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2

Thinking Like An
Economist
In this chapter, look for the answers to
these questions:
 What are economists’ two roles? How do they differ?
 What are models? How do economists use models?
 What are the elements of the Circular-Flow Diagram?
What concepts does this diagram illustrate?
 How is the Production Possibilities Frontier related
to opportunity cost? What other concepts does it
illustrate?
 What is the difference between microeconomics and
macroeconomics? Between positive and normative?
CHAPTER 2 THINKING LIKE AN ECONOMIST 1
Assumptions & Models
 Assumptions simplify the complex world,
make it easier to understand.
 Example: When studying international trade,
we might assume the world consists of
two countries and two goods.
Very unrealistic, but simplifies the problem
and yields useful insights about the more
complicated real world.
 Economists use models to study economic
issues. A model is a highly simplified
representation of a more complicated reality.

CHAPTER 2 THINKING LIKE AN ECONOMIST 2


Some Familiar Models

A road map

CHAPTER 2 THINKING LIKE AN ECONOMIST 3


Some Familiar Models

A model of human
anatomy from high
school biology class

CHAPTER 2 THINKING LIKE AN ECONOMIST 4


Some Familiar Models

A model airplane

CHAPTER 2 THINKING LIKE AN ECONOMIST 5


Some Familiar Models

The model teeth at the Don’t forget


dentist’s office to floss!

CHAPTER 2 THINKING LIKE AN ECONOMIST 6


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.
 Includes two types of “actors”:
• households
• firms
 Includes two markets:
• the market for goods and services
• the market for “factors of production”
CHAPTER 2 THINKING LIKE AN ECONOMIST 7
Factors of Production
 The factors of production are the resources
that the economy uses to produce goods &
services. They include:
• labor
• land
• capital (buildings & machines used in
production)

CHAPTER 2 THINKING LIKE AN ECONOMIST 8


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

CHAPTER 2 THINKING LIKE AN ECONOMIST 9


FIGURE 1: The Circular-Flow Diagram

Firms Households

Firms:
 buy/hire factors of production,
use them to produce goods
and services
 sell goods & services
CHAPTER 2 THINKING LIKE AN ECONOMIST 10
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
CHAPTER 2 THINKING LIKE AN ECONOMIST 11
Question

 Draw CFD. Identify the parts of model that


correspond to the flow of G &S and flow of $ for
each of the following activities.
• Martin earn $ 15 per hr working in factory
• Mary spends $ 6 for pizzas
• Raj’s bakery pays $500 for the rent on its shop
• Maria purchases a new pair of earrings for $200

CHAPTER 2 THINKING LIKE AN ECONOMIST 12


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 labour hours per month
available for production.
CHAPTER 2 THINKING LIKE AN ECONOMIST 13
PPF Example
 Producing one computer requires 100 hours labour.
 Producing one ton of wheat requires 10 hours labour.
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
PPF Example

Production Wheat
Point
(tons)
on Com- 6,000
graph puters Wheat E
5,000
A 500 0 D
4,000
B 400 1,000
3,000 C
C 250 2,500
2,000
D 100 4,000 B
1,000
E 0 5,000 A
0
0 100 200 300 400 500 600
Computers

CHAPTER 2 THINKING LIKE AN ECONOMIST 15


ACTIVE LEARNING 1:
Points on 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: Wheat
100 computers, (tons)
6,000
3000 tons wheat
5,000
 Point F requires 4,000
40,000 hours
of labor. 3,000
F
Possible but 2,000
not efficient: 1,000
could get more
0
of either good
0 100 200 300 400 500 600
w/o sacrificing
Computers
any of the other.
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ACTIVE LEARNING 1:
Answers
 Point G: Wheat
300 computers, (tons)
6,000
3500 tons wheat
5,000
 Point G requires
4,000 G
65,000 hours
of labor. 3,000
Not possible 2,000
because 1,000
economy
0
only has
0 100 200 300 400 500 600
50,000 hours.
Computers
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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
Wheat
The slope of a line
(tons) equals the “rise
–1000 over the run” –
6,000 slope = = –10
100 the amount the line
5,000
rises when you
4,000
move to the right
3,000 by one unit.
2,000
Here, the
1,000 opportunity cost of
0 a computer is
0 100 200 300 400 500 600 10 tons of wheat.
Computers

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A C T I V E L E A R N I N G 2:
PPF and Opportunity Cost
In which country is the opportunity cost of cloth lower?
FRANCE ENGLAND
Wine Wine
600 600

500 500

400 400

300 300

200 200

100 100

0 0
0 100 200 300 400 0 100 200 300 400
Cloth Cloth
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A C T I V E L E A R N I N G 2:
Answers
England, because its PPF is not as steep as France’s.
country shd. Produce more of that good for which OC is
less
FRANCE ENGLAND
Wine
Wine
600
600
500
500
400
400
300
300
200
200
100
100
0
0
0 100 200 300 400
0 100 200 300 400
Cloth
Cloth 23
Economic Growth and the PPF
With additional Wheat
resources or an (tons) Economic
improvement in 6,000 growth shifts
the PPF
technology, 5,000 outward.
the economy can
4,000
produce more
computers, 3,000

more wheat, 2,000

or any combination 1,000


in between. 0
0 100 200 300 400 500 600
Computers

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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.

CHAPTER 2 THINKING LIKE AN ECONOMIST 25


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
CHAPTER 2 THINKING LIKE AN ECONOMIST 26
Why the PPF Might Be Bow-Shaped

At point A, At A, opp. cost of

Beer
A mtn bikes is low.
most workers are
producing beer,
even those that
are better suited
to building
mountain bikes.
So, do not have to
give up much beer
to get more bikes. Mountain
Bikes
CHAPTER 2 THINKING LIKE AN ECONOMIST 27
Why the PPF Might Be Bow-Shaped

At B, most workers

Beer
At B, opp. cost
are producing bikes.
of mtn bikes
The few left in beer is high.
are the best brewers.
Producing more B
bikes would require
shifting some of the
best brewers away
from beer production,
would cause a big
Mountain
drop in beer output.
Bikes
CHAPTER 2 THINKING LIKE AN ECONOMIST 28
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

CHAPTER 2 THINKING LIKE AN ECONOMIST 29


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.

CHAPTER 2 THINKING LIKE AN ECONOMIST 30


Q1. Maria can read 20 pages of Economics in an hour.
She can also read 50 pages of sociology in an hour.
She spends 5 hours per day studying.
• Draw Maria’s PPF for reading economics &
sociology.
• What is Maria’s OC of reading 100 pages of
sociology?
Q2. Italy & Greece both produces loaves of bread &
bottles of olive oil. Suppose Italian workers can
produce 10 loaves of bread & 5 bottles of olive oil per
hr. and Greek worker produce 8 loaves of bread & 8
bottles of olive oil per hr.
• Which country has absolute adv? Which country has
comparative adv?
CHAPTER 2 THINKING LIKE AN ECONOMIST 31
Q3. Explain PPF between 2 goods, a clean
environment & quantity of industrial output.
Show what happens to the PPF if engineers
develop a new way of producing electricity that
emits fewer pollution?
Q4. An economy consist of 3 workers: X ,Y & Z.
each work 10 hr a day & can produce 2 services:
mowing lawn & washing cars. In an hour, X can
either mow 1 lawn or wash 1 car. Y can either
mow 1 lawn or wash 2 cars. Z can either mow 2
lawns or wash 1 car

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Calculate how much of each service is produces
under label A, B, C, D.
• All 3 spend all their time mowing lawns(A)
• All 3 spend all their time washing cars (B)
• All 3 spend half their time on each activity(c)
• X spends half his time on each activity, while Y
washes cars and Z only mows lawn(D)
a) Graph PPF for this economy
b) Explain why the PPF has the shape it does

CHAPTER 2 THINKING LIKE AN ECONOMIST 33


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.

CHAPTER 2 THINKING LIKE AN ECONOMIST 34


The Economist as Scientist
 Economists play two roles:
• Scientists: try to explain the world
• Policy advisors: try to improve it
 In the first role, economists employ the
scientific method: the dispassionate
development and testing of theories about
how the world works.

CHAPTER 2 THINKING LIKE AN ECONOMIST 35


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.,
NITI Aayog(Policy Commission) or National Institution for
Transforming India Aayog is a policy think-tank of
Government of India that replaces Planning Commission and
aims to involve the states in economic policy-making in India. It
will be providing strategic and technical advice to the central
CHAPTER 2 THINKING LIKE AN ECONOMIST 36
and the state governments.
Neeti Aayog

National Institution for Transforming India

Agency overview

Formed 1 January 2015; 7 months ago

Planning Commission
Preceding Agency

Jurisdiction Government of India

Headquarters New Delhi

Agency executive Narendra Modi, Chairperson

CHAPTER Website
2 THINKING niti.gov.in
LIKE AN ECONOMIST 37
ACTIVE LEARNING 3:
Identifying positive vs. normative
Which of these statements are “positive” and which
are “normative”? How can you tell the difference?
a. Prices rise when the government increases the
quantity of money.
b. The government should print less money.
c. A tax cut is needed to stimulate the economy.
d. An increase in the price of gasoline will cause an
increase in consumer demand for video rentals.

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ACTIVE LEARNING 3:
Answers
a. Prices rise when the government increases the
quantity of money.
Positive, describes a relationship, could use data
to confirm or refute.
b. The government should print less money.
Normative, this is a value judgment, cannot be
confirmed or refuted.

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ACTIVE LEARNING 3:
Answers
c. A tax cut is needed to stimulate the economy.
Normative, another value judgment.
d. An increase in the price of gasoline will cause an
increase in consumer demand for video rentals.
Positive, describes a relationship.
Note that a statement need not be true to be
positive.

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Ques. Whether statement is positive or negative?
a) Increase in minimum wage will increase rate of
teenage unemployment.
b) Government should raise the tax on tobacco to
reduce the quantity of cigarettes sold.
c) Increase in rate of growth of money supply will
lead to rise in the price level.
d) Increase in rate of interest will cause decline in
investment.
e) The government should provide health care to
anyone who does not have insurance.
CHAPTER 2 THINKING LIKE AN ECONOMIST 41
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.

CHAPTER 2 THINKING LIKE AN ECONOMIST 42


Questions
Q1. Use PPF to describe the idea of “efficiency”?
Q2. State & explain whether it is microeconomics or
macroeconomics:
a) Worker’s decision about how many hours to work.
b) The effect of government spending on the nation’s
unemployment rate.
c) Impact of new technology in the market for DVD
recorder.
d) The relationship between education & economic
growth.
e) The optimal choice of output for firm that produces
electric heaters.
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