OverviewThe Economic Way of Thinking by jianglifang

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									         Overview
The Economic Way of Thinking
The Theory of Economics does not furnish a
body of settled conclusions immediately
applicable to policy. It is a method rather than a
doctrine, an apparatus of mind, a technique of
thinking which helps its possessor to draw
correct conclusions.
                             --John Maynard Keynes
      The essence of economics
• Voluntary trade can create wealth
• Specialization and exchange promote
  economic growth
• Market prices signal relative scarcities and
  coordinates the allocation of resources
• Perfectly competitive markets are efficient
Voluntary trade can create wealth!
• Wealth is whatever people value.
• Value is in the eyes of the chooser.
• Both traders increase their own wealth
  by cooperating in an exchange.
Voluntary trade can create wealth!
Jack has an apple. He is willing to pay $1 for an
apple, and $2 for a pear.
Rose has a pear. She is willing to pay $1 for a
pear, and $2 for an apple.
Both of them are willing to trade with the other.
Before trade, the total wealth is $2.
After trade, the total wealth is $4.
Voluntary trade can create wealth!
• Where does the additional wealth come from?
• Trade is a productive process.
• Production is trying to add value to the input.
• Jack uses an apple as input and obtains a pear
  as output
• Rose uses a pear as input and obtains an apple
  as output
Voluntary trade can create wealth!
• Economics growth consists not in increasing
  the production of things, but in increasing the
  production of wealth.
• Trade is a process of creating wealth.
Specialization can promote economic growth!

 • Specialization = pursuit of one’s comparative
   advantage
 • Specialization can expand production
   possibilities (wealth) by trading for something
   that is more costly to produce on their own
 • Recall that economic growth is represented by
   the expansion of production possibilities
Specialization can promote economic growth!
Specialization can promote economic growth!
Specialization can promote economic growth!

 PPFs without specialization and trade
Specialization can promote economic growth!
 Suppose both specialize
 Exchange of 3 Lager for 3 stout
Specialization can promote economic growth!
Each enjoys a combination that lies beyond original
frontiers
Specialization can promote economic growth!

 • People expect to enjoy greater wealth by
   specializing in activities in which they believe
   themselves to have a comparative advantage
 • We often ask questions about our
   comparative advantages
   – “What major is best for me?”
   – “What opportunities will I enjoy after I graduate?”
       The Role of Market Prices
• The market is where supply meets demand
• Scarcity is a relationship between desirability
  and availability, or between demand and
  supply
• Market prices inform us of relative scarcities.
• Prices convey useful information that
  coordinates the allocation of resources
       The Role of Market Prices
• In other words, price is the signal that helps
  people to determine their comparative
  advantages
  – Entrepreneurs use prices to determine what to
    produce
  – Employees use wages to determine what job they
    will take
      The Role of Market Prices
• When price is higher than it is supposed to be
  (higher than the equilibrium price), a surplus
  occurs.
• A surplus informs the sellers that the
  production is overvalued
• They will cut off production and reallocate
  resources elsewhere.
      The Role of Market Prices
• When price is lower than it is supposed to be
  (lower than the equilibrium price), a shortage
  occurs.
• A shortage informs the sellers that the
  production is undervalued
• They will reallocate resources from elsewhere
  and increase the production.
      The Role of Market Prices
• Question: What happens to current price if
  some people know the price to increase in the
  future?
       The Role of Market Prices
• Answer: Expectation of a rise in price will increase
  the demand and decrease the supply. A change in
  expectations about tomorrow’s price can alter
  today’s price (self-fulfilling prophecy)
• A rise in current price will help the consumers
  and producers (even those without the
  information that the price will rise in the future)
  to reallocate resources and hence prepare for the
  future.
      The Role of Market Prices
Pakistan just had a bad harvest in wheat. Out of
the goodness of our good heats, we want to
help them.
Question: Do you think it is wise to help them by
sending them wheat?
      The Role of Market Prices
• Answer: If we send them wheat, it will
  distort/depress the price of wheat in their
  domestic market.
• In the long run, this will prevent resources to
  be allocated for wheat production in Pakistan.
• It is better to help them with money, with
  which they can buy wheat either from US
  market or domestic market.
   Perfectly Competitive Markets
• Economically efficient  the additional
  benefits outweigh the additional costs
• Perfectly competitive market is efficient (total
  surplus is maximized).
      Ask the Right Questions
Three guys go to a motel and get a room. The
total charge is $30, and each guy pays $10.
After they go to their room, the desk clerk
realizes he over charged them. He forgot
about the special rate of $25 tonight. The
clerk can’t leave his desk, so he contacts the
maid, gives her five $1 bills, and asks her to go
to the room and reimburse the three guys.
     Ask the Right Questions
On her way, the maid wonders how she can
divide $5 among three people. She decides,
since they aren’t aware of the overcharge
anyway, to give them $3 back and secretly
pocket the remaining $2. No one will be any
the wiser.
      Ask the Right Questions
Now for the brainteaser:
Each guy paid, in effect, $9: 3 times 9 equals
27. And the maid pocketed $2, for a total of
$29. But the three guys originally paid $30,
not $29.
       Where did the other dollar go?
        Ask the Right Questions
• It is nonsensical to ask “Where did the other
  dollar go?” because there is no answer to that
  question
• The right question “Where did the rest of the
  overpayment go?”

• Economics gives you with the ability to see
  through the nonsense.
          Ask the Right Questions
• When evaluating an economic policy, we should
  pay more attention to the unintended
  consequences, instead of the motives
• What are the motives?


• Think outside the box. Don’t get confused by
  the motives
• What are the unintended consequences?
     Unintended Consequences
• We cannot assume people behave the same
  way facing in a new situation
• Enforcement of a policy changes people’s
  incentives, which results in unintended
  consequences that are not expected by the
  policy-makers
           Rent control: Goal
• Make sure low-income people may get cheap
  rent
• Reduce their living expenses
  Rent control: Unintended Consequences
• Lots of people cannot find an apartment to live.
  People resort to other ways to compete for
  available apartments (long lines, reading
  obituary, bribery, etc.)
• Landlords have little incentive to maintain
  quality. Landlords will discriminate using non-
  price criteria
• The low price cannot attract people to construct
  new rental units
      Rent control: Let the market work

• When the price is allowed to fluctuate,
  increased price will attract resources to be used
  to build new rental units to be built
   Agricultural Price Support: Goal
• Protect family farmers
• Without the price support, family farmers will
  be driven out of market due to economic losses
  caused by high production cost
         Agricultural Price Support
         Unintended consequences
• Create economic profits for corporate farms
  with lower production costs
• Profits attract outsiders to bid for farmland and
  increase the price of farmland
• Higher cost of land increases production cost
  – For owners of farmland, economic losses is
    mitigated by the greater implicit value of their land;
  – For many farm families who rent their land, there is
    no such compensation
          Agricultural Price Support
            Let the Market Work

• The market price should have informed the
  family farmers to reallocate resources where
  they are more highly valued
            Minimum Wage
• Goal: protect unskilled workers
• Unintended consequences: Unemployment.
  Especially for those with low skills.
       Unintended Consequences
• Economics was christened “the dismal science”
  because its analysis frustrated so many hope
  and desires.
• On the other hand, knowing what is not
  possible can spare us many disappointments
  and avoid many disasters.
       The Role of Government
• Competitive markets are efficiency, so the
  government should keep economic intervention
  minimal for competitive market
• Then, what is the role of government?
Three conditions for economic efficiency
• Large numbers of buyers and sellers; no one
  party has the ability to manipulate the market
  (counterexample: monopoly)
• No externalities (counterexamples: pollution,
  education, public goods, common resources)
• Complete information available about the
  quality of the goods (counterexample: used car)
       The Role of Government
• Government does have a role to play in the
  economic system
• E.g. protecting property rights, regulating
  monopoly and promoting competition, taxing
  pollution, subsidizing education, providing
  public goods, regulating the use of common
  resources, protecting the poor
• But controlling the market prices should be
  cautioned
     Is Market Economy Perfect?
• Market economy is not perfect or all-wise
• There are a lot of problems with this economic
  system (e.g. inequality)
• It is a mistake to contrast a less-than-ideal
  situation with an ideal-but-unattainable
  situation.
     Is Market Economy Perfect?
• Democracy is the worst form of government
  except all those other forms that have been
  tried from time to time. —Winston Churchill
• Market economy is the worst form of economic
  system except all those other forms that have
  been tried from to time.
 Want to know more about economics?

• One of the best
  economic textbooks
• Insightful book with
  storytelling
• No complicated
  technical analysis or
  graphs
 Want to know more about economics?

• Which is more
  dangerous, a gun or a
  swimming pool? A
  shark or a football?
• What do school
  teachers and sumo
  wrestlers have in
  common?
• How incentives work?
 Want to know more about economics?
• Why do the keypads on
  drive-up cash machines
  have Braille dots?
• Why are round-trip
  fares from Orlando to
  Kansas City higher than
  those from Kansas City
  to Orlando?
• Cost-benefit analysis
      Are people really rational?
• Behavioral Economics
• How people really
  make decisions?
• We will see from the
  book that people often
  make irrational
  decisions.
 Beyond Economics:
Can economics make
    you happy?
          Beyond Economics:
    Can economics make me happy?
• Economics investigates the allocation of
  scare resources
• It assumes available resources cannot
  satisfy wants, and there is always a tension
  between availability and desirability
           Beyond Economics:
     Can economics make me happy?
• Happiness is getting what you want.
• According to economics, people can never
  satisfy, so we can never be happy…
• But…
• Wealth is whatever people value.
• Value is in the eyes of the chooser.
          Beyond Economics:
    Can economics make me happy?
• Buddha wanted nothing—and that’s pretty
  much what he got.
• Since he had found what he wanted, he
  became wealthy.
• And he was happy.
       How to Become Happy?
        A word of wisdom…
• Desire everything.
• Need nothing.
• Choose whatever shows up.

								
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