Thinking Like an Economist Chapter 2 Copyright © 2001 by Harcourt, Inc. All rights reserved.   Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777.

Economics 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. 2

The Economic Way of Thinking Includes developing abstract models from theories and the analysis of the models. Uses two approaches: Descriptive (reporting facts, etc.) Analytical (abstract reasoning) 5

Two Roles of Economists When they are trying to explain the world, they are scientists. When they are trying to change the world, they are policymakers. 30

The Economist as a Scientist The economic way of thinking . . . Involves thinking analytically and objectively. Makes use of the scientific method. 3

Observation, Theory and More Observation! The Scientific Method Develops theories, collects, and analyzes data to prove the theories. Uses abstract models to help explain how a complex, real world operates. Observation, Theory and More Observation! 4

Economic Models The Circular Flow Model 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 Model The Production Possibilities Frontier

The Circular-Flow Model The circular-flow model is a simple way to visually show the economic transactions that occur between households and firms in the economy. 6

The Circular-Flow Diagram Spending Revenue Goods & Services sold Goods & Services bought Firms Market for Goods and Services Households Market for Factors of Production Labor, land, and capital Inputs for production Wages, rent, and profit Income 7

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. 14

The Production Possibilities Frontier Quantity of Computers Produced D 3,000 C 2,200 600 A 2,000 700 B 1,000 300 1,000 Quantity of Cars Produced 15

Microeconomics 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. How the markets, as a whole, interact at the national level. 13

Economists in Washington . . . . . . serve as advisers in the policymaking process of the three branches of government: Legislative Executive Judicial 33

Positive versus Normative Analysis Positive statements are statements that describe the world as it is. Called descriptive analysis Economists as scientists make positive statements Normative statements are statements about how the world should be. Called prescriptive analysis Economists as policymakers make normative statements 31

Why Economists Disagree They may disagree on theories about how the world works. They may hold different values and, thus, different normative views. 35

Examples of What Most Economists Agree On A ceiling on rents reduces the quantity and quality of housing available. Tariffs and import quotas usually reduce general economic welfare. 36

ECONOMIC ANALYSIS EASY AS 1..., 2..., 3... 1. Where are you before any changes? Mark a beginning point based on the scenario. (A) Tell how you knew where to start. What was the change? What happened in the scenario? Did production of one good increase? Did we go to war? Restate it simply here. What was the result of the change? Short Run Where are we now? What was the immediate impact on the two variables? Which way on the line did we move? Are we inside the line? Show the result with a new point. (B) Long Run What happened to the location of the production possibilities frontier? Did it move in or out? If it moved show the new location with a new line and arrows indicating the direction of change. Tell what changed to cause this movement (this must be a change in a resource or technology).

PRODUCTION POSSIBILITIES CURVE Scenario: While at full-employment new developments in computer technology cause many business to invest in new computer systems. Begin: Change: Result of Change: Short run: Long run: Capital Goods Consumer Goods

While at full-employment new developments in computer technology cause many business to invest in new computer systems. Begin: A , because at full-employment Change: US companies increase purchase and production of capital goods. 3. Result of Change: Move to B Short run: Consumer goods decrease and Capital goods increase Long run: Production Possibilities Curve shifts outward due to more capital. B Ca2 Capital Goods A Ca1 Co2 Co1 Consumer Goods