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(for example, working
costs to go to college? Most people are likely to answer by adding together their expendi-
instead of going to school).
tures on tuition, room and board, books, and the like, and then deducting any scholarship
funds they may receive. Suppose that amount comes to $15,000.
Economists keep score differently. They first want to know how much you would be
earning if you were not attending college. Suppose that salary is $20,000 per year. This
may seem irrelevant, but because you give up these earnings by attending college, they
must be added to your tuition bill. You have that much less income because of your




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Chapter 1 5
What Is Economics?



education. On the other side of the ledger, economists would not count all of the univer-
sity™s bill for room and board as part of the costs of your education. They would want to
know how much more it costs you to live at school rather than at home. Economists would
count only these extra costs as an educational expense because you would have incurred
these costs whether or not you attend college. On balance, college is probably costing you
much more than you think. And, as we will see later, taking opportunity cost into account
in any personal planning you do will help you to make more rational decisions.

Idea 2: Attempts to Repeal the Laws of Supply
and Demand”The Market Strikes Back
When a commodity is in short supply, its price naturally tends to rise. Sometimes disgrun-
tled consumers badger politicians into “solving” this problem by making the high prices
illegal”by imposing a ceiling on the price. Similarly, when supplies are plentiful”say,
when fine weather produces extraordinarily abundant crops”prices tend to fall. Falling
prices naturally dismay producers, who often succeed in getting legislators to impose
price floors.
But such attempts to repeal the laws of supply and demand usually backfire and some-
times produce results virtually the opposite of those intended. Where rent controls are
adopted to protect tenants, housing grows scarce because the law makes it unprofitable to
build and maintain apartments. When price floors are placed under agricultural products,
surpluses pile up because people buy less.
As we will see in Chapter 4 and elsewhere in this book, such consequences of interfer-
ence with the price mechanism are no accident. They follow inevitably from the way in
which free markets work.

Idea 3: The Surprising Principle of Comparative Advantage
China today produces many products that Americans buy in huge quantities”including
toys, textiles, and electronic equipment. American manufacturers often complain about
Chinese competition and demand protection from the flood of imports that, in their view,
threatens American standards of living. Is this view justified?
Economists think that it is often false. They maintain that both sides normally gain
from international trade. But what if the Chinese were able to produce everything more
cheaply than we can? Wouldn™t Americans be thrown out of work and our nation be
impoverished?
A remarkable result, called the law of comparative advantage, shows that, even in this
extreme case, the two nations could still benefit by trading and that each could gain as a
result! We will explain this principle first in Chapter 3 and then more fully in Chapter 17.
But for now a simple parable will make the reason clear.
Suppose Sally grows up on a farm and is a whiz at plowing. But she is also a successful
country singer who earns $4,000 per performance. Should Sally turn down singing engage-
ments to leave time to work the fields? Of course not. Instead, she should hire Alfie, a much
less efficient farmer, to do the plowing for her. Sally may be better at plowing, but she earns
so much more by singing that it makes sense for her to specialize in that and leave the farm-
ing to Alfie. Although Alfie is a less skilled farmer than Sally, he is an even worse singer.
So Alfie earns his living in the job at which he at least has a comparative advantage (his
farming is not as inferior as his singing), and both Alfie and Sally gain. The same is true of
two countries. Even if one of them is more efficient at everything, both countries can gain
by producing the things they do best comparatively.

Idea 4: Trade Is a Win-Win Situation
One of the most fundamental ideas of economics is that both parties must expect to gain
something in a voluntary exchange. Otherwise, why would they both agree to trade? This
principle seems self-evident. Yet it is amazing how often it is ignored in practice.




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Part 1
6 Getting Acquainted with Economics



For example, it was widely believed for centuries that in international trade one coun-
try™s gain from an exchange must be the other country™s loss (Chapter 17). Analogously,
some people feel instinctively that if Ms. A profits handsomely from a deal with Mr. B,
then Mr. B must have been exploited. Laws sometimes prohibit mutually beneficial ex-
changes between buyers and sellers”as when an apartment rental is banned because the
rental rate is “too high” (Chapter 4), or when a willing worker is condemned to remain
unemployed because the wage she is offered is “too low,” or when the resale of tickets to
sporting events (“ticket scalping”) is outlawed even though the buyer is happy to get the
ticket that he could not obtain at a lower price (Chapter 4).
In every one of these cases”and many more”well-intentioned but misguided reason-
ing blocks the possible mutual gains that arise from voluntary exchange and thereby inter-
feres with one of the most basic functions of an economic system (see Chapters 3 and 4).


Idea 5: Government Policies Can Limit Economic
Fluctuations”But Don™t Always Succeed
One of the most persistent problems of market economies has been their tendency to go
through cycles of boom and bust. The booms, as we shall see, often bring inflation. The
busts always raise unemployment. Years ago, economists, businesspeople, and politicians
viewed these fluctuations as inevitable: There was nothing the government could or
should do about them.
That view is now considered obsolete. As we will learn in Part 2, and especially Part 3,
modern governments have an arsenal of weapons that they can and do deploy to try to mit-
igate fluctuations in their national economies”to limit both inflation and unemployment.
Some of these weapons constitute what is called fiscal policy: control over taxes and govern-
ment spending. Others come from monetary policy: control over money and interest rates.
But trying to tame the business cycle is not the same as succeeding. Economic fluctua-
tions remain with us, and one reason is that the government™s fiscal and monetary poli-
cies sometimes fail”for both political and economic reasons. As we will see in Part 3,
policy makers do not always make the right decisions. And even when they do, the
economy does not always react as expected. Furthermore, for reasons we will explain
later, it is not always clear what the “right” decision is.


Idea 6: The Short-Run Trade-Off between Inflation
and Unemployment
The U.S. economy was lucky in the second half of the 1990s. A set of fortuitous events”
falling energy prices, tumbling computer prices, a rising dollar, and so on”pushed infla-
tion down even while unemployment fell to its lowest level in almost 30 years. During the
1970s and early 1980s, the United States was not so fortunate. Skyrocketing prices for food
and, especially, energy sent both inflation and unemployment up to extraordinary
heights. In both episodes, then, inflation and unemployment moved in the same direction.
But economists maintain that neither of these two episodes was “normal.” When we
are experiencing neither unusually good luck (as in the 1990s) nor exceptionally bad luck
(as in the 1970s), there is a trade-off between inflation and unemployment”meaning that low
unemployment normally makes inflation rise and high unemployment normally makes
inflation fall. We will study the mechanisms underlying this trade-off in Parts 2 and 3, es-
pecially in Chapter 16. It poses one of the fundamental dilemmas of national economic
policy.

Idea 7: Productivity Growth Is (Almost) Everything
in the Long Run
In Geneva, Switzerland, today, workers in a watch factory turn out more than 100 times
as many mechanical watches per year as their ancestors did three centuries earlier. The
productivity of labor (output per hour of work) in cotton production has probably gone



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Chapter 1 7
What Is Economics?



up more than 1,000-fold in 200 years. It is estimated that rising labor productivity has in-
creased the standard of living of a typical American worker approximately sevenfold in
the past century (see Chapter 7).
Other economic issues such as unemployment, monopoly, and inequality are impor-
tant to us all and will receive much attention in this book. But in the long run, nothing has
as great an effect on our material well-being and the amounts society can afford to spend
on hospitals, schools, and social amenities as the rate of growth of productivity”the
amount that an average worker can produce in an hour. Chapter 7 points out that what
appears to be a small increase in productivity growth can have a huge effect on a coun-
try™s standard of living over a long period of time because productivity compounds like
the interest on savings in a bank. Similarly, a slowdown in productivity growth that per-
sists for a substantial number of years can have a devastating effect on living standards.


Epilogue
These ideas are some of the more fundamental concepts you will find in this book”ideas
that we hope you will retain beyond the final exam. There is no need to master them right
now, for you will hear much more about each as you progress through the book. By the
end of the course, you may be amazed to see how natural, or even obvious, they will
seem.


INSIDE THE ECONOMIST™S TOOL KIT
We turn now from the kinds of issues economists deal with to some of the tools they use
to grapple with them.


Economics as a Discipline
Although economics is clearly the most rigorous of the social sciences, it nevertheless
looks decidedly more “social” than “scientific” when compared with, say, physics. An
economist must be a jack of several trades, borrowing modes of analysis from numerous
fields. Mathematical reasoning is often used in economics, but so is historical study. And
neither looks quite the same as when practiced by a mathematician or a historian. Statis-
tics play a major role in modern economic inquiry, although economists had to modify
standard statistical procedures to fit their kinds of data.


The Need for Abstraction
SOURCE: From The Wall Street Journal. Permission, Cartoon Features Syndicate.




Some students find economics unduly abstract and “unrealistic.”
The stylized world envisioned by economic theory seems only a
distant cousin to the world they know. There is an old joke about
three people”a chemist, a physicist, and an economist”
stranded on an desert island with an ample supply of canned
food but no tools to open the cans. The chemist thinks that light-
ing a fire under the cans would burst the cans. The physicist ad-
vocates building a catapult with which to smash the cans against
some boulders. The economist™s suggestion? “Assume a can
opener.”
Economic theory does make some unrealistic assumptions;
you will encounter some of them in this book. But some abstrac-
tion from reality is necessary because of the incredible complex-
ity of the economic world, not because economists like to sound
absurd.
”Yes, John, we™d all like to make economics less dismal . . . “
Compare the chemist™s simple task of explaining the interac- NOTE: The nineteenth-century British writer Thomas Carlyle described eco-
tions of compounds in a chemical reaction with the economist™s nomics as the “dismal science,” a label that stuck.




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Part 1
8 Getting Acquainted with Economics



complex task of explaining the interactions of people in an economy. Are molecules moti-
vated by greed or altruism, by envy or ambition? Do they ever imitate other molecules?
Do forecasts about them influence their behavior? People, of course, do all these things
and many, many more. It is therefore vastly more difficult to predict human behavior than
to predict chemical reactions. If economists tried to keep track of every feature of human
behavior, they would never get anywhere. Thus:
Abstraction from unimportant details is necessary to understand the functioning of
anything as complex as the economy.
Abstraction means An analogy will make clear why economists abstract from details. Suppose you have
ignoring many details so as just arrived for the first time in Los Angeles. You are now at the Los Angeles Civic
to focus on the most impor-
Center”the point marked A in Maps 1 and 2, which are alternative maps of part of Los
tant elements of a problem.
Angeles. You want to drive to the Los Angeles County Museum of Art, point B on each
map. Which map would be more useful?
Map 1 has complete details of the Los Angeles road system. This makes it hard to read
and hard to use as a way to find the art museum. For this purpose, Map 1 is far too de-
tailed, although for some other purposes (for example, locating some small street in Hol-
lywood) it may be far better than Map 2.
In contrast, Map 2 omits many minor roads”you might say they are assumed away”so
that the freeways and major arteries stand out more clearly. As a result of this simplifica-
tion, several routes from the Civic Center to the Los Angeles County Museum of Art
emerge. For example, we can take the Hollywood Freeway west to Alvarado Boulevard,
go south to Wilshire Boulevard, and then head west again. Although we might find a
shorter route by poring over the details in Map 1, most strangers to the city would be bet-
ter off with Map 2. Similarly, economists try to abstract from a lot of confusing details
while retaining the essentials.
Map 3, however, illustrates that simplification can go too far. It shows little more than
the major interstate routes that pass through the greater Los Angeles area and therefore



MAP 1
Detailed Road Map of Los Angeles

Map © by Rand McNally, RL. 08-S-32. Reprinted by permission.




NOTE: Point A marks the Los Angeles Civic Center and Point B marks the Los Angeles County Museum of Art.




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