Chapter 1

The Nature
of Economics
Introduction

The average student loan debt of a college graduate

exceeds $30,000. In recent years, it has become more
difficult for young people with student loans to repay
their debts with their jobs and wage earnings.
Do people who borrow to finance their college
education act in their own self-interest?
You will explore this question in Chapter One.

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1.1 The Power of Economic Analysis

• Incentives
– Rewards for engaging in a particular activity
– The nature of self-interested responses to
incentives is the starting point for economic
analysis.

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 1.1 The Power of Economic
Analysis (cont’d)

• The economic way of thinking is a

framework to analyze solutions to
economic problems
– How much time to study
– Choosing which courses to take
– Whether the U.S. government should encourage
or discourage immigration

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 1.1 The Power of Economic
Analysis (cont’d)
• The economic way of thinking gives you the
power to reach informed conclusions about
what is happening in the world.
• Economic analysis helps you make better
decisions and increases your understanding
when watching or reading the news on the
Web.

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 1.1 The Power of Economic
Analysis (cont’d)

• Economic analysis is a way of thinking

about all decisions.
• These decisions could be about:
– Your education, career, or financing your home
– Your involvement in the business world
– How you cast your ballot as a voter

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 1.1 The Power of Economic
Analysis (cont’d)

• Economics
– The study of how people allocate their limited
resources to satisfy their unlimited wants
– The study of how people make choices

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 1.1 The Power of Economic
Analysis (cont’d)

• Resources
– Things used to produce other things to satisfy
people’s wants

• Wants
– What people would buy if their incomes were
unlimited

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 1.1 The Power of Economic
Analysis (cont’d)

• With limited income (resources), people

must make choices to satisfy their wants.
• We never have enough of everything,
including time, to satisfy our every desire.

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 1.1 The Power of Economic
Analysis (cont’d)

• Individuals, businesses, and nations face

alternatives, and choices must be made.
• Economics studies how these choices are
made.

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1.2 The Three Basic Economic Questions
and Two Opposing Sets of Answers

• Microeconomics
– The study of decision making undertaken by
individuals (or households) and by firms
– Like looking though a microscope to focus on
the smaller parts of the economy:
• The effects of changes in gasoline prices
• A family’s choice of having a baby
• An individual firm’s decision to advertise

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1.2 The Three Basic Economic Questions
and Two Opposing Sets of Answers (cont’d)

• Macroeconomics
– The study of the behavior of the economy as a
whole
– Deals with economywide phenomena:
• The national unemployment rate
• The rate of inflation
• The yearly output of goods and services in a nation

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1.2 The Three Basic Economic Questions
and Two Opposing Sets of Answers (cont’d)

• Macroeconomics deals with aggregates, or

totals—such as total output in an economy.
• Modern economic theory blends micro and
macro concepts.

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1.2 The Three Basic Economic Questions
and Two Opposing Sets of Answers (cont’d)

• Economic system
– The institutional mechanism through which
resources are utilized to satisfy human wants

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1.2 The Three Basic Economic Questions
and Two Opposing Sets of Answers (cont’d)

• Three economic questions:

1. What and how much will be produced?
2. How will items be produced?
3. For whom will items be produced?

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1.2 The Three Basic Economic Questions
and Two Opposing Sets of Answers (cont’d)

• Two opposing answers in the form of

economic systems:
– Centralized command and control (central
planning): Authority that makes all economic
decisions
– Price system (market system): Decentralized
decision making process, in which prices are
terms (signals) under which people agree to
make exchanges

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Policy Example: Government Green
Energy Financing Flops

• The command and control approach was

used to make decisions regarding the
development of green energy technologies.
• Since the end of the last decade, the
federal government has boosted its funding
for the operations of a number of green
energy companies, many of which have
failed.

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Table 1-1 Failed Green Energy
Recipients of Government Funding Offers

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1.2 The Three Basic Economic Questions
and Two Opposing Sets of Answers (cont’d)

• Economic systems of the world’s nations

(e.g., U.S.) are mixed systems that
incorporate aspects of both centralized
command and control and a decentralized
price system.

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International Policy Example: In China, Chongqing
Plus Guangdon Equals a Mixed Economy

• China has operated two economic systems.

• The Chongqing system, named for the
nation’s southwestern city, relies on
government-owned enterprises for
production.
• The Guangdon system, named for a coastal
province, emphasizes private businesses in
deciding what, how, and for whom
production should take place.

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1.3 The Economic Approach:
Systematic Decisions

• Economists assume that individuals act as if

motivated by self-interest and respond
predictably to opportunities for gain.

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1.3 The Economic Approach:
Systematic Decisions (cont’d)

“It is not from the benevolence of the

butcher, the brewer, or the baker that we
expect our dinner, but from their regard to
their own interest.”
—Adam Smith, An Inquiry into the Nature and
Causes of the Wealth of Nations, 1776

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1.3 The Economic Approach:
Systematic Decisions (cont’d)

• Rationality assumption
– The assumption that people do not intentionally
make decisions that would leave themselves
worse off

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1.3 The Economic Approach:
Systematic Decisions (cont’d)

• Questions:
– Does the fact that some people make apparently
irrational choices invalidate the rationality
assumption in economics?
– Can economic models be applied to situations in
which behavior is at odds with what we expect
from rational people?

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Example: Why Did Costco Borrow $3.5
Billion to Distribute to Its Shareholders?

• In late 2012, wholesale-club operator

Costco decided to borrow $3.5 billion and
transmitted this amount to its shareholders
in the form of dividend payments.
• Many tax experts called this decision
“completely rational” as it generated
substantial income tax savings for the
shareholders due to a lower federal tax rate
in 2012.

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1.3 The Economic Approach:
Systematic Decisions (cont’d)

• Responding to incentives
– Rationality and the use of incentives:
• Positive incentives
• Negative incentives

– Making choices:
• Balancing costs and benefits

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1.3 The Economic Approach:
Systematic Decisions (cont’d)

• Some examples of incentives

– Responding to positive incentives:
• Schoolchildren getting gold stars, working to have a
“better life” for yourself

– Responding to negative incentives:

• Penalties, punishments, using credit cards to avoid
check overdrafts

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1.3 The Economic Approach:
Systematic Decisions (cont’d)

• Defining self-interest
– The pursuit of one’s goals:
• Prestige
• Friendship
• Love

– Does not always mean increasing one’s wealth.

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Example: Taking Care of Others—and
Self

• U.S. residents give about 2 percent of their

income in charitable donations.
• Their self-interest motives seem to include
concerns for the well-being of others.
• In the United States, tax deduction for
charitable donations is another self-
interested incentive.

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1.4 Economics as a Science

• Economics is a social science that employs

the same kinds of methods used in other
sciences, such as biology.
• Economics uses models to explain economic
phenomena in the real world.

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1.4 Economics as a Science (cont’d)

• Models or theories
– Simplified representations of the real world used
as the basis for predictions or explanations
– Should capture only the essential relationships
that are sufficient to analyze a problem
– Cannot be faulted as unrealistic simply because
they do not capture all details of the real world
• A map is the quintessential model.

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1.4 Economics as a Science (cont’d)

• Assumptions
– The set of circumstances in which a model is
applicable
– Every model, or theory, must be based on a set
of assumptions.

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Example: Getting Directions

• A map is a simplifying model of reality.

• The degree of simplification varies across
maps; some contain more detail than
others.
• Economic models attempt to focus on what
is relevant to the problem at hand and omit
what is not.

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1.4 Economics as a Science (cont’d)

• Ceteris paribus assumption

[KAY-ter-us PEAR-uh-bus]
– Nothing changes except the factor or factors
being studied.
– “Other things constant”
– “Other things equal”

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1.4 Economics as a Science (cont’d)

• Economics is an empirical science

– Real-world data is used to evaluate the
usefulness of a model.
– Models are useful if they predict economic
phenomena.
– Economic models predict how people react,
not how they think.

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1.4 Economics as a Science (cont’d)

• Behavioral economics
– Approach to the study of consumer behavior:
• Emphasizes psychological limitations and complications
that may interfere with rational decision making
– Proponents believe that it is “unrealistic” to
assume:
• Unbounded selfishness
• Unbounded willpower
• Unbounded rationality

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1.4 Economics as a Science (cont’d)

• Bounded rationality
– Hypothesis that people are nearly, not fully,
rational:
• They cannot examine every choice available to them.
• They appear to use rules of thumb to sort alternatives.

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What If ... the government “nudges”
people to influence their decision making?

• Evidence supports that people do not have

unbounded willpower, and they do not
always have decisions consistent with their
long-term goals.
– A law in the United Kingdom requires people to
contribute to a pension plan unless they
consciously opt out of it.
– This has resulted in more people opting to
contribute to pension plans than before.

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1.5 Positive versus Normative
Economics
• Positive economics
– Purely descriptive statements or scientific
predictions, such as “If A, then B”
– A statement of what is

• Normative economics
– Analysis involving value judgments; relates to
whether things are good or bad
– A statement of what ought to be

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You Are There: How a Tax Differential
Aided a Texas Pro Basketball Team

• Dwight Howard faces a decision between

playing for an NBA basketball team in Los
Angeles or in Houston.
• The Los Angeles team has offered him a
pre-tax salary of $23.6 million a year, while
the Houston team has offered him $22
million.
• Howard decides to move to Houston
because Texas has no state income tax,
which make its after-tax earnings higher
than if he plays in Los Angeles.
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Issues & Applications: Incentive Effects
of Student Loans for College Graduates

• The average inflation-adjusted student loan

debt of college graduates has doubled to
over $30,000 today.
• College graduates with student loans view
their debts as disincentives to buying big-
ticket items like a house or a new car.
• Is the observation of more people running
up increasingly large student loan debt
inconsistent with the rationality
assumption?

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