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Chapter 2: Thinking like an Economist Objectives 1.) The Economist as Scientist 2.) The Scientific Method 3.) Observation, Theory, Assumptions Every field of study has its own terminology Mathematics integrals axioms vector spaces Psychology ego id torts Law Promissory estoppel venues cognitive dissonance Every field of study has its own terminology Economics Supply Opportunity cost Comparative advantage Elasticity Consumer Surplus Demand Deadweight loss 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. The Economist as a Scientist The economic way of thinking . . . Involves thinking analytically and objectively. Makes use of the scientific method. The Scientific Method Uses abstract models to help explain how a complex, real world operates. Develops theories, collects, and analyzes data to prove the theories. Observation, Theory and More Observation! 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. The Economic Way of Thinking Includes developing abstract models from theories and the analysis of the models. Uses two approaches: Descriptive (reporting facts, etc.) Analytical (abstract reasoning) What is an Economic Model? An Economic Model is a simplified, small-scale version of some aspect of the economy. Economic Models are often expressed in equations, by graphs, or in words. Two Examples of Economic Models are: 1.) Circular - flow diagram 2.) The Production Possibilities Frontier Revenue Goods and services sold FIRMS •Produce and sell goods and services. •Hire and use factors of production. Inputs for production Wages, rent and profit Spending MARKETS FOR GOODS AND SERVICES •Firms sell •Households buy Goods and services bought The Circular Flow (Figure 2-1) HOUSEHOLDS •Buy and consume goods and services •Own and sell factors of production. Labor, land, and capital MARKETS FOR FACTORS OF PRODUCTION • Households sell • Firms buy Income = Flow of goods and services = Flow of dollars 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 The Circular-Flow Diagram Markets for Goods & Services Firms sell Households buy Markets for Factors of Production Households sell Firms buy The Circular-Flow Diagram Factors of Production Inputs used to produce goods and services Land, labor, and capital The Production Possibilities Frontier 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. Quantity of Computers Produced D 3,000 The Production Possibilities Frontier (Figure 2-2) C A 2,200 2,000 B 1,000 0 300 600 700 1,000 Quantity of Cars Produceed Concepts Illustrated by the Production Possibilities Frontier Efficiency Tradeoffs Opportunity Cost Economic Growth A Shift in the Production Possibilities Frontier (Figure 2-3) Quantity of Computers Produced 4,000 3,000 E 2,100 2,000 A 0 700 750 1,000 Quantity of Cars Produced Microeconomics Microeconomics is the study of how households and firms make decisions and how they interact in markets. Goal: to explain the prices and quantities of individual goods and services. Macroeconomics Macroeconomics is the study of the national economy and the global economy and the way that economic aggregates grow and fluctuate. Goal: to explain average prices and total employment, income, inflation and economic growth. Two Roles of Economists When they are trying to explain the world, they are scientists. When they are trying to change the world, they are policymakers. Role of Economists 1. Positive Analysis -- positive statements: claims that attempt to describe the world as it is. 2. Normative Analysis -- normative statements: claims that attempt to prescribe how the world should be. Positive or Normative Statements? ? An increase in the minimum wage will cause a decrease in employment among the least-skilled. ? Positive or Normative Statements? ? Higher federal budget deficits will cause interest rates to increase. ? ? Positive or Normative Statements? ? ? The income gains from a higher minimum wage are worth more than any slight reductions in employment. ? ? Positive or Normative Statements? ? ? State governments should be allowed to collect from tobacco companies the costs of treating smoking-related illnesses among the poor. ? Economists in Washington . . . . . . serve as advisers in the policymaking process of the three branches of government: Legislative Executive Judicial Why Economists Disagree? 1.) Differences in scientific judgments. 2.) Differences in values. PROPOSITION AND PERCENTAGE OF ECONOMISTS WHO AGREE 1. A ceiling on rents reduces the quantity and quality of housing available. (93%) 2. Tariffs and import quotas usually reduce general economic welfare. (93%) 3. Flexible and floating exchange rates offer an effective international monetary arrangement. (90%) PROPOSITION AND PERCENTAGE OF ECONOMISTS WHO AGREE 4. Fiscal policy (e.g., tax cut and/or government expenditure increase) has a significant stimulative impact on less then fully employed economy. (90%) 5. If the federal budget is to be balanced, it should be done over the business cycle rather than yearly. (85%) 6. Cash payments increase the welfare of recipients to a greater degree than do transfers-in-kind of equal cash value. (84%) PROPOSITION AND PERCENTAGE OF ECONOMISTS WHO AGREE 7. A large federal budget deficit has an adverse effect on the economy. (83%) 8. The minimum wage increases unemployment among young and unskilled workers. (79%) 9. The government should restructure the welfare system along the lines of a “negative income tax.” (79%) 10. Effluent taxes and marketable pollution permits represent a better approach to pollution control than imposition of pollution ceilings. (78%) Demand Curve Price of Novels 12 10 8 6 4 2 0 0 5 10 15 20 Quantity of Novels Purchased 25 30 Novels Purchased by Emma B. Income Price $20,000 $30,000 $40,000 $10 2 novels 5 novels 8 novels 9 6 9 12 8 10 13 16 7 14 17 20 6 18 21 24 5 22 25 28 Shifting Demand Curves When income increases, the demand curve shifts to the right. 12 Price of Novels 10 8 $20,000 $30,000 $40,000 6 4 When income decreases, the demand curve shifts to the left. 2 0 0 5 10 15 20 Quantity of Novels Purchased 25 30 Calculating the Slope Price of Novels 12 10 8 Demand 6 4 2 0 0 10 20 Quantity of Novels Purchased 30 Summary In order to address subjects with objectivity, economics makes use of the scientific method. The field of economics is divided into two subfields: microeconomics and macroeconomics. Summary Economics relies on both positive and normative analysis. Positive statements assert how the world “is” while normative statements assert how the world “should be.” Economists may offer conflicting advice due to differences in scientific judgments or to differences in values.