Notes on How Economists Think: Scientific Method, Models, and Core Concepts (Microeconomics) -
Economists as scientists and the scientific method
Economists practice science like chemistry or physics: they form theories, collect data, test predictions, and revise beliefs based on evidence.
Science in economics involves: observation, developing theories, gathering data, testing predictions, and refining models.
Analogy to drug testing: drugs have side effects and vary by individual; similarly, economic policies can have heterogeneous effects across people.
Testing difficulties in economics:
Real-world tests are hard to control; you can’t run large-scale controlled experiments like in medicine.
Sample size vs. population: small samples (e.g., a few thousand people) may not capture effects in a 330-million-person country.
Even with experiments (e.g., tax cuts), external validity and generalizability are concerns.
Historical natural experiments: economists rely on changes that occur in history to infer causal effects when lab-like experiments are impossible (e.g., policy changes, reforms).
History as a guide has limits: past outcomes may not perfectly predict the future (technology, institutions, demographics change).
Assumptions are essential: they simplify reality to make models workable; different questions/time horizons require different assumptions.
Important constraint: models are simplified representations that omit detail but help analyze trade-offs and mechanisms.
How economists test theories and use history
Direct experiments are often infeasible; economists use natural experiments and historical data to infer effects.
Problems with historical extrapolation: different eras have different technologies, institutions, and constraints; not all past patterns repeat exactly.
The role of assumptions is to narrow variables and isolate relationships; the art is choosing the right assumptions for the question and horizon.
A famous quip about economists working for presidents highlights the ambiguity and trade-offs in policy advice: what might be good in theory may be costly in practice due to political constraints and short-term incentives.
Models and simplified pictures of the economy
Circular flow diagram (a simple model):
Firms (businesses) produce goods/services using factors of production.
Households own factors (labor, capital, land) and consume goods/services.
Markets for goods/services: households are buyers, firms are sellers.
Markets for factors: households supply factors, firms demand factors.
Omissions: government and foreign sector are not shown in this simplified view.
Production Possibilities Frontier (PPF): a key model used to illustrate trade-offs.
It shows the maximum possible combinations of two outputs an economy can produce with available resources and technology.
Points on the frontier are efficient (productive efficiency); points inside are inefficient; points outside are infeasible.
The curve is typically bowed outward (concave to the origin).
Straight-line example vs bowed curve:
A straight line implies a constant opportunity cost (trade-off), e.g., two cars per computer or vice versa (OC constant).
A bowed curve implies increasing opportunity costs: as you produce more of one good, you sacrifice increasingly more of the other good because resources are not perfectly adaptable (specialization and differing productivity).
Opportunity cost (OC): what you give up to obtain more of another good.
Example: If moving from producing computers to cars involves giving up 2 computers per car (constant OC), then the OC of 100 cars could be 200 computers; equivalently, OC per car = 2 computers.
Why the curve bows outward (increasing OC): differences in technologies and skills across productive activities; workers specialized in one task may not switch to another instantly with the same productivity; gradual reallocation reduces efficiency.
Guns and butter (historical example): trade-off between military spending (guns) and consumer spending (butter); allocations affect growth, stability, and standards of living; the curve helps analyze the opportunity costs of such choices.
The slope of the PPF changes with technology and resource allocation; a more productive technology in one sector shifts the frontier outward more in that sector.
Technology, growth, and shifts of the PPF
Technological progress shifts the PPF to the right: for the same resources, an economy can produce more of one or both goods.
Example: improved computer technology allowing more computers without sacrificing cars (or with smaller sacrifice), shifting the frontier outward for computers and potentially altering the trade-off curve.
If technology improves in one area but not another, the frontier becomes steeper (or flatter) in the affected region, changing the opportunity costs.
Economic growth is represented by a rightward shift of the PPF; the country can produce more overall without increasing inputs.
Short-run vs long-run outcomes: inflation, unemployment, and distribution of gains
Inflation and unemployment:
Inflation can help some (e.g., debtors) and hurt others (fixed incomes, savers).
Inflation can contribute to economic downturns if it undermines confidence or reduces real purchasing power; inflation is not a direct cause of unemployment but can contribute to conditions that cause recessions.
Winners and losers from policy:
No policy makes everyone better off; winners and losers arise due to distributional effects and different values.
The same policy (e.g., tax cuts) benefits some (often higher-income groups) and costs others, depending on the structure and funding.
The role of real assets and debt during inflation:
Debtors can benefit from inflation if nominal debt is fixed and the real value of repayments falls.
Asset owners (e.g., real estate) may benefit if inflation raises asset prices and the debt burden declines in real terms.
Those on fixed incomes or with wages not keeping up with inflation are harmed.
The link between inflation, growth, and employment is complex; inflation is not a universal fix and has distributional consequences.
Positive vs normative economics and policy evaluation
Positive statements: descriptive claims about how the world is (measurable, testable).
Example: “The world’s economy is growing at about 2%.”
Normative statements: prescriptive claims about how the world ought to be (values-laden).
Example: “We should raise taxes to fund programs for people.”
Evaluation involves both facts and values; different economists may disagree due to differing normative views or time horizons.
Policy advice in practice:
Politicians care about reelection and short-term outcomes; economists assess longer-term effects, which may conflict with political incentives.
Differences in values and perspectives lead to disagreements about policy size and direction.
Degree of consensus among economists on specific issues:
Example: about 80% agree that trade barriers are bad; 8% disagree; 12% have no opinion.
There can be broad agreement on long-run effects, but policy choices still reflect political and value judgments.
Institutions, data, and the policy process
The Council of Economic Advisers (CEA): advises the president on economic policy; prepares the Annual Economic Report.
Office of Management and Budget (OMB), Department of Treasury, Department of Labor: interact with economic policy and labor market data.
Labor market data and unemployment: monthly jobs numbers are released on the first Friday of every month; based on surveys of about 60,000 households and are revised over time.
The political economy of statistics:
Policymakers may question data and even push back on numbers that don’t fit their narrative or political goals.
Debates about data integrity and interpretation can reflect incentives and power dynamics.
The role of economists in policymaking:
Economists provide analysis and model-based forecasts, but politicians may prioritize short-term political gains or ideological preferences.
There can be a gap between expert advice and enacted policy due to different priorities and time horizons.
The macro view: GDP, deficits, and the external sector
GDP identity (expenditure approach):
where
Trade balance and deficits:
A trade deficit occurs when exports are less than imports (NX < 0).
Government budget deficit:
For example, a deficit around dollars (i.e., ) means the government is spending that much more than it collects in taxes.
Financing deficits can involve debt, printing money, or other mechanisms, with long-run implications for inflation and interest rates.
How to address a large deficit:
Increase taxes or cut spending; both face political obstacles.
Alternative is reducing consumption, which lowers imports and can reduce the trade deficit, but may harm growth and employment in the short term.
Immigration and the labor supply:
A potential source to increase labor supply if domestic workers are insufficient; debates about openness vs. restriction persist in policy discussions.
Rest of the world and dollar dominance:
The global economy trades using dollars; other countries supply goods in exchange for dollars, reflecting demand for U.S. financial assets and the dollar’s reserve currency status.
Some worry about long-run competitiveness if the country runs persistent deficits and loses market share; others see the dollar system as a basis for global trade.
A key takeaway:
The existence of deficits and external imbalances does not automatically prove a policy is good or bad; the impacts depend on growth, inflation, employment, and distributional effects over time.
Quick recap: big ideas to remember
Economics uses the scientific method: theory, data, testing, revision.
Models (circular flow, PPF) simplify reality to reveal core mechanisms and trade-offs.
PPF shows efficient, inefficient, and infeasible production; bowed-out shape reflects increasing opportunity costs and resource specialization.
Technology shifts the PPF outward, signaling growth.
Inflation and unemployment involve distributional winners and losers; there is no one-size-fits-all policy win.
Positive vs normative statements distinguish facts from values; policy comes with trade-offs and political constraints.
Consensus among economists exists on many issues (e.g., trade barriers generally bad), but policy is driven by values and incentives.
GDP and the macro framework connect domestic activity to the external sector; deficits and trade balances interact with growth and employment over time.
Policy design must consider data quality, political incentives, and long-term vs short-term effects; economists provide tools, not guarantees.