Ashesi University: Principles of Microeconomics Prof S. Armah Chapter 2 (Principles of Microeconomics by G. Mankiw): Topic : Thinking Like an Economist Spring 2011

Thinking Like an Economist Every field of study has its own terminology Mathematics integrals  axioms  vector spaces Psychology ego  id  cognitive dissonance Law promissory  estoppel  torts  venues Economics supply  opportunity cost  elasticity  consumer surplus  demand  comparative advantage  isocost deadweight loss externality anti-trust isoquant estoppel: A rule of evidence whereby a person is barred from denying the truth of a fact that has already been settled Tort: The legal definition of Tort is The body of the law which allows an injured person to obtain compensation from the person who caused the injury.

Thinking Like an Economist Economics trains you to. . . . Think in terms of alternatives. Evaluate the cost of individual and social choices. Examine and understand how certain events and issues are related. 2

THE ECONOMIST AS A SCIENTIST The economic way of thinking . . . Involves thinking analytically and objectively. Makes use of the Scientific Method. 1] Define: The Scientific method The dispassionate development and testing of theories about how the world works. 2] According to your textbook, what is one difficulty that economists/social scientists but not Physicists face in generating data 3

The Scientific Method: Observation, Theory, and More Observation Uses abstract models to help explain how a complex, real world operates. Develops theories, collects, and analyzes data to evaluate the theories. Qn1: Why is using data to evaluate theories more difficult in economics than in Physics? – Qn2: What is the purpose of an economic model? Qn3: why are assumptions useful? Qn1: Why is using data to evaluate theories more difficult in economics than in Physics? -> Answer -> Economist cannot generate his own data in most cases. He has to make do with whatever data is available.   Qn2: What is the purpose of an economic model? Answer Simplify reality, and increase our understanding What are the main features of an economic model: Made up of diagrams and equations Qn3: why are assumptions useful? Answer They simplify the problem without significantly altering the answer 4

The Role of Assumptions Economists make assumptions in order to make the world easier to understand. The art in scientific thinking is deciding which assumptions to make. Economists use different assumptions to answer different questions.

Two of the most basic economic models include: Economists use models to simplify reality in order to improve our understanding of the world Two of the most basic economic models include: The Circular Flow Diagram The Production Possibilities Frontier

Our First Model: The Circular-Flow Diagram The circular-flow diagram is a visual model of the economy that shows how dollars flow through markets among households and firms. There are 2 decision makers (HH and Firms) There are 2 markets (Goods and Factor Markets) Firms sell in the goods market but buy in the factor market HH buy in the goods market but sell in the factor market Inner loop/ORANGE LOOP represents flow of inputs and output between HH and firms NOT MONEY Outer loop/GREEN represents the flow of dollars between HH and firms   The Circular Flow Diagram A simple model of the economy. It ignores the role of government and international trade (In this sense we are mainly interested in a closed economy. In a closed economy, the country does not trade with other countries) Before we go through the PowerPoint presentation, here are the main features Basic Features There are 2 decision makers (HH and Firms) There are 2 markets (Goods market and Factor Market) Firms sell in the goods market but buy in the factor market HH buy in the goods market but sell in the factor market Inner loop/ORANGE LOOP represents flow of inputs and output between HH and firms NOT MONEY Outer loop/GREEN represents the flow of dollars between HH and firms 6

Figure 1 The Circular Flow There are 2 decision makers (HH and Firms) There are 2 markets (Goods and Factor Markets) Firms sell in the goods market but buy in the factor market HH buy in the goods market but sell in the factor market Inner loop/ORANGE LOOP represents flow of inputs and output between HH and firms NOT MONEY Outer loop/GREEN represents the flow of dollars between HH and firms Firms sell Households buy MARKETS FOR GOODS AND SERVICES Revenue Spending Goods and services sold Goods and services bought FIRMS Produce and sell goods and services Hire and use factors of production Buy and consume goods and services Own and sell factors of production HOUSEHOLDS Households sell Firms buy MARKETS FOR FACTORS OF PRODUCTION Factors of production Labor, land, and capital Wages, rent, and profit Income = Flow of inputs and outputs = Flow of dollars Copyright © 2004 South-Western

Our First Model: The Circular-Flow Diagram Firms Produce and sell goods and services Hire and use factors of production Households Buy and consume goods and services Own and sell factors of production 7

Our First Model: The Circular-Flow Diagram Markets for Goods and Services Firms sell Households buy Markets for Factors of Production Households sell Firms buy 7

Our First Model: The Circular-Flow Diagram Factors of Production Inputs used to produce goods and services Land, labor, and capital PROVIDE NAMES FOR THE FOLLOWING Price of land Price of Labor Price of Capital 7

Our Second Model: The Production Possibilities Frontier The production possibilities frontier is a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology. 14

Figure 2 The Production Possibilities Frontier Quantity of Computers Produced 3,000 D C 2,200 600 A 700 2,000 Production possibilities frontier 1,000 300 B 1,000 Quantity of Cars Produced Copyright©2003 Southwestern/Thomson Learning

Our Second Model: The Production Possibilities Frontier Concepts Illustrated by the Production Possibilities Frontier Efficiency Tradeoffs Opportunity Cost Economic Growth 21

Figure 3 A Shift in the Production Possibilities Frontier Quantity of Computers Produced 4,000 3,000 1,000 2,100 750 E 2,000 700 A Quantity of Cars Produced Copyright © 2004 South-Western

Microeconomics and Macroeconomics Microeconomics focuses on the individual parts of the economy. How households and firms make decisions and how they interact in specific markets Macroeconomics looks at the economy as a whole. Economy-wide phenomena, including inflation, unemployment, and economic growth 13

THE ECONOMIST AS POLICY ADVISOR When economists are trying to explain the world, they are scientists. When economists are trying to change the world, they are policy advisors. 30

POSITIVE VERSUS NORMATIVE ANALYSIS Positive statements are statements that attempt to describe the world as it is. Called descriptive analysis (No value judgement implied. How the world is) Normative statements are statements about how the world should be. (Value judgement implied. How the world should be) Called prescriptive analysis 31

POSITIVE VERSUS NORMATIVE ANALYSIS ? Positive or Normative Statements? An increase in the minimum wage will cause a decrease in employment among the least-skilled. POSITIVE Higher federal budget deficits will cause interest rates to increase. ? ? 32

POSITIVE VERSUS NORMATIVE ANALYSIS ? Positive or Normative Statements? The government should raise the tax on tobacco to reduce the quantity of cigarettes sold. NORMATIVE If the government prints more 2-cedi notes, the value of the Ghana cedi should plummet. POSITIVE ? ? 32

POSITIVE VERSUS NORMATIVE ANALYSIS ? Positive or Normative Statements? The income gains from a higher minimum wage are worth more than any slight reductions in employment. NORMATIVE State governments should be allowed to collect from tobacco companies the costs of treating smoking-related illnesses among the poor. ? ? 32

Economists in Washington . . . serve as advisers in the policymaking process of the three branches of government: Legislative Executive Judicial 33

Economists in Washington Some government agencies that collect economic data and make economic policy: Department of Commerce http://www.commerce.gov Bureau of Labor Statistics http://www.bls.gov Congressional Budget Office http://www.cbo.gov Federal Reserve Board http://www.federalreserve.gov 33

Ghana / Africa Data Sites The Bank of Ghana (General, Monetary, Financial information) http://www.bog.gov.gh/ World Development Indicators (WDI) http://data.worldbank.org/indicator Ghana Statistical Service (Ghana Specific Data) http://www.statsghana.gov.gh/AboutUs.html

WHY ECONOMISTS DISAGREE They may disagree about the validity of alternative positive theories about how the world works. They may have different values and, therefore, different normative views about what policy should try to accomplish. 35

Table 2 Ten Propositions about Which Most Economists Agree Copyright © 2004 South-Western

Summary Economists try to address their subjects with a scientist’s objectivity. They make appropriate assumptions and build simplified models in order to understand the world around them. Two simple economic models are the circular-flow diagram and the production possibilities frontier.

Summary Economics is divided into two subfields: Microeconomists study decisionmaking by households and firms in the marketplace. Macroeconomists study the forces and trends that affect the economy as a whole

Summary A positive statement is an assertion about how the world is. A normative statement is an assertion about how the world ought to be. When economists make normative statements, they are acting more as policy advisors than scientists.

Summary Economists who advise policymakers offer conflicting advice either because of differences in scientific judgments or because of differences in values. At other times, economists are united in the advice they offer, but policymakers may choose to ignore it.