Economics: Science, Models, and Assumptions

Economics as a Science

• Economics studies the practice of scientists
• They devise theories, collect data, and analyze data to verify or refute theories
• The scientific method is essential to science

The Scientific Method

• Development and testing of theories explain how the world works
• Experiments in economics are often impractical
• Natural experiments offered by history and quantitative macroeconomic models act as substitutes for experiments

The Role of Assumptions

• Assumptions simplify complex situations, making them easier to understand
• Choosing which assumptions to make is key to the art of scientific thinking
• Economists use different assumptions for different questions and time horizons

Economic Models

• Economists use models as simplified descriptions of complex reality
• They come as diagrams and equations, built with assumptions
• Models omit many details to simplify equality and are subject to revision

The Circular-Flow Diagram

• The economy consists of millions of people engaged in economic activities
• The circular-flow diagram is a visual model of the economy
• It simplifies the economy by including only two types of decision-makers
• It shows how dollars and goods/services flow through markets among households and firms
• 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
• In markets for goods and services, households are buyers and firms are sellers
• In markets for factors of production, households are sellers and firms are buyers

The Production Possibilities Frontier

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

Efficient Outcomes on the PPF

• Points are efficient when the economy maximizes scarce resource use
• Trade-off is that society faces at an efficient point
• More of one good can only be produced by producing less of another

Opportunity Costs

• The opportunity cost of producing one good the units of another good that must be given up
• At Point A: Opportunity cost of 100 cars is 200 computers, so the opportunity cost of 1 car is 2 computers
• Opportunity cost equals the slope of PPF

Inefficient Outcomes

• Points inside the PPF are inefficient
• Production is less than it could be given available resources
• Eliminating sources of inefficiency allows for increased production of all goods

Points of the PPF

• Point F: 80 airplanes and 4,000 tons of soybeans is not possible
• Point G: 30 airplanes and 2,500 tons of soybeans is possible, but not efficient

The Production Possibilities Frontier Shift

• A technological advance in the computer industry enables the economy to produce more computers for any output of cars

The Economist as Policy Advisor

• Economists explain the causes of economic events as scientists
• Economists recommend policies to improve economic outcomes as advisors

Positive vs. Normative Analysis

• Positive statements describe the world and can be confirmed or refuted with evidence
• Normative statements prescribe how the world ought to be, involving values and facts
• "Minimum-wage laws cause unemployment" is a positive statement
• "The government should raise the minimum wage" is a normative statement

Economists in Washington

• The Council of Economic Advisors advises the president and writes the annual Economic Report
• Economists serve as advisors in the Office of Management and Budget, Treasury, Labor, Justice, Federal Reserve, and Congressional Budget Office

Why Economist's Advice Is Not Followed

• The president receives advice from economic, communication, press, legislative, and political advisors
• The president makes the decision after weighing all advice

Why Economists Disagree

• Differences in scientific judgments regarding validity of alternative theories
• Different hunches result in disagreements about the size of parameters that measure how economic variables relate
• Differences in values and political philosophies cause disagreements about public policy

Graphing

• Graphs visually express relationships difficult to convey with equations or words
• Graphs reveal interesting patterns
• Examples of graphs for single variables: pie charts, bar graphs, time-series graphs
• Ordered pairs of points use x and y coordinates

Related Variables

• Negatively related variables move in opposite directions on a downward-sloping curve
• Positively related variables move in the same direction on an upward-sloping curve
• Omitted variables and reverse causality can cause deceptive graphs

Supply and Demand

• Supply and demand are market forces reflecting supply-demand interaction
• The meaning of "markets" and "competitive" should also be considered

Market

• A market constitutes buyers and seller of a particular good or service
• Buyers as a group, determine the demand of a product
• Sellers as a group, determine the supply of teh product

Competitive Market

• A competitive market involves many buyers and sellers
• Each has an eligible impact on market price
• Price and quantity sold are determined by all sellers and buyers as they interact in the marketplace
• A perfectly competitive market has no single buyer or seller with market-price influence

Law of Demand

• Quantity demanded is the amount buyers are willing and able to purchase at a given price
• The law of demand states when the price of a good rises, the quantity demanded falls, and vice versa, other things being equal

Individual Demand

• Individual demand is the demand for a product by an individual
• Demand schedule shows relationship between price and quantity
• A demand curve graphs the relationship between the price and quantity

Market Demand

• Market demand sums individual demands for a particular good or service
• A market demand curve shows aggregate quantity demanded at varying prices, holding other influencing factors constant

Shifts in Demand Curve

• Market demand curves hold other factors constant and can shift over time
• Curve shifts to the right when changes increase quantity buyers want to purchase at any given price.
• Curve shifts left when changes decrease the quantity buyers want to purchase at any given price.

Variables Influencing Buyers

• Variables that can shift the demand curve include income, prices of related goods, tastes, expectations, and number of buyers

Income

• Normal goods see an increase in demand with increased income
• Inferior goods see a decrease in demand with increased income

Price Relations

• Substitute goods are used in place of each other, and an increase in one's price increases demand for the other
• Complementary goods are used together, and an increase in one's price decreases demand for the other

Other Demand Factors

• Unique tastes, shaped by historical and physiological forces, affect demand
• Expectations regarding income and future prices play a role
• Market demand varies with the number of buyers

Law of Supply

• Quantity supplied is the amount sellers are willing and able to sell
• The law of supply states that the price of a good rises, the quantity supplied also rises, and vice versa

Individual Supply

• Individual supply is a seller's supply for a product
• Supply schedule shows relationship between price and quantity
  • A graph shows relationship between pric3 and quanitity

Market Supply

• Market supply sums individual supply of all sellers
• Market supply curve shows how total quantity supplied varies as price varies, holding other factors constant

Shifts in Supply curve

• Curve shifts to right when changes increase quantity sellers want to sell at any given price
• Curve Shifts to left when changes decrease quantity sellers want to sell at any given price

Variables that influence Sellers

• Factors that can shift the curve includes Input prices, technology, expectations, number of sellers
• The supply of a good moves in the opposite direction of the prices of inputs
• New technology for turning inputs into outputs, and advances in technology increases supply
• Expected highger prices decrease current supply, and market supply depends on how many sellers there are in the market

Together

• Equilibrium balances quantities buyers are willing/able to buy and sellers are willing/able to sell
• Various market forces are in balance
  • Balances the quantity supplied and the quantity demanded

Surplus and Shortage

• Surplus quantity supplied is greater than quantity demanded
• Sellers may cut price until equilibrium is reached
• Shortage quanitity demanded is greater than quantity supplied

Market Correction

• Sellers can raise prices without losing sales
• Adjustments occur to reach a market balance

Law of Supply and Demand

• The price of goods brings quantity supplied and quantity demanded into balance

Elasticity of Demand

• Elasticity measures behavioral sensitivity
• Price elasticity measures responsiveness of quantity demanded to price change

Elastic and Inelastic Demand

• Elastic and inelastic are a Quatity demanded responds substantially to price changes Inelastic quantity demanded responds only slightly to price changes
• Determinants of price elasticity of demand include the availability of close substitutes
• Goods with close substitutes have elastic demand
• Goods with no close substitutes have inelastic demand
• Luxuries have elastic demand
• Necessities have inelastic demand
• More narrowly defined markets have elastic demand
• More extended time horizons lead to more elastic demand

Computing Price Elasticty of Demand

• The percentage change in demand is divded by the change in the price
• use absolute value. (drop the minus sign)

Midpoint Method Solution

• The midpoint method involves that dividing the changes by the midpoint of the initial and final amounts

Demand Elasticity Values

• Demand categorized as elastic when price elasticity > 1
• Demand is inelastic when price elasticity < 1
• Demand has unit elasticity when price elasticity = 1
• Demand is perfectly inelastic when elasticity = 0, resulting in a vertical demand curve
• Demand is perfectly elastic when elasticity = infinity, resulting in a horizontal demand curve

Total Revenue

• Total Revenue (TR) Amount paid by buyers and received by sellers of a good
• Price x Quantity
• The area of the box under the demand curve equals the total revenue
• Demand elasticity impacts how total revenue changes with price shifts
• 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 upon price changes

Linear Demand Curve

• The curve has a constaint slope
• Points are elastic with with high prices and low quantity
• Points are inelastic demand wht high quantity

Income & Cross-Price Elasticity

• Income elasticity measures the change is the quantity demanded of a good in repsonse to revenue changes for a given income
• Normal goods have a position income elasticity
• Inferior goods have a negative elasticity
• Cross Price of elastic demand
• Measures quanititydemanded for other product that respond good to change in price of 2
• Substitutues have a postive, while Complements have a negative

Elasticity of Supply

• Measures quantity supplied responding well, with the price of that product that has a
• Percentage change in quantity supplied divided by price elastic demand response
• Always positive

Types of Elasticity of Supplied

• Given to end Q1 P1 And Q2 P2, and that measure is based on a midpoint mthod
• The point is more elastic
• More elastic supply responds substantially to price changes , while an inelastic
• Determinant of price lasticity supply: Time period; Supply is more elastic in the long run

The Variety of Supply Curves

• Supply has price elasticity > 1
• Supply is unelastic when price elasticty
• perfectly elastic and perfectly inelastic
• Perfectly elastic and horizontal slope

Supply Curve's Elasticity

• supply shifts to the right
• Higher quantity and lower price
• Demand is ineatsic: Total revenue falls

Three applications of supply

• Good news for farming , wheat increases per acre by 20 percent
• Supply curve shifts to the right for a supply good that is shifted to the right
• The new tech is good, higher demand

OPEC

• Increase of price 73, 74 71 to 81
• Suppy decreased , increase in price
• demand elasticity is there

Drug Relations

• Increase the number of federal agents
• Supply shift left
• Demand is inelastic
• Higher prices means that Higher cash
• Potential crime activity
• So drug interdiction increases crimes decreased a littlw
• Demand may be more elastic to lower addiction

Module 2: Economy's Income and Expendurt

• A key variable in macroeconomics: national income From economic growth to Business Cycles
• Product measures
• economy is a good output
• dollar to a buyer is income for the seller

Diagram

• simple depection
• payment and revenues
• payments

Ommissions

• Taxes
• Financial
• Foreigns tradin g
• Asset and curencies

GDP

• Gross Value
• good and services produce in a country and in a given period
• market price is measured
• A market value the way
• All goods and services in the same unit
• dos an orange
• Things that don’t have a market Value are excluded
• The market has to produce at a given point

GDP

• Solid licitilly , not produced here
• Goods intended to reach the end consumer
• Goods that used at components
• Ingerendents produce more value
• That include production of output
• Tane
• Services like cleaning

Borders

• The borders of the country
• specific interval of time

Supply and Demand of Elasticity

• y= c= I + G+ Nx
• government purchases
• product to GDP

Explore economics as a science using theories and data. Understand assumptions, economic models, and diagrams. Learn how economists use models to describe economic reality in a simplified way.