2 Thinking Like an Economist Chapter

Chapter

2 Thinking Like an Economist

The Economist as a Scientist • Scientific Methodology – Develop hypotheses/theories/models about “how things work” • In our case: how markets works, what are the incentives that drive behavior

– Collect data which can be used to test validity of these theories • In economics – observational rather than experimental data

– Analyze these data to verify or refute these theories

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Scientific Method

The Economist as a Scientist Economic models • Diagrams & equations – May omit many details – Allow us to see what’s truly important

• Built with assumptions • Simplify reality to improve our understanding of it

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The Economist as a Scientist The role of assumptions • Assumptions • What do we assume about market behavior that we can’t/don’t test – Demand: omitting non-related goods, goods that are not “reasonable” substitutes/complements – Long-run versus short-run (e.g., impact of gas prices)

• Why do we do it? – simplify the complex world – focus our thinking on the major factors that affect the problem of interest » different assumptions to answer different questions » Short-run/long-run effects

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Building a Model • Why? – Explain the past and/or predict the future – Understand factors that motivate individuals and firms to take the actions that they do in the marketplace – Possibly be able to influence the decisions they make • Make the markets more efficient -> create bigger benefits for all (consumers and firms)

Overview • Basic assumptions underlying economic modeling – Rationality and self-interest – Marginal analysis • Totals versus marginal (incremental analysis)

Economic Models •

The Scientific Method (Hubbard and O’Brien) 1. Decide on assumptions to be used in developing the model 2. Formulate a testable hypothesis 3. Use economic data to test the hypothesis 4. Revise the model if it fails to explain well the economic data 5. Retain the revised model to help answer similar economic questions in the future

Scientific Method

Role of Assumptions • Assumptions – Role of assumptions is to • reduce the complexity of the problem to its key elements and, • focus on the items that have the most significant impact (“80/20” rule) – 80% of the impact is due to 20% of the factors

• Robust – If relaxing the assumptions has minimal impact on your conclusions then the model is deemed “robust” and is largely unaffected by these testable or non-testable assumptions – “robustness” is a desirable property Don’t just forget about them – do they have a significant or minor impact on the model’s results/predictions?

The Economist as a Scientist Our first model: The circular-flow diagram • Circular-flow diagram – Visual model of the economy – Shows how dollars flow through markets among households and firms

• Decision makers • Firms & Households

• Markets • For goods and services • For factors of production

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The Circular Flow of Economic Activity • Households and firms interact so closely that the well-being of one depends on the well-being of the other. • This interaction is represented by the circular flow model.

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Figure 3.1 The Circular Flow of Economic Activity

Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

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The Economist as a Scientist Our first model: The circular-flow diagram • Firms – Produce goods and services – Use factors of production / inputs

• Households – Own factors of production – Consume goods and services

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Figure 1 The circular flow This 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 (where households are buyers and firms are sellers) and in the markets for the factors of production (where firms are buyers and households are sellers). The outer set of arrows shows the flow of dollars, and the inner set of arrows shows the corresponding flow of inputs and outputs. 15

The Economist as a Scientist Our second model: The production possibilities frontier • Production possibilities frontier – Combinations of output that the economy can possibly produce – Given the available • Factors of production (both raw materials and labor) • Production technology (used to produce the good) 16

Figure 2 The production possibilities frontier Quantity of Computers Produced C

F

3,000

A

2,200 2,000

B

Production Possibilities Frontier

D

1,000

E 0

300

600 700

The production possibilities frontier shows the combinations of output - in this case, cars and computers - that the economy can possibly produce. The economy can produce any combination on or inside the frontier. Points outside the frontier are not feasible given the economy’s resources.

1,000 Quantity of Cars Produced

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What does this model show? • The maximum combinations of cars and computers that can be produced by this economy – Given it’s current natural resources, labor and technology

• Illustrates the trade-off, or opportunity costs, of producing more of one of the products, e.g., more cars – i.e. the reduction in producing the other product, e.g., fewer computers 18

The Economist as a Scientist • Efficient levels of production – on the “frontier” (on the curve or “frontier”) – getting all that economy from scarce resources (maximum level of production) – Trade-off: reduce production of other good • (labor and other resources have to be reallocated)

• Inefficient levels of production (Points inside the curve) – Indicates resources are underutilized 19

The Economist as a Scientist • Opportunity cost of one good – Give up the other good

• Bowed out production possibilities frontier – Opportunity cost of a car – highest • Economy - producing many cars and fewer computers

– Opportunity cost of a car – lower • Economy - producing fewer cars and many computers

– Resource specialization 20

The Economist as a Scientist • Changing the PPF – Technological advance • Outward shift of the production possibilities frontier • Allows for economic growth, i.e., can produce more of both goods with existing resources

– Increasing labor’s production • Education – increases productivity (output per hour per employee) • Immigration – increasing size of labor pool

– Increasing availability of natural resources

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Figure 3 A shift in the production possibilities frontier Quantity of Computers Produced 4,000

3,000 G

2,300 2,200

A

0

600 650

A technological advance in the computer industry enables the economy to produce more computers for any given number of cars. As a result, the production possibilities frontier shifts outward. If the economy moves from point A to point G, then the production of both cars and computers increases.

1,000 Quantity of Cars Produced

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The Economist as a Policy Adviser Positive vs. Normative analysis • Positive statements – Attempt to describe the world as it is – Descriptive – Confirm or refute by examining evidence

• Normative statements – Attempt to prescribe how the world should be – Prescriptive 23

APPENDIX

Graphing: a brief review • Graphs’ purposes: – Visually express ideas that might be less clear if described with equations or words – Powerful way of finding and interpreting patterns

• Graphs of a single variable – Pie chart – Bar graph – Time-series graph

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Figure A-1 Types of graphs (a, b) (a) Pie Chart

(b) Bar Graph

The pie chart in panel (a) shows how U.S. national income is derived from various sources. The bar graph in panel (b) compares the average income in four countries.

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Figure A-1 Types of graphs (c) (c) Time-Series Graph

The time-series graph in panel (c) shows the productivity of labor in U.S. businesses from 1950 to 2000.

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APPENDIX

Graphing: a brief review • Graphs of two variables: the coordinate system – Display two variables on a single graph – Scatterplot – Ordered pairs of points • x-coordinate – Horizontal location

• y-coordinate – Vertical location

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Figure A-2 Using the coordinate system

Grade point average is measured on the vertical axis and study time on the horizontal axis. Albert E., Alfred E., and their classmates are represented by various points. We can see from the graph that students who study more tend to get higher grades.

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APPENDIX

Graphing: a brief review • Curves in the coordinate system • Data – Number of novels – Price of novels – Income

• Demand curve – Effect of a good’s price – On the quantity of the good consumers want to buy – For a given income 29

Table A-1 Novels purchased by Emma Income Price

$20,000

$30,000

$40,000

$10 9 8 7 6 5

2 novels 6 10 14 18 22 Demand curve, D3

5 novels 9 13 17 21 25 Demand curve, D1

8 novels 12 16 20 24 28 Demand curve, D2

This table shows the number of novels Emma buys at various incomes and prices. For any given level of income, the data on price and quantity demanded can be graphed to produce Emma’s demand curve for novels, as shown in Figures A-3 and A-4.

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APPENDIX

Graphing: a brief review • Curves in the coordinate system • Negatively related variables – The two variables move in opposite direction – Downward sloping curve

• Positively related variables – The two variables move in the same direction – Upward sloping curve

• Movement along a curve • Shifts in a curve 31

Figure A-3 Demand curve Price of Novels $11 10 9 8 7 6 5 4 3 2 1

(5, $10) (9, $9) (13, $8) (17, $7) (21, $6) (25, $5) Demand, D1

30 Quantity of novels purchased The line D1 shows how Emma’s purchases of novels depend on the price of novels when her income is held constant. Because the price and the quantity demanded are negatively related, the demand curve slopes downward. 32

0

5

10

15

20

25

Figure A-4 Shifting demand curves Price of $11 Novels 10 9 8 7 6 5 4 3 2 1

(13, $8)

When income increases, the demand curve shifts to the right.

(16, $8)

(10, $8) When income decreases, the demand curve shifts to the left.

D2 (income= $40,000)

D3 D1 (income= (income= $20,000) $30,000)

5 10 13 15 16 20 25 30 Quantity of novels purchased 0 The location of Emma’s demand curve for novels depends on how much income she earns. The more she earns, the more novels she will purchase at any given price, and the farther to the right her demand curve will lie. Curve D1 represents Emma’s original demand curve when her income is $30,000 per year. If her income rises to $40,000 per year, her demand curve shifts to D2. If her income falls to $20,000 per 33 year, her demand curve shifts to D3.

APPENDIX

Graphing: a brief review • Slope of a line – Ratio of the vertical distance covered – To the horizontal distance covered – As we move along the line y Slope  x – Δ (delta) = change in a variable – The “rise” (change in y) divided by the “run” (change in x).

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APPENDIX

Graphing: a brief review • Slope of a line – Fairly flat upward-sloping line • Slope = small positive number

– Steep upward-sloping line • Slope = large positive number

– Downward sloping line • Slope = negative number

– Horizontal line • Slope = zero

– Vertical line • Infinite slope 35

Figure A-5 Calculating the slope of a line Price of Novels $11 10 9 8 7 6 5 4 3 2 1 0

(13, $8) 6-8=-2

(21, $6) 21-13=8 Demand, D1

5

10 13 15

20 21 25

30 Quantity of novels purchased

To calculate the slope of the demand curve, we can look at the changes in the xand y-coordinates as we move from the point (21 novels, $6) to the point (13 novels, $8). The slope of the line is the ratio of the change in the y-coordinate (–2) 36 to the change in the x-coordinate (+8), which equals –1⁄4.

APPENDIX

Graphing: a brief review • Cause and effect – One set of events • Causes another set of events

– Omitted variables • Lead to a deceptive graph

– Reverse causality • Decide that event A causes event B • Facts: event B causes event A

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Figure A-6 Graph with an Omitted Variable

The upward-sloping curve shows that members of households with more cigarette lighters are more likely to develop cancer. Yet we should not conclude that ownership of lighters causes cancer because the graph does not take into account the number of cigarettes smoked.

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Figure A-7 Graph Suggesting Reverse Causality

The upward-sloping curve shows that cities with a higher concentration of police are more dangerous. Yet the graph does not tell us whether police cause crime or crimeplagued cities hire more police.

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