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Thinking Like an Economist

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PowerPoint Slides prepared by:

Andreea CHIRITESCU

Eastern Illinois University

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Thinking Like an Economist

How do economists study the world?
What tools and methods do they use?

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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The Economist as a Scientist

Scientific method

Development and testing of theories about how the world works
Observation, data, theory, and more observation

Conducting experiments

Difficult / impossible
Rely on natural experiments and data

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The Economist as a Scientist

The role of assumptions

Assumptions

Economists build models to make sense of complexity.

Different assumptions

To answer different questions
Short-run or long-run effects

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The Economist as a Scientist

Circular-flow diagram

Visual model of the economy
Shows how dollars flow through markets among households and firms

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Figure 1

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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.

The circular flow

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Figure 1

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Production possibilities frontier: a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology.

The Production Possibilities Frontier

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The Economist as a Scientist

Microeconomics

The study of how households and firms make decisions
And how they interact in markets

Macroeconomics

The study of economy-wide phenomena, including inflation, unemployment, and economic growth

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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

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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

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Types of Graphs (a)

The pie chart in panel (a) shows how U.S. national income in 2008 was derived from various sources.

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Figure A-1

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Types of Graphs (b)

The bar graph in panel (b) compares the 2008 average income in four countries.

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Figure A-1

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Types of Graphs (c)

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

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Figure A-2

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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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Table A-1

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Novels Purchased by Emma

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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Figure A-3

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Demand Curve

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.

Quantity of novels

purchased

5

15

10

25

20

30

0

Price of

Novels

1

2

3

4

5

6

7

8

9

10

$11

Demand, D₁

(25, $5)

(21, $6)

(17, $7)

(13, $8)

(9, $9)

(5, $10)

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Figure A-4

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Shifting Demand Curves

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 year, her demand curve shifts to D₃.

Quantity of novels purchased

5

15

10

25

20

30

0

Price of

Novels

1

2

3

4

5

6

7

8

9

10

$11

D₃

(income=

$20,000)

(10, $8)

D₂(income=

$40,000)

(16, $8)

D₁

(income=

$30,000)

(13, $8)

13

16

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

When income decreases, the demand curve shifts to the left.

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Graphing: a brief review

Slope

Ratio of the vertical distance covered
To the horizontal distance covered
As we move along the line

Δ (delta) = change in a variable
The “rise” (change in y) divided by the “run” (change in x).

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Figure A-5

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Calculating the Slope of a Line

To calculate the slope of the demand curve, we can look at the changes in the x- and 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) to the change in the x-coordinate (+8), which equals –1⁄4.

Quantity of novels purchased

5

15

10

25

20

30

0

Price of

Novels

1

2

3

4

5

6

7

8

9

10

$11

Demand, D₁

(21, $6)

(13, $8)

13

21

6-8=-2

21-13=8

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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

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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

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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 crime-plagued cities hire more police.