CHAPTER
Thinking Like An Economist
Economics
PRINCIPLES OF
N. Gregory Mankiw
© 2009 South-Western, a part of Cengage Learning, all rights reserved
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?
1
The Economist as Scientist
Economists play two roles:
1. Scientists: try to explain the world
2. 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.
THINKING LIKE AN ECONOMIST 2
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.
THINKING LIKE AN ECONOMIST 3
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”
THINKING LIKE AN ECONOMIST 4
Factors of Production
Factors of production: the resources the
economy uses to produce goods & services,
including
labor
land
capital (buildings & machines used in
production)
THINKING LIKE AN ECONOMIST 5
FIGURE 1: The Circular-Flow Diagram
Households:
Own the factors of production,
sell/rent them to firms for income
Buy and consume goods & services
Firms Households
Firms:
Buy/hire factors of production,
use them to produce goods
and services
Sell goods & services
THINKING LIKE AN ECONOMIST 6
FIGURE 1: The Circular-Flow Diagram
Revenue Spending
Markets for
G&S Goods &
G&S
sold Services bought
Firms Households
Factors of Labor, land,
production Markets for capital
Factors of
Wages, rent, Production Income
profit
THINKING LIKE AN ECONOMIST 7
Our Second Model:
The Production Possibilities Frontier
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.
THINKING LIKE AN ECONOMIST 8
PPF Example
Producing one computer requires 100 hours labor.
Producing one ton of wheat requires 10 hours labor.
Employment of
Production
labor hours
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
Production Wheat
Point
(tons)
on Com- 6,000
graph puters Wheat E
5,000
A 500 0 D
4,000
B 400 1,000
3,000 C
C 250 2,500
2,000
D 100 4,000 B
1,000
E 0 5,000 A
0
0 100 200 300 400 500 600
Computers
THINKING LIKE AN ECONOMIST 10
ACTIVE LEARNING 1
Points off the PPF
A. On the graph, find the point that represents
(100 computers, 3000 tons of wheat), label it F.
Would it be possible for the economy to produce
this combination of the two goods?
Why or why not?
B. Next, find the point that represents
(300 computers, 3500 tons of wheat), label it G.
Would it be possible for the economy to produce
this combination of the two goods?
11
ACTIVE LEARNING 1
Answers
Wheat
Point F: (tons)
100 computers, 6,000
3000 tons wheat 5,000
Point F requires 4,000
40,000 hours
3,000
of labor. F
Possible but 2,000
not efficient: 1,000
could get more 0
of either good 0 100 200 300 400 500 600
w/o sacrificing Computers
any of the other.
12
ACTIVE LEARNING 1
Answers
Wheat
Point G: (tons)
300 computers, 6,000
3500 tons wheat 5,000
Point G requires 4,000 G
65,000 hours 3,000
of labor.
2,000
Not possible
because 1,000
economy 0
only has 0 100 200 300 400 500 600
50,000 hours. Computers
13
The PPF: What We Know So Far
Points on the PPF (like A – E)
possible
efficient: all resources are fully utilized
Points under the PPF (like F)
possible
not efficient: some resources underutilized
(e.g., workers unemployed, factories idle)
Points above the PPF (like G)
not possible
THINKING LIKE AN ECONOMIST 14
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.
THINKING LIKE AN ECONOMIST 15
The PPF and Opportunity Cost
Wheat
The slope of a line
(tons) equals the
–1000 “rise over the run,”
6,000 slope = = –10
100 the amount the line
5,000
rises when you
4,000
move to the right
3,000 by one unit.
2,000
Here, the
1,000 opportunity cost of
0 a computer is
0 100 200 300 400 500 600 10 tons of wheat.
Computers
THINKING LIKE AN ECONOMIST 16
ACTIVE LEARNING 2
PPF and Opportunity Cost
In which country is the opportunity cost of cloth lower?
FRANCE ENGLAND
Wine Wine
600 600
500 500
400 400
300 300
200 200
100 100
0 0
0 100 200 300 400 0 100 200 300 400
Cloth Cloth17
ACTIVE LEARNING 2
Answers
England, because its PPF is not as steep as France’s.
FRANCE ENGLAND
Wine Wine
600 600
500 500
400 400
300 300
200 200
100 100
0 0
0 100 200 300 400 0 100 200 300 400
Cloth Cloth18
Economic Growth and the PPF
With additional Wheat
resources or an (tons) Economic
6,000 growth shifts
improvement in
the PPF
technology, 5,000 outward.
the economy can 4,000
produce more
3,000
computers,
2,000
more wheat,
or any combination 1,000
in between. 0
0 100 200 300 400 500 600
Computers
THINKING LIKE AN ECONOMIST 19
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.
THINKING LIKE AN ECONOMIST 20
Why the PPF Might Be Bow-Shaped
As the economy
Beer
shifts resources
from beer to
mountain bikes:
PPF becomes
steeper
opp. cost of
mountain bikes
increases
Mountain
Bikes
THINKING LIKE AN ECONOMIST 21
Why the PPF Might Be Bow-Shaped
At point A, At A, opp. cost of
Beer
A mtn bikes is low.
most workers are
producing beer,
even those that
are better suited
to building bikes.
So, do not have to
give up much beer to
get more bikes.
Mountain
Bikes
THINKING LIKE AN ECONOMIST 22
Why the PPF Might Be Bow-Shaped
At B, most workers
Beer
At B, opp. cost
are producing bikes.
of mtn bikes
The few left in beer is high.
are the best brewers.
Producing more B
bikes would require
shifting some of the
best brewers away
from beer production,
would cause a big
Mountain
drop in beer output.
Bikes
THINKING LIKE AN ECONOMIST 23
Why the PPF Might Be Bow-Shaped
So, PPF is bow-shaped when different workers
have different skills, different opportunity costs
of producing one good in terms of the other.
The PPF would also be bow-shaped when
there is some other resource, or mix of
resources with varying opportunity costs
(E.g., different types of land suited for
different uses).
THINKING LIKE AN ECONOMIST 24
The PPF: A Summary
The PPF shows all combinations of two goods
that an economy can possibly produce,
given its resources and technology.
The PPF illustrates the concepts of
tradeoff and opportunity cost,
efficiency and inefficiency,
unemployment, and economic growth.
A bow-shaped PPF illustrates the concept of
increasing opportunity cost.
THINKING LIKE AN ECONOMIST 25
Microeconomics and Macroeconomics
Microeconomics is the study of how households
and firms make decisions and how they interact
in markets.
Macroeconomics is the study of economy-wide
phenomena, including inflation, unemployment,
and economic growth.
These two branches of economics are closely
intertwined, yet distinct – they address different
questions.
THINKING LIKE AN ECONOMIST 26
The Economist as Policy Advisor
As scientists, economists make
positive statements,
which attempt to describe the world as it is.
As policy advisors, economists make
normative statements,
which attempt to prescribe how the world should be.
Positive statements can be confirmed or refuted,
normative statements cannot.
Govt employs many economists for policy advice.
27
ACTIVE LEARNING 3
Identifying positive vs. normative
Which of these statements are “positive” and which
are “normative”? How can you tell the difference?
a. Prices rise when the government increases the
quantity of money.
b. The government should print less money.
c. A tax cut is needed to stimulate the economy.
d. An increase in the price of burritos will cause an
increase in consumer demand for video rentals.
28
ACTIVE LEARNING 3
Answers
a. Prices rise when the government increases the
quantity of money.
Positive – describes a relationship, could use
data to confirm or refute.
b. The government should print less money.
Normative – this is a value judgment, cannot be
confirmed or refuted.
29
ACTIVE LEARNING 3
Answers
c. A tax cut is needed to stimulate the economy.
Normative – another value judgment.
d. An increase in the price of burritos will cause an
increase in consumer demand for video rentals.
Positive – describes a relationship.
Note that a statement need not be true to be
positive.
30
Why Economists Disagree
Economists often give conflicting policy advice.
They sometimes disagree about the validity of
alternative positive theories about the world.
They may have different values and, therefore,
different normative views about what policy
should try to accomplish.
Yet, there are many propositions about which
most economists agree.
THINKING LIKE AN ECONOMIST 31
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.
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
to improve the world. 32
