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N. GREGORY MANKIW The Economist as a Scientist, Part 1

PRINCIPLES OF
MICROECONOMICS • Economics is a science
Eight Edition • Economists are scientists
– Devise theories
– Collect data
CHAPTER Thinking Like an – Analyze these data “I’m a social scientist,
Michael. That means I
Economist • Verify or refute their
theories
can’t explain electricity
or anything like that, but
if you ever want to know
– Use the scientific method about people, I’m your
PowerPoint Slides prepared by: man.”
V. Andreea CHIRITESCU
Eastern Illinois University
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The Economist as a Scientist, Part 2 The Economist as a Scientist, Part 3

• Scientific method The role of assumptions

– Dispassionate development and testing of • Assumptions
theories about how the world works – Can simplify the complex world and make
– Observation, theory, more observation it easier to understand
• Conducting experiments in economics – The art in scientific thinking: deciding
– Is often impractical which assumptions to make
• Substitute for laboratory experiments • Different assumptions
– Economists pay close attention to the – To answer different questions
natural experiments offered by history – To study short-run or long-run effects
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The Economist as a Scientist, Part 4 The Economist as a Scientist, Part 5

• Economic models • Circular-flow diagram

– Visual model of the economy
– Diagrams and equations
– Shows how dollars flow through markets
– Omit many details
among households and firms
– Allow us to see what’s truly important
• Two decision makers
– Built with assumptions
– Firms and Households
– Simplify reality to improve our
understanding of it • Two markets
– For goods and services
– For factors of production (inputs)
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The Economist as a Scientist, Part 6 The Economist as a Scientist, Part 7

• Firms Firms and Households interact in markets

– Produce goods and services • Markets for goods and services
– Use factors of production (inputs) – Firms are sellers
• Households – Households are buyers
– Own factors of production • Markets for factors of production
– Consume goods and services – Firms are buyers
– Households are sellers

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Figure 1 The circular flow

The Economist as a Scientist, Part 8
This diagram is a schematic
representation of the
organization of the
economy.
• Production possibilities frontier
Decisions are made by
households and firms. – A graph
Households and firms
interact in the markets for – Combinations of output that the economy
goods and services (where
households are buyers and can possibly produce
firms are sellers) and in the
markets for the factors of
production (where firms are
– Given the available
buyers and households are
sellers). • Factors of production
The outer set of arrows
shows the flow of dollars, • Production technology
and the inner set of arrows
shows the corresponding
flow of inputs and outputs.

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Figure 2 The production possibilities frontier

The Economist as a Scientist, Part 9
The production possibilities
frontier shows the
combinations of output—in
• Efficient levels of production
this case, cars and
computers—that the economy – The economy is getting all it can from the
can possibly produce.
The economy can produce scarce resources available
any combination on or inside
the frontier.
Points outside the frontier are
– Points on the production possibilities
not feasible given the
economy’s resources.
frontier
The slope of the production
possibilities frontier measures – Trade-off:
the opportunity cost of a car in
terms of computers. This • The only way to produce more of one good is
opportunity cost varies,
depending on how much of
to produce less of the other good
the two goods the economy is
producing. • Moving from point A to point B: give up 200
computers to produce 100 more cars
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The Economist as a Scientist, Part 10 The Economist as a Scientist, Part 11

• Inefficient levels of production • Bowed outward production possibilities

frontier
– Points inside production possibilities
frontier – Opportunity cost of a car is highest
• When the economy is producing many cars
• Opportunity cost of producing one good and fewer computers
– Give up producing units of the other good – Opportunity cost of a car is lower
– Slope of the production possibilities • When the economy is producing fewer cars
frontier and many computers
– Resource specialization
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The Economist as a Scientist, Part 12 Figure 3 A shift in the production possibilities frontier

• Technological advance A technological advance in

the computer industry
enables the economy to
– Outward shift of the production produce more computers
for any given number of
possibilities frontier cars.
As a result, the production
– Economic growth possibilities frontier shifts
outward.
– Produce more of both goods If the economy moves
from point A to point G,
then the production of both
cars and computers
increases.

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The Economist as a Scientist, Part 13 The Economist as Policy Adviser, Part 1

• Microeconomics • Positive statements: descriptive

– The study of how households and firms – Attempt to describe the world as it is
make decisions and how they interact in – Confirm or refute by examining evidence:
markets “Minimum-wage laws cause
• Macroeconomics unemployment”
– The study of economy-wide phenomena, • Normative statements: prescriptive
including inflation, unemployment, and – Attempt to prescribe how the world should
economic growth be: “The government should raise the
minimum wage”
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The Economist as Policy Adviser, Part 2 The Economist as Policy Adviser, Part 3

• Economists in Washington • Economists in Washington

– Council of Economic Advisers – Office of Management and Budget
• Advise the president of the – Department of the Treasury
United States
– Department of Labor
• Annual Economic Report of the
President: discusses recent “Let’s switch. I’ll make – Department of Justice
the policy, you
developments in the economy implement it, and he’ll – Congressional Budget Office
and presents the council’s explain it.”
analysis of current policy issues – The Federal Reserve

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The Economist as Policy Adviser, Part 4 Why Economists Disagree, Part 1

• Economists’ advice is not always followed
• Economists may disagree
– Economic advisers: what policy is best
– Validity of alternative positive theories
– Communication advisers: how best to explain about how the world works
it to the public
• Economists may have different values
– Press advisers: how the news media will
report – Different normative views about what
– Legislative affairs advisers: how Congress policy should try to accomplish
will view the proposal
– Political advisers: effect on the electorate
– The president: decision
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Why Economists Disagree, Part 2 Why Economists Disagree, Part 3

Differences in scientific judgments Differences in values

• Different hunches about • Peter and Paula – take the same amount
– Validity of alternative theories of water from the town well
– Size of important parameters – Peter’s income = $100,000
• Measure how economic variables are related • Tax = $10,000 (10%)
– Paula’s income = $20,000
• Tax = $4,000 (20%)

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Why Economists Disagree, Part 4 ASK THE EXPERTS

Ticket Resale
Perception versus Reality “Laws that limit the resale of tickets for
• Rent control entertainment and sports events make
– Adversely affects availability and quality of potential audience members for those events
housing worse off on average.”
– Costly way of helping the neediest
members of society
– Many cities use rent control
• Trade barriers (tariffs and import quotas)
– Economists oppose it
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Table 1 Propositions about Which Most Economists Agree, Part 1 Table 1 Propositions about Which Most Economists Agree, Part 2

Proposition (and percentage of economists who agree) 11. The gap between Social Security funds and expenditures will become
1. A ceiling on rents reduces the quantity and quality of housing available. (93%) unsustainably large within the next 50 years if current policies remain
2. Tariffs and import quotas usually reduce general economic welfare. (93%) unchanged. (85%)
3. Flexible and floating exchange rates offer an effective international monetary 12. Cash payments increase the welfare of recipients to a greater degree than do
arrangement. (90%) transfers-in kind of equal cash value. (84%)
4. Fiscal policy (for example, tax cut and/or government expenditure increase) has 13. A large federal budget deficit has an adverse effect on the economy. (83%)
a significant stimulative impact on a less than fully employed economy. (90%) 14. The redistribution of income in the United States is a legitimate role for the
5. The United States should not restrict employers from outsourcing work to foreign government.(83%)
countries. (90%) 15. Inflation is caused primarily by too much growth in the money supply. (83%)
6. Economic growth in developed countries like the United States leads to greater 16. The United States should not ban genetically modified crops. (82%)
levels of well-being. (88%) 17. A minimum wage increases unemployment among young and unskilled workers.
7. The United States should eliminate agricultural subsidies. (85%) (79%)
8. An appropriately designed fiscal policy can increase the long-run rate of capital 18. The government should restructure the welfare system along the lines of a
formation. (85%) “negative income tax.” (79%)
9. Local and state governments should eliminate subsidies to professional sports 19. Effluent taxes and marketable pollution permits represent a better approach to
franchises. (85%) pollution control than the imposition of pollution ceilings. (78%)
10. If the federal budget is to be balanced, it should be done over the business cycle 20. Government subsidies on ethanol in the United States should be reduced or
rather than yearly. (85%) eliminated. (78%)

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Graphing: A Brief Review, Part 1 Figure A-1 Types of Graphs

• Graphs serve two purposes:

– Visually express ideas that might be less
clear if described with equations or words
– Powerful way of finding and interpreting
patterns
• Graphs of a single variable The pie chart in panel (a) shows how U.S. national income is derived from various sources.

– Pie chart The bar graph in panel (b) compares the average income in four countries.

– Bar graph The time-series graph in panel (c) shows the productivity of labor in U.S. businesses over
time.

– Time-series graph
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Graphing: A Brief Review, Part 2 Figure A-2 Using the Coordinate System

• Graphs of two variables: the coordinate

system
– Display two variables on a single graph
– Scatterplot
– Ordered pairs of points
• x-coordinate
– Horizontal location
• y-coordinate
Grade point average is measured on the vertical axis and study time on the horizontal axis.
– Vertical location Albert E., Alfred E., and their classmates are represented by various points.
We can see from the graph that students who study more tend to get higher grades.

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Graphing: A Brief Review, Part 3 Table A-1 Novels Purchased by Emma

Price For $30,000 For $40,000 For $50,000
Curves in the coordinate system Income: Income: Income:
$10 2 novels 5 novels 8 novels
• Data 9 6 9 12

– Number of novels purchased 8 10 13 16

7 14 17 20
– Price of novels and Income 6 18 21 24
5 22 25 28
• Demand curve Demand curve, D3 Demand curve, D1 Demand curve, D2
– Effect of a good’s price This table shows the number of novels Emma buys at various incomes and prices.
For any given level of income, the data on price and quantity demanded can be graphed to
– On the quantity of the good consumers produce Emma’s demand curve for novels, as shown in Figures A-3 and A-4.

want to buy
– For a given income
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Graphing: A Brief Review, Part 4 Figure A-3 Demand Curve

• Negatively related variables
– The two variables move in opposite direction
– Downward sloping curve
• Positively related variables
– The two variables move in the same direction
– Upward sloping curve
• Movement along a curve
• Shifts in a curve
The line D1 shows how Emma’s purchases of novels depend on the price of novels when her
income is held constant. Because the price and the quantity demanded are negatively related,
the demand curve slopes downward.

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Figure A-4 Shifting Demand Curves Graphing: A Brief Review, Part 5

• Slope
– Ratio of the vertical distance covered
– To the horizontal distance covered
– As we move along the line
• Δ (delta) = change in a variable
• The “rise” (change in y) divided by the “run”
(change in x).
The location of Emma’s demand curve for novels depends on how much income she earns.
The more she earns, the more novels she will purchase at any given price, and the farther to
y
Slope 
the right her demand curve will lie. Curve D1 represents Emma’s original demand curve when
her income is $40,000 per year.
If her income rises to $50,000 per year, her demand curve shifts to D2.
If her income falls to $30,000 per year, her demand curve shifts to D3.
x
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Graphing: A Brief Review, Part 6 Figure A-5 Calculating the Slope of a Line

• Slope
– Fairly flat upward-sloping line
• Slope is a small positive number
– Steep upward-sloping line
• Slope is a large positive number
– Downward sloping line
• Slope is a negative number
– Horizontal line: slope is zero To calculate the slope of the demand curve, we can look at the changes in the x- and y-
coordinates as we move from the point (21 novels, $6) to the point (13 novels, $8). The slope
– Vertical line: infinite slope of the line is the ratio of the change in the y-coordinate (–2) to the change in the x-coordinate
(+8), which equals –1 4.

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Graphing: A Brief Review, Part 7 Figure A-6 Graph with an Omitted Variable

• Cause and effect

– One set of events
• Causes another set of events
– Omitted variables
• Lead to a deceptive graph
The upward-sloping curve shows that members of households with more cigarette
lighters are more likely to develop cancer. Yet we should not conclude that ownership
of lighters causes cancer because the graph does not take into account the number of
cigarettes smoked.

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Graphing: A Brief Review Figure A-7 Graph Suggesting Reverse Causality

• Cause and effect

– Reverse causality
• Decide that event A causes event B
• Facts: event B causes event A

The upward-sloping curve shows that cities with a higher concentration of

police are more dangerous. Yet the graph does not tell us whether police
cause crime or crime-plagued cities hire more police.

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