The Scope and Method of Economics
The study of economics should begin with a sense of wonder. Pause for a moment and consider a typicalv day in your life.
It might start with a bagel made in a local bakery with flour produced in Minnesota from wheat grown in Kansas and bacon from pigs raised in Ohio packaged in plastic made in New Jersey. You spill coffee from Colombia on your shirt made in Texas from textiles shipped from South Carolina.
After class you drive with a friend on an interstate highway that is part of a system that took 20 years and billions of dollars to build. You stop for gasoline refined in Louisiana from Saudi Arabian crude oil brought to the United States on a supertanker that took 3 years to build at a shipyard in Maine. Later you log onto the Web with a laptop assembled in Indonesia from parts made in China and Skype with your brother in Mexico City, and you call a buddy on your iPhone with parts
from a dozen countries. You use or consume tens of thousands of things, both tangible and intangible, every day: buildings, music, staples, paper, toothpaste, tweezers, pizza, soap, digital watches, fire protection, banks, electricity, eggs, insurance, football fields, buses, rugs, subways, health services,
sidewalks, and so forth. Somebody made all these things. Somebody organized men and women and materials to produce and distribute them. Thousands of decisions went into their completion. Somehow they got to you.
In the United States, over 139 million people—almost half the total population—work at hundreds of thousands of different jobs producing over $14 trillion worth of goods and services every year. Some cannot find work; some choose not to work. Some are rich; others are poor. The United States imports over $200 billion worth of automobiles and parts and about $300 billion worth of petroleum and petroleum products each year; it exports around $62 billion worth of agricultural products, including food. Every month the United States buys around $25 billion worth of goods and services from China, while China buys about $5 billion worth from the United States. High-rise office buildings go up in central cities. Condominiums and homes are built in the suburbs. In other places, homes are abandoned and boarded up. Some countries are wealthy. Others are impoverished. Some are growing. Some are not. Some businesses are doing well. Others are going bankrupt. As the 10 th edition of our text goes to press, the world is beginning to recover from a period during which many people felt the pain of a major economic downturn. In the United States at the beginning of 2010 more than 15 million people who wanted to work could not find a job. Millions around the world found themselves with falling incomes and wealth. At any moment in time, every society faces constraints imposed by nature and by previous generations. Some societies are handsomely endowed by nature with fertile land, water, sunshine, and natural resources. Others have deserts and few mineral resources. Some societies receive much from previous generations—art, music, technical knowledge, beautiful buildings, and productive factories. Others are left with overgrazed, eroded land, cities leveled by war, or polluted natural environments. All societies face limits.
The purpose of this chapter and the next is to elaborate on this definition and to introduce the subject matter of economics. What is produced? How is it produced? Who gets it? Why? Is the result good or bad? Can it be improved?
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There are four main reasons to study economics: to learn a way of thinking, to understand society, to understand global affairs, and to be an informed citizen.
To Learn a Way of Thinking
Probably the most important reason for studying economics is to learn a way of thinking. Economics has three fundamental concepts that, once absorbed, can change the way you look at everyday choices: opportunity cost, marginalism, and the working of efficient markets.
Opportunity Cost What happens in an economy is the outcome of thousands of individual decisions. People must decide how to diviwhether to work, whether to go to school, and how much to save. Businesses must decide what to produce, how much to produce, how much to charge, and where to locate. It is not surprising that economic analysis focuses on the process of decision making. Nearly all decisions involve trade-offs. A key concept that recurs in analyzing the decisionmaking process is the notion of opportunity cost. The full “cost” ode their incomes among all the goods and services available in the marketplace. They must decide f making a specific choice includes what we give up by not making the alternative choice. The best alternative that we forgo, or give up, when we make a choice or a decision is called the opportunity cost of that decision.
Nearly all decisions involve trade-offs. A key concept that recurs in analyzing the decisionmaking process is the notion of opportunity cost. The full “cost” of making a specific choice includes what we give up by not making the alternative choice. The best alternative that we forgo, or give up, when we make a choice or a decision is called the opportunity cost of that decision. When asked how much a movie costs, most people cite the ticket price. For an economist, this is only part of the answer: to see a movie takes not only a ticket but also time. The opportunity cost of going to a movie is the value of the other things you could have done with the same money and time. If you decide to take time off from work, the opportunity cost of your leisure is the pay that you would have earned had you worked. Part of the cost of a college education is the income you could have earned by working full-time instead of going to school. If a firm purchases a new piece of equipment for $3,000, it does so because it expects that equipment to generate more profit. There is an opportunity cost, however, because that $3,000 could have been deposited in an interest-earning account. To a society, the opportunity cost of using resources to launch astronauts on a space shuttle is the value of the private/civilian or other government goods that could have been produced with the same resources.
Opportunity costs arise because resources are scarce. Scarce simply means limited.
Consider one of our most important resources—time. There are only 24 hours in a day, and we must live our lives under this constraint. A farmer in rural Brazil must decide whether it is better to continue to farm or to go to the city and look for a job. A hockey player at the University of Vermont must decide whether to play on the varsity team or spend more time studying.
Marginalism A second key concept used in analyzing choices is the notion of marginalism. In weighing the costs and benefits of a decision, it is important to weigh only the costs and benefits that arise from the decision.
Suppose, for example, that you live in New Orleans and that you are weighing the costs and benefits of visiting your mother in Iowa. If business required that you travel to Kansas City, the cost of visiting Mom would be only the additional, or marginal, time and money cost of getting to Iowa from Kansas City. Consider the video game business. It has been estimated that to create and produce a complex multiplayer role-playing game like World of Warcraft (WOW) costs as much as $500 million. Once the game has been developed, however, the cost of selling and delivering it to another player is close to zero. The original investment (by Activision) made to create WOW is considered a sunk cost. Once the game has been developed, Activision cannot avoid these costs because they have already been incurred. Activision’s business decisions about pricing and distributing WOW depend not on the sunk costs of production, but on the incremental or marginal costs of production. For Activision, those costs are close to zero. There are numerous examples in which the concept of marginal cost is useful. For an airplane that is about to take off with empty seats, the marginal cost of an extra passenger is essentially zero; the total cost of the trip is roughly unchanged by the addition of an extra passenger. Thus, setting aside a few seats to be sold at big discounts through www.priceline.com or other Web sites can be profitable even if the fare for those seats is far below the average cost per seat of making the trip. As long as the airline succeeds in filling seats that would otherwise have been empty, doing so is profitable.
Efficient Markets—No Free Lunch Suppose you are ready to check out of a busy grocery store on the day before a storm and seven checkout registers are open with several people in each line. Which line should you choose? Usually, the waiting time is approximately the same no matter which register you choose (assuming you have more than 12 items). If one line is much shorter than the others, people will quickly move into it until the lines are equalized again.
As you will see later, the term profit in economics has a very precise meaning. Economists, however, often loosely refer to “good deals” or risk-free ventures as profit opportunities. Using the term loosely, a profit opportunity exists at the checkout lines when one line is shorter than the others. In general, such profit opportunities are rare. At any time, many people are searching for them; as a consequence, few exist. Markets like this, where any profit opportunities are eliminated almost instantaneously, are said to be efficient markets. (We discuss markets, the institutions through which buyers and sellers interact and engage in exchange, in detail in Chapter 2.)
The common way of expressing the efficient markets concept is “there’s no such thing as a free lunch.” How should you react when a stockbroker calls with a hot tip on the stock market? With skepticism. Thousands of individuals each day are looking for hot tips in the market. If a particular tip about a stock is valid, there will be an immediate rush to buy the stock, which will quickly drive up its price. This view that very few profit opportunities exist can, of course, be carried too far. There is a story about two people walking along, one an economist and one not. The non-economist sees a $20 bill on the sidewalk and says, “There’s a $20 bill on the sidewalk.” The economist replies, “That is not possible. If there were, somebody would already have picked it up.”
There are clearly times when profit opportunities exist. Someone has to be first to get the news, and some people have quicker insights than others. Nevertheless, news travels fast, and there are thousands of people with quick insights. The general view that large profit opportunities are rare is close to the mark.
The study of economics teaches us a way of thinking and helps us make decisions.
To Understand Society
Another reason for studying economics is to understand society better. Past and present economic decisions have an enormous influence on the character of life in a society. The current state of the physical environment, the level of material well-being, and the nature and number of jobs are all products of the economic system. To get a sense of the ways in which economic decisions have shaped our environment, imagine looking out a top-floor window of an office tower in any large city. The workday is about to begin. All around you are other tall glass and steel buildings full of workers. In the distance, you see the smoke of factories. Looking down, you see thousands of commuters pouring off trains and buses and cars backed up on freeway exit ramps. You see trucks carrying goods from one place to another.
You also see the face of urban poverty: Just beyond the freeway is a large public housing project and, beyond that, burned-out and boarded-up buildings. What you see before you is the product of millions of economic decisions made over hundreds of years. People at some point decided to spend time and money building those buildings and factories. Somebody cleared the land, laid the tracks, built the roads, and produced the cars and buses. Economic decisions not only have shaped the physical environment but also have determined the character of society. At no time has the impact of economic change on a society been more evident than in England during the late eighteenth and early nineteenth centuries, a period that we now call the Industrial Revolution. Increases in the productivity of agriculture, new manufacturing technologies, and development of more efficient forms of transportation led to a massive movement of the British population from the countryside to the city. At the beginning of the eighteenth century, approximately 2 out of 3 people in Great Britain worked in agriculture. By 1812, only 1 in 3 remained in agriculture; by 1900, the figure was fewer than 1 in 10. People jammed into overcrowded cities and worked long hours in factories. England had changed completely in two centuries—a period that in the run of history was nothing more than the blink of an eye. It is not surprising that the discipline of economics began to take shape during this period. Social critics and philosophers looked around and knew that their philosophies must expand to accommodate the changes. Adam Smith’s Wealth of Nations appeared in 1776. It was followed by the writings of David Ricardo, Karl Marx, Thomas Malthus, and others. Each tried to make sense out of what was happening. Who was building the factories? Why? What determined the level of wages paid to workers or the price of food? What would happen in the future, and what should happen? The people who asked these questions were the first economists.
Similar changes continue to affect the character of life in more recent times. In fact, many argue that the late 1990s marked the beginning of a new Industrial Revolution. As we turned the corner into the new millennium, the “e” revolution was clearly having an impact on virtually every aspect of our lives: the way we buy and sell products, the way we get news, the way we plan vacations, the way we communicate with each other, the way we teach and take classes, and on and on. These changes have had and will clearly continue to have profound impacts on societies across the globe, from Beijing to Calcutta to New York. These changes have been driven by economics. Although the government was involved in the early years of the World Wide Web, private firms that exist to make a profit (such as Facebook, YouTube, Yahoo!, Microsoft, Google, Monster.com, Amazon.com, and E-Trade) created almost all the new innovations and products. How does one make sense of all this? What will the effects of these innovations be on the number of jobs, the character of those jobs, the family incomes, the structure of our cities, and the political process both in the United States and in other countries? During the last days of August 2005, Hurricane Katrina slammed into the coasts of Louisiana and Mississippi, causing widespread devastation, killing thousands, and leaving hundreds of thousands homeless. The economic impact of this catastrophic storm was huge. Thinking about various markets involved helps frame the problem. For example, the labor market was massively affected. By some estimates, over 400,000 jobs were lost as the storm hit. Hotels, restaurants, small businesses, and oil refineries, to name just a few, were destroyed. All the people who worked in those establishments instantaneously lost their jobs and their incomes. The cleanup and rebuilding process took time to organize, and it eventually created a great deal of employment.
The storm created a major disruption in world oil markets. Loss of refinery capacity sent gasoline prices up immediately, nearly 40 percent to over $4 per gallon in some locations. The price per gallon of crude oil rose to over $70 per barrel. Local governments found their tax bases destroyed, with no resources to pay teachers and local officials. Hundreds of hospitals were destroyed, and colleges and universities were forced to close their doors, causing tens of thousands of students to change their plans. While the horror of the storm hit all kinds of people, the worst hit were the very poor, who could not get out of the way because they had no cars or other means of escape. The storm raised fundamental issues of fairness, which we will be discussing for years to come.
Another reason for studying economics is to understand society better. Past and present economic decisions have an enormous influence on the character of life in a society. The current state of the physical environment, the level of material well-being, and the nature and number of jobs are all products of the economic system. To get a sense of the ways in which economic decisions have shaped our environment, imagine looking out a top-floor window of an office tower in any large city. The workday is about to begin. All around you are other tall glass and steel buildings full of workers. In the distance, you see the smoke of factories. Looking down, you see thousands of commuters pouring off trains and buses and cars backed up on freeway exit ramps. You see trucks carrying goods from one place to another.
You also see the face of urban poverty: Just beyond the freeway is a large public housing project and, beyond that, burned-out and boarded-up buildings. What you see before you is the product of millions of economic decisions made over hundreds of years. People at some point decided to spend time and money building those buildings and factories. Somebody cleared the land, laid the tracks, built the roads, and produced the cars and buses. Economic decisions not only have shaped the physical environment but also have determined the character of society. At no time has the impact of economic change on a society been more evident than in England during the late eighteenth and early nineteenth centuries, a period that we now call the Industrial Revolution. Increases in the productivity of agriculture, new manufacturing technologies, and development of more efficient forms of transportation led to a massive movement of the British population from the countryside to the city. At the beginning of the eighteenth century, approximately 2 out of 3 people in Great Britain worked in agriculture. By 1812, only 1 in 3 remained in agriculture; by 1900, the figure was fewer than 1 in 10. People jammed into overcrowded cities and worked long hours in factories. England had changed completely in two centuries—a period that in the run of history was nothing more than the blink of an eye. It is not surprising that the discipline of economics began to take shape during this period. Social critics and philosophers looked around and knew that their philosophies must expand to accommodate the changes. Adam Smith’s Wealth of Nations appeared in 1776. It was followed by the writings of David Ricardo, Karl Marx, Thomas Malthus, and others. Each tried to make sense out of what was happening. Who was building the factories? Why? What determined the level of wages paid to workers or the price of food? What would happen in the future, and what should happen? The people who asked these questions were the first economists.
Similar changes continue to affect the character of life in more recent times. In fact, many argue that the late 1990s marked the beginning of a new Industrial Revolution. As we turned the corner into the new millennium, the “e” revolution was clearly having an impact on virtually every aspect of our lives: the way we buy and sell products, the way we get news, the way we plan vacations, the way we communicate with each other, the way we teach and take classes, and on and on. These changes have had and will clearly continue to have profound impacts on societies across the globe, from Beijing to Calcutta to New York. These changes have been driven by economics. Although the government was involved in the early years of the World Wide Web, private firms that exist to make a profit (such as Facebook, YouTube, Yahoo!, Microsoft, Google, Monster.com, Amazon.com, and E-Trade) created almost all the new innovations and products. How does one make sense of all this? What will the effects of these innovations be on the number of jobs, the character of those jobs, the family incomes, the structure of our cities, and the political process both in the United States and in other countries? During the last days of August 2005, Hurricane Katrina slammed into the coasts of Louisiana and Mississippi, causing widespread devastation, killing thousands, and leaving hundreds of thousands homeless. The economic impact of this catastrophic storm was huge. Thinking about various markets involved helps frame the problem. For example, the labor market was massively affected. By some estimates, over 400,000 jobs were lost as the storm hit. Hotels, restaurants, small businesses, and oil refineries, to name just a few, were destroyed. All the people who worked in those establishments instantaneously lost their jobs and their incomes. The cleanup and rebuilding process took time to organize, and it eventually created a great deal of employment.
The storm created a major disruption in world oil markets. Loss of refinery capacity sent gasoline prices up immediately, nearly 40 percent to over $4 per gallon in some locations. The price per gallon of crude oil rose to over $70 per barrel. Local governments found their tax bases destroyed, with no resources to pay teachers and local officials. Hundreds of hospitals were destroyed, and colleges and universities were forced to close their doors, causing tens of thousands of students to change their plans. While the horror of the storm hit all kinds of people, the worst hit were the very poor, who could not get out of the way because they had no cars or other means of escape. The storm raised fundamental issues of fairness, which we will be discussing for years to come.
The study of economics is an essential part of the study of society.
To Understand Global Affairs
A third reason for studying economics is to understand global affairs. News headlines are filled with economic stories. The environmental disaster associated with BP’s oil spill has the potential to affect the future price of oil if deep sea drilling is banned, the price of fish, the extent of tourism, and tourist-related employment in the Gulf and numerous other markets. The discovery in 2010 of major new diamond deposits in Zimbabwe has implications for the future stability of Mugabe’s government, with implications for developments in the rest of the region. China’s new position as a major trading partner of both the United States and Europe clearly has implications for political interactions among these nations. Greece’s economic struggles in 2010 over its large debt is affecting the enthusiasm of the rest of Europe’s citizens for the European Union. In a relatively open, market oriented world, it is impossible to understand political affairs without a grounding in economics. While there is much debate about whether or not economic considerations dominate international relations, it is clear that they play a role as political leaders seek the economic well-being of their citizenry.
An understanding of economics is essential to an understanding of global affairs.
To Be an Informed Citizen
A knowledge of economics is essential to being an informed citizen. In 2009, most of the world suffered from a major recession, with diminished economic growth and high unemployment. Millions of people around the world lost their jobs. Governments from China to the United Kingdom to the United States all struggled to figure out policies to help their economies recover. Understanding what happens in a recession and what the government can and cannot do to help in a recovery is an essential part of being an informed citizen. Economics is also essential in understanding a range of other everyday government decisions at the local and federal levels. Why do governments pay for public schools and roads, but not cell phones? In 2010, the federal government under President Obama moved toward universal health care for U.S. citizens. How do you understand the debate of whether this is or is not a good idea? In some states, scalping tickets to a ball game is illegal. Is this a good policy or not? Some governments control the prices that firms can charge for some goods, especially essentials like milk and bread. Is this a good idea? Every day, across the globe, people engage in political decision making around questions like these, questions that depend on an understanding of economics.
To be an informed citizen requires a basic understanding of economics.
A third reason for studying economics is to understand global affairs. News headlines are filled with economic stories. The environmental disaster associated with BP’s oil spill has the potential to affect the future price of oil if deep sea drilling is banned, the price of fish, the extent of tourism, and tourist-related employment in the Gulf and numerous other markets. The discovery in 2010 of major new diamond deposits in Zimbabwe has implications for the future stability of Mugabe’s government, with implications for developments in the rest of the region. China’s new position as a major trading partner of both the United States and Europe clearly has implications for political interactions among these nations. Greece’s economic struggles in 2010 over its large debt is affecting the enthusiasm of the rest of Europe’s citizens for the European Union. In a relatively open, market oriented world, it is impossible to understand political affairs without a grounding in economics. While there is much debate about whether or not economic considerations dominate international relations, it is clear that they play a role as political leaders seek the economic well-being of their citizenry.
An understanding of economics is essential to an understanding of global affairs.
To Be an Informed Citizen
A knowledge of economics is essential to being an informed citizen. In 2009, most of the world suffered from a major recession, with diminished economic growth and high unemployment. Millions of people around the world lost their jobs. Governments from China to the United Kingdom to the United States all struggled to figure out policies to help their economies recover. Understanding what happens in a recession and what the government can and cannot do to help in a recovery is an essential part of being an informed citizen. Economics is also essential in understanding a range of other everyday government decisions at the local and federal levels. Why do governments pay for public schools and roads, but not cell phones? In 2010, the federal government under President Obama moved toward universal health care for U.S. citizens. How do you understand the debate of whether this is or is not a good idea? In some states, scalping tickets to a ball game is illegal. Is this a good policy or not? Some governments control the prices that firms can charge for some goods, especially essentials like milk and bread. Is this a good idea? Every day, across the globe, people engage in political decision making around questions like these, questions that depend on an understanding of economics.
To be an informed citizen requires a basic understanding of economics.
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