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Chapter 2

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Bridget O' Shaughnessy

Chapter 2 notes Economists try to address their subject with a scientist’s objectivity. Like all scientists, they make appropriate assumptions and build simplified models in order to understand the world around them. Two simple economic models are the circular flow diagram and the production possibilities frontier Scientific Method: experiments are often difficult in economics. Economics studying inflation are not allowed to manipulate a nation’s monetary policy simply to generate useful data. Economics, like astronomers and evolutionary biologists, usually have to make do with whatever data the world happens to give them To find substitutes for laboratory experiments, economists pay close attention to the natural experiments offered by history The role of assumptions- economists make assumptions to simplify the complex world and make it easier to understand. To study the effects of international trade, for example, we may assume that the world consists of only two countries and that each country produces only two goods. Of course the world consists of dozens of countries, each of which produces thousands of different types of goods. But by doing this, we can focus our thinking. ECONOMIC MODELS Economists use models to learn about the world; models composed of diagrams and equations -models may omit many details to allow us to see what is truly important -all the models are built with assumptions; economists assume away many of the details of the economy that are irrelevant for studying the question at hand THE CIRCULAR-FLOW DIAGRAM -is a visual model of the economy that shows how dollars flow through markets among households and firms -in this model, the economy is simplified to include only two types of decision makers- households and firms. Firms produce goods and services using inputs, such as labour, land (natural resources) and capital (buildings, and machines). These inputs are called factors of production. Households own the factors of productions and consume all the goods and services that the firms produce. -In the market for goods and services, households are buyers and firms are sellers, and in the markets for the factors of production, households are sellers (selling their labour, etc) and firms are buyers. -In these markets, households provide the inputs that the firms use to produce goods and services -this offers a simple way of organizing all the economic transactions that occur between h+f in economy Inner loop of the diagram represents the flows of inputs and outputs. The households sell their labour, land and capital to the firms in the market for the factors of production. The firms then use these factors to produce g+s, which in turn are sold to households in the markets for g+s. Hence, the factors of production flow from households to firms, and g+s flow from firms to households. The outer loop of the circular flow diagram represents the corresponding flow of dollars. 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, such as the wages of their workers. What’s left is the profit of the firm owners, who themselves are members of households. Hence, spending on goods and services flows from households to firms, and income in the form of wages, rent and profit flows from firms to households. Second Mod
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