Understanding Economics: The Science of Making Predictions

1. Economics is a social science (like: sociology, psychology, political science, etc.) . . . in contrast to physical sciences (like: physics, chemistry, biology, etc.). Goal of any science is to make valid conditional predictions about real phenomena: “If X occurs then, other things equal, Y will occur.”

2. Scientific method: (http://en.wikipedia.org/wiki/Scientific_method) • Observation motivates the development of a theory. • Theory (or model) yields conditional predictions. • Observation to validate theory. (Are the theory’s conditional predictions consistent with reality?) Theories (models): Collections of assumptions that simplify reality in the interest of tractability. (Theory’s assumptions might be described in words, equations, or graphs.)

3. The “art” of scientific thinking: Which aspects of reality are essential - and must be reflected in the model’s assumptions? Which are unimportant - and can be safely ignored? Scientists and non-scientists use “theory” in different ways: “Oh, that’s just a theory.”

4. “Good” theories vs. “bad” theories? “Quality” of a theory is judged by the accuracy of its conditional predictions (predictive power). The role of observation to assess the predictive power of theories. “Other things equal” qualifier is where all the difficulty arises.

5. Controlling for other factors in testing the validity of a theory’s predictions: Experimental science: Use “laboratory data” from an experiment designed to hold other factors constant. Non-experimental science (like economics?): Have to rely on historical data . . . (in which many factors change simultaneously) . . . and statistical methods to “disentangle” the separate effects of individual factors. Econometrics (http://en.wikipedia . . . )

6. Wikipedia.org: An online collaborative encyclopedia (currently the 7th-most visited site on internet) Content is user-supplied and user-edited. But is it reliable? . . . . . . in particular, is it reliable for undergraduate- level study in economics? “Is Wikipedia a Credible Source for Undergraduate Economics Students?” (pdf available online) Sam Meier, B.S. Economics, 2008, UNI

7. Meier identified a set of 20 principles-level topics: production possibilities frontier, comparative advantage, elasticity, minimum wage, tariffs, economies of scale, Prisoner’s Dilemma, etc. Checked Wikipedia entries against Mankiw’s text for obvious omissions or content errors. Enlisted the help of UNI economics professors to judge Wikipedia entries in their areas of expertise. Bottom line: Wikipedia does a pretty good job with economics.

8. Recall: Theories (models) are made up of assumptions. In Econ 101, our models’ assumptions will often be described using graphs. Our first graph: Production possibilities frontier. Context: A make-believe economy with resources that can be used to produce two goods: cars and computers (say).

9. Because resources are scarce, it is not feasible to produce unlimited quantities of both goods. Quantity of computers produced (computers/ month) Point B (infeasible output combination) Point A (feasible output combination) Quantity of cars produced (cars/month)

10. Quantity of computers produced (computers/ month) Point B Point A Quantity of cars produced (cars/month) Production possibilities frontier: The boundary between the sets of feasible and infeasible output combinations.

11. Quantity of computers produced (computers/ month) Point B Point A Quantity of cars produced (cars/month) Point B: infeasible Point A: feasible. Point C: feasible and “efficient” (it’s not possible to get more of one good without giving up some of the other). Point C

12. (computers/ month) Point D 20 Point E 15 30 50 (cars/month) Starting at point D, the opportunity cost of 20 additional cars/month is 5 computers/month.

13. 1 2 (computers/ month) Point F (cars/month) At any point on the ppf, the absolute value of the slope of the ppf gives the opportunity cost of 1 unit of the good on the horizontal axis in terms of units of the good on the vertical axis. For point F: 2 computers/car.

14. What does the “bowed-outward” shape of ppf signify? As we move down and to the right along ppf (more cars, fewer computers) the opportunity cost of cars increases. Why? Resources are specialized . . . . . . some are better suited to making cars, . . . some are better suited to making computers.

15. (computers/ month) Point G Point H (cars/month) At point G: all resources used to make computers. “low” opportunity cost of cars At point H: almost all resources used to make cars. “high” opportunity cost of cars

16. Under some circumstances, ppf is linear (a case we’ll encounter in chapter 3) Context: Farmer has 100 acres of land that can be used to grow corn or soybeans. Only one resource – land. Each acre of land is as productive as every other. Each acre can grow: 100 bushels of corn or 50 bushels of soybeans or any combination of two (e.g., 50 bu. corn and 25 bu. soybeans)

17. soybeans (bu./yr.) Production possibilities frontier B 5,000 A corn (bu./yr.) 10,000 Suppose the farmer planted all 100 acres in corn: pt. A Suppose the farmer planted all 100 acres in soybeans: pt. B Opportunity cost of corn = 0.5 bu. soybeans / bu. corn (constant)

18. soybeans (bu./yr.) 7,500 5,000 corn (bu./yr.) 10,000 Now suppose that scientists develop a new soybean hybrid with 50% greater yield. Opportunity cost of corn increases.