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

Chapter 2:Chapter 2:

Thinking like an Thinking like an EconomistEconomist

Chapter 2:Chapter 2:

Thinking like an Thinking like an EconomistEconomist

ObjectivesObjectivesObjectivesObjectives

1.) The Economist as Scientist

2.) The Scientific Method

3.) Observation, Theory, Assumptions

Every field of study has its own Every field of study has its own terminologyterminology

Every field of study has its own Every field of study has its own terminologyterminology

Mathematics

axiomsintegrals

vector spacesPsychology

egoid

cognitive dissonanceLaw

torts

venues

Promissory estoppel

Every field of study has its Every field of study has its own terminologyown terminology

Every field of study has its Every field of study has its own terminologyown terminology

Economics

Supply

Demand

Elasticity

Consumer Surplus

Comparative advantage

Opportunity cost

Deadweight loss

Economics trains you to. . . . Economics trains you to. . . .

Think in terms of alternatives.Think in terms of alternatives. Evaluate the cost of individual and Evaluate the cost of individual and

social choices.social choices. Examine and understand how certain Examine and understand how certain

events and issues are related.events and issues are related.

The Economist as a ScientistThe Economist as a Scientist

The economic way of thinking . . .The economic way of thinking . . . Involves thinking analyticallyInvolves thinking analytically andand

objectively.objectively.Makes use of theMakes use of the scientific methodscientific method..

The Scientific MethodThe Scientific Method

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

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

Observation, Theory and More Observation!

The Role of AssumptionsThe Role of AssumptionsThe Role of AssumptionsThe Role of Assumptions

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

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

The Economic Way of ThinkingThe Economic Way of Thinking

Includes developing Includes developing abstract modelsabstract models from theories and thefrom theories and the analysis of the analysis of the models.models.

Uses two approaches:Uses two approaches:

Descriptive (reporting facts, etc.) Analytical (abstract reasoning)

What is an Economic What is an Economic Model?Model?

What is an Economic What is an Economic Model?Model?

An Economic Model is a simplified, An Economic Model is a simplified, small-scale version of some aspect of small-scale version of some aspect of the economy.the economy.

Economic Models are often expressed Economic Models are often expressed in equations, by graphs, or in words.in equations, by graphs, or in words.

An Economic Model is a simplified, An Economic Model is a simplified, small-scale version of some aspect of small-scale version of some aspect of the economy.the economy.

Economic Models are often expressed Economic Models are often expressed in equations, by graphs, or in words.in equations, by graphs, or in words.

Two Examples of Two Examples of Economic Models are:Economic Models are:

Two Examples of Two Examples of Economic Models are:Economic Models are:

1.) Circular - flow diagram1.) Circular - flow diagram

2.) The Production Possibilities 2.) The Production Possibilities FrontierFrontier

1.) Circular - flow diagram1.) Circular - flow diagram

2.) The Production Possibilities 2.) The Production Possibilities FrontierFrontier

MARKETS FORGOODS AND SERVICES

•Firms sell •Households buy

MARKETS FORFACTORS OFPRODUCTION

• 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, rentand profit

Inputs forproduction

Goods andservices sold

Goods andservices bought

Spending

Labor, land,and capital

Revenue

Income = Flow of goodsand services

= Flow of dollars

The Circular Flow(Figure 2-1)

The Circular-Flow DiagramThe Circular-Flow Diagram

Households

Buy and consume goods and services

Own and sell factors of production

Firms

Produce and sell goods and services

Hire and use factors of production

The Circular-Flow DiagramThe Circular-Flow Diagram

Markets for Factors of Production

Households sell

Firms buy

Markets for Goods & Services

Firms sell

Households buy

The Circular-Flow DiagramThe Circular-Flow DiagramThe Circular-Flow DiagramThe Circular-Flow Diagram

Factors of ProductionFactors of Production

Inputs used to produce goods and Inputs used to produce goods and servicesservices

Land, labor, and capitalLand, labor, and capital

Factors of ProductionFactors of Production

Inputs used to produce goods and Inputs used to produce goods and servicesservices

Land, labor, and capitalLand, labor, and capital

The Production Possibilities The Production Possibilities FrontierFrontier

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

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

0

1,000

2,000

3,000

2,200

300 600 700 1,000

B

A

C

D

Quantity ofComputersProduced

Quantity ofCars Produceed

The Production Possibilities Frontier

(Figure 2-2)

Concepts Illustrated by the Production Concepts Illustrated by the Production Possibilities FrontierPossibilities Frontier

EfficiencyEfficiency TradeoffsTradeoffs Opportunity CostOpportunity Cost Economic GrowthEconomic Growth

2,1002,000

3,000

4,000

0

A

E

700 750 1,000 Quantity ofCars Produced

Quantity ofComputers

Produced

A Shift in theProductionPossibilities

Frontier(Figure 2-3)

MicroeconomicsMicroeconomicsMicroeconomicsMicroeconomics

Microeconomics is the study of how Microeconomics is the study of how households and firms make decisions and households and firms make decisions and how they interact in markets.how they interact in markets.

Goal: to explain the prices and quantities Goal: to explain the prices and quantities of individual goods and services.of individual goods and services.

Microeconomics is the study of how Microeconomics is the study of how households and firms make decisions and households and firms make decisions and how they interact in markets.how they interact in markets.

Goal: to explain the prices and quantities Goal: to explain the prices and quantities of individual goods and services.of individual goods and services.

Macroeconomics is the study of the national Macroeconomics is the study of the national economy and the global economy and the way economy and the global economy and the way that economic aggregates grow and fluctuate.that economic aggregates grow and fluctuate.

Goal: to explain average prices and total Goal: to explain average prices and total employment, income, inflation and economic employment, income, inflation and economic growth.growth.

Macroeconomics is the study of the national Macroeconomics is the study of the national economy and the global economy and the way economy and the global economy and the way that economic aggregates grow and fluctuate.that economic aggregates grow and fluctuate.

Goal: to explain average prices and total Goal: to explain average prices and total employment, income, inflation and economic employment, income, inflation and economic growth.growth.

MacroeconomicsMacroeconomicsMacroeconomicsMacroeconomics

Two Roles of EconomistsTwo Roles of Economists

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

When they are trying to change the When they are trying to change the world, they are world, they are policymakers.policymakers.

Role of EconomistsRole of EconomistsRole of EconomistsRole 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?Positive or Normative Statements?Positive or Normative Statements?Positive or Normative Statements?

An increase in the minimum wage will An increase in the minimum wage will cause a decrease in employment among cause a decrease in employment among

the least-skilled.the least-skilled.

An increase in the minimum wage will An increase in the minimum wage will cause a decrease in employment among cause a decrease in employment among

the least-skilled.the least-skilled.

?

?

?

Positive or Normative Statements?Positive or Normative Statements?Positive or Normative Statements?Positive or Normative Statements?

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

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

?

? ?

?

Positive or Normative Statements?Positive or Normative Statements?Positive or Normative Statements?Positive or Normative Statements?

The income gains from a higher The income gains from a higher minimum wage are worth more than minimum wage are worth more than any slight reductions in employment.any slight reductions in employment.

The income gains from a higher The income gains from a higher minimum wage are worth more than minimum wage are worth more than any slight reductions in employment.any slight reductions in employment.

?

??Positive or Normative Statements?Positive or Normative Statements?Positive or Normative Statements?Positive or Normative Statements?

State governments should be allowed to State governments should be allowed to collect from tobacco companies the costs collect from tobacco companies the costs

of treating smoking-related illnesses of treating smoking-related illnesses among the poor.among the poor.

State governments should be allowed to State governments should be allowed to collect from tobacco companies the costs collect from tobacco companies the costs

of treating smoking-related illnesses of treating smoking-related illnesses among the poor.among the poor.

Economists in Washington . . .Economists in Washington . . .

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

1.) Differences in scientific 1.) Differences in scientific judgments.judgments.

2.) Differences in values.2.) Differences in values.

1.) Differences in scientific 1.) Differences in scientific judgments.judgments.

2.) Differences in values.2.) Differences in values.

Why Economists Disagree?Why Economists Disagree?Why Economists Disagree?Why Economists Disagree?

PROPOSITION AND PERCENTAGE OF PROPOSITION AND PERCENTAGE OF ECONOMISTS WHO AGREEECONOMISTS WHO AGREE


1. A ceiling on rents reduces the quantity and quality 1. A ceiling on rents reduces the quantity and quality of housing available. (93%)of housing available. (93%)

2. Tariffs and import quotas usually reduce general 2. Tariffs and import quotas usually reduce general economic welfare. (93%)economic welfare. (93%)

3. Flexible and floating exchange rates offer an 3. Flexible and floating exchange rates offer an effective international monetary arrangement. effective international monetary arrangement. (90%)(90%)

1. A ceiling on rents reduces the quantity and quality 1. A ceiling on rents reduces the quantity and quality of housing available. (93%)of housing available. (93%)

2. Tariffs and import quotas usually reduce general 2. Tariffs and import quotas usually reduce general economic welfare. (93%)economic welfare. (93%)

3. Flexible and floating exchange rates offer an 3. Flexible and floating exchange rates offer an effective international monetary arrangement. effective international monetary arrangement. (90%)(90%)

4.4. Fiscal policy (e.g., tax cut and/or government Fiscal policy (e.g., tax cut and/or government expenditure increase) has a significant stimulative expenditure increase) has a significant stimulative impact on less then fully employed economy. impact on less then fully employed economy. (90%)(90%)

5. If the federal budget is to be balanced, it should be 5. If the federal budget is to be balanced, it should be done over the business cycle rather than yearly. done over the business cycle rather than yearly. (85%)(85%)

6. Cash payments increase the welfare of recipients 6. Cash payments increase the welfare of recipients to a greater degree than do transfers-in-kind of to a greater degree than do transfers-in-kind of equal cash value. (84%)equal cash value. (84%)

4.4. Fiscal policy (e.g., tax cut and/or government Fiscal policy (e.g., tax cut and/or government expenditure increase) has a significant stimulative expenditure increase) has a significant stimulative impact on less then fully employed economy. impact on less then fully employed economy. (90%)(90%)

5. If the federal budget is to be balanced, it should be 5. If the federal budget is to be balanced, it should be done over the business cycle rather than yearly. done over the business cycle rather than yearly. (85%)(85%)

6. Cash payments increase the welfare of recipients 6. Cash payments increase the welfare of recipients to a greater degree than do transfers-in-kind of to a greater degree than do transfers-in-kind of equal cash value. (84%)equal cash value. (84%)



7. A large federal budget deficit has an adverse 7. A large federal budget deficit has an adverse effect on the economy. (83%)effect on the economy. (83%)

8. The minimum wage increases unemployment 8. The minimum wage increases unemployment among young and unskilled workers. (79%)among young and unskilled workers. (79%)

9. The government should restructure the welfare 9. The government should restructure the welfare system along the lines of a “negative income tax.” system along the lines of a “negative income tax.” (79%)(79%)

10. Effluent taxes and marketable pollution permits 10. Effluent taxes and marketable pollution permits represent a better approach to pollution control represent a better approach to pollution control than imposition of pollution ceilings. (78%)than imposition of pollution ceilings. (78%)

7. A large federal budget deficit has an adverse 7. A large federal budget deficit has an adverse effect on the economy. (83%)effect on the economy. (83%)

8. The minimum wage increases unemployment 8. The minimum wage increases unemployment among young and unskilled workers. (79%)among young and unskilled workers. (79%)

9. The government should restructure the welfare 9. The government should restructure the welfare system along the lines of a “negative income tax.” system along the lines of a “negative income tax.” (79%)(79%)

10. Effluent taxes and marketable pollution permits 10. Effluent taxes and marketable pollution permits represent a better approach to pollution control represent a better approach to pollution control than imposition of pollution ceilings. (78%)than imposition of pollution ceilings. (78%)



Demand Curve

0

2

4

6

8

10

12

0 5 10 15 20 25 30

Quantity of Novels Purchased

Pri

ce o

f N

ovel

s

Price $20,000 $30,000 $40,000

$10 2 novels 5 novels 8 novels

9 6 9 12

8 10 13 16

7 14 17 20

6 18 21 24

5 22 25 28

Income

Novels Purchased by Emma B.

Shifting Demand Curves

0

2

4

6

8

10

12

0 5 10 15 20 25 30


Pri

ce o

f Nov

els

$20,000 $30,000 $40,000

When incomedecreases, the demandcurve shifts to the left.

When incomeincreases, the demandcurve shifts to the right.

Calculating the Slope

0

2

4

6

8

10

12

0 10 20 30


Pri

ce o

f N

ovel

s

Demand

SummarySummary

In order to address subjects with In order to address subjects with objectivity, economics makes use of objectivity, economics makes use of the scientific method. the scientific method.

The field of economics is divided into The field of economics is divided into two subfields: microeconomics and two subfields: microeconomics and macroeconomics.macroeconomics.

SummarySummary

Economics relies on both positive and Economics relies on both positive and normative analysis. Positive normative analysis. Positive statements assert how the world “is” statements assert how the world “is” while normative statements assert how while normative statements assert how the world “should be.”the world “should be.”

Economists may offer conflicting Economists may offer conflicting advice due to differences in scientific advice due to differences in scientific judgments or to differences in values.judgments or to differences in values.

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

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