Chapter 2: Thinking Like an Economist

Circular Flow Diagram, PPF,

They try to address their subject with the same
objective lens.
- They use the scientific method (devise theories,
collect data, and analyze the data to refute/validate
1. The Economist as a Scientist How do economists think like scientists? their theories)
1. The Scientific Method:
Observation, Theory, and More What do economists use in relation to the scientific
Observation method? Theory and Observation
An economist experiencing rapidly rising prices may
be moved by his observation to theorize that it
occurred due to the government printing too much
money. He can then collect data on various
Give an example of an economist using observation and countries and observe if there is a relationship
theory. between the two or not.
It is impractical to conduct experiments since they'd
Though economists use observation and theory, what have to manipulate a whole nation's economic
obstacle do they face? policy just to generate data
What are economists' substitute for laboratory
experiments? The natural experiments offered by history
Because they give us insight into the economy of
Why is looking at episodes in history important to study for the past and allow us to illustrate and evaluate the
economics? economic theories of the present
Assumptions can simplify a complex world and
1.b The Role of Assumption What is the role of assumptions in economics? make it easier to understand.
Because some assumptions may be used in specific
Why do economists use different approaches in answering scenarios but not in others (as they would not
different questions? accurately reflect reality, etc.)
 When economists study how prices respond to
changes in the amount of money in circulation.

- The price of magazines, for example, only change

once every few years. This leads to different
assumptions in different time horizons. So, we can
assume that in the short run, the prices are not
going to change much. We can even make the
extreme and artificial assumption that prices are
completely fixed.

Give an example where economists use different In the long run, however, we can assume that prices
assumptions in different scenarios. are completely flexible.
Simplified description of reality, often consisting
1.c Economic Models What are economic models? diagrams and equations.
What is a simplification of reality, often consisting diagrams
and equations. Economic model
Models are built with _____ assumptions
All models simplify reality to improve our
What is the purpose of models? understanding of it.
To improve our understanding of the question at
Why are models simplified? hand
One that simplifies our thinking about the
economy. It should explain in general terms how
the economy is organized and how participants in
What kind of model do we need in Economics? the economy interact with each other.
a visual model of the economy showing how
1.d Our First Model: The Circular money flows through markets among households
Flow Diagram What is the circular flow diagram and firms
1. Firms
Who are the 2 decision makers in a circular flow diagram? 2. Households
What is the visual model of the economy showing how
money flows in markets among households and firms? Circular Flow Diagram
They produce the goods and services using inputs (factors
of production) Firms
They own the factors of production and consume the goods
and services produced by firms Households
 - land
- labor
What are the factors of production? - capital (buildings and machines)
What are the 2 types of markets households and firms 1. Market for Goods and Services
interact in? 2. Market for Factors of Production
In the market for goods and services, who are the buyers? Households
In the market for goods and services, who are the sellers? Firms
In the market for factors of production, who are the
buyers? Firms
In the market for factors of production, who are the sellers? households
It offers a simple way of organizing economic transactions
between households and firms in an economy Circular Flow Diagram
1. Inner loop - flow of inputs and outputs
What are the 2 loops of the Circular Flow Diagram? 2. Outer loop - flow of money
- Households sell land, labor, and capital to firms for
them to use it as inputs in the market for factors of
production.
- Firms then use these to produce goods and
services which will eventually be sold to households
Explain the inner loop of the circular flow diagram. in the market for goods and services.
What is the inner loop of the circular flow diagram? Flow of inputs and outputs
What is the outer loop of the circular flow diagram? The flow of money
Households spend money to buy goods and
services.
Firms use some of the revenue to pay for the
factors of production, such as the wages of their
workers and rent.
The rest of the money is profit of the owners who
Explain the outer loop of the circular flow diagram. are also members of households
 - Dollar starts at the household
- Use dollar to buy a cup of coffee at the market for
goods and services
- When it reaches the register, it's considered as
revenue for the firm
- The firm can use the revenue in the market for
factors of production to pay for inputs like rent to
the landlord or wages to employees
- The dollar once again enters some household and
Explain the circular flow diagram using an example. the economy's circular flow begins
True or False
The circular flow diagram is a simple model of the economy true
Who makes the decisions in a circular flow diagram? households and firms
It's important to keep it simple and only retain what
is crucial for an understanding of how the economy
Why should the circular flow diagram be simple and not is organized. It is useful when thinking about how
include other details? the pieces of the economy work together.
True or False
Most models use math true
A graph that shows the combination of output that
the economy can produce given the available
1.e Our Second Model: The factors of production and available production
Production Possibilities Frontier What is the Production Possibilities Frontier? technology
The PPF is a graph that shows the combination of output
that the economy can produce given the ________ and 1. available factors of production
________ 2. available production technology
How many goods does a PPF consider? 2 Goods
Is every conceivable outcome on a PPF feasible? No
At what point/s in the PPF can the economy produce? At any point on or inside the PPF, but not outside it
What is the slope of the PPF? The opportunity cost
In the PPF, how do you measure the opportunity cost? You can look at the slope
Can the economy produce goods outside the points on the
PPF? No
when the economy is getting all it can from the
Describe an efficient outcome on a PPF scarce resources available
Where are the efficient points on the PPF points on the PPF
 There is no way to produce more of one good
What is an efficient outcome? without producing less of another
In a PPF, what means there is no way to produce more of
one good without producing less of the other? Efficient Outcome
When the economy is producing less than it could
What is an inefficient outcome in PPF with the resources available
Where are the inefficient outcomes located in the PPF? points in the PPF
When the economy is producing less for some reason, what
outcome is seen on the PPF? Inefficient Outcome
What happens when the source of inefficiency is The economy can increase the production of BOTH
eliminated? goods
Principle 1: Society faces trade-offs
Principle 2: The cost of something is what you give
What principles are shown in a PPF? up to get it
When an economy is producing efficiently
- the trade-off of producing an additional good B is
How does a PPF show principle 1? producing less of good A
We can see the opportunity cost measured in terms
How does a PPF show principle 2? of the other good
Is the opportunity cost constant in a PPF? No
What does the opportunity cost depend on in a PPF? Depends on how many of a good you are producing
At point F, where most resources are being used on
computers, we also have some of the most skilled
automobile workers using their abilities to make
computers instead of cars. When we try to change
production and use those workers to produce
additional cars, the opportunity cost is not as high
since they probably werent the most skilled at
making computers anyway.

On the other hand, at Point E, we already have

most of our economy’s resources dedicated to
making cars. If we try to make additional cars, we’re
forced to get computer technicians outside of
Steeper slope = greater working on computers and forcing them to make
opportunity cost cars. This causes a great loss in computers. The
Less steep slope = lower Explain the opportunity cost in terms of its flat and steep opportunity cost is higher, and so the slope is
opportunity cost slopes (or its bowed shape) steeper.
 Can trade-offs change over time? Yes
What does the opportunity cost in a PPF depend on? how many of Good A or B it is producing
What are the ways for an economy to increase the 1. Advancement in technology
production of goods in an economy? 2. Increased workers
Society can move from a point in the old frontier to a point
in the new frontier. Where it goes on the new frontier
depends on The preferences of the economy
- Scarcity
- Efficiency
- Trade-off
The Production Possibilities Frontier highlights some simple - Opportunity Cost
but powerful ideas: - Economic Growth
When an economy's technological advancement allows it to
produce more of one good, the PPF shifts ____ outward
- Decisions of individual households or firms OR
- Interaction of households and firms in markets for
1.f Microeconomics and specific goods and services (sum of all the activities
Macroeconomics In what levels do we study economics? of all these decision makers in the market)
What are the 2 broad subfields economics is traditionally
divided into Macroeconomics and microeconomics
The study of how households and firms make
What is microeconomics? decisions and interact in specific markets
What is the study of how households and firms make
decisions and interact in specific markets? Microeconomics
The study of economy-wide phenomena including
What is macroeconomics? inflation, unemployment, and economic growth
What is the study of economy-wide phenomena including
inflation, unemployment, and economic growth Macroeconomics
- changes in the overall economy arise from the
decisions of millions of individuals
-so, it is impossible to understand macroeconomic
How are macroeconomics and microeconomics closely developments without understanding the
intertwined? underlying microeconomic decisions
Are microeconomics and macroeconomics distinct? If yes, Yes. They address different questions, use different
how? models, and are often taught in different courses
2. The Economist as a Policy When economists are asked to explain the world, they are
Adviser _____. Scientists
 When economists are asked to improve the world, they are
______ policy advisers
What is the goal of an economist as a scientist? To explain the world
What is the goal of a scientist as a policy adviser? To improve the world
Statements that attempt to describe the world as it
What are positive statements? is. These are descriptive
2.a Positive versus Normative
Analysis What statements are descriptive statements? Positive statements
These are claims that attempt to prescribe how the
What are normative statements? world ought to be. These are prescriptive.
What statements are prescriptive? Normative statements
For positive statements, we can confirm/refute
them by analyzing evidence. Normative statements
What is the difference between a positive and a normative include values and facts so they cannot be judged
statement? on data alone
True or false
positive and normative statements are fundamentally
different but often intertwined true
Positive views about how the world works affects
normative views about what policies are desirable.
But, normative conclusions cannot come from
positive analysis alone because they also involve
How are positive and normative statements intertwined? value judgement.
Can normative conclusions come from positive analysis
alone? No, because they also need value judgement
When economists make normative statements, they are
speaking as policy advisers
2.b Economists in Washington Why are economists’ advice not always straightforward Because of Principle 1: People face trade-offs.
because figuring out a right policy is only the first
2.c Why Economists' Advice is part; after hearing feedback they might decide not
Not Always Followed Why are economists' advice not always followed? to push through
1. Economists may disagree with the validity of the
alternative positive theories of how the world
works
2. Economists may have different values and
therefore different normative views about what
3. Why Economists Disagree What are the 2 basic reasons why economists disagree? government policy should aim to accomplish
3.a Difference in Scientific True or False
Judgements Economics is a young science True
- the validity of alternative theories or
In terms of scientific judgements, economists may have - about the size of important parameters that
different hunches on: measure how economic variables are related
- Advocates for consumption tax say that it will
encourage households to save more since their
income won’t be taxed. and, it allows for more
room for capital accumulation which yields more
productivity

- Advocates of the current income tax system on

the other hand, say that household saving would
probably not react to a change in tax laws

- They have different normative views because of

their different positive views about the
responsiveness of household saving to tax
Example of difference in scientific judgement incentives
will perfecting the science of economics tell us whether no, because normative analysis goes beyond
3.b Difference in Values peter or paula pays too much? scientific knowledge
1. Political Process
Why do policies like rent control and barriers to free trade 2. Economists have not yet convinced enough of the
3.c Perception vs Reality persist if the experts are united in their opposition? public that the policies are undesirable