CHAPTER

Thinking Like An Economist

Economics
ESSENTIALS OF

N. Gregory Mankiw

© 2009 South-Western, a part of Cengage Learning, all rights reserved

 The Economist as Scientist
 Economists play two roles:
1. Scientists: try to explain the world
2. Policy advisors: try to improve it
 In the first, economists employ the
scientific method,
the dispassionate development and testing of
theories about how the world works.

THINKING LIKE AN ECONOMIST 2

 Assumptions & Models
 Assumptions simplify the complex world,
make it easier to understand.
 Example: To study international trade,
assume two countries and two goods.
Unrealistic, but simple to learn and
gives useful insights about the real world.
 Model: a highly simplified representation of
a more complicated reality.
Economists use models to study economic
issues.

THINKING LIKE AN ECONOMIST 3

 Some Familiar Models

A road map

THINKING LIKE AN ECONOMIST 4

 Some Familiar Models

A model of human
anatomy from high
school biology class

THINKING LIKE AN ECONOMIST 5

 Some Familiar Models

A model airplane

THINKING LIKE AN ECONOMIST 6

 Some Familiar Models

The model teeth at the Don’t forget

dentist’s office to floss!

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 Our First Model:
The Circular-Flow Diagram
 The Circular-Flow Diagram: a visual model of
the economy, shows how dollars flow through
markets among households and firms
 Two types of “actors”:
 households
 firms
 Two markets:
 the market for goods and services
 the market for “factors of production”

THINKING LIKE AN ECONOMIST 8

 Factors of Production
 Factors of production: the resources the
economy uses to produce goods & services,
including
 labor
 land
 capital (buildings & machines used in
production)
 Organization

THINKING LIKE AN ECONOMIST 9

FIGURE 1: The Circular-Flow Diagram

Households:
 Own the factors of production,
sell/rent them to firms for income
 Buy and consume goods & services

Firms Households

Firms:
 Buy/hire factors of production,

use them to produce goods

and services
THINKING
Sell goods & services
LIKE AN ECONOMIST 10
FIGURE 1: The Circular-Flow Diagram

Revenue Spending
Markets for
G&S Goods &
G&S
sold Services bought

Firms Households

Factors of Labor, land,

production Markets for capital
Factors of
Wages, rent, Production Income
profit
THINKING LIKE AN ECONOMIST 11
 Our Second Model:
The Production Possibilities Frontier
 The Production Possibilities Frontier (PPF):
a graph that shows the combinations of
two goods the economy can possibly produce
given the available resources and the available
technology
 Example:
 Two goods: computers and wheat
 One resource: labor (measured in hours)
 Economy has 50,000 labor hours per month
available for production.
THINKING LIKE AN ECONOMIST 12
 PPF Example
 Producing one computer requires 100 hours labor.
 Producing one ton of wheat requires 10 hours labor.
Employment of
Production
labor hours
Computers Wheat Computers Wheat
A 50,000 0 500 0
B 40,000 10,000 400 1,000
C 25,000 25,000 250 2,500
D 10,000 40,000 100 4,000
E 0 50,000 0 5,000
 PPF Example
Wheat
Production
Point (tons)
on Com- 6,000
graph puters Wheat E
5,000
4,000
D
A 500 0
B 400 1,000 3,000 C
C 250 2,500 2,000
B
D 100 4,000 1,000
A
E 0 5,000 0
0 100 200 300 400 500 600
Computers

THINKING LIKE AN ECONOMIST 14

ACTIVE LEARNING 1
Points off the PPF
A. On the graph, find the point that represents
(100 computers, 3000 tons of wheat), label it F.
Would it be possible for the economy to produce
this combination of the two goods?
Why or why not?
B. Next, find the point that represents
(300 computers, 3500 tons of wheat), label it G.
Would it be possible for the economy to produce
this combination of the two goods?

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 ACTIVE LEARNING 1
Answers
Wheat
 Point F: (tons)
100 computers, 6,000
3000 tons wheat 5,000
 Point F requires 4,000
40,000 hours
3,000
of labor. F
Possible but 2,000
not efficient: 1,000
could get more 0
of either good 0 100 200 300 400 500 600
w/o sacrificing Computers
any of the other.
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ACTIVE LEARNING 1
Answers
Wheat
 Point G: (tons)
300 computers, 6,000
3500 tons wheat 5,000

 Point G requires 4,000 G

65,000 hours 3,000
of labor. 2,000
Not possible
1,000
because
economy 0
only has 0 100 200 300 400 500 600
50,000 hours. Computers

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 The PPF: What We Know So Far
Points on the PPF (like A – E)
 possible
 efficient: all resources are fully utilized
Points under the PPF (like F)
 possible
 not efficient: some resources underutilized
(e.g., workers unemployed, factories idle)
Points above the PPF (like G)
 not possible

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 The PPF and Opportunity Cost
 Recall: The opportunity cost of an item
is what must be given up to obtain that item.
 Moving along a PPF involves shifting resources
(e.g., labor) from the production of one good to
the other.
 Society faces a tradeoff: Getting more of one
good requires sacrificing some of the other.
 The slope of the PPF tells you the opportunity
cost of one good in terms of the other.

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 Economic Growth and the PPF
With additional Wheat
(tons) Economic
resources or an
6,000 growth shifts
improvement in the PPF
technology, 5,000 outward.
the economy can 4,000
produce more
3,000
computers,
2,000
more wheat,
or any combination 1,000
in between. 0
0 100 200 300 400 500 600
Computers

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 Why the PPF Might Be Bow-Shaped

As the economy

Beer
shifts resources
from beer to
mountain bikes:
 PPF becomes
steeper
 opp. cost of
mountain bikes
increases
Mountain
Bikes
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 Why the PPF Might Be Bow-Shaped
 So, PPF is bow-shaped when different workers
have different skills, different opportunity costs
of producing one good in terms of the other.
 The PPF would also be bow-shaped when
there is some other resource, or mix of
resources with varying opportunity costs
(E.g., different types of land suited for
different uses).

THINKING LIKE AN ECONOMIST 22

 The PPF: A Summary
 The PPF shows all combinations of two goods
that an economy can possibly produce,
given its resources and technology.

 The PPF illustrates the concepts of

tradeoff and opportunity cost,
efficiency and inefficiency,
unemployment, and economic growth.

 A bow-shaped PPF illustrates the concept of

increasing opportunity cost.

THINKING LIKE AN ECONOMIST 23

 Microeconomics and Macroeconomics
 Microeconomics is the study of how households
and firms make decisions and how they interact
in markets.
 Macroeconomics is the study of economy-wide
phenomena, including inflation, unemployment,
and economic growth.
 These two branches of economics are closely
intertwined, yet distinct – they address different
questions.

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 The Economist as Policy Advisor
 As scientists, economists make
positive statements,
which attempt to describe the world as it is.
 As policy advisors, economists make
normative statements,
which attempt to prescribe how the world should be.
 Positive statements can be confirmed or refuted,
normative statements cannot.
 Govt employs many economists for policy advice.
E.g., the U.S. President has a Council of Economic
Advisors, which the author of this textbook chaired
from 2003 to 2005.
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ACTIVE LEARNING 3
Identifying positive vs. normative
Which of these statements are “positive” and which
are “normative”? How can you tell the difference?
a. Prices rise when the government increases the
quantity of money.
b. The government should print less money.
c. A tax cut is needed to stimulate the economy.
d. An increase in the price of burritos will cause an
increase in consumer demand for video rentals.

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ACTIVE LEARNING 3
Answers
a. Prices rise when the government increases the
quantity of money.
Positive – describes a relationship, could use
data to confirm or refute.
b. The government should print less money.
Normative – this is a value judgment, cannot be
confirmed or refuted.

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ACTIVE LEARNING 3
Answers
c. A tax cut is needed to stimulate the economy.
Normative – another value judgment.
d. An increase in the price of burritos will cause an
increase in consumer demand for video rentals.
Positive – describes a relationship.
Note that a statement need not be true to be
positive.

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CHAPTER SUMMARY

 As scientists, economists try to explain the world

using models with appropriate assumptions.
 Two simple models are the Circular-Flow Diagram
and the Production Possibilities Frontier.
 Microeconomics studies the behavior of
consumers and firms, and their interactions in
markets. Macroeconomics studies the economy
as a whole.
 As policy advisers, economists offer advice on how
to improve the world.
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