Introduction to Macroeconomics

1. An Overview of Macroeconomics


1. What Is Macroeconomics
2. Macroeconomic Goals
A. Low Unemployment Rate
B. Price Stability
1. Inflation and Deflation
2. Changes in Purchasing Power and Uncertainty
3. Interest Rate
C. Economic Growth
1. Measuring Total Output
2. Correcting for Price Inflation
3. Cycles in Economic Growth
D. Complementary and Conflicting Goals
3. Key Principles of Economics
A. Limited Resources, Unlimited Wants, Scarcity, and Opportunity Cost
1. Resources and the Production Process
2. Scarcity, Choice, and Opportunity Cost
3. Economic Goods Versus Free Goods
4. Examples of Opportunity Costs
5. Allocation of Scarce Resources - the Role of Prices
B. Individual Behavior and Rational Self-Interest
C. Relationship Between Opportunity Cost and Rational Self-Interested Behavior
D. Decisions Are Made at the Margin
3. Economic Theory in Practice
A. Economic Theory and Models
B. Empirical Applications
C. Normative Versus Positive Economics

1. What Is Macroeconomics?

Microeconomics is the study of the behavior of individual economic agents. Microeconomics asks how individuals allocate their time, income and wealth among various opportunities for labor, leisure, consumption, and savings. Microeconomics also studies the process by which individual firms decide on output levels, possibly prices, and the resources that will be used in the production process.

Macroeconomics, on the other hand, is concerned with the economic issues that involve the overall economic performance of the nation, rather than that of particular individuals or firms. Macroeconomics does implicitly deal with the behavior of individual economic agents in the sense that national outcomes are the sum of individual actions. But macroeconomics deals with totals, or aggregate measures of the economy, like national income or average unemployment rates, rather than differences among individuals. Macroeconomics asks how economic aggregates are determined, why problems related to aggregate economic performance occur, and what government can and should do about such problems.

"Political Economy or Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of wellbeing."

Alfred Marshall, Principles of Economics (1890) Book 1, Chapter 1.
The full text of this book is available from the History of Economic Thought web site.

Macroeconomics - analysis of the behavior of an economy as a whole.

Microeconomics - analysis of the behavior of individual decision-making units (individuals, households, firms).

2. Macroeconomic Goals

One objective of macroeconomics is to develop better laws and government policies to maximize the welfare of society. More specifically, economists focus on several major goals, such as:

This is far from an exhaustive list. Some economists may give higher priority to other goals such as an equitable distribution of income, elimination of the government budget deficit, balanced foreign trade, economic efficiency, reduction of pollution, economic security, and so on. Nevertheless, we highlight these three goals because these are the primary subjects of this course.

  1. Low Unemployment Rate
  2. Unemployment is a very personal problem. A high unemployment rate may mean the job you had was eliminated, the job you have is less secure, or the new job opportunities you hope to consider may not exist. For the macroeconomist unemployment represents a societal problem -- unemployed workers do not produce goods and services but they continue to consume them.

    A person is Unemployed if he/she had no employment during the reference week (the calendar week, Sunday through Saturday, which includes the 12th day of the month), was available for work, except for temporary illness, and had made specific efforts to find employment some time during the 4-week-period ending with the reference week (or was on temporary layoff).

    Unemployment Rate - number of unemployed individuals divided by the total of those employed and unemployed (the total labor force).

    Average Annual U.S. Unemployment Rates Figure 1-1. Average Annual U.S. Unemployment Rates.

    Data Source: U.S. Dept. of Labor, Bureau of Labor Statistics (

    This macroeconomics course may not enable you to personally take steps to lower the unemployment rate (other than your own), but it should give you a better idea as to why high unemployment rates can persist and who or what may be responsible. In fact, you may come to recognize that some government policies that purportedly save American jobs may do just the opposite.

  3. Price Stability
    1. Inflation and Deflation
    2. When the average level of prices increases over time, the economy is said to be experiencing inflation. When the average level of prices declines, as it did in the 1930s, we have deflation.

      Inflation Rate - percentage increase in the average level of prices

      Deflation Rate - percentage decline in the average level of prices

      Average Annual U.S. Inflation Rates Figure 1-2. Annual U.S. Inflation Rates.

      Data Source: U.S. Dept. of Labor, Bureau of Labor Statistics (

      How is the "average level of prices" determined? Every month the Bureau of Labor Statistics sends out people to determine prices and quantities from producers, stores, and households nationwide. The prices on all the different goods and services are weighted according to quantities sold or purchased to arrive at an average price, or price index. Of course the devil is in the details. There are many different price indexes and different ways of calculating each one. In a later chapter we will cover the most commonly cited measures of average prices and inflation, such as the Consumer Price Index, and how they are calculated.

      Consumer Price Index (CPI) - an approximate measure of the cost of living of consumers. The CPI is based on a typical "market basket" of goods and services purchased by the average household.

      It is important to recognize that we can have inflation even though the prices on some products are falling. For example, during the 1990s, the rate of inflation averaged about 4 per cent per year even though the prices of computers and other electronic products declined significantly. Price increases in some sectors of the economy must have outweighed price declines in other sectors in order for the average level of prices to rise.

    3. Changes in Purchasing Power and Uncertainty
    4. Inflation isn't necessarily detrimental to everyone. Who is hurt and who benefits from inflation? Take a person who has been saving for retirement. With an unexpected increase in inflation, those savings suddenly represent less purchasing power. Retirement may no longer be as comfortable as hoped for. Now consider a young couple who has just borrowed to buy a home. With an unexpected increase in inflation they may be looking pretty good. The home they purchased may now be worth more but the loan they must repay stays the same. Those with savings are hurt and those who are in debt benefit. For individuals inflation (and deflation) is a concern because it largely represents a redistribution of wealth.

      The redistribution of wealth with inflation or deflation does not represent the macroeconomic problem of price instability. Do you save or do you borrow? Price instability introduces uncertainty, which depresses overall economic activity.

    5. Interest Rate
    6. Not only do goods and services have prices related to them, but money also has a "price." What would it cost you to stash $1,000 in your mattress? What does it cost you to borrow a $1,000 from a bank? The price of money is the nominal interest rate. Macroeconomics examines supply and demand and the role of prices, as well as savings and investment and the role of interest rates.

      Interest rates are related to price inflation. Let's say you have some money in the bank earning 7 percent interest (the "nominal" interest rate). If the rate of inflation is 10 percent per year, will you be better or worse off over time? Well, you may feel better because you have some money in the bank available for emergencies, but the average cost of goods and services is rising faster than the value of your savings. In this case the "real" interest rate (the nominal interest rate adjusted for expected inflation) may be negative indicating that the purchasing power of your bank deposit is actually declining.

      Nominal Interest Rate - the market interest rate that is paid by borrowers to lenders.

      Real Interest Rate = nominal interest rate - expected rate of price inflation.

      The distinction between nominal and real will be an important one in this course. Here we distinguish between nominal and real interest rates. Below we describe the difference between nominal and real GDP. A nominal value is defined as "face" value or market value (a value that is agreed to between a buyer and seller). A real value, on the other hand, is a calculated value. Generally, the difference between nominal and real in economics relates to correcting for price inflation.

      If you don't own a home you probably don't have a good feel for what interest rates can cost you. In 2001, the average price of a home sold in the U.S. was $212,000 (U.S. Census Bureau, Current Construction Reports: The 2001 average interest rate on a 30-year fixed rate mortgage was 7.0 percent (Freddie Mac: Interest payments on a 7 percent loan for a $212,000 home would be $1,410 per month (on top of this add property taxes, insurance, etc.). In 1981, the average mortgage rate was 16.6 percent. Payments on a 16.6 percent loan for a $212,000 home would total $2,953 per month, more than double! Each 1 percent increase in the mortgage loan rate raises the monthly interest payment for the average price home by over $150 per month.

      Not only may high interest rates depress home buying and other investment, but also changes in interest rates, whether up or down, create uncertainty and disrupt markets.

  4. Economic Growth
  5. Economic growth represents an increase in the total physical output of final goods and services in an economy. But, how do we measure total output?

    1. Measuring Total Output
    2. Total output is measured by the market (dollar) value of all final goods and services produced by an economy during a given period of time, usually a year. Why do we measure output in dollar value rather than actual physical units of output? Quite simply, you can't add production of 1,000 cars to the production of 10,000 dolls and say we produced 11,000 goods. But, if we take quantities times market prices, we can say we produced $20 million worth of cars and $100 thousand worth of dolls for total output of $20.1 million.

      A nation's aggregate output is most commonly measured by two very similar concepts, called gross domestic product (GDP) and gross national product (GNP).

      Nominal Gross Domestic Product (GDP) - the market value of final goods and services (i.e., sold to final consumers) produced by a nation during a specific period, usually 1 year

      Nominal Gross National Product (GNP) - the market value of final goods and services produced by labor and property supplied by the residents of a nation during a specific period, usually 1 year.

      The difference between GNP and GDP is the income from the goods and services produced abroad using the labor and property supplied by U.S. residents less payments to the rest of the world for the goods and services produced in the United States using the labor and property supplied by foreign residents (referred to a net factor payments from abroad). In a simple example, the profits of a Toyota plant in Tennessee would be included in GDP, but not GNP; while the profits of a Ford Motor plant in Mexico would be included in GNP, but not GDP.

      What's the significance of the usually small difference between GNP and GDP? If all you own is your own labor, then what you are probably most interested in is the growth of output and the related job opportunities within the U.S. That would include the Tennessee Toyota plant, and you may care little about the Ford plant in Mexico. On the other hand, if you are a wealthy capitalist and your health and welfare depends on the Dow Jones Industrial Average (the stock market), then you are probably more interested in the output of U.S. firms, no matter where their production plants are located. Because our economic models and government policies are generally limited to domestic operations, GDP is usually the favored measure of total output.

      Some countries are much more sensitive to the differences between GNP and GDP than the U.S. Countries that have many citizens working abroad may have a much larger GNP than GDP. The reason is that remittances sent home by workers abroad are part of a country's GNP but not its GDP.

    3. Correcting for Price Inflation
    4. There's one significant problem in measuring any economic aggregate in monetary (dollar) terms. Prices change. For example, if we produced $1 billion worth of cars last year, and $1.1 billion worth of cars this year, did the number of cars produced increase? Not necessarily. If the average price of cars increased by more than 10 percent, then actual physical (real) output declined, even though the total current (nominal) value of output increased. We can (approximately) correct for inflation and derive values of economic aggregates (e.g., GDP, income, consumption expenditures, investment, net imports, etc.) in real terms. The method for correcting nominal measures to real measures will be covered in the same chapter as the calculation of inflation indexes.

      Real GDP - value of total output corrected for any changes in prices

      Economic Growth - change in the physical output of an economy, typically measured as the change in Real GDP.

      Annual Change in U.S. Real GDP Figure 1-3. Annual Change in U.S. Real GDP.

      Data Source: U.S. Dept. of Commerce, Bureau of Economic Analysis (

      The bane of economists are news journalists who must have been bored with economics as undergraduates and skipped class. All too often we read of the horrors of how some spending is out of control. Headline -- federal government spending has increased almost 80 percent over the last 15 years! The only horror is that we are being misled. After correcting for inflation, real government spending has increased by less than 8 percent. In fact, as most government employees can attest, real government spending has declined by over 17 percent since 1991.

    5. Cycles in Economic Growth
    6. One feature of the economy that has fascinated economists are the recurrent cycles of booms and busts in economic growth (as well as unemployment and inflation). The typical business cycle includes a period of economic expansion, a peak of activity and growth, a period of contraction with declining economic activity, and a low point, usually referred to as a trough.

      Between 1945 and 1990, contractions (peak-to-trough) have lasted an average of 11 months, while expansions (trough-to-peak) have averaged 50 months. For a chronology of business cycles since 1854, refer to the National Bureau of Economic Research (

      Business Cycle - Recurrent, systematic fluctuations in the level of business activity, often characterized by changes in growth rate of real GDP.

      Recession - a period of decline in total output, income, employment, and trade, usually lasting from six months to a year.

      Depression - a recession that is major both in scale and duration

      Economists continue to be absorbed by what causes business cycles to recur and what government policies can be enacted to constrain excessive economic expansions or reverse contractions, i.e. smooth out the cycle. This course will investigate macroeconomic models that address the latter issue - what can government do to dampen the swings in economic activity over the business cycle.

  6. Complementary and Conflicting Goals
  7. Enacting policy to achieve one goal may also lead to the achievement of another goal. For example, the stimulation of economic growth may also lower the unemployment rate. When the achievement of one goal helps to achieve another, these goals are said to be complementary. Unfortunately, stimulating the economy to promote economic growth and lower the unemployment rate may also lead to an increase in price inflation. Economic growth (or low unemployment) and low inflation are conflicting goals. This conflict, one of many tradeoffs, is the reason economics has been described as the "dismal" science.

    Achieving one of the three primary macroeconomic goals may also conflict with other goals. For example, if we wish to increase consumption by households (i.e., increase the standard of living) we may have to reduce the level of investment, which would lower long-run economic growth.

3. Key Principles of Economics

Now that we have defined the key variables that will concern us in this course, we can now consider some fundamental principles underlying our macroeconomic (and microeconomic) models.

  1. Limited Resources, Unlimited Wants, Scarcity and Opportunity Cost
  2. Economics is driven by two inescapable realities. First, the resources we are endowed with are limited. Second, our wants and desires are essentially unlimited. We all want more. I may rationalize my current situation by saying that I'm very happy with what I have. Then my mind is likely to wander to the high-definition television or vacation in Hawaii I wish I could afford.

    Economics is generally defined as the study of how our limited resources are allocated to satisfy our unlimited wants for goods and services. The combination of limited resources and unlimited wants implies a shortage, or scarcity. Scarcity forces us to make choices. And whenever we must make choices, we must give up something else that we also desire. This foregone want or desire represents an opportunity cost of the action we do choose. If we didn't have to make costly choices there wouldn't be a need for economists, and you wouldn't have to take this course.

    1. Resources and the Production Process
    2. Resources are the inputs used to produce goods and services. Resources include both nonhuman and human resources.

      Nonhuman resources:
      Natural resources - land, minerals, energy.
      Real capital - buildings, plant and equipment, and materials (inventories) used in the productive process.

      Human resources - labor

      Goods and services are the output of the production process that we value or desire.

      Goods - tangible things that satisfy people's wants and desires.

      Services - intangible but useful activities that are valued by people.

      The production process is:

      + Human
      => Capital Goods + Consumer Goods + Services

      Notice that we have real capital as a nonhuman resource and capital goods as a product. The process of producing capital goods and accumulating real capital is known as investment.

      An important distinction is that the term "capital" generally does not include land and labor. Capital is the result of investment and forgone current consumption while land and labor are not. Capital resources include any resources that are used to produce other goods and are themselves produced.

      Economists also frequently refer to human capital. This term may be defined as the education and training that add to the productivity of labor. Human capital has two of the important characteristics of physical capital: (1) training and education require an investment of time that cannot be used in consumption (e.g., leisure activities); and (2) it results in an increase in the productive capacity of the economy, since a trained worker can produce more than an untrained one.

      Another important distinction that we will make here, and in future chapters, is that financial capital (stocks, bonds, bank deposits, cash) is not an economic resource. Financial capital is simply a piece of paper that designates a claim of ownership. A piece of paper by itself produces nothing. In general, when we use the term capital in this course we do not mean financial capital. Capital (or real capital, or capital goods) refers to buildings, factories, equipment -- physical objects used by individuals and firms in production processes. Similarly, investment refers to the accumulation of real capital and not financial investment, such as the purchase of stocks or a government bond. Remember, this an economics and not a business or accounting class.

    3. Scarcity, Choice, and Opportunity Cost
    4. The combination of limited resources and unlimited wants implies a shortage, or scarcity. Because goods and services are produced from limited resources, goods and services are also scarce.

      Scarcity requires choice and implies costs. A scarce resource used to satisfy one need means there is some other need that is foregone. If we use our limited resources to educate our children, or invest in medical research, or explore outer space, we will have less for other things. The cost of any activity is what must be given up, also called the opportunity cost.

      Scarcity - the condition whereby resources, goods, and services available to individuals are limited relative to the wants and desires for them.

      Opportunity Cost - the highest valued alternative sacrificed in making any choice.

      Costs are more than price tags in stores. If you spend one hour studying for an exam you should hopefully realize some benefit. But what is the cost? You're not cash poorer from studying. But your time is a limited human resource, which you could have used to sleep, write the great American novel, or watch The Simpsons. The opportunity cost of studying arises from the alternative benefits that you don't get to enjoy.

      Implication of scarcity - protection of private property rights is required.

      [I]f the requirements of a society for a good are larger than its available quantity, it is impossible...for the respective needs of all individuals composing the society to be completely satisfied...Here human self interest finds an incentive to make itself felt, and where the available quantity does not suffice for all, every individual will attempt to secure his own requirements as completely as possible to the exclusion of others.

      In this struggle, the various individuals will attain very different degrees of success...[T]he requirements of some members of the society will not be met at all, or will be met only incompletely. These persons will therefore have interests opposed to those of the present possessors with respect to each portion of the available quantity of goods. But with this opposition of interest, it becomes necessary for society to protect the various individuals in the possession of goods subject to this relationship against all possible acts of force. In this way, then, we arrive at the economic origin of our present legal order, and especially of the so-called protection of ownership, the basis of property.

      Carl Menger, Principles of Economics (1871) Chapter 2.

    5. Economic Goods Versus Free Goods
    6. We can further refine our definition of goods -- between economic goods and free goods. Economic goods are those goods that are scarce -- the available quantities are less than the need or desire for them. Free goods, on the other hand, are available in sufficient supply to satisfy all possible demands at a zero price.

      There is an opportunity cost associated with consumption of an economic good, but there is no opportunity cost with consumption of a free good. For example, if you take a drink of water from the Mississippi River you are not denying some other want or need of the use of that water. There is enough to go around. But the doctor you see to treat you for your illness from drinking polluted water is not free because the doctor's time is no longer available to satisfy the needs of another sick person.

      Economic Goods and Services - goods and services that are scarce. There is an opportunity cost involved in their use or consumption.

      Free Goods - things that are available in sufficient amounts to satisfy all possible needs. There is no opportunity cost involved in their use or consumption.

      We could also explain the distinction between economic and free goods in microeconomic terms. The desire for an economic good exceeds the available supply at a zero price. This implies that the price of an economic good or service must be greater than zero to balance available supply and demand, i.e., efficiently allocate limited resources. The demand for free goods, on the other hand, is less than the amount available at a price of zero. If an entrepreneur tried to charge a price for a free good there would be no buyers since consumers could just as easily get it freely from nature.

      There aren't too many examples of free goods. Air is a free good, but clean air isn't. Water is a free good, but clean water delivered to your tap isn't. What's the difference between free river water and costly tap water? Water that is unsuitable for drinking must be piped to a treatment plant and then to your home. These operations and equipment involve resources that are scarce even when the water itself is not. Economic goods require economizing behavior, i.e., achieving a specific benefit at the lowest cost in terms of the resources used.

    7. Examples of Opportunity Costs
    8. As mentioned above, opportunity cost is often greater than direct cash costs. The cash cost for some activities may even be zero. Consider the student at school on scholarship. The student still faces an opportunity cost of attending school -- income given up by not working. The benefit of school should be greater than or at least equal to the opportunity cost of a student's time.

      Cash cost may be large, but still less than the opportunity cost. Vacation expense is an example. Scuba diving in Bonaire is not cheap, but on top of the cash expense you are also giving up some other activity that yields benefits, like working. The vacation benefit must be greater than or equal to the cash cost plus the value of foregone opportunities.

      The wedge between cash cost and opportunity cost is not limited to choices involving human resources (time). How often do we hear someone say the government needs to spend more money on...feeding the hungry, housing the homeless, developing new medical cures, lowering the student-to-teacher ratios, and so on? Unfortunately, these pleadings usually ignore opportunity costs. If we do more, what do we give up to do it? Ask any economist - there ain't no such thing as a free lunch.

      In chapter 2, Opportunity Cost, Specialization, and Trade, we will build our first economic model, called the Production Possibilities Curve, that is built directly on the concept of opportunity cost.

    9. Allocation of Scarce Resources - the Role of Prices
    10. When resources are scarce the availability of goods and services produced from those resources will not satisfy all needs and desires for them. How do we allocate (or ration) scarce resources among all the competing demands? In primitive societies it was survival of the fittest. Modern equivalents are first-come-first-served (the modern version of survival of the fittest), contests, lotteries, and other decision-making processes that ignore opportunity costs.

      An alternative system of allocating scarce resources that has been used by many societies throughout history is the government decree. Whether it is a feudal landlord, benevolent dictator, or communist government, some individual or group decides how much should be produced and for whom. Opportunity costs may be considered but more often ignored when distributing resources according to perceived need or by sharing equally.

      In modern economies prices serve as the allocation mechanism. Prices provide a means for suppliers to reveal scarcity and consumers to reveal their desires. For example, an increase in price may be a signal to producers that consumer demand for a good has increased. Producers react to the new wants of consumers by reallocating scarce resources such as raw materials and labor from some other good to produce more of the desired good. An increase in price may also be a signal to consumers that the supply of a good has become more scarce. For example, severe cold weather in Florida may destroy an orange crop. The price of oranges rises, which motivates consumers to switch their purchases to another product. Prices can be revealed thorough auctions or, more commonly the market system, which is described in more detail in chapter 3, Microeconomic Laws of Demand and Supply.

  3. Individual Behavior and Rational Self-Interest
  4. Underlying most microeconomic and macroeconomic models is the assumption that individuals act rationally to pursue their economic self-interest. Rational is defined as "based on reasoning." Self-interest is defined as "one's own personal advantage." We can express the assumption of rational self-interest more formally:

    But the assumption of rational self-interest is stronger than the above. We can also add:

    Self-interest should not be confused with selfishness. Self-interest does not mean that you act without regard for the needs of others. Altruistic or charitable behavior is perfectly compatible with self-interested behavior. If a person values altruism, then the act that benefits others will also provide personal benefits and will therefore be in that person's rational self-interest. An individual's perceptions of benefits and costs are influenced by personal tastes, values, social philosophy, etc. Economists make no judgements but simply takes tastes as given.

    Rational self-interested behavior represents the foundation on which most of microeconomics is founded. It is because people act according to their rational self-interest that their behavior is somehow predictable. People will respond in a particular way to changes in costs and benefits. As the cost (price) of a choice increases, fewer people will make that choice. As benefits increase, more people will make that choice. Macroeconomics, on the other hand, has had a more difficult time accommodating the principle of rational self-interest. For example, the Keynesian macroeconomic model, which we will tackle in a later chapter, features certain behavioral assumptions about the labor market and prices that are seemingly irrational. More recent macroeconomic research has attempted to derive models that are consistent with the assumption of rational self-interested behavior on the part of individuals in the economy.

  5. Relationship Between Opportunity Cost and Rational Self-Interested Behavior
  6. We can easily show that decisions based on full consideration of opportunity costs are identical to decisions based on rational self-interested behavior. In fact, these two principles say the same thing, just in different ways.

    Let's start with the rational self-interested behavior. Our simple definition proposed that individuals can compare the benefits and costs of a particular action and will only act if benefits exceed costs (i.e., the net benefit is positive). Here we assume that costs include only direct resource costs (e.g., time and money).

    Benefit - Direct Resource Cost = Net Benefit

    B - C = B - C

    Now we can expand our definition to rational self-interested behavior to the comparison of two alternative actions.

    Alternative Benefit - Direct Resource Cost = Net Benefit

    Buy a music CD: B1 - C1 = B1 - C1
    Buy a movie video: B2 - C2 = B2 - C2

    We assume that individuals can compare the benefits and costs of alternative actions and pursue the option that yields the greatest net benefit. For example, you would buy a music CD if:

         (B1 - C1) > (B2 - C2)

    Or, if direct resource costs are equal, buy a music CD if:

         B1 > B2

    Now let's consider the principle of opportunity cost. The cost of a particular action includes not only direct resource costs (C1) but also the net benefit of the highest valued foregone alternative (B2-C2). The net benefit of buying a music CD can be represented:

    Benefit - Total Cost = Net Benefit

    B1 - C1 + (B2 - C2) = B1 - C1 - (B2 - C2)

    Buy a music CD if the net benefit is greater than zero:

         B1 - C1 - (B2 - C2) > 0

    Which can be rewritten:

         B1 - C1 > (B2 - C2)

    This is the same result obtained for the rational self-interest maximizing behavior presented above. And, if direct resource costs (C1 and C2) are equal, you buy a music CD if B1 > B2.

  7. Decisions Are Made at the Margin
  8. Our discussion and examples of opportunity cost and rational self-interested behavior presented decisions as all-or-nothing or all-or-something else events. Economic theory attempts to be more general than this. It's not what you decide to do but how much. It's not whether or not to eat, but how much to eat. It's not whether or not to study, but how long to study. Economists call this making decisions at the margin. Individuals evaluate changes in benefits and costs arising from small changes to the current situation.

    Marginal Benefit - the increase in total benefit from the production or consumption of one additional unit of a good or service.

    Marginal Cost - the increase in total cost from the production or consumption of one additional unit of a good or service.

    Marginal decisions are made all the time. A student will study up to the point that the marginal benefit from one more hour of study equals the marginal opportunity cost of the additional hour spent studying. Studying any longer than this may contribute to an even higher grade, but the grade improvement would not be worth the additional opportunity cost in terms of other activities given up (like sleep).

    Because marginal decisions are made by individuals, marginal analysis is a key concept in microeconomics. But it also has its applications in macroeconomics. For example, in a later chapter on the Keynesian macroeconomic model we ask how much does consumption increase when national income increases by $1. The answer is the marginal propensity to consume.

4. Economic Theory in Practice

  1. Economic Theory and Models
  2. Theories are propositions about outcomes that are expected to occur under certain circumstances. A macroeconomic theory is a collection of ideas about how the aggregate economy works or should work.

    Any theory is always provisional, in the sense that it is only a hypothesis; you can never prove it. No matter how many times the results of experiments (or observations of economic conditions) agree with some theory, you can never be sure that the next time the result will not contradict the theory. Each time new experiments are observed to agree with the predictions the theory survives, and our confidence in it increases; but if ever a new observation is found to disagree, we may have to abandon or modify the theory.

    "Experimental confirmation of a prediction is merely a measurement. An experiment disproving a prediction is a discovery"

    Enrico Fermi.

    Most economic theories are developed in terms of an economic model, that may be expressed using verbal exposition or mathematical methods (e.g., graphs, algebra, calculus, game theory, etc.).

    A good economic model satisfies two requirements:

    One important characteristic of useful models is that they should be simple and as easy to apply as possible. This is the principle of Occam's Razor -- cut away all the complicating details that do not significantly contribute to the reliability or validity of a model. A model should be simple because reality is too complex to understand in its entirety. Perhaps you know it as KISS - Keep It Simple Stupid.

    There are two underlying principles to Occam's Razor:

    1. Do not include variables or complications that do not change the implications or predictions of the model. The position of the stars may influence the behavior of some individuals; but since it doesn't influence macroeconomic outcomes, we can fortunately leave this (and many other variables) out of our macroeconomic models.
    2. Isolate and hold constant extraneous variables that, while they may significantly impact the model, are not the principle interest of the theory being developed. This is often expressed by economists through the Latin phrase ceteris paribus, meaning "other things being equal." For example, in microeconomic demand theory, changes in population may significantly affect product demand, but when we want to evaluate the impact of a change in price or income on demand at a point in time we can simplify the model by assuming that population remains constant.

    "And as a man without a culture or society, he was uniquely free to apply Occam's razor, or, if you like, the Law of Parsimony, to virtually any situation, to wit: The simplest explanation of a phenomenon is, nine times out of ten, say, truer than a really fancy one."

    Kurt Vonnegut, Timequake (1998).

  3. Fallacy of Composition
  4. We noted at the start of this chapter that the distinction between the study of microeconomics and macroeconomics relates to the level at which the economy is studied. Microeconomics focuses on the individual and the firm while macroeconomics focuses on groups of persons and industries. Although economists generally attempt to ensure that macroeconomic theories are consistent with microeconomic theories of individual behavior, this can be a mistake.

    The fallacy of composition suggests that you can't always generalize based on a single experience. Suppose you had never heard a rap song and then you hear one with very objectionable lyrics. You might wrongly conclude that all rap songs were anti-social. In economics you can't generalize to the aggregate based on the expected behavior of an individual acting alone. The benefits and costs of an individual acting alone may be very different from the incentives facing an individual acting in a group even when the objective is the same. For example, I might think that if I stand up at a concert I can get a better view of the stage. But if everyone stands up, nothing is gained and standing for several hours will be less comfortable than sitting.

  5. Normative Versus Positive Economics
  6. Economic theory is not limited to explaining or predicting what will happen under certain conditions, referred to a positive economic theory. Economists may also propose normative economic theories, which involve value judgements about how the economy (or society) should work. The key word is should. Consider the distribution of income. Positive economic theory would explain how certain government policies affect the distribution of income but not address the question of whether the different government policies are desirable or not. Normative economic theory, on the other hand, may develop some justification that an equal distribution of income is desired and then recommend certain government policies to achieve that distribution of income.

    Positive Economics - understanding how an economy works. Explains the world as it is and how forces can cause it to change.

    Normative Economics - advocating how the economy ought to work. Involves a value judgement.

    Although the macroeconomic goals we presented at the start of this chapter, to guide the discussion of our theories, are essentially normative in nature, the theories and models we will develop in this course are positive. Our objective is to learn what influences macroeconomic outcomes, to both explain the past and to look into the future.

File last modified: May 1, 2003

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