Review

(“Thinking Like an Economist”)

Ref: Ch 2, Cap 2, Mankiw

The Economist as a Scientist

• Economics = science
• Economists = scientists
• Devise theories
• Collect data
• Analyze these data
• Verify or refute their theories
• Scientific method
• Dispassionate development and testing of theories about
how the world works

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The Economist as a Scientist

The scientific method: observation, theory, and more observation

• Observation
• Theory
• Conducting experiments
• Difficult / impossible
• Observation
• Close attention to natural experiments - history

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The Economist as a Scientist

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 effects
• Long-run effects

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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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The Economist as a Scientist

Our first model: The circular-flow diagram

• Circular-flow diagram
• Visual model of the economy
• Shows how $ (reais/dollars) flow through markets among households and
firms
• Decision makers
• Firms & Households
• Markets
• For gods and services
• For factors of production

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The Economist as a Scientist

Our first model: The circular-flow diagram

• Firms
• Produce goods and services
• Use factors of production / inputs
• Households
• Own factors of production
• Consume goods and services

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The Economist as a Scientist

Our first model: The circular-flow diagram

• Markets for goods and services
• Firms – sellers
• Households – buyers
• Markets for inputs
• Firms – buyers
• Households - sellers

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The circular flow
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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The Economist as a Scientist

Our second model: The production possibilities frontier

• Production possibilities frontier
• A graph
• Combinations of output that the economy can possibly produce
• Given the available
• Factors of production
• Production technology

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 The production possibilities frontier
Quantity of
Computers The production possibilities
Produced frontier shows the
combinations of output - in
C this case, cars and
3,000 F
computers - that the
Production
economy can possibly
A Possibilities
2,200 produce.
B Frontier
2,000 The economy can produce
any combination on or
inside the frontier.
D Points outside the frontier
1,000
are not feasible given the
E
economy’s resources.

0 300 600 700 1,000 Quantity of

Cars
Produced
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The Economist as a Scientist

• Efficient levels of production

• Economy’s getting all it can
• From the scarce resources available
• Points on the production possibilities frontier
• Trade-off:
• The only way to get more of one good
• Is to get less of the other good
• Inefficient levels of production
• Points inside production possibilities frontier

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The Economist as a Scientist

• Opportunity cost of one good

• Give up the other good
• Bowed out production possibilities frontier
• Opportunity cost of a car – highest
• Economy - producing many cars and fewer computers
• Opportunity cost of a car – lower
• Economy - producing fewer cars and many computers
• Resource specialization

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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
Quantity of
Computers
Produced A technological advance in
4,000 the computer industry
enables the economy to
produce more computers
3,000 for any given number of
2,300 G cars. As a result, the
2,200 production possibilities
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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The Economist as a Scientist

Microeconomics and Macroeconomics

• Microeconomics
• The study of how households and firms make decisions
• And how they interact in markets
• Macroeconomics
• The study of 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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The Economist as a Policy Adviser

Economists in Washington / Brasília

• Council of Economic Advisers / SAG, Secretaria de Política Econômica
• Advise the president of the United states
• Write the annual Economic Report of the President
• Department of Treasury / Secretaria do Tesouro
• Department of Labor / Ministério do Trabalho
• Department of Justice / MJSP
• Congressional Budget Office / CMO
• The Federal Reserve / BCB (BACEN)

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The Economist as a Policy
Adviser

Why economists’ advice is not always followed

• President
• Economic advisers - Economic policy
• Communication advisers
• Press advisers
• Legislative affairs advisers
• Political advisers

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Why Economists Disagree

• Economists - may disagree

• Validity of alternative positive theories about how the
world works
• Economists - may have different values
• Different normative views about what policy should try to
accomplish

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Why Economists Disagree

Differences in scientific judgments

• Different hunches about
• Validity of alternative theories
• Size of important parameters
• Measure how economic variables are related
• E.g.: Tax household’s income or consumption
• Different normative views about the tax system
• Different positive views about the responsiveness of saving to tax
incentives

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Why Economists Disagree

•Peter and Paula - take the same amount of

water from the town well
• Total cost of water= $7.000
• Peter’s income= $50,000
• Paula’s income= $10,000

•How much tax do you think each one

should pay?

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Why Economists Disagree

Differences in values
•Peter and Paula - take the same amount of
water from the town well.
• Peter’s income= $50,000
• Tax= $5,000 (10%)
• Paula’s income= $10,000
• Tax= $2,000 (20%)

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Why Economists Disagree

Perception vs. Reality

• Rent control - adversely affects availability and
quality of housing
• Costly way of helping the neediest members of society
• Many cities use rent control
• Trade barriers – economist oppose it
• Import on certain goods - restricted

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 Graphing: a brief review
• Graphs’ purposes:
– Visually express ideas that might be less clear if
described with equations or words
– Powerful way of finding and interpreting patterns
• Graphs of a single variable
– Pie chart
– Bar graph
– Time-series graph

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 Types of graphs (a, b)

(a) Pie Chart (b) Bar Graph

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 Types of graphs (c)
(c) Time-Series Graph

The time-series graph in panel

(c) shows the productivity of
labor in U.S. businesses
from 1950 to 2000.

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 Graphing: a brief review
• Graphs of two variables: the coordinate system
– Display two variables on a single graph
– Scatterplot
– Ordered pairs of points
• x-coordinate
– Horizontal location
• y-coordinate
– Vertical location

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 Using the coordinate system

Grade point average is measured on the vertical axis and study time on the
horizontal axis. Albert E., Alfred E., and their classmates are represented by
various points. We can see from the graph that students who study more tend to
get higher grades. 29
 Graphing: a brief review
• Curves in the coordinate system
• Data
– Number of novels
– Price of novels
– Income
• Demand curve
– Effect of a good’s price
– On the quantity of the good consumers want to buy
– For a given income

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 Graphing: a brief review
• Curves in the coordinate system
• Negatively related variables
– The two variables move in opposite direction
– Downward sloping curve
• Positively related variables
– The two variables move in the same direction
– Upward sloping curve
• Movement along a curve
• Shifts in a curve

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 Demand curve
Price of
Novels
$11
10 (5, $10)
9 (9, $9)
8 (13, $8)
7 (17, $7)
6 (21, $6)
5 (25, $5)
4 Demand, D1
3
2
1

0 5 10 15 20 25 30 Quantity of novels
purchased

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 Shifting demand curves
Price of $11 When income
Novels 10 increases, the demand
(13, $8)
curve shifts to the right.
9
(16, $8)
8
7 (10, $8) D2 (income=
6 $40,000)
5 When income
decreases, the D3
4 D1
demand curve (income=
3 (income=
shifts to the left. $20,000)
2 $30,000)
1

0 5 10 13 15 16 20 25 30 Quantity of novels purchased

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 Graphing: a brief review
• Slope of a line
– Ratio of the vertical distance covered
– To the horizontal distance covered
– As we move along the line
y
Slope 
x
– Δ (delta) = change in a variable
– The “rise” (change in y) divided by the “run” (change
in x).

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 Graphing: a brief review
• Slope of a line
– Fairly flat upward-sloping line
• Slope = small positive number
– Steep upward-sloping line
• Slope = large positive number
– Downward sloping line
• Slope = negative number
– Horizontal line
• Slope = zero
– Vertical line
• Infinite slope
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 Calculating the slope of a line
Price of
Novels
$11
10
9
8 (13, $8)
7 6-8=-2
6 (21, $6)
5 21-13=8
4 Demand, D1
3
2
1

0 5 10 13 15 20 21 25 30 Quantity of novels purchased

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 Graphing: a brief review

• Cause and effect

– One set of events
• Causes another set of events
– Omitted variables
• Lead to a deceptive graph
– Reverse causality
• Decide that event A causes event B
• Facts: event B causes event A

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Graph with an Omitted Variable

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Graph Suggesting Reverse Causality

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