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CHAPTER
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?
Thinking Like An Economist
 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?
© 2009 South-Western, a part of Cengage Learning, all rights reserved 1

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The Economist as Scientist Assumptions

 Economists play two roles:  Assumptions simplify the complex world,
1. Scientists: try to explain the world make it easier to understand.
2. Policy advisors: try to improve it  Example: To study international trade,
 In the first, economists employ the assume two countries and two goods.
scientific method, Unrealistic, but simple to learn and
the dispassionate development and testing of gives useful insights about the real world.
theories about how the world works.

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Economic Models Some Familiar Models

 Model:
 A highly simplified representation of
a more complicated reality.
 Economists use models to study economic A road map
issues.

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Some Familiar Models Some Familiar Models

A model of human
anatomy from high
school biology class
A model airplane

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Our First Model:

Some Familiar Models
The Circular-Flow Diagram
 The Circular-Flow Diagram: a visual model of
The model teeth at the Don’t forget the economy, shows how dollars flow through
dentist’s office to floss! 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”

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FIGURE 1: The Circular-Flow Diagram

Factors of Production
Households:
 Factors of production: the resources the
economy uses to produce goods & services,  Own the factors of production,
sell/rent them to firms for income
including
 Buy and consume goods & services
 labor
 land
Firms Households
 capital (buildings & machines used in
production)
Firms:
 Buy/hire factors of production,
use them to produce goods
and services
 Sell goods & services
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FIGURE 1: The Circular-Flow Diagram

Problem
Revenue Spending  Draw a circular-flow diagram. Identify the parts of the
Markets for
G&S Goods & model that correspond to the flow of goods and
G&S
sold Services services and the flow of dollars for each of the
bought
following activities.
a. Selena pays a storekeeper $1 for a quart of
Firms Households milk.
b. Stuart earns $4.5 per hour working at a fast-
Factors of food restaurant.
Labor, land,
production Markets for capital c. Shanna spends $7 to buy a movie ticket.
Factors of
Production d. Salma earns $10,000 from her 10 percent
Wages, rent, Income
profit
ownership of Acme Industrial.
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Our Second Model:

Problem: Answer
The Production Possibilities Frontier
 The Production Possibilities Frontier (PPF):
a graph that shows the combinations of
output that the economy can possibly produce
given the available resources and the available
technology.

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PPF Example PPF Example

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Our Second Model: PPF Example

The Production Possibilities Frontier  Producing one computer requires 100 hours labor.
 Example:  Producing one ton of wheat requires 10 hours labor.
 Two goods: computers and wheat Employment of
Production
 One resource: labor (measured in hours) labor hours
 Economy has 50,000 labor hours per month Computers Wheat Computers Wheat
available for production.
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
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PPF Example ACTIVE LEARNING 1

Points off the PPF
Point Production
A. On the graph, find the point that represents
on Com- (100 computers, 3000 tons of wheat), label it F.
graph puters Wheat E Would it be possible for the economy to produce
A 500 0 D this combination of the two goods?
B 400 1,000 Why or why not?
C
C 250 2,500
B. Next, find the point that represents
D 100 4,000 B (300 computers, 3500 tons of wheat), label it G.
E 0 5,000 A Would it be possible for the economy to produce
this combination of the two goods?

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ACTIVE LEARNING 1 ACTIVE LEARNING 1

Answers Answers
 Point F:  Point G:
100 computers, 300 computers,
3000 tons wheat 3500 tons wheat
 Point F requires  Point G requires G
40,000 hours 65,000 hours
of labor. F of labor.
Possible but Not possible
not efficient: because
could get more economy
of either good only has
w/o sacrificing 50,000 hours.
any of the other.
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The PPF: What We Know So Far The PPF and Opportunity Cost
Points on the PPF (like A – E)  Recall: The opportunity cost of an item
 possible is what must be given up to obtain that item.
 efficient: all resources are fully utilized  Moving along a PPF involves shifting resources
Points under the PPF (like F) (e.g., labor) from the production of one good to
 possible the other.
 not efficient: some resources underutilized  Society faces a tradeoff: Getting more of one
(e.g., workers unemployed, factories idle) good requires sacrificing some of the other.
Points above the PPF (like G)  The slope of the PPF tells you the opportunity
 not possible cost of one good in terms of the other.

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The PPF and Opportunity Cost ACTIVE LEARNING 2

The slope of a line
PPF and Opportunity Cost
equals the In which country is the opportunity cost of cloth lower?
–1000 “rise over the run,”
slope = = –10 FRANCE ENGLAND
100 the amount the line
rises when you
move to the right
by one unit.

Here, the
opportunity cost of
a computer is
10 tons of wheat.

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ACTIVE LEARNING 2 Economic Growth and the PPF

Answers
With additional
England, because its PPF is not as steep as France’s. Economic
resources or an
growth shifts
FRANCE ENGLAND improvement in
the PPF
technology, outward.
the economy can
produce more
computers,
more wheat,
or any combination
in between.

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The Shape of the PPF Why the PPF Might Be Bow-Shaped

 The PPF could be a straight line, or bow-shaped
As the economy

Beer
 Depends on what happens to opportunity cost shifts resources
as economy shifts resources from one industry from beer to
to the other. mountain bikes:
 If opp. cost remains constant,  PPF becomes
PPF is a straight line. steeper
(In the previous example, opp. cost of a
 opp. cost of
computer was always 10 tons of wheat.)
mountain bikes
 If opp. cost of a good rises as the economy increases
produces more of the good, PPF is bow-shaped. Mountain
Bikes
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Why the PPF Might Be Bow-Shaped Why the PPF Might Be Bow-Shaped

At point A, At A, opp. cost of At B, most workers

Beer

Beer
A mtn bikes is low. At B, opp. cost
most workers are are producing bikes.
of mtn bikes
producing beer, The few left in beer is high.
even those that are the best brewers.
are better suited Producing more B
to building bikes. bikes would require
So, do not have to shifting some of the
give up much beer to best brewers away
get more bikes. from beer production,
would cause a big
Mountain Mountain
drop in beer output.
Bikes Bikes
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Why the PPF Might Be Bow-Shaped The PPF: A Summary

 So, PPF is bow-shaped when different workers  The PPF shows all combinations of two goods
have different skills, different opportunity costs that an economy can possibly produce,
of producing one good in terms of the other. given its resources and technology.
 The PPF would also be bow-shaped when
there is some other resource, or mix of
 The PPF illustrates the concepts of
tradeoff and opportunity cost,
resources with varying opportunity costs
efficiency and inefficiency,
(E.g., different types of land suited for
unemployment, and economic growth.
different uses).
 A bow-shaped PPF illustrates the concept of
increasing opportunity cost.

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Problem Problem: Answer

 An economy consists of three workers: Larry, Moe, and Curly. Each works 10
hours a day and can produce two services: mowing lawns and washing
cars. In an hour, Larry can either mow one lawn or wash one car; Moe can
either mow one lawn or wash two cars; and Curly can either mow two lawns
or wash one car.
a. Calculate how much of each service is produced in the following
scenarios, which we label A, B, C, and D:
• All three spend all their time mowing lawns. (A)
• All three spend all their time washing cars. (B)
• All three spend half their time on each activity. (C)
• Larry spends half his time on each activity, while Moe only washes cars
and Curly only mows lawns. (D)
b. Graph the production possibilities frontier for this economy. Using your
answers to part a, identify points A, B, C, and D on your graph.
c. Explain why the production possibilities frontier has the shape it does.
d. Are any of the allocations calculated in part a inefficient? Explain.

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Microeconomics and Macroeconomics The Economist as Policy Advisor

 Microeconomics is the study of how households  As scientists, economists make
and firms make decisions and how they interact positive statements,
in markets. which attempt to describe the world as it is.
 As policy advisors, economists make
 Macroeconomics is the study of economy-wide
normative statements,
phenomena, including inflation, unemployment,
which attempt to prescribe how the world should be.
and economic growth.
 Positive statements can be confirmed or refuted,
 These two branches of economics are closely normative statements cannot.
intertwined, yet distinct – they address different
 Govt employs many economists for policy advice.
questions.
E.g., the U.S. President has a Council of Economic
Advisors, which the author of this textbook chaired
from 2003 to 2005.
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ACTIVE LEARNING 3 ACTIVE LEARNING 3

Identifying positive vs. normative Answers
Which of these statements are “positive” and which a. Prices rise when the government increases the
are “normative”? How can you tell the difference? quantity of money.
a. Prices rise when the government increases the Positive – describes a relationship, could use
quantity of money. data to confirm or refute.
b. The government should print less money. b. The government should print less money.
c. A tax cut is needed to stimulate the economy. Normative – this is a value judgment, cannot be
confirmed or refuted.
d. An increase in the price of burritos will cause an
increase in consumer demand for video rentals.

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ACTIVE LEARNING 3 Why Economists Disagree

Answers  Economists often give conflicting policy advice.
c. A tax cut is needed to stimulate the economy.
 They sometimes disagree about the validity of
Normative – another value judgment. alternative positive theories about the world.
d. An increase in the price of burritos will cause an  They may have different values and, therefore,
increase in consumer demand for video rentals. different normative views about what policy
Positive – describes a relationship. should try to accomplish.
Note that a statement need not be true to be  Yet, there are many propositions about which
positive. most economists agree.

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Propositions about Which Most Propositions about Which Most

Economists Agree (and % who agree) Economists Agree (and % agreeing)
 The gap between Social Security funds and
 A ceiling on rents reduces the quantity and quality expenditures will become unsustainably large
of housing available. (93%) within the next fifty years if current policies remain
 Tariffs and import quotas usually reduce general unchanged. (85%)
economic welfare. (93%)  A large federal budget deficit has an adverse effect
 The United States should not restrict employers on the economy. (83%)
from outsourcing work to foreign countries. (90%)  A minimum wage increases unemployment among
young and unskilled workers. (79%)
 The United States should eliminate agriculture
subsidies. (85%)  Effluent taxes and marketable pollution permits
represent a better approach to pollution control
continued… than imposition of pollution ceilings. (78%)
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CHAPTER SUMMARY

 As scientists, economists try to explain the world

using models with appropriate assumptions.
 Two simple models are the Circular-Flow Diagram
and the Production Possibilities Frontier. Thank You!
 Microeconomics studies the behavior of
consumers and firms, and their interactions in
markets. Macroeconomics studies the economy
as a whole.
 As policy advisers, economists offer advice on how
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