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Economic Thinking

ECO 284Display your name cardPlace your Chapter 3

summary in your file.Place your answers to

Chap. 3 Review Questions on the front table

Homework #4 (PPF work sheet) due Friday.

2

The Nature and Role of Theory.

The uses of theories (simplified models).Everyone uses them. . .to describe, explain, predict, or understand.

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Abstraction

Models leave out much specific informationBut answer the basic question.Model builders must make judgments:

What information to include, and which details may be safely omitted.

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Judging Theories

Logical soundness of assumptions and hypotheses

How well a theory predicts.Theories should yield testable predictions.

Methodology

Economists build models

Answer important questions

• Why does international (int’l) trade occur?

• What goods will a country import (export)?

• How much will be traded and at what price?

• Will trade affect wages, or other factor payments?

Methodology

Models are abstract, yield predictions

simplify reality

verbal

mathematical

• geometric

• algebraic

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Parts of a Theory.

Variables take on different values.Assumptions give us a starting point for

deductive reasoning.Hypothesis - a statement about how two or

more variables are related.Predictions are deduced from the

assumptions and hypotheses of the theory.

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Occam’s RazorThe simplest workable theories are also the

most useful.a.k.a. “The Principle of Parsimony”Einstein: “Everything should be made as

simple as possible, but not more so.”

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Formulating Theories

Variables noted, assumptions made, hypotheses formulated.

Predictions are deduced from the assumptions and hypotheses.

Predictions are stated.

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Testing Theories

Predictions are tested.Evidence either confirms or rejects theory.If confirmed, can the results be reproduced?If rejected, then either a new theory is

formed, or the old one is amended.

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Arguments

Argument -- a sequence of statements together with a claim.

Sequence -- two or more statements.Claim -- that one of statements, called the

conclusion, follows from the others, called the premises.

An argument is sound if it is correct and all its premises are true.

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Deductive Arguments

In a valid deductive argument it is impossible for the premise to be true and the conclusion false.

Example: Knowledge is power. Power corrupts. Therefore knowledge corrupts.

Another: Economists are scoundrels. Eastwood is an economist. Therefore Eastwood is a scoundrel.

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Inductive Arguments

In a correct inductive argument it is improbable for the conclusion to be false if the premise is true.

Example: None of Eastwood’s mid-term exam questions were tricky. Therefore none of his final exam questions will be tricky.

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The Fallacy of False Cause

This fallacy occurs when in argument one mistakes what is not the cause of a given effect for its real cause.

When an argument takes the following form, it is often incorrect: Event A occurs, then Event B occurs Therefore A causes B.

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Variants of the False-Cause Fallacy

Post hoc, ergo propter hoc (Latin) translates roughly as “after this, therefore because of this.”

Accidental correlation: A occurs when B occurs. Therefore A causes B (or vice-versa).

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The Fallacy of Composition

Assuming that what is true for the individual is true for the group.

Frederic Bastiat’s “Petition of the Candle Makers” illustrates this fallacy.

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The Fallacy of Decomposition

Assuming that what is true for the group is true for the individual.

Example: Gator-Aid tastes sweet. Therefore all the ingredients of Gator-Aid must taste sweet.

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Errors in Economic Thinking.

Misunderstanding the Ceteris Paribus condition (Latin phrase meaning “all other things remaining the same”).

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Normative versus Positive Analysis

Normative statements contain a value judgment (about what should be).

Positive statements describe, explain or predict (what was, what is, or what will be).

Positive statements may be true or false, but disagreements about them may be resolved by obtaining the facts.

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Concepts Central to the Economic Way of Thinking.

Rational Self-Interest: People are rational, calculating, and driven by self interest

Opportunity Cost ( the value of the most highly preferred alternative not taken.) Every decision entails a choice, and every choice entails a cost.

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Economic Policy Objectives

Efficiency

Equity

Growth

Stability

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The Factors of Production

K = Capital (machinery, computers, buildings)

E = Entrepreneurship combining factors to enable production

L = Labor (productive efforts)N = Land and natural resourcesCELL

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A Circular Flow Model

Two markets: One for products (output), one for factors (of production)

Households Own factors, sell their services to firms Buy products from firms

Firms Combine factors to produce products Sell products to households

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Production Possibility Frontier (PPF) Assumptions:

Quantities of productive factors are fixed, but can be allocated among different types of production.

Technology is constant.All scarce resources are fully and efficiently

employed.

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Concepts and the PPF

ScarcityNecessity of ChoiceOpportunity CostEconomic Growth

Due to an increase in L, N, or K Due to technological progress

International Trade (many applications)

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Example PPF

0100200300400500600700800900

1000

0 100 200 300 400 500 600

Tax Forms (millions/yr)

Bee

f (m

ill.

lb

./yr

.)

A:(__,___) B:(___,____)

C:(___,___)

D

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Example PPF

0100200300400500600700800900

1000

0 100 200 300 400 500 600

Tax Forms (millions/yr)

Bee

f (m

ill.

lb

./yr

.)

A:(0,1000) B:(200,950)

C:(400,700)

D: (600, 0)

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Slope of the PPF

Calculate the slope between points A&B, B&C, C&D:

Include the unitsIs there a relationship between the slope of

the PPF and the concept of opportunity cost?

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Reciprocal of the PPF’s Slope

The opportunity cost of the good on the y-axis is (1/slope); e.g., between points A and B the opp. cost of beef is -4 tax forms given up per lb. beef.

In this example, the opportunity cost of a good increases as its output increases. Why might one expect this?

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Constant Opportunity Cost

1 2 3 4SOYBEANS, S (millions of bushels per year)

1

2

3

5

4

TE

XT

ILE

S, T

(mil

lion

s of

yar

ds

per

yea

r)

America’sPPF

1

4

a'

a

A’s opportunity cost:

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Constant Opportunity Cost

1 2 3 4SOYBEANS, S (millions of bushels per year)

1

2

3

5

4

TE

XT

ILE

S, T

(mil

lion

s of

yar

ds

per

yea

r)

America’sPPF

1

4

a'

a

A’s opportunity cost:2 bushels S costs 1 yard T,|slope| = 0.5 yd./bu.

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Constant Opportunity Cost

1 2 3 4SOYBEANS, S (millions of bushels per year)

1

2

3

5

4

TE

XT

ILE

S, T

(mil

lion

s of

yar

ds

per

yea

r)

America’sPPF

1

Britain’sPPF

4

a'

b

a

A’s opportunity cost:2 bushels S costs 1 yard T,|slope| = 0.5 yd./bu.

B’s opportunity cost:

b’

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Constant Opportunity Cost

1 2 3 4SOYBEANS, S (millions of bushels per year)

1

2

3

5

4

TE

XT

ILE

S, T

(mil

lion

s of

yar

ds

per

yea

r)

America’sPPF

1

Britain’sPPF

4

a'

b

a

A’s opportunity cost:2 bushels S costs 1 yard T,|slope| = 0.5 yd./bu.

B’s opportunity cost:1 bushel S costs 3 yards T,|slope| = 3 yd./bu.

b’

Increasing Opportunity Cost

SOYBEANS, S (millions of bushels per year)

6

18

40 8 12

12

2

14

20

6 millionyards S

6 million bushelsof T

a'Opportunity costof 1 bushel of S is1 yard T,|slope| = 1 yd./bu.

TE

XT

ILE

S, T

(mil

lion

s of

yar

ds

per

yea

r)

America’s PPF

Increasing Opportunity Cost

6

24

40 8 12

30

36

15

7 9

a

Opportunity costof 1 bushel of S is

TE

XT

ILE

S, T

(mil

lion

s of

yar

ds

per

yea

r)

SOYBEANS, S (millions of bushels per year)

Britain’s PPF

2 millionbushels of S

Increasing Opportunity Cost

6

24

40 8 12

30

36

15

7 9

18millionyardsof T

a

Opportunity costof 1 bushel of S is 9yards of T, |slope| = 9 yd./bu.

TE

XT

ILE

S, T

(mil

lion

s of

yar

ds

per

yea

r)

SOYBEANS, S (millions of bushels per year)

Britain’s PPF

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Why Do Nations Trade?

Absolute Advantage:A nation (individual) is said to have an absolute advantage in producing a good when it can produce that good with fewer resources. This greater efficiency in production is due to superior technology.

Smith thought this explained trade patterns.

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Comparative Advantage:

A nation (individual) is said to have a comparative advantage in producing a good when it can produce that good at a lower opportunity cost.

Ricardo -- differing technologiesHeckscher-Ohlin -- differing resource

endowments

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The PPF and International Trade

Assume that there are two countries with differing opportunity costs.

Are there gains from trade?

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PPFs for two individuals

0

200

400

600

800

1000

1200

0 200 400 600 800 1000 1200

Fish (lbs/yr)

Co

con

uts

( b

u./

yr.)

Rob

Friday

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The PPF and International Trade

World output increases due to specialization.

What does each country gain from trade?Requires an understanding of Consumption

Possibilities (CPF) a line from a country’s production point with slope equal to the trade price of good X

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CPF with a price ratio of 1(bu/lb)

0

200

400

600

800

1000

1200

0 200 400 600 800 1000 1200

Fish (lbs/yr)

Co

con

uts

( b

u./

yr.)

Rob's

Guy's production point

CPF

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If Guy and Rob share equally

0

200

400

600

800

1000

1200

0 200 400 600 800 1000 1200

Fish (lbs/yr)

Co

con

uts

( b

u./

yr.)

Rob's

Guy's production

Both could eat (600,600)