Thinking Like an Economist

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 The Economist as a Scientist
• Economics
– Science
• Economists
– Scientists
• Devise theories
• Collect data
• Analyze these data
– Verify or refute their theories

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

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Figure 1
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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 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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Figure 2
The production possibilities frontier
Quantity of
Computers The production
Produced possibilities frontier
shows the combinations
C of output—in this case,
3,000 F
cars and
Production
computers—that the
A Possibilities economy can possibly
2,200
2,000 B Frontier produce. The economy
can produce any
combination on or inside
D the frontier. Points
1,000
outside the frontier are
E not feasible given the
economy’s resources.
0 300 600 700 1,000 Quantity of
Cars Produced

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• Efficient levels of production
– The economy is getting all it can
• From the scarce resources available
– Points on the production possibilities
frontier
– Trade-off:
• The only way to produce more of one good
• Is to produce less of the other good

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• Inefficient levels of production
– Points inside production possibilities
frontier
• Opportunity cost of producing one good
– Give up producing the other good
– Slope of the production possibilities
frontier

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• 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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• Technological advance
– Outward shift of the production possibilities
frontier
– Economic growth
– Produce more of both goods

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

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 The Economist as a Scientist
• 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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