2 Thinking Like An Economist

In this chapter, look for the answers to

these questions:
 What are economists’ two roles? How do they differ?
 What are models? How do economists use models?
 What are the elements of the Circular-Flow Diagram?
What concepts does this diagram illustrate?
 How is the Production Possibilities Frontier related
to opportunity cost? What other concepts does it
illustrate?
 What is the difference between microeconomics and
macroeconomics? Between positive and normative?
CHAPTER 2 THINKING LIKE AN ECONOMIST 1
 The Economist as Scientist
 Economists play two roles:
• Scientists: try to explain the world
• Policy advisors: try to improve it
 In the first role, economists employ the
scientific method: the dispassionate
development and testing of theories about
how the world works.

CHAPTER 2 THINKING LIKE AN ECONOMIST 2

 Assumptions & Models
 Assumptions simplify the complex world,
make it easier to understand.
 Example: When studying international trade,
we might assume the world consists of
two countries and two goods.
Very unrealistic, but simplifies the problem
and yields useful insights about the more
complicated real world.
 Economists use models to study economic
issues. A model is a highly simplified
representation of a more complicated reality.

CHAPTER 2 THINKING LIKE AN ECONOMIST 3

 Some Familiar Models

A road map

CHAPTER 2 THINKING LIKE AN ECONOMIST 4

 Some Familiar Models

A model of human
anatomy from high
school biology class

CHAPTER 2 THINKING LIKE AN ECONOMIST 5

 Some Familiar Models

A model airplane

CHAPTER 2 THINKING LIKE AN ECONOMIST 6

 Some Familiar Models

The model teeth at the Don’t forget

dentist’s office to floss!

CHAPTER 2 THINKING LIKE AN ECONOMIST 7

Our First Model:
The Circular-Flow Diagram
 The Circular-Flow Diagram: A visual model of
the economy, shows how dollars flow through
markets among households and firms.
 Includes two types of “actors”:
• households
• firms
 Includes two markets:
• the market for goods and services
• the market for “factors of production”
CHAPTER 2 THINKING LIKE AN ECONOMIST 8
 Factors of Production
 The factors of production are the resources
that the economy uses to produce goods &
services. They include:
• labor
• land
• capital (buildings & machines used in
production)

CHAPTER 2 THINKING LIKE AN ECONOMIST 9

FIGURE 1: The Circular-Flow Diagram

Households:
 own the factors of production,
sell/rent them to firms for income
 buy and consume goods & services

Firms Households

CHAPTER 2 THINKING LIKE AN ECONOMIST 10

FIGURE 1: The Circular-Flow Diagram

Firms Households

Firms:
 buy/hire factors of production,
use them to produce goods
and services
 sell goods & services
CHAPTER 2 THINKING LIKE AN ECONOMIST 11
FIGURE 1: The Circular-Flow Diagram

Revenue Spending
Markets for
G&S Goods &
G&S
sold Services bought

Firms Households

Factors of Labor, land,

production Markets for capital
Factors of
Wages, rent, Production Income
profit
CHAPTER 2 THINKING LIKE AN ECONOMIST 12
Our Second Model:
The Production Possibilities Frontier
 The Production Possibilities Frontier (PPF):
A graph that shows the combinations of
two goods the economy can possibly produce
given the available resources and the available
technology.
 Example:
• Two goods: computers and wheat
• One resource: labor (measured in hours)
• Economy has 50,000 labor hours per month
available for production.
CHAPTER 2 THINKING LIKE AN ECONOMIST 13
 PPF Example
 Producing one computer requires 100 hours labor.
 Producing one ton of wheat requires 10 hours labor.
Employment of
Production
labor hours
Computers Wheat Computers Wheat
A 50,000 0 500 0
B 40,000 10,000 400 1,000
C 25,000 25,000 250 2,500
D 10,000 40,000 100 4,000
E 0 50,000 0 5,000
 PPF Example

Production Wheat
Point
(tons)
on Com- 6,000
graph puters Wheat E
5,000
A 500 0 D
4,000
B 400 1,000
3,000 C
C 250 2,500
2,000
D 100 4,000 B
1,000
E 0 5,000 A
0
0 100 200 300 400 500 600
Computers

CHAPTER 2 THINKING LIKE AN ECONOMIST 15

ACTIVE LEARNING 1:
Points on 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?

16
ACTIVE LEARNING 1:
Answers
 Point F: Wheat
100 computers, (tons)
6,000
3000 tons wheat
5,000
 Point F requires 4,000
40,000 hours
of labor. 3,000
F
Possible but 2,000
not efficient: 1,000
could get more
0
of either good
0 100 200 300 400 500 600
w/o sacrificing
Computers
any of the other.
17
ACTIVE LEARNING 1:
Answers
 Point G: Wheat
300 computers, (tons)
6,000
3500 tons wheat
5,000
 Point G requires
4,000 G
65,000 hours
of labor. 3,000
Not possible 2,000
because 1,000
economy
0
only has
0 100 200 300 400 500 600
50,000 hours.
Computers
18
 The PPF: What We Know So Far
 Points on the PPF (like A – E)
• possible
• efficient: all resources are fully utilized
 Points under the PPF (like F)
• possible
• not efficient: some resources underutilized
(e.g., workers unemployed, factories idle)
 Points above the PPF (like G)
• not possible

CHAPTER 2 THINKING LIKE AN ECONOMIST 19

 The PPF and Opportunity Cost
 Recall: The opportunity cost of an item
is what must be given up to obtain that item.
 Moving along a PPF involves shifting resources
(e.g., labor) from the production of one good to
the other.
 Society faces a tradeoff: Getting more of one
good requires sacrificing some of the other.
 The slope of the PPF tells you the opportunity
cost of one good in terms of the other.

CHAPTER 2 THINKING LIKE AN ECONOMIST 20

 The PPF and Opportunity Cost
Wheat
The slope of a line
(tons) equals the “rise
–1000 over the run” –
6,000 slope = = –10
100 the amount the line
5,000
rises when you
4,000
move to the right
3,000 by one unit.
2,000
Here, the
1,000 opportunity cost of
0 a computer is
0 100 200 300 400 500 600 10 tons of wheat.
Computers

CHAPTER 2 THINKING LIKE AN ECONOMIST 21

A C T I V E L E A R N I N G 2:
PPF and Opportunity Cost
In which country is the opportunity cost of cloth lower?
FRANCE ENGLAND
Wine Wine
600 600

500 500

400 400

300 300

200 200

100 100

0 0
0 100 200 300 400 0 100 200 300 400
Cloth Cloth
22
A C T I V E L E A R N I N G 2:
Answers
England, because its PPF is not as steep as France’s.
FRANCE ENGLAND
Wine Wine
600 600

500 500

400 400

300 300

200 200

100 100

0 0
0 100 200 300 400 0 100 200 300 400
Cloth Cloth
23
 Economic Growth and the PPF
With additional Wheat
resources or an (tons) Economic
improvement in 6,000 growth shifts
the PPF
technology, 5,000 outward.
the economy can
4,000
produce more
computers, 3,000

more wheat, 2,000

or any combination 1,000

in between. 0
0 100 200 300 400 500 600
Computers

CHAPTER 2 THINKING LIKE AN ECONOMIST 24

 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.

CHAPTER 2 THINKING LIKE AN ECONOMIST 25

 Why the PPF Might Be Bow-Shaped

As the economy

Beer
shifts resources
from beer to
mountain bikes:
• PPF becomes
steeper
• opp. cost of
mountain bikes
increases
Mountain
Bikes
CHAPTER 2 THINKING LIKE AN ECONOMIST 26
 Why the PPF Might Be Bow-Shaped

At point A, At A, opp. cost of

Beer
A mtn bikes is low.
most workers are
producing beer,
even those that
are better suited
to building
mountain bikes.
So, do not have to
give up much beer
to get more bikes. Mountain
Bikes
CHAPTER 2 THINKING LIKE AN ECONOMIST 27
 Why the PPF Might Be Bow-Shaped

At B, most workers

Beer
At B, opp. cost
are producing bikes.
of mtn bikes
The few left in beer is high.
are the best brewers.
Producing more B
bikes would require
shifting some of the
best brewers away
from beer production,
would cause a big
Mountain
drop in beer output.
Bikes
CHAPTER 2 THINKING LIKE AN ECONOMIST 28
 Why the PPF Might Be Bow-Shaped
 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

CHAPTER 2 THINKING LIKE AN ECONOMIST 29

 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 tradeoff and opportunity cost,
efficiency and inefficiency,
unemployment, and economic growth.

 A bow-shaped PPF illustrates the concept of

increasing opportunity cost.

CHAPTER 2 THINKING LIKE AN ECONOMIST 30

 Microeconomics and Macroeconomics
 Microeconomics is the study of how
households and firms make decisions
and how they interact in markets.
 Macroeconomics is the study of economy-wide
phenomena, including inflation, unemployment,
and economic growth.
 These two branches of economics are closely
intertwined, yet distinct: they address different
questions.

CHAPTER 2 THINKING LIKE AN ECONOMIST 31

 The Economist as Policy Advisor
 As scientists, economists make
positive statements,
which attempt to describe the world as it is.
 As policy advisors, economists make
normative statements,
which attempt to prescribe how the world should be.
 Positive statements can be confirmed or refuted,
normative statements cannot.
 Govt employs many economists for policy advice.
E.g., the U.S. President has a Council of Economic
Advisors, which the author of this textbook recently
chaired.
CHAPTER 2 THINKING LIKE AN ECONOMIST 32
ACTIVE LEARNING 3:
Identifying positive vs. normative
Which of these statements are “positive” and which
are “normative”? How can you tell the difference?
a. Prices rise when the government increases the
quantity of money.
b. The government should print less money.
c. A tax cut is needed to stimulate the economy.
d. An increase in the price of gasoline will cause an
increase in consumer demand for video rentals.

33
ACTIVE LEARNING 3:
Answers
a. Prices rise when the government increases the
quantity of money.
Positive, describes a relationship, could use data
to confirm or refute.
b. The government should print less money.
Normative, this is a value judgment, cannot be
confirmed or refuted.

34
ACTIVE LEARNING 3:
Answers
c. A tax cut is needed to stimulate the economy.
Normative, another value judgment.
d. An increase in the price of gasoline will cause an
increase in consumer demand for video rentals.
Positive, describes a relationship.
Note that a statement need not be true to be
positive.

35
 Why Economists Disagree
 Economists often give conflicting policy advice.
 They sometimes disagree about the validity of
alternative positive theories about the world.
 They may have different values and, therefore,
different normative views about what policy
should try to accomplish.
 Yet, there are many propositions about which
most economists agree.

CHAPTER 2 THINKING LIKE AN ECONOMIST 36

 Propositions about Which Most
Economists Agree (and % agreeing)
 A ceiling on rents reduces the quantity and quality
of housing available. (93%)
 Tariffs and import quotas usually reduce general
economic welfare. (93%)
 A large federal budget deficit has an adverse effect
on the economy. (83%)
 A minimum wage increases unemployment among
young and unskilled workers. (79%)
 Effluent taxes and marketable pollution permits
represent a better approach to pollution control
than imposition of pollution ceilings. (78%)
CHAPTER 2 THINKING LIKE AN ECONOMIST 37
 FYI: Who Studies Economics?
 Ronald Reagan, President of the United States
 Barbara Boxer, U.S. Senator
 Sandra Day-O’Connor, Supreme Court Justice
 Anthony Zinni, General, U.S. Marine Corps
 Kofi Annan, Secretary General, United Nations
 Meg Witman, Chief Executive Officer, eBay
 Steve Ballmer, Chief Executive Officer, Microsoft
 John Elway, NFL Quarterback
 Tiger Woods, Golfer
 Ben Stein, Political Speechwriter, Actor, Game Show Host
 Arnold Schwarzenegger, Governor of California, Actor
 Mick Jagger, Singer for the Rolling Stones
CHAPTER 2 THINKING LIKE AN ECONOMIST 38
 The prairie dog has always been considered a problem for American cattle ranchers.
They dig holes that cattle and horses can step in, and they eat grass necessary for
cattle. Recently, ranchers have discovered that there is a demand for prairie dogs as
pets. In some areas, prairie dogs can sell for as high as $150 each. Cattlemen are now
fencing off prairie dog towns on their land so these towns will not be disturbed by their
cattle.
Draw a rancher’s production possibilities frontier showing increasing opportunity cost of
cattle production in terms of prairie dog production. Using a separate graph for each
situation, show what would happen to the initial production possibilities frontier in each of
the following situations:

a. The outcome is efficient, with ranchers choosing to produce equal numbers of cattle and prairie
dogs.
b. As a protest against the government introducing the gray wolf back into the wild in their state,
ranchers decide to withhold 25 percent of the available grassland for grazing.
c. The price of prairie dogs increases to $200 each, so ranchers decide to allot additional land for
prairie dogs.
d. The government grants new leases to ranchers, giving them 10,000 new acres of grassland
each for grazing.
e. A drought destroys most of the available grass for grazing of cattle, but not for prairie dogs since
they also eat plant roots.

CHAPTER 2 THINKING LIKE AN ECONOMIST 39

CHAPTER 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.

CHAPTER 2 THINKING LIKE AN ECONOMIST 40