Thinking Like an Economist: Principles and Models
The Dual Roles of the Economist and the Scientific Method
Economists serve two primary functions in society: they act as scientists and as policy advisers. In their capacity as scientists, economists attempt to explain the world as it is, using the scientific method to develop and test theories about the way the world works. This involves the dispassionate development of theories, the collection of data, and the subsequent analysis of that data to either verify or refute the proposed theories. The scientific method in economics follows a specific cycle: observation, where data is collected and analyzed; the development of a theory based on those observations; and further observation to evaluate the theory's validity. Unlike physical sciences, economists generally cannot use laboratory experiments. Instead, they must pay close attention to natural experiments offered by history to understand economic causalities. In their second role as policy advisers, economists attempt to improve the world by recommending specific actions to change economic outcomes.
Models and Assumptions in Economic Analysis
Because the world is highly complex, economists use assumptions to simplify reality and make it easier to comprehend. For instance, when studying international trade, an economist might assume the world consists of only two countries and two goods. While unrealistic, this simplification allows the researcher to focus on the essential dynamics of trade before applying the lessons to a more complex, multi-national world. Economic models are built on such assumptions and typically omit many minor details to allow the observer to see what is truly important. All economic models are visual or mathematical simplifications of reality meant to improve our understanding, and as such, all models are subject to revision as new data or insights become available.
The Circular-Flow Diagram: A Visual Model of Economic Interaction
The circular-flow diagram is a fundamental visual model of the economy that illustrates how dollars flow through markets between two primary sets of decision-makers: households and firms. In this model, these two groups interact in two distinct types of markets. The first is the Market for Goods and Services, where households are the buyers and firms are the sellers. In this market, households spend money to buy goods and services that firms have produced. The second is the Market for Factors of Production (inputs), where households are the sellers and firms are the buyers. Households provide factors of production such as labor, land, and capital to firms. In exchange, firms pay households wages, rent, and profit. This interaction creates a continuous loop: households receive income from firms, which they then spend on goods and services, providing revenue to firms, which is then used to pay for the factors of production supplied by the households.
The Production Possibilities Frontier (PPF) and Efficiency
The Production Possibilities Frontier (PPF) is a graph showing the various combinations of two outputs that an economy can possibly produce given the available factors of production and the current state of technology. For example, consider a country that only produces two goods: airplanes and soybeans. With a fixed amount of labor and technology, the country might be able to produce either tons of soybeans, airplanes, or a combination of both. Specific production points on the graph illustrate different states of the economy. Any point located exactly on the PPF, such as Point , Point , Point , Point , or Point , represents an efficient level of production. Efficiency means the economy is getting all it can from the scarce resources available, and all resources are fully utilized. Conversely, any point located inside the PPF, such as Point , is considered inefficient because some resources are underutilized, such as unemployed workers or idle factories. Points located outside the PPF, like Point , are not feasible given the current resources and technology.
Opportunity Cost, Tradeoffs, and the Shape of the PPF
Moving along the PPF transitionally involves shifting resources from the production of one good to another, which forces society to face a tradeoff: getting more of one good require sacrificing some of the other. The slope of the PPF represents the opportunity cost of one good in terms of the other. If the PPF is a straight line, the opportunity cost remains constant. For example, if the opportunity cost of airplane is always tons of soybeans, the graph will be linear. However, the PPF is often bowed outward, indicating an increasing opportunity cost. This happens because different workers have different skills and different resources have varying suited uses. At a point where most resources are used to produce beer, even workers who would be better at building mountain bikes are stuck producing beer; thus, moving them to bike production results in a large gain in bikes for a small loss in beer (a low opportunity cost). Conversely, if most workers are already building bikes, only the most specialized brewers remain in the beer industry. Moving them to bike production would cause a huge loss in beer for only a minor gain in bikes, resulting in a high opportunity cost.
Economic Growth and Shifts in the PPF
The PPF is not static; it can shift over time. If there is an increase in the available factors of production, such as an increase in the labor force, or an improvement in production technology, the economy experiences economic growth. This growth is represented by an outward shift of the entire PPF. After such a shift, the economy can produce more of both goods or any combination between the new intercepts. For instance, an economy originally limited to tons of soybeans and airplanes might shift outward to a new frontier where it can produce tons of soybeans or airplanes.
Distinguishing Between Microeconomics and Macroeconomics
The field of economics is divided into two broad subfields. Microeconomics is the study of how households and firms make decisions and how they interact in specific markets. This includes analyzing how a family decides what to buy or how a firm decides what price to charge for a product. Macroeconomics is the study of economy-wide phenomena. It focuses on forces and trends that affect the economy as a whole, including the study of inflation, unemployment rates, and overall economic growth.
Positive Versus Normative Analysis
Economists use different types of statements depending on whether they are acting as scientists or policy advisers. Positive statements are descriptive; they attempt to describe the world as it is. These assertions can be confirmed or refuted by examining empirical evidence. For example, the statement "An increase in the price of burritos will cause an increase in consumer demand for movie streaming" is a positive statement because it describes a relationship that can be tested, even if the statement itself turns out to be false. Normative statements are prescriptive; they attempt to prescribe how the world ought to be. These involve value judgments and cannot be confirmed or refuted by data alone. For example, "The government should print less money" or "A tax cut is needed to stimulate the economy" are normative statements because they reflect a preference or policy goal rather than a simple factual observation.
Economists in the Policy-Making Process
Economists hold various influential positions within the United States government. The Council of Economic Advisers, which consists of three members and a staff of several dozen economists, advises the President and writes the annual Economic Report of the President. Economists at the Office of Management and Budget (OMB) help formulate spending plans and regulatory policies. The Department of the Treasury employs economists to design tax policy, while the Department of Labor uses economists to analyze workforce data and formulate labor-market policies. The Department of Justice uses economists to enforce antitrust laws. Furthermore, the Congressional Budget Office (CBO) provides independent advice to Congress, and the Federal Reserve sets the nation's monetary policy. Despite this extensive input, economists' advice is not always followed. Presidents must balance economic recommendations with the input of communication advisers, press advisers, legislative affairs advisers, and political advisers.
Reasons for Disagreement Among Economists
Economists often provide conflicting advice for two main reasons. First, they may have differences in scientific judgments. This occurs when economists have different hunches about the validity of various theories or different judgments regarding the size of parameters that measure the relationship between economic variables. Second, they may have differences in values or political philosophies, leading to different normative views on what policy goals should be prioritized. However, even with these disagreements, there are many fundamental propositions where the vast majority of economists agree.
Collective Agreement: Consensus Among Economists
Research indicates high levels of consensus among economists on several key issues. The following percentages represent the proportion of economists who agree with these specific propositions:
A ceiling on rents reduces the quantity and quality of housing available:
Tariffs and import quotas usually reduce general economic welfare:
The United States should not restrict employers from outsourcing work to foreign countries:
The United States should eliminate agricultural subsidies:
Local and state governments should eliminate subsidies to professional sports franchises:
Cash payments increase the welfare of recipients more than transfers in-kind of equal value:
A large federal budget deficit has an adverse effect on the economy:
The United States should not ban genetically modified crops:
A minimum wage increases unemployment among young and unskilled workers:
Government subsidies on ethanol in the United States should be reduced or eliminated:
Questions & Discussion
During a Think-Pair-Share exercise, a scenario is presented involving a PBS NewsHour segment. Two economists are debating free trade; one supports it while the other opposes it. A roommate observing this might conclude that experts know nothing because they cannot agree. However, the insight provided is that disagreement usually stems from different positive theories or different value judgments. If one person discovers that of economists actually agree that free trade is best, it becomes clear that the disagreement on television may not represent the consensus of the field. Furthermore, discovering that the economist opposed to free trade works for a labor union would provide additional context for their normative position, as their specific interests or political philosophy might deviate from the broader scientific consensus.