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 scientist’s 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 diagram:a visual model of the economy
that shows how dollars flow through markets among
households and firms. See Figure 2-1 on page 24 4
• 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. What’s 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 economy’s 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 efficient8
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. 9
• 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 economy’s 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
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