CHAPTER 1

THE NATURE AND METHOD

OF ECONOMICS

Learning Objectives
Is the study of economics of consequence
or importance?
What is the methodology of economics? In other
words, how should we study economics? What
are the proper methods by which the study of
economics is best achieved?
What specific problems, limitations and pitfalls
can we encounter in studying economics?
What characterises or identifies an economic
perspective?

The Roles of Economics

Economics is concerned with the efficient use
of limited productive resources for the purpose
of attaining the maximum satisfaction of our
material wants.
Why study economics? John Maynard Keynes
offered this response:
The ideas of economists and political philosophers, both when they
are right and when they are wrong, are more powerful than is
commonly understood. Indeed the world is ruled by little else.
Practical men, who believe themselves to be quite exempt from any
intellectual influences, are usually the slaves of some defunct
economist.
Keynes, 1936

The Age of The Economists

Adam Smith
David Ricardo
John Stuart Mill
Karl Marx
Jon Maynard Keynes
Plus many modern contributors

The Roles of Economics

Economics for citizenship
To create well-informed members of society

Economics in business
To provide business with strategic information
and interpretations

Personal applications
To assist individuals, as workers and income
receivers,
to gain and retain economic security

Definition of Economics
The social science concerned with the efficient
use of limited or scarce resources to achieve
maximum satisfaction of human materials
wants.
Human wants are unlimited, but the means to
satisfy the wants are limited.

The Economic Perspective

Scarcity and choice
Resources are limited and this necessitates choices.
Resources can only be used for one purpose at a
time.
Scarcity requires that choices be made. we have to
decide (make a choice) what we will have and
what we will forgo.
The cost of any good, service, or activity is the value
of what must be given up to obtain it (opportunity
cost).

The Economic Perspective (cont.)

Rational behaviour
Behaviour that involves decisions and actions in
order to achieve the greatest satisfaction or
maximum fulfilment of goals.
We make different decisions under different
circumstances.
Our decisions may change as costs and benefits
change
Rational self-interest is not the same as selfishness.

The Economic Perspective (cont.)

Marginalism: benefits and costs
Marginal means extra or additional or the change
in.
Most decisions concern a change in current
conditions; therefore the economic perspective is
largely focused on marginal analysis.
Each option considered weighs the marginal
benefit against the marginal cost.

The Economic Perspective (cont.)

Marginalism: benefits and costs
Whether the decision is personal or one made by
business or government, the principle is the same:
The marginal cost of an action should not
exceed its marginal benefits.
Conflicts between long and short-run objectives may
result in decisions that appear to be irrational, where
in fact they are not.

Why Study Economics?:

Economics helps people to make sense of every day
activity they observe around them.
The study of economics helps to develop an
individuals analytical skills and allows students to
better predict the logical consequences of their
actions.
Economic principles enable business managers to
make more intelligent decisions.

 Economics can help individuals make better

buying decisions, better employment choices, and
better financial investments.
Economics is mainly an academic, not a
vocational subject. Its primary objective is to
examine problems and decisions from social
rather than personal point of view.

Economic Methodology
Economists use the scientific method to establish
theories, laws, and principles.
The scientific method consists of:

The observation of facts (real data)

The formulations of explanations of cause and
effect relationships (hypotheses) based upon the
facts.
The testing of the hypotheses.
The acceptance, rejection, or modification of the
hypotheses.
The determination of a theory, law, principle, or
model.

 Theoretical economics: The systematic arranging of

facts, interpretation of the facts, making
generalizations.
Principles: used to explain and/or predict the behavior
of individuals and institutions.
Terminology: principles, laws, theories, and models
are all terms that refer to generalizations about
economic behavior
Generalization: Economic principles are expressed as
the tendencies of the typical or average
consumer, worker, or business firm.

 Other things equal: or ceteris paribus

assumption: In order to judge the effect one variable
has upon another it is necessary to hold other
contributing factors constant. Natural scientists can
test with much greater precision than can economists.
They have the advantage of controlled laboratory
experiment. Economists must test their theories using
the real world as their laboratory.
Abstractions: Economic principles, theories or
models are abstractions, simplifications, which
attempt to find the important connections and
relationships of economic behavior.

 Induction
A method of reasoning that proceeds from facts
to generalisations

Deduction
Reasoning from assumptions to conclusions by
testing a hypothesis

Microeconomics and Macroeconomics

Macroeconomics examines the economy as a
whole.
It includes measures of total output, total
employment, total income, aggregate
expenditures, and the general price level.
Microeconomics looks at specific economic
units.
It is concerned with the individual industry, firm
or household and the price of specific products
and resources.

Policy Economics: Positive and Normative

Positive economics deals with facts (and theories about these facts)
and avoids value judgments. Attempts to set out scientific
statements about economic behaviour.
Normative economics are based upon someones value judgments
about what the economy should be like or what particular policy
action should be recommended, based on a given economic
generalisation or relationship. It embodies subjective feeling about
what ought to be

Normative economic statements come into play

at the level of policy economics

Economic Goals
1. Economic growth
2. Full employment
3. Economic efficiency
4. Price-level stability
5. Economic freedom
6. An equitable distribution of income
7. Economic security
8. External balance

Economic goals (cont.)

Interpretation
The basic economic goals inevitably entail problems
of interpretation what are sizeable, high degree
and equitable?

Complementary goals
Some of the goals are complementary

Conflicting goals
Many goals are conflicting or mutually exclusive,
and involve trade-offs

Priorities
When goals conflict, society has to prioritise

Formulating Economic Policy

Three basic steps in policy formulation:
1. Stating goals
Define the goals clearly

2. Policy options
State and recognise the possible effects of
alternative policies designed to achieve the goal

3. Evaluation
Review the policies and evaluate their
effectiveness

Pitfalls To Objective Thinking

Bias
Loaded terminology
Definitions
Fallacy of composition
What is true for the individual or part is not
necessarily true for the group or whole

Cause and effect

Post-hoc fallacy
Correlation versus causation

Economic quackery

Graphs and Their Meaning

Appendix to Chapter 1

Constructing a graph
Two-dimensional graph
Horizontal axis representing independent
variable
Vertical axis representing dependent variable
Intersection (0) is origin

Direct and indirect relationships

Graphing relationships between variables
Direct relationship
where the values of two related variable change
in the same direction e.g. consumption and
income
Inverse relationship
where the values of two related variables move in
opposite directions e.g. ticket prices and
attendance

Direct relationship
$500
As Y increases, C increases

Consumption (C)

$400

C = 50 + 0.5Y
$300

d
$200
$100

Consumption

c
b
a

$100

$200

$300

$400

Income (Y)

Inverse relationship
Ticket Price (P)

$25
$20
$15
$10

As P increases, Q decreases

P = 25 1.25Q
c
d

Ticket demand

$5

4
8
12
16
Attendance in thousands (Q)

20

Dependent and independent variables

Dependent variable
The variable which changes as a consequence
of a change in some other (independent) variable

Independent variable
The variable which causes a change in some
other (dependent) variable

Other variables held constant

When economists plot the relationship between
any two variables, they assume that other things
being equal; that is, all other factors that might
affect consumption, are presumed to be constant
or unchanged

Slope of a straight line

The ratio of the vertical change (the rise or fall)
to the corresponding horizontal change involved
in moving between two points

Positive slope
Consumption (C)

$500

vertical change
50
Slope

0.5
horizontal change 100

$400

C = 50 + 0.5Y
$300

d
$200

c
vertical change = +50

b
$100

Consumption

a
horizontal change = +100

$100

$200

$300
$400
Income (Y)

Negative slope
Ticket price (P)

$25
$20

vertical change
5
Slope

1.25
b horizontal change 4
P = 25 1.25Q
c

5
$15
$10

+4
d
e Ticket demand

$5

f
4
8
12
16
Attendance in thousands (Q)

20

Slope of a line
Three addenda:
Measurement units

The slope of a line is affected by the choice of units

for either variable

Marginal analysis

The slope of a line measures marginal changes

Infinite and zero slopes

Variables that are unrelated or independent of one another

will be represented by a line parallel to the vertical or
horizontal axis, and will have a slope of
infinity or zero, respectively

Slope of a line (cont.)

Intercept
The vertical intercept is the point at which the
line
meets the vertical axis

Equation form
Linear equation
y = a + bx
where: y = the dependent variable
a = the vertical intercept
b = the slope of the line
x = the independent variable

Y
Tangent
a

a
A

X
Slope of a non-linear relationship or curve

Y
40
30
b

20
10
0

10

20

Slope of a curve (cont.)

30

40