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THINKING LIKE AN ECONOMIST Chapter 2 Economist as Scientist Economists try to address their subject with a scientific objectivity. The essence of science is the scientific method. Scientific methods... start from crude observation then develop a rigorous theory or model that explains the observed phenomenon finally test the theory by collecting and analyzing data from many different sources. Hence scientific methods include... developing abstract models and the analysis of the models:deductive or analytical method collecting and analyzing data systematically: inductive or empirical method Economic Models The purpose of models is to learn about reality in a simple and intuitive way and not to capture all the details of reality. Learning anatomy with plastic models of the human body Economists use models, often composed of diagrams and equations In simplifying the reality, the role of assumptions is important. The art in scientific thinking is deciding which assumptions to make. Our First Model: The Circular-Flow Model The economy consists of millions of people engaged in many activities. The circular-flow model is a simple way to visually show the economic transactions that occur between households and firms in the economy. The Circular-Flow Diagram Market for Goods and Services Firms Households Market for Factors of Production The Circular-Flow Diagram Market for Goods and Services Revenue Spending Firms Households Market for Factors of Production The Circular-Flow Diagram Market for Goods and Services Revenue Spending Firms Households Wage, rent, and profit Income Market for Factors of Production The Circular-Flow Diagram Market for Goods and Services Revenue Spending Firms Wage, rent, and profit Households Inputs for production Labor, land and capital Market for Factors of Production Income The Circular-Flow Diagram Market for Goods and Services Revenue Goods and services sold Goods and services bought Firms Wage, rent, and profit Spending Households Inputs for production Labor, land and capital Market for Factors of Production Income Revenue Goods and services sold MARKETS FOR GOODS AND SERVICES Firms sell Households buy FIRMS Produce and sell goods and services. Hire and use factors of production. Inputs for production Wages, rent, and profit Figure 2-1 Spending Goods and services bought HOUSEHOLDS Buy and consume goods and services. Own and sell factors of production. MARKETS FOR FACTORS OF PRODUCTION Households sell Firms buy Labor, land, and capital Income 5 Flow of goods and services 5 Flow of dollars Our Second Model: 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. By assuming that a given economy produces only two goods, it shows tradeoffs the economy faces. Linear Production Possibility Curve A rancher produces two goods: meat and potato Hours needed to produce one pound of: meat is 1 hour potato is 8 hours. Total working hours: 40 hours Amount Produced in 40 hours Potatoes 0 1 2 3 4 5 Meat 40 32 24 16 8 0 Opportunity Cost of 1 Pound of Potato = 8 Pound of Meat Production Possibility Curve of A Rancher Meat (pounds) The slope of PPC represents the opportunity cost of potato 40 A point inside the PPC is inefficient 20 A point on the PPC is efficient. B A point outside the PPC is infeasible. 0 2½ 5 Potatoes (pounds) Bowed-Out Production Possibility Curve 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. 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. Quantity of Computers Produced 3,000 D C 2,200 A 2,000 Production 1,000 B possibilities frontier 0 Figure 2-2 300 600 700 1,000 Quantity of Cars Produced The Production Possibilities Frontier Quantity of Computers Produced 4,000 3,000 2,100 2,000 A 0 700 750 1,000 Quantity of Cars Produced The Production Possibilities Frontier Quantity of Computers Produced 4,000 3,000 2,100 2,000 A 0 700 750 1,000 Quantity of Cars Produced Ideas Illustrated by the Production Possibilities Frontier Efficiency Tradeoffs Opportunity Cost Economic Growth Studying Economics with Data Time Series, Cross Section, and Panel Data Absolute Values versus Rate of Change Rate of change = (X1-X0)/X0 = X1/X0 -1 The rate of increase in unemployment can fall even though unemployment is increasing. Real versus Nominal Values real GDP= nominal GDP/Price index real growth=nominal growth-inflation rate Types of Data Time-Series Data UK Unemployment (Millions) 1995 2.5 1996 2.3 1997 2.01 1998 1.83 1999 1.81 Cross-section Data Average Rates of growth, unemplyment and inflation between 1990-1999 France Germany Japan UK Growth rate 1.7 2.3 1.4 Unemployment rate 11.3 7.8 3.1 Inflation rate 1.9 2.5 1.1 USA 1.7 8.4 3.6 2.6 5.8 3.3 Omitted Variable Fallacy It is very common to use graphs to argue about how one variable (X) causes another variable (Y). Such a graphical relationship can often be deceptive unless we properly control all other variables (Z) that might also affect Y. Does the number of cigarette lighters cause risk of lung cancer? Omitted Variable Fallacy The number of Risk of cigarette lighters found in the house Cancer 1 2 3 4 5 6 10% 20% 30% 40% 50% 60% Omitted Variable Fallacy The number of The number of Risk of cigarette packs cigarette smoked by the lighters found in resident of the the house Cancer house 1 1 2 1.5 3 2 4 2.5 5 3 6 3.5 10% 20% 30% 40% 50% 60% Positive versus Normative Analysis Positive statements are statements that describe the world as it is. Called descriptive analysis Normative statements are statements about how the world should be. Called prescriptive analysis Positive or Normative ? An increase in the minimum wage will cause a decrease in employment among the leastskilled. Higher federal budget deficits will cause interest rates to increase. The income gains from a higher minimum wage are worth more than any slight reductions in employment. Governments should be allowed to collect from tobacco companies the costs of treating smoking-related illnesses.