Download Guideline for Macroeconomics and more Study Guides, Projects, Research Economic Analysis in PDF only on Docsity!
I N T H I S C H A P T E R
Y O U W I L L...
D i s c u s s h o w i n c e n t i v e s a f f e c t p e o p l e ’ s b e h a v i o r
L e a r n t h e m e a n i n g o f o p p o r t u n i t y c o s t
L e a r n t h a t e c o n o m i c s i s a b o u t t h e a l l o c a t i o n o f s c a r c e r e s o u r c e s
E x a m i n e s o m e o f t h e t r a d e o f f s t h a t p e o p l e f a c e
S e e h o w t o u s e m a r g i n a l r e a s o n i n g w h e n m a k i n g d e c i s i o n s
The word economy comes from the Greek word for “one who manages a house- hold.” At first, this origin might seem peculiar. But, in fact, households and economies have much in common. A household faces many decisions. It must decide which members of the household do which tasks and what each member gets in return: Who cooks din- ner? Who does the laundry? Who gets the extra dessert at dinner? Who gets to choose what TV show to watch? In short, the household must allocate its scarce re- sources among its various members, taking into account each member’s abilities, efforts, and desires. Like a household, a society faces many decisions. A society must decide what jobs will be done and who will do them. It needs some people to grow food, other people to make clothing, and still others to design computer software. Once soci- ety has allocated people (as well as land, buildings, and machines) to various jobs,
T E N P R I N C I P L E S
O F E C O N O M I C S
3
C o n s i d e r w h y t r a d e a m o n g p e o p l e o r n a t i o n s c a n b e g o o d f o r e v e r y o n e
D i s c u s s w h y m a r k e t s a r e a g o o d , b u t n o t p e r f e c t , w a y t o a l l o c a t e r e s o u r c e s
L e a r n w h a t d e t e r m i n e s s o m e t r e n d s i n t h e o v e r a l l e c o n o m y
4 PA R T O N E I N T R O D U C T I O N
it must also allocate the output of goods and services that they produce. It must decide who will eat caviar and who will eat potatoes. It must decide who will drive a Porsche and who will take the bus. The management of society’s resources is important because resources are scarce. Scarcity means that society has limited resources and therefore cannot pro- duce all the goods and services people wish to have. Just as a household cannot give every member everything he or she wants, a society cannot give every indi- vidual the highest standard of living to which he or she might aspire. Economics is the study of how society manages its scarce resources. In most societies, resources are allocated not by a single central planner but through the combined actions of millions of households and firms. Economists therefore study how people make decisions: how much they work, what they buy, how much they save, and how they invest their savings. Economists also study how people inter- act with one another. For instance, they examine how the multitude of buyers and sellers of a good together determine the price at which the good is sold and the quantity that is sold. Finally, economists analyze forces and trends that affect the economy as a whole, including the growth in average income, the fraction of the population that cannot find work, and the rate at which prices are rising. Although the study of economics has many facets, the field is unified by sev- eral central ideas. In the rest of this chapter, we look at Ten Principles of Economics. These principles recur throughout this book and are introduced here to give you an overview of what economics is all about. You can think of this chapter as a “pre- view of coming attractions.”
H O W P E O P L E M A K E D E C I S I O N S
There is no mystery to what an “economy” is. Whether we are talking about the economy of Los Angeles, of the United States, or of the whole world, an economy is just a group of people interacting with one another as they go about their lives. Because the behavior of an economy reflects the behavior of the individuals who make up the economy, we start our study of economics with four principles of in- dividual decisionmaking.
P R I N C I P L E # 1 : P E O P L E FA C E T R A D E O F F S
The first lesson about making decisions is summarized in the adage: “There is no such thing as a free lunch.” To get one thing that we like, we usually have to give up another thing that we like. Making decisions requires trading off one goal against another. Consider a student who must decide how to allocate her most valuable re- source—her time. She can spend all of her time studying economics; she can spend all of her time studying psychology; or she can divide her time between the two fields. For every hour she studies one subject, she gives up an hour she could have used studying the other. And for every hour she spends studying, she gives up an hour that she could have spent napping, bike riding, watching TV, or working at her part-time job for some extra spending money.
s c a r c i t y the limited nature of society’s resources
e c o n o m i c s the study of how society manages its scarce resources
6 PA R T O N E I N T R O D U C T I O N
spend on tuition, books, room, and board. Yet this total does not truly represent what you give up to spend a year in college. The first problem with this answer is that it includes some things that are not really costs of going to college. Even if you quit school, you would need a place to sleep and food to eat. Room and board are costs of going to college only to the ex- tent that they are more expensive at college than elsewhere. Indeed, the cost of room and board at your school might be less than the rent and food expenses that you would pay living on your own. In this case, the savings on room and board are a benefit of going to college. The second problem with this calculation of costs is that it ignores the largest cost of going to college—your time. When you spend a year listening to lectures, reading textbooks, and writing papers, you cannot spend that time working at a job. For most students, the wages given up to attend school are the largest single cost of their education. The opportunity cost of an item is what you give up to get that item. When making any decision, such as whether to attend college, decisionmakers should be aware of the opportunity costs that accompany each possible action. In fact, they usually are. College-age athletes who can earn millions if they drop out of school and play professional sports are well aware that their opportunity cost of college is very high. It is not surprising that they often decide that the benefit is not worth the cost.
P R I N C I P L E # 3 : R AT I O N A L P E O P L E T H I N K AT T H E M A R G I N
Decisions in life are rarely black and white but usually involve shades of gray. When it’s time for dinner, the decision you face is not between fasting or eating like a pig, but whether to take that extra spoonful of mashed potatoes. When ex- ams roll around, your decision is not between blowing them off or studying 24 hours a day, but whether to spend an extra hour reviewing your notes instead of watching TV. Economists use the term marginal changes to describe small incre- mental adjustments to an existing plan of action. Keep in mind that “margin” means “edge,” so marginal changes are adjustments around the edges of what you are doing. In many situations, people make the best decisions by thinking at the margin. Suppose, for instance, that you asked a friend for advice about how many years to stay in school. If he were to compare for you the lifestyle of a person with a Ph.D. to that of a grade school dropout, you might complain that this comparison is not helpful for your decision. You have some education already and most likely are deciding whether to spend an extra year or two in school. To make this decision, you need to know the additional benefits that an extra year in school would offer (higher wages throughout life and the sheer joy of learning) and the additional costs that you would incur (tuition and the forgone wages while you’re in school). By comparing these marginal benefits and marginal costs, you can evaluate whether the extra year is worthwhile. As another example, consider an airline deciding how much to charge passen- gers who fly standby. Suppose that flying a 200-seat plane across the country costs the airline $100,000. In this case, the average cost of each seat is $100,000/200, which is $500. One might be tempted to conclude that the airline should never sell a ticket for less than $500. In fact, however, the airline can raise its profits by
o p p o r t u n i t y c o s t whatever must be given up to obtain some item
m a r g i n a l c h a n g e s small incremental adjustments to a plan of action
C H A P T E R 1 T E N P R I N C I P L E S O F E C O N O M I C S 7
thinking at the margin. Imagine that a plane is about to take off with ten empty seats, and a standby passenger is waiting at the gate willing to pay $300 for a seat. Should the airline sell it to him? Of course it should. If the plane has empty seats, the cost of adding one more passenger is minuscule. Although the average cost of flying a passenger is $500, the marginal cost is merely the cost of the bag of peanuts and can of soda that the extra passenger will consume. As long as the standby pas- senger pays more than the marginal cost, selling him a ticket is profitable. As these examples show, individuals and firms can make better decisions by thinking at the margin. A rational decisionmaker takes an action if and only if the marginal benefit of the action exceeds the marginal cost.
P R I N C I P L E # 4 : P E O P L E R E S P O N D T O I N C E N T I V E S
Because people make decisions by comparing costs and benefits, their behavior may change when the costs or benefits change. That is, people respond to incen- tives. When the price of an apple rises, for instance, people decide to eat more pears and fewer apples, because the cost of buying an apple is higher. At the same time, apple orchards decide to hire more workers and harvest more apples, be- cause the benefit of selling an apple is also higher. As we will see, the effect of price on the behavior of buyers and sellers in a market—in this case, the market for apples—is crucial for understanding how the economy works. Public policymakers should never forget about incentives, for many policies change the costs or benefits that people face and, therefore, alter behavior. A tax on gasoline, for instance, encourages people to drive smaller, more fuel-efficient cars. It also encourages people to take public transportation rather than drive and to live closer to where they work. If the tax were large enough, people would start driving electric cars. When policymakers fail to consider how their policies affect incentives, they can end up with results that they did not intend. For example, consider public pol- icy regarding auto safety. Today all cars have seat belts, but that was not true 40 years ago. In the late 1960s, Ralph Nader’s book Unsafe at Any Speed generated much public concern over auto safety. Congress responded with laws requiring car companies to make various safety features, including seat belts, standard equip- ment on all new cars. How does a seat belt law affect auto safety? The direct effect is obvious. With seat belts in all cars, more people wear seat belts, and the probability of surviving a major auto accident rises. In this sense, seat belts save lives. But that’s not the end of the story. To fully understand the effects of this law, we must recognize that people change their behavior in response to the incentives they face. The relevant behavior here is the speed and care with which drivers op- erate their cars. Driving slowly and carefully is costly because it uses the driver’s time and energy. When deciding how safely to drive, rational people compare the marginal benefit from safer driving to the marginal cost. They drive more slowly and carefully when the benefit of increased safety is high. This explains why peo- ple drive more slowly and carefully when roads are icy than when roads are clear. Now consider how a seat belt law alters the cost–benefit calculation of a ratio- nal driver. Seat belts make accidents less costly for a driver because they reduce the probability of injury or death. Thus, a seat belt law reduces the benefits to slow and careful driving. People respond to seat belts as they would to an improvement
BASKETBALL STAR KOBE BRYANT UNDERSTANDS OPPORTUNITY COST AND INCENTIVES. DESPITE GOOD HIGH SCHOOL GRADES AND SAT SCORES , HE DECIDED TO SKIP COLLEGE AND GO STRAIGHT TO THE NBA, WHERE HE EARNED ABOUT $10 MILLION OVER FOUR YEARS.
C H A P T E R 1 T E N P R I N C I P L E S O F E C O N O M I C S 9
side wins and the other side loses. In fact, the opposite is true: Trade between two countries can make each country better off. To see why, consider how trade affects your family. When a member of your family looks for a job, he or she competes against members of other families who are looking for jobs. Families also compete against one another when they go shopping, because each family wants to buy the best goods at the lowest prices. So, in a sense, each family in the economy is competing with all other families. Despite this competition, your family would not be better off isolating itself from all other families. If it did, your family would need to grow its own food, make its own clothes, and build its own home. Clearly, your family gains much from its ability to trade with others. Trade allows each person to specialize in the activities he or she does best, whether it is farming, sewing, or home building. By trading with others, people can buy a greater variety of goods and services at lower cost. Countries as well as families benefit from the ability to trade with one another. Trade allows countries to specialize in what they do best and to enjoy a greater va- riety of goods and services. The Japanese, as well as the French and the Egyptians and the Brazilians, are as much our partners in the world economy as they are our competitors.
P R I N C I P L E # 6 : M A R K E T S A R E U S U A L LY A G O O D WAY
T O O R G A N I Z E E C O N O M I C A C T I V I T Y
The collapse of communism in the Soviet Union and Eastern Europe may be the most important change in the world during the past half century. Communist countries worked on the premise that central planners in the government were in the best position to guide economic activity. These planners decided what goods and services were produced, how much was produced, and who produced and consumed these goods and services. The theory behind central planning was that only the government could organize economic activity in a way that promoted economic well-being for the country as a whole. Today, most countries that once had centrally planned economies have aban- doned this system and are trying to develop market economies. In a market econ- omy, the decisions of a central planner are replaced by the decisions of millions of firms and households. Firms decide whom to hire and what to make. Households decide which firms to work for and what to buy with their incomes. These firms and households interact in the marketplace, where prices and self-interest guide their decisions. At first glance, the success of market economies is puzzling. After all, in a mar- ket economy, no one is looking out for the economic well-being of society as a whole. Free markets contain many buyers and sellers of numerous goods and services, and all of them are interested primarily in their own well-being. Yet, despite decentralized decisionmaking and self-interested decisionmakers, market economies have proven remarkably successful in organizing economic activity in a way that promotes overall economic well-being. In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, economist Adam Smith made the most famous observation in all of economics: Households and firms interacting in markets act as if they are guided by an “in- visible hand” that leads them to desirable market outcomes. One of our goals in
“For $5 a week you can watch baseball without being nagged to cut the grass!”
m a r k e t e c o n o m y an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services
1 0 PA R T O N E I N T R O D U C T I O N
this book is to understand how this invisible hand works its magic. As you study economics, you will learn that prices are the instrument with which the invisible hand directs economic activity. Prices reflect both the value of a good to society and the cost to society of making the good. Because households and firms look at prices when deciding what to buy and sell, they unknowingly take into account the social benefits and costs of their actions. As a result, prices guide these indi- vidual decisionmakers to reach outcomes that, in many cases, maximize the wel- fare of society as a whole. There is an important corollary to the skill of the invisible hand in guiding eco- nomic activity: When the government prevents prices from adjusting naturally to supply and demand, it impedes the invisible hand’s ability to coordinate the mil- lions of households and firms that make up the economy. This corollary explains why taxes adversely affect the allocation of resources: Taxes distort prices and thus the decisions of households and firms. It also explains the even greater harm caused by policies that directly control prices, such as rent control. And it explains the failure of communism. In communist countries, prices were not determined in the marketplace but were dictated by central planners. These planners lacked the information that gets reflected in prices when prices are free to respond to market
It may be only a coincidence that Adam Smith’s great book, An Inquiry into the Nature and Causes of the Wealth of Na- tions, was published in 1776, the exact year American revolu- tionaries signed the Declara- tion of Independence. But the two documents do share a point of view that was preva- lent at the time—that individu- als are usually best left to their own devices, without the heavy hand of government guiding their actions. This political phi- losophy provides the intellectual basis for the market econ- omy, and for free society more generally. Why do decentralized market economies work so well? Is it because people can be counted on to treat one another with love and kindness? Not at all. Here is Adam Smith’s description of how people interact in a market economy:
Man has almost constant occasion for the help of his brethren, and it is vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love in his favor, and show them that it is for their own advantage to do for him what he requires of them.... It is not from the benevolence of
the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.... Every individual... neither intends to promote the public interest, nor knows how much he is promoting it.... He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.
Smith is saying that participants in the economy are moti- vated by self-interest and that the “invisible hand” of the marketplace guides this self-interest into promoting general economic well-being. Many of Smith’s insights remain at the center of mod- ern economics. Our analysis in the coming chapters will al- low us to express Smith’s conclusions more precisely and to analyze fully the strengths and weaknesses of the mar- ket’s invisible hand.
ADAM SMITH
F Y I
Adam Smith
and the
Invisible Hand
1 2 PA R T O N E I N T R O D U C T I O N
H O W T H E E C O N O M Y A S A W H O L E W O R K S
We started by discussing how individuals make decisions and then looked at how people interact with one another. All these decisions and interactions together make up “the economy.” The last three principles concern the workings of the economy as a whole.
P R I N C I P L E # 8 : A C O U N T R Y ’ S S TA N D A R D O F
L I V I N G D E P E N D S O N I T S A B I L I T Y T O
P R O D U C E G O O D S A N D S E R V I C E S
The differences in living standards around the world are staggering. In 1997 the average American had an income of about $29,000. In the same year, the average Mexican earned $8,000, and the average Nigerian earned $900. Not surprisingly, this large variation in average income is reflected in various measures of the qual- ity of life. Citizens of high-income countries have more TV sets, more cars, better nutrition, better health care, and longer life expectancy than citizens of low-income countries. Changes in living standards over time are also large. In the United States, incomes have historically grown about 2 percent per year (after adjusting for changes in the cost of living). At this rate, average income doubles every 35 years. Over the past century, average income has risen about eightfold. What explains these large differences in living standards among countries and over time? The answer is surprisingly simple. Almost all variation in living stan- dards is attributable to differences in countries’ productivity —that is, the amount of goods and services produced from each hour of a worker’s time. In nations where workers can produce a large quantity of goods and services per unit of time, most people enjoy a high standard of living; in nations where workers are less productive, most people must endure a more meager existence. Similarly, the growth rate of a nation’s productivity determines the growth rate of its average income. The fundamental relationship between productivity and living standards is simple, but its implications are far-reaching. If productivity is the primary deter- minant of living standards, other explanations must be of secondary importance. For example, it might be tempting to credit labor unions or minimum-wage laws for the rise in living standards of American workers over the past century. Yet the real hero of American workers is their rising productivity. As another example, some commentators have claimed that increased competition from Japan and other countries explains the slow growth in U.S. incomes over the past 30 years. Yet the real villain is not competition from abroad but flagging productivity growth in the United States. The relationship between productivity and living standards also has profound implications for public policy. When thinking about how any policy will affect liv- ing standards, the key question is how it will affect our ability to produce goods and services. To boost living standards, policymakers need to raise productivity by ensuring that workers are well educated, have the tools needed to produce goods and services, and have access to the best available technology.
p r o d u c t i v i t y the amount of goods and services produced from each hour of a worker’s time
C H A P T E R 1 T E N P R I N C I P L E S O F E C O N O M I C S 1 3
In the 1980s and 1990s, for example, much debate in the United States centered on the government’s budget deficit—the excess of government spending over gov- ernment revenue. As we will see, concern over the budget deficit was based largely on its adverse impact on productivity. When the government needs to finance a budget deficit, it does so by borrowing in financial markets, much as a student might borrow to finance a college education or a firm might borrow to finance a new factory. As the government borrows to finance its deficit, therefore, it reduces the quantity of funds available for other borrowers. The budget deficit thereby reduces investment both in human capital (the student’s education) and physical capital (the firm’s factory). Because lower investment today means lower productivity in the future, government budget deficits are generally thought to de- press growth in living standards.
P R I N C I P L E # 9 : P R I C E S R I S E W H E N T H E
G O V E R N M E N T P R I N T S T O O M U C H M O N E Y
In Germany in January 1921, a daily newspaper cost 0.30 marks. Less than two years later, in November 1922, the same newspaper cost 70,000,000 marks. All other prices in the economy rose by similar amounts. This episode is one of his- tory’s most spectacular examples of inflation, an increase in the overall level of prices in the economy. Although the United States has never experienced inflation even close to that in Germany in the 1920s, inflation has at times been an economic problem. During the 1970s, for instance, the overall level of prices more than doubled, and President Gerald Ford called inflation “public enemy number one.” By contrast, inflation in the 1990s was about 3 percent per year; at this rate it would take more than
i n f l a t i o n an increase in the overall level of prices in the economy
“Well it may have been 68 cents when you got in line, but it’s 74 cents now!”
C H A P T E R 1 T E N P R I N C I P L E S O F E C O N O M I C S 1 5
monetary and fiscal policy are potentially so powerful, how policymakers should use these instruments to control the economy, if at all, is a subject of continuing debate.
Q U I C K Q U I Z : List and briefly explain the three principles that describe how the economy as a whole works.
C O N C L U S I O N
You now have a taste of what economics is all about. In the coming chapters we will develop many specific insights about people, markets, and economies. Mas- tering these insights will take some effort, but it is not an overwhelming task. The field of economics is based on a few basic ideas that can be applied in many dif- ferent situations. Throughout this book we will refer back to the Ten Principles of Economics highlighted in this chapter and summarized in Table 1-1. Whenever we do so, a building-blocks icon will be displayed in the margin, as it is now. But even when that icon is absent, you should keep these building blocks in mind. Even the most sophisticated economic analysis is built using the ten principles introduced here.
Ta b l e 1 - 1
T EN P RINCIPLES OF E CONOMICS
HOW PEOPLE #1: People Face Tradeoffs M AKE DECISIONS (^) #2: The Cost of Something Is What You Give Up to Get It #3: Rational People Think at the Margin #4: People Respond to Incentives HOW PEOPLE INTERACT #5: Trade Can Make Everyone Better Off #6: Markets Are Usually a Good Way to Organize Economic Activity #7: Governments Can Sometimes Improve Market Outcomes HOW THE ECONOMY #8: A Country’s Standard of Living Depends on Its AS A WHOLE WORKS Ability to Produce Goods and Services #9: Prices Rise When the Government Prints Too Much Money #10: Society Faces a Short-Run Tradeoff between Inflation and Unemployment
1 6 PA R T O N E I N T R O D U C T I O N
The fundamental lessons about individual decisionmaking are that people face tradeoffs among alternative goals, that the cost of any action is measured in terms of forgone opportunities, that rational people make decisions by comparing marginal costs and marginal benefits, and that people change their behavior in response to the incentives they face.
The fundamental lessons about interactions among people are that trade can be mutually beneficial, that
markets are usually a good way of coordinating trade among people, and that the government can potentially improve market outcomes if there is some market failure or if the market outcome is inequitable. The fundamental lessons about the economy as a whole are that productivity is the ultimate source of living standards, that money growth is the ultimate source of inflation, and that society faces a short-run tradeoff between inflation and unemployment.
S u m m a r y
scarcity, p. 4 economics, p. 4 efficiency, p. 5 equity, p. 5 opportunity cost, p. 6
marginal changes, p. 6 market economy, p. 9 market failure, p. 11 externality, p. 11 market power, p. 11
productivity, p. 12 inflation, p. 13 Phillips curve, p. 14
K e y C o n c e p t s
- Give three examples of important tradeoffs that you face in your life.
- What is the opportunity cost of seeing a movie?
- Water is necessary for life. Is the marginal benefit of a glass of water large or small?
- Why should policymakers think about incentives?
- Why isn’t trade among countries like a game with some winners and some losers? 6. What does the “invisible hand” of the marketplace do? 7. Explain the two main causes of market failure and give an example of each. 8. Why is productivity important? 9. What is inflation, and what causes it?
- How are inflation and unemployment related in the short run?
Q u e s t i o n s f o r R e v i e w
- Describe some of the tradeoffs faced by the following: a. a family deciding whether to buy a new car b. a member of Congress deciding how much to spend on national parks c. a company president deciding whether to open a new factory d. a professor deciding how much to prepare for class
- You are trying to decide whether to take a vacation. Most of the costs of the vacation (airfare, hotel, forgone wages) are measured in dollars, but the benefits of the vacation are psychological. How can you compare the benefits to the costs?
- You were planning to spend Saturday working at your part-time job, but a friend asks you to go skiing. What
is the true cost of going skiing? Now suppose that you had been planning to spend the day studying at the library. What is the cost of going skiing in this case? Explain.
- You win $100 in a basketball pool. You have a choice between spending the money now or putting it away for a year in a bank account that pays 5 percent interest. What is the opportunity cost of spending the $100 now?
- The company that you manage has invested $5 million in developing a new product, but the development is not quite finished. At a recent meeting, your salespeople report that the introduction of competing products has reduced the expected sales of your new product to $3 million. If it would cost $1 million to finish
P r o b l e m s a n d A p p l i c a t i o n s
I N T H I S C H A P T E R
Y O U W I L L...
L e a r n t h e d i f f e r e n c e b e t w e e n p o s i t i v e a n d n o r m a t i v e s t a t e m e n t s
L e a r n t w o s i m p l e m o d e l s — t h e c i r c u l a r f l o w a n d t h e p r o d u c t i o n p o s s i b i l i t i e s f r o n t i e r
S e e h o w e c o n o m i s t s a p p l y t h e m e t h o d s o f s c i e n c e
C o n s i d e r h o w a s s u m p t i o n s a n d m o d e l s c a n s h e d l i g h t o n t h e w o r l d
D i s t i n g u i s h b e t w e e n m i c r o e c o n o m i c s a n d m a c r o e c o n o m i c s
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 promissory estoppel. Economics is no different. Supply, demand, elasticity, comparative advantage, consumer surplus, deadweight loss—these terms are part of the economist’s lan- guage. In the coming chapters, you will encounter many new terms and some fa- 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, psychologist, or lawyer overnight, learning to think like an economist will take
T H I N K I N G L I K E
A N E C O N O M I S T
1 9
E x a m i n e t h e r o l e o f e c o n o m i s t s i n m a k i n g p o l i c y
C o n s i d e r w h y e c o n o m i s t s s o m e t i m e s d i s a g r e e w i t h o n e a n o t h e r
C H A P T E R 2 T H I N K I N G L I K E A N E C O N O M I S T 2 1
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 econ- omy works.
T H E S C I E N T I F I C M E T H O D : O B S E R VAT I O N ,
T H E O R Y, A N D M O R E O B S E R VAT I O N
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 still 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 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 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 world’s 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
2 2 PA R T O N E I N T R O D U C T I O N
give 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.
T H E R O L E O F A S S U M P T I O N S
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 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 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 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 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.
E C O N O M I C M O D E L S
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
