Economics as a Science

Economics as a Science

• Economists function as scientists by devising theories, collecting data, and analyzing data to verify or refute their theories.
• The scientific method is central to economics.

The Scientific Method

• The scientific method is used to develop and test theories about how the world works.
• Conducting experiments in economics is often impractical.
• Alternatives to economic experiments include paying attention to natural historical events and developing quantitative macroeconomic models that can be used as labs.

The Role of Assumptions

• Assumptions simplify complex scenarios for easier understanding.
• The art of scientific thinking lies in choosing the right assumptions.
• Economists use different assumptions to address different questions and time horizons.

Economic Models

• Economists use models, which are simplified descriptions of complex reality.
• Models can be diagrams or equations.
• Models are built with assumptions, omit many details to simplify equality, and are subject to revision.

The Circular-Flow Diagram

• The economy comprises millions of people engaged in various activities like buying, selling and manufacturing.
• The circular-flow diagram provides a visual model of the economy.
• It is simplified to include only two decision-makers: households and firms.
• It illustrates the flow of dollars and goods/services between households and firms through markets.
• Firms produce goods and services (outputs) using factors of production (inputs).
• Households own factors of production (labor, capital) and consume goods and services.
• Households and firms interact in two types of markets: markets for goods and services, firms are sellers and in markets for production factors, households are sellers.

The Production Possibilities Frontier

• The Production Possibilities Frontier (PPF) is a graph showing the combinations of outputs an economy can produce with available factors of production and production technology.
• Any point on or beneath the curve on a PPF is a possible output combination.
• Points outside the frontier are not feasible given limited resources
• The slope of the production possibilities frontier measures the opportunity cost of one good in terms of the other, which can vary depending on production levels.

Efficient Outcomes

• Points on the PPF are efficient, meaning the economy is maximizing its use of scarce resources.
• A tradeoff exists at an efficient point, where producing more of one good requires producing less of another.

Opportunity Costs

• The opportunity cost of producing a good is the quantity of another good that must be given up
• Opportunity cost equals slope of PPF

Inefficient Outcomes

• Points inside the PPF are inefficient.
• At an inefficient point, the economy is able to producing less than it could from available resources.
• Eliminating the source of inefficiency allows for increased production of both goods.

The Economist as Policy Advisor

• Economists are scientists who explain the causes of economic events as well as policy advisors who recommend policies to improve economic outcomes.

Positive vs. Normative Analysis

• Positive statements are descriptive claims about how the world is, and can be confirmed or refuted by examining evidence, such as "Minimum-wage laws cause unemployment."
• Normative statements are prescriptive claims about how the world ought to be, involving values and facts, such as "The government should raise the minimum wage."

Economists in Washington

• The Council of Economic Advisers advises the president and writes the annual Economic Report of the President.
• Economists serve as advisors in various government offices, including the Office of Management and Budget, the Department of the Treasury, and the Federal Reserve.

Why Economists' Advice Is Not Always Followed

• The president receives advice from various advisors, including communication, press, legislative affairs, and political advisors, not only just economic advisors.
• The president makes decisions after weighing all advice

Why Economists Disagree

• Disagreements arise from differences in scientific judgments, such as the validity of alternative theories or the size of parameters measuring economic variables.
• Differences in values and political philosophies cause disagreement over public policy.

Graphing: A Brief Review

• Graphs serve to visually express ideas and find interesting patterns.

Graphs of Two Variables: The Coordinate System

• Two variables can be displayed on a single graph using a scatterplot.
• Ordered pairs of points have an x-coordinate (horizontal location) and a y-coordinate (vertical location).

Curves in the Coordinate System

• A scatterplot of fine data observations forms a curve.
• Negatively related variables move in opposite directions, forming a downward-sloping curve.
• Positively related variables move in the same direction, forming an upward-sloping curve.

Cause and Effect

• One set of events can cause another.
• A strong relationship between two variables means to conclude a causal relationship.
• Omitted variables or reverse causality can lead to deceptive graphs.

Markets and Competition

• Supply and demand are frequently used by economists, make market economies, and refer to the behavior of people as they interact in competitive markets.

What is a Market?

• A market includes a group of buyers and sellers for a specific good or service.
• Buyers as a group determine the demand for a product.
• Sellers as a group determine the supply of the product.

Competitive Market

• A competitive market consists of many buyers and sellers, of which affect market price.
• Price and quantity sold is determined by all sellers and buyers as they interact in the marketplace.
• In a perfectly competitive market, no single buyer or seller has influence over the market price.

Law of Demand

• Quantity demanded is the amount buyers are willing and able to purchase at a given price.
• Keeping other things equal, the quantity demanded falls when the price of a good rises, and rises when the price falls.

Demand

• Individual demand is the demand of an individual for a product.
• A demand schedule shows the relationship between the price of a good and the quantity demanded, while a demand curve is a graph of that relationship.

Market Demand

• Market demand is the sum of all individual demands for a particular good or service.
• A market demand curve illustrates how the total quantity demanded varies with price changes, holding constant other factors.

Shifts in the Demand Curve

• A change increases quantity buyers want to purchase at any price shifts demand curve to the right and decrease shifts to the left.

Variables That Influence Buyers that can shift the demand curve

• Income shifts the demand curve, depending on whether the good is normal or inferior.
• Prices of related goods may shift the demand curve like substitutes and complements.
• Tastes, Expectations and Number of buyers shift the demand curve.

Supply

• Quantity supplied is the amount of a good that sellers are willing and able to sell.
• Keeping other things equal, the quantity supplied rises when the price of a good rises, and falls when the price falls.

Individual Supply

• Individual supply is the supply of a seller for a product.
• A supply schedule shows the relationship between the price of a good and the quantity supplied.
• A supply curve graphs the relationship between price and quantity supplied.

Market Supply Curve

• Market supply curve shows total qty supplied varies as price varie, as all producer factors stay constant

Shifts in the Supply Curve when the price or demand changes

• Change increases quantity sellers want to sell at any price shifts supply curve to the right.
• Change decreases quantity sellers want to sell at any price shifts supply curve to the left

What Effects Supply curves

• Input prices affect the supply cuve to shift, plus Technology, Expectations about input prices and other factors and lastly Number of sellers

Supply and Demand Together: Equilibrium

• At equilibrium, the quantity of the good that buyers are willing and able to buy equals the quantity that sellers offer.
• Various market forces are in balance.
• Equilibrium results from equalizing qty demand and qty supplied

Surplus

• When quantity supplied is greater than the quantity demanded, there is excess supply.
• Sellers respond by cutting prices to increase the quantity demanded and decrease the quantity supplied and prices continue to adjust until market reaches equilibrium

Shortage

• Quantity demanded is greater than quantity supplied
• There is excess demand in market

Law of Supply and Demand

• The law of supply and demand claims that the price of any good adjusts to balance the quantity supplied and the quantity demanded.
• Surplus and shortage are usually temporary as prices move toward their equilibrium level

Analyzing Changes in Equilibrium which require these steps:

• Decide shifting supply or demand curve.
• Decide in which direction the curve shifts.
• Use diagram and to se how the shift changes the equilibrium price and quantity

Shifts in Curves vs. Movements Along Them

• A shift in the supply curve or the demand curve occurs when a variable other than is price that affects quantity sold
• A movement occurs when quantity sold changes which reflects changes in price

Elasticity of Demand

• The term “elasticity” captures the responsiveness of quantity demanded or quantity supplied to a change in one of its determinants.

Price Elasticity of Demand

• Price elasticity of demand measures how much the quantity demanded responds to a change in the price.
• Elastic demand means quantity demanded responds substantially to price changes; inelastic demand means quantity demanded responds only slightly to price changes.

Determinants of Price Elasticity of Demand

• Availability of close substitutes will increase elasticity for goods that have goods with no close substitute
• Elastic demand: luxuries/Inelastic demand: necessities
• Elastic demand: Narrowly defined markets cause elastic demand since there are many alternatives
• More elastic demand: Longer time horizons (as consumers adapt)
• Computing: Percentage change in quantity demanded divided by percentage change in price.

The Midpoint Method

• The midpoint method divides the change by the midpoint (or average) of the initial and final levels to solve for percentage change
• Demand varies with elasticity.

Total Revenue

• Total revenue is the amount paid by buyers and received by sellers, calculated as the price of the good times the quantity sold (P x Q).
• With elastic demand, price and total revenue move in opposite directions.
• With inelastic demand, price and total revenue move in the same direction.
• With unit elastic demand, total revenue remains constant when price changes.

The Income Elasticity of Demand

• Income elasticity of demand measures how the quantity demanded of a good responds to a change in customers income
• Normal goods have a positive income elasticity.
• Inferior goods have a negative income elasticity.
• Computed as Percentage change in quantity demanded/Percentage change in income

The Cross Price Elasticity of Demand

• Cross-Price Elasticity of demand measures how the qty demanded of one good changes, responding to changes related to price of another good
• Substitutes have a positive cross-price elasticity and Complements have a negative cross-price elasticity.

Elasticity of Supply

• Price elasticity of supply measures how the quantity supplied of a good responds to a change in the price of that good.
• It is calculated as Percentage change in quantity supplied divided by percentage change in price, always positive
• Elastic Supply: Quantity supplied responds substantially to price changes and Inelastic Supply: Quantity supplied responds only slightly to price changes
• The main determinant is time period; supply is more elastic in the long run

Applications and Cases for Supply and Demand

• Good news for products can bring bad new to industry due to a change in revenue.

Module 2: Economy's Income and Expenditure

• Total spending rises from one year to the next when economy produces more and selling at higher price

Nominal GDP and Real GDP

• Nominal GDP is the production of goods and service valued at current prices.
• Real GDP is the production of goods and service valued at constant prices.

GDP Deflator

• GDP Deflator measures the current level of prices relative to the level of prices in the base year.

Case Study: Years of Real GDP

• The real GDPS and GDP growth has had interrupted by recessions.

Is GDP good to measure economic well-being? If so, what are the indicators

• Best single measure of well being b/c more GDP=better economy, total income and total expenditure
  • Leisure and quality are not included

Consumer Price Index

• A measure of the overall cost of the goods and services bought by a typical consumer
• Computes and reports change in CPI every month -The typical consumer divides into categories of goods and services

How CPI is computed

• Survey Consumers to determine a fixed basket