Transcript Thinking Like an Economist

THINKING LIKE AN
ECONOMIST
Chapter 2
Economist as Scientist



Economists try to address their subject with a scientific
objectivity. The essence of science is the scientific
method.
Scientific methods...
 start from crude observation
 then develop a rigorous theory or model that explains
the observed phenomenon
 finally test the theory by collecting and analyzing
data from many different sources.
Hence scientific methods include...
 developing abstract models and the analysis of the
models:deductive or analytical method
 collecting and analyzing data systematically:
inductive or empirical method
Economic Models


The purpose of models is to learn about reality
in a simple and intuitive way and not to capture
all the details of reality.
Learning anatomy with plastic models of the
human body
Economists use models, often composed of
diagrams and equations
In simplifying the reality, the role of
assumptions is important. The art in scientific
thinking is deciding which assumptions to
make.
Our First Model: The
Circular-Flow Model
The economy consists of millions of
people engaged in many activities.
 The circular-flow model is a simple way
to visually show the economic
transactions that occur between
households and firms in the economy.

The Circular-Flow Diagram
Market for Goods and
Services
Firms
Households
Market for Factors of
Production
The Circular-Flow Diagram
Market for Goods and
Services
Revenue
Spending
Firms
Households
Market for Factors of
Production
The Circular-Flow Diagram
Market for Goods and
Services
Revenue
Spending
Firms
Households
Wage, rent,
and profit
Income
Market for Factors of
Production
The Circular-Flow Diagram
Market for Goods and
Services
Revenue
Spending
Firms
Wage, rent,
and profit
Households
Inputs for
production
Labor, land
and capital
Market for Factors of
Production
Income
The Circular-Flow Diagram
Market for Goods and
Services
Revenue
Goods and
services sold
Goods and
services bought
Firms
Wage, rent,
and profit
Spending
Households
Inputs for
production
Labor, land
and capital
Market for Factors of
Production
Income
Revenue
Goods
and services
sold
MARKETS
FOR
GOODS AND SERVICES
Firms sell
Households buy
FIRMS
Produce and sell
goods and services.
Hire and use factors
of production.
Inputs for
production
Wages, rent,
and profit
Figure 2-1
Spending
Goods and
services
bought
HOUSEHOLDS
Buy and consume
goods and services.
Own and sell factors
of production.
MARKETS
FOR
FACTORS OF PRODUCTION
Households sell
Firms buy
Labor, land,
and capital
Income
5 Flow of goods
and services
5
Flow of dollars
Our Second Model: The
Production Possibilities
Frontier
The production possibilities frontier is a
graph showing the various combinations
of output that the economy can possibly
produce given the available factors of
production and technology.
 By assuming that a given economy
produces only two goods, it shows
tradeoffs the economy faces.

Linear Production
Possibility Curve
A rancher produces two goods: meat and
potato
 Hours needed to produce one pound of:

meat is 1 hour
potato is 8 hours.

Total working hours: 40 hours
Amount Produced in 40 hours
Potatoes
0
1
2
3
4
5
Meat
40
32
24
16
8
0
Opportunity Cost of 1 Pound of Potato = 8 Pound of Meat
Production Possibility
Curve of A Rancher
Meat (pounds)
The slope of PPC represents
the opportunity cost of potato
40
A point inside the PPC is
inefficient
20
A point on the PPC is
efficient.
B
A point outside the PPC is
infeasible.
0
2½
5
Potatoes (pounds)
Bowed-Out Production
Possibility Curve
Linear PPC reflects constant opportunity
cost. But the opportunity cost of good A
in terms of good B may depend on how
much each good the society is producing.
 When the economy is using most of its
resources to make cars, even workers and
tools best suited to making computers are
being used to make cars; the opportunity
cost of a car will be very large.

Quantity of
Computers
Produced
3,000
D
C
2,200
A
2,000
Production
1,000
B
possibilities
frontier
0
Figure 2-2
300
600
700
1,000
Quantity of
Cars Produced
The Production Possibilities
Frontier
Quantity of
Computers
Produced
4,000
3,000
2,100
2,000
A
0
700 750
1,000
Quantity of
Cars Produced
The Production Possibilities
Frontier
Quantity of
Computers
Produced
4,000
3,000
2,100
2,000
A
0
700 750
1,000
Quantity of
Cars Produced
Ideas Illustrated by the
Production Possibilities Frontier
Efficiency
 Tradeoffs
 Opportunity Cost
 Economic Growth

Studying Economics with Data
Time Series, Cross Section, and Panel
Data
 Absolute Values versus Rate of Change

Rate of change = (X1-X0)/X0 = X1/X0 -1
The rate of increase in unemployment can
fall even though unemployment is
increasing.

Real versus Nominal Values
real GDP= nominal GDP/Price index
real growth=nominal growth-inflation rate
Types of Data
Time-Series Data
UK Unemployment
(Millions)
1995
2.5
1996
2.3
1997
2.01
1998
1.83
1999
1.81
Cross-section Data
Average Rates of growth, unemplyment and inflation between 1990-1999
France
Germany Japan
UK
Growth rate
1.7
2.3
1.4
Unemployment rate
11.3
7.8
3.1
Inflation rate
1.9
2.5
1.1
USA
1.7
8.4
3.6
2.6
5.8
3.3
Omitted Variable Fallacy
It is very common to use graphs to argue
about how one variable (X) causes
another variable (Y).
 Such a graphical relationship can often
be deceptive unless we properly control
all other variables (Z) that might also
affect Y.
 Does the number of cigarette lighters
cause risk of lung cancer?

Omitted Variable Fallacy
The number of
Risk of
cigarette
lighters found in
the house
Cancer
1
2
3
4
5
6
10%
20%
30%
40%
50%
60%
Omitted Variable Fallacy
The number of
The number of
Risk of
cigarette packs
cigarette
smoked by the
lighters found in
resident of the
the house
Cancer
house
1
1
2
1.5
3
2
4
2.5
5
3
6
3.5
10%
20%
30%
40%
50%
60%
Positive versus Normative
Analysis


Positive statements are statements that
describe the world as it is.
Called descriptive analysis

Normative statements are statements
about how the world should be.

Called prescriptive analysis
Positive or Normative ?




An increase in the minimum wage will cause a
decrease in employment among the leastskilled.
Higher federal budget deficits will cause
interest rates to increase.
The income gains from a higher minimum
wage are worth more than any slight reductions
in employment.
Governments should be allowed to collect from
tobacco companies the costs of treating
smoking-related illnesses.