Chapter 2 (Thinking like an economist) PDF

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The teacher is AFM Ataur Rahman...

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Chapter 2: Thinking like an economist People of every discipline have their own way of analysis, the unique way of attacking problems, Economics is no different However normally they have a common methodology to solve problems which is sufficiently open to accommodate peculiarity of each discipline. That methodology is sometimes known as scientific methodology. Here the word science is not limited to physical sciences only rather it is open for any discipline that encourages systematic and logical way of thinking. In that sense economist are like scientists, they do not work with reagents or machines or electricity but the way they try to solve the problem is the same was an engineer or physicist would like to solve his problem, this is wat we call scientific method The method runs like observation, theory and more observation Our theorization process starts from observing our subjects In hard science our subjects are mostly inanimate things and thus we are more certain about their behavior In care of pharmacy our subjects are human body and physiologically they behave more or less same (not exactly same) when intervened But behaviors of human beings vary widely when they are put in similar situation Therefore, our problem-solving techniques are different from those of physicians and engineers Scientific method of problem solving Inductive method, observation then theory and then observation and then updated theory and then more observation and so on Models Economists use models Models are abstraction of real life No physical models Mathematical models So economic models are mathematical abstraction of real lives Role of assumption Ceteris paribus Ceteris paribus (often abbreviated to simply cet. par.) is a Latin term for ‘other things being equal’ and represents a convenient device used by economists to isolate the subject of study. For example, if we were examining the effect on the demand for a specific good in a given time period as a result of a change in its price, then the other influences affecting demand

(e.g. income, fashion, the prices of other goods, etc.) are assumed to remain unchanged, or constant. Similarly, if we were studying the influence of a change in income upon the demand for that same good, we then assume those other influences, including its price, remain constant. In reality, economic activity is complex, and typically more than one variable is changing at the same time. For example, as the firm is changing the price of one of its goods, household incomes might also be rising, advertising expenditure falling and consumers could anyway be revising their opinion of the product. It is also likely that rival firms might alter their sales strategies, affecting the demand for both their products and the goods we are investigating. To study the relationship between a change in price and demand, we invoke our assumption of ceteris paribus and effectively ‘freeze’ the picture. The assumption of ceteris paribus is therefore a convenient framework to begin the study of what we accept is a more complex relationship. By initially examining how demand changes only in relation to a single variable, for example price, we are then able to illustrate the demand relationship in a simple, two-dimensional diagram. Circular flow diagram Economic activities move in a circle, money starts at some point and then comes back to that point after completing a full cycle.

If this is a real economy then what are the complexities that we are suppressing a) Some of the firms can save in that case they are both savers (belongs to household group) and producers (belongs to firm group) b) Some market can serve both end users as well as producers c) Government is missing from here d) If someone saves money and then keeps it under the mattress rather than keeping it in the bank then it cannot be considered as savings These are practical problems and we suppress these problems and keep the model simple so that we can get required insights from it This cycle is important as it gives everybody a chance to earn money and fulfill his or her need So, if this cycle gets stuck somewhere or gets broken then economy is in trouble The cycle has two opposing flows one signifies flows of goods and services and other is flow of money Production possibility frontier Production Possibility Frontier (PPF) is a graph that gives us the combination of all goods and services that an economy can produce using all its resources and using existing technology Bulging outward

PPF is normally a downward sloping curve bulging outward Change in technology level, product specific technology improvement General Purpose Technology (GPT) improvement electricity, internet, block chain etc.

Policy making Economists are not always honored Why economists differ Perception vs reality Positive versus Normative Analysis An example of a positive statement is “higher taxes discourage work effort.” It is a positive statement because it is a claim that describes the world as it is. An example of a normative statement is “the government should reduce tax rates.” It is a normative statement because it is a claim that prescribes how the world should be. Many other examples are possible.

Class work: Should Medical School Be Free? The U.S. population continues to increase, which by itself would increase the demand for medical services. In addition, the average age of the population is rising, and older people need more medical care than do younger people. So, over time, the number of doctors needs to increase. As mentioned at the beginning of this chapter, the U.S. Health Resources and Services Administration (HRSA) estimates that the number of doctors needed to provide patient care will rise from about 805,000 in 2010 to 922,000 in 2020. Can we be sure that these additional doctors will be available in 2020? The HRSA forecasts that, in fact, there will be a shortage of 56,000 doctors in 2020. The bulk of that shortage is likely to be in primary care physicians, or family doctors. As we will discuss in later chapters, ordinarily we expect that when consumers want more of a product, higher wages and salaries and more job openings will attract workers to that industry. But producing more doctors is a long process. After completing his or her undergraduate education, a doctor spends four years in medical school and then three to five years at a teaching hospital, pursuing a residency in a particular field of medicine. Apparently convinced that hospitals will not train enough doctors unless they get help, Congress contributes $10 billion per year to teaching hospitals, based on the number of residents they train. Peter Bach of the Sloan-Kettering Cancer Center and Robert Kocher of the Brookings Institution have proposed that medical schools should charge no tuition. They argue that nearly all students graduate from medical school owing money on student loans, with the average student owing more than $160,000. We might expect that these debts, although large, would not deter students from applying to medical school, because in 2013, the average income of physicians was more than $250,000 per year. Bach and Kocher argue, though, that the high cost of medical school has two bad outcomes: Some good students do not apply because they either do not want to be saddled with such large debts or are unable to borrow sufficient money, and many students avoid going into primary care—where average incomes are $190,000—in favor of specialties such as plastic surgery or anesthesiology—where average incomes are $325,000. Questions: a. Should medical education be subsidized or free? b. Should more doctors work as GP (General Practitioners) or go for specialization?

Theories are not always clear about what is going to happen. Decisions are based on data and data collection procedure is not always as explicit as in other hard sciences Differences in values Proposition (and percentage of economists who agree) 1. A ceiling on rents reduces the quantity and quality of housing available. (93%)

2. Tariffs and import quotas usually reduce general economic welfare. (93%) 3. Flexible and floating exchange rates offer an effective international monetary arrangement. (90%) 4. Fiscal policy (e.g., tax cut and/or government expenditure increase) has a significant stimulative impact on a less than fully employed economy. (90%) 5. The United States should not restrict employers from outsourcing work to foreign countries. (90%) 6. Economic growth in developed countries like the United States leads to greater levels of wellbeing. (88%) 7. The United States should eliminate agricultural subsidies. (85%) 8. An appropriately designed fiscal policy can increase the long-run rate of capital formation. (85%) 9. Local and state governments should eliminate subsidies to professional sports franchises. (85%) 10. If the federal budget is to be balanced, it should be done over the business cycle rather than yearly. (85%) 11. The gap between Social Security funds and expenditures will become unsustainably large within the next 50 years if current policies remain unchanged. (85%) 12. Cash payments increase the welfare of recipients to a greater degree than do transfers-inkind of equal cash value. (84%) 13. A large federal budget deficit has an adverse effect on the economy. (83%) 14. The redistribution of income in the United State is a legitimate role for the government. (83%) 15. Inflation is caused primarily by too much growth in the money supply. (83%) 16. The United States should not ban genetically modified crops. (82%) 17. A minimum wage increases unemployment among young and unskilled workers. (79%) 18. The government should restructure the welfare system along the lines of a “negative income tax.” (79%) 19. Effluent taxes and marketable pollution permits represent a better approach to pollution control than imposition of pollution ceilings. (78%) 20. Government subsidies on ethanol in the United States should be reduced or eliminated. (78%) Source: Richard M. Alston, J. R. Kearl, and Michael B. Vaughn, “Is There Consensus among Economists in the 1990s?”

Microeconomics: Microeconomics is the study of how households and firms make decisions and how they interact in markets. Macroeconomics: Macroeconomics is the study of economy-wide phenomena, including inflation, unemployment, and economic growth. Problems and answers Problem 1: Draw a circular-flow diagram. Identify the parts of the model that correspond to the flow of goods and services and the flow of dollars for each of the following activities. a. Selena pays a storekeeper $1 for a quart of milk. b. Stuart earns $4.50 per hour working at a fast-food restaurant. c. Shanna spends $30 to get a haircut. d. Sally earns $10,000 from her 10 percent owner ship of Acme Industrial.

Problem 2: Imagine a society that produces military goods and consumer goods, which we’ll call “guns” and “butter.” a. Draw a production possibilities frontier for guns and butter. Using the concept of opportunity cost, explain why it most likely has a bowed-out shape. Figure 6 shows a production possibilities frontier between guns and butter. It is bowed out because the opportunity cost of butter depends on how much butter and how many guns the economy is producing. When the economy is producing a lot of butter, workers and machines

best suited to making guns are being used to make butter, so each unit of guns given up yields a small increase in the production of butter. Thus, the frontier is steep and the opportunity cost of producing butter is high. When the economy is producing a lot of guns, workers and machines best suited to making butter are being used to make guns, so each unit of guns given up yields a large increase in the production of butter. Thus, the frontier is very flat and the opportunity cost of producing butter is low. b. Show a point that is impossible for the economy to achieve. Show a point that is feasible but inefficient. Point A is impossible for the economy to achieve; it is outside the production possibilities frontier. Point B is feasible but inefficient because it is inside the production possibilities frontier. c. Imagine that the society has two political parties, called the Hawks (who want a strong military) and the Doves (who want a smaller military). Show a point on your production possibilities frontier that the Hawks might choose and a point the Doves might choose. The Hawks might choose a point like H, with many guns and not much butter. The Doves might choose a point like D, with a lot of butter and few guns. d. Imagine that an aggressive neighboring country reduces the size of its military. As a result, both the Hawks and the Doves reduce their desired production of guns by the same amount. Which party would get the bigger “peace dividend,” measured by the increase in butter production? Explain. If both Hawks and Doves reduced their desired quantity of guns by the same amount, the Hawks would get a bigger peace dividend because the production possibilities frontier is much flatter at point H than at point D. As a result, the reduction of a given number of guns, starting at point H, leads to a much larger increase in the quantity of butter produced than when starting at point D.

Class work: Classify with explanation each of the following statements as positive or normative. a. Society faces a short-run trade-off between inflation and unemployment. The statement that society faces a short-run tradeoff between inflation and unemployment is a positive statement. It deals with how the economy is, not how it should be. Since economists have examined data and found that there is a short-run negative relationship between inflation and unemployment, the statement is a fact, thus it is a positive statement. b. A reduction in the rate of money growth will reduce the rate of inflation. The statement that a reduction in the rate of growth of money will reduce the rate of inflation is a positive statement. Economists have found that money growth and inflation are very closely related. The statement thus tells how the world is, and so it is a positive statement. c. The Federal Reserve should reduce the rate of money growth. The statement that the Federal Reserve should reduce the rate of growth of money is a normative statement. It states an opinion about something that should be done, not how the world is. d. Society ought to require welfare recipients to look for jobs. The statement that society ought to require welfare recipients to look for jobs is a normative statement. It does not state a fact about how the world is. Instead, it is a statement of how the world should be and is thus a normative statement. e. Lower tax rates encourage more work and more saving. The statement that lower tax rates encourage more work and more saving is a positive statement. Economists have studied the relationship between tax rates and work, as well as the relationship between tax rates and saving. They have found a negative relationship in both cases. So, the statement reflects how the world is, and is thus a positive statement....