1 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.

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 information §But answer the basic question. §Model builders must make judgments: l What information to include, and l 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 l 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 l simplify reality l verbal l 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 Razor §The 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.

14 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: l Event A occurs, then Event B occurs l Therefore A causes B.

15 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).

16 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.

17 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”).

19 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.

20 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.

21 Economic Policy Objectives §Efficiency §Equity §Growth §Stability

22 The Factors of Production §K = Capital (machinery, computers, buildings) §E = Entrepreneurship combining factors to enable production §L = Labor (productive efforts) §N = Land and natural resources §CELL

23 A Circular Flow Model §Two markets: One for products (output), one for factors (of production) §Households l Own factors, sell their services to firms l Buy products from firms §Firms l Combine factors to produce products l Sell products to households

24 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 §Scarcity §Necessity of Choice §Opportunity Cost §Economic Growth l Due to an increase in L, N, or K l Due to technological progress §International Trade (many applications)

26 Example PPF

27 Example PPF

28 Slope of the PPF §Calculate the slope between points A&B, B&C, C&D: §Include the units §Is there a relationship between the slope of the PPF and the concept of opportunity cost?

29 Opportunity Cost & Slope §Points A&B, slope = -50/200= -1 lb beef / 4 tax forms =-0.25 lb beef/form. §Points B&C, slope = -250/200= -5 lb beef / 4 tax forms =-1.25 lb beef/form. §Points C&D, slope = -700/200= -7 lb beef / 2 tax forms =-3.5 lb beef/form. §The slope of the PPF is the opportunity cost of the good on the x-axis.

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?

31 Constant Opportunity Cost SOYBEANS, S (millions of bushels per year) TEXTILES, T (millions of yards per year) America’s PPF 1 4 a' a A’s opportunity cost:

32 Constant Opportunity Cost SOYBEANS, S (millions of bushels per year) TEXTILES, T (millions of yards per year) America’s PPF 1 4 a' a A’s opportunity cost: 2 bushels S costs 1 yard T, |slope| = 0.5 yd./bu.

33 Constant Opportunity Cost SOYBEANS, S (millions of bushels per year) TEXTILES, T (millions of yards per year) America’s PPF 1 Britain’s PPF 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 SOYBEANS, S (millions of bushels per year) TEXTILES, T (millions of yards per year) America’s PPF 1 Britain’s PPF 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) million yards S 6 million bushels of T a' Opportunity cost of 1 bushel of S is 1 yard T, |slope| = 1 yd./bu. TEXTILES, T (millions of yards per year) America’s PPF

Increasing Opportunity Cost a Opportunity cost of 1 bushel of S is TEXTILES, T (millions of yards per year) SOYBEANS, S (millions of bushels per year) Britain’s PPF

2 million bushels of S Increasing Opportunity Cost million yards of T a Opportunity cost of 1 bushel of S is 9 yards of T, |slope| = 9 yd./bu. TEXTILES, T (millions of yards per year) SOYBEANS, S (millions of bushels per year) Britain’s PPF

38 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 ____________________. This greater efficiency in production is due to superior technology. §Smith thought this explained trade patterns.

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.

40 Comparative Advantage: §A nation (individual) is said to have a comparative advantage in producing a good when it can produce that good __________ __________________________________. §Ricardo -- differing technologies §Heckscher-Ohlin -- differing resource endowments

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 technologies §Heckscher-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

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) l a line from a country’s production point l with slope equal to the trade price of good X

45 CPF with a price ratio of 1(bu/lb)

46 If Guy and Rob share equally

47 Prior Example SOYBEANS, S (millions of bushels per year) TEXTILES, T (millions of yards per year) America’s PPF 1 Britain’s PPF 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’

48 Allocative Mechanisms §Markets §Brute Force §Queuing §Random §Tradition §Government

49 Classifying Economic Systems §Who makes decisions? l Centralized or l Decentralized §Who owns which resources? l individuals or l the state

50 Private Property Rights §Fee-Simple property rights are broadest l use the good as you choose, as long as you violate noone’s rights l trade or give these rights to anyone l or deny others the right to use a good §Most argue that property rights are determined by law.

51 Communism v. Capitalism §Communism entails state ownership and centralized decision making §Pure capitalism implies private ownership and decentralized decision making