Thinking Like an Economist

1 Economics as a Science
Economy doesn’t differ from science. Economists follow scientific method to formulate their theories
about economy. Economists study people. And, unlike electrons, people have a mind of their own.
People can be motivated by all kinds of things and are not so forth coming about their motivations.
People are difficult to predict.

1.1 Scientific Method (by Provost’s observation)

 Pseudoscience: using past data to explain the present. You can’t win Freud. He could explain
anything by blaming it on the past. It is not legitimate.
 Science: using past data to predict the future. (Einstein) was taking a risk, because the future
is uncertain. Freud was not taking a risk. Ex: Time is not linear. That theory is falsifiable. Freud’s
is not.
 See chart in blue phone’s photo gallery.

1.2 Following the Scientific Method Means

1. Make a risky prediction (formulate a falsifiable hypothesis)
2. Go out of your way to prove your hypothesis wrong
3. Be ready to let go of your beloved theory when you face contradictory evidence
4. The more we reject false hypothesis the closer we are to the truth (Being wrong means we’re
crossing out the things that don’t work)

2 The Scientific Method in Economics: Positive vs.

Normative Analysis
2.1 Positive Statement
It’s a statement of fact: It describes how the world is and one can scientifically test its validity.

2.2 Normative Statement

It’s a value-judgement. It describes how the world ought to be and one cannot scientifically test its
validity. (Subjective)

According to A, B is better than C. Is Positive! We can go back to A for validation.

Should  Normative (Check blue phone pics for examples)

3 Microeconomics vs. Macroeconomics
3.1 Microeconomics
The study of how individuals, households, and firms make decisions and how they interact in markets.

 Ex: Price controls of rental units, the effect of sales tax on tobacco, the effect of unionization
on the shipping industry, impact of foreign competition on the automobile industry, impact of
sugar quotas & subsidies.

3.2 Macroeconomics
The study of economy-wide phenomena. Ex: 2008 market crash, 1920s depression.

 Ex: economic growth, inflation, unemployment, income taxation, fiscal and monetary policy.
 You can’t understand macro without micro.
 Economists agree 95% in micro, and disagree in macro. Macro is more complex. Too many
variables and too diverse scientific and value judgements.

4 Models in Economics: The World on the Back of an

Envelope
Model = representation of some aspect of the world. Models can be graphical, theoretical, or
mathematical. A graph is a model.

4.1 To Keep in Mind

1. Models should fit reality, not the other way around
2. The assumptions of models can be simplistic (not 100& realistic) but still useful
3. Faulty assumptions can be dangerous (Simplistic but not faulty)
4. Models are judged by how well they predict

4.2 Tradeoffs in Models: Signal vs. Noise

1. A signal is the pattern underlying the data (pattern of behavior)
2. The noise is a random fluctuation
3. A model that is better at detecting the signal is also better at predicting
4. A model that picks up more noise may be better at explaining interesting anecdotes, but is
worse at predicting.

4.3 Remember
- You can always find an anecdote to support your claim! (Freud: psychologist)
- What you need is to uncover a signal which will give you better predictive power (Einstein)
“The race is not always to the swift, or the battle to the strong” – Bible
“But that’s how you bet” - Economists
5 First Model: The Circular-Flow Diagram
Read the textbook. It’s simple enough there.

6 Second Model: The Production Possibilities Frontier

(PPF)
We don’t compare apples and oranges as we don’t compare time and money. We need a common
denominator. “Suppose you value your time as $10/hour”

If you don’t know, find the indifference point (by graph)

PPF = It’s a graphical representation of the maximum amount of any two products (goods and
services) that can be produced from a fixed set of resources.

Sloping down (because tradeoffs), concave up

Doesn’t tell us price or value. But it does tell efficiency

6.1 The law of increasing opportunity cost

- Opportunity cost is increasing across the PPF
- The points on the graph are efficient
- The points under is inefficient, but possible
- The points over are impossible to achieve

6.2 Examples
- If there is high unemployment, it’ll be under the PPF but the PPF won’t change
- If there’s an improved process for one good, the curve only moves along the axis of that
good, the other axis for the other good doesn’t shift

7 An Application of PPF: To Save or Not to Save

 Time, preference, rate. Kids don’t have the savings mentality adults have.
 Time preference rate; How much would I be willing to accept to postpone my consumption
to the future  different depending on the person
 Tradeoff between consumption and investment.

7.1 Consumer Good

Good used for personal satisfaction

7.2 Capital Good

Good used to produce other goods

[view graph in phone storage; a point left to A on the left graph is possible, but it’d mean starvation
= death. On the right graph, investing makes the PPF shift bigger, more opportunities to further
invest in the future]