Chapter 2: Thinking Like An Economist

^^The Economist as a Scientist^^

The Scientific Method: Observation & Theory

• Economists approach economic studies with objectivity. They devise theories, collect data, and analyze these data in order to verify or disprove their theories.
  • This is similar to how a scientist, like a physicist or a biologist, approaches their respective fields.
• As such, economists work using the Scientific Method as it is also applicable in studying a nation’s economy.
  • Scientific Method → The dispassionate development and testing of theories about how the world works.
• However, in Economics, conducting experiments is often impractical.
  • Therefore, economists can only rely on existing data.
  • Economists can also substitute experimentation by looking at past economic events and using historical data.

The Role of Assumptions

• Assumptions can simplify complex concepts and ideas, which make them easier to understand.
  • For instance, in studying internal trade, economists sometimes assume that the world consists of only two countries each producing only two goods. This simplification allows them to focus on the essence of the problem.
• Economists also use different assumptions to answer different questions.

Economic Models

• Economists use models to represent and examine various economic issues.
  • These models are useful in learning about how economics works in the real world.
• Models are built with assumptions.

==The Circular Flow Diagram==

• %%Circular Flow Diagram%% → A visual model of the economy that shows how money flows through the market among households and firms.
• In this diagram, the economy is simplified into two decision makers, the Firms and the Households.
  • Firms → Produce goods and services using Inputs.
  • These Inputs are also called the Factors of Production. This consists of Labor, Land, and Capital.
  • Households → Owns the factors of production and consumes the goods and services produced by firms.
• The diagram also shows how firms and households interact and make transactions in the two types of markets.
  • Markets for Goods and Services → In this market, the Households buy Outputs produced from the Factors of Production, while the Firms sell these Outputs.
  • Markets for the Factors of Production → In this market, the Households are sellers of Factors of Production, while the Firms buy these to produce their goods and services.
• There are two loops in the Circular Flow Diagram which are distinct, but related.
  • Inner Loop → Represents the Flow of Inputs and Outputs.
  • Households sell the Factors of Production (Labor, Land, and Capital) to the firms.
  • The firms then use the Factors of Production to create goods and services, which they sell to households.
  • Outer Loop → Represents the Flow of Money (or Dollars).
  • Households buy goods and services from firms using money.
  • The firms then use some of the revenue from these sales to pay for the Factors of Production, such as wages for their workers. They also use this revenue to make a profit.

==The Production Possibilities Frontier==

• %%Production Possibilities Frontier%% → A graph that shows the combination of outputs an economy can produce given the available Factors of Production and Production Technology.

  

• The image above shows the Production Possibilities Frontier of a certain economy.

  • Given its resources, this economy can either produce 1,000 cars and no computers, or 3,000 computers and no cars. However, these represent two extreme possibilities. More likely, the economy will divide its resources between the two industries.
  • For instance, they can produce 600 cars and 2,200 computers (as seen in Point A). Or, they can move some of their resources–or Factors of Production–from the car industry to the computer industry and produce 700 cars and 2,000 computers instead (as seen in Point B).

• Since resources are scarce, not every outcome on the Production Possibilities Frontier is feasible.

  • As seen in the image above, the economy does not have enough resources and technology to produce at Point C. This is an Unattainable Level of Production.

• Given its resources, the economy can only produce at any point on or inside the Production Possibilities Frontier.

• Efficient Levels of Production → Occurs when the economy is producing ON its Production Possibilities Frontier.

  • In the image above, these are Points F, A, B, E

• Inefficient Levels of Production → Occurs when the economy is producing BELOW its Production Possibilities Frontier.

  • In the image above, this is Point D

• The Production Possibilities Frontier also shows one trade-off that society faces.

  • The Production Possibilities Frontier shows the opportunity cost of one good as measured in terms of another good.
  • For instance, when the economy moves from Point A to Point B, society produces 100 more cars, but produces 200 fewer computers.
  • Thus, the opportunity cost of producing an additional car is two computers.
  • The opportunity cost of a car in terms of computers it not constant, but dependent on how many cars and computers the economy is producing.
  • The opportunity cost of producing a car is highest when the economy is producing many cars and few computers (such as at Point E).
  • On the other hand, the opportunity cost of producing a car is lowest when the economy is producing few cars and many computers (such as at Point F).

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• A Production Possibilities Frontier’s trade-off can also change over time.
  • For instance, when there is a technological advancement in computer production, an economy can produce more computers without decreasing car production, as seen in the image above.
  • As a result, the Production Possibilities Frontier shifts outward.
  • This means that the economy has grown.
    • As seen in the image above, the Production Possibilities Frontier has moved from Point A to G, where they are now able to enjoy more computers and cars.

^^Microeconomics and Macroeconomics^^

• Microeconomics → The study of how households and firms make decisions and how they interact in specific markets.
  • Focuses on economic decisions made on an individual level.
• Macroeconomics → The study of economy-wide phenomena, such as inflation, unemployment, and economic growth.
  • Focuses on phenomena which affects the overall economy.
• Microeconomics and Macroeconomics are closely intertwined.
  • This is because the changes in the overall economy are a result of the individual decisions of households and firms.
  • It is thus impossible to understand macroeconomic phenomena without considering the associated microeconomic decisions.

^^The Economist as a Policy Adviser^^

Positive vs. Normative Analysis

• Positive Statements → Descriptive
  • Describes the world as it is.
• Normative Statements → Prescriptive
  • Attempts to make a claim about how the world should be.
• A key difference between these two statements is how their validity is judged.
  • Positive Statements require gathering facts and analyzing data, while Normative Statements require values as well as facts and data.
• Positive and Normative statements are also often intertwined.
  • Positive views on how the world works can affect one’s normative views.

Why an Economists’ Advice is Not Always Followed

• When economists offer advice to a president or other elective government officials, their recommendations are not always followed.
  • Political leaders do not only listen to the advice of their economic advisers. They also listen to the advice of their communication advisers, press advisers, legislative affairs advisers, and the like.
• While economists offer crucial input, their advice is only one component of a complex policy-making process.

^^Why Economists Disagree^^

• Economists conflict due to two main reasons:
  • Economists may disagree about the validity of alternative positive theories on how the world works.
  • Economists may have different values, and therefore, have different normative views on which government policy to follow.

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