Definition, Nature and Scope

of Economics
1. Defining Economics
2. Methodology of Economics
3. Microeconomics vs. Macroeconomics
4. Graphs and Curves in Economics
 Definition
• The word economy comes from a Greek word
“oikonomias” for “one who manages a
household.”
• A household and an economy
face many decisions:
– Which goods shall be produced & in what quantities?
– What resources should be used in production?
• Who will work? Use more capital or labor?
– How should the produced goods be distributed?
• Who gets how much?
• At what price should the goods be sold?
 Society and Scarce Resources
• Society and Scarce Resources:
– Economists view the world through the lens of
scarcity
– The management of society’s resources is
important because resources are scarce.
– Scarcity. . . means that society has limited
resources and therefore cannot produce all the
goods and services people wish to have
– Scarcity limits options & necessitates that we
make choices
• Economics is the study of how society
manages its scarce resources.
 Ten principles of Economics
• There are ten basic principles of
Economics which can be divided into
three broad areas:
How people make decisions
• People face tradeoffs.
• The cost of something is what you give up to get
it.
• Rational people think at the margin.
• People respond to incentives
 Ten principles of economics
How people interact with each other
– Trade can make everyone better off.
– Markets are usually a good way to organize
economic activity.
– Governments can sometimes improve
economic outcomes.
 Ten principles of Economics
There are forces and trends that affect how
the economy as a whole works.
– The standard of living depends on a country’s
production.
– Prices rise when the government prints too
much money.
– Society faces a short-run tradeoff between
inflation and unemployment
 Principle 1: People face trade-offs
• To get one thing, we usually have to give
up another thing. So more of one thing
means less of another.
– Guns v. books
– Food v. clothing
– Leisure time v. work
• Making decisions requires trading
off one goal against another.
 Principle 2: The cost of something
is what you give up to acquire it
• Decisions require comparing costs and
benefits of alternatives.
– Whether to go to college or to work?
– Whether to study or go out on a date?
– Whether to go to class or sleep in?

• The opportunity cost of an item is what

you give up to obtain that item or sacrifices
made in order to obtain that item.
Principle 3: Rational People think at
the Margin
• Economics is grounded on the assumption
of “rational self-interest” – meaning
individuals pursue actions that will enable
them to achieve their greatest satisfaction
• Marginal changes are small, incremental
adjustments to an existing plan of action
• People make decisions by comparing
costs and benefits at the margin.
 Principle 4: People respond to
incentives
• Marginal changes in costs or benefits
motivate people to respond.
• The decision to choose one
alternative over another occurs when
that alternative’s marginal benefits
exceed its marginal costs!
 Principle 5: Trade can make
everyone better off
• People gain from their ability to trade with
one another.
• Competition results in gains from trading.
• Trade allows people to specialize in what
they do best.
• Specialization improves efficiency with
which resources are used.
 Principle 6: Markets are usually a
good way to organise economic
activity
• A market economy is an economy that
allocates resources through the
decentralized decisions of many firms and
households as they interact in markets for
goods and services.
– Households decide what to buy and who to
work for.
– Firms decide who to hire and what to produce
 Principle 6 cont.
– Because households and firms look at prices
when deciding what to buy and sell, they
unknowingly take into account the social costs
of their actions.
– As a result, prices guide decision makers to
reach outcomes that tend to maximize the
welfare of society as a whole
 Principle 7: Governments can
sometimes improve market
outcomes
• Market failure occurs when the market fails to
allocate resources efficiently.
• When the market fails (breaks down)
government can intervene to promote efficiency
and equity
• Market failure may be caused by
– an externality, which is the impact of one person or
firm’s actions on the well-being of a bystander.
– market power, which is the ability of a single person
or firm to unduly influence market prices.
Principle 8: The Standards of Living
Depends on a Country’s Production
• Standard of living may be measured in different
ways:
– By comparing personal incomes.
– By comparing the total market value of a nation’s
production
• Almost all variations in living standards are
explained by differences in countries’
productivities.
• Productivity is the amount of goods and services
produced from each hour of a worker’s time.
 Principle 9: Prices Rise when a
Government Prints too much
Money
• Inflation is an increase in the overall level
of prices in the economy.
• One cause of inflation is the growth in the
quantity of money.
• When the government creates large
quantities of money, the value of the
money falls.
Principle 10: Society faces a Short-
run tradeoff between Inflation and
Unemployment
• The Phillips Curve illustrates the tradeoff
between inflation and unemployment:
Inflation  Unemployment
It’s a short-run tradeoff!
 METHODOLOGY OF
ECONOMICS
• Economics trains you to. . . .
– Think in terms of alternatives.
– Evaluate the cost of individual and social
choices.
– Examine and understand how certain events
and issues are related
 Is Economics a Science?
• The scientific method deals with
questions which can be verified or
falsified by actual observations of the
real world. It involves:
– observation,
– Hypothesis,
– theory and more observation
• The economic way of thinking . . .
– Involves thinking analytically and objectively.
– Makes use of the scientific method
 Economics relies on the scientific
method
• Consists of a number of elements:
– The observation of facts (real world data)
– Make simplifying assumptions and formulate a
hypothesis,
– A hypothesis is a possible explanation of cause and
effect
– Make predictions based on the hypothesis-
– Testing the explanation by comparing the outcomes
of specific events to the outcome predicted by the
hypothesis
– The acceptance, rejection, or modification of the
hypothesis, based on the comparisons.
 Scientific method
– Continue to test the hypothesis against the facts. As
more favourable results accumulate, the hypothesis
evolves into a theory
– A well tested and widely accepted theory is referred
to as a law or economic principle
– Combinations of such laws or principles are
incorporated into models.
– Laws, principles, and models enable the economist
like the natural scientist, to understand and explain
reality and predict the outcomes of particular actions
 Facts, theories, and policies in
economics
• The process of deriving theories and principles
is called theoretical economics
– Involves establishing economic theories by gathering,
systematically arranging, and generalising from facts
• Good economic theories are tested for validity
against facts
• Well tested theories become economic laws or
principles
• Such laws and principles are used to formulate
economic policies.
• Hence theoretical versus policy economics
 Theories, laws, and principles and
models
• Hypothesis-needs initial testing
• Theory has been tested but needs more
testing
• A law is a theory that has provided strong
predictive accuracy over and over
• A model is a simplified representation of
how something works in the real world.
 Abstractions
• Economic theories, principles and models are
abstractions-they are simplification that omit
irrelevant facts and circumstances
• Economic models do not mirror the full
complexity of the real world.
• The process of sorting out and analysing facts
involves simplification and removal of clutter
• Is economic theory unrealistic?
• Economists simplify-that is develop theories and
buil models –to give meaning to an otherwise
confusing maze of facts
 Economic Generalisations
• Economic theories, principles and laws are
generalisations of economic behaviour.
• Imprecise because economic factors are usually
diverse.
• Economic principles are expressed as the
tendencies of typical or average consumers,
workers, or business firms
– E.g. Consumer spending ↑ and household disposable
income↑
– Quantity demanded↑ and price ↓
 The Role of Assumptions in
Economics
• Why do economists make assumptions?
• Economists make assumptions in order to make the
world easier to understand.
• The art in scientific thinking is deciding which
assumptions to make.
• Economists use different assumptions to answer
different questions
• ceteris paribus – other things equal assumption-assume
that all other variables except those under immediate
consideration are held constant for a particular analysis
• Difference between natural science and economics-
controlled experiment vs changing real world
 Economic models
• Economists use models to simplify reality
in order to improve our understanding of
the world
• Two of the most basic economic models
include:
– The Circular Flow Diagram
– The Production Possibilities Frontier
 Circular flow diagram
• The circular-flow diagram is a visual model of
the economy that shows how money flows
through markets among households and
firms
 Economic Policy
• Economic Policies are courses of action
based on economic principles
• They are used to resolve specific
economic problems
• Economic policies are normally applied to
problems after they arise. They can also
be used to “prevent” or moderate the
event e.g. unemployment, inflation etc.
 Steps in Economic policy
formulation
• State the goal-clear statement of
economic goal
• Determine the policy options-assessment
of economic impact, benefits, costs and
political feasibility of alternative policies
• Implement and evaluate selected policy
 Basic Economic Goals
• Economic Growth– produce more & better goods/services
• Full employment – provide suitable jobs for all citizens who are willing
& able to work
• Economic efficiency- achieve maximum fulfillment of wants using
available productive resources
• Price level stability – avoid large upswings & downswings in the
general price level
• Economic freedom- guarantee that business, workers, and
consumers have a high degree of freedom in their economic activities
• Equitable distribution of income – ensure that no group of
citizens faces poverty while others enjoy abundance
• Economic security- provide for chronically ill, disabled,
unemployed etc to earn minimal levels of income
• Balance of trade – seek overall balance with rest of world in trade &
financial transactions
• Sometimes goals compliment each other, at times conflict
• When they conflict, tradeoffs arise
 Microeconomics Vs
Macroeconomics
• Microeconomics focuses on the individual
parts of the economy-individual economic
agents and individual markets.
– How households and firms make decisions
and how they interact in specific markets
• Macroeconomics looks at the economy as
a whole.
– Economy-wide phenomena, including
inflation, unemployment, and economic
growth
 Positive Vs Normative Statements
• Positive statements are statements that attempt to
describe the world as it is.
• They are objective statements dealing with
matters of fact or they question about how things
actually are hence they are called descriptive
analysis.
• Positive statements are made without obvious
value-judgements and emotions.
• They may suggest an economic relationship that
can be tested by recourse to the available
evidence.
Positive and Normative Economics
• Positive economics can be described as “what is, what
was, and what probably will be” economics.
• Statements are based on economic theory rather than
raw emotion.
• Often these statements will be expressed in the form of a
hypothesis that can be analysed and evaluated.
• Examples:
– When the Government finances a budget deficit by borrowing
from the Central bank money supply will rise
– Lower taxes may stimulate an increase in the active labour
supply
– A national minimum wage is likely to cause a contraction in the
demand for low-skilled labour
– The per capita income in Botswana is higher than in Namibia
Positive and Normative Statements
• Normative statements are statements about
how the world should be.
• They are subjective - based on opinion
only - often without a basis in fact or
theory.
• They are value-laden, emotional
statements that focus on "what ought to
be".
– Called prescriptive analysis
Positive and Normative Statements
• Examples of Normative Statements
– The decision to privatise BTC is unwise and should
be reversed
– The decision to cut student allowance is undesirable
as it will make it difficult for students to attend classes
– A national minimum wage is totally undesirable as it
does not help the poor and causes higher
unemployment and inflation
– The national minimum wage should be increased to
P500 as a method of reducing poverty
– Protectionism is the only proper way to improve the
living standards of workers whose jobs are threatened
by cheap imports
 Logical Fallacy
• Fallacy of composition:
– occurs when one incorrectly attempts to generalize
from a relationship that is true for each individual, but
is not true for the whole group.
• Association as causation fallacy, also known
as the post hoc, ergo propter hoc fallacy.
– Occurs if one incorrectly assumes that one event is
the cause of another simply because it precedes the
other event.
 Some Questions
• Distinguish between inductive and
deductive reasoning in economic analysis
• Discuss three elements included in the
economic perspective
Graphs & Curves in Economics
• A graph is a visual representation of the
relationship between two variables
– If the graph is straight line, relationship is linear
– If graph slopes upward to the right, it depicts a
direct relationship between the two variables,
i.e., variables changes in the same direction.
Example - consumption & income
– If graph slopes downward to the right, it depicts
an inverse relationship, i.e., the variables change
in opposite directions. Example – price & quantity
demanded
 Dependent & independent variables
• Economists want to determine which variable is the
cause & which is the effect
– Independent variable is the cause or source; it is
the variable that changes first
– Dependent variable is the effect or outcome; it is
the variable that changes because of the change in
the independent variable
– Slope of a straight line is the ratio of the vertical
change (the drop) to the horizontal change (the run)
between any two points of the line
– Slope is important because it reflects marginal
changes, i.e., those involving 1 more (or 1 less) unit.
 Slope & vertical intercept
• Vertical intercept of a line is the point
where the line meets the vertical axis
• In the price quantity demanded equation it
shows the price at which quantity
demanded is zero.
• Equation of a linear relationship
• Y = a + bX;
– y is dependent variable
– a is vertical intercept
– x is dependent variable