Chapter 1

Introducing the economic way of thinking

Sunil Kumar

School of Economics
 Key concepts

• Defining the economic problem

• Defining the three types of resources
• Understanding entrepreneurship
• What are macro and microeconomics?
• The purpose of modelling
• What is ceteris paribus?
• Defining positive and normative economics

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 The problem of scarcity
• Scarcity forces us all to make choices as we
never have the amount of goods and services
we want:
– individuals: more clothes, etc.
– governments: more security, etc.
• Economics aims to explain what occurs as a
result of scarcity because wants are forever
greater than the available resources.

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 The economic problem

• Scarcity is also called ‘the economic problem’

• Economists aim to show how individuals,
groups and society can achieve the most
wants given the resources at their disposal.

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 Resources

• Resources are the basic categories of inputs

used to produce goods and services.
• Resources are also called the factors of
production and are split into three main
categories:
– land
– labour
– capital.

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 Resources: land
• Any natural resource provided by nature used in
the process of production, for example forests,
minerals, wildlife, oil, rivers, lakes and oceans.
• May be renewable or non-renewable.

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 Resources: labour

• The mental and physical capacity of workers to

produce goods and services, for example:
– farmers
– nurses
– lawyers.

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 Entrepreneurship
• Entrepreneurship is a special type of labour:
– the creative ability of individuals to organize
and manage the combination of resources to
produce goods and services.

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 Resources: capital
• Capital relates to human-made goods that
produce goods and services.
• Capital does not directly satisfy wants but is used
to produce the goods and services desired, such
as a factory that produce televisions.
• Money is not included in the economic definition
of capital as it is simply a measure of value
placed on goods.

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 Economics: the study of scarcity and
choice

• Economics is the study of how society chooses to

allocate its scarce resources to the production of
goods and services in order to satisfy unlimited
wants.

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 Two branches of economics

• Microeconomics is the branch of economics that

studies decision-making by a single individual,
household, firm, industry or level of government.
• Macroeconomics is the branch of economics that
studies decision-making for the economy as a
whole.

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 The methodology of economics
• Economists (like other scientists) use scientific
method.
• Scientific method is a step-by-step procedure for
solving problems.
1 Identify the problem.
2 Develop a model.
3 Test the model.

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The steps in the model-building process

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 More about models
• A model is a simplified view of reality.
• It sets out the relationship between variables;
causes and effects.
• A model is valid when it enables economists to
forecast or predict the results of various changes
in variables.

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 Example: petrol consumption
• Identifying the problem
– Petrol consumption has fallen. Why?
• Developing a model
– Select variables − price of petrol, price of cars.
– Express them verbally, graphically or
mathematically.
• Testing the model
– Gather data which tells us how well the model
estimates or predicts relationships.

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 Hazards of the economic
way of thinking
• There are two potential problems to be aware of:
– the ceteris paribus assumption
– possible confusion of association and causation.

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 Ceteris paribus
• Ceteris (pronounced ‘keteris’) paribus is a Latin phrase which
means ‘other things remaining unchanged’.
• Economists use this method as it enables them to see how a
change in one variable affects the overall outcome.
• Imagine: if all the variables change at the same time, how
would we know which one caused the change?

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 Association vs. causation
• We cannot always assume that when one event follows another,
the first caused the second.
• For example, assume exports from Indonesia rose last month.
Two events might be associated:
– The hole in the ozone layer grew last month.
– Currency movements reduced the cost to Australians of
buying Indonesian goods.
• But are they both possible causes?

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 Why do economists disagree?
• Economists agree on many things.
• As in other professions, disagreements occur.
• One explanation for disagreements is the difference between
positive and normative economics. There could be many
explanations.

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 Positive Economics
• Positive economics is an analysis limited to statements that are
verifiable.
• Positive statements are testable − they can be proven true or
false.
• Examples
– ‘Airbags save lives.’
– ‘Smoking is harmful to your health.’

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 Normative Economics

• Normative economics is an analysis based on value judgements.

• Normative statements cannot be proven by facts to be true or
false.
• They express opinions – good, bad, ought to, should.
• Examples:
– ‘Every teenager who wants a job should have one.’
– ‘The government should allocate more money to education.’

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Appendix to Chapter 1

Applying graphs to Economics

 Key concepts
• Why use graphs in economics?
• What is a direct relationship?
• What is an inverse relationship?
• What is an independent relationship between two variables?
• How do we measure the slope of a line?
• How do graphs show three-variable relationships?

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 Graphs in Economics
• Graphs are one of the simplest ways to present, aid and help us to
understand relationships and to ‘see’ economic concepts at work.
• Graphs help economists to understand the relationships that exist
between variables.
• You should learn to draw, describe and interpret them.

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 A Direct Relationship

• A direct relationship is a positive association between two

variables.
• When one variable increases, the other also increases.
• When one variable decreases, the other also decreases.
• Note the line on the next slide has a positive slope.

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A Direct Relationship

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 An Inverse Relationship
• An inverse relationship is a negative association between two
variables.
• When one variable increases, the other decreases.
• When one variable decreases, the other increases.
• Note the line on the next slide has a negative slope.

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An Inverse Relationship

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 An Independent Relationship
• An independent relationship is a zero association between
two variables.
• When one variable changes, the other remains unchanged.

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An Independent or No Relationship

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 The slope of a straight line
• The ratio of change in the variable on the vertical axis (the rise or
fall) to change in the variable on the horizontal axis (the run).
• Slope = rise/run
= ∆vertical axis/∆horizontal axis
= ∆Y/∆X

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 The slope of a curve

• A ‘straight-line’ relationship is a linear relationship.

• The slope of a curve changes from one point on the curve to
another.
• To determine the slope of a curve at any point, draw a tangent to
the line at that point, and measure the slope of the tangent.

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The slope of a curve

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 Introducing a third variable
• How can a model drawn in two dimensions show the impact
of changes in a third variable?
• We must distinguish between movements and shifts.
– Movements along a graph show changes in one of the
variables on the graph’s axes.
– Shifts show changes in other variables.

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A 3-variable Relationship

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