Ch2-THINKING LIKE AN ECONOMIST

 Before delving into the substance and details of

economics, it is helpful to have an overview of how
economists approach the world.
 This chapter, therefore, discusses the field’s
methodology.
 What is distinctive about how economists confront a
question?
 What does it mean to think like an economist?

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 THE ECONOMIST AS SCIENTIST

Economists try to address their subject with

a scientist’s objectivity.

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 THE ECONOMIST AS SCIENTIST
THE SCIENTIFIC METHOD
 The scientific method involves
observation, theory, and more
observation.
 Economists use theory and
observation like other scientists, but
they do face an obstacle that makes
their task especially challenging:

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 Experiments are often difficult in
economics.
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• Physicists studying gravity can drop many objects in their laboratories to

generate data to test their theories.
• By contrast, economists studying inflation are not allowed to manipulate
a nation’s monetary policy simply to generate useful data.
• Economists, like astronomers and evolutionary biologists, usually have to
make do with whatever data the world happens to give them.

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 THE ECONOMIST AS SCIENTIST
THE ROLE OF ASSUMPTIONS

 Assumptions can simplify the complex world and make it

easier to understand.
 The art in scientific thinking is deciding which
assumptions to make.

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• To study the effects of international trade, for example, we may assume that
the world consists of only two countries and that each country produces only
two goods.

• Of course, the real world consists of dozens of countries, each of which

produces thousands of different types of goods.

• But by assuming two countries and two goods, we can focus our thinking.

• Once we understand international trade in an imaginary world with two

countries and two goods, we are in a better position to understand
international trade in the more complex world in which we live.

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 THE ECONOMIST AS SCIENTIST
ECONOMIC MODELS
 Economists also use models to learn about the world
that are most often composed of diagrams and
equations.
 Economic models omit many details to allow us to see
what is truly important.
 All the models are built with assumptions.

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 THE ECONOMIST AS SCIENTIST
OUR FIRST MODEL:
THE CIRCULAR-FLOW DIAGRAM

 Circular-Flow Diagram: A visual model of the economy

that shows how dollars flow through markets among
households and firms.

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• The economy consists of millions of people engaged in many activities—

buying, selling, working, hiring, manufacturing, and so on.

• To understand how the economy works, we must find some way to simplify our
thinking about all these activities.

• In other words, we need a model that explains, in general terms, how the
economy is organized and how participants in the economy interact with one
another.

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 FIGURE 2.1
The Circular Flow

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• Households and firms interact in two types of markets. In the markets for goods and services,
households are buyers and firms are sellers.

• In particular, households buy the output of goods and services that firms produce. In the markets for
the factors of production, households are sellers and firms are buyers.

• In these markets, households provide the inputs that the firms use to produce goods and services.

• The circular-flow diagram offers a simple way of organizing all the economic transactions that occur
between households and firms in the economy.

• The two loops of the circular-flow diagram are distinct but related.

• The inner loop of the circular-flow diagram represents the flows of inputs and outputs.

• The households sell the use of their labour, land, and capital to the firms in the markets for the
factors of production.

• The firms then use these factors to produce goods and services, which in turn are sold to
households in the markets for goods and services.

• The outer loop of the diagram represents the corresponding flow of dollars.

• The households spend money to buy goods and services from the firms.

• The firms use some of the revenue from these sales to pay for the factors of production, such as
the wages of their workers.

• What’s left is the profit of the firm owners, who themselves are members of households.

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 THE ECONOMIST AS SCIENTIST
MICROECONOMICS AND MACROECONOMICS

 Microeconomics: The study of how households and firms

make decisions and how they interact in markets.
 Macroeconomics: The study of economy-wide
phenomena, including inflation, unemployment, and
economic growth.

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• A microeconomist might study the effects of rent control on housing in

Toronto, the impact of foreign competition on the Canadian auto industry, or
the effects of compulsory school attendance on workers’ earnings.

• A macroeconomist might study the effects of borrowing by the federal

government, the changes over time in the economy’s rate of unemployment, or
alternative policies to raise growth in national living standards.

• Microeconomics and macroeconomics are closely intertwined. Because

changes in the overall economy arise from the decisions of millions of
individuals, it is impossible to understand macroeconomic developments
without considering the associated microeconomic decisions.

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THE ECONOMIST AS POLICY ADVISER

 When economists are trying to explain the world,

they are scientists.
 When they are trying to help improve it, they are
policy advisers.

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 THE ECONOMIST AS POLICY ADVISER
POSITIVE VERSUS NORMATIVE ANALYSIS

 Positive statements: Claims that attempt to describe the

world as it is.
 Normative statements: Claims that attempt to prescribe
how the world should be.

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• A key difference between positive and normative statements is how we judge

their validity.

• We can, in principle, confirm or refute positive statements by examining

evidence. An economist might evaluate Polly’s statement by analyzing data on
changes in minimum wages and changes in unemployment over time. By
contrast, evaluating normative statements involves values as well as facts.
Norm’s statement cannot be judged using data alone.

• Deciding what is good or bad policy is not merely a matter of science. It also
involves our views on ethics, religion, and political philosophy.

• As you study economics, keep in mind the distinction between positive and
normative statements because it will help you stay focused on the task at
hand.

• Much of economics is positive: It just tries to explain how the economy works.
Yet those who use economics often have goals that are normative.

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Active Learning
Discussion Questions

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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 THE ECONOMIST AS POLICY ADVISER
ECONOMISTS IN OTTAWA

 Economists at Finance Canada help design tax policy.

 Economists at Industry Canada help design and enforce
Canada’s competition laws.
 Economists at Global Affairs Canada help negotiate
trade agreements with other countries.

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• Economists outside the government also give policy advice.

• The C.D. Howe Institute, the Fraser Institute, the Institute for Research on
Public Policy, the Canadian Centre for Policy Alternatives, and other
independent organizations publish reports by economists that analyze
current issues such as poverty, unemployment, and the deficit.

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 THE ECONOMIST AS POLICY ADVISER
ECONOMISTS IN OTTAWA (CONTINUED)

 Economists at Employment and Social Development

Canada analyze data on workers and on those looking
for work to help formulate labour-market policies.
 Economists at Environment Canada help design
environmental regulations. Statistics Canada employs
economists to collect the data analyzed by other
economists and then give policy advice.

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• Economists outside the government also give policy advice.

• The C.D. Howe Institute, the Fraser Institute, the Institute for Research on
Public Policy, the Canadian Centre for Policy Alternatives, and other
independent organizations publish reports by economists that analyze
current issues such as poverty, unemployment, and the deficit.

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TABLE 2.1
Websites of Some Major Economic Organizations

ECONOMISTS IN OTTAWA (CONTINUED)

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 THE ECONOMIST AS POLICY ADVISER
WHY ECONOMISTS’ ADVICE IS NOT ALWAYS
FOLLOWED

 Any economist who advises government knows that his or

her recommendations are not always heeded.
 In the real world, figuring out the right policy is only part of
the job for the government.

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• In the real world, figuring out the right policy is only part of the job for the
government—sometimes the easiest part. For example, consider a political
party that forms the government receiving advice from its economic advisers
about what policy is best from their perspective. This is just the beginning of
the process.

• Communications advisers will then assess how best to explain the proposed
policy to the public, and they will try to anticipate any misunderstandings that
might make the challenge more difficult.

• Press advisers will anticipate how the news media will report on the proposal
and what opinions will likely be expressed on the nation’s editorial pages.

• Political advisers will weigh in to discuss which groups will organize to support
or oppose the proposed policy, how this proposal will affect party standing
among different groups in the electorate, and whether it will affect support for
other policy initiatives. After hearing and weighing all of this advice, a decision
will be made on how to proceed.

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 WHY ECONOMISTS DISAGREE
 There are two basic reasons:
 They can disagree about
the validity of alternative
positive theories about
how the world works.
 They can have different
values and, therefore,

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different normative views
about what a policy
should try to accomplish.
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 WHY ECONOMISTS DISAGREE
DIFFERENCES IN SCIENTIFIC JUDGMENTS

 Economists often disagree about the direction in which

truth lies.
 For example, economists disagree about whether the
government should levy taxes based on a household’s
income or its consumption.

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• Advocates of a switch from the current income tax to a consumption tax

believe that the change would encourage households to save more, because
income that is saved would not be taxed. Higher saving, in turn, would free
resources for capital accumulation, leading to more rapid growth in
productivity and living standards.

• Advocates of the current income tax system believe that household saving
would not respond much to a change in the tax laws.

• These two groups of economists hold different normative views about the tax
system because they have different positive views about the responsiveness of
saving to tax incentives.

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 WHY ECONOMISTS DISAGREE
PERCEPTION VERSUS REALITY
 Because of differences in scientific judgments and
differences in values, some disagreement among
economists is inevitable.
 But they do often share a common view.

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TABLE 2.2
Propositions about Which Most Economists Agree

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TABLE 2.2
Propositions about Which Most Economists Agree (Continued)

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