ECONOMICS

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Thinking Like an Economist
Every field of study has its own terminology
 Mathematics
• integrals  axioms  vector spaces

 Psychology
• ego  id  cognitive dissonance

 Law
• promissory  estoppel  torts  venues

 Economics
• supply  opportunity cost  elasticity  consumer surplus  demand  comparative advantage  deadweight loss

Thinking Like an Economist
Economics trains you to. . . .
 To think about how to maximise the wealth of nations  Think in terms of alternatives.  Evaluate the cost of individual and social choices.  Examine and understand how certain events and issues are related.

THE ECONOMIST AS A SCIENTIST
The economic way of thinking . . .
 Involves thinking analytically and objectively.  Makes use of the scientific method.  Uses abstract models to help explain how a complex, real world operates.  Develops theories, collects and analyzes data to evaluate the theories.

The Scientific Method: Observation, Theory, and More Observation

• Uses abstract models (law of demand, production law ) to help explain how a complex, real world operates. • Develops theories, collects and analyzes data to evaluate the theories.

The Role of Assumptions • Some standard assumptions: 1. other things remain the same 2. human behaviour will not change etc. • Economists make assumptions in order to make the world easier to understand. • The art in scientific thinking is deciding which assumptions to make. • Economists use different assumptions to answer different questions.

Economic Models • Economists use models to simplify reality in order to improve our understanding of the world. • Two of the most basic economic models are:
• The Circular Flow Diagram • The Production Possibilities Frontier

Our First Model: The Circular-Flow Diagram

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• The circular-flow diagram is a visual model of the economy that shows how dollars flow through markets among households and firms.

Figure 1 The Circular Flow
MARKETS FOR GOODS AND SERVICES •Firms sell Goods •Households buy and services sold Revenue Spending Goods and services bought

FIRMS •Produce and sell goods and services •Hire and use factors of production

HOUSEHOLDS •Buy and consume goods and services •Own and sell factors of production

Factors of production Wages, rent, and profit

Labor, land, MARKETS and capital FOR FACTORS OF PRODUCTION •Households sell •Firms buy Income = Flow of inputs and outputs = Flow of dollars

Our First Model: The Circular-Flow Diagram • Firms
• Produce and sell goods and services • Hire and use factors of production

• Households
• Buy and consume goods and services • Own and sell factors of production

Our First Model: The Circular-Flow Diagram • Markets for Goods and Services
• Firms sell • Households buy

• Markets for Factors of Production
• Households sell • Firms buy

Our First Model: The Circular-Flow Diagram • Factors of Production
• Inputs used to produce goods and services • Land, labor, and capital Mostly we use two models: 1. labour (L) 2. Capital (k)

Our Second Model: The Production Possibilities Frontier • The production possibilities frontier is a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology.

Figure 2 The Production Possibilities Frontier
Quantity of Computers Produced

3,000 2,200 2,000 A

C

B Production possibilities frontier

1,000

D

0

300

600 700

1,000

Quantity of Cars Produced

Our Second Model: The Production Possibilities Frontier • Concepts illustrated by the production possibilities frontier
• Efficiency • Trade-offs • Opportunity cost: the second best alternative use is called opportunity cost (opportunity lost) • Economic growth

Figure 3 A Shift in the Production Possibilities Frontier
Quantity of Computers Produced 4,000

3,000 G A

2,300 2,200

0

600 650

Quantity of 1,000 Cars Produced

Microeconomics and Macroeconomics • Microeconomics focuses on the individual parts of the economy.
• How households and firms make decisions and how they interact in specific markets

• Macroeconomics looks at the economy as a whole.
• Economy-wide phenomena, including inflation, unemployment, and economic growth

THE ECONOMIST AS POLICY ADVISOR
• When economists are trying to explain the world, they are scientists. • When economists are trying to change the world, they are policy advisors.

Positive versus Normative Analysis • Positive statements are statements that attempt to describe the world as it is.
• Called descriptive analysis

• Normative statements are statements about how the world should be.
• Called prescriptive analysis

Positive Versus Normative Analysis

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• Are the following positive or normative statements?
• An increase in the minimum wage will cause a decrease in employment among the least-skilled. • POSITIVE • Higher federal budget deficits will cause interest rates to increase. • POSITIVE

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Positive Versus Normative Analysis • Are the following positive or normative statements?

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• The income gains from a higher minimum wage are worth more than any slight reductions in employment. • NORMATIVE • State governments should be allowed to collect from tobacco companies the costs of treating smoking-related illnesses among the poor. • NORMATIVE

Economists in Washington • . . . serve as advisers in the policymaking process of the three branches of government:
• Legislative • Executive • Judicial

A PARABLE FOR THE MODERN ECONOMY

Imagine an economic system with only two goods, potatoes and milk and only two people, a potato farmer and a cattle rearer
– What should each person produce? – Why should these people trade?

Production Possibilities

• Suppose the farmer and rearer decide not to engage in trade:
– Each consumes only what he or she can produce alone. – The production possibilities frontier is also the consumption possibilities frontier. – Without trade, economic gains are diminished.

Figure 1 The Production Possibilities Frontier
(a) The Farmer’ s Production Possibilities Frontier Milk

8

If there is no trade, the farmer chooses this production and consumption.

4

A

0

16

32

Potatoes (ounces)

Copyright©2003 Southwestern/Thomson Learning

Figure 1 The Production Possibilities Curve
(b) The Rancher ’s Production Possibilities Frontier Milk 24 If there is no trade, the rancher chooses this production and consumption.

12

B

0

24

48 Potatoes (ounces)

Copyright©2003 Southwestern/Thomson Learning

Specialization and Trade

• Suppose instead the farmer and the rancher decide to specialize and trade…
– Both would be better off if they specialize in producing the product they are more suited to produce, and then trade with each other.

The farmer should produce potatoes. The rancher should produce meat.

Figure 2 How Trade Expands the Set of Consumption Opportunities
(a) The Farmer’ s Production and Consumption Milk

8

Farmer's consumption with trade

5 4

A* A

Farmer's production and consumption without trade Farmer's production with trade 32 Potatoes (ounces)

0 16 17

Copyright©2003 Southwestern/Thomson Learning

Figure 2 How Trade Expands the Set of Consumption Opportunities
(b) The Rancher’s Production and Consumption Meat (ounces) 24 Rancher's production with trade

18 13 B

Rancher's consumption with trade B*

12

Rancher's production and consumption without trade

0

12

24 27

48 Potatoes (ounces)

Copyright © 2004 South-Western

COMPARATIVE ADVANTAGE

• Differences in the costs of production determine the following:
– Who should produce what? – How much should be traded for each product?

COMPARATIVE ADVANTAGE

• Two ways to measure differences in costs of production:
– The number of hours required to produce a unit of output (for example, one pound of potatoes). – The opportunity cost of sacrificing one good for another.

Absolute Advantage

• The comparison among producers of a good according to their productivity.
– Describes the productivity of one person, firm, or nation compared 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.

Absolute Advantage

• The Rearer needs only 10 minutes to produce an ounce of potatoes, whereas the Farmer needs 15 minutes. • The Rearer needs only 20 minutes to produce an ounce of meat, whereas the Farmer needs 60 minutes. The Rancher has an absolute advantage in the production of both meat and potatoes.

Opportunity Cost and Comparative Advantage

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• Compares producers of a good according to their opportunity cost, that is, what must be given up to obtain some item • The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good. • Who has the comparative advantage in the production of each good?

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Comparative Advantage and Trade

• Potato costs…
– The Rearer’s opportunity cost of an ounce of potatoes is ½ a liter of milk – The Farmer’s opportunity cost of an ounce of potatoes is ¼ a liter of milk

• Meat costs…
– The Rearer’s opportunity cost of a liter of milk is 2 ounces of potatoes. – The Farmer’s opportunity cost of a liter of milk is 4 ounces of potatoes...

Comparative Advantage and Trade

…so, the Rearer has a comparative advantage in the production of milk but the Farmer has a comparative advantage in the production of potatoes.

Comparative Advantage and Trade

• Comparative advantage and differences in opportunity costs are the basis for specialized production and trade. • Whenever potential trading parties have differences in opportunity costs, they can each benefit from trade.

Gains from Trade

Comparative Advantage and Trade

• Benefits of Trade
– Trade can benefit everyone in a society because it allows people to specialize in activities in which they have a comparative advantage.

FYI—The Legacy of Adam Smith and David Ricardo

• Adam Smith
– In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, Adam Smith performed a detailed analysis of trade and economic interdependence, which economists still adhere to today.

• David Ricardo
– In his 1816 book Principles of Political Economy and Taxation, David Ricardo developed the principle of comparative advantage as we know it today.

APPLICATIONS OF COMPARATIVE ADVANTAGE

• Should Tiger Woods Mow His Own Lawn?

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APPLICATIONS OF COMPARATIVE ADVANTAGE

Should the United States trade with other countries?
• Each country has many citizens with different interests. International trade can make some individuals worse off, even as it makes the country as a whole better off.
– Imports—goods produced abroad and sold domestically – Exports—goods produced domestically and sold abroad

Summary
• Economists try to address their subjects with a scientist’s objectivity.
– They make appropriate assumptions and build simplified models in order to understand the world around them. – Two simple economic models are the circular-flow diagram and the production possibilities frontier.

Summary
• Economics is divided into two subfields:
– Microeconomics is the study of decision-making by households and firms in the marketplace. – Macroeconomics is the study of the forces and trends that affect the economy as a whole.

Summary
• A positive statement is an assertion about how the world is. • A normative statement is an assertion about how the world ought to be. • When economists make normative statements, they are acting more as policy advisors than scientists.

Summary
• Economists who advise policymakers offer conflicting advice either because of differences in scientific judgments or because of differences in values. • At other times, economists are united in the advice they offer, but policymakers may choose to ignore it.

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