Chapter1: Principles and Practice of Economics

1.1 Scope of economics

- An economic agent is an individual or a group that makes choices. For example, a
consumer chooses to eat bacon cheeseburgers or tofu burgers.
- Scarce resources are things that people want, where the quantity that people want (if
the resources were being given away for free) exceeds the quantity that is available.
- Scarcity exists because people have unlimited wants in a world of limited resources.
- Economics is the study of how agents choose to allocate scarce resources and how
those choices affect society.
- Positive economics: Describes what people actually do
- Normative economics: Recommends what people, including society, ought to do
- Microeconomics: study of how individuals, households, firms, and governments make
choices, and how those choices affect prices, the allocation of resources, and the well-
being of other agents.
- Macroeconomics is the study of the economy as a whole like the growth rate of a
country’s total economic output, the percentage increase in overall prices (the inflation
rate), or the fraction of the labor force that is looking for work but cannot find a job (the
unemployment rate)

1.2 Principle of economics

1. Optimization: Economists believe that people’s goal of optimization—picking the best feasible
option—explains most choices that people make, including minor decisions like
accepting an invitation to see a movie and major decisions like deciding whom to marry

Trade offs: All optimization problems involve trade-offs. Trade-offs arise when some benefits
must be given up in order to gain others. Think about Facebook. If you spend an hour on
Facebook, then you cannot spend that hour doing other things. For example, you cannot work
at most part-time jobs at the same time you are editing your Facebook profile

Budget constraint: Economists use budget constraints to describe trade-offs. A budget

constraint is the set of things that a person can choose to do (or buy) without breaking her
budget (eg. you have 5 hours of free time a day (your budget), if u spend 2 hour surfing the
web, you will only be able to work 3 hours)

Opportunity cost: the best alternative use of a resource

Assigning a monetary value to an opportunity cost: Economists often try to put

a monetary value on opportunity cost. One way to estimate the monetary value of an hour
of your time is to analyze the consequences of taking a part-time job or working additional
hours at the part-time job you already have

Cost benefit analysis: a calculation that identifies the best option by summing
benefits and subtracting costs, with both benefits and costs denominated in a common unit
of measurement, like dollars. Cost-benefit analysis is used to identify the alternative that
has the greatest net benefit, which is the sum of the benefits of choosing an alternative
minus the sum of the costs of choosing that alternative.

For eg, suppose that you and a friend are going to Miami Beach
from Boston for spring break. The only question is whether you should drive or fly. From a
benefit perspective, driving saves you $100—the difference between driving expenses of $200
and a plane ticket of $300. s. But out-of-pocket costs aren’t the only thing to consider. Driving
also costs you an extra 40 hours of time—the difference between 50 hours of round-trip
driving time and about 10 hours of round-trip airport/flying time. Spending 40 extra hours
traveling is a cost of driving, even if it isn’t a direct out-of-pocket cost

$100 (benefit because reduction in out of pocket costs) - (extra 40 hours travelling) x ($10/h) = -
$300

2. Equilibrium: The second principle of economics holds that economic systems tend
to be in equilibrium, a situation in which no agent would benefit personally by changing
his or her own behavior, given the choices of others. The economic system is in equilibrium
when each agent cannot do any better by picking another course of action. In other words,
equilibrium is a situation in which everyone is simultaneously optimizing.

Here’s an example. Suppose the market price of gasoline is $2 per gallon and the
The gasoline market is in equilibrium. Three conditions will need to be satisfied:
1. The amount of gasoline produced by gasoline sellers—oil companies—will equal
the amount of gasoline purchased by buyers.
2. Oil companies will only operate wells where they can extract oil and produce gasoline at a
cost that is less than the market price of gasoline: $2 per gallon.
3. The buyers of gasoline will only use it for activities that are worth at least $2 per
gallon—like driving to their best friend’s wedding—and they won’t use it for activities that are
worth less than $2 per gallon.
In equilibrium, both the sellers and the buyers of gasoline are optimizing, given the market price
of gasoline. Nobody would benefit by changing his or her own behavior.

3. Empiricism: The third principle of economics is an emphasis on empiricism—

evidence-based analysis. In other words, analysis that uses data. Economists use data to
develop theories, to test theories, to evaluate the success of different government policies,
and to determine what is causing things to happen in the world
 Chapter2 Economics methods and economic questions

Empiricism—using data to analyze the world—is at the heart of all scientific analysis.
The scientific method is the name for the ongoing process that economists, other social
scientists, and natural scientists use to:
1. Develop models of the world
2. Evaluate those models by testing them with data

Models and Data

2.1 The scientific method
Scientific models are used to make predictions that can be checked with empirical
evidence—in other words, facts that are obtained through observation and measurement.
When conducting empirical analyses, economists refer to a model’s predictions as
hypotheses. Whenever such hypotheses are contradicted by the available data, economists
return to the drawing board and try to come up with a better model that yields new hypotheses.
- A model is only an approximation and a model is not exactly correct
- A model makes prediction that can be tested with data

Mean: the sum of all the different values divided by the number of values and is a commonly
used technique for summarizing data
Median: the median value is calculated by ordering the numbers from least to greatest and then
finding the value halfway through the list

2.2 Causation and Correlation

Causation: occurs when one thing directly affects another.
Variable: a changing factor or characteristic.
Correlation: Correlation means that two variables tend to change at the same time—as one
variable changes, the other changes as well
Positive correlation: implies that two variables tend to move
in the same direction—for example, surveys reveal that people who have a relatively high
income are more likely to be married than people who have a relatively low income. I
Negative correlation: implies that the two variables tend to move in opposite directions
Zero correlation: When the variables

When Correlation Does Not Imply Causality - There are two main reasons we
should not jump to the conclusion that a correlation between two variables implies a
particular causal relationship:
1. Omitted variables
An omitted variable is something that has been left out of a study that, if included,
would explain why two variables are correlated.
Recall that the amount of red content in the store’s ads is positively correlated with the growth
rate of their sales. However, the red color does not necessarily cause the store’s sales to rise.
The arrival of the Christmas season causes both the store’s ads to be red and month-over-
month sales revenue to rise. Thus, the Christmas season is an omitted variable that explains
why red ads tend to occur at around
the time that sales tend to rise.

2. Reverse causality
Reverse causality occurs when we mix up the direction of cause and effect.
For example, consider the fact that relatively wealthy people tend to be relatively healthy, too.
This has led some social scientists to conclude that greater wealth causes better health—
because, for instance, wealthy people can afford better healthcare. However, this could be a
case of reverse causality: better health may cause greater wealth. For example, healthy people
can work harder and have fewer healthcare expenditures than less healthy people. It turns out
that both causal channels seem to exist: greater wealth causes better health and better health
causes greater wealth
One method of determining cause and effect is to run an experiment—a controlled method
of investigating causal relationships among variables.
To run an experiment, researchers usually create a treatment (test) group and a control group.
Participants are assigned randomly to participate either as a member of the
treatment group or as a member of the control group, which is not treated in a special
way.
Randomization is the assignment of subjects by chance, rather than by choice, to
a treatment group or to a control group. The treatment group and the control group are
treated identically, except along a single dimension that is intentionally varied across the
two groups. Ultimately, the purpose of the experiment is to determine the impact of this
variation

2.3 Economic Questions and Answers

Economists like to think about our research as a process in which we pose and answer
questions. Good questions come in many different forms. But the most exciting economic
questions share two properties.
1. Good economic questions address topics that are important to individual economic agents
and/or to our society.
2. Good economic questions can be answered
 Chapter 3: Optimization: Doing the Best You Can
- Economists use optimization to predict most of the choices that people, households,
businesses, and governments make

- Economists call the best feasible choice the optimum, which you can see labeled on the
total cost curve. To sum up our discussion so far, optimization using total value has
three steps:
1. Translate all costs and benefits into common units, like dollars per month.
2. Calculate the total net benefit of each alternative.
3. Pick the alternative with the highest net benefit

- A cost-benefit calculation that focuses on the difference between one feasible alternative
and the next feasible alternative is called marginal analysis. Marginal analysis compares
the consequences—costs and benefits—of doing one step more of something.

- In general, marginal cost is the extra cost generated by moving from one feasible
alternative to the next feasible alternative

- Principle of Optimization at the Margin, which states that an optimal feasible alternative
has the property that moving to it makes you better off and moving away from it makes
you worse off.

- To sum up, marginal analysis has three steps:

1. Translate all costs and benefits into common units, like dollars per month.
2. Calculate the marginal consequences of moving between alternatives.
3. Apply the Principle of Optimization at the Margin by choosing the best alternative with
the property that moving to it makes you better off and moving away from it makes you
worse off.
Marginal analysis—in other words, the three steps outlined above—can be used to solve
any optimization problem