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Chapter 2
Thinking Like an Economist
Ratna K. Shrestha
Overview
The Economist as a Scientist The Economist as a Policy-Maker Where Economists Disagree and where
Economists Agree
Economics Trains us to Think
– in terms of alternatives.
– and understand the cost of individual and
social choices.
– and provide us with insights into how
certain events and issues are related.
Thinking Like an Economist
The economic way of thinking requires one to
think analytically and objectively.
The economic way of thinking is like the
Scientific Method.
Scientific Method
Scientific Method uses abstract models to help understand how a complex real-world operates.
e.g., biologist use plastic replica of human body to study anatomy.
The Scientific Method develops theory, collects and analyzes data to prove the theory.
Economic Way of Thinking Includes
the development of abstract models from theories and the analysis of the models using two approaches:– descriptive: reporting facts, etc.– analytical: abstract reasoning
As do other scientists, economists make assumptions in developing models. To study international trade for example, we may assume two countries and two goods.
The Circular-Flow Model
The economy consists of millions of people involved in many activities.
The circular-flow model provides a simple way of describing all the economic transactions that occur in a Market Economy.
It emphasizes decentralization in that economic decisions are made by Households and Businesses in Product and Resource Markets.
The Circular-Flow Model
Households Businesses
Resource Markets
Product Markets
Diagram: The Circular-Flow Model
Households Businesses
Product Markets
Flow ofResources
SupplyResources
DemandResources
Resource Markets
Diagram: The Circular-Flow Model
Households Businesses
Product Markets
Flow of
SupplyResources
DemandResources
LandLaborCapital
Resource Markets
Diagram: The Circular-Flow Model
Households Businesses
Product Markets
Flow of Goodsand Services
SupplyGoods &Services
DemandGoods &Services
Resource Markets
The Circular-Flow Model
Households Businesses
Product Markets
The Flow of Dollars
$ Spending $ Revenue
Resource Markets
Diagram: The Circular-Flow Model
Households Businesses
Product Markets
The Flow of Dollars
$ Revenue
$ Expenses$ Income
$ Spending
Resource Markets
Diagram: The Circular-Flow Model
Households Businesses
Product Markets
The Flow of Dollars
$ Revenue
$ Expenses$ Income
RentWagesProfit
$ Spending
Resource Markets
Diagram: The Circular-Flow Model
Households Businesses
Product Markets
$$
$$
Dollar FlowReal Flow
Resource Markets
The Circular-Flow Diagram
Households
Buy and consume goods and services
Own and sell factors of production
Firms
Produce and sell goods and services
Hire and use factors of production
A Second Economic Model:
Production Possibilities Frontier (PPF)…is a graph that shows the various combinations of output that the economy can possibly produce given the available factors of production and technology.
Production Possibilities FrontierC
om
pu
ters
Cars0
Production Possibilities FrontierC
om
pu
ters
700
A
Cars0
2000
Production Possibilities FrontierC
om
pu
ters
3000
700
A
Cars
E
0
2000
Production Possibilities FrontierC
om
pu
ters
3000
1000700
A
Cars
E
F
0
2000
Production Possibilities FrontierC
om
pu
ters
3000
1000700
A
Cars
E
F
0
2000
Concepts Illustrated by the PPF
Efficiency Tradeoffs Opportunity Cost Economic Growth
Efficient Resource Use
Production Possibilities FrontierC
om
pu
ters
3000
1000
2000
700
A
Cars
E
F
0
B?1000
300
Production Possibilities FrontierC
om
pu
ters
3000
1000
2000
700
A
Cars
E
F
0
1000
900
C
Tradeoffs
Production Possibilities FrontierC
om
pu
ters
3000
1000
2000
700
A
Cars
E
F
0
1000
900
C
Opportunity Cost of next 200 cars is 1000 computers. Opportunity cost of 1 car is 5 computers
OpportunityCost
4,000
The PPFQuantity of ComputersProduced
Quantity ofCars Produced
3,000
2,000A
7000 1,000
E2,100
750
Improvement in technology in the production of Computers
Economic Growth
Production Possibilities FrontierC
om
pu
ters
3000
1000
2000
700Cars
0
1000
300
Improvement in technology in the production
of both
Microeconomics and Macroeconomics
Microeconomics focuses on “the individual parts of the economy.”– e.g. individual markets– e.g. price increase in the housing market
Macroeconomics looks at the “economy as a whole.”– e.g. aggregate of markets– e.g. average price increase for all goods– e.g. unemployment
Two Roles of Economists
When they are trying to explain the world, they are
Scientists.
When they are trying to change the world they are
Policy-makers.
Positive versus Normative Analysis
Positive: Statements or assertions dealing with matters of fact or questions about how things are (descriptive analysis).
Normative: Statements that reflect individual opinions about how the world should be (prescriptive analysis).
Positive or Normative Statements?
An increase in the minimum wage will cause a decrease in employment among the least skilled.
Higher federal budget deficits will cause interest rates to increase.
The income gains from a higher minimum wage are worth more than any slight reduction in employment.
Provincial governments should be allowed to collect from tobacco companies the costs of treating smoking-related illnesses among the poor.
– Two main benefits from studying economics:
1. Understanding
2. Expanded career opportunities
1. Understanding– Economic ideas is all around you. You
cannot ignore them. – As you progress with you study of
economics, you’ll gain a deeper understanding of what is going on around you.
WHY ECONOMICS IS WORTH STUDYING?
2. Expanded Career Opportunities– Most students of economics don’t become
economists.– But knowledge of economics is vital is
many fields such as banking, finance, business, management, insurance, real estate, law, government, journalism, health care and the arts.
– Economics graduates are not the highest-paid professional, but they are close to the top.
WHY ECONOMICS IS WORTH STUDYING?
The Costs of Studying Economics– The main cost of studying economics is forgone leisure time.– Most students find that economics is difficult and that it takes time to master.– The trick is practice, or learning by doing.
Benefits Versus Costs–Weigh up your benefits and costs!
WHY ECONOMICS IS WORTH STUDYING?
Economists in Government
Department of Finance: formulate tax policy. Industry Canada: design competition policy. Foreign Affairs: assist with trade agreements. Human Resources Development Canada:
formulate labor market policies. Bank of Canada: implement monetary policy. Environment Canada: design environment
laws.
Economists in the Private Sector
C.D. Howe Institute — suggest policy options.
Fraser Institute — suggest policy options. Provide forecasts for companies. Assist firms manage resources efficiently. Assist with investment decisions.
Do Economists Always Agree With Each Other? Three reasons why they don’t:
Disagree about the validity of alternative
positive theories
Each have different values, thus different
normative views
Examples of When Economists (Majority) Do Agree
A ceiling on rents reduces the quantity and quality of housing available.
Tariffs and import quotas usually reduce general economic welfare.
Tax cuts has a significant stimulative impact on a less than fully employed economy.
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