Lesson 2 Economic Methods Flashcards
Challenge in scientific theory for economists
- Unable to conduct experiments bc it’s impractical
- Usually make do with given data + focus on natural experiments (war in Middle East stopping crude oil)
Assumptions
Economists make assumptions to make world easier to understand
(assuming certain prices that rarely change are fixed)
Models
1) Typically mathematical models with diagrams
2) built on assumptions, right model at right time
Circular-flow Diagram
1) contains only firms + households
2) firms = produce goods + services using inputs (factors of production)
3) households own factors of production + consume services provided by firms
Two types of markets for households/firms
1) Markets for goods/services = households r buyers + firms r sellers
Households get output
2) Markets for factors of production = households r sellers + firms r buyers
households provide inputs
Outer vs Inner Loops
1) Inner loop = flow of inputs + outputs
2) Households sell the use of their labor + land in return for goods which households then buy
3) Outer loop = flow of money
4) Households spend money to buy goods + that money is used to pay for production + profit goes to owners WHO ARE HOUSEHOLD MEMBERS
Limitations of Circular Flow diagram
1) doesn’t account for role of government or international trade
Factors of production
1) labor, land, capital used by firms to produce services
Production Possibilities Frontier
1) shows various combinations of output between 2 objects (in reality there are thousands of interactions) that economy can produce given its constraints
2) Can produce all of one, nothing of the other BUT prolly does a combination
3) economy cannot produce anything outside the graph
4) efficient –> ON graph vs inefficient INSIDE graph
Trade-offs with production-possibilities frontier
1) once you’re on graph –> efficient so only way to improve is by doing a trade-off
2) PPF gives opportunity cost (to make 10 more cars you reduce 20 computers)
3) slope = represents the cost
4) PPF can shift based on new innovations
PPF Bowed shape
1) Most PPFs are bowed
2) when economy uses most of its resources for one product (Computers) the remaining people (mechanics) aren’t that good SO reduced the # of mechanics isn’t gonna increase computer production by much
Macro vs Micro
1) Micro = study of households + firms + interaction in specific markets
2) Macro = study of overall economy
Positive vs Normative
1) Positive = descriptive, making claim about how world is (can be evaluated on facts) TESTABLE
2) Normative = make a claim of how world should be (needs to be evaluated on facts AND values)
Important to reduce bias by putting aside normative views
Why do economists disagree
1) differences in scientific judgement
2) differences in values
3) perception vs reality
Movements along curve vs shifts of curve
1) movement along curve –> when price changes (when variables on axis change)
2) shift of curve –> when a variable not named on axis changes
Demand slopes meaning
1) steep demand curve (bigger #) = similar demand even with change in prices –> inelastic
2) flat demand curve (smaller #) = demand is greatly affected by prices (elastic)
Difficulties with causality
1) Omitted Variables = confounding variable
C interfering with relationship btwn A and B
2) Reverse causality = may incorrectly assume that A causes B instead of B causing A
Benefits of trade
allows people to live life outside their PPF (get more goods without working more bc of specialization)
Comparative Advantage
Producer who gives up less of other good to produce Good X has smaller opportunity cost and therefore has comparative advantage
Absolute Advantage
the ability to produce a good using fewer inputs than another producer
Can someone have both absolute and comparative advantage in both goods
NO, they can have absolute advantage in both BUT impossible to have comparative advantage in both
Gains from specialization + trade based on
COMPARATIVE ADVANTAGE
1) if ppl produce goods where have comparative advantage –> total production rises (pie is bigger SO everyone could be better off depending on how it is divided)
When do both parties gain from trade
1) when price they trade at is btwn their opportunity costs
ex = Ruby’s opportunity cost is 2 oz potato/oz meat and Frank’s is 4 oz potato/oz meat SO price of trade is 3 (in middle)
What happens if price of trade is above/below opportunity cost
1) If above opportunity cost –> everyone would sell product
2) If below opportunity cost –> everyone would buy product
Need a buyer AND seller
Ex: Osaka mows lawn in 2 hours, Hari in 4 hours. Osaka could film an ad for 30K in those 2 hours and Hari could earn 50 in those 4 hours. Who has absolute advantage, comparative advantage, what should trade price be?
1) Osaka has absolute advantage mowing lawn since she can do it in less time (2 hours vs 4 hours)
2) Hari has comparative advantage mowing lawn since his opportunity cost is lower (50 vs 30,000)
3) Price for trade should be btwn opportunity costs so between 50 - 30,000 to ensure both are better off
Imports vs Exports
1) Imports = good produced abroad + sold domestically (coming INTO country)
2) exports = goods produced domestically + sold abroad (going OUT of country)
Ex with countries: American farmer can produce 2 tons of food a month and 1 car a month. Japan can produce 1 ton of food a month and one car. Identify who has absolute advantage, comparative advantage, and what they should specialize in
1) America has absolute advantage in producing food
2) To produce one car, America gives up 2 tons while Japan only gives up 1 ton SO Japan has comparative advantage with cars + America has comparative advantage with food
3) SO, America should produce extra food + trade it with Japan and Japan should produce extra cars and trade with America. Result = both countries enjoy more prosperity
