Chapter 1 – Economics: The Study of Choice
Summary
Chapter 2 – Confronting Scarcity: Choices in Production
Summary
Chapter 3 – Demand and Supply
Summary
Chapter 4 – Applications of Demand and Supply
Summary
Chapter 5 – Elasticity: A Measure of Response
Summary
Content
1.1 Defining Economics
Economists study the choices that people make, and scarcity forces us to make choices. Scarce goods are those for which the choice of one alternative requires giving up another. The opportunity cost of any choice is the value of the best alternative forgone in making that choice. Some key choices assessed by economists include what to produce, how to produce it, and for whom it should be produced.
1.2 The Field of Economics
Economics is distinguished from other academic disciplines that also study choices by an emphasis on the central importance of opportunity costs in evaluating choices, the assumption of maximizing behavior that serves the interests of individual decision makers, and a focus on evaluating choices at the margin.
Economic analyses may be aimed at explaining individual choice or choices in an individual market; such investigations are largely the focus of microeconomics. The analysis of the impact of those individual choices on such aggregates as total output, the level of employment, and the price level is the concern of macroeconomics.
1.3 The Economists' Tool Kit
Working within the framework of the scientific method, economists formulate hypotheses and then test them. These tests can only refute a hypothesis; hypotheses in science cannot be proved. A hypothesis that has been widely tested often comes to be regarded as a theory; one that has won virtually universal acceptance is a law. Because of the complexity of the real world, economists rely on models that rest on a series of simplifying assumptions. The models are used to generate hypotheses about the economy that can be tested using real-world data.
Statements of fact and hypotheses are positive statements. Normative statements, unlike positive statements, cannot be tested and provide a source for potential disagreement.
Content
Content
Content
Content
Economics is a social science that examines how people choose among the alternatives available to them. It is social because it involves people and their behavior. It is a science because it uses, as much as possible, a scientific approach in its investigation of choices.
All choices mean that one alternative is selected over another. Selecting among alternatives involves three ideas central to economics: scarcity, choice, and opportunity cost.
Scarcity
Scarcity implies that we must give up one alternative in selecting another. Land use is an example of scarcity. If a house is built is on a parcel of land, a gas station can't be built there (without tearing down the house). A free good is a good that is not scarce. Gravity is a free good, since it can hold things to the earth without needing something else to drift into space.
Choices Due to Scarcity and the Fundamental Economic Questions
The choices we confront as a result of scarcity raise these three fundamental economic questions: What should be produced? How should goods and services be produced? For whom should goods and services be produced?
Opportunity Cost
Every choice has an opportunity cost and opportunity costs affect the choices people make. The opportunity cost of any choice is the value of the best alternative that had to be forgone in making that choice.
Try It!
Try these three practice problems to check whether you understand the concepts of scarcity, choice, and opportunity cost.
We have examined the basic concepts of scarcity, choice, and opportunity cost in economics. In this section, we will look at economics as a field of study. We begin with the characteristics that distinguish economics from other social sciences.
The Economic Way of Thinking
Economists focus on the opportunity costs of choices, they assume that individuals make choices in a way that maximizes the value of an objective defined in terms of their own self-interest, and they assume that individuals make those choices at the margin.
Microeconomics and Macroeconomics
Economics is divided into two broad areas: microeconomics and macroeconomics. Microeconomics focuses on individual decision-making, and macroeconomics focuses on the total level of economic activity.
Putting Economics to Work
A wide range of career opportunities is open to economics majors. Empirical evidence suggests that students who enter the job market with a major in economics tend to earn more than do students in most other majors. Further, economics majors do particularly well on the LSAT.
Content
Our resources are limited. At any one time, we have only so much land, so many factories, so much oil, so many people. But our wants, our desires for the things that we can produce with those resources, are unlimited. We would always like more and better housing, more and better education—more and better of practically everything.
If our resources were also unlimited, we could say yes to each of our wants—and there would be no economics. Because our resources are limited, we cannot say yes to everything. To say yes to one thing requires that we say no to another. Whether we like it or not, we must make choices.
Our unlimited wants are continually colliding with the limits of our resources, forcing us to pick some activities and to reject others.
Scarcity is the condition of having to choose among alternatives.
A scarce good is one for which the choice of one alternative requires that another be given up.
Consider a parcel of land. The parcel presents us with several alternative uses. We could build a house on it. We could put a gas station on it. We could create a small park on it. We could leave the land undeveloped in order to be able to make a decision later as to how it should be used.
Suppose we have decided the land should be used for housing. Should it be a large and expensive house or several modest ones? Suppose it is to be a large and expensive house. Who should live in the house? If the Lees live in it, the Nguyens cannot. There are alternative uses of the land both in the sense of the type of use and also in the sense of who gets to use it. The fact that land is scarce means that society must make choices concerning its use.
Virtually everything is scarce. Consider the air we breathe, which is available in huge quantity at no charge to us. Could it possibly be scarce? The test of whether air is scarce is whether it has alternative uses. What uses can we make of the air? We breathe it. We pollute it when we drive our cars, heat our houses, or operate our factories. In effect, one use of the air is as a garbage dump. We certainly need the air to breathe. But just as certainly, we choose to dump garbage in it. Those two uses are clearly alternatives to each other. The more garbage we dump in the air, the less desirable—and healthy—it will be to breathe. If we decide we want to breathe cleaner air, we must limit the activities that generate pollution. Air is a scarce good because it has alternative uses. Not all goods, however, confront us with such choices. A free good is one for which the choice of one use does not require that we give up another. One example of a free good is gravity. The fact that gravity is holding you to the earth does not mean that your neighbor is forced to drift up into space! One person’s use of gravity is not an alternative to another person’s use.
There are not many free goods. Outer space, for example, was a free good when the only use we made of it was to gaze at it. But now, our use of space has reached the point where one use can be an alternative to another. Conflicts have already arisen over the allocation of orbital slots for communications satellites.
Thus, even parts of outer space are scarce. Space will surely become more scarce as we find new ways to use it. Scarcity characterizes virtually everything. Consequently, the scope of economics is wide indeed.
The choices we confront as a result of scarcity raise three sets of issues. Every economy must answer the following questions:
1. What should be produced?
Using the economy’s scarce resources to produce one thing requires giving up another. Producing better education, for example, may require cutting back on other services, such as health care. A decision to preserve a wilderness area requires giving up other uses of the land. Every society must decide what it will produce with its scarce resources.
2. How should goods and services be produced?
There are all sorts of choices to be made in determining how goods and services should be produced. Should a firm employ a few skilled or a lot of unskilled workers? Should it produce in its own country or should it use foreign plants? Should manufacturing firms use new or recycled raw materials to make their products?
3. For whom should goods and services be produced?
If a good or service is produced, a decision must be made about who will get it. A decision to have one person or group receive a good or service usually means it will not be available to someone else. For example, representatives of the poorest nations on earth often complain that energy consumption per person in the United States is 17 times greater than energy consumption per person in the world’s 62 poorest countries. Critics argue that the world’s energy should be more evenly allocated. Should it? That is a “for whom” question. Every economy must determine what should be produced, how it should be produced, and for whom it should be produced. We shall return to these questions again and again.
It is within the context of scarcity that economists define what is perhaps the most important concept in all of economics, the concept of opportunity cost. Opportunity cost is the value of the best alternative forgone in making any choice.
The opportunity cost to you of reading the remainder of this chapter will be the value of the best other use to which you could have put your time. If you choose to spend $20 on a potted plant, you have simultaneously chosen to give up the benefits of spending the $20 on pizzas or a paperback book or a night at the movies. If the book is the most valuable of those alternatives, then the opportunity cost of the plant is the value of the enjoyment you otherwise expected to receive from the book.
The concept of opportunity cost must not be confused with the purchase price of an item. Consider the cost of a college or university education. That includes the value of the best alternative use of money spent for tuition, fees, and books. But the most important cost of a college education is the value of the forgone alternative uses of time spent studying and attending class instead of using the time in some other endeavor. Students sacrifice that time in hopes of even greater earnings in the future or because they place a value on the opportunity to learn. Or consider the cost of going to the doctor. Part of that cost is the value of the best alternative use of the money required to see the doctor. But, the cost also includes the value of the best alternative use of the time required to see the doctor. The essential thing to see in the concept of opportunity cost is found in the name of the concept. Opportunity cost is the value of the best opportunity forgone in a particular choice. It is not simply the amount spent on that choice.
Identify the elements of scarcity, choice, and opportunity cost in each of the following scenarios. After you are done, you may click through to see the answers.
1.
The Environmental Protection Agency is considering an order that a 500-acre area on the outskirts of a large city be preserved in its natural state, because the area is home to a rodent that is considered an endangered species. Developers had planned to build a housing development on the land.
2.
The manager of an automobile assembly plant is considering whether to produce cars or sport utility vehicles (SUVs) next month. Assume that the quantities of labor and other materials required would be the same for either type of production.
3.
A young man who went to work as a nurses’ aide after graduating from high school leaves his job to go to college, where he will obtain training as a registered nurse.
The 500-acre area is scarce because it has alternative uses: preservation in its natural state or a site for homes. A choice must be made between these uses. The opportunity cost of preserving the land in its natural state is the forgone value of the land as a housing development. The opportunity cost of using the land as a housing development is the forgone value of preserving the land.
The scarce resources are the plant and the labor at the plant. The manager must choose between producing cars and producing SUVs. The opportunity cost of producing cars is the profit that could be earned from producing SUVs; the opportunity cost of producing SUVs is the profit that could be earned from producing cars.
The man can devote his time to his current career or to an education; his time is a scarce resource. He must choose between these alternatives. The opportunity cost of continuing as a nurses’ aide is the forgone benefit he expects from training as a registered nurse; the opportunity cost of going to college is the forgone income he could have earned working full-time as a nurses’ aide.
Economists study choices that scarcity requires us to make. This fact is not what distinguishes economics from other social sciences; all social scientists are interested in choices.
An anthropologist might study the choices of ancient peoples; a political scientist might study the choices of legislatures; a psychologist might study how people choose a mate; a sociologist might study the factors that have led to a rise in single-parent households. Economists study such questions as well. What is it about the study of choices by economists that makes economics different from these other social sciences?
Three features distinguish the economic approach to choice from the approaches taken in other social sciences:
The emphasis economists place on opportunity cost, the idea that people make choices that maximize the value of objectives that serve their self-interest, and a focus on the effects of small changes are ideas of great power. They constitute the core of economic thinking. The following three sections examine these ideas in greater detail.
Opportunity Costs Are Important
Summary
Individuals Maximize in Pursuing Self-Interest
Summary
Choices Are Made at the Margin
Summary
The elements of opportunity cost, maximization, and choices at the margin can be found in each of two broad areas of economic analysis: microeconomics and macroeconomics. Your economics course, for example, may be designated as a “micro” or as a “macro” course. We will look at these two areas of economic thought in the next section.
If doing one thing requires giving up another, then the expected benefits of the alternatives we face will affect the ones we choose. Economists argue that an understanding of opportunity cost is crucial to the examination of choices.
As the set of available alternatives changes, we expect that the choices individuals make will change. A rainy day could change the opportunity cost of reading a good book; we might expect more reading to get done in bad than in good weather. A high income can make it very costly to take a day off; we might expect highly paid individuals to work more hours than those who are not paid as well. If individuals are maximizing their level of satisfaction and firms are maximizing profits, then a change in the set of alternatives they face may affect their choices in a predictable way.
The emphasis on opportunity costs is an emphasis on the examination of alternatives. One benefit of the economic way of thinking is that it pushes us to think about the value of alternatives in each problem involving choice.
What motivates people as they make choices? Perhaps more than anything else, it is the economist’s answer to this question that distinguishes economics from other fields.
Economists assume that individuals make choices that they expect will create the maximum value of some objective, given the constraints they face. Furthermore, economists assume that people’s objectives will be those that serve their own self-interest.
Economists assume, for example, that the owners of business firms seek to maximize profit. Given the assumed goal of profit maximization, economists can predict how firms in an industry will respond to changes in the markets in which they operate. As labor costs in the United States rise, for example, economists are not surprised to see firms moving some of their manufacturing operations overseas.
Similarly, economists assume that maximizing behavior is at work when they examine the behavior of consumers. In studying consumers, economists assume that individual consumers make choices aimed at maximizing their level of satisfaction. In the next chapter, we will look at the results of the shift from skiing to snowboarding; that is a shift that reflects the pursuit of self-interest by consumers and by manufacturers.
In assuming that people pursue their self-interest, economists are not assuming people are selfish. People clearly gain satisfaction by helping others, as suggested by the large charitable contributions people make.
Pursuing one’s own self-interest means pursuing the things that give one satisfaction. It need not imply greed or selfishness.
Economists argue that most choices are made “at the margin.” The margin is the current level of an activity. Think of it as the edge from which a choice is to be made. A choice at the margin is a decision to do a little more or a little less of something.
Assessing choices at the margin can lead to extremely useful insights. Consider, for example, the problem of curtailing water consumption when the amount of water available falls short of the amount people now use. Economist s argue that one way to induce people to conserve water is to raise its price. A common response to this recommendation is that a higher price would have no effect on water consumption, because water is a necessity. Many people assert that prices do not affect water consumption because people “need” water.
But choices in water consumption, like virtually all choices, are made at the margin. Individuals do not make choices about whether they should or should not consume water. Rather, they decide whether to consume a little more or a little less water. Household water consumption in the United States totals about 105 gallons per person per day. Think of that starting point as the edge from which a choice at the margin in water consumption is made. Could a higher price cause you to use less water brushing your teeth, take shorter showers, or water your lawn less? Could a higher price cause people to reduce their use, say, to 104 gallons per person per day? To 103? When we examine the choice to consume water at the margin, the notion that a higher price would reduce consumption seems much more plausible. Prices affect our consumption of water because choices in water consumption, like other choices, are made at the margin.
ContentThe field of economics is typically divided into two broad realms: microeconomics and macroeconomics.
It is important to see the distinctions between these broad areas of study.
Microeconomics is the branch of economics that focuses on the choices made by individual decision-making units in the economy—typically consumers and firms—and the impacts those choices have on individual markets.
Macroeconomics is the branch of economics that focuses on the impact of choices on the total, or aggregate, level of economic activity.
Why do tickets to the best concerts cost so much? How does the threat of global warming affect real estate prices in coastal areas? Why do women end up doing most of the housework? Why do senior citizens get discounts on public transit systems? These questions are generally regarded as microeconomic because they focus on individual units or markets in the economy.
Is the total level of economic activity rising or falling? Is the rate of inflation increasing or decreasing? What is happening to the unemployment rate? These are questions that deal with aggregates, or totals, in the economy; they are problems of macroeconomics. The question about the level of economic activity, for example, refers to the total value of all goods and services produced in the economy. Inflation is a measure of the rate of change in the average price level for the entire economy; it is a macroeconomic problem. The total levels of employment and unemployment in the economy represent the aggregate of all labor markets; unemployment is also a topic of macroeconomics.
Both microeconomics and macroeconomics give attention to individual markets. But in microeconomics that attention is an end in itself; in macroeconomics it is aimed at explaining the movement of major economic aggregates—the level of total output, the level of employment, and the price level.
We have now examined the characteristics that define the economic way of thinking and the two branches of this way of thinking: microeconomics and macroeconomics. In the next section, we will have a look at what one can do with training in economics.
Economics is one way of looking at the world. Because the economic way of thinking has proven quite useful, training in economics can be put to work in a wide range of fields. One, of course, is in work as an economist. Undergraduate work in economics can be applied to other careers as well.
Careers in Economics
Economists work for government agencies, business firms and universities. Forecasting, analysis, and research are common activities that economists do.
Applying Economics to Other Fields
Summary
Economists work in three types of organizations. About 58% of economists work for government agencies. The remainder work for business firms or in colleges and universities.
Economists working for business firms and government agencies sometimes forecast economic activity to assist their employers in planning. They also apply economic analysis to the activities of the firms or agencies for which they work or consult. Economists employed at colleges and universities teach and conduct research.
Peruse the website of your college or university’s economics department. Chances are the department will discuss the wide variety of occupations that their economics majors enter. Unlike engineering and accounting majors, economics and other social science majors tend to be distributed over a broad range of occupations
Suppose that you are considering something other than a career in economics. Would choosing to study economics help you?
The evidence suggests it may. Suppose, for example, that you are considering law school. The study of law requires keen analytical skills; studying economics sharpens such skills. Economists have traditionally argued that undergraduate work in economics serves as excellent preparation for law school. Economist Michael Nieswiadomy of the University of North Texas collected data on Law School Admittance Test (LSAT) scores for undergraduate majors listed by 2,200 or more students taking the test in 2003.
Table 1.1 "LSAT Scores and Undergraduate Majors"
Major field |
LSAT average 2003-2004 |
2003-2004 Rank |
1994-1995 Rank |
1991-1992 Rank |
|
Economics |
156.6 |
1 |
1 |
1 |
|
Engineering |
155.4 |
2 |
4 |
2 |
|
History |
155.0 |
3 |
2 |
3 |
|
English |
154.3 |
4 |
3 |
4 |
|
Finance |
152.6 |
5 |
6 |
5 |
|
Political Science |
152.1 |
6 |
9 |
9 |
|
Psychology |
152.1 |
7 |
7 |
8 |
|
Accounting |
151.1 |
8 |
8 |
6 |
|
Communications |
150.5 |
9 |
10 |
10 |
|
Sociology |
150.2 |
10 |
12 |
13 |
|
Bus. Administration |
149.6 |
11 |
13 |
12 |
|
Criminal Justice |
144.7 |
12 |
14 |
14 |
ThisHere are the average LSAT scores and rankings for the 12 undergraduate majors with more than 2200 students taking the test to enter law school in the 2003–2004 academic year.
Source: Michael Nieswiadomy, “LSAT Scores of Economics Majors: 2003–2004 Class Update,” Journal of Economic Education, 37(2) (Spring 2006): 244–247 and Michael Nieswiadomy, “LSAT Scores of Economics Majors” Journal of Economic Education, 29(4) (Fall 1998): 377–379.
Did the strong performance by economics, engineering, and history majors mean that training in those fields sharpens analytical skills tested in the LSAT, or that students with good analytical skills are more likely to major in them? Both factors were probably at work. Economics clearly attracts students with good analytical skills—and studying economics helps develop those skills.
Economics majors shine in other areas as well. According to the Bureau of Labor Statistics Occupational Outlook Handbook, a strong background in economic theory, mathematics, and statistics provides the basis for competing for the best job opportunities, particularly research assistant positions, in a broad range of fields. Many graduates with bachelor’s degrees will find good jobs in industry and business as management or sales trainees or as administrative assistants. Because economists are concerned with understanding and interpreting financial matters, among other subjects, they will also be attracted to and qualified for jobs as financial managers, financial analysts, underwriters, actuaries, securities and financial services sales workers, credit analysts, loan and budget officers, and urban and regional planners.
Table 1.2 "Average Yearly Salary Offers, May 2006 and Occupational Outlook 2004–2014, Selected Majors/Occupations" shows average yearly salary offers for bachelor degree candidates for May 2006 and the outlook for related occupations to 2014.
Table 1.2 Average Yearly Salary Offers, May 2006 and Occupational Outlook 2004–2014, Selected Majors/Occupations
|
|
Average $ Offer May, 2006 |
Projected % Change in Total Employment in Occupation 2004-2014 |
|
Computer Engineering |
54,200 |
10.1 |
|
Electrical/Electronic Engineering |
54,053 |
11.8 |
|
Computer Science |
50,892 |
25.6 |
|
Accounting |
46,188 |
22.4 |
|
Economics and Finance |
45,058 |
12.4 |
|
Management Information Systems |
44,755 |
25.9 |
|
Logistics and Materials Management |
43,426 |
13.2 |
|
Business Administration |
40,976 |
17.0 |
|
Environmental Sciences (including forestry and conservation science) |
39,750 |
6.3 |
|
Other Business Majors (e.g., Marketing) |
37,446 |
20.8 |
|
Human Resources (ind. Labor Relations) |
36,256 |
15.9 |
|
Geology and Geological Sciences |
35,034 |
8.3 |
|
Sociology |
33,752 |
4.7 |
|
Political Science/Government |
33,151 |
7.3 |
|
Liberal Arts & Science (general studies) |
32,627 |
N/A |
|
Public Relations |
32,623 |
21.7 |
|
Special Education |
31,817 |
23.3 |
|
Elementary Education |
31,778 |
18.2 |
|
Foreign Languages |
31,364 |
N/A |
|
Letters (incl. English) |
31,204 |
20.4 |
|
Other Social Sciences (including Criminal Justice and History) |
30,788 |
12.3 |
|
Psychology |
30,308 |
9.9 |
|
Pre-elementary Education |
27,550 |
22.4 |
|
Social Work |
25,865 |
19.6 |
|
Visual and Performing Arts |
21,726 |
15.2 |
Sources: National Association of Colleges and Employers, Salary Survey, Spring 2006 http://naceweb.org ; Bureau of Labor Statistics, 2006–2007 edition of the Occupational Outlook Handbook; Occupational Employment, Training, and Earnings: Educational Level Report (May, 2006) URL: http://data.bls.gov/oep/noeted/empoptd.jsp (note: N/A = not reported; that is, no specific occupation was reported in BLS report; Other business majors, Other social sciences, Social work (including Sociology), and Environmental Sciences are weighted averages of various disciplines, calculated by authors.)
One’s choice of a major, or minor, is not likely to be based solely on considerations of potential earnings or the prospect of landing a spot in law school. You will also consider your interests and abilities in making a decision about whether to pursue further study in economics. And, of course, you will consider the expected benefits of alternative courses of study. What is your opportunity cost of pursuing study of economics? Does studying more economics serve your interests and will doing so maximize your satisfaction level? These considerations may be on your mind as you begin to study economics at the college level and obviously students will make many different choices. But, should you decide to pursue a major or minor in economics, you should know that a background in this field is likely to serve you well in a wide range of careers.