Economists use scientific analysis to develop theories, or models, that help explain economic behavior. An economic theory, or economic model, is a simplification of economic reality that is used to make predictions about the real world. A theory, or model, such as the circular-flow model, captures the important elements of the problem under study but need not spell out every detail and interrelation. In fact, adding more details may make a theory more unwieldy and, therefore, less useful. For example, a wristwatch is a model that tells time, but a watch festooned with extra features is harder to read at a glance and is therefore less useful as a time-telling model. The world is so complex that we must simplify it to make sense of things. Store mannequins simplify the human form (some even lack arms and heads). Comic strips and cartoons simplify characters leaving out fingers (in the case of Foxtrot, The Simpsons, and Family Guy) or a mouth (in the caseof Dilbert), for instance. You might think of economic theory as a s tripped-down, or streamlined, version of economic reality. A good theory helps us understand a messy and confusing world. Lacking a theory of how things work, our thinking can become cluttered with facts, one piled on another, as in a messy closet. You could think of a good theory as a closet organizer for the mind. A good theory offers a helpful guide to sorting, saving, and understanding information.
The Role of Theory
Most people don’t understand the role of theory. Perhaps you have heard, “Oh, that’s fine in theory, but in practice it’s another matter.” The implication is that the theory in question provides little aid in practical matters. People who say this fail to realize that they are merely substituting their own theory for a theory they either do not believe or do not understand. They are really saying, “I have my own theory that works better.” All of us employ theories, however poorly defined or understood. Someone who pounds on the Pepsi machine that just ate a quarter has a crude theory about how that machine works. One version of that theory might be, “The quarter drops through a series of whatchamacallits, but sometimes it gets stuck. If I pound on the machine, then I can free up the quarter and send it on its way.” Evidently, this theory is widespread enough that people continue to pound on machines that fail to perform (a real problem for the vending machine industry and one reason newer machines are fronted with glass). Yet, if you were to ask these mad pounders to explain their “theory” about how \ the machine works, they would look at you as if you were crazy.
The Scientific Method
To study economic problems, economists employ a process of theoretical investigation called the scientific method, which consists of four steps, as outlined in Exhibit 3.
The Role of Theory
Most people don’t understand the role of theory. Perhaps you have heard, “Oh, that’s fine in theory, but in practice it’s another matter.” The implication is that the theory in question provides little aid in practical matters. People who say this fail to realize that they are merely substituting their own theory for a theory they either do not believe or do not understand. They are really saying, “I have my own theory that works better.” All of us employ theories, however poorly defined or understood. Someone who pounds on the Pepsi machine that just ate a quarter has a crude theory about how that machine works. One version of that theory might be, “The quarter drops through a series of whatchamacallits, but sometimes it gets stuck. If I pound on the machine, then I can free up the quarter and send it on its way.” Evidently, this theory is widespread enough that people continue to pound on machines that fail to perform (a real problem for the vending machine industry and one reason newer machines are fronted with glass). Yet, if you were to ask these mad pounders to explain their “theory” about how \ the machine works, they would look at you as if you were crazy.
The Scientific Method
To study economic problems, economists employ a process of theoretical investigation called the scientific method, which consists of four steps, as outlined in Exhibit 3.
Step One: Identify the Question and Define Relevant Variables The scientific method begins with curiosity: Someone wants to answer a question. Thus, the first step is to identify the economic question and define the variables relevant to a solution. For example, the question might be, “What is the relationship between the price of Pepsi and the quantity of Pepsi purchased?” In this case, the relevant variables are price and quantity. A variable is a measure that can take on different values at different times. The variables of concern become the elements of the theory, so they must be selected with care.
Step Two: Specify Assumptions
The second step is to specify the assumptions under which the theory is to apply. One major category of assumptions is the other-things-constant assumption in Latin, the ceteris paribus assumption. The idea is to identify the variables of interest and then focus exclusively on the relationships among them, assuming that nothing else important changes that other things remain constant. Again, suppose we are interested in how the price of Pepsi influences the amount purchased. To isolate the relation between
these two variables, we assume that there are no changes in other relevant variables such as consumer income, the average temperature, or the price of Coke. We also make assumptions about how people behave; these are called behavioral assumptions. The primary behavioral assumption is rational self-interest. Earlier we assumed that each decision maker pursues self-interest rationally and makes choices accordingly. Rationality implies that each consumer buys the products expected to maximize his or her level of satisfaction. Rationality also implies that each firm supplies the products expected to maximize the firm’s profit. These kinds of assumptions are called behavioral assumptions because they specify how we expect economic decision makers to behavewhat makes them tick, so to speak.
Step Three: Formulate a Hypothesis
The third step in the scientific method is to formulate a hypothesis, which is a theory about how key variables relate to each other. For example, one hypothesis holds that if the price of Pepsi goes up, other things constant, then the quantity purchased declines The hypothesis becomes a prediction of what happens to the quantity purchased if the price increases. The purpose of this hypothesis, like that of any theory, is to help make predictions about cause and effect in the real world.
Step Four: Test the Hypothesis
In the fourth step, by comparing its predictions with evidence, we test the validity of a hypothesis. To test a hypothesis, we must focus on the variables in question, while carefully controlling for other effects assumed not to change. The test leads us either to (1) reject the hypothesis, or theory, if it predicts worse than the best alternative theory or (2) use the hypothesis, or theory, until a better one comes along. If we reject the hypothesis, we can go back and modify our approach in light of the results. Please spend a moment now reviewing the steps of the scientific method in Exhibit 3.
Normative Versus Positive
Economists usually try to explain how the economy works. Sometimes they concern themselves not with how the economy does work but how it should work. Compare these two statements: “The U.S. unemployment rate is 8.0 percent,” and “The U.S. unemployment rate should be lower.” The first, called a positive economic statement, is an assertion about economic reality that can be supported or rejected by reference to the facts. Positive economics, like physics or biology, attempts to understand the world around us. The second, called a normative economic statement, reflects an opinion. And an opinion is merely that it cannot be shown to be true or false by reference to the facts. Positive statements concern what is; normative statements concern what, in someone’s opinion, should be. Positive statements need not necessarily be true, but theymust be subject to verification or refutation by reference to the facts. Theories are expressed as positive statements such as “If the price of Pepsi increases, then the quantity demanded decreases.”
Most of the disagreement among economists involves normative debates such as the appropriate role of government rather than statements of positive analysis. To be sure, many theoretical issues remain unresolved, but economists generally agree on most fundamental theoretical principles that is, about positive economic analysis. For example, in a survey of 464 U.S. economists, only 6.5 percent disagreed with the statement “A ceiling on rents reduces the quantity and quality of housing available.” This is a positive statement because it can be shown to be consistent or inconsistent with the evidence. In contrast, there was much less agreement on normative statements such as “The distribution of income in the United States should be more equal.” Half the economists surveyed “generally agreed,” a quarter “generally disagreed,” and a quarter “agreed with provisos.”3 Normative statements, or value judgments, have a place in a policy debate such as the proper role of government, provided that statements of opinion are distinguished from statements of fact. In such policy debates, you are entitled to your own opinion, but you are not entitled to your own facts.
Economists Tell Stories
Despite economists’ reliance on the scientific method for developing and evaluating theories, economic analysis is as much art as science. Formulating a question, isolating the key variables, specifying the assumptions, proposing a theory to answer the question, and devising a way to test the predictions all involve more than simply an understanding of economics and the scientific method. Carrying out these steps requires good intuition and the imagination of a storyteller. Economists explain their theories by telling stories about how they think the economy works. To tell a compelling story, an economist relies on case studies, anecdotes, parables, the personal experience of the listener, and supporting data. Throughout this book, you’ll hear stories that bring you closer to the ideas under consideration. The stories, such as the one about the Pepsi machine, breathe life into economic theory and help you personalize abstract ideas. Go online to www.cengagebrain.com to read a case study about the popularity of vending machines in Japan
Predicting Average Behavior
The goal of an economic theory is to predict the impact of an economic event on economic choices and, in turn, the effect of these choices on particular markets or on the economy as a whole. Does this mean that economists try to predict the behavior of particular consumers or producers? Not necessarily, because a specific individual may behave in an unpredictable way. But the unpredictable actions of numerous individuals tend to cancel one another out, so the average behavior of groups can be predicted more accurately. For example, if the federal government cuts personal income taxes, certain households may decide to save the entire tax cut. On average, however, household spending increases. Likewise, if Burger King cuts the price of Whoppers, the manager can better predict how much sales will increase than how a specific customer coming through the door will respond. The random actions of individuals tend to offset one another, so the average behavior of a large group can be predicted more accurately than the behavior of a particular individual. Consequently, economists tend to focus on the average, or typical, behavior of people in groups for example, as average taxpayers or average Whopper consumers rather than on the behavior of a specific individual.
Step Three: Formulate a Hypothesis
The third step in the scientific method is to formulate a hypothesis, which is a theory about how key variables relate to each other. For example, one hypothesis holds that if the price of Pepsi goes up, other things constant, then the quantity purchased declines The hypothesis becomes a prediction of what happens to the quantity purchased if the price increases. The purpose of this hypothesis, like that of any theory, is to help make predictions about cause and effect in the real world.
Step Four: Test the Hypothesis
In the fourth step, by comparing its predictions with evidence, we test the validity of a hypothesis. To test a hypothesis, we must focus on the variables in question, while carefully controlling for other effects assumed not to change. The test leads us either to (1) reject the hypothesis, or theory, if it predicts worse than the best alternative theory or (2) use the hypothesis, or theory, until a better one comes along. If we reject the hypothesis, we can go back and modify our approach in light of the results. Please spend a moment now reviewing the steps of the scientific method in Exhibit 3.
Normative Versus Positive
Economists usually try to explain how the economy works. Sometimes they concern themselves not with how the economy does work but how it should work. Compare these two statements: “The U.S. unemployment rate is 8.0 percent,” and “The U.S. unemployment rate should be lower.” The first, called a positive economic statement, is an assertion about economic reality that can be supported or rejected by reference to the facts. Positive economics, like physics or biology, attempts to understand the world around us. The second, called a normative economic statement, reflects an opinion. And an opinion is merely that it cannot be shown to be true or false by reference to the facts. Positive statements concern what is; normative statements concern what, in someone’s opinion, should be. Positive statements need not necessarily be true, but theymust be subject to verification or refutation by reference to the facts. Theories are expressed as positive statements such as “If the price of Pepsi increases, then the quantity demanded decreases.”
Most of the disagreement among economists involves normative debates such as the appropriate role of government rather than statements of positive analysis. To be sure, many theoretical issues remain unresolved, but economists generally agree on most fundamental theoretical principles that is, about positive economic analysis. For example, in a survey of 464 U.S. economists, only 6.5 percent disagreed with the statement “A ceiling on rents reduces the quantity and quality of housing available.” This is a positive statement because it can be shown to be consistent or inconsistent with the evidence. In contrast, there was much less agreement on normative statements such as “The distribution of income in the United States should be more equal.” Half the economists surveyed “generally agreed,” a quarter “generally disagreed,” and a quarter “agreed with provisos.”3 Normative statements, or value judgments, have a place in a policy debate such as the proper role of government, provided that statements of opinion are distinguished from statements of fact. In such policy debates, you are entitled to your own opinion, but you are not entitled to your own facts.
Economists Tell Stories
Despite economists’ reliance on the scientific method for developing and evaluating theories, economic analysis is as much art as science. Formulating a question, isolating the key variables, specifying the assumptions, proposing a theory to answer the question, and devising a way to test the predictions all involve more than simply an understanding of economics and the scientific method. Carrying out these steps requires good intuition and the imagination of a storyteller. Economists explain their theories by telling stories about how they think the economy works. To tell a compelling story, an economist relies on case studies, anecdotes, parables, the personal experience of the listener, and supporting data. Throughout this book, you’ll hear stories that bring you closer to the ideas under consideration. The stories, such as the one about the Pepsi machine, breathe life into economic theory and help you personalize abstract ideas. Go online to www.cengagebrain.com to read a case study about the popularity of vending machines in Japan
Predicting Average Behavior
The goal of an economic theory is to predict the impact of an economic event on economic choices and, in turn, the effect of these choices on particular markets or on the economy as a whole. Does this mean that economists try to predict the behavior of particular consumers or producers? Not necessarily, because a specific individual may behave in an unpredictable way. But the unpredictable actions of numerous individuals tend to cancel one another out, so the average behavior of groups can be predicted more accurately. For example, if the federal government cuts personal income taxes, certain households may decide to save the entire tax cut. On average, however, household spending increases. Likewise, if Burger King cuts the price of Whoppers, the manager can better predict how much sales will increase than how a specific customer coming through the door will respond. The random actions of individuals tend to offset one another, so the average behavior of a large group can be predicted more accurately than the behavior of a particular individual. Consequently, economists tend to focus on the average, or typical, behavior of people in groups for example, as average taxpayers or average Whopper consumers rather than on the behavior of a specific individual.
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