THINKING LIKE AN ECONOMISTLecturer: Jack Wu

IS THE ECONOMIST A SCIENTIST?

Economics = queen of social science (Only Nobel Prize in Economics)

Economics in Business is like Physics in Engineering

Economists = scientists Devise theories Collect data Analyze these data

Verify or refute their theories

ECONOMIC MODELS Economists use models to simplify reality in

order to improve our understanding of the world

Economists make assumptions in order to make the world easier to understand.

Economists use different assumptions to answer different questions.

BASIC ECONOMIC MODELS

Two of the most basic economic models include: The Circular Flow Diagram The Production Possibilities Frontier

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.

Decision makers Firms & Households

Markets For goods and services For factors of production

THE CIRCULAR FLOW DIAGRAM

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 sellgoods and services

•Hire and use factorsof 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

QUESTION

What are missing in this circular flow diagram?

QUICK QUIZ 1

Identify the parts of the circular-flow diagram immediately involved in the following transactions.

John buys a car from Ford for $25,000. Ford pays George $4,000/month for work on

the assembly line. Julie gets a $20 hair cut. Joe receives $5,000 of dividends on his Ford

stock.

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.

Productionpossibilitiesfrontier

A

B

C

Quantity ofCars Produced

2,200

600

1,000

3000 700

2,000

3,000

1,000

Quantity ofComputers

Produced

D

NOTES

The production possibilities frontier shows the combinations of output - in this case, cars and computers - that the economy can possibly produce.

The economy can produce any combination on or inside the frontier.

Points outside the frontier are not feasible given the economy’s resources.

EFFICIENT OR INEFFICIENT?

Efficient levels of production Economy’s getting all it can from the scarce

resources available Points on the production possibilities frontier Trade-off:

The only way to get more of one good is to get less of the other good

Positive opportunity cost

Inefficient levels of production Points inside production possibilities frontier. Zero opportunity cost.

SHAPE OF PRODUCTION POSSIBILITIES FRONTIER Concave curve (bowed outward): The opportunity cost of producing one good

increases as the production of this good rises.

REASON:Some resources are better suited to the

production of this good than another good (and vice versa).

Straight line: The opportunity cost of producing one good is

constant as the production of this good rises.

A SHIFT IN PRODUCTION POSSIBILITIES FRONTIER Resource Availability Changes (natural resources, human resources,

physical resources) Technology Changes

A SHIFT IN THE PRODUCTION POSSIBILITIES FRONTIER DUE TO A TECHNOLOGICAL ADVANCE IN COMPUTER INDUSTRY

15

Quantity ofComputersProduced

Quantity ofCars Produced

0 600 650 1,000

3,000

A2,2002,300

4,000

G

TECHNOLOGICAL ADVANCE

A technological advance in the computer industry enables the economy to produce more computers for any given number of cars. As a result, the production possibilities frontier shifts outward. If the economy moves from point A to point G, then the production of both cars and computers increases.

IMPORTANT CONCEPTS

Concepts illustrated by the Production Possibilities Frontier Efficiency Tradeoffs Opportunity Cost Economic Growth

QUICK QUIZ 2

A small country produces two goods: corn (measured in bushels) and trucks. Points on a production possibilities frontier are shown as follows:

A B C D ETrucks 0 10 20 30 40Corns 70 60 45 25 0

QUICK QUIZ 2 (CONTINUED)

To draw the production possibilities frontier.

To calculate the opportunity cost of increasing the number of trucks produced by ten:

between 0 and 10 between 10 and 20 between 20 and 30 between 30 and 40

QUICK QUIZ 3

Draw a production possibilities frontier for a society that produces food and clothing.

1.The drought reduces the amount of food that can be produced.

2.An advanced technology of producing clothing is developed.

3.Society’s labor forces rise.

POSITIVE AND 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

QUICK QUIZ 3

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.

WHY ECONOMISTS DISAGREE?

Economists may disagree Validity of alternative positive theories about

how the world works Economists may have different values

Different normative views about what policy should try to accomplish

DISCUSSION QUESTION

Draw a production possibilities frontier for a society that produces food and clothing.

1.The drought reduces the amount of food that can be produced.

2.An advanced technology of producing clothing is developed.

3.Society’s labor forces fall. 4.Society allocates more resources on food

production and less resources on clothing production.