Thinking Like an Economist

Overview

This chapter introduces the foundational methods and concepts that economists use to analyze the world. It covers the roles of economists, the use of models, the circular-flow diagram, the production possibilities frontier (PPF), and the distinction between microeconomics and macroeconomics, as well as positive and normative statements.

The Roles of Economists

Economist as Scientist

• Scientists: Economists seek to explain how the world works by developing and testing theories.

• Scientific Method: Involves observation, theory development, and further observation to evaluate theories. Unlike natural sciences, economics often relies on natural experiments from history rather than laboratory experiments.

• Process:

  1. Collect and analyze data (Observation)

  2. Develop a theory based on data

  3. Evaluate the theory with further observation

Economist as Policy Advisor

• Policy Advisors: Economists recommend policies to improve economic outcomes.

• They use their understanding of economic events (positive analysis) and make value judgments about what should be done (normative analysis).

Assumptions and Models in Economics

Assumptions

• Economists make assumptions to simplify the complex world and make it easier to understand.

Models

• Models are simplified representations of reality, built with assumptions to highlight what is important.

• All models are subject to revision as new data and insights become available.

The Circular-Flow Diagram

Elements of the Circular-Flow Diagram

• Visual Model: Shows how dollars flow through markets among households and firms.

• Two Decision Makers: Firms and households.

• Two Markets:

  • Market for goods and services

  • Market for factors of production (inputs)

How the Circular-Flow Works

• Firms: Hire and use factors of production; produce and sell goods and services.

• Households: Own and sell factors of production; buy and consume goods and services.

Flow of Money: Households spend money to buy goods and services from firms; firms pay households for factors of production (wages, rent, profit).

The Production Possibilities Frontier (PPF)

Definition and Purpose

• PPF: A graph that shows the various combinations of outputs that the economy can possibly produce, given available resources and technology.

Example: Airplanes and Soybeans

• Assume a country produces only airplanes and soybeans with fixed resources and technology.

• Possible combinations:

Efficient Production: Points on the PPF (e.g., A, B, C, D, E) use all resources fully. Inefficient Production: Points inside the PPF (e.g., G) indicate underutilized resources. Not Feasible: Points outside the PPF (e.g., F) are unattainable with current resources.

Opportunity Cost and the Slope of the PPF

• Moving along the PPF involves shifting resources from one good to another, illustrating tradeoffs.

• Opportunity Cost: The slope of the PPF represents the opportunity cost of one good in terms of the other.

For example, to produce the first 1,000 tons of soybeans, the economy gives up 20 airplanes.

Economic Growth and the PPF

• Economic growth (more resources or better technology) shifts the PPF outward, allowing more production of both goods.

The Shape of the PPF

• Straight Line PPF: Indicates constant opportunity cost.

• Bowed Outward PPF: Indicates increasing opportunity cost as more of one good is produced.

Why Bowed Outward? Different workers have different skills, and resources may be better suited for producing one good over another, leading to varying opportunity costs.

Microeconomics vs. Macroeconomics

• Microeconomics: The study of how households and firms make decisions and interact in markets.

• Macroeconomics: The study of economy-wide phenomena, such as inflation, unemployment, and economic growth.

Positive vs. Normative Statements

• Positive Statements: Descriptive; attempt to describe the world as it is. Can be confirmed or refuted by evidence.

• Normative Statements: Prescriptive; attempt to prescribe how the world should be. Based on value judgments and cannot be confirmed or refuted by evidence.

Economists in Policy and Government

Roles in Government

• Council of Economic Advisers: Advises the president and writes the annual Economic Report of the President.

• Office of Management and Budget: Formulates spending plans and regulatory policies.

• Department of the Treasury: Designs tax policy.

• Department of Labor: Analyzes labor data and formulates labor-market policies.

• Department of Justice: Enforces antitrust laws.

• Congressional Budget Office: Advises Congress.

• Federal Reserve: Sets monetary policy.

Why Economists' Advice May Not Be Followed

• The president receives advice from multiple sources (economists, communication advisers, press advisers, legislative affairs advisers, political advisers) and makes the final decision.

Why Economists Disagree

• Differences in Scientific Judgments: Economists may have different hunches about the validity of alternative theories or the size of parameters relating economic variables.

• Differences in Values or Political Philosophies: Normative views about what policy should try to accomplish can differ.

Propositions Most Economists Agree On

• A ceiling on rents reduces the quantity and quality of housing available. (93%)

• Tariffs and import quotas usually reduce general economic welfare. (93%)

• The United States should not restrict employers from outsourcing work to foreign countries. (90%)

• The United States should eliminate agricultural subsidies. (85%)

• Local and state governments should eliminate subsidies to professional sports franchises. (85%)

• Cash payments increase the welfare of recipients more than transfers in-kind of equal cash value. (84%)

• A large federal budget deficit has an adverse effect on the economy. (83%)

• The United States should not ban genetically modified crops. (82%)

• A minimum wage increases unemployment among young and unskilled workers. (79%)

• Government subsidies on ethanol in the United States should be reduced or eliminated. (78%)

Summary

• Economists use assumptions and models to simplify and analyze complex economic phenomena.

• The circular-flow diagram and the PPF are key models for understanding economic interactions and tradeoffs.

• Microeconomics focuses on individual decision makers; macroeconomics studies the economy as a whole.

• Positive statements describe the world as it is; normative statements prescribe how it should be.

• Economists may disagree due to differences in scientific judgments or values, but there are many areas of consensus.