Chapter 2: Thinking Like an
ECN 104 – Introductory Economics The economist as scientist
• Scientific Method: the dispassionate
development and testing of theories on the
workings of the universe.
• Since experiment is very difficult to conduct in
economics, economists use historical events as
• Example: decrease in housing sales after
interest rate hike.
2 Assumptions and Economic Models
• Assumption is used to simplify complexity of
• Example: To study consumption behavior,
we may assume there are only two goods.
Unrealistic, but will give a valuable insight
on consumption behavior .
• Economic model is an explanation of workings
of an economic phenomenon, based on
3 The Circular-Flow Diagram
• Circular-Flow Diagram is diagram that visualizes
the organization of the economy.
• There are two types of decision makers.
• Households and firms
• There are two markets.
• Good/service market and market for factors of
• Factors of production are the inputs that are
necessary for production such as land, labour and
4 The Circular-Flow Diagram
• In the market for goods and services,
households are buyers and firms are sellers.
• In the market for factors of production,
households are sellers and firms are buyers.
• If you trace a loonie in the economy for period
of time, it will be used in transactions in the
above two markets repeatedly.
5 The Circular-Flow Diagram
Revenue Markets for Spending
Goods & Goods & Goods &
Services sold Services Services bought
Factors of Labour, land,
production Markets for
Wages, rent, Production Income
profit Production Possibilities Frontier
• Production Possibilities Frontier (PPF) is a
graph that represents all the possible
combinations of goods the economy can
• We assume that there are two goods.
• Since the factors of production are limited in
quantity, not every combination of goods is
7 Production Possibilities Frontier
• Production plans A,
B are feasible . Car
• Output C is not
feasible, the C
produce this A
• Output B is B
efficient, we getting
the most out of
8 PPF and opportunity cost
• Opportunity cost is what you have to
give up in order to obtain something.
• If economy moves from one efficient
point to other on the PPF , it faces a
trade-off. Increasing the produc