The three principles of economics include optimization, equilibrium, and empiricism.

1.1 The Principles and Practice of Economics

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1. The Scope of Economics

The Scope of Economics

Three Principles of Economics

The First Principle of Economics: Optimization

The Second Principle of Economics: Equilibrium

The Third Principle of Economics: Empiricism

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What area of your life is NOT covered by economics?

1. The Scope of Economics

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Economic Agent = Any group or individual that makes choices, such as consumers, firms, parents, politicians, etc.

1. The Scope of Economics

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Economics studies all human behavior.

Choice, not money, is the unifying feature of all the things that economists study.

Not all economic agents, however are individuals.

1. The Scope of Economics

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Economics is the study of how agents make choices among scarce resources and how those choices affect society.

1. The Scope of Economics

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What does it mean if something is “scarce”?

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Scarce resources: Are things that people want, where the quantity that people want exceeds the quantity that is available.

Scarcity exists because people have unlimited wants in a world of limited resources.

We will analyze how to use economic reasoning to compare the costs and benefits of the alternative options and make the best choices.

1. The Scope of Economics

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Positive Economics: Describes what economic agents actually do (or will do). Objective statements which can be tested with data. E.g.1 In 2010, 50% of US households earned less than $52,000 per year. E.g.2 In 2020 US households will save about 5% of their income.

1. The Scope of Economics

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Normative Economics: Describes what economic agents ought to do. Subjective judgments based on feelings, tastes, or opinions. The person being advised should determine the preferences to be used E.g An economist helping a worker to decide how much to save for retirement. Public policy questions asking what society should do are normative economic questions

1. The Scope of Economics

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Microeconomics The study of individuals, firms, government

Macroeconomics

The study of the whole economy

1. The Scope of Economics

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Microeconomics: Explains a small piece of the overall economy. Macroeconomics: Studies the economy as a whole.

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Three Principles of Economics: 1. Optimization = making the best choice possible with given information 2. Equilibrium = when everyone is optimizing; no one would be better off with a different choice 3. Empiricism = using data to figure out answers to interesting questions

2. Three Principles of Economics

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You want to buy a $20 book. If you drive 3 miles, you can buy it for $10.

You want to buy a $1,000 computer. If you drive 3 miles, you can buy it for $990.

3. The First Principle of Economics: Optimization

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Economic agents try to choose the best feasible option given the information that they have. Feasible options are those that are available and affordable Financial budget and many other different constraints.

3. The First Principle of Economics: Optimization

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The definition refers to the available information. Optimization means that we weight the potential risks in a decision, not that we perfectly foresee the future When someone choses the best feasible option given the information that is available, economists say that the decision maker is being rational. The test of optimization is the quality of the decision and not the outcome.

3. The First Principle of Economics: Optimization

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Trade-offs arise when some benefits must be given up in order to gain others. A budget constraint is the set of things that a person can choose to do (or buy). These are useful economic tools because quantify trade-offs.

3. The First Principle of Economics: Optimization

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Optimization requires to take account of the opportunity cost. It is the cost in terms of the best alternative that you are sacrifying. Assigning a monetary value to the opportunity cost will simplify the analysis. e.g. the value of your time as the average wage of a part-time job.

3. The First Principle of Economics: Optimization

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Cost-benefit analysis = Optimization It is useful for normative and positive economics.

3. The First Principle of Economics: Optimization

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Evidenced-Based Economics Example:

What is the cost of using Facebook?

3. The First Principle of Economics: Optimization

4. The Second Principle of Economics: Equilibrium

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Equilibrium: A situation when no one benefits by changing his/her behavior. Economists believe that this is a good description of what actually happens when groups of people interact.

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What Does Equilibrium Really Mean?

4. The Second Principle of Economics: Equilibrium

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The Free Rider Problem: Exists when an individual or group is able to enjoy the benefits of a situation without incurring the costs

4. The Second Principle of Economics: Equilibrium

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Which one is experiencing equilibrium?

4. The Second Principle of Economics: Equilibrium

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Is there an incentive for him to change his behavior?

4. The Second Principle of Economics: Equilibrium

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Is this an equilibrium?

4. The Second Principle of Economics: Equilibrium

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It would be beneficial to the group to coordinate their decisions but they have an incentive to deviate from that agreement. Equilibrium analysis explains why individuals often fail to serve the interest of the group and how the incentive structure can be redesigned to fix these problems.

4. The Second Principle of Economics: Equilibrium

5. The Third Principle of Economics: Empiricism

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Economists are interested in testing their theories and understanding what is causing things to happen.

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Crowded beaches and hot temperatures go together.

So if we want to make it cooler, keep

people from going to the beach!

5. The Third Principle of Economics: Empiricism

Key Ideas

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Economics is the study of people’s choices.

The first principle of economics is that people try to optimize; they try to choose the best available option.

The second principle of economics is that economic systems tend to be in equilibrium, a situation in which nobody would benefit by changing his or her own behavior.

Key Ideas

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The third principle of economics is empiricism—analysis that uses data. Economists use data to test theories and to determine what is causing things to happen in the real world.