Thinking Like an Economist

The Economist as a Scientist

• Overview of Economic Science:

  • Economics operates as a scientific discipline, and economists function as scientists who dispassionately develop and test theories about how the world works.

  • Core steps in the scientific method used by economists:

  • Devise economic theories.

  • Collect empirical data.

  • Analyze the collected data.

  • Verify or refute theories based on data analysis.

  • Distinctions in economic methodology:

  • Social scientists study human behavior and market interactions rather than physical or electrical phenomena.

  • Conducting controlled laboratory experiments in economics is frequently impractical or impossible.

  • Instead of laboratory experiments, economists rely on natural experiments provided by historical events and historical data.

• The Role of Assumptions:

  • Assumptions simplify a complex world, making economic phenomena easier to understand without eliminating essential features.

  • The art of scientific thinking involves determining which assumptions are appropriate to make under specific circumstances.

  • Economists adjust assumptions depending on the horizon or question being analyzed:

  • Short-run analysis often assumes prices are fixed or sticky.

  • Long-run analysis assumes prices are flexible.

Economic Models

• Purpose of Economic Models:

  • Economists use models consisting of diagrams, graphs, and equations to omit unnecessary details and illustrate fundamental economic concepts.

• The Circular-Flow Diagram:

  • A visual model of the economy showing how dollars, inputs, and outputs flow through markets among households and firms.

• Primary Decision-Makers:

  • Households:

    • Own and sell factors of production (labor, land, and capital).

    • Buy and consume goods and services produced by firms.

  • Firms:

    • Produce and sell goods and services.

    • Hire and use factors of production.

• Types of Markets:

  • Markets for Goods and Services:

    • Firms are sellers; households are buyers.

    • Goods and services sold by firms flow to households.

    • Spending by households flows to firms as revenue.

  • Markets for Factors of Production:

    • Households are sellers; firms are buyers.

    • Households supply labor, land, and capital to firms.

    • Firms pay wages, rent, and profit, which flow to households as income.

• Visual Structure of Flows:

  • Inner Loop (Red Arrows): Flow of physical inputs and outputs (factors of production from households to firms, and final goods and services from firms to households).

  • Outer Loop (Green Arrows): Flow of dollars (spending by households into revenue for firms, and costs paid by firms into income for households).

The Production Possibilities Frontier

• Definition and Structure:

  • The Production Possibilities Frontier (PPF) is a graph showing various combinations of output (such as cars and computers) that an economy can produce given available factors of production and technology.

• Key Points on the PPF Graph:

  • Point A: Produces $600$ cars and $2,200$ computers (efficient point on the frontier).

  • Point B: Produces $700$ cars and $2,000$ computers (efficient point on the frontier).

  • Point C: Lies outside the frontier; represents an output level that is unattainable with current resources and technology.

  • Point D: Produces $300$ cars and $1,000$ computers; lies inside the frontier, representing an inefficient outcome where resources are underutilized or misallocated.

  • Point E: Produces $1,000$ cars and $0$ computers (extreme endpoint on the x-axis).

  • Point F: Lies on the frontier near the upper-left, producing few cars (e.g., $100$ cars) and high quantities of computers (e.g., $2,900$ computers).

• Efficiency, Trade-Offs, and Opportunity Cost:

  • Efficient Production:

  • An economy produces efficiently when it gets all it can from available scarce resources.

  • Efficient outcomes are represented by points directly on the PPF curve (Points A, B, E, and F).

  • Trade-off principle: To produce more of one good, the economy must produce less of another good.

  • Example: Moving from Point A ($600$ cars, $2,200$ computers) to Point B ($700$ cars, $2,000$ computers) yields $100$ additional cars at the opportunity cost of $200$ computers.

  • Inefficient Production:

  • Points strictly inside the PPF (Point D) reflect inefficiency, such as high unemployment or misallocation of resources.

  • Opportunity Cost and PPF Slope:

  • The opportunity cost of producing one good in terms of another is measured by the slope of the PPF curve.

  • Bowed-Outward PPF Shape:

    • The PPF is bowed outward from the origin because resources are specialized.

    • When producing mostly computers and few cars (Point F), workers best suited for car production are producing computers; moving them to car production yields a low opportunity cost in lost computers.

    • When producing many cars and few computers (Point B or E), workers best suited for computer production are making cars; producing additional cars requires transferring highly efficient computer workers, resulting in a high opportunity cost for cars.

• Technological Advance and Shifts in the PPF:

  • Technological innovations increase potential output and cause the PPF to shift outward.

• A technological advance specific to the computer industry expands computer production capabilities for any given quantity of cars.

• Outward shift represents economic growth, allowing the economy to produce more of both goods.

• Example: Moving from initial Point A ($600$ cars, $2,200$ computers) to new Point G ($650$ cars, $2,300$ computers) on the expanded frontier.

Policy Advisory and Economic Analysis

• Positive versus Normative Analysis:

  • Positive Statements:

  • Descriptive claims that state how the world is.

  • Can be confirmed or refuted by examining empirical data and evidence.

  • Example: "Minimum-wage laws cause unemployment."

  • Normative Statements:

  • Prescriptive claims that state how the world ought to be.

  • Involve value judgments, ethics, and policy priorities in addition to economic facts.

  • Example: "The government should raise the minimum wage."

• Common Logical Pitfalls in Economic Analysis:

  • Fallacy of Composition: The mistaken belief that what is true for a part or individual must also be true for the whole group or economy.

  • Association is Not Causation: The error of concluding that because two events occur together, one event must cause the other.

• Economists in Government Role:

  • Economists provide advisory assistance to executive and legislative branches to inform policy design.

• Primary Federal Agencies and Offices Employing Economists:

  • Council of Economic Advisers (CEA): Advises the U.S. President and authors the annual Economic Report of the President.

  • Office of Management and Budget (OMB)

  • Department of the Treasury

  • Department of Labor

  • Department of Justice

  • Congressional Budget Office (CBO)

  • The Federal Reserve System

Consensus Among Economists

• Agreement Rates on Key Policy Propositions:

  • A ceiling on rents reduces the quantity and quality of housing available: $93\%$

  • Tariffs and import quotas usually reduce general economic welfare: $93\%$

  • Flexible and floating exchange rates offer an effective international monetary arrangement: $90\%$

  • Fiscal policy (e.g., tax cuts and/or government expenditure increases) has a significant stimulative impact on a less than fully employed economy: $90\%$

  • The United States should not restrict employers from outsourcing work to foreign countries: $90\%$

  • Economic growth in developed countries like the United States leads to greater levels of well-being: $88\%$

  • The United States should eliminate agricultural subsidies: $85\%$

  • An appropriately designed fiscal policy can increase the long-run rate of capital formation: $85\%$

  • Local and state governments should eliminate subsidies to professional sports franchises: $85\%$

  • The gap between Social Security funds and expenditures will become unsustainably large within the next $50$ years if current policies remain unchanged: $85\%$

  • Cash payments increase the welfare of recipients to a greater degree than do transfers-in-kind of equal cash value: $84\%$

  • A large federal budget deficit has an adverse effect on the economy: $83\%$

  • The redistribution of income in the United States is a legitimate role for the government: $83\%$

  • Inflation is caused primarily by too much growth in the money supply: $83\%$

  • The United States should not ban genetically modified crops: $82\%$

  • A minimum wage increases unemployment among young and unskilled workers: $79\%$

  • The government should restructure the welfare system along the lines of a "negative income tax": $79\%$

  • Effluent taxes and marketable pollution permits represent a better approach to pollution control than the imposition of pollution ceilings: $78\%$

  • Government subsidies on ethanol in the United States should be reduced or eliminated: $78\%$