Chapter 2 - Thinking like an Economist
The Economist as Scientist
The Scientific Method: Observation, Theory and More Observation.
Isaac Newton allegedly became intrigued on the day when he saw an apple fall from a tree.
This observation motivated Newton to develop a theory of gravity that applies not only to an
apple falling to the earth but to any two objects in the universe. The interplay between theory
and observation also occurs in economics. An economist might live in a country
experiencing rapidly increasing prices on be moved by the observation to develop a theory
of inflation.
The Role of Assumptions.
Economists make assumptions: Assumptions can simplify the complex world and make it
easier to understand. To study the effects of international trade, for example, we might
assume that the world consists of only two countries that each country produces only two
goods. By considering a world with only two countries and two goods, we can focus our
thinking on the essence of the problem. Economists use different assumptions to answer
different questions. Suppose that we want to study what happens to the economy when the
government changes the number of dollars in circulation. An important piece of this analysis
as it turns out is how prices respond. Many prices in the economy change infrequently.
Knowing this fact may lead us to make different assumptions when studying the effects of
the policy change over different time horizons. For studying the short-run effects of the policy
we may assume that prices do not change much. We may even take the extreme and
artificial assumption that all prices are completely fixed.
Economic Models
Economists use models to learn about the world their models consist of diagrams and
equation. As we use models to examine various economic issues throughout this book, you
will see that all the models are built with assumptions.
The Circular Flow
The economy consists of millions of people engaged in many activities - buying, selling,
working, hiring, manufacturing, and so on. To understand how the economy works, we must
find some way to simplify our thinking about all these activities. In other words, we need a
model that explains, in general terms, how the economy is organized and how participants in
the economy interact with one another. The Circular-Flow Diagram is simplified to include
only two types of decisions makers; firms and households. Firms produce goods and
services using inputs such as labor, land, and capital. These inputs are called the factors of
production. Households and firms interact in two types of markets. In the market for goods
and services, households are buyers and firms are sellers. In the markets for the factors of
production, households are sellers, and firms are buyers. The circular-flow diagram offers a
simple way of organizing the economic transactions that occur between households and
firms in the economy. The two loops of the circular flow diagram are distinct but related. The
inner loop represents the flows of inputs and outputs. The households sell the use of their
labor, land, and capital to the firms in the markets for the factors or production. The firms
then use these factors to produce goods and services. The outer loop of the diagram
represents the corresponding flow of dollars. The households spend money to buy goods
and services from the firms. The firms use some of the revenue from these sales to pay for
The Economist as Scientist
The Scientific Method: Observation, Theory and More Observation.
Isaac Newton allegedly became intrigued on the day when he saw an apple fall from a tree.
This observation motivated Newton to develop a theory of gravity that applies not only to an
apple falling to the earth but to any two objects in the universe. The interplay between theory
and observation also occurs in economics. An economist might live in a country
experiencing rapidly increasing prices on be moved by the observation to develop a theory
of inflation.
The Role of Assumptions.
Economists make assumptions: Assumptions can simplify the complex world and make it
easier to understand. To study the effects of international trade, for example, we might
assume that the world consists of only two countries that each country produces only two
goods. By considering a world with only two countries and two goods, we can focus our
thinking on the essence of the problem. Economists use different assumptions to answer
different questions. Suppose that we want to study what happens to the economy when the
government changes the number of dollars in circulation. An important piece of this analysis
as it turns out is how prices respond. Many prices in the economy change infrequently.
Knowing this fact may lead us to make different assumptions when studying the effects of
the policy change over different time horizons. For studying the short-run effects of the policy
we may assume that prices do not change much. We may even take the extreme and
artificial assumption that all prices are completely fixed.
Economic Models
Economists use models to learn about the world their models consist of diagrams and
equation. As we use models to examine various economic issues throughout this book, you
will see that all the models are built with assumptions.
The Circular Flow
The economy consists of millions of people engaged in many activities - buying, selling,
working, hiring, manufacturing, and so on. To understand how the economy works, we must
find some way to simplify our thinking about all these activities. In other words, we need a
model that explains, in general terms, how the economy is organized and how participants in
the economy interact with one another. The Circular-Flow Diagram is simplified to include
only two types of decisions makers; firms and households. Firms produce goods and
services using inputs such as labor, land, and capital. These inputs are called the factors of
production. Households and firms interact in two types of markets. In the market for goods
and services, households are buyers and firms are sellers. In the markets for the factors of
production, households are sellers, and firms are buyers. The circular-flow diagram offers a
simple way of organizing the economic transactions that occur between households and
firms in the economy. The two loops of the circular flow diagram are distinct but related. The
inner loop represents the flows of inputs and outputs. The households sell the use of their
labor, land, and capital to the firms in the markets for the factors or production. The firms
then use these factors to produce goods and services. The outer loop of the diagram
represents the corresponding flow of dollars. The households spend money to buy goods
and services from the firms. The firms use some of the revenue from these sales to pay for
