Thinking Like an Economist Chapter 2

Every field of study has its own terminology Mathematics axioms integrals vector spaces Psychology ego id cognitive dissonance Law torts venues Promissory estoppel

Every field of study has its own terminology Economics Opportunity cost Elasticity Supply Consumer Surplus Comparative advantage Deadweight loss Demand

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. 3

Observation, Theory and More Observation! The Scientific Method Uses abstract models to help explain how a complex, real world operates. Develops theories, collects, and analyzes data to prove the theories. Observation, Theory and More Observation! 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.

The Economic Way of Thinking Includes developing abstract models from theories and the analysis of the models. Uses two approaches: Descriptive (reporting facts, etc.) Analytical (abstract reasoning) 5

Economic Models The Circular Flow Model 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 Model The Production Possibilities Frontier

The Circular-Flow Model The circular-flow model is a simple way to visually show the economic transactions that occur between households and firms in the economy. 6

The Circular-Flow Diagram Spending Revenue Market for Goods and Services Goods & Services sold Goods & Services bought Firms Households Wages, rent, and profit Income Labor, land, and capital Inputs for production Market for Factors of Production 7

Figure 1 The Circular Flow 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

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

The Circular-Flow Diagram Markets for Goods & Services Firms sell Households buy Markets for Factors of Production Households sell Firms buy 7

The Circular-Flow Diagram Factors of Production Inputs used to produce goods and services Land, labor, and capital 7

The Production Possibilities Frontier The production possibilities frontier is a graph showing the various combinations of output that the economy can possibly produce given the available factors of production and technology. 14

The Production Possibilities Frontier Quantity of Computers Produced D 3,000 C 2,200 A 2,000 Production possibilities frontier B 1,000 300 600 700 1,000 Quantity of Cars Produced 15

Concepts Illustrated by the Production Possibilities Frontier Efficiency Tradeoffs Opportunity Cost Economic Growth 21

The Production Possibilities Frontier Quantity of Computers Produced 4,000 An outward shift in the production possibilities frontier 3,000 E 2,100 750 2,000 A 700 1,000 Quantity of Cars Produced 15

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. How the markets, as a whole, interact at the national level. 13

Two Roles of Economists When they are trying to explain the world, they are scientists. When they are trying to change the world, they are policymakers. 30

Positive versus Normative Analysis Positive statements are statements that describe the world as it is. Called descriptive analysis Normative statements are statements about how the world should be. Called prescriptive analysis 31

Positive or Normative Statements? An increase in the minimum wage will cause a decrease in employment among the least-skilled. Positive ? 32

Positive or Normative Statements? Higher federal budget deficits will cause interest rates to increase. Positive ? ? 32

Positive or Normative Statements? The income gains from a higher minimum wage are worth more than any slight reductions in employment. Positive ? ? 32

Positive or Normative Statements? State governments should be allowed to collect from tobacco companies the costs of treating smoking-related illnesses among the poor. Positive ? 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

Why Economists Disagree They may disagree on theories about how the world works. They may hold different values and, thus, different normative views. 35

Table 2 Ten Propositions about Which Most Economists Agree

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 The field of economics is divided into two subfields: microeconomics and macroeconomics. Microeconomists study decisionmaking by households and firms in the marketplace. Macroeconomists study the forces and trends that affect the economy as a whole.

Summary Economics relies on both positive and normative analysis. Positive statements is an assertion about how the world “is”。 normative statements 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 may 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.

Graphical Review

Figure 2A-1 (a) Pie Chart Individuals (23%) Private Insurers (32%) Other (4%) 1996 Value (in Government (41%) billions of dollars) (b) Bar Graph General Electric $140 ($126 billion) 120 Exxon ($99 billion) 100 ($68 billion) 80 IBM General 60 Motors ($39 billion) 40 20 output per hour of labor, (c) Time-Series Graph Productivity Index (farm 1977 = 100) 160 140 120 100 80 60 40 Figure 2A-1 20 1950 1960 1970 1980 1990 4 43

Figure 2A-2 Grade Point Average 4.0 3.5 Albert E. 3.0 (25, 3.5) 2.5 Alfred E. 2.0 (5, 2.0) 1.5 1.0 0.5 5 10 15 20 25 30 35 40 Study Time (hours per week) Figure 2A-2 5 44

Figure 2A-3 Price of Novels $11 (5, $10) 10 (9, $9) 9 (13, $8) 8 (17, $7) 7 (21, $6) 6 5 (25, $5) Demand, D 4 1 3 2 1 5 10 15 20 25 30 Quantity of Novels Figure 2A-3 Purchased 6 45

Figure 2A-4 Price of Novels $11 10 (13, $8) 9 (16, $8) 8 When income increases, (10, $8) the demand curve 7 shifts to the right. 6 When income D 5 3 decreases, the (income = D D (income = 1 2 demand curve 4 $20,000) (income = $40,000) shifts to the left. $30,000) 3 2 1 5 10 13 15 16 20 25 30 Quantity of Novels Figure 2A-4 Purchased 7 46

Figure 2A-5 Price of Novels $11 10 9 (13, $8) 8 7 6 2 8 5 2 2 (21, $6) Demand, D 1 4 3 2 1 5 10 13 15 20 21 25 30 Quantity of Novels Figure 2A-5 Purchased 8 47

Risk of Cancer Number of Lighters in House Figure 2A-6 9 48

Figure 2A-7 Violent Crimes (per 1,000 people) Police Officers Police Officers (per 1,000 people) Figure 2A-7 10 49