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Chapter 2Chapter 2
Thinking Like an Thinking Like an EconomistEconomist
©© 2002 by Nelson, a division of Thomson Canada Limited 2002 by Nelson, a division of Thomson Canada Limited
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 2
In this chapter you will…In this chapter you will… See how economists apply the See how economists apply the
method of science.method of science. Consider how assumptions and Consider how assumptions and
models can shed light on the models can shed light on the world.world.
Learn two simple models - the Learn two simple models - the circular flow and production circular flow and production possibilities frontier.possibilities frontier.
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 3
In this chapter you will…In this chapter you will… Distinguish between Distinguish between
microeconomics and microeconomics and macroeconomics.macroeconomics.
Learn the difference between and Learn the difference between and normative statements.normative statements.
Examine the role of economists in Examine the role of economists in making policy.making policy.
Consider why economists Consider why economists sometimes disagree with one sometimes disagree with one another.another.
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 4
Thinking Like an EconomistThinking Like an EconomistEvery field of study has its own terminology
– Mathematics• integrals axioms vector spaces
– Psychology• ego id cognitive dissonance
– Law• promissory estoppels torts venues
– Economics• supply opportunity cost elasticity
consumer surplus demand comparative advantage deadweight loss
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 5
Thinking Like an EconomistThinking Like an EconomistEconomics trains you to. . . .
– Think in terms of alternatives.– Evaluate the cost of individual and
social choices.– Examine and understand how certain
events and issues are related.
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 6
THE ECONOMIST AS A SCIENTISTTHE ECONOMIST AS A SCIENTISTThe economic way of thinking . . .
– Involves thinking analytically and objectively.
– Economists…• Devise theories• Collect data• Analyze the data to verify or refute their
theories – Economics makes use of the scientific
method.
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 7
The Scientific Method: The Scientific Method: observation, theory, and more observation, theory, and more
observationobservation• Uses abstract models to help explain how
a complex, real world operates.
• Develops theories, collects, and analyzes data to evaluate the theories.
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 8
The Role of AssumptionsThe Role of Assumptions• Economists make assumptions in order to
make the world easier to understand.• The art in scientific thinking is deciding
which assumptions to make.• Economists use different assumptions to
answer different questions.
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 9
Economic ModelsEconomic Models• Economists use models to simplify
reality in order to improve our understanding of the world
• Two of the most basic economic models include:– The Circular Flow Diagram– The Production Possibilities
Frontier
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 10
Our First Model: The Circular-Flow Our First Model: The Circular-Flow DiagramDiagram
• The circular-flow diagram is a visual model of the economy that shows how dollars flow through markets among households and firms.
Figure 1: The Circular FlowFigure 1: The Circular Flow
Copyright © 2004 South-Western
Spending
Goods andservicesbought
Revenue
Goodsand servicessold
Labour, land,and capital
Income
= Flow of inputs and outputs
= Flow of dollars
Factors ofproduction
Wages, rent,and profit
FIRMS•Produce and sellgoods and services
•Hire and use factorsof production
•Buy and consumegoods and services
•Own and sell factorsof production
HOUSEHOLDS
•Households sell•Firms buy
MARKETSFOR
FACTORS OF PRODUCTION
•Firms sell•Households buy
MARKETSFOR
GOODS AND SERVICES
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 12
Our First Model: The Circular-Flow Our First Model: The Circular-Flow DiagramDiagram
• Firms– Produce and sell goods and services– Hire and use factors of production
• Households– Buy and consume goods and services– Own and sell factors of production
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 13
Our First Model: The Circular-Flow Our First Model: The Circular-Flow DiagramDiagram
• Markets for Goods and Services– Firms sell– Households buy
• Markets for Factors of Production– Households sell– Firms buy
• Factors of Production– Inputs used to produce goods and
services– Land, labour, and capital
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 14
Our Second Model: Our Second Model: The Production Possibilities FrontierThe Production Possibilities Frontier
• The production possibilities frontierproduction 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.
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 15
Quantity of Computers Produced
Quantity of Cars Produced
0
Figure 2-2: Figure 2-2: The Production Possibilities FrontierThe Production Possibilities Frontier
3000
2000
700
A
1000
300
B
2200
600
C
D
1000
Production possibilities frontier
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 16
• Concepts Illustrated by the Production Possibilities Frontier – Efficiency– Tradeoffs– Opportunity Cost– Economic Growth
Our Second Model: Our Second Model: The Production Possibilities FrontierThe Production Possibilities Frontier
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 17
Figure 2-3. A Shift in the Production Possibilities Figure 2-3. A Shift in the Production Possibilities FrontierFrontier
Quantity of Computers Produced
Quantity of Cars Produced
3000
2000
700
A
0
4000
2100
750
E
1000
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 18
Microeconomics and MacroeconomicsMicroeconomics and Macroeconomics• Microeconomics focuses on the individual
parts of the economy.– How households and firms make
decisions and how they interact in specific markets
• Macroeconomics looks at the economy as a whole.– Economy-wide phenomena, including
inflation, unemployment, and economic growth
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 19
THE ECONOMIST AS POLICY THE ECONOMIST AS POLICY ADVISERADVISER
• When economists are trying to explain the world, they are scientists.
• When economists are trying to change the world, they are policy advisor.
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 20
Positive Positive VersusVersus Normative Statements Normative Statements
• 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
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 21
• Positive or Normative Statements? – An increase in the minimum wage will cause a
decrease in employment among the least-skilled.
POSITIVE
– Higher federal budget deficits will cause interest rates to increase.
POSITIVE
Positive Versus Normative StatementsPositive Versus Normative Statements
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 22
• Positive or Normative Statements? – The income gains from a higher minimum
wage are worth more than any slight reductions in employment.
NORMATIVE
– State governments should be allowed to collect from tobacco companies the costs of treating smoking-related illnesses among the poor.
NORMATIVE
Positive Positive VersusVersus Normative Statements Normative Statements
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 23
Economists in OttawaEconomists in Ottawa• Department of Finance: Design tax policy.
(www.fin.gc.ca)• Industry Canada: Design and enforce anti-
monopoly laws. (www.ic.gc.ca)• Department of Foreign Affairs and
International Trade: Negotiate trade agreements with other countries. (www.defait.gc.ca)
• Human Resources Development Canada: Analyze data on workers to help formulate labour-market policies. (www.hrdc.gc.ca)
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 24
Economists in OttawaEconomists in Ottawa• Environment Canada: Environmental
regulation. (www.ec.gc.ca)• Canadian International Development
Agency: Advice on overseas development projects. (www.acdi-cida.gc.ca)
• Statistics Canada: Collect data used by other economists to give policy advice. (www.statcan.ca)
• Bank of Canada: Analyze financial markets and macroeconomic developments. (www.bank-banque-canada.ca)
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 25
Economists in the private sector…Economists in the private sector…… publish reports that analyze current
issues such as poverty, unemployment, and the deficit.
• C.D. Howe Institute (www.cdhowe.org)• The Fraser Institute (
www.fraserinstitute.ca)
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 26
WHY ECONOMISTS DISAGREEWHY ECONOMISTS DISAGREE• They may disagree about the validity
of alternative positive theories about how the world works.
• They may have different values and, therefore, different normative views about what policy should try to accomplish.
Table 2-2. Ten Propositions About Which Most Table 2-2. Ten Propositions About Which Most Economists AgreeEconomists Agree
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 28
SummarySummary
• Economists try to address their subjects with a scientist’s objectivity.– They make appropriate assumptions
and build simplified models in order to understand the world around them.
– Two simple economic models are the circular-flow diagram and the production possibilities frontier.
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 29
• Economics is divided into two subfields:– Microeconomists study decision
making by households and firms in the marketplace.
– Macroeconomists study the forces and trends that affect the economy as a whole
SummarySummary
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 30
• A positive statement is an assertion about how the world is.
• A normative statement is an assertion about how the world ought to be.
• When economists make normative statements, they are acting more as policy advisors than scientists.
SummarySummary
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 31
• Economists who advise policymakers offer conflicting advice either because of differences in scientific judgments or because of differences in values.
• At other times, economists are united in the advice they offer, but policymakers may choose to ignore it.
SummarySummary
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 32
AppendixAppendixGraphing: A Brief Graphing: A Brief
ReviewReview
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 33
Graphs of a single variableGraphs of a single variable
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 34
Graphs of two variables: The Graphs of two variables: The Coordinate SystemCoordinate System
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 35
Curves in the Coordinate SystemCurves in the Coordinate System
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 36
Curves in the Coordinate SystemCurves in the Coordinate System
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 37
Slope = ∆Slope = ∆yy / ∆ / ∆xx
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 38
Cause and effect Cause and effect
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 39
Cause and effect Cause and effect
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 2: Page 40
The EndThe End