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Chapter 2 Thinking Like an Economist a Every subject has its own methodology economists also have their own way to approach problems The Economist as Scientist Economists devise theories collect data and then analyze these data in an attempt to verify or refute their theorem just like what other scientists do 1 Scientific method the dispassionate envelopment and testing of theories about how the world works the same method also applies to other scientific field o observation develop a theory and more observation o unlike physicists who can actually test almost every theory by building experiments it is not the case for economists as such practice would be impractical ex test the effect of inflation on entire nation o economists have to make do with whatever data the world happens to give them research is somewhat limited in order to find a substitute for laboratory experiments economists pay close attention to the natural experiments offered by history 2 The Role of Assumption o assumption can simplify the complex world and make it easier to understand for instance instead of make a model that includes every single nations on earth we just make a model assuming there are only two countries on earth to see what is truly important between their trade This would simplify the complex world and show economists what is really happening o different assumption for different problems in different situations is very important in success of the model ex the assumption that gravity works in a vacuum is reasonable for studying a falling marble but not for studying a falling beach ball because we would ignore the significant increase in impact of air resistance between the two objects 3 Economic Model o economic models mostly consist of diagrams and equations o economic models omit many details to allow us to see what is truly important simplify reality to improve our understanding of it o economic models help us to understand how economy is organized and how participants in the economy interact with one another 4 The Circuar Fow Model o a visual model of the economy that shows how dollars flow through markets among households and firms o factors of production production inputs such as labor land and capital buildings and machines o markets for goods and services households buy products and firms sell o markets for the factor of production households sell inputs labor and firms buy Product lviarket Pavrnent for Goods amp Services Revenues Goods and Services Goods and Services Households Businesses WDUIS Inputs T Income Wages Rent amp Profit lvlarlltet for Factors of Production 5 Production Possibilities Frontier o production possibilities frontier shows the various combinations of output that the economy can possibly produce given the available factors of production and the available production technology that firms use to turn these factors into output o with the resources i has the economy can produce at any point on or inside the production possibilities frontier but it cannot produce at points outside the frontier o an outcome is efficient if the economy is getting all it can from the scarce resources it has available points on the production possibilities frontier represent the efficient levels of production points inside the production possibilities frontier are inefficient outcome o if we have reached an efficient point on the frontier the only way of producing more of one good is to producing less of the other which is the opportunity cost in the following figure notice that the opportunity cost of a car equals the slope of the ppf Quantity of Computers Produced O 3000 F Q C j139f Tquot 39 A 39Z 9335oaouii a 3ikooo 2ooo 39 d9g Hkjg9Q3yoqIopoooooouuuuubooo us I 39 B Production possibilities frontier 9 A COI OOIIIOOOOOOlOOIOIOOIOI 2 quot1 I F ill J i A quot 6351 quot 39 39 J f4 39 1 p gpololloooooonooooooooooo zz39o39 x 39 v 4 o P G solo P 700 1000 Quantity of Cars Produced O o although ppt shows the tradeoff between the outputs of different goods at a given time the tradeoff can change over time o the ppt simplifies a complex economy to highlight some basic but powerful ideas scarcity efficiency tradeoffs opportunity cost and economic growth 6 Microeconomics and Macroeconomics o Micro study how households and firms make decisions and how they interact in specific markets o Macro study economywide phenomena o Micro and Macro are closely intertwined the change in overall economy arise from decisions of individual households and firms The Economist as Policy Advisor o 1 Positive versus Normative Analysis o Positive statements are descriptive they make a claim about how the world is in principle positive statements can be tested by examining evidence o Normative statements are prescriptive they make a claim about how the world ought to be deciding good or bad policy is notjust a matter of science but many other views 2 Economists in Politics o the influence of economists on policy goes beyond their role as advisers their research and writings often affect policy indirectly 3 Economists advice is not always followed even when they offer crucial input but their advice is only one ingredient of a complex pie o simply put politics is way too complicated and there are many other factors besides economy influence poicy maker s decision ex political support budget congress Disagreement among Economists Two basic reasons o economists may disagree about the validity of alternative positive theories about how the world works o economists may have different values and therefore different normative views about what government policy should aim to accomplish Differences in Scientific Judgments o in any science as the search for truth continues scientists sometimes disagree about the direction in which the truth lies o with different scientificjudgements economists disagree due to different hunches about the validity of alternative theories different hunches about the size of important parameters that measure how economic variables are related Differences in Values o different political religious and personal views alter economists just as others on controversial events ex different levels of taxation on different groups with different social status Although economists often disagree with one another they normally have common ideas on how the world works o on many controversial issues economists agree in a much larger percentage than general public