CHAPTER 1

The Scope and Method of

Economics

Prepared by: Fernando Quijano and

Yvonn Quijano

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The Study of Economics

• Economics is the study of

how individuals and societies
choose to use the scarce
resources that nature and
previous generations have
provided.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Why Study Economics?

• Probably the most important reason

for studying economics is to learn
a way of thinking.

• Three fundamental concepts:

• Opportunity cost

• Marginalism, and

• Efficient markets

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Opportunity Cost

• Opportunity cost is the best

alternative that we forgo, or give
up, when we make a choice or a
decision.

• Opportunity costs arise because

time and resources are scarce.
Nearly all decisions involve trade-
offs.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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.

• For example, when deciding whether to produce

additional output, a firm considers only the
additional (or marginal cost), not the sunk cost.
• Sunk costs are costs that cannot be avoided,
regardless of what is done in the future, because
they have already been incurred.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Efficient Markets

• An efficient market is one in which

profit opportunities are eliminated
almost instantaneously.

• There is no free lunch! Profit

opportunities are rare because, at
any one time, there are many
people searching for them.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 More Reasons to Study Economics

• Economics involves the study of societal and

global affairs concerning resource allocation.

• Economics is helpful to us as voters. Voting

decisions require a basic understanding of
economics.

• Money and financial systems are an important

component of the economic system, but are not
the most fundamental issue in economics.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The Scope of Economics

• Microeconomics is the branch of economics

that examines the functioning of individual
industries and the behavior of individual
decision-making units—that is, business firms
and households.

• Macroeconomics is the branch of economics

that examines the economic behavior of
aggregates— income, output, employment, and
so on—on a national scale.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The Diverse Fields of Economics

Examples of microeconomic and macroeconomic concerns

Production Prices Income Employment
Microeconomics Production/Output Price of Individual Distribution of Employment by
in Individual Goods and Services Income and Wealth Individual
Industries and     Businesses &
Businesses Price of medical Wages in the auto Industries
  care industry Jobs in the steel
How much steel Price of gasoline Minimum wages industry
How many offices Food prices Executive salaries Number of
How many cars Apartment rents Poverty employees in a
firm
Macroeconomics National Aggregate Price National Income Employment and
Production/Output Level Total wages and Unemployment in
    salaries   the Economy
Total Industrial Consumer prices  
Output Producer Prices Total corporate Total number of
Gross Domestic Rate of Inflation profits jobs
Product Unemployment
Growth of Output rate

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The Method of Economics

• Normative economics, also called policy

economics, analyzes outcomes of economic
behavior, evaluates them as good or bad, and
may prescribe courses of action.

• Positive economics studies economic

behavior without making judgments. It
describes what exists and how it works.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The Method of Economics

• Positive economics includes:

• Descriptive economics, which involves the
compilation of data that describe phenomena and
facts.
• Economic theory that involves building models of
behavior. A theory is a statement or set of related
statements about cause and effect, action and
reaction.
• Empirical economics refers to the collection
and use of data to test economic theories.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Theories and Models

• A theory is a general statement of cause and

effect, action and reaction. Theories involve
models, and models involve variables.

• A model is a formal statement of a theory.

Models are descriptions of the relationship
between two or more variables.

• Ockham’s razor is the principle that irrelevant

detail should be cut away. Models are
simplifications, not complications, of reality.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Theories and Models

• A variable is a measure that can change from

observation to observation.

• Using the ceteris paribus, or all else equal,

assumption, economists study the relationship
between two variables while the values of other
variables are held unchanged.

• The ceteris paribus device is part of the process

of abstraction used to focus only on key
relationships.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Theories and Models

• In formulating theories and models we must

avoid two pitfalls:
• The Post Hoc Fallacy: It is erroneous to believe that
if event A happened before event B, then A caused B.
• The Fallacy of Composition: It is erroneous to
believe that what is true for a part is also true for the
whole. Theories that seem to work well when applied
to individuals often break down when they are applied
to the whole.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Economic Policy

Criteria for judging economic outcomes:

• Efficiency, or allocative efficiency. An efficient

economy is one that produces what people want at
the least possible cost.

• Equity, or fairness of economic outcomes.

• Growth, or an increase in the total output of an

economy.

• Stability, or the condition in which output is steady

or growing, with low inflation and full employment
of resources.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 How to Read and Understand Graphs

• Each point on the Cartesian

plane is a combination of
(X,Y) values.

• The relationship between X

and Y is causal. For a given
value of X, there is a
corresponding value of Y, or
X causes Y.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Reading Between the Lines

• A line is a continuous string

of points, or sets of (X,Y)
values on the Cartesian
plane.
• The relationship between X
and Y on this graph is
negative. An increase in the
value of X leads to a
decrease in the value of Y,
and vice versa.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Positive and Negative Relationships

An upward-sloping line
describes a positive
relationship between X
and Y.

A downward-sloping
line describes a
negative relationship
between X and Y.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The Components of a Line
• The algebraic expression of
this line is as follows:
Y = a + bX
where:
Y = dependent variable
X = independent variable
a = Y-intercept, or value of
Y when X = 0.
+ = positive relationship
Y Y1  Y0 between X and Y
b=  b = slope of the line, or the
X X1  X0
rate of change in Y
given a change in X.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Different Slope Values

5 7
b  0 .5 b   0 .7
10 10

0 10
b 0 b 
10 0

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Strength of the Relationship Between
X and Y

• This line is relatively flat.

Changes in the value of X have
only a small influence on the
value of Y.

• This line is relatively steep.

Changes in the value of X have a
greater influence on the value of
Y.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The Difference Between a Line and a Curve

Equal increments in Equal increments in

X lead to constant X lead to diminished
increases in Y. increases in Y.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Interpreting the Slope of a Curve

• Graph A has • Graph B has

a positive and a negative
decreasing slope, then a
slope. positive slope.

• Graph C shows • Graph D

a negative and shows a
increasing negative and
relationship decreasing
between X and slope.
Y.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair