Econ1 Lecture Ch2

Economics 1
Principles of Economics
Thinking Like an
Economist
(Chapter 2)
Dr. Patrick D. Convery
1
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
2
and macroeconomics? Between positive and
I. The Economist as a
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.
II. 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.
Def: Model = a highly simplified

representation of a more complicated
reality.
Economists use models to study economic
issues.
4
III. The Circular-Flow

Diagram
1 of 4
Def: 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
5

Diagram
2 of 4
Def: Factors of production = the

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

Diagram
3 of 4
Firms
Households:
Own the factors of production,
sell/rent them to firms for income
Buy and consume goods &
services
Households
Firms:
Buy/hire factors of
production,
use them to produce goods
and services
Sell goods & services

Diagram
4 of 4
Revenue
sell G & S
Markets for
Goods &
Services
Spending
buy G & S
Firms
Factors of
production
Wages, rent, profit
Households
Markets for
Factors of
Production
Labor, land,
capital
Income
8
IV. The Production Possibilities

Frontier
1 of 13
Def: 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.
9

Frontier
2 of 13
Example: U.S. and Japan
Two countries: the U.S. and Japan.
Two goods: computers and wheat.
One resource: labor, measured in hours.
We will look at how much of both goods

each country produces and consumes
if the country chooses to be self-sufficient.
if it trades with the other country.
10

Frontier
3 of 13
Example: U.S.
The U.S. has 50,000 hours of labor

available for production, per month.
Producing one computer requires

100 hours of labor.
Producing one ton of wheat requires

10 hours of labor.
11

Frontier
Producing one computer requires 100 hours labor.
Producing one ton of wheat requires 10 hours labor.
Employment of
labor hours
Production
Computers
Wheat
Computers
Wheat
50,000
500
40,000
10,000
400
1,000
25,000
25,000
250
2,500
10,000
40,000
100
4,000
50,000
5,000
12

Frontier
Whea
5 of 13
t
(tons
5,00
0)
Example: The U.S. PPF
4,00
0
3,00
0
2,00
0
1,00
0
0
The U.S. has enough

labor to produce 500
or
5000 tons of
computers,
wheat,
or any combination
along the PPF.
Computer
100 200 300 400 500 s
13

Frontier
Whea
6 of 13
t
(tons
5,00
0)
4,00
0
3,00
0
2,00
0
1,00
0
0
Example: The U.S. Without

Trade
Suppose the U.S. uses half its
labor to produce each of the
twoThen
goods.
it will produce and
consume
250 computers and
2500 tons of wheat.
Computer
100 200 300 400 500 s
Note: Without trade, a country consumes14 what it produc

Frontier
7 of 13
Example: Japan
Japan has 30,000 hours of labor

available for production, per month.

125 hours of labor.
Producing one ton of wheat requires

25 hours of labor.
15

Frontier
8 of 13
Whea
t
(tons
)
2,000
Example: Japans PPF

Japan has enough labor
to produce 240
computers,
or 1200 tons of
or any combination
wheat,
along the PPF.
1,000
100
200
300
Computer
s
16

Frontier 9 of 13
Whea
t
(tons
)
2,000
Example: Japan Without

Trade
1,000
Suppose Japan uses half its labor

to produce each good.
Then it will produce and
consume120 computers and
600 tons of wheat.
100
200
300
Computer
s
17

Frontier
10 of 13
Example: Consumption With and

Without Trade
Without trade,
U.S. consumers get 250 computers
and 2500 tons wheat.
Japanese consumers get 120 computers
and 600 tons wheat.
We will compare consumption without trade
to consumption with trade.
First, we need to see how much of each
18
good is produced and traded by the
two

Frontier
11 of 13
Example: Consumption Under Trade

Suppose the U.S. exports 700 tons of
wheat to Japan, and imports 110
computers from Japan.
(So, Japan imports 700 tons wheat and
exports 110 computers.)
How much of each good is consumed in
the U.S.? Plot this combination on the
U.S. PPF.
19
How much of each good is consumed
in
IV. The Production Possibilities Frontier

12 of 13
Whea
t
U.S. Consumption With Trade
(tons
computer
5,00
s
0)
produced 160
4,00
+
110
0
imported
3,00
exported 0
0
= amount
270
2,00
consumed
0
1,00
0
Computer
0
100 200 300 400 500 s
20
wheat
3400
0
700
2700

Frontier
13 of 13
Japans Consumption With Trade
Whea
t
(tons
)
2,000
computers wheat
produced 240
0
+
0
700
imported
exported 110
0
= amount
130
700
consumed
1,000
100
200
300
Computer
s
21
Trade Makes Both Countries Better Off

U.S.
Consumption Consumptio Gains from
without trade n with trade trade
Computers 250
270
20
Wheat
2700
200
2500
Japan
Consumption Consumptio Gains from
without trade n with trade trade
Computers 120
130
10
Wheat
700
100
600
22
V. Where Do These Gains Come

From?
1 of 2
Def: Absolute Advantage = The

ability to produce a good using
fewer inputs than another producer.
The U.S. has an absolute advantage

in wheat: producing a ton of wheat
uses 10 labor hours in the U.S. vs.
25 in Japan.
If each country has an absolute

advantage
23
V. Where Do These Gains Come

From?
2 of 2
Which country has an absolute

advantage in computers?
125 labor hours in Japan, but only
100 in the U.S.
The U.S. has an absolute advantage
in both goods!
So why does Japan specialize in computers?
Why do both countries gain from trade?
24
VI. Two Measures of the Cost of a

Good
Two countries can gain from trade when

each specializes in the good it produces at
lowest cost.
Absolute advantage measures the cost of
a good in terms of the inputs required to
produce it.
Recall: Another measure of cost is
opportunity cost.
In our example, the opportunity cost of a
computer is the amount of wheat that
could be
25
produced using the labor needed to produce
VII. Opportunity Cost and

Comparative Advantage
1 of 2
Def: Comparative Advantage = The

ability to produce a good at a lower
opportunity cost than another
producer
Which country has the comparative
advantage in computers?
To answer this, must determine the
opportunity cost of a computer in
each country.
26
VII. Opportunity Cost and

Comparative Advantage
2 of 2
The opportunity cost of a computer is

10 tons of wheat in the U.S., because
producing one computer requires 100 labor
hours,
which instead could produce 10 tons of
wheat.
5 tons of wheat in Japan, because
producing one computer requires 125 labor
hours,
which instead could produce 5 tons of
wheat.
27
VIII. Comparative Advantage and

Trade
Gains from trade arise from

comparative advantage (differences
in opportunity costs).
When each country specializes in

the good(s) in which it has a
comparative advantage, total
production in all countries is higher,
the worlds economic pie is
bigger, and all countries can gain
from trade.
28
IX. The PPF and Opportunity

Cost
6,900
5,914
slope =
4,929
1000
= 10
100
3,943
Wheat
(tons) 2,957
1,971
986
0
97
194 291 389 486 583

Computers
The slope of a line

equals the
rise over the
run, the amount
the line rises
when you move to
the right by one
unit.
Here, the
opportunity cost of
a computer is
10 tons of wheat.
29
Example
Q: In which country is the opportunity cost of cloth lower?
FRANCE
690
591
591
493
493
394
394
Wine
296
Wine
296
197
197
99
99
98
196
294
ENGLAND
690
392
490
98
196
Cloth
Cloth
30
294
392
490
Example
A: England, because its PPF is not as steep as Frances.
FRANCE
690
591
591
493
493
394
394
Wine
296
Wine
296
197
197
99
99
98
196
294
ENGLAND
690
392
490
98
196
Cloth
Cloth
31
294
392
490
X. Economic Growth and the

PPF
With additional
6,900
resources or an
5,914
improvement in
4,929
technology,
the economy can
3,943
Wheat
produce more
(tons) 2,957
computers,
1,971
more wheat,
or any combination
986
in between.
0
Economic
growth shifts
the PPF
outward.
97 194 291 389 486 583

Computers
32
XI. The Shape of the PPF

The PPF could be a straight line or bowshaped.
It depends on what happens to the
opportunity cost as the economy shifts
resources from one industry to the other.
If the opportunity cost remains constant,

the PPF is a straight line.
(In the previous example, the opp. cost
of a computer was always 10 tons of wheat.)
If the opportunity cost of a good rises as
more of the good is produced, PPF is
33
bow-shaped.
As the economy
shifts resources
from beer to
mountain bikes:
PPF becomes
steeper.
opp. cost of
mountain bikes
increases.
Beer
XII. Why the PPF Might Be BowShaped
Mountain
Bikes
34

A
Beer
At point A,
most workers are
producing beer,
even those who
are better suited
to building bikes.
So, we do not
have to give up
much beer to get
more bikes.
At A, opp. cost of
mtn bikes is low.
Mountain
Bikes
35
At B, most workers
are producing
bikes.
The few left in beer
are the best
brewers.
Producing more
bikes would require
shifting some of
the best brewers
away from beer
production,
causing a big drop
Beer

At B, opp. cost
of mtn bikes
is high.
B
Mountain
Bikes
36
In short, 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
37
PPF 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
38
XIII. 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.
The Government 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
39
2005.
Example
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

40
music downloads.
Example
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.
41
Example
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.
42
XIV. 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.
43
XV. Propositions about Which Most

Economists Agree (and % who agree) 1 of
2
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
44
XV. Propositions about Which Most

Economists Agree (and % agreeing) 2 of 2
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 of45 pollution
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.
46

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Econ1 Lecture Ch2

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Economics 1

Look for the Answers

Economists play two roles:

In the first, economists employ the

II. Assumptions & Models

Assumptions simplify the complex world,

Def: Model = a highly simplified

III. The Circular-Flow

Def: The Circular-Flow Diagram = a visual

Two types of actors:

III. The Circular-Flow

Def: Factors of production = the

III. The Circular-Flow

III. The Circular-Flow

IV. The Production Possibilities

Def: The Production Possibilities Frontier

IV. The Production Possibilities

Example: U.S. and Japan

Two countries: the U.S. and Japan.

Two goods: computers and wheat.

One resource: labor, measured in hours.

We will look at how much of both goods

IV. The Production Possibilities

The U.S. has 50,000 hours of labor

Producing one computer requires

Producing one ton of wheat requires

IV. The Production Possibilities

IV. The Production Possibilities

Example: The U.S. PPF

The U.S. has enough

IV. The Production Possibilities

Example: The U.S. Without

Note: Without trade, a country consumes14 what it produc

IV. The Production Possibilities

Japan has 30,000 hours of labor

Producing one computer requires

Producing one ton of wheat requires

IV. The Production Possibilities

Example: Japans PPF

IV. The Production Possibilities

Example: Japan Without

Suppose Japan uses half its labor

IV. The Production Possibilities

Example: Consumption With and

IV. The Production Possibilities

Example: Consumption Under Trade

IV. The Production Possibilities Frontier

IV. The Production Possibilities

Japans Consumption With Trade

Trade Makes Both Countries Better Off

V. Where Do These Gains Come

Def: Absolute Advantage = The

The U.S. has an absolute advantage

If each country has an absolute

V. Where Do These Gains Come

Which country has an absolute

VI. Two Measures of the Cost of a

Two countries can gain from trade when

VII. Opportunity Cost and

Def: Comparative Advantage = The

VII. Opportunity Cost and

The opportunity cost of a computer is

VIII. Comparative Advantage and

Gains from trade arise from