THINKING LIKE AN ECONOMIST

THINKING LIKE AN ECONOMIST

THE SCIENTIFIC METHOD: OBSERVATION, THEORY, AND MORE OBSERVATION:

The interplay between theory and observation occurs in the field of economics.

For example:

Theory of inflation: Rapid increases in prices.

Observation: High inflation arises when the government prints too much money.

   To test this theory, the economists collect and analyze data on prices and money from many different countries.

THE ROLE OF ASSUMPTIONS

Assumptions can make the world easier to understand. To study the effects of international trade, we may assume that the world consists of only two countries and that each country produces only two goods. The art in scientific thinking is deciding which assumptions to make economic models.

ECONOMIC MODELS

Economic models omit many details to focus on what is truly important. Economists assume away many of the details of the economy that are irrelevant for studying the question at hand.

Ø All models—in physics, biology, or economics— simplify reality in order to improve our understanding of it.

FIRST MODEL: THE CIRCULAR-FLOW DIAGRAM

The economy consists of millions of people engaged in many activities—buying, selling, working, hiring, manufacturing, and so on. To understand how the economy works, we must find some way to simplify our thinking about all these activities. We need a model that explains, in general terms, how the economy is organized and how participants in the economy interact with one another.

THE CIRCULAR FLOW

Schematic representation of the organization of the economy.Households and firms interact in the markets for goods and services (where households are buyers and firms are sellers) and in the markets for the factors of production (where firms are buyers and households are sellers).

SECOND MODEL: THE PRODUCTION POSSIBILITIES FRONTIER

The production possibilities frontier is a graph that shows the various combinations of output that the economy can possibly produce given the available factors of production and the available production technology. The economy can produce at any point on or inside the production possibilities frontier, but it cannot produce at points outside the frontier.

THE PRODUCTION POSSIBILITIES FRONTIER

An outcome is said to be efficient if the economy is getting all it can from the scarce resources it has available.

The production possibilities frontier shows one tradeoff that society faces. Once we have reached the efficient points on the frontier, the only way of getting more of one good is to get less of the other.

The production possibilities frontier shows the opportunity cost of one good as measured in terms of the other good.

The opportunity cost of vehicles in terms of smartphones depends on how much of each good the economy is producing.

MICROECONOMICS AND MACROECONOMICS

Microeconomics is the study of how households and firms make decisions and how they interact in specific markets.

Macroeconomics is the study of economy-wide phenomena. It is impossible to understand macroeconomic developments without considering the associated microeconomic decisions.

THE ECONOMIST AS POLICY ADVISER

Economists are asked to explain the causes of economic events. Why is unemployment higher for university educated people than for people with less education?

Recommend policies to improve economic outcomes. What, should the government do to improve the economic situation in rural areas?

When economists are trying to explain the world, they are scientists. When they are trying to help improve it, they are policy advisers.

POSITIVE VERSUS NORMATIVE ANALYSIS

Positive statement: Minimum-wage laws cause unemployment (claim about how the world works).

Normative statement: The government should raise the minimum wage (how the world ought to be).

    We can, in principle, confirm or refute positive statements by examining evidence.

Evaluating normative statements involves values as well as facts. Deciding what is good or bad policy is not merely a matter of science. It also involves our views on ethics, religion, and political philosophy.

   Our positive views about how the world works affect our normative views about what policies are desirable.