Chapter 2 - Thinking Like an Economist
The Scientific Method: Observation, Theory, and More Observation:
Issac Newton’s theory of gravity (not only applies to the apple falling to the earth, but to any two objects in the universe)
Involves theory and observation that occurs in the field of economics
In order to test the theory of inflation, economists could collect and analyze data on prices and money from many different countries
Economists rely on history as data
The Role of Assumptions:
Assumptions can simplify the complex world for an easier understanding
An example would be, taking an understanding of two out of the many countries that produce only two goods. By doing so, we can focus our thinking on the essence of the problem.
Knowing that prices in the economy change infrequently can lead to different assumptions when studying the effects of a policy change
Economic Models:
Consists of diagrams and equations
Models built with assumptions
Simplify reality to improve our understanding of it
Our First Model: The Circular-Flow Diagram
A visual model of the economy that shows how dollars flow through markets among households and firms
Firms produce goods and services using inputs [labor, land, capital (building and machines)]
These inputs are called factors of production (owned by households)
An example would be, a dollar starting in a household. The owner of the dollar buys a cup of coffee and that dollar ends up in the cash register, as revenue for the firm. Whether that coffee shop uses the dollar to pay rent to its landlord or pay the wages of its workers, the dollar enters the income of some household. Therefore, the economy’s circular flow starts once again.
Our Second Model: The Production Possibilities Frontier
A graph that shows the various combinations of outputs that the economy can possibly produce given the available factors of production and the available production technology
An outcome can be the economy getting all it can from the scarce resources it has available.
As mentioned previously, people face trade-offs. Once the economy has reached the efficient points on the frontier, the only way of producing more of one good is to produce less of the other.
Society is also capable of moving production from a point on the old frontier to another point on the new frontier through economic growth.
Production possibilities frontier simplifies a complex economy to highlight the powerful basic ideas: scarcity, efficiency, trade-offs, opportunity cost, and economic growth.
Microeconomics and Macroeconomics:
Microeconomics- the study of how households and firms make decisions and how they interact in markets
An example would be,
studying the effects of rent control on housing in NYC.
Macroeconomics: the study for economy-wide phenomena, including inflation, unemployment, and economic growth
An example would be, the changes over time in the economy’s rate of unemployment
Positive V.S. Normative Analysis:
Positive statements- claims that attempt to describe the world as it is (descriptive)
Normative statements- claims that attempt to prescribe how the world should be (prescriptive)
Both are often intertwined in a person’s set of beliefs
Economists in Washington:
Presidents relied on economists’ advice
Economists acknowledge the trade-offs involved in most policy decisions
Economists’ roles impact policy makings as advisors and through their research and writings indirectly
Why Economists’ Advice Is Not Always Followed
Economists’ advice is only the first step of any policy-making while offering their crucial input that’s then passed onto other representatives for their opinions
Economists may disagree about the validity of alternative positive theories about how the world works.
Economists may have different values and therefore different normative views about what policy should try to accomplish.
Differences in Scientific Judgements:
Different economists believe in different hunches about the validity of alternative theories or about the size of important parameters that measure how economic variables are related.
An example would be, disagreeing about whether the government should tax a household’s income or its consumption (spending).
Differences in Values:
An example would be, Peter has an income of $100,000 and is taxed $10,000, or 10 percent of his income. Paula has an income of $20,000 and is taxed $4,000, or 20 percent of her income.
Whatever their current situations/lifestyle may be, there may never be an answer as to whether Peter or Paula pays too much.
This example provides us a clear understanding as to why economists sometimes disagree about public policy.
Perception V.S. Reality:
Because of differences in scientific judgments and differences in values, disagreements among economists are inevitable.
Graphing:
Pie charts, Bar graphs, Time-Series graphs, Coordinate plane
Graphs offer a way to visually express ideas that might be less clear if described with equations or words
Graphs provide an easy way of finding and interpreting patterns in data
It’s important to distinguish between movements along a curve and shifts of a curve
Can be used to argue how the economy works: how one set of events causes another set of events
The Scientific Method: Observation, Theory, and More Observation:
Issac Newton’s theory of gravity (not only applies to the apple falling to the earth, but to any two objects in the universe)
Involves theory and observation that occurs in the field of economics
In order to test the theory of inflation, economists could collect and analyze data on prices and money from many different countries
Economists rely on history as data
The Role of Assumptions:
Assumptions can simplify the complex world for an easier understanding
An example would be, taking an understanding of two out of the many countries that produce only two goods. By doing so, we can focus our thinking on the essence of the problem.
Knowing that prices in the economy change infrequently can lead to different assumptions when studying the effects of a policy change
Economic Models:
Consists of diagrams and equations
Models built with assumptions
Simplify reality to improve our understanding of it
Our First Model: The Circular-Flow Diagram
A visual model of the economy that shows how dollars flow through markets among households and firms
Firms produce goods and services using inputs [labor, land, capital (building and machines)]
These inputs are called factors of production (owned by households)
An example would be, a dollar starting in a household. The owner of the dollar buys a cup of coffee and that dollar ends up in the cash register, as revenue for the firm. Whether that coffee shop uses the dollar to pay rent to its landlord or pay the wages of its workers, the dollar enters the income of some household. Therefore, the economy’s circular flow starts once again.
Our Second Model: The Production Possibilities Frontier
A graph that shows the various combinations of outputs that the economy can possibly produce given the available factors of production and the available production technology
An outcome can be the economy getting all it can from the scarce resources it has available.
As mentioned previously, people face trade-offs. Once the economy has reached the efficient points on the frontier, the only way of producing more of one good is to produce less of the other.
Society is also capable of moving production from a point on the old frontier to another point on the new frontier through economic growth.
Production possibilities frontier simplifies a complex economy to highlight the powerful basic ideas: scarcity, efficiency, trade-offs, opportunity cost, and economic growth.
Microeconomics and Macroeconomics:
Microeconomics- the study of how households and firms make decisions and how they interact in markets
An example would be,
studying the effects of rent control on housing in NYC.
Macroeconomics: the study for economy-wide phenomena, including inflation, unemployment, and economic growth
An example would be, the changes over time in the economy’s rate of unemployment
Positive V.S. Normative Analysis:
Positive statements- claims that attempt to describe the world as it is (descriptive)
Normative statements- claims that attempt to prescribe how the world should be (prescriptive)
Both are often intertwined in a person’s set of beliefs
Economists in Washington:
Presidents relied on economists’ advice
Economists acknowledge the trade-offs involved in most policy decisions
Economists’ roles impact policy makings as advisors and through their research and writings indirectly
Why Economists’ Advice Is Not Always Followed
Economists’ advice is only the first step of any policy-making while offering their crucial input that’s then passed onto other representatives for their opinions
Economists may disagree about the validity of alternative positive theories about how the world works.
Economists may have different values and therefore different normative views about what policy should try to accomplish.
Differences in Scientific Judgements:
Different economists believe in different hunches about the validity of alternative theories or about the size of important parameters that measure how economic variables are related.
An example would be, disagreeing about whether the government should tax a household’s income or its consumption (spending).
Differences in Values:
An example would be, Peter has an income of $100,000 and is taxed $10,000, or 10 percent of his income. Paula has an income of $20,000 and is taxed $4,000, or 20 percent of her income.
Whatever their current situations/lifestyle may be, there may never be an answer as to whether Peter or Paula pays too much.
This example provides us a clear understanding as to why economists sometimes disagree about public policy.
Perception V.S. Reality:
Because of differences in scientific judgments and differences in values, disagreements among economists are inevitable.
Graphing:
Pie charts, Bar graphs, Time-Series graphs, Coordinate plane
Graphs offer a way to visually express ideas that might be less clear if described with equations or words
Graphs provide an easy way of finding and interpreting patterns in data
It’s important to distinguish between movements along a curve and shifts of a curve
Can be used to argue how the economy works: how one set of events causes another set of events
