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Chapter 2
Thinking Like An Economist

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The Economist as Scientist

§ Economists play two roles:
1. Scientists: try to explain the world
2. Policy advisors: try to improve it
§ In the first, economists employ the
scientific method,
the dispassionate development and testing of
theories about how the world works.

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Assumptions & Models

§ Assumptions simplify the complex world,
make it easier to understand.
§ Example: To study international trade,
assume two countries and two goods.
Unrealistic, but simple to learn and
gives useful insights about the real world.
§ Model: a highly simplified representation of
a more complicated reality.
Economists use models to study economic
issues.

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Some Familiar Models

A road map

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Some Familiar Models

A model of human
anatomy from high
school biology class

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Some Familiar Models

A model airplane

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Some Familiar Models

The model teeth at the Don’t forget

dentist’s office to floss!

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Our First Model:

The Circular-Flow Diagram
§ The Circular-Flow Diagram: a visual model of
the economy, shows how dollars flow through
markets among households and firms
§ Two types of “actors”:
§ households
§ firms
§ Two markets:
§ the market for goods and services
§ the market for “factors of production”

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Factors of Production
§ Factors of production: the resources the
economy uses to produce goods & services,
including
§ labor
§ land
§ capital (buildings & machines used in
production)

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FIGURE 1: The Circular-Flow Diagram

Households:
§ Own the factors of production,
sell/rent them to firms for income
§ Buy and consume goods & services

Firms Households

Firms:
§ Buy/hire factors of production,
use them to produce goods
and services
§ Sell goods & services
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FIGURE 1: The Circular-Flow Diagram

Revenue Spending
Markets for
G&S Goods &
G&S
sold Services bought

Firms Households

Factors of Labor, land,

production Markets for capital
Factors of
Wages, rent, Production Income
profit
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!"#$%&'%()*'$+),-
This diagram is a
schematic representation
of the organization of the
economy. Decisions are
made by households and
firms. Households and
firms interact in the
markets for goods and
services (where
households are buyers and
firms are sellers) and in the
markets for the factors of
production (where firms are
buyers and households are
sellers). The outer set of
arrows shows the flow of
dollars, and the inner set of
arrows shows the
corresponding flow of
inputs and outputs.
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Our Second Model:

The Production Possibilities Frontier
§ The Production Possibilities Frontier (PPF):
a graph that shows the combinations of
two goods the economy can possibly produce
given the available resources and the available
technology
§ Example:
§ Two goods: computers and wheat
§ One resource: labor (measured in hours)
§ Economy has 50,000 labor hours per month
available for production.
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PPF Example
§ Producing one computer requires 100 hours labor.
§ Producing one ton of wheat requires 10 hours labor.
Employment of
Production
labor hours

Computers Wheat Computers Wheat

A 50,000 0 500 0

B 40,000 10,000 400 1,000

C 25,000 25,000 250 2,500

D 10,000 40,000 100 4,000

E 0 50,000 0 5,000

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PPF Example

Point Production
on Com-
graph puters Wheat
E
A 500 0 D
B 400 1,000
C
C 250 2,500
D 100 4,000 B
E 0 5,000 A

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ACTIVE LEARNING 1
Points off the PPF
A. On the graph, find the point that represents
(100 computers, 3000 tons of wheat), label it F.
Would it be possible for the economy to produce
this combination of the two goods?
Why or why not?

B. Next, find the point that represents

(300 computers, 3500 tons of wheat), label it G.
Would it be possible for the economy to produce
this combination of the two goods?

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ACTIVE LEARNING 1
Answers
§ Point F:
100 computers,
3000 tons wheat
§ Point F requires
40,000 hours
of labor. F
Possible but
not efficient:
could get more
of either good
w/o sacrificing
any of the other.
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ACTIVE LEARNING 1
Answers
§ Point G:
300 computers,
3500 tons wheat

§ Point G requires G
65,000 hours
of labor.
Not possible
because
economy
only has
50,000 hours.
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The PPF: What We Know So Far

Points on the PPF (like A – E)
§ possible
§ efficient: all resources are fully utilized
Points under the PPF (like F)
§ possible
§ not efficient: some resources underutilized
(e.g., workers unemployed, factories idle)

Points above the PPF (like G)

§ not possible

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The PPF and Opportunity Cost

§ Recall: The opportunity cost of an item
is what must be given up to obtain that item.
§ Moving along a PPF involves shifting resources
(e.g., labor) from the production of one good to
the other.
§ Society faces a tradeoff: Getting more of one
good requires sacrificing some of the other.
§ The slope of the PPF tells you the opportunity
cost of one good in terms of the other.

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The PPF and Opportunity Cost

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ACTIVE LEARNING 2
PPF and Opportunity Cost
In which country is the opportunity cost of cloth lower?
FRANCE ENGLAND

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ACTIVE LEARNING 2
Answers
England, because its PPF is not as steep as France’s.
FRANCE ENGLAND

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Economic Growth and the PPF

With additional
Economic
resources or an
growth shifts
improvement in
the PPF
technology,
outward.
the economy can
produce more
computers,
more wheat,
or any combination
in between.

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The Shape of the PPF

§ The PPF could be a straight line, or bow-shaped
§ Depends on what happens to opportunity cost
as economy shifts resources from one industry
to the other.
§ If opp. cost remains constant,
PPF is a straight line.
(In the previous example, opp. cost of a
computer was always 10 tons of wheat.)
§ If opp. cost of a good rises as the economy
produces more of the good, PPF is bow-shaped.

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Why the PPF Might Be Bow-Shaped

As the economy
Beer

shifts resources
from beer to
mountain bikes:
§ PPF becomes
steeper
§ opp. cost of
mountain bikes
increases
Mountain
Bikes
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Why the PPF Might Be Bow-Shaped

§ So, PPF is bow-shaped when different workers
have different skills, different opportunity costs
of producing one good in terms of the other.
§ The PPF would also be bow-shaped when
there is some other resource, or mix of
resources with varying opportunity costs
(E.g., different types of land suited for
different uses).

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The PPF: A Summary

§ The PPF shows all combinations of two goods
that an economy can possibly produce,
given its resources and technology.

§ The PPF illustrates the concepts of

tradeoff and opportunity cost,
efficiency and inefficiency,
unemployment, and economic growth.

§ A bow-shaped PPF illustrates the concept of

increasing opportunity cost.

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Microeconomics and Macroeconomics

§ Economics is commonly split into two parts:
microeconomics and macroeconomics.
§ Microeconomics examines the behaviour of
single economic agents and the way these
agents interact in the marketplace along with the
outcomes of their interactions.
§ Macroeconomics examines the behaviour of the
economy at an aggregate level.

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Microeconomics and Macroeconomics

§ Microeconomics is the study of how households
and firms make decisions and how they interact
in markets.
§ Macroeconomics is the study of economy-wide
phenomena, including inflation, unemployment,
and economic growth.
§ These two branches of economics are closely
intertwined, yet distinct – they address different
questions.

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Microeconomics and Macroeconomics

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The Economist as Policy Advisor

§ As scientists, economists make
positive statements,
which attempt to describe the world as it is.
§ As policy advisors, economists make
normative statements,
which attempt to prescribe how the world should be.
§ Positive statements can be confirmed or refuted,
normative statements cannot.
§ Govt employs many economists for policy advice.
E.g., the U.S. President has a Council of Economic
Advisors, which the author of this textbook chaired
from 2003 to 2005.
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Why Economists Disagree

§ Economists often give conflicting policy advice.
§ They sometimes disagree about the validity of
alternative positive theories about the world.
§ They may have different values and, therefore,
different normative views about what policy
should try to accomplish.
§ Yet, there are many propositions about which
most economists agree.

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Propositions about Which Most

Economists Agree (and % who agree)
§ A ceiling on rents reduces the quantity and
quality of housing available. (93%)
§ Tariffs and import quotas usually reduce general
economic welfare. (93%)
§ The United States should not restrict employers
from outsourcing work to foreign countries. (90%)
§ The United States should eliminate agriculture
subsidies. (85%)

continued…
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CHAPTER SUMMARY

§ As scientists, economists try to explain the world

using models with appropriate assumptions.
§ Two simple models are the Circular-Flow Diagram
and the Production Possibilities Frontier.
§ Microeconomics studies the behavior of
consumers and firms, and their interactions in
markets. Macroeconomics studies the economy
as a whole.
§ As policy advisers, economists offer advice on how
to improve the world.
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