Module 1

OK… you have made it to the first lecture. Good job and welcome!

These modules are written assuming you have read the chapter first… you
don’t literally have to read the chapter first but knowledge is assumed. So do
what works best but you may want to try to read the book first.

Really.

Scat!

Get outta here. Shoo. Take a hike!

Here we go…

The most common definition of economics is: the study of how society allocates scarce resources in an
attempt to satisfy unlimited wants. A simpler version might be: the study of choice in the face of
scarcity.

But before we go further into what economics is - let’s clarify what it is not because there are a lot of
misconceptions floating around. Economics is not the study of how to make money.
It is not the study of how to pick stocks on the stock market. Economics may be
useful to pursue those goals – but it is much broader in scope. To consider those
“economics” is like describing a nurse as “someone who takes temperatures.” Yes,
nurses do take temperatures… but they do a whole lot more than that.

Economics does not favor corporate profits over the environment or corporate profits over
individual well-being. The lessons of economics do not inherently favor one group over any other
group. Many people equate economics with business. That is wrong. I hope you leave this course
understanding why.

Economics is a social science. Social sciences are the study of human behavior. Economics is not
housed with business, accounting, and finance – in the business major. It is grouped with disciplines
like Sociology, Psychology, History, Political Science, and Anthropology… the social sciences.

One more thing to remember as we set off… there are no “answers” to normative questions. How much
should society spend on welfare payments to the poor? Each person has a different opinion.
Economics can shed light on some of the pros and cons of different methods of providing
welfare but it says nothing about the degree to which society should pursue that goal.
We elect politicians to make decisions on the major normative questions we face.
Instead of 300 million people arguing about what we should do we only have a few
hundred people arguing about what we should do. And that is ugly enough!!

OK… so what is economics about? Well, we will learn economic principles and apply
them to our economy. So what is the economy? To give you a feel for that let me ask
the obvious question: what did you have for breakfast?

Say you had toast and eggs. Let’s consider for a moment how much work and
coordination went into the eggs that you can buy at Safeway for $4.89 per 36 eggs. (After studying
economics you will be forever forced to take advantage of all the Safeway “buy 1 get
1 free” deals. The only days I ever run out of eggs are Easter and Halloween.)

This is a rather long answer but it is all entirely relevant to what we are about to
study. In fact, I hope you read this again at the end of the quarter as you review for the
final.

Some farmer somewhere in Idaho is raising chickens (if the farmer were in California he would by law
have to give his chickens more room inside their cage –
which is more costly – so they won’t come
from California unless I and others are
willing to pay more in order to let some
random chicken that we will never meet
stretch its legs. Idaho chickens will live their
entire lives inside smaller cages). Anyway, this farmer buys chicken feed from a
company that has purchased corn and other ingredients from farmers across the
country. The corn farmers are encouraged to produce corn due to government
price guarantees. The feed comes in plastic bags produced in China by a factory
that pays their workers 40¢ per hour to produce plastic bags
10 hours per day. These workers don’t know me and couldn’t
care less about my breakfast. The bags have been shipped over on a huge tanker
along with the growing pile of plastic toys that I am pretty sure will still be
sitting in my backyard after the coming earthquake when my house falls down.
Anyway, the tanker has a crew of 20 people – all work way harder than me and
get paid way less. So the farmer feeds his chickens, chases away foxes, keeps
them disease free, and eventually collects lots of eggs. Perhaps he does this by
hiring workers – some of whom may be illegal immigrants being paid $5 per hour – below the
nationally mandated minimum wage - or perhaps he uses some sort of conveyor belt to
automatically collect them. Either way, he has the eggs placed carefully in boxes
to be sold at the local market. A middleman buys them and turns around and sells
them to Safeway. Safeway sends a big truck out to pick them up – a truck that,
on the way, stops to fill up with gas that was imported as crude oil from
Venezuela. The Socialist Venezuelan government probably does not approve
of my capitalist lifestyle – but they are still willing to sell their oil to me for
some reason. You’d think they would just give it to me. Anyway, the crude oil arrived
on a different tanker and was refined in Martinez, CA at a multi-million dollar facility
that not only refines oil but also spews dioxin into the San Francisco Bay. This kills
some fish and makes the water less safe to drink. But I want my omelet so deal with it. The
Safeway truck picks up the eggs and takes them to a distribution plant. That truck, by the way,
has parts from 22 different countries and was assembled in Tennessee. A different machine
carefully places the eggs into Safeway cartons produced in China (…see above for details). Once in
their carton, a different Safeway truck picks them up and delivers them to the Los Altos Safeway at 2
AM. Then some guy spends his night unloading eggs off the truck and onto the shelves. He makes
$22.50 per hour and also has health benefits – but is thinking about going on strike for higher wages.

OK… I could go on for pages … but I am hoping you get the point. Think about all the work and
coordination we have just summarized. Literally thousands of people and chickens from all over the
world – who may not even like me – have cooperated so that I can walk into the store any time I want
and buy eggs for ≈ 15¢ apiece. They do it so cheaply (cheeply?) that students often toss them at my
house. And that is just eggs!! If you consider the cheap production of tomatoes, shaving cream, toilet
paper, water balloons and all the other products I find in my front yard, then you begin to get a sense of
how amazing our economic system is.

And that is what the economy is.

How does society determine what to produce, how to produce, and for whom to produce? How do we
figure out how many eggs to produce? Why is that farmer raising chickens instead of sheep? How do
we figure out how to collect eggs – by hand or machine? How in the world do we convince people to
stock shelves at 2 AM? How do we allocate those eggs amongst us? Why did I get the eggs?

How our society answers these questions describes our economic system. And the quick answer is that
we use markets along with some degree of government regulation.

Self-interest

Economics assumes we are self-interested. Some people don’t like this assumption because they
believe we should care about others as much as we care about ourselves. Perhaps we should. We don’t.
Virtually every day you can find a story about a disaster somewhere in the world. The other day
a bus went off a cliff in India and killed 50 people. Now, suppose you read that in your
newspaper as you sip your morning coffee … perhaps for a few seconds you think, “Oh,
that’s too bad”… but you will quickly move on because you want to find out what
Lindsey Lohan has done now or to find the score of last night’s game. Perhaps you
spill your coffee laughing when you read that Paris Hilton is going to star in a movie
about … well … about anything. Now you are upset because you had a new killer shirt
on … and you know what? You have completely forgotten that 50 people just died in
India. You are going to spend a lot more time worried about your coffee stain than the fact
that there are now 100 kids who will forever be missing a parent.

If you could prevent that accident by cutting off your left hand would you do it?

From the standpoint of the people on the bus this is not a close decision. Of
course you should cut the hand off. We are talking about 50 lives here! Cut
the hand off, save 50 lives, change your shirt and get on with your life.

Unfortunately for those on the bus you might very well put your interests ahead of their interests…
even if by an objective standard your decision results in greater net human suffering.

Are you mean and evil? No… you are human. Humans are self-interested. Yet there are still plenty of
people that want to debate this aspect of human nature. I can no longer get excited about this debate
because the evidence around me is so overwhelming. I am resigned to the fact that there will always be
people who note that some small tribe on some island somewhere share chores and food equally … and
therefore conclude that human nature need not be self-interested. As if one example (which I question
anyway) offsets the millions of counter-examples.

When we model the world we want to model how people actually behave as opposed to how we wish
people behaved. In my example above, the oil refinery polluted the water with dioxin because to do
otherwise would be costly. Is that good? I don’t know … but it is accurate. The factory in China paid
their workers 40¢ per hour because to pay them more would reduce profits. Is that right? Should they
pay them $4 per hour? $10? I suppose the workers would like that… but to pay them more would
lower the profits of the firm. They will pay them just enough to attract the quality they want to the
factory. No more, no less. I don’t know if that is good or if that is right… all I know is that it is
accurate. You may wish the factory paid them more. So do I. But economics does not treat wishes
kindly. If we are concerned about the plight of workers in poor countries than we had better understand
the forces that create wages. It is, of course, much easier to simply argue that corporations should pay
them more. But that is not going to be a very effective strategy because it is essentially arguing that the
employers should engage in charity (by offering more than the going wage). There is nothing wrong
with charity – but it is not how businesses make money. When people argue that businesses should
“pay them more” I often have the urge to say, “Yes, why don’t you go open up a factory and pay $10
per hour.” The problem will be that you will quickly run out of money because you will be operating at
a loss. Perhaps we should think twice before demonizing the one providing employment.

People often complain about the greed of others while ignoring their own greed. When Safeway
charges me $4.89 for eggs I rarely say, “Here… let me pay $10… see… I really like eggs.” I know
many that complain about the greed of their landlords but few who pay more than their landlord asks.
In fact, most people would gladly live in their apartment for free. Face it… you are as greedy as your
landlord! Your landlord is thinking, “My tenants are so d*** greedy that they would probably live in
that apartment for free if they could.” And he is right!

So we have a bunch of people and firms running around doing things in their own self-interest. Doesn’t
this result in anarchy? The amazing thing is that it does not. Adam Smith famously wrote, "It is not
from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their
regard to their own self-interest. We address ourselves, not to their
humanity but to their self-love, and never talk to them of our own
necessities but of their advantages." He noted that it is as if we are
guided by an invisible hand – our self-interested acts typically result
in socially constructive transactions.1 I want my toothpaste for free. If
I have to pay I guess I will… but I want to pay as little as possible. Of
course if one brand is better than another I will willingly pay a little
(Rare picture of an invisible hand)
more for it. But I still want it for free! I would rather save my money
for beer than to pay workers in a toothpaste factory. The toothpaste
company, on the other hand, wants me to pay $100 per tube of toothpaste. How could they be so self-
interested? However, they have a couple problems … the higher the price they charge the less I will
buy and competitors that will undercut them.

So what is the result of this confluence of greed? Toothpaste firms strive to produce high-quality low-
priced toothpaste. I pay enough to make toothpaste production attractive to producers – but competition
will ensure that I don’t pay much more than that.

Opportunity cost

Foothill College recently rebuilt the student center at a cost of several million dollars. Somehow
society made the decision to use our resources (physical labor, concrete, wood, engineering skills,
tractors, cranes…) to do this. It is beautiful. Was it a good idea? Well, perhaps there is a school in East
Palo Alto that has run-down buildings, old broken desks, and no library to speak of. The resources we
spent rebuilding the Foothill student center could have gone to rebuilding that East PA school. That,
perhaps, is the opportunity cost of the new student center. Still a good idea?

What is the opportunity cost of going to 4 years of college? As your book notes, a big part of it is the
income you could have earned if you were working (more). This could add up to a couple hundred

1
Not always… in fact much of the course deals with exceptions to this statement. These are called market failures.
thousand dollars. Is it worth it? Probably… you are investing in your skills today (foregoing
consumption) in order to lead a more productive and interesting life in the future.

But what if you were LeBron James? (Mr. James is a professional basketball player who went straight
from high school to pro ball. He did not get a college education!) Was that a good idea?

You bet! The opportunity cost of one year right now for LeBron James is tens of millions of dollars.
Education is worth a lot… but it is not worth tens of millions of dollars per year! So it is a very rational
thing for LeBron to play basketball while the opportunity cost of his time is so high…he can always get
a college education later if he chooses to (when the opportunity cost of his time is lower). Most of us
are not giving up the option of making millions of dollars to take this class –if you were you probably
would not be reading this.

So now you know why free tickets to a movie are not really free, why cruise-ship romances fade once
you return home, why you listen to the radio in your car but hardly any other time, and why being sick
on a rainy weekend is cheaper than being sick on a sunny weekend. Opportunity cost.

Rational cost – benefit analysis

The fundamental economic tool is cost-benefit analysis. Weigh the benefits of an action against the
costs… and when the benefits outweigh the cost then it is wise to undertake that
action – economics calls that a rational choice. Economics assumes rational
behavior. That is, individuals do not intentionally make decisions that leave them
worse off. Rational behavior is a broad behavioral assumption that greatly simplifies
our analysis. It may not hold for every decision of every person… but that is ok.2
The world is complicated. We need some simplifying assumptions if we are to get a
grip on what is going on. And this assumption, when you look at how we behave, is pretty good.

When you are confronted with an important choice (UCLA vs UCSD, Accounting vs Art, Thousand
Island vs Blue Cheese…) it is surprisingly helpful to make a physical list of the costs and benefits of
your options. It helps organize your thoughts. Economics also breaks decision-making down into small
(marginal) decisions. You can often substitute the word “extra” in for marginal. Thus you frequently
compare the marginal benefits of an action to the marginal costs of an action. If MB > MC … do it. If
MB < MC … do not do it. If they are equal you are technically indifferent… though for simplicity the
assumption is you take that action. A couple homework problems force you to think this through… just
remember the above rule to get them right. This logic comes up over and over in this course.

Sunk costs

I once went to some weird “new-age” musical symphony. It was horrible. But did we walk out in the
middle? Well, eventually we did but it took us awhile. For a bit we felt like, “yes, this is bad but we
paid $40 per ticket… we had better stay.” Finally we acted rationally and left. Why is leaving rational?
Because the money we paid was a sunk cost. Sunk cost: a cost paid that you cannot get back. Sunk
costs should not be a factor in your decisions… because no matter what action you take you can’t
recover the costs (by definition). In poker the saying is, “Don’t throw good money after bad.”

Staying through a bad concert or a bad movie is essentially saying, “OK, in response to wasting my
money I am now going to waste my time too.”

2
A growing field of economics (behavioral economics) is looking more closely at some of the behavioral inconsistencies out there.
Correlations

If you survey lots of people you will find that, in general, taller people are heavier. We would therefore
say that height and weight are positively correlated - as one increases the other increases. Conversely,
temperature and sales of hot cocoa are inversely (negatively) correlated (when it gets hotter people buy
less hot cocoa). As one increases the other decreases. A correlation between variables means that
they tend to move together.

Correlations are all over the place. And there is a big lesson here that is pretty much ignored in our
textbook so I will give it a bit of ink right here. The lesson is:
Correlation is not causation.
I want to expand on the book discussion because this is such an important insight. Two things being
correlated does not necessarily mean that one is causing the other. It may be the case - but does not
have to be the case. For one thing, it may be random chance.

Super Bowl prediction: When an NFC team wins the Super Bowl (in late January) the stock market
(as measured by the Dow Jones Industrial Average) in that year rises. When an AFC team wins,
the DJIA falls. This has been true over 80% of the time!!! That is a pretty strong
correlation. When something is true 80% of the time you might want to start betting on
it.

So is the Super Bowl causing the stock market to rise or fall? It is pretty tough to
make that argument. It is more likely random chance. And thus we have shown that
correlation does not imply causation.

It is also easy to get causation backward: I have noticed that virtually every evening I begin to see car
headlights turning on around 6 PM… and 30 minutes later it is dark. My conclusion is that people
turning their headlights on creates darkness!!

Cities with more police tend to have more crime. So it is pretty obvious to me that hiring policemen
causes crime. What do you think?

Here is what you should think: your instructor is an idiot. He tends to assume “a” causes “b” when it
could be that “b” causes “a.”

In the examples so far the mistake is pretty obvious. If all relationships in the world were so obvious
then we wouldn’t have to worry so much about this lesson. The problem is that many times we are
trying to explain correlations between variables in which the true relationship is much more difficult
for us to see. Does raising the minimum wage increase or decrease poverty? (you may be surprised
when you read about it in a later chapter - the answer is more complicated then you think)

Here is another – not so obvious – reason that correlation may not mean causation: a 3rd variable
working behind the scenes can create an observed correlation (a so-called spurious correlation).

Consider education level and income. It is not hard to find studies that show that college graduates earn
$x more per year then high-school (only) graduates. Education and income are positively correlated.
But does this mean that higher education leads to higher income? Well… probably it does… but let’s
be careful about how we measure that relationship. I will now present a 3rd variable that is going to
make the correlation appear stronger than it truly is:
 The wealth of the family you are born into.

Children born into wealthy families will tend to land higher income jobs regardless of
education for many reasons: expectations placed on the child, parental connections,
luxury to search for higher income jobs without having to worry about paying rent.
Take me: I moved home after college and was able to live there for free until I found my
career. I was therefore able to work and save some money up for a one-year
backpacking trip through Southeast Asia in my mid-20s. This turned out to be a life-
changing experience. I came back determined to go to grad school in Economics in order to better
understand the huge inequalities of wealth in this world. My point here is that to a large degree I was
able to find my career because I was lucky to be born into a loving, moderately wealthy family. Had I
been born into a very poor family it probably would have played out differently.

In addition, children in wealthy families will tend to have higher education levels regardless of
motivation and intellect for the same reasons: expectations and cost. Take me: not going
to college never once entered my mind… all my friends went, both my brothers
went…it was simply what you do after high school. No questions asked. And my
parents paid for my undergraduate education. It was not until years later that I found out
that, for kids with different family finances and expectations, college is an option.

SO… what does it mean?

It means that the correlation we “see” between education and income may result
because wealthy kids tend to attain higher education levels and wealthy kids land
higher income jobs! The high-income people that we observe might have high-
income not because they have high-education but because they tend to be the
people that were born into wealthy well-connected families. High-education just
happens to go along with being born into a wealthy family. Maybe education has
nothing to do with it. Perhaps the key to financial success is not education but being born into a
wealthy family! To the extent this is true then the studies we see overstate the importance of education
- unless it is controlled for.

“Controlled for” means you have held the variable in question constant in your study – thereby taking
it away as an explanatory variable. In this example we would want to hold “wealth of the child’s family”
constant. How? Well, perhaps we could ask people what high school they went to – and treat kids of
the same high school as being of relatively equal wealth. Or maybe the zip code they grew up in is a
better proxy of family wealth. So you take all the kids in the Beverly Hills zip code and treat them as a
group. To the extent that wealth is constant then you are removing it as an explanatory variable. Do the
same thing for a poor area zip code. If all the families are equally poor then it will not be family wealth
that causes differences in outcome.

This will be imperfect. In the physical sciences - like chemistry and physics - it is possible to pretty
much hold all outside variables constant when performing an experiment. Then you can repeat your
experiment several times to reduce random variations and become more confident in your results. The
social sciences have a problem holding variables constant because the laboratory is the real world.
There are multiple variables affecting relationships and you will never be able to hold them all constant.

After all, I have focused on wealth of the family… but I just as easily could have used “motivation of
the individual” as the 3rd variable. (Motivated individuals will tend to wind up with higher paying jobs
and with more education… so motivation creates an observed positive correlation between education
and income). A proper study would hold that, along with other relevant variables, constant as well. The
fact that it is impossible to do this is part of what makes economics so fascinating and frustrating.

Before I leave this example I had better make one more comment: although we should entertain the
potential that education does not matter as we search for causations of high-income, I do not in fact
believe that to be the case. No matter where you start you will have a more fulfilling life if you get
more education. So don’t drop out of school based on my example. The point is that we cannot simply
look at correlations to explain reality. We need theories (explanations of observed fact) to help explain
relationships. Why? Because correlation is not causation!

Discussion (you will find prompts in the discussion chamber for these and other topics):

1. We put our interests ahead of other’s interest all the time. Think about your behavior yesterday and
today. Give the class 4 examples of self-interested behavior on your part. Did you do something
that does not seem to follow the self-interest assumption? Do tell.
2. Provide an example of a correlation that is not causation. These can be silly or serious. Explain
why the correlation exists despite the lack of causality. Comment on other classmates’ examples.

Questions

1. One day I was driving back from Livermore to Palo Alto. I drive about 1 mile per
minute (or 60 MPH). I was driving west on (freeway) 580. When I hit 680 (point a on map
below) I had a choice:
- take 680 south (a to c). Estimated driving time – 1 hour.
- take 680 north 5 minutes (a to b) so that I could continue on 580 west (680 and 580 merge for
those 5 miles). Estimated driving time – 1 hour and 15 minutes.

580 w (b to c): 1:10

b

a to b: 5 minutes

a
580 w

c
680 s (a to c):
1 hour

Obviously I should have gone south. But, as luck would have it, I mistakenly took 680 north. The
next exit was the 580 west interchange (5 miles away). My initial reaction was, “well, doubling
back is a total waste of time because I don’t want to backtrack over this area I am going through
right now - and I will be at the 580 interchange anyway - so I will just take 580 west home…” Is
this a good decision?

2. My friend flew to Seattle and back on the same day to watch a Seattle Mariners baseball game. I
asked, “Isn’t that kind of expensive?” He replied, “No. In fact, it was totally free because I used
frequent-flier coupons.” Do you agree? Explain.
3. Take out a piece of paper and make two columns. On one side write down all the benefits of
smoking cigarettes and on the other write down all the costs. Do this even if you don’t smoke - you
may find it habit forming (so to speak). I will show you my list next chapter.

4. Studies have shown that cigarette smoking is negatively correlated with grade point average (GPA).
People that smoke more cigarettes tend to also have lower GPAs. So does smoking lead to a lower
GPA? Reason and explain.

5. Read this short article and answer the questions that follow.

PAINKILLERS LINKED TO MISCARRIAGE RISK

2 February, 2001
RESEARCHERS have concluded that taking widely used painkillers in early pregnancy could trigger a
miscarriage.

Women are several times more likely to lose their baby if they have been given prescriptions for
aspirin, ibuprofen, ketoprofen and naproxen, according to a Danish study. It found the risk doubled for
those who had taken the drugs between seven and nine weeks before a miscarriage, and a seven-fold
risk among women who took it in the week before they miscarried.

Researchers compared 4,268 women who miscarried in the first 12 weeks of pregnancy, of whom 63
had taken the painkillers, with 29,750 who had live births.

However, researchers admit that the painkillers might have been prescribed to treat the pain that
indicated an impending miscarriage. The Royal College of Obstetricians and Gynaecologists has
advised pregnant women to avoid the painkillers. But a spokeswoman for the college added: "The
report has not shown that these drugs cause miscarriage, only that they are associated with
miscarriage."

a. The article states there is “a seven-fold risk (of losing the baby) among women who took (a
painkiller) in the week before they miscarried.” Now, consider two pregnant women: Jane and
Amy. You force Jane to take one of the painkillers mentioned above while Amy takes nothing.
Is Jane 7 times more likely to lose her baby within a week? Why (not)?

b. Assume for a minute that I tell you that in reality painkillers have absolutely no impact on
chances of miscarriage. Given that, how would you expect the following sets of variables to be
correlated? Draw a line on each graph that shows the correlation. (In graph b, amount of pain
refers to the pain felt before taking a painkiller (it does not reflect that fact that pain may fall
after you take a painkiller).
a b c
chances of
miscarriage painkillers chances of
consumed miscarriage

amount
amount painkillers
of pain
of pain consumed