Macro

CH-2: Thinking Like an Economist

The Economist as a Scientist The Circular Flow This diagram is a schematic representation of the
organization of the economy. Decisions are made by households and
Economists play two roles: firms. Households and firms interact in the markets for goods and
1. Scientists: try to explain the world services (where households are buyers and firms are sellers) and in
2. Policy advisors: try to improve it the markets for the factors of production (where firms are buyers
and households are sellers). The outer set of arrows shows the flow
• As scientists, economists employ the scientific method – of dollars, and the inner set of arrows shows the corresponding flow
Dispassionate development and testing of theories about how the of inputs and outputs.
world works  The two loops of the circular-flow diagram are distinct but
• Assumptions related. The inner loop represents the flows of inputs and
–Simplify the complex world and make it easier to understand outputs. The households sell the use of their labor, land,
Example: to study international trade, assume two countries and and capital to the firms in the markets for the factors of
two goods production. The firms then use these factors to produce
• Economists use models to study economic issues goods and services, which in turn are sold to households in
– Highly simplified representation of a more complicated reality the markets for goods and services. The outer loop of the
Examples of models: diagram represents the corresponding flow of dollars. The
 The model teeth at the dentist’s office households spend money to buy goods and services from
 A model of human anatomy from high school biology class the firms. The firms use some of the revenue from these
 A road map sales to pay for the factors of production, such as the
• Circular-flow diagram wages of their workers. What’s left is the profit of the firm
–Visual model of the economy owners, who are themselves members of households.
–Shows how dollars flow through markets among households and The PPF
firms  Production possibilities frontier
• Two decision makers –Firms and Households –A graph: combinations of output that the economy can possibly
• Interacting in two markets produce
– Market for goods and services –Given the available
– Market for factors of production (inputs) • Factors of production and technology
Example:
• Two goods: computers and wheat
• One resource: labor (measured in hours)
• Economy has 50,000 labor hours per month available for
production
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 are underutilized (e.g., workers
unemployed, factories idle)
• Points above the PPF (like G)
– Not possible
• Moving along a PPF – Involves shifting resources 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 –The opportunity cost of one good in terms of
the other
The Shape of the PPF
• Shape of the PPF The Economist as a Scientist
–Straight line: constant opportunity cost • Microeconomics –The study of how households and firms make
 Previous example: the opportunity cost of 1 computer is decisions and how they interact in markets
10 tons of wheat • Macroeconomics –The study of economy-wide phenomena, including
– Bowed outward: increasing opportunity cost inflation, unemployment, and economic growth
 As more units of a good are produced, we need to give up
increasing amounts of the other good produced The Economist as Policy Adviser
• Positive statements: descriptive
–Attempt to describe the world as it is
– Confirm or refute by examining evidence: “Minimum-wage laws
cause unemployment”
• Normative statements: prescriptive
–Attempt to prescribe how the world should be: “The government
should raise the minimum wage”

Why the PPF Might Be Bowed Outward

• The PPF is bowed outward when:
– Different workers have different skills
– Different opportunity costs of producing one good in terms of the
other
–There is some other resource, or mix of resources with varying
opportunity costs
• E.g., different types of land suited for different uses
Why Economists Disagree
• Economists often gives conflicting policy advice  Economists try to address their subject with a scientist’s
– Can disagree about the validity of alternative positive theories about objectivity. Like all scientists, they make appropriate
the world assumptions and build simplified models to understand the
– May have different values and, therefore, different normative views world around them. Two simple economic models are the
about what policy should try to accomplish circular-flow diagram and the production possibilities
• Yet, there are many propositions about which most economists frontier
agree  The field of economics is divided into two subfields:
microeconomics and macroeconomics. Microeconomists
study decision making by households and firms and the
interactions among households and firms in the
marketplace. Macroeconomists study the forces and trends
that affect the economy as a whole.
 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 advisers than as scientists
 Economists who advise policymakers sometimes 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 the advice because of
the many forces and constraints imposed by the political
process
Propositions about Which Most Economists Agree (and percentage of
economists who agree)
circular-flow diagram - a visual model of the economy that shows how
1. A ceiling on rents reduces the quantity and quality of housing
dollars flow through markets among households and firms
available. (93%)
production possibilities frontier - a graph that shows the combinations
2. Tariffs and import quotas usually reduce general economic
of output that the economy can possibly produce given the available
welfare. (93%)
factors of production and the available production technology
3. The United States should not restrict employers from
microeconomics - the study of how households and firms make
outsourcing work to foreign countries. (90%)
decisions and how they interact in markets
4. The United States should eliminate agricultural subsidies.
macroeconomics - the study of economywide phenomena, including
(85%)
inflation, unemployment, and economic growth
5. Local and state governments should eliminate subsidies to
positive statements - claims that attempt to describe the world as it is
professional sports franchises (85%)
normative statements - claims that attempt to prescribe how the
6. Cash payments increase the welfare of recipients to a greater
world should be
degree than do transfers-in kind of equal cash value. (84%)
7. A large federal budget deficit has an adverse effect on the
1. An economic model is
economy. (83%)
c. a simplified representation of some aspect of the economy.
8. The United States should not ban genetically modified crops.
2. The circular-flow diagram illustrates that, in markets for the factors
(82%)
of production,
9. A minimum wage increases unemployment among young and
a. households are sellers, and firms are buyers.
unskilled workers. (79%)
3. A point inside the production possibilities frontier is
10. Government subsidies on ethanol in the United States should
b. feasible but not efficient.
be reduced or eliminated. (78%)
4. An economy produces hot dogs and hamburgers. If a discovery of
Summary
the remarkable health benefits of hot dogs were to change consumers’
• Economists are scientists
preferences, it would…
– Make appropriate assumptions and build simplified models
c. move the economy along the production possibilities frontier.
– The circular-flow diagram and the production possibilities frontier
5. All of the following topics fall within the study of microeconomics
• Microeconomists study decision making by households and firms and
EXCEPT
their interactions in the marketplace
d. the influence of the government budget deficit on economic
• Macroeconomists study the forces and trends that affect the
growth.
economy as a whole
6. Which of the following is a positive, rather than a normative,
• A positive statement is an assertion about how the world is
statement?
• A normative statement is an assertion about how the world ought to
a. Law X will reduce national income.
be
• As policy advisers, economists make normative statements
• Economists sometimes offer conflicting advice
– Differences in scientific judgments
– Differences in values