage laws on employment.

The Principles and Practice of Economics

Human Behavior and Choice

Economists study human behaviour, focusing on the choices individuals and groups make. The central theme is choice, not money, as the unifying feature of all economic analysis. Virtually every aspect of life involves economic decision-making.

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

• Scope of Economics: Examines how agents make choices among scarce resources and how these choices affect society.

The Scope of Economics

Scarcity and Resource Allocation

Economics investigates how agents allocate scarce resources—things people want but are limited in supply. Scarcity necessitates trade-offs and prioritization in decision-making.

• Scarce Resources: Items for which the quantity desired exceeds the quantity available.

• Application: Governments must decide how to allocate limited funds between healthcare, education, and environmental protection.

Normative and Positive Economics

Distinguishing Facts from Values

Economics distinguishes between positive economics (objective analysis of what is) and normative economics (subjective judgments about what ought to be).

• Positive Economics: Describes and explains economic phenomena without value judgments. Example: "Some people took more than one candy and not everyone got a piece."

• Normative Economics: Prescribes policies or actions based on values or opinions. Example: "Each student should just take one so that everyone gets a piece."

Microeconomics vs. Macroeconomics

Levels of Economic Analysis

• Microeconomics: Studies the incentives and choices of individuals, firms, and governments. Example: How a firm decides the quantity of goods to produce.

• Macroeconomics: Examines the economy as a whole, including the effects of monetary and fiscal policy on microeconomic incentives and choices. Example: How changes in interest rates affect national unemployment levels.

Three Principles of Economics

Summary of Core Concepts

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

• Equilibrium: When everyone is optimizing, and no one would be better off with a different choice.

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

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

Making Choices Under Constraints

Optimization involves making the best possible choice given available information. While individuals may not always succeed in optimizing due to imperfect information or cognitive limitations, they generally attempt to do so.

• Trade-offs: All optimization problems involve trade-offs, where some benefits must be sacrificed to gain others.

• Budget Constraint: The set of options a person can choose without exceeding their budget. Economists use budget constraints to describe trade-offs. Example: Deciding whether to spend money on a book or save for a computer.

• Opportunity Cost: The value of the best alternative forgone when making a choice. Example: The opportunity cost of attending university may be the income from a job you could have taken instead.

Formula: Budget Constraint

The budget constraint can be expressed as:

$P_x x + P_y y \\leq M$

Where $P_x$ and $P_y$ are the prices of goods $x$ and $y$, and $M$ is the total budget.

Formula: Opportunity Cost

Opportunity cost is not a strict formula but is conceptually defined as:

$ext{Opportunity Cost of A} = ext{Value of Best Alternative to A}$

Additional info:

• The "Dismal Science" label for economics refers to its focus on scarcity and trade-offs, often highlighting difficult choices and constraints.

• Examples such as the allocation of candies in a classroom illustrate the difference between positive and normative economics.