Thinking Like an Economist
• Every field of study has its own terminology
• Mathematics
• Integral, derivative, vector space, cosine, hypotenuse
• Psychology
• Cognitive dissonance, coping, determinism, ego, id
• Law
• Plaintiff, deposition, appeal, verdict, subpoena
• Economics
• Supply, demand, opportunity cost, elasticity, surplus, shortage,
welfare, comparative advantage, deadweight loss
Copyright © 2004 South-Western/Thomson Learning
Thinking Like an Economist
• Economics trains you to. . . .
• Think in terms of alternatives.
• Evaluate the cost of individual and social choices.
• Examine/understand how events and issues are related.
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The Scientific Method: Observation,
Theory, and More Observation
• Uses abstract models to help explain how a
complex, real world operates.
• Develops theories, collects, and analyzes data to
evaluate the theories.
• Economists make assumptions in order to make
the world easier to understand.
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Economic Models
• Economists use models to simplify reality in
order to improve our understanding of the world
• Two of the most basic economic models include:
• The Circular Flow Diagram
• The Production Possibilities Frontier
Copyright © 2004 South-Western/Thomson Learning
Our First Model: The Circular-Flow
Diagram
• The circular-flow diagram is a visual model of the
economy that shows how dollars flow through
markets among households and firms.
• Factors of Production
• Inputs used to produce goods and services
• Land, labor, capital and entrepreneurship
Copyright © 2004 South-Western/Thomson Learning
Figure 1 The Circular Flow
Revenue
Goods
and services
sold
MARKETS
FOR
GOODS AND SERVICES
•Firms sell
•Households buy
Wages, rent,
and profit
Goods and
services
bought
HOUSEHOLDS
•Buy and consume
goods and services
•Own and sell factors
of production
FIRMS
•Produce and sell
goods and services
•Hire and use factors
of production
Factors of
production
Spending
MARKETS
FOR
FACTORS OF PRODUCTION
•Households sell
•Firms buy
Labor, land,
and capital
Income
= Flow of inputs
and outputs
= Flow of dollars
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Our First Model: The Circular-Flow
Diagram
• Markets for Goods and Services
• Firms sell
• Households buy
• Markets for Factors of Production
• Households sell
• Firms buy
Copyright © 2004 South-Western/Thomson Learning
Our Second Model: The Production
Possibilities Frontier
• The production possibilities frontier is a graph that
shows the combinations of output that the
economy can possibly produce given the available
factors of production and the available production
technology.
Copyright © 2004 South-Western/Thomson Learning
Figure 2 The Production Possibilities Frontier
Quantity of
Computers
Produced
3,000
D
C
2,200
2,000
A
Production
possibilities
frontier
B
1,000
0
300
600 700
1,000
Quantity of
Cars Produced
Copyright©2003 Southwestern/Thomson Learning
Our Second Model: The Production
Possibilities Frontier
• Concepts Illustrated by the Production
Possibilities Frontier
• Scarcity
• Efficiency
• Tradeoffs
• Opportunity Cost
• Economic Growth
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Facts Regarding Value
As more of a particular item is consumed in a given
time period…
• The value of the next unit will eventually fall.
• Value is based on benefits received.
• Diminishing marginal value
• Need to see this in Demand
• Rolos, Washer & Dryer, Automobiles, Houses
Copyright © 2004 South-Western/Thomson Learning
Facts Regarding Cost
As more of a particular item is produced in a given
time period…
• The cost of the next unit will eventually rise.
• Cost is based on what is given up.
• Rising marginal opportunity cost
• Need to see this in Supply
• Work, Vacations, Wheat or Oranges, China & India
Copyright © 2004 South-Western/Thomson Learning
Microeconomics and Macroeconomics
• Microeconomics focuses on the individual parts of
the economy.
• How households and firms make decisions and how they
interact in specific market settings.
• Macroeconomics looks at the economy as a whole.
• Economy-wide phenomena, including inflation,
unemployment, and economic growth.
See HW1 for Micro/Macro Practice
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The Power of Economics
• Economists try to explain the world (science).
• Positive economic analysis: observe and describe,
scientific, objective, builds understanding
• Economists try to change the world (policy).
• Normative economic analysis: prescribe what should be,
policy recommendation, subjective, improve/change.
See HW1 for Positive/Normative Practice
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POSITIVE VERSUS NORMATIVE
ANALYSIS
• Positive or Normative Statements?
• An increase in the minimum wage will cause a decrease
in employment among the least-skilled.
?
?
• The federal minimum wage should not be raised.
Copyright © 2004 South-Western/Thomson Learning
POSITIVE VERSUS NORMATIVE
ANALYSIS
• Positive or Normative Statements?
• Higher federal budget deficits will cause interest rates to
increase.
?
?
• The federal government should be required to run a
balanced budget.
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ECONOMISTS DISAGREE
• They may disagree about the validity of alternative
positive theories on how the world works.
• They may have different normative views about
what policies to pursue and what policies should
try to accomplish.
• But all economists agree on two things…..
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ECONOMISTS AGREE
• Good normative policy prescriptions must be
based on sound positive economic analysis.
• And……
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Summary
• Economists use models to help describe the world
in economic terms.
• They make appropriate assumptions and build simplified
models in order to understand the world around them.
• Two simple economic models are the circular-flow
diagram and the production possibilities frontier.
Copyright © 2004 South-Western/Thomson Learning
Summary
• Economics is divided into two subfields:
• Microeconomists study decision-making by households
and firms in the market settings.
• Macroeconomists study the forces and trends that affect
the economy as a whole.
Copyright © 2004 South-Western/Thomson Learning
Summary
• Positive economic analysis is a description about
how the world is (science, observation).
• Normative economic analysis is a prescription of
how the world should be (policy recommendation).
• Good normative policy prescriptions must be based
on sound and thorough positive economic analysis.
Copyright © 2004 South-Western/Thomson Learning