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Introduction to Economics

Chapter 1: Scope and Method of Economics

Chapter 1

1. The Scope and Method of Economics

Economics is the study of how individual and societies choose to use the scarce resources that nature and previous generations have passed to them. In a large measure, it is the behavioral science studying individual choices and more broadly societal choices added up from them. Either you are planning the upcoming holiday against limited time or slicing a gigantic watermelon with several of your siblings, you are doing economics.

1.1. Scope of Economics

You are probably surprised that this brimming page is just a very rough introduction to economics, narrating only on some of the most fundamental terms. Yes, economics has deep roots and close ties in most society problems and global affairs, it also has come a long way with social philosophy, thus bringing about the breadth and depth of this discipline. Anyway, let's first take a brief look at the two major divisions of economics: microeconomics and macroeconomics.

1.1.1. Microeconomics

Microeconomics studies behaviors of individual decision makers such as you in a particular market such as that for refrigerator, and their interrelationships. Microeconomics examines the factors that influence individual economic choices and how the choices of various decision makers are coordinated by markets. To illustrate, microeconomics explains how price and quantity supplied for a certain product interact, determine each other and finally come to equilibrium.

1.1.2. Macroeconomics

Unlike microeconomics that studies particular markets, macroeconomics dedicates itself into the overall behavior and performance of an entire economy. What happens in an economy is the outcome of thousands of millions of individual decisions, and macroeconomics puts all the small pieces that are subjects of microeconomics together to focus on the big picture, as at a national or a global level.

1.2. Analytic Tools and Methods of Economics

1.2.1. A Key Assumption: Rational Self-Interest

A key assumption for economic analysis is that individuals, be it a person, a family or a firm, tend to make choices and select alternatives rationally, that they believe in their best interest. By rational, economists mean simply that people try to make the best choice they can, given the available information and resource. Uncertainty exists and people do not know what will turn out to be the most self-benefiting, so they simply select the alternatives that they expect to yield them the most satisfaction and happiness or the ones with the highest possibility to achieve it. In general, rational self-interest means that given a certain condition, individuals try to minimize the expected cost for a benefit or maximize the expected benefit with a cost.

1.2.2. Opportunity Cost

Opportunity cost is one of the most frequently used tools for modern economic analysis, deriving many important economic theories and models. It is also a powerful tool in analyzing individual decision-making process. Whoever you are, an individual, a company or a nation, you face opportunity cost when making decisions.

Nearly all decisions involve trade-offs. When we are choosing, we are also giving up. Every action and choice is associated with advantages and disadvantages, costs and gains. A key concept that recurs again and again in analyzing the decision-making process is the notion of opportunity cost. The full cost of making a specific choice is what we give up by not taking the alternative. That which we forgo, when making a choice or decision is called the opportunity cost of the decision. More precisely, opportunity cost is not all that we are not choosing added up, instead, it is the most valued one among all that we let go. Sometimes opportunity cost can be measured in terms of money, although money is usually not the only part of it.

Opportunity cost is subjective. Only the chooser can determine the most attractive alternative for itself from its special point of view. We each has a different list of things valued in decline from top to bottom due to our different aims of life and philosophy. Even for the same activity or good or service, different individuals take it with different opportunity cost.

Nevertheless, the chooser seldom knows the actual value of the second best alternative forgone, since focusing on only the expectedly best alternative makes all other possible alternatives irrelevant. In light of this, you will never know the exact value of what you let go if you give up an evening of pizza and conversation with friends to work on a term paper.

1.2.3. Marginal Analysis & Sunk Cost

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 is derived directly from, or contingent of the decision. See the example below.

Economic choices are largely based on a comparison between the expected marginal cost and the expected marginal benefit of the action under consideration. Marginal means incremental, additional, or extra. Rational decision makers will make the choice as long as the expected marginal benefit from the change incurred by the choice exceeds the expected marginal cost. To acquire an intuitive vision of marginalism, refer to the illustration below.

In marginal analysis, one of the concepts that cannot be missed out is sunk cost. Sunk costs are costs that cannot be avoided for any nonzero units of products and that do not change regardless of the quantity of production. As opposed to sunk cost, marginal cost is the cost that is relevant to the quantity produced and that do not occur with a zero production. To simplify, marginal cost is the very cost incurred by one additional unit of production.

1.2.4. Positive vs. Normative

The questions economics asks and attempts to answer fall into two categories. Positive economics is an assertion about economic reality that can be supported or rejected by reference to the facts. It is used to understand the behavior and operation of economic systems, rather than passing judgments on them. Normative economics reflects opinions and values, judging whether the outcomes are good or bad. Simply speaking, positive economics deal with what is while normative economics is concerned with what should be.

1.2.5. 4 Steps to Reach a Conclusion

Theories or models are formal conclusions achieved or discovered through scientific procedures. In economic analysis and research though, it is not so "scientific". As in physical experiments, variables and factors can be controlled and manipulated very precisely, enabling you to anticipate almost everything. Economists, nevertheless, do research and perform experiments in a much more complex and unpredictable situation, trying to achieve conclusions primarily by observation. They are unable to control known variables in ways they want them to, not to mention those possibly missed out, scrambling the data or simply misleading them. What physicists discover can be formulated exactly in mathematics as they are in reality, and always correct; whereas things an economist discovers do not always hold true and some of them arouse dispute.

Anyway, to study economists problems, economists employ a process of theoretical investigation called the scientific method comprised of 4 steps:

1. Identify and define the question as well as relevant variable.
2. Make assumptions, that is the prerequisites or condition for the theory to apply.
3. Formulate a hypothesis, that is how variables relate to and affect one another.
4. Validation of the hypothesis, testing the predictions against actual evidence.

If the answer to step 4 is negative, then either the hypothesis is incorrect or the previous two steps do not go smoothly; otherwise, hypothesis passes the validity test and a theory or model is confirmed.

1.3. From economic Theories to economic Policy

1.3.1. The Building of Theories and Models

A model is a formal statement of a theory. No matter what discipline, be it physics, meteorology, astronomy or economics, researchers use models to explain the world, and models are built upon variables. A variable is a measure that can change from time to time or from observation to observation. Price is a variable, it differs from time to time. But why does it alter itself? No, it does not alter itself. That it hardly stay still is because other variables have impacts on it, either positive or negative, linear or nonlinear. The real world is so complex that we just cannot make out all the variables that govern it, but abstract some of them, to put together a model. In this sense, models are all simplifications, stripping away detail to expose only those that are important to the question being asked. An intuitive example of modeling is the charting of a map. Most maps are two-dimensional representations of a three-dimensional world, showing only things we are concerned about, omitting pretty much of the geographical details.

Now we know what a variable is and why a model is different from the real world. But how exactly it is built? One of the techniques, or scientific methods, is the device of All Else Equal, or ceteris paribus. Very handy it is when we try to isolate the impact of one single factor upon something. What is the impact of a 10% rise in gasoline price on driving behaviors, ceteris paribus, or assuming that nothing else changes? We can tell that a reduction in driving occurs, but how much less, assuming no simultaneous change in other related things, income, number of children, population, laws and so forth?

In a word, the concept helps us simplify reality in order to focus on the relationships that we are interested in. We can then delve into the relationship between just two variables by simply assuming that all else remain intact during any procedure.

Economists literally find 3 means to represent a model or convey an economic idea, words, graphs, and equations. Pros and cons exist for each of them. Words convey simple ideas effectively, but not adequate for multi-variable models or two-variable model that is to show the mathematical nature of the quantitative relationship. Graphs do this job intuitively, and in a more specific as well as accurate way. It does not only give you the big picture, but also shows you what it is like at a specific point. Equations are not used as frequently as the former two, but presents us the underlying process, so more suitable for in-depth research and modeling. Below is a graph depicting the demand curve how Matthew responds to telephone price changes.

1.3.2. Economic Policy and 4 Criteria for Judging

Theories and models are positive statements, helping us understand the mechanism of the world, but the formulation of economic policy requires a second step, the step to further these theories and models into practice to get to what we think it should be. What are the objectives? How to define better, that is what changes to our situation are positive? Do we better off or worse off? Four criteria are frequently applied in making these judgments:

• Efficiency
  In economics, efficiency means allocative efficiency. An efficient economy is one that produces what people want and does so at the lowest possible cost. More technically, an efficient change in the allocation of resources is one that at least potentially makes some people better off without making others worse off. Since most changes in an economy will leave some people better off and others worse off, we have to devise a way of comparing gains and losses from a given change. So, a change is considered at least potentially efficient if the value of the resulting gains exceeds that of the resulting losses.
• Equity
  Fairness. Few people agree on what is fair and what is unfair, though. For thousands of years, philosophers wrestle with the principles of justice to guide social decisions.
  Despite the impossibility of defining equity or fairness universally, public policy makers judge and regulate the fairness of economic outcomes all the time. 
• Growth
  Economic growth is an increase in the total output of an economy. That is what happens when we invent new and better ways of producing what we use now and develop new products and services. However, all economic policies do not encourage economic growth, some discourage it.
• Stability
  Economic stability refers to the condition in which national output is steady or growing, with low inflation and full employment of resources. An economy may at times be unstable, characterized by high unemployment and severe inflation. The causes of instability and attempts to stabilize the economy by government regulation are the subject matter of macroeconomics.