Lecture 2

2
Why Economists Disagree?

In some cases, the disagreement may be

positive in nature because
Our knowledge of the economy is imperfect
Certain facts are in dispute
In most cases, the disagreement is normative
in nature because
While the facts may not be in dispute
Differingvalues of economists lead them to dissimilar
conclusions about what should be done
 3
Sources of Disagreement among
Economists

Differences in Scientific Judgments (opinions regarding

interpretation)
Differences in Measuring Impact of Policy
The problem of perception versus reality
Why study Economics?

Ten Principles of Economics
How People Make Decisions
1. Decision makers face trade-offs.
"Guns vs. Butter" argument
Clean environment vs. high levels of
income argument
Efficiency vs. Equality: dividing the pie
the role of gov't
2. All things incur opportunity costs
What must you give up in order to get
something else?
5
3. People are economically rational
Decision making at the margins
The concept of marginal costs vs marginal
benefits
4. Incentives Matter
What induces a person to act?
Government Policy and Social
Objectives

Ten Principles of Economics
How People Interact
5. Trade makes every one better off
Comparative advantage and
opportunity costs
6. Free markets are the most efficient
way to organize economic activity
Moving the allocation and production
decisions to the individual
Price are an important allocation
criterion
6
7. Governments can sometimes
improve market outcomes
The key word is 'sometimes'
The property rights issue
Market power: ability to influence
outcomes
Market failure: inefficient allocation
of resources
 7
Ten Principles of Economics
How The Economy As A Whole Works

8. The Standard of Living reflects the 10. Is there a short-term trade-off

ability to produce goods and services between Inflation and
What causes differences in the standard Unemployment
of living across countries?
What causes inflation: too much
Why is productivity important? money or too much demand or both?
Why are property rights and stable Does the economy need some level
democratic governments necessary? of inflation to work?
9. Governments can upset the The role of governmental policy
economic cart
Financing
public services by printing
money >>> inflation
Economist as Scientist/Investigator

The economic way of thinking: involves thinking analytically and

objectively.
Economics = Science => Economist=Scientist

The Scientific Method

CollectData (observation or experimentation)
Formulate Behavioral Hypotheses
Make Predictions (attention to role of uncertainty)
Run Experiments to prove/disprove behavioral hypotheses.
 9

Economist as Scientist/Investigator

The Role of Assumptions

Simplifying facts about the world around us
Identifying the essential elements of the few to generalize about the many
The Role of Models
Models are used to describe the way the world works
Models consist of diagrams and equations
Example 1: The Circular Flow of Money and Goods (Figure 1)
Methods of Economics

Economics relies heavily on modeling

Economic theories must have a well-constructed model
While most models are physical constructs
Economists use words, diagrams, and mathematical statements
Graphing Data

A graph reveals a causal

relationship between two
variables.
The vertical line is the y-axis.
Independent variable.
The horizontal line is the x-axis.
Dependent variable.
How do we show a negative
and a positive relationship
between variables?
 Two Simple Rules for Movements vs.
Shifts

Rule One
When an independent variable changes and that
variable does not appear on the graph, the curve on
the graph will shift.
Rule Two
When an independent variable changes and does
appear on the graph, a movement along the existing
curve will occur. The curve will not shift.
 15
Two Fundamental Assumptions
The economy is complex
Economists make sense of all
this activity in two steps
In Microeconomic models
1
First, the decision makers in the
Individual households firms
Government agencies
economy are divided into three broad
groups:
Households
In Macroeconomic models
Business
Government agencies 2 Household sector
Business sector
The next step in Government sector
understanding the
economy is to make Foreign sector
two critical
assumptions about
decision makers
 16

First Fundamental Assumption

Every economic decision maker tries to make the best out of any situation
Typically, making the best out of a situation means maximizing some quantity
While economists often have spirited disagreements about what is being maximized,
there is virtually unanimous agreement that any economic model should begin with the
assumption that someone is maximizing something
The first fundamental assumption seems to imply that we are all engaged in a
relentless, conscious pursuit of narrow goals
An implication contradicted by much of human behavior
In truth, we only rarely make decisions with conscious, hard calculations
Why, then, do economists assume that people make decisions consciously, when, in reality, they often
dont?
 17
First Fundamental Assumption
This is an important question
Economists answer it this way
The ultimate purpose of building an economic model is to understand and predict behavior
The behavior of households, firms, government, and the overall economy
As long as people behave as if they are maximizing something, then we can build a good model by
assuming that they are
One last thought about the assumption that people maximize something
It does not imply that people are selfish or that economists think they are
Economics also recognizes that people often care about their friends, their neighbors,
and the broader society in which whey live
 18

Second Fundamental Assumption

Every economic decision maker faces constraints
Societysoverall scarcity of resources constrains each of us individually in much the
same way as the overall scarcity of space in a crowded elevator limits each riders
freedom of movement
Together, the two fundamental assumptions help define the approach economists take
in answering questions about the world
Economists always begin with the same three questions
1. Who are the individual decision makers?
2. What are they maximizing?
3. What constraints do they face?
Thisapproach is used so heavily by economists that it is one of the basic principles of economics
you will learn in this book
Circular Flow of Money and Goods 19
Factor Inputs and Outputs
Diagram is a schematic
representation of the organization
of the economy.
Decisions are made by households
and firms.
Households and firms interact in
the markets for goods and services
and in the markets for the factors
of production.
The outer set of arrows shows the
flow of dollars, and the inner set of
arrows shows the corresponding
flow of inputs and outputs.
Technological Possibilities

Inputs are commodities or services that are used to

produce goods and services. An economy uses its existing
technology to combine inputs to produce outputs.

Outputs are the various useful goods or services that result

from the production process and are either consumed or
employed in further production.

Factors of Production (Land,Labor and Capital)

Production Possibilities Frontier

Possibilities Margarine Cars

A 0 25
B 2 20
C 4 15
D 6 10
E 8 5
F 10 0
 22

Production Possibilities Frontier

Production possibilities frontier

A graph showing the various combinations of output that the
economy can possibly produce
Given the available
Factors of production (labor, capital, materials)
Production technology (capital intensity)
 Figure 2 The Production Possibilities Frontier
Quantity of
Computers
Produced

3,000 D

C
2,200
2,000 A
Production
possibilities
frontier
1,000 B

0 300 600 700 1,000 Quantity of

Cars Produced
Copyright2003 Southwestern/Thomson Learning
 24
The production
Quantity of possibilities frontier
Computers
Produced shows the combinations
of output - in this case,
3,000 F
C cars and computers - that
Production
Possibilities
the economy can possibly
A
2,200
2,000 B Frontier produce.
The economy can
D produce any combination
1,000
E on or inside the frontier.
Points outside the frontier
0 1,000 Quantity of
300 600 700
Cars
are not feasible given the
Produced economys resources.
A shift in the production possibilities frontier 25
Quantity of
Computers
A technological advance in
Produced the computer industry
4,000 enables the economy to
produce more computers for
3,000 any given number of cars.
2,300 G As a result, the production
2,200 possibilities frontier shifts
A
outward. If the economy
moves from point A to point
G, then the production of
both cars and computers
increases.
0 600 650 1,000 Quantity of
Cars Produced
 PPF illustrates:
Efficiency
Tradeoffs
Opportunity Cost
Economic Growth