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.
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
-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
-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
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.