Chapter 1: The Scope of Economic Analysis

1
Chapter 1 The Scope of Economic Analysis

• HKAL Microeconomics
• T. W. G. Hs.
• Lo Kon Ting Memorial College
• References
• A-Level Microeconomics, CH. 1, 2 15
• HKALE Microeconomics, CH. 1, 2, 14 19
• ???????????????
• Exchange and Production, CH. 1 5

2
What is Economics?

• an empirical science resting on the assertion or
  postulate of self-interest to explain observable
  economic behavior or phenomena
• history repeats itself, however, facts do not
  speak for themselves
• economists therefore need to theorize in order
  to explain and predict facts/economic phenomena.

3
What is Economics?

• As an empirical science, economic theories are
  constructed
• to explain human behavior by finding out what
  conditions lead to what consequences
• to predict the occurrence of similar events in
  the future and how behavior will change when
  there is a change in the constraints they face.

4
Positive Versus Normative Economics

• Positive economics contains descriptive
  statements, propositions and predictions about
  the world.
• Normative economics makes statements about what
  ought to be, or about what a person, organization
  or nation ought to do.
• Ex 1 Is A-L economics concerning about positive
  or normative one?

5
Attributes of Economic Analysis

• Economic analysis is solely scientific and
  strictly positive.
• Economic theory rests on understanding of human
  traits.
• theories are abstractions of the world
• to theorize is to pick out the relevants from
  the irrelevants
• Economists construct and test theories.

6
Methodology Scientific Inquiry Constructing
Theories

• interesting real-world observations prompt the
  construction of a theory
• postulating economic behavior (i.e. making axioms
  or basic assumptions)
• picking out 'relevants' from the 'irrelevants'
  (i.e. making abstractions)

7
Methodology Scientific Inquiry Constructing a
Theory

• establishing the interrelationship among
  variables and ideas in the form of hypothesis
  (including test conditions predicted
  outcomes) i.e. If A, then B via logical
  deduction
• making a logically consistent implication or
  prediction

8
Methodology Scientific Inquiry Constructing a
Theory

• confronting the real-world observations with the
  testable implication (i.e. testing the
  hypothesis/model/theory)
• a theory is valid if it is confirmed/not rejected
  by the facts

9
Methodology Scientific Inquiry Constructing a
Theory

• a theory is invalid if it is rejected by facts,
  and is being discarded or amended with adding
  more constraints and is being re-tested.

10
Six Basic Postulates

• Each person desires many goods has many goals.
• For each person, some goods are scarce.
• Each person is willing to forsake some of a good
  to get more of other goods.

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Six Basic Postulates

• The more of a good one has, the larger the total
  personal use value, but the lower the marginal
  personal value of a unit.
• Not all people have identical tastes and
  preferences.
• People are innovative but consistent.

12
The Validity and Usefulness of a Theory

• a theory is said to be a useful if it has
  implications that are potentially refutable but
  have not yet refuted
• Ex 2 Can a theory be proved wrong?
• We never say a theory is 'proven' because we just
  do not know whether the next set of collected
  data will still agree with the implications or
  not.

13
The Validity and Usefulness of a Theory

• If the empirically collected data agree with the
  implications, then the theory is said to be
  'confirmed' and 'valid'. If not, it is 'refuted'
  or 'rejected' and 'invalid'.
• A theory that can never be rejected is useless
  because it is either a tautology (a definitional
  identity) or we are not clear what is about.

14
The Validity and Usefulness of a Theory

• The usefulness of a theory is based on its
  explanatory and predictive power.
• As Milton Friedman said, "The value of a model
  does not depend on the 'realism' of its
  assumptions but on its ability to explain or
  predict real world events.

15
Attributes of a Useful Theory

• economic theory must be a simplification of
  reality
• assumptions may be unrealistic because
• the statement does not give an exhaustive
  description of an object
• the statement is false or highly improbable
• the statement (excluding test conditions) is used
  to formulate pure cases or ideal types
• the arguments must be logically consistent
• if A then B and B then C, A is preferred to C

16
Attributes of a Useful Theory

• implications and predictions must be testable or
  observable
• the theory is potentially refutable by facts
• variables in the theory must be observable

17
Attributes of a Useful Theory

• the power to generalize
• if a hypothesis is repeatedly supported by the
  evidence and repeatedly accepted (or confirmed),
  it may be called a law
• Great predictive power, not forecasting power
• Ex 3 What is the difference between forecast
• predict?

18
Hypothesis, Ad Hoc Theory and Tautology

• Hypothesis is logically deducted, testable,
  refutable, and usually expressed in terms of 'If
  A (assumptions), then B (implications).

19
Hypothesis, Ad Hoc Theory and Tautology

• Rejected theory can be modified by adding more
  assumptions to the theory at the expense of
  losing its power to generalize, i.e. it can apply
  to a narrower variety of situations.

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Hypothesis, Ad Hoc Theory and Tautology

• an ad hoc theory is a very specific theory that
  can be applied only to one (or a few) particular
  situation.

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Hypothesis, Ad Hoc Theory and Tautology

• An example of ad hoc theory
• If it rains outdoor without umbrella
  without raincoat without cap without hat
  without shelter not standing under a tree not
  standing under a cover (A),
• then youll get wet (B).
• Example from Steven N. S. Cheung dropping
  temperature in high mountains

22
Hypothesis, Ad Hoc Theory and Tautology

• A tautology (a definitional identity) is so
  generalized and true for all values of the
  variables.
• Example A four-leg-animal has four legs
• It is empty and has no explanatory nor predictive
  power at all.

23
Hypothesis, Ad Hoc Theory and Tautology

• But a tautology could be developed into a useful
  theory if testable conditions are added. The
  Coase Theorem and Quantity Theorem of Money are
  two examples of these.

24
Hypothesis, Ad Hoc Theory and Tautology

• Ex 4 Is an ad hoc theory or a tautology better
  theory?

25
Hypothesis, Ad Hoc Theory and Tautology

• A useful theory must then strive for the right
  balance between the degree of generality and
  refutability by avoiding adding too specific or
  generalized conditions to its construction.
  Therefore, a useful theory must fall in between
  the ad hoc theory and tautology.

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Hypothesis, Ad Hoc Theory and Tautology.
27
Logical Fallacies

• Logically speaking, we must affirm the
  antecedent in the hypothesis in order for the
  consequent to follow with logical necessity.
• If A is true, then B is true A is true,
  therefore B is true.

28
Logical Fallacies
Example If Jessie is a trained secretary, then
she knows how to use a typewriter correctly
Jessie is a trained secretary, therefore she
knows how to use a typewriter correctly.
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Logical Fallacies

• On the other hand, we can deny the truth of a
  hypothesis with reference to the facts denying
  the consequent.
• If A is true, then B is true B is NOT true,
  therefore A is NOT true.

30
Logical Fallacies

• Example If Jessie is a trained secretary, then
  she knows how to use a typewriter correctly
• Jessie does not know how to use a typewriter
  correctly, therefore she is not a trained
  secretary.

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Logical Fallacies

• Fallacy 1 Affirming the consequent
• If A is true, then B is true if B is true,
  therefore A is true.
• Example If Jessie is a trained secretary, then
  she knows how to use a typewriter correctly
  Jessie knows how to use a typewriter correctly,
  therefore she is a trained secretary.

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Logical Fallacies

• Fallacy 2 Denying the antecedent
• If A is true, then B is true if A is not true,
  therefore B is not true.
• Example If Jessie is a trained secretary, then
  she knows how to use a typewriter correctly
  Jessie is not a trained secretary, therefore she
  must not know how to use a typewriter correctly.

33
Logical Fallacies

• When A is said to be a necessary condition for
  B, it means that occurrence (or true) of B
  implies the occurrence (or true) of A, i.e. If
  A is true, then B is true B is true, therefore A
  is true.

34
Logical Fallacies

• While A is said to be a sufficient condition
  for B, it means that the occurrence (or true)
  of A implies the occurrence (or true) of B,
  i.e. If A is true, then B is true A is true,
  therefore B is true.

35
Logical Fallacies

• When A is both a necessary and sufficient
  condition for B, it means that the occurrence
  of one implies the occurrence (or true) of the
  other, i.e. If A is true, then B is true A is
  true, therefore B is true and B is true,
  therefore A is true.

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Logical Fallacies

• Economic proposition/hypothesis of If A, then B
  only posits that A is a sufficient condition
  for the occurrence of B, i.e.
• If A is true, then B is true A is true,
  therefore B is true. (Affirming the antecedent
  but with no logical fallacy)

37
Logical Fallacies

• Example If If Jessie is a trained secretary,
  then she knows how to use a typewriter correctly
  Jessie is a trained secretary, therefore she
  knows how to use a typewriter correctly.

38
Logical Fallacies

• By confronting the hypothesis with observable
  facts, if Jessie is a trained secretary and good
  at using a typewriter, the hypothesis is said to
  be confirmed if, however, she is a trained
  secretary but does NOT know how to use a
  typewriter, the hypothesis (though is free from
  logical fallacy) is said to be rejected (by
  facts).

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Logical Fallacies

• If A is true, then B is true B is NOT true,
  therefore A is NOT true. (Denying the consequent
  but with no logical fallacy.)

40
Logical Fallacies

• Example If Jessie is a trained secretary, then
  she knows how to use a typewriter correctly
  Jessie does NOT know how to use correctly a
  typewriter, therefore she is NOT a trained
  secretary.

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Logical Fallacies

• By confronting with observable facts, if Jessie
  does NOT know how to use a typewriter correctly
  and is NOT a trained secretary, the hypothesis is
  said to be confirmed if, however, she does NOT
  know of using correctly a typewriter but is
  indeed a trained secretary the hypothesis is said
  to be rejected.

42
Constrained Maximization

• Economists assume individuals make choices
  subject to constraints (i.e. rules of the game)
  in order to maximize his gains (in terms of
  utility, income, wealth, rent or profit)
• In economics, individual choice and self-interest
  are basic postulates used to explain an
  individual's maximizing behavior, subject to
  constraints (available alternatives).
• Ex 5 What are the major constraints?

43
Major Constraints
Constraints One-man economy Society
Scarcity of resources Yes Yes
Production cost Yes Yes
Transaction costs No Yes
Property rights No Yes
44
Transaction Costs

• Transaction costs, in their broadest sense,
  encompass all those costs that cannot be
  conceived to exist in a Robinson Crusoe economy
  where there are no property rights, transactions
  or any kind of economic organization.

45
Transaction Costs

• Economic organization is defined as any
  production and exchange activities which are not
  guided by the invisible hand of the market, then
  all organization costs are transaction costs.
• Transaction costs are actually institutional
  costs, including the costs of organization and
  law enforcement.

46
Transaction Costs as a Spectrum of Institutional
Costs
47
Transaction Costs as a Spectrum of Institutional
Costs

• information cost or searching cost
• defining cost or delineating cost
• the cost incurred in setting the limits in the
  use of property rights by legal or social
  institutions
• measurement cost and pricing cost
• negotiating and contracting or exchange costs
• policing and enforcing costs

48
Transaction Costs as a Spectrum of Institutional
Costs

• In a one-man economy, information costs and
  policing costs (say of preventing wild animals)
  would still exist. However, they are not regarded
  as transaction costs. They are regarded as the
  production costs incurred in maintaining the
  living standard.
• As it is almost impossible to distinguish clearly
  between different types of costs, we simply lump
  them together as transaction costs.

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Ways of Reducing Transaction Costs

1. the use of money as a common medium of exchange
2. the existence of a marketplace
3. the existence of middlemen
4. the upholding of private property rights by an
   effective government
5. the existence of social custom and etiquette

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Scarcity, Choices Opportunity Cost

• Scarcity
• we want more than we have
• a relative concept
• a universal problem
• Ex 6 Is shortage the same as scarcity?

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Scarcity, Choices Opportunity Cost
Scarcity Shortage
Definition We want more than we have at zero P Qd is larger than Qs at a positive P
Cause Unlimited wants cannot satisfied with limited resources Market price is controlled a level below the equilibrium
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Scarcity, Choices Opportunity Cost
Scarcity Shortage
Curable? NO way to eliminate By allowing the market price to adjust to the equilibrium level
Others the existence of scarcity does NOT imply the problem of shortage the existence of shortage implies the problem of scarcity
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Scarcity, Choices Opportunity Cost
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Scarcity, Choices Opportunity Cost

• With scarcity, we choose the option that incurs
  the lowest opportunity cost.
• Opportunity cost is defined as the highest-valued
  option necessarily forgone in making choice.
• Whenever we choose, opportunity cost arises.
• Ex 7 Does cost exist in Robinson Crusoe or
  one-man
• economy?

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Scarcity, Choices Opportunity Cost

• Whenever there is competition, discrimination
  then follows.
• To discriminate is just to separate the winners
  from the losers in a competition.

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Scarcity, Choices Opportunity Cost

• The criteria of competition (i.e. rules of the
  game or constraints) are not just important in
  deciding who are winners or losers, but also
  affect human behavior. A change in the
  competition criteria will definitely induce
  changes in human behavior.

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Forms of Competition

• Price Competition
• Goods services are allocated to the highest
  bidder under the price or market system.
• Resources allocation under price competition is
  said to be efficient because the product will be
  in the hands of the highest-valued users.

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Forms of Competition

• Non-price Competition
• by social customs traditions
• by seniority or beauty
• by religion affiliation
• by academic performance
• by violence or physical force
• by queuing or first come first served
• by lottery or ballot or rationing or luck

Ex 7 Which form of competition is more efficient?
59
Remarks on Opportunity Cost

• We can predict whether a certain act will be
  pursued voluntarily or not by means of comparing
  its value (i.e. the maximum one is willing to
  pay) with its cost (i.e. the maximum one will
  have to sacrifice).
• If its value exceeds cost, the act will be taken,
  vice versa.

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Remarks on Opportunity Cost

• Bad consequences and the cost of a choice are NOT
  the same.

Ex 8 If Peter Mary are secondary teachers
earning 16000 per month, is their opportunity
cost of quitting the job definitely the same?
Explain.
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Remarks on Opportunity Cost

• Costs are not necessarily expressed in terms of
  money or out-of-pocket cost.
• full cost explicit cost implicit cost
• explicit cost out-of-pocket cost money cost
• implicit cost income forgone

Ex 9 Referring to Ex 8, will Peter Mary bear
the same opportunity cost when they decide to
become a secondary teacher?
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Remarks on Opportunity Cost

• No choice, no cost.
• Time itself is not a cost, however, the
  highest-valued alternative use of that period is
  part of cost.
• When cost increases, it does NOT imply one is
  worse off.
• however, it means the value of the highest-valued
  alternative use increases.

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Historical or Sunk Cost

• Historical or sunk cost
• is simply a past expenditure (for a past act)
• is the original cost at which a firm acquired a
  factor
• Ex 8 Distinguish sunk cost from opportunity cost.

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Sunk Cost and Opportunity Cost
Sunk Cost Opportunity Cost
An accounting cost, which is historical in nature Not an accounting cost
An ex-post concept post and backward-looking An ex-ante concept anticipated and forward-looking
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Sunk Cost and Opportunity Cost
Sunk Cost Opportunity Cost
Cannot be avoided, i.e. irrecoverable Can be avoid
Does NOT affect present or future decision-making A determinant of maximum decision-making lower cost is preferred
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Functions of Invisible Hand

• Ex 9 What is/are the function(s) of price?
• Price transmits information for resources
  allocation.
• Price provides incentives that motivate
  decision-makers to act because it rewards correct
  decisions and penalizes wrong ones.

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Functions of Invisible Hand

• Price distributes income as it determines who
  gain how much of what.
• The above 3 functions are inter-related.

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Property Rights

• Property rights to something are the entire set
  of peoples expectations regarding what they can
  and may do.
• Property rights are the rules of the game, which
  serve to determine the winners and losers when
  the rules of the game change, the winners and
  losers will change.

69
Property Rights

• In a capitalist system, property rights exist on
  capital and consumer goods and on personal
  services. People compete in the free market and
  the price mechanism determines resource
  allocation and income distribution.

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Property Rights

• In a socialist system, income-generating goods
  are controlled by the government and are not
  transferable at market prices. Control of scarce
  and valuable resources is gained by access to
  political power rather than through the price
  mechanism.

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Private Property Rights

• A good or an asset is defined as private
  property, if and only if, within well-defined
  limits, its owner has three distinct sets of
  rights
• the exclusive right to use
• the exclusive right to receive income
• the transfer right

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Private Property Rights

• The exclusive right to use is the right to
  exclude other individuals so that the owner alone
  may decide on the use of a good.
• The exclusive right to receive income means that
  the owner has the exclusive right to extract
  income generated by the use of a good.

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Private Property Rights

• The transfer right means that the owner has the
  full right to transfer or alienate a property or
  resource to anyone he or she sees fit. It implies
  the right to enter into contracts with anyone and
  to choose their form.
• However, in practice, exclusivity and
  transferability of a good are frequently matters
  of degree.

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Goods, Bads and Neuters

• A good is any desired entity or object a good is
  something of which some is preferred to more.
• A bad is any undesired entity or object a bad is
  something of which less is preferred to more.
• A neuter is something which a person is
  indifferent to having, and does not care whether
  he or she acquires more of it or less.

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Economic Goods and Free Goods

• Economic goods
• a scarce good/made of scarce resources
• a desired entity that we want more than we have
• more of it is preferred to less
• commanding a positive price
• Qd is larger than Qs at zero price

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Economic Goods and Free Goods

• Free goods
• a non-scarce good/made of non-scarce resources
• a desired entity that we do not want more than we
  have
• more of it is not preferred
• commanding no price
• Qd is smaller than Qs at zero price

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Production Possibility Curve (PPC) Efficiency

• Assumptions behind PPC
• a country produces only two goods
• resources available are given
• technology is given
• Definition of PPC
• The PPC shows all combinations of two goods that
  a country can produce, given the resources and
  the best technology available.

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Production Possibility Curve (PPC) Efficiency

• Downward-sloping PPC shows concepts of scarcity,
  choice opportunity cost

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Production Possibility Curve (PPC) Efficiency

• Production points on the PPC, e.g. A, B, C D,
  yield production efficiency

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Production Possibility Curve (PPC) Efficiency

• Pareto optimal/condition or efficiency means
  efficient use of resources.
• Pareto condition refers to consumption efficiency
  and production efficiency.

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Production Possibility Curve (PPC) Efficiency

• Pareto condition is a state where it is no longer
  possible to change the allocation of resources so
  that one individual will gain without loss to
  another.
• It is a state that the wastage of resources is
  kept at minimum.

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Production Possibility Curve (PPC) Efficiency

• The PPC is concave to the origin.

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Production Possibility Curve (PPC) Efficiency

• Concaved PPC implies increasing opportunity cost

84
Production Possibility Curve (PPC) Efficiency

• Linear PPC implies constant opportunity cost

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Production Possibility Curve (PPC) Efficiency

• Area outside the PPC, e.g. Point G unattainable
  area

G
?
86
Production Possibility Curve (PPC) Efficiency

• Area inside the PPC, e.g. Point U inefficient
  production area

U
?
87
Production Possibility Curve (PPC) Efficiency

• Outward-shifting of the PPC economic growth

88
Production Possibility Curve (PPC) Efficiency

• Outward-shifting of the PPC economic growth

89
Production Possibility Curve (PPC) Efficiency

• Outward-shifting of the PPC economic growth

90
Production Possibility Curve (PPC) Efficiency

• Inward-shifting of the PPC economic recession

91
Production Possibility Curve (PPC) Efficiency

• Inward-shifting of the PPC economic recession

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Production Possibility Curve (PPC) Efficiency

• Inward-shifting of the PPC economic recession

Good Y
B
?
?
4
B
PPC 2
PPC 1
2
1
0
Good X