1.1: What's it all about?

The big issues

Economics is the study of human behaviour. Since it uses scientific methods it is called a social science. We study human behaviour to better understand and improve our world. During his acceptance speech, a recent Nobel Laureate in Economics suggested:

Economics, at its best, is a set of ideas and methods for the improvement of society. It is not, as so often seems the case today, a set of ideological rules for asserting why we cannot face the challenges of stagnation, job loss and widening inequality.

Christopher Sims, Nobel Laureate in Economics 2011

This is an elegant definition of economics and serves as a timely caution about the perils of ideology. Economics evolves continuously as current observations and experience provide new evidence about economic behaviour and relationships. Inference and policy recommendations based on earlier theories, observations and institutional structures require constant analysis and updating if they are to furnish valuable responses to changing conditions and problems.

Much of today's developed world still faces severe challenges as a result of the financial crisis that began in 2008. Unemployment rates among young people are at historically high levels in several economies, many government balance sheets are in disarray, and inequality is on the rise. In addition to the challenges posed by this severe economic cycle, the world simultaneously faces structural upheaval: Overpopulation, climate change, political instability and globalization challenge us to understand and modify our behaviour.

These challenges do not imply that our world is deteriorating. Literacy rates have been rising dramatically in the developing world for decades; child mortality has plummeted; family size is a fraction of what it was 50 years ago; prosperity is on the rise in much of Asia; life expectancy is increasing universally and deaths through wars are in a state of long-term decline.

These developments, good and bad, have a universal character and affect billions of individuals. They involve an understanding of economies as large organisms with interactive components.

Aggregate output in a national economy

A national economy is a complete multi-sector system, made up of household, business, financial, government and international sectors. Each of these sectors is an aggregate or sum of a many smaller economic units with very similar characteristics. The government sector, for example aggregates the taxing and spending activities of local, provincial and national governments. Similarly, the household sector is an aggregate of the income, spending and saving of all households but not the specifics of each individual household. Economic activity within any one of these sectors reflects, in part, the conditions and choices made in that sector. But it is also affects and is affected by conditions and actions in the other sectors. These interactions and feedbacks within the system mean that the workings of the macro-economy are more complex than the operation of the sum of its parts.

Macroeconomics: the study of the economy as a system in which interactions and feedbacks among sectors determine national output, employment and prices.

For example, consider a simple economy with just household, business and financial sectors. The household sector earns income by providing labour to the other sectors. Households make choices about spending or saving this income. Businesses make decisions about the sizes of their establishments, their labour forces, and their outputs of goods and services. The financial sector provides banking services: bank deposits, loans, and the payments system used by all three sectors.

Suppose households decide to spend more on goods and services and save less. That decision by itself does not change household sector income, but it does increase business sector sales and revenues. It also reduces the flow of household savings into bank deposits in the financial sector. As a result the business sector has an incentive to increase employment and output and perhaps to borrow from the financial sector to finance that expansion. Increased employment in the business sector increases incomes in the household sector and further increases household expenditure and savings. These inter-sector linkages and feedbacks produce a response in aggregate economy greater than the initial change.

Expanding this simple example to include more sectors increases its complexity but does not change the basics. A change in behaviour within a sector,or disturbance from outside that sector, changes aggregate levels of output, employment and prices. A complete multisector macroeconomic theory and model is required to understand the effects, on the aggregate economy, of changes in either internal or external economic conditions. It is also essential for the design of policies to manage the macroeconomic conditions.

Mitigating the effects of a large random shock from outside the economy, like the COVID-19 pandemic, disrupts all sectors of the economy. Flows of income, expenditure, revenue,and output among sectors are reduced sharply both by the pandemic and by government and financial sectors policy responses.

Application Box 1.1 COVID-19 and the Economy

The COVID-19 pandemic attacked Canada in early 2020. It revealed the complexities and interdependencies that drive the macro economy. Control and elimination of the disease depends on stopping person to person transmission. This is why the government mandated personal and social distancing for individuals plus self-isolation and quarantine in some cases. In addition businesses, mainly in the service sector, that relied on face to face interactions with customers or live audiences were forced to close.

As a result, businesses lost sales revenues and cut output. They reduced employment to cut labour costs, but overhead costs remained. Households lost employment and employment incomes. They reduced their discretionary spending, but their overhead costs continued. As a result the economy faced a unique, simultaneous collapse in overall private supply and demand and the risk of a deep recession. The government and financial sectors intervened with fiscal and monetary policy support. Government introduced a wide range of new income supports for the household sector, and loan and subsidy programs to support businesses, funded by large increases in the government's budget deficit. The central bank lowered interest rates and increased the monetary base to support the government's borrowing requirements, and the credit demands on private banks and other financial institutions. The banking system lost the normal growth in customer deposits, but worked to accommodate the needs of their business and household clients.

This unprecedented support from government fiscal policy and central bank monetary policy will offset part of the loss in national output and income. But it will not reverse it. Recovery will begin with the reopening of business and the growth of employment at some time in the uncertain future. The size of the estimated effect of COVID-19 on the Canadian economy is stark. In its Monetary Policy Report, April 2020, The Bank of Canada estimates that real GDP in Canada will be 1% to 7.5% lower in 2020Q1 and lower by 15-30% in 2020Q2 than in 2019Q4. The Monetary Policy Report is available on the Bank of Canada's website at www.bankofcanada.ca.

Individual behaviours

Economic actions, at the level of the person or organization, form the subject matter of microeconomics. Formally, microeconomics is the study of individual behaviour in the context of scarcity. Not all individual behaviours are motivated by self-interest; many are motivated by a concern for the well being of society-at-large. Philanthropic societies are goal-oriented and seek to attain their objectives in an efficient manner.

Microeconomics: the study of individual behaviour in the context of scarcity.

Individual economic decisions need not be world-changing events, or motivated by a search for profit. Microeconomics is also about how we choose to spend our time and money. There are quite a few options to choose from: Sleep, work, study, food, shelter, transportation, entertainment, recreation and so forth. Because both time and income are limited we cannot do all things all the time. Many choices are routine or are driven by necessity. You have to eat and you need a place to live. If you have a job you have committed some of your time to work, or if you are a student some of your time is committed to lectures and study. There is more flexibility in other choices. Critically, microeconomics seeks to understand and explain how we make choices and how those choices affect our behaviour in the workplace, the marketplace, and society more generally.

A critical element in making choices is that there exists a scarcity of time, or income or productive resources. Decisions are invariably subject to limits or constraints, and it is these constraints that make decisions both challenging and scientific.

Microeconomics also concerns business choices. How does a business use its funds and management skill to produce goods and services? The individual business operator or firm has to decide what to produce, how to produce it, how to sell it and in many cases, how to price it. To make and sell pizza, for example, the pizza parlour needs, in addition to a source of pizza ingredients, a store location (land), a pizza oven (capital), a cook and a sales person (labour). Payments for the use of these inputs generate income to those supplying them. If revenue from the sale of pizzas is greater than the costs of production, the business earns a profit for the owner. A business fails if it cannot cover its costs.

In these micro-level behaviours the decision makers have a common goal: To do as well as they can, given the constraints imposed by the operating environment. The individual wants to mix work and leisure in a way that makes her as happy or contented as possible. The entrepreneur aims at making a profit. These actors, or agents as we sometimes call them, are maximizing. Such maximizing behaviour is a central theme in this book and in economics at large.

Markets and government

Markets play a key role in coordinating the choices of individuals with the decisions of business. In modern market economies goods and services are supplied by both business and government. Hence we call them mixed economies. Some products or services are available through the marketplace to those who wish to buy them and have the necessary income—as in cases like coffee and wireless services. Other services are provided to all people through government programs like law enforcement and health care.

Mixed economy: goods and services are supplied both by private suppliers and government.

Markets offer the choice of a wide range of goods and services at various prices. Individuals can use their incomes to decide the pattern of expenditures and the bundle of goods and services they prefer. Businesses sell goods and services in the expectation that the market price will cover costs and yield a profit.

The market also allows for specialization and separation between production and use. Rather than each individual growing her own food, for example, she can sell her time or labour to employers in return for income. That income can then support her desired purchases. If businesses can produce food more cheaply than individuals the individual obviously gains from using the market – by both having the food to consume, and additional income with which to buy other goods and services. Economics seeks to explain how markets and specialization might yield such gains for individuals and society.

We will represent individuals and firms by envisaging that they have explicit objectives – to maximize their happiness or profit. However, this does not imply that individuals and firms are concerned only with such objectives. On the contrary, much of microeconomics and macroeconomics focuses upon the role of government: How it manages the economy through fiscal and monetary policy, how it redistributes through the tax-transfer system, how it supplies information to buyers and sets safety standards for products.

Since governments perform all of these society-enhancing functions, in large measure governments reflect the social ethos of voters. So, while these voters may be maximizing at the individual level in their everyday lives, and our models of human behaviour in microeconomics certainly emphasize this optimization, economics does not see individuals and corporations as being devoid of civic virtue or compassion, nor does it assume that only market-based activity is important. Governments play a central role in modern economies, to the point where they account for more than one third of all economic activity in the modern mixed economy.

Governments supply goods and services in many spheres, for example, health and education. The provision of public education is motivated both by a concern for equality and a realization that an educated labour force increases the productivity of an economy. Likewise, the provision of law and order, through our legal system broadly defined, represents more than a commitment to a just society at the individual level; without a legal system that enforces contracts and respects property rights, the private sector of the economy would diminish dramatically as a result of corruption, uncertainty and insecurity. It is the lack of such a secure environment in many of the world's economies that inhibits their growth and prosperity.

Let us consider now the methods of economics, methods that are common to science-based disciplines.