CHPATER 2 Thinking Like an Economist LEARNING OBJECTIVES: How economists apply the methods of science. Two simple models the circular flow and the production possibilities frontier. The difference between microeconomics and macroeconomics. The difference between positive and normative statements. 1
The Economist as Scientist Economists Follow the Scientific Method. Observations help us to develop theory. Data can be collected and analyzed to evaluate theories. Using data to evaluate theories is more difficult in economics than in physical science because economists are unable to generate their own data and must make do with whatever data are available. Thus, economists pay close attention to the natural experiments offered by history. 2
Assumptions and Economic Models Economists make assumptions for the same reason: Assumptions can simplify the complex world and make it easier to understand. Example. To understand international trade, it may be helpful to start out assuming that there are only two countries in the world producing only two goods. Once we understand how trade would work between these two countries, we can extend our analysis to a greater number of countries and goods. 3
Assumptions and Economic Models Economists use different assumptions to answer different questions. Economists Use Economic Models to Explain the World Around Us. the circular flow the production possibilities frontier 4
Our First Model : The Circular-Flow Diagram Definition of circular-flow diagram: a visual model of the economy that shows how dollars flow through markets among households and firms. There are two decision makers in the model: households and firms. There are two markets: the market for goods and services and the market for factors of production. Firms produce goods and services using inputs, such as: Labor Land Capital (buildings and machines) 5
Figure 1. The circular flow Revenue Goods and services hold spending Goods and services bought Factors of production Labor, land, and capital Wages, rent, and profit Income 6
Course Work 1 Draw a circular-flow diagram. Identify the parts of the model that correspond to the flow of goods and services and the flow of dollars for each of the following activities. a. Elena pays a storekeeper $1 for a quart of milk. b. Stuart earns $4.50 per hour working at a fast-food restaurant. c. Shanna spends $30 to get a haircut. d. Sally earns %10,000 from her 10 percent ownership of Acme Industrial. 7
Our Second Model: The Production Possibilities Frontier (PPF) Definition of production possibilities frontier: 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. Let s assume an economy that produces only two goods - cars and computers. Together, the car industry and the computer industry use all of the economy s factors of production. If the economy uses all its resources in the car industry, it produces 1000 cars and no computers. If the economy uses all its resources in the computer industry, it produces no cars and 3000 computers. The economy divides its resources between the two industries: A. 600 cars and 2200 computers B. 700 cars and 2000 computers 8
Our Second Model: The Production Possibilities Frontier (PPF) Quantity of Computers produced 3,000 2,200 2,000 A B Production Possibilities frontier 0 600 700 1,000 Quantity of Cars produced 9
Because resources are scarce, not every conceivable outcome is feasible. With the resources it has, the economy can produce at any point on or inside the PPF, but it cannot produce at points outside the frontier. Quantity of Computers produced 3,000 C The economy cannot produce the amount of cars and computers represented by point C. 2,200 2,000 A B D 0 600 700 1,000 Quantity of Cars produced 10
An outcome is said to be efficient if the economy is getting all it can from the scarce resources it has available. D A:cars 300 600, computers 1000 2200 D B:cars 300 700, computers 1000 2000 Quantity of Computers produced 3,000 Points on the production PPF represent efficient levels of production. 2,200 2,000 A B 1,000 D 0 300 600 700 1,000 Quantity of Cars produced 11
The PPF shows one trade-off that society faces. A B:It gives up 200 computers to get 100 additional cars. At point A, the opportunity cost of 100 cars is 200 computers Quantity of Computers produced (Y) 3,000 2,200 2,000 A B 0 600 700 1,000 Quantity of 12 Cars produced (X)
The opportunity cost of a car in term of the number of computer is not constant in this economy but depends on how many cars and computers the economy is producing. Quantity of Computers produced (Y) 3,000 F When the economy is producing few cars and many computers, the frontier is flatter, and the opportunity cost of a car is lower. 2,200 2,000 A B When the economy is producing many cars and few computers, the frontier is step, and the opportunity cost of a car is higher. E 0 600 700 1,000 Quantity of 13 Cars produced (X)
The PPF shows the trade-off between the outputs of different goods at a given time, but the trade-off can change over time. Quantity of Computers produced (Y) 4,000 A technological advance in the computer industry raises the number of computers that a worker can produce per week. 3,000 2,100 2,000 A G Society can move production from a point on the old frontier to a point on the new frontier. 0 700 750 1,000 Quantity of 14 Cars produced (X)
Course Work 2 Two goods: computers and wheat. One resource: labor (measured in hours) Economy has 50,000 labor hours per month available for production. Producing one computer requires 100 hours labor. Producing one ton of wheat requires 10 hours labor. Employment of labor hours Computers Wheat Production Computers Wheat A 50,000 B 40,000 C 25,000 D 10,000 E 0 15
Course Work 2 Point on graph A B C D E Production Computers Wheat Wheat (tons) 6,000 5,000 4,000 3,000 2,000 1,000 0 0 100 200 300 400 500 600 Computers 16
Course Work 2 On the graph, find the point that represents (100 computers, 3000 tons of wheat), label it F. Would it be possible for the economy to produce this combination of the two goods? Why or why not? Next, find the point that represents (300 computers, 3500 tons of wheat), label it G. Would it be possible for the economy to produce this combination of the two goods? 17
Course Work 3 In which country is the opportunity cost of cloth lower? Wine FRANCE Wine ENGLAND 600 600 500 500 400 400 300 300 200 200 100 100 0 0 100 200 300 400 Cloth 0 0 100 200 300 400 Cloth 18 18
Microeconomics and Macroeconomics Definition of microeconomics: the study of how households and firms make decisions and how they interact in markets. Definition of macroeconomics: the study of economy-wide phenomena, including inflation, unemployment, and economic growth. 19
Positive versus Normative Analysis Definition of positive statements: claims that attempt to describe the world as it is. Definition of normative statements: claims that attempt to prescribe how the world should be. Example. the minimum wage causes unemployment the government should raise the minimum wage. 20