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The Economy as a Whole and the Standard of Living

CONCEPT 8 ("Production and the Standard of Living"): The standard of living of the average person in a particular country is dependent on its production of goods and services. A rise in the standard of living requires a rise in the output of goods and services.

CONCEPT 9 ("Money and Inflation"): If the monetary authorities of a country annually print money in excess of the growth of output of goods and services it will eventually lead to inflation.

CONCEPT 10 ("Inflation-Unemployment Tradeoff"): In the short run, society faces a short-run tradeoff between inflation and its level of unemployment.

These concepts will be elaborated on throughout this textbook. Be sure to be on the lookout for the icon that alerts you that one of these concepts is being discussed. We now turn to our first topic, the economic way of thinking.

The Egdndmig

PERspEGtivE

economic peRSFecTive

A viewpoint that envisions individuals and institutions making rational decisions by comparing the marginal benefits and marginal costs associated with their actions.

Close your eyes for a minute and pretend you are in paradise, a place where you can have anything you want whenever you desire it. On a particular day you may decide you want a new pair of jeans, a new portable computer, a cellular phone, tickets to see 'N Sync, and a new red Ferrari sports car to cruise around in. Your friends may have a completely different list of wants, but all of their desires will also be satisfied. Indeed, everyone's desires are satisfied. The following day you can start all over and make any request you have, and they will all be fulfilled. And so it will continue forever. Your body will never get old or sick, you will have all the friends and love you want, etc., etc.

Of course, paradise may be waiting for us in the afterlife, but in this world our wants greatly outstrip our ability to satisfy them. Anytime there is a situation in which wants are greater than the resources to meet those desires, we have an economic problem. It is this reality that gives economists their unique perspective. This economic perspective or economic way of thinking has several critical and closely interrelated features.

Scarcity and Choice

From our definition of economics, it is easy to see why economists view the world through the lens of scarcity. Since human and property resources are scarce (limited), it follows that the goods and services we produce must also be limited. Scarcity limits our options and necessitates that we make choices. Because we "can't have it all," we must decide what we will have, and what we must forgo.

Limited resources have given economics its core: the idea that "there is no free lunch." You may get treated to lunch, making it "free" to you, but there is a cost to someone—ultimately to society. Scarce inputs of land, equipment, farm labour, the labour of cooks and waiters, and managerial talent are required. Because these resources could be used in other production activities, they and the other goods and services they could have produced are sacrificed in making the lunch available. Economists call these sacrifices o ortunity costs. To get more of one thing, you forgo the opportunity of getting something else. So, the cost of that which you get is the value of that which is sacrificed to obtain it. We will say much more about opportunity costs in Chapter 2.

CHAPTER ONE • THE NATURE AND METHOD OF ECONOMICS

Rational Behaviour

Economics is grounded on the assumption of "rational self-interest." Individuals pursue actions that will allow them to achieve their greatest satisfaction. Rational behaviour implies that individuals will make different choices under different circumstances. For example, Jones may decide to buy Coca-Cola in bulk at a warehouse store rather than at a convenience store where it is much more expensive. That will leave him with extra money to buy something else that provides satisfaction. Yet, while driving home from work, he may stop at the convenience store to buy a single can of Coca-Cola.

Rational self-interest also implies that individuals will make different choices. High school graduate Alvarez may decide to attend college or university to major in business. Baker may opt to take a job at a warehouse and buy a new car. Chin may accept a signing bonus and join the Armed Forces. All three choices reflect the pursuit of self-interest and are rational, but they are based on different preferences and circumstances.

Of course, rational decisions may change as costs and benefits change. Jones may switch to Pepsi when it is on sale. And, after taking a few business courses, Alvarez may decide to change her major to social work.

Rational self-interest is not the same as selfishness. People make personal sacrifices to help family members or friends, and they contribute to charities because they derive pleasure from doing so. Parents help pay for their children's education for the same reason. These self-interested, but unselfish, acts help maximize the givers' satisfaction as much as any personal purchase of goods or services. Self-interest behaviour is simply behaviour that enables a person to achieve personal satisfaction, however that may be derived.

MARGINAL ANALYSIS The comparison or marginal ("extra" or "additional") benefits and marginal costs, usually for decision making.

Marginal Analysis: Benefits and Costs

The economic perspective focuses largely on marginal analysis—comparisons of marginal benefits and marginal costs. (Used this way, "marginal" means "extra," "additional," or "a change in.") Most choices or decisions involve changes in the status quo (the existing state of affairs). Should you attend school for another year or not? Should you study an extra hour for an exam? Should you add fries to your fast-food order? Similarly, should a business expand or reduce its output? Should government increase or decrease health care funding?

Each option involves marginal benefits and, because of scarce resources, marginal costs. In making choices rationally, the decision maker must compare those two amounts. Example: You and your fiancé are shopping for an engagement ring. Should you buy a V4-carat diamond, a V2-carat diamond, a /4-carat diamond, or a larger one? The marginal cost of the larger diamond is the added expense beyond the smaller diamond. The marginal benefit is the greater lifetime pleasure (utility) from the larger stone. If the marginal benefit of the larger diamond exceeds its marginal cost, you should buy the larger stone. But if the marginal cost is more than the marginal benefit, you should buy the smaller diamond instead.

In a world of scarcity, the decision to obtain the marginal benefit associated with some specific option always includes the marginal cost of forgoing something else. The money spent on the larger diamond means forgoing something else. Again, there is no free lunch!

One surprising implication of decisions based on marginal analysis is that there can be too much of a good thing. Although certain goods and services seem inherently desirable—education, health care, a pristine environment—we can in fact have too much of them. "Too much" occurs when we keep obtaining them beyond the

Part One • An Introduction to Economics and the Economy point where their marginal cost (the value of the forgone options) equals their marginal benefit. Then we are sacrificing alternative products that are more valuable at the margin—the place where we consider the very last units of each. Society can have too much health care and you can have too many fries. (Key Question 1)

This chapter's Last Word provides an everyday application of the economic perspective.

• Economics is concerned with obtaining maximum satisfaction through the efficient use of scarce resources.

• The economic perspective stresses (a) resource scarcity and the necessity of making choices, (b) the assumption of rational behaviour, and (c) comparisons of marginal benefit and marginal cost.

• Economics is concerned with obtaining maximum satisfaction through the efficient use of scarce resources.

• The economic perspective stresses (a) resource scarcity and the necessity of making choices, (b) the assumption of rational behaviour, and (c) comparisons of marginal benefit and marginal cost.

Egdndmig Methdddlggy scientific MEtHDD The systematic pursuit of knowledge through the formulation of a problem, collection of data, and the formulation and testing of hypotheses.

Like the physical and life sciences, as well as other social science, economics relies on the scientific method. It consists of a number of elements:

• The observation of facts (real world data);

• Based on those facts, the formulation of possible explanations of cause and effect (hypotheses).

• The testing of these explanations by comparing the outcomes of specific events to the outcomes predicted by the hypotheses.

• 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 referred to as a model. A very well-tested and widely accepted theory is referred to as a law or rinci le.

Laws, principles, and models enable the economist, like the natural scientist, to understand and explain economic phenomena and to predict the various outcomes of particular actions. But as we will soon see, economic laws and principles are usually less certain than the laws of physics or chemistry.

Deriving Theories

Economists develop models of the behaviour of individuals (consumers, workers) and institutions (business, government) engaged in the production, exchange, and consumption of goods and services. They start by gathering facts about economic activity and economic outcomes. Because the world is cluttered with innumerable interrelated facts, economists, like all scientists, must select the useful information. They must determine which facts are relevant to the problem under consideration. But even when this sorting process is complete, the relevant information may at first seem random and unrelated.

The economist draws on the facts to establish cause-effect hypotheses about economic behaviour. Then the hypotheses are tested against real world observation and

McConnell-Brue-Barbiero: I I. An Introduction to I 1. The Nature and Method I I © The McGraw-Hill

Microeconomics, Ninth Economics of Economics Companies, 2003

Canadian Edition chapter one • the nature and method of economics

FIGURE 1-M THE RELATIONSHIP BETWEEN FACTS, THEORIES, 'AND POLICIES IN ECONOMICS

Theoretical economics involves establishing economic theories by gathering, systematically arranging, and generalizing from facts. Economic theories are tested for validity against facts. Economists use these theories—the most reliable of which are called laws or principles—to explain and analyze the economy. Policy economics entails using the economic laws and principles to formulate economic policies.

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