Chapter 2 : Thinking Like an

Economist
Principles of Economics
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?
The Economist as a Scientist

• Economists play two roles:

1. Scientists: try to explain the world
2. Policy advisors: try to improve it
• As scientists, economists employ the
scientific method
• Dispassionate development and testing of
theories about how the world works
The Economist as a Scientist

• Assumptions
• Simplify the complex world and make it easier to
understand
• Example: to study international trade,
assume two countries and two goods
• Economists use models to study economic issues
• Highly simplified representation of
a more complicated reality
The Economist as a Scientist

• Examples of models:
• The model teeth at the dentist’s office Don’t forget

• A model of human anatomy from high to floss!

school biology class

• A road map

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The Economist as a Scientist

• Circular-flow diagram
• Visual model of the economy
• Shows how money flow through markets among
households and firms
• Two decision makers
• Firms and Households
• Interacting in two markets
• Market for goods and services
• Market for factors of production (inputs)
Three Basic Questions

• What gets produced?

How is it produced?
Who gets what is produced?
• These questions are positive or descriptive. Understanding how a
system function is important before we can ask the normative
questions of whether the system produces good or bad out-comes
and how we might make improvements.
Every society has some system or process that transforms its
scarce resources into useful goods and services. In doing so, it
must decide what gets produced, how it is produced, and to
whom it is distributed. The primary resources that must be
allocated are land, labor, and capital.

factors of production: (or factors) The inputs into the

Economic Models
Figure 1 The circular flow

Households:
▪Own the factors of production,
sell/rent them to firms for income Household
Firms ▪Buy and consume goods & services s

Firms:
▪Buy/hire factors of production,
use them to produce goods
and services
▪Sell goods & services
 Revenue Spending
G&S Markets for
G&S
sold Goods &
bought
Services

Household
Firms
s

Factors of Labor,
production land,
capital
Markets for
Factors of
Wages, rent, Production
Income
profit
2. Model: The PPF- Production Possibilities
Frontier

• Production possibilities frontier

• A graph: combinations of output that the economy
can possibly produce
• Given the available
• Factors of production and technology
• Example:
• Two goods: computers and wheat
• One resource: labor (measured in hours)
• Economy has 50,000 labor hours per month available for
production
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 6,900
Point
on Com- 5,914
graph puters Wheat E
4,929
D
A 500 0 3,943

(tons)
Wheat
B 400 1,000 2,957 C
C 250 2,500 1,971

986
B
D 100 4,000
0
A
E 0 5,000 0 97 194 291 389 486 583
Computers
Examples

On the graph below, 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?
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?
 Example
6,900

• Point F: 100 5,914

computers, 3000 tons 4,929

wheat 3,943
•

(tons)
Wheat
Requires 40,000 hours 2,957
of labor F
• Possible but not
1,971

efficient: could get 986

more 0
0 97 194 291 389 486 583
of either good without
sacrificing any of the Computers

other
 6,900

5,914

• Point G: 300 4,929

computers, 3500
3,943
tons wheat G

(tons)
Wheat
• Requires 65,000 2,957

hours of labor. 1,971

• Not possible 986
because the
0
economy only has 0 97 194 291 389 486 583
50,000 hours Computers
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 are underutilized
(e.g., workers unemployed, factories idle)
• Points above the PPF (like G)
• Not possible
The PPF

• Moving along a PPF

• Involves shifting resources 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
• The opportunity cost of one good in terms of the
other
Economic Growth and the PPF Economic
growth
6,900
shifts the
5,914 PPF
4,929
outward.
With additional resources
or an improvement in 3,943

(tons)
Wheat
technology, 2,957
the economy can
produce more computers, 1,971

986

more wheat, 0
0 97 194 291 389 486 583
Computers

or any combination in
between.
The Shape of the PPF

• Shape of the PPF

• Straight line: constant opportunity cost
• Previous example: the opportunity cost of 1 computer
is 10 tons of wheat
• Bowed outward: increasing opportunity cost
• As more units of a good are produced, we need to give
up increasing amounts of the other good produced

Remind Opportunity cost: The best alternative that we forgo,

or give up, when we make a choice or a decision
Why Economists Disagree

• Economists often give conflicting policy advice

• Can disagree about the validity of alternative
positive theories about the world
• 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
Questions
1.Using the data in the table,
Q1 graph the ppf (with carpet on
the vertical axis).

2.Does the principle of

“increasing opportunity cost”
hold in this nation? Explain
briefly. (Hint: What happens to
the opportunity cost of carpet—
measured in number of looms—
as carpet production increases?)

3.If this country chooses to

produce both carpet and looms,
what will happen to the ppf over
time? Why?