Chapter
2
Thinking Like an Economist
The Economist as a Scientist
• Scientific Methodology
– Develop hypotheses/theories/models about
“how things work”
• In our case: how markets works, what are the
incentives that drive behavior
– Collect data which can be used to test validity
of these theories
• In economics – observational rather than
experimental data
– Analyze these data to verify or refute these
theories
2
Scientific Method
The Economist as a Scientist
Economic models
• Diagrams & equations
– May omit many details
– Allow us to see what’s truly important
• Built with assumptions
• Simplify reality to improve our understanding
of it
4
The Economist as a Scientist
The role of assumptions
• Assumptions
• What do we assume about market behavior that
we can’t/don’t test
– Demand: omitting non-related goods, goods that are
not “reasonable” substitutes/complements
– Long-run versus short-run (e.g., impact of gas prices)
• Why do we do it?
– simplify the complex world
– focus our thinking on the major factors that affect the
problem of interest
» different assumptions to answer different questions
» Short-run/long-run effects
5
Building a Model
• Why?
– Explain the past and/or predict the future
– Understand factors that motivate individuals
and firms to take the actions that they do in
the marketplace
– Possibly be able to influence the decisions
they make
• Make the markets more efficient -> create bigger
benefits for all (consumers and firms)
Overview
• Basic assumptions underlying economic
modeling
– Rationality and self-interest
– Marginal analysis
• Totals versus marginal (incremental analysis)
Economic Models
•
The Scientific Method (Hubbard and
O’Brien)
1. Decide on assumptions to be used in
developing the model
2. Formulate a testable hypothesis
3. Use economic data to test the hypothesis
4. Revise the model if it fails to explain well the
economic data
5. Retain the revised model to help answer
similar economic questions in the future
Scientific Method
Role of Assumptions
• Assumptions
– Role of assumptions is to
• reduce the complexity of the problem to its key elements and,
• focus on the items that have the most significant impact (“80/20”
rule)
– 80% of the impact is due to 20% of the factors
• Robust
– If relaxing the assumptions has minimal impact on your
conclusions then the model is deemed “robust” and is largely
unaffected by these testable or non-testable assumptions
– “robustness” is a desirable property
Don’t just forget about them – do they have a significant or
minor impact on the model’s results/predictions?
The Economist as a Scientist
Our first model: The circular-flow diagram
• Circular-flow diagram
– Visual model of the economy
– Shows how dollars flow through markets
among households and firms
• Decision makers
• Firms & Households
• Markets
• For goods and services
• For factors of production
11
The Circular Flow of Economic Activity
• Households and firms interact so closely
that the well-being of one depends on the
well-being of the other.
• This interaction is represented by the circular flow
model.
3-12
Cop
Figure 3.1
The Circular Flow of Economic Activity
Copyright © 2006 Pearson Addison-Wesley. All rights
reserved.
3-13
The Economist as a Scientist
Our first model: The circular-flow diagram
• Firms
– Produce goods and services
– Use factors of production / inputs
• Households
– Own factors of production
– Consume goods and services
14
Figure 1
The circular flow
This diagram is a
schematic representation
of the organization of the
economy. Decisions are
made by households and
firms. Households and
firms interact in the
markets for goods and
services (where
households are buyers and
firms are sellers) and in the
markets for the factors of
production (where firms are
buyers and households are
sellers). The outer set of
arrows shows the flow of
dollars, and the inner set of
arrows shows the
corresponding flow of
inputs and outputs.
15
The Economist as a Scientist
Our second model: The production possibilities
frontier
• Production possibilities frontier
– Combinations of output that the economy
can possibly produce
– Given the available
• Factors of production (both raw materials and
labor)
• Production technology (used to produce the
good)
16
Figure 2
The production possibilities frontier
Quantity of
Computers
Produced
C
F
3,000
A
2,200
2,000
B
Production
Possibilities
Frontier
D
1,000
E
0
300
600 700
The production possibilities
frontier shows the
combinations of output - in
this case, cars and
computers - that the
economy can possibly
produce.
The economy can produce
any combination on or
inside the frontier.
Points outside the frontier
are not feasible given the
economy’s resources.
1,000 Quantity of
Cars
Produced
17
What does this model show?
• The maximum combinations of cars and
computers that can be produced by this
economy
– Given it’s current natural resources, labor and
technology
• Illustrates the trade-off, or opportunity costs,
of producing more of one of the products,
e.g., more cars
– i.e. the reduction in producing the other
product, e.g., fewer computers
18
The Economist as a Scientist
• Efficient levels of production – on the
“frontier” (on the curve or “frontier”)
– getting all that economy from scarce
resources (maximum level of production)
– Trade-off: reduce production of other good
• (labor and other resources have to be reallocated)
• Inefficient levels of production (Points inside
the curve)
– Indicates resources are underutilized
19
The Economist as a Scientist
• Opportunity cost of one good
– Give up the other good
• Bowed out production possibilities frontier
– Opportunity cost of a car – highest
• Economy - producing many cars and fewer
computers
– Opportunity cost of a car – lower
• Economy - producing fewer cars and many
computers
– Resource specialization
20
The Economist as a Scientist
• Changing the PPF
– Technological advance
• Outward shift of the production possibilities
frontier
• Allows for economic growth, i.e., can produce
more of both goods with existing resources
– Increasing labor’s production
• Education – increases productivity (output per
hour per employee)
• Immigration – increasing size of labor pool
– Increasing availability of natural resources
21
Figure 3
A shift in the production possibilities frontier
Quantity of
Computers
Produced
4,000
3,000
G
2,300
2,200
A
0
600 650
A technological advance in
the computer industry
enables the economy to
produce more computers
for any given number of
cars. As a result, the
production possibilities
frontier shifts outward. If
the economy moves from
point A to point G, then the
production of both cars and
computers increases.
1,000 Quantity of
Cars Produced
22
The Economist as a Policy Adviser
Positive vs. Normative analysis
• Positive statements
– Attempt to describe the world as it is
– Descriptive
– Confirm or refute by examining evidence
• Normative statements
– Attempt to prescribe how the world should
be
– Prescriptive
23
APPENDIX
Graphing: a brief review
• Graphs’ purposes:
– Visually express ideas that might be less clear if
described with equations or words
– Powerful way of finding and interpreting patterns
• Graphs of a single variable
– Pie chart
– Bar graph
– Time-series graph
24
Figure A-1
Types of graphs (a, b)
(a) Pie Chart
(b) Bar Graph
The pie chart in panel (a) shows how U.S. national income is derived from various
sources. The bar graph in panel (b) compares the average income in four countries.
25
Figure A-1
Types of graphs (c)
(c) Time-Series Graph
The time-series graph in panel
(c) shows the productivity of
labor in U.S. businesses
from 1950 to 2000.
26
APPENDIX
Graphing: a brief review
• Graphs of two variables: the coordinate system
– Display two variables on a single graph
– Scatterplot
– Ordered pairs of points
• x-coordinate
– Horizontal location
• y-coordinate
– Vertical location
27
Figure A-2
Using the coordinate system
Grade point average is measured on the vertical axis and study time on the
horizontal axis. Albert E., Alfred E., and their classmates are represented by
various points. We can see from the graph that students who study more tend to
get higher grades.
28
APPENDIX
Graphing: a brief review
• Curves in the coordinate system
• Data
– Number of novels
– Price of novels
– Income
• Demand curve
– Effect of a good’s price
– On the quantity of the good consumers want to buy
– For a given income
29
Table A-1
Novels purchased by Emma
Income
Price
$20,000
$30,000
$40,000
$10
9
8
7
6
5
2 novels
6
10
14
18
22
Demand curve, D3
5 novels
9
13
17
21
25
Demand curve, D1
8 novels
12
16
20
24
28
Demand curve, D2
This table shows the number of novels Emma buys at various incomes and
prices. For any given level of income, the data on price and quantity
demanded can be graphed to produce Emma’s demand curve for novels, as
shown in Figures A-3 and A-4.
30
APPENDIX
Graphing: a brief review
• Curves in the coordinate system
• Negatively related variables
– The two variables move in opposite direction
– Downward sloping curve
• Positively related variables
– The two variables move in the same direction
– Upward sloping curve
• Movement along a curve
• Shifts in a curve
31
Figure A-3
Demand curve
Price of
Novels
$11
10
9
8
7
6
5
4
3
2
1
(5, $10)
(9, $9)
(13, $8)
(17, $7)
(21, $6)
(25, $5)
Demand, D1
30 Quantity of novels
purchased
The line D1 shows how Emma’s purchases of novels depend on the price of
novels when her income is held constant. Because the price and the quantity
demanded are negatively related, the demand curve slopes downward.
32
0
5
10
15
20
25
Figure A-4
Shifting demand curves
Price of $11
Novels
10
9
8
7
6
5
4
3
2
1
(13, $8)
When income
increases, the demand
curve shifts to the right.
(16, $8)
(10, $8)
When income
decreases, the
demand curve
shifts to the left.
D2 (income=
$40,000)
D3
D1
(income=
(income=
$20,000)
$30,000)
5
10 13 15 16 20
25
30 Quantity of novels purchased
0
The location of Emma’s demand curve for novels depends on how much income she
earns. The more she earns, the more novels she will purchase at any given price,
and the farther to the right her demand curve will lie. Curve D1 represents Emma’s
original demand curve when her income is $30,000 per year. If her income rises to
$40,000 per year, her demand curve shifts to D2. If her income falls to $20,000 per
33
year, her demand curve shifts to D3.
APPENDIX
Graphing: a brief review
• Slope of a line
– Ratio of the vertical distance covered
– To the horizontal distance covered
– As we move along the line
y
Slope 
x
– Δ (delta) = change in a variable
– The “rise” (change in y) divided by the “run” (change
in x).
34
APPENDIX
Graphing: a brief review
• Slope of a line
– Fairly flat upward-sloping line
• Slope = small positive number
– Steep upward-sloping line
• Slope = large positive number
– Downward sloping line
• Slope = negative number
– Horizontal line
• Slope = zero
– Vertical line
• Infinite slope
35
Figure A-5
Calculating the slope of a line
Price of
Novels
$11
10
9
8
7
6
5
4
3
2
1
0
(13, $8)
6-8=-2
(21, $6)
21-13=8
Demand, D1
5
10 13 15
20 21 25
30 Quantity of novels purchased
To calculate the slope of the demand curve, we can look at the changes in the xand y-coordinates as we move from the point (21 novels, $6) to the point (13
novels, $8). The slope of the line is the ratio of the change in the y-coordinate (–2)
36
to the change in the x-coordinate (+8), which equals –1⁄4.
APPENDIX
Graphing: a brief review
• Cause and effect
– One set of events
• Causes another set of events
– Omitted variables
• Lead to a deceptive graph
– Reverse causality
• Decide that event A causes event B
• Facts: event B causes event A
37
Figure A-6
Graph with an Omitted Variable
The upward-sloping curve shows that members of households with more cigarette
lighters are more likely to develop cancer. Yet we should not conclude that ownership
of lighters causes cancer because the graph does not take into account the number of
cigarettes smoked.
38
Figure A-7
Graph Suggesting Reverse Causality
The upward-sloping curve shows that cities with a higher concentration of police are
more dangerous. Yet the graph does not tell us whether police cause crime or crimeplagued cities hire more police.
39