Naked Economics Chapter 1 Summary

Chapter 1: Economics and Economic Reasoning

What Economics Is: * Economics- the study of how human beings coordinate their wants and desires, given the decision-making mechanisms, social customs, and political realities of the society * Coordination- how the three central problems facing any economy are solved * The Three Central Problems of Economics Include * What, and how much, to produce * How to produce it * For whom to produce it * Scarcity- the goods available are too few to satisfy individuals desires

Scarcity: * Scarcity has 2 Elements: our wants and our means of fulfilling those wants * The degree of scarcity is constantly changing * An economy deals with scarcity through COERCION *
Limiting people’s wants and increasing the amount of work individuals are willing to do to fulfill those wants

Modern Economics: * Early Times: * Economics was base on deduction (a method of reasoning in which one deduces a theory based on a set of almost elf evident principles) * The traditional principles are the assumptions that people are rational and self interested * Modern Economics * Based on induction (a method of reasoning in which one develops general principles by looking for patterns in the data

A Guide to Economic Reasoning * Economic reasoning involves abstracting from the unimportant elements of a question and focusing on the important ones by creating a simple model that captures the essence of the issue or problem * Levitt’s Model * People do what is in their best interest financially and it assumes that people rely on a cost/benefit analysis to make decisions * Every choice has costs and benefits decisions are made by comparing the two

Marginal Costs and Marginal Benefits * The relevant costs and relevant benefits to economic reasoning are the expected incremental (additional) costs incurred and the expected incremental benefits that result from that decision * Marginal Cost- the additional cost to you over and above the costs you have already incurred * Means not counting the suck costs (costs that have already been incurred and cannot be recovered) * Marginal Benefit- the additional benefit above what you have already derived * Comparing Marginal Cost and Marginal Benefits will often tell you how you should adjust your activities to be as well off as possible * Economic Decision Rule: * If the marginal benefits of doing something exceed the marginal costs, do it * If the marginal costs of doing something exceed the marginal benefits do not * Economic reasoning is based on the premise that everything has a Cost
Opportunity Cost * Opportunity cost- is the benefit that you might have gained from choosing the next-best alternative

Economic and Market Forces * Economic forces- the necessary reactions to scarcity * Market force- economic force that is given relatively free rein by society to work through the market * Ration by changing prices * When there is a shortage the price goes up * When there is a surplus price goes down * The invisible hand- the price mechanism (the rise and fall of prices guide our actions in a market) * Economic Reality- controlled by Social, cultural and political forces * Often Social and Political Forces work against the invisible hand * The invisible hand ensures that the quantity supplied equal the quantity demanded at some price * Countries laws and social norms determine whether the invisible hand will be allowed to work * What happens in a society can be seen as the reaction to, and interaction of, these three forces: economic forces, political and legal forces, and social and historical forces

Economic Insights * Abduction- method of analysis that uses a combination of inductive methods and deductive
methods * Economic Model- a framework that places the generalized insights of the theory in a more specific contextual setting * Economic Principle- a commonly held economic insight stated as a law or general assumption * Experimental Economics- a branch of economics that studies the economy through controlled laboratory experiments * Natural Experiments- naturally occurring events that approximate a controlled experiment where something has changed in one place but has not changed somewhere else * Theorems- propositions that are logically true based on the assumptions in a model * Precepts- policy rules that conclude that a particular course of action is preferable * Theories, models, and principles must be combined with a knowledge of real world economic institutions to arrive at specific policy recommendations

The Invisible Hand Theorem * When the quantity supplied is greater than the quantity demanded, price has a tendency to fall * When the quantity demanded is greater than the quantity supplied, price has a tendency to rise * Efficiency- achieving a goal as cheaply as possible * Invisible Hand Theorem- a market economy, through the price mechanism, will tend to allocate resources efficiently * Modern traditional economists use models that focus on traditional assumptions of rationality and self interest * Modern Behavioral Economists modify these assumptions, and are working on models that incorporate some predictably irrational behavior

Microeconomics and Macroeconomics * Microeconomics- the study of individual choice and how that choice is influenced by economic forces * Opportunity Cost and the Invisible Hand are Microeconomic theories * Macroeconomics- the study of the economy as a whole

Economic Institutions * Economic Institution- any institution that significantly affects economic decisions * Economic Institutions differ between countries * Cost-plus-markup rules- a firm determines what its costs are and the result is the price it sets * To apply economic theory to reality you must have a sense of economic institutions

Economic Policy Options * Economic Policies- actions (or inactions) taken by the government to influence economic actions * To carryout economic policy effectively, one must understand how institutions might change as a result of the economic policy * Some policies are designed to change institutions directly- these are much more difficult to implement but they offer the largest potential for gain

Objective Policy Analysis * Objective- keeps the analyst’s value judgment separate from the analysis * 3 Categories of Economics 1. Positive Economics- study of what is and how the economy works. a. It explores the pure theory of economics b. It discovers agreed upon empirical regularities- called empirical facts c. One looks for empirical facts and develops theorems (propositions that logically follow from the assumptions of one’s model d. Theorems and agreed upon empirical facts form the foundation of economic science 2. Normative Economics- Study of what the goals of the economy should be 3. The Art of Economics- (political economy)- the application of the knowledge learned in positive economics to the achievement of the goals one as determined in normative economics e. The Art of economics branch is specifically about policy f. It is designed to arrive at precepts or guides for policy g. Precepts are based on theorems and empirical facts developed in positive economics and goals developed in normative economics

Policy and Social and Political Forces * Politicians, not economist, determine economic policy * When economic theory is applied to reality we must account for political and social forces