Thinking Like an Economist

Highlighted Sections

The Circular Flow Diagram

Production Possibilities Frontiers

Micro vs. Macro Economics

Positive vs. Normative Economic Issues

The Circular Flow Diagram – (Back to top)

The circular flow diagram (Figure 2-1 from your text which is recreated at right) depicts a simplified view of how the pieces of the economy fit together. Highlights include:

Notice that goods and services and resources flow around the economy in one direction, while money flows around the economy in the opposite direction. This is because money is normally exchanged for goods and services, or for resources.
Recall that factors of production in the economy are generally lumped into three broad categories: labor, land, and capital. The respective names for the prices of labor, land, and capital are wages, rent and profit.
Households (people) in the circular flow own all the labor, land and capital. In markets for factors of production, households sell the services of labor, land and capital to firms in exchange for wages, rent and profits.

*Many students will observe that economists assume all labor, land and capital is owned by people, yet many firms in the economy own land and capital. This apparent incongruency can be cleared up by noting that all firms are ultimately owned by people, so any land and capital owned by firms is actually owned by the owners of these firms.
In markets for goods and services, households spend their income on products that are produced by firms. The money spent on goods and services is called spending (by households) and income (by firms), but spending and income are the same number.

*Suppose you go to McDonald's and spend $3.99 on a Big Mac Extra Value Meal. You have made an expenditure of $3.99 but, at the same time, McDonald's just made $3.99 in income. Think of expenditures and income as two sides of the same coin.
Households (people) have two functions in the economy. First, they sell their labor, land, and capital to firms in order to make income, and second, they spend their income on the goods and services that firms produce.
Firms have two functions in the economy. First, they purchase the services of labor, land, and capital, and second, they use labor, land, and capital to produce goods and services, which they sell to households.
In economics, technology is represented by a firm's ability to transform labor, land, and capital into goods and services. When firms can produce more goods and services than before, while using the same amount of labor, land, and capital, economists say technology has improved.

Production Possibilities Frontiers – (Back to top)

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The production possibilities frontier is a simple model relating resources and technology to the amount of total output the economy can produce. In the figure at right, assume that the economy produces only two goods – cars and computers. The PPF is the dark blue curve and it defines the maximum combinations (or bundles) of cars and computers the economy can produce. The light-blue shaded area under the PPF represents bundles of goods the economy can also produce. However, all bundles in the shaded area are less than the economy's maximum output. Producing under the PPF (like at point B) indicates that the economy is not producing efficiently (recall the definition of efficiency from the previous chapter). Points outside the PPF (like D) are not attainable given the current endowment of resources and technology. However, the economy is said to "grow" when the PPF shifts out over time. You can see how the PPF moves in the figure at right by moving the slider to the right or left.

Q: How can we get the PPF to shift out over time, allowing the economy to produce more in the future than today?
A: Because we are constrained by our endowment of resources (land, labor, and capital) and by our technology, we need an increase in our resource supplies or our available productive technology.

Q: Why does the PPF have a negative slope?
A: The PPF has a negative slope because of the concept of scarcity. Because resources (land, labor, and capital) are scarcely provided to the economy and the economy uses resources to produce goods and services, there will be a tradeoff any time more of one good is desired. For example, suppose we want to increase our production of cars. If we are already producing efficiently (getting the most out of the resources we have), the only way to increase our output of cars is to take some resources away from the production of computers. This, however, will decrease our output of computers – hence a tradeoff between cars and computers.

Micro vs. Macro Economics – (Back to top)

The difference between microeconomics and macroeconomics lies primarily in the scope of topics that they investigate.

Microeconomics is a study of the decisions made by individual agents or actors in the economy. Questions that are studied in a micro course include:

How much of various goods will a consumer choose to consume given his or her income and the prices of the goods?
How much output should a firm choose to produce in order to maximize its profits?
How much labor and capital should a firm choose to hire in order to produce efficiently?
How much time will a person spend working and how much time will they spend in leisure activities?

Macroeconomics, on the other hand, deals with issues that affect the economy as a whole (or in the aggregate). Some questions from a typical macro course include:

What are the real effects of the U.S. national debt on the U.S. economy?
How will the monetary policy chosen by the Federal Reserve affect interest rates and investment within the economy?
Will a recession in Germany (a major trading partner with the U.S.) affect our economic growth?
What would a balanced budget amendment do to policymakers' ability to control the U.S. economy?
Can we implement policies that will reduce both unemployment and inflation in the long run?

Positive vs. Normative Economics – (Back to top)

In economics, there are positive and normative statements or issues. The difference between the two is that positive statements are descriptive, while normative statements involve some type of value judgement.

Positive statements would include the following:

GDP in the U.S. economy was about $7 trillion last year.
The New York City rent control laws have created a shortage of housing in the city.
Dave's car is red.

Note that these statements can all be verified as true or false by examining relevant data. This is important, because if you found out that Dave's car was blue, you would have falsified the last statement. Positive statements are descriptive, but not necessarily true.

Normative statements cannot be falsified by simply examining relevant data because they involve a value judgement. Here are a few normative statements:

NAFTA (the North American Free Trade Agreement) is bad for the U.S. economy because it has caused some of our jobs to move to Mexico.
Higher interest rates would be good for the U.S. economy in the next six months.
The U.S. government should be required to balance its budget every year.

All of these statements involve value judgements. For example, a person who made the second statement is probably of the opinion that the economy is growing too fast, so higher interest rates (which have the effect of slowing down the economy) would be good for the economy. People who disagree probably don't share this opinion but cannot also falsify the second statement.