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Thinking Like an Economist

A workshop on economic principles.

September 1, 2003


Douglas Clement Editor, The Region
Thinking Like an Economist

To explain the inner workings of an economist's brain would seem an impossible and thankless task, especially if journalists—skeptics by training—are the audience. The stereotypical economist, after all, is more enamored of theory than reality, unable to reach conclusions and boring beyond all words.

It was fortunate, then, that Russell Cooper drew the assignment—and shattered the illusion. The University of Texas economist mixed wit, energy, clarity and down-to-earth examples as he held forth on the principles of economics at this year's Supply, Demand & Deadlines conference. "I'm trying to get you to the heart of the way that economists think—and we actually do think," he joked. "And hopefully this will be helpful to you when you write about what's going on in the economy, and when you interview an economist."

Cutting to the chase, Cooper spelled out six key points, central principles of economics:

  • Individuals (including households and firms) act optimally
  • Competition works
  • Measurement matters
  • No free lunches
  • Government intervention with caution
  • Correlation is not causality

"If my undergraduates can get these six key points down," he said, "they will have passed the course." But with just three hours to cover 16 weeks worth of undergraduate material, a few points might not get the full discussion they deserve. "There's no way I'm going to cover all the material I have here," he predicted (accurately), leafing through his outline.

As introduction, Cooper explained that understanding the principles of economics first requires a grasp of its methods. Economic methodology entails working with both facts and theory. Facts provide motivation for—and the means to evaluate—theory. But theory is necessary if one is to know which facts are worth gathering. Interaction between the two is therefore essential to good economics—a constant circular process of formulating theory, gathering data, testing theory against data and revising theory. "It's right, as some observers say, that economists go around and around in circles," he said. "We think we see progress there, but for outsiders it may not be so obvious."

That said, Cooper turned to the first principle of economic thinking:

Individuals act optimally

"From an economist's perspective, individual firms and households are incredible in terms of optimizing, in terms of gaining their objectives, doing the best they can subject to their constraints."

Economists, said Cooper, think about individuals—both households and firms—as "agents" who act in their own self-interest, and do so as well as they possibly can in the face of time, information, budget and legal constraints. "When I go out and consume my beer and chocolate," he said, "I'm not thinking 'how many jobs am I creating by consuming beer vs. chocolate?' I'm thinking about my own welfare—self-interested in that way." The same applies to all products and services, and to all individuals. And self-interest, itself, can be defined broadly, to include one's dog, cat, family or broader community. "All of those things may influence my own welfare, or utility, but once I know what makes me feel good, economists believe, I will act in my own self-interest."

And individuals do so at the margin. Conscious of the constraints we face, we are constantly balancing the costs and benefits of different allocations of our time and money—hour by hour, dollar by dollar. An individual decides whether to spend a dollar on beer or chocolate (or anything else) based on what choice they believe will bring them the greatest marginal benefit.

"So what's the outcome of all this?" asked Cooper. "In this ideal world, ... households are optimally allocating their dollars and time so that ... I should be unable, given their resources, to make them better off by reallocating their budget across goods."

Cooper discussed the implications of this principle in three situations involving government intervention: decisions of individuals to smoke vs. the motivation of governments to curb smoking; individual vs. government incentives regarding education; and the incentive effects of marginal tax rates. "This is all part of this perspective that households are maximizing, and so at the margin they can't reallocate across activities to make themselves better off," he reiterated. "If a government policy comes in that changes something at the margin ... then you will see households respond."

Do individuals always act optimally? If not, what implications does that have for this theory? Cooper had three responses. First, it can be hard to know all the constraints and objectives that people face in making their decisions, so judging them suboptimal (as an outsider might) is risky. Second, when it comes to individual firms, those that don't profit- maximize will disappear. "There's a survival of the fittest, Darwinian outcome with firms, if not households," noted Cooper. And third, while the optimizing individual theory doesn't fit all the data, alternative theories—bounded rationality, behavioral economics—aren't quite satisfactory, either. "We don't have the alternative theory in a well-formulated way," he said, "so we always end up back at this view of the self-interested households." Whatever the optimizing model's flaws, nothing yet developed by economists has better predictive power. (In the end, models too must face their own Darwinian battle.)

The other keys

In similar fashion, Cooper ran through the other five principles.

When economists say competition works they mean that, given some basic assumptions—all firms offer their products for sale at prices given by the market; there are markets for all products, including such things as pollution rights; and there are no impediments to smooth market function, such as government regulations like minimum wages or price controls—market economies provide the societally optimal allocation of goods and services. "One of the most remarkable results in economics," said Cooper, "is what we sometimes call the 'invisible hand' theorem." In a market economy, the optimizing behavior of all individuals results in an optimum for the economy as a whole. "Is there any way to take all the goods and services that are produced and redistribute them in some way to make everybody better off? In a competitive market outcome, the answer is no." The outcome is optimal, say economists, and it doesn't get any better than that. "Individual behavior, plus the way in which we interact in markets, gives rise to socially desirable outcomes in the form that I just defined," Cooper said in summary. Still, he qualified, "there are some ifs, ands and buts. This market mechanism may fail for a couple of reasons. ..."

Measurement matters—the third key principle—might be "a boring topic," Cooper allowed, "but it's one that I think is very, very important." He focused on three variables and four common misconceptions. Gross domestic product "is defined to be the market value of all of the final goods and services produced within a country in a given period of time," said Cooper. The unemployment rate is the percentage of people in the labor force who aren't employed. And the consumer price index measures change over time in the cost of living. Each of these variables is subject to conceptual and measurement problems, but each is a key macroeconomic indicator for the purposes of monetary and fiscal policy as well as economic analysis.

Four misconceptions are common when it comes to measurement of economic variables, according to Cooper.

  • There is often confusion between the real and nominal values of different variables—inflation frequently isn't taken into account, and it should be.
  • The same applies to interest rates—the distinction between real and nominal interest rates is crucial when trying to understand individual economic behavior. People don't care about money per se, say economists; they care about the goods and services it can purchase, now and in the future. So when people contemplate a loan, for instance, they need to think about the real interest rate: the nominal interest rate charged on the loan minus expected inflation.
  • Deficits are the difference between government receipts and expenditures in any given year; national debt is the historical aggregation of annual deficits, the total amount owed by a government. Confusion between the two is widespread.
  • And discounted present value. A dollar today is not the same as a dollar tomorrow. When interest rates are positive, today's dollar is worth more than tomorrow's (and vice versa). But many people add dollar amounts across long spans of time—in budget projections, mortgage calculations, lottery estimates—without regard to the fact that they're adding apples and oranges. The true value of today's and tomorrow's dollars is determined by the interest rate, and calculating the discounted present value of sums is essential to sound economic decision-making.

The fourth key point: there's no free lunch. "We can't create stuff out of thin air; everything has a cost, an opportunity cost," explained Cooper. "It may not be explicit. The politicians who are promising something over here may not want to tell you about how it's going to be financed, but in the end it's got to come from somewhere. OK? No free lunch."

Fifth, government intervention with caution. Competition works, but it takes the occasional day off. If monopolies exist, if markets don't exist for certain products or services, or if some production costs aren't fully covered by producers, perfect competition isn't present and markets fail. "The natural thing to do," said Cooper, "is to turn to government and say 'you solve this problem.' But our training as economists says to us to be hesitant. First of all, it's not so obvious that governments can so easily solve problems." Government intervention may make the problem worse or have unintended consequences. "And second of all ... the government can be used as a tool by those who have [vested] interests in particular outcomes."

Sixth, correlation is not causality. If economists often disagree, it may be because their models differ—their explanations of the economic world diverge. And verifying or refuting explanations is difficult for economists because, unlike physicists or biologists, they generally can't run experiments in a laboratory. Moreover, like the rest of us, economists have difficulty distinguishing between the correlation of two variables and a causal relationship between them. Does the rooster's crow cause the sun to rise? Does deflation lead to depression? Does education bring about economic growth? Mere correlation doesn't prove a cause-and-effect relationship. "What's hard about economics is that correlations are easy to find, but we want more, we want to know about causality," said Cooper.

Invitation to a longer journey

In six principles and three hours, Cooper had laid out the basics of economics. It was a quick tour of the economic brain, but the quality of journalists' questions throughout indicated that Cooper had stimulated curiosity rather than skepticism. And if a full understanding of the economic way of thinking requires a longer journey, Cooper's brief tour had provided an enticing vista of what lies ahead.

See Economic Research and Data for links to GDP, CPI and employment data.

Douglas Clement
Editor, The Region

Douglas Clement was a managing editor at the Minneapolis Fed, where he wrote about research conducted by economists and other scholars associated with the Minneapolis Fed and interviewed prominent economists.