Thinking like an economist

Economics trains you to

Think in terms of alternatives your choice set.
Evaluate opportunity cost of individual & social choices.
Understand how economy-wide or market outcomes are
related to individual behaviour.

The economic way of thinking

involves thinking analytically & objectively
makes use of the scientific method
Scientific method
Uses abstract models to help explain how a complex,
real world operates.

Develops theories, collects & analyses data to evaluate

the theories it sets out to try to refute them.
Refutation criterion
When we test theories in science & economics we do
not try to show they are true.

We try to show they are wrong by confronting them

with evidence.

If we cant show they are wrong we tentatively accept

the theories they arent inconsistent with evidence.

Thus science consists of propositions set out so they

can be falsified but which have not yet been falsified.
Role of assumptions
Economists make simplifying assumptions to assist in
understanding the world.

The art in scientific thinking is deciding which

assumptions to make to strip aside irrelevant detail.

The objective is to come up with good predictions

about economic behavior.
Good predictions
Making good predictions might involve using maths
even if participants in a market dont use maths.

There is a difference between how people behave (e.g.

in a market) & how to describe their behaviour.
Billiards (M. Friedman)

Friedman argued
a skilled billiard
player just feels
subjectively how to
play a good shot.

But if we sought to
describe the shot
this involves
advanced maths.
Economic models
Economists use models to simplify reality in order to
improve our understanding of the world.

Think of models as road maps.

A road map is an unrealistic model

Where are trees,

colours & houses?

Is this unrealistic
object useful?

Yes trees, colours &

houses add to realism
but not to the use of
this map. In fact
including them would
reduce maps value.
Economic models

Two important basic economic models include:

The circular-flow diagram

The production possibilities frontier
Model 1: The circular-flow model
The circular-flow model (or diagram) is a visual
model of the economy as a whole.

It shows how dollars flow through markets among

households & firms.
The circular-flow diagram
MARKETS
Revenue FOR Spending
GOODS AND SERVICES
Goods Firms sell Goods and
and services Households buy services
sold bought

FIRMS HOUSEHOLDS
Produce and sell Buy and consume
goods and services goods and services
Hire and use factors Own and sell factors
of production of production

Factors of MARKETS Labour, land,

production FOR and capital
FACTORS OF PRODUCTION
Wages, rent, Households sell Income
and profit Firms buy
= Flow of inputs
and outputs
= Flow of dollars

Copyright 2004 South-Western

In the circular-flow model
Firms

Produce & sell goods & services.

Hire & use factors of production.

Households

Buy & consume goods & services.

Own and sell factors of production.
In the circular-flow model
In markets for goods & services

Firms sell
Households buy

In markets for factors of production

Households sell
Firms buy
In the circular-flow model
Factors of production

Inputs used to produce goods & services (land,

labour & capital).

Get paid land rents, wages, rental returns on capital.

In the circular flow model...
We assume away international transactions & role of
government.

These can be accommodated more complex figure.

Model 2: Production possibility frontier
(PPF)
The PPF is a graph showing the combinations of
output that the economy can possibly produce given
available factors of production & the available
production technology.

Consider a simple economy producing only cars &

computers.
Quantity of
computers
PPF

3,000 D

C
2,200
2,000 A
Production
possibilities
frontier
1,000 B

0 300 600 700 1,000 Quantity of cars

Copyright2003 Southwestern/Thomson Learning
PPF
Concepts illustrated by the PPF:

Efficiency maximum amount of each output given the

levels of other output. Points on PPF.
Tradeoffs on PPF we can only get more of one output
by giving up some of the other.
Opportunity cost rate at which tradeoffs are made.
Economic growth a shift in PPF
 A shift in the PPF
Quantity of
computers
produced

4,000

3,000

2,100 E
2,000
A

0 700 750 1,000 Quantity of

cars produced
Copyright 2004 South-Western
Microeconomics & macroeconomics
Microeconomics focuses on individual parts of the
economy.
How households & firms make decisions & how they
interact in specific markets. (Our concern!)

Macroeconomics looks at economy as a whole.

Economy-wide phenomena, including inflation,
unemployment & economic growth.
Economics science & policy
When economists are trying to explain the world, they
are scientists. They are explaining what is.

When economists are trying to improve the world,

they are policy advisers. Arguing what should be.

It is important to understand these different roles.

Positive vs. normative analysis
Positive statements are claims that describe the world
as it is.

Called descriptive analysis.

Normative statements are claims that attempt to

describe how the world should be.

Called prescriptive analysis.

Positive vs. normative analysis
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.

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.
POSITIVE
Why economists disagree
Economists are often seen as argumentative types who
disagree. Often this is exaggerated but

Economists may disagree about the validity of

alternative positive theories about how the world
works.

More typically they have different values & therefore,

different normative views about what policy should try
to accomplish.
Summary
Economists try to address their subjects with scientific
objectivity.

They make assumptions & build simplified models

to understand the world around them.

Two simple economic models are the circular-flow

model & the PPF.
Summary

Economics is divided into two subfields:

Microeconomics.

Macroeconomics
Summary

A positive statement is an assertion about how the

world is.

A normative statement is an assertion about it ought

to be.

When economists make normative statements, they

are acting more as policy advisors than scientists.
Summary

Economists who advise policymakers offer conflicting

advice because of differences in scientific judgments
or differences in values.

At other times, economists are united in the advice

they offer, but policymakers may (of course) choose to
ignore it.