LECTURE NOTES (Week I)
INTRODUCTION AND MOTIVATION
These notes aim to provide you with a brief introduction to the subject of economics as
a science, the way in which economists think and analyze the outside world, as well as give
you an overview of some of the basic ideas and concepts that economics is based on. A lot
of the material that follows is inspired by or adapted from chapters 1and 2 of Doug Allen’s
book ”Economic Principles: Seven Ideas for Thinking... Almost About Anything”1 and Gary
Becker’s lectures in price theory.
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What is Economics?
Most non-economists have an incorrect idea of what is the subject of economics. If you tell your
college friends from the humanities or physical sciences that you are taking or have taken courses
in economics many of them will ask you questions like: ”So what would happen to the stock
market in the next month?”, ”Would the exchange rate between the Canadian and US dollar go
up (down)” or ”When will the economy exit the recession?”. These are definitely questions that
economists are interested in but they constitute just a small part of what economics is about.
People not trained in economics have the idea that economists are people who assign monetary
value to everything and who do not care about anything that does not make money. This is
simply not true. Money, the GDP, the interest rate or the exchange rate may be the most
popular (judging by the newspaper titles) objects of interest for economists but they are not
the subject of economics. Actually there is no such thing as the subject of economics because
everything around us can be studied using economic theory. This is true because contemporary
economics is a way of thinking about behavior. Practically every instance of human
behavior - individual or collective we see in real life can be explained using economics:
- why grocery stores often use coupons instead of lowering the prices
- why we often see two gas stations owned by competitors right across each other;
- why a 6-inch sub in ”Subway” costs more than half of the foot-long sub;
- why people marry;
- why people go to school.
In this course we will concentrate on a particular part of economics called ’microeconomics’.
Given the meaning of the Greek word ’micro’ (small) it is logical to expect that we will be
thinking about and studying the behavior of smaller economic units. This is indeed true as
microeconomics studies the behavior and the interactions between individual people (called
’consumers’) or individual firms (’producers’). Thus we will not study any of the ’popular’
economic topics listed above as the interest rate, the exchange rate or GDP. However, this does
not mean that what we will be studying has nothing to do with these issues. On the contrary,
all these ’macro’ questions are simply a result of the aggregate behavior of the numerous micro
units that we will analyze. Just as a physicist would know everything about the Universe if
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You can buy the book (not required for this course) or download the first five chapters for free at http://
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he knew the location and law of motion of every atom of which it consists, we, in principle,
could find out everything about the macro phenomena if we understand really well their micro
foundations. Microeconomics thus is an indispensable building block for any economic theory.
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How Do Economists Think?
Economics)
(The Methodology of
1. Economists make assumptions
Every piece of economic analysis relies on certain behavioral assumptions. These assumptions correspond to the axioms in mathematics or logic - they cannot be proved or disproved
but can be only accepted (believed in) or not. This makes economics look a lot like religion.
Most of the assumptions that economists use are widely accepted among them (although not
necessarily among other social scientists) and thus serve as a common ground that enables
people practicing economics to easily understand each other. The practice of economists to
sometimes make arguable assumptions is often criticized by other sciences. The following is
a joke written probably by some people who do not particularly like the way economists use
assumptions. A physicist, an engineer and an economist were travelling on a ship which got hit
by a storm and they ended up the only survivors on an uninhabited island. There was nothing
to eat there, apart from a single can of food that they found on the beach. All three were very
happy about their discovery and they immediately started thinking of how to open the can.
The physicist first suggested that they use his eyeglasses as a magnifying glass and heat the
can till it explodes. The engineer then said that he had a better idea and proposed that they
use a stone to bash in the can and get the food out. Finally, the economist said: ”You guys are
complicating things too much. Let’s assume that we have a can opener and then everything
is very easy”. The joke teaches us a good lesson - we should never forget that assuming the
solution of a problem is not a good scientific practice.
2. Economists use formal language to construct models based on the assumptions they make
There are two important things to note in the above statement that characterizes the second
step in the economic way of thinking. The first is the fact that economics uses formal language
by which we mean mathematics (symbolic logic) or verbal logic. The use of logic in economic
analysis implies that the only way to refute its results is to refute the assumptions they are
based on. Given that one accepts the assumptions as true, all results that follow are logical
consequences of them and thus must be true as well.
The second important thing to note is that economists construct ’models’. By a model we
mean a simplification of reality. For example you could think that an economic model is to the
real world what a model train is to a real train - it looks similar, it predicts similar behavior
but many things are simply not present in the model while they exist in its real counterpart.
Because a model is by definition a simplification of reality we cannot expect that it should be
able to explain or predict everything that happens in the real world, i.e. it will definitely be
wrong or silent about certain phenomena. After all, a model that is able to explain the world
must be at least as complex as the world itself and, in addition, must be able to explain itself
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and so on. Instead, when constructing economic models economists usually concentrate on
explaining a particular feature of the world they find interesting disregarding (assuming away)
many other features of the reality.
3. Economists try to construct useful models
There can be thousands of economic models about any observed instance of human behavior.
Thus it is important to know which models are ’useful’, i.e. what are the characteristics of a
good economic model:
- models that explain stuff: a model is useful if it can explain some event or behavior
that has occurred in reality. A model that has no connection to reality may be a good exercise
in abstract mathematics but is of no use to economists as social scientists.
- models that are testable: any useful economic model must generate results or
predictions that allow for it to be tested against data. A model that can explain any possible
data set (say by a change in its parameter values) has a low value. Every useful model should
have robust testable predictions that enable it to be rejected or not when faced with data. In
particular, this implies that models that explain everything by assuming difference in tastes
among economic agents are not useful. It is very easy to say that differences in observed behavior
are simply due to differences in people’s tastes, e.g. I ride the bus while Bill Gates has a yacht
because we simply like it this way. Unfortunately such a model has no testable implications as
it simply assigns a different taste to every difference in behavior.
- models that are simple: if there are two models that explain a certain phenomenon
in the same way and one is simpler than the other, then the simpler model is more useful. This
rule is known as the ”Occam’s razor” and is based on the philosophical principle that simpler
explanations are more likely to be the true ones or, in other words, one should not make more
assumptions than the minimum needed.
The following is a good joke about how not to construct models. A physicist, a biologist and
a mathematical economists were staying one day in front of a business building and observed
that two people came in and after 5 minutes three came out. As good scientists they immediately
set up to construct a model which explains the phenomenon they have just observed. The
physicist said: well, two in, three out - it is basically the same, we must have some measurement
error. The biologist then said: no, no this isn’t right, it’s pretty obvious what has happened some reproduction must have occurred in the building. Finally the math economist interrupted
them saying: I don’t know really what went on in this building but all I know is that if one
person walks in right now the building will be empty.
One final remark about the use of models in economics: suppose we have constructed a
useful model that complies with all of the above criteria. There still may be some people who
think that the assumptions on which it is based are too simplistic and that people do not behave
in such way in reality. The typical answer of an economist to this type of criticism is that we
indeed may not know or be wrong about how exactly people behave. If, however the results
that our model predicts match with what we see in reality, then the assumption that we have
made that people behave ”as if” living in our model is not only innocuous but also very useful
- it allows us to simplify the reality and explain and predict behavior without having to know
what really may be going on in the world or human brains.
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What Do Economists Do?
Economists analyze individual and social human behavior, including the behavior of institutions
created by men as firms, the government or the market. There are two ways in which economics
analysis can be done (economic models can be used):
1. Explain behavior - we mentioned that a useful economic model must be able to
explain things observed in reality. Economics does not explain only past behavior, however, it
tries to explain future behavior (make forecasts) as well. In general the types of behavior that
economics explains can be aggregated into three main groups:
- the allocation of resources
- the determination of prices
- market operation
The type of economic analysis that aims at explaining past, present or future behavior is
also known as ’positive analysis’, where by ’positive’ we mean that it is based on objectively
assessing and identifying economic outcomes.
2. Prescribe behavior - the second main function that economists perform is to
prescribe behavior, i.e. tell people, firms or governments what should or should not be done
or, in general, how should the economy be organized. An analysis characterized with such
prescriptions is called ’normative analysis’. Examples include: should we raise the taxes for the
higher income brackets, should we raise the minimum wage, should we ban the imports of steel
from Europe, should we privatize the railroad industry, etc. Such analysis cannot be proved
right or wrong - it is totally subjective and depending on the judgement, values and beliefs
of the particular individual(s) performing it. This does not mean however that such type of
analysis has no economic basis. On the contrary every good normative analysis must be based
on a careful positive analysis of the issues and outcomes involved. The positive analysis can
help the economist who performs a normative evaluation by providing him with all the relevant
information on which to base his normative decision. As such the ability to perform positive
economic analysis is indispensable for any policy evaluation. In this course we would be mostly
concentrating on the theory used in positive analysis.
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The Main Ideas In Economics
All economics can be based broadly on a single concept - that of scarcity. We say that
something is scarce if people want (demand) more of it than the amount available when the
thing is free of charge. This immediately implies that every scarce good must have a positive
price. We see that most of the things that exist in the world are scarce by that definition - cars,
houses, food, etc. even time (people receive money to supply their available time). Air is not
scarce (yet) but clean air definitely is. The fact that we live in a world characterized by scarcity
implies that we must constantly face trade-offs: in order to have more of something we have
to get less of something else. In other words, scarcity requires that people constantly make
choices. If nothing was scarce then every person could have as much of everything they want
and they would not have to make any choices. But this is exactly what economics is about 4
we study human behavior, i.e. the choices that people make. Unfortunately, or fortunately for
economists, this is not the case in the real world - we cannot have everything. Even Bill Gates
faces scarcity - with all his money he still cannot buy more than 24 hours a day. The great
economist and Nobel prize winner Milton Friedman summarized this idea by saying: ”There is
no such thing as a free lunch”.
4.1
How To Deal With Scarcity?
Given the scarcity around us, a logical question is what is the best way to deal with it - i.e. what
is the best way to employ the resources in limited availability to become as satisfied as we can
be. Since the founder of economics Adam Smith economists answer this question by assuming
that people deal with scarcity by engaging in a particular type of behavior aimed to make them
as happy as they can be. This behavior is called ’maximizing behavior’ or ’optimization’. Let
me stress once again that economists make and believe in the assumption that people behave
in this way. We will see below why this is a good assumption which is better than other
alternatives.
1. Maximizing Behavior: economists believe that people are not stupid, that they
are rational, i.e. everything (the only goal) that all people want is to improve their well-being.
It is hard to deny that any of us would rather be miserable than happy. The idea that people
maximize their happiness should not be confused with maximizing one’s income or wealth (what
many non-economists think economics is all about). While having more money can potentially
enable one to become happier, it is perfectly possible that a person obtains satisfaction by giving
away money, e.g. for charity and there is nothing irrational about it. Similarly eating junk
food may look like an irrational behavior but it is not if people value the short-term satisfaction
obtained by eating a greasy hot dog more than the marginal increase in lifetime or health after
50 years.
Maximization gives us idea of how people respond to incentives - another important
concept in economics. Since people are always maximizing their well-being the only way to
make them do something is to provide incentives for them - i.e. to make their well-being
depend on the thing. Nobody would work if she would be paid the same regardless of how
much she has done. Nobody would go to college if they didn’t believe that this increases their
chances of getting a good well-paid job in the future. Nobody would abide the law if there were
no moral or other punishments for disobeying it. Incentives are really important. Communism
failed because the system could not provide the right incentives for people. Everyone was paid
basically the same and jobs were for life which led to huge amounts of shirking and nobody
putting real effort. Without the market and its institutions to provide the necessary incentives
the system was doomed to fail from its inception. Another example is the problem of widespread
corruption in many less developed countries. Most of the corruption occurs because people in
the government are poorly paid and thus they use their position to get some more income on
the side. The threat of firing them is not very deterring as they would probably have higher
wages outside the government sector. It seems then that a way to stop corruption would be to
raise the salaries of potentially corrupt officials so that they would have a lot to lose with their
job.
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2. Equilibrium: the second main idea in economics is that of equilibrium, i.e. a
situation in which no one wants to change their behavior. Maximization leads to an equilibrium
- if we are in equilibrium it cannot be possible that someone can do something that improves her
well-being as it would be a change of behavior which contradicts the definition of equilibrium.
Thus all beneficial trades must be exhausted in equilibrium. If we believe (as most economists
do) that the world is in equilibrium or achieves one pretty fast after some external perturbation,
this implies that no one can get rich fast and easy without having to work for it. Thus all people
who post ads in the newspapers that they can give you the secret to make ”big bucks” are simply
liars - if they really knew how they wouldn’t tell you, would they? Actually the only way they
can get rich is by finding enough stupid people to reply to these ads.
Here is a story that illustrates the idea of equilibrium. Imagine that you are on the highway
trying to get home after work and you hit a traffic jam and wonder which lane would get
you home faster. If people are maximizing and an equilibrium is attained, the lane you take
shouldn’t matter for the end result - if one of the lanes were consistently faster that would
mean that many people from the other lane would change their behavior by switching to the
’fast’ lane which would mean that there was no equilibrium. Another popular story related to
maximization and equilibrium is the joke about Chicago professor Eugene Fama, a firm believer
in people’s rationality and market efficiency. The joke goes as follows: Fama and a student were
walking on the street and the student observes a $100 bill on the sidewalk and rushes to pick
it up. Fama then reaches out and holds him saying: ”This bill should be fake and worthless
because if it were real someone else should have picked it up already”. This is why business
people do not like economics.
4.2
Why Believe in Maximization?
So is maximization really a valid assumption that gives us a good idea how to explain and
predict human behavior? The answer is yes. There are two main reasons that economists
assume and strongly believe that people maximize.
1. Maximization works - even if we suspect that people are not actually consciously
maximizing when making their choices (I don’t sit down and solve a complex maximization
problem whenever I want to buy a sandwich), if we believe that people behave as if they were
maximizing, we do a really good job of explaining and predicting their behavior.
2. Evolution - the idea of maximization also has a founding in evolutionary biology.
Species which do not maximize or who do not adapt in the best way to changes in the environment simply disappear. Similarly people or firms that do not maximize are eventually doomed
to get poorer and poorer (or go bankrupt) and become less relevant or non-existent from an
economic point of view. Maximization is thus an evolutionary sound behavior. That does
not mean, however, that all maximization must be done consciously or after some complicated
deliberation. Hardly anyone would believe that chameleons have learned to change their skin
color because they were so smart and figured this out. Instead, this is most likely due to some
random mutation - all chameleons who couldn’t do it were probably eaten.
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