Chapter 2 Book and Lecture Notes
Chapter 2 Book and Lecture Notes ECON 200
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Popular in Economcs
This 8 page Bundle was uploaded by Hailey Notetaker on Wednesday October 7, 2015. The Bundle belongs to ECON 200 at University of Washington taught by Instructor Ken Ho in Fall 2015. Since its upload, it has received 4 views. For similar materials see Microeconomic in Economcs at University of Washington.
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Date Created: 10/07/15
Chapter 2 Thinking Like an Economist Monday October 5 2015 1155 PM The Economist as Scientist I Economists approach the study of the economy in much the same way a physicist approaches the study of matter and a biologist approaches the study of life 0 Devise theories collect data and then analyze these data in an attempt to verify or refute their theories 0 Scienti c method the dispassionate development and testing of theories about how the world works The Scientific Method Observation Theory and More Observation 0 Interplay between theory and observation occurs in economics 0 An economist might live in a country experiencing rapidly increasing prices and be moved by this observation to develop a theory of inflation O The economist comes up with a theory and then tests it by collecting and analyzing data 0 If the data doesn39t correlate to his theory he may begin to doubt it if there was a correlation then the economist would become more confident in the theory I In economics conducting experiments is often impractical O Economists studying inflation are not allowed to manipulate a nation39s monetary policy simply to generate useful data 0 Economists usually have to make do with whatever data the world happens to give them I To find a substitute for laboratory experiments economists pay close attention to the natural experiments offered by history 0 Episodes in history are valuable to study because they give us insight into the economy of the past and they allow us to illustrate and evaluate economic theories of the present The Role of Assumptions 0 Economists make assumptions because they can simplify the complex world and make it easier to understand 0 To study the effects of international trade we might assume that the world consists of only two countries and that each country produces only two goods 0 By doing this we can focus out thinking on the essence of the problem 0 The art of scientific thinking is deciding which assumptions to make 0 Economists use different assumptions to answer different questions I when studying the shortrun and longrun effects of a change in the quantity of money Economic Models 0 Economists use models to learn about the world mostly consisting of diagrams and equations 0 may omit details to allow us to see what is truly important o All models are built with assumptions Our First Model The CircularFlow Diagram 0 We need a model that explains in general terms how the economy is organized and how participants in the economy interact with one another Circularflow diagram a visual model of the economy that shows how dollars flow through markets among households and firms 0 Two types of decision makers 0 Households own the factors of production and consume all the goods and services that the firms produce 0 Firms produce goods and services using inputs such as labor land and capital buildings and machines I Inputs are called the factors of production 0 Two different types of markets 0 Marketsfor goods and services households are buyers and firms are sellers I Households buy the output of goods and services that firms produce 0 Marketsfor the factors ofproduction households are sellers and firms are buyers I Households provide the inputs that firms use to produce goods and services Mr W Gees gokd V m C NooloM gfAlt Q r I r m ANA Book Notes Page 1 S WMOCI Ac 6H8 Ogu Cw W6 mm if Mn HQUSLNVXS LQbGY 39 LOV CQUQi39L go dm V S MKLHM PVGd Mww amvs 6439 gt Qv dcu C SV U0 m6t5rm fr z l V 3ka Au all low L5 0 The two loops of the diagram are distinct but related 0 Inner loop represents the flows of inputs and outputs I Households sell the use of their labor land and capital to the firms in the markets for the factors of production I Firms then use these factors to produce goods and services which in turn are sold to households in the markets for goods and services 0 Outer loop represents the corresponding flow of dollars I Households spend money to buy goods and services from the firms I Firms use some of the revenue from these sales to pay for the factors of production such as wages of their workers 0 A more complex model would include the roles of government and international trade Our Second Model The Production Possibilities Frontier 0 Most economic models are built using the tools of mathematics 0 Production possibilities frontier a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology 0 The two endpoints of the PPF represent the extreme possibility of the economy only producing one of the goods 0 More likely the economy divides its resources between the two industries producing some care and some computers 0 Because resources are scarce not every conceivable outcome is feasible 0 The economy cannot produce the amount of cars and computers that requires more factors of production I Given the technology available for manufacturing cars and computers the economy does not have enough of the factors of production to support that level of output 0 With the resources it has the economy can produce at any point on or inside the PPF but it cannot produce at points outside the frontier 0 An outcome is said to be efficient if the economy is getting all it can from the scarce resources it has available 0 Points on rather than inside the PPF represent efficient levels of production 0 A point inside would represent an inefficient outcome I For some reason perhaps widespread unemployment the economy is producing less than it could from the resources it has available 0 One of the principles of economics is that people face tradeoffs o PPF shows one trade off that society faces 0 Once we have reached an efficient point on the frontier the only way of producing more of one good is to produce less of the other 0 The cost of something is what you give up to get it opportunity cost 0 The PPF shows the opportunity cost of one good as measured in terms of the other good 0 The opportunity cost of a car equals the slope of the production frontier 0 The opportunity cost in this economy depends on how many cars and computers the economy is producing o Reflected in the shape of the PPF O Bowed outward the opportunity cost of a car is highest when the economy is producing many cars and gew computers 0 When the economy is producing few cars and many computers the frontier is flatter and the opportunity cost of a car is lower 0 Economists believe that production possibilities frontiers often have this bowed shape Book Notes Page 2 0 When the economy is using most of its resources to make computers the resouces best suited to car production such as skilled autoworkers are being used in the computer industry I Because these workers probably arent very good at making computers increasing car production by one unit will cause only a slight reduction in the number of computers produced 0 When the economy is using most of its resources to make cars the resources best suited to making cars are already at work in the car industry Producing an additional car means moving some of the best computer technicians out of the computer industry and turning them into autoworkers I a substantial loss of computer output I The opportunity cost of a car is high and the frontier is steep 0 The PPF shows the tradeoff between the outputs of different goods at a given time but the tradeoff can change over time 0 Suppose a technological advance in the computer industry raises the number of computers that a worker can produce per week This advance expands society39s set of opportunities I For any given number of cars the economy can now make more computers I As a result the PPF shifts outward from the computer point 0 The PPF simplifies a complex economy to highlight some basic but powerful ideas 0 Scarcity o Efficiency 0 Tradeoffs O Opportunity cost 0 Economic growth Microeconomics and Macroeconomics 0 Economics is studied on various levels 0 Study the decisions of individual firms and households 0 Or the interaction of households and firms in markets for specific goods and services 0 Or the operation ofthe economy as a whole which is the sum of the activities of all these decision makers in all these markets 0 Microeconomics the study of how households and firms make decisions and how they interact in markets 0 Macroeconomics the study of economywide phenomena including inflation unemployment and economic growth The Economist as Policy Advisor 0 Economists are often asked to explain the causes of economic events 0 Sometimes asked to recommend policies to improve economic outcomes 0 When economists are trying to explain the world they are scientists 0 When they are trying to help improve it they are policy advisors Positive versus Normative Analysis 0 In general statements about the world come in two types 0 Positive statements claims that attempt to describe the world as it is descriptive I Make a claim about how the world is I Scientist I Can confirm or refute by examining evidence 0 Normative statements claims that attempt to prescribe how the world should be prescriptive I Make a claim about how the world ought to be I Policy maker I Can39t bejudged using data alone I Opinionated 0 Positive views about how the world works affect normative views about what policies are desirable Economists in Washington 0 Economists39 advice is not always straightforward 0 People face tradeoffs which are involved in most policy decisions Why the Economists Advice is Not Always Followed 0 The process by which economic policy is actually made differs in many ways from idealized policy process 0 Economists offer crucial input into the policy process but their advice is only one ingredient of a complex recipe Why Economists Disagree 0 Two basic reasons why economists so often appear to give conflicting advice to policymakers O Economists may disagree about the validity of alternative positive theories about how the world works 0 Economists may have different values and therefore different normative views about what government policy should aim to accomplish Differences in Scientific Judgments 0 Economimsts sometimes disagree because they have different hunches about the valididty of alternative theories or about the size of important parameters that measure how economic Book Notes Page 3 variables are related Differences in Values 0 Policies cannot be judged on scientific grounds alone Sometimes economists give conflicting advice because they have different values Perception v Reality 0 Because of idfferences in scientific judgments and differences in values some disagreement among economists is inevitable 0 However economists agree with one another to a much greater extent than is sometimes understood 0 Many economists all agree that certain policies are good and certain policies are bad Book Notes Page 4 Chapter 2 Thinking Like an Economist Monday October 5 2015 639 PM The Economist as Scientist o Economists play two roles 1 Scientists try to explain the world I Not explain society I Explain human behavior 2 Policy advisors try to improve it 0 In the first economists employ the scientific method the disspassionate development and testing of theories about how the world works 0 Observation 0 Build a model 0 Collect data 0 Test model 0 Economists conduct field experiments and natural experiments policy change observe the results from the policy Assumptions and Models 0 Assumptions simplify the complex world make it easier to understand 0 Example to study international trade assume two countries and two goods 0 Unrealistic but simple to learn and gives useful insights about the real world 0 Model a highly simplified representation of a more complicated reality Economists use models to study economic issues Some Familiar Models 0 A road map 0 A model of human anatomy from high school biology class 0 The model teeth at the dentist39s office Our First Model The Circular Flow Diagram 0 The circular flow diagram a visual model of the economy shows how dollars flow through markets among households and firms 0 Two types of quotactorsquot o Households 0 Firms 0 Two markets 0 The market for goods and services 0 The market for quotfactors of productionquot 0 Factors of production the resources the economy uses to produce goods and services including 0 Labor 0 Land 0 Capital buildings and machines used in production Households 0 Own the factors of production sellrent them to firms for income 0 Buy and consume goods and services Firms Households Firms 0 Buyhire factors of production use them to Produce goods and services 0 Sell goods and services S WeiLCM no 6148 Ogv mCNOOlOM a mm 3 m AWN I I1 I l Gees Damp Lecture Notes Page 1 H U LO XOGY Coopikocx 40ng 3 MGMM 9Y6 Xx C 5V A Q N Wm6e5rw lsfre 4 n 3 HM all 5 ob 0 Green represents incomepayment 0 Red represents flows of goods and services 0 We omit foreign sector government and financial systems in the diagram 0 The idea is that your spending is someone else39s income Our Second Model the Production Possibilities Frontier o The Production Possibilities Frontier PFF a graph that shows the combinations of two goods the economy can possibly produce given the available resources and the available technology 0 Example Two goods computer and wheat One resource labor measured in hours Economy has 50000 labor hours per month available for production Producint one computer requires 100 hours of labor Producing one ton of wheat requires 10 hours of labor pl cu OOOOO 0 Point F requires 40000 hours of labor Possible but not efficient could get 1 o G b More of either good without sacrificing any of the other 0 Point G requires 65000 hours of labor Not possible because economy only has 50000 hours 366 1 up 350 i gbb 00quot 6 l I l l r I gt loo 1 same 5m too The PPF What We Know 50 Far 0 Graph that iistrates the tradeoff between two goods in an economy 0 Any combo is achievable in the PPF 0 Points on the PPF like A E 0 Possible 0 Efficient all resources are fully utilized 0 Points under the PPF like F 0 Possible 0 Not efficient some resources udnerutilized eg workers unemployed factories idle 0 Points above the PPF like G 0 Not possible PPF and Opportunity Cost 0 Recall the opportunity cost of an item is what must be given up to obtain that item 0 Moving along a PPF involves shifting resrouces eg labor from the production of one good to the other 0 Society faces a tradeoff getting more of one good requires sacrificing some of the other 0 The slope of the PPF tells you the opportunity cost of one good in temrs of the other WMM Lecture Notes Page 2 b 06 D O l r0 Q 3 J 39 0 The Slope of a line equals the quotrise over runquot the amount the line rises when you move to the a e c39 D 0 right by one unit g SQ b 0 Here the opportunity cost of a computer is 10 tons of wheat oils 6 5 i so L 5 6 l 00 C l l t r I OQ 16 Stratum 5 50 Loo Dana A Q 05 b N g 6 5 hquot 0 with additional resources or an improvement in technology the eocnomy can produce more 0 h computers more wheat or any combination between them A 5 5quot b 39 1 ob L i 5 b l 00 C l I l t r r loo 1 Scabies 9m 00 0 Transfixed resources and technology 0 With added resources or technology the economy can produce more so the graph shifts right 0 Ifthe economy only adds more technology then the graph will only increase on that side ie more computer engineers USMM 9055 N ggm M up SPW 39 y 006 C l l l r r gt loo 1 scenes 9m 00 The Shape of the PPF 0 The PPF could be a straight line or bowshaped 0 Depends on what happens to opportunity cost as economy shifts resoruces from one industry to the other 0 If opportunity cost remains constant PPF is a straight line in the previous example opportunity cost of a computer was always 10 tons of wheat o If the opportunity cost of a good rises as more of the good is produced PPF is bowshaped Lecture Notes Page 3 0 As the economy shifts resources from beer to mountain bikes 0 PPF becomes steeper o Opportunity cost of mountain bikes increases 0 At point A most workers are producing beer even those who are better suited to building bikes 0 So do not have to give up much beer to get more bikes 0 At point B most workers are producing bikes The few left in beer are the best brewers o Producing more bikes would require shifting some of the best brewers away from beer production causing a big drop in beer output MO lt5 1 Why the PPF Might be BowShaped 0 PPF is bow shaped when different workers have different skills different opportunity costs of producing one good terms of the other 0 The PPF would also be bowshaped when there is some other resource or mix of resources with varying opportunity costs eg different types of land suited for different uses The PPF A Summam 0 The PPF shows all combinations of two goods that an economy can possibly produce given its resources and technology 0 The PPF illustrates the concepts of tradeoff and opportunity cost efficiency and inefficiency unemployment and economic growth 0 A bowshaped PPF illustrates the concept of increasing opportunity cost Microeconomics and Macroeconomics 0 Microeconomics is the study of how households and firms make decisions and how they interact in markets 0 Macroeconomics is the study of economywide phenomena including inflation unemployment and economic growth 0 These two branches of economics are closely intertwined yet distinctthey address different questions The Economist as Policy Advisor 0 As scientists economists make positive statements which attempt to describe the world as it is o Aren39t good or bad just a statement 0 As policy advisors economists make normative statements which attempt to prescribe how the world should be 0 Positive statements can be confirmed or refuted normative statements cannot Why Economists Disagree 0 Economists often give conflicting policy advice 0 They sometimes disagree about the validity of alternative positive theories about the world 0 They may have different values and therefore different normative views about what policy should try to accomplish 0 Yet there are many propositions about which most economists agree Lecture Notes Page 4
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