IN THIS CHAPTER See how economists pply the method Consider how assumptions and models can shed light on the worl Learn two simple models-the circular flow and th roduction possibilities frontier Distinguish between microeconomics and macroeconomics THINKING LIKE AN ECONOMIST Learn the difference between positive and normative statements Every field of study has its own language and its own way of thinking. Mathe- maticians talk about axioms, integrals, and vector spaces. Psychologists talk about ego, id, and cognitive dissonance. Lawyers talk about venue, torts, and promissor estoppel Economics is no different Supply, demand, elasticity, comparative advantage, Examine the role of consumer surplus, deadweight loss-these terms are part of the economists lan- economists in guage. In the coming chapters, you will encounter many new terms and some fa- making polle miliar words that economists use in specialized ways. At first, this new language may seem needlessly arcane. But, as you will see, its value lies in its ability to pro- vide you a new and useful way of thinking about the world in which you live The single most important purpose of this book is to help you learn the econ- omist's way of thinking. Of course, just as you cannot become a mathematician, Consider wh psychologist, or lawyer overnight, learning to think like an economist will take economists times disagl with one another 19
IN THIS CHAPTER YOU WILL . . . Learn the difference between positive and normative statements Learn two simple models—the circular flow and the production possibilities frontier See how economists apply the methods of science Consider how assumptions and models can shed light on the world Distinguish between microeconomics and macroeconomics Every field of study has its own language and its own way of thinking. Mathematicians talk about axioms, integrals, and vector spaces. Psychologists talk about ego, id, and cognitive dissonance. Lawyers talk about venue, torts, and promissory estoppel. Economics is no different. Supply, demand, elasticity, comparative advantage, consumer surplus, deadweight loss—these terms are part of the economist’s language. In the coming chapters, you will encounter many new terms and some familiar words that economists use in specialized ways. At first, this new language may seem needlessly arcane. But, as you will see, its value lies in its ability to provide you a new and useful way of thinking about the world in which you live. The single most important purpose of this book is to help you learn the economist’s way of thinking. Of course, just as you cannot become a mathematician, psychologist, or lawyer overnight, learning to think like an economist will take THINKING LIKE AN ECONOMIST 19 Examine the role of economists in making policy Consider why economists sometimes disagree with one another
20 PART ONE INTRODUCTION some time. Yet with a combination of theory, case studies, and examples of eco- nomics in the news, this book will give you ample opportunity to develop and practice this skill Before delving into the substance and details of economics, it is helpful to have an overview of how economists approach the world. This chapter, therefore, dis- cusses the field's methodology What is distinctive about how economists confront a question? What does it mean to think like an economist? THE ECONOMIST AS SCIENTIST Economists try to address their subject with a scientists objectivity. They approach the study of the economy in much the same way as a physicist approaches the study of matter and a biologist approaches the study of life: They devise theories, collect data, and then analyze these data in an attempt to verify or refute their To beginners, it can seem odd to claim that economics is a science. After ists do not work with test tubes or telescopes. The essence of science, "Im a social scientist, Michael. That means I can't explain electricity or anything like that, but if you ever want to know about people I'm your man
20 PART ONE INTRODUCTION some time. Yet with a combination of theory, case studies, and examples of economics in the news, this book will give you ample opportunity to develop and practice this skill. Before delving into the substance and details of economics, it is helpful to have an overview of how economists approach the world. This chapter, therefore, discusses the field’s methodology. What is distinctive about how economists confront a question? What does it mean to think like an economist? THE ECONOMIST AS SCIENTIST Economists try to address their subject with a scientist’s objectivity. They approach the study of the economy in much the same way as a physicist approaches the study of matter and a biologist approaches the study of life: They devise theories, collect data, and then analyze these data in an attempt to verify or refute their theories. To beginners, it can seem odd to claim that economics is a science. After all, economists do not work with test tubes or telescopes. The essence of science, “I’m a social scientist, Michael. That means I can’t explain electricity or anything like that, but if you ever want to know about people I’m your man
CHAPTER 2 THINKING LIKE AN ECONOMIST however, is the scientific method-the dispassionate development and testing of theories about how the world works. This method of inquiry is as applicable to studying a nations economy as it is to studying the earth's gravity or a species evolution. As Albert Einstein once put it, The whole of science is nothing more than the refinement of everyday thinking Although Einsteins comment is as true for social sciences such as economics as it is for natural sciences such as physics, most people are not accustomed to looking at society through the eyes of a scientist. Lets therefore discuss some of the ways in which economists apply the logic of science to examine how an econ omy works THE SCIENTIFIC METHOD: OBSERVATION THEORY AND MORE OBSERVATION Isaac Newton, the famous seventeenth-century scientist and mathematician, al legedly became intrigued one day when he saw an apple fall from an apple 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. Subse- quent testing of Newton's theory has shown that it works well in many circum- stances(although, as Einstein would later emphasize, not in all circumstances) Because Newton's theory has been so successful at explaining observation, it is till taught today in undergraduate physics courses around the world. This interplay between theory and observation also occurs in the field of eco nomics. An economist might live in a country experiencing rapid increases in prices and be moved by this observation to develop a theory of inflation. The theory might assert that high inflation arises when the government prints too much money. (As you may recall, this was one of the Ten Principles of Economics in Chapter 1. ) To test this theory, the economist could collect and analyze data on prices and money from many different countries. If growth in the quantity of money were not at all related to the rate at which prices are rising, the economist would start to doubt the validity of his theory of inflation. If money growth and in- flation were strongly correlated in international data, as in fact they are, the econ- omist would become more confident in his theory. Although economists use theory and observation like other scientists, they do face an obstacle that makes their task especially challenging: Experiments are often difficult in economics. Physicists studying gravity can drop many objects in their laboratories to generate data to test their theories. By contrast, economists study ing inflation are not allowed to manipulate a nation's monetary policy simply to generate useful data. Economists, like astronomers and evolutionary biologis usually have to make do with whatever data the world happens to give them. To find a substitute for laboratory experiments, economists pay close attention to the natural experiments offered by history. When a war in the Middle East in- terrupts the flow of crude oil, for instance, oil prices skyrocket around the world For consumers of oil and oil products, such an event depresses living standards For economic policymakers, it poses a difficult choice about how best to respond But for economic scientists, it provides an opportunity to study the effects of a key natural resource on the worlds economies, and this opportunity persists long after the wartime increase in oil prices is over. Throughout this book, therefore, we con- sider many historical episodes. These episodes are valuable to study because they
CHAPTER 2 THINKING LIKE AN ECONOMIST 21 however, is the scientific method—the dispassionate development and testing of theories about how the world works. This method of inquiry is as applicable to studying a nation’s economy as it is to studying the earth’s gravity or a species’ evolution. As Albert Einstein once put it, “The whole of science is nothing more than the refinement of everyday thinking.” Although Einstein’s comment is as true for social sciences such as economics as it is for natural sciences such as physics, most people are not accustomed to looking at society through the eyes of a scientist. Let’s therefore discuss some of the ways in which economists apply the logic of science to examine how an economy works. THE SCIENTIFIC METHOD: OBSERVATION, THEORY, AND MORE OBSERVATION Isaac Newton, the famous seventeenth-century scientist and mathematician, allegedly became intrigued one day when he saw an apple fall from an apple 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. Subsequent testing of Newton’s theory has shown that it works well in many circumstances (although, as Einstein would later emphasize, not in all circumstances). Because Newton’s theory has been so successful at explaining observation, it is still taught today in undergraduate physics courses around the world. This interplay between theory and observation also occurs in the field of economics. An economist might live in a country experiencing rapid increases in prices and be moved by this observation to develop a theory of inflation. The theory might assert that high inflation arises when the government prints too much money. (As you may recall, this was one of the Ten Principles of Economics in Chapter 1.) To test this theory, the economist could collect and analyze data on prices and money from many different countries. If growth in the quantity of money were not at all related to the rate at which prices are rising, the economist would start to doubt the validity of his theory of inflation. If money growth and inflation were strongly correlated in international data, as in fact they are, the economist would become more confident in his theory. Although economists use theory and observation like other scientists, they do face an obstacle that makes their task especially challenging: Experiments are often difficult in economics. Physicists studying gravity can drop many objects in their laboratories to generate data to test their theories. By contrast, economists studying inflation are not allowed to manipulate a nation’s monetary policy simply to generate useful data. Economists, like astronomers and evolutionary biologists, usually have to make do with whatever data the world happens to give them. To find a substitute for laboratory experiments, economists pay close attention to the natural experiments offered by history. When a war in the Middle East interrupts the flow of crude oil, for instance, oil prices skyrocket around the world. For consumers of oil and oil products, such an event depresses living standards. For economic policymakers, it poses a difficult choice about how best to respond. But for economic scientists, it provides an opportunity to study the effects of a key natural resource on the world’s economies, and this opportunity persists long after the wartime increase in oil prices is over. Throughout this book, therefore, we consider many historical episodes. These episodes are valuable to study because they
22 PART ONE INTRODUCTION ive us insight into the economy of the past and, more important, because they al low us to illustrate and evaluate economic theories of the present THE ROLE OF ASSUMPTIONS If you ask a physicist how long it would take for a marble to fall from the top of a ten-story building, she will answer the question by assuming that the marble falls in a vacuum. Of course, this assumption is false. In fact, the building is surrounded by air, which exerts friction on the falling marble and slows it down. Yet the physi cist will correctly point out that friction on the marble is so small that its effect is negligible. Assuming the marble falls in a vacuum greatly simplifies the problem lbstantially affecting th Economists make assumptions for the same reason: Assumptions can make the world easier to understand. To study the effects of international trade, for ex ample, we may assume that the world consists of only two countries and that each country produces only two goods. Of course, the real world consists of dozens of countries, each of which produces thousands of different types of goods. But by as suming two countries and two goods, we can focus our thinking. Once we under- stand international trade in an imaginary world with two countries and two goods, we are in a better position to understand international trade in the more complex world in which we live The art in scientific thinking-whether in physics, biology, or economics-is deciding which assumptions to make. Suppose, for instance, that we were drop ping a beach ball rather than a marble from the top of the building. Our physicist ould realize that the assumption of no friction is far less accurate in this case Friction exerts a greater force on a beach ball than on a marble. The assumption that gravity works in a vacuum is reasonable for studying a falling marble but not for studying a falling beach ball Similarly, economists use different assumptions to answer different questions Suppose that we want to study what happens to the economy when the govern- ment changes the number of dollars in circulation. An important piece of this analysis, it turns out, is how prices respond. Many prices in the economy change infrequently; the newsstand prices of magazines, for instance, are changed only every few years. 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 make the extreme and artificial assumption that all prices are completely fixed. For studying the long-run effects of the policy, how ever, we may assume that all prices are completely flexible. Just as a physicist uses different assumptions when studying falling marbles and falling beach balls,econ- omists use different assumptions when studying the short-run and long-run ef fects of a change in the quantity of money. ECONOMIC MODELS High school biology teachers teach basic anatomy with plastic replicas of the hu man body. These models have all the major organs-the heart, the liver, the kid- neys, and so on. The models allow teachers to show their students in a simple way how the important parts of the body fit together. Of course, these plastic models
22 PART ONE INTRODUCTION give us insight into the economy of the past and, more important, because they allow us to illustrate and evaluate economic theories of the present. THE ROLE OF ASSUMPTIONS If you ask a physicist how long it would take for a marble to fall from the top of a ten-story building, she will answer the question by assuming that the marble falls in a vacuum. Of course, this assumption is false. In fact, the building is surrounded by air, which exerts friction on the falling marble and slows it down. Yet the physicist will correctly point out that friction on the marble is so small that its effect is negligible. Assuming the marble falls in a vacuum greatly simplifies the problem without substantially affecting the answer. Economists make assumptions for the same reason: Assumptions can make the world easier to understand. To study the effects of international trade, for example, we may assume that the world consists of only two countries and that each country produces only two goods. Of course, the real world consists of dozens of countries, each of which produces thousands of different types of goods. But by assuming two countries and two goods, we can focus our thinking. Once we understand international trade in an imaginary world with two countries and two goods, we are in a better position to understand international trade in the more complex world in which we live. The art in scientific thinking—whether in physics, biology, or economics—is deciding which assumptions to make. Suppose, for instance, that we were dropping a beach ball rather than a marble from the top of the building. Our physicist would realize that the assumption of no friction is far less accurate in this case: Friction exerts a greater force on a beach ball than on a marble. The assumption that gravity works in a vacuum is reasonable for studying a falling marble but not for studying a falling beach ball. Similarly, 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, it turns out, is how prices respond. Many prices in the economy change infrequently; the newsstand prices of magazines, for instance, are changed only every few years. 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 make the extreme and artificial assumption that all prices are completely fixed. For studying the long-run effects of the policy, however, we may assume that all prices are completely flexible. Just as a physicist uses different assumptions when studying falling marbles and falling beach balls, economists use different assumptions when studying the short-run and long-run effects of a change in the quantity of money. ECONOMIC MODELS High school biology teachers teach basic anatomy with plastic replicas of the human body. These models have all the major organs—the heart, the liver, the kidneys, and so on. The models allow teachers to show their students in a simple way how the important parts of the body fit together. Of course, these plastic models
CHAPTER 2 THINKING LIKE AN ECONOMIST are not actual human bodies, and no one would mistake the model for a real per- son. These models are stylized, and they omit many details. Yet despite this lack of realism-indeed, because of this lack of realism-studying these models is useful for learning how the human body works Economists also use models to learn about the world, but instead of being made of plastic, they are most often composed of diagrams and equations. Like a biology teachers plastic model, economic models omit many details to allow us to see what is truly important. Just as the biology teachers model does not in- clude all of the bodys muscles and capillaries, an economist's model does not include every feature of the economy As we use models to examine various economic issues throught out this book I will see that all the models are built with assumptions. Just as a physicist be- gins the analysis of a falling marble by assuming away the existence of friction, economists assume away many of the details of the economy that are irrelevant for studying the question at hand. All models-in physics, biology, or economics- simplify reality in order to improve our understanding of it. OUR FIRST MODEL: THE CIRCULAR-FLOW DIAGRAM The economy consists of millions of people engaged in many activities-buying selling, working, hiring, manufacturing, and so on. To understand how the econ- omy works, we must find some way to simplify our thinking about all these activ- ities. 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 Figure 2-1 presents a visual model of the economy, called a circular-flow circular-flow diagram diagram. In this model, the economy has two types of decisionmakers-house- a visual model of the economy th holds and firms. Firms produce goods and services using inputs, such as labor, shows how dollars flow through land, and capital(buildings and machines). These inputs are called the factors of markets among households and firms production Households own the factors of production and consume all the goods and services that the firms produce Households and firms interact in two types of markets. In the markets for goods and services, households are buyers and firms are sellers. In particular, households buy the output of goods and services that firms produce. In the mar- kets for the factors of production, households are sellers and firms are buyers. In these markets, households provide firms the inputs that the firms use to produce goods and services. The circular-flow diagram offers a simple way of organizing all the economic transactions that occur between households and firms in the The inner loop of the circular-flow diagram represents the flows of goods and services between households and firms. The households sell the use of their labor land, and capital to the firms in the markets for the factors of production. The firms then use these factors to produce goods and services, which in turn are sold to households in the markets for goods and services. Hence, the factors of produ tion flow from households to firms, and goods and services flow from firms to household The outer loop of the circular-flow diagram represents the corresponding flow 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 factors of
CHAPTER 2 THINKING LIKE AN ECONOMIST 23 are not actual human bodies, and no one would mistake the model for a real person. These models are stylized, and they omit many details. Yet despite this lack of realism—indeed, because of this lack of realism—studying these models is useful for learning how the human body works. Economists also use models to learn about the world, but instead of being made of plastic, they are most often composed of diagrams and equations. Like a biology teacher’s plastic model, economic models omit many details to allow us to see what is truly important. Just as the biology teacher’s model does not include all of the body’s muscles and capillaries, an economist’s model does not include every feature of the economy. As we use models to examine various economic issues throughout this book, you will see that all the models are built with assumptions. Just as a physicist begins the analysis of a falling marble by assuming away the existence of friction, economists assume away many of the details of the economy that are irrelevant for studying the question at hand. All models—in physics, biology, or economics— simplify reality in order to improve our understanding of it. OUR FIRST MODEL: THE CIRCULAR-FLOW DIAGRAM 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. Figure 2-1 presents a visual model of the economy, called a circular-flow diagram. In this model, the economy has two types of decisionmakers—households and firms. Firms produce goods and services using inputs, such as labor, land, and capital (buildings and machines). These inputs are called the factors of production. Households own the factors of production and consume all the goods and services that the firms produce. Households and firms interact in two types of markets. In the markets for goods and services, households are buyers and firms are sellers. In particular, households buy the output of goods and services that firms produce. In the markets for the factors of production, households are sellers and firms are buyers. In these markets, households provide firms the inputs that the firms use to produce goods and services. The circular-flow diagram offers a simple way of organizing all the economic transactions that occur between households and firms in the economy. The inner loop of the circular-flow diagram represents the flows of goods and services between households and firms. The households sell the use of their labor, land, and capital to the firms in the markets for the factors of production. The firms then use these factors to produce goods and services, which in turn are sold to households in the markets for goods and services. Hence, the factors of production flow from households to firms, and goods and services flow from firms to households. The outer loop of the circular-flow 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 factors of circular-flow diagram a visual model of the economy that shows how dollars flow through markets among households and firms