Macroeconomic

Fundamentals
4
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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 related.

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 The Real Purpose of
Macroeconomics
• To explain how we as a nation can optimally
use our resources in order to achieve the highest
standard of living possible.

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 How can a nation optimally use its
resources?
a. A great amount of government involvement, price
controls active monetary policy, etc.
b. The government involvement should be minimal and
limited to tasks related to defending individual rights,
national defense and security, maintenance of peace
and order, etc.
c. Having a combination of moderate government
involvement and private initiatives in achieving the
highest standards of living.

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 THE ECONOMIST AS A
SCIENTIST
The economic way of thinking . . .
• Involves thinking analytically and
objectively.
• Makes use of the scientific
method.

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The Scientific Method: Observation, Theory,
and More Observation
• 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

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.

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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

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Our 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.

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Figure 1.1 The Simple Circular Flow

MARKETS
Revenue FOR Spending
GOODS AND SERVICES
Goods •Firms sell Goods and
and services •Households buy services
sold bought

FIRMS HOUSEHOLDS
•Produce and sell •Buy and consume
goods and services goods and services
•Hire and use factors •Own and sell factors
of production of production

Factors of MARKETS Labor, land,

production FOR and capital
FACTORS OF PRODUCTION
Wages, rent, •Households sell Income
and profit •Firms buy
= Flow of inputs
and outputs
= Flow of dollars

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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

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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

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Our First Model: The Circular-Flow Diagram
• Factors of Production
• Inputs used to produce goods
and services
• Land, labor, capital, &
entrepreneur

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Figure 1.2 The Complex Circular Flow
Foreign
Supply of Products
Markets

Purchases Products
of Products Market
Products
Services Services

Households Businesses
Government
Taxes Taxes

Resource
(Inputs)
Supply of Labor and Resources Market

Purchases of (Demand for) Labor and Resources

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 Supply, Demand, and Government
Policies
• In a free, unregulated market system, market
forces establish equilibrium prices and
exchange quantities.
• While equilibrium conditions may be efficient,
it may be true that not everyone is satisfied.
• One of the roles of economists is to use their
theories to assist in the development of policies,
therefore, the government can sometimes
intervene.

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 CONTROLS ON PRICES
• Are usually enacted when policymakers believe
the market price is unfair to buyers or sellers.
• Result in government-created price ceilings and
floors.

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 CONTROLS ON PRICES

• Price Ceiling
• A legal maximum on the price at which a good can
be sold.
• Price Floor
• A legal minimum on the price at which a good can
be sold.

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How Price Ceilings Affect Market Outcomes

• Two outcomes are possible when the

government imposes a price ceiling:
• The price ceiling is not binding if set above the
equilibrium price.
• The price ceiling is binding if set below the
equilibrium price, leading to a shortage.

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Figure 1 A Market with a Price Ceiling

(a) A Price Ceiling That Is Not Binding

Price of
Ice-Cream
Cone
Supply

$4 Price
ceiling
3
Equilibrium
price

Demand

0 100 Quantity of
Equilibrium Ice-Cream
quantity Cones
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Figure 1 A Market with a Price Ceiling

(b) A Price Ceiling That Is Binding

Price of
Ice-Cream
Cone
Supply

Equilibrium
price

$3

2 Price
Shortage ceiling

Demand

0 75 125 Quantity of
Quantity Quantity Ice-Cream
supplied demanded Cones
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How Price Ceilings Affect Market Outcomes

• Effects of Price Ceilings

• A binding price ceiling creates
1. shortages because QD > QS.
• Example: Gasoline shortage of the 1970s (base on case
study in the next slide)
2. nonprice rationing
• Examples: discrimination by sellers
Price discrimination happens on areas wherein the same
commodity or services were sold to buyers of different
location but with higher price depending on the income
of the buyers.
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 CASE STUDY: Lines at the Gas Pump

• In 1973, OPEC raised the price of crude

oil in world markets. Crude oil is the
major input in gasoline, so the higher oil
prices reduced the supply of gasoline.
• Who was responsible for this?

• Economists blame government

regulations that limited the price oil
companies could charge for
gasoline.

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Figure 2 The Market for Gasoline with a Price Ceiling

(a) The Price Ceiling on Gasoline Is Not Binding

Price of
Gasoline

Supply, S1
1. Initially,
the price
ceiling
is not
binding . . . Price ceiling

P1

Demand
0 Q1 Quantity of
Gasoline
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Figure 2 The Market for Gasoline with a Price Ceiling

(b) The Price Ceiling on Gasoline Is Binding

Price of S2
Gasoline 2. . . . but when
supply falls . . .

S1
P2

Price ceiling

P1 3. . . . the price
4. . . . ceiling becomes
resulting binding . . .
in a
shortage. Demand
0 QS QD Q1 Quantity of
Gasoline
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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.

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Our Second Model: The Production
Possibilities Frontier
• Concepts Illustrated by the Production
Possibilities Frontier
• Efficiency
• Tradeoffs
• Opportunity Cost
• Economic Growth

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 Figure 2.1 The Production Possibilities Frontier
Quantity of
Computers If an economy is operating at a point
Produced on the production possibilities
curve, all resources are used, and
they are utilized as efficiently as
possible
3,000 D

C
2,200
2,000 A
Production
possibilities
frontier
1,000 B

0 300 600 700 1,000 Quantity of

Cars Produced
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The Production Possibilities Frontier
• Tells us that each point on the curve illustrates an
output combination that is produced given the limited
number of resources.
• However, every point inside the curve (for example,
point B) represents an output combination that is
produced with less than the available resources being
utilized, thus making other resources idle.
• Any point outside of the curve (for example, point D)
indicate that such output combination is unattainable
considering the limited resources of the country.

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 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 advisor.

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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

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 POSITIVE VERSUS NORMATIVE
ANALYSIS
• 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
• Positive or Normative Statements?
• The income gains from a higher minimum wage are
?
worth more than any slight reductions in
employment.
POSITIVE

? • State governments should be allowed to collect

from tobacco companies the costs of treating
smoking-related illnesses among the poor.
NORMATIVE
?
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WHY ECONOMISTS DISAGREE
• They may disagree about the
validity of alternative positive
theories about how the world
works.

• They may have different

values and, therefore,
different normative views
about what policy should try
to accomplish.

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 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.

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 Summary
• Economics is divided into two subfields:
• Microeconomists study decisionmaking by
households and firms in the marketplace.
• Macroeconomists study the forces and trends that
affect the economy as a whole

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 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.

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 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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