2. THINKING LIKE AN ECONOMIST Chapter 2

3. Economist as Scientist n Economists try to address their subject with a scientific objectivity. The essence of science is the scientific method. n Scientific methods... ästart from crude observation äthen develop a rigorous theory or model that explains the observed phenomenon äfinally test the theory by collecting and analyzing data from many different sources. n Hence scientific methods include... ädeveloping abstract models and the analysis of the models:deductive or analytical method äcollecting and analyzing data systematically: inductive or empirical method

4. Economic Models n The purpose of models is to learn about reality in a simple and intuitive way and not to capture all the details of reality. äLearning anatomy with plastic models of the human body äEconomists use models, often composed of diagrams and equations n In simplifying the reality, the role of assumptions is important. The art in scientific thinking is deciding which assumptions to make.

5. Our First Model: The Circular-Flow Model n The economy consists of millions of people engaged in many activities. n The circular-flow model is a simple way to visually show the economic transactions that occur between households and firms in the economy.

6. The Circular-Flow Diagram

15. Spending Goods and services bought Revenue Goods and services sold Labor, land, and capital Income 5Flow of goods and services 5Flow of dollars Inputs for 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 Figure 2-1

16. Our Second Model: The Production Possibilities Frontier n The production possibilities frontier is a graph showing the various combinations of output that the economy can possibly produce given the available factors of production and technology. n By assuming that a given economy produces only two goods, it shows tradeoffs the economy faces.

17. Linear Production Possibility Curve n A rancher produces two goods: meat and potato n Hours needed to produce one pound of: ämeat is 1 hour äpotato is 8 hours. n Total working hours: 40 hours

18. Amount Produced in 40 hours Opportunity Cost of 1 Pound of Potato = 8 Pound of Meat

19. Production Possibility Curve of A Rancher 20 Potatoes (pounds)2½ B 0 Meat (pounds) The slope of PPC represents the opportunity cost of potato 5 40 A point inside the PPC is inefficient A point on the PPC is efficient. A point outside the PPC is infeasible.

20. Bowed-Out Production Possibility Curve n Linear PPC reflects constant opportunity cost. But the opportunity cost of good A in terms of good B may depend on how much each good the society is producing. n When the economy is using most of its resources to make cars, even workers and tools best suited to making computers are being used to make cars; the opportunity cost of a car will be very large.

21. 3,000 1,000 2,000 2,200 Production possibilities frontier A B C Quantity of Cars Produced 70060030001,000 Quantity of Computers Produced D Figure 2-2

22. The Production Possibilities Frontier 3,000 2,000 2,100 A Quantity of Cars Produced 70075001,000 Quantity of Computers Produced 4,000

23. The Production Possibilities Frontier 3,000 2,000 2,100 A Quantity of Cars Produced 70075001,000 Quantity of Computers Produced 4,000

24. The Production Possibilities Frontier 3,000 2,000 2,100 A Quantity of Cars Produced 70075001,000 Quantity of Computers Produced 4,000 E

25. 3,000 2,000 2,100 A Quantity of Cars Produced 70075001,000 Quantity of Computers Produced 4,000 E Figure 2-3

26. Ideas Illustrated by the Production Possibilities Frontier n Efficiency n Tradeoffs n Opportunity Cost n Economic Growth

27. Studying Economics with Data n Time Series, Cross Section, and Panel Data n Absolute Values versus Rate of Change äRate of change = (X 1 -X 0 )/X 0 = X 1 /X 0 -1 äThe rate of increase in unemployment can fall even though unemployment is increasing. n Real versus Nominal Values äreal GDP= nominal GDP/Price index äreal growth=nominal growth-inflation rate

28. Types of Data

29. Omitted Variable Fallacy n It is very common to use graphs to argue about how one variable (X) causes another variable (Y). n Such a graphical relationship can often be deceptive unless we properly control all other variables (Z) that might also affect Y. n Does the number of cigarette lighters cause risk of lung cancer?

30. Omitted Variable Fallacy

32. Positive versus Normative Analysis Positive statements are statements that describe the world as it is. ä Called descriptive analysis Normative statements are statements about how the world should be. ä Called prescriptive analysis

33. Positive or Normative ? n An increase in the minimum wage will cause a decrease in employment among the least- skilled. n Higher federal budget deficits will cause interest rates to increase. n The income gains from a higher minimum wage are worth more than any slight reductions in employment. n Governments should be allowed to collect from tobacco companies the costs of treating smoking-related illnesses.