1 WHAT IS ECONOMICS?

After studying this chapter, you will be able to:

 Define economics and distinguish between
microeconomics and macroeconomics

 Explain the two big questions of economics

 Explain the key ideas that define the economic way of

thinking

 Explain how economists go about their work as social

scientists and policy advisers

© 2016 Pearson Education, Ltd.

 Microeconomics
Second Edition

Chapter 1
The Principles
and Practice of
Economics

Copyright © 2018, 2015 Pearson Education, Inc. All Rights Reserved

Copyright © 2018, 2015 Pearson Education, Inc. All Rights Reserved
 Key Ideas (1 of 2)

1. Economics is the study of people’s choices.

2. The first principle of economics is that people try to

optimize; they try to choose the best available
option.

3. The second principle of economics is that

economic systems tend to be in equilibrium, a
situation in which nobody would benefit by
changing his or her own behavior.
© 2016 Pearson Education, Ltd.
 Key Ideas (2 of 2)

4. The third principle of economics is empiricism

—analysis that uses data. Economists use data
to test theories and to determine what is
causing things to happen in the real world.

© 2016 Pearson Education, Ltd.

 The Principles and Practice of
Economics (1 of 4)
Evidenced-Based Economics Example: Is Facebook free?

© 2016 Pearson Education, Ltd.

The Principles and Practice of
Economics (2 of 4)
What area of your life is NOT
covered by economics?

© 2016 Pearson Education, Ltd.

 The Principles and Practice of
Economics (3 of 4)

Economists study
human behavior
Choice—not money—is the unifying feature of all
the things that economists study

© 2016 Pearson Education, Ltd.

 The Principles and Practice of
Economics (4 of 4)

Economic Agent = Any

group or individual that
makes choices, such as
consumers, firms,
parents, politicians,
etc.

© 2016 Pearson Education, Ltd.

The Scope of Economics (1 of 6)

What does it mean if

something is “scarce”?

© 2016 Pearson Education, Ltd.

 The Scope of Economics (2 of 6)

Scarce resources are things that people want,

where the quantity that people want often exceeds

the quantity that is available.

© 2016 Pearson Education, Ltd.

 The Scope of Economics (3 of 6)

Economics studies how agents make choices

among scarce resources and how those choices

affect society.

© 2016 Pearson Education, Ltd.

 The Scope of Economics (4 of 6)

How many pieces should each person have taken?

© 2016 Pearson Education, Ltd.

 The Scope of Economics (5 of 6)

Positive Economics – how it is

Some people took more than one and not
everyone got a piece

Normative economics – should be

Each student should just take one so that
everyone gets a piece

© 2016 Pearson Education, Ltd.

 The Scope of Economics (6 of 6)

Microeconomics
The study of how individuals,
firms, and governments
make choices

Macroeconomics
The study of the whole
economy

© 2016 Pearson Education, Ltd.

The First Principle of Economics: Optimization
Trade-offs and Budget Constraints (1 of 5)

Optimization = making the best choice possible

with given information
People don’t always succeed in optimizing—we are
not calculating machines—but people generally try to
optimize.

© 2016 Pearson Education, Ltd.

The First Principle of Economics: Optimization
Trade-offs and Budget Constraints (2 of 5)
What is the optimal level of crime? Resources
Tradeoff

© 2016 Pearson Education, Ltd.

 The First Principle of Economics:
Optimization Trade-offs and Budget
Constraints (3 of 5)

You want to buy a You want to buy a

$20 book. If you $1,000 computer.
drive 3 miles, you If you drive 3
can buy it for $10. miles, you can buy
it for $990.
© 2016 Pearson Education, Ltd.
 The First Principle of Economics:
Optimization Trade-offs and Budget
Constraints (4 of 5)

What does it cost What does it cost

you to not drive to you to not drive
buy the book? $10! to buy the
computer?

© 2016 Pearson Education, Ltd.

 The First Principle of Economics:
Optimization Trade-offs and Budget
Constraints (5 of 5)

Costs Benefits

© 2016 Pearson Education, Ltd.

 The Principles and Practice of
Economics
Evidenced-Based Economics Example: Is Facebook free?

© 2016 Pearson Education, Ltd.

 Is Economics Good for You? (1 of 3)

What are the costs and benefits of this course?

© 2016 Pearson Education, Ltd.

 Is Economics Good for You? (2 of 3)

Costs Benefits
• Tuition • Graduation

• Other courses • Knowledge

• Higher earnings
• Sleep?
potential?
• Stress? • Learning to think
like an Economist!

© 2016 Pearson Education, Ltd.

 Definition of Economics

All economic questions arise because we want more than

we can get.
Our inability to satisfy all our wants is called scarcity.
Because we face scarcity, we must make choices.
The choices we make depend on the incentives we
face.
An incentive is a reward that encourages an action or a
penalty that discourages an action.

© 2016 Pearson Education, Ltd.

 Definition of Economics

Economics is the social science that studies the choices

that individuals, businesses, governments, and entire
societies make as they cope with scarcity and the
incentives that influence and reconcile those choices.
Economics divides in two main parts:
 Microeconomics
 Macroeconomics

© 2016 Pearson Education, Ltd.

 Definition of Economics

Microeconomics is the study of choices that individuals

and businesses make, the way those choices interact in
markets, and the influence of governments.
An example of a microeconomic question is: Why are
people buying more e-books and fewer hard copy books?
Macroeconomics is the study of the performance of the
national and global economies.
An example of a macroeconomic question is: Why is the
unemployment rate in the United States so high?

© 2016 Pearson Education, Ltd.

 Two Big Economic Questions

Two big questions summarize the scope of economics:

 How do choices end up determining what, how, and for
whom goods and services get produced?
 When do choices made in the pursuit of self-interest
also promote the social interest?

© 2016 Pearson Education, Ltd.

 Two Big Economic Questions

Self-Interest
You make choices that are in your self-interest—choices
that you think are best for you.
Social Interest
Choices that are best for society as a whole are said to be
in the social interest.

© 2016 Pearson Education, Ltd.

 Two Big Economic Questions

What, How, and For Whom?

Goods and services are the objects that people value
and produce to satisfy human wants.
What?
Agriculture accounts for less than 1 percent of total U.S.
production, manufactured goods for 22 percent, and
services for 77 percent.
In China, agriculture accounts for 11 percent of total
production, manufactured goods for 47 percent, and
services for 43 percent.

© 2016 Pearson Education, Ltd.

 Two Big Economic Questions

Figure 1.1 shows these

numbers for the United
States and China.
It also shows the numbers
for Brazil.
What determines these
patterns of production?
How do choices end up
determining the quantity of
each item produced in the
United States and around
the world?

© 2016 Pearson Education, Ltd.

 Two Big Economic Questions

How?
Goods and services are produced by using productive
resources that economists call factors of production.
Factors of production are grouped into four categories:
 Land
 Labor
 Capital
 Entrepreneurship

© 2016 Pearson Education, Ltd.

 Two Big Economic Questions

The “gifts of nature” that we use to produce goods and

services are land.
The work time and work effort that people devote to
producing goods and services is labor.
The quality of labor depends on human capital, which is
the knowledge and skill that people obtain from education,
on-the-job training, and work experience.
The tools, instruments, machines, buildings, and other
constructions that businesses use to produce goods and
services are capital.
The human resource that organizes land, labor, and
capital is entrepreneurship.
© 2016 Pearson Education, Ltd.
 Two Big Economic Questions

Figure 1.2 shows a

measure of the growth
of human capital in the
United States over the
last century—the
percentage of the
population that has
completed different
levels of education.
Economics explains
these trends.

© 2016 Pearson Education, Ltd.

 Two Big Economic Questions

For Whom?
Who gets the goods and services depends on the incomes
that people earn.
 Land earns rent.
 Labor earns wages.
 Capital earns interest.
 Entrepreneurship earns profit.

© 2016 Pearson Education, Ltd.

 Two Big Economic Questions

Do Choices Made in the Pursuit of Self-Interest also

Promote the Social Interest?
Every day, 320 million Americans and 7.2 billion people in
other countries make economic choices that result in
What, How, and For Whom goods and services are
produced.
These choices are made by people who are pursuing their
self-interest.
Are they promoting the social interest?

© 2016 Pearson Education, Ltd.

 Economic Way of Thinking

Six key ideas define the economic way of thinking:

 A choice is a tradeoff.
 People make rational choices by comparing benefits
and costs.
 Benefit is what you gain from something.
 Cost is what you must give up to get something.
 Most choices are “how-much” choices made at the
margin.
 Choices respond to incentives.

© 2016 Pearson Education, Ltd.

 Economic Way of Thinking

A Choice Is a Tradeoff
The economic way of thinking places scarcity and its
implication, choice, at center stage.
You can think about every choice as a tradeoff—an
exchange—giving up one thing to get something else.
On Saturday night, will you study or have fun?
You can’t study and have fun at the same time, so you
must make a choice.
Whatever you choose, you could have chosen something
else. Your choice is a tradeoff.

© 2016 Pearson Education, Ltd.

 Economic Way of Thinking

Making a Rational Choice

A rational choice is one that compares costs and
benefits and achieves the greatest benefit over cost for the
person making the choice.
Only the wants of the person making a choice are relevant
to determine its rationality.
The idea of rational choice provides an answer to the first
question: What goods and services will be produced and
in what quantities?
The answer is: Those that people rationally choose to buy!

© 2016 Pearson Education, Ltd.

 The Economic Way of Thinking

How do people choose rationally?

The answers turn on benefits and costs.

Benefit: What you Gain

The benefit of something is the gain or pleasure that it

brings and is determined by preferences

Preferences are what a person likes and dislikes and the

intensity of those feelings.

© 2016 Pearson Education, Ltd.

 The Economic Way of Thinking

Cost: What you Must Give Up

The opportunity cost of something is the highest-valued
alternative that must be given up to get it.
What is your opportunity cost of going to a live concert?
Opportunity cost has two components:
1. The things you can’t afford to buy if you purchase the
concert ticket.
2. The things you can’t do with your time if you attend
the concert.

© 2016 Pearson Education, Ltd.

 The Economic Way of Thinking

How Much? Choosing at the Margin

You can allocate the next hour between studying and
instant messaging your friends.
The choice is not all or nothing, but you must decide how
many minutes to allocate to each activity.
To make this decision, you compare the benefit of a little
bit more study time with its cost—you make your choice at
the margin.

© 2016 Pearson Education, Ltd.

 The Economic Way of Thinking

To make a choice at the margin, you evaluate the

consequences of making incremental changes in the use
of your time.
The benefit from pursuing an incremental increase in an
activity is its marginal benefit.
The opportunity cost of pursuing an incremental increase
in an activity is its marginal cost.
If the marginal benefit from an incremental increase in an
activity exceeds its marginal cost, your rational choice is to
do more of that activity.

© 2016 Pearson Education, Ltd.

 The Economic Way of Thinking

Choices Respond to Incentives

A change in marginal cost or a change in marginal benefit
changes the incentives that we face and leads us to
change our choice.
The central idea of economics is that we can predict how
choices will change by looking at changes in
incentives. (HW, overtime)
Incentives are also the key to reconciling self-interest and
the social interest.

© 2016 Pearson Education, Ltd.

 Economics: A Social Science and
Policy Tool
Economist as Social Scientist
Economists distinguish between two types of statement:
 Positive statements
 Normative statements
A positive statement can be tested by checking it against
facts.
A normative statement expresses an opinion and cannot
be tested.

© 2016 Pearson Education, Ltd.

 Economics: A Social Science and
Policy Tool
Unscrambling Cause and Effect
Economists create and test economic models.
An economic model is a description of some aspect of
the economic world that includes only those features that
are needed for the purpose at hand.

© 2016 Pearson Education, Ltd.

 Economics: A Social Science and
Policy Tool
A model is tested by comparing its predictions with the
facts.
But testing an economic model is difficult, so economists
also use:
 Natural experiments
 Statistical investigations
 Economic experiments

© 2016 Pearson Education, Ltd.

 Key Ideas

1. A model is a simplified description of reality.

2. Economists use data to evaluate the
accuracy of models and understand how
the world works.

3. Correlation does not imply causality.

© 2016 Pearson Education, Ltd.

 Key Ideas

4. Experiments help economists to measure

cause and effect.

5. Economic research focuses on questions that

are important to society and can be answered
with models and data.

© 2016 Pearson Education, Ltd.

 Evidence-Based Economics
Is college worth it?

© 2016 Pearson Education, Ltd.

 Evidence-Based Economics

Evidenced-Based Example:
2015-2016 academic year tuition averaged
$3,435 for community colleges
$9,410 for instate public colleges
$23,893 for out-of-state public colleges $32,405
for nonprofit private colleges
At least $15,000 per year in opportunity cost

© 2016 Pearson Education, Ltd.

 The Scientific Method
The scientific method (also referred to as
empiricism) is composed of two steps:
1. Developing models that explain some part of
the world
2. Testing those models using data to see how
closely the model matches what we actually
observe

© 2016 Pearson Education, Ltd.

The Scientific Method (2 of 17)

What is this?
Does it look like anyone you know?

© 2016 Pearson Education, Ltd.

 The Scientific Method (3 of 17)

Model

A simplified
description of reality
Is this an airplane?

© 2016 Pearson Education, Ltd.

The Scientific Method
Evidenced-Based Example:

Returns to education

Assumption—one more year of education

results in a 10% increase in future earnings

© 2016 Pearson Education, Ltd.

The Scientific Method

Returns to education:

If you would earn $15 per hour with 13 years of

education, with one more year of education

(your 1st year of college) you would earn:

First Year $15 × 1.10 = $16.50

© 2016 Pearson Education, Ltd.

The Scientific Method

Returns to education:

If you would earn $16.50 with 14 years of

education, with one more year of education (2 nd
year of college), you would earn:

Second Year $16.50 x 1.10 = $18.15

© 2016 Pearson Education, Ltd.

The Scientific Method (8 of 17)

Returns to education:

The third year: $18.15 x 1.1 = $19.97

The fourth year: $19.97 x 1.1 = $21.97

© 2016 Pearson Education, Ltd.

The Scientific Method (9 of 17)

Returns to education:

Hypothesis:

Getting a college degree (years 13-16)

increases wages from $15 to $21.97, or 46.5%

[(($21.97 - $15)/$15) = .4647]

© 2016 Pearson Education, Ltd.

 The Scientific Method

Two important features of models:

1.They are not exact. Not everyone will see his

or her wages increase by 10% with every
additional year of education

2.They generate predictions that can be tested

with data

© 2016 Pearson Education, Ltd.

The Scientific Method (11 of 17)

Hypothesis: Each additional year of education

increases wages by 10% True or False?

© 2016 Pearson Education, Ltd.

 The Scientific Method (12 of 17)
Exhibit 2.3 Average Annual Earnings of 30-Year-Old
Americans by Education Level (2014 data)

© 2016 Pearson Education, Ltd.

 The Scientific Method (13 of 17)

How much higher is the wage for college

graduates than for high school graduates?
College = $51,215
High School = $32,912

College results in a wage that is 56% higher.

$51, 215
32 , 912  1.56
Model predicted 46% higher. Is that close enough?

© 2016 Pearson Education, Ltd.

 The Scientific Method

If college graduates earn, on average,

$51,215/year, does that mean that all college

graduates earn that much?

© 2016 Pearson Education, Ltd.

The Scientific Method (15 of 17)

The median is the value in the middle of a

group of numbers, and the mean is the average

value of the group of numbers

© 2016 Pearson Education, Ltd.

 Causation and Correlation (2 of 13)

A study from England showed that cows who were

named gave more milk than unnamed cows

Causation? or Correlation?

Buttercup

© 2016 Pearson Education, Ltd.

 Causation and Correlation (5 of 13)

Correlation - When two things are related

Positive correlation – they both change in the
same direction
Negative correlation – they change in opposite
directions

© 2016 Pearson Education, Ltd.

 Economic Questions and
Answers
Two Properties of a Good Economic Question:

1. Relevant and important

Economic research contributes to social

welfare

2. Can be answered

Economic questions can be answered

empirically
© 2016 Pearson Education, Ltd.
 APPENDIX
Graphs in Economics

© 2016 Pearson Education, Ltd.

After studying this chapter, you will be able to:
 Make and interpret a scatter diagram

 Identify linear and nonlinear relationships and

relationships that have a maximum and a minimum

 Define and calculate the slope of a line

 Graph relationships among more than two variables

© 2016 Pearson Education, Ltd.

 Graphing Data

A graph reveals a relationship.

A graph represents “quantity”
as a distance.
A two-variable graph uses two
perpendicular scale lines.
The vertical line is the y-axis.
The horizontal line is the x-axis.
The zero point in common to
both axes is the origin.

© 2016 Pearson Education, Ltd.

 Graphing Data

Economists measure variables that describe what, how,

and for whom goods and services are produced.

These variables are quantities produced and prices.

Figure A1.2 shows two examples of economic graphs.

© 2016 Pearson Education, Ltd.

 Graphing Data

Figure A1.2(a) is a graph

about movie tickets in
2013.
Point A tells us what the
quantity and price were.
You can “read” this graph
as telling you that in 2013:
1.3 billion movie tickets
were bought at a price of
$8.16 a ticket.

© 2016 Pearson Education, Ltd.

 Graphing Data

Figure A1.2(b) is a graph

about movie tickets and
DVDs bought in 2013.
Point B tells us what these
quantities were.
You can “read” this graph
as telling you that in 2013,
1.3 billion movie tickets
and 112 million DVDs were
bought.

© 2016 Pearson Education, Ltd.

 Graphing Data

Scatter Diagrams
A scatter diagram plots the value of one variable against
the value of another variable for a number of different
values of each variable.

A scatter diagram reveals whether a relationship exists

between the two variables.

Figure A1.3 (on the next slide) shows some data on box
office tickets sold and the number of DVDs sold for nine of
the most popular movies in 2011.

The table gives the data and the graph describes the
relationship between box office tickets sold and DVD sales.
© 2016 Pearson Education, Ltd.
Graphing Data

© 2016 Pearson Education, Ltd.

 Graphing Data

Point A tells us that Monsters

University sold 33 million
tickets at the box office and 2.3
million DVDs.
The points reveal that there is
a tendency for larger box office
sales to bring greater DVD
sales. ...
But you couldn’t predict how
many DVDs a movie would sell
just by knowing its box office
sales.

© 2016 Pearson Education, Ltd.

 Graphing Data

Figure A1.4(a) is a scatter

diagram of income and
expenditure, on average,
from 2001 to 2013.
Point A shows that in 2006,
income was $38,000 and
expenditure was $31,000.
The graph shows that as
income increases, so does
expenditure, and the
relationship is a close one.

© 2016 Pearson Education, Ltd.

 Graphing Data

Figure A1.4(b) is a scatter

diagram of inflation and
unemployment in the
United States from 2001
through 2013.
The points show a weak
relationship between the
two variables.

© 2016 Pearson Education, Ltd.

 Graphs used in Economic Models

Graphs are used in economic models to show the

relationship between variables.
The patterns to look for in graphs are the four cases in
which
 Variables move in the same direction.
 Variables move in opposite directions.
 Variables have a maximum or a minimum.
 Variables are unrelated.

© 2016 Pearson Education, Ltd.

 Graphs used in Economic Models

Variables That Move in the Same Direction

A relationship between two variables that move in the
same direction is called a positive relationship or a
direct relationship.
A line that slopes upward shows a positive relationship.
A relationship shown by a straight line is called a linear
relationship.
The three graphs on the next slide show positive
relationships.

© 2016 Pearson Education, Ltd.

Graphs used in Economic Models

© 2016 Pearson Education, Ltd.

 Graphs used in Economic Models

Variables That Move in Opposite Directions

A relationship between two variables that move in opposite
directions is called a negative relationship or an inverse
relationship.
A line that slopes downward shows a negative
relationship.
The three graphs on the next slide show negative
relationships.

© 2016 Pearson Education, Ltd.

Graphs used in Economic Models

© 2016 Pearson Education, Ltd.

 Graphs used in Economic Models

Variables That Have a Maximum or a Minimum

The two graphs on the next slide show relationships that
have a maximum and a minimum.
These relationships are positive over part of their range
and negative over the other part.

© 2016 Pearson Education, Ltd.

Graphs used in Economic Models

© 2016 Pearson Education, Ltd.

 Graphs used in Economic Models

Variables That are Unrelated

Sometimes, we want to emphasize that two variables are
unrelated.
The two graphs on the next slide show examples of
variables that are unrelated.

© 2016 Pearson Education, Ltd.

Graphs used in Economic Models

© 2016 Pearson Education, Ltd.

 The Slope of a Relationship

The slope of a relationship is the change in the value of

the variable measured on the y-axis divided by the change
in the value of the variable measured on the x-axis.
We use the Greek letter  (capital delta) to represent
“change in.”
So y means the change in the value of the variable
measured on the y-axis and x means the change in the
value of the variable measured on the x-axis.
Slope equals y/x.

© 2016 Pearson Education, Ltd.

 The Slope of a Relationship

The Slope of a Straight

Line
The slope of a straight line
is constant.
Graphically, the slope is
calculated as the “rise”
over the “run.”
The slope is positive if the
line is upward sloping.

© 2016 Pearson Education, Ltd.

 The Slope of a Relationship

The slope is negative if the

line is downward sloping.

© 2016 Pearson Education, Ltd.

 The Slope of a Relationship

The Slope of a Curved Line

The slope of a curved line at a point varies depending on
where along the curve it is calculated.
We can calculate the slope of a curved line either at a
point or across an arc.

© 2016 Pearson Education, Ltd.

 The Slope of a Relationship

Slope at a Point
The slope of a curved
line at a point is equal to
the slope of a straight
line that is the tangent to
that point.
Here, we calculate the
slope of the curve at
point A.

© 2016 Pearson Education, Ltd.

 The Slope of a Relationship

Slope Across an Arc

The average slope of a
curved line across an arc
is equal to the slope of a
straight line that joins the
endpoints of the arc.
Here, we calculate the
average slope of the curve
along the arc BC.

© 2016 Pearson Education, Ltd.

 Graphing Relationships Among More
Than Two Variables
When a relationship involves more than two variables, we
can plot the relationship between two of the variables by
holding other variables constant—by using ceteris paribus.
Ceteris paribus
Ceteris paribus means “if all other relevant things remain
the same.”

Figure A1.12 shows a relationship among three variables.

© 2016 Pearson Education, Ltd.

 Graphing Relationships Among More
Than Two Variables
The table gives the quantity of ice cream consumed at
different prices as the temperature varies.

© 2016 Pearson Education, Ltd.

 Graphing Relationships Among More
Than Two Variables
To plot this relationship we hold the temperature at 70°F.
At $2.75 a scoop, 10 gallons are consumed.

© 2016 Pearson Education, Ltd.

 Graphing Relationships Among More
Than Two Variables
We can also plot this relationship by holding the
temperature constant at 90°F.
At $2.75 a scoop, 20 gallons are consumed.

© 2016 Pearson Education, Ltd.

 Graphing Relationships Among More
Than Two Variables
When temperature is constant at 70°F and the price of ice
cream changes, there is a movement along the blue curve.

© 2016 Pearson Education, Ltd.

 Graphing Relationships Among More
Than Two Variables
When temperature is constant at 90°F and the price of ice
cream changes, there is a movement along the red curve.

© 2016 Pearson Education, Ltd.

 Graphing Relationships Among More
Than Two Variables
When Other Things Change
The temperature is held constant along each curve, but in
reality the temperature can change.

© 2016 Pearson Education, Ltd.

 Graphing Relationships Among More
Than Two Variables
When the temperature rises from 70°F to 90°F, the curve
showing the relationship shifts rightward from the blue
curve to the red curve.

© 2016 Pearson Education, Ltd.