Chapter 1
Introduction
Because the textbook stresses economic analysis as it applies to the labor market, students must
understand the ways economic analyses are used. The basic purpose of Chapter 1 is to introduce
students to the two major modes of economic analysis: positive and normative. Because both
modes of analysis rest on some very fundamental assumptions, Chapter 1 discusses the bases of
each mode in some detail.
In our treatment of positive economics, the concept of rationality is defined and discussed, as is
the underlying concept of scarcity. There is, in addition, a lengthy discussion of what an
economic model is, and an example of the behavioral predictions flowing from such a model is
presented. The discussion
of normative economics emphasizes its philosophical underpinnings and includes a discussion of
the conditions under which a market would fail to produce results consistent with the normative
criteria.
Labor market examples of governmental remedies are provided.
The appendix to Chapter 1 introduces the student to ordinary least squares regression analysis. It
begins with univariate analysis, introduced in a graphical context, explaining the concepts of
dependent and independent variables, the “intercept” and “slope” parameters, the “error term,”
and the t statistic. The analysis then moves to multivariate analysis and the problem of omitted
variables.
n List of Major Concepts
1. The essential features of a market include the facilitation of contact between buyers
and sellers, the exchange of information, and the execution of contracts.
2. The uniqueness of labor services affects the characteristics of the labor market.
3. Positive economics is the study of economic behavior, and underlying this theory of
behavior are the basic assumptions of scarcity and rationality.
4. Normative economics is the study of what “should be,” and theories of social optimality
are based in part on the underlying philosophical principle of “mutual benefit.”
,5. A market “fails” when it does not permit all mutually beneficial trades to take place,
and there are three common reasons for such failure.
6. A governmental policy is “Pareto-improving” if it encourages additional mutually
beneficial transactions. At times, though, the goal of improving Pareto efficiency
conflicts with the goal of generating more equity.
7. The concept that governmental intervention in a market may be justified on grounds
other than the principle of mutual benefit is discussed. (For example, government
intervention may be justified on the grounds that income redistribution is a desirable
social objective.)
, 8. (Appendix) The relationship between two economic variables (e.g., wages and quit
rates) can be plotted graphically; this visual relationship can also be summarized
algebraically.
9. (Appendix) A way to summarize a linear relationship between two variables is through
ordinary least squares regression analysis—a procedure that plots the “best” line (the
one that minimizes the sum of squared deviations) through the various data points.
The parameters describing this line are estimated, and the uncertainty surrounding
these estimates is summarized by the standard error of the estimate.
10. (Appendix) The multivariate procedure for summarizing the relationship between a
dependent variable and two or more independent variables is a generalization of the
univariate procedure, and each coefficient can be interpreted as the effect on the
dependent variable of a one-unit change in the relevant independent variable, holding
the other variables constant.
11. (Appendix) If an independent variable that should be in an estimating equation is left
out, estimates of the other coefficients may be biased away from their true values.
n Answers to Even-Numbered Review Questions
2. Are the following statements “positive” or “normative”? Why?
a. Employers should not be required to offer pensions to their employees.
b. Employers offering pension benefits will pay lower wages than they would if they did
not
offer a pension program.
c. If further immigration of unskilled foreigners is prevented, the wages of unskilled
immigrants already here will rise.
d. The military draft compels people to engage in a transaction they would not voluntarily
enter into; it should therefore be avoided as a way of recruiting military personnel.
e. If the military draft were reinstituted, military salaries would probably fall.
Answer: a. normative
b. positive
c. positive
d. normative
e. positive
4. What are the functions and limitations of an economic model?
Answer: The major function of an economic model is to strip away real-world complexities
and focus on a particular cause/effect relationship. In this sense an economic model
is analogous to an architect’s model of a building. An architect may be interested
in designing a building that fits in harmoniously with its surroundings, and in
designing such a building the architect may employ a model that captures the
essentials of his or her concerns (namely, appearance) without getting into the
complexities of plumbing, electrical circuits, and the design of interior office
, space. Similarly, an economic model will often focus on a particular kind of
behavior and ignore complexities that are either not germane to that behavior or of
only indirect importance.
Models used to generate insights about responses to a given economic stimulus
are often not intended to forecast actual outcomes. For example, if we are
interested in how behavior is affected by Stimulus B, with Factors C, D, and E
held constant, our model may not correctly forecast the observed behavior if
Stimuli C through E also change.
6. A law in one town of a Canadian province limits large supermarkets to just four
employees on Sundays. Analyze this law using the concepts of normative economics.
Answer: This law clearly suppresses a transaction into which both employers and
employees may wish to engage. That is, there may be employees who wish to
work on Sundays (perhaps at increased pay), and the law prevents this mutually
beneficial transaction from occurring.
8. In discussing ways to reduce lung diseases caused by workplace hazards, one
commentator stated the following:
Gas masks are very uncomfortable to wear, but economists would argue that they are
the socially preferred method for reducing the inhalation of toxic substances whenever
they can be produced for less than it takes to alter a ventilation system.
Answer: Workers and consumers are utility maximizers, so the loss of utility is a social
cost that must be counted when deciding whether a particular governmental
mandate generates social benefits in excess of social costs. Thus, gas masks
cannot be said to be less costly just because they are cheaper to produce; worker
discomfort is also a cost that must be taken in to account.
n Answers to Even-Numbered Problems
2. (Appendix) Suppose that a least squares regression yields the following estimate:
Wi –1 0.3Ai, where W is the hourly wage rate (in dollars) and A is the age in years.
A second regression from another group of workers yields this estimate:
a. How much is a 20-year-old predicted to earn based on the first estimate?
b. How much is a 20-year-old predicted to earn based on the second estimate?
Answer: a. W –1 0.3 20 5 dollars per hour.
b. W 3 + 0.3 20 – 0.01 20 20 3 6 – 4 5 dollars per hour.
4. (Appendix) Suppose you have information on which of the 13 randomly selected
teenage workers in the fast-food industry worked part-time and which worked full-
time. Variable Fi is equal to 1 if the worker is employed full time, and it is equal to zero
Introduction
Because the textbook stresses economic analysis as it applies to the labor market, students must
understand the ways economic analyses are used. The basic purpose of Chapter 1 is to introduce
students to the two major modes of economic analysis: positive and normative. Because both
modes of analysis rest on some very fundamental assumptions, Chapter 1 discusses the bases of
each mode in some detail.
In our treatment of positive economics, the concept of rationality is defined and discussed, as is
the underlying concept of scarcity. There is, in addition, a lengthy discussion of what an
economic model is, and an example of the behavioral predictions flowing from such a model is
presented. The discussion
of normative economics emphasizes its philosophical underpinnings and includes a discussion of
the conditions under which a market would fail to produce results consistent with the normative
criteria.
Labor market examples of governmental remedies are provided.
The appendix to Chapter 1 introduces the student to ordinary least squares regression analysis. It
begins with univariate analysis, introduced in a graphical context, explaining the concepts of
dependent and independent variables, the “intercept” and “slope” parameters, the “error term,”
and the t statistic. The analysis then moves to multivariate analysis and the problem of omitted
variables.
n List of Major Concepts
1. The essential features of a market include the facilitation of contact between buyers
and sellers, the exchange of information, and the execution of contracts.
2. The uniqueness of labor services affects the characteristics of the labor market.
3. Positive economics is the study of economic behavior, and underlying this theory of
behavior are the basic assumptions of scarcity and rationality.
4. Normative economics is the study of what “should be,” and theories of social optimality
are based in part on the underlying philosophical principle of “mutual benefit.”
,5. A market “fails” when it does not permit all mutually beneficial trades to take place,
and there are three common reasons for such failure.
6. A governmental policy is “Pareto-improving” if it encourages additional mutually
beneficial transactions. At times, though, the goal of improving Pareto efficiency
conflicts with the goal of generating more equity.
7. The concept that governmental intervention in a market may be justified on grounds
other than the principle of mutual benefit is discussed. (For example, government
intervention may be justified on the grounds that income redistribution is a desirable
social objective.)
, 8. (Appendix) The relationship between two economic variables (e.g., wages and quit
rates) can be plotted graphically; this visual relationship can also be summarized
algebraically.
9. (Appendix) A way to summarize a linear relationship between two variables is through
ordinary least squares regression analysis—a procedure that plots the “best” line (the
one that minimizes the sum of squared deviations) through the various data points.
The parameters describing this line are estimated, and the uncertainty surrounding
these estimates is summarized by the standard error of the estimate.
10. (Appendix) The multivariate procedure for summarizing the relationship between a
dependent variable and two or more independent variables is a generalization of the
univariate procedure, and each coefficient can be interpreted as the effect on the
dependent variable of a one-unit change in the relevant independent variable, holding
the other variables constant.
11. (Appendix) If an independent variable that should be in an estimating equation is left
out, estimates of the other coefficients may be biased away from their true values.
n Answers to Even-Numbered Review Questions
2. Are the following statements “positive” or “normative”? Why?
a. Employers should not be required to offer pensions to their employees.
b. Employers offering pension benefits will pay lower wages than they would if they did
not
offer a pension program.
c. If further immigration of unskilled foreigners is prevented, the wages of unskilled
immigrants already here will rise.
d. The military draft compels people to engage in a transaction they would not voluntarily
enter into; it should therefore be avoided as a way of recruiting military personnel.
e. If the military draft were reinstituted, military salaries would probably fall.
Answer: a. normative
b. positive
c. positive
d. normative
e. positive
4. What are the functions and limitations of an economic model?
Answer: The major function of an economic model is to strip away real-world complexities
and focus on a particular cause/effect relationship. In this sense an economic model
is analogous to an architect’s model of a building. An architect may be interested
in designing a building that fits in harmoniously with its surroundings, and in
designing such a building the architect may employ a model that captures the
essentials of his or her concerns (namely, appearance) without getting into the
complexities of plumbing, electrical circuits, and the design of interior office
, space. Similarly, an economic model will often focus on a particular kind of
behavior and ignore complexities that are either not germane to that behavior or of
only indirect importance.
Models used to generate insights about responses to a given economic stimulus
are often not intended to forecast actual outcomes. For example, if we are
interested in how behavior is affected by Stimulus B, with Factors C, D, and E
held constant, our model may not correctly forecast the observed behavior if
Stimuli C through E also change.
6. A law in one town of a Canadian province limits large supermarkets to just four
employees on Sundays. Analyze this law using the concepts of normative economics.
Answer: This law clearly suppresses a transaction into which both employers and
employees may wish to engage. That is, there may be employees who wish to
work on Sundays (perhaps at increased pay), and the law prevents this mutually
beneficial transaction from occurring.
8. In discussing ways to reduce lung diseases caused by workplace hazards, one
commentator stated the following:
Gas masks are very uncomfortable to wear, but economists would argue that they are
the socially preferred method for reducing the inhalation of toxic substances whenever
they can be produced for less than it takes to alter a ventilation system.
Answer: Workers and consumers are utility maximizers, so the loss of utility is a social
cost that must be counted when deciding whether a particular governmental
mandate generates social benefits in excess of social costs. Thus, gas masks
cannot be said to be less costly just because they are cheaper to produce; worker
discomfort is also a cost that must be taken in to account.
n Answers to Even-Numbered Problems
2. (Appendix) Suppose that a least squares regression yields the following estimate:
Wi –1 0.3Ai, where W is the hourly wage rate (in dollars) and A is the age in years.
A second regression from another group of workers yields this estimate:
a. How much is a 20-year-old predicted to earn based on the first estimate?
b. How much is a 20-year-old predicted to earn based on the second estimate?
Answer: a. W –1 0.3 20 5 dollars per hour.
b. W 3 + 0.3 20 – 0.01 20 20 3 6 – 4 5 dollars per hour.
4. (Appendix) Suppose you have information on which of the 13 randomly selected
teenage workers in the fast-food industry worked part-time and which worked full-
time. Variable Fi is equal to 1 if the worker is employed full time, and it is equal to zero
