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Chapter 2

Chapter 2

4 Pages

Course Code
ECN 104
Eric Kam

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Principles of MicroeconomicsChapter 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 money 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 shortrun 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 longrun 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 economists model doesnt include every feature of the economy Our First Model The CircularFlow DiagramIn this model the economy is simplified to include only two types of decision makershouseholds 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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