Lecture Two: The Economic Way of Thinking
September 15, 2011
The Economic Way of Thinking
Choosing at the Margin
People make choices at the margin, which means that they evaluate the
consequences of making incremental changes in the use of their resources.
The benefit from pursuing an incremental increase in an activity is its marginal
The opportunity cost of pursuing an incremental increase in an activity is its
The efficient allocation of resources is achieved when the marginal benefit equal
the marginal cost.
Responding to Incentives
Our choices respond to incentives.
For any activity, if marginal benefit exceeds the marginal cost, people have an
incentive to do more of that activity.
If marginal cost exceeds marginal benefit, people have an incentive to do less of
Incentives are also the ket to reconciling self interest and the social interest.
Social Science and Policy Tool
Economics as a Social Science
Economists distinguish between two types of statements
- What is: positive statements
- What ought to be: normative statements
A positive statement can be tested using scientific facts. A normative statement is
not possible to prove or test because it is an ideal scenario.
Unscrambling Cause and Effect The task of economic science is to discover what positive statements that re
consistent with what we observe in the world and that enable us to understand
how the economic world works.
An economic model is a description of some aspect of the economic world that
includes only those features that are needed for the purpose at hand.
Exogenous - the change of the cause
Endogenous - the effect of the variables
A model is tested by comparing its predictions with the facts. Testing an
economic model is difficult, so economists also use
- Natural experiments
- Statistical investigations
- Economic experiments
Economics as a Policy Tool
Economics is a way of approaching problems in all aspects of out lives. Three
broad areas are:
- Personal economic policy
- Business economic policy
- Government economic policy (tax breaks, incentives, encouraging industry,