Principles of Macroeconomics Chapter 2 PDF

Seventh Edition Principles of Macroeconomics Wojciech Gerson (1831-1901) N. Gregory Mankiw CHAPTER...

Seventh Edition Principles of Macroeconomics Wojciech Gerson (1831-1901) N. Gregory Mankiw CHAPTER Thinking Like 2 an Economist © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  In this chapter, look for the answers to these questions What are economists’ two roles? How do they differ? What are models? How do economists use them? What are the elements of the Circular-Flow Diagram? What concepts does the diagram illustrate? How is the Production Possibilities Frontier related to opportunity cost? What other concepts does it illustrate? What is the difference between microeconomics and macroeconomics? Between positive and normative? © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  The Economist as Scientist  Economists play two roles: 1. Scientists: try to explain the world 2. Policy advisors: try to improve it  In the first, economists employ the scientific method, the dispassionate development and testing of theories about how the world works. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 2 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Assumptions & Models  Assumptions simplify the complex world, make it easier to understand.  Example: To study international trade, assume two countries and two goods. Unrealistic, but simple to learn and gives useful insights about the real world.  Model: a highly simplified representation of a more complicated reality. Economists use models to study economic issues. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 3 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Some Familiar Models A road map ©wavebreakmedia/Shutterstock.com © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 4 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Some Familiar Models A model of human anatomy from high school biology class ©Accord/Shutterstock.com © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 5 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Some Familiar Models ©Olga Rosi/Shutterstock.com A model airplane © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 6 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Some Familiar Models The model teeth at the dentist’s office Don’t forget to floss! ©ittipon/Shutterstock.com © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 7 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Our First Model: The Circular-Flow Diagram  The Circular-Flow Diagram: a visual model of the economy, shows how dollars flow through markets among households and firms  Two types of “actors”:  households  firms  Two markets:  the market for goods and services  the market for “factors of production” © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 8 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Factors of Production  Factors of production: the resources the economy uses to produce goods & services, including  labor  land  capital (buildings and machines used in production) © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 9 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  FIGURE 1: The Circular-Flow Diagram Households:  Own the factors of production, sell/rent them to firms for income  Buy and consume goods & services Firms Households Firms:  Buy/hire factors of production, use them to produce goods and services  Sell goods & services © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 10 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  FIGURE 1: The Circular-Flow Diagram Revenue Spending Markets for G&S Goods & G&S sold Services bought Firms Households Factors of Labor, land, production Markets for capital Factors of Wages, rent, Production Income profit © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 11 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Our Second Model: The Production Possibilities Frontier  The Production Possibilities Frontier (PPF): a graph that shows the combinations of two goods the economy can possibly produce given the available resources and the available technology  Example:  Two goods: computers and wheat  One resource: labor (measured in hours)  Economy has 50,000 labor hours per month available for production. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 12 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  PPF Example Producing one computer requires 100 hours labor. Producing one ton of wheat requires 10 hours labor. Employment of Production labor hours Computers Wheat Computers Wheat A 50,000 0 500 0 B 40,000 10,000 400 1,000 C 25,000 25,000 250 2,500 D 10,000 40,000 100 4,000 E 0 50,000 0 5,000  PPF Example Production Wheat Point (tons) on Com- 6,000 graph puters Wheat E 5,000 A 500 0 D 4,000 B 400 1,000 3,000 C C 250 2,500 2,000 D 100 4,000 B 1,000 E 0 5,000 A 0 0 100 200 300 400 500 600 Computers © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 14 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  ACTIVE LEARNING 1 Points off the PPF A. On the graph, find the point that represents (100 computers, 3000 tons of wheat), label it F. Would it be possible for the economy to produce this combination of the two goods? Why or why not? B. Next, find the point that represents (300 computers, 3500 tons of wheat), label it G. Would it be possible for the economy to produce this combination of the two goods? © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  ACTIVE LEARNING 1 Answers Wheat  Point F: (tons) 100 computers, 6,000 3000 tons wheat 5,000  Point F requires 4,000 40,000 hours of labor. 3,000 F Possible but 2,000 not efficient: 1,000 could get more 0 of either good 0 100 200 300 400 500 600 w/o sacrificing Computers any of the other. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  ACTIVE LEARNING 1 Answers Wheat  Point G: (tons) 300 computers, 6,000 3500 tons wheat 5,000  Point G requires 4,000 G 65,000 hours 3,000 of labor. Not possible 2,000 because 1,000 economy 0 only has 0 100 200 300 400 500 600 50,000 hours. Computers © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  The PPF: What We Know So Far Points on the PPF (like A – E)  possible  efficient: all resources are fully utilized Points under the PPF (like F)  possible  not efficient: some resources underutilized (e.g., workers unemployed, factories idle) Points above the PPF (like G)  not possible © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 18 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  The PPF and Opportunity Cost  Recall: The opportunity cost of an item is what must be given up to obtain that item.  Moving along a PPF involves shifting resources (e.g., labor) from the production of one good to the other.  Society faces a tradeoff: Getting more of one good requires sacrificing some of the other.  The slope of the PPF tells you the opportunity cost of one good in terms of the other. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 19 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  The PPF and Opportunity Cost Wheat The slope of a line (tons) equals the –1000 6,000 slope = = –10 “rise over the run,” 100 5,000 the amount the line 4,000 rises when you move to the right by 3,000 one unit. 2,000 Here, the 1,000 opportunity cost of 0 a computer is 0 100 200 300 400 500 600 10 tons of wheat. Computers © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 20 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 PPF and Opportunity Cost In which country is the opportunity cost of cloth lower? FRANCE ENGLAND Wine Wine 600 600 500 500 400 400 300 300 200 200 100 100 0 0 0 100 200 300 400 0 100 200 300 400 Cloth Cloth ACTIVE LEARNING 2 Answers England, because its PPF is not as steep as France’s. FRANCE ENGLAND Wine Wine 600 600 500 500 400 400 300 300 200 200 100 100 0 0 0 100 200 300 400 0 100 200 300 400 Cloth Cloth  Economic Growth and the PPF With additional Wheat (tons) Economic resources or an growth shifts 6,000 improvement in the PPF technology, 5,000 outward. the economy can 4,000 produce more 3,000 computers, 2,000 more wheat, or any combination 1,000 in between. 0 0 100 200 300 400 500 600 Computers © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 23 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  The Shape of the PPF  The PPF could be a straight line or bow-shaped.  Depends on what happens to opportunity cost as economy shifts resources from one industry to the other.  If opp. cost remains constant, PPF is a straight line. (In the previous example, opp. cost of a computer was always 10 tons of wheat.)  If opp. cost of a good rises as more of the good is produced, PPF is bow-shaped…. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 24 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Why the PPF Might Be Bow-Shaped Beer As the economy shifts resources from beer to mountain bikes:  PPF becomes steeper  opp. cost of mountain bikes increases Mountain Bikes © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 25 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Why the PPF Might Be Bow-Shaped At A, opp. cost of Beer At point A, A mtn bikes is low. most workers are producing beer, even those who are better suited to building bikes. So, do not have to give up much beer to get more bikes. Mountain Bikes © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 26 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Why the PPF Might Be Bow-Shaped At B, most workers Beer At B, opp. cost are producing bikes. of mtn bikes The few left in beer is high. are the best brewers. Producing more B bikes would require shifting some of the best brewers away from beer production, causing a big drop in Mountain beer output. Bikes © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 27 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Why the PPF Might Be Bow-Shaped  So, PPF is bow-shaped when different workers have different skills, different opportunity costs of producing one good in terms of the other.  The PPF would also be bow-shaped when there is some other resource, or mix of resources with varying opportunity costs (E.g., different types of land suited for different uses). © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 28 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  The PPF: A Summary  The PPF shows all combinations of two goods that an economy can possibly produce, given its resources and technology.  The PPF illustrates the concepts of tradeoff and opportunity cost, efficiency and inefficiency, unemployment, and economic growth.  A bow-shaped PPF illustrates the concept of increasing opportunity cost. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 29 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Microeconomics and Macroeconomics  Microeconomics is the study of how households and firms make decisions and how they interact in markets.  Macroeconomics is the study of economy-wide phenomena, including inflation, unemployment, and economic growth.  These two branches of economics are closely intertwined, yet distinct—they address different questions. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 30 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  The Economist as Policy Advisor  As scientists, economists make positive statements, which attempt to describe the world as it is.  As policy advisors, economists make normative statements, which attempt to prescribe how the world should be.  Positive statements can be confirmed or refuted, normative statements cannot.  Govt employs many economists for policy advice. E.g., the U.S. President has a Council of Economic Advisors, which the author of this textbook chaired from 2003 to 2005. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 31 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  ACTIVE LEARNING 3 Identifying positive vs. normative 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 music downloads. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  ACTIVE LEARNING 3 Answers a. Prices rise when the government increases the quantity of money. Positive – describes a relationship, could use data to confirm or refute. b. The government should print less money. Normative – this is a value judgment, cannot be confirmed or refuted. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  ACTIVE LEARNING 3 Answers c. A tax cut is needed to stimulate the economy. Normative – another value judgment. d. An increase in the price of burritos will cause an increase in consumer demand for music downloads. Positive – describes a relationship. Note that a statement need not be true to be positive. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Why Economists Disagree  Economists often give conflicting policy advice.  They sometimes disagree about the validity of alternative positive theories about the world.  They may have different values and, therefore, different normative views about what policy should try to accomplish.  Yet, there are many propositions about which most economists agree. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 35 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Propositions about Which Most Economists Agree (and % who agree)  A ceiling on rents reduces the quantity and quality of housing available. (93%)  Tariffs and import quotas usually reduce general economic welfare. (93%)  The United States should not restrict employers from outsourcing work to foreign countries. (90%)  The United States should eliminate agriculture subsidies. (85%) continued… © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 36 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Propositions about Which Most Economists Agree (and % agreeing)  The gap between Social Security funds and expenditures will become unsustainably large within the next fifty years if current policies remain unchanged. (85%)  A large federal budget deficit has an adverse effect on the economy. (83%)  A minimum wage increases unemployment among young and unskilled workers. (79%)  Effluent taxes and marketable pollution permits represent a better approach to pollution control than imposition of pollution ceilings. (78%) © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 37 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  FYI: Who Studies Economics?  Ronald Reagan, President of the United States  Barbara Boxer, U.S. Senator  Sandra Day-O’Connor, Former Supreme Court Justice  Anthony Zinni, Former General, U.S. Marine Corps  Kofi Annan, Former Secretary General, United Nations  Meg Witman, Chief Executive Officer, eBay  Steve Ballmer, Chief Executive Officer, Microsoft  Arnold Schwarzenegger, Former Gov. of California, Actor  Ben Stein, Political Speechwriter, Actor, Game Show Host  Mick Jagger, Singer for the Rolling Stones  John Elway, NFL Quarterback  Tiger Woods, Golfer  Diane von Furstenburg, Fashion Designer © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 38 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Summary As scientists, economists try to explain the world using models with appropriate assumptions. Two simple models are the Circular-Flow Diagram and the Production Possibilities Frontier. Microeconomics studies the behavior of consumers and firms, and their interactions in markets. Macroeconomics studies the economy as a whole. As policy advisers, economists offer advice on how to improve the world. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.