Unit 1:

BASIC ECONOMIC CONCEPTS

Subject: Introduction to Economics

Topic 3: THINKING LIKE AN ECONOMIST

Topics
1. The Economist as Scientist
2. The Economist as Policy Adviser
3. Some Economic Tools
a) Choice and Opportunity Cost
b) Comparative, Specialization and Exchange
c) The Economy’s Production Possibility Frontier
4. Why Economist Disagree
5. Some Pitfalls of Faulty Economic Analysis

Objectives

See how economists apply the methods of science

Consider how assumptions and models can shed light on the world
Learn two simple models—the circular flow and the production possibilities frontier
Examine the role of economists in making policy
Consider why economists sometimes disagree with one another

The Economist as Scientist (The Economic Way of Thinking)

 Every field of study has its own terminology.

 For 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

 Economists try to address their subject with a scientist’s objectivity. They approach the
study of the economy in much the same way as a physicist approaches the study of matter
and a biologist approaches the study of life: They devise theories, collect data, and then
analyze these data in an attempt to verify or refute their theories. This is the use of the
scientific method

 The scientific method: observation, theory, and more observation This interplay between
theory and observation also occurs in the field of economics. An economist might live in a
country experiencing rapid increases in prices and be moved by this observation to develop
a theory of inflation. The theory might assert that high inflation arises when the government
prints too much money. (As you may recall, this was one of the Ten Principles of
Economics.) To test this theory, the economist could collect and analyze data on prices and
money from many different countries. If growth in the quantity of money were not at all
related to the rate at which prices are rising, the economist would start to doubt the validity
of his theory of inflation. If money growth and inflation were strongly correlated in
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 international data, as in fact they are, the economist would become more confident in his
theory.

 Although economists use theory and observation like other scientists, they do face an
obstacle that makes their task especially challenging: Experiments are often difficult in
economics.

 Economists make assumptions for the same reason: Assumptions can make the world easier
to understand. To study the effects of international trade, for example, we may assume that
the world consists of only two countries and that each country produces only two goods.

 The art in scientific thinking—whether in physics, biology, or economics—is deciding

which assumptions to make. Similarly, economists use different assumptions to answer
different questions. Suppose that we want to study what happens to the economy when the
government changes the number of peso in circulation. An important piece of this analysis,
it turns out, is how prices respond. Many prices in the economy change infrequently;

 Economists also use models to learn about the world, they are most often composed of
diagrams and equations. Like a biology teacher’s plastic model, economic models omit
many details to allow us to see what is truly important. Just as the biology teacher’s model
does not include all of the body’s muscles and capillaries, an economist’s model does not
include every feature of the economy. Models to examine various economic issues are built
with assumptions.

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.
Recall the steps of a scientific method:
Step 1: Identify the question and define relevant variables
Step 2: Specify assumptions
Step 3: Formulate a hypothesis
Step 4: Test the hypothesis
Conclusion:
• Reject the hypothesis or
• Use the hypothesis until a better one comes comes along

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 economic
behavior assumptions to answer different questions such as:

a) Self-Interest assumption

Economists assume that individuals act as if they are motivated by self-interest and respond
in predictable ways to changing circumstances. This means that self-interest is a good
predictor of human behavior in most situations. Self-interest can include benevolence. Self-

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 interest is not the same as selfishness but simply means that people try to improve their own
situation.

b) Rational Behavior assumption

Economists assume that people, for the most part, engage in rational behavior. Rational
behavior merely means that people do the best they can, based on their values and
information, under current and anticipated future circumstances. Rational individuals weigh
the benefits and costs of their actions and they only pursue actions if they perceive the
benefits to be greater than the costs.

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

There are four economic decision makers in the economy: : households, firms, governments
and the rest of the world. Their interaction determines how the economy’s resources are
allocated. The circular-flow diagram in Figure 1 below offers a simple way of organizing all the
economic transactions that occur between households and firms in the economy.

Households and firms interact in two types of markets. In the markets for goods and services
(or product market), households are buyers and firms are sellers of goods and services.
Households demand the goods and services produced by firms and are the resource owners. In
the markets
for the factors of production (or factor market), households are sellers of factors of production
or inputs and firms are buyers. In these markets, households provide firms the inputs that the
firms use to produce goods and services. These inputs are called the factors of production.
Thus, households own the factors of production and consume all the goods and services that the
firms produce. Firms produce goods and services using inputs, such as labor, land, and capital
(buildings and machines).

Firms, government and the rest of the world demand the resources that households supply and
then use these resources to supply the goods and services that households demand. The rest of
the world includes foreign households, firms and government that supply resources and demand
resources and products.

Markets are the means by which buyers and sellers carry out exchange. Market is a set of
arrangments by which buyers and sellers carry out exchange at mutually agreeable terms
Product market is a market in which a good or service is bought and sold Resource marker is a
market in which a resource is bought and sold

Circular-flow diagram: a visual model of the economy that shows how dollars flow through
markets among households and firms.It is a schematic representation of the organization of the
economy. Decisions are made by households and firms. Households and firms interact in the
markets for goods and services (where households are buyers and firms are sellers) and in the
markets for the factors of production (where firms are buyers and households are sellers). The

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outer set of arrows shows the flow of monney (dollars, peso, etc) and the inner set of arrows
shows the corresponding flow of goods and services.

Revenue Spending
(=GDP) (=GDP)
MARKETS FOR
GOODS AND
Good and SERVICES
Good and
services sold
services
bought

FIRMS HOUSEHOLDS

Inputs for Land, labor

Production and capital
MARKETS FOR
FACTORS OF
PRODUCTION
Income (=GDP)
Wages, rent,
interest and
profit (=GDP)
Flow of goods & services
Flow of money: pesos

THE CIRCULAR FLOW DIAGRAM

Figure 1. Circular flow diagram.

The diagram above represents the transactions between firms and households in a simple
economy. In the upper loop, the arrow emanating from firms to households represents the sale
by firms of goods and services to households. On the other hand, the arrow from households to
firms represents the payments. In the lower loop, the arrow originating from the households to
the firms shows that firms hire labor and capital from households in order to produce goods and
services. The arrow emanating from the firms indicates their payments for the use of the
factors of production.

o Assumption: The economy composed of households and firms only

o Households: own factors of production, consume goods and service
o Firms: hire factors of production to produce goods and services

If with government and foreign agents, need to account for :

a. Government purchases of goods and services.
b. Government payments for factor services (wages, rent, interest).
c. Transfer payments between different agents.
d. Firms and households pay taxes to government.
e. Taxes paid on income, property, goods and services.
f. Transactions with the foreign sector.

Transfer payments – are transactions wherein one party is not obliged to deliver a good or
service in return for the payment. Examples: retirement benefits, unemployment benefits,
scholarships, and donations.

Transactions with foreign sector Includes sales of goods and services, assets, and transfers
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• Exports - sales of domestically produced goods to other countries
• Imports - goods bought from other countries
The Economist As Policy Adviser

Often economists are asked to explain the causes of economic events. Sometimes economists
are asked to recommend policies to improve economic outcomes. For instance, what should
the government do to improve the economic well-being of teenagers? When economists are
trying to explain the world, they are scientists. When they are trying to help improve it, they are
policy advisers. Economists serve as advisers in the policymaking process of the three
branches of government: Legislative, Executive and Judicial

Positive versus Normative Statements

In general, statements about the world are of two types. One type is Positive statements..
Positive statements are descriptive. They make a claim about how the world is. A second type
of statement, such is normative. Normative statements are prescriptive. They make a claim
about how the world ought to be.

A key difference between positive and normative statements is how we judge their validity. We
can, in principle, confirm or refute positive statements by examining evidence. Evaluating
normative statements involves values as well as facts. Normative statement cannot be judged
using data alone. Deciding what is good or bad policy is not merely a matter of science. It also
involves our views on ethics, religion, and political philosophy.

Of course, positive and normative statements may be related. Our positive views about how
the world works affect our normative views about what policies are desirable. For example,
positive statement claim that the minimum wage causes unemployment, if true, might lead us
to reject the normative conclusion that the government should raise the minimum wage. Yet
our normative conclusions cannot come from positive analysis alone. Instead, they require
both positive analysis and value judgments.

Examples:
Positive statements
 Minimum-wage laws cause unemployment.
 A increase in the minimum wage will cause a decrease in employment among the
least-skilled.
 Higher budget deficits will cause interest rates to increase.

Normative:
 The government should raise the minimum wage.
 State governments should be allowed to collect from tobacco companies the costs
of treating smoking-related illnesses among the poor.

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

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 Some government agencies that collect economic data and make economic policy:
National Statistics and Development Board
Department of Trade and Industry
Department of Labor and Employment
National Statistics Office
Bureau of Agricultural Statistics
Congressional Budget Office
Federal Reserve Board/BSP

Why Economist Disagree?

Why do economists so often appear to give conflicting advice to policymakers? There are
two basic reasons:
1) Differences in scientific judgments. Economists may disagree about the validity of
alternative positive theories about how the world works. Economists sometimes
disagree because they have different hunches about the validity of alternative
theories or about the size of important parameters.
2) Differences in values. Economists may have different values and, therefore,
different normative views about what policy should try to accomplish.

In many cases, however, economists do offer a united view.

Perceptions versus Reality

Because of the above differences, some disagreement among economists is inevitable. This
amount of disagreement however should not be overstated. Economists agree with one
another far more than is sometimes understood

Pitfalls to Avoid in Scientific Thinking

1. Confusing correlation and causation. Correlation – when two events occur together.
Causation – when one event brings about another event. The fact that two events usually
occur together (correlation) does not necessarily mean that once caused the other to occur
(causation).
2. The fallacy of composition – this means that even something is true for an individual, it is
not necessarily true for many individuals as a group.

Some Tools of Economic Analysis

1. Choice and Opportunity Cost

2. Comparative, Specialization and Exchange
3. The Economy’s Production Possibility Frontier

Choices, Opportunity Costs and Trade-offs

The opportunity cost of a choice is the benefit expected from the best alternative that is
foregone. Everybody faces scarcity and any activity we engage has an opportunity cost
associated with it. Opportunity costs are subjective. Each individual must calculate the

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expected value of the best alternative for himself because the opportunity cost of any activity is
the value of the best alternative choice that is foregone and different people have different
alternative choices, opportunity cost differ for different people. We do what we do because we
have nothing better to do. If we had something better to do, we would do it. Calculating
opportunity cost requires time and information. Because we do not have enough time taking
information, often we do not know the true value of the forsaken alternative, so we make
mistakes. Opportunity cost may also vary with circumstances.

Sunk cost is a cost that cannot be recovered no matter what you do. Sunk costs should be
ignored in making decisions

 Scarcity forces us to choose, means we all have to make choices. The essence of
economics is to understand fully the implications that scarcity has for wise decision making.
In a world of scarcity, we all face tradeoffs. Society too must make tradeoffs.
 Every choice involves a cost. The highest forgone opportunity resulting from a decision is
called opportunity cost. Another way to put it is that “to choose is to lose” or “an opportunity
cost is an opportunity lost”. Thus, opportunity cost is what you give up when you make a
choice.
 When we are forced to choose, we give up the next highest valued alternative

Specialization, Comparative Advantage and Exchange

 We all specialize. People tend to dedicate their resources to one primary activity, whether it
be child rearing, driving a car, and so on because of opportunity cost. Specializing is
concentrating in the production of one or a few goods. This focus allows them to make the
best use of their limited resources
 Specialization is important for individuals, businesses, regions, and nations, that is by
specializing in the production of the good in which they have comparative advantage.
Comparative advantage occurs when a person or country can produce a good or service at
a lower opportunity cost than others.

The Law of Comparative Advantage. Combined output can increase when the individual with
the lowest opportunity cost for producing a particular good specializes in producing that good.
Dividing production in accordance with the law of comparative advantage leads to increase
production. Since all people are not efficient in producing all goods and services, total output is
greater when each individual specializes in producing the goods or services that she/he can
produce more relatively more efficiently.

A person has an absolute advantage when he/she can perform tasks with fewer resources
than any other person. A person has a comparative advantage when he/she can produce a
given product at a lower opportunity cost than someone else. Each person should specialize in
the task fro which he/she has a comparative advantage. The law of comparative advantage
applies to firms, regions and nations as well as to individuals.

 The advantages of specialization are: (a) employees acquire greater skill from repetition,
(b) employees avoid wasted time in shifting from one task to another, (c) employees do
types of work for which they are best suited, and (d) specialization promotes the use of
specialized equipment for specialized tasks.

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 Specialization and trade lead to greater wealth and prosperity. Trade, or voluntary
exchange, directly increases wealth by making both parties better off. Trade increases
wealth by allowing a person or a nation to specialize in those products that it produces at a
lower opportunity cost and to trade them for products that others produce at a lower
opportunity cost. The economy can also create more wealth when each person specializes
in a task that he or she does best.
 Barter is a system in which products are exchanged directly for other products
 Money is a medium of exchange because everyone is willing to accept it in exchange for
goods and services. Money makes it easier to exchange goods and services.
 In order take advantage of comparative advantage, resources must specialize.
Specialization implies that people do not produce most of the goods and services that they
wish to consume. Further, people do not produce a single product by themselves
 Because of comparative advantage and specialization, people do not produce most of the
things they want and must enter into exchange to acquire them. This specialization is
generally part of the division of labor- the separating of production into various tasks and
the assigning of individuals to these separate tasks.
 Division of labor is productive for several reasons:
a) Tasks can be assigned according to preference and abilities
b) As people perform the same task over and over, they become better at them
c) There is no time lost in moving from one task to another
d) Specialization of labor allows for the introduction of more sophisticated techniques

Specialization and Trade

Specilizing is concentrating in the production of one, or few, goods. This focus allows people to
make the best use (and thus gain the most benefit from) of their resources. People specialize
because by concentrating their energies on the activities to which they are best suited,
individuals incurlower opportunity costs. If they can produce a good or service at a lower
opportunity cost than others, we say that they have a comparative advantage in the production
of that good or service.

We all specialize to some extent and rely on others to produce most of the goods and services
we want. The work that we choose to do reflects our specialization.

Advantages of Specialization:

a) Employees acquire greater skill from repetition

b) Wated time from shifting from one task to another is avoided.
c) Employees do the type of work for which they are best suited
d) Promotes the use of specialized equipment for specialized task

Specialization and trade Lead to Greater Wealth and Prosperity

Trade, or volunary exchange, directly increases wealth by making both parties better off (or
they would’t trade. Trade increases wealth by allowing a person, a region, or a nation to
specialize in those products that it produces at a lower opportunity cost and to trade them for
products that others propduce at lower opportunity cost. Exploiting our comparative advantage,
and then trading, allows us to produce, and therefore consume, more than we could otherwise
from our scarce resources.
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The Economy’s Production Possibilities – (the second model)

Production possibilities frontier: a graph that shows the combinations of output that the
economy canpossibly produce given the available factors of production and theavailable
production technology. The economy can produce any combination on or inside the frontier.
Points outside the frontier are not feasible given the economy’s resources.

An outcome is said to be efficient if the economy is getting all it can from the scarce resources
it has available. Points on (rather than inside) the production possibilities frontier represent
efficient levels of production. When the economy is producing at such a point, say point A,
there is no way to produce more of one good without producing less of the other. Point B
represents an inefficient outcome. For some reason, perhaps widespread unemployment, the
economy is producing less than it could from the resources it has available:

The production possibilities frontier is bowed outward. This means that the opportunity cost of
one good say cars in terms of another good (computers) depends on how much of each good
the economy is producing. When the economy is using most of its resources to make cars, the
production possibilities frontier is quite steep. Because even workers and machines best suited
to making computers are being used to make cars, the economy gets a substantial increase in
the number of computers for each car it gives up. By contrast, when the economy is using
most of its resources to make computers, the production possibilities frontier is quite flat. In this
case, the resources best suited to making computers are already in the computer industry, and
each car the economy gives up yields only a small increase in
the number of computers.

The production possibilities frontier shows the tradeoff between the production of different
goods at a given time, but the tradeoff can change over time. For example, if a technological
advance in the computer industry raises the number of computers that a worker can produce
per week, the economy can make more computers for any given number of cars. As a result,
the production possibilities frontiershifts outward, Because of this economic growth, society
might move to more computers and more cars. The production possibilities frontier simplifies a
complex economy to highlight and clarify some basic ideas.

Assumptions:
 Fixed resources
 Fully employed resources
 Technology unchange

1. Efficiency and the Production Possibilities Frontier (PPF)

 The production possibilities frontier describes the possible combinations of two
goods that can be produced when resources are used fully and efficiently. It is
constructed for a given amount of resources and a given level of technology
 Resources are used efficiently when they cannot be combined differently in any
way that would increase the production of one good without decreasing the

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 production of the other good. At any point on the PPF, more of one good can be
produced only by producing less of the other.

Inefficient and Unattainable Production

 Points inside the PPF represent combinations of the two goods that are produced
inefficiently
 Points outside the PPF represent combinations of the two goods that cannot be
attained, give society’s resources and technology

2. Shape of the Production Possibilities Frontier

 The PPF slopes down because when resources are used fully and efficiently, more
of one good can be produced only by producing less of the other good
 The PPF is bowed out when not all resources are equally productive in producing
both goods
 The law of increasing opportunity cost applies to production of both goods: as
additional units of one good are produced, more and more of the other good must
be sacrificed

3. What can Shift the Production Possibilities Frontier

 Over time the PPF may shift out or in

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  Shift in PPF will occur as a result of:
a) Changes in resource availability
b) Increases in the capital stock
c) Effects of technological change

4. What we can Learn from the PPF

a) The PPF demonstrates efficiency because it describes the efficient combinations of
output that are possible
b) The PPF demonstrates scarcity because there is a limit to what can be produced
c) The downward slope of the PPF indicates opportunity cost
d) The bowed shape of the PPF indicates the law of increasing opportunity cost
e) The PPF illustrates the need to make choices
f) Outward shift in the PPF reflect economic growth

Other tools

Economic Analysis is a Marginal Analysis

 Marginal means “incremental” or “decremental”. Incremental, additional or extra; used
to describe a change in an economic variable.
 Economic choise is based on a comparison of the expected marginal benefit and the
expected marginal cost of the action under consideration
 An individual decision maker changes his or her behavior whenever the expected
marginal benefit from doing so is greater than the expected marginal cost

 Economists are usually interested in the effects of additional, or marginal, changes in a

given situation. Many choices we face involve marginal thinking. Marginal thinking is
focusing on the additional or marginal choices; marginal choices involve the effects of
adding or subtracting, from the current situation, the small (or large) incremental changes
to a plan of action.
 People try to make themselves better off. People make decision based on what they
expect to happen. Individual will pursue an activity or alter their behavior if they expect the
marginal benefits to be greater than the marginal costs, which is the rule of rational choice.
 The optimal (best) level of pollution, crime and safety are greater than zero. Zero pollution
would be too far costly in terms of what we have to give up.
 Marginal thinking is focusing on the additional or marginal, choices; marginal choices
involve the effects of adding or subtracting, from the current situation, the small (large)
incremental changes to a plan of action. Many choices we face involve marginal thinking. It
is how much of something to do rather than whether to do something. It is not whether you
eat but how nmuch you eat. For people to make themselves better off, they alter their
behavior if the expected marginal benefits from doing so outweigh the expectged marginal
costs, which is the rule of rational choice. It means that individuals will pursue an activity if
the expected marginal benefits are greater than the expected marginal costs.
 Economic theory is often called marginal analysis because it assumes that people are
always weighing the expected marginal benefits against the expected marginal costs. Net
benefit is the difference between the expected marginal benefits and the expected marginal
costs.

Markets and Improved Efficiency

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Efficiency – is when an economy gets the most out of its scarce resources. The market
economy provides a way for millions of producers and consumers to allocate resources.
Markets simply provide what buyers are willing and able to pay for and what sellers are willing
and able to produce. Buyers and sellers indicate their wants through their action and inaction
in the market place and it is this collective “voice” that determines how resources are allocated.
Market prices serve as the language of the market system. The market acts to bring about the
level of prices that allows buyers and sellers to coordinate their plans.

 In a world of scarcity, competition is inescapable and one method of allocating resources

among competing resources is the market economy.
 Competitive markets are powerful – they make existing products better and/or less
expensive, they can improve production processes and they can create new products.
Buyers and sellers indicate their wants through their action and inaction in the marketplace
and it is a collective “voice” that determines how resources are allocated.
 Market prices communicate important information to buyers and sellers. The prices
charged by suppliers communicate the relative availability of products to consumers; the
prices consumers are willing to pay communicate the relative value consumers place on
products to producers. That is, market prices provide a way for both consumers and
suppliers to communicate about the relative value of resources
 What effect do price controls have on the market system? It distorts market signals. Price
controls – both price floors and price ceilings – are government-mandated minimum or
maximum prices.Prices are set above or below what they would be in a market economy.
Government policies sometimes force prices above or below what they would be in a
market economy. Price controls effectively strip the market price of its meaning for both
buyers and sellers. Price controls prevent the market from communicating relevant
information between consumers and suppliers. A price floor set above the market price
prevents suppliers from communicating their willingness to sell for less to consumers. A
price ceiling set below the market pricve prevents consumers from indicating their
willingness to pay more to suppliers.

 Market prices provide important information. The prices charged by suppliers communicate
the relative availability of products to consumers; the prices consumers are willing to pay
communicate the relative value consumers place on products to producers. That is, market
prices provide a way for both consumers and suppliers to communicate about the relative
value of resources.

 When the economy fails to allocate resources efficiently on its own is called market
failure. Such situations represent such as externalities – where costs be imposed on some
individuals without their consent and monopoly – where firms may have market power to
distort prices in their favor, and where information in the market may not be communicated
honestly and accurately and where firms may have market power to distort prices in their
favor

SUMMARY

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Steps in Model Building Process

Identify the Collect data, test

Develop a model the model, and
Problem
based on formulate a
simplified conclusion
assumptions

Links between scarcity, choice and opportunity cost

Economics is the study of how individuals and society choose to allocate scarce resources to
satisfy unlimited wants. Faced with unlimited wants and scarce resources, we must make
resources among alternatives

Unlimited wants Scarcity Society chooses

Scarcity Opportunity
Choice Cost

Scarcity means no society has enough resources to produce all the goods and services to
satisfy all human wants. As a result, society is always confronted with the problem of making
choices. This means that each decision has a sacrifice in terms of an alternative not chosen

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