Session2-Thinking Like an Economist

8/2/2019 Session2-Thinking Like an Economist

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Economic Analysisfor Business

Session 2: Thinking Like anEconomist

InstructorSandeep [email protected]


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CHAPTER 2 THINKINGLIKE AN ECONOMIST

The Economist as Scientist

Economists play two roles:

Scientists: try to explain the world

Policy advisors: try to improve it

In the first role, economists employ thescientific method: the dispassionatedevelopment and testing of theoriesabouthow the world works.


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Assumptions & Models Assumptions simplify the complex world,

make it easier to understand. Example: When studying international trade,

we might assume the world consists oftwo countries and two goods.

Very unrealistic, but simplifies the problemand yields useful insights about the morecomplicated real world.

Economists use models to study economicissues. A model is a highly simplifiedrepresentation of a more complicated reality.


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Some Familiar Models

A road map


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A model of human

anatomy from highschool biologyclass


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A model

airplane


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The model teeth atthe dentists office

Dont forgetto floss!


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Our First Model:

The Circular-Flow Diagram

The Circular-Flow Diagram: A visual modelof the economy, shows how dollars flowthrough markets among households andfirms.

Includes two types of actors:

households

firms

Includes two markets: the market for goods and services

the market for factors of production


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But before: Factors ofProduction The factors of production are the

resources that the economy uses toproduce goods & services. Theyinclude:

labor

land

capital (buildings & machines used in

production)


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FIGURE 1: The Circular-Flow Diagram

Households:

own the factors of production,sell/rent them to firms for income

buy and consume goods & services

HouseholdsFirms


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HouseholdsFirms

Firms:

buy/hire factors of production,use them to produce goodsand services

sell goods & services


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Markets forFactors ofProduction

HouseholdsFirms

IncomeWages, rent,profit

Factors of

production

Labor, land,

capital

Spending

G & Sbought

G & Ssold

RevenueMarkets for

Goods &Services


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Our Second Model:

The Production Possibilities Frontier

The Production Possibilities Frontier(PPF):A graph that shows the combinations oftwo goods the economy can possibly

produce given the available resources andthe available technology.

Example:

Two goods: computers and wheat One resource: labor (measured in hours)

Economy has 50,000 labor hours per monthavailable for production.


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PPF Example

Producing one computer requires 100 hours

labor. Producing one ton of wheat requires 10 hours

labor.

5,0000

4,000100

2,500250

1,000400

50,0000

40,00010,000

25,00025,000

10,00040,000

0500050,000

E

D

C

B

A

WheatComputersWheatComputers

ProductionEmployment of

labor hours


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Pointon

graph

ProductionCom-

putersWheat

A 500 0

B 400 1,000

C 250 2,500

D 100 4,000

E 0 5,0000

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat

(tons)

A

B

C

D

E

PPF Example


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ACTIVE LEARNING 1:Points on the PPF

A. On the graph, find the point that represents(100 computers, 3000 tons of wheat), label it F.Would it be possible for the economy to producethis combination of the two goods?

Why or why not?

B. Next, find the point that represents(300 computers, 3500 tons of wheat), label it G.

Would it be possible for the economy to producethis combination of the two goods?

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ACTIVE LEARNING 1:Answers

17

Point F:100 computers,3000 tons wheat

Point F requires

40,000 hours

of labor.

Possible but

not efficient:

could get more

of either good

w/o sacrificing

any of the other.

0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat(tons)

F


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18

0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat(tons)

Point G:300 computers,

3500 tons wheat

Point G requires

65,000 hours

of labor.

Not possible

because

economy

only has

50,000 hours.

G


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CHAPTER 2 THINKING

LIKE AN ECONOMIST

The PPF: What We Know Far

Points on the PPF (like AE) possible

efficient: all resources are fully utilized

Points under the PPF (like F) possible

not efficient: some resourcesunderutilized(e.g., workers unemployed, factories idle)

Points above the PPF (like G)

not possible


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CHAPTER 2 THINKING

LIKE AN ECONOMIST

The PPF and Opportunity Cost

Recall: The opportunity cost of an item

is what must be given up to obtain thatitem. Moving along a PPF involves shifting

resources (e.g., labor) from the production of

one good to the other. Society faces a tradeoff: Getting more of

one good requires sacrificing some of the

other.

The slope of the PPF tells you the

opportunity cost of one good in terms of the

other.


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The PPF and Opportunity Cost

The slope of a line

equals the riseover the run the amount the linerises when you

move to the rightby one unit.

0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat

(tons)1000

100slope = =10

Here, the

opportunity cost ofa computer is

10 tons of wheat.


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ACTIVE LEARNING 2:

PPF and Opportunity Cost

22

In which country is the opportunity cost of cloth lower?

0

100

200

300

400

500

600

0 100 200 300 400

Cloth

Wine

0

100

200

300

400

500

600

0 100 200 300 400

Cloth

Wine

FRANCE ENGLAND


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ACTIVE LEARNING 2:

Answers

23

England, because its PPF is not as steep as Frances.

0

100

200

300

400

500

600

0 100 200 300 400

Cloth

Wine

0

100

200

300

400

500

600

0 100 200 300 400

Cloth

Wine

FRANCE ENGLAND


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0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat

(tons)

Economic Growth and thePPFWith additional

resources or animprovement intechnology,the economy can

produce morecomputers,

more wheat,

or anycombination in

between.

Economicgrowth shiftsthe PPFoutward.


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The Shape of the PPF

The PPF could be a straight line, or bow-

shaped

Depends on what happens to opportunity costas economy shifts resources from oneindustryto the other.

If opp. cost remains constant,

PPF is a straight line.

(In the previous example, opp. cost of acomputer was always 10 tons of wheat.)

If opp. cost of a good rises as the economy

produces more of the good, PPF is bow-


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Why the PPF Might Be Bow-Shaped

MountainBikes

Beer

As the economyshifts resources

from beer to

mountain bikes:

PPF becomessteeper

opp. cost of

mountain bikesincreases


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A


At point A,most workers areproducing beer,even those that

are better suitedto buildingmountain bikes.

So, do not have

togive up muchbeer to get morebikes.

MountainBikes

Beer

At A, opp. cost ofmtn bikes is low.


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B


At B, most workersare producing bikes.The few left in beerare the bestbrewers.

Producing morebikes would requireshifting some of thebest brewers away

from beerproduction,would cause a big

drop in beer output.

MountainBikes

Beer

At B, opp. costof mtn bikesis high.


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So, PPF is bow-shaped when different

workers have different skills, differentopportunity costs of producing onegood in terms of the other.

The PPF would also be bow-shapedwhen there is some other resource, ormix of resources with varying

opportunity costs. E.g., different types of land suited for

different uses


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The PPF: A Summary The PPF shows all combinations of two

goods that an economy can possiblyproduce,given its resources and technology.

The PPF illustrates the concepts

of tradeoff and opportunity cost,efficiency and inefficiency,

unemployment, and economic growth.

A bow-shaped PPF illustrates the concept ofincreasing opportunity cost.


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Microeconomics and Macroeconomics

Microeconomics is the study of howhouseholds and firms make decisionsand how they interact in markets.

Macroeconomics is the study of economy-wide phenomena, including inflation,unemployment, and economic growth.

These two branches of economics are

closely intertwined, yet distinct: theyaddress different questions.


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The Economist as Policy Advisor As scientists, economists make

positive statements,

which attempt to describe the world as it is.

As policy advisors, economists make

normative statements,

which attempt to prescribe how the world shouldbe.

Positive statements can be confirmed or refuted,normative statements cannot.

Govt employs many economists for policyadvice. E.g., the U.S. President has a Councilof Economic Advisors, which the author of thistextbook recently chaired.


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ACTIVE LEARNING 3:Identifying positive vs. normative

Which of these statements are positive and whichare normative? How can you tell the difference?

a. Prices rise when the government increases the

quantity of money.

b. The government should print less money.

c. A tax cut is needed to stimulate the economy.

d. An increase in the price of gasoline will causean increase in consumer demand for video

rentals.

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a. Prices rise when the government increases thequantity of money.

Positive, describes a relationship, could use data

to confirm or refute.

b. The government should print less money.

Normative, this is a value judgment, cannot be

confirmed or refuted.

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Thank you

Session2-Thinking Like an Economist

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