1. Ashesi University: Principles of Microeconomics
Prof S. Armah
Chapter 2 (Principles of Microeconomics by G. Mankiw):
Topic : Thinking Like an Economist
Spring 2011

2. Thinking Like an Economist
Every field of study has its own terminology
Mathematics
integrals  axioms  vector spaces
Psychology
ego  id  cognitive dissonance
Law
promissory  estoppel  torts  venues
Economics
supply  opportunity cost  elasticity  consumer surplus  demand  comparative advantage  isocost deadweight loss externality anti-trust isoquant
estoppel: A rule of evidence whereby a person is barred from denying the truth of a fact that has already been settled
Tort: The legal definition of Tort is The body of the law which allows an injured person to obtain compensation from the person who caused the injury.

3. Thinking Like an Economist
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

4. THE ECONOMIST AS A SCIENTIST
The economic way of thinking . . .
Involves thinking analytically and objectively.
Makes use of the Scientific Method.
1] Define: The Scientific method
The dispassionate development and testing of theories about how the world works.
2] According to your textbook, what is one difficulty that economists/social scientists but not Physicists face in generating data 3

5. The Scientific Method: Observation, Theory, and More Observation
Uses abstract models to help explain how a complex, real world operates.
Develops theories, collects, and analyzes data to evaluate the theories.
Qn1: Why is using data to evaluate theories more difficult in economics than in Physics? –
Qn2: What is the purpose of an economic model?
Qn3: why are assumptions useful?
Qn1: Why is using data to evaluate theories more difficult in economics than in Physics? ->
Answer -> Economist cannot generate his own data in most cases. He has to make do with whatever data is available.
Qn2: What is the purpose of an economic model?
Answer Simplify reality, and increase our understanding
What are the main features of an economic model: Made up of diagrams and equations
Qn3: why are assumptions useful?
Answer They simplify the problem without significantly altering the answer 4

6. The 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.

7. Two of the most basic economic models include:
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

8. Our First Model: The 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.
There are 2 decision makers (HH and Firms)
There are 2 markets (Goods and Factor Markets)
Firms sell in the goods market but buy in the factor market
HH buy in the goods market but sell in the factor market
Inner loop/ORANGE LOOP represents flow of inputs and output between HH and firms NOT MONEY
Outer loop/GREEN represents the flow of dollars between HH and firms
The Circular Flow Diagram
A simple model of the economy. It ignores the role of government and international trade (In this sense we are mainly interested in a closed economy. In a closed economy, the country does not trade with other countries)
Before we go through the PowerPoint presentation, here are the main features
Basic Features
There are 2 decision makers (HH and Firms)
There are 2 markets (Goods market and Factor Market)
Firms sell in the goods market but buy in the factor market
HH buy in the goods market but sell in the factor market
Inner loop/ORANGE LOOP represents flow of inputs and output between HH and firms NOT MONEY
Outer loop/GREEN represents the flow of dollars between HH and firms 6

9. Figure 1 The Circular Flow
There are 2 decision makers (HH and Firms)
There are 2 markets (Goods and Factor Markets)
Firms sell in the goods market but buy in the factor market
HH buy in the goods market but sell in the factor market
Inner loop/ORANGE LOOP represents flow of inputs and output between HH and firms NOT MONEY
Outer loop/GREEN represents the flow of dollars between HH and firms
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
Copyright © South-Western

10. Our First Model: The Circular-Flow Diagram
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 7

11. Our First Model: The Circular-Flow Diagram
Markets for Goods and Services
Firms sell
Households buy
Markets for Factors of Production
Households sell
Firms buy 7

12. Our First Model: The Circular-Flow Diagram
Factors of Production
Inputs used to produce goods and services
Land, labor, and capital
PROVIDE NAMES FOR THE FOLLOWING
Price of land
Price of Labor
Price of Capital 7

13. Our Second Model: The 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. 14

14. Figure 2 The Production Possibilities Frontier
Quantity of
Computers
Produced
3,000 D C
2,200
600 A
700
2,000
Production
possibilities
frontier
1,000
300 B
1,000
Quantity of
Cars Produced
Copyright©2003 Southwestern/Thomson Learning

15. Our Second Model: The Production Possibilities Frontier
Concepts Illustrated by the Production Possibilities Frontier
Efficiency
Tradeoffs
Opportunity Cost
Economic Growth 21

16. Figure 3 A Shift in the Production Possibilities Frontier
Quantity of
Computers
Produced
4,000
3,000
1,000
2,100
750 E
2,000
700 A
Quantity of
Cars Produced
Copyright © South-Western

17. 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.
Economy-wide phenomena, including inflation, unemployment, and economic growth 13

18. THE ECONOMIST AS POLICY ADVISOR
When economists are trying to explain the world, they are scientists.
When economists are trying to change the world, they are policy advisors. 30

19. POSITIVE VERSUS NORMATIVE ANALYSIS
Positive statements are statements that attempt to describe the world as it is.
Called descriptive analysis (No value judgement implied. How the world is)
Normative statements are statements about how the world should be. (Value judgement implied. How the world should be)
Called prescriptive analysis 31

20. POSITIVE VERSUS NORMATIVE ANALYSIS?
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. ? ? 32

21. POSITIVE VERSUS NORMATIVE ANALYSIS?
Positive or Normative Statements?
The government should raise the tax on tobacco to reduce the quantity of cigarettes sold.
NORMATIVE
If the government prints more 2-cedi notes, the value of the Ghana cedi should plummet.
POSITIVE ? ? 32

22. POSITIVE VERSUS NORMATIVE ANALYSIS?
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. ? ? 32

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

24. Economists in Washington
Some government agencies that collect economic data and make economic policy:
Department of Commerce
Bureau of Labor Statistics
Congressional Budget Office
Federal Reserve Board 33

25. Ghana / Africa Data Sites
The Bank of Ghana (General, Monetary, Financial information)
World Development Indicators (WDI)
Ghana Statistical Service (Ghana Specific Data)

26. WHY 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. 35

27. Table 2 Ten Propositions about Which Most Economists Agree
Copyright © South-Western

28. Summary
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.

29. Summary Economics is divided into two subfields:
Microeconomists study decisionmaking by households and firms in the marketplace.
Macroeconomists study the forces and trends that affect the economy as a whole

30. Summary 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.

31. Summary
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.