Unit 1: The Nature and Method of Economics - Objective 2:
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
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
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
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
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.
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
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
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
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
Note that demand conditions have no impact on the PPF—only supply factors determine its
shape and position.
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
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
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