© 2011 thomson south-western the principles of personal decision making are:the principles of...

© 2011 Thomson South-Western

• The principles of personal decision making are:• People face trade-offs.• The cost of something is what you give up to get it. • Rational people think at the margin.• People respond to incentives.

Principles of Economics Recap


• The principles of economic interaction are:• Trade can make everyone better off.• Markets are usually a good way to organize

economic activity. • Governments can sometimes improve market

outcomes.

Principles of Economics Recap


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


What does it mean to ‘Think Like an Economist’?

Think in terms of alternatives Tradeoffs people face Opportunity cost of decisions people make Marginal benefits vs. marginal costs of a decision

Evaluate the cost (benefit) of individual and social choices Identify externalities

Understand rationale behind public policies Overcome market failures or internalize externalities


The Economist as Scientist

• Applies Scientific Method• Develops theories, collects and analyzes data to

evaluate the theories.• Observations to develop hypotheses• Data to test/evaluate the hypotheses• If supported, it becomes a theory• If not, it is modified and then evaluated again

• Uses abstract models to help explain how a complex, real world operates.


Applying the Scientific Method

• Hypothesis (based on Observations):• The Standard of Living depends on a country’s

ability to produce goods and services.• That is, GDP depends on Productivity

• Collect data:• GDP data & Productivity data

• Test the hypothesis:• Does the data support the hypothesis?


Applying the Scientific Method

• Hypothesis (based on Observations):• Housing Vouchers help low-income households

live near higher performing public schools

• Collect data:• Where housing voucher holders live, and

performance of public elementary schools

• Test the hypothesis:• Does the data support the hypothesis?

• No, in fact housing voucher holders live near lower performing public schools than other households with similarly low income


• Economists make assumptions in order to make the world easier to understand.• 2 products vs. 1 billion products

• The art in scientific thinking is deciding which assumptions to make.• When is it appropriate to assume prices are fixed?

• Economists use different assumptions to answer different questions.• Short run effects of printing more money?

• Assume prices are fixed

• Long run effects of printing more money?• Assume all prices change

Why do Economists make Assumptions?


Simplifying the Economy with Models

• Economists use models to simplify reality in order to improve our understanding of the world.

• Two of the most basic economic models are:• 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

• Households sell• Firms buy

MARKETSFOR

FACTORS OF PRODUCTION

• Firms sell• Households buy

MARKETSFOR

GOODS AND SERVICES


Factors of Production

• What are the Factors of Production?• Labor, Land & Capital (& Entrepreneurship)

• Who owns the Factors of Production?• Individuals, Households

• What payment does the HH receive for the Factors of Production?• Wages, Rent (& Profit)


Figure 1 The Circular Flow

Spending

Goods andservicesbought

Revenue

Goodsand servicessold

Labor, land,and capital

Income

= Flow of inputs and outputs

= Flow of dollars

Factors ofproduction

Wages, rent,and profit

FIRMS• Produce and sell

goods and services• Hire and use factors

of production

• Buy and consumegoods and services

• Own and sell factorsof production

HOUSEHOLDS

• Households sell• Firms buy

MARKETSFOR

FACTORS OF PRODUCTION

• Firms sell• Households buy

MARKETSFOR

GOODS AND SERVICES


Our Second Model: The Production Possibilities Frontier

• The production possibilities frontier is a graph that shows:• Combinations of output that the economy can

possibly produce • Assumptions: usually only two goods included

• Given the available factors of production and the available production technology.• Assumptions: factors of production (resources) and

technology are fixed


Figure 2 The Production Possibilities Frontier

Productionpossibilitiesfrontier

B

D

A

Quantity ofCars Produced

2,200

600

1,000

3000 700

2,000

3,000

1,000

Quantity ofComputers

Produced

C



• Concepts illustrated by the production possibilities frontier 1. Efficiency

• If the economy is getting all it can from the scarce resources it has available.


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

Points off the PPF

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

To produce 1 computer = 100 hoursTo produce 1 ton of wheat = 10 hours

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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.

0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat (tons)

F




Answers

0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat (tons)

Point G:300 computers, 3500 tons wheat

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

G





BA


2,200

6000 700

2,000

3,000

1,000


Produced



• Concepts illustrated by the production possibilities frontier 1. Efficiency

• If the economy is getting all it can from the scarce resources it has available.

2. Trade-offs (Principle #1: People face trade-offs)• If want more computers, need to give up some cars

3. Opportunity cost (Principle #2: Cost of something is what you give up to get it)

• Cost of computers is number of cars must sacrifice




B

D

A


2,200

600

1,000

3000 700

2,000

3,000

1,000


Produced

C


The PPF and Opportunity Cost

The slope of a line equals the “rise over the run,” the amount the line rises when you move to the right by one unit.

0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat (tons)

–1000100

slope = = –10

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



PPF and Opportunity Cost

In which country is the opportunity cost of cloth lower?

0

100

200

300

400

500

600

0 100 200 300 400Cloth

Wine

0

100

200

300

400

500

600

0 100 200 300 400Cloth

WineFRANCE ENGLAND



Answers

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

0

100

200

300

400

500

600

0 100 200 300 400Cloth

Wine

0

100

200

300

400

500

600

0 100 200 300 400Cloth

WineFRANCE ENGLAND


The Shape of the PPF

• The PPF could be a 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.


Why the PPF Might Be Bow-Shaped

Mountain Bikes

Bee

r

As the economy shifts resources from beer to mountain bikes:

PPF becomes steeper

opp. cost of mountain bikes increases



At point A, most workers are producing beer, even those who are better suited to building bikes.

So, do not have to give up much beer to get more bikes.

A

Mountain Bikes

Bee

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



At B, most workers 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, causing a big drop in beer output.

B

Mountain Bikes

Bee

r

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



• So, PPF is bow-shaped 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).



• Concepts illustrated by the production possibilities frontier 4. Economic growth

• Depicted by a movement outwards of the PPF


Figure 3 A Shift in the Production Possibilities Frontier


2,200

600

2,300

6500

4,000

3,000

1,000


Produced

A

G


The PPF: A Summary

• The PPF shows all combinations of two goods that an economy can possibly produce, given its resources and technology.

• The PPF illustrates the concepts of efficiency and inefficiency, tradeoff and opportunity cost, and economic growth.

• A bow-shaped PPF illustrates the concept of increasing opportunity cost.


Another role for Economists: Policy Advisors

• When economists are trying to explain the world, they are scientists.

• When economists are trying to change the world, they are policy advisors.


Positive versus Normative Analysis

• Positive statements are statements that attempt to describe the world as it is.• Called descriptive analysis, factual

• Normative statements are statements about how the world should be.• Called prescriptive analysis, NOT factual


Positive Versus Normative Analysis

• Are the following 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



• Are the following 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



?

?

• Much of economics is Positive:• It just explains how the economy works

• However, the goals of those who learn economics are often Normative:• They are learning how to improve the economy


Economists in Washington

• Some government agencies that collect economic data and make economic policy include:• 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.

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


• 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.

Summary


• Economists who advise policymakers offer conflicting advice either because of differences in scientific judgments or because of differences in values.

• At other times, economists are united in the advice they offer, but policymakers may choose to ignore it.


For Next Class:1. Read Chapter 3

2. Practice Problems –

Study Guide –

Review Terms and Definitions (1-11)

True/False Questions (1-15)

Multiple Choice Questions (1-20)

Mankiw Text –

Problems and Applications (2a-d, 4a-d, 6 and review graphing appendix)

Quiz on Chapter 2 Due Next Tuesday

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