Thinking Like An Economist

In this chapter, look for the answers to these questions:

1. What are economists’ two roles? How do they differ?

2. What are models? How do economists use them?
1. Circular-Flow Diagram
2. Production Possibilities Frontier

3. What are the elements of the Circular-Flow Diagram?

4. How is the Production Possibilities Frontier related to
opportunity cost? What other concepts does it illustrate?

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

Assumptions simplify the complex world, make it easier to

understand.
Example: To study international trade, assume two countries and two goods.
Unrealistic, but simple to learn and gives useful insights about the real world.
Model: a highly simplified representation of a more
complicated reality.
Economists use models to study economic issues.
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 Some Familiar Models
A model
A road map airplane

A model of human anatomy from

high school biology class
The model teeth at
the dentist’s office

To understand how the economy works, we must find some way to simplify our thinking
about all these activities. In other words, we need a model that explains, in general terms,
how the economy is organized and how participants in the economy interact with one another

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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.
 or
 The circular-flow diagram offers a simple way of organizing the economic
transactions that occur between households and firms in the economy.

 Two types of “actors”:

 1.households
 2.firms

 Two markets:
 1.the market for goods and services
 2.the market for “factors of production”
Factors of production: the resources the economy uses to produce goods & services, including
Labor, land, capital (buildings & machines used in production) 5
In this model, the economy is simplified to include only two types of decision
makers—firms and households. Firms produce goods and services using
inputs, such as labor, land, and capital (buildings and machines). These inputs
are called the factors of production. Households own the factors of production
and consume all the goods and services that the firms produce.

Households and firms interact in two types of markets.

In the markets for goods and services, households are buyers, and firms
are sellers. In particular, households buy the output of goods and services that
firms produce.
In the markets for the factors of production, households are sellers, and
firms are buyers. In these markets, households provide the inputs that firms
use to produce goods and services.
The inner circle represents the flows of inputs and outputs. The households sell the use of
their labor, land, and capital to the firms in the markets for the factors of production. The
firms then use these factors to produce goods and services, which
in turn are sold to households in the markets for goods and services.

The outer circle of the diagram represents the corresponding flow of dollars. The households
spend money to buy goods and services from the firms. The firms use some of the revenue
from these sales to pay for the factors of production, such as the wages of their workers.
What’s left is the profit of the firm owners, who are themselves members of households.
Our Second Model:
The Production Possibilities Frontier
 The Production Possibilities Frontier (PFF)is a graph that
 shows the various combinations of output—in this case, cars
and computers— that the economy can possibly produce
given the available factors of production and the available
production technology that firms use to turn these factors into
output..
 Example:
 let’s consider an economy that produces only two goods—
cars and computers. Together, the car industry and the
computer industry use all of the economy’s factors of
production.

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Possibilities:
1. If the economy uses all its resources in the car industry, it produces 1,000 cars
and no computers.
2. If it uses all its resources in the computer industry, it produces 3,000 computers
and no cars.

The two endpoints of the production possibilities frontier represent these extreme
possibilities. More likely, the economy divides its resources between the two
industries, producing some cars and some computers.

For example, it can produce 600 cars and 2,200 computers, shown in the figure by
point A. Or,
by moving some of the factors of production to the car industry from the computer
industry, the economy can produce 700 cars and 2,000 computers, represented by
point B.
A-B Trade Off:
society produce 100 more cars at the expense of producing 200 fewer computers.

A-B Opportunity Cost:

when society move A-B ,it gives up 200 computers to get 100 additional cars.
Because resources are scarce, not every conceivable outcome is feasible. For example, no
matter how resources are allocated between the two industries, the economy cannot
produce the amount of cars and computers represented by point C.
Given the technology available for manufacturing cars and computers, the economy does
not have enough of the factors of production to support that level of
output. With the resources it has, the economy can produce at any point on or inside the
production possibilities frontier, but it cannot produce at points outside
the frontier.

An outcome is said to be efficient if the economy is getting all it can from the scarce
resources it has available. Points on (rather than inside) the production possibilities frontier
represent efficient levels of production.
When the economy is producing at such a point, say point A, there is no way to produce
more of one good without producing less of the other.

Point D represents an inefficient outcome. For some reason, perhaps widespread

unemployment, the economy is producing less than it could from the resources it has
available: It is producing only 300 cars and 1,000 computers. If the source of the
inefficiency is eliminated, the economy can increase its production of both goods.

For example, if the economy moves from point D to point A, its production of cars
increases from 300 to 600, and its production of computers increases from 1,000 to 2,200.
One of the Ten Principles of Economics discussed in previous Chapter is that principle # 1:
people face trade-offs.
The production possibilities frontier shows one trade-off that society faces. Once we have
reached an efficient point on the frontier, the only way of producing more of one good is to
produce less of the other. When the economy moves from point A to point B, for instance,
society produces 100 more cars at the expense of producing 200 fewer computers

This trade-off helps us understand another of the principle # 2: The cost of something is
what you give up to get it. This is called the opportunity cost.

The production possibilities frontier shows the opportunity cost of one good as measured in
terms of the other good. When society moves from point A to point B, it gives up 200
computers to get 100 additional cars. That is, at point A, the opportunity cost of 100 cars is
200 computers. Put another way, the opportunity cost of each car is two computers. Notice
that the opportunity cost of a car equals the slope of the production possibilities frontier.
Economists believe that production possibilities frontiers often have this bowed shape.
When the economy is using most of its resources to make computers, the resources best suited
to car production, such as skilled autoworkers, are being used in the computer industry.
Because these workers probably aren’t very good at making computers, increasing car
production by one unit will cause only a slight reduction in the number of computers
produced.
Thus, at point F, the opportunity cost of a car in terms of computers is small, and the
frontier is relatively flat.
By contrast, when the economy is using most of its resources to make cars, such as at
point E, the resources best suited to making cars are already at work in the car industry.
Producing an additional car means moving some of the best computer technicians out of
the computer industry and turning them into autoworkers. As a result, producing an
additional car requires a substantial loss of computer output. The opportunity cost of a car
is high, and the frontier is steep.

The production possibilities frontier shows the trade-off between the outputs of different
goods at a given time, but the trade-off can change over time.

For example, suppose a technological advance in the computer industry raises the
number of computers that a worker can produce per week. This advance expands
society’s set of opportunities. For any given number of cars, the economy can now make
more computers. If the economy does not produce any computers, it can still produce
1,000 cars, so one endpoint of the frontier stays the same. But if the economy devotes
some of its resources to the computer industry, it will produce more computers from those
resources. As a result, the production possibilities frontier shifts outward,
This figure illustrates what happens when an economy grows. Society can move production
from a point on the old frontier to a point on the new frontier. Which point it chooses
depends on its preferences for the two goods. In this example, society moves from point A to
point G, enjoying more computers (2,300 instead of 2,200) and more cars (650 instead of
600).
The production possibilities frontier simplifies a complex economy to highlight some basic but
powerful ideas: scarcity, efficiency, trade-offs, opportunity cost, and economic growth
 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.
• If opp. cost of a good rises as the economy produces more of the
good, PPF is bow-shaped.

Why the PPF Might Be Bow-Shaped

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).

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Economists use the term absolute advantage when comparing the productivity of one
person, firm, or nation to that of another. The producer that requires a smaller quantity of
inputs to produce a good is said to have an absolute advantage in producing that good.

Economists use the term comparative advantage when describing the opportunity costs
faced by two producers. So, the ability to produce a good at a lower opportunity cost than
another producer is called comparative advantage.