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Chapter 2

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ECN 104
Tsogbadral Galaabaatar

Economics as a science Economists approach theories in a similar (scientific) method to scientists. They devise theories, collect data, and then analyze these data in an attempt to verify or refute the theories. Scientific method-the dispassionate development and testing of theories about how the world works. The scientific method: observation, theory, and more observation The interplay between theory and observation occurs in economics (similar to Isaac Newton’s theory of gravity (apple)). When an economist comes up with a theory, they must test this theory with collecting and analyzing data from other countries. Experiments are often difficult in economics. A substitute for lab experiments is to pay close attention to the natural experiments offered by history because they give us insight into the economy of the past and because they allow us to illustrate and evaluate economic theories of the present. The role of assumption Assumptions can simplify the complex world and make it easier to understand. Scientific thinking is deciding which assumption to make. Economists use different assumptions when studying the short-run and long-run effects of a change in the quantity of money. Economic models Economist use models composed of diagrams and equations to learn about the world. -economic models omit many details to allow us to see what is truly important. -they are made with assumptions Our first model: The circular-flow diagram Circular-flow diagram-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-household and firms. Firms produce goods and services using inputs, such as labour, land (natural resources), and capital (buildings and machines). This is called factors of production. Households own the factors of production and consume all the goods and service that the firms produce. Households and firms interact in two types of markets. Markets for goods and services, households are buyers and firms are sellers. Households buy the output of goods and services that firms produce. Markets for the factors of production, households are sellers and firms are buyers. Households provide the inputs that firms use to produce goods and services The inner loop of the circular-flow diagram represents the flows of input and outputs. -the factors of production flow from households to firms, and goods and services flow from firms to households. The outer loop of the cir
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