Chapter 2: Thinking like an economist 1/8/2013 11:17:00 AM
The economist as scientist:
Economists try to address their subject with a scientist’s objectivity.
They approach the study of the economy with the scientific method.
The scientific method: Observation, Theory, and more observation.
Economists use theory and observation
o Experiments are often difficult in economics
o Usually have to make do with whatever data the world
happens to give them.
To find substitute for lab experiments, economists pay close
attention to the natural experiments offered by history.
The Role of Assumptions
Economist make assumptions to simplify the complex world and
make it easier to understand.
Uses different assumptions to answer different questions.
For studying the short-run effects of the policy, we may assume
that prices do not change much.
For studying long-run effects of the policy, we assume that all
prices are completely flexible.
Economists use models to learn about the world which most often
composed of diagrams and equations.
o Does not include every feature of the economy
All models are built with assumptions
o Simplifies reality in order to improve the understanding of it.
The Circular-Flow Diagram A visual model of the economy that shows how dollars flow through markets
among households and firms.
Includes two types of decision makers
Owns the factors of production
Consume all the goods and services
Produce goods and services using inputs (factor of
production) such as labor, land (natural resources), and
capital (buildings and machines).
Both interact in two types of markets:
o Markets for goods and services:
Households are buyers and firms are sellers
o Markets for the factors of production:
Households are sellers and firms are buyers.
Households provide the inputs that the firms use to
produce goods and services.
The inner loop represents the flow of inputs and outputs.
o The households sells the use of their labour, land, and capital
to the firms in the markets for the factors of production. The
firms then use these factors to produce goods and services, which in turn are sold to the households in the markets for
goods and services.
The outer loop represents the corresponding flow of dollars.
o The households spend money to buy goods and services from
the firms. The firms use some of the revenue from these sales
to pay for the factors of production. What’s left is the profit of
the firm owners, who themselves are members of households.
The production possibilities Frontier (Second model)
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.
With the resources it has, the economy can produce at any point on
or inside the production, but it cannot produce at points outside.
An outcome is said to be efficient, if the economy is getting all it
can from the scarce resources it has available.
o Points on the production possibilities frontier represent
efficient levels of production.
There is no way to produce more on one product
without producing the other product less. (Tradeoff) Inside the production possibilities frontier represents inefficient
Microeconomic vs. Macroeconomic
Microeconomic: study of how households and firms make decisions
and how they interact in specific markets.
o Ex. study the effects of rent control on housing in Toronto
Macroeconomic: study of economy wide phenomena.
o Ex. Inflation, Unemployment, Economic Growth.
It is impossible to understand macroeconomic developments
without considering associated microeconomic decisions.
The economist as Policy Adviser
When economists are trying to explain the world, they are
When they are trying to help improve it, they are policy advisers.
Positive vs. Normative Analysis.
Positive statement: are descriptive, they make a claim about how
the world is.
o Ex. Min. wage laws cause unemployment
o Usually by scientists
o Confirm or refute positive statements by examining evidence.
Normative statement: prescriptive, they make a claim about how
the world ought to be.
o Ex. The government should raise the minimum wage.
o Usually by policy advisers.
o Evaluating it involves values as well as facts but cannot be
judged using data alone. Deciding what is good or bad policy
is not merely a matter of science. It also involves our views
on ethnics, religion, and political philosophy.
A key difference between positive and normative statements is how
we judge their validity.
Positive views about how the world works affect normative views
about what policies are desirable. Much of economics is positive but often have goals that are
Economists in Ottawa
Harry Truman (U.S. President) was right in realizing that
economists’ advice is not always straight forward.
The influence of economists on policy goes beyond their role as
advisers: Their research and writings often affect policy indirectly.
Why Economists disagree
Two reaons why economists so often appear to give conflicting
advice to policymakers
o Economists may disagree about the validity of alternative
positive theories about how the world works
o Economists may have different values and, therefore,
different normative views about what policy should try to
At other times, economists are united in the advice they offer, but
policymakers may choose to ignore it.
The Proposition about which Most economists Agree
1) A ceiling on rents reduces the quantity and quality of housing available.
2) Tariffs and import quotas usually reduce general economic welfare. (93%)
3) Flexible and floating exchange rates offer an effective international
monetary arrangement (90%)
4) Fiscal Policy (e.g., tax cut and/or government expenditure increase) has a
significant stimulative impact on a less than fully employed economy. (90%)
5) If the federal budge is to be balanced, it should be done over the business
cycle rather than yearly (85%)
6) Cash payments increase the welfare of recipients to a greater degree than
do transfers-in-kind of equal cash value. (84%)
7) A large federal budget deficit has an adverse effect on the economy.
8) A minimum wage increases unemployment among young and unskilled
workers. (79%) 9) The government should restructure the welfare system along the lines of
a “negative income tax.” (79%)
10) Effluent taxes and marketable pollution permits represent a better
approach to pollution control than imposition of pollution ceilings. (78%)
use economic arguments and systems to persuade companies to
clean up pollution and to help conserve natural areas. Chapter 1: Introduction 1/8/2013 11:17:00
Comes from Greek word for “one who manages a household”
Like the economy, household must allocate its scarce resources
among its various members, taking into account each member’s
abilities, efforts, and desires.
What jobs will be done and who will do them.
The management of society’s resources (e.g. people, land, buildings
machinery) is important because resources are scarce.
Scarcity: that society has limited resources and therefore cannot
produce all the goods and services people wisht o have.
Economics: the study of how society manages its scarce resources
In most societies, resources are allocated not by a single central
planner but through the combined actions of millions of households
Economists studies how people make decisions:
o How they work
o What they buy
o How much they save
o How they invest their savings
o Also studies how people interact with each other
o Analyzes forces and trends that affect the economy as a
whole. (Average income, unemployment…etc.)
10 principles of economics
HOW PEOPLE MAKE DECISIONS
The behavior of an economy reflects the behavior of the individuals.
Principle #1: People Face Tradeoffs
Making decisions requires trading off one goal against another
o There’s no such thing a free
o Ex. If someone chooses to spend their time studying, they
give up that time to study instead of napping, biking…etc. When people are grouped into societies, they face different kinds of
o Classic tradeoff: Between “guns and butter”
The more we spend on national defence (guns) to
protect our shores from foreign agressors, the less we
can spend on consumer goods (butter) to raise the
o In modern society, the tradeoff between a clean environment
and a high level of income
Laws that require firms to reduce pollution raise the
cost of producing goods and services.
Higher cost = lower wages, charging higher prices,
earning smaller profits.
o Tradeoff between efficiency and equity.
Efficiency: the society is getting the most it can from its
scarce resources (size of the pie)
Equity: the benefits of those resources are distributed
fairly among society’s members. (how the pie is
The two goals tend to conflict.
When the government tries to cut the economic
pie into more equal slices, the pie gets smaller.
Rich people help support the poorer people who
needs support but in the end the people who work
harder gets less reward.
Principle #2: The cost of Something is what you give up to get it.
Opportunity cost: whatever must be given up to obtain another
Principle #3: Rational People Think at the Margin
Economists normally assume that people are rational
o Rational people: systematically and purposefully do the best
they can to achieve their objectives, given the opportunities
they have. o Marginal changes: Small incremental adjustments to a plan of
Marginal changes are adjustments around the edges of
what you are doing.
Ex. You decision is not between blowing them off
or studying 24 hours a day, but whether to spend
an extra hour reviewing your notes instead of
o Rational people often make decisions by comparing marginal
benefits and marginal costs.
They only take the action if and only if the marginal
benefit of the action exceeds the marginal cost.
Explains why airlines are willing to sell tickets
below average cost and why people are willing to
pay more for diamonds than for water.
Principle #4: People Respond to Incentives
Incentive: something (such as the prospect of a punishment or a
reward) that induces a person to act.
Because rational people make decisions by comparing costs and
benefits, they respond to incentives.
Analyzing any policy, we must consider not only the direct effects
but also the indirect effects that work through incentives. It the
policy changes incentives, it will cause people to alter their
HOW PEOPLE INTERACT
Principle #5: Trade can make everyone better off
Trade between countries can make each country better off.
Although there will be competition, trade allows each person to
specialize in the activities he or she does best. By trading with
others, people can buy greater variety of goods and services at
lower cost. Principle #6: Markets are usually a good way to organize economic
Market economy: replaced the central planner system with an
economy that allocates resources through the decentralized
decisions of many firms and households as they interact in markets
for goods and services.
o Central Planners: Those who decides what goods and services
were produced, how much was produced, and who produced
and consumed these goods and services.
Are in communist countries.
o The market economy tends to contain more self-interested
decision makers, however proven to be successful in a way
that promotes overall economic well-being.
Adam Smith: Households and firms interacting in markets act as if
they are guided by an “invisible hand” that leads them to desirable
o Market prices reflect both the value of a good to society and
the cost to society of making the good.
o Prices adjust to guide these individual buyers and sellers to
reach outcomes that, in many cases, maximize the welfare of
society as a whole.
o When the government prevents prices from adjusting
naturally to supply and demand, it impedes the indivisible
hand’s ability to coordinate the millions of households and
firms that make up the economy.
Explains why taxes adversely affect the allocation of
Principle #7: Governments can sometimes improve market outcomes
One reason we need government is that the indivisible hand can
work if rules are enforced and institutions are maintained
Markets work only if property rights are enforced
o Property rights: The ability of an individual to own and
exercise control over scarce resources. Another reason we need government: the invisible hand is
powerful, but it is not omnipotent (unlimited power, able to do
Two broad reasons for government to intervene:
o Promote efficiency
o Promote equity
Most policies aim either to enlarge the economic pie or to change
how the pie is divided
Market failure: refer to a situation in which the market on its own
fails to produce an efficient allocation of resources.
o Possible causes of market failure:
Externality: impact of one person’s actions on the well-
being of a bystander.
Market power: refers to the ability of a single economic
actor (or small group of actors) to have a substantial
influence on market prices.
A market economy rewards people according to their ability to
produce things that other people are willing to pay for.
HOW THE ECONOMY AS A WHOLE WORKS
Principle #8: A country’s standard of living depends on its ability to
produce goods and services.
Almost all variation in living standards in attributable to differences
in countries’ productivity
o Productivity: the amount of goods and services produced
from each hour of a worker’s time.
The growth rate of a nation’s productivity determines the growth
rate of its average income.
To boost living standards, policymakers need to raise productivity
by ensuring that workers are well educated, have the tools needed
to produce goods and services, and have access to the best
available technology Principle #9: Prices Rise when the government prints too much
Inflation: Increase in the overall level of prices in the economy
Growth in the quantity of money causes inflation.
o When a government creates large quantities of the nation’s
money, the value of the money falls.
Principle #10: Society faces a short-run tradeoff between inflation and
Simply means that, over a period of time many economic policies
push inflation and unemployment in opposite directions.
Although higher level of prices increases the quantity of money in
the long run. It is more complex and controversial in the short run.
Short-run effects of monetary injections:
o Stimulates the overall level of spending and thus the demand
for goods and services.
o Higher demand may, over time, cause firms to raise their
prices. But also encourages them to increase the quantity of
goods and services they produce and to hire more workers to
produce those goods and services.
o More hiring = lower unemployment.
Business cycle: the irregular and largely unpredictable fluctuations
in the economic activity, as measured by production of goods and
services or employment.
Short-run tradeoff between inflation and unemployment can be
exploited/influenced by changing the amount that government
spends, taxes, amount of money printed. Part 2 1/8/2013 11:17:00 AM
Graphing: A Brief Review
Many of the concepts that economists study can be expressed with
o Often these economic variables are related to one another
Ex. when the price of bananas rises, people buy fewer
Graphs serve two purposes:
When developing economic theories, graphs offer a way to visually
express ideas that might be more clear then describing it with
When analyzing economic data, graphs provide a way to finding
how variables are in fact related in the world.
Graphs of a Single Variable
Three common types of graphs are: Pie chart, Bar Graph, and
Graphs of Two Variables: The Coordinate System
Displays the relationship between two variables on a single graph
Positive correlation: the relationship between the two variables are
Negative correlation: the relationship between the two variables are
Curves in the Coordinate System
Economists prefer looking at how one variable affects another,
holding everything else constant.
Demand Curve: traces the effect of a good’s price on the quantity of the
good consumers want to buy
When the demand curve is downward sloping, and the two variables
are moving opposite direction, it is to say that the two variables are
When two variables move in the same direction, the curve relating
them is upward sloping, we say the variables are positively related. Movement along a curve: When the demand curve stays the same
and only the point moves along it
o Happens when a variable on an axis on the graph changes.
Shifts of a curve: When the demand curve actually shifts out.
o It is necessary to shift a curve when a variable that is not
named on either axis changes, the curve shifts.
Helps answer questions about how much one variable responds to
changes in another variable
The triangles are: Greek letter (delta) stands for the
change in variable.
Slope will be a small positive number for a fairly flat upward
o Large number for a steep upward-sloping line
o Negative number for a downward sloping line.
o Horizontal line = slope of 0
Slope = y1 – y2 / x1 – x2
Cause and Effect
Economists often use graphs to argue about how one set of events
causes another set of events.
Issues with cause and effect:
o We might decide that one variable on our graph is causing
changes in the other variable, when actually those changes
are caused by a third omitted variable.
It is difficult to hold everything else constant.
o Reverse Causality: We might decide that A causes B when in
fact B causes A.
Ex. Rather then police causing crime, crime may cause
an increase in police hiring.
An easy way to determine the direction of causality is to
examine which variable moves first. Flaw: often people change their behavior not in
response to a change in their present conditions
but in response to a change in their expectations
of future conditions.
Ex. Couples often buy a minivan in
anticipation of the birth of a child. The
minivan comes before the baby, but we
wouldn’t want to conclude that the sale of
minivans causes the population to grow. Chapter 3: Interdependence
And Gains from Trade 1/8/2013 11:17:00 AM
Consumption possibilities frontier: What the production possibilities
frontier also becomes when it is self-sufficient and without trade.
o Ex. the Farmer decides to grow his own potatoes and meat
Specialization and Trade
The result of specialization and trade allows consumers to have
more products in the end without working any more hours.
Even if one producer is better at producing both products then
producer B, it will still benefit them both if they choose to specialize
only in one of the product and then trade.
Absolute Advantage is used when comparing the productivity of one
person, firm, or nation to that of another.
The producer that requires a smaller quantity of inputs to produce a
good is said to have an absolute advantage in producing that good.
Opportunity cost and comparative advantage
Opportunity cost: whatever must be given up to obtain some item
o It measures the tradeoff between the two goods that each
o Ex. a farmer produces 1kg of potatoes in 15 mins but because
he needs 60 mins to produce 1 kg of meat, 15 minutes of
work would yield 0.25 kg of meat. Therefore the farmer’s
opportunity cost of 1 kg of potatoes is 0.25 kg of meat.
Comparative advantage: is used when describing the opportunity
costs of two producers.
o The producer who gives up less of other goods to produce
good X has the smaller opportunity cost of producing good X
and is said to have a comparative advantage in producing it.
It is possible for one person to have an absolute advantage in both
goods, it is impossible for one person to have a comparative
advantage in both goods. o Because the opportunity cost of one good is the inverse of the
opportunity cost of the other, if a person’s opportunity cost of
one good is relatively high, his opportunity cost of the other
good must be relatively low.
o Unless two people have exactly the same opportunity cost,
one person will have a comparative advantage in one good,
and the other person will have a comparative advantage in
the other good.
Comparative Advantage and Trade
The gains from specialization and trade are not based on absolute
advantage but rather on comparative advantage.
Total production in economy rises
Each producer benefits from trade by obtaining a good
at a price that is lower than his or her opportunity costs
of that good.
The Price of Trade
For both parties to gain from trade, the price at which they trade
must lie between the two opportunity costs.
o If the price was below both of their opportunity costs, then
both would want to be the consumers
o If the price was above their opportunity costs, then both
would want to be the producers
o However in this case, both cant be the seller or consumer.
Should Canada Trade with Other Countries?
Imports: goods and services produced abroad and sold domestically
Exports: Goods and Services produced domestically and sold
The principle of comparative advantage states that each good
should be produced by the country that has the smaller opportunity
cost of producing that good. The Market Forces Of
Supply and Demand 1/8/2013 11:17:00 AM
Market and Competition
Supply and demand refer to the behavior of people as they interact
with one another in markets
What is a Market?
Market: a group of buyers and sellers of a particular good or
o The buyers determine the demand for the product
o The seller determines the supply of the product
There are different forms of market
o Markets for agricultural commodities are sometimes highly
Buyers and sellers meet at a specific time and place,
where an auctioneer helps set prices and arrange sales
o Most markets are less organized.
Ex. Market for ice cream
What is Competition?
Most markets in the economy are highly competitive
o Ex. Ice cream, buyers know there are several sellers which
offer similar products and as a result the price and quantity of
the ice cream is not determined by any single buyer or seller.
Instead, price and quantity are determined by ALL buyers and
sellers as they interact in the market place.
Competitive market: a description to a market in which there are so
many buyers and sellers that each has a negligible impact on the
o Highest form of competition
o The goods offered for sale are all exactly the same
o The buyers and sellers are so numerous that no single buyer
or seller has any influence over the market price.
o Price takers: buyers and sellers must accept the price the
market determines. o Ex. wheat market: because no single buyer or seller can
influence the price of wheat, each takes the price as given.
Monopoly: A market with only one seller, and this seller sets the
price. The seller is a monopoly.
Some markets fall between the extremes of perfect competition and
The Demand Curve: The relationship between price and quantity demanded
Quantity demanded: the amount of the good that buyers are willing
and able to purchase
o One determinant that plays the central role of quantity
demanded is the PRICE of the good.
o Quantity demanded is negatively related to the price
As price rises demand falls and vice versa
Law of Demand: Other things equal, when the price of a good rises,
the quantity demanded of the good falls, and when the price falls,
the quantity demanded rises.
Demand Schedule: A table that shows the relationship between the
price of a good and the quantity demanded.
o Holding constant everything else that influences how much
consumers of the good want to buy.
Demand curve: a graph of the relationship between the price of a
good and the quantity demanded.
Market Demand vs. Individual Demand
Market demand: which is the sum of all the individual demands for
a particular good or service.
o The individual demand curves are summed horizontally to
obtain the market demand curve.
o We add the individual quantities found on the horizontal axis
of each individual demand curve.
Shifts in the Demand Curve
If something happens to alter the quantity demanded at any given
price, the demand curve shifts. o Ex. nutritionist discovered ice cream leads people with longer
and healthier lives which would raise the demand for ice
cream causing a shift in the demand curve.
Demand curve shift to the right = Increase in demand
Demand curve shift to the left = Decrease in demand
Most important variables that can shift the demand curve:
Normal good: The demand for the good falls when
Inferior good: The demand for the good rise