Transcript Chapter 3
CHAPTER 3 Thinking Like an Economist 3-1 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Questions • Is economics a science? • What do economists mean by a model? • Why do economists use mathematical models so much? • What patterns and habits of thought must you learn to successfully think like an economist? 3-2 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Economics • is a social science – focuses on human beings and how they behave • debates within economics last longer than those in natural sciences – less likely to end in consensus • economists are unable to undertake largescale experiments • the subjects studied by economists--people-have minds of their own – expectations of the future play an important role 3-3 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Importance of Expectations: An Example • The stock market crash of 1929 changed what Americans expected about the future of the economy spending production layoffs income • Expectations that future income would be lower became realized 3-4 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Figure 3.1 - The Stock Market, 1928-1932 3-5 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Economics • is a quantitative science – uses arithmetic to measure economic variables of interest – uses mathematical models to relate economic variables of interest • involves a particular way of thinking about the world using – unique technical language – a specific set of data 3-6 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Economists • use a special set of analogies and metaphors to describe the functioning of the macroeconomy – curves “shift” – money has a “velocity” – the central bank “pushes the economy up the Phillips curve” 3-7 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Figure 3.2 - Pushing the Economy Up the Phillips Curve 3-8 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Dominant Concepts • the image of the “circular flow of economic activity” • the use of the word “market” • the idea of “equilibrium” • use of graphs and diagrams 3-9 – equations depicted by geometric curves – situations of equilibrium occur where curves cross – changes in economy demonstrated by shifts in the curves Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Circular Flow • patterns of spending, income, and production flowing through the economy – flow of purchasing power 3-10 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Circular Flow • “income side” – firms buy the factors of production from households – money payments flow from firms to households • “expenditure side” – households buy goods and services from firms – money payments flow from households to firms 3-11 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Figure 3.3 - The Circular Flow Diagram 3-12 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Circular Flow • can be made to be more realistic by adding – the government – financial markets – international trade and finance 3-13 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Figure 3.4 - The Circular Flow of Economic Activity 3-14 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Different Measures of the Circular Flow • “expenditure side” measure – consumption – investment – government purchases – net exports • “income side” measure – purchases of labor, capital, and natural resources owned directly or indirectly by households 3-15 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Different Measures of the Circular Flow • “uses of income” measure – where households decide to use their income • saving • taxes • consumption 3-16 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Markets • are used as a metaphor for the complex processes of matching and exchange that take place in the economy – economists assume that buyers and sellers are well-informed about prevailing prices and quantities 3-17 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Equilibrium • is a point (or points) of balance at which some economic quantity is neither rising nor falling – once equilibrium is identified, economists can determine how fast economic forces will push the economy to the points of equilibrium 3-18 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Graphs and Equations • an algebraic equation relating two variables can also be represented as a curve drawn on a graph • the solution to a set of two equations is the point on a graph where the two curves that represent the equations intersect 3-19 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Figure 3.5 - Two Forms of the Production Function 3-20 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Using Graphs Instead of Equations • behavioral relationships become curves that shift around on a graph • conditions of economic equilibrium can be represented by the points where the curves describing behavioral relationships intersect 3-21 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Using Graphs Instead of Equations • changes in the state of the economy can be shown as movements in the intersection of the curves 3-22 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Building Models • restrict the problem to only a few behavioral relationships and equilibrium conditions • capture these relationships and equilibrium conditions in simple algebraic equations – use diagrams to represent the equations • apply the model to the real world 3-23 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Important Concepts in Macroeonomic Models • representative agents – assume that all participants in the economy are the same – examine the decision-making of one individual and then generalize to the economy as a whole 3-24 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Important Concepts in Macroeonomic Models • opportunity costs – occur when any decision is made – measured by the value of the best alternative foregone 3-25 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Important Concepts in Macroeonomic Models • expectation formation – macroeconomic models must explain • the amount of time people spend thinking about the future • the information that people have available • the rules of thumb used to turn information into expectations 3-26 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Important Concepts in Macroeonomic Models • expectation formation – static expectations • decision makers do not think about the future – adaptive expectations • decision makers assume that the future is going to be like the recent past 3-27 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Important Concepts in Macroeonomic Models • expectation formation – rational expectations • decision makers spend as much time as they can thinking about the future and know as much about the structure and behavior of the economy as the model builder does 3-28 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Building and Solving an Economic Model • write equations that represent behavioral relationships – state how the “effects” are related to the “causes” • draw a diagram to help visualize the relationship • consider equilibrium conditions – can be shown as intersections on diagram 3-29 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Building and Solving an Economic Model: An Example • The production function relates – the economy’s capital-labor ratio (K/L) – the level of technology or efficiency of the labor force (E) – the level of real GDP per worker (Y/L) Y/L F(K/L, Et ) • Cobb-Douglas production function Y/L (K/L) E1t- 3-30 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Building and Solving an Economic Model: An Example • Equilibrium condition for balanced growth – the ratio of the economy’s capital stock (K) to its level of output (Y) must be constant s K/Y * ng 3-31 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Building and Solving an Economic Model: An Example • Equilibrium condition for balanced growth s K/Y κ* ngδ • s=share of total income in the economy saved and invested • n=proportional growth rate of the labor force • g=proportional growth rate of the efficiency of the labor force • =the depreciation rate 3-32 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Building and Solving an Economic Model: An Example • arithmetic can be used to determine the steady-state output per worker – Let E=$10,000, =1/2, s=25%, n=1%, g=1%, and =3%. s 25% K/Y κ* 5 n g δ 1% 1% 3% 3-33 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Building and Solving an Economic Model: An Example s 25% K/Y κ* 5 n g δ 1% 1% 3% • since K/Y=5, this must imply that K/L=5 Y/L • substituting for and Et in the CobbDouglas production function (0.5) Y/L (K/L) 3-34 (0.5) 10,000 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Building and Solving an Economic Model: An Example • in equilibrium, both conditions must hold K/L 5 Y/L 5 K/L 100 K/L $250,000 Y/L $50,000 3-35 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Building and Solving an Economic Model: An Example • algebra can be used to determine the steady-state output per worker Y/L (K/L) E1- 1- Y/L [(Y/L) (K/Y)] E (Y/L)1- (K/Y) E1- 3-36 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Building and Solving an Economic Model: An Example 1 (Y/L) (K/Y) E • putting in the balanced-growth condition s (Y/L) n g 3-37 1 E Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Building and Solving an Economic Model: An Example • Let E=$10,000, =1/2, s=25%, n=1%, g=1%, and =3% 0.25 (Y/L) .01 .01 .03 0 .5 0 .5 10,000 (Y/L) $50,000 3-38 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Building and Solving an Economic Model: An Example • graphs can also be used to show the steady-state output per worker – the production function can be drawn with output per worker (Y/L) on the vertical axis and capital per worker (K/L) on the horizontal axis – the equilibrium condition for balanced growth can also be shown • K/L=s/(n+g+) 3-39 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Figure 3.6 - Equilibrium Output per Worker 3-40 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Advantages of Using Algebra • best way to summarize cause-andeffect behavioral relationships – allows us to consider different possible systematic relationships by changing the value of parameters 3-41 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Figure 3.7 - A Single Equation, a Host of Relationships 3-42 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Figure 3.8 - Changing Parameter Values and the Shape of the Cobb-Douglas Production Function 3-43 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Figure 3.9 - The Effect of Changes in the Efficiency of Labor on the Shape of the Production Function 3-44 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Summary • Don’t be surprised to find economists’ ways of thinking strange and new-that is always the case when you learn any new intellectual discipline • Don’t be surprised to find economics more abstract than you thought – Today’s economic courses focus more on analytic tools and chains of reasoning and less on institutional descriptions 3-45 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Summary • Economics is a relatively mathematical subject because so much of what it analyzes can be measured – Economists use arithmetic to count things and use algebra because it is the best way to analyze and understand arithmetic 3-46 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Summary • When macroeconomists build models, they usually follow four key strategies – strip down a complicated process to a few economy-wide behavioral relationships and equilibrium conditions – ignore differences between people in the economy – look at opportunity costs – focus on expectations of the future 3-47 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.