Friday, August 11, 2006

Econ101: A Starter

What is economics? It's all about choice and choosing. Things are scarce. So we make choices. Economics1 is a way to explain why some guy chooses a banana over an orange, given the money in his pocket.2 That's all. Never mind the long and boring definitions in the textbooks. When somebody wakes you up in the middle of the night and ask what economics is, just remember one word: CHOICE.

What is the implication of scarcity and the act of choosing? Tradeoff. When our guy chooses the banana, he gives up the opportunity of having the orange. We say, the opportunity cost of his having the banana is his foregoing the orange.3

How does he choose? By comparing the benefit and cost of the action.4 What does it tell us when we see the guy ends up eating the banana? It tells us that for that guy at that time, the benefits of eating banana exceeds the costs.

When "the guy ends up eating the banana", he is revealing his preference. That is, without telling us anything, we have an information about his preference. This is called revealed preference (RP). Or, it can be that he just tells us that he prefers banana over orange. This is stated preference (SP). We tend to believe RP more than SP. Whenever what you do contradicts what you say, we believe the former.

But why do we rely our analysis on what people do? Because we assume people are rational. That is, people do whatever best for him at any given time. Is the assumption alright? Think about a person playing billiard. Is it alright to assume he is rational? That is, is it safe to assume that what he would do is consistent with the physics dictum that "the angle of incidence equals the angle of reflection"? We think it is safe. But there are crazy people, no? Yes, but there are definitely more non-crazy people out there then the crazy ones. So we're fine.

Should the guy eat the banana? We don't know. What we do know, by way of inference, is the guy prefers banana to orange. And as a rational person, he eats the banana. So, when you offer him to choose between the two, he would take the banana. This is a positive approach to economics, as opposed to normative approach. Positive approach is all about "what is" or "if X then Y". Normative approach is a matter of "what should be". We are more confident in positive approach. In fact, we try not to do normative approach. And we encourage you not to believe economic analysis with too many "should"s in it.

Stay tuned.

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1 In this Econ101 series, all economics keywords/phrases will be highlighted like this.
2 From now on, we will be using masculine pronouns. Blame the convention.
3 This is a brutal simplification. The guy can choose to have half banana and half orange. Or the story might as well be: choosing between sweet orange and sour orange, the latter being cheaper for an obvious reason. But don't worry about this complication now. Opportunity cost is central to economics, so we will devote another whole posting for it sometime later.
4 You might say, "Well, no, I don't do that". Trust us, you do -- in one way or another.

13 comments:

  1. excuse me chief, can you please do it again. I still don't understand why he chose banana over orange?

    Personally, i prefer orange.

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  2. Aco, you're taking Ujang's "reason to blog" seriously. Right on!

    Ujang, contributions please! ;-p

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  3. Good question, T/S. But I'm sorry you have to wait until we talk about utility. For now, let's just say, the random guy chooses banana, because he wants to eat banana. Or more carefully: we observed him ate banana many times. Given the information, we infer that he would opt for banana, should he be confronted with the options.

    Arya, thanks! Ujang and other hosts will definitely jump in. Economic fallacies are so endemic out there, don't you think? Let's fight them.

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  4. thanks for the intro. will you talk about behavioral economics 101 as well? the good old 'rational at any given time' assumption happens to be a very fragile one, psychologically speaking.

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  5. let me decide what you choose. i'm your mom, remember. :)
    no kidding.

    my point is that economic decisions should make conditions better from time0 to time1. otherwise, failed or error.

    anyway, who's gonna make predictions for the time1 condition? the analysts like you guys. just help us to decide.

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  6. if these guys failed to explain econ 101 try this: http://www.econlib.org/library/CEECategory.html (told you, anyone must teach me html codes). try explaining why kwik is wrong regarding the oil price using scarcity and opportunity cost. i like that. always turn me on.

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  7. Tirta, you're welcome. About behavioral economics, to be frank, the term, we think, is a misnomer. Economics is about behavior. It is a study of the way people behave or respond to incentives. Of course, we're going to cover more on "rationality" assumption. It's just that we're trying to make this series more structured. (Consider it as a substitute for a tiring textbook) But we'll get there. Thanks for reminding, though.

    Anonymous, the main task of economists is to help understand what is going on and what the likely consequences of a decision, both intended and unintended. We hope that would help people make informed decision by themselves.

    dHani, thanks for the link. They don't offer coffee, though, your friends there. Boring :-D

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  8. aco: i never said they're fun. i'm just saying they're resourceful. useful. like those geeks you kept seeing to improvize your laptop. boring but useful. you teach any micro class this semester?

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  9. did i miss something there? - arya's comment - how does banana over orange woo women?

    ahemm...

    this is trully bizzar-o-nomics...

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  10. The field of behavioral economics helps a lot in adding interesting and insightful caveats of the "old neoclassical rationality", but a student of behavioral economics also knows what it can or cannot do (yet). The results from laboratory research and field experiments that have been done in the field can help explain what would be thought as irrational behavior in the "standard neoclassical approach". However, in explaining market outcomes, "the old neoclassical rationality" can still do its job very well.

    If I were to teach an introductory econ class, I probably won't spend too much time on behavioral economics. Do I recommend the students to take a behavioral economics class? Absolutely, provided that they have passed Econ 101.

    *T/S, between your obsession with the banana vs orange issue here and your comment about the Hardy Boys in the previous post, are you insinuating something?

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  11. Arya, I remember vaguely that this is what we at the Cafe were supposed to do when we signed on as hosts. So, right on, indeed.

    It's nice to know that you're doing your share on your blog and Aco on his.

    We should have one of those cute little "Make Poverty History" banners but with the words "Make Economic Fallacies History". Haha.

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  12. mmm.. still analyzing whether to go for a banana split or an orange split..

    mmm.. still can't decide..

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  13. nice blog, and thanx for a very simple introduction about economics, really like it. And hope you dont mind if i add link your blog...
    :)

    -chemist, really wanna turn to be an economist-

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