Chapter 2: Thinking like an Economist Chapter 2: Thinking like an Economist

ObjectivesObjectives 1.) The Economist as Scientist 2.) The Scientific Method 3.) Observation, Theory, Assumptions

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 Supply Demand Elasticity Consumer Surplus Comparative advantage Opportunity cost Deadweight loss

Economics trains you to.... uThink in terms of alternatives. uEvaluate the cost of individual and social choices. uExamine and understand how certain events and issues are related. uThink in terms of alternatives. uEvaluate the cost of individual and social choices. uExamine and understand how certain events and issues are related.

The Economist as a Scientist The economic way of thinking... uInvolves thinking analytically and objectively. uMakes use of the scientific method. The economic way of thinking... uInvolves thinking analytically and objectively. uMakes use of the scientific method.

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

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

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

What is an Economic Model? n An Economic Model is a simplified, small-scale version of some aspect of the economy. n Economic Models are often expressed in equations, by graphs, or in words. n An Economic Model is a simplified, small-scale version of some aspect of the economy. n Economic Models are often expressed in equations, by graphs, or in words.

Two Examples of Economic Models are: 1.) Circular - flow diagram 2.) The Production Possibilities Frontier 1.) Circular - flow diagram 2.) The Production Possibilities Frontier

MARKETS FOR GOODS AND SERVICES Firms sell Households buy MARKETS FOR FACTORS OF PRODUCTION Households sell Firms buy 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. Wages, rent and profit Inputs for production Goods and services sold Goods and services bought Spending Labor, land, and capital Revenue Income = Flow of goods and services = Flow of dollars The Circular Flow (Figure 2-1)

The Circular-Flow Diagram Households u Buy and consume goods and services u Own and sell factors of production Firms u Produce and sell goods and services u Hire and use factors of production

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

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

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.

0 1,000 2,000 3,000 2, ,000 B A C D Quantity of Computers Produced Quantity of Cars Produceed The Production Possibilities Frontier (Figure 2-2)

Concepts Illustrated by the Production Possibilities Frontier uEfficiency uTradeoffs uOpportunity Cost uEconomic Growth uEfficiency uTradeoffs uOpportunity Cost uEconomic Growth

2,100 2,000 3,000 4,000 0 A E ,000 Quantity of Cars Produced Quantity of Computers Produced A Shift in the Production Possibilities Frontier (Figure 2-3)

MicroeconomicsMicroeconomics n Microeconomics is the study of how households and firms make decisions and how they interact in markets. n Goal: to explain the prices and quantities of individual goods and services. n Microeconomics is the study of how households and firms make decisions and how they interact in markets. n Goal: to explain the prices and quantities of individual goods and services.

n Macroeconomics is the study of the national economy and the global economy and the way that economic aggregates grow and fluctuate. n Goal: to explain average prices and total employment, income, inflation and economic growth. n Macroeconomics is the study of the national economy and the global economy and the way that economic aggregates grow and fluctuate. n Goal: to explain average prices and total employment, income, inflation and economic growth. MacroeconomicsMacroeconomics

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

Role of Economists 1. Positive Analysis -- positive statements: claims that attempt to describe the world as it is. 2. Normative Analysis -- normative statements: claims that attempt to prescribe how the world should be.

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

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

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

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

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

1.) Differences in scientific judgments. 2.) Differences in values. 1.) Differences in scientific judgments. 2.) Differences in values. Why Economists Disagree?

PROPOSITION AND PERCENTAGE OF ECONOMISTS WHO AGREE 1. A ceiling on rents reduces the quantity and quality of housing available. (93%) 2. Tariffs and import quotas usually reduce general economic welfare. (93%) 3. Flexible and floating exchange rates offer an effective international monetary arrangement. (90%) 1. A ceiling on rents reduces the quantity and quality of housing available. (93%) 2. Tariffs and import quotas usually reduce general economic welfare. (93%) 3. Flexible and floating exchange rates offer an effective international monetary arrangement. (90%)

4. Fiscal policy (e.g., tax cut and/or government expenditure increase) has a significant stimulative impact on less then fully employed economy. (90%) 5. If the federal budget is to be balanced, it should be done over the business cycle rather than yearly. (85%) 6. Cash payments increase the welfare of recipients to a greater degree than do transfers-in-kind of equal cash value. (84%) 4. Fiscal policy (e.g., tax cut and/or government expenditure increase) has a significant stimulative impact on less then fully employed economy. (90%) 5. If the federal budget is to be balanced, it should be done over the business cycle rather than yearly. (85%) 6. Cash payments increase the welfare of recipients to a greater degree than do transfers-in-kind of equal cash value. (84%) PROPOSITION AND PERCENTAGE OF ECONOMISTS WHO AGREE

7. A large federal budget deficit has an adverse effect on the economy. (83%) 8. The minimum wage increases unemployment among young and unskilled workers. (79%) 9. The government should restructure the welfare system along the lines of a “negative income tax.” (79%) 10. Effluent taxes and marketable pollution permits represent a better approach to pollution control than imposition of pollution ceilings. (78%) 7. A large federal budget deficit has an adverse effect on the economy. (83%) 8. The minimum wage increases unemployment among young and unskilled workers. (79%) 9. The government should restructure the welfare system along the lines of a “negative income tax.” (79%) 10. Effluent taxes and marketable pollution permits represent a better approach to pollution control than imposition of pollution ceilings. (78%) PROPOSITION AND PERCENTAGE OF ECONOMISTS WHO AGREE

Income Novels Purchased by Emma B.

When income decreases, the demand curve shifts to the left. When income increases, the demand curve shifts to the right.

SummarySummary u In order to address subjects with objectivity, economics makes use of the scientific method. u The field of economics is divided into two subfields: microeconomics and macroeconomics. u In order to address subjects with objectivity, economics makes use of the scientific method. u The field of economics is divided into two subfields: microeconomics and macroeconomics.

SummarySummary uEconomics relies on both positive and normative analysis. Positive statements assert how the world “is” while normative statements assert how the world “should be.” uEconomists may offer conflicting advice due to differences in scientific judgments or to differences in values. uEconomics relies on both positive and normative analysis. Positive statements assert how the world “is” while normative statements assert how the world “should be.” uEconomists may offer conflicting advice due to differences in scientific judgments or to differences in values.