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P R I N C I P L E S O F

P R I N C I P L E S O F

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P R I N C I P L E S O F

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  1. P R I N C I P L E S O F FOURTH EDITION Thinking Like An Economist 2

  2. In this chapter, look for the answers to these questions: • What are economists’ two roles? How do they differ? • What are models? How do economists use them? • What are the elements of the Circular-Flow Diagram? What concepts does the diagram illustrate? • How is the Production Possibilities Frontier related to opportunity cost? What other concepts does it illustrate? • What is the difference between microeconomics and macroeconomics? Between positive and normative? CHAPTER 2 THINKING LIKE AN ECONOMIST

  3. The Economist as Scientist • Economists play two roles: • Scientists: try to explain the world • Policy advisors: try to improve it • In the first, economists employ the scientific method, the dispassionate development and testing of theories about how the world works. CHAPTER 2 THINKING LIKE AN ECONOMIST

  4. Assumptions & Models • Assumptions simplify the complex world, make it easier to understand. • Example: To study international trade, assume two countries and two goods. Unrealistic, but simple to learn and gives useful insights about the real world. • Model: a highly simplified representation of a more complicated reality. Economists use models to study economic issues. CHAPTER 2 THINKING LIKE AN ECONOMIST

  5. Our First Model: The Circular-Flow Diagram • The Circular-Flow Diagram: A visual model of the economy, shows how dollars flow through markets among households and firms. • Two types of “actors”: • households • firms • Two markets: • the market for goods and services • the market for “factors of production” CHAPTER 2 THINKING LIKE AN ECONOMIST

  6. Factors of Production • Factors of production: the resources the economy uses to produce goods & services, including • labor • land • capital (buildings & machines used in production) CHAPTER 2 THINKING LIKE AN ECONOMIST

  7. . The FourFactors of Production 1. Land [natural resources] – [“gifts of nature”] Water Wind “Gifts of Nature” Fossil fuels Sun

  8. . 2. Labor [human resources] anyone who works [“paid work”] A. Physical – pro athletes & lumberjacks B.Intellectual – accountants & lawyers “Hired Help”

  9. . 3. Capital Resources – all “man-made inputs” used to produce consumer products (machinery, physical plants, & tools). A. Capital goods – goods [machinery, buildings, & tools] used to produce other goods. [crane, Ford plant, hammer]

  10. . Rent Wages Interest Profits Land Labor Capital Entrepreneur 4. Entrepreneurship – Combines land, labor, & capital to produce products. Resource payments. The resource owners receive rent [for the use of their land; wages[for their labor];interest [payment for financial capital], and profits[for their entrepreneurial ability].

  11. Firms Households FIGURE 1: The Circular-Flow Diagram Households: • own the factors of production, sell/rent them to firms for income • buy and consume goods & services CHAPTER 2 THINKING LIKE AN ECONOMIST

  12. Firms FIGURE 1: The Circular-Flow Diagram Households Firms: • buy/hire factors of production, use them to produce goods and services • sell goods & services CHAPTER 2 THINKING LIKE AN ECONOMIST

  13. Revenue Spending Markets for Goods & Services G & S sold G & S bought Firms Households Factors of production Labor, land, capital Markets for Factors of Production Income Wages, rent, profit FIGURE 1: The Circular-Flow Diagram CHAPTER 2 THINKING LIKE AN ECONOMIST

  14. CIRCULAR FLOW MODEL $ COSTS $ INCOMES RESOURCE MARKET RESOURCES INPUTS BUSINESSES HOUSEHOLDS GOODS & SERVICES GOODS & SERVICES PRODUCT MARKET $ REVENUE $ CONSUMPTION

  15. The Circular-Flow Diagram Product Market 1 2 What flow are the following? A. Consumer expenditures? B. Goods and services? C. Land, labor, capital, and entrepreneurs? D. Rent, wages, interest, and profits? 2 1 4 Businesses 3 Households Labor 3 4 Resource Market

  16. The Circular-Flow Diagram Resource Market 1 2 • What flow are the following? • A. Goods/services? • B. Consumer expenditures? • C. Land, labor, capital and • entrepreneurial ability? • Rent, wages, interest, • and profits? 4 3 1 2 Households Businesses 3 4 Product Market

  17. Our Second Model: The Production Possibilities Frontier 0 • The Production Possibilities Frontier (PPF): A graph that shows the combinations of two goods the economy can possibly produce given the available resources and the available technology. • Example: • Two goods: computers and wheat • One resource: labor (measured in hours) • Economy has 50,000 labor hours per month available for production. CHAPTER 2 THINKING LIKE AN ECONOMIST

  18. PRODUCTION POSSIBILITIES Assumes... Efficiency Fixed Resources for example... Fixed Technology Two Products A Consumer Good A Capital Good

  19. Employment of labor hours Production Computers Wheat Computers Wheat A 50,000 0 500 0 B 40,000 10,000 400 1,000 C 25,000 25,000 250 2,500 D 10,000 40,000 100 4,000 E 0 50,000 0 5,000 PPF Example 0 • Producing one computer requires 100 hours labor. • Producing one ton of wheat requires 10 hours labor.

  20. PPF Example E D C B A CHAPTER 2 THINKING LIKE AN ECONOMIST

  21. The PPF and Opportunity Cost • Recall: The opportunity cost of an item is what must be given up to obtain that item. • Moving along a PPF involves shifting resources (e.g., labor) from the production of one good to the other. • Society faces a tradeoff: Getting more of one good requires sacrificing some of the other. • The slope of the PPF tells you the opportunity cost of one good in terms of the other. CHAPTER 2 THINKING LIKE AN ECONOMIST

  22. slope = The PPF and Opportunity Cost The slope of a line equals the “rise over the run” – the amount the line rises when you move to the right by one unit. –1000 = –10 100 Here, the opportunity cost of a computer is 10 tons of wheat. CHAPTER 2 THINKING LIKE AN ECONOMIST

  23. ACTIVE LEARNING 2: PPF and Opportunity Cost In which country is the opportunity cost of cloth lower? FRANCE ENGLAND 29

  24. ACTIVE LEARNING 2: Answers England, because its PPF is not as steep as France’s. FRANCE ENGLAND 30

  25. Economic Growth and the PPF With additional resources or an improvement in technology, the economy can produce more computers, Economic growth shifts the PPF outward. more wheat, or any combination in between. CHAPTER 2 THINKING LIKE AN ECONOMIST

  26. The Shape of the PPF • The PPF could be a straight line, or bow-shaped • Depends on what happens to opportunity cost as economy shifts resources from one industry to the other. • If opp. cost remains constant, PPF is a straight line. (In the previous example, opp. cost of a computer was always 10 tons of wheat.) • If opp. cost of a good rises as the economy produces more of the good, PPF is bow-shaped. CHAPTER 2 THINKING LIKE AN ECONOMIST

  27. And How Is Economic Growth Demonstrated on a Graph? Like This Economic Growth [Ability to produce a larger total output over time] C A b Capital Goods a 0 B D Consumer Goods

  28. Beer Mountain Bikes Why the PPF Might Be Bow-Shaped As the economy shifts resources from beer to mountain bikes: • PPF becomes steeper • opp. cost of mountain bikes increases CHAPTER 2 THINKING LIKE AN ECONOMIST

  29. Why the PPF Might Be Bow-Shaped At point A, most workers are producing beer, even those that are better suited to buildingmountain bikes. So, do not have to give up much beer to get more bikes. At A, opp. cost of mtn bikes is low. A Beer Mountain Bikes CHAPTER 2 THINKING LIKE AN ECONOMIST

  30. Why the PPF Might Be Bow-Shaped At B, most workers are producing bikes. The few left in beer are the best brewers. Producing more bikes would require shifting some of the best brewers away from beer production, would cause a big drop in beer output. At B, opp. cost of mtn bikes is high. Beer B Mountain Bikes CHAPTER 2 THINKING LIKE AN ECONOMIST

  31. PRODUCTION POSSIBILITIES What if we could only produce ... 10,000 Robot Arms or 400,000 Pizzas Using all of our resources, to get some pizza, we must give up some robot arms! for example...

  32. PRODUCTION POSSIBILITIES in table form PIZZA 0 1 2 3 4 (in hundred thousands) Robots 10 9 7 4 0 (in thousands)

  33. PRODUCTION POSSIBILITIES in table form PIZZA 0 1 2 3 4 (in hundred thousands) Robots 10 9 7 4 0 (in thousands) graphical form Robots (thousands) Pizzas(hundred thousands)

  34. PRODUCTION POSSIBILITIES in table form PIZZA 0 1 2 3 4 (in hundred thousands) Robots 10 9 7 4 0 (in thousands) graphical form Robots (thousands) Pizzas(hundred thousands)

  35. PRODUCTION POSSIBILITIES in table form PIZZA 0 1 2 3 4 (in hundred thousands) Robots 10 9 7 4 0 (in thousands) graphical form Robots (thousands) Pizzas(hundred thousands)

  36. PRODUCTION POSSIBILITIES in table form PIZZA 0 1 2 3 4 (in hundred thousands) Robots 10 9 7 4 0 (in thousands) graphical form Robots (thousands) Pizzas (hundred thousands)

  37. PRODUCTION POSSIBILITIES in table form PIZZA 0 1 2 3 4 (in hundred thousands) Robots 10 9 7 4 0 (in thousands) graphical form Robots (thousands) Pizzas (hundred thousands)

  38. PRODUCTION POSSIBILITIES in table form PIZZA 0 1 2 3 4 (in hundred thousands) Robots 10 9 7 4 0 (in thousands) graphical form Robots (thousands) Pizzas (hundred thousands)

  39. PRODUCTION POSSIBILITIES Limited Resources means a limited output... At any one point in time, a full-employment, full-production economy must sacrifice some of product to obtain more of product .

  40. PRODUCTION POSSIBILITIES Q 14 13 12 11 10 9 8 7 6 5 4 3 2 1 Unattainable A B W C Attainable & Efficient Robots(thousands) D Attainable but Inefficient E 1 2 3 4 5 6 7 8 Pizzas(hundred thousands) Q

  41. PRODUCTION POSSIBILITIES Notes... LAW OF INCREASING OPPORTUNITY COSTS Q 14 13 12 11 10 9 8 7 6 5 4 3 2 1 Unattainable A B C W Attainable & Efficient Robots (thousands) D Attainable but Inefficient E 1 2 3 4 5 6 7 8 Pizzas (hundred thousands) Q

  42. PRODUCTION POSSIBILITIES Notes... LAW OF INCREASING OPPORTUNITY COSTS Economic resources are not completely adapt- able to other uses. It will be a CONCAVE curve Q 14 13 12 11 10 9 8 7 6 5 4 3 2 1 Unattainable A B C W Attainable & Efficient Robots (thousands) D Attainable but Inefficient E 1 2 3 4 5 6 7 8 Pizzas (hundred thousands) Q

  43. PRODUCTION POSSIBILITIES Q 14 13 12 11 10 9 8 7 6 5 4 3 2 1 Robots(thousands) Q 1 2 3 4 5 6 7 8 Pizzas(hundred thousands) Unemployment & Underemployment Shown by Point U More of either or both is possible U