EC 201 Chapter 2 Thinking Like an Economist The Economist as a Scientist Economists devise theories collect data and then analyze these data in an attempt to verify or refute their theories Circular Flow Diagram In the flow diagram the only decisions makers are firms and households Factors of Production Firms produce the goods and services using inputs such as labor land and capital Households own the factors of production and consume all the goods and services that the firms produce Household and Firm interaction In the markets for goods and services households are buyers and firms are sellers In particular households buy the output of goods and services that firms produce In the markets for the factors of production households are sellers and firms are buy ers In these markets households provide the inputs that firms use to produce goods and services The inner loop of the flow chart represents the flows of inputs and outputs The house holds sell the use of their labor land and capital to the firms in the markets for the fac tors of production The firms then use these factors to produce goods and services which in turn are sold to households in the markets for goods and services The outer loop of the diagram represents the corresponding flow of dollars The house holds revenue from these sales to pay for the factors of production such as the wages of their workers What s left is the profit of the firm owners who themselves are mem bers of a household The Production Possibilities Frontier Production Possibilities Frontier PPF is a graph that shows the various combina tions of output that the economy can possibly produce given the available factors of pro duction and the available production technology that firms use to turn these factors into output An outcome is said to efficient if the economy is getting all it can from the scarce re sources it has available Points on rather than inside the PPF represent efficient levels of production When the economy is producing at such a point like A there is no way to produce more of one good without producing less of the other Point D represents an inefficient outcome This is because it is not using the total amount of resources and technology available to produce the most amount of each good Opportunity Cost the cost of something is what you give up to get it For example in the PPF if you wanted to increase the amount of cars produced you will be giving up the amount of computers you would have been able to produce with those resources and technology The production possibilities frontier simplifies a complex economy to highlight some basic but powerful ideas scarcity efficiency trade offs opportunity cost and economic growth 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 When economists are trying to explain the world they are scientists When they try to help improve the world they are policy advisers Positive versus Normative Analysis Example of how policy advisers and scientists have different goals Suppose that two people are discussing minimum wage laws POLLY Minimum wage laws cause unemployment NORM The government should raise the minimum wage Polly is speaking like a scientists and making a claim on how the world works Norm is speaking like a policy adviser making a claim how he would like to change the world Positive statements these are descriptive They make a claim about how the world is Normative statements these are prescriptive They make a claim about how the world ought to be The key difference between positive and normative statements is how we judge their validity Much of economics is positive it just tries to explain how the economy works Yet those who use economics often have normative goals They want to learn how to improve the economy When you hear economists making normative statements you know they are speaking not as a scientists but as a policy adviser Economists sometimes disagree because they have different hunches about the validity of alternative theories or about the size of important parameters that measure how the eco nomic variables are related