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Thinking Like an EconomistThinking Like an Economist

Thinking Like an EconomistThinking Like an Economist

Every field of study has its own terminologyEvery field of study has its own terminology– MathematicsMathematics

integrals integrals axioms axioms vector spaces vector spaces

– PsychologyPsychology ego ego id id cognitive dissonance cognitive dissonance

– LawLaw promissory promissory estoppel estoppel torts torts venues venues

– EconomicsEconomics supply supply opportunity cost opportunity cost elasticity elasticity consumer surplus consumer surplus

demand demand comparative advantage comparative advantage deadweight loss deadweight loss

Thinking Like an EconomistThinking Like an Economist

Economics trains you to. . . . Economics trains you to. . . . – Think in terms of alternatives.Think in terms of alternatives.– Evaluate the cost of individual and social Evaluate the cost of individual and social

choices.choices.– Examine and understand how certain events Examine and understand how certain events

and issues are related.and issues are related.

THE ECONOMIST AS A THE ECONOMIST AS A SCIENTISTSCIENTIST

The economic way of thinking . . .The economic way of thinking . . .– Involves thinking analytically and objectively.Involves thinking analytically and objectively.– Makes use of the scientific method.Makes use of the scientific method.

The Scientific Method: Observation, The Scientific Method: Observation, Theory, and More ObservationTheory, and More Observation

Uses abstract models to help explain how a Uses abstract models to help explain how a complex, real world operates.complex, real world operates.

Develops theories, collects, and analyzes Develops theories, collects, and analyzes data to evaluate the theories.data to evaluate the theories.

The Role of AssumptionsThe Role of Assumptions

Economists make assumptions in order to Economists make assumptions in order to make the world easier to understand.make the world easier to understand.

The art in scientific thinking is deciding The art in scientific thinking is deciding which assumptions to make.which assumptions to make.

Economists use different assumptions to Economists use different assumptions to answer different questions.answer different questions.

Economic ModelsEconomic Models

Economists use models to simplify reality in Economists use models to simplify reality in order to improve our understanding of the order to improve our understanding of the worldworld

Two of the most basic economic models Two of the most basic economic models include:include:– The Circular Flow DiagramThe Circular Flow Diagram– The Production Possibilities FrontierThe Production Possibilities Frontier

Our First Model: The Circular-Flow Our First Model: The Circular-Flow DiagramDiagram

The The circular-flow diagramcircular-flow diagram is a visual model of is a visual model of the economy that shows how dollars flow the economy that shows how dollars flow through markets among households and through markets among households and firms.firms.

Figure 1 The Circular FlowFigure 1 The Circular Flow

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Spending

Goods andservicesbought

Revenue

Goodsand servicessold

Labor, land,and capital

Income

= Flow of inputs and outputs

= Flow of dollars

Factors ofproduction

Wages, rent,and profit

FIRMS•Produce and sellgoods and services

•Hire and use factorsof production

•Buy and consumegoods and services

•Own and sell factorsof production

HOUSEHOLDS

•Households sell•Firms buy

MARKETSFOR

FACTORS OF PRODUCTION

•Firms sell•Households buy

MARKETSFOR

GOODS AND SERVICES

Our First Model: The Circular-Flow Our First Model: The Circular-Flow DiagramDiagram

FirmsFirms– Produce and sell goods and servicesProduce and sell goods and services– Hire and use factors of productionHire and use factors of production

HouseholdsHouseholds– Buy and consume goods and servicesBuy and consume goods and services– Own and sell factors of productionOwn and sell factors of production

Our First Model: The Circular-Flow Our First Model: The Circular-Flow DiagramDiagram

Markets for Goods and ServicesMarkets for Goods and Services– Firms sellFirms sell– Households buyHouseholds buy

Markets for Factors of ProductionMarkets for Factors of Production– Households sellHouseholds sell– Firms buyFirms buy

Our First Model: The Circular-Flow Our First Model: The Circular-Flow DiagramDiagram

Factors of ProductionFactors of Production– Inputs used to produce goods and servicesInputs used to produce goods and services– Land, labor, and capitalLand, labor, and capital

Our Second Model: The Production Our Second Model: The Production Possibilities FrontierPossibilities Frontier The The production possibilities frontierproduction possibilities frontier is a graph is a graph

that shows the combinations of output that that shows the combinations of output that the economy can possibly produce given the the economy can possibly produce given the available factors of production and the available factors of production and the available production technology.available production technology.

Figure 2 The Production Possibilities FrontierFigure 2 The Production Possibilities Frontier

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Productionpossibilitiesfrontier

A

B

C

Quantity ofCars Produced

2,200

600

1,000

3000 700

2,000

3,000

1,000

Quantity ofComputers

Produced

D

Our Second Model: The Production Our Second Model: The Production Possibilities FrontierPossibilities Frontier Concepts Illustrated by the Production Concepts Illustrated by the Production

Possibilities Frontier Possibilities Frontier – EfficiencyEfficiency– TradeoffsTradeoffs– Opportunity CostOpportunity Cost– Economic GrowthEconomic Growth

Figure 3 A Shift in the Production Possibilities Figure 3 A Shift in the Production Possibilities FrontierFrontier

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E

Quantity ofCars Produced

2,000

700

2,100

7500

4,000

3,000

1,000

Quantity ofComputers

Produced

A

Microeconomics and MacroeconomicsMicroeconomics and Macroeconomics

MicroeconomicsMicroeconomics focuses on the individual focuses on the individual parts of the economy.parts of the economy.– How households and firms make decisions and How households and firms make decisions and

how they interact in specific marketshow they interact in specific markets

MacroeconomicsMacroeconomics looks at the economy as a looks at the economy as a whole.whole.– Economy-wide phenomena, including inflation, Economy-wide phenomena, including inflation,

unemployment, and economic growthunemployment, and economic growth

THE ECONOMIST AS POLICY THE ECONOMIST AS POLICY ADVISORADVISOR

When economists are trying to explain the When economists are trying to explain the world, they are scientists.world, they are scientists.

When economists are trying to change the When economists are trying to change the world, they are policy advisor.world, they are policy advisor.

POSITIVE VERSUS NORMATIVE POSITIVE VERSUS NORMATIVE ANALYSISANALYSIS

Positive statementsPositive statements are statements that are statements that attempt to describe the world as it is.attempt to describe the world as it is.– Called descriptive analysisCalled descriptive analysis

Normative statementsNormative statements are statements about are statements about how the world should be.how the world should be.– Called prescriptive analysisCalled prescriptive analysis

Positive or Normative Statements? Positive or Normative Statements? – An increase in the minimum wage will cause a An increase in the minimum wage will cause a

decrease in employment among the least-decrease in employment among the least-skilled.skilled.

POSITIVEPOSITIVE

– Higher federal budget deficits will cause interest Higher federal budget deficits will cause interest rates to increase.rates to increase.

POSITIVEPOSITIVE

?

?POSITIVE VERSUS POSITIVE VERSUS

NORMATIVE ANALYSISNORMATIVE ANALYSIS

?

Positive or Normative Statements? Positive or Normative Statements? – The income gains from a higher minimum wage are The income gains from a higher minimum wage are

worth more than any slight reductions in worth more than any slight reductions in employment.employment.

NORMATIVENORMATIVE

– State governments should be allowed to collect State governments should be allowed to collect from tobacco companies the costs of treating from tobacco companies the costs of treating smoking-related illnesses among the poor.smoking-related illnesses among the poor.

NORMATIVENORMATIVE

?

?POSITIVE VERSUS POSITIVE VERSUS

NORMATIVE ANALYSISNORMATIVE ANALYSIS

?

Economists in WashingtonEconomists in Washington

. . . serve as advisers in the policymaking . . . serve as advisers in the policymaking process of the three branches of process of the three branches of government:government:– LegislativeLegislative– ExecutiveExecutive– JudicialJudicial

Economists in WashingtonEconomists in Washington

Some government agencies that collect Some government agencies that collect economic data and make economic policy:economic data and make economic policy:– Department of CommerceDepartment of Commerce

http://www.commerce.govhttp://www.commerce.gov

– Bureau of Labor StatisticsBureau of Labor Statistics http://www.bls.govhttp://www.bls.gov

– Congressional Budget OfficeCongressional Budget Office http://www.cbo.govhttp://www.cbo.gov

– Federal Reserve BoardFederal Reserve Board http://www.federalreserve.govhttp://www.federalreserve.gov

WHY ECONOMISTS DISAGREEWHY ECONOMISTS DISAGREE

They may disagree about the validity of They may disagree about the validity of alternative positive theories about how the alternative positive theories about how the world works.world works.

They may have different values and, They may have different values and, therefore, different normative views about therefore, different normative views about what policy should try to accomplish. what policy should try to accomplish.

Table 2 Ten Propositions about Which Most Table 2 Ten Propositions about Which Most Economists AgreeEconomists Agree

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SummarySummary

Economists try to address their subjects Economists try to address their subjects with a scientist’s objectivity.with a scientist’s objectivity.– They make appropriate assumptions and build They make appropriate assumptions and build

simplified models in order to understand the simplified models in order to understand the world around them.world around them.

– Two simple economic models are the circular-Two simple economic models are the circular-flow diagram and the production possibilities flow diagram and the production possibilities frontier.frontier.

SummarySummary

Economics is divided into two subfields:Economics is divided into two subfields:– Microeconomists study decisionmaking by Microeconomists study decisionmaking by

households and firms in the marketplace.households and firms in the marketplace.– Macroeconomists study the forces and trends Macroeconomists study the forces and trends

that affect the economy as a wholethat affect the economy as a whole

SummarySummary

A positive statement is an assertion about A positive statement is an assertion about how the world is.how the world is.

A normative statement is an assertion about A normative statement is an assertion about how the world ought to be.how the world ought to be.

When economists make normative When economists make normative statements, they are acting more as policy statements, they are acting more as policy advisors than scientists.advisors than scientists.

SummarySummary

Economists who advise policymakers offer Economists who advise policymakers offer conflicting advice either because of conflicting advice either because of differences in scientific judgments or differences in scientific judgments or because of differences in values.because of differences in values.

At other times, economists are united in the At other times, economists are united in the advice they offer, but policymakers may advice they offer, but policymakers may choose to ignore it.choose to ignore it.