Slide 1Economics and the Scientific MethodBuilding Economic ModelsBuilding Economic ModelsBuilding Economic ModelsThe Circular-Flow DiagramThe Circular-Flow DiagramProduction Possibilities FrontierProduction Possibilities FrontierApplying Economic ModelsECON 203: Principles of MicroeconomicsClass 2: Economic Models1Economics and the Scientific Method•Social sciences vs. natural sciences.–The role of experiments.•Scientific method in economics–Observation.•Prices tend to be higher in markets with few firms than in markets with many firms.–Hypothesis.•The number of firms affects the prices charged by firms.–Theory and economic models.•Markets with Perfect Competition / Monopolies / Oligopolies–Data collection.•Collect data on prices from markets with different numbers of firms to test theories and predictions.2Building Economic Models•Observing economic patterns.–Given the lack of experiments, economists pay close attention to economic patterns.•Historical patterns: economic changes that occur over time.•Geographic patterns: economic differences across locations.3Building Economic Models•Making assumptions.–Assumptions help simplify reality to make it easier to understand.•A map cannot be of the size of the city.•Similarly to study markets we consider a simplified picture of how they function.–Examples of assumptions in economics.•Firms maximize profits. •People maximize utility subject to a trade-off between consumption and leisure.4Building Economic Models•Applying economic theory and concepts.–Use graphs and equations from economic theory with simplifying assumptions to explain real-world observations.•Testing models.–Collect data from different economic contexts.–Test predictions of the economic model under different circumstances. 5The Circular-Flow Diagram•Explains how the economy is organized and the interaction between different economic participants.•Assumptions.–Two decision makers: firms and households.•Economic theory and concepts.–Firms produce goods and services using production factors (labor, land, and capital).–Households own the production factors and consume all the goods and services that firms produce.–Firms and households trade in two markets.•Market for goods and services.•Markets for production factors.6The Circular-Flow Diagram7Firms- Sell goods and services.- Buy production factors.Households- Sell production factors.- Buy goods and services.Market for Goods and Services- Firms sell.- Households buy.Market for Production Factors- Households sell.- Firms buy.RevenueGoods and services Goods and servicesExpenditureIncomeCostsProduction factors Production factorsProduction Possibilities Frontier•A graph that shows all the combinations of output that the economy can produce given the available production factors and technology.•Assumptions–Only two goods are produced: cars and computers.–Together, the two goods use all available production factors.•Economic theory and concepts.–Scarcity: the economy can only produce certain combinations of the two goods.–Opportunity cost: producing more of cars decreases the amount that can be produced of computers.–Efficiency: the economy maximizes production by using all production factors available.8Production Possibilities Frontier9Applying Economic Models•Economists in research and academia often use models to describe the way the economy works. •Economists in policy and advising often use models to prescribe ways to improve economic outcomes.•Positive statements: describe the way the world is.–Increasing the supply of money leads to inflation.•Normative statements: prescribe opinions about how the world should be.–The government should decrease the supply of money.•Positive statements are based on science, while normative statements involve
View Full Document
Unlocking...