Thinking Like an Economist, Chapter 2

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 related.
The economic way of thinking . . .
 Involves thinking analytically and objectively.
 Uses abstract models to help explain how a
complex, real world operates.
 Develops theories, collects and analyzes data to
evaluate the theories.
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 The Role of Assumptions
• Assumptions
– Can simplify the complex world
• Make it easier to understand
– Focus our thinking - essence of the problem
• Economists use different assumptions to
answer different questions.

2
 Economic models . . .
• Simplify reality to improve our understanding
of it
• Omit many details
• Allow us to see what’s truly important
• Are built with assumptions

• Two of the most basic economic models are:

– The Circular Flow Diagram
– The Production Possibilities Frontier
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FIGURE 1: The Circular-Flow Diagram
Revenue Spending
Markets for
Goods & Goods &
Goods &
Services Services Services
sold bought

Firms Households

Factors of Labor, land,

production Markets for capital
Factors of
Wages, rent, Production Income
profit
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The Production Possibilities Frontier (PPF)
• A graph that shows combinations of
output that the economy can possibly
produce . . .
– . . . given the available
»factors of production
»production technology

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The Production Possibilities Frontier (PPF)
Quantity of
Computers
Figure 2
Produced

3,000 F C

A
2,200
2,000 B
Production
possibilities
frontier
1,000 D
E

0 300 600 700 1,000 Quantity of

Cars Produced 6
The Production Possibilities Frontier (PPF)
Quantity of
Computers
Figure 3: A Shift . . .
Produced

4,000

3,000

2,300 G
2,200
A

0 600 650 1,000 Quantity of

Cars Produced 7
Microeconomics and Macroeconomics
• Microeconomics
– Looks at the individual parts of the economy
– . . . how households and firms make decisions
– . . . and how they interact in markets
• Macroeconomics
– Looks at the economy as a whole
– . . . economy-wide phenomena, including
inflation, unemployment, and economic
growth
8
 The Economist as a Policy Adviser

• When economists are trying to explain the

world, they are scientists.
• When economists are trying to change the
world, they are policy advisors.

9
 The Economist as a Policy Adviser
Positive vs. Normative
• Positive statements
– Attempt to describe the world as it is
– Descriptive
– Can confirm or refute by examining evidence
• Normative statements
– Attempt to prescribe how the world should be
– Prescriptive

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 Positive Versus Normative Analysis
• Are the following positive or normative
statements?
?
– An increase in the minimum wage will cause a
? decrease in employment among the least-
skilled.
– POSITIVE
?
– The income gains from a higher minimum
wage are worth more than any slight
reductions in employment. ?
– NORMATIVE 11
 Positive Versus Normative Analysis
• Are the following positive or normative
statements?
– State governments should be allowed to ?
collect from tobacco companies the costs of

? treating smoking-related illnesses among the

poor.
– NORMATIVE
– An increase in the price of burritos will cause
an increase in consumer demand for video
rentals
– POSITIVE
? 12
 Why Economists Disagree
Is this policy fair?
• Peter and Paula - take the same amount of
water from the town well
• To pay for the well, the town collects taxes
• Peter makes $50,000 and is taxed $5000
• Paula makes $10,000, and is taxed $2000

13
 Why Economists Disagree
• Economists may disagree about the validity
of alternative positive theories about how
the world works.
• Economists may have different values and,
therefore, different normative views about
what policy should try to accomplish.

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