Economic thinking is scientific. The proof of the pudding is in the eating. How useful an economic theory is depends on how well it predicts the future consequences of economic action. Economists world. Good theories are con- develop economic theories using scientific thinking based on basic principles. The idea is consistent with and help explain real-world events. Theories that are inconsistent with the to predict how incentives will affect decision makers and compare the predictions against real-world events. If the events in the real world are consistent with a theory, we say that real world are invalid and must be rejected. the theory has predictive value and is therefore valid. If it is impossible to test the theoretical relationships of a discipline, the discipline does not qualify as a science. Because economics deals with human beings who can think and respond in a variety of ways, can economic theories really be tested? The answer to this question is yes, if, on average, human beings respond in predictable and consistent ways to changes in economic conditions. The economist believes that this is the case, even though not all individuals will respond in the specified manner. Economists usually do not try to predict the behavior of a specific individual; instead, they focus on the general behavior of a large number of individuals.
In the 1950s, economists began to do laboratory experiments to test economic theories. Individuals were brought into laboratories to see how they would act in buying and selling situations, under differing rules. For example, cash rewards were given to individuals who, when an auction was conducted, were able to sell at high prices and buy at low prices, thus approximating real-world market incentives. These experiments have verified many of the important propositions of economic theory.
Laboratory experiments, however, cannot duplicate all real economic interactions. How can we test economic theory when controlled experiments are not feasible? This is a problem, but economics is no different from astronomy in this respect. Astronomers can use theories tested in physics laboratories, but they must also deal with the world as it is. They cannot change the course of the stars or planets to see what impact the change would have on the gravitational pull of Earth. Similarly, economists cannot arbitrarily change the prices of cars or unskilled-labor services in real markets just to observe the effects on quantities purchased or levels of employment. However, economic conditions (for example, prices, production costs, technology, and transportation costs), like the location of the planets, do change from time to time. As actual conditions change, an economic theory can be tested by comparing its predictions with real-world outcomes. Just as the universe is the main laboratory of the astronomer, the real-world economy is the primary laboratory of the economist.
Archive for July, 2009
The test of a theory is its ability to predict
July 9th, 2009Beware of the secondary effects: Economic actions often generate indirect as well as direct effects
July 7th, 2009In addition to direct effects that are quickly visible, people’s decisions often generate indirect, or “secondary,” effects that may be observable only with time. Failure to consider secondary effects is one of the most common economic errors because these effects are often quite different from initial, or direct, effects. Frederic Bastiat, a nineteenth-century French economist, stated that the difference between a good and a bad economist is that the bad economist considers only the immediate, visible effects.
The true cause of these secondary effects might not be seen, even later, except by those using the logic of good economics.
Perhaps a few simple examples that involve both immediate (direct) and secondary (indirect) effects will help illustrate the point. The immediate effect of an aspirin is a bitter taste in one’s mouth. The secondary effect, which is not immediately observable, is relief from a headache. The short-term direct effect of drinking twelve cans of beer might be a warm, jolly feeling. In contrast, the secondary effect is likely to be a sluggish feeling the next morning, and perhaps a pounding headache.
Sometimes, as in the case of the aspirin, the secondary effect-headache relief-is actually an intended consequence of the action. In other cases, however, the secondary effects are unintended. Changes in government policy often alter incentives, indirectly affecting how much people work, earn, invest, consume, and conserve for the future. When a change alters incentives, unintended consequences that are quite different from the intended consequences may occur.
Let’s consider a couple of examples that illustrate the potential importance of unin- tended side effects. In an effort to reduce gasoline consumption, the federal government mandates that automobiles be more fuel efficient. Is this regulation a sound policy? It may be, but when evaluating the policy’s overall impact, one should not overlook its secondary effects. To achieve the higher fuel efficiency, auto manufacturers will reduce the size and weight of vehicles. As a result, there will be more highway deaths-about 2,000 more per year-than would otherwise occur because these lighter cars do not offer as much protec- tion for occupants. Furthermore, because the higher mileage standards for cars and light trucks make driving cheaper, people tend to drive more than they otherwise would. Thi increases congestion and results in a smaller reduction in gasoline consumption than was intended by the regulation. Once you consider the secondary effects, the fuel efficiency regulations are much less beneficial than they might first appear.
Trade restrictions between nations have important secondary effects as well. The proponents of tariffs and quotas on foreign goods almost always ignore the secondary effects of their policies. Import quotas restricting the sale of foreign-produced sugar in the U.S. market, for example, have led to sugar prices that are about three times what they are in the rest of the world. The proponents of this policy-primarily sugar producers-argue that the quotas “save jobs” and increase employment. No doubt, the employment of sugar growers in the United States is higher than it otherwise would be. But what about the secondary effects? The higher sugar prices mean it’s more expensive for U.S. firms to produce candy and other products that use a lot of sugar. As a result, many candy producers, including the makers of Life Savers, Jaw Breakers, Red Hots, and Fannie May and Fanny Farmer chocolates, have moved to countries like Canada and Mexico, where sugar can be purchased at its true market price. Thus, employment among sugar-using firms in the United States is reduced. Further, because foreigners sell less sugar in the United States, they have less purchasing power with which to buy products we export to them. This, too, reduces U.S. employment. Once the secondary effects of trade restrictions like the sugar quota program are taken into consideration, we have no reason to expect that U.S. employment will increase as a result. There may be more jobs in favored industries, but there will be less employment in others. Trade restrictions reshuffle employment rather than increase it. But those who unwittingly fail to consider the secondary effects will miss this point. Clearly, consideration of the secondary effects is an important ingredient of the economic way of thinking.
Although information can help us make better choices, its acquisition is costly
July 6th, 2009Information that helps us make better choices is valuable. However, the time needed to gather it is scarce, making information costly to acquire. As a result, people economize on their search for information just like they do anything else. For example, when you purchase a pair of jeans, you might evaluate the quality and prices of jeans at several different stores. At some point, though, you will decide that additional comparison shopping is simply not worth the trouble. You will make a choice based on the limited information you already have.
The process is similar when individuals search for a restaurant, a new car, or a roommate. They will seek to acquire some information, but at some point, they will decide that the expected benefit derived from gathering still more information is simply not worth the cost. When differences among the alternatives are important to decision makers, they will spend more time and effort gathering information. People are much more likely to read a consumer ratings magazine before purchasing a new automobile than they are before purchasing a new can opener. Because information is costly for people to acquire, limited knowledge and uncertainty about the outcome generally characterize the decision-making process.
Individuals make decisions at the margin
July 5th, 2009When making a choice between two alternatives, individuals generally focus on the difference in the costs and benefits between alternatives. Economists describe this process as marginal decision making, or “thinking at the margin.” The last time you went to eat fast food, you probably faced a decision that highlights this type of thinking. Will you get the $1.50 cheeseburger and the $1.00 medium drink, or instead get the $3.00 value meal that has the cheeseburger and drink and also comes with a medium order of fries? Naturally, individual decision making focuses on the difference between the alternatives. The value meal costs 50 cents more (its marginal cost) but will give you one extra food item-the fries (its marginal benefit). Your marginal decision is whether it is worth the extra 50 cents to have the fries. If you pay attention, you’ll notice yourself frequently thinking at the margin. Next time you find yourself asking a salesclerk “How much more is this one?” when you are choosing between two items, you are doing a marginal analysis.
Marginal choices always involve the effects of net additions to or subtractions from current conditions. In fact, the word additional is often used as a substitute for marginal. For example, a business decision maker might ask, “What is the marginal cost of producing one more, or additional, unit?’ Marginal decisions may involve large or small changes. involves additional costs and additional benefits. Given the current situation, what marginal benefits (additional sales revenues, for example) can be expected from the new factory, and what will be the marginal cost of constructing it? What is the marginal benefit versus marginal cost of purchasing a new stapler? The answers to these questions will determine whether building the new factory or buying the new stapler is a good decision.
It is important to distinguish between average and marginal. A manufacturer’s average cost of producing automobiles (which would be the total cost of production divided by the total number of cars the manufacturer produces) may be $25,000, but the marginal cost of producing an additional automobile (or an additional 1,000 automobiles) might be much lower, say, $10,000 per car. Costs associated with research, testing, design, molds, heavy equipment, and similar factors of production must be incurred whether the manufacturer is going to produce 1,000 units, 10,000 units, or 100,000 units. Such costs will clearly contribute to the average cost of an automobile, but they will change very little as additional units are produced. Thus, the marginal cost of additional units may be substantially less than the average cost. Should production be expanded or reduced? That choice should be based on marginal costs, which indicate the change in total cost due to the decision.
Confusion between marginal and total benefits or costs can also be a source of error. Almost all of the choices we make are marginal, rather than all-or-nothing decisions. For example. we don’t make decisions between eating or wearing clothes-dining well in the nude versus starving in style. Instead, we choose between having a little more food at the cost of a little less clothing, or a little less of something else. So the relevant comparison is not betkween the total value of food and the total value of clothing but between their marginal values.
People commonly ignore the implications of marginal thinking in their comments, but seldom in their actions. Thus, the concept is far better at explaining how people act than what they say. Students are often overheard telling other students that they shouldn’t skjp class because they have paid to enroll in it. Of course, the tuition is not a factor relevant at I The “one more unit” could be a new factory or a new stapler. It is marginal because it in-the margin-it will be the same whether or not the student attends class on that particular day. The only real marginal considerations are what the student will miss that day (a quiz, information for the exam, etc.) versus what he or she could do with the extra time by skipping class. This explains why even students who tell others they paid too much for the class to skip it will ignore the tuition costs when they themselves decide to skip class. When we confront a decision, the marginal benefit and marginal cost associated with the choice will determine our decision. Marginal analysis will be used extensively throughout this course. As we develop this concept further, you should pay special attention to understanding how to use it properly.
Individuals choose purposefully-they try to get the most from their limited resources.
July 3rd, 2009People try not to deliberately waste their valuable resources. Instead, they try to choose the options that best advance their personal desires and goals at the least possible cost. This is called economizing behaviour. Economizing behavior is the result of purposeful, or rational, decision making. When choosing among things of equal benefit, an economizer will select the cheapest option. For example, if a pizza, a lobster dinner, and a sirloin steak are expected to yield identical benefits for Mary (including the enjoyment of eating them), economizing behavior implies that Mary will select the cheapest of the three alternatives, probably the pizza. Similarly, when choosing among alternatives of equal cost, economizing decision makers will select the option that yields the greatest benefit. If the prices of several dinner specials are equal, for example, economizers will choose the one they like the best. Because of economizing behavior, the desires or preferences of individuals are revealed by the choices they make. Purposeful choosing implies that decision makers have some basis for their evaluation of alternatives. Economists refer to this evaluation as tility-the benefit or satisfaction that an individual expects from the choice of a specific alternative. Utility is highly subjective, often differing widely from person to person. The steak dinner that delights one person may be repulsive to another (a vegetarian, for example).
The idea that people behave rationally to get the greatest benefit at the least possible cost is a powerful tool. It can help us understand their choices. However, we need to realize that a rational choice is not the same thing as a “right” choice. If we want to understand people’s choices, we need to understand their own subjective evaluations of their options us they see them. As we have said, different people have different preferences. If Joan prefers $50 worth of chocolate to $SO worth of vegetables, buying the chocolate would be the rational choice for her, even though some outside observer might say that Joan is making a ‘‘bad‘’ decision. Similarly, some motorcycle riders choose to ride without a helmet because they believe the enjoyment they get from riding without one is greater than the cost (the risk of injury). When people weigh the benefits they receive from an activity against its cost, they are making a rational choice-even though it might not be the choice you or I would make in the same situation.
The use of scarce resources is costly, so trade-offs must be made.
July 2nd, 2009Economists sometimes refer to this as the “there is no such thing as a free lunch” principle. Because resources are scarce, the use of resources to produce one good diverts those resources from the production of other goods. A parcel of undeveloped land could be used for a new hospital or a parking lot, or it could simply be left undeveloped. No option is free of cost-there is always a trade-off. The choice to pursue any one of these options means the others must be sacrificed. The highest valued alternative that must be sacrificed is the opportunity cost of the option chosen. For example, if you use one hour of your scarce time to study economics, you will have one hour less time to watch television, read magazines, sleep, work at a job, or study other subjects. Whichever one of these options you would have chosen had you not spent the hour studying economics is your highest valued option forgone. If you would have been sleeping, then the opportunity cost of this hour spent studying economics is a forgone hour of sleep. In economics, the opportunity cost of an action is the highest valued option given up when a choice is made.
It is important to recognize that the use of scarce resources to produce a good is always costly, regardless of who pays for the good or service produced. In many countries, various kinds of schooling are provided free of charge to students. However, provision of the schooling is not free to the community as a whole. The scarce resources used to produce the schooling-to construct the building, hire teachers, buy equipment, and so on-could have been used instead to produce more recreation, entertainment, housing, medical care, or other goods. The opportunity cost of the schooling is the highest valued option given up because the resources required for its production were instead used for schooling.
By now the central point should be obvious. As we make choices, we are continually faced with trade-offs. Using resources to do one thing leaves fewer resources to do another. Consider one final example. Mandatory air bags in automobiles save an estimated 400 lives each year. Economic thinking, however, forces us to ask ourselves if the $SO billion spent on air bags could have been used in a better way-perhaps say, for cancer research that could have saved more than 400 lives per year. Most people don’t like to think of air bags and cancer research as an “eitherlor” proposition. It’s more convenient to ignore these trade-offs. But if we want to get the most out of our resources, we have to consider all of our alternatives. In this case, the appropriate analysis is not lives saved with air bags versus dollars spent on them, but the number of lives that could have been saved (or other things that could have been accomplished) if the $SO billion had been used differently. A candid consideration of hard trade-offs like this is essential to using our resources wisely.