The Issues and Methods of Economics

Key concepts discussed in this chapter: economics as a social science, positive economics, normative economics, economic model, economic theory, economic way of thinking, production possibilities frontier (PPF), opportunity cost, productive efficiency, allocative efficiency, Pareto efficiency, specialization, absolute advantage, comparative advantage

Economics as a science

As a matter of fact, all key economic questions and problems arise because human wants exceed the resources available to satisfy them. Our inability to satisfy all our wants is called scarcity. Faced with scarcity we must make choices. We must choose the available alternatives. Therefore, economics as a science can be defined as follows:

Economics : Social science that studies the choices that individuals, businesses, government and the entire society make as they cope with scarcity

The subject matter of economics is divided into two main components:

• Microeconomics
• Macroeconomics

Microeconomics is the study of the choices that individual economic agents make, the interaction of these choices, and the influence that governments exert on these choices. The key word in understanding microeconomics is individual.

Macroeconomics is the study of the aggregate (total) effects on the national economy and the global economy of the choices that individuals, households, businesses and governments make. The key word in understanding macroeconomics is aggregate.

The economic choices that individual economic agents such as individuals, households, businesses and governments make and the interactions of those choices answer the following three major microeconomic questions:

• What goods and services should be produce and in what quantities?
• How are goods and services produced?
• For whom are the various goods and services produced?

Microeconomic theory will help us answer these questions. In answering these questions, economists generally find that individuals want more than is available, and that is why the problem of scarcity arises. Being social scientists, economists try to discover how the economic world works. In doing so, they distinguish between two types of statements or two types of economic analysis:

• Positive statements or positive economic analysis
• Normative statements or normative economic analysis

Positive statement is a proposition that can be settled by an appeal to facts. It is testable, either true or false and is associated with the statement “what it is” without any policy recommendations. Example of the statement is “Air pollution in large cities is high”. Positive analysis is a value-free approach to inquiry.

Normative statement is associated with the proposition “what ought to be”. It is not based on facts and usually points to some policy recommendations. Example of the statement is: “We ought to clean up our environment”. Normative analysis is based on value judgment. In general, the following words are good indicators of a normative statement: ought to, have to, should, and must.

Modeling in economics

The task of economic science is first to discover and catalogue positive statements that are consistent with what we observe in the world and that enable us to understand how the economic world works.

This task can be broken into three steps:

• Observing and measuring
• Model building
• Testing

Observing and measuring result in economists keeping track of huge amounts of economic data. These data are needed to build economic models.

Economic model : A description of some aspects of the economic world that includes only those features that are needed for the purpose at hand

At large, economic model is an abstraction (simplification) of the real world. It is composed of a number of assumptions and relationships between economic variables from which conclusions and/or predictions are deducted.

Assumptions are apriori statements or what economists call stylized facts. They are accepted without any proof. Assumptions are an important component of an economic model. They help economists create the required environment to make use of mathematical relationships.

In general, relationships take on a form of equations and/or inequalities that involve economic variables, constants and parameters. A set of equations and inequalities defines the structure of a model. Equations in economic models are of 3 types: definitional equations, behavioral equations and conditional equations. A definitional equation is identity which is equality between two alternative expressions that have exactly the same meaning.

A behavioral equation specifies the way in which a given variable behaves in response to changes in other variables.

A conditional equation states a requirement to be satisfied.

Mathematical way of presenting economic models is not the only one. At large economic models can be presented in various forms such as:

• by words = logical or verbal models
• by tables = statistical models
• by graphs = graphical models
• by mathematical expressions = mathematical models

All of them are useful ways to analyze economic information. For instance, economists make extensive use of graphs because they are very illustrative and help one better absorb specifics of underlying economic processes.

And finally, after a model is constructed it has to be tested because the model might conflict with the existing data. A model that has repeatedly passed the test of corresponding with real-world data is the basis of an economic theory.

Economic theory : A generalization that summarizes what we understand about economic choices that people make and the economic performance of industries and nations

Theories are then usually used to address normative aspects of economic analysis. So, economics is a social science that studies the allocation of scarce resources to satisfy unlimited wants.This involves analyzing the production, distribution, trade and consumption of goods and services.

Economics is said to be positive when it attempts to explain the consequences of different choices given a set of assumptions or a set of observations, and normative when it prescribes that a certain action should be taken.

Economic way of thinking

The economic way of thinking assumes that a typical response to an economic problem of scarcity is rational behavior. This way of thinking is somewhat different from the natural sciences’. Five core ideas summarize it, and these ideas form the basis of all microeconomics models.

They are:

• People make rational choices by comparing costs and benefits
• Cost is what you must give up to get something
• Benefit is what you gain when you get something and is measured by what you are willing to give up to get it
• Rational choice is made on a margin
• People respond to incentives

In general, rational choice is a choice that uses the available resources most effectively to satisfy the wants of an economic agent making the choice.

Cost in economics is viewed in terms of opportunity cost. Opportunity cost is the cost of something you must give up to get what you want. The concept arises because of scarcity: If you use resource in some specific way then you actually forgo opportunity to use the scarce resource in any other way. Formal definition of opportunity cost is

Opportunity cost : The value of the most valuable alternative that was not chosen The benefit of something is the gain or pleasure that it brings. Economists measure benefits by what a person is willing to give up getting it.

A choice on the margin is a choice that is made by comparing all the relevant alternatives systematically and incrementally. Therefore, instead of just costs and benefits we have to take into consideration marginal costs and marginal benefits:

Marginal cost : The cost that arises from a one-unit increase in an activity. The marginal cost of something is what you must give up to get one more unit of it

Marginal benefit : The benefit that arises from a one-unit increase in an activity. The marginal benefit of something is measured by what you are willing to give up getting one more unit of it

People make rational choices and use our scarce resources in the way that makes them as well off as possible when they take those actions for which marginal benefits exceed or equals marginal costs . In making their choices, people respond to incentives. An incentive is an inducement to take a particular action.

The inducement can be a reward in the form of an increase in benefit or a decrease in cost. On the other hand, an incentive can be a punishment with the opposite result. In general, a change in marginal benefit or a change in marginal cost brings a change in the incentives that people face and eventually leads them to change their actions.

Therefore, in order to make a rational choice, we must determine the costs and benefits of the alternatives.

Production possibilities frontier (PPF)

Formal definition of the production possibilities frontier is:

Production Possibilities Frontier : The boundary between the combinations of goods and services that can be produced and the combinations that cannot be produced, given the available factors of production and state of technology

First of all, it is necessary to define what economists mean by factors of production also called inputs of production or resources. At large it is possible to define the following factors of production (inputs of production, resources):

• Labor – a set of human efforts
• Physical capital – a set of capital goods (assets) such as equipment, machinery, tools, buildings,
• structures, etc.
• Land and natural resources such as, for example, oil, coal, natural gas, etc.
• Entrepreneurship – a set of managerial skills

In order to illustrate the limits of production, we focus our attention on two goods only. The following graph illustrates the concept of the PPP: In that graph, X-axis measures quantity of good X in some units while Y-axis measures quantity of good Y.

Figure 1

It turns out that the PPF is a valuable tool for illustrating the effects of scarcity and its consequences. It puts three features of production possibilities in focus:

• Attainable versus unattainable combinations: Combinations of two goods represented by pointsX, A, B and C or in general any point inside or on the PPF are attainable while combinationassociated with point D is unattainable given the economy’s resources
• Efficient versus inefficient combinations: Combinations A, B and C or any point on the PPF are efficient combinations while combinations inside the PPF like point X are inefficient
• Trade-offs: Movement from p. C to point A shows the trade-off between goods X and Y sincean increase in X corresponds to a decrease in Y and vice versa

Full employment of all economy’s resources occurs when all the available factors of production are being used up which is represented by points A, B, C on the above graph. Therefore, combinations inside the PPF are associated with unemployment of some or all resources.

PPF and opportunity costs

The concept of opportunity cost is often expressed by economists in the form of the following expression: “There is no such a thing as free lunch” which means that there is always cost involved. However, if the economy produces inside the PPF (point X), then it is possible to increase production of one good without giving up the other: Consider movement from point X to point A on the above graph.

When production takes place on the PPF, we face a trade-off; however, we do not face a trade-off if we produce inside the PPF. Trade-off or movement along the PPP is always associated with opportunity costs. PPF helps us define the opportunity costs associated with production of both goods numerically. Technically opportunity cost is a ratio – the change in the quantity of one good divided by the change in the quantity of the other good or in our case we can express opportunity cost of good X as follows:

OCx = ΔY/ ΔX

It means that opportunity cost of good X is equal to the ΔY quantity of good Y given up per extra unit of good X gained. It is associated with movement along the PPF like from p. A to p. B. Graphically it is slope of the PPF. In turn, opportunity cost of good Y is inverse of the opportunity cost of good X or

OCy = 1/ OCx

and it is associated with movement along the PPF like from p. B to p. A. In general, when we move along the PPF in any direction extra unit of one good requires more and more of the other good being sacrificed which is reflected in the bowed out shape of the PPF.

As intermediate conclusion:

• negative slope of the PPF reflects trade-off between two goods
• slope of the PPF at any point shows opportunity cost of the good on the horizontal axis
• opportunity cost of one good is the inverse of the opportunity cost of the other
• opportunity cost of producing a good increases with an increase in the quantity of the good
• which results in a concave (bowed outward) PPF

Economic efficiency

In economics, efficiency occurs when we produce the quantities of goods and services that people value the most. Resource use is efficient when we cannot produce more of a good or service without giving up some of another good or service that people value more highly. These two statements characterize economic efficiency as allocative efficiency and productive efficiency:

Productive efficiency : A situation in which an economy produces the maximum output with given technology and resources; it cannot produce more of one good or service without producing less of some other good or service

It means that under productive efficiency, production takes place on the PPF.

Allocative efficiency : The most highly valued combination of goods and services on the PPF Given the above definition we can state that all combinations on the PPF achieve productive efficiency. Each of these combinations, however, is associated with specific distribution. Only one of them achieves allocative efficiency or only one combination is the most highly valued by people – the consumers. In order to find this combination, we need to know the value of each available combination. We can express it in terms of marginal benefits people receive from consumption.

In general, the more we have of any good or service, the smaller is our marginal benefit from extra unit of it which is known as the principle of diminishing (decreasing) marginal benefit. Mathematically the principle of diminishing marginal benefit implies that marginal benefit is a decreasing function of the quantity of a good or service consumed.

As previously discussed, the bowed out shape of the PPF is due to the fact that marginal opportunity cost or just marginal cost is an increasing function of quantity. In order to achieve allocative efficiency, we must compare the marginal benefit of a good or service MB with its marginal cost MC. The point when MC = MB is the point of allocative efficiency. In the above discussed case of two goods, this condition with respect to one good (usually good X) coupled with the PPF for two goods X and Y produces optimal combination of the two goods that is allocatively efficient.

It should be pointed out that allocative efficiency is a broader and deeper concept than productive efficiency since it is associated with the so-called Pareto efficiency:

Pareto efficiency : An allocation is Pareto efficient if there is no other allocation in which some other individual is better off and no individual is worse off

Specialization, absolute and comparative advantage

Producers can produce several goods or they can concentrate on producing one good and then exchange some of their own good for those produced by others. The latter is called specialization:

Specialization : Concentrating on the production of only one good

The same can be said about nations and regions. According to economic theory, people (nations, regions) have to produce the good in which they have comparative advantage defined as follows:

Comparative advantage : The ability of a person to perform an activity or produce a good or service at a lower opportunity cost than someone else

This concept is usually compared to the concept of absolute advantage:

Absolute advantage : When one person is more productive than another person in several or even all activities

It turns out that it is possible to have absolute advantage in producing all goods and services while it is impossible to have comparative advantage in all goods and services. Moreover, it appears to be that it is beneficial for a producer (nation, region) to find its comparative advantage, specialize on production of a good or service according to it and then exchange it for other goods and services.

The concept of comparative advantage is the most powerful in the context of international trade. Usually trading countries have different absolute advantages in producing goods. For example (Lee, 1999), suppose that there are only two goods, cars and computers, and one productive resource (input of production) which is some composite of land, labor, and capital. Assume also that producing 100 cars requires 2 units of the productive resource (PR) in Country 1 and 4 units in Country 2, and producing 1,000 computers requires 3 units of PR in Country 1 and 4 in Country 2. This information is summarized in the following table:

	Country 1	Country 2
100 cars	2	4
1,000 computers	3	4

As seen from the table, Country 1 has an absolute advantage in producing both cars and computers. It may seem that Country 1 can realize no gain by trading with Country 2. Why not produce both cars and computers here, in Country 1? The answer to this question is: Because it costs more to produce computers in Country 1 than in Country 2.

All costs are opportunity costs. The cost of producing computers is the cars that could have been produced. Using the three units of PR required to produce 1,000 computers in Country 1 requires sacrificing the production of 150 cars. Using the four units of PR required to produce 1,000 computers in Country 2 requires sacrificing only 100 cars. So even though Country 1 has an absolute advantage in producing computers, Country 2 has a comparative advantage.

Compared to what has to be sacrificed, Country 2 produces computers for only two-thirds as much as it costs in Country 1. However, Country 1 has a comparative advantage over Country 2 in the production of cars. Producing 100 cars here costs 666 computers, while producing 100 cars in Country 2 costs 1,000 computers. Clearly Country 1 benefits from specializing in cars, which it produces more cheaply than Country 2, and trading with Country 2 for some of the computers it produces more cheaply.

If, for example, Country 1 produced both cars and computers it might devote 70 units of PR to car production and 30 units to computer production, yielding 3,500 cars and 10,000 computers. If Country 2 produced both products, it might devote 56 units of PR to car production and 24 to computer production, yielding 1,400 cars and 6,000 computers. On the other hand, by specializing in their comparative advantages, Country 1 can produce 5,000 cars and Country 2 can produce 20,000 computers, or a total of 100 additional cars and 4,000 additional computers. Country 1 could trade 1,450 cars to Country 2 for 12,500 computers and have 50 additional cars (3,550) and 2,500 more computers (12,500), while Country 2 would have 50 more cars (1,450) and 1,500 more computers (7,500). It implies that trade is productive since it generates more output of both products.