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Economic Thinking. ECO 284 Display your name card Place your Chapter 3 summary in your file. Place your answers to Chap. 3 Review Questions on the front table Homework #4 (PPF work sheet) due Friday. The Nature and Role of Theory. The uses of theories (simplified models). - PowerPoint PPT Presentation
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1
Economic Thinking
ECO 284Display your name cardPlace your Chapter 3
summary in your file.Place your answers to
Chap. 3 Review Questions on the front table
Homework #4 (PPF work sheet) due Friday.
2
The Nature and Role of Theory.
The uses of theories (simplified models).Everyone uses them. . .to describe, explain, predict, or understand.
3
Abstraction
Models leave out much specific informationBut answer the basic question.Model builders must make judgments:
What information to include, and which details may be safely omitted.
4
Judging Theories
Logical soundness of assumptions and hypotheses
How well a theory predicts.Theories should yield testable predictions.
Methodology
Economists build models
Answer important questions
• Why does international (int’l) trade occur?
• What goods will a country import (export)?
• How much will be traded and at what price?
• Will trade affect wages, or other factor payments?
Methodology
Models are abstract, yield predictions
simplify reality
verbal
mathematical
• geometric
• algebraic
7
Parts of a Theory.
Variables take on different values.Assumptions give us a starting point for
deductive reasoning.Hypothesis - a statement about how two or
more variables are related.Predictions are deduced from the
assumptions and hypotheses of the theory.
8
Occam’s RazorThe simplest workable theories are also the
most useful.a.k.a. “The Principle of Parsimony”Einstein: “Everything should be made as
simple as possible, but not more so.”
9
Formulating Theories
Variables noted, assumptions made, hypotheses formulated.
Predictions are deduced from the assumptions and hypotheses.
Predictions are stated.
10
Testing Theories
Predictions are tested.Evidence either confirms or rejects theory.If confirmed, can the results be reproduced?If rejected, then either a new theory is
formed, or the old one is amended.
11
Arguments
Argument -- a sequence of statements together with a claim.
Sequence -- two or more statements.Claim -- that one of statements, called the
conclusion, follows from the others, called the premises.
An argument is sound if it is correct and all its premises are true.
12
Deductive Arguments
In a valid deductive argument it is impossible for the premise to be true and the conclusion false.
Example: Knowledge is power. Power corrupts. Therefore knowledge corrupts.
Another: Economists are scoundrels. Eastwood is an economist. Therefore Eastwood is a scoundrel.
13
Inductive Arguments
In a correct inductive argument it is improbable for the conclusion to be false if the premise is true.
Example: None of Eastwood’s mid-term exam questions were tricky. Therefore none of his final exam questions will be tricky.
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The Fallacy of False Cause
This fallacy occurs when in argument one mistakes what is not the cause of a given effect for its real cause.
When an argument takes the following form, it is often incorrect: Event A occurs, then Event B occurs Therefore A causes B.
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Variants of the False-Cause Fallacy
Post hoc, ergo propter hoc (Latin) translates roughly as “after this, therefore because of this.”
Accidental correlation: A occurs when B occurs. Therefore A causes B (or vice-versa).
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The Fallacy of Composition
Assuming that what is true for the individual is true for the group.
Frederic Bastiat’s “Petition of the Candle Makers” illustrates this fallacy.
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The Fallacy of Decomposition
Assuming that what is true for the group is true for the individual.
Example: Gator-Aid tastes sweet. Therefore all the ingredients of Gator-Aid must taste sweet.
18
Errors in Economic Thinking.
Misunderstanding the Ceteris Paribus condition (Latin phrase meaning “all other things remaining the same”).
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Normative versus Positive Analysis
Normative statements contain a value judgment (about what should be).
Positive statements describe, explain or predict (what was, what is, or what will be).
Positive statements may be true or false, but disagreements about them may be resolved by obtaining the facts.
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Concepts Central to the Economic Way of Thinking.
Rational Self-Interest: People are rational, calculating, and driven by self interest
Opportunity Cost ( the value of the most highly preferred alternative not taken.) Every decision entails a choice, and every choice entails a cost.
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Economic Policy Objectives
Efficiency
Equity
Growth
Stability
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The Factors of Production
K = Capital (machinery, computers, buildings)
E = Entrepreneurship combining factors to enable production
L = Labor (productive efforts)N = Land and natural resourcesCELL
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A Circular Flow Model
Two markets: One for products (output), one for factors (of production)
Households Own factors, sell their services to firms Buy products from firms
Firms Combine factors to produce products Sell products to households
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Production Possibility Frontier (PPF) Assumptions:
Quantities of productive factors are fixed, but can be allocated among different types of production.
Technology is constant.All scarce resources are fully and efficiently
employed.
25
Concepts and the PPF
ScarcityNecessity of ChoiceOpportunity CostEconomic Growth
Due to an increase in L, N, or K Due to technological progress
International Trade (many applications)
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Example PPF
0100200300400500600700800900
1000
0 100 200 300 400 500 600
Tax Forms (millions/yr)
Bee
f (m
ill.
lb
./yr
.)
A:(__,___) B:(___,____)
C:(___,___)
D
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Example PPF
0100200300400500600700800900
1000
0 100 200 300 400 500 600
Tax Forms (millions/yr)
Bee
f (m
ill.
lb
./yr
.)
A:(0,1000) B:(200,950)
C:(400,700)
D: (600, 0)
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Slope of the PPF
Calculate the slope between points A&B, B&C, C&D:
Include the unitsIs there a relationship between the slope of
the PPF and the concept of opportunity cost?
30
Reciprocal of the PPF’s Slope
The opportunity cost of the good on the y-axis is (1/slope); e.g., between points A and B the opp. cost of beef is -4 tax forms given up per lb. beef.
In this example, the opportunity cost of a good increases as its output increases. Why might one expect this?
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Constant Opportunity Cost
1 2 3 4SOYBEANS, S (millions of bushels per year)
1
2
3
5
4
TE
XT
ILE
S, T
(mil
lion
s of
yar
ds
per
yea
r)
America’sPPF
1
4
a'
a
A’s opportunity cost:
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Constant Opportunity Cost
1 2 3 4SOYBEANS, S (millions of bushels per year)
1
2
3
5
4
TE
XT
ILE
S, T
(mil
lion
s of
yar
ds
per
yea
r)
America’sPPF
1
4
a'
a
A’s opportunity cost:2 bushels S costs 1 yard T,|slope| = 0.5 yd./bu.
33
Constant Opportunity Cost
1 2 3 4SOYBEANS, S (millions of bushels per year)
1
2
3
5
4
TE
XT
ILE
S, T
(mil
lion
s of
yar
ds
per
yea
r)
America’sPPF
1
Britain’sPPF
4
a'
b
a
A’s opportunity cost:2 bushels S costs 1 yard T,|slope| = 0.5 yd./bu.
B’s opportunity cost:
b’
34
Constant Opportunity Cost
1 2 3 4SOYBEANS, S (millions of bushels per year)
1
2
3
5
4
TE
XT
ILE
S, T
(mil
lion
s of
yar
ds
per
yea
r)
America’sPPF
1
Britain’sPPF
4
a'
b
a
A’s opportunity cost:2 bushels S costs 1 yard T,|slope| = 0.5 yd./bu.
B’s opportunity cost:1 bushel S costs 3 yards T,|slope| = 3 yd./bu.
b’
Increasing Opportunity Cost
SOYBEANS, S (millions of bushels per year)
6
18
40 8 12
12
2
14
20
6 millionyards S
6 million bushelsof T
a'Opportunity costof 1 bushel of S is1 yard T,|slope| = 1 yd./bu.
TE
XT
ILE
S, T
(mil
lion
s of
yar
ds
per
yea
r)
America’s PPF
Increasing Opportunity Cost
6
24
40 8 12
30
36
15
7 9
a
Opportunity costof 1 bushel of S is
TE
XT
ILE
S, T
(mil
lion
s of
yar
ds
per
yea
r)
SOYBEANS, S (millions of bushels per year)
Britain’s PPF
2 millionbushels of S
Increasing Opportunity Cost
6
24
40 8 12
30
36
15
7 9
18millionyardsof T
a
Opportunity costof 1 bushel of S is 9yards of T, |slope| = 9 yd./bu.
TE
XT
ILE
S, T
(mil
lion
s of
yar
ds
per
yea
r)
SOYBEANS, S (millions of bushels per year)
Britain’s PPF
39
Why Do Nations Trade?
Absolute Advantage:A nation (individual) is said to have an absolute advantage in producing a good when it can produce that good with fewer resources. This greater efficiency in production is due to superior technology.
Smith thought this explained trade patterns.
41
Comparative Advantage:
A nation (individual) is said to have a comparative advantage in producing a good when it can produce that good at a lower opportunity cost.
Ricardo -- differing technologiesHeckscher-Ohlin -- differing resource
endowments
42
The PPF and International Trade
Assume that there are two countries with differing opportunity costs.
Are there gains from trade?
43
PPFs for two individuals
0
200
400
600
800
1000
1200
0 200 400 600 800 1000 1200
Fish (lbs/yr)
Co
con
uts
( b
u./
yr.)
Rob
Friday
44
The PPF and International Trade
World output increases due to specialization.
What does each country gain from trade?Requires an understanding of Consumption
Possibilities (CPF) a line from a country’s production point with slope equal to the trade price of good X
45
CPF with a price ratio of 1(bu/lb)
0
200
400
600
800
1000
1200
0 200 400 600 800 1000 1200
Fish (lbs/yr)
Co
con
uts
( b
u./
yr.)
Rob's
Guy's production point
CPF
46
If Guy and Rob share equally
0
200
400
600
800
1000
1200
0 200 400 600 800 1000 1200
Fish (lbs/yr)
Co
con
uts
( b
u./
yr.)
Rob's
Guy's production
Both could eat (600,600)