Study Notes on Principles of Microeconomics from Mankiw

Chapter Objectives (1 of 2)

  • By the end of this chapter, you should be able to:

    • Explain how the circular flow diagram explains the economy.

    • Describe how the production possibilities frontier explains aggregate production.

    • Determine if an output level is exhibiting allocative or productive efficiency.

    • Describe opportunity cost in the context of the production possibilities frontier.

    • Describe the factors that cause the production possibilities frontier to shift.

Chapter Objectives (2 of 2)

  • Further capabilities:

    • Contrast macroeconomic concepts versus microeconomic concepts.

    • Contrast when an economist acts as a policy adviser and when an economist acts as a scientist.

The Economist as Scientist

Economics is a Science

  • Economists are scientists.

  • They:

    • Devise theories.

    • Collect data.

    • Analyze the data to verify or refute their theories.

  • The essence of science is the scientific method.

The Scientific Method

  • Observation, Theory, and More Observation:

    • Involves the development and testing of theories about how the world works.

    • Conducting experiments in economics is often impractical, so natural experiments are used instead.

  • Economists conduct economic inquiries by closely observing real-world situations and events (natural experiments).

The Role of Assumptions

  • Assumptions help simplify the complex world, making it easier to understand.

  • The art in scientific thinking involves deciding which assumptions to adopt:

    • Economists use different assumptions for different questions and time horizons.

Economic Models

  • Economic Models:

    • Consist of diagrams and equations that omit many details and are built with assumptions.

    • They simplify reality and are subject to revision based on new data and insights.

Our First Model: The Circular-Flow Diagram (1 of 3)

  • Circular-flow diagram:

    • This is a visual model of the economy.

    • It shows how dollars flow through markets among households and firms.

Our First Model: The Circular-Flow Diagram (2 of 3)

  • Firms:

    • Produce goods and services.

    • Utilize factors of production (inputs).

  • Households:

    • Own factors of production.

    • Consume goods and services.

Our First Model: The Circular-Flow Diagram (3 of 3)

  • Markets for Goods and Services:

    • Households act as buyers in these markets.

    • Firms act as sellers.

  • Markets for Factors of Production:

    • Households act as sellers in these markets.

    • Firms act as buyers.

Figure 1: The Circular Flow

  • This diagram represents the organization of the economy:

    • Decisions are made by households and firms.

    • Interaction occurs in markets for goods and services and for factors of production.

    • The outer arrows depict cash flow, while the inner arrows represent the flow of inputs and outputs.

Our Second Model: The Production Possibilities Frontier

  • The Production Possibilities Frontier (PPF):

    • A graph illustrating the available combinations of outputs that an economy can produce with present resources and technology.

Figure 2: The Production Possibilities Frontier

  • The PPF displays combination outputs, such as cars and computers:

    • Points on or below the frontier represent feasible output combinations.

    • Points beyond the frontier are unattainable with current resources.

  • The slope of the PPF illustrates the opportunity cost of producing one good over another, which varies based on production levels.

Efficient Outcomes

  • Points on the PPF indicate efficient outcomes:

    • The economy fully utilizes its resources.

    • To produce more of one good, the production of the other must decrease.

    • Example: Transitioning from point A to point B results in 100 additional cars with a loss of 200 computers.

Opportunity Costs

  • Opportunity cost relates to what one must give up to produce a unit of another good.

    • Example: At point A, the opportunity cost for 100 cars is 200 computers, equating to an opportunity cost of 2 computers per car. This is reflected in the slope of the PPF.

Inefficient Outcomes

  • Points located within the PPF represent inefficiency:

    • Example: At point D, the economy produces below its potential.

    • Removing sources of inefficiency can boost production for both goods.

Active Learning 1: Points off the PPF

  • Assessing feasible combinations:

    • Point F: 80 airplanes and 4,000 tons of soybeans – Not possible.

    • Point G: 30 airplanes and 2,500 tons of soybeans – Possible but not efficient.

Shape of the PPF (1 of 3)

  • The opportunity cost is not constant; it depends on the levels of production:

    • This is depicted in the shape of the PPF.

Shape of the PPF (2 of 3)

  • The Bowed Outward shape of the PPF indicates:

    • Higher opportunity costs when many cars are produced compared to computers.

    • Lower opportunity costs when fewer cars are produced compared to computers.

    • This phenomenon is due to resource specialization where factors of production are not homogeneous.

Shape of the PPF (3 of 3)

  • Technological Advancement leads to an outward shift of the PPF, indicating economic growth and the ability to produce more of both goods.

Figure 3: A Shift in the Production Possibilities Frontier

  • Example of technological advancement in the computer sector allows increased production capacity for both goods:

    • Transition from point A to point G shows an increase in production of cars and computers.

Microeconomics and Macroeconomics

  • Microeconomics:

    • Focuses on the decisions made by households and firms and their market interactions.

  • Macroeconomics:

    • Studies economy-wide phenomena including inflation, unemployment, and economic growth.

The Economist as Policy Adviser

Scientists or Policy Advisers?

  • Economists act both as scientists and policy advisers:

    • As scientists, they explain causes of economic events.

    • As policy advisers, they recommend policies aimed at improving economic outcomes.

Positive versus Normative Analysis

  • Positive statements: Descriptive and fact-based claims that can be confirmed or refuted through evidence.

  • Normative statements: Prescriptive claims involving values and judgments about what should be.

Economists in Washington (1 of 2)

  • Council of Economic Advisers:

    • Advises the president and composes the annual Economic Report.

    • Analyzes recent economic developments and current policy issues.

Economists in Washington (2 of 2)

  • Other advisory offices include:

    • Office of Management and Budget

    • Department of the Treasury

    • Department of Labor

    • Department of Justice

    • Congressional Budget Office

    • The Federal Reserve

Why Economists’ Advice Is Often Not Followed

  • Economists’ advice can compete with advice from various other advisory roles within the presidency:

    • Decisions ultimately made by the president, which may reflect other interests coexisting with economic advice.

Why Economists Disagree

Differences in Scientific Judgments

  • Discrepancies arise from differing assessments regarding the validity of theories or the estimation of parameters that link economic variables.

Differences in Values

  • Economists might disagree due to differing personal values or political philosophies:

    • Different views on public policy goals and what should be accomplished through such policies.

Perception versus Reality

  • Economists often agree more than perceived:

    • Policy persistence despite expert disagreement can arise from the political process and a lack of public persuasion by economists.

Ask the Experts: Ticket Resale

  • It is posited that laws limiting ticket resale harm potential audience members.

Let’s Get Going

  • Student improvement in economic thinking skills are anticipated through engagement with the material.

Think-Pair-Share Activity

  • Opportunity for discussion and thought about differences in economic perspectives on free trade.

  • Consideration of majority economist support for free trade as a means to clarify differing views.

Self-Assessment

  • Example of thinking like an economist in personal decision-making, such as the decision to buy a car.

Appendix: Graphing: A Brief Review

Graphs: Purposes

  • Graphs visually clarify concepts that might be less clear through text alone, also serving as powerful tools for pattern recognition.

Graphs of a Single Variable

  • Types include:

    • Pie chart: shows parts of a whole.

    • Bar graph: compares quantities.

    • Time-series graph: displays changes over time.

Figure A-1: Types of Graphs

  • Graphs illustrate various aspects of economic data:

    • National income distribution

    • Comparative income analysis of countries

    • Labor productivity trends over time.

Graphs of Two Variables: The Coordinate System

  • Enables the display of two variables in a single graph:

    • Employs scatterplots with ordered pairs of points.

    • Each point indicates specific values for the respective variables.

Figure A-2: Using the Coordinate System

  • Example graph showing a correlation between grade point average and study time.

Curves in the Coordinate System

  • Demand curves depict the quantity demanded concerning price and income variants:

    • Downward-sloping curves depict a negatively-related demand scenario.

Table A-1: Novels Purchased by Emma

  • Data table illustrating quantity demanded at varying price points based on income levels.

Demand Curve

  • Depicts the relationships between price and quantity:

    • Negatively limited variables represent a negative slope; positively related ones represent a positive slope.

Figure A-3: Demand Curve

  • A representation reflecting how Emma's novel purchases change in response to price fluctuations at constant income levels.

Figure A-4: Shifting Demand Curves

  • Describes the impact of income changes on Emma's demand curve, shifting right or left depending on income levels.

Slope (1 of 2)

  • Defined as the ratio of vertical change to horizontal change, detailing movement along a line.

Slope (2 of 2)

  • Characteristics of slope are described:

    • Flat upward slope indicates small positive number.

    • Steep upward slope indicates large positive number.

    • Negative slope for downward slope, zero for horizontal, and infinite for vertical lines.

Figure A-5: Calculating the Slope of a Line

  • Example of slope calculation involved in measuring demand curve changes.

Cause and Effect

  • Understanding causal relationships is essential; omitted variables can misrepresent graph interpretations.

Figure A-6: Graph with an Omitted Variable

  • Example demonstrating misleading correlation: ownership of lighters and cancer incidence.

Reverse Causality

  • Reverse causality suggests that events can influence each other in unintended directions, complicating analysis and interpretations.

Figure A-7: Graph Suggesting Reverse Causality

  • A graph illustrating the relationship between police presence and crime rates, raising questions regarding the directionality of the causation.