Thinking Like an
Economist
2
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Thinking Like an Economist
• Every field of study has its own terminology
• Mathematics
• integrals ❖ axioms ❖ vector spaces
• Psychology
• ego ❖ id ❖ cognitive dissonance
• Law
• promissory ❖ estoppel ❖ torts ❖ venues
• Economics
• supply ❖ opportunity cost ❖ elasticity ❖ consumer
surplus ❖ demand ❖ comparative advantage
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 and understand how certain events and
issues are related.
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The Role of Assumptions
• Economists make assumptions in order to make
the world easier to understand.
• The art in scientific thinking is deciding which
assumptions to make.
• Economists use different assumptions to
answer different questions.
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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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permitted in a license distributed with a certain product or service or otherwise on a password-protected Copyright
website ©for classroom
2004 use.
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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
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The Economist as a Scientist
• Economic models
• Diagrams & equations
• Omit many details
• Allow us to see what’s truly important
• Built with assumptions
• Simplify reality to improve our understanding of
it
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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.
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Figure 1 The Circular Flow
MARKET
Revenu S FOR Spendin
e GOODS AND SERVICES g
Good •Firms sell Goods
s
and •Households buy and
service
services
sol sbough
d t
FIRMS HOUSEHOLD
•Produce and sell S and consume
•Buy
goods and goods and
services
•Hire and use factors services
•Own and sell factors
of of
production production
Factors MARKET Labor, land,
of
productio S FOR and
n FACTORS OF PRODUCTION capital
Wages, rent, •Households sell Incom
and •Firms buy e
profit = Flow of inputs
and
outputs
= Flow of
dollars
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Our First Model: The Circular-Flow Diagram
• Firms
• Produce and sell goods and services
• Hire and use factors of production
• Households
• Buy and consume goods and services
• Own and sell factors of production
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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
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Our First Model: The Circular-Flow Diagram
• Factors of Production
• Inputs used to produce goods and services
• Land, labor, and capital
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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.
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The production possibilities frontier
Figure 2
Quantity of
Computers The production
Produced possibilities frontier
shows the combinations
C of output—in this case,
3,000 F
cars and
Production
computers—that the
A Possibilities
2,200 economy can possibly
B Frontier
2,000 produce. The economy
can produce any
combination on or inside
D the frontier. Points
1,000
outside the frontier are
E not feasible given the
economy’s resources.
0 300 600 700 1,000Quantity of
Cars Produced
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The Economist as a Scientist
• Efficient levels of production
• The economy is getting all it can
• From the scarce resources available
• Points on the production possibilities frontier
• Trade-off:
• The only way to produce more of one good
• Is to produce less of the other good
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permitted in a license distributed with a certain product or service or otherwise on a password-protected Copyright
website ©for classroom
2004 use.
South-Western/Thomson Learning
The Economist as a Scientist
• Inefficient levels of production
• Points inside production possibilities frontier
• Opportunity cost of producing one good
• Give up producing the other good
• Slope of the production possibilities frontier
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permitted in a license distributed with a certain product or service or otherwise on a password-protected Copyright
website ©for classroom
2004 use.
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The Economist as a Scientist
• Technological advance
• Outward shift of the production possibilities
frontier
• Economic growth
• Produce more of both goods
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A shift in the production possibilities frontier
Figure 3
Quantity of
Computers
Produced
A technological advance
4,000 in the computer industry
enables the economy to
produce more computers
3,000 for any given number of
G cars. As a result, the
2,300 production possibilities
2,200
A frontier shifts outward. If
the economy moves
from point A to point G,
then the production of
both cars and computers
increases.
0 600 650 1,000 Quantity of
Cars Produced
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Microeconomics and Macroeconomics
• Microeconomics focuses on the individual parts of
the economy.
• How households and firms make decisions and how
they interact in specific markets
• Macroeconomics looks at the economy as a
whole.
• Economy-wide phenomena, including inflation,
unemployment, and economic 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 should be
• Prescriptive
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