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CHAPTER 2
THINKING LIKE AN
ECONOMIST
LOGO
Contents
Roles of economists1
Models in economics2
Circular-flow diagram3
Production possibilities frontier4
5
CHAPTER 2 THINKING LIKE AN ECONOMIST
5 Microeconomics and Macroeconomics
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Roles of economist
Scientists:
try to explain the
world
Economist
Policy
advisors:
try to improve it
CHAPTER 2 THINKING LIKE AN ECONOMIST
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The economist as
a scientistIn the first,
economists employ
the
scientific method,
the dispassionate
development and
testing of theories
about how the world
works
CHAPTER 2 THINKING LIKE AN ECONOMIST
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The scientific method
Observation , theory and more observation
Newton’s theory of gravity
Theory of inflation
Obstacle for economist
Natural experiments from history
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The role of
Assumption
Assumptions simplify the complex world,
make it easier to understand.
Example: To study international trade,
assume two countries and two goods.
Unrealistic, but simple to learn and
gives useful insights about the real world.
The art in scientific thinking is deciding
which assumption to make.
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Economic Models
The Circular Flow Diagram
The Production Possibilities Frontier
CHAPTER 2 THINKING LIKE AN ECONOMIST
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The Circular-Flow
Diagram
The Circular-Flow Diagram: A visual model of
the economy, shows how money flow through
markets among households and firms.
Two types of “actors”:
households
firms
Two markets:
the market for goods and services
the market for “factors of production”
CHAPTER 2 THINKING LIKE AN ECONOMIST
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The Circular Flow
Copyright © 2004 South-Western
Spending
Goods and
services
bought
Revenue
Goods
and services
sold
Labor, land,
and capital
Income
= Flow of inputs
and outputs
= Flow of revenue
Factors of
production
Wages, rent,
and profit
FIRMS
•Produce and sell
goods and services
•Hire and use factors
of production
•Buy and consume
goods and services
•Own and sell factors
of production
HOUSEHOLDS
•Households sell
•Firms buy
MARKETS
FOR
FACTORS OF PRODUCTION
•Firms sell
•Households buy
MARKETS
FOR
GOODS AND SERVICES
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The Production
Possibilities Frontier
The production possibilities frontier is 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.
CHAPTER 2 THINKING LIKE AN ECONOMIST
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Figure 2 The Production Possibilities Frontier
Copyright©2003 Southwestern/Thomson Learning
Production
possibilities
frontier
A
B
C
Quantity of
Cars Produced
2,200
600
1,000
3000 700
2,000
3,000
1,000
Quantity of
Computers
Produced
D
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The Production
Possibilities Frontier
Concepts Illustrated by the Production
Possibilities Frontier
Efficiency
Tradeoffs
Opportunity Cost
Economic Growth
CHAPTER 2 THINKING LIKE AN ECONOMIST
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Figure 3 A Shift in the Production Possibilities Frontier
Copyright © 2004 South-Western
E
Quantity of
Cars Produced
2,000
700
2,100
7500
4,000
3,000
1,000
Quantity of
Computers
Produced
A
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Microeconomics and
Macroeconomics
Micro-
economics
focuses on the
individual parts of
the economy
Economics
Macro-
economics
looks at the economy
as a whole
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The Economist as
Policy Advisor
When they are trying to explain the world,
they are scientists
When they are trying to change the world,
they are policy advisor
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Positive versus
normative analysis
Example :-
Polly : Minimum wage laws cause
unemployment.
Norma : The government should raise the
minimum wages.
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Positive versus
normative analysis
Positive statements are statements that
attempt to describe the world as it is.
Called descriptive analysis
Normative statements are statements about
how the world should be.
Called prescriptive analysis
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Positive versus
normative analysis
Positive or Normative Statements?
An increase in the minimum wage will cause a
decrease in employment among the least-
skilled.
State governments should be allowed to
collect from tobacco companies the costs of
treating smoking-related illnesses among the
poor.
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Economists in
Washington
President Harry Truman once said that he
wanted to find a one armed economists.
When he asked his economist for advice
they answered, ” On the one hand ,…On
the other hand…”.
Since 1946 the Presidents of U.S. has
received guidance from Council of
Economic advisers.
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Why Economists
Disagree
Economists may disagree about the
validity of alternative positive theories
about how the world works
Economists may have different values
and, therefore, different normative views
about what policy should try to accomplish
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Why Economists
Disagree
Differences in scientific judgments
Differences in values
Perception v/s reality
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Propositions Which
Economists Agree
Differences in scientific judgments
Differences in values
Perception v/s reality
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SUMMARY
As scientists, economists try to explain the world
using models with appropriate assumptions.
Two simple models are the Circular-Flow Diagram
and the Production Possibilities Frontier.
Microeconomics studies the behavior of consumers
and firms, and their interactions in markets.
Macroeconomics studies the economy as a whole.
As policy advisers, economists offer advice on how
to improve the world.
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