1. Chapter 2 Thinking Like an Economist 2002 by Nelson, a division of Thomson Canada Limited

2. Chapter 2: Page 2 In this chapter you will…  See how economists apply the method of science.  Consider how assumptions and models can shed light on the world.  Learn two simple models - the circular flow and production possibilities frontier.  See how economists apply the method of science.  Consider how assumptions and models can shed light on the world.  Learn two simple models - the circular flow and production possibilities frontier.

3. Chapter 2: Page 3 In this chapter you will…  Distinguish between microeconomics and macroeconomics.  Learn the difference between and normative statements.  Examine the role of economists in making policy.  Consider why economists sometimes disagree with one another.  Distinguish between microeconomics and macroeconomics.  Learn the difference between and normative statements.  Examine the role of economists in making policy.  Consider why economists sometimes disagree with one another.

4. Chapter 2: Page 4 Thinking Like an Economist Every field of study has its own terminology –Mathematics integrals  axioms  vector spaces –Psychology ego  id  cognitive dissonance –Law promissory  estoppels  torts  venues –Economics supply  opportunity cost  elasticity  consumer surplus  demand  comparative advantage  deadweight loss Every field of study has its own terminology –Mathematics integrals  axioms  vector spaces –Psychology ego  id  cognitive dissonance –Law promissory  estoppels  torts  venues –Economics supply  opportunity cost  elasticity  consumer surplus  demand  comparative advantage  deadweight loss

5. Chapter 2: Page 5 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. 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.

6. Chapter 2: Page 6 THE ECONOMIST AS A SCIENTIST The economic way of thinking... –Involves thinking analytically and objectively. –Economists… Devise theories Collect data Analyze the data to verify or refute their theories –Economics makes use of the scientific method. The economic way of thinking... –Involves thinking analytically and objectively. –Economists… Devise theories Collect data Analyze the data to verify or refute their theories –Economics makes use of the scientific method.

7. Chapter 2: Page 7 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. Uses abstract models to help explain how a complex, real world operates. Develops theories, collects, and analyzes data to evaluate the theories.

8. Chapter 2: Page 8 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. 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.

9. Chapter 2: Page 9 Economic Models 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 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

10. Chapter 2: Page 10 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.

11. Figure 1: The Circular Flow Copyright © 2004 South-Western Spending Goods and services bought Revenue Goods and services sold Labour, land, and capital Income = Flow of inputs and outputs = Flow of dollars Factors of production Wages, rent, and profit 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 Firms sell Households buy MARKETS FOR GOODS AND SERVICES

12. Chapter 2: Page 12 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 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

13. Chapter 2: Page 13 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 Factors of Production – Inputs used to produce goods and services – Land, labour, and capital Markets for Goods and Services – Firms sell – Households buy Markets for Factors of Production – Households sell – Firms buy Factors of Production – Inputs used to produce goods and services – Land, labour, and capital

14. Chapter 2: Page 14 Our Second Model: The Production Possibilities Frontier production possibilities frontierThe 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.

15. Chapter 2: Page 15 Quantity of Computers Produced Quantity of Cars Produced 0 Figure 2-2: The Production Possibilities Frontier 3000 2000 700 A 1000 300 B 2200 600 C D 1000 Production possibilities frontier

16. Chapter 2: Page 16 Concepts Illustrated by the Production Possibilities Frontier –Efficiency –Tradeoffs –Opportunity Cost –Economic Growth Concepts Illustrated by the Production Possibilities Frontier –Efficiency –Tradeoffs –Opportunity Cost –Economic Growth Our Second Model: The Production Possibilities Frontier

17. Chapter 2: Page 17 Figure 2-3. A Shift in the Production Possibilities Frontier Quantity of Computers Produced Quantity of Cars Produced 3000 2000 700 A 0 4000 2100 750 E 1000

18. Chapter 2: Page 18 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 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

19. Chapter 2: Page 19 THE ECONOMIST AS POLICY ADVISER When economists are trying to explain the world, they are scientists. When economists are trying to change the world, they are policy advisor. When economists are trying to explain the world, they are scientists. When economists are trying to change the world, they are policy advisor.

20. Chapter 2: Page 20 Positive Versus Normative Statements 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 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

21. Chapter 2: Page 21 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. POSITIVE 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. POSITIVE Positive Versus Normative Statements

22. Chapter 2: Page 22 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. NORMATIVE 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. NORMATIVE Positive Versus Normative Statements

23. Chapter 2: Page 23 Economists in Ottawa Department of Finance: Design tax policy. (www.fin.gc.ca)www.fin.gc.ca Industry Canada: Design and enforce anti- monopoly laws. (www.ic.gc.ca)www.ic.gc.ca Department of Foreign Affairs and International Trade: Negotiate trade agreements with other countries. (www.defait.gc.ca)www.defait.gc.ca Human Resources Development Canada: Analyze data on workers to help formulate labour-market policies. (www.hrdc.gc.ca)www.hrdc.gc.ca Department of Finance: Design tax policy. (www.fin.gc.ca)www.fin.gc.ca Industry Canada: Design and enforce anti- monopoly laws. (www.ic.gc.ca)www.ic.gc.ca Department of Foreign Affairs and International Trade: Negotiate trade agreements with other countries. (www.defait.gc.ca)www.defait.gc.ca Human Resources Development Canada: Analyze data on workers to help formulate labour-market policies. (www.hrdc.gc.ca)www.hrdc.gc.ca

24. Chapter 2: Page 24 Economists in Ottawa Environment Canada: Environmental regulation. (www.ec.gc.ca)www.ec.gc.ca Canadian International Development Agency: Advice on overseas development projects. (www.acdi-cida.gc.ca)www.acdi-cida.gc.ca Statistics Canada: Collect data used by other economists to give policy advice. (www.statcan.ca)www.statcan.ca Bank of Canada: Analyze financial markets and macroeconomic developments. (www.bank-banque- canada.ca)www.bank-banque- canada.ca Environment Canada: Environmental regulation. (www.ec.gc.ca)www.ec.gc.ca Canadian International Development Agency: Advice on overseas development projects. (www.acdi-cida.gc.ca)www.acdi-cida.gc.ca Statistics Canada: Collect data used by other economists to give policy advice. (www.statcan.ca)www.statcan.ca Bank of Canada: Analyze financial markets and macroeconomic developments. (www.bank-banque- canada.ca)www.bank-banque- canada.ca

25. Chapter 2: Page 25 Economists in the private sector… … publish reports that analyze current issues such as poverty, unemployment, and the deficit. C.D. Howe Institute (www.cdhowe.org)www.cdhowe.org The Fraser Institute (www.fraserinstitute.ca)www.fraserinstitute.ca … publish reports that analyze current issues such as poverty, unemployment, and the deficit. C.D. Howe Institute (www.cdhowe.org)www.cdhowe.org The Fraser Institute (www.fraserinstitute.ca)www.fraserinstitute.ca

26. Chapter 2: Page 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. 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.

27. Table 2-2. Ten Propositions About Which Most Economists Agree

28. Chapter 2: Page 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. 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. Chapter 2: Page 29 Economics is divided into two subfields: –Microeconomists study decision making by households and firms in the marketplace. –Macroeconomists study the forces and trends that affect the economy as a whole Summary

30. Chapter 2: Page 30 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. 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. Summary

31. Chapter 2: Page 31 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. 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. Summary

32. Chapter 2: Page 32 Appendix Graphing: A Brief Review

33. Chapter 2: Page 33 Graphs of a single variable

34. Chapter 2: Page 34 Graphs of two variables: The Coordinate System

35. Chapter 2: Page 35 Curves in the Coordinate System

36. Chapter 2: Page 36 Curves in the Coordinate System

37. Chapter 2: Page 37 Slope = ∆y / ∆x

38. Chapter 2: Page 38 Cause and effect

39. Chapter 2: Page 39 Cause and effect

40. Chapter 2: Page 40 The End