1. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-1 CHAPTER 3 Thinking Like an Economist

2. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-2 Questions Is economics a science? What do economists mean by a model? Why do economists use mathematical models so much? What patterns and habits of thought must you learn to successfully think like an economist?

3. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-3 Economics is a social science –focuses on human beings and how they behave debates within economics last longer than those in natural sciences –less likely to end in consensus economists are unable to undertake large- scale experiments the subjects studied by economists--people-- have minds of their own –expectations of the future play an important role

4. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-4 The Importance of Expectations: An Example The stock market crash of 1929 changed what Americans expected about the future of the economy Expectations that future income would be lower became realized  spending  production layoffs  income

5. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-5 Figure 3.1 - The Stock Market, 1928-1932

6. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-6 Economics is a quantitative science –uses arithmetic to measure economic variables of interest –uses mathematical models to relate economic variables of interest involves a particular way of thinking about the world using –unique technical language –a specific set of data

7. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-7 Economists use a special set of analogies and metaphors to describe the functioning of the macroeconomy –curves “shift” –money has a “velocity” –the central bank “pushes the economy up the Phillips curve”

8. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-8 Figure 3.2 - Pushing the Economy Up the Phillips Curve

9. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-9 Dominant Concepts the image of the “circular flow of economic activity” the use of the word “market” the idea of “equilibrium” use of graphs and diagrams –equations depicted by geometric curves –situations of equilibrium occur where curves cross –changes in economy demonstrated by shifts in the curves

10. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-10 The Circular Flow patterns of spending, income, and production flowing through the economy –flow of purchasing power

11. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-11 The Circular Flow “income side” –firms buy the factors of production from households –money payments flow from firms to households “expenditure side” –households buy goods and services from firms –money payments flow from households to firms

12. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-12 Figure 3.3 - The Circular Flow Diagram

13. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-13 Circular Flow can be made to be more realistic by adding –the government –financial markets –international trade and finance

14. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-14 Figure 3.4 - The Circular Flow of Economic Activity

15. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-15 Different Measures of the Circular Flow “expenditure side” measure –consumption –investment –government purchases –net exports “income side” measure –purchases of labor, capital, and natural resources owned directly or indirectly by households

16. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-16 Different Measures of the Circular Flow “uses of income” measure –where households decide to use their income saving taxes consumption

17. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-17 Markets are used as a metaphor for the complex processes of matching and exchange that take place in the economy –economists assume that buyers and sellers are well-informed about prevailing prices and quantities

18. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-18 Equilibrium is a point (or points) of balance at which some economic quantity is neither rising nor falling –once equilibrium is identified, economists can determine how fast economic forces will push the economy to the points of equilibrium

19. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-19 Graphs and Equations an algebraic equation relating two variables can also be represented as a curve drawn on a graph the solution to a set of two equations is the point on a graph where the two curves that represent the equations intersect

20. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-20 Figure 3.5 - Two Forms of the Production Function

21. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-21 Using Graphs Instead of Equations behavioral relationships become curves that shift around on a graph conditions of economic equilibrium can be represented by the points where the curves describing behavioral relationships intersect

22. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-22 Using Graphs Instead of Equations changes in the state of the economy can be shown as movements in the intersection of the curves

23. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-23 Building Models restrict the problem to only a few behavioral relationships and equilibrium conditions capture these relationships and equilibrium conditions in simple algebraic equations –use diagrams to represent the equations apply the model to the real world

24. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-24 Important Concepts in Macroeonomic Models representative agents –assume that all participants in the economy are the same –examine the decision-making of one individual and then generalize to the economy as a whole

25. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-25 Important Concepts in Macroeonomic Models opportunity costs –occur when any decision is made –measured by the value of the best alternative foregone

26. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-26 Important Concepts in Macroeonomic Models expectation formation –macroeconomic models must explain the amount of time people spend thinking about the future the information that people have available the rules of thumb used to turn information into expectations

27. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-27 Important Concepts in Macroeonomic Models expectation formation –static expectations decision makers do not think about the future –adaptive expectations decision makers assume that the future is going to be like the recent past

28. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-28 Important Concepts in Macroeonomic Models expectation formation –rational expectations decision makers spend as much time as they can thinking about the future and know as much about the structure and behavior of the economy as the model builder does

29. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-29 Building and Solving an Economic Model write equations that represent behavioral relationships –state how the “effects” are related to the “causes” draw a diagram to help visualize the relationship consider equilibrium conditions –can be shown as intersections on diagram

30. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-30 Building and Solving an Economic Model: An Example The production function relates –the economy’s capital-labor ratio (K/L) –the level of technology or efficiency of the labor force (E) –the level of real GDP per worker (Y/L) Cobb-Douglas production function

31. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-31 Building and Solving an Economic Model: An Example Equilibrium condition for balanced growth –the ratio of the economy’s capital stock (K) to its level of output (Y) must be constant

32. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-32 Building and Solving an Economic Model: An Example Equilibrium condition for balanced growth s=share of total income in the economy saved and invested n=proportional growth rate of the labor force g=proportional growth rate of the efficiency of the labor force =the depreciation rate

33. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-33 Building and Solving an Economic Model: An Example arithmetic can be used to determine the steady-state output per worker –Let E=$10,000, =1/2, s=25%, n=1%, g=1%, and =3%.

34. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-34 Building and Solving an Economic Model: An Example since K/Y=5, this must imply that K/L=5  Y/L substituting for  and E t in the Cobb- Douglas production function

35. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-35 Building and Solving an Economic Model: An Example in equilibrium, both conditions must hold

36. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-36 Building and Solving an Economic Model: An Example algebra can be used to determine the steady-state output per worker

37. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-37 Building and Solving an Economic Model: An Example putting in the balanced-growth condition

38. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-38 Building and Solving an Economic Model: An Example Let E=$10,000, =1/2, s=25%, n=1%, g=1%, and =3%

39. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-39 Building and Solving an Economic Model: An Example graphs can also be used to show the steady-state output per worker –the production function can be drawn with output per worker (Y/L) on the vertical axis and capital per worker (K/L) on the horizontal axis –the equilibrium condition for balanced growth can also be shown K/L=s/(n+g+)

40. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-40 Figure 3.6 - Equilibrium Output per Worker

41. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-41 The Advantages of Using Algebra best way to summarize cause-and- effect behavioral relationships –allows us to consider different possible systematic relationships by changing the value of parameters

42. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-42 Figure 3.7 - A Single Equation, a Host of Relationships

43. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-43 Figure 3.8 - Changing Parameter Values and the Shape of the Cobb-Douglas Production Function

44. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-44 Figure 3.9 - The Effect of Changes in the Efficiency of Labor on the Shape of the Production Function

45. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-45 Chapter Summary Don’t be surprised to find economists’ ways of thinking strange and new-- that is always the case when you learn any new intellectual discipline Don’t be surprised to find economics more abstract than you thought –Today’s economic courses focus more on analytic tools and chains of reasoning and less on institutional descriptions

46. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-46 Chapter Summary Economics is a relatively mathematical subject because so much of what it analyzes can be measured –Economists use arithmetic to count things and use algebra because it is the best way to analyze and understand arithmetic

47. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 3-47 Chapter Summary When macroeconomists build models, they usually follow four key strategies –strip down a complicated process to a few economy-wide behavioral relationships and equilibrium conditions –ignore differences between people in the economy –look at opportunity costs –focus on expectations of the future