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Chapter 2

ECON 201 Chapter Notes - Chapter 2: Opportunity Cost, Macroeconomics, Political Philosophy

Course Code
ECON 201

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Chapter 2: Thinking Like an Economist
The Economist as Scientist
The Scientific Method: Observation, Theory, and More Observation
Problem: An economists might live in a country experiencing rapidly
increasing prices
Observation: Develop theory of inflation
Theory: High inflation arises when government prints too much
Test: Collect and analyze data on prices and money from many
different countries
More Observation:
If the growth in the quantity of money were completely
unrelated to the rate of price increase, the economist
would start to doubt the validity of this theory of inflation
If the money growth and inflation were strongly correlated
in international data (they are), the economist would
become more confident in the theory
In economics, conducting experiments is often impractical
Usually have to make do with whatever data exists
Economists pay close attention to the natural experiments offered by
Ex. War in the Middle East interrupts the flow of crude oil which
cause oil prices to skyrocket around the world —> living standards
Event provided an opportunity to study the effects of a key
natural resource on the world’s economy
The Role of Assumptions
Assumptions can simplify the complex world and make it easier to
Ex. To study the effects of international trade, we might assume
that the world consists of only two countries and each country
produces only two goods
Economists use different assumptions to answer different questions
Ex. When studying short-run vs. long-run effects of a change in
the quantity of money
Economic Models
Diagrams, equations
Omit many details to allow us to see what is truly important
Does not include every feature of the economy
Built with assumptions
Simplify reality to improve our understanding of it
The Circular-Flow Diagram- a visual model of the economy that shows how
dollars flow through markets among households and firms
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Explains how the economy is organized and how participants in the
economy interact with one another
The economy is simplified to include only two types of decision makers—
firms and households
Organizes the economic transactions that occur between
households and firms in the economy
Firms- produce goods and services using the factors of production
Inputs such as land, labor and capital (buildings and
Households- own the factors of production and consume all of the
goods and services that the firms produce
Households and firms interact in two types of markets
Markets for goods and services
Households are buyers
Buy the output of goods and services
Firms are sellers
Produce goods and services
Market for the factors of production
Households are sellers
Provide the inputs
Firms are buyers
Use inputs to produce goods and services
Two loops of the circular-flow diagram
Inner loop- inputs and outputs
Households sell the use of their labor, land, and capital to
the firms in the markets for the factors of production
Firms use these factors to produce goods and services
Goods and services are sold to households
Outer loop- represents the corresponding flow of dollars
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