Introduction to Economics
This is an introductory course in economics. As with most introductory courses there are certain foundations that must be laid before the structure of the discipline may be meaningfully examined. This chapter and the following two chapters will lay those foundations -- the rudimentary definitions, and basic concepts upon which the following ideas will be built are discussed. Further, there is a general discussion of the methods used by economists in their analyses.
Specifically, this chapter will focus on specific definitions, policy, and objective
thinking. A discussion of the role of assumptions in model building will also be offered as a basis for understanding the economic models that will be built in the following chapters.
Definitions
Economics is a social science. In other words, it is a systematic examination of
human behavior, based on the scientific method, and reliant upon rigorous analysis of that behavior. Economics is the mother discipline from which most of the business
disciplines arose. Most people have a vague idea of what the word economics means, but precise definitions generally require some academic exposure to the subject.
Economics is the study of the ALLOCATION of SCARCE resources to meet UNLIMITED human wants. In other words, economics is the study of human behavior as it pertains to material well-being. The key words in this definition are in all capital letters. Because there are a finite number of resources available, the fact that human want exceed that (are unlimited) then the resources are scare relative to the want for them. Because there are fewer resources than wants there must be allocation mechanism of some sort – markets, government, law of the jungle, etc.
Robert Heilbroner describes economics as the "Worldly Philosophy." A "Worldly
Philosophy" is concerned with matters of how our material or worldly well-being is best served. In fact, economics is the organized examination of how, why and for what purposes people conduct their day-to-day activities, particularly as it relates to the accumulation of wealth, earning an income, spending their resources, and other matters concerning material well-being. This worldly philosophy has been used to explain most
rational human behavior. (Irrational behavior being the domain of specialties in
sociology, psychology, history, and anthropology.) Underlying all of economics is the base assumption that people act in their own perceived best interest (at least most of the time and in the aggregate). Without the assumption of rational behavior, economics would be incapable of explaining the preponderance of observed economic activity. As limiting as this assumption may seem, it appears to be an accurate description of reality.
In 1776 Adam Smith penned An Inquiry into the Nature and Causes of the Wealth of Nations. With its publication, capitalism was born, from the ashes of the
mercantilist system that preceded it. Smith described an economic system of cottage
industries and relatively unfettered pursuit of self-interest, and how that unfettered
pursuit of self-interest could result in a system that distributed its limited resources in an efficient fashion.
Experimental economics, using rats in mazes, suggests that rats will act in their
own best interest (incidentally, Kahneman won a Noble Prize for this sort of research – it is serious business, not just fun and games like it sounds). Rats, it was discovered, prefer root beer to water. The result is that rats will pay a greater price (longer mazes and electric shocks) to obtain root beer than they will to obtain water. Therefore it appears to be a reasonable assumption that humans are no less rational – as Adam Smith postulates in his view of how we might best obtain our dinner.
Most academic disciplines have evolved over the years to become collections of closely associated scholarly endeavors of a specialized nature. Economics is no
exception. An examination of one of the scholarly journals published by the American
Economics Association, The Journal of Economic Literature, reveals a classification
scheme for the professional literature in economics. Several dozen specialties are
identified in that classification scheme, everything from national income accounting, to
labor economics, to international economics. In other words, the realm of economics
has expanded over the centuries that it is nearly impossible for anyone to be an expert
in all aspects of the discipline, so each economist generally specializes in some narrow
portion of the discipline. The decline of the generalist is a function of the explosion of
knowledge in most disciplines.
In general, economics is bifurcated by the focus of the analysis – that is, there
are two bundles of issues that are examined by economists. These bundles of issues are considered together, by the level of the activity upon which the analysis is focused.
Economics is generally classified into two general categories of inquiry, these two
categories are:
(1) microeconomics and (2) macroeconomics.
Microeconomics is concerned with decision-making by individual economic agents such as firms and consumers. In other words, microeconomics is concerned with the behavior of individuals or groups organized into firms, industries, unions, and other identifiable agents. The focus of microeconomics is on decision-
making, and hence markets.
Microeconomics is the subject matter of this course
Macroeconomics is concerned with the aggregate performance of the
entire economic system. That is, the performance of the U.S. economy or, in a more modern sense, the global economy. The issues of unemployment, inflation, economic development and growth, the balance of trade, and business cycles are the topics that occupy most of the attention of students of macroeconomics. These matters are the topics to be examined the course that follows this one Methods in Economics
Economists seek to understand the behavior of people and economic systems
using scientific methods. These scientific endeavors can be classified into two
categories of activities, these are:
(1) economic theory and (2) empirical economics.
Theoretical and empirical economics are very much related activities, even though
distinguished here for simplicity of presentation.
Economic theory relies upon principles to analyze behavior of economic agents. These theories are typically rigorous, mathematical representations of human
behavior with respect to the production or distribution of goods and services in microeconomics – and the aggregate economy in macroeconomics. A good theory is one that accurately predicts future human behavior and can be supported with evidence.
Economic theory tends to be a very abstract area of the discipline. Mathematical modeling was introduced into the discipline early in the eighteenth century by such scholars as Mill and Ricardo. In the middle of the twentieth century, an economist, Paul Samuelson, from M.I.T., published his book, Mathematical Foundations of Economic
Analysis, and from the that point forward, economic theory was to become heavily
mathematical – gone were the days of the institutionalists from the mainstream of
economic theory. (Incidentally Paul Samuelson won the Nobel Prize for Foundations,and he is a Hoosier, Stiglitz is also from Indiana, and both are from Gary, Indiana).
The above table presents a list of those who have won Nobel Prizes in Economic
Science. Notice that the overwhelming majority of these persons are Americans – two of whom are from Indiana, and several are from the University of Chicago. It is also interesting to note that one must be living to receive the Nobel Prize; so many famous economists who met their end before receiving the prize will not be listed. Further, it is also interesting to note that the Nobel Prize in Economic Sciences is the newest of the prizes, beginning with Tinbergen’s award in 1969.
Empirical economics relies upon facts to present a description of
economic activity. Empirical economics is used to test and refine theoretical
economics, based on tests of economic theory. The area referred to as econometrics is the arena in economics in which empirical tests of economic theory occurs. The area is founded in mathematical statistics and is critical to our ability to test the veracity of economic theories.
Theory concerning human behavior is generally constructed using one of two
forms of logic – inductive logic or deductive logic. Most of the social studies, i.e.,
sociology, psychology and anthropology typically rely on inductive logic to create theory. Inductive logic creates principles from observation. In other words, the
scientist will observe evidence and attempt to create a principle or a theory based on
any consistencies that may be observed in the evidence.
Economics relies primarily on deductive logic to create theory. Deductive logic
involves formulating and testing hypotheses. In other words, the theory is created, and then data is applied in a statistical test to see if the theory can be rejected.
Often the theory that will be tested comes form inductive logic or sometimes
informed guess-work. The development of rigorous models expressed as equations
typically lend themselves to rigorous statistical methods to determine whether the models are consistent with evidence from reality. The tests of hypotheses can only serve to reject or fail to reject a hypothesis. Therefore, empirical methods are focused on rejecting hypotheses and those that fail to be rejected over large numbers of tests generally attain the status of principle.
However, examples of both types of logic can be found in each of the social
sciences and in most of the business disciplines. In each of the social sciences it is common to find that the basic theory is developed using inductive logic. With increasing regularity standard statistical methods are being employed across all of the social sciences and business disciplines to test the validity and the predictability of theories
developed using these logical constructs.
The usefulness of economics depends on how accurate economic theory
predicts human behavior. In other words, a good theory is one that is an accurate
description of reality. Economics provides an objective mode of analysis, with rigorous models that permit the discounting of the substantial bias that is usually present with
discussions of economic issues. The internal consistency brought to economic theory by mathematical models of economic behavior provides for this consistency. However, no model is any better than the assumptions that underpin that model. If the assumptions are unrealistic, so too will be the models' predictions.
The objective mode of analysis is an attempt to make a social study more
scientific. That is, a systematic analysis of rational human behavior. “Rational” is a
necessary component of this attempt. It is the rationality that makes behavior
predictable, and what most economists don’t like to admit is without this underlying
premise, economics quickly falls into a quagmire of irreproducible results and disjointed
theories.
The purpose of economic theory is to describe behavior, but behavior is
described using models. Models are abstractions from reality - the best model is the one that best describes reality and is the simplest (the simplest requirement is called Occam's Razor). Economic models of human behavior are built upon assumptions; or simplifications that allow rigorous analysis of real world events, without irrelevant
complications. Often (as will be pointed-out in this course) the assumptions underlying a model are not accurate descriptions of reality. When the model's assumptions are
inaccurate then the model will provide results that are consistently wrong (known as bias).
One assumption frequently used in economics is ceteris paribus which means
all other things equal (notice that economists, like lawyers and doctors will use Latin for simple ideas). This assumption is used to eliminate all sources of variation in the model except those sources under examination (not very realistic!).
Economic Goals, Policy, and Reality
Most people and organizations do, at least, rudimentary planning, the purpose of
planning is the establishment of an organized effort to accomplish some economic goals. Planning to finish your education is an economic goal. Goals are, in a sense, an idea of what should be (what we would like to accomplish). However, goals must be realistic and within our means to accomplish, if they are to be effective guides to action.
This brings another classification scheme to bear on economic thought. Economics
can be again classified into positive and normative economics. Positive economics is concerned with what is; and normative economics is concerned with what should
be. Economic goals are examples of normative economics. Evidence concerning economic performance or achievement of goals falls within the domain of positive economics.
The normative versus positive economics arguments begs the question of
whether economics is truly a value free science. In fact, economics contains numerous value judgments. Rational behavior assumes that people will always behave in their own self-interest. Self-interest is therefore presented as a positive element of behavior.
In fact, it is a value judgment. Self-interest is probably descriptive of the majority of
Americans’ behaviors over the majority of time, however, each of us can think of
instances where self-less behavior is observed, and is frequently encouraged.
Efficiency is a measurable concept, and is taken as a desirable outcome. However, efficiency is not always desirable. Equity or fairness is also something prized by most people. The efficiency criterion in economics is not always consistent with
equity; in fact, these two ideas are often in conflict.
Economics also generally assumes that more is preferred to less by all
consumers and firms. However, there are disposal problems, distributional effects, and other problems where more may not be such a good thing. Obesity is a result of more, but a bad result. Pollution, poverty, and crime may also be examined as more begetting problems.
Most nations have established broad social goals that involve economic issues.
The types of goals a society adopts depends very much on the stage of economic development, system of government, and societal norms. Most societies will adopt one
or more of the following goals:
(1) economic efficiency,
(2) economic growth,
(3) economic freedom,
(4) economic security,
(5) an equitable distribution of income,
(6) full employment,
(7) price level stability, and
(8) a reasonable balance of trade.
Each goal (listed above) has obvious merit. However, goals are little more than
value statements in this broad context. For example, it is easy for the very wealthy to
cite as their primary goal, economic freedom, but it is doubtful that anybody living in poverty is going to get very excited about economic freedom; but equitable distributions of income, full employment and economic security will probably find rather wide support among the poor. Notice, if you will, goals will also differ within a society, based on socio-political views of the individuals that comprise that society.
Economics can hardly be separated from politics because the establishment of
national goals occurs through the political arena. Government policies, regulations, law, and public opinion will all effect goals and how goals are interpreted and whether they have been achieved. A word of warning, eCONomics can be, and has often been used, to further particular political agendas.
The assumptions underlying a model used to analyze a particular set of
circumstances will often reflect the political agenda of the economist doing the analysis. An example liberals are fond of is, Ronald Reagan argued that government deficits were inexcusable, and that the way to reduce the deficit was to lower peoples' taxes -- thereby spurring economic growth, therefore more income that could be taxed at a lower rate and yet produce more revenue. Mr. Reagan is often accused, by his detractors, of having a specific political agenda that was well-hidden in this analysis. His alleged goal was to cut taxes for the very wealthy and the rest was just rhetoric to make his tax cuts for rich acceptable to most of the voters. (Who really knows?) Conservatives are fonder of criticizing the Clinton administration’s assertions that the way to reduce the deficit was to spend money where it was likely to be respent, and hence grow the economy and the result was more tax revenues, hence eliminate the deficit. Most political commentators, both left and right, have mastered the use of assumptions and high sounding goals to advance a specific agenda. This adds to the lack of objectivity that seems to increasingly dominate discourse on economic problems.
On the other hand, goals can be public spirited and accomplish a substantial
amount of good. President Lincoln was convinced that the working classes should have access to higher education. The Morrell Act was passed 1861 and created Land Grant institutions for educating the working masses (Purdue, Michigan State, Iowa State, and Kansas State (the first land grant school) are all examples of these types of schools). By educating the working class, it was believed that several economic goals could be achieved, including growth, a more equitable distribution of income, economic security
and freedom. In other words, economic goals that are complementary are consistent and can often be accomplished together. Therefore, conflict need not be the centerpiece of establishing economic goals.
Because any society's resources are limited there must be decisions about which goals should be most actively pursued. The process by which such decisions are made is called prioritizing. Prioritizing is the rank ordering of goals, from the most important to the least important. Prioritizing of goals also involve value judgments, concerning which
goals are the most important. In the public policy arena prioritizing of economic goals is the subject of politics.
Policy
Policy can be generally classified into two categories, public and private policy.
The formulation of public and private policy is the creation of guidelines, regulations, or
law designed to effect the accomplishment of specific economic (or other) goals.
Public policy is how economic goals are pursued. Therefore, to understand goals one needs to understand something of the process of formulating policy.
Business students will have an in depth treatment of policy making in Administrative Policy (J401) and the School of Public and Environmental Affairs requires a similar course in some of its degree programs. For students in other programs the brief treatment here will suffice for present purposes.
The steps in formulating policy are:
1. stating goals - must be measurable with specific stated objective to be accomplished.
2. options - identify the various actions that will accomplish the stated goals & select one, and
3. evaluation - gather and analyze evidence to determine whether policy
was effective in accomplishing goal, if not reexamine options and select option most likely to be effective.
Both the public and private policy formulation process is a dynamic one.
Economic goals change with public opinion and with achievement. Step 1 involves the value statement of setting goals.
Step 2 involves selecting the appropriate model and the options associated with that model to accomplish the specified goal.
The final step involves gathering evidence and the appropriate analysis to determine whether the policy needs revision. The process of formulating policy is therefore a loop, and requires continuous monitoring and revising.
The major difference between public policy and private policy is that private
policy is not subject to democratic processes. The Board of Directors or management of a company will decide what goals are to be accomplished and what policy options are best used to do so. Often private policy is made behind closed-doors without public accountability, even though there are often public costs imposed. The strength of public policy is created in the open, with public debate, and often has the force of law (and not
just company rules and regulations).
Objective Thinking
Most people bring many misconceptions and biases to economics. After all, economics deals with people's material well-being – a very serious matter to most.
Because of political beliefs and other value system components rational, objective
thinking concerning various economic issues fail. Rational and objective thought
requires approaching a subject with an open-mind and a willingness to accept what ever answer the evidence suggests is correct. In turn, such objectivity requires the shedding of the most basic preconceptions and biases -- not an easy assignment. What conclusions an individual draws from an objective analysis using economic principles, are not necessarily cast in stone. The appropriate decision based on economic principles may be inconsistent with other values. The respective evaluation of the economic and "other values" (i.e., ethics) may result in a conflict. If an inconsistency between economics and ethics is discovered in a particular application, a rational person will normally select the option that is the least costly (i.e., the majority view their integrity as priceless). An individual with a low value for ethics or morals may find that a criminal act, such as theft, as involving minimal costs. In other words, economics does not provide all of the answers; it provides only those answers capable
of being analyzed within the framework of the discipline.
There are several common pitfalls to objective thinking in economics. Among the most common of these pitfalls, which affect economic thought, are:
(1) the fallacy of composition, and
(2) post hoc, ergo prompter hoc.
Each of these will be reviewed, in turn in the following paragraphs.
The fallacy of composition is the mistaken belief that what is true for the individual must be true for the group. An individual or small group of individuals may exhibit behavior that is not common to an entire population.
For example,
if one individual in this class is a I.U. fan then everyone in this class must be an I.U. fan is an obvious fallacy of composition. Statistical inference can be drawn from a sample of individuals, but only within confidence intervals that provide information concerning the likelihood of making an erroneous conclusion (E270, Introduction to Statistics provides a more in depth discussion of confidence intervals and inference).
Post hoc, ergo prompter hoc means after this, hence because of this, and
is a fallacy in reasoning. Simply because one event follows another does not
necessarily imply there is a causal relation. One event can follow another and be
completely unrelated, this is simple coincidence. One event can follow another, but there may be something other than direct causal relation that accounts for the timing of the two events. For example, during the thirteenth century people noticed that the black
plague occurred in a location when the population of cats increased. Unfortunately, some concluded that the plague was caused by cats so they killed the cats. In fact, the plague was carried by fleas on rats. When the rat population increased, cats were attracted to the area because of the food supply. The rat populations increased, and so did the population of fleas that carried the disease. This increase in the rat population
also happened to attract cats, but cats did not cause the plague, if left alone they may
have gotten rid of the real carriers (the rats, therefore the fleas).
Perhaps it is interesting to note that in any scientific endeavor there is a basic
truth. Simple answers to complex problems are appealing, abundant, and often wrong. This twist on Occam’s razor is true. Too often the desire to have a simple
solution will blind individuals, and public opinion to the more complex and often more harsh realities. One must take great care to assure that this simple trap does not befall one in their search for truth, because not all truth is simple.
Policy is fraught with danger. Failure to anticipated the consequences of certain
aspects of policy may cause results that were neither intended nor anticipated by the policy-makers; this is referred to as the law of unintended consequences.
The following box presents an excellent historical example of the law of
unintended consequences.
Statistical Methods in Economics
The use of statistical methods in empirical economics can result in errors in inference. Most of the statistical methods used in econometrics (statistical examination of economic data) rely on correlation. Correlation is the statistical association of two or more variables. This statistical association means that the two variables move predictably with or against each other. To infer that there is a causal relation between two variables that are correlated is an error. For example, a graduate student once found that Pete Rose's batting average was highly correlated with movement in GNP during several baseball seasons. This spurious correlation cannot reasonably be considered path-breaking economic research.
On the other hand, we can test for causation (where one variable actually causes another). Granger causality states that the thing that causes another must occur first, that the explainer must add to the correlation, and must be sensible. As with most statistical methods Granger causality models permit testing for the purpose of rejecting that a causal relation does not exist, it cannot be used to prove causality exists. These types of statistical methods are rather sophisticated and are generally examined in upper division or graduate courses in statistics.
As is true with economics, statistics are simply a tool for analyzing evidence.
Statistical models are also based on assumptions, and too often, statistical methods are used for purposes for which they were not intended. Caution is required in accepting statistical evidence. One must be satisfied that the data is properly gathered, and appropriate methods were applied before accepting statistical evidence. Statistics do not lie, but sometimes statisticians do!
Objectivity and Rationality
Objective thinking in economics also includes rational behavior. The underlying
assumptions with each of the concepts examined in this course assumes that people will act in their perceived best interest. Acting in one's best interests is how rationality is defined. The only way this can be done, logically and rigorously, is with the use of marginal analysis. This economic perspective involves weighing the costs against the benefits of each additional action. In other words, if benefits of an additional action will be greater than the costs, it is rational to do that thing, otherwise it is not. Too often people permit the costs already paid to influence their decision-making, and hence they
are lead astray by not focusing on the margin. The problem with rationality is perception. Often what people believe is in their own self-interest may not be. (Remember the Pig Iron example). Education and the gathering of information helps to make perceptions more accurate views of reality. In other words, the more we can eliminate our biases and faulty perceptions, the more likely we are to act in our own interest. However, there are costs associated with information gathering and with education, therefore rationality may be costly.