CHAPTER 2

THINKING LIKE AN
ECONOMIST
 Contents

1 Roles of economists

2 Models in economics

3 Circular-flow diagram

4 Production possibilities frontier

5
5 Microeconomics and Macroeconomics

CHAPTER 2 THINKING LIKE AN ECONOMIST LOGO

 Roles of economist

Economist

Scientists: Policy
advisors:
try to explain the
world try to improve it

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 The economist as
a scientist
In the first,
economists employ
the
scientific method,
the dispassionate
development and
testing of theories
about how the world
works

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 The scientific method
Observation , theory and more observation

Newton’s theory of gravity

Theory of inflation

Obstacle for economist

Natural experiments from history

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 The role of
Assumption
Assumptions simplify the complex world,
make it 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.
The art in scientific thinking is deciding
which assumption to make.

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 Economic Models

The Circular Flow Diagram

The Production Possibilities Frontier

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 The Circular-Flow
Diagram
The Circular-Flow Diagram: A visual model of
the economy, shows how money 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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 The Circular Flow

MARKETS
Revenue FOR Spending
GOODS AND SERVICES
Goods •Firms sell Goods and
and services •Households buy services
sold bought

FIRMS HOUSEHOLDS
•Produce and sell •Buy and consume
goods and services goods and services
•Hire and use factors •Own and sell factors
of production of production

Factors of MARKETS Labor, land,

production FOR and capital
FACTORS OF PRODUCTION
Wages, rent, •Households sell Income
and profit •Firms buy
= Flow of inputs
and outputs
= Flow of revenue

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 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.

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 Figure 2 The Production Possibilities Frontier
Quantity of
Computers
Produced

3,000 D

C
2,200
2,000 A
Production
possibilities
frontier
1,000 B

0 300 600 700 1,000 Quantity of

Cars Produced LOGO
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 The Production
Possibilities Frontier
Concepts Illustrated by the Production
Possibilities Frontier
 Efficiency
 Tradeoffs
 Opportunity Cost
 Economic Growth

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 Figure 3 A Shift in the Production Possibilities Frontier

Quantity of
Computers
Produced

4,000

3,000

2,100 E
2,000
A

0 700 750 1,000 Quantity of

Cars Produced LOGO
Copyright © 2004 South-Western
 Microeconomics and
Macroeconomics

Economics

Micro- Macro-
economics economics
focuses on the looks at the economy
individual parts of as a whole
the economy

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 The Economist as
Policy Advisor

 When they are trying to explain the world,

they are scientists

When they are trying to change the world,

they are policy advisor

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 Positive versus
normative analysis
Example :-

Polly : Minimum wage laws cause

unemployment.

Norma : The government should raise the

minimum wages.

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 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

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 Positive versus
normative analysis
Positive or Normative Statements?

 An increase in the minimum wage will cause a

decrease in employment among the least-
skilled.

 State governments should be allowed to

collect from tobacco companies the costs of
treating smoking-related illnesses among the
poor.

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 Economists in
Washington
President Harry Truman once said that he
wanted to find a one armed economists.
When he asked his economist for advice
they answered, ” On the one hand ,…On
the other hand…”.
Since 1946 the Presidents of U.S. has
received guidance from Council of
Economic advisers.

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 Why Economists
Disagree
 Economists may disagree about the
validity of alternative positive theories
about how the world works

 Economists may have different values

and, therefore, different normative views
about what policy should try to accomplish

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 Why Economists
Disagree

Differences in scientific judgments

Differences in values

Perception v/s reality

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 Propositions Which
Economists Agree

Differences in scientific judgments

Differences in values

Perception v/s reality

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 SUMMARY
 As scientists, economists try to explain the world
using models with appropriate assumptions.
 Two simple models are the Circular-Flow Diagram
and the Production Possibilities Frontier.
 Microeconomics studies the behavior of consumers
and firms, and their interactions in markets.
Macroeconomics studies the economy as a whole.
 As policy advisers, economists offer advice on how
to improve the world.

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