Economics is a social science that studies individuals’ economic behavior, economic phenomena, as well as how individual agents, such as consumers, firms, and government agencies, make trade-off choices that allocate limited resources among competing uses.
People’s desires are unlimited, but resources are limited, therefore individuals must make tradeoffs. We need economics to study this fundamental conflict and how these trade-offs are best made.
Four basic questions must be answered by any economic institution:
- What goods and services should be produced and in what quantity?
- How should the product be produced?
- For whom should it be produced and how should it be distributed?
- Who makes the decision?
The answers depend on the use of economic institutions. There are two basic economic institutions that have been so far used in the real world:
(1) Market economic institution (the price mechanism): Most decisions on economic activities are made by individuals. This primarily decentralized decision system is the most important economic institution discovered for reaching cooperation amongst individuals and solving the conflicts that occur between them. The market economy has been proven to be only economic institution, so far, that can keep sustainable development and growth within an economy.
(2) Planed economic institution: Most decisions on economic activities are made by governments, which are mainly centralized decision systems.
1.2 Economic Theory
An economic theory, which can be considered an axiomatic approach, consists of a set of assumptions and conditions, an analytical framework, and conclusions (explanations and/or predications) that are derived from the assumptions and the analytical framework. Like any science, economics is concerned with the explanation of observed phenomena and also makes economic predictions and assessments based on economic theories. Economic theories are developed to explain the observed phenomena in terms of a set of basic assumptions and rules.
Roles of Economic Theory
An economic theory has three possible roles: (1) It can be used to explain economic behavior and economic phenomena in the real world. (2) It can make scientific predictions or deductions about possible outcomes and consequences of adopted economic mechanisms when economic environments and individuals’ behavior are appropriately described. (3) It can be used to refute
faulty goals or projects before they are actually undertaken. If a conclusion is not possible in theory, then it is not possible in a real world setting, as long as the assumptions were approximated realistically.
Generality of Economic Theory
An economic theory is based on assumptions imposed on economic environments, individuals’ behavior, and economic institutions. The more general these assumptions are, the more powerful, useful, or meaningful the theory that comes from them is. The general equilibrium theory is considered such a theory.
Limitation of Economic Theory
When examining the generality of an economic theory, one should realize any theory or assumption has a boundary, limitation, and applicable range of economic theory. Thus, two common misunderstandings in economic theory should be avoided. One misunderstanding is to over-evaluate the role of an economic theory. Every theory is based on some imposed assumptions. Therefore, it is important to keep in mind that every theory is not universal, cannot explain everything, but has its limitation and boundary of suitability. When applying a theory to make an economic conclusion and discuss an economic problem, it is important to notice the
boundary, limitation, and applicable range of the theory. It cannot be applied arbitrarily, or a wrong conclusion will be the result.
The other misunderstanding is to under-evaluate the role of an economic theory. Some people consider an economic theory useless because they think assumptions imposed in the theory are unrealistic. In fact, no theory, whether in economics, physics, or any other science, is perfectly correct. The validity of a theory depends on whether or not it succeeds in explaining and predicting the set of phenomena that it is intended to explain and predict. Theories, therefore, are continually tested against observations. As a result of this testing, they are often modified, refined, and even discarded.
The process of testing and refining theories is central to the development of modern economics as a science. One example is the assumption of perfect competition. In reality, no competition is perfect. Real world markets seldom achieve this ideal status. The question is then not whether any particular market is perfectly competitive, almost no one is. The appropriate question is to
what degree models of perfect competition can generate insights about real-world markets. We think this assumption is approximately correct in certain situations. Just like frictionless models in physics, such as in free falling body movement (no air resistance), ideal gas (molecules do not collide), and ideal fluids, frictionless models of perfect competition generate useful insights in the economic world.
It is often heard that someone is claiming they have toppled an existing theory or conclusion, or that it has been overthrown, when some condition or assumption behind it is criticized. This is usually needless claim, because any formal rigorous theory can be criticized at anytime because no assumption can coincide fully with reality or cover everything. So, as long as there are no logic errors or inconsistency in a theory, we cannot say that the theory is wrong. We can only criticize it for being too limited or unrealistic.
What economists should do is to weaken or relax the assumptions, and obtain new theories based on old theories. We cannot say though that the new theory topples the old one, but instead that the new theory extends the old theory to cover more general situations and different economic environments.
1.3 What is Macroeconomics?
Definition (Macroeconomics): is the study of relationships between aggregate economic variables, such as between output, unemployment, and the rate of inflation Macroeconomics was born out of the Great Depression in the 1930s due to the work of John Maynard Keynes, a British economist. It was the result of people desperately wanting to know what caused the Depression and how it could be ended. People study macroeconomics to understand two types of behaviour of an economy and everything in macroeconomics ultimately centres on these two issues:
Why study macro-economics
- Curiosity — people want to figure out how what we observe happens
- To Become Educated — as ―the development of character or mental powers‖ which is very different from being trained which is ―to teach a person a specified skill by practice
- Employment. — Employment can be gained directly through the education and knowledge received at university
How Do We Study Macroeconomics?
Economics is a social science which means it involves studying society to understand why people do what they do, but it tries to approach it ‖scientifically‖. Note that this approach is not the myth of the neutral uninvolved scientist in a white lab coat seeking the greater absolute truth. Instead, it is prejudiced, emotive, involved people seeking to make some sense of what we observe and experience. Note also that Economics is not business, which is more a vocational orientated subject designed to help start and run companies.
1.4 Economic Models
A fundamental tool used by economists to understand people‘s behaviour and thus the economy, and one which we will use repeatedly through this course, is an economic ―model‖.
Definition (Economic Model): is a theory that summarizes, often in mathematical terms, relationships among economic variables.
Definition (Theory): is a system of ideas explaining something, especially one based on general principles independent of the particular things to be explained. or, an economic theory is a generalization based on a few principles that enables us to understand and predict the economic choices made by people. For example, the common characterization of what we study in economics is a self-interested rational person with scarce resources and voluntary choices. In developing a model we use two types of variables: exogenous variables and endogenous variables:
Definition (Exogenous Variables): are determined outside of the model. so that they do not capture the decisions made by people in which we are primarily
Interested in learning about. Assuming that some variables are exogenous helps to simplify matters by not having everything being decided at once.
Definition (Endogenous Variables): are determined within the model. and do capture the decisions made by people in which we are primarily interested in learning about.
So a model is a set of very general ―assumptions‖ plus some more specific assumptions. Using deductive logic we can then deduce what we expect to happen given certain circumstances.
1.5 Why Macroeconomics is Different from Microeconomics
The Issue of Aggregation
Since the previously described approach to developing an economic understanding of society is generic in nature, an obvious question to ask is what makes macroeconomics different from microeconomics since they both just involve studying economic behaviour of people? Recall that microeconomics is the study of the decisions made by firms and households, and how these decision makers interact in the marketplace.
Macroeconomics is the study of the decision made by all firms and households, and the interactions of these decision makers in all markets. Furthermore, when studying a single market we invoke the ceteris paribus assumption but in macroeconomics this is no longer true since we are studying all markets at the same time. So macroeconomics is different because of the sheer scale, all markets are aggregated together, and because the general effects of any changes in behaviour have to be taken into account, rather than just analyzing economic decisions in isolation from each other.
Micro-economic theory
Investigates how individuals and firms in society allocate scarce resources among competing consumption and production goals respectively It also studies factors affecting the relative prices of different goods and factors of production in individual markets (e.g. the supply of demand for milk)
Macro-economic theory
It is concerned with aggregate variables such as the aggregate demand by all consumers for all goods and services produced in an economy over a given period of time
Among aggregate economic phenomena macro-economic theory considers include
- Inflation
- The interest rate
- The rate of income /output
- The rate of unemployment
- Government spending
- Private domestic investment
- Aggregate disposable income
- The general price level
Macro-economic theory is the explanation of how the aggregate variables interact to produce the state of a nation‘s economic situation.
Macro economics summarized in three models
The study of macroeconomics is organized around three models that describe the world as follows:
- The very long run: concerned with the long run behavior of the economy. It is the domain of growth theory, which focuses on the growth of productive capacity i.e the factors of production and the technology that firms use to produce goods and services.
- The long run: here the product capacity is treated as given. The level of productive capacity determines output, and fluctuations in demand relative to this level of supply determine prices and inflation.
- The short run: where fluctuations in demand determine how much of the available capacity is used and thus the level of output and employment
