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Chapter 1 9
What Is Economics?

will not help a visitor find the art MAP 2
museum. Of course, this map was Major Los Angeles Arteries and Freeways
never intended to be used as a
detailed tourist guide, which
brings us to an important point:
There is no such thing as one
“right” degree of abstraction
and simplification for all ana-
lytic purposes. The proper de-
gree of abstraction depends on
the objective of the analysis. A
model that is a gross oversim-
plification for one purpose
Map © by Rand McNally, R.L.04-S-14. Reprinted by permission.

may be needlessly complicated
for another.
Economists are constantly seek-
ing analogies to Map 2 rather than
Map 3, treading the thin line be-
tween useful generalizations about
complex issues and gross distor-
tions of the pertinent facts. For ex-
ample, suppose you want to learn
why some people are fabulously
rich while others are abjectly poor.
People differ in many ways, too
many to enumerate, much less to
study. The economist must ignore
Greater Los Angeles Freeways
most of these details to focus on the
important ones. The color of a per-
son™s hair or eyes is probably not
important for the problem but, un-
fortunately, the color of his or her
skin probably is because racial dis-
crimination can depress a person™s
income. Height and weight may
not matter, but education probably
does. Proceeding in this way, we
can pare Map 1 down to the man-
ageable dimensions of Map 2. But
there is a danger of going too far,
stripping away some of the crucial
factors, so that we wind up with
SOURCE: California Department of Transportation

Map 3.

The Role of
Economic Theory
Some students find economics
“too theoretical.” To see why we
can™t avoid it, let™s consider what
we mean by a theory.
To an economist or natural sci-
entist, the word theory means A theory is a deliberate
something different from what it means in common speech. In science, a theory is not an simplification of relation-
untested assertion of alleged fact. The statement that aspirin provides protection against ships used to explain how
heart attacks is not a theory; it is a hypothesis, that is, a reasoned guess, which will prove those relationships work.

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Part 1
10 Getting Acquainted with Economics

to be true or false once the right sorts of experiments have been completed. But a theory
is different. It is a deliberate simplification (abstraction) of reality that attempts to ex-
plain how some relationships work. It is an explanation of the mechanism behind ob-
served phenomena. Thus, gravity forms the basis of theories that describe and explain
the paths of the planets. Similarly, Keynesian theory (discussed in Parts 2 and 3) seeks
to describe and explain how government policies affect unemployment and prices in the
national economy.
People who have never studied economics often draw a false distinction between the-
ory and practical policy. Politicians and businesspeople, in particular, often reject abstract
economic theory as something that is best ignored by “practical” people. The irony of
these statements is that

It is precisely the concern for policy that makes economic theory so necessary and

To analyze policy options, economists are forced to deal with possibilities that have not
actually occurred. For example, to learn how to shorten periods of high unemployment,
they must investigate whether a proposed new policy that has never been tried can help.
Or to determine which environmental programs will be most effective, they must under-
stand how and why a market economy produces pollution and what might happen if the
government taxed industrial waste discharges and automobile emissions. Such questions
require some theorizing, not just examination of the facts, because we need to consider pos-
sibilities that have never occurred.
The facts, moreover, can sometimes be highly misleading. Data often indicate that two
Two variables are said to be
variables move up and down together. But this statistical correlation does not prove that
correlated if they tend to
go up or down together. either variable causes the other. For example, when it rains, people drive their cars more
Correlation need not imply slowly and there are also more traffic accidents. But no one thinks that it is the slower
driving that causes more accidents when it™s raining. Rather, we understand that both
phenomena are caused by a common underlying factor”more rain. How do we know
this? Not just by looking at the correlation between data on accidents and driving speeds.
Data alone tell us little about cause and effect. We must use some simple theory as part of
our analysis. In this case, the theory might explain that drivers are more apt to have acci-
dents on rain-slicked roads.
Similarly, we must use theoretical analysis, and not just data alone, to understand how,
if at all, different government policies will lead to lower unemployment or how a tax on
emissions will reduce pollution.

Statistical correlation need not imply causation. Some theory is usually needed to inter-
pret data.

What Is an Economic Model?
An economic model is a representation of a theory or a part of a theory, often used to
An economic model is a
simplified, small-scale ver- gain insight into cause and effect. The notion of a “model” is familiar enough to chil-
sion of some aspect of the dren; and economists”like other researchers”use the term in much the same way that
economy. Economic models
children do.
are often expressed in
A child™s model airplane looks and operates much like the real thing, but it is much
equations, by graphs, or
smaller and simpler, so it is easier to manipulate and understand. Engineers for Boeing
in words.
also build models of planes. Although their models are far larger and much more elabo-
rate than a child™s toy, they use them for much the same purposes: to observe the
workings of these aircraft “up close” and to experiment with them to see how the models
behave under different circumstances. (“What happens if I do this?”) From these experi-
ments, they make educated guesses as to how the real-life version will perform.
Economists use models for similar purposes. The late A. W. Phillips, the famous
engineer-turned-economist who discovered the “Phillips curve” (discussed in Chapter
16), was talented enough to construct a working model of the determination of national

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Licensed to:

Chapter 1 11
What Is Economics?

income in a simple economy by using colored water flowing
through pipes. For years this contraption has graced the base-
ment of the London School of Economics. Although we will
explain the models with words and diagrams, Phillips™s engi-
neering background enabled him to depict the theory with
tubes, valves, and pumps.
Because many of the models used in this book are depicted
in diagrams, for those of you who need review, we explain the
construction and use of various types of graphs in the appen-
dix to this chapter. Don™t be put off by seemingly abstract mod-
els. Think of them as useful road maps. And remember how

SOURCE: Science Museum/Science & Society Picture Library
hard it would be to find your way around Los Angeles with-
out one.

Reasons for Disagreements: Imperfect
Information and Value Judgments
“If all the earth™s economists were laid end to end, they could
not reach an agreement,” the saying goes. Politicians and re-
porters are fond of pointing out that economists can be found on
both sides of many public policy issues. If economics is a sci-
ence, why do economists so often disagree? After all, astron-
omers do not debate whether the earth revolves around the sun A. W. Phillips built this model in the early 1950s to
or vice versa. illustrate Keynesian theory.
This question reflects a misunderstanding of the nature of sci-
ence. Disputes are normal at the frontier of any science. For example, astronomers once did
argue vociferously over whether the earth revolves around the sun. Nowadays, they argue
about gamma-ray bursts, dark matter, and other esoterica. These arguments go mostly
unnoticed by the public because few of us understand what they are talking about. But
economics is a social science, so its disputes are aired in public and all sorts of people feel
competent to join economic debates.
Furthermore, economists actually agree on much more than is commonly supposed.
Virtually all economists, regardless of their politics, agree that taxing polluters is one of
the best ways to protect the environment, that rent controls can ruin a city (Chapter 4),
and that free trade among nations is usually preferable to the erection of barriers
through tariffs and quotas (see Chapter 17). The list could go on and on. It is probably
true that the issues about which economists agree far exceed the subjects on which they
Finally, many disputes among economists are not scientific disputes at all. Sometimes
the pertinent facts are simply unknown. For example, you will learn in Chapter 17 that the
appropriate financial penalty to levy on a polluter depends on quantitative estimates of
the harm done by the pollutant. But good estimates of this damage may not be available.
Similarly, although there is wide scientific agreement that the earth is slowly warming,
there are disagreements over how costly global warming may be. Such disputes make it
difficult to agree on a concrete policy proposal.
Another important source of disagreements is that economists, like other people,
come in all political stripes: conservative, middle-of-the-road, liberal, radical. Each may
have different values, and so each may hold a different view of the “right” solution to
a public policy problem”even if they agree on the underlying analysis. Here are two
1. We suggested early in this chapter that policies that lower inflation are likely to
raise unemployment. Many economists believe they can measure the amount of
unemployment that must be endured to reduce inflation by a given amount. But
they disagree about whether it is worth having, say, three million more people out
of work for a year to cut the inflation rate by 1 percent.

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Licensed to:
Part 1
12 Getting Acquainted with Economics

2. In designing an income tax, society must decide how much of the burden to put
on upper-income taxpayers. Some people believe the rich should pay a dispropor-
tionate share of the taxes. Others disagree, believing it is fairer to levy the same
income tax rate on everyone.
Economists cannot answer questions like these any more than nuclear physicists could
have determined whether dropping the atomic bomb on Hiroshima was a good idea. The
decisions rest on moral judgments that can be made only by the citizenry through its
elected officials.
Although economic science can contribute theoretical and factual knowledge on a par-
ticular issue, the final decision on policy questions often rests either on information
that is not currently available or on social values and ethical opinions about which peo-
ple differ, or on both.

1. To help you get the most out of your first course in eco- 2. Common sense is not always a reliable guide in explaining
nomics, we have devised a list of seven important ideas economic issues or in making economic decisions.
that you will want to retain beyond the final exam. 3. Because of the great complexity of human behavior,
Briefly, they are the following: economists are forced to abstract from many details, to
a. Opportunity cost is the correct measure of cost. make generalizations that they know are not quite true,
and to organize what knowledge they have in terms of
b. Attempts to fight market forces often backfire.
some theoretical structure called a “model.”
c. Nations can gain from trade by exploiting their com-
4. Correlation need not imply causation.
parative advantages.
5. Economists use simplified models to understand the
d. Both parties can gain in a voluntary exchange.
real world and predict its behavior, much as a child uses
e. Governments have tools that can mitigate cycles of
a model railroad to learn how trains work.
boom and bust, but these tools are imperfect.
6. Although these models, if skillfully constructed, can illu-
f. In the short run, policy makers face a trade-off be-
minate important economic problems, they rarely can
tween inflation and unemployment. Policies that re-
answer the questions that confront policy makers. Value
duce one normally increase the other.
judgments involving such matters as ethics are needed
g. In the long run, productivity is almost the only thing for this purpose, and the economist is no better equipped


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