EC120 Chapter 2- Thinking Like an Economist Week 1
The Economist as Scientist
-Economists devises theories, collect data, and then analyze these data
The Scientific Method: Observation, Theory, and More Observation
-An economist may live in a country experiencing rapid increases in prices and be moved by this
observation to develop a theory of inflation
-To test this theory the economist could collect and analyze data on prices and money from many
-Experiments are often difficult in economics
-Economists have to find a substitute for laboratory experiments economist pay close attention to the
natural experiments that are offered by history
The Role of Assumptions
-Economists make assumptions
-Assumptions can simplify the complex world and make is easier to understand.
-Ex. Simplifying the world to two countries and each of which makes two goods.
-The art is deciding which assumptions to make
-For studying short run effects we may assume that prices do not change much
-Economists use models to learn about the world; composed of diagrams and equations.
-An economist’s model does not include every feature of the economy
-Models are built with assumptions – simplifying reality in order to improve our understanding of it
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
-Firms produce goods and services using inputs, such as labour, land, and capital. Called factors of
-Households own the factors of production and consume all the goods and services that the firms
-Households and firms interact in two types of markets. In the markets for goods and services,
households are buyers and firms are sellers. In the markets for the factors of production, households are
sellers and firms are buyers. EC120 Chapter 2- Thinking Like an Economist Week 1
Our Second Model: The Production Possibilities Frontier
-Production Possibilities Frontier-a graph that shows the combinations of output that the economy can
possible produce given the available factors of production and the available production technology
-Points inside the curve represent efficient levels of production
-The curve shows one tradeoff that society face
-The curve shows the opportunity cost of one good as measured in terms of the other good.
-When society moves from point A to point B it gives up 200 computers to get 100 additional cards. That
is, at point A, the opportunity cost of 100 cars is 200 computers. Another way: the opportunity cost of
each car is two computers.
-Note that it is not a constant.
Microeconomics and Macroeconomics
-Economics is studied on various levels. We can study the interaction of households and firms. Or we
can study the interaction of households and firms in markets for specific goods and services. Or we can
study the operation of the economy as a whole, which is just the sum of the activities of all these
decision makers in all th