Nature and Method Of Economics

19/08/2014

Economics of Accounting
Professionals (ECON910)
Kankesu (Jay) Jayanthakumaran
Lecturer/Tutor:
Chris Keane

1

Chapters 1&2
Chapter 1: The nature and method of economics

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The roles of economics
• Economics is concerned with the efficient use of limited productive resources for the purpose of attaining the maximum satisfaction of our material wants. • Why study economics? John Maynard Keynes offered this response:
‘The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else.
Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.’
Keynes, 1936

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The Age of the Economists
•
•
•
•
•

Adam Smith (1776 landmark book The Wealth of Nations)
David Ricardo (1817 Principles of Political Economy and taxation)
John Stuart Mill (1848 Principles of Political Economy)
Copyr
Karl Marx (1847 Wage-Labour and Capital) ight 2004
John Maynard Keynes (1936 The General Theory of
McGr
Employment, Interest and Money)

• plus many modern contributors

4

awHill
Austr
alia
Pty
Ltd
PPTs
t/a
Micro
econo mics 7/e by
Jacks
on and McIve

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The roles of economics
• Economics for citizenship
– To create well-informed members of society.

• Economics in business
– To provide business with strategic information and interpretations. • Personal applications
– To assist individuals, as workers and income receivers, to gain and retain economic security.

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Methodology of economics
• What do economists do? What are their goals? What methods do they use?
– Economists derive economic principles that are useful in formulating policies designed to solve economic problems.

• The methods used by economists are:
1. Facts — descriptive or empirical economics concerned with gathering facts relevant to an economic problem.
2. Principles or theories — economists generalise about economic behaviour formulating economic theory.
3. Policies — formulating policies for correcting the problem under scrutiny called applied economics.
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Induction and Deduction
• Induction (Facts –Induction-Theory- Policy)
– A method of reasoning that proceeds from facts to generalisations • Deduction (Testing theories by facts)
– Reasoning from assumptions to conclusions by testing a hypothesis
– Both are complementary.

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Slides prepared by Muni Perumal, University of Canberra, Australia.

Descriptive economics
• Complex in economics unlike physical sciences
– Economics is a social science involving the complexities of individuals and institutions
– Facts are difficult to gather and interpret
– Economists must use discretion in collecting data, and must distinguish economic from non-economic facts.

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Economic theory
• Facts must be arranged systematically, interpreted and generalised to derive appropriate economic theory. • Theories or principles are the end result of economic analysis. These are meaningful statements drawn from facts.

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Terminology of economic theory
• Economists use the terms ‘laws’, ‘principles’,
‘theories’ and ‘models’ to represent generalisations, or statements of regularity, concerning the economic behaviour of individuals and institutions.
• A model is a simplified picture of reality, an abstract generalisation of how the relevant data actually behave. Copyright © 2011 McGraw-Hill Australia Pty Ltd
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Generalisations in economics
• Economic principles are generalisations, and are subject to exceptions and to quantitatively imprecise statements. • Economic principles are often stated in terms of averages or statistical probabilities.
• Generalisations, properly handled and interpreted, can be both meaningful and useful.

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Economic theory
• The ‘other things being equal’ assumption
– The process of analysis, that all other variables, other than the one being considered are constant, often referred to as ceteris paribus.

• Abstractions in economics
– Economic theories do not encompass the full complexity of reality.
– An economic model enables us to understand reality because it avoids the details of reality.

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Microeconomics and macroeconomics
• Macroeconomics deals with the economy as a whole, or with the basic subdivisions or aggregates that make up the economy
– An aggregate is a collection of specific economic units that are treated as if they were one unit.

• Microeconomics is concerned with specific economic units and a detailed consideration of the behaviour of these individuals units.

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Positive and Normative
Economics
• Positive economics are based upon facts without value judgements: “What is” (unemployment is 4.9% of labour force)
• Normative economics are based upon subjective beliefs. . .
“what ought to be” (unemployment ought to be reduced to 3% in labour force)
– Normative economic statements come into play at the level of policy economics

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Slides prepared by Muni Perumal, University of Canberra, Australia.

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Economic goals
1. Economic growth
2. Full employment
3. Economic efficiency
4. Price-level stability
5. Economic freedom
6. An equitable distribution of income
7. Economic security
8. External balance

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Economic goals
• Interpretation
– The basic economic goals inevitably entail problems of interpretation — what are ‘sizeable’, ‘high degree’ and ‘equitable’?

• Complementary goals
– Some of the goals are complementary.

• Conflicting goals
– Many goals are conflicting or mutually exclusive, and involve trade-offs.

• Priorities
– When goals conflict, society has to prioritise.

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Formulating economic policy
Three basic steps in policy formulation:
1. Stating goals
– Define the goals clearly.

2. Policy options
– State and recognise the possible effects of alternative policies designed to achieve the goal.

3. Evaluation
– Review the policies and evaluate their effectiveness.

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Pitfalls to Objective Thinking
• Bias (surplus budget)
• Loaded terminology (creeping socialism)
• Definitional difficulties (investment is not buying shares but the purchase of real and tangible capital assets)
• Fallacy of composition (A wage increase to x – higher prices offset the increase in salary)
• Cause and effect
– Post-hoc fallacy (crying and raining)
– Correlation versus causation (more education result in more income)

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The economic perspective
• Scarcity and choice
– Resources are limited and this necessitates choices.

• Rational behaviour
– Behaviour that involves decisions and actions in order to achieve the greatest satisfaction or maximum fulfilment of goals.
– People will make different choices, because their circumstances, preferences and available information differ. Copyright © 2011 McGraw-Hill Australia Pty Ltd
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The economic perspective
• Marginalism: benefits and costs
– Decision that compares marginal benefits and marginal costs
– Incremental benefits available from any changes are compared to the incremental costs of making the change.

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Summary
•
•

Gathering data, developing principles and applying
Two approaches
– The deductive: testable hypotheses (Testing theories by facts)
– The inductive: derive generalisation (Facts –Induction-Theory- Policy)

•

Two levels
– Macroeconomics: aggregation
– Microeconomics: firms and individuals

•

Policy prescriptions
– Positive economics: what is? Normative economics: what ought to be?
– The statement of economic goals: growth and equitable distribution of income – Effects of policies: costs and benefits
– Effectiveness and consequences of chosen policies

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Slides prepared by Muni Perumal, University of Canberra, Australia.

Graphs and their meaning
Appendix to Chapter 1

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Constructing a graph
• Two-dimensional graph
– Horizontal axis representing independent variable
– Vertical axis representing dependent variable
– Intersection (0) is origin

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Direct and indirect relationships
• Graphing relationships between variables
– Direct relationship: where the values of two related variable change in the same direction e.g. consumption and income.
– Inverse relationship: where the values of two related variables move in opposite directions e.g. ticket prices and attendance.

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Dependent and independent variables • Dependent variable
– The variable which changes as a consequence of a change in some other (independent) variable.

• Independent variable
– The variable which causes a change in some other
(dependent) variable.

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Other variables held constant
• When economists plot the relationship between any two variables, they assume that ‘other things being equal’; that is, all other factors that might affect consumption, are presumed to be constant or unchanged. Copyright © 2011 McGraw-Hill Australia Pty Ltd
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Positive slope

Consumption (C)

$500

Slope 

vertical change
 50

 0.5 horizontal change  100

$400

C = 50 + 0.5Y
$300

Consumption e d
$200

c vertical change = +50

b
$100

a horizontal change = +100

o

$100

$200

$300
$400
Income (Y)

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Negative slope

Ticket price (P)

$25

a

5 vertical change

 1.25 b horizontal change  4

Slope 

$20

–5
$15
$10

P = 25 – 1.25Q c +4 d e Ticket demand

$5

0

f
4
8
12
16
Attendance in thousands (Q)

20

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Slope of a line
Three addenda
• Measurement units
– The slope of a line is affected by the choice of units for either variable.

• Marginal analysis
– The slope of a line measures marginal changes.

• Infinite and zero slopes
– Variables that are unrelated or independent of one another will be represented by a line parallel to the vertical or horizontal axis, and will have a slope of infinity or zero, respectively.

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Slope of a line
• Intercept
– The vertical intercept is the point at which the line meets the vertical axis

• Equation form
– Linear equation y = a + bx where: y = the dependent variable a = the vertical intercept b = the slope of the line x = the independent variable

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Chapter 2
The economising problem Copyright © 2011 McGraw-Hill Australia Pty Ltd
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The foundation of economics
The economising problem is underpinned by two fundamental facts:
• Unlimited or insatiable wants of society for goods and services that give utility
– ‘Utility’ is the economist’s term for pleasure or satisfaction. • Economic resources are limited or scarce
– ‘Economic resources’ refers to all natural, human and manufactured resources that go into the production of goods and services.

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Economic resources
Two broad categories of resources:
• Property resources
– Land
– Raw materials
– Capital

• Human resources
– Labour
– Entrepreneurial ability.

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Land
• Broader than commonly understood.
• An economic resource which includes all the natural resources that go into the production of goods and services. • Income received by land is rent.

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Capital
• All the manufactured aids to production used to produce goods and services and to distribute them to the final consumer without directly satisfying human wants.
• ‘Capital’ as used in economics does not refer to money—money as such produces nothing, and is not considered an economic resource.
• The process of producing and accumulating these capital goods is known as investment.
• Payment for capital is interest.
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Labour
• Broader than commonly used.
• All human physical and mental talents (excluding entrepreneurial talent) that can be used in producing goods and services.
• Income accruing to labour is wage.

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Entrepreneurial ability
• A specialised form of human resource.
• Involves the combining of the other resources to produce a product, make non-routine decisions, innovate and bear risk.
• Profit is the reward for entrepreneurship.

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Relative intensity of resource use in production
• Land-intensive commodity is a commodity in which the production process uses a relatively large amount of land.
• Labour-intensive product uses relatively large amounts of labour.
• Capital-intensive product uses relatively larger amounts of capital.

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Economics and efficiency
• Efficiency is the use or administering of scarce resources to produce the maximum amount of desired goods and services, thereby achieving the greatest possible fulfilment of society’s wants.

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Economics and efficiency (cont.)
• To achieve efficiency, there must be full employment and full production.
• Full employment
– All available resources are employed.

• Full production
– The maximum amount of goods and services are produced from the employed resources of an economy. • Full employment implies two kinds of efficiency
– Allocative efficiency
– Productive efficiency.
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Economics and efficiency (cont.)
• Allocative efficiency
– Occurs when all available resources are devoted to the combination of goods most wanted by society.

• Productive efficiency
– Occurs when goods or services are produced using the lowest cost production methods.

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Economics and efficiency (cont.)
• Specialisation and efficiency
– Specialisation enhances efficiency.

• Two types of specialisation
– Division of labour
– Geographic specialisation.

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The economising problem illustrated • The production possibilities curve (PPC) can be used to illustrate the concept of choice and opportunity cost.
• Demonstrates that society must make choices about which goods and services to produce and which to go without.

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Production possibilities curve
Assumptions
• Efficiency: The economy is operating at full employment and achieving productive efficiency
• Fixed resources
• Fixed technology
• Two products only: capital good and consumer good.

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Production possibilities curve (cont.)
• Points on the PPC represent a maximum output of the two products.
• Points inside the PPC are attainable, but are inefficient and undesirable.
• Points outside the curve are superior but unobtainable, given the assumptions of fixed technology and resources.

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Production possibilities of chocolate and tractors with full employment
___________________________________________________
Type of product

Production alternatives
A
B
C
D
E
Chocolates (‘00000)
0
1
2
3
4
Tractors (‘000)
10
9
7
4
0
___________________________________________________

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The production possibilities curve
Q

A

10

Tractors (thousands)

Unattainable

B

9
8

C

7

W

6

U

5

Attainable and efficient D

4
3
2 Attainable
1

but inefficient

E
0

1

2

3

4

5

6

7

8

Q

Chocolate bars (hundred thousands)

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Production possibilities curve
• Opportunity cost
– The amount of other products that must be sacrificed to obtain an additional unit of a good.

• The PPC is concave to the origin because of the law of increasing opportunity costs
– More and more of a good must be given up to obtain additional units of the other good.

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Law of increasing opportunity costs • Based on the fact that economic resources are not completely adaptable to alternative uses, they are imperfect substitutes.
• Resources lack perfect flexibility or interchangeability. Copyright © 2011 McGraw-Hill Australia Pty Ltd
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Allocative efficiency
• Resources are efficiently allocated to any product when the output is such that its marginal benefit equals its marginal cost (MB = MC).

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The production possibility curve
• Points inside the production possibility curve illustrate unemployment or productive inefficiency.
• A movement towards full employment and productive efficiency from a point such as U will entail a greater output of at least one, if not both, products.

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Unemployment and underemployment
Q

A

10

B

Tractors (thousands)

9

A greater output of at least one if not both

8

C

7
6
5

D

4

U

3
2
1

E
0

1

2

3

4

5

6

7

8

Q

Chocolate bars (hundred thousands)

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Economic growth and the PPC
• Economic growth can be represented as an outward shift (to the right) of the PPC.
• Economic growth results from:
– Expanding resource supplies
– Technological advances.

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Economic growth and PPC

Tractors (thousands)

Q 14
13
12
11
10
9
8
7
6
5
4
3
2
1

A′
B′

C′

D′

E′
1
2
3
4
5
6
7
Chocolate bars (hundred thousands)

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Q
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Five fundamental questions:
What? How? Whom?
1. How much total output is to be produced?
2. What combination of outputs is to be produced?
3. How are these outputs to be produced?
4. Who is to receive/consume these outputs?
5. How can change be accommodated?

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Alternative economic systems
• How the fundamental questions are answered depends on the type of economic system.
• Economies differ on two grounds:
– Ownership of the means of production
– How economic activity is coordinated.

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Alternative economic systems
• Pure capitalism (or laissez-faire)
– Private ownership of property and resources
– Freedom of enterprise and choice
– A system of markets and prices.

• The command economy
– Characterised by public ownership of resources and property – Centralised economic planning.

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Alternative economic systems
• Mixed systems
– A mixture of pure capitalism and command economy
– Authoritarian capitalism refers to a regime with a high degree of government control, with privately owned property – Market socialism is characterised by public ownership of property, with markets playing a significant role.

• The traditional economy
– In the traditional or customary economies found in many less developed countries, production methods, exchange and the distribution of income are all sanctioned by custom.
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