2. Theories or Models An Economic model is a simplified way to explain how the economy (or parts of it) work and to make predictions about what could happen when something changes. Begins with observing the economy All Scientific inquiry starts with observations about what is happening in the world. Economists gather information and describe the economy by organizing the data. This data can be shown with tables of numbers which we can translate into a picture (graph). However, this is only the start: Descriptions are not explanations… …this is why economic models or theories are needed: To explain the data that is collected

3. Two types of Scientific inquiry Positive Economics...making objective statements about economic phenomena that can be tested and proved right or wrong. What “is”. a. Explaining why events occur b. Predicting under what circumstances economic events will occur in the future… Example: An increase in income taxes will cause consumer spending to go down Normative Economics...a way of determining the desirability of outcomes based on some value judgments (opinions). What “should be”. a. Recommending appropriate courses of actions to take. Example: Taxes should be lowered in order to increase consumer spending. b. Criteria: 1. Efficiency 2. Equity

4. Theories or models include four steps 1. Identify what you want to study (variables) 2. Make assumptions on variable behavior 3. Make hypothesis or Predictions (In the form of IF... THEN…) c eteris paribus: All other things held constant. ( This is an implicit assumption made with all predictions) It means that we only use two variables at a time when making predictions (do this in order to isolate how one variable affect one other variable)......everything else is assumed not to change. 4. Test your predictions If wrong you may have to adjust theory

5. Studying Scarcity and opportunity cost Example: Suppose a person is stranded on an island. 1. Identify the variables –can gather coconuts or catch fish –has resources (time and labor) and technology (know how) 2. Make assumptions –limited resources (given amount of time and labor) –given or fixed technology (his knowledge of tree climbing and fishing) 3. Make Predictions –How many coconuts can he gather and how many fish can he catch with a limited amount of time and labor? 4. Test Predictions

6. Quantity of Coconuts Quantity of Fish Production Possibilities Frontier Coconuts per week Fish per week 400 0 20 30 20 10 5 15 A B C D E B A E D C 30 20 40 10 20 501015 Z Unattainable with given resources & technology Scarcity is shown by the mere existence of the PPF Tom What if Tom wanted more fish? The only way he can get more fish is to give up some coconuts. Suppose he is at point C and wants 5 more fish. To get 5 more fish he has to give up 10 coconuts. Moving up & down the PPF illustrates the concept of opportunity cost. For Tom, he has to give up 2 coconuts for every fish gained. Opportunity cost is measured by the slope of the PPF, which is a marginal value.

7. Quantity of Coconuts Quantity of Fish Production Possibilities Frontier Coconuts per week Fish per week 400 0 20 30 20 10 5 15 A B C D E B A E D C 30 20 40 10 20 501015 Tom X Point X is a level of production that Tom can make, but would he want to? From point X it is possible for Tom to either increase Fish or Coconuts without having to give up any of the other good. The only way that is possible is if he is not being as efficient as possible (he is not maxing out production of one good given production of the other). He is not fully exploiting his opportunities. So any point below the PPF is productively inefficient. Z unattainable with given resources & technology Allocative efficiency: Economy needs to produce those goods that consumers desire and in correct quantity. Market-Capitalist system should achieve this.

8. Quantity of Coconuts Quantity of Fish B A E D C 30 20 40 10 20 501015 Quantity of Coconuts Quantity of Fish B’ A’ E’ D’ C’ 3020 40 10 20 5 0 10 15 TomHank 1 fish: 2 Coconut 1 Coconut: 1/2 Fish 1 fish: 1/2 Coconut 1 Coconut: 2 Fish Produce the good at the lowest opportunity cost: Tom – Coconuts; Hank – Fish This is called a Comparative advantage, producing a good at a lower opportunity cost than someone else. Suppose that Tom initially is at point C and Hank is at point C’

9. Quantity of Coconuts Quantity of Fish B A E D C 30 20 40 10 20 501015 Quantity of Coconuts Quantity of Fish B’ A’ E’ D’ C’ 3020 40 10 20 5 0 10 15 TomHank 1 fish: 2 Coconut 1 Coconut: 1/2 Fish 1 fish: 1/2 Coconut 1 Coconut: 2 Fish Suppose that Tom initially is at point C and Hank is at point C’ Tom now only produces Coconuts (point A) and Hank only produces Fish (point E’). Together they can now produce 40 of each instead of 30 separately. Suppose Tom and Hank agree that Tom will exchange 15 coconuts for 15 fish. They will now be able to consume more of both! F F’

10. Comparative vs. Absolute advantage Comparative advantage refers to an ability to produce at a lower opportunity cost than another Absolute advantage refers to the ability to do something better (such as produce more) than another. It is possible to have a comparative advantage over another without having an absolute advantage in anything. –Comparative advantage is based on relative costs between two goods for an individual and not being physically better. –An individual will always have a comparative advantage in something. Since this model is based on scarcity and opportunity cost we can say that not only can trade (based on comparative advantage) between individuals make each better off but two countries can also benefit from trade with one another.

11. Production Possibilities Frontier for a Country Looking at an individual’s production gives us important insights on scarcity and opportunity cost. To gain more insight we can apply the model to an entire country which also faces the problem of scarcity. A big difference is that for an individual they are the only resource and it is the same resource producing both goods. However, for an entire nation there people, land, and machinery who have differing abilities in producing goods & services. − This is called specialization of resources − Some resources are better able to produce one good better than the other good

12. Types of Resources: Land is the bounty of the Earth: includes natural resources such as oil, coal, minerals, etc. Labor includes both physical and mental human effort Capital are the tools, equipment, and factories to help Labor produce goods & services To produce capital one must use resources to create it Entreprenurship is the ability to organize resources & take risks to develop new ways of production and new products. Technology: Is the knowledge of how to produce goods and services. –An increase in technology means firms are able to produce more goods and services with the same amount of resources. –The same amount of goods with the less resources.

13. Quantity of Coconuts Quantity of Fish B A E D C 30 20 40 10 20 501015 Tom Quantity of Coconuts Quantity of Fish B A E D C 150,000 80,000 160,000 70,000 120,000 20,0000 40,000 60,000 Country A When resources are specialized this leads to increasing opportunity costs: As the production of a good increases a country must give up greater amounts of the other good to get the same increase of production as before. A to B: 10,000 coconuts B to C: 30,000 coconuts C to D: 50,000 coconuts D to E: 70,000 coconuts

14. Quantity of Coconuts Quantity of Fish B A E D C 150,000 80,000 160,000 70,000 120,000 20,0000 40,000 60,000 Country A The position of the PPF is dependent on the amount of resources a country has and the level of technology. If the quantity of resources increases or technology improves, then the PPF will shift to the right. New PPF This is called Economic Growth: More goods & services can be produced than before. Also called an increase in the standard of living. Model says that only increases in resources and improvements in technology can increase standard of living

15. Quantity of Coconuts Quantity of Fish B A E D C 150,000 80,000 160,000 70,000 120,000 20,0000 40,000 60,000 Country A New PPF If technology only improves for one good (a new fishing technique increases the catch with same amount of ships) then the PPF will shift out from that axis only. This does not mean that we can only produce more fish. The increase in fish technology frees up resources that can move to coconut production so that both can increase production. We can conclude that any technology improvement can make a country better off.

16. Other Ingredients to Economic Growth Private Property and Property rights –Private citizens own resources and have the right to employ them as they see fit in a market-capitalist economy –If you don’t benefit from your investment why bother to invest in the first place? Competition in the marketplace –This forces firms to improve and innovate to earn profit Limited government and stable institutions Adam Smith in a 1755 lecture: “Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism but peace, easy taxes, and a tolerable administration of justice: all the rest being brought about by the natural course of things”

17. >Economics in Action A Tale of Two Colonies One of the most informative contrasts in long-run growth is between Canada and Argentina. Economic historians believe that the average level of per capita income was about the same in the two countries as late as the 1930s. After World War II, however, Argentina’s economy performed poorly, largely due to political instability and bad macroeconomic policies. Meanwhile, Canada made steady progress. Thanks to the fact that Canada has achieved sustained long-run growth since 1930, but Argentina has not, Canada today has almost as high a standard of living as the United States—and is about three times as rich as Argentina.

18. Amount of Environmental Improvement Quantity of All other goods 0 The PPF model is very flexible. The goods on each axis represent goods in which a tradeoff exists. Put any two goods where a tradeoff exists on each axis and use model to illustrate the problem. Example: Environmental improvement To get a cleaner environment a country must sacrifice production of all other goods. How much will they have to give up? A B C D Same increase Let’s say we start at point A, which is very polluted. To get cleaner we must give up some amount of other goods. At point A to B it is not very much. But if we were to start at point C and then decide to get the same increase in environmental improvement... …we must give up MORE of all other goods then if we started at point A

19. Amount of Capital Goods Amount of Consumption goods 0 A B Economic growth and Capital Goods Capital goods are a resource –the greater the production of capital goods the greater the shift outward of the PPF (faster economic growth) Tradeoff: Today we must give up consumption goods. –that is we must Save more today Saving is the sacrifice of current consumption Example: Let’s say that our country decides on more consumption today. Move from point A to point B. PPF B PPF A We still produce capital goods so the PPF still shifts to the right. But we don’t produce as much capital as point A. Future possibilities are greater if today’s economy is at point A instead of point B due to the greater amounts of capital goods A Country that produces more Capital goods today will have more production possibilities in the Future (Faster Economic Growth)

20. The Circular-Flow Diagram Money Factors Goods and services Factors Households Firms Markets for goods and services Factor Markets Goods and services Money The circular-flow diagram is a model that represents the transactions in an economy by flows around a circle.

21. Circular-Flow of Economic Activities A household is a person or a group of people that share their income. A firm is an organization that produces goods and services for sale. –Firms sell goods and services that they produce to households in markets for goods and services. –Firms buy the resources they need to produce—factors of production—in factor markets. Ultimately, factor markets determine the economy’s income distribution, how total income is divided among the owners of the various factors of production.

22. Growth in the U.S. Economy from 1962 -1988

23. When and Why Economists Disagree There are two main reasons economists disagree: Which simplifications to make in a model Values

24. Problems in theory building 1. Fallacy of Composition The often mistaken belief that what is true for a part is necessarily true for the whole. When I stand up at a ballgame, I can see better. Therefore, if everyone stands up, everyone will be able to see better? If Farmer Jones produces more corn, her revenues will rise. If all farmers produce more corn, their revenues will all rise? 2. Post hoc, ergo Propter Hoc If event A happens before event B, it is not necessarily true that event A caused event B. I went to the beach and it began to rain. It must have rained because I went to the beach? We increased our advertising budget and people stopped buying our product. Our advertising must be discouraging consumers? Correlation vs. Causation Two variables are correlated if one variable changes with the other variable. This does not mean that the first variable causes changes in the second variable.

25. APPLICATION: Correlation vs. Causation Cities with high crime rates also have many automobiles. Does this mean that automobiles cause crime? President Bush took office in 2001 and soon after the economy began to get worse. Does this mean that the Bush inauguration caused the worsening economy?

26. 1.Almost all economics is based on models. An important assumption in economic models is the other things equal assumption, which allows analysis of the effect of a change in one factor by holding all other relevant factors unchanged. 2.One important economic model is the production possibility frontier. It illustrates: opportunity cost, efficiency, and economic growth. There are two basic sources of growth: an increase in factors of production, resources such as land, labor, capital, and human capital, inputs that are not used up in production, and improved technology. Summary

27. 3.Another important model is comparative advantage, which explains the source of gains from trade between individuals and countries. Everyone has a comparative advantage in something. This is often confused with absolute advantage, an ability to produce a particular good or service better than anyone else. 4.In the simplest economies, people barter or trade goods and services for one another—rather than trade them for money, as in a modern economy. The circular-flow diagram represents transactions within the economy as flows of goods, services, and money between households and firms. These transactions occur in markets for goods and services and factor markets. Summary

28. 5.Economists use economic models both for positive economics, which describes how the economy works, and for normative economics, which prescribes how the economy should work. Positive economics often involves making forecasts. Economists can determine correct answers for positive questions, but typically not for normative questions, which involve value judgments. 6.There are two main reasons economists disagree. One, they may disagree about which simplifications to make in a model. Two, economists may disagree—like everyone else—about values. Summary