Economics: Lecture Notes- Chapter 2
After learning this chapter you must know:
Why do economists make assumptions and use models
What is the Cirdular Flow Diagram
What is the Profuction Possibility Frontier
The difference between Positive Economics versus Normative Economics
KEY POINTS:
Economists try to address their subject with a scientist’s objectivity. Like all scientists, they
make appropriate assumptions and build simplified models to understand the world around
them. Two simple economic models are the circular-flow diagram and the production
possibilities frontier.
The field of economics is divided into two subfields: microeconomics and macroeconomics.
Microeconomists study decision making by households and firms and the interaction among
households and firms in the marketplace. Macroeconomists study the forces and trends that
affect the economy as a whole.
A positive statement is an assertion about how the world is. A normative statement is an
assertion about how the world ought to be. When economists make normative statements,
they are acting more as policy advisers than as scientists.
Economists who advise policymakers sometimes offer conflicting advice either because of
differences in scientific judgments or because of differences in values. At other times,
economists are united in the advice they offer, but policymakers may choose to ignore the
advice because of the many forces and constraints imposed by the political process.
I. The Economist as Scientist
Economics is a social science. It has aspects of both behavioral science such as phycology but
also a science, there are observations, collections of data, theory and specific scientific
methods of approach.
A. Economists Follow the Scientific Method.
1. Observations help us to develop theory.
2. Data can be collected and analyzed to evaluate theories.
3. Using data to evaluate theories is more difficult in economics than in physical science
because economists are unable to generate their own data and must make do with
whatever data are available.
4. Thus, economists pay close attention to the natural experiments offered by history.
B. Assumptions Make the World Easier to Understand.
1. Example: to understand international trade, it may be helpful to start out assuming
that there are only two countries in the world producing only two goods. Once we
understand how trade would work between these two countries, we can extend our
analysis to a greater number of countries and goods.
2. One important role of a scientist is to understand which assumptions one should
make.
3. Economists often use assumptions that are somewhat unrealistic but will have small
effects on the actual outcome of the answer.
C. Economists Use Economic Models to Explain the World around Us.
For example: a road map it does not show where all of the stop signs, gas stations, or
restaurants are located. It assumes that the earth is flat and two-dimensional. But, despite
these simplifications, a map usually helps travelers get from one place to another. Thus, it
is a good model.
1. Most economic models are composed of diagrams and equations.
2. The goal of a model is to simplify reality in order to increase our understanding. This
is where the use of assumptions is helpful.
D. Our First Model: The Circular Flow Diagram
Figure 1
1. Definition of circular-flow diagram: a visual model of the economy that
shows how dollars flow through markets among households and firms.
2. This diagram is a very simple model of the economy. Note that it ignores
the roles of government and international trade.
a. There are two decision makers in the model: households and firms.
Households are the main consuming unit in the economy and the firm is the
primary producing unit in the economy. Firms produce and households
consume.
b. There are two markets: the market for goods and services and the market for
factors of production.
c. Firms are sellers in the market for goods and services and buyers in the
market for factors of production. In other words, firms sell products (such as
milk and clothing ( to households, but firms hire the households tom work on
their firms so they can produce a variety of products.
d. Households are buyers in the market for goods and services and sellers in the
market for factors of production. Households buy products such as milk and
clothing the the markets for goods and services, and they supply themselves
as workers, so the can earn salaries so they can buy goods and services.
e. The inner loop represents the flows of inputs and outputs between households
and firms.
f. The outer loop represents the flows of dollars between households and firms.
E. Our Second Model: The Production Possibilities Frontier (Please watch the video, as it
will be much easier to understand
PPF- Production Possibility Frontier – Maximum amount of consumer goods and capital
goods a society can produced at a certain point in time given fixed resources.
Characteristics:
1. All Points on the graph, indicate- efficiency. Efficiency means that all resources are being
used. If your resource is labor, then everyone in that society has a job and is producing.
2. Points outside the graph- means not feasible, this society does not have enough resources
to produce at that level
3. Inside the graph- means inefficient- not all resources are being used. If your resource is
labor- it means unemployment.
4. 4. The PPF graph illustrates the concept of Opportunity Cost. In order to produce more of
one good- must give up production to the other good.
5. To increase overall production- resources must increase, this can be seen by a shift
outward of the PPF curve.
o Definition of production possibilities frontier: 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.
o Example: an economy that produces two goods, cars and computers.
a. If all resources are devoted to producing cars, the economy would produce
1,000 cars and zero computers.
b. If all resources are devoted to producing computers, the economy would
produce 3,000 computers and zero cars.
c. More likely, the resources will be divided between the two industries,
producing some cars and some computers. The feasible combinations of
output are shown on the production possibilities frontier.
Figure 2
3. Because resources are scarce, not every combination of computers and cars is
possible. Production at a point outside of the curve (such as C) is not possible
given the economy’s current level of resources and technology.
4. Production is efficient at points on the curve (such as A and B). This implies that
the economy is getting all it can from the scarce resources it has available. There
is no way to produce more of one good without producing less of another.
5. Production at a point inside the curve (such as D) is inefficient.
a. This means that the economy is producing less than it can from the resources
it has available.
b. If the source of the inefficiency is eliminated, the economy can increase its
production of both goods.
6. The production possibilities frontier reveals Principle #1: People face trade-offs.
a. Suppose the economy is currently producing 600 cars and 2,200 computers.
b. To increase the production of cars to 700, the production of computers must
fall to 2,000.
7. Principle #2 is also shown on the production possibilities frontier: The cost of
something is what you give up to get it (opportunity cost).
a. The opportunity cost of increasing the production of cars from 600 to 700 is
200 computers.
b. Thus, the opportunity cost of each car is two computers.
8. The opportunity cost of a car depends on the number of cars and computers
currently produced by the economy.
a. The opportunity cost of a car is high when the economy is producing many
cars and few computers.
b. The opportunity cost of a car is low when the economy is producing few cars
and many computers.
9. Economists generally believe that production possibilities frontiers often have this
bowed-out shape because some resources are better suited to the production of
cars than computers (and vice versa).
Example of producing Corn and Wheat
Table 3 – Production Possibility Frontier Table
Points on PPF Total Corn Production* Total Wheat Production*
A 700 100
B 650 200
C 510 380
D 400 500
E 300 550
*Millions of bushels
Please look at the table above: To move from point A to point B means to increase
production of wheat by 100 units, but at the same time you must give up producing 150
units of corn.
To move from B to C- to produce additional 180 units of wheat, you must give up producing
140 units of corn.
METHOD OF ECONOMICS
Positive economics – an approach in economics that seeks to understand behavior and
the operation of systems without making judgments. It describes what exists and how it
works.
Normative Economics – An approach to economics that analyzes outcomes of economic
behavior, evaluates them as good or bad, and may prescribe courses of action.
II. The Economist as Policy Adviser
A. Positive versus Normative Analysis
1. Example of a discussion of minimum-wage laws: Polly says, “Minimum-wage laws
cause unemployment.” Norma says, “The government should raise the minimum
wage.”
2. Definition of positive statements: claims that attempt to describe the
world as it is.
3. Definition of normative statements: claims that attempt to prescribe how
the world should be.
4. Positive statements can be evaluated by examining data, while normative
statements involve personal viewpoints.
5. Positive views about how the world works affect normative views about which
policies are desirable.
6. Much of economics is positive; it tries to explain how the economy works. But
those who use economics often have goals that are normative. They want to
understand how to improve the economy.
B. Economists in Washington
1. Economists are aware that trade-offs are involved in most policy decisions.
2. The president receives advice from the Council of Economic Advisers (created in
1946).
3. Economists are also employed by administrative departments within the various
federal agencies such as the Office of Management and Budget, the Department
of Treasury, the Department of Labor, the Congressional Budget Office, and the
Federal Reserve.
4. The research and writings of economists can also indirectly affect public policy.
C. Why Economists’ Advice Is Not Always Followed
1. The process by which economic policy is made differs from the idealized policy
process assumed in textbooks.
2. Economists offer crucial input into the policy process, but their advice is only part
of the advice received by policymakers.
III. Why Economists Disagree
A. Differences in Scientific Judgments
1. Economists may disagree about the validity of alternative positive theories or
about the size of the effects of changes in the economy on the behavior of
households and firms.
2. Example: some economists feel that a change in the tax code that would
eliminate a tax on income and create a tax on consumption would increase
saving in this country. However, other economists feel that the change in the tax
system would have little effect on saving behavior and therefore do not support
the change.
B. Differences in Values
C. Perception versus Reality
1. While it seems as if economists do not agree on much, this is in fact not true.
Table 1 contains 20 propositions that are endorsed by a majority of economists.