ECON 1BB3 Study Guide - Midterm Guide: Demand Curve, Green Economy, Negative Income Tax
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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)