Thursday, January 18, 2007

The Nature of Economics (Tutorial 1 2007)

1. Why is economics not a laboratory science?

Step 1: Define: Laboratory science - sciences in which research can be done in a laboratory setting.
Step 2: Key Command Word: Why is ____ not _____? (Show Comprehension skills by giving examples/ illustrating)

Economics CANNOT be a laboratory science because variables affecting a particular economic phenomenon cannot be separated or isolated for study, unlike that for physical sciences.

For example, there are many factors determining the demand for a particular good, such as cars. When the economist observes the effect of changes in the price of a good on the purchase of that good by households, he has no control over the other factors (e.g. income), which may also change, unlike for a laboratory science, where factors can be isolated.

Also, the human element is present in economics. Human behaviour is never fully unpredictable, unlike that for inanimate things and natural forces. Hence, the study of economics is never precise and can only be based on the "Law of Large Numbers" (i.e. looking at human economic behaviour in a group and not an individual specimen in a laboratory)

2. What is the scientific method and how does it relate to theoretical economics?

Step 1: Defining Key Terms: The scientific method, as used by economists, is an approach whereby the economist observes the behaviour of man, followed by a process of reasoning and formulation of economic theories and finally testing them for their validity.

Step 2: Key Command Word: "How does it relate…?": The scientific method is used by economists to firstly formulate economic theories before determining if they can be accepted as laws or principles. These economic laws or principles are formulated to explain and/or predict behavior of individuals or institutions.

What is the difference between a hypothesis and an economic law or principle?

Step 1: Defining Key Terms: A hypothesis is a “guessimate” as to the possible cause-and effect relationships between and among facts given. An economic law or principle is a theory that is found to be sufficiently profound and universal after testing it against empirical evidence. In other words, it can be found to have "strong empirical regularity".

Step 2: Key Command Word: "What is the difference …..?": An economic law or principle is formulated only after the hypothesis has been tested for validity.

3. Explain the following statement:

a. “Good economic policy requires good economic theory.”

Step 1: Define key terms (i.e. show knowledge of key terms):

• Economic policy: A course of action intended to help a government resolve a specific economic problem or to further a country’s economic goals. E.g. to maintain full employment, achieve a higher rate of economic growth, reduce income inequalities, maintain price stability etc.

• Economic theory: A coherent and plausible explanation of how two or more economic variables are related. For example, the theory of demand shows a (simplified) relationship between the price of any good and its quantity demanded.

Step 2: Explain statement (i.e. give the meaning of, show your comprehension of):

• A good economic theory is one that is able to (fairly) accurately explain and yield predictions about real-life economic phenomenon that occurs. A good economic policy, on the other hand, refers to one that is effective. Economic policies are developed and assessed based on economic theories. In other words, economic theories are the foundation of economic policies. Therefore, an economic policy (action taken) can only be effective (i.e. good) if the underlying economic theory is correct (i.e. good).

b. “Facts serve to sort out good and bad hypotheses.”

Step 1: Define key terms (i.e. show knowledge of key terms):

• Facts: Real-world (observable) empirical evidence/data.

• Hypotheses: A proposed (tentative) explanation for an observed phenomenon, which is yet to be tested. A hypothesis is usually made up of a prediction about the relationship between two or more economic variables. E.g. greater consumer spendings are the result of higher consumer incomes.

Step 2: Explain statement (i.e. give the meaning of, show your comprehension of):

• A good hypothesis refers to one that is found to “work”, i.e. to be consistent with what is happening in the real world. When economists want to sort out (separate) good and bad hypotheses, they must subject them to systematic and repeated comparisons with relevant real-world data (i.e. facts). Good hypotheses will be confirmed by these data while bad hypotheses will be found to be invalid and must be discarded. Hence, it can be said that facts are useful in sorting out good and bad hypotheses.

c. “The ceteris paribus assumption helps isolate key economic relationships.”

Step 1: Define key terms (i.e. show knowledge of key terms):

• Facts: “Other things being equal” assumption = ceteris paribus assumption. The ceteris paribus assumption means that “all other relevant factors do not change” when we are looking at the relationship between two particular factors. E.g. when we say the rise in price of hamburgers results in people buying fewer hamburgers, ceteris paribus, we mean that all other things that may affect hamburger purchases (e.g. income, tastes, price of noodles) are assumed to remain unchanged.

• Key economic relationships: Relationships between factors that are most important in explaining a particular economic phenomenon/behaviour.

Step 2: Explain statement (i.e. give the meaning of, show your comprehension of):

• Unlike natural scientists that are able to carry out controlled experiments to ascertain relationships between two variables, e.g. plant growth and sunlight in a laboratory, economists must test their theories using real-world data, generated by the actual operation of the economy. Under these conditions, it is difficult to ascertain economic relationships between two variables as “other things” do change and may impact and influence the data collected. In other words, if more than one explanatory factor is involved, it can be difficult to sort out what has caused what.
The “other things being equal” assumption is hence extremely important as it allows economists to zero in and to isolate the effects of factors in an economic phenomenon. In this way, key economic relationships can be ascertained or established.

Tuesday, January 16, 2007

The Economics of Gifts

by Gregory Mankiw

A man is debating what to give his girlfriend for her birthday. "I know," he says to himself, "I'll give her cash. After all, I don't know her tastes as well as she does, and with cash, she can buy anything she wants." But when he hands her the money, she is offended. Convinced he doesn't really love her, she breaks off the relationship.

What's the economics behind this story?

In some ways, gift giving is a strange custom. As the man in our story suggests, people typically know their own preferences better than others do, so we might expect everyone to prefer cash to in-kind transfers. If your employer substituted merchandise of his choosing for your paycheck, you would likely object to the means of payment. But your reaction is very different when someone who (you hope) loves you does the same thing.

One interpretation of gift giving is that it reflects asymmetric information and signaling. The man in our story has private information that the girlfriend would like to know: Does he really love her? Choosing a good gift for her is a signal of his love. Certainly, the act of picking out a gift, rather than giving cash, has the right characteristics to be a signal. It is costly (it takes time), and its cost depends on private information (how much he loves her). If he really loves her, choosing a good gift is easy because he is thinking about her all the time. If he doesn't love her, finding the right gift is more difficult. Thus, giving a gift that suits the girlfriend is one way for him to convey the private information of his love for her. Giving cash shows that he isn't even bothering to try.

The signaling theory of gift giving is consistent with another observation: People care most about the custom when the strength of affection is most in question. Thus, giving cash to a girlfriend or boyfriend is usually a bad move. But when college students receive a check from their parents, they are less often offended. The parents' love is less likely to be in doubt, so the recipient probably won't interpret the cash gift as a signal of lack of affection.

I Love Economics

How I Learned to Stop Worrying and Love Economics

read article here..

now aren't you glad you're taking Economics or have taken it??


I Love Economics


Category: philosophies

I love economics. By economics I mean the study of the efficient use of resources. It’s a really cool science and I recommend that everyone take at least an introductory class or two on the subject.

I know that some of my readers are already students of economics. For the rest of you, I’ll define a couple of things here. You have probably heard the term “macroeconomics”. This is economics on the large scale such as your state/province or nation. The other term is “microeconomics” which is economics on the small scale, such as your home or your employer. A third term of interest is “econometrics” which is simply the math associated with economics. These terms should get you started.

In all honesty, I haven’t made it very far in my economics studies. I have taken only introductory level classes in Microeconomics and Macroeconomics. Sure, I got ‘A’s in both of them, but those two classes do not make me an expert. They just whet my appetite for more. They let me understand quite a bit about why things work. The knowledge gained lets me be concerned at the retirement of Alan Greenspan. Thank you, Dr. Asigbee for being such a good teacher.

When I finish my current degree, I’m going to try to take a class in econometrics. I’m pretty good at math (Calculus is my friend) so I should be able to handle it. Though I won’t have a purely theoretical statistics class by then, I will have taken business statistics. I really want to understand this stuff better. If time and money allow, I may just get a degree in economics.

Before I go further in my studies I would like to posit an idea. See, I come from a science background (sort of). I can see where all these different sciences seem to work the same. This was really driven home when my Chemistry professor talked about how the math for entropy in chemistry is about the same as the math for entropy in economics. The little light bulb popped on above my head.

I remember how waves propagate through a metal plate. If you know what a plate is made of and you know its shape, then you can do math to tell how waves should travel through it. For this discussion, I’ll assume sound waves. To experiment you just have to apply the wave at one point and then measure the waves at other points to see if they match your math.

What’s neat about this is that if there is something hidden in the metal that you can’t see, the waves will be affected by it and you will be able to do new math to analyze the hidden thing. Let’s say there is an air bubble in the middle of the bubble. Sound waves will slow down as they enter the air pocket and bend. This is the same way light bends when it goes through a marble or a fish bowl. That bent light is pretty obvious to our eyes and the bent sound will be pretty obvious to the testing equipment.

After running a few tests, we can calculate the nature of the impurity in the metal with some confidence. The materials analysis folks do this all the time. In this modern day, we science can do some pretty neat stuff that way.

Now comes the economics part. I wonder if we can take an economic system and treat it like a sheet of metal. Can we apply the materials analysis math and science to the study of an economic entity? Let me explain.

Assume that we have a small economic system such as a town that is completely self-sufficient and isolated from everything else. There is no such place, of course, but I’m doing a hypothetical situation and keeping it simple. We are going to assume that this system is ideal; that is to say that they follow all of our understanding of economic rules.

Because we assume this system to be ideal, we can predict the affect of economic events. So, we do our predictions and then observe when these events take place in our system. If things are really perfect, the outcome will be as we predicted and everybody is happy. What happens if the results are not what we predicted?

Like in our metal plate, if things don’t react in a perfect way, we will see it in the result. We need to take the results and model backwards to find the “imperfection”. As we gather more data and combine our results, we get a better understanding of the internal makeup of the system. Once our model of the system is complete we can make more accurate predictions.

But wait, there’s more. If we have a really thorough understanding of the system, then we can make adjustments in an effort to divert or prevent problems. In the metal plate, if we want a wave to go from one side and out a specific point on the other side, we can use our knowledge of the makeup to plan how to do this. The same could happen in our economic system. If we see a problem ahead of time we can make those adjustments needed to avoid those problems.

We already do this to a certain extent in the United States. When the Federal Reserve Board changes interest rates, that is done to maintain stability in our economy. The wide swinging business cycles of the late nineteenth and early twentieth centuries taught us that we need to maintain some control if we are to avoid another Great Depression. From this large example, you can see that it could be useful to make these predictions.

Imagine that you own a company, either a huge multinational conglomerate or a local pet shop; you want to take the actions needed to keep you afloat on the economic seas. One of the best tools you could have is a predictor that can tell you what storms are coming. With advance warning you could know to batten down the hatches or to move elsewhere. This is why economics is so important.

It is likely that my thoughts on the matter are not original. I am just a novice at such things, but a pretty good novice. I know enough to see the benefit of knowing so much more.