Seventh Edition

Essentials of
Economics

Wojciech Gerson (1831-1901)

N. Gregory Mankiw

2
CHAPTER Thinking Like
an Economist
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 OBJECTIVES:
 What will you learn in this chapter?

 The Production Possibilities Frontier

 What the characteristics of good economic
modeling are.
 The Circular-Flow Diagram
 How to distinguish between:
 Positive and normative analysis.

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 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 them?
• What are the elements of the Circular-Flow Diagram?
What concepts does the 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?
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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.

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 Models
Economic models show how people, firms, and
governments make decisions about managing
resources, and how their decisions interact.
• Models are a simplification of complex
problems.
• Models include:
– Groups of individuals and their choices.
– Markets to study.
• What makes a model useful?
– Makes clear assumptions.
– Describes the real world accurately.
– Predicts cause and effect.

1-5
 Assumptions & Models
 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 road map

©wavebreakmedia/Shutterstock.com

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 Some Familiar Models

A model of human
anatomy from high
school biology class

©Accord/Shutterstock.com

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 Some Familiar Models

©Olga Rosi/Shutterstock.com
A model airplane

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 Some Familiar Models

The model teeth at the

dentist’s office Don’t
forget to
floss!

©ittipon/Shutterstock.com

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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
 Two types of “actors”:
 households
 firms
 Two markets:
 the market for goods and services
 the market for “factors of production”

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 Factors of Production
 Factors of production: the resources the
economy uses to produce goods & services,
including
 labor
 land
 capital (buildings and machines used in
production)

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 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

Firms:
 Buy/hire factors of production,

use them to produce goods

and services
 Sell goods & services
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 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
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 3. The two most important actors of the economy
are:
A. land and capital.
B. households and firms.
C. firms and government.
D. exports and imports.

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 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 labor hours per month
available for production.
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 PPF Example
• Producing one computer requires 100 hours labor.
• Producing one ton of wheat requires 10 hours labor.

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

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

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 ACTIVE LEARNING 1
Points off 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
Wheat
 Point F: (tons)
100 computers, 6,000
3000 tons wheat
5,000
 Point F requires
4,000
40,000 hours
3,000
of labor. 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
Wheat
 Point G: (tons)
300 computers, 6,000
3500 tons wheat
5,000
 Point G requires 4,000 G
65,000 hours
3,000
of labor.
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
–1000
6,000 slope = = –10 “rise over the run,”
100
5,000 the amount the line
4,000 rises when you
move to the right by
3,000
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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ACTIVE LEARNING 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
ACTIVE LEARNING 2
Answers

England, because its PPF is not as steep as France’s.

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
 Economic Growth and the PPF
With additional Wheat
(tons) Economic
resources or an growth shifts
6,000
improvement in the PPF
technology, 5,000 outward.
the economy can 4,000
produce more 3,000
computers,
2,000
more wheat,
1,000
or any combination
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 more of the good
is produced, PPF is bow-shaped….

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 Why the PPF Might Be Bow-Shaped

Beer
As the economy
shifts resources
from beer to
mountain bikes:
 PPF becomes
steeper
 opp. cost of
mountain bikes
increases
Mountain
Bikes
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 Why the PPF Might Be Bow-Shaped
At A, opp. cost of

Beer
At point A, A mtn bikes is low.
most workers are
producing beer,
even those who
are better suited
to building bikes.
So, do not have to
give up much beer
to get more bikes.
Mountain
Bikes
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 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 bikes B
would require shifting
some of the best
brewers away from
beer production,
causing a big drop in
Mountain
beer output.
Bikes
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 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).

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 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.

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 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.

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Consider the production possibilities frontier
displayed in the figure shown. A society faced
with this curve, which point can’t be obtained?

1-35
The opportunity cost of a bushel of apples is:

20/400 = 1/20
1-36
Consider the production possibilities frontier displayed
in the figure shown. If this society chooses to produce
200 bushels of apples, how many watermelons can be
produced?
No more than 10 watermelon
1-37
Consider the production possibilities frontier in the
figure shown. As more and more cigars are produced:

A. The opportunity cost of cars decreases

B. the opportunity cost of cars stays the same
C. the opportunity cost of cars increases
D. the opportunity costs of cars decreases then increases
1-38
 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., the U.S. President has a Council of Economic
Advisors, which the author of this textbook chaired
from 2003 to 2005.
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 Kinh tế học chứng thực và chuẩn tắc
 Đứng trước cùng một hiện tượng kinh tế như sự kiện giá dầu mỏ liên tục tăng
trong thời gian gần đây và vượt ngưỡng 60 USD/thùng:
 – Một nhà kinh tế, khi đưa ra phán xét hiện tượng này là xấu, và cho rằng cần
phải làm mọi cách để kiềm chế hay hạ giá dầu xuống, thì người này đã nhìn
nhận vấn đề dưới góc độ chuẩn tắc.
 – Trong khi đó, nhà kinh tế học thực chứng (người áp dụng phương pháp phân
tích thực chứng) sẽ cố gắng thu thập, kiểm định số liệu nhằm mô tả và lí giải:
Xu hướng tăng giá của dầu mỏ diễn ra như thế nào? Những động lực kinh tế
nào nằm đằng sau chi phối sự kiện trên (sự gia tăng nhanh chóng của nhu cầu
về dầu mỏ của các nước trên thế giới?…
 Các nhận định chuẩn tắc luôn luôn dựa trên các giá trị cá nhân. Những giá trị
đó là khác nhau tùy thuộc vào thế giới quan, quan điểm đạo đức, tôn giáo hay
triết lí chính trị của từng người.
 Trong cuộc sống, chúng ta cần cả sự phân tích thực chứng khi muốn hiểu
chính xác hơn về thế giới xung quanh, song cũng cần đến sự phân tích chuẩn
tắc khi muốn hay phải bày tỏ thái độ của mình trước các vấn đề mà xã hội
đang đối diện. 40
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Active Learning: Positive and normative statements

For each of the following, categorize as

either a positive or normative
statement.
– GDP fell by 0.5% during last quarter.
– Given an inflation rate of 2%, no one
should be concerned with higher costs of
living.
– The DOW rose above 15,000 on May 3,
2013.

1-41
Active Learning: Positive and normative statements

For each of the following, categorize as

either a positive or normative statement.
– GDP fell by .5% during last quarter.
• Positive statement.
– Given an inflation rate of 2%, no one should
be concerned with higher costs of living.
• Normative statement.
– The DOW rose above 15,000 on May 3, 2013.
• Positive statement.

1-42
 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 burritos will cause an
increase in consumer demand for music
downloads.

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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 burritos will cause an

increase in consumer demand for music
downloads.
Positive – describes a relationship.
Note that a statement need not be true to be
positive.

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 4. Which of the following is an example of a
normative statement?
A. The average price of a Whopper Jr. is $1.69.
B. The United States ought to adopt a flat rate
personal income tax.
C. A higher percentage of prostitutes incarcerated
in Miami test positive for AIDS when compared
to registered prostitutes in Nevada.
D. Average growth in real GDP per year was 1.84
percent between 2000 and 2010.

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 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.

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 Propositions about Which Most
Economists Agree (and % who agree)
 A ceiling on rents reduces the quantity and quality
of housing available. (93%)
 Tariffs and import quotas usually reduce general
economic welfare. (93%)
 The United States should not restrict employers
from outsourcing work to foreign countries. (90%)
 The United States should eliminate agriculture
subsidies. (85%)

continued…

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 Propositions about Which Most
Economists Agree (and % agreeing)
 The gap between Social Security funds and
expenditures will become unsustainably large
within the next fifty years if current policies remain
unchanged. (85%)
 A large federal budget deficit has an adverse effect on
the economy. (83%)
 A minimum wage increases unemployment among
young and unskilled workers. (79%)
 Effluent taxes and marketable pollution permits
represent a better approach to pollution control
than imposition of pollution ceilings. (78%) 49
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 FYI: Who Studies Economics?
 Ronald Reagan, President of the United States
 Barbara Boxer, U.S. Senator
 Sandra Day-O’Connor, Former Supreme Court Justice
 Anthony Zinni, Former General, U.S. Marine Corps
 Kofi Annan, Former Secretary General, United Nations
 Meg Witman, Chief Executive Officer, eBay
 Steve Ballmer, Chief Executive Officer, Microsoft
 Arnold Schwarzenegger, Former Gov. of California, Actor
 Ben Stein, Political Speechwriter, Actor, Game Show Host
 Mick Jagger, Singer for the Rolling Stones
 John Elway, NFL Quarterback
 Tiger Woods, Golfer
 Diane von Furstenburg, Fashion Designer
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 Summary
• As scientists, economists try to explain the world
using models with appropriate assumptions.
• Two simple models are the Circular-Flow Diagram
and the Production Possibilities Frontier.
• Microeconomics studies the behavior of
consumers and firms, and their interactions in
markets. Macroeconomics studies the economy
as a whole.
• As policy advisers, economists offer advice on
how to improve the world.
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