Economic Thinking

1. Economic Thinking • ECO 284 • Display your name card • Place your Chapter 3 summary in your file. • Place your answers to Chap. 3 Review Questions on the front table • Homework #4 (PPF work sheet) due Friday.

2. The Nature and Role of Theory. • The uses of theories (simplified models). • Everyone uses them. . . • to describe, explain, predict, or understand.

3. Abstraction • Models leave out much specific information • But answer the basic question. • Model builders must make judgments: • What information to include, and • which details may be safely omitted.

4. Judging Theories • Logical soundness of assumptions and hypotheses • How well a theory predicts. • Theories should yield testable predictions.

5. Methodology • Economists build models • Answer important questions • Why does international (int’l) trade occur? • What goods will a country import (export)? • How much will be traded and at what price? • Will trade affect wages, or other factor payments?

6. Methodology • Models are abstract, yield predictions • simplify reality • verbal • mathematical • geometric • algebraic

7. Parts of a Theory. • Variables take on different values. • Assumptions give us a starting point for deductive reasoning. • Hypothesis - a statement about how two or more variables are related. • Predictions are deduced from the assumptions and hypotheses of the theory.

8. Occam’s Razor • The simplest workable theories are also the most useful. • a.k.a. “The Principle of Parsimony” • Einstein: “Everything should be made as simple as possible, but not more so.”

9. Formulating Theories • Variables noted, assumptions made, hypotheses formulated. • Predictions are deduced from the assumptions and hypotheses. • Predictions are stated.

10. Testing Theories • Predictions are tested. • Evidence either confirms or rejects theory. • If confirmed, can the results be reproduced? • If rejected, then either a new theory is formed, or the old one is amended.

11. Arguments • Argument -- a sequence of statements together with a claim. • Sequence -- two or more statements. • Claim -- that one of statements, called the conclusion, follows from the others, called the premises. • An argument is sound if it is correct and all its premises are true.

12. Deductive Arguments • In a valid deductive argument it is impossible for the premise to be true and the conclusion false. • Example: Knowledge is power. Power corrupts. Therefore knowledge corrupts. • Another: Economists are scoundrels. Eastwood is an economist. Therefore Eastwood is a scoundrel.

13. Inductive Arguments • In a correct inductive argument it is improbable for the conclusion to be false if the premise is true. • Example: None of Eastwood’s mid-term exam questions were tricky. Therefore none of his final exam questions will be tricky.

14. The Fallacy of False Cause • This fallacy occurs when in argument one mistakes what is not the cause of a given effect for its real cause. • When an argument takes the following form, it is often incorrect: • Event A occurs, then Event B occurs • Therefore A causes B.

15. Variants of the False-Cause Fallacy • Post hoc, ergo propter hoc (Latin) translates roughly as “after this, therefore because of this.” • Accidental correlation: A occurs when B occurs. Therefore A causes B (or vice-versa).

16. The Fallacy of Composition • Assuming that what is true for the individual is true for the group. • Frederic Bastiat’s “Petition of the Candle Makers” illustrates this fallacy.

17. The Fallacy of Decomposition • Assuming that what is true for the group is true for the individual. • Example: Gator-Aid tastes sweet. Therefore all the ingredients of Gator-Aid must taste sweet.

18. Errors in Economic Thinking. • Misunderstanding the Ceteris Paribus condition (Latin phrase meaning “all other things remaining the same”).

19. Normative versus Positive Analysis • Normative statements contain a value judgment (about what should be). • Positive statements describe, explain or predict (what was, what is, or what will be). • Positive statements may be true or false, but disagreements about them may be resolved by obtaining the facts.

20. Concepts Central to the Economic Way of Thinking. • Rational Self-Interest: People are rational, calculating, and driven by self interest • Opportunity Cost ( the value of the most highly preferred alternative not taken.) Every decision entails a choice, and every choice entails a cost.

21. Economic Policy Objectives • Efficiency • Equity • Growth • Stability

22. The Factors of Production • K = Capital (machinery, computers, buildings) • E = Entrepreneurship combining factors to enable production • L = Labor (productive efforts) • N = Land and natural resources • CELL

23. A Circular Flow Model • Two markets: One for products (output), one for factors (of production) • Households • Own factors, sell their services to firms • Buy products from firms • Firms • Combine factors to produce products • Sell products to households

24. Production Possibility Frontier (PPF)Assumptions: • Quantities of productive factors are fixed, but can be allocated among different types of production. • Technology is constant. • All scarce resources are fully and efficiently employed.

25. Concepts and the PPF • Scarcity • Necessity of Choice • Opportunity Cost • Economic Growth • Due to an increase in L, N, or K • Due to technological progress • International Trade (many applications)

26. Example PPF

27. Example PPF

28. Slope of the PPF • Calculate the slope between points A&B, B&C, C&D: • Include the units • Is there a relationship between the slope of the PPF and the concept of opportunity cost?

29. Reciprocal of the PPF’s Slope • The opportunity cost of the good on the y-axis is (1/slope); e.g., between points A and B the opp. cost of beef is -4 tax forms given up per lb. beef. • In this example, the opportunity cost of a good increases as its output increases. Why might one expect this?

30. Constant Opportunity Cost 5 A’s opportunity cost: 4 4 3 TEXTILES, T (millions of yards per year) 2 a 1 1 America’s PPF a' 1 2 3 4 SOYBEANS, S (millions of bushels per year)

31. Constant Opportunity Cost 5 A’s opportunity cost: 2 bushels S costs 1 yard T, |slope| = 0.5 yd./bu. 4 4 3 TEXTILES, T (millions of yards per year) 2 a 1 1 America’s PPF a' 1 2 3 4 SOYBEANS, S (millions of bushels per year)

32. Constant Opportunity Cost 5 A’s opportunity cost: 2 bushels S costs 1 yard T, |slope| = 0.5 yd./bu. B’s opportunity cost: 4 4 b 3 Britain’s PPF TEXTILES, T (millions of yards per year) 2 a b’ 1 1 America’s PPF a' 1 2 3 4 SOYBEANS, S (millions of bushels per year)

33. Constant Opportunity Cost 5 A’s opportunity cost: 2 bushels S costs 1 yard T, |slope| = 0.5 yd./bu. B’s opportunity cost: 1 bushel S costs 3 yards T, |slope| = 3 yd./bu. 4 4 b 3 Britain’s PPF TEXTILES, T (millions of yards per year) 2 a b’ 1 1 America’s PPF a' 1 2 3 4 SOYBEANS, S (millions of bushels per year)

34. Increasing Opportunity Cost 6 million bushels of T Opportunity cost of 1 bushel of S is 1 yard T, |slope| = 1 yd./bu. 20 a' 18 14 TEXTILES, T (millions of yards per year) 12 6 million yards S 6 America’s PPF 0 2 4 8 12 SOYBEANS, S (millions of bushels per year)

35. Increasing Opportunity Cost 36 30 Opportunity cost of 1 bushel of S is 24 TEXTILES, T (millions of yards per year) a 15 Britain’s PPF 6 0 4 7 8 9 12 SOYBEANS, S (millions of bushels per year)

36. Increasing Opportunity Cost 36 30 Opportunity cost of 1 bushel of S is 9 yards of T, |slope| = 9 yd./bu. 24 18million yards of T TEXTILES, T (millions of yards per year) a 15 Britain’s PPF 2 million bushels of S 6 0 4 7 8 9 12 SOYBEANS, S (millions of bushels per year)

37. Why Do Nations Trade? • Absolute Advantage:A nation (individual) is said to have an absolute advantage in producing a good when it can produce that good with fewer resources. This greater efficiency in production is due to superior technology. • Smith thought this explained trade patterns.

38. Comparative Advantage: • A nation (individual) is said to have a comparative advantage in producing a good when it can produce that good at a lower opportunity cost. • Ricardo -- differing technologies • Heckscher-Ohlin -- differing resource endowments

39. The PPF and International Trade • Assume that there are two countries with differing opportunity costs. • Are there gains from trade?

40. PPFs for two individuals

41. The PPF and International Trade • World output increases due to specialization. • What does each country gain from trade? • Requires an understanding of Consumption Possibilities (CPF) • a line from a country’s production point • with slope equal to the trade price of good X

42. CPF with a price ratio of 1(bu/lb)

43. If Guy and Rob share equally