Introduction to Economics

What is Economics?

Economics is founded on two fundamental facts namely unlimited wants and limited (scarce)
resources. By unlimited wants is meant that people’s wants (desires) for goods and services are
many and diverse. In addition to biological needs such as air, water, food, clothing, and shelter,
people also desire many goods and services that are associated with a high standard of living.

Goods and services are the means by which society satisfies its many wants. In order to produce
these goods and services, society uses its productive resources such as land, labour, capital and
managerial abilities. However, in relation to society’s wants, productive resources are limited in
supply. Therefore society can only produce a limited quantity of goods and services. Thus, the
limited productive capacity of society’s economic resources makes it impossible to satisfy all its
wants.

Therefore, economics is defined as the social science that studies how society manages (allocates)
its scarce resources in order to achieve maximum satisfaction of its unlimited wants.

Hence, economics is concerned with the efficient management of society’s scarce resources.

What is an Economy?

An economy or economic system is simply an organisational mechanism through which society

allocates its scarce resources. Society can allocate its resources either through central planning or
through the market system. The word economy comes from a Greek word meaning “one who
manages a household”. The similarity between an economy and a household comes from the fact
that they both face many economic decisions.

The Economic perspective

An economic problem exists whenever wants exceed the resources available to satisfy them. The
existence of an economic problem gives economists a unique way of viewing the world called the
economic perspective. There are three interrelated features that define the economic way of
thinking (economic perspective). These are scarcity and choice, rational behaviour, and marginal
analysis.

Scarcity and Choice

Economists view the world through the lens of scarcity. Scarcity means that society has limited
economic resources. Given that human and property resources are scarce, it also follows that the
goods and services produced from such resources are also limited. Thus, scarcity limits society’s
choices and necessitates choices about what to have and what to forgo. In other words, since we
cannot have everything we want, we have to decide to have and what to forgo. Just like a household
cannot give every member everything he or she wants, a society cannot give every individual the
highest standard of living to which he or she might aspire. The term opportunity cost is used to

1
describe these sacrifices. Specifically, the opportunity cost of an item is the value of the item/s that
you give up to obtain it. Thus, when making any decision, such as whether to attend college,
decision makers should be aware of the opportunity costs that accompany each possible action.

Rational Behaviour

Economics is grounded on the assumption of ‘rational self-interest’. This means that individuals
are assumed to behave rationally. In other words, individuals pursue actions that allow them to
achieve the greatest satisfaction. Rational behavior implies two things. Firstly, it implies that
individuals will make different choices under different circumstances. For example, you may
decide to buy Coca-Cola in bulk at a wholesale store rather than at a supermarket store where it is
much more expensive. That will leave you with extra money to buy something else that provides
satisfaction. Yet, while driving home from work, you may stop at the convenience store to buy a
single bottle of Coca-Cola. Secondly, rational self-interest also implies that individuals will make
different choices. For example, when you complete high school, you may decide to attend college
or university to major in business while your friend may opt to take a job in the mines. These
choices reflect the pursuit of self-interest and are rational and are based on different preferences
and circumstances. However, rational decisions may change as costs and benefits change.

Marginal Analysis

The economic perspective focuses largely on marginal analysis. The term ‘marginal’ in this
context means “extra,” “additional,” or “a change in”. Marginal analysis involves a comparison of
marginal benefits and marginal costs when making decisions. Economists use the term ‘marginal
changes’ to describe small incremental adjustments to an existing plan of action. Most choices or
decisions that we make in life involve incremental changes to the existing state of affairs. For
example, should you attend school for an extra year or not? Should you study an extra hour for an
exam? Should a business expand or reduce its output? Should government increase or reduce
health care funding? Each of the decisions involves marginal benefits and marginal costs because
resources are scarce. The scarcity of resources implies that the decision to obtain the marginal
benefit associated with some specific option always includes the marginal cost of forgoing
something else. Thus, when making decisions economic agents must be aware of the marginal
benefits and marginal costs of each decision.

Consider the decision to purchase a 12 inch or 16 inch LCD TV set. The marginal cost of the 16
inch LCD TV set is the added expense beyond the 12 inch LCD TV set. The marginal benefit is
the larger picture experience. If the marginal benefit of the larger TV set exceeds its marginal cost,
you should buy the larger TV set. But if the marginal cost is more than the marginal benefit, you
should buy the smaller TV set. If a decision is made to purchase the larger TV set, it means that
the money spent on the larger TV set could have been spent on something else.

The Scope of Economics

Economics is broadly divided into two parts namely microeconomics and macroeconomics.

2
Microeconomics and Macroeconomics

Microeconomics is the study of how households and firms make decisions and how they interact
in specific markets. It looks at the specific economic units or segments that make up the economy.
For example, we study an individual industry, firm, or household. Microeconomics might measure
the price of a specific product, the number of workers employed by a single firm, the revenue or
income of a particular firm or household, or the expenditures of a specific firm, government entity,
or family.

Macroeconomics is the study of the economy as a whole or its basic subdivisions or aggregates
such as the government, household, and business sectors. An aggregate is a collection of specific
economic units treated as if they were one unit. For example, consumers in the economy can be
lumped together and treated as if they were one huge unit called “consumers.” By using aggregates,
macroeconomics seeks to obtain an overview, or general outline, of the structure of the economy
and the relationships of its major aggregates. Macroeconomics deals with economic measures such
as total output, total employment, total income, aggregate expenditures, and the general level of
prices in analyzing various economic problems. It gives very little attention to specific units
making up the various aggregates.

Microeconomics and macroeconomics are closely intertwined. Since changes in the overall
economy arise from decisions of millions of individuals, it is impossible to understand
macroeconomic developments without considering the associated microeconomic decisions. For
Example, the problem of unemployment is usually treated as a macroeconomic topic because
unemployment relates to aggregate spending. However, the decisions made by individual workers
in searching for jobs and the way specific product and labour markets operate are also critical in
determining the unemployment rate.

Positive and Normative Economics

Both macroeconomics and microeconomics involve facts, theories, and policies and each contains
elements of positive economics and normative economics. Positive economics focuses on facts
and cause-and-effect relationships. Positive economics avoids value judgments and tries to
establish scientific statements about economic behaviour. It deals with what the economy is
actually like. Positive analysis is factual and plays a critical role in policy analysis.

Normative economics, on the other hand, incorporates value judgments about what the economy
should be like. It looks at the desirability of certain aspects of the economy and underlies
expressions of support for particular economic policies. Positive economics is concerned with
“what is”, while normative economics is concerned with “what ought to be”. Whenever words
such as “ought” or “should” appear in a sentence, there is a strong chance that you are encountering
a normative statement.

Examples

Positive statement: “The unemployment rate in several European nations is higher than that in
Canada.”

3
Normative statement: “European nations ought to undertake policies to reduce their unemployment
rates.”

Positive statement: “Other things equal, if tuition is substantially increased, college and university
enrolment will fall.”

Normative statement: “College and university tuition should be lowered so that more students can
obtain an education.”

Most of the disagreement among economists involves normative, value-based policy questions.
There may also be some disagreement about which theories or models best represent the economy
and its parts. But economists agree on a full range of economic principles. Most economic
controversy thus reflects differing opinions or value judgments about what society should be like.

The Method of Economics

Economists study the economy in the same way that physicists study matter and biologists study
life. They use the scientific method in their study of the economy. Economics is a science because
it relies on the scientific method to study the economy. Thus, economists are scientists because
they use the scientific method to study how the economy works.

The Scientific Method

The scientific method is a systematic pursuit of knowledge through the formulation of a problem,
collection of data and the formulation and testing of hypotheses. It is a method of inquiry which
involves the development and testing of theories about how the world works. The essence of any
science is the scientific method. The scientific method consists of the following elements:

 Observation of real world facts (real world data)

 Formulation of possible explanations of cause and effect called hypotheses based on
observed facts
 Testing of these explanations or hypotheses by comparing the outcomes of specific events
to the outcomes predicted by the hypothesis
 The acceptance, rejection, or modification of the hypotheses, based on these comparisons.
 The continued testing of the hypotheses against the facts. As favourable results accumulate,
the hypotheses evolve into a theory, sometimes called a model. A very well-tested and
widely accepted theory is referred to as a law or principle.

Laws, principles, and models enable economists to understand and explain economic phenomena
and to predict the various outcomes of particular actions or events. However, economic laws and
principles are usually less certain than the laws of physics or chemistry.

4
Theoretical Economics

Economic theories or models about the behaviour of individuals (consumers and workers) and
institutions (business and government) are derived by gathering facts about economic activity and
economic outcomes. The facts to be gathered must be relevant to the problem under study. Once
these facts are collected, they form the basis for formulating hypotheses (cause–effect
explanations) about economic behaviour. The hypotheses are then tested against real world
observation and data. The purpose of testing these hypotheses is to discover hypotheses that rise
to the level of theories, principles or laws about how individuals and institutions behave. This
process of deriving economic theories, principles or laws about the behaviour of individuals and
institutions is called theoretical economics. Economic theories and principles enable economists
to predict and explain the likely effects of actions undertaken by economic agents (individuals and
institutions). Good theories are those that do a good job of explaining and predicting. Since facts
may change over time, economists have to continually check theories against the changing
economic environment.

It is also important to understand the following points that relate to economic principles:

Terminology:

The terms “hypotheses,” “theories,” “models,” “laws” and “principles” may overlap but they
usually reflect the degree of confidence in the generalizations.

 A hypothesis needs initial testing

 A theory or model is an hypothesis that has been tested but needs more testing

 A law or principle is a theory or model that has provided strong predicative accuracy
repeatedly

Generalizations

Economic theories, principles, and laws are generalizations about economic behaviour or the
economy itself. They are imprecise because of the diversity of economic facts; no two individuals
or institutions act in exactly the same way. Economic principles are expressed as the tendencies of
typical or average consumers, workers, or business firms. For example, when economists say that
consumer spending rises when personal income increases, they are well aware that some
households may save all of an increase in their incomes. But, on average, and for the entire
economy, spending goes up when income increases.

Other Things Being Equal Assumption

Economists use the ceteris paribus or other-things-being-equal assumption to arrive at their

generalizations. This assumption means that all other variables except those under immediate
consideration are held constant for a particular analysis. For example, consider the relationship
between the price of sugar and the amount of it purchased. To study this relationship, we assume
that, of all the factors that might influence the amount of sugar purchased (for example, consumer
5
incomes and preferences), only the price of sugar is allowed to vary. This enables us to focus on
the “price of sugar and purchases of sugar” relationship without being confused by changes in
other variables.

Abstractions

Economic theories are abstractions. This means that they are simplifications that omit irrelevant
facts and circumstances. Economic models do not mirror the full complexity of the real world. The
process of sorting out and analyzing facts involves simplification and removal of irrelevant facts.
However, this “abstraction” leads some people to consider economic theory impractical and
unrealistic. But, Economic theories are practical because they are abstractions. The full scope of
economic reality is simply too complex to be understood in totality.

Graphical Expression

Many of the economic models are expressed graphically as we shall see later.

Applied or Policy Economics

Applied economics, or policy economics is the application of theories and data to formulate
policies that aim to resolve a specific economic problem or further an economic goal. Economic
theories provide a foundation for economic policy. Economic policy is normally applied to
problems after they arise. However, it can also be used to avoid or moderate undesirable events
such as unemployment, inflation, or an increase in poverty. For example, the central bank may
reduce interest rates to increase spending and prevent a recession.

Formulating Economic Policy

There are three basic steps in policy-making:

Step 1: State the goal of the policy

This step involves making a clear statement of the economic goal in a specific way. For example,
if the goal is to achieve “full employment,” The goal may be stated as follows: Everyone between
16 and 65 years of age should have a job or everyone who wants to work should have a job.
The goal of the policy must be specific.

Step 2: Determine the policy options

This involves formulating alternative policies designed to achieve the stated goal, and determining
the possible effects of each policy. This requires a detailed assessment of the economic impact,
benefits, costs, and political feasibility of the alternative policies. For example, to achieve full
employment, should government use fiscal policy (which involves changing government spending
and taxes), monetary policy (which entails altering the supply of money), an education and training
policy that enhances worker employability, or a policy of wage subsidies to firms that hire
disadvantaged workers?

6
Step 3: Implement and evaluate the policy that was selected

After implementing the policy, we need to evaluate how well it worked. Only through unbiased
evaluation can we improve on economic policy. Did a specific change in taxes or the money supply
alter the level of employment to the extent predicted? Did deregulation of a particular industry (for
example, banking) yield the predicted beneficial results? If not, why not? What were the harmful
side effects, if any? How might the policy be altered to make it work better?

Economic Goals

Economic policies are designed to achieve specific economic goals. The following are some of the
economic goals that different countries pursue:

 Economic growth: Means to produce more and better goods and services or develop a
higher standard of living.

 Full employment: Means to provide suitable jobs for all citizens who are willing and able
to work.

 Economic efficiency: Means to achieve the maximum fulfillment of wants using the
available productive resources.

 Price-level stability: Means to avoid large upswings and downswings in the general price
level (avoid inflation and deflation).

 Economic freedom: Means to guarantee businesses, workers, and consumers a high degree
of freedom of choice in their economic activities.

 Equitable distribution of income: Means to ensure that no group of citizens faces poverty
while most others enjoy abundance.

 Economic security: Means to provide for those who are chronically ill, disabled,
unemployed, aged, or otherwise unable to earn minimal levels of income.

 Balance of trade: Means to seek a reasonable overall balance with the rest of the world in
international trade and financial transactions.

There may be disagreements about the specific definitions of these economic goals. In addition
some goals may complement each other or conflict. When goals conflict, society must develop a
system to prioritize the objectives it seeks. For example, if more economic freedom is accompanied
by less economic security and more economic security allows less economic freedom, society must
assess the tradeoffs and decide on the optimal (best) balance between them.

7
Pitfalls to Objective Thinking

It is often difficult to think about economic issues objectively because they often affect us
personally. The following is a list of common pitfalls to avoid in successfully applying the
economic perspective:

Biases

To apply the economic perspective successfully one must shed off biases and preconceptions that
are not supported by facts. This is because biases cloud thinking and interfere with objective
analysis. An example of a bias is when one believes that corporate profits are excessive or that
lending money is always superior to borrowing money.

Loaded Terminology

Loaded terminology is terminology that is emotionally biased, or loaded. This is common in

newspaper articles where the writer or the interest group he or she represents may have a cause to
promote or an axe to grind and may slant an article accordingly. For example, high profits may
be labelled “obscene,” low wages may be called “exploitive,” or self-interested behaviour may be
called “greed.” Government workers may be referred to as “mindless bureaucrats and those
favouring stronger government regulations may be called “socialists.” Analysing economic issues
objectively requires rejecting or discounting such terminology.

Definitions

Many terms used in economics have precise technical definitions that are quite different from those
implied by their common usage. However, this is generally not a problem if everyone understands
these definitions and uses them consistently. For example, investment to the average citizen means
the purchase of stocks and bonds in security markets. But to the economist, investment means the
purchase of newly created real (physical) capital assets such as machinery and equipment or the
construction of a new factory building. It does not mean the purely financial transaction of
swapping cash for securities.

Fallacy of Composition

The fallacy of composition is the assumption that what is true for one individual or part of a whole
is necessarily true for a group of individuals or the whole. This assumption is not correct. A
statement that is valid for an individual or part is not necessarily valid for the larger group or whole.
For example, you are at a football game and the home team makes an outstanding play. In the
excitement, you leap to your feet to get a better view. If you, an individual, stand, your view of the
game is improved.” But this is not true for the group because if everyone stands to watch the game,
nobody including you will probably have a better view than when all remain seated.

8
Causation Fallacies

Causation is sometimes difficult to identify in economics. The two important fallacies that often
interfere with economic thinking are Post Hoc Fallacy and Correlation and Causation.

Post Hoc Fallacy

This fallacy refers to a situation where one concludes that because event A precedes event B, A is
the cause of B. This kind of faulty reasoning is known as the post hoc, ergo propter hoc or “after
this, therefore because of this” fallacy. Suppose that early each spring the medicine man of a tribe
performs a special dance. A week or so later the trees and grass turn green. Can we safely conclude
that event A, the medicine man’s dance, has caused event B, the landscape’s turning green? A
professional football team hires a new coach and the team’s record improves. Is the new coach the
cause? But perhaps the presence of more experienced and talented players or an easier schedule is
the true cause.

Correlation versus Causation

Correlation between two events or two sets of data indicates only that they are associated in some
systematic and dependable way. For example, we may find that when variable X increases, Y also
increases. But this correlation does not necessarily mean that there is causation— that an increase
in X is the cause of an increase in Y. The relationship could be purely coincidental or dependent
on some other factor, Z, not included in the analysis. Economists have found a positive correlation
between education and income. In general, people with more education earn higher incomes than
those with less education. Common sense suggests education is the cause and higher incomes are
the effect; more education implies a more knowledgeable and productive worker, and such workers
receive larger salaries.

But causation could also partly run the other way. People with higher incomes could buy more
education, just as they buy more furniture and other things steaks.