978-1305971509 Chapter 2 Lecture Notes

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Chapter 2/Thinking Like an Economist ❖ 13

WHAT’S NEW IN THE EIGHTH EDITION:

There is a new Ask the Experts feature on “Ticket Resale.”

LEARNING OBJECTIVES:

By the end of this chapter, students should understand:

how economists apply the methods of science.

how assumptions and models can shed light on the world.

two simple models—the circular $ow and the production possibilities frontier.

the di&erence between microeconomics and macroeconomics.

the di&erence between positive and normative statements.

the role of economists in making policy.

why economists sometimes disagree with one another.

CONTEXT AND PURPOSE:

Chapter 2 is the second chapter in a three-chapter section that serves as the introduction of

the text. Chapter 1 introduced ten principles of economics that will be revisited throughout

the text. Chapter 2 develops how economists approach problems while Chapter 3 will

explain how individuals and countries gain from trade.

The purpose of Chapter 2 is to familiarize students with how economists approach

economic problems. With practice, they will learn how to approach similar problems in this

dispassionate systematic way. They will see how economists employ the scienti-c method,

the role of assumptions in model building, and the application of two speci-c economic

models. Students will also learn the important distinction between two roles economists can

play: as scientists when we try to explain the economic world and as policymakers when we

try to improve it.

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2THINKING LIKE AN ECONOMIST

14 ❖ Chapter 2/Thinking Like an Economist

KEY POINTS:

 Economists try to address their subject with a scientist’s objectivity. Like all scientists,

they make appropriate assumptions and build simpli-ed models to understand the world

around them. Two simple economic models are the circular-$ow diagram and the

production possibilities frontier.

 The -eld of economics is divided into two sub-elds: microeconomics and

macroeconomics. Microeconomists study decision making by households and -rms and

the interactions among households and -rms in the marketplace. Macroeconomists study

the forces and trends that a&ect the economy as a whole.

 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 advisers than as scientists.

 Economists who advise policymakers sometimes o&er con$icting advice either because

of di&erences in scienti-c judgments or because of di&erences in values. At other times,

economists are united in the advice they o&er, but policymakers may choose to ignore

the advice because of the many forces and constraints imposed by the political process.

CHAPTER OUTLINE:

I. The Economist as Scientist

A. Economists Follow the Scienti-c Method.

1. Observations help us to develop theory.

2. Data can be collected and analyzed to evaluate theories.

3. Using data to evaluate theories is more diCcult in economics than in physical

science because economists are unable to generate their own data and must

make do with whatever data are available.

4. Thus, economists pay close attention to the natural experiments o&ered by

history.

B. Assumptions Make the World Easier to Understand.

1. Example: to understand international trade, it may be helpful to start out

assuming that there are only two countries in the world producing only two goods.

Once we understand how trade would work between these two countries, we can

extend our analysis to a greater number of countries and goods.

2. One important role of a scientist is to understand which assumptions one should

make.

3. Economists often use assumptions that are somewhat unrealistic but will have

small e&ects on the actual outcome of the answer.

C. Economists Use Economic Models to Explain the World around Us.

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Chapter 2/Thinking Like an Economist ❖ 15

To illustrate to the class how simple but unrealistic models can be useful,

bring a road map to class. Point out how unrealistic it is. For example, it

does not show where all of the stop signs, gas stations, or restaurants are

located. It assumes that the earth is $at and two-dimensional. But, despite

these simpli-cations, a map usually helps travelers get from one place to

another. Thus, it is a good model.

1. Most economic models are composed of diagrams and equations.

2. The goal of a model is to simplify reality to increase our understanding.

Assumptions help to simplify reality.

D. Our First Model: The Circular Flow Diagram

Figure 1

1. De-nition of circular-,ow diagram: a visual model of the economy that

shows how dollars ,ow through markets among households and 2rms.

2. This diagram is a very simple model of the economy. Note that it ignores the roles

of government and international trade.

a. There are two decision makers in the model: households and -rms.

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16 ❖ Chapter 2/Thinking Like an Economist

b. There are two markets: the market for goods and services and the market for

factors of production.

c. Firms are sellers in the market for goods and services and buyers in the

market for factors of production.

d. Households are buyers in the market for goods and services and sellers in the

market for factors of production.

e. The inner loop represents the $ows of inputs and outputs between households

and -rms.

f. The outer loop represents the $ows of dollars between households and -rms.

E. Our Second Model: The Production Possibilities Frontier

1. De-nition of production possibilities frontier: 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.

Spend more time with this model than you think is necessary. Be aware

that students need to feel con-dent with this -rst graphical and

mathematical model. Be deliberate with every point. If you lose them with

this model, they may be gone for the rest of the course.

2. Example: an economy that produces two goods, cars and computers.

a. If all resources are devoted to producing cars, the economy would produce

1,000 cars and zero computers.

b. If all resources are devoted to producing computers, the economy would

produce 3,000 computers and zero cars.

c. More likely, the resources will be divided between the two industries,

producing some cars and some computers. The feasible combinations of

output are shown on the production possibilities frontier.

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Chapter 2/Thinking Like an Economist ❖ 17

You may want to include time dimensions for variables. This will help

students to realize that a new production possibilities frontier occurs for

each period. The axes show the levels of output per period.

ALTERNATIVE CLASSROOM EXAMPLE:

A small country produces two goods: mp3 players and music downloads. Points

on a production possibilities frontier can be shown in a table or a graph:

A B C D E

mp3 Players 0 100 200 300 400

Music

Downloads

70,000 60,000 45,000 25,000 0

The production possibilities frontier should be drawn from the numbers above.

Students should be asked to calculate the opportunity cost of increasing the

number of mp3 players produced by 100:

 between 0 and 100

 between 100 and 200

 between 200 and 300

 between 300 and 400

3. Because resources are scarce, not every combination of computers and cars is

possible. Production at a point outside of the curve (such as C) is not possible

given the economy’s current level of resources and technology.

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Figure 2

18 ❖ Chapter 2/Thinking Like an Economist

It is useful to point out that the production possibilities frontier depends on

two things: the availability of resources and the level of technology.

4. Production is eCcient at points on the curve (such as A and B). This implies that

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

is no way to produce more of one good without producing less of another.

5. Production at a point inside the curve (such as D) is ineCcient.

a. This means that the economy is producing less than it can from the resources

it has available.

b. If the source of the ineCciency is eliminated, the economy can increase its

production of both goods.

6. The production possibilities frontier reveals Principle #1: People face trade-o&s.

a. Suppose the economy is currently producing 600 cars and 2,200 computers.

b. To increase the production of cars to 700, the production of computers must

fall to 2,000.

7. Principle #2 is also shown on the production possibilities frontier: The cost of

something is what you give up to get it (opportunity cost).

a. The opportunity cost of increasing the production of cars from 600 to 700 is

200 computers.

b. Thus, the opportunity cost of each car is two computers.

8. The opportunity cost of a car depends on the number of cars and computers

currently produced by the economy.

a. The opportunity cost of a car is high when the economy is producing many

cars and few computers.

b. The opportunity cost of a car is low when the economy is producing few cars

and many computers.

9. Economists generally believe that production possibilities frontiers often have this

bowed-out shape because some resources are better suited to the production of

cars than computers (and vice versa).

Be aware that students often have trouble understanding why opportunity

costs rise as the production of a good increases. You may want to use

several speci-c examples of resources that are more suited to producing

cars than computers (e.g., an experienced mechanic) as well as examples

of resources that are more suited to producing computers than cars (e.g.,

an experienced computer programmer).

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Chapter 2/Thinking Like an Economist ❖ 19

10. The production possibilities frontier can shift if resource availability or technology

changes. Economic growth can be illustrated by an outward shift of the

production possibilities frontier.

Figure 3

You may also want to teach students about budget constraints at this time

(call them “consumption possibilities frontiers”). This reinforces the idea of

opportunity cost, and allows them to see how opportunity cost can be

measured by the slope. Also, it will introduce students to the use of

straight-line production possibilities frontiers (which appear in Chapter 3).

However, be careful if you choose to do this as students often -nd the

di&erence between straight-line and concave production possibilities

frontiers challenging.

ALTERNATIVE CLASSROOM EXAMPLE:

Ivan receives an allowance from his parents of $20 each week. He spends his

entire allowance on two goods: ice cream cones (which cost $2 each) and tickets

to the movies (which cost $10 each).

Students should be asked to calculate the opportunity cost of one movie and the

opportunity cost of one ice cream cone.

Ivan’s consumption possibilities frontier (budget constraint) can be drawn. It

should be noted that the slope is equal to the opportunity cost and is constant

because the opportunity cost is constant.

Ask students what would happen to the consumption possibilities frontier if Ivan’s

allowance changes or if the price of ice cream cones or movies changes.

F. Microeconomics and Macroeconomics

1. Economics is studied on various levels.

a. De-nition of microeconomics: the study of how households and 2rms

make decisions and how they interact in markets.

b. De-nition of macroeconomics: the study of economy-wide phenomena,

including in,ation, unemployment, and economic growth.

2. Microeconomics and macroeconomics are closely intertwined because changes in

the overall economy arise from the decisions of individual households and -rms.

3. Because microeconomics and macroeconomics address di&erent questions, each

-eld has its own set of models which are often taught in separate courses.

II. The Economist as Policy Adviser

A. Positive versus Normative Analysis

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20 ❖ Chapter 2/Thinking Like an Economist

1. Example of a discussion of minimum-wage laws: Portia says, “Minimum-wage

laws cause unemployment.” Noah says, “The government should raise the

minimum wage.”

2. De-nition of positive statements: claims that attempt to describe the

world as it is.

3. De-nition of normative statements: claims that attempt to prescribe how

the world should be.

4. Positive statements can be evaluated by examining data, while normative

statements involve personal viewpoints.

5. Positive views about how the world works a&ect normative views about which

policies are desirable.

Use several examples to illustrate the di&erences between positive and

normative statements and stimulate classroom discussion. Possible

examples include the minimum wage, budget de-cits, tobacco taxes,

legalization of marijuana, and seat-belt laws.

Have students bring in newspaper articles and in groups, identify each

statement in an editorial paragraph as being a positive or normative

statement. Discuss the di&erences among news stories, editorials, and

blogs and the analogy to economists as scientists and as policy advisers.

6. Much of economics is positive; it tries to explain how the economy works. But

those who use economics often have goals that are normative. They want to

understand how to improve the economy.

B. Economists in Washington

1. Economists are aware that trade-o&s are involved in most policy decisions.

2. The president receives advice from the Council of Economic Advisers (created in

1946).

3. Economists are also employed by administrative departments within the various

federal agencies such as the OCce of Management and Budget, the Department

of Treasury, the Department of Labor, the Congressional Budget OCce, and the

Federal Reserve.

4. The research and writings of economists can also indirectly a&ect public policy.

C. Why Economists’ Advice Is Not Always Followed

1. The process by which economic policy is made di&ers from the idealized policy

process assumed in textbooks.

2. Economists o&er crucial input into the policy process, but their advice is only part

of the advice received by policymakers.

III. Why Economists Disagree

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Chapter 2/Thinking Like an Economist ❖ 21

A. Di&erences in Scienti-c Judgments

1. Economists may disagree about the validity of alternative positive theories or

about the size of the e&ects of changes in the economy on the behavior of

households and -rms.

2. Example: some economists feel that a change in the tax code that would

eliminate a tax on income and create a tax on consumption would increase saving

in this country. However, other economists feel that the change in the tax system

would have little e&ect on saving behavior and therefore do not support the

change.

B. Di&erences in Values

C. Perception versus Reality

1. While it seems as if economists do not agree on much, this is in fact not true.

Table 1 contains 20 propositions that are endorsed by a majority of economists.

Table 1

2. Almost all economists believe that rent control adversely a&ects the availability

and quality of housing.

3. Most economists also oppose barriers to trade.

D. Ask the Experts: Ticket Resale

1. The -rst “Ask the Experts” box shows that 80% of economic experts agree that

laws that limit resale of tickets make potential audience members worse o&.

Use the “Ask the Expert” questions and responses from economists

throughout the text to spark discussions. In this case, ask students their

opinion on ticket scalping laws. Discuss the opportunity for potential

audience members to pay a price higher than the stated ticket price to be

able to attend the event rather than be excluded from the event because

there are no more tickets available at the stated ticket price.

IV. In the News: Why You Should Study Economics

1. Training in economics helps us to understand fallacies and to anticipate

unintended consequences.

2. This excerpt from a commencement address by Robert D. McTeer, Jr., the former

President of the Federal Reserve Bank of Dallas describes why students should

study economics.

V. Appendix—Graphing: A Brief Review

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22 ❖ Chapter 2/Thinking Like an Economist

Many instructors may be unaware of how much trouble beginning students

have grasping the most basic graphs. It is important for instructors to

make sure that students are comfortable with these techniques.

A. Graphs of a Single Variable

Figure A-1

1. Pie Chart

2. Bar Graph

3. Time-Series Graph

B. Graphs of Two Variables: The Coordinate System

Figure A-2

1. Economists are often concerned with relationships between two or more

variables.

2. Ordered pairs of numbers can be graphed on a two-dimensional grid.

a. The -rst number in the ordered pair is the x-coordinate and tells us the

horizontal location of the point.

b. The second number in the ordered pair is the y-coordinate and tells us the

vertical location of the point.

3. The point with both an x-coordinate and y-coordinate of zero is called the origin.

4. Two variables that increase or decrease together have a positive correlation.

5. Two variables that move in opposite directions (one increases when the other

decreases) have a negative correlation.

C. Curves in the Coordinate System

1. Often, economists want to show how one variable a&ects another, holding all

other variables constant.

Table A-1

Figure A-3

a. An example of this is a demand curve.

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Chapter 2/Thinking Like an Economist ❖ 23

b. The demand curve shows how the quantity of a good a consumer wants to

purchase varies as its price varies, holding everything else (such as income)

constant.

c. If income does change, this will alter the amount of a good that the consumer

wants to purchase at any given price. Thus, the relationship between price

and quantity desired has changed and must be represented as a new demand

curve.

Figure A-4

d. A simple way to tell if it is necessary to shift the curve is to look at the axes.

When a variable that is not named on either axis changes, the curve shifts.

D. Slope

Figure A-5

1. We may want to ask how strongly a consumer reacts if the price of a product

changes.

a. If the demand curve is very steep, the quantity desired does not change much

in response to a change in price.

b. If the demand curve is very $at, the quantity desired changes a great deal

when the price changes.

2. The slope of a line is the ratio of the vertical distance covered to the horizontal

distance covered as we move along the line (“rise over run”).

slope = y

3. A small slope (in absolute value) means that the demand curve is relatively $at; a

large slope (in absolute value) means that the demand curve is relatively steep.

E. Cause and E&ect

1. Economists often make statements suggesting that a change in Variable A causes

a change in Variable B.

2. Ideally, we would like to see how changes in Variable A a&ect Variable B, holding

all other variables constant.

3. This is not always possible and could lead to a problem caused by omitted

variables.

Figure A-6

a. If Variables A and B both change at the same time, we may conclude that the

change in Variable A caused the change in Variable B.

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24 ❖ Chapter 2/Thinking Like an Economist

b. But, if Variable C has also changed, it is entirely possible that Variable C is

responsible for the change in Variable B.

4. Another problem is reverse causality.

Figure A-7

a. If Variable A and Variable B both change at the same time, we may believe

that the change in Variable A led to the change in Variable B.

b. However, it is entirely possible that the change in Variable B led to the change

in Variable A.

c. It is not always as simple as determining which variable changed -rst because

individuals often change their behavior in response to a change in their

expectations about the future. This means that Variable A may change before

Variable B but only because of the expected change in Variable B.

There are two very good examples in the text that you should use in class.

To discuss the omitted variable problem, point out to students that a rise in

the sales of cigarette lighters is positively related to the number of

individuals diagnosed with lung cancer. To discuss reverse causality, show

that an increase in minivan sales is followed by an increase in birth rates.

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