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Definitions Microeconomics – the study of how households and firms make decisions and how they interact in markets. Chapter 2 Thinking Like an Economist Positive versus Normative Analysis Positive statements are descriptive. n They make a claim about how the world is. n They are capable of being verified (proven true or false). Normative statements are claims that attempt to proscribe how the world should be. n They deal with values, ethics, and other principles that cannot be verified. Macroeconomics – the study of economy-wide phenomena, including inflation, unemployment, and economic growth. Positive or Normative Statements? u u u u An increase in the minimum wage will cause a decrease in employment among the least skilled. Higher federal budget deficits will cause interest rates to increase. The income gains from a higher minimum wage are worth more than any slight reduction in employment. Provincial governments should be allowed to collect from tobacco companies the costs of treating smoking-related illnesses among the poor. Economic Models The Circular Flow Model A model abstracts from the details of reality. A model is a simplified description of some aspect of the economy. Economy consists of two sectors: n Households/individuals – own productive resources. n n Firms – use inputs or factors to produce goods and services. 1 The Circular Flow Model The Circular Flow Model Productive resources (also known as means of production or factors) include: n Natural resources - Oil, lumber, fish, etc. n Human resources n Capital resources -man-made inputs like buildings, machinery, etc. Households and firms meet/interact in markets. 1. Factor (resource) market – firms purchase inputs from households 2. Product market – households purchase goods and services from firms. Diagram: The Circular-Flow Model Diagram: The Circular-Flow Model Product Markets Product Markets Businesses Households Households Flow of Resources Supply Resources Resource Markets Businesses Demand Resources Resource Markets Diagram: The Circular-Flow Model Product Markets Diagram: The Circular-Flow Model Demand Goods & Services Product Markets Supply Goods & Services Flow of Goods and Services Households Supply Resources Flow of Land Labour Capital Resource Markets Businesses Demand Resources Businesses Households Supply Resources Demand Resources Resource Markets 2 Diagram: The Circular-Flow Model Diagram: The Circular-Flow Model $ g din en Sp Product Markets $R ev en ue $ g din en Sp The Flow of Dollars Households Businesses $ In co me es ns pe x $E Resource Markets Resource Markets Diagram: The Circular-Flow Model g din en p $S Product Markets Diagram: The Circular-Flow Model Product Markets $R ev en ue $ $ In co me Rent Wages Profit Resource Markets Businesses es ns pe x $E How do markets co-ordinate supply and supply? n n n What ensures that firms produce (supply) the amount of goods that households wish to consume (purchase)? In a market system, resource allocations are based on the decisions of individual producers and consumers, without any central direction (“decentralized economy ”). How are activities co-ordinated within the market? $ Dollar Flow Real Flow The Flow of Dollars Households $R ev en ue The Flow of Dollars Businesses Households Product Markets Businesses Households $ $ Resource Markets Supply and demand models explain how activities are coordinated within each market Prices guide seller and buyer behaviour. n n When there is too much (little) supply, prices fall (rise). In response to falling (rising) prices, producers cut back (increase) production. 3 A Second Economic Model: Production Possibilities Frontier…. Computers … is a graph that shows the various combinations of output that the economy can possibly produce given the available factors of production and technology. Also called the PPF. Production Possibilities Frontier Cars 0 Production Possibilities Frontier Production Possibilities Frontier E A 2000 Computers Computers 3000 A 2000 Cars 0 Cars 700 0 Production Possibilities Frontier Production Possibilities Frontier 3000 3000 E E A 2000 Computers Computers 700 F 0 700 1000 A 2000 F Cars 0 700 1000 Cars 4 Production Possibilities Frontier Principles of Economics Illustrated by the Production Possibilities Frontier . . . E Efficient Resource Use u u u u Efficiency Tradeoffs Opportunity Cost Economic Growth Computers 3000 A 2000 B? 1000 F 0 300 1000 700 Cars Production Possibilities Frontier E Pt. B is not efficient, since we could produce more of both goods with available resources. Computers n Tradeoffs 3000 A 2000 C 1000 F 0 700 1000 900 Cars Production Possibilities Frontier E n If the economy is using resources efficiently, then tradeoffs are involved. To produce more cars, must produce fewer computers. 3000 Computers n 2000 Opportunity Cost of next 200 cars is 1000 computers. Opportunity cost of 1 car is 5 computers A C 1000 Opportunity Cost F 0 700 900 1000 Cars 5 Production Possibilities Frontier Economic Growth Computers The economy as a whole can produce more goods as: n More resources become available n Technology improves, allowing for more efficient usage of existing resources. Economic growth is representing by a shifting out the PPF. 3000 2000 1000 0 300 700 1000 Cars 6