Chapter 2Chapter 2Chapter 2Chapter 2

Thinking Like an Thinking Like an EconomistEconomist

Thinking Like an Thinking Like an EconomistEconomist

2002 by Nelson, a division of Thomson Canada Limited2002 by Nelson, a division of Thomson Canada Limited2002 by Nelson, a division of Thomson Canada Limited2002 by Nelson, a division of Thomson Canada Limited

Chapter 2: Page 2

In this chapter you will…In this chapter you will… See how economists apply the See how economists apply the

method of science.method of science. Consider how assumptions and Consider how assumptions and

models can shed light on the models can shed light on the world.world.

Learn two simple models - the Learn two simple models - the circular flow and production circular flow and production possibilities frontier.possibilities frontier.

See how economists apply the See how economists apply the method of science.method of science.

Consider how assumptions and Consider how assumptions and models can shed light on the models can shed light on the world.world.

Learn two simple models - the Learn two simple models - the circular flow and production circular flow and production possibilities frontier.possibilities frontier.

Chapter 2: Page 3

In this chapter you will…In this chapter you will… Distinguish between Distinguish between

microeconomics and microeconomics and macroeconomics.macroeconomics.

Learn the difference between and Learn the difference between and normative statements.normative statements.

Examine the role of economists in Examine the role of economists in making policy.making policy.

Consider why economists Consider why economists sometimes disagree with one sometimes disagree with one another.another.

Distinguish between Distinguish between microeconomics and microeconomics and macroeconomics.macroeconomics.

Learn the difference between and Learn the difference between and normative statements.normative statements.

Examine the role of economists in Examine the role of economists in making policy.making policy.

Consider why economists Consider why economists sometimes disagree with one sometimes disagree with one another.another.

Chapter 2: Page 4

Thinking Like an EconomistThinking Like an Economist

Every field of study has its own terminology– Mathematics

• integrals axioms vector spaces

– Psychology• ego id cognitive dissonance

– Law• promissory estoppels torts venues

– Economics• supply opportunity cost elasticity

consumer surplus demand comparative advantage deadweight loss

Every field of study has its own terminology– Mathematics

• integrals axioms vector spaces

– Psychology• ego id cognitive dissonance

– Law• promissory estoppels torts venues

– Economics• supply opportunity cost elasticity

consumer surplus demand comparative advantage deadweight loss

Chapter 2: Page 5

Thinking Like an EconomistThinking 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.

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.

Chapter 2: Page 6

THE ECONOMIST AS A SCIENTISTTHE ECONOMIST AS A SCIENTIST

The economic way of thinking . . .– Involves thinking analytically and

objectively.– Economists…

• Devise theories• Collect data• Analyze the data to verify or refute their

theories

– Economics makes use of the scientific method.

The economic way of thinking . . .– Involves thinking analytically and

objectively.– Economists…

• Devise theories• Collect data• Analyze the data to verify or refute their

theories

– Economics makes use of the scientific method.

Chapter 2: Page 7

The Scientific Method: The Scientific Method: observation, theory, and more observation, theory, and more

observationobservation

• Uses abstract models to help explain how a complex, real world operates.

• Develops theories, collects, and analyzes data to evaluate the theories.

• Uses abstract models to help explain how a complex, real world operates.

• Develops theories, collects, and analyzes data to evaluate the theories.

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The Role of AssumptionsThe 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.

• 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.

Chapter 2: Page 9

Economic ModelsEconomic 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

• 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

Chapter 2: Page 10

Our First Model: The Circular-Flow Our First Model: The Circular-Flow DiagramDiagram

• The circular-flow diagram is a visual model of the economy that shows how dollars flow through markets among households and firms.

• The circular-flow diagram is a visual model of the economy that shows how dollars flow through markets among households and firms.

Figure 1: The Circular FlowFigure 1: The Circular Flow

Copyright © 2004 South-Western

Spending

Goods andservicesbought

Revenue

Goodsand servicessold

Labour, land,and capital

Income

= Flow of inputs and outputs

= Flow of dollars

Factors ofproduction

Wages, rent,and profit

FIRMS•Produce and sellgoods and services

•Hire and use factorsof production

•Buy and consumegoods and services

•Own and sell factorsof production

HOUSEHOLDS

•Households sell•Firms buy

MARKETSFOR

FACTORS OF PRODUCTION

•Firms sell•Households buy

MARKETSFOR

GOODS AND SERVICES

Chapter 2: Page 12

Our First Model: The Circular-Flow Our First Model: The Circular-Flow DiagramDiagram

• 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

• 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

Chapter 2: Page 13

Our First Model: The Circular-Flow Our First Model: The Circular-Flow DiagramDiagram

• Markets for Goods and Services– Firms sell– Households buy

• Markets for Factors of Production– Households sell– Firms buy

• Factors of Production– Inputs used to produce goods and

services– Land, labour, and capital

• Markets for Goods and Services– Firms sell– Households buy

• Markets for Factors of Production– Households sell– Firms buy

• Factors of Production– Inputs used to produce goods and

services– Land, labour, and capital

Chapter 2: Page 14

Our Second Model: Our Second Model: The Production Possibilities FrontierThe Production Possibilities Frontier

• The production possibilities frontierproduction 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.

• The production possibilities frontierproduction 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.

Chapter 2: Page 15

Quantity of Computers Produced

Quantity of Cars Produced

0

Figure 2-2: Figure 2-2: The Production Possibilities FrontierThe Production Possibilities Frontier

3000

2000

700

A

1000

300

B

2200

600

C

D

1000

Production possibilities frontier

Chapter 2: Page 16

• Concepts Illustrated by the Production Possibilities Frontier – Efficiency– Tradeoffs– Opportunity Cost– Economic Growth

• Concepts Illustrated by the Production Possibilities Frontier – Efficiency– Tradeoffs– Opportunity Cost– Economic Growth

Our Second Model: Our Second Model: The Production Possibilities FrontierThe Production Possibilities Frontier

Chapter 2: Page 17

Figure 2-3. A Shift in the Production Possibilities Figure 2-3. A Shift in the Production Possibilities FrontierFrontier

Quantity of Computers Produced

Quantity of Cars Produced

3000

2000

700

A

0

4000

2100

750

E

1000

Chapter 2: Page 18

Microeconomics and MacroeconomicsMicroeconomics 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

• 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

Chapter 2: Page 19

THE ECONOMIST AS POLICY THE ECONOMIST AS POLICY ADVISERADVISER

• When economists are trying to explain the world, they are scientists.

• When economists are trying to change the world, they are policy advisor.

• When economists are trying to explain the world, they are scientists.

• When economists are trying to change the world, they are policy advisor.

Chapter 2: Page 20

Positive Positive VersusVersus Normative Statements Normative Statements

• Positive statements are statements that attempt to describe the world as it is.– Called descriptive analysis

• Normative statements are statements about how the world should be.– Called prescriptive analysis

• Positive statements are statements that attempt to describe the world as it is.– Called descriptive analysis

• Normative statements are statements about how the world should be.– Called prescriptive analysis

Chapter 2: Page 21

• Positive or Normative Statements? – An increase in the minimum wage will cause a

decrease in employment among the least-skilled.

POSITIVE

– Higher federal budget deficits will cause interest rates to increase.

POSITIVE

• Positive or Normative Statements? – An increase in the minimum wage will cause a

decrease in employment among the least-skilled.

POSITIVE

– Higher federal budget deficits will cause interest rates to increase.

POSITIVE

Positive Versus Normative StatementsPositive Versus Normative Statements

Chapter 2: Page 22

• Positive or Normative Statements? – The income gains from a higher minimum

wage are worth more than any slight reductions in employment.

NORMATIVE

– State governments should be allowed to collect from tobacco companies the costs of treating smoking-related illnesses among the poor.

NORMATIVE

• Positive or Normative Statements? – The income gains from a higher minimum

wage are worth more than any slight reductions in employment.

NORMATIVE

– State governments should be allowed to collect from tobacco companies the costs of treating smoking-related illnesses among the poor.

NORMATIVE

Positive Positive VersusVersus Normative Statements Normative Statements

Chapter 2: Page 23

Economists in OttawaEconomists in Ottawa

• Department of Finance: Design tax policy. (www.fin.gc.ca)

• Industry Canada: Design and enforce anti-monopoly laws. (www.ic.gc.ca)

• Department of Foreign Affairs and International Trade: Negotiate trade agreements with other countries. (www.defait.gc.ca)

• Human Resources Development Canada: Analyze data on workers to help formulate labour-market policies. (www.hrdc.gc.ca)

• Department of Finance: Design tax policy. (www.fin.gc.ca)

• Industry Canada: Design and enforce anti-monopoly laws. (www.ic.gc.ca)

• Department of Foreign Affairs and International Trade: Negotiate trade agreements with other countries. (www.defait.gc.ca)

• Human Resources Development Canada: Analyze data on workers to help formulate labour-market policies. (www.hrdc.gc.ca)

Chapter 2: Page 24

Economists in OttawaEconomists in Ottawa

• Environment Canada: Environmental regulation. (www.ec.gc.ca)

• Canadian International Development Agency: Advice on overseas development projects. (www.acdi-cida.gc.ca)

• Statistics Canada: Collect data used by other economists to give policy advice. (www.statcan.ca)

• Bank of Canada: Analyze financial markets and macroeconomic developments. (www.bank-banque-canada.ca)

• Environment Canada: Environmental regulation. (www.ec.gc.ca)

• Canadian International Development Agency: Advice on overseas development projects. (www.acdi-cida.gc.ca)

• Statistics Canada: Collect data used by other economists to give policy advice. (www.statcan.ca)

• Bank of Canada: Analyze financial markets and macroeconomic developments. (www.bank-banque-canada.ca)

Chapter 2: Page 25

Economists in the private sector…Economists in the private sector…

… publish reports that analyze current issues such as poverty, unemployment, and the deficit.

• C.D. Howe Institute (www.cdhowe.org)• The Fraser Institute

(www.fraserinstitute.ca)

… publish reports that analyze current issues such as poverty, unemployment, and the deficit.

• C.D. Howe Institute (www.cdhowe.org)• The Fraser Institute

(www.fraserinstitute.ca)

Chapter 2: Page 26

WHY ECONOMISTS DISAGREEWHY ECONOMISTS DISAGREE

• They may disagree about the validity of alternative positive theories about how the world works.

• They may have different values and, therefore, different normative views about what policy should try to accomplish.

• They may disagree about the validity of alternative positive theories about how the world works.

• They may have different values and, therefore, different normative views about what policy should try to accomplish.

Table 2-2. Ten Propositions About Which Most Table 2-2. Ten Propositions About Which Most Economists AgreeEconomists Agree

Chapter 2: Page 28

SummarySummary

• Economists try to address their subjects with a scientist’s objectivity.– 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.

• Economists try to address their subjects with a scientist’s objectivity.– 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.

Chapter 2: Page 29

• Economics is divided into two subfields:– Microeconomists study decision

making by households and firms in the marketplace.

– Macroeconomists study the forces and trends that affect the economy as a whole

SummarySummary

Chapter 2: Page 30

• 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 advisors than scientists.

• 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 advisors than scientists.

SummarySummary

Chapter 2: Page 31

• Economists who advise policymakers 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 it.

• Economists who advise policymakers 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 it.

SummarySummary

Chapter 2: Page 32

AppendixAppendixGraphing: A Brief Graphing: A Brief

ReviewReview

Chapter 2: Page 33

Graphs of a single variableGraphs of a single variable

Chapter 2: Page 34

Graphs of two variables: The Graphs of two variables: The Coordinate SystemCoordinate System

Chapter 2: Page 35

Curves in the Coordinate SystemCurves in the Coordinate System

Chapter 2: Page 36

Curves in the Coordinate SystemCurves in the Coordinate System

Chapter 2: Page 37

Slope = ∆Slope = ∆yy / ∆ / ∆xx

Chapter 2: Page 38

Cause and effect Cause and effect

Chapter 2: Page 39

Cause and effect Cause and effect

Chapter 2: Page 40

The EndThe End