chapter 02_thinking like an economist

8/11/2019 Chapter 02_Thinking Like an Economist

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PowerPoint Slides prepared by:Andreea CHIRITESCUEastern Illinois University

Thinking Like an Economist

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The Economist as a Scientist

Economics

Science

Economists

Scientists Devise theories

Collect data

Analyze these data Verify or refute their theories

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Scientific method

Dispassionate development and testing oftheories about how the world works

Observation, theory, and moreobservation

Conducting experiments

Difficult / impossible Observation

Close attention to natural experiments

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The role of assumptions

Assumptions

Can simplify the complex world

Make it easier to understand Focus our thinking - essence of the

problem

Different assumptions To answer different questions

Short-run or long-run effects

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Economic models

Diagrams & equations

Omit many details

Allow us to see whats truly important Built with assumptions

Simplify reality to improve our

understanding of it

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Circular-flow diagram

Visual model of the economy

Shows how dollars flow through markets

among households and firms Decision makers

Firms & Households

Markets For gods and services

For factors of production

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Firms

Produce goods and services

Use factors of production / inputs

Households Own factors of production

Consume goods and services

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Markets for goods and services

Firmssellers

Householdsbuyers

Markets for inputs Firmsbuyers

Households - sellers

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This diagram is aschematic representation of

the organization of theeconomy. Decisions aremade by households andfirms. Households andfirms interact in the marketsfor goods and services

(where households arebuyers and firms aresellers) and in the marketsfor the factors of production(where firms are buyersand households are

sellers). The outer set ofarrows shows the flow ofdollars, and the inner set ofarrows shows thecorresponding flow ofinputs and outputs.

The circular flow


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Production possibilities frontier

A graph

Combinations of output that the economy

can possibly produce Given the available

Factors of production

Production technology

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Production

PossibilitiesFrontier

The productionpossibilities frontiershows the combinationsof outputin this case,cars and computersthat the economy can

possibly produce. Theeconomy can produceany combination on orinside the frontier. Pointsoutside the frontier arenot feasible given the

economys resources.

The production possibilities frontier

3,000

1,000

1,000

300 600 700

2,0002,200

FC

AB

E

Quantity of

ComputersProduced

Quantity of

Cars Produced

0

D


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Efficient levels of production

The economy is getting all it can

From the scarce resources available

Points on the production possibilitiesfrontier

Trade-off:

The only way to produce more of one good Is to produce less of the other good

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Inefficient levels of production

Points inside production possibilitiesfrontier

Opportunity cost of producing one good Give up producing the other good

Slope of the production possibilities

frontier

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Bowed out production possibilities frontier

Opportunity cost of a carhighest

Economy - producing many cars and fewercomputers

Opportunity cost of a carlower

Economy - producing fewer cars and manycomputers

Resource specialization

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Technological advance

Outward shift of the production possibilitiesfrontier

Economic growth

Produce more of both goods

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A shift in the production possibilities frontierQuantity of

Computers

Produced

Quantity of

Cars Produced

0 600 650 1,000

3,000

A2,2002,300

A technological advancein the computer industryenables the economy toproduce more computersfor any given number of

cars. As a result, theproduction possibilitiesfrontier shifts outward. Ifthe economy movesfrom point A to point G,then the production of

both cars and computersincreases.

4,000

G


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Microeconomics

The study of how households and firmsmake decisions

And how they interact in markets Macroeconomics

The study of economy-wide phenomena,

including inflation, unemployment, andeconomic growth

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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 shouldbe

Prescriptive

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Why Economists Disagree

Economists may disagree

Validity of alternative positive theoriesabout how the world works

Economists may have different values Different normative views about whatpolicy should try to accomplish

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Differences in scientific judgments

Different hunches about

Validity of alternative theories

Size of important parameters Measure how economic variables are related

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Differences in values

Peter and Paula - take the same amountof water from the town well

Peters income= $50,000 Tax= $5,000 (10%)

Paulas income= $10,000

Tax= $2,000 (20%)

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Proposition (and percentage of economists who agree)

1. A ceiling on rents reduces the quantity and quality of housing available. (93%)

2. Tariffs and import quotas usually reduce general economic welfare. (93%)3. Flexible and floating exchange rates offer an effective international monetaryarrangement. (90%)

4. Fiscal policy (e.g., tax cut and/or government expenditure increase) has asignificant stimulative impact on a less than fully employed economy. (90%)

5. The United States should not restrict employers from outsourcing work to foreigncountries. (90%)

6. Economic growth in developed countries like the United States leads to greaterlevels of wellbeing. (88%)

7. The United States should eliminate agricultural subsidies. (85%)

8. An appropriately designed fiscal policy can increase the long-run rate of capitalformation. (85%)

9. Local and state governments should eliminate subsidies to professional sportsfranchises. (85%)

10. If the federal budget is to be balanced, it should be done over the business cyclerather than yearly. (85%)

Propositions about Which Most Economists Agree


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11. The gap between Social Security funds and expenditures will becomeunsustainably large within the next 50 years if current policies remain unchanged.

(85%)12. Cash payments increase the welfare of recipients to a greater degree than dotransfers-in-kind of equal cash value. (84%)

13. A large federal budget deficit has an adverse effect on the economy. (83%)

14. The redistribution of income in the United State is a legitimate role for thegovernment. (83%)

15. Inflation is caused primarily by too much growth in the money supply. (83%)

16. The United States should not ban genetically modified crops. (82%)

17. A minimum wage increases unemployment among young and unskilled workers.(79%)

18. The government should restructure the welfare system along the lines of anegative income tax. (79%)

19. Effluent taxes and marketable pollution permits represent a better approach topollution control than imposition of pollution ceilings. (78%)

20. Government subsidies on ethanol in the United States should be reduced oreliminated. (78%)

Propositions about Which Most Economists Agree

G hi b i f i


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Graphing: a brief review

Graphs purposes:

Visually express ideas that might be lessclear 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

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Types of Graphs (a)

The pie chart in panel (a) shows how U.S. national income in 2008 was derivedfrom various sources.


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Types of Graphs (b)

The bar graph in panel (b) compares the 2008 average income in four countries.


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Types of Graphs (c)

The time-series graph in panel (c) shows the productivity of labor in U.S.businesses from 1950 to 2000.

G hi b i f i


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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

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Using the Coordinate System

Grade point average is measured on the vertical axis and study time on thehorizontal axis. Albert E., Alfred E., and their classmates are represented by variouspoints. We can see from the graph that students who study more tend to get highergrades.



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Curves in the coordinate system

Data Number of novels

Price of novels

Income Demand curve

Effect of a goods price

On the quantity of the good consumerswant to buy

For a given income

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Novels Purchased by Emma

This table shows the number of novels Emma buys at various incomes and prices. Forany given level of income, the data on price and quantity demanded can be graphed toproduce Emmas demand curve for novels, as shown in Figures A-3 and A-4.



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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

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Demand Curve

The line D1shows how Emmas purchases of novels depend on the price of novelswhen her income is held constant. Because the price and the quantity demanded arenegatively related, the demand curve slopes downward.

Quantity of novels

purchased

5 1510 2520 300

Price of

Novels

1

2

3

4

5

6

7

8

9

10$11

Demand, D1

(25, $5)

(21, $6)

(17, $7)

(13, $8)

(9, $9)

(5, $10)


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Shifting Demand Curves

The location of Emmas demand curve for novels depends on how much income she earns. Themore she earns, the more novels she will purchase at any given price, and the farther to theright her demand curve will lie. Curve D1represents Emmas original demand curve when herincome is $30,000 per year. If her income rises to $40,000 per year, her demand curve shifts toD2. If her income falls to $20,000 per year, her demand curve shifts to D3.

Quantity of novels purchased5 1510 2520 300

Price of

Novels

1

2

3

4

5

6

7

8

910

$11

D3(income=

$20,000)

(10, $8) D2 (income=

$40,000)

(16, $8)

D1(income=

$30,000)

(13, $8)

13 16

When incomeincreases, the demandcurve shifts to the right.

When incomedecreases, thedemand curveshifts to the left.



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Slope

Ratio of the vertical distance covered To the horizontal distance covered

As we move along the line

(delta) = change in a variable The rise (change in y) divided by the run

(change in x).

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x

ySlope



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Slope

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

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Calculating the Slope of a Line

To calculate the slope of the demand curve, we can look at the changes in the x- and y-coordinates as we move from the point (21 novels, $6) to the point (13 novels, $8). The slope ofthe line is the ratio of the change in the y-coordinate (2) to the change in the x-coordinate (+8),which equals14.

Quantity of novels purchased5 1510 2520 300

Price of

Novels

1

2

3

4

5

6

7

8

9

10$11

Demand, D1

(21, $6)

(13, $8)

13 21

6-8=-2

21-13=8



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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

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Graph with an Omitted Variable

The upward-sloping curve shows that members of households with more cigarettelighters are more likely to develop cancer. Yet we should not conclude that ownershipof lighters causes cancer because the graph does not take into account the numberof cigarettes smoked.


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chapter 02_thinking like an economist

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