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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 bodyEconomists 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.
Market for Goods andServices
Market for Factors ofProduction
Firms Households
The Circular-Flow Diagram
Market for Goods andServices
Revenue
Market for Factors ofProduction
Firms Households
Spending
The Circular-Flow Diagram
Market for Goods andServices
Revenue
Market for Factors ofProduction
Firms Households
Wage, rent,and profit
Income
Spending
The Circular-Flow Diagram
Market for Goods andServices
Revenue
Market for Factors ofProduction
Firms Households
Wage, rent,and profit
Income
Spending
Labor, landand capital
Inputs forproduction
The Circular-Flow Diagram
Market for Goods andServices
Revenue
Market for Factors ofProduction
Firms Households
Wage, rent,and profit
Income
SpendingGoods andservices sold
Goods andservices bought
Labor, landand capital
Inputs forproduction
The Circular-Flow Diagram
Spending
Goods andservicesbought
Revenue
Goodsand servicessold
Labor, land,and capital
Income
5 Flow of goodsand services
5 Flow of dollars
Inputs forproduction
Wages, rent,and profit
FIRMSProduce and sellgoods and services.Hire and use factorsof production.
Buy and consumegoods and services.Own and sell factorsof production.
HOUSEHOLDS
Households sellFirms buy
MARKETSFOR
FACTORS OF PRODUCTION
Firms sellHouseholds buy
MARKETSFOR
GOODS AND SERVICES
Figure 2-1
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 hourpotato is 8 hours.
Total working hours: 40 hours
Potatoes Meat0 401 322 243 164 85 0
Amount Produced in 40 hours
Opportunity Cost of 1 Pound of Potato = 8 Pound of Meat
Production Possibility Curve of A Rancher
20
Potatoes (pounds)2½
B
0
Meat (pounds)The slope of PPC represents the opportunity cost of potato
5
40
A point inside the PPC is inefficient
A point on the PPC is efficient.
A point outside the PPC is infeasible.
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.
3,000
1,000
2,000
2,200
Production
possibilities
frontier
A
B
C
Quantity of
Cars Produced
7006003000 1,000
Quantity of
Computers
Produced
D
Figure 2-2
The Production Possibilities Frontier
3,000
2,0002,100
A
Quantity ofCars Produced
700 7500 1,000
Quantity ofComputers
Produced4,000
The Production Possibilities Frontier
3,000
2,0002,100
A
Quantity ofCars Produced
700 7500 1,000
Quantity ofComputers
Produced4,000
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 indexreal growth=nominal growth-inflation rate
Types of Data
Time-Series DataUK Unemployment 1995 1996 1997 1998 1999(Millions) 2.5 2.3 2.01 1.83 1.81
Cross-section Data
Average Rates of growth, unemplyment and inflation between 1990-1999
France Germany Japan UK USAGrowth rate 1.7 2.3 1.4 1.7 2.6Unemployment rate 11.3 7.8 3.1 8.4 5.8Inflation rate 1.9 2.5 1.1 3.6 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?
The number of
cigarette
lighters found in
the house
Risk of
Cancer1 10%2 20%3 30%4 40%5 50%6 60%
Omitted Variable Fallacy
The number of
cigarette
lighters found in
the house
The number of cigarette packs smoked by the resident of the house
Risk of
Cancer1 1 10%2 1.5 20%3 2 30%4 2.5 40%5 3 50%6 3.5 60%
Omitted Variable Fallacy
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 least-skilled.
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.
