Thinking Like an Economist Lecturer: Jack Wu

Economic Models Economists use models to simplify reality in order to improve our understanding of the world Economists make assumptions in order to make the world easier to understand. Economists use different assumptions to answer different questions.

Basic Economic Models Two of the most basic economic models include: The Circular Flow Diagram The Production Possibilities Frontier

Circular-Flow Diagram The circular-flow diagram is a visual model of the economy that shows how dollars flow through markets among households and firms.

The Circular Flow Diagram Firms sell Households buy MARKETS FOR GOODS AND SERVICES Revenue Spending Goods and services sold Goods and services bought FIRMS Produce and sell goods and services Hire and use factors of production Buy and consume goods and services Own and sell factors of production HOUSEHOLDS Households sell Firms buy MARKETS FOR FACTORS OF PRODUCTION Factors of production Labor, land, and capital Wages, rent, and profit Income = Flow of inputs and outputs = Flow of dollars

Quick Quiz 1 Identify the parts of the circular-flow diagram immediately involved in the following transactions. John buys a car from Ford for $25,000. Ford pays George $4,000/month for work on the assembly line. Julie gets a $20 hair cut. Joe receives $5,000 of dividends on his Ford stock.

Production Possibilities Frontier The production 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.

Quantity of Computers Produced Quantity of Cars Produced

Shape of Production Possibilities Frontier Concave curve (bowed outward): The opportunity cost of producing one good increases as the production of this good rises. REASON: Some resources are better suited to the production of this good than another good (and vice versa). Straight line: The opportunity cost of producing one good is constant as the production of this good rises.

Important Concepts Concepts illustrated by the Production Possibilities Frontier Efficiency Tradeoffs Opportunity Cost Economic Growth

Quick Quiz 2 A small country produces two goods: corn (measured in bushels) and trucks. Points on a production possibilities frontier are shown as follows: A B C D E Trucks 0 10 20 30 40 Corns 70 60 45 25 0

Quick Quiz 2 (continued) To draw the production possibilities frontier. To calculate the opportunity cost of increasing the number of trucks produced by ten: between 0 and 10 between 10 and 20 between 20 and 30 between 30 and 40

A Shift in Production Possibilities Frontier Resource Availability Changes Technology Changes

A Technology Advance in Computer Industry Quantity of Computers Produced Quantity of Cars Produced

Quick Quiz 3 Draw a production possibilities frontier for a society that produces food and clothing. 1.The drought reduces the amount of food that can be produced. 2.An advanced technology of producing clothing is developed. 3.Society’s labor forces rise.

Positive and Normative Analysis 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

Quick Quiz 4 Positive or Normative Statements? An increase in the minimum wage will cause a decrease in employment among the least-skilled. State governments should be allowed to collect from tobacco companies the costs of treating smoking-related illnesses among the poor.