Understanding how economies function is the basic purpose of studying economics. We seek to know how an economy is organized, how it behaves, and how successfully it achieves its basic objectives. Then, if we’re lucky, we can discover better ways of attaining those same objectives.
Economists don’t formulate an economy’s objectives. Instead, they focus on the means avail- able for achieving given goals. In 1978, for example, the U.S. Congress identified “full employ- ment” as a major economic goal. Congress then directed future presidents (and their economic Market Failure
Market Failure
Government Failure Government Failure
government failure: Govern- ment intervention that fails to improve economic outcomes.
government failure: Govern- ment intervention that fails to improve economic outcomes.
Seeking Balance Seeking Balance
End vs. Means End vs. Means
market failure: An imperfec- tion in the market mechanism that prevents optimal outcomes.
Comparative data on the percentage of goods and services the various national governments provide are available from the Penn World Tables at www.pwt.econ.upenn.edu
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C H A P T E R 1 : E C O N O M I C S : T H E C O R E I S S U E S 17
advisers) to formulate policies that would enable us to achieve full employment. The econo- mist’s job is to help design policies that will best achieve this and other economic goals.
The study of economics is typically divided into two parts: macroeconomics and microeco- nomics. Macroeconomics focuses on the behavior of an entire economy—the “big picture.”
In macroeconomics we worry about such national goals as full employment, control of infla- tion, and economic growth, without worrying about the well-being or behavior of specific individuals or groups. The essential concern of macroeconomics is to understand and improve the performance of the economy as a whole.
Microeconomics is concerned with the details of this big picture. In microeconomics we focus on the individuals, firms, and government agencies that actually compose the larger economy. Our interest here is in the behavior of individual economic actors. What are their goals? How can they best achieve these goals with their limited resources? How will they respond to various incentives and opportunities?
A primary concern of macro economics, for example, is to determine how much money, in total, consumers will spend on goods and services. In micro economics, the focus is much narrower. In micro, attention is paid to purchases of specific goods and services rather than just aggregated totals. Macro likewise concerns itself with the level of total business investment, while micro examines how individual businesses make their invest- ment decisions.
Although they operate at different levels of abstraction, macro and micro are intrinsically related. Macro (aggregate) outcomes depend on micro behavior, and micro (individual) behavior is affected by macro outcomes. One can’t fully understand how an economy works until one understands how all the individual participants behave. But just as you can drive a car without knowing how its engine is constructed, you can observe how an economy runs without completely disassembling it. In macroeconomics we observe that the car goes faster when the accelerator is depressed and that it slows when the brake is applied. That’s
Macro vs. Micro Macro vs. Micro
Analysis: Government-directed production, prices, and incomes may increase equalities but blunt incentives. Private property and market-based incomes motivate higher productivity and growth.
WO R L D V I E W
China’s Leaders Back Private Property
SHANGHAI, Dec. 22—China’s Communist Party leaders on Monday proposed amendments to the nation’s constitution that would enshrine a legal right to private property. . . . Virtually assured of adoption in the party-controlled National People’s Congress, the amendments constitute a significant advance in China’s ongoing transition from communism to capitalism. They amount to recognition that the economic future of the world’s most populous country rests with private enterprise—a radical departure from the political roots of this land still known as the People’s Republic of China.
Not since the Communist Party swept to power in 1949 in a revolution built on antipathy toward landowners and industri- alists have Chinese been legally permitted to own property.
Under the leadership of Chairman Mao, millions of people suf- fered persecution for being tainted with “bad” class back- grounds that linked them to landowning pasts.
But in present-day China the profit motive has come to per- vade nearly every area of life. The site in Shanghai where the
Communist Party was founded is now a shopping and enter- tainment complex anchored by a Starbucks coffee shop. From the poor villages in which most Chinese still live to the cities now dominated by high-rises, the market determines the price of most goods and decisions about what to produce. Business is widely viewed as a favored, even noble, undertaking.
The state-owned firms that once dominated China’s economy have traditionally been sustained by credit from state banks, regardless of their balance sheets. Today, many are bankrupt, and banks are burdened by about $500 billion in bad loans, according to private economists. The government has cast privatization as the prescription for turning them around, creat- ing management incentives to make them profitable.
—Peter S. Goodman Source: Washington Post, December 23, 2003. © 2003 The Washington Post, excerpted with permission. www.washingtonpost.com
macroeconomics: The study of aggregate economic behavior, of the economy as a whole.
microeconomics: The study of individual behavior in the econ- omy, of the components of the larger economy.
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18 T H E E C O N O M I C C H A L L E N G E
all we need to know in most situations. At times, however, the car breaks down. When it does, we have to know something more about how the pedals work. This leads us into micro studies. How does each part work? Which ones can or should be fixed?
Our interest in microeconomics is motivated by more than our need to understand how the larger economy works. The “parts” of the economic engine are people. To the extent that we care about the well-being of individuals, we have a fundamental interest in micro- economic behavior and outcomes. In this regard, we examine how individual consumers and business firms seek to achieve specific goals in the marketplace. The goals aren’t always related to output. Gary Becker won the 1992 Nobel Prize in economics for demonstrating how economic principles also affect decisions to marry, to have children, to engage in criminal activities—or even to complete homework assignments in an economics class.
The distinction between macroeconomics and microeconomics is one of many simplifi- cations we make in studying economic behavior. The economy is much too vast and com- plex to describe and explain in one course (or one lifetime). Accordingly, we focus on basic relationships, ignoring annoying detail. In so doing, we isolate basic principles of eco- nomic behavior and then use those principles to predict economic events and develop economic policies. This means that we formulate theories, or models, of economic behavior and then use those theories to evaluate and design economic policy.
Our model of consumer behavior assumes, for example, that people buy less of a good when its price rises. In reality, however, people may buy more of a good at increased prices, especially if those high prices create a certain snob appeal or if prices are expected to increase still further. In predicting consumer responses to price increases, we typically ignore such possibilities by assuming that the price of the good in question is the only thing that changes. This assumption of “other things remaining equal” (unchanged) (in Latin, ceteris paribus ) allows us to make straightforward predictions. If instead we described consumer responses to increased prices in any and all circumstances (allowing everything to change at once), every prediction would be accompanied by a book full of exceptions and qualifications. We’d look more like lawyers than economists.
Although the assumption of ceteris paribus makes it easier to formulate economic the- ory and policy, it also increases the risk of error. If other things do change in significant ways, our predictions (and policies) may fail. But, like weather forecasters, we continue to make predictions, knowing that occasional failure is inevitable. In so doing, we’re moti- vated by the conviction that it’s better to be approximately right than to be dead wrong.
Politics. Politicians can’t afford to be quite so complacent about economic predictions.
Policy decisions must be made every day. And a politician’s continued survival may depend on being more than approximately right. George H. Bush’s loss in the 1992 election resulted in part from his repeated predictions that the economy was “turning around.” When this optimistic forecast proved wrong, voters lost faith in President Bush’s ability to direct the economy. Ironically, his son gained a critical advantage in the superclose 2000 presidential election because of another economic slowdown and a slumping stock market. Once again, voters sought a new economic policy team.
After he took office, President George W. Bush immediately sought to change the mix of output. Even before the September 11, 2001, terrorist attacks, he wanted more “guns,” as reflected in added defense spending. He also secured tax cuts to boost private consumption and investment. Were these the right choices? Economic theory can’t completely answer that ques- tion. Choices about the mix of output are ultimately political—decisions that must take into account not only economic trade-offs (opportunity costs) but also social values. “Politics”—
the balancing of competing interests—is an inevitable ingredient of economic policy.
Imperfect Knowledge. One last word of warning before you read further. Economics claims to be a science, in pursuit of basic truths. We want to understand and explain how the economy works without getting tangled up in subjective value judgments. This may be an impossible task. First, it’s not clear where the truth lies. For more than 200 years economists have been arguing about what makes the economy tick. None of the competing theories has Theory vs. Reality
Theory vs. Reality
ceteris paribus: The assump- tion of nothing else changing.
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C H A P T E R 1 : E C O N O M I C S : T H E C O R E I S S U E S 19
performed spectacularly well. Indeed, few economists have successfully predicted major economic events with any consistency. Even annual forecasts of inflation, unemployment, and output are regularly in error. Worse still, never-ending arguments about what caused a major economic event continue long after it occurs. In fact, economists are still arguing over the primary causes of the Great Depression of the 1930s!
In part, this enduring controversy reflects diverse sociopolitical views on the appropriate role of government. Some people think a big public sector is undesirable, even if it improves economic performance. But the controversy has even deeper roots. Major gaps in our understanding of the economy persist. We know how much of the economy works, but not all of it. We’re adept at identifying all the forces at work, but not always successful in gaug- ing their relative importance. In point of fact, we may never find an absolute truth, because the inner workings of the economy change over time. When economic behavior changes, our theories must be adapted.
In view of all these debates and uncertainties, don’t expect to learn everything there is to know about the economy today in this text or course. Our goals are more modest. We want to develop a reasonable perspective on economic behavior, an understanding of basic principles. With this foundation, you should acquire a better view of how the economy works. Daily news reports on economic events should make more sense. Congressional debates on tax and budget policies should take on more meaning. You may even develop some insights that you can apply toward running a business or planning a career, or—if the Nobel Prize–winning economist Gary Becker is right—developing a lasting marriage.
T H E E C O N O M Y T O M O R R O W
THE JOURNEY TO MARS
January 3, 2004, was a milestone in space exploration. That was the day the first robotic space vehicle— Spirit —landed on Mars. The pictures Spirit transmitted back to Earth unveiled a whole new boundary for human exploration. It created a challenge President Bush was quick to confront. Within days he announced an ambitious new agenda for America’s space program:
• By 2010 the United States is to complete the International Space Station.
• By 2008, a new Crew Exploration Vehicle, capable of ferrying astronauts and scientists to the Space Station, will be developed and ready for use.
• By 2015, the Crew Exploration Vehicle will begin extended human missions to the moon.
• After 2015, human missions to Mars will begin.
Scientists and ordinary citizens around the world cheered both Spirit’s accomplishments and President Bush’s vision. People heard echoes of President Kennedy’s May 1961 promise that mankind would soon set foot on the moon—a promise that seemed equally implausible at the time, but ultimately proved to be attainable.
Opportunity Costs. The journey to Mars is not only a technological commitment but an economic commitment as well. The resources used to complete the Space Station, to colo- nize the moon, and to journey onto Mars and worlds beyond all have alternative uses here on Earth. Some of the same scientists could be developing high-speed rail systems, safer domestic flights, or more eco-friendly technologies. The technological resources being poured into space exploration could be perfecting cell phone quality or simply accelerating online data transmissions. If we devoted as many resources to medical research as space research, we might find more ways to extend and improve life here on Earth. Or we could use all those resources to develop safe water and sanitation systems for the globally poor.
In other words, the journey to Mars will entail opportunity costs, that is, the sacrifice of earthly goods and services that could be produced with those same resources.
AFP/Getty Images
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20 T H E E C O N O M I C C H A L L E N G E
Review NASA’s budget at www.whitehouse.gov or
www.cbo.gov. For more information on the space program, visit www.nasa.gov
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