Thinking Like an Economist: Chapter 2 Study Notes

Thinking Like an Economist

Overview

This chapter introduces the foundational methods and models used by economists to analyze the world. It explains the roles of economists, the use of models, and key concepts such as the circular-flow diagram and the production possibilities frontier (PPF). It also distinguishes between microeconomics and macroeconomics, and between positive and normative statements.

The Roles of Economists

Scientists vs. Policy Advisors

• Scientists: Economists try to explain the world by developing and testing theories using the scientific method.

• Policy Advisors: Economists recommend policies to improve economic outcomes, often involving value judgments.

As scientists, economists:

• Collect and analyze data (observation).

• Develop theories based on observed data.

• Evaluate theories with further observation.

• Cannot use laboratory experiments, so they rely on natural experiments from history.

Assumptions and Models in Economics

Assumptions

• Economists make assumptions to simplify the complex world and make it easier to understand.

Economic Models

• Models omit many details to focus on what is truly important.

• They are built with assumptions and are subject to revision as new information becomes available.

The Circular-Flow Diagram

Definition and Structure

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

• There are two main decision makers: households and firms.

• They interact in two types of markets:

  • Market for goods and services: Firms sell, households buy.

  • Market for factors of production (inputs): Households sell, firms buy (factors include labor, land, capital).

Actors	Roles in Factor Market	Roles in Goods & Services Market
Households	Sell factors of production	Buy goods and services
Firms	Buy factors of production	Sell goods and services

Flows: Money flows from households to firms as spending, and from firms to households as income (wages, rent, profit).

The Production Possibilities Frontier (PPF)

Definition

• The production possibilities frontier (PPF) is a graph that shows the various combinations of output that the economy can possibly produce given the available factors of production and technology.

Example

Suppose a country produces only airplanes and soybeans. With fixed resources and technology, the following combinations are possible:

Airplanes	Tons of Soybeans
0	5,000
20	4,000
50	2,500
80	1,000
100	0

Points on the PPF (e.g., A-E) are efficient (all resources fully utilized). Points inside the PPF are inefficient (resources underutilized), and points outside are not feasible.

Opportunity Cost and the Slope of the PPF

• Moving along the PPF involves shifting resources from one good to another, illustrating the concept of opportunity cost.

• The slope of the PPF at any point shows the opportunity cost of one good in terms of the other.

Example Calculation:

• To produce the first 1,000 tons of soybeans, the economy gives up 20 airplanes.

• Opportunity cost of 1 airplane: $\frac{1000}{20} = 50$ tons of soybeans.

• Opportunity cost of 1 ton of soybeans: $\frac{20}{1000} = 0.02$ airplanes.

Economic Growth and the PPF

• With additional resources or improved technology, the PPF shifts outward, allowing more of both goods to be produced.

The Shape of the PPF

• Straight-line PPF: Constant opportunity cost (resources are equally adaptable for both goods).

• Bowed-outward PPF: Increasing opportunity cost (resources are not equally adaptable; as more of one good is produced, increasingly more of the other must be given up).

Why Bowed Outward? Different workers have different skills, and resources have varying opportunity costs.

Microeconomics vs. Macroeconomics

• Microeconomics: The study of how households and firms make decisions and interact in markets.

• Macroeconomics: The study of economy-wide phenomena, such as inflation, unemployment, and economic growth.

Positive vs. Normative Statements

• Positive statements: Descriptive; attempt to describe the world as it is. Can be confirmed or refuted by evidence.

• Normative statements: Prescriptive; attempt to prescribe how the world should be. Involve value judgments and cannot be confirmed or refuted by evidence.

Examples:

• "Prices rise when the government increases the quantity of money." (Positive)

• "The government should print less money." (Normative)

Economists in Policy and Government

• Economists serve as advisers in various government agencies, including:

  • Council of Economic Advisers

  • Office of Management and Budget

  • Department of the Treasury

  • Department of Labor

  • Department of Justice

  • Congressional Budget Office

  • The Federal Reserve

Despite expert advice, policy decisions are influenced by many factors, including political and communication advisers.

Why Economists Disagree

• Differences in scientific judgments (validity of theories, size of parameters).

• Differences in values or political philosophies (normative views).

• Despite disagreements, there are many propositions on which most economists agree (e.g., tariffs reduce welfare, rent ceilings reduce housing quality).

Summary Table: Propositions Most Economists Agree On

Proposition	Percent Agree
Rent ceilings reduce quantity and quality of housing	93%
Tariffs and import quotas reduce economic welfare	93%
Outsourcing should not be restricted	90%
Agricultural subsidies should be eliminated	85%
Cash payments increase welfare more than in-kind transfers	84%
Large federal budget deficit has adverse effects	83%
Minimum wage increases unemployment among young/unskilled	79%

Key Terms and Concepts

• Scientific Method: Systematic approach to research involving observation, theory development, and empirical testing.

• Model: Simplified representation of reality used to analyze economic situations.

• Opportunity Cost: The value of the next best alternative foregone when making a choice.

• Efficiency: Using resources in such a way as to maximize the production of goods and services.

• Tradeoff: The idea that to gain something, something else must be given up.

Summary

• Economists use models and the scientific method to analyze the world.

• The circular-flow diagram and PPF are foundational models in economics.

• Microeconomics focuses on individual decision-makers; macroeconomics on the economy as a whole.

• Positive statements describe the world; normative statements prescribe policies.

• Disagreements among economists arise from differences in scientific judgments and values, but consensus exists on many core issues.