Thinking like an Economist

Thinking Like an Economist
Every field of study has its own terminology
Mathematics
integrals ❖ axioms ❖ vector spaces
Psychology
ego ❖ id ❖ cognitive dissonance
Law
promissory ❖ estoppel ❖ torts ❖ venues
Economics
supply ❖ opportunity cost ❖ elasticity ❖ consumer surplus ❖ demand ❖ comparative advantage ❖ deadweight loss

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.

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

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.

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.

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

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.

Figure 1 The Circular Flow
Copyright © 2004 South-Western
Spending
Revenue
Income
= Flow of inputs
and outputs
= Flow of dollars

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

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

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

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.

Figure 2 The Production Possibilities Frontier
Copyright©2003 Southwestern/Thomson Learning
Quantity of
Cars Produced
0
3,000
1,000
Quantity of
Computers
Produced

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

Figure 3 A Shift in the Production Possibilities Frontier
Copyright © 2004 South-Western
Quantity of
Cars Produced
0
Quantity of
Computers
Produced

Microeconomics and Macroeconomics
Microeconomics focuses on the individual parts of the economy.
How households and firms make decisions and how they interact in specific markets
Macroeconomics looks at the economy as a whole.
Economy-wide phenomena, including inflation, unemployment, and economic growth

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.

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

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
?
?
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.
NORMATIVE
State governments should be allowed to collect from tobacco companies the costs of treating smoking-related illnesses among the poor.
NORMATIVE
?
?
POSITIVE VERSUS NORMATIVE ANALYSIS
?

Economists in Washington
. . . serve as advisers in the policymaking process of the three branches of government:
Legislative
Executive
Judicial

Economists in Washington
Some government agencies that collect economic data and make economic policy:
Department of Commerce
http://www.commerce.gov
Bureau of Labor Statistics
http://www.bls.gov
Congressional Budget Office
http://www.cbo.gov
Federal Reserve Board
http://www.federalreserve.gov

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.

Table 2 Ten Propositions about Which Most Economists Agree
Copyright © 2004 South-Western

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.

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

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.