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Thinking Like an Economist

Thinking Like an Economist
Economics trains you to. . . .
Think in terms of alternatives.
Evaluate the cost of individual and social choices.
Examine and understand how certain events and issues are

The Scientific Method: Observation, Theory, and More
Uses abstract models to help explain how a complex, real
world operates.

Develops theories, collects, and analyzes data to evaluate the


The Role of Assumptions
Economists make assumptions in order to make the world
easier to understand.
The art in scientific thinking is deciding which assumptions to
Economists use different assumptions to answer different

Economic Models
Economists use models to simplify reality in order to improve
our understanding of the world

Two of the most basic economic models include:

The Circular Flow Diagram
The Production Possibilities Frontier

First Model: The Circular-Flow Diagram
The circular-flow diagram is a visual model of the economy
that shows how dollars flow through markets among
households and firms

First Model: The Circular-Flow Diagram

Produce and sell goods and services
Hire and use factors of production
Buy and consume goods and services
Own and sell factors of production
Markets for Goods and Services
Firms sell
Households buy
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.

Second Model: The Production Possibilities Frontier

Second Model: The Production Possibilities Frontier
Concepts illustrated by the Production Possibilities Frontier
Opportunity Cost
Economic Growth

Second Model: The Production Possibilities Frontier
Shift in the Production Possibilities Frontier

The economist
When economists are trying to explain the world, they are
When economists are trying to change the world, they are
policy advisor.

Positive versus normative analysis
Positive statements are statements that attempt to describe the world as it
Called descriptive analysis
Ex: an increase in the minimum wage will cause a decrease in employment
among the least-skilled.
Normative statements are statements about how the world should be.
Called prescriptive analysis
Ex: government should be allowed to collect from tobacco companies the
costs of treating smoking-related illnesses among the poor.

Resources & Factors of Production
Factors of Production
an economic term that describes the inputs are used in the
production of goods or services in order to make an
economic profit.
A firms demand for a factor of production is derived from its
decision to supply a good in a market.

Resources & Factors of production

Different from money
Money used to purchase goods and service for consumption
Capital is more durable and used to generate wealth through

Resources & Factors of Production

What are costs?
According to the Law of Supply:
Firms are willing to produce and sell a greater quantity of a good
when the price of the good is high.

The Firms Objective:

The economic goal of the firm is to maximize profits.

Total Revenue, Total Cost, and Profit
Total Revenue
The amount a firm receives for the sale of its output.
Total Cost
The market value of the inputs a firm uses in production.

Profit is the firms total revenue minus its total cost.

Profit = Total revenue - Total cost

Costs as Opportunity Costs
A firms cost of production includes all the opportunity costs
of making its output of goods and services.
Explicit and Implicit Costs
A firms cost of production include explicit costs and implicit
Explicit costs are input costs that require a direct outlay of money by
the firm.
Implicit costs are input costs that do not require an outlay of money
by the firm.

The Production Function
The production function shows the relationship between
quantity of inputs used to make a good and the quantity of
output of that good.
Q = f ( L, C, N )
Q = Quantity of output
L = Labor
C = Capital
N = Land

Features of Production Function:
1. Substitutability:
The factors of production or inputs are substitutes of one another which make it possible to vary the total
output by changing the quantity of one or a few inputs, while the quantities of all other inputs are held

2. Complementarity:
The factors of production are also complementary to one another, that is, the two or more inputs are to
be used together as nothing will be produced if the quantity of either of the inputs used in the
production process is zero.

3. Specificity:
It reveals that the inputs are specific to the production of a particular product. Machines and
equipments, specialized workers and raw materials are a few examples of the specificity of factors of
production. The specificity may not be complete as factors may be used for production of other
commodities too.

The Production Function
Marginal Product
The marginal product of any input in the production process
is the increase in output that arises from an additional unit of
that input.

The Production Function
Diminishing marginal product is the property whereby the
marginal product of an input declines as the quantity of the
input increases.
Example: As more and more workers are hired at a firm, each
additional worker contributes less and less to production because the
firm has a limited amount of equipment.
The slope of the production function measures the marginal
product of an input, such as a worker.

Table 13-1: A production function and total cost

Diminishing Marginal Product

The various measures of cost
Costs of production may be divided into fixed costs and
variable costs.
Fixed costs are those costs that do not vary with the quantity
of output produced.
Variable costs are those costs that do vary with the quantity
of output produced.

Fixed and Variable Costs
Average Costs
Average costs can be determined by dividing the firms costs by
the quantity of output it produces.
The average cost is the cost of each typical unit of product.
Average Costs
Average Fixed Costs (AFC)
Average Variable Costs (AVC)
Average Total Costs (ATC)
Average Costs

Fixed cost FC
Quantity Q

Variable cost VC
Quantity Q

Total cost TC
Quantity Q

Table 13-2: The various measures of cost

Fixed and Variable Costs
Marginal Cost
Marginal cost (MC) measures the increase in total cost that
arises from an extra unit of production.
Marginal cost helps answer the following question:
How much does it cost to produce an additional unit of output?

(change in total cost) TC

(change in quantity) Q

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.
The goal of firms is to maximize profit, which equals total
revenue minus total cost.
When analyzing a firms behavior, it is important to include all
the opportunity costs of production.
A firms total costs are divided between fixed and variable
costs. Fixed costs do not change when the firm alters the
quantity of output produced; variable costs do change as
the firm alters quantity of output produced.
Average total cost is total cost divided by the quantity of
Marginal cost is the amount by which total cost would rise if
output were increased by one unit.
The marginal cost always rises with the quantity of output.