Thinking Like an Economist Copyright 2004 SouthWesternThomson Learning

Thinking Like an Economist Copyright © 2004 South-Western/Thomson Learning 2

Thinking Like an Economist • Economics trains you to. . • Think in terms of alternatives. • Evaluate the cost of individual and social choices. • Examine and understand how certain events and issues are related. Copyright © 2004 South-Western/Thomson Learning

THE ECONOMIST AS A SCIENTIST • The economic way of thinking. . . • Involves thinking analytically and objectively. • Makes use of the scientific method. Copyright © 2004 South-Western/Thomson Learning

The Scientific Method: Observation, Theory, and More Observation • Uses abstract models to help explain how a complex, real world operates. • Develops theories, collects, and analyzes data to evaluate theories. Copyright © 2004 South-Western/Thomson Learning

The Role of Assumptions • Economists make assumptions in order to make the world easier to understand. • The art in scientific thinking is deciding which assumptions to make. • Economists use different assumptions to answer different questions. Copyright © 2004 South-Western/Thomson Learning

Economic Models • Economists use models to simplify reality in order to improve our understanding of the world • Two of the most basic economic models include: • The Circular Flow Diagram • The Production Possibilities Frontier Copyright © 2004 South-Western/Thomson Learning

Our First Model: The Circular-Flow Diagram • The circular-flow diagram is a visual model of the economy that shows how dollars flow through markets among households and firms. Copyright © 2004 South-Western/Thomson Learning

• a market is any kind of arrangement that allows the potential buyers and sellers of a particular good or service to interact. • Although it is true that many markets involve direct face-to face interaction between buyers and sellers, that is not an essential element of the exchange. Indeed, technology has dramatically altered the manner in which many buyers and sellers complete their transactions. Copyright © 2004 South-Western/Thomson Learning

consumer goods and services – things consumers buy because the goods or services provide them with satisfaction – are exchanged in markets called product markets. Markets for inputs used in the production process are called factor markets. These markets are where the factors of production (natural resources, labor, capital, and entrepreneurship) are bought and sold. Copyright © 2004 South-Western/Thomson Learning

• What is the goal then of the circular flow model? Without any centralized coordination or control of individual decisions about what, how, and for whom to produce, markets work to insure the availability of the many types and qualities of goods and services that consumers want by providing incentives for producers to make and offer to sell their goods and services day after day, year after year, in the marketplace Copyright © 2004 South-Western/Thomson Learning

THE MAGIC OF MARKETS! • What did you have for breakfast this morning? • How did this type of food arrive in your house? • How did someone in the family know what and how much to buy for breakfast? • How did the store it was purchased from know someone would buy it? • How does the local fast food restaurant know how many workers to schedule for each shift during the week? Copyright © 2004 South-Western/Thomson Learning

• What would happen if a change in consumer preferences and buying patterns significantly reduced the demand for a good or service? • What would happen if higher production costs significantly reduced the supply of a good or service? • For most goods and services, is a central authority needed to decide what, how, and for whom to buy and sell in competitive markets? Copyright © 2004 South-Western/Thomson Learning

What’s For Lunch? • Please Rank your menu preferences by first, second, third, and fourth. Please write down your ranking according to choice. Menu 1: Veggie pizza Menu 2: Cheeseburger Menu 3: Chef salad Menu 4: Chicken nuggets Copyright © 2004 South-Western/Thomson Learning

• I will now be distributing menu cards to students, all students need to stand up, then only the students who received a card with their top menu choice should sit down. Copyright © 2004 South-Western/Thomson Learning

• Those who are still standing, please attempt to trade menu cards ONLY with other students who are still standing. Students should trade cards ONLY if a trade improves the satisfaction of BOTH students, by moving them higher up on their menu rankings. • Then have all of the students who now hold their first menu choice sit down. Copyright © 2004 South-Western/Thomson Learning

1) Is it likely that a random distribution of menu items, such as demonstrated at the beginning of Part 1, will fully satisfy all consumers? 2) Did the trading in Part 2 of the Activity increase total satisfaction of the consumers? Copyright © 2004 South-Western/Thomson Learning

Allocative Efficiency One way to describe allocative efficiency (assuming that all individuals’ preferences are accepted and counted) is to say that resources are allocated efficiently when it is NOT possible to benefit one person without making someone else worse off. Copyright © 2004 South-Western/Thomson Learning

Figure 1 The Circular Flow MARKETS FOR GOODS AND SERVICES • Firms sell Goods • Households buy and services sold Revenue Wages, rent, and profit Goods and services bought HOUSEHOLDS • Buy and consume goods and services • Own and sell factors of production FIRMS • Produce and sell goods and services • Hire and use factors of production Factors of production Spending MARKETS FOR FACTORS OF PRODUCTION • Households sell • Firms buy Labor, land, and capital Income = Flow of inputs and outputs = Flow of dollars Copyright © 2004 South-Western

Our First Model: The Circular-Flow Diagram • Firms • Produce and sell goods and services • Hire and use factors of production • Households • Buy and consume goods and services • Own and sell factors of production Copyright © 2004 South-Western/Thomson Learning

Our First Model: The Circular-Flow Diagram • Markets for Goods and Services • Firms sell • Households buy • Markets for Factors of Production • Households sell • Firms buy Copyright © 2004 South-Western/Thomson Learning

Our First Model: The Circular-Flow Diagram • Factors of Production • Inputs used to produce goods and services • Land, labor, and capital http: //www. producingohio. org/action/circular/index. h tml Copyright © 2004 South-Western/Thomson Learning

Our Second Model: The Production Possibilities Frontier • The production possibilities frontier is a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology. Copyright © 2004 South-Western/Thomson Learning

Figure 2 The Production Possibilities Frontier Quantity of Computers Produced 3, 000 D C 2, 200 2, 000 A Production possibilities frontier B 1, 000 0 300 600 700 1, 000 Quantity of Cars Produced Copyright© 2003 Southwestern/Thomson Learning

Our Second Model: The Production Possibilities Frontier • Concepts Illustrated by the Production Possibilities Frontier • • Efficiency Tradeoffs Opportunity Cost Economic Growth Copyright © 2004 South-Western/Thomson Learning

Figure 3 A Shift in the Production Possibilities Frontier Quantity of Computers Produced 4, 000 3, 000 2, 100 2, 000 0 E A 700 750 1, 000 Quantity of Cars Produced Copyright © 2004 South-Western

Microeconomics and Macroeconomics • Microeconomics focuses on the individual parts of the economy. • How households and firms make decisions and how they interact in specific markets • Macroeconomics looks at the economy as a whole. • Economy-wide phenomena, including inflation, unemployment, and economic growth Copyright © 2004 South-Western/Thomson Learning

Ze end of Ze Vorld! • Productivity is a function of the available human and physical capital, the mix of the skills and abilities of the labor force and the machines, buildings, tools, and technology available to workers. • A key determinant of labor productivity (output per man-hour) is the amount of physical capital available to labor. The more capital available to workers, all other conditions held equal, the more productive the laborer will be. In simplest terms, workers who use tools and machines produce more with their labor than those who have none. • Disasters change the mix of human and physical capital, but they do so in different ways. The extent of the reduction and the effect on productivity depends on how much damage or destruction is sustained by the various types of resources and how the disaster affects the capital to labor ratio in the economy. Copyright © 2004 South-Western/Thomson Learning

WHAT IF? ? ? The detrimental economic effects of disasters are easier to see When the capital-to-labor ratio falls. • Suppose a small, island nation is devastated by a huge tsunami. There was adequate warning and the population was safely evacuated, but all the buildings and machinery on the island were destroyed. The labor force (human capital) is intact, and with the help of relief organizations that set up temporary shelter, people quickly return to the island to try to put their lives back together. • The shock to its capital (and land) resources immediately and drastically shrinks the nation’s ability to produce goods and services. While the people are ready and willing to work, they have none of the tools, machinery and technology they used before the storm hit. Copyright © 2004 South-Western/Thomson Learning

A different scenario • Suppose that, instead of a tsunami, the small island nation suffers an epidemic that devastates the population but leaves land capital resources intact. Disasters may create the misleading impression of being “good for the economy” if they cause capital-to-labor ratios to rise. Copyright © 2004 South-Western/Thomson Learning

Pandemics • A pandemic, for example, has a greater impact on labor-intensive production (subsistence agriculture, for example) than on capital-intensive production (information processing or industrial manufacturing), as shown by the greater shrinkage on the horizontal axis of the PPF below. Copyright © 2004 South-Western/Thomson Learning

CASE STUDY • Were the Black Plague and the Spanish Influenza “Good for the Economy”? • Two of the worst pandemics in recorded human history were the Black Plague that struck Europe in mid-14 th century, and the Spanish Influenza that raged during World War I. Studies focusing on economic conditions following these pandemics are representative of occasions in which disaster seems to be good for the economy. Copyright © 2004 South-Western/Thomson Learning

The Black Plague • The Black Plague spread throughout Europe, moving north from Sicily and Italy where it arrived from Asia on merchant ships. Death toll estimates from the Plague range from 25 -33% of total European population. • Studies of the economies of Europe after the Black Death have revealed evidence of increasing wages in agriculture and rising incomes for craftsmen, leading to the assertion that the Plague raised real per capita incomes in medieval Europe. Copyright © 2004 South-Western/Thomson Learning

CONCLUSION: Plague • Although it is likely that some serfs enjoyed higher standards of living because of the rise in the capital -labor ratio, this finding should not distract us from our original question of whether disasters are good for the economy. Economic change always produces winners and losers, and that some survivors’ economic well-being improved after the Black Death is not surprising. The bigger picture, however, remains clear: total output fell dramatically and the Black Death was not good for European economies. Copyright © 2004 South-Western/Thomson Learning

Spanish Influenza • The Spanish Influenza pandemic started in the United States and spread quickly to Europe on World War I troop ships. Its name came from headlines in Spain, where news coverage of the epidemic was not suppressed as it was in the countries fighting in WWI. Death toll estimates range from 20 -40 million, exceeding the total of all combat deaths in WWI, WWII, Korea, and Vietnam. The death toll in the United States was so high that it dropped American average life expectancy by ten years! Copyright © 2004 South-Western/Thomson Learning

SPANISH FLU A Philadelphia Federal Reserve study of the Spanish flu notes that although collecting data from the time period and separating the impacts of the pandemic from those of WWI make economic analysis difficult, the impact was clearly negative: • The Fed study cites National Bureau of Economic Research confirming that August 1918 -March 1919, the height of the epidemic, was also a downturn in the U. S. economy associated with falling production and business failure. (Kish) • Additionally, the Congressional Budget Office has estimated that if the U. S. experienced a similar pandemic today, gross domestic product (GDP) would fall by 5%. (Kish) Copyright © 2004 South-Western/Thomson Learning

• Note that this study refers to differences in the recovery process across the states. As we saw in the analysis of the Black Plague, the immediate effect of the pandemic was to reduce real income by reducing inputs to production. Here we see that where the decline in output was initially greatest (in those states with the biggest population losses), there was also the most vigorous recovery. But it is important to remember that these faster growth rates proceeded from lower initial income levels. ) • The explanation here harks back to our PPF model and the change in capital-to-labor ratios. Although there were fewer workers after the pandemic, there was an average of more capital per worker, increasing the productivity of the surviving workers. However, remember that the frontier has still retreated, indicating less total capital and lower total output. Copyright © 2004 South-Western/Thomson Learning

• We should not let these numerical results obscure the scale of the human tragedy involved – that “smaller population” may be an overly benign description of the human death toll. • Thus, the examples of the Black Death and the Spanish Flu illustrate how some survivors may actually benefit from disaster. Further examination shows us, however, that while economic benefits may accrue to some survivors, they do not negate the very real costs imposed by a pandemic – costs not only to individuals and families, but to the economy as a whole. Copyright © 2004 South-Western/Thomson Learning

• The contention that disasters are “good for the economy” overlooks the cost of unrealized human potential. Human loss is poignantly obvious on the personal scale but is largely invisible on the scale of “the economy. ” While such loss is hard to measure on either scale, it is nonetheless real and significant. • If we take the economic value of human life into account, however, it is clear that epidemics have a high cost. How high, of course, depends on the economic value one assigns to life. People who die during epidemics, along with their families, obviously lose out economically. One could, moreover, add other losses to this if one places an economic value on intangible impacts such as the lost companionship and love felt by friends and relatives of the dead Copyright © 2004 South-Western/Thomson Learning

• New Orleans is so fun!!! But then destruction duh duh…How can we apply economics to Katrina? ? ? Lets have fun with hurricanes! Copyright © 2004 South-Western/Thomson Learning

THE ECONOMIST AS POLICY ADVISOR • When economists are trying to explain the world, they are scientists. • When economists are trying to change the world, they are policy advisor. Copyright © 2004 South-Western/Thomson Learning

POSITIVE VERSUS NORMATIVE ANALYSIS • Positive statements are statements that attempt to describe the world as it is. • Called descriptive analysis • Normative statements are statements about how the world should be. • Called prescriptive analysis Copyright © 2004 South-Western/Thomson Learning

POSITIVE VERSUS NORMATIVE ANALYSIS • Positive or Normative Statements? ? ? • An increase in the minimum wage will cause a decrease in employment among the least-skilled. POSITIVE • Higher federal budget deficits will cause interest rates to increase. POSITIVE ? Copyright © 2004 South-Western/Thomson Learning

POSITIVE VERSUS NORMATIVE ANALYSIS • Positive or Normative Statements? ? ? • The income gains from a higher minimum wage are worth more than any slight reductions in employment. NORMATIVE • State governments should be allowed to collect from tobacco companies the costs of treating smoking-related illnesses among the poor. NORMATIVE ? Copyright © 2004 South-Western/Thomson Learning

Economists in Washington • . . . serve as advisers in the policymaking process of the three branches of government: • Legislative • Executive • Judicial Copyright © 2004 South-Western/Thomson Learning

Economists in Washington • Some government agencies that collect economic data and make economic policy: • Department of Commerce • http: //www. commerce. gov • Bureau of Labor Statistics • http: //www. bls. gov • Congressional Budget Office • http: //www. cbo. gov • Federal Reserve Board • http: //www. federalreserve. gov Copyright © 2004 South-Western/Thomson Learning

WHY ECONOMISTS DISAGREE • They may disagree about the validity of alternative positive theories about how the world works. • They may have different values and, therefore, different normative views about what policy should try to accomplish. Copyright © 2004 South-Western/Thomson Learning

Table 2 Ten Propositions about Which Most Economists Agree Copyright © 2004 South-Western

Summary • Economists try to address their subjects with a scientist’s objectivity. • They make appropriate assumptions and build simplified models in order to understand the world around them. • Two simple economic models are the circular-flow diagram and the production possibilities frontier. Copyright © 2004 South-Western/Thomson Learning

Summary • Economics is divided into two subfields: • Microeconomists study decisionmaking by households and firms in the marketplace. • Macroeconomists study the forces and trends that affect the economy as a whole Copyright © 2004 South-Western/Thomson Learning

Summary • A positive statement is an assertion about how the world is. • A normative statement is an assertion about how the world ought to be. • When economists make normative statements, they are acting more as policy advisors than scientists. Copyright © 2004 South-Western/Thomson Learning

Summary • Economists who advise policymakers offer conflicting advice either because of differences in scientific judgments or because of differences in values. • At other times, economists are united in the advice they offer, but policymakers may choose to ignore it. Copyright © 2004 South-Western/Thomson Learning