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Chapter 2
Thinking Like an Economist.
Introduction
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In this chapter we are going to introduce two very simple examples of economic thinking and
model-building which illustrate how individual production decisions are made.
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We will simplify real-world scenarios and use some basic assumptions to construct a model
capable of offering simple answers to questions such as “what to produce?”
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This analysis will relay heavily on graphs and some basic algebra.
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These are questions that deal with societies, questions that deal with people. Economics is a
social science. Although advanced economics employ a great deal of mathematics this is not
finance and its essence is very similar to those of sociology, political science and anthropology.
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In sum, we are going to deal with matters using the jargon and techniques that economists use.
The Economist As Scientist
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Economics uses a fair amount of jargon. A big part of this course consists of familiarizing
yourself with the lingo. But that is not the most important part of the course.
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The most critical thing to learn from this experience is to use the economic methodology and
this is nothing but the scientific method applied to the study of social issues.
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The scientific method of study has four distinctive phases. This is how we follow them:
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Observation of reality. First we identify a problem to study. We focus on a particular aspect
of social reality (e.g.: there was a large increase in the cost of living –inflation, in the 70s .)
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Collection of data: We need to properly document the phenomenon observed so we can put
together a complete record of event (e.g.: we record the prices of various commodities.)
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Construction of Theories: In economics these are called models and are logical and
verifiable argumentations that link all the aspects of reality that we are trying to explain
(e.g.: because the price of oil (source of energy) went up production costs went up too.)
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Testing of Theories: Controlled experiments are generally used to verify theories but that is
very difficult to do with a social science, so we employ statistical tools (i.e.: econometrics.)
It is important to remember that economic models are abstract representations of reality that
help us analyze very complicated problems and reach meaningful conclusions.
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Reality is extremely complex in details, so we need to simplify them, focusing on the critical
elements of any given problem in order to give a useful answer to any pertinent question.
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Most often we make assumptions about reality that help us simplify complicated situations.
Economics draws fire from other disciplines because it is accused of over-simplification.
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Similarly, some people consider economics an obscure discipline that has nothing to do with
the real world when in fact it is just the tools of analysis that are somehow abstract (e.g.: a lot
of advanced mathematics), not the object of analysis per se.

We use a huge amount of graphs in economics because they convey a great deal of
information in a small amount of space.
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All graphs will be two-dimensional because the instructor has not yet mastered mental
holograms and because we will analyze only relations between two variables at a time.
Circular Flow Diagram Model
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This particular model tries to represent in a simple graphic way how the economy is
organized and how the different economic participants interact with one another. Not a
small feat!
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We will streamline our model by focusing on the main economic actors (producers and
consumers) although we can easily include other actors –such as the government.
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Similarly we will focus on the two main markets where firms and households interact: the
market for goods and services and the market for factors of production.
[See Figure 1]
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Notice how goods and services flow in circular fashion from firms to households and labor and
capital flow from households to firms.
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Similarly, money flows from consumers to producers as payment for goods and services in the
same amount as firms pay households for their capital and labor. Hence the name of the model.
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How could this model be expanded? Including government, international trade, profits, taxes…
Production Possibilities Frontier Model
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As a society one of the most critical questions that we need to answer is that of what to
produce. Should we invest our resources in space exploration or in cancer research? Should
we build wider highways or high-speed railway lines?
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Of course these are very complicated questions and we don’t have the magic ball with all the
answers, we only have a very elegant and internally consistent way of dealing with them.
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We need to construct a model that captures the essence of the problem. We need to simplify:
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We will deal with only two production alternatives at a time (computers and cars) because in
that way we can use two-dimensional graphs.
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We will assume that the only two factors of production involved in the production of these two
goods are labor (L) and physical capital (K), combined employing the existing technology (A).
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We will study the answer to this question at an specific moment in time, that is, L, K, and A are
considered fixed (do not increase or decrease).
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The Production Possibilities Frontier (PPF) is a curve that shows the different combinations
of two goods that can be produced with the available factors of production and technology.
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It is a graphical representation of the tradeoffs that an economy faces when deciding how
many units of each good to produce:
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The corner points represent the exclusive production of one of the two goods.
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It takes the form of a concave curve because as we increase the production of any of the goods
its opportunity cost increases (we have to give up increasingly larger amounts of the other
good that is becoming progressively scarcer).
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We can identify the slope of the PPF with the opportunity cost of producing each good.
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Points inside the PPF are considered inefficient because they can be achieved and yet
production factors are left unemployed.
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Points outside the PPF are considered unattainable because there are not enough production
factors to achieve them.
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Points on the PPF are considered to be both attainable and efficient.
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The PPF can shift rightward if any (or all) the production factors increase in volume or if the
available technology improves. That will make previously unattainable combinations part of
the now expanded PPF.
Microeconomics and Macroeconomics
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There are different fields of study in economics (the same way there are in physics or
psychology.) We can group these fields in two main levels:
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Microeconomics: the study of how individual households and firms make decisions and
how they interact in particular markets.
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Macroeconomics: the study of how whole societies interact in markets and with one
another. These interactions take the form of economy-wide phenomena, such as inflation,
unemployment, and economic growth.
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These two fields are closely intertwined because changes in the overall economy arise from the
decisions of individual households and firms. Macro models must have micro foundations.
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Nonetheless, because microeconomics and macroeconomics address different questions, they
sometimes take different approaches and are often taught in separate courses.
The Economist as Policy Adviser
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Economists usually take on two different roles: as scientists trying to understand and explain
how the world works or as advisors offering possible solutions to help improve it.
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These are two different roles because in the former role the economist produces positive
analysis where as in the later role she produces normative analysis:
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Positive statements are claims that attempt to describe the world as it is –free of judgments.
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Normative statements are claims that attempt to prescribe how the world should be.
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Positive statements can be easily evaluated and verified using data, while normative statements
involve personal viewpoints that are most often unassailable.
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This is why very often economists disagree about their views of reality. Valuing differently the
concepts of efficiency and equity produces different perceptions about reality.
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Even if economists agree on basic positive statements they can disagree on the details. For
example, economists often disagree about the size of the effects of changes in the economy on
the behavior of households and firms (e.g.: how much would lower taxes affect consumption?)