Principles of Microeconomics Chapter 2&3 Thinking Like an Economist; Interdependence & Gains from Trade

Ch. 2 - Thinking Like an Economist

2-1 The Economist as Scientist 

• Economists use the scientific method, which is the dispassionate development and testing of theories

• The Scientific Method: observation, theory, and more observation

  • Challenge of using theory and observation like other scientists: it is impractical to conduct experiments, so economists usually have to use world data given 

  • Rely on natural experiments (an example being how the Middle East war increased crude oil prices) 

• The Role of Assumptions

  • Economists make assumptions to simplify the complex world

  • Must decide which assumptions to use to study short-run or long-run effects

• Economic Models

  • Models are simplified to improve understanding

• Our First Model: Circular-flow diagram

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  • Only 2 types of decision makers: firms & households 

  • 2 types of markets (markets for goods and services, markets for factors of production) 

  • Inner loop represents flows of inputs & outputs

  • Outer loop represents corresponding flow of $$ 

  • Remainder of revenue is profit for firm owners, who are themselves members of households

• Our Second Model: The Production Possibilities Frontier

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  • A graph that shows various combinations of output that the economy can possibly produce given the available factors of production and available production tech 

  • Endpoints represent extreme possibilities

  • Economy can produce any combination on or inside frontier (curve) 

  • Slope measures opportunity cost

  • Points on frontier = efficient (ex. Pt A) 

  • Once reaching an efficient point, must face trade-off or opportunity cost (1st principle of economics) 

  • Opportunity cost is greater when frontier is steeper

  • SHIFTS IN THE PPF: caused by technological advances and increase in capital or labor, but is unaffected by unemployment

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• Microeconomics & Macroeconomics 

  • Microeconomics studies households and firms in specific markets, whereas macroeconomics studies economy-wide phenomena

2-2 The Economist as Policy Adviser

• Positive vs. Normative analysis

  • Positive statements: descriptive; claim about how the world is; can be evaluated using evidence

  • Normative statements: prescriptive; claim about how the world ought to be; evaluated using values/ethics AND facts

  • Positive views affect normative views about what policies are desirable

• Economists in Washington

  • Policy decisions are difficult because of TRADEOFFS

• Why Economists’ advice is not always followed

  • Other factors to consider before making an economic decision 

2-3 Why Economists Disagree

• Economists disagree about validity of alternative positive theories 

• Economists have different values → different normative views

• Differences in scientific judgments

• Differences in values

• Perception vs. reality 

  • Economists agree more often than sometimes understood

  • Most economists oppose ceilings on rent and trade restrictions, but government goes against those suggestions often

Ch. 3 - Interdependence and the Gains From Trade

3-1 A Parable for the Modern Economy

• There are gains from trade if 1. The 2 subjects can only produce one good or 2. The 2 subjects can produce both goods, but only the secondary good at a very high cost

• Production Possibilities: 

  • If the country is self-sufficient and does not trade, the PPF is also the consumption possibilities frontier

• Specialization and Trade: 

  • Specialization and trade allows people to consume at a point OUTSIDE PPF 

3-2 Comparative Advantage: The Driving Force of Specialization

• Absolute Advantage

  • Someone has the absolute advantage when they require smaller quantities of inputs (ex. time) to produce a good

• Opportunity Cost and Comparative Advantage

  • The opportunity cost of one item is the INVERSE of the opportunity cost of the other item

  • Comparative advantage: the opportunity cost faced by 2 producers; the producer with smaller opportunity cost of producing Good X has the comparative advantage

  • Impossible for someone to have comparative advantage in BOTH goods

  • Should specialize based on comparative advantage

• Comparative Advantage and Trade

  • Specialization allows the total production in economy to rise (increase efficiency)

• The Price of the Trade

  • For both parties to gain from trade, the price at which they trade must lie between BOTH their opportunity costs

3-3 Applications of Comparative Advantage

• Should LeBron James Mow His Own Lawn? 

• Should the US Trade with Other Countries? 

  • Imports: goods produced abroad and sold domestically 

  • Exports: goods produced domestically and sold abroad

  • International trade can make INDIVIDUALS worse off, but COUNTRY as a whole better off