N.

GREGORY MANKIW
PRINCIPLES OF
MACROECONOMICS
Eight Edition

CHAPTER Thinking Like an

2 Economist
PowerPoint Slides prepared by:
V. Andreea CHIRITESCU
Eastern Illinois University
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 The Economist as a Scientist
• Economics is a science
• Economists are scientists
– Devise theories
– Collect data
– Analyze these data “I’m a social scientist,
Michael. That means I
• Verify or refute their theories can’t explain electricity or
anything like that, but if
– Use the scientific method you ever want to know
about people, I’m your
man.”

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 The Economist as a Scientist
• Scientific method
– Dispassionate development and testing of
theories about how the world works
– Observation, theory, more observation
• Conducting experiments in economics
– Is often impractical
• Substitute for laboratory experiments
– Economists pay close attention to the
natural experiments offered by history
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 The Economist as a Scientist
The role of assumptions
• Assumptions
– Can simplify the complex world and make
it easier to understand
– The art in scientific thinking: deciding
which assumptions to make
• Different assumptions
– To answer different questions
– To study short-run or long-run effects
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 The Economist as a Scientist
• Economic models
– Diagrams and equations
– Omit many details
– Allow us to see what’s truly important
– Built with assumptions
– Simplify reality to improve our
understanding of it

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 The Economist as a Scientist
• Circular-flow diagram
– Visual model of the economy
– Shows how dollars flow through markets
among households and firms
• Two decision makers
– Firms and Households
• Two markets
– For goods and services
– For factors of production (inputs)
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 The Economist as a Scientist
• Firms
– Produce goods and services
– Use factors of production (inputs)
• Households
– Own factors of production
– Consume goods and services

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 The Economist as a Scientist
Firms and Households interact in markets
• Markets for goods and services
– Firms are sellers
– Households are buyers
• Markets for factors of production
– Firms are buyers
– Households are 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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 The Economist as a Scientist
• 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

The production possibilities

Quantity of frontier shows the combinations
Computers of output—in this case, cars
Produced and computers—that the
economy can possibly produce.
The economy can produce any
C combination on or inside the
3,000 F frontier.
Production Points outside the frontier are
A Possibilities not feasible given the
2,200 Frontier economy’s resources.
2,000 B The slope of the production
possibilities frontier measures
the opportunity cost of a car in
terms of computers. This
D
1,000 opportunity cost varies,
E depending on how much of the
two goods the economy is
producing.
0 300 600 700 1,000
Quantity of
Cars Produced

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 The Economist as a Scientist
• 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
• Moving from point A to point B: give up 200
computers to produce 100 more cars
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 The Economist as a Scientist
• Inefficient levels of production
– Points inside production possibilities
frontier
• Opportunity cost of producing one good
– Give up producing units of the other good
– Slope of the production possibilities frontier

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 The Economist as a Scientist
• Bowed outward production possibilities
frontier
– Opportunity cost of a car is highest
• When the economy is producing many cars
and fewer computers
– Opportunity cost of a car is lower
• When the economy is producing fewer cars
and many computers
– Resource specialization

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 The Economist as a Scientist
• 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
A technological advance in
Produced the computer industry
4,000 enables the economy to
produce more computers
for any given number of
cars.
3,000 As a result, the production
possibilities frontier shifts
2,300 G
outward.
2,200 If the economy moves from
A point A to point G, then the
production of both cars and
computers increases.

0 600 650 1,000 Quantity of

Cars Produced
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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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 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”

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 The Economist as Policy Adviser
• Economists in Washington
– Council of Economic Advisers
• Advise the president of the United
States
• Annual Economic Report of the
President: discusses recent “Let’s switch. I’ll make
developments in the economy the policy, you
implement it, and he’ll
and presents the council’s explain it.”
analysis of current policy issues

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 The Economist as Policy Adviser
• Economists in Washington
– Office of Management and Budget
– Department of the Treasury
– Department of Labor
– Department of Justice
– Congressional Budget Office
– The Federal Reserve

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 The Economist as Policy Adviser
• Economists’ advice is not always followed
– Economic advisers: what policy is best
– Communication advisers: how best to explain
it to the public
– Press advisers: how the news media will
report
– Legislative affairs advisers: how Congress will
view the proposal
– Political advisers: effect on the electorate
– The president: decision
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 Why Economists Disagree
• Economists may disagree
– Validity of alternative positive theories
about how the world works
• Economists may have different values
– Different normative views about what
policy should try to accomplish

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 Why Economists Disagree
Differences in scientific judgments
• Different hunches about
– Validity of alternative theories
– Size of important parameters
• Measure how economic variables are related

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 Why Economists Disagree
Differences in values
• Peter and Paula – take the same amount
of water from the town well
– Peter’s income = $100,000
• Tax = $10,000 (10%)
– Paula’s income = $20,000
• Tax = $4,000 (20%)

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 Why Economists Disagree
Perception versus Reality
• Rent control
– Adversely affects availability and quality of
housing
– Costly way of helping the neediest
members of society
– Many cities use rent control
• Trade barriers (tariffs and import quotas)
– Economists oppose it
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 ASK THE EXPERTS
Ticket Resale
“Laws that limit the resale of tickets for
entertainment and sports events make potential
audience members for those events worse off on
average.”

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 Table 1 Propositions about Which Most Economists Agree

Proposition (and percentage of economists who agree)

1. A ceiling on rents reduces the quantity and quality of housing available. (93%)
2. Tariffs and import quotas usually reduce general economic welfare. (93%)
3. Flexible and floating exchange rates offer an effective international monetary
arrangement. (90%)
4. Fiscal policy (for example, tax cut and/or government expenditure increase) has a
significant stimulative impact on a less than fully employed economy. (90%)
5. The United States should not restrict employers from outsourcing work to foreign
countries. (90%)
6. Economic growth in developed countries like the United States leads to greater
levels of well-being. (88%)
7. The United States should eliminate agricultural subsidies. (85%)
8. An appropriately designed fiscal policy can increase the long-run rate of capital
formation. (85%)
9. Local and state governments should eliminate subsidies to professional sports
franchises. (85%)
10. If the federal budget is to be balanced, it should be done over the business cycle
rather than yearly. (85%)

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 Table 1 Propositions about Which Most Economists Agree

11. The gap between Social Security funds and expenditures will become
unsustainably large within the next 50 years if current policies remain unchanged.
(85%)
12. Cash payments increase the welfare of recipients to a greater degree than do
transfers-in kind of equal cash value. (84%)
13. A large federal budget deficit has an adverse effect on the economy. (83%)
14. The redistribution of income in the United States is a legitimate role for the
government.(83%)
15. Inflation is caused primarily by too much growth in the money supply. (83%)
16. The United States should not ban genetically modified crops. (82%)
17. A minimum wage increases unemployment among young and unskilled workers.
(79%)
18. The government should restructure the welfare system along the lines of a
“negative income tax.” (79%)
19. Effluent taxes and marketable pollution permits represent a better approach to
pollution control than the imposition of pollution ceilings. (78%)
20. Government subsidies on ethanol in the United States should be reduced or
eliminated. (78%)

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 Graphing: A Brief Review
• Graphs serve two purposes:
– Visually express ideas that might be less
clear if described with equations or words
– Powerful way of finding and interpreting
patterns
• Graphs of a single variable
– Pie chart
– Bar graph
– Time-series graph

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 Figure A-1 Types of Graphs

The pie chart in panel (a) shows how U.S. national income is derived from various sources.

The bar graph in panel (b) compares the average income in four countries.

The time-series graph in panel (c) shows the productivity of labor in U.S. businesses over
time.

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 Graphing: A Brief Review
• Graphs of two variables: the coordinate
system
– Display two variables on a single graph
– Scatterplot
– Ordered pairs of points
• x-coordinate
– Horizontal location
• y-coordinate
– Vertical location

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 Figure A-2 Using the Coordinate System

Grade point average is measured on the vertical axis and study time on the horizontal axis.
Albert E., Alfred E., and their classmates are represented by various points.
We can see from the graph that students who study more tend to get higher grades.

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 Graphing: A Brief Review
Curves in the coordinate system
• Data
– Number of novels purchased
– Price of novels and Income
• Demand curve
– Effect of a good’s price
– On the quantity of the good consumers
want to buy
– For a given income

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 Table A-1 Novels Purchased by Emma

This table shows the number of novels Emma buys at various incomes and prices.
For any given level of income, the data on price and quantity demanded can be graphed to
produce Emma’s demand curve for novels, as shown in Figures A-3 and A-4.

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 Graphing: A Brief Review
• Negatively related variables
– The two variables move in opposite
direction
– Downward sloping curve
• Positively related variables
– The two variables move in the same
direction
– Upward sloping curve
• Movement along a curve
• Shifts in a curve
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 Figure A-3 Demand Curve
Price of
Novels $11
(5, $10)
10
(9, $9)
9
(13, $8)
8
(17, $7)
7
(21, $6)
6
(25, $5)
5
4 Demand, D1
3
2
1

0 5 10 15 20 25 30 Quantity of novels
purchased
The line D1 shows how Emma’s purchases of novels depend on the price of novels when her
income is held constant. Because the price and the quantity demanded are negatively related,
the demand curve slopes downward.

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 Figure A-4 Shifting Demand Curves

Price of $11 When income increases,

Novels the demand curve shifts
10 (13, $8)
to the right.
9
(16, $8)
8
7 (10, $8)
D2 (income=
6 $50,000)
5 When income
decreases, the D3
4 D1
demand curve (income=
3 $30,000) (income=
shifts to the left.
$40,000)
2
1

0 5 10 13 15 16 20 25 30 Quantity of novels purchased

The location of Emma’s demand curve for novels depends on how much income she earns.
The more she earns, the more novels she will purchase at any given price, and the farther to
the right her demand curve will lie. Curve D1 represents Emma’s original demand curve when
her income is $40,000 per year.
If her income rises to $50,000 per year, her demand curve shifts to D2.
If her income falls to $30,000 per year, her demand curve shifts to D3.
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 Graphing: A Brief Review
• Slope
– Ratio of the vertical distance covered
– To the horizontal distance covered
– As we move along the line
• Δ (delta) = change in a variable
• The “rise” (change in y) divided by the
“run” (change in x).

Δy
Slope =
Δx
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 Graphing: A Brief Review
• Slope
– Fairly flat upward-sloping line
• Slope is a small positive number
– Steep upward-sloping line
• Slope is a large positive number
– Downward sloping line
• Slope is a negative number
– Horizontal line: slope is zero
– Vertical line: infinite slope

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 Figure A-5 Calculating the Slope of a Line
Price of
Novels
$11
10
9
8 (13, $8)
7 6–8=–2
6 (21, $6)
5 21 – 13 = 8
4 Demand, D1
3
2
1

0 5 10 13 15 20 21 25 30 Quantity of novels purchased

To calculate the slope of the demand curve, we can look at the changes in the x- and y-
coordinates as we move from the point (21 novels, $6) to the point (13 novels, $8). The slope
of the line is the ratio of the change in the y-coordinate (–2) to the change in the x-coordinate
(+8), which equals –1⁄4.

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 Graphing: A Brief Review
• Cause and effect
– One set of events
• Causes another set of events
– Omitted variables
• Lead to a deceptive graph

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 Figure A-6 Graph with an Omitted Variable

The upward-sloping curve shows that members of households with more cigarette
lighters are more likely to develop cancer. Yet we should not conclude that ownership of
lighters causes cancer because the graph does not take into account the number of
cigarettes smoked.

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 Graphing: A Brief Review
• Cause and effect
– Reverse causality
• Decide that event A causes event B
• Facts: event B causes event A

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 Figure A-7 Graph Suggesting Reverse Causality

The upward-sloping curve shows that cities with a higher concentration of

police are more dangerous. Yet the graph does not tell us whether police
cause crime or crime-plagued cities hire more police.

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