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CH 2 Lecture Notes 2

The document provides an overview of key economic concepts including: 1) Economists develop theories to explain observations like inflation, and test theories using international data on money growth and price increases. 2) The circular flow diagram models the economy as firms producing goods that households consume, with funds flowing from households to firms for goods and back from firms to households through factor markets. 3) Microeconomics studies individual and market decisions while macroeconomics analyzes economy-wide phenomena like growth and unemployment.

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129 views4 pages

CH 2 Lecture Notes 2

The document provides an overview of key economic concepts including: 1) Economists develop theories to explain observations like inflation, and test theories using international data on money growth and price increases. 2) The circular flow diagram models the economy as firms producing goods that households consume, with funds flowing from households to firms for goods and back from firms to households through factor markets. 3) Microeconomics studies individual and market decisions while macroeconomics analyzes economy-wide phenomena like growth and unemployment.

Uploaded by

NIRAJ kumar
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© © All Rights Reserved
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CH 2 - Lecture notes 2

Introduction to economics (Indian Institute of Technology Bombay)

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Thinking Like an Economist


Interplay between theory and observation also occurs in economics. An economist might live in a country
experiencing rapidly increasing prices and be moved by this observation to develop a theory of inflation. The theory
might assert that high inflation arises when the government prints too much money. To test this theory, the
economist could collect and analyze data on prices and money from many different countries. If growth in the
quantity of money were completely unrelated to the rate of price increase, the economist would start to doubt the
validity of this theory of inflation. If money growth and inflation were strongly correlated in international data, as in
fact they are, the economist would become more confident in the theory. To find a substitute for laboratory
experiments, economists pay close attention to the natural experiments offered by history.
The art in scientific thinking—whether in physics, biology, or economics—is deciding which assumptions to make. Eg,
assuming if prices are fixed or are in flux, etc.

Our First Model: The Circular-Flow Diagram


In this model, the economy is simplified to include only two types of decision makers—firms and households. Firms
produce goods and services using inputs, such as labour, land, and capital (buildings and machines). These inputs are
called the factors of production. Households own the factors of production and consume all the goods and services
that the firms produce.
In the markets for goods and services, households are buyers, and firms are sellers. In particular, households buy the
output of goods and services that firms produce. In the markets for the factors of production, households are sellers,
and firms are buyers. In these markets, households provide the inputs that firms use to produce goods and services.
The two loops of the circular-flow diagram are distinct but related. The inner loop represents the flows of inputs and
outputs. The households sell the use of their labour, land, and capital to the firms in the markets for the factors of
production. The firms then use these factors to produce goods and services, which in turn are sold to households in
the markets for goods and services. The outer loop of the diagram represents the corresponding flow of dollars.
The firms use some of the revenue from these sales to pay for the factors of production, such as the wages of their
workers. What’s left is the profit of the firm owners, who themselves are members of households. Revenue ends up
back in households after firms purchase factors of production, and the cycle restarts.

Our Second Model: The Production Possibilities Frontier


The production possibilities frontier is a graph that shows the various combinations of output—in this case, cars and
computers—that the economy can possibly produce given the available factors of production and the available
production technology that firms use to turn these factors into output.
Figure 2 shows this economy’s production possibilities frontier. If the economy uses all its resources in the car
industry, it produces 1,000 cars and no computers. If it uses all its resources in the computer industry, it produces
3,000 computers and no cars. The two endpoints of the production possibilities frontier represent these extreme
possibilities. Points outside the frontier are not feasible given the economy’s resources. The slope of the production
possibilities frontier measures the opportunity cost of a car in terms of computers.

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Microeconomics and Macroeconomics

Economics is also studied on various levels. We can study the decisions of individual households and firms. Or we can
study the interaction of households and firms in markets for specific goods and services. Or we can study the
operation of the economy as a whole, which is the sum of the activities of all these decision makers in all these
markets.
Microeconomics is the study of how households and firms make decisions and how they interact in specific markets.
Macroeconomics is the study of economywide phenomena, including inflation, unemployment, and economic
growth. A microeconomist might study the effects of rent control on housing in New York City, the impact of foreign
competition on the U.S. auto industry, or the effects of compulsory school attendance on workers’ earnings. A
macroeconomist might study the effects of borrowing by the federal government, the changes over time in the
economy’s rate of unemployment, or alternative policies to promote growth in national living standards.
Microeconomics and macroeconomics are closely intertwined. Because changes in the overall economy arise from
the decisions of millions of individuals, it is impossible to understand macroeconomic developments without
considering the associated microeconomic decisions.
Despite the inherent link between microeconomics and macroeconomics, the two fields are distinct. Because they
address different questions, each field has its own set of models, which are often taught in separate courses.

the economist as policy adviser

When economists are trying to explain the world, they are scientists. When they are trying to help improve it, they
are policy advisers.

Positive versus Normative Analysis

Positive statements are descriptive. They make a claim about how the world is. A second type of statement, such as
Norm’s, is normative. Normative statements are prescriptive. They make a claim about how the world ought to be.
A key difference between positive and normative statements is how we judge their validity. We can, in principle,
confirm or refute positive statements by examining evidence. By contrast, evaluating normative statements involves
values as well as facts. Deciding what is good or bad policy is not just a matter of science. It also involves our views
on ethics, religion, and political philosophy.
Yet normative conclusions cannot come from positive analysis alone; they involve value judgments as well.

Economists in Washington
Economists are aware that trade-offs are involved in most policy decisions. A policy might increase efficiency at the
cost of equality. It might help future generations but hurt current generations. An economist who says that all policy
decisions are easy or clear-cut is an economist not to be trusted.

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Making economic policy in a representative democracy is a messy affair—and there are often good reasons why
presidents (and other politicians) do not advance the policies that economists advocate. Economists offer crucial
input into the policy process, but their advice is only one ingredient of a complex recipe.
Why do economists so often appear to give conflicting advice to policymakers? There are two basic reasons:
• Economists may disagree about the validity of alternative positive theories about how the world works.
• Economists may have different values and therefore different normative views about what government
policy should aim to accomplish.

Rent control, a policy that sets a legal maximum on the amount landlords can charge for their apartments. Almost all
economists believe that rent control adversely affects the availability and quality of housing and is a costly way of
helping the neediest members of society. Nonetheless, many city governments ignore the advice of economists and
place ceilings on the rents that landlords may charge their tenants. Page 32 and 33!

Swarada Bharadwaj

08-23-19

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