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Chapter 2

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McMaster University
Bridget O' Shaughnessy

Unit 1: The Nature and Method of Economics - Objective 2: Scientific Methodology 1.2.1 The Scientific Method and the Role of Assumptions The Scientific Method Economics as a social science is different from other sciences such as physics, in which controlled research experiments can be conducted in a laboratory setting. Experiments in the science of economics are conducted by  observing the economic world around us  coming up with theories for explaining the observations  collecting data to conduct statistical analysis for testing the theories offered  accepting or rejecting the theory only after rigorous statistical analysis. It is important to note that history has an important role in the science of economics because it provides data and also suggests patterns for observations to be formed. The Role of Assumptions Assumptions play a central role in constructing economic models by simplifying the complex world and making it easier to understand. It is important to make reasonable assumptions regarding an economic model, or else the model may be subject to harsh criticism by fellow economists. In the next objective of this unit, we will see the interplay between assumptions and building economic models. 1.2.2 Economic Models Economic models are simplifications—that is, they omit many irrelevant details so as to permit us to focus on the question at hand. As discussed earlier, by first introducing and explaining assumptions, economists are later able to build a model or simplification so as to explain the desired economic behaviour. The two models we will explore are the circular- flow diagram and the production possibilities frontier. The Circular-flow Diagram The circular-flow diagram model tells us, in general terms, how the economy is organized and how participants in the economy interact with each other. One important assumption of this model is that, for the sake of simplicity, there are only two participants or decision makers: households and firms. Note that two other possible economic participants—governments and the foreign sector—have been assumed away. Furthermore, the two players—households and firms—are assumed to interact in just two markets: the market for goods and services (output market), and the market for factors of production (input or resource market). Refer to Figure 2.1 on page 25 of the textbook for an illustration of the two loops flowing in opposite directions. The inner loop depicts the flow of inputs and output, whereas the outer flow depicts the monetary exchange associated with the flow of inputs and output. It is important to understand why the two loops flow in opposite direction. When, for example, the labour input, as shown by the inner loop, flows out of households into firms via the input market, firms have to pay a monetary compensation for the labour resource in the form of wages which flow back into households as seen in the outer loop. So, resources flowout of households and their dollar compensations flow back into households. The opposite direction of the two flows can also be seen in the interaction between households and firms in the market for goods and services (the output market). The inner loop illustrates how products flow into households from firms via the output market, whereas the outer loop flowing out from households to firms depicts dollar payments made by these households for their consumption of these goods and services. As described above, we can see that the circular-flow diagram offers a simple way of organizing all the economic transactions that occur between households and firms in the economy. For further details regarding this model, review pages 24–25. Let us now turn our attention to the second economic model, the production possibilities frontier. The Production Possibilities Frontier Watch the video introduction entitled ―Production Possibilities Frontier.‖ Be sure to have the speaker volume on your computer turned up so you don’t miss the audio commentary. The production possibilities frontier (PPF) is a graph that shows the combinations of output of two products that the economy can possibly produce given the available inputs and production technology. This model assumes that  the economy produces only two goods. In fact, they could be two types or categoriesof goods rather than two specific goods. For example, one type could be capital goodssuch as machines, tools and the other type could be consumer goods such as iPods and beer.  at any point of time, the economy has a fixed stock of factors of production or inputs such as labour, land, and machinery.  at any point of time, the economy has a fixed state of technology available for production. Pages 26–29 of the textbook illustrate and describe one example of the PPF as it applies to two goods: cars and computers. Below are some additional examples. Example 1 Given the following data, we can draw a production possibilities frontier. Production Alternatives Capital goods Consumer goods A 100 0 B 80 100 C 60 180 D 40 240 E 20 280 F 0 300 Figure 1.1: Production possibilities frontier The production possibility frontier shows us the maximum combinations of two goods that can be produced, assuming fixed resources and fixed technology. If the economy is producing at production alternative D, then 240 units of consumer goods and 40 units of capital goods will be produced. If the economy were to move to production alternative E, and produce 280 units of consumer goods, then 20 units of capital goods would have to be sacrificed in order to obtain 40 additional units of consumer goods. The sacrifice of 20 units of capital is called the opportunity cost of producing the 40 units of consumer goods. Production at alternative E gives more immediate returns in the form of consumer goods, but also has the effect, by producing fewer capital goods, of reducing economic growth. Producing more consumer goods than capital goods will diminish the stock of capital goods, so that in the future the economy will no longer have the same capacity to produce consumer goods. Suppose the choice is to produce 40 units of capital goods and 100 units of consumer goods. We can locate this alternative G in Figure 1.1. Point G is inside the production possibilities curve. This is an inefficient production alternative. The society is able to produce more of both capital and consumer goods by moving to any production alternative on the PPF. Hence, production alternative G indicates underemployed or unemployed resources. Suppose a major advance in technology occurs that allows this economy to produce everything more efficiently. This advance is equivalent to a growth in productive capacity. The production possibility frontier then moves to the right (dotted line in Figure 1.1). Now more of both consumer and capital goods can be produced with any combination of resources. Note that demand conditions have no impact on the PPF—only supply factors determine its shape and position. Example 2 As our economy grows and production increases, people have begun to show some concern over the deterioration of the environment. Using a production possibilities frontier, we can illustrate the choice between environmental quality and all other goods. Figure 1.2, below, describes the relationship between the quantity of goods produced and the quality of the environment. The more goods produced, the poorer the environmental quality. Figure 1.2: Environmental quality and the production possibilities curve Suppose we are at production alternative B. The air quality index is 30 and the output of goods and services is 425. A decision is made to improve the environmental quality to an air quality index of 60 (point A). The opportunity cost of doing this is 125 units of goods and services. Resources must be transferred from the production of goods and services to the reduction of pollution. The sacrifice in terms of goods and services is the opportunity or alternative cost of the production of more clean air. If a new production process were invented that allowed goods to be produced with less pollution, more goods could be produced at every level of pollution. This development is equivalent to a new production possibility frontier, represented by the dotted line in Figure 1.2. Example 3 Figure 1.3: Production possibilities frontier—agriculture and defence Suppose a country has all of its resources in agriculture (point E on Figure 1.3 at left), when suddenly a neighbouring country inva
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