lecture 1 thinking like an economistflash.lakeheadu.ca/~kyu/e2017/mi1.pdf · 2019-08-29 · the use...

Lecture 1 Thinking Like an EconomistBusiness 2017 Managerial Economics

Economics 2017 Microeconomics I

Kam Yu

Fall 2020

Outline

1 Scientific KnowledgeInduction and DeductionUncertainty and Complexity

2 Economics as a Social ScienceEarly Social ThinkersEconomic History

3 MicroeconomicsThe Market EconomyThe EconomistEconomic Modelling

4 Economic Thinking

Kam Yu (Lakehead) Lecture 1 Thinking Like an Economist Fall 2020 2 / 37

Scientific Knowledge

The Scientific Revolution

“Progress that is both rapid enough to be noticed and stable enough tocontinue over many generations has been achieved only once in the historyof our species. It began at approximately the time of the scientificrevolution, and is still under way. It has included improvements not only inscientific understanding, but also in technology, political institutions, moralvalues, art, and every aspect of human welfare.”

– David Deutsch in The Beginning of Infinity


Scientific Knowledge

The Scientific Method

1 Observations of the world.

2 Forming a theory or modelbehind the pattern: the theoryhas to be testable and falsifiable.

3 Repeated empirical testings ofthe theory.

4 Accept the theory as justifiedbelief until it is proven false.


http://youtu.be/_-gdzOxe7aE

Scientific Knowledge Induction and Deduction

Tools Used in the Scientific Method

The first step of recognizing a pattern, and the third steps of testingthe theory by empirical observations are examples of the inductivemethod.

Statistical techniques are often used in the inductive process.

The theory, or model, is a deductive process. Results andconsequences are derived from the assumptions by logical deduction.

In physical and economic science, a theory is often expressed inmathematical form.



Inductive versus Deductive Thinking



Covering the Chessboard


Scientific Knowledge Uncertainty and Complexity

Hierarchies of Scientific Knowledge

Many scientists think that any discipline of science can be derived fromthe knowledge from a more fundamental level.

Sociology/Political Science/Economics

Psychology

Neuroscience

Biology

Biochemistry

Chemistry

Physics

But cosmologist George Elllis does not agree with this principle.



Why a Jumbo Jet Can Fly?

Answer from physicists:

It flies because air molecules move atdifferent speeds at the top and bot-tom wing surfaces to create a pressuredifference that lifts the plane againstgravity—Bernoulli’s principle.




Answer from the pilots:

It flies because the pilots are control-ling the plane, with the skills they ac-quired under rigorous training.




Answer from engineers:

It flies because the plane is designed tofly, using the technology in mechani-cal engineering, material science, andprecision manufacturing. A car can-not fly because it was not designed tofly.




Answer from economists:

It flies because the airline companyrunning it is making a profit.



It’s a Complex World

Because of complexity, each discipline of science may have it’s ownlogical structure and cannot be derived from a more fundamentallevel.

Social science probably cannot be studied using knowledge in physicsor chemistry.

But laws at the fundamental levels are still true. An airline flying thejumbo jets has to make a profit. But the airplanes must obeyBernoulli’s principle.



Why the Concorde is not Flying?



Why the Concorde is not Flying?

It could fly at Mach 2.04, an engineering marvel.

It took only 3.5 hours to fly from New York to Paris.

It had an excellent safety record.

During its entire operation history from 1976 to 2003, British Airwaysand Air France failed to make a single dim in profit on each flight.

Effectively, tax payers in the two countries were subsidizing richcustomers for supersonic travels.

Since 2003, no commercial airline has operated any supersonic flightservice.


https://www.economist.com/blogs/gulliver/2019/01/reinventing-concorde

https://www.economist.com/blogs/gulliver/2019/01/reinventing-concorde

Economics as a Social Science Early Social Thinkers

Thomas Hobbes

Social contract theory — Society needs a strong central authority toavoid chaos, which is the natural state of the world:

“In such condition, there is no place for industry; because thefruit thereof is uncertain: and consequently no culture of the earth;no navigation, nor use of the commodities that may be importedby sea; no commodious building; no instruments of moving, andremoving, such things as require much force; no knowledge ofthe face of the earth; no account of time; no arts; no letters; nosociety; and which is worst of all, continual fear, and danger ofviolent death; and the life of man, solitary, poor, nasty, brutish,and short.”

— Leviathan (1651)


Economics as a Social Science Early Social Thinkers

Adam Smith

Economic freedom — division of labour, invisible hand, and self-interest:“Every individual necessarily labours to render the annual rev-

enue of the society as great as he can. He generally, indeed, neitherintends to promote the public interest, nor knows how much he ispromoting it . . . he intends only his own gain, and he is in this, asin many other cases, led by an invisible hand to promote an endwhich was no part of his intention. . . .

It is not from the benevolence of the butcher, the brewer, orthe baker, that we expect our dinner, but from their regard to theirown interest. We address ourselves, not to their humanity but totheir self-love, and never talk to them of our own necessities butof their advantages.”


Economics as a Social Science Economic History

Ancient History

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Figure !.! World economic history in one picture. Incomes rose sharply in many countries after 1800 but declined in others.

typical English worker of 1800, even though the English table by then included such exotics as tea, pepper, and sugar.

And hunter-gatherer societies are egalitarian. Material consumption varies little across the members. In contrast, inequality was pervasive in the agrarian economies that dominated the world in 1800. The riches of a few dwarfed the pinched allocations of the masses. Jane Austen may have written about re-fined conversations over tea served in china cups. But for the majority of the English as late as 1813 conditions were no better than for their naked ancestors of the African savannah. The Darcys were few, the poor plentiful.

So, even according to the broadest measures of material life, average welfare, if anything, declined from the Stone Age to 1800. The poor of 1800, those who lived by their unskilled labor alone, would have been better off if transferred to a hunter-gatherer band.

The Industrial Revolution, a mere two hundred years ago, changed for-ever the possibilities for material consumption. Incomes per person began to undergo sustained growth in a favored group of countries. The richest mod-ern economies are now ten to twenty times wealthier than the 1800 average. Moreover the biggest beneficiary of the Industrial Revolution has so far been

! " # $ % & ' ( )

Source: Gregory Clark (2007) A Farewell to Alms: A Brief Economic History of the World,Princeton University Press.



A Closer Look, 1000–2015

Source: The Economy, Curriculum Open-access Resources in Economics (CORE).


http://www.core-econ.org


The World in 2019

1 Developing countries are catching up slowly but steadily. Extremepoverty has been declining over the years.

2 Wealth is not just measured in terms of dollar per person, but also inproduct variety. A Tale of Two Tribes:

Tribe Income Per Person Stock Keeping Unit

Yanomamo $90 500 to 10,000New Yorker $36,000 1 to 100 million

Source: Beinhocker (2006, 8–9)

3 Prominent features of a modern economy:

Division of labourThe use of fossil fuel to underpin most economic activitiesPositive correlation between economic freedom and economicdevelopment


https://ourworldindata.org

Microeconomics The Market Economy

Capitalism

In this course we study how capitalism works. Capitalism is characterizedby

1 Private ownership of capitals:

Durable consumption goods like houses, cars, phones, computers, etc.Production resources like machinery, factory and office buildings, etc.Intellectual properties such as education, knowledge, patents,copyrights, etc.

2 Free markets: People are free to trade goods and services voluntaryunder the constraints of laws and regulations.

Not everything we consume are produced by the firms in the free market.Some goods and services such as national defence, roads and highways,and basic healthcare insurance are provided collectively by the government.We live in a “mixed economy”.



How Economists See the World



Ingredients of a Market

Buyers

Sellers

Voluntary exchanges

Terms and conditions of the contract

Outcomes: market price and quantity of the exchanges

Entrepreneurs: enterprising persons who discover and exploreprofitable opportunities and organize and manage production ventures

Assumption: all parties behave in their self interests.


http://www.newyorker.com/magazine/2010/01/18/the-sure-thing


The Economic Problem

Two facts:

1 Resources such as capital, labour, energy, land, and talent are in limitsupply (scarcity)

2 People always want more than what they have (unless you are a realBuddhist)

Problems to be resolved:

1 What will be produced?

2 How will things be produced?

3 Who get what?

4 Who make these decisions?


Microeconomics The Economist

What Do Economists Do?

Social scientist — study and explain how society resolve the economicproblem by looking at people’s incentives and behaviours undervarious constraints.

Policy analyst — Design and analysis of how government policies andregulations to achieve efficiency and fairness.

Business consultant and advisor — Translate an organization’sproblem into an economic model, find the best solution, and translatethe results back into business actions and strategies.


Microeconomics The Economist

Tools that Economists Use

Economic theory or models — A model is an abstract representationof reality. Examples are

a highway mapa electrical circuit diagraman organization charta formal mathematical systema prototype

Empirical analysis — collecting raw data, data construction, andstatistical analysis.

Forecasting — Combining theoretical and empirical analysis to predictthe future.


Microeconomics Economic Modelling

Modelling: Abstraction vs Reality


Economic Thinking

Basic Assumptions

Capitalism: private property rights and free market exchanges(economic freedom)

Individual choice based on self interest

Rationality

self-interest standard of rationalitypresent-aim standard of rationalitybounded rationality


http://www.nytimes.com/2016/09/18/opinion/sunday/the-difference-between-rationality-and-intelligence.html

Economic Thinking

Methodology

The cost-benefit approach — Actions are taken when the totalbenefit of the action exceeds the total cost.

Marginal analysis — Decisions are based on the extra (marginal)benefit of taking further action against the extra cost of doing so.

Optimal Decision — The best solution is often achieved when themarginal benefit is equal to the marginal cost.


Economic Thinking

Common Pitfalls in Decision Making

In this course we focus on the neoclassical model. It assumes thatagents behave in the rational manners prescribed in the assumptions.

Psychologists have found that people’s actual behaviours are differentfrom the model. Some common observations are as follows:

1 Ignoring opportunity cost

The nature of interest rateUniversity education and life time earnings: For example, getting a BAdegree involves

1 Direct costs: tuition fee, books and other expenditures, studying time,2 Opportunity cost: lost incomes, lost work experience, spending time

with family and friends.


Economic Thinking

Financial Returns of Education


Economic Thinking


Economic Thinking

2 Failing to ignore sunk costs

looking ahead, not backwardthe Vietnam war, the Iraq war, . . .

3 Measuring costs and benefits as proportions rather than absolutevalues

4 Failure to differentiate the concept of average value and marginalvalue


Economic Thinking

Limitation of the Invisible Hand

Externality (Sky-train free riders in Vancouver)

Property rights (music downloads, east coast fishery)

Transaction costs and Coase Theorem

Economic institutions1 informal institutions — history, culture, religion, language, and other

social norms and conventions.2 formal institutions — the constitution, laws and statutes, rules and

regulations, government policies, etc.


Economic Thinking

Summary

Capitalism as an economic system emerged after the industrialrevolution.

Economists try to use a scientific approach to study how people makedecisions, and the social consequences of their individual behaviours.

What we learn in this course is called the neoclassical models. Itassumes that people behave in a rational manner.

Studies have shown that people often behave differently from theneoclassical assumptions.


Economic Thinking

More on University Education

David Brooks on the purpose of getting a university degree:

1 The commercial purpose: Getting a good job and starting a career

2 Cognitive purpose: Acquiring information and learning how to think

3 Moral purpose: Building an integrated self


http://www.nytimes.com/2014/09/09/opinion/david-brooks-becoming-a-real-person.html

https://www.newyorker.com/books/under-review/the-bullshit-job-boom

Economic Thinking

The Importance of Critical Thinking

Sociologists Richard Arum and Josipa Roksa found that graduateswith good critical thinking abilities had a significant advantage intheir career development.

Those graduates were much less likely to be unemployed, lose theirjobs during an economic downturn, or end up in an unskilledoccupation.

Most students are unaware of the differences due to increasinglyinflated grades and the drumbeat of college self-promotion.

So what is this elusive ability called critical thinking? It’smulti-dimensional.


http://www.nytimes.com/2014/09/03/upshot/the-economic-price-of-colleges-failures.html

http://www.nytimes.com/2014/08/29/opinion/david-brooks-the-mental-virtues.html

lecture 1 thinking like an economistflash.lakeheadu.ca/~kyu/e2017/mi1.pdf · 2019-08-29 · the use...

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