Introduction to Economics

Core Concepts

Economics

studies the consequences of decision making in the face of scarcity.

Decisions

may be individual, family, business, governmental, or societal.

Scarcity

exists because the desire for goods, services, and resources exceeds availability.

Resources

include land, labor (time), capital (tools, equipment, buildings), human capital.

• used to produce goods and services.

• limited in supply.

Coping with Scarcity: Two Imaginable Options

• each person produces everything s/he consumes

  • “jack of all trades, master of none”

• each person produces one thing and then trades for consumption

  • division and specialization of labor

  • described by Adam Smith in The Wealth of Nations (1776)

    • pin manufacturing example (18 distinct tasks)

Adam Smith, 1723–1790

Productivity and the Division of Labor

Benefits from division of labor:

current competency:

specialization according to skills, talents, and interests

acquired competency:

specialization -> quicker learning

economies of scale:

larger organization size -> lower costs per unit

Costs from division of labor:

• resulting need to trade

• possible work dissatisfaction (alienation)

Why Learn Economics?

Learn economics in order to:

understand the world:

How do markets work? What causes unemployment?

critically evaluate arguments

When is “common sense” actually nonsense?

promote good policy

What the costs and benefts of the policies you vote for?

Micro vs Macro

Microeconomics

studies individuals and particular markets.

• Emphasis on constrained choice.

• Example: determinants of the price and quantity of a single good.

Macroeconomics

studies the economy as a whole (e.g., determinants of inflation and unemployment).

• Emphasis on economy-wide outcomes.

• Example: determinants of current inflation.

Microeconomic Questions: Some Examples

Microeconomic questions:

• How do budget-constrained individuals choose among goods and services?

• How do individuals trade-off saving vs consumption?

• How do firms decide how much to produce and how to produce it?

• How does a market determine price and quantity?

• How does tax policy affect the decisions of individuals and firms?

Macroeconomic Questions: Some Examples

Macroeconomic questions:

• What is the overall level of production in a society?

• How is the overall level of production changing over time in the short run?

• How is the overall level of production changing over time in the long run?

• What determines the overall level of production?

• How can we compare the standard of living across countries?

• What determines the social distribution on income and wealth?

• How do monetary and fiscal policy affect inflation and unemployment in the short run?

• How do monetary and fiscal policy affect inflation and unemployment in the long run?

What Is a Theory?

• more than just an idea or hunch,

• a system of ideas that helps us organize our interpretations of a system.

• an explanatory framework for a domain of possible experiences.

physical sciences

reserve the term ‘theory’ for hypotheses that are widely accepted due to the weight of the accumulated evidence

social sciences

use the term ‘theory’ just to mean an abstract model plus a hypothesis

What Is a Scientific Theory?

• a scientific theory generates scientific hypotheses.

scientific hypothesis

• observations must be able to affect the credibility of the theory

• experience (observations) can force revisions to beliefs (about the accuracy of the theory).

If we are committed to a theory regardless of the evidence, we are not doing science. A scientific theory is vulnerable to the evidence.

Systems and Models

model

characterizes a real or imaginary system, known as the target system.

system

• an object or process with components, along with

• the structure of their interrelations.

Model Development

Model development

efforts to conceptualize, implement, or improve a model.

ignores many real-world features

• some are too costly to consider

• some are judged to be irrelevant (to the model-development goals)

Model Development Process

Sometimes model development is purely verbal or graphical.

However, scientific model development often involves implementing the conceptual model as a mathematical model, computational model, or physical model.

Figure f:modelingProcess100 provides a stylized illustration of key steps in model development and analysis.

Questions about Modeling

A “good” model helps us achieve the goals we had when creating it.

• understand

• predict

• control

The usefulness of a model should be assessed in terms of its goals.

• A pedagogical model may aid understanding without being useful for prediction.

• A statistical model may help predict without adding much understanding.

• A more realistic model need not be a more useful model.

Related question: what makes a map useful?

Can a map of Middle Earth be useful?

Epstein on Why We Model

[Epstein-2008-JASSS] offers 16 reasons other than prediction.

1. Explain (very distinct from predict)

   plate tectonics and earthquakes; electrostatics and lightning; evolution and speciation

2. Guide data collection

3. Illuminate core dynamics

4. Suggest dynamical analogies

5. Discover new questions

6. Promote a scientific habit of mind

7. Bound (bracket) outcomes to plausible ranges

8. Illuminate core uncertainties.

Epstein on Why We Model (cont.)

9. Offer crisis options in near-real time

10. Demonstrate tradeoffs / suggest efficiencies

11. Challenge the robustness of prevailing theory through perturbations

12. Expose prevailing wisdom as incompatible with available data

13. Train practitioners

14. Discipline the policy dialogue

15. Educate the general public

16. Reveal the apparently simple (complex) to be complex (simple)

Two Camps: RAD vs. KISS

Realism, Accuracy, and Detail (RAD):

• realism is a virtue

• create accurate and detailed representations of relationships

• closer resemblance to nitty-gritty empirical investigations

Keep it stylized and simple (KISS):

• simplicity is a virtue

• create highly stylized representations of relationships

• closer resemblance to formal mathematical theory building

Simplified Circular Flow Diagram for the Macro Economy

Economic models often highlight interactions between different parts of the economy.

(Keeping it very simple!)

Video: Simplified Circular Flow Diagram

Video from the St Louis Fed (Economic Lowdown)

Economic Systems: Traditional Economy

An economic system is traditional if

• occupations tend to stay in the family

• most families farm traditional crops

• a family produces most of what it consumes

• there is little economic progress or technological advance

Economic Systems: Command Economy

An economic system is a command economy if a central authority (government):

• sets production goals and methods of production

• sets prices (including wages)

• may set low or zero prices on “necessities” (e.g., healthcare, education)

Examples: Pharonic Egypt; Medieval manor life

Examples: Cuba and North Korea have large command elements to their economies.

Economic Systems: Free-Market Economy

An economic system is a free-market economy if

• decentralized (non-governmental) private decision makers determine production decisions (private enterprise)

• market supply and market demand determine prices and wages

• even the prices of “necessities” (e.g., healthcare, education) are market determined

Economic Systems: Mixed Economy

Most actual economies combine market and command elements.

• there is an entire spectrum from primarily free markets to primarily command allocations.

• most economies subsidize some “necessities” (e.g., basic healthcare, K12 education)

Personal and Economic Freedom

Personal freedom correlates with economic freedom:

Rules of the Economic Game

Reliable rules reduce risk and uncertainty. The rules of the game include:

• laws protecting person and property.

• laws enforcing contracts.

• regulations.

Regulations can:

• promote competitive innovation (e.g., anti-trust).

• or inhibit competition (e.g., excessive patenting).

References

Introduction to FRED

Economic data

• describe and measure the economics concepts

FRED

• Federal Reserve Economic Data

• online display as tables or charts

• easily downloadable

Video: What Is FRED?