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CHAPTER 3
Thinking Like an Economist
3-1
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Questions
• In what way and to what degree can
we say that economics is a science?
• What do economists mean by a
“model”?
• Why are economists so attracted to
formal, mathematical models?
• What patterns and habits of thought
must you learn to successfully think
like an economist?
3-2
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Economics
• 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 largescale experiments
• the subjects studied by economists–people–
have minds of their own
– expectations of the future play an important role
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
The Importance of
Expectations: An Example
• The stock market crash of 1929
changed what Americans expected
about the future of the economy
 spending
 production
layoffs
 income
• Expectations that future income would
be lower became realized
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 3.1 - The Stock Market, 1928-1932
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Economics
• Economics is a quantitative science
– uses arithmetic to measure economic
variables of interest
– uses mathematical models to relate
economic variables of interest
3-6
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Economics
• To describe the economy, economists
focus on a few simple behavioral
relationships
– cause-and-effect links between economic
quantities
• The process of reducing the
complexity of the real world is known
as “building a model”
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Economics
• A large part of economics involves a
particular set of tools
– a unique way of thinking
– a technical language
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
The Rhetoric of Economics
• 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”
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 3.2 - Pushing the Economy Up the
Phillips Curve
Inflation
Phillips curve
1989: 5.3% unemployment, 4.4% inflation
1986: 7% unemployment, 2.6% inflation
Unemployment
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
The Rhetoric of Economics
• Four dominant concepts
– the image of the circular flow of
purchasing power through the economy
– the use of the word “market”
– the idea of equilibrium
– the use of graphs and diagrams to
express economic relationships
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
The Circular Flow
• The circular flow of economic activity
describes the patterns of spending,
income, and production flowing
through the economy
– it is the flow of purchasing power
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
The Circular Flow
• The “income side”
– firms buy the factors of production from
households
– money payments flow from firms to
households
• The “expenditure side”
– households buy goods and services from
firms
– money payments flow from households to
firms
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 3.3 - The Circular Flow Diagram
Flow of incomes
Households
Businesses
Flow of expenditures
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Circular Flow
• The circular flow diagram can be
made to be more realistic by adding
– the government
– financial markets
– international trade and finance
3-15
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 3.4 - The Circular Flow of
Economic Activity
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Different Measures of the
Circular Flow
• The “expenditure side” measure
– consumption
– investment
– government purchases
– net exports
• The “income side” measure
– purchases of labor, capital, and natural
resources owned directly or indirectly by
households
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Different Measures of the
Circular Flow
• The “uses of income” measure
– where households decide to use their
income
• saving
• taxes
• consumption
3-18
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Different Measures of the
Circular Flow
• If we compare the expenditure-side
measure of GDP with the income-side
or uses-of-income-side, we will find
that they are equal
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Markets
• Economists use markets 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
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Equilibrium
• 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 those points of
equilibrium
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
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
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 3.5 - Two Forms of the Production
Function
Equations
Curves
Y/L
Y
K
 F( , E)
L
L
K/L
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
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 the
behavioral relationships intersect
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Using Graphs Instead of
Equations
• Changes in the state of the economy
can be shown as movements in the
intersection of the curves
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Building Models
• Simplification is at the core of
economists’ model building
– no one understands excessively
complicated models
– the predictions generated by simple
models are nearly as good as the ones
generated by more complex models
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
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
3-27
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Important Concepts in
Macroeonomic Models
• Opportunity Cost
– occurs when any decision is made
– measured by the value of the best
alternative foregone
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Important Concepts in
Macroeonomic Models
• Expectation Formation
– every macroeconomic model 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
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
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
– rational expectations
• decision makers know as much about the
structure and behavior of the economy as the
model builder does
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
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
3-31
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
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)
Y/L  F(K/L,E)
• Cobb-Douglas production function

1-
Y/L  (K/L)  E
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
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
s
K/Y  * 
ng
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Building and Solving an Economic
Model: An Example
• Equilibrium condition for balanced
growth
s
K/Y  κ* 
ngδ
• s=share of total income in the economy that
is 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
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
The Advantages of Using
Algebra
• Algebra is the best way to summarize
cause-and-effect behavioral
relationships in economics
– allows us to consider different possible
systematic relationships by changing the
values of parameters
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• Economists’ ways of thinking are
strange – peculiar to their intellectual
discipline
• Economics is abstract
– economic courses focus more on analytic
tools and chains of reasoning and less on
institutional descriptions
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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
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
3-37
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
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 and
how they affect the present
3-38
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.