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CHAPTER 2
Thinking Like An Economist
THINKING LIKE AN ECONOMIST
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In this chapter, look for the answers to
these questions:
ƒ What are economists’ two roles? How do they differ?
ƒ What are models? How do economists use models?
ƒ What are the elements of the Circular-Flow Diagram?
What concepts does this diagram illustrate?
ƒ How is the Production Possibilities Frontier related
to opportunity cost? What other concepts does it
illustrate?
ƒ What is the difference between between positive and
normative?
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The Economist as Scientist
ƒ Economists play two roles:
• Scientists: try to explain the world
• Policy advisors: try to improve it
ƒ In the first role, economists employ the
scientific method: the dispassionate
development and testing of theories about
how the world works.
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Assumptions & Models
ƒ Assumptions simplify the complex world,
make it easier to understand.
ƒ Example: When studying international trade,
we might assume the world consists of
two countries and two goods.
Very unrealistic, but simplifies the problem
and yields useful insights about the more
complicated real world.
ƒ Economists use models to study economic
issues. A model is a highly simplified
representation of a more complicated reality.
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First Model:
The Circular-Flow Diagram
ƒ The Circular-Flow Diagram: A visual model of
the economy, shows how dollars flow through
markets among households and firms.
ƒ Includes two types of “actors”:
• households
• firms
ƒ Includes two markets:
• the market for goods and services
• the market for “factors of production”
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Factors of Production
ƒ The factors of production are the resources
that the economy uses to produce goods &
services. They include:
• labor
• land
• capital (buildings & machines used in
production)
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FIGURE 1: The Circular-Flow Diagram
Revenue
G&S
sold
Markets for
Goods &
Services
Firms
G&S
bought
Households
Factors of
production
Wages, rent,
profit
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Spending
Markets for
Factors of
Production
THINKING LIKE AN ECONOMIST
Labor, land,
capital
Income
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Second Model:
The Production Possibilities Frontier
ƒ The Production Possibilities Frontier (PPF):
A graph that shows the combinations of
two goods the economy can possibly produce
given the available resources and the available
technology.
ƒ Example:
• Two goods: computers and wheat
• One resource: labor (measured in hours)
• Economy has 50,000 labor hours per month
available for production.
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PPF Example
ƒ Producing one computer requires 100 hours labor.
ƒ Producing one ton of wheat requires 10 hours labor.
Employment of
labor hours
Production
Computers
Wheat
Computers
Wheat
A
50,000
0
500
0
B
40,000
10,000
400
1,000
C
25,000
25,000
250
2,500
D
10,000
40,000
100
4,000
E
0
50,000
0
5,000
PPF Example
Production
Point
on
Comgraph puters Wheat
A
500
0
B
400
1,000
C
250
2,500
D
100
4,000
E
0
5,000
Wheat
(tons)
6,000
5,000
E
D
4,000
3,000
C
2,000
B
1,000
A
0
0
100 200 300 400 500 600
Computers
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The PPF: What We Know So Far
ƒ Points on the PPF
• possible
• efficient: all resources are fully utilized
ƒ Points under the PPF
• possible
• not efficient: some resources underutilized
(e.g., workers unemployed, factories idle)
ƒ Points above the PPF
• not possible
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The PPF and Opportunity Cost
ƒ Recall: The opportunity cost of an item
is what must be given up to obtain that item.
ƒ Moving along a PPF involves shifting resources
(e.g., labor) from the production of one good to
the other.
ƒ Society faces a tradeoff: Getting more of one
good requires sacrificing some of the other.
ƒ The slope of the PPF tells you the opportunity
cost of one good in terms of the other.
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The PPF and Opportunity Cost
Wheat
(tons)
6,000
–1000
slope =
= –10
100
5,000
4,000
3,000
2,000
1,000
0
0
100 200 300 400 500 600
The slope of a line
equals the “rise
over the run” –
the amount the line
rises when you
move to the right
by one unit.
Here, the
opportunity cost of
a computer is
10 tons of wheat.
Computers
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PPF and Opportunity Cost Example
In which country is the opportunity cost of cloth lower?
FRANCE
ENGLAND
Wine
Wine
600
600
500
500
400
400
300
300
200
200
100
100
0
0
0
100 200 300 400
Cloth
0
100 200 300 400
Cloth
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Economic Growth and the PPF
With additional
resources or an
improvement in
technology,
the economy can
produce more
computers,
more wheat,
or any combination
in between.
Wheat
(tons)
6,000
Economic
Economic
growth
growth shifts
shifts
the
the PPF
PPF
outward.
outward.
5,000
4,000
3,000
2,000
1,000
0
0
100 200 300 400 500 600
Computers
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The Shape of the PPF
ƒ The PPF could be a straight line, or bow-shaped
ƒ Depends on what happens to opportunity cost
as economy shifts resources from one industry
to the other.
• If opp. cost remains constant,
PPF is a straight line.
(In the previous example, opp. cost of a
computer was always 10 tons of wheat.)
• If opp. cost of a good rises as the economy
produces more of the good, PPF is bow-shaped.
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As the economy
shifts resources
from beer to
mountain bikes:
•
PPF becomes
steeper
•
opp. cost of
mountain bikes
increases
Beer
Why the PPF Might Be Bow-Shaped
Mountain
Bikes
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At point A,
most workers are
producing beer,
even those that
are better suited
to building
mountain bikes.
Beer
Why the PPF Might Be Bow-Shaped
A
So, do not have to
give up much beer
to get more bikes.
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THINKING LIKE AN ECONOMIST
At
At A,
A, opp.
opp. cost
cost of
of
mtn
mtn bikes
bikes is
is low.
low.
Mountain
Bikes
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At B, most workers
are producing bikes.
The few left in beer
are the best brewers.
Beer
Why the PPF Might Be Bow-Shaped
Producing more
bikes would require
shifting some of the
best brewers away
from beer production,
would cause a big
drop in beer output.
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THINKING LIKE AN ECONOMIST
At
At B,
B, opp.
opp. cost
cost
of
of mtn
mtn bikes
bikes
is
is high.
high.
B
Mountain
Bikes
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Why the PPF Might Be Bow-Shaped
ƒ So, PPF is bow-shaped when different workers
have different skills, different opportunity costs
of producing one good in terms of the other.
ƒ The PPF would also be bow-shaped when
there is some other resource, or mix of
resources with varying opportunity costs.
• E.g., different types of land suited for
different uses
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The Economist as Policy Advisor
ƒ As scientists, economists make
positive statements,
which attempt to describe the world as it is.
ƒ As policy advisors, economists make
normative statements,
which attempt to prescribe how the world should be.
ƒ Positive statements can be confirmed or refuted,
normative statements cannot.
ƒ Govt employs many economists for policy advice.
E.g., the U.S. President has a Council of Economic
Advisors, which the author of this textbook recently
chaired.
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Identifying positive vs. normative
Which of these statements are “positive” and which
are “normative”? How can you tell the difference?
a. Prices rise when the government increases the
quantity of money.
b. The government should print less money.
c. A tax cut is needed to stimulate the economy.
d. An increase in the price of gasoline will cause an
increase in consumer demand for video rentals.
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Why Economists Disagree
ƒ Economists often give conflicting policy advice.
ƒ They sometimes disagree about the validity of
alternative positive theories about the world.
ƒ They may have different values and, therefore,
different normative views about what policy
should try to accomplish.
ƒ Yet, there are many propositions about which
most economists agree.
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