Chapter 2 Thinking Like an Economist

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Chapter 2 Thinking Like an Economist

• Outline of Topics
• T1 The Economist as Scientist
• When they are trying to explain the world, they
  are Scientists
• T2 The Economist as Policy Adviser
• When they are trying to change the world they are
  
• Policy-makers
• T3 Why Economists Disagree

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T1 The Economist as Scientist

• It seem odd to claim that economics is a science
  because economists do not work with test tubes or
  telescopes.
• However, economists try to address their subject
  with a scientists objectivity. They devise
  theories, collect data and then analyze these
  data in an attempt to verify or refute their
  theories.
• Economist and scientist share the same essence of
  science. That is the scientific method-the
  dispassionate development and testing of theories
  about how the world works.

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T 1.1 The role of assumptions

• Economists make assumptions because assumption
  can make the world easier to understand
• Economists use different assumptions to answer
  different questions.
• For example, suppose we want to study what
  happens to the economy when the government
  changes the number of dollars in circulation. We
  need to know how prices respond. Then, we need to
  make different assumptions when studying the
  effects of the policy change over different time
  horizons. For studying the short run effect, we
  assume that prices do not change much however,

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• For studying long run effects, we assume that all
  prices are completely flexible.
• T 1.2 Economic Models
• Economists use models to learn about the world,
  but instead of being made of tangible materials,
  they are most often composed of diagrams and
  equations.Economic models omit many details to
  allow us to see what is truly important.
• T 1.3 First Model The Circular-Flow Diagram
• Circular-flow diagrama visual model of the
  economy that shows how dollars flow through
  markets among households and firms. See Figure
  2-1 on page 24

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• Two types of decision makers households and
  firms
• Two types of markets
• The markets for goods and services
• The markets for the factors of productions
• Factors of production labour, capital and land
• Households own the factors of production
  consume all the goods and service that the firms
  produce
• Households are buyers and firms are sellers in
  the markets for goods and services however,
  households are sellers and firms are buyers in
  the markets for the factors of production.

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• The inner loop of the circular-flow diagram
  represents the flows of goods and service between
  households and firms. The households sell the use
  of their labour, land, and capital to the firms
  in the markets for the factors of production. The
  firms then use these factors to produce goods and
  services, which in turn are sold to households in
  the market for goods and services. Hence, the
  factors of production flow from households to
  firms, and goods and services flow from firms to
  households.

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• The outer loop of the circular-flow diagram
  represents the corresponding flow of dollars. The
  household spend money to buy goods and services
  form the firms. The firms use some of the revenue
  from these sales to pay for the factors of
  production, eg, the wages of their workers.
  Whats left is the profit of the firm owners, who
  themselves are members of households. Hence,
  spending on goods and services flows from
  households to firms, and income in the form of
  wages, rent, and profit flows from firms to
  households.

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• T1.4 Second model The Production Possibilities
  Frontier, (PPF, See Figure 2-2 on page 25)
• PPF is a graph that shows the various
  combinations of output that the economy can
  possibly produce given the available factors of
  production and technology.
• The economy can produce any combination on or
  inside the frontier. Points outside the frontier
  are not feasible given the economys resources.
  Points on the PPF represent efficient levels of
  production. When the economy is producing at such
  a point, say point A, there is no way to produce
  more of one good without producing less of the
  other. Point A C feasible and efficient

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T1.4 PPF

• Point B represents an inefficient outcome. For
  some reason, perhaps widespread unemployment, the
  economy is producing less than it could from the
  resources it has available. If the resource of
  the inefficiency were eliminated, the economy
  could move from point B to Point A, increasing
  production of both cars and computers. Point B
  feasible but inefficient.
• Tradeoffs moving from point A to point C,
  society produces more computers (2000 to 2200)
  but at the expense of producing fewer cars (700
  to 600)
• Opportunity Cost moving from point A to point C,
  society gives up 100 cars to get 200 additional
  computers. At point A, the opportunity cost of
  200 computers is 100 cars.

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• T1.4 PPF
• A shift in the PPF ( See Figure 2-3 on page 27)
• If a technological advance in the computer
  industry raises the number of computers that a
  worker can produce per week, the economy can make
  more of computers for any given number of cars.
  As a result, the PPF shifts outwards as in Figure
  2-3. Because of this economic growth, society
  might move production from point A to point E,
  enjoying more computers and more cars.
• T1.5 Microeconomics Macroeconomics
• Microeconomics the study of how households and
  firms make decisions and how they interact in
  markets

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• Example A micro-economist might study the
  effects of rental control on housing in Victoria
  or the impact of foreign competition on the
  Canadian auto industry.
• Macroeconomics the study of economy-wide
  phenomena, including inflation, unemployment, and
  economic growth.
• Example A macroeconomist might study the effects
  of borrowing by the federal government, the
  changes over time in the economys rate of
  unemployment, or alternative policies to raise
  growth in national living standards.

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• T2 The Economist as Policy Adviser
• T 2.1 Positive Vs.Normative Analysis
• Positive statements are descriptive. They make a
  claim about how the world is
• Positive statements or assertions deal with
  matters of fact or questions about how things
  are.
• Example Minimum-wage laws cause unemployment
  among the least skilled
• Normative statements are prescriptive. They make
  a claim about how the world ought to be.
• Normative statements reflect individual opinions.
• Example The government should raise the
  minimum wage

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• A key difference between positive and normative
  statements is how we judge their validity.
• In principle, we can confirm or refute positive
  statements by examining evidence. An economist
  might evaluate positive statement by analyzing
  data on changes in minimum wages and changes in
  unemployment over time.
• By contrast, evaluating normative statements
  involves values as well as facts. Normative
  statements cannot be judged using data alone. It
  might also involve our views on ethics, religion,
  and political philosophy.

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• T3. Why Economists Disagree
• The are two basic reasons
• Economists may disagree about the validity of
  alternative positive theories about how the world
  works.
• Economists may have different values and
  therefore, different normative views about what
  policy should try to accomplish
• Yet, one should not overstate the amount of
  disagreement. In many cases, economists do offer
  a united view.
• Proposition 1 A ceiling on rents reduces the
  quantity and quality of housing available. (93
  of Economists agree)
• See page 33 for other propositions