1.3 What Do Economists Do?

Economic outcomes in society result from decisions made by millions of people within that society’s framework of economic and political institutions. Producers and consumers of goods and services and owners of resources make economic choices that influence not just their own economic well-being but also that of society and its members. When you decide to purchase one good rather than another, save part of your income, or enter an occupation, your choice becomes part of the market process that helps determine society’s economic outcomes. In a market economy, your choices are constrained only by your income, your abilities, and the institutions of society—laws, rules, and regulations. For a market economy to best fulfill its basic function of coordinating economic activity to produce a good outcome for society, that market economy’s legal and institutional framework must contain three key elements: well-specified property rights, contract law, and the rule of law.

Economic Science

To understand a system as complex as a market economy, in which millions of economic agents interact with each other within the framework of legal and economic institutions, economists approach their subject with the same scientific objectivity as do geneticists, astrophysicists, and chemists. Like these natural scientists, economists observe the world, develop theories, then use data and statistical methods to provide evidence for or against their theories.

Thinking of economics as a science may seem somewhat strange to you since we usually picture scientists as people wearing white coats, working in a laboratory, and using equipment like microscopes or telescopes. Yet, the economist attempting to understand the effects of a change in federal income tax rates on national output and employment uses the same framework of analysis as does a biologist attempting to understand how meadow jumping mice survive hibernation at less than 5% of normal metabolism. In both cases, the framework of analysis is the scientific method.

The Scientific Method

The interaction between observation and theory provides the basis for the scientific method. Through observation, scientists identify regularities in the world that may be cause-effect relationships. A famous example is the story of Sir Isaac Newton, the scientist and mathematician whose 17th-century observation of an apple falling from a tree supposedly caused him to develop the theory of gravity. The observation of other falling objects showed the wide application of Newton’s theory. Supported by further observation, the theory was generalized to apply to objects throughout the universe. Although it was later shown that some physical interactions cannot be understood using Newton’s theory, it worked well enough to become the foundation of classical physics.

Economists also use the interaction between observation and theory to identify and understand cause-effect relationships in the economic world. For example, Adam Smith noticed that the general price increases (inflation) in Europe in the 16th and early 17th centuries corresponded to the massive export of gold and silver from America to Spain and other parts of Europe during the same period. Since gold and silver constituted international money, Smith suggested that the European inflation was caused by an increase in the money supply. The relationship between the importation of precious metals and general price increases had been noted earlier by others, and later observation of the rapid inflation that accompanied the massive printing of paper money—for example, during the American Revolution and Civil War—convinced economists to accept the quantity theory of money, the idea that increases in a country’s money supply lead to proportional increases in the general level of prices. Although economists today recognize that changes in the quantity of money and in prices are not strongly correlated in the short run, careful analysis of data from many countries shows that money growth rates and inflation rates are highly correlated over time. Hence, the process of observation, theory, and further observation has led economists to understand that if the government prints too much money, inflation will result.

Economists are at a disadvantage in using the scientific method. Unlike most natural scientists, who can test their theories using controlled experiments in laboratories, economists—especially macroeconomists—cannot easily conduct such experiments. While some economists conduct small-scale microeconomic experiments under controlled circumstances, governments do not let economists experiment on existing economies for the purpose of testing theories. How, then, do economists test their theories if the data they observe is not the result of a controlled experiment?

There are two ways in which economists can compensate for the inability to conduct controlled experiments. One way is to identify the natural experiments that result from historical circumstances. The development of the quantity theory of money as a systematic explanation of inflation is a good example. Periods of significant increases in money growth through the importation of precious metals and periods of high rates of money growth through printing paper money, in contrast to normal periods of little or no monetary growth, were natural experiments for economists interested in testing the theory that increases in money growth rates would lead to increases in inflation rates. In more recent times, there have been several natural experiments involving the impact on national living standards of large changes in the prices of petroleum products. These changes include the significant increases in world oil prices after the formation of the OPEC cartel in 1973, the significant decreases in the 1980s, and the more recent sharp reductions in oil and natural gas prices resulting from greatly increased production in the United States and Canada as well as from increased production in OPEC countries as they attempted to protect their market shares. These natural experiments provide data supporting the economic theory that decreases in world petroleum prices depress living standards in countries that are net exporters of petroleum products and raise living standards in countries that are net importers of petroleum products.

Even if there are no large changes in economic conditions of the kind we would classify as natural experiments, economists can still test their economic theories using the sophisticated statistical analysis of econometrics. This tool allows economists to analyze cause-effect relationships in a complex economic environment where many variables are changing at the same time, even if the variables experience only modest changes. For example, suppose an economist wishes to test the theory that increases in per capita income will result in increases in per capita saving. However, the theory also says that changes in interest rates and changes in wealth affect saving. If income, interest rates, wealth, and saving are all changing at once, it may seem extremely difficult or impossible to determine if increases in income cause increases in saving. Fortunately, econometric analysis allows the economist to identify the independent effect of an increase in per capita income on per capita saving, even if interest rates and wealth are also changing—similar to conducting a controlled experiment. In addition, the econometric tool allows the economist to estimate the quantitative impact of a small change in per capita income on per capita saving. The analysis of the impact of small changes is called marginal analysis, and it is economists’ most useful analytic method. The statistical tool of econometrics and the mathematical tool of calculus are specifically designed to perform marginal analysis.

Assumptions

The world is a very complicated place—so complicated that scientists cannot understand it just by looking at it. This is true of the economic world as well as the natural world. Faced with such complexity, scientists use assumptions to help simplify the world to the point where important cause-effect relationships can be identified and understood. For example, if you ask a chemist at what temperature water boils, she may respond that water boils at 212 degrees F or 100 degrees C. In this answer, she is assuming that the boiling point is being measured at the air pressure of one atmosphere, often equated with the average air pressure at sea level. She is also assuming that the water is pure. Salt water, for example, boils at higher temperatures than does pure water. Without these simplifying assumptions, the answer would have to be, “It depends.” In particular, it depends on the elevation of the place the water is boiled and on the other determinants of air pressure at that time and place: temperature, humidity, and storm patterns. It also depends on the kind and quantity of any impurities in the water.

Economists must also use simplifying assumptions to help them understand a complex economic environment. For example, in analyzing factors that determine international trade patterns, economists often start with the assumptions that there are only two countries in the world, that they produce and trade only two products, and that they use only two categories of economic resources to produce those products. Economists also may assume that there are no costs to transport goods between the countries. Additional simplifying assumptions are often made about the quantities of resources, the kind of technology, and the preferences of consumers in the two countries. The particular set of assumptions used depends on the causal relationship the economist is trying to understand. Even though the theory that results from these simplifying assumptions is based on an imaginary world of two countries, economists have found that the basic insights that come from this 2 × 2 × 2 world are also applicable to the real economic world of many countries, many traded goods, and many kinds of resources.

It should be obvious from these examples that assumptions are not true statements about the world. Rather, they are simplifications of reality or abstractions from reality that allow scientists to ignore many complicating factors and concentrate on only one or a few important causal factors as they try to understand cause-effect relationships in the real world. People sometimes claim that a particular scientific theory is not a good theory because the assumptions upon which it is based are not “true.” If this were the measure of whether theories are good or bad, there would be no good theories. The proper test of an assumption is not whether it is true or false but whether it is useful in helping the scientist develop a good theory. In commenting on theories, people sometimes say, “That is good in theory, but not in practice.” A theory that is not good in practice is not a good theory. A good theory is one that allows scientists to explain past events or predict future events in the real world; the best theories do both.

Economics is a behavioral science. Economic outcomes are the result of the behavior of millions of consumers, producers, and resource owners whose choices are coordinated by the market and influenced by the institutions of society. There are many motivations of all kinds that influence the behavior of individuals in an economy—so many, in fact, that economists cannot even know what they all might be, nor how they might affect behavior. Economists cut through this complexity by making a simplifying behavioral assumption, namely, that people always base their decisions only on their economic self-interest. This assumption is not a true statement about the world. Sometimes, people make selfless decisions. For example, on the morning of September 11, 2001, as the terrorist attack in New York City began, city firefighters and police officers were changing shifts. Hundreds of firefighters from both shifts ran into the burning towers to try to save people they didn’t know. What they did know was the significant probability that they would die in the effort. In fact, 343 firefighters and 60 police officers were killed that day, including a great many who were not even on duty. None of them were behaving in their narrow economic interest. You can probably think of times when you made decisions that were not in your own economic interest. Yet, people apparently behave in their economic self-interest enough of the time for the assumption that they will always do so to be extremely useful in helping economists understand cause-effect relationships in the economy. It is hard to find a theory in economics that is based on a different behavioral assumption.

Models

In earth science classes, teachers use models to identify the basic layers of the earth: the crust, mantle, outer core, and inner core. The model may be simply a two-dimensional drawing in the text or on the whiteboard, or it may be a plastic sphere that can be opened to show each of the succeeding layers, represented as smooth, nested concentric spheres. The model, painted to show the position of the oceans and continents, is a simplified representation of the actual earth. For example, the actual layers of the earth are not perfect spheres but have varying thicknesses; the crust of the earth is not smooth but has irregular mountains and valleys and is fractured into tectonic plates that constantly move; the mantle has several layers. Although the model is not an accurate representation of the earth, its depiction of the basic layers of the earth has the advantage of being simple enough to help students understand the relative positions and functions of those layers.

Economists also use models to increase their understanding of the economic world, but they are not like the plastic models used in geology. Economists’ models usually consist of diagrams and mathematical equations, but they can also be simple verbal models. In this course, most of the models are diagrams based on mathematical equations. The production possibilities frontier diagrams in Section 2.2 and the supply and demand diagrams in Section 3.5 are examples of such models. The chapter on GDP uses a simple verbal model of the economy to illustrate the interactions among important economic sectors. These models represent economic theories that economists have developed and tested using the scientific method. The theories themselves are based on simplified assumptions, and the models are often simplified representations of the theories. Because of their simplicity, the economic models used in this text are effective in helping students understand the key relationships and interactions that determine the outcome of economic activity.

Economic Policy

If you are interested in economic events or news in general, you may be aware of how frequently economists are asked to explain the causes of economic events or conditions. These questions may include, “What caused the financial crisis of 2008 and the Great Recession that followed?” or “Why are women still paid less than men?” or “Why has the growth rate of the Chinese economy fallen significantly over the last decade?” Economists answer these questions based on their scientific understanding of how the economic world works.

Likewise, economists are often asked to make forecasts about future economic trends or events. These questions include, “How will the trend in world petroleum prices affect the U.S. economy and U.S. oil and gas producers?” or “How will the adoption of a digital currency affect the position of the U.S. dollar in world economic and financial markets?” or “How will the Russia-Ukraine war affect the post-war growth rates of the two countries?” These questions are considerably more difficult since they require economists to make assumptions about the future course of related geopolitical and economic conditions in addition to using their understanding of economic cause-effect relationships. Wise economists begin the answer to these questions with “if” or “assuming.” Economists are also asked to recommend policies to improve economic outcomes for society or for groups within society. These questions include, “What should the government do to increase the rate of economic growth?” or “What policies would best help reduce the number of children living in poverty?” or “What is the best way to ensure that people who have paid into the Social Security retirement program will receive their promised benefits?” When economists are explaining the causes of economic outcomes, they are acting as scientists. When they are identifying ways to help improve economic outcomes, they are acting as policy advisors.

Positive Economics and Normative Economics

In the middle of the 18th century, the Scottish philosopher and economic thinker David Hume asserted that “you cannot deduce ought from is,” meaning that value judgments (what you think should be) cannot be based only on facts (what is). Today, economists use Hume’s idea to distinguish between positive economics (economic science) and normative economics (economic policy). In economics, positive statements are descriptive; they try to describe the world the way it is. Normative statements are prescriptive; they try to describe the world the way the person thinks it ought to be. The following statements about tariffs illustrate the difference.

Alice’s statement is positive, the result of economic science. John’s statement is normative and is influenced by John’s value judgments. When economists make positive statements, they are speaking as scientists; when they make normative statements, they are speaking as policy advisors. The distinction between positive and normative statements is very important. Economic science provides a mechanism (the scientific method) to check the validity of positive science, but no such mechanism exists to check the validity of normative statements. Because they involve value judgments or opinions as well as facts, normative statements cannot be judged solely on the basis of data analysis.

Economists as Policy Advisors

Economists play key roles as advisors in the executive and legislative branches of government. Perhaps the most visible advisory role is the President’s Council of Economic Advisors (CEA), which exists to advise the president of the United States on economic policy. The CEA consists of a three-person council with a staff of a few dozen professional economists. Traditionally, the council members represent expertise in macroeconomics, microeconomics, and international economics. In addition, executive branch departments and government agencies of all kinds hire economists to help them formulate their set of economic policies. In the legislative branch, Congress uses the expertise of economists at the Congressional Budget Office to evaluate policy proposals. Individual members of the House and Senate often hire economists to advise them on the economic impacts of proposed legislation. The Federal Reserve employs many economists to analyze economic conditions in the U.S. and foreign countries.

Economists in these policy advisory positions should be careful not to blur the line between their own normative value judgments and their expertise as positive economic scientists. The proper role of the economist as policy advisor is to present to the policymaker with the likely economic effects of alternative economic policies, as identified through positive economic analysis. The normative policy decision should properly be made by the elected or appointed policymaker, based on the positive information supplied by the economic advisor. What the policy advisor should not do is imply that her own normative policy preference is simply the positive result of economic science. The following imaginary conversation between the president and his economic advisor illustrates the proper role of an economist as a policy advisor.

How much influence do economists exert as scientists and policy advisors? The great economist John Maynard Keynes, father of macroeconomics, believed economists’ policy influence was very large and came as a result of both their scientific research and their roles as policy advisors. In 1935, he wrote the following:

The situation hasn’t changed since Keynes wrote these words. Many economists, including Keynes, continue to have a large impact on public policy, both directly and indirectly.

Why Do Economists Disagree?

There is not much disagreement among economists on positive economic analysis. After all, the scientific method provides a proven way to test economic theories. Though economists may occasionally disagree over which alternative economic theory is most accurate or applicable in a specific situation, most disagreement is over normative policy issues. Even over those issues, there is not as much disagreement as people may think. On some important policy issues, such as international trade policy and price controls, there is little difference of opinion among economists. Policy disagreements are usually the result of different value judgments, which may represent different political philosophies; different ethical, moral, religious, or philosophical beliefs; or different life experiences.

Moving Ahead

In this chapter, you have learned some basic ideas about the field of economics and about what economists do. In the next two chapters, you will learn the fundamental economic principles of analysis that help explain economic interactions in a market economy: efficiency, exchange, supply, and demand. An understanding of these principles will increase your ability to think like an economist.

John Maynard Keynes thought that economics was not a particularly difficult subject but one at which few people really excelled. His explanation of this seeming paradox was that to excel at economics, the economist must possess a rare combination of gifts: “He must be mathematician, historian, statesman, philosopher—in some degree.” Keynes continued, “he must understand symbols and speak in words. He must contemplate the particular in terms of the general, and touch abstract and concrete in the same flight of thought.” Finally, “He must study the present in light of the past for the purpose of the future.”2

As you continue your study of economics and begin to think more and more like an economist, you may approach the high standard Keynes suggests. This text is designed to help you proceed toward that goal.