Chapter 1

The Principles
and Practice of
Economics
1 The Principles and Practice of Economics

Chapter Outline
1.1 The Scope of Economics
1.2 Three Principles of Economics
1.3 The First Principle of Economics: Optimization
1.4 The Second Principle of Economics: Equilibrium
1.5 The Third Principle of Economics: Empiricism
1.6 Is Economics Good for You?
1 The Principles and Practice of Economics

Key Ideas
1. Economics is the study of people’s choices.
2. The first principle of economics is that people try to optimize;
they try to choose the best available option.
3. The second principle of economics is that economic systems tend
to be in equilibrium, a situation in which nobody would benefit by
changing his or her own behavior.
1 The Principles and Practice of Economics

Key Ideas
4. The third principle of economics is empiricism—analysis that
uses data. Economists use data to test theories and to determine
what is causing things to happen in the real world.
1.1 The Scope of Economics

• The main element common to every economic

issue/case is “choice” (not money!).

• Economists usually treat every human

behavior/action as the result of a choice that is
freely made by the relevant economic agent(s).

• And our choices are the product of the interaction

between our preferences and the set of
alternatives among which we can choose from.
1.1 The Scope of Economics

Economic Agent =
Any group or
individual that makes
choices, such as
consumers, firms,
parents, politicians,
etc.
1.1 The Scope of Economics

• What does it mean if something is “scarce”?

• Recall that previously we said our choices are affected from the set of
alternatives that we can choose from.
• The concept of “scarcity” means that, in most of the cases once we
make a select a specific alternative, we have to give up some others as
well.
• “Scarcity” exists because people have unlimited wants in a world of
limited resources. Therefore, we cannot always satisfy all of our wants
at the same time and we need to identify the want/need with the
highest priority.
1.1 The Scope of Economics

Economics studies how agents make choices

among scarce resources and how those choices
affect society.
1.1 The Scope of Economics

• Positive Economics: describes what has happened

in the past or predicts what will happen in the future
• “XYZ economy has grown by 5% last quarter” –
this is a positive economic statement.
• Positive statements can be confirmed or tested with
data. Since the results of those tests cannot be
interpreted differently by various people, positive
statements tend to be objective.
1.1 The Scope of Economics

• Normative Economics: depends on subjective statements as

it is mostly about what people should do – which varies from
people to people.
• “XYZ economy must provide free health care” – this is a
normative economic statement, because the results of such
kind of a policy affect different parts of the population
differently.
• Free health care is mostly demanded by poor
households/individuals (as free health care improves their
quality of life), and objected/opposed by rich individuals (as
free health care means higher taxes to be paid by the rich) in
most societies.
1.1 The Scope of Economics

Microeconomics
The study of individuals,
firms, government

Macroeconomics
The study of the whole
economy
1.1 The Scope of Economics

Microeconomics
Focuses on a small piece
of the overall economy

Macroeconomics
Focuses on economy-
wide phenomena
1.2 Three Principles of Economics

Three Principles of Economics:

1. Optimization = making the best choice possible

with given information

2. Equilibrium = when everyone is optimizing; no

one would be better off with a different choice

3. Empiricism = using data to figure out answers to

interesting questions
1.3 The First Principle of Economics: Optimization
Cost-Benefit Analysis

Costs Benefits

© 2015 Pearson Education, Ltd.

1.3 The First Principle of Economics: Optimization
Cost-Benefit Analysis
• 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 ahs 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.
1.3 The First Principle of Economics: Optimization
Cost-Benefit Analysis
• Optimization: People decide what to do by consciously or
unconsciously weighing all of the known advantages and
disadvantages of the different available options and try to pick
the best feasible option.
• Feasibility: In order for an option to be feasible for an
economic agent, the agent must have enough budget to be able
to afford that option. In addition to this, a feasible option must
also be physically possible – for example you may want to
study for an additional hour in order to earn a higher grade
from this course, but what if you are already studying for 24
hours a day? Studying 25 hours a day is physically impossible!
1.3 The First Principle of Economics: Optimization
Cost-Benefit Analysis
• The ability of an economic agent to optimize is also limited with
the information that she/he has regarding the choice she/he
faces. Any decision can depend only on the information
available at the time of the choice.
• If you are hit by a drunk driver when you drive from Los
Angeles to San Diego, this does not mean that you failed to
optimize and you are an irrational person.
• However, if you let a drunk friend of yours to drive you from
Los Angeles to San Diego, even if you do not get in a car
accident because of this choice, you make a suboptimal choice
as letting your drunk friend to drive you in not the best choice
available to you.
1.3 The First Principle of Economics: Optimization
Cost-Benefit Analysis
• Previously we said that economics is about the
optimal management of scarce resources.
• If resources are scarce, then we face trade-offs:
Choosing an option also means giving up another
one.
• The budget constraint: the set of things that a person
can choose to do (or buy) without breaking her
budget.
1.3 The First Principle of Economics: Optimization
Cost-Benefit Analysis
• Suppose that in each day you have 5 free hours from your
main job. Furthermore, assume that you have a computer and
internet connection so that you can browse the Web during
your free time. You can also work in a secondary part-time job
and earn extra income.
• How can you allocate your 5 hours of free time between the
two alternatives? What is your budget constraint?
• 5 Hours=Hours surfing the Web + Hours working part-time
• So, according to the equation above, if you increase the hours
you spend surfing the Web, you have to reduce the hours you
spend working at the part-time job – you face a trade-off!
1.3 The First Principle of Economics: Optimization
Cost-Benefit Analysis
• In order to quantify the extent of the trade-offs that we face,
we use a concept called as the opportunity cost.
• The opportunity cost of selecting a specific feasible option is
the second best option that is given up because of this choice.
• Suppose that you have a budget of 1000 dollars for your
annual vacation. Assume that you have three candidate
destinations: A, B, and C each costing 1000 dollars
individually.
• Can you go to all three destinations for your vacation given
your budget of 1000 dollars? No! Therefore, you have to
choose one option out of the three feasible alternatives.
1.3 The First Principle of Economics: Optimization
Cost-Benefit Analysis
• Suppose that out of the three options A is the best, B is in the
middle and C is the worst according to your preferences.
• In this case, which alternative would you choose? Given your
preferences and your budget set, the rational choice would be
A.
• However, by choosing A, you also chose not going to
destinations B and C – specifically we say that you freely gave
up the opportunity to go to either one of those destinations.
• As you like B more than C, the opportunity cost of going to A
is giving up the destination B (in other words, C is an
irrelevant alternative here).
1.3 The First Principle of Economics: Optimization
Cost-Benefit Analysis
• A more subtle example
• Suppose you are on spring break and you are flying from Boston
to Miami for your vacation. Now, while the destination is set, the
means of transportation is the thing that you have to think of
• Plane ticket to Miami costs $300, and the trip to airport plus the
flight lasts for 10 hours.
• Or you can drive to Miami. The car rental and gas cost $200 in
total. However, the car trip to Miami lasts for 50 hours.
• Now let’s assign a monetary value to the opportunity cost of our
time: the value of each hour is $10 (you earn $10 per hour in
your job).
• Which one is the optimal means of transportation in this case?
1.3 The First Principle of Economics: Optimization
Cost-Benefit Analysis

• If you choose driving, you save $100 – as the plane ticket

costs $300 while the car trip only costs $200. So the
difference $300-$200=$100 is the money that you save by
choosing the car trip.
• However there is a catch! While you initially save $100, you
also have to spend a much higher amount of time during
transportation when you choose to drive to Miami, and this
is itself costly since you have to leave your work 40 hours
earlier compared to the plane flight – and each extra hour
not spent in work also corresponds to income lost! So, car
also results in 40x$10=$400 of extra income loss.
• Therefore, what is the net benefit of choosing the car ? Save
$100 but also lose $400. Therefore, the net benefit is $100-
$400=-$300. CHOOSE THE PLANE.
1.3 The Principles and Practice of Economics

Evidenced-Based Economics Example:

What is the cost of using Facebook?
1.4 The Second Principle of Economics: Equilibrium

Equilibrium
A situation when no one benefits by changing
his/her behavior
1.4 The Second Principle of Economics: Equilibrium

What Does Equilibrium Really Mean?

1.4 The Second Principle of Economics: Equilibrium

The Free Rider Problem

Exists when an individual or group
is able to enjoy the benefits of a situation
without incurring the costs
1.4 The Second Principle of Economics: Equilibrium

Which one is
experiencing
equilibrium?
1.4 The Second Principle of Economics: Equilibrium

Is there an incentive
for him to change his
behavior?
1.4 The Second Principle of Economics: Equilibrium

Is this an equilibrium?
1.5 The Third Principle of Economics: Empiricism

Crowded beaches
and hot temperatures
go together.

So if we want to make it cooler, keep

people from going to the beach!
1.6 Is Economics Good for You?

What are the costs and benefits of this course?

1.6 Is Economics Good for You?

Costs

• Tuition
• Other courses
• Sleep?
• Stress?
1.6 Is Economics Good for You?