Ten Principles of Economics 2

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In this chapter, look for the answers to these questions:

What are economists’

In this chapter, look for the answers to these questions: What are
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 and macroeconomics? Between positive and normative?

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THINKING LIKE AN ECONOMIST

The Economist as Scientist

Economists play two roles:
1. Scientists: try

THINKING LIKE AN ECONOMIST The Economist as Scientist Economists play two roles:
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.

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Assumptions & Models

Assumptions simplify the complex world, make it

THINKING LIKE AN ECONOMIST Assumptions & Models Assumptions simplify the complex world,
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.
Model: a highly simplified representation of a more complicated reality. Economists use models to study economic issues.

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THINKING LIKE AN ECONOMIST

Some Familiar Models

A road map

THINKING LIKE AN ECONOMIST Some Familiar Models A road map

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Some Familiar Models

A model of human anatomy from high

THINKING LIKE AN ECONOMIST Some Familiar Models A model of human anatomy
school biology class

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THINKING LIKE AN ECONOMIST

Some Familiar Models

A model airplane

THINKING LIKE AN ECONOMIST Some Familiar Models A model airplane

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THINKING LIKE AN ECONOMIST

Some Familiar Models

The model teeth at the dentist’s office

THINKING LIKE AN ECONOMIST Some Familiar Models The model teeth at the dentist’s office

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THINKING LIKE AN ECONOMIST

Our First Model: The Circular-Flow Diagram

The Circular-Flow Diagram: a

THINKING LIKE AN ECONOMIST Our First Model: The Circular-Flow Diagram The Circular-Flow
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”

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THINKING LIKE AN ECONOMIST

Factors of Production

Factors of production: the resources the economy

THINKING LIKE AN ECONOMIST Factors of Production Factors of production: the resources
uses to produce goods & services, including
labor
land
capital (buildings & machines used in production)
Entrepreneurship

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FIGURE 1: The Circular-Flow Diagram

Households:
Own the factors of production,

THINKING LIKE AN ECONOMIST FIGURE 1: The Circular-Flow Diagram Households: Own the
sell/rent them to firms for income
Buy and consume goods & services

Firms:
Buy/hire factors of production, use them to produce goods and services
Sell goods & services

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FIGURE 1: The Circular-Flow Diagram

THINKING LIKE AN ECONOMIST FIGURE 1: The Circular-Flow Diagram

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Our Second Model: The Production Possibilities Frontier

The Production Possibilities

THINKING LIKE AN ECONOMIST Our Second Model: The Production Possibilities Frontier The
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.

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PPF Example

Producing one computer requires 100 hours labor.
Producing one ton of wheat

PPF Example Producing one computer requires 100 hours labor. Producing one ton
requires 10 hours labor.

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THINKING LIKE AN ECONOMIST

A

B

C

D

E

PPF Example

THINKING LIKE AN ECONOMIST A B C D E PPF Example

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A. On the graph, find the point that represents (100 computers, 3000 tons

A. On the graph, find the point that represents (100 computers, 3000
of wheat), label it F. Would it be possible for the economy to produce this combination of the two goods? Why or why not?
B. Next, find the point that represents (300 computers, 3500 tons of wheat), label it G. Would it be possible for the economy to produce this combination of the two goods?

A C T I V E L E A R N I N G 1 Points off the PPF

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A C T I V E L E A R N I

A C T I V E L E A R N I
N G 1 Answers

Point F: 100 computers, 3000 tons wheat

Point F requires 40,000 hours of labor. Possible but not efficient: could get more of either good w/o sacrificing any of the other.

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A C T I V E L E A R N I

A C T I V E L E A R N I
N G 1 Answers

Point G: 300 computers, 3500 tons wheat

Point G requires 65,000 hours of labor. Not possible because economy only has 50,000 hours.

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The PPF: What We Know So Far

Points on the

THINKING LIKE AN ECONOMIST The PPF: What We Know So Far Points
PPF (like A – E)
possible
efficient: all resources are fully utilized
Points under the PPF (like F)
possible
not efficient: some resources underutilized (e.g., workers unemployed, factories idle)
Points above the PPF (like G)
not possible

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The PPF and Opportunity Cost

Recall: The opportunity cost of

THINKING LIKE AN ECONOMIST The PPF and Opportunity Cost Recall: The opportunity
an item is what must be given up to obtain that item.

Moving along a PPF involves shifting resources (e.g., labor) from the production of one good to the other.
Society faces a tradeoff: Getting more of one good requires sacrificing some of the other.
The slope of the PPF tells you the opportunity cost of one good in terms of the other.

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The PPF and Opportunity Cost

The slope of a line

THINKING LIKE AN ECONOMIST The PPF and Opportunity Cost The slope of
equals the “rise over the run,” the amount the line rises when you move to the right by one unit.

–1000

100

= –10

Here, the opportunity cost of a computer is 10 tons of wheat.

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A C T I V E L E A R N I

A C T I V E L E A R N I
N G 2 PPF and Opportunity Cost

In which country is the opportunity cost of cloth lower?

FRANCE

ENGLAND

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A C T I V E L E A R N I

A C T I V E L E A R N I
N G 2 Answers

FRANCE

ENGLAND

England, because its PPF is not as steep as France’s.

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Economic Growth and the PPF

With additional resources or an

THINKING LIKE AN ECONOMIST Economic Growth and the PPF With additional resources
improvement in technology, the economy can produce more computers,

more wheat,

or any combination in between.

Economic growth shifts the PPF outward.

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The Shape of the PPF

The PPF could be a

THINKING LIKE AN ECONOMIST The Shape of the PPF The PPF could
straight line, or bow-shaped
Depends on what happens to opportunity cost as economy shifts resources from one industry to the other.
If opp. cost remains constant, PPF is a straight line.
(In the previous example, opp. cost of a computer was always 10 tons of wheat.)
If opp. cost of a good rises as the economy produces more of the good, PPF is bow-shaped.

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Why the PPF Might Be Bow-Shaped

As the economy shifts

THINKING LIKE AN ECONOMIST Why the PPF Might Be Bow-Shaped As the
resources from beer to mountain bikes:
PPF becomes steeper
opp. cost of mountain bikes increases

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THINKING LIKE AN ECONOMIST

A

Why the PPF Might Be Bow-Shaped

At point A, most

THINKING LIKE AN ECONOMIST A Why the PPF Might Be Bow-Shaped At
workers are producing beer, even those that are better suited to building bikes.
So, do not have to give up much beer to get more bikes.

Mountain Bikes

Beer

At A, opp. cost of mtn bikes is low.

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THINKING LIKE AN ECONOMIST

B

Why the PPF Might Be Bow-Shaped

At B, most workers

THINKING LIKE AN ECONOMIST B Why the PPF Might Be Bow-Shaped At
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, would cause a big drop in beer output.

Mountain Bikes

Beer

At B, opp. cost of mtn bikes is high.

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Why the PPF Might Be Bow-Shaped

So, PPF is bow-shaped

THINKING LIKE AN ECONOMIST Why the PPF Might Be Bow-Shaped So, PPF
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 different uses).

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The PPF: A Summary

The PPF shows all combinations of

THINKING LIKE AN ECONOMIST The PPF: A Summary The PPF shows all
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 cost.

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Microeconomics and Macroeconomics

Microeconomics is the study of how households

THINKING LIKE AN ECONOMIST Microeconomics and Macroeconomics Microeconomics is the study of
and firms make decisions and how they interact in markets.
Macroeconomics is the study of economy-wide phenomena, including inflation, unemployment, and economic growth.
These two branches of economics are closely intertwined, yet distinct – they address different questions.

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The Economist as Policy Advisor

As scientists, economists make positive statements, which attempt

The Economist as Policy Advisor As scientists, economists make positive statements, which
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.
Govt 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 2005.

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A C T I V E L E A R N I

A C T I V E L E A R N I
N G 3 Identifying positive vs. normative

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 video rentals.

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A C T I V E L E A R N I

A C T I V E L E A R N I
N G 3 Answers

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.

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A C T I V E L E A R N I

A C T I V E L E A R N I
N G 3 Answers

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 video rentals.
Positive – describes a relationship. Note that a statement need not be true to be positive.

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Why Economists Disagree

Economists often give conflicting policy advice.
They

THINKING LIKE AN ECONOMIST Why Economists Disagree Economists often give conflicting policy
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.

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Propositions about Which Most Economists Agree (and % who

THINKING LIKE AN ECONOMIST Propositions about Which Most Economists Agree (and %
agree)

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…

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Propositions about Which Most Economists Agree (and % agreeing)

The

THINKING LIKE AN ECONOMIST Propositions about Which Most Economists Agree (and %
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 of pollution ceilings. (78%)

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FYI: Who Studies Economics?

Ronald Reagan, President of the United States
Barbara Boxer, U.S.

FYI: Who Studies Economics? Ronald Reagan, President of the United States Barbara
Senator
Sandra Day-O’Connor, Former Supreme Court Justice
Anthony Zinni, Former General, U.S. Marine Corps
Kofi Annan, Former Secretary General, United Nations
Meg Witman, Chief Executive Officer, eBay
Steve Ballmer, Chief Executive Officer, Microsoft
Arnold Schwarzenegger, Governor of California, Actor
Ben Stein, Political Speechwriter, Actor, Game Show Host
Mick Jagger, Singer for the Rolling Stones
John Elway, NFL Quarterback
Tiger Woods, Golfer
Diane von Furstenburg, Fashion Designer
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