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Chapter 2

Chapter 2

Course Code
ECN 104
Eric Kam

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Principles of Microeconomics
Chapter 2
The Scientific Method: Observation, Theory, and More Observation
An economist might live in a country experiencing rapid increases in prices
and be moved by this observation to develop a theory of inflation. The theory
might assert that high inflation arises when the government prints too much
To test this theory, the economist could collect and analyze data prices and
money from many different countries. If growth in the quantity of money
were not at all related to the rate at which prices are rising, the economist
would start to doubt the validity of his theory of inflation.
The Role of Assumptions
Assumptions can 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.
Economists use different assumptions to answer different questions.
Suppose that we want to study what happens to the economy when the
government changes the number of dollars in circulation. An important piece
of this analysis, it turns out, is how prices respond. Many prices in the
economy change infrequently; the newsstand prices of magazines, for
instance, are changed only every few years.
Knowing this fact may lead us to make different assumptions when
studying the effects of the policy change over different time horizons. For
studying the short-run effects of the policy, we may assume that prices do
not change much. We may even make the extreme and artificial assumption
that all prices are completely fixed. For studying the long-run effects of the
policy, however, we may assume that all prices are completely flexible.
Economic Models
Economic models omit many details to allow us to see what is truly
important; an economist’s model doesn’t include every feature of the
Our First Model: The Circular-Flow Diagram
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 the factors of production. Households
own the factors of production and consume all the goods and services that
the firms produce.
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