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ThinkingLikeAnEconomist2PRINCIPLESOFF
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NThinkingLikeAnEconomist2PRInthischapter,lookfortheanswerstothesequestions:Whatareeconomists’tworoles?Howdotheydiffer?Whataremodels?Howdoeconomistsusemodels?WhataretheelementsoftheCircular-FlowDiagram?Whatconceptsdoesthisdiagramillustrate?HowistheProductionPossibilitiesFrontierrelated
toopportunitycost?Whatotherconceptsdoesitillustrate?Whatisthedifferencebetweenmicroeconomicsandmacroeconomics?Betweenpositiveandnormative?CHAPTER2THINKINGLIKEANECONOMISTInthischapter,lookfortheTheEconomistasScientistEconomistsplaytworoles:Scientists:trytoexplaintheworldPolicyadvisors:trytoimproveitInthefirstrole,economistsemploythescientificmethod:thedispassionatedevelopmentandtestingoftheoriesabout
howtheworldworks.CHAPTER2THINKINGLIKEANECONOMISTTheEconomistasScientistEconAssumptions&ModelsAssumptionssimplifythecomplexworld,
makeiteasiertounderstand.Example:Whenstudyinginternationaltrade,
wemightassumetheworldconsistsof
twocountriesandtwogoods. Veryunrealistic,butsimplifiestheproblem
andyieldsusefulinsightsaboutthemorecomplicatedrealworld.Economistsusemodelstostudyeconomicissues.Amodelisahighlysimplifiedrepresentationofamorecomplicatedreality.CHAPTER2THINKINGLIKEANECONOMISTAssumptions&ModelsAssumptionSomeFamiliarModelsAroadmapCHAPTER2THINKINGLIKEANECONOMISTSomeFamiliarModelsAroadmapSomeFamiliarModelsAmodelofhuman
anatomyfromhigh
schoolbiologyclassCHAPTER2THINKINGLIKEANECONOMISTSomeFamiliarModelsAmodelofSomeFamiliarModelsAmodelairplaneCHAPTER2THINKINGLIKEANECONOMISTSomeFamiliarModelsAmodelaiSomeFamiliarModelsThemodelteethatthedentist’sofficeDon’tforgettofloss!CHAPTER2THINKINGLIKEANECONOMISTSomeFamiliarModelsThemodelOurFirstModel:
TheCircular-FlowDiagramTheCircular-FlowDiagram:Avisualmodeloftheeconomy,showshowdollarsflowthroughmarketsamonghouseholdsandfirms.Includestwotypesof“actors”:householdsfirmsIncludestwomarkets:themarketforgoodsandservicesthemarketfor“factorsofproduction”CHAPTER2THINKINGLIKEANECONOMISTOurFirstModel:
TheCirculFactorsofProductionThefactorsofproductionaretheresourcesthattheeconomyusestoproducegoods&services.Theyinclude:laborlandcapital(buildings&machinesusedinproduction)CHAPTER2THINKINGLIKEANECONOMISTFactorsofProductionThefactoFIGURE1:TheCircular-FlowDiagramHouseholds:ownthefactorsofproduction,
sell/rentthemtofirmsforincomebuyandconsumegoods&servicesHouseholdsFirmsCHAPTER2THINKINGLIKEANECONOMISTFIGURE1:TheCircular-FlowFIGURE1:TheCircular-FlowDiagramHouseholdsFirmsFirms:buy/hirefactorsofproduction,
usethemtoproducegoodsandservicessellgoods&servicesCHAPTER2THINKINGLIKEANECONOMISTFIGURE1:TheCircular-FlowFIGURE1:TheCircular-FlowDiagramMarketsforFactorsofProductionHouseholdsFirmsIncomeWages,rent,profitFactorsofproductionLabor,land,capitalSpendingG&SboughtG&SsoldRevenueMarketsforGoods&ServicesCHAPTER2THINKINGLIKEANECONOMISTFIGURE1:TheCircular-FlowOurSecondModel:
TheProductionPossibilitiesFrontierTheProductionPossibilitiesFrontier(PPF):
Agraphthatshowsthecombinationsof
twogoodstheeconomycanpossiblyproducegiventheavailableresourcesandtheavailabletechnology.Example:Twogoods:computersandwheatOneresource:labor(measuredinhours)Economyhas50,000laborhourspermonthavailableforproduction.0CHAPTER2THINKINGLIKEANECONOMISTOurSecondModel:
TheProduPPFExampleProducingonecomputerrequires100hourslabor.Producingonetonofwheatrequires10hourslabor.5,00004,0001002,5002501,00040050,000040,00010,00025,00025,00010,00040,0000500050,000EDCBAWheatComputersWheatComputersProductionEmploymentof
laborhours0CHAPTER2THINKINGLIKEANECONOMISTPPFExampleProducingonecompuPointongraphProductionCom-putersWheatA5000B4001,000C2502,500D1004,000E05,000ABCDEPPFExampleCHAPTER2THINKINGLIKEANECONOMISTPointongraphProductionCom-puA
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PointsonthePPFA. Onthegraph,findthepointthatrepresents
(100computers,3000tonsofwheat),labelitF.
Woulditbepossiblefortheeconomytoproducethiscombinationofthetwogoods?
Whyorwhynot?B. Next,findthepointthatrepresents
(300computers,3500tonsofwheat),labelitG.Woulditbepossiblefortheeconomytoproducethiscombinationofthetwogoods?16CHAPTER2THINKINGLIKEANECONOMISTACTIVELEARNINGA
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Answers17PointF:
100computers,3000tonswheatPointFrequires40,000hours
oflabor.
Possiblebut
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w/osacrificinganyoftheother.FCHAPTER2THINKINGLIKEANECONOMISTACTIVELEARNINGA
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Answers18PointG:
300computers,3500tonswheatPointGrequires65,000hours
oflabor.
Notpossiblebecauseeconomy
onlyhas
50,000hours.GCHAPTER2THINKINGLIKEANECONOMISTACTIVELEARNINGThePPF:WhatWeKnowSoFarPointsonthePPF(likeA–E)possibleefficient:allresourcesarefullyutilizedPointsunderthePPF(likeF)possiblenotefficient:someresourcesunderutilized
(e.g.,workersunemployed,factoriesidle)PointsabovethePPF(likeG)notpossibleCHAPTER2THINKINGLIKEANECONOMISTThePPF:WhatWeKnowSoFarPThePPFandOpportunityCostRecall:Theopportunitycostofanitem
iswhatmustbegivenuptoobtainthatitem.MovingalongaPPFinvolvesshiftingresources(e.g.,labor)fromtheproductionofonegoodtotheother.Societyfacesatradeoff:Gettingmoreofonegoodrequiressacrificingsomeoftheother.TheslopeofthePPFtellsyoutheopportunitycostofonegoodintermsoftheother.CHAPTER2THINKINGLIKEANECONOMISTThePPFandOpportunityCostReThePPFandOpportunityCostTheslopeofalineequalsthe“riseovertherun”–
theamountthelineriseswhenyoumovetotherightbyoneunit.–1000100slope==–10Here,theopportunitycostofacomputeris
10tonsofwheat.CHAPTER2THINKINGLIKEANECONOMISTThePPFandOpportunityCostThA
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PPFandOpportunityCost22Inwhichcountryistheopportunitycostofclothlower?FRANCEENGLANDCHAPTER2THINKINGLIKEANECONOMISTACTIVELEARNINGA
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Answers23England,becauseitsPPFisnotassteepasFrance’s.FRANCEENGLANDCHAPTER2THINKINGLIKEANECONOMISTACTIVELEARNINGEconomicGrowthandthePPFWithadditionalresourcesoranimprovementintechnology,
theeconomycanproducemorecomputers,morewheat,oranycombinationinbetween.EconomicgrowthshiftsthePPFoutward.CHAPTER2THINKINGLIKEANECONOMISTEconomicGrowthandthePPFWitTheShapeofthePPFThePPFcouldbeastraightline,orbow-shapedDependsonwhathappenstoopportunitycost
aseconomyshiftsresourcesfromoneindustry
totheother.Ifopp.costremainsconstant,
PPFisastraightline. (Inthepreviousexample,opp.costofacomputerwasalways10tonsofwheat.)Ifopp.costofagoodrisesastheeconomyproducesmoreofthegood,PPFisbow-shaped.CHAPTER2THINKINGLIKEANECONOMISTTheShapeofthePPFThePPFcoWhythePPFMightBeBow-ShapedMountainBikesBeerAstheeconomyshiftsresources
frombeertomountainbikes:PPFbecomessteeperopp.costofmountainbikesincreasesCHAPTER2THINKINGLIKEANECONOMISTWhythePPFMightBeBow-ShapeAWhythePPFMightBeBow-ShapedAtpointA,
mostworkersare
producingbeer,
eventhosethat
arebettersuited
tobuilding
mountainbikes.So,donothaveto
giveupmuchbeertogetmorebikes.MountainBikesBeerAtA,opp.costofmtnbikesislow.CHAPTER2THINKINGLIKEANECONOMISTAWhythePPFMightBeBow-ShapBWhythePPFMightBeBow-ShapedAtB,mostworkersareproducingbikes.
Thefewleftinbeerarethebestbrewers.Producingmorebikeswouldrequireshiftingsomeofthebestbrewersawayfrombeerproduction,
wouldcauseabigdropinbeeroutput.MountainBikesBeerAtB,opp.costofmtnbikes
ishigh.CHAPTER2THINKINGLIKEANECONOMISTBWhythePPFMightBeBow-ShapWhythePPFMightBeBow-ShapedSo,PPFisbow-shapedwhendifferentworkershavedifferentskills,differentopportunitycostsofproducingonegoodintermsoftheother.ThePPFwouldalsobebow-shapedwhenthereissomeotherresource,ormixofresourceswithvaryingopportunitycosts.E.g.,differenttypesoflandsuitedfor
differentusesCHAPTER2THINKINGLIKEANECONOMISTWhythePPFMightBeBow-ShapeThePPF:ASummaryThePPFshowsallcombinationsoftwogoodsthataneconomycanpossiblyproduce,
givenitsresourcesandtechnology.ThePPFillustratestheconcepts
oftradeoffandopportunitycost,
efficiencyandinefficiency,
unemployment,andeconomicgrowth.Abow-shapedPPFillustratestheconceptofincreasingopportunitycost.CHAPTER2THINKINGLIKEANECONOMISTThePPF:ASummaryThePPFshoMicroeconomicsandMacroeconomicsMicroeconomicsisthestudyofhowhouseholdsandfirmsmakedecisions
andhowtheyinteractinmarkets.Macroeconomicsisthestudyofeconomy-widephenomena,includinginflation,unemployment,andeconomicgrowth.Thesetwobranchesofeconomicsarecloselyintertwined,yetdistinct:theyaddressdifferentquestions.CHAPTER2THINKINGLIKEANECONOMISTMicroeconomicsandMacroeconomTheEconomistasPolicyAdvisorAsscientists,economistsmake
positivestatements,
whichattempttodescribetheworldasitis.Aspolicyadvisors,economistsmake
normativestatements,
whichattempttoprescribehowtheworldshouldbe.Positivestatementscanbeconfirmedorrefuted,
normativestatementscannot.Govtemploysmanyeconomistsforpolicyadvice.E.g.,theU.S.PresidenthasaCouncilofEconomicAdvisors,whichtheauthorofthistextbookrecentlychaired.CHAPTER2THINKINGLIKEANECONOMISTTheEconomistasPolicyAdvisoA
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Identifyingpositivevs.normativeWhichofthesestatementsare“positive”andwhichare“normative”?Howcanyoutellthedifference?a. Pricesrisewhenthegovernmentincreasesthequantityofmoney.b. Thegovernmentshouldprintlessmoney.c. Ataxcutisneededtostimulatetheeconomy.d. Anincreaseinthepriceofgasolinewillcauseanincreaseinconsumerdemandforvideorentals.33CHAPTER2THINKINGLIKEANECONOMISTACTIVELEARNINGA
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Answersa. Pricesrisewhenthegovernmentincreasesthequantityofmoney. Positive,describesarelationship,couldusedatatoconfirmorrefute.b. Thegovernmentshouldprintlessmoney.
Normative,thisisavaluejudgment,cannotbeconfirmedorrefuted.34CHAPTER2THINKINGLIKEANECONOMISTACTIVELEARNINGA
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Answersc. Ataxcutisneededtostimulatetheeconomy. Normative,anothervaluejudgment.d. Anincreaseinthepriceofgasolinewillcauseanincreaseinconsumerdemandforvideorentals. Positive,describesarelationship.
Notethatastatementneednotbetruetobepositive.35CHAPTER2THINKINGLIKEANECONOMISTACTIVELEARNINGWhyEconomistsDisagreeEconomistsoftengiveconflictingpolicyadvice.Theysometimesdisagreeaboutthevalidityofalternativepositivetheoriesabouttheworld.Theymayhavedifferentvaluesand,therefore,differentnormativeviewsaboutwhatpolicyshouldtrytoaccomplish.Yet,therearemanypropositionsaboutwhichmosteconomistsagree.CHAPTER2THINKINGLIKEANECONOMISTWhyEconomistsDisagreeEconomiPropositionsaboutWhichMost
EconomistsAgree(and%agreeing)Aceilingonrentsreducesthequantityandqualityofhousingavailable.(93%)Tariffsandimportquotasusuallyreducegeneraleconomicwelfare.(93%)Alargefederalbudgetdef
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