ECON 356 - Outline One

The Nature and Method of Economics

1.  What is economics?

2.  Economics is a social science - we study people.  What assumptions do most (but not all) economists make about human action?

3.  What do economists do?  What are the problems they address?

What Do Economists Do In An Attempt To Address These Problems?  

Rules of the game (institutions): 

Two important things to consider about the rules or institutions in society:

    a.  How did the rules come about?  Where did they come from?  This is important.  Why?  Because we will get different outcomes from different rules -- and different outcomes depending upon where the rules came from.  (More on this later). 

 Basically there are two ways rules come about:

        Spontaneous evolution or order (as in common law) - our behavior drives the rules.  Examples:

        Legislation (congress tells us what we can and can't do).  Examples:

    It is interesting that we often think that a legislated rule is necessary - let's say for coordination to take place -- when it really isn't.  The legislated rules will often lead to higher costs and fewer benefits for the people involved.  Why?  Because people will act in such a way that benefits themselves (using knowledge only they have - the legislators don't have) -- and in doing so unwritten rules emerge spontaneously on their own.

Example:  Traffic lights!  http://www.youtube.com/watch?v=yoUHMvpH67o  

    b.  How broad vs. how specific are the rules?  This is also very important.  Why?  Because broad rules allow for individuals to utilize their own individual knowledge of time and circumstance, whereas specific rules are more strict -- they allow for less individual initiative and use of knowledge.  There is also a difference in how incentives are affected by the rules as well.  (More on this soon).

Incentives matter:  At least most economists think they do (given the assumptions about behavior we made earlier).

So the process of analysis is such:

Rules create Incentives, which lead to certain Actions, which create certain Outcomes

It is the economist’s job to determine (or at least attempt to determine) which rules will lead to which outcomes.

Unintended outcomes or consequences: 

        Question:  which rules (those that arise spontaneously or those that come about through legislation) do you think will lead to more, and probably larger, unintended consequences?  Why?

Rules Need to Be Predictable and Steady (meaning individuals understand them and know they won't change soon) to be Followed: 

Which Rules Are the Best?  This depends upon what people want.  If we want a higher standard of living in terms of more food, clothing, shelter and free time -- private property rights, free trade and the rule of law.  Why?

Notice how broad these rules are.  They don't specify what can and can't be traded, how property must be used, and the rule of law gives us more certainty about the rules -- it basically says that everyone, regardless of who they are, are subject to the same rules.   As the rules get more specific and as they come about through legislation -- less individual choice and knowledge can be utilized -- and more unintended consequences come about (especially if people don't like the rule). 

Let's use our model with property rights, and free trade

These rules lead to what incentives (again, assuming people act in their own self interest)?  Why?

What actions do we see then?  Why?

What outcomes come about from these actions? 

4.  The question of methods -- how do economists differ from the hard sciences?  How do economists differ among themselves - i.e., assumptions about knowledge - a big deal!

5.  What does "opportunity cost" mean?  Can you apply the concept? 

Question::  why do most students start college right after finishing high school?  Can you supply more than one answer?  Are there exceptions to your theory?

6.  Economists build models (theories) in order to understand social phenomena.  In building these theories we should:

a.  state all assumptions

b.  don't ignore opportunity costs (the broken window fallacy).  This involves discussing the "unseen" parties.

c.  don't ignore subjective value or costs/benefits -- this is a pitfall that "welfare" or cost/benefit analysis often fall into -- we will be careful.

d.  don't ignore sunk costs

e.  don't confuse marginal with average (or even total)

f.  don't look at only the short run -- look at the long run outcomes

7.  Efficiency - we will really look into this concept -- it is not as easy as it appears.  In general, though, we will define wealth in this class in a certain way:

            Wealth: 

            Efficiency and Wealth: 

            Externalities:

So some economist's might say that efficiency is a "myth" because of uncertainty.  The idea of "maximizing" or "minimizing" something is nonsense once we emphasize subjective knowledge and change (or processes vs. end states).

Discussion:  The Callahan reading -