Foundations Of Economics Analysis Lecture Part 1

FOUNDATIONS OF ECONOMIC ANALYSIS This chapter presents a number of important concepts that are useful in understanding how the economy works, and in thinking about how we might make it work better as citizens and through government action. We start by describing different ways to investigate economic phenomena. This is followed by an examination of two models that offer different approaches to defining and understanding the economy. The final section provides an introduction to the nature of markets. The concepts discussed in this chapter provide much of the foundational knowledge for later chapters. 1. OUR TOOLS FOR UNDERSTANDING Explanations of economic phenomena draw on two different approaches to seeking knowledge: empiricism and rationalism. 1.1 EMPIRICISM An empiricist argues that knowledge primarily comes to us from the five senses (seeing, hearing, touching, tasting, and smelling). In economics, empirical investigation is mainly about making observations that are then represented in words or images, as well as collecting numerical data. The time-series and cross-sectional data for various economic indicators, presented in Chapter 0 are good examples of empirical investigation. empirical investigation: analysis based on observation and recording of specific events, represented in words, images, or numerical data Historical investigation, which involves using knowledge of historical events to help explain economic phenomena, is also usually empirical. The Great Depression of the 1930s, major wars, changing roles of women in the workforce, the invention of computers, and the financial crash of 2007-8—all are examples of historical events that have had a significant economic impact. historical investigation: study of past events Induction is a central tool of empiricism. For example, if we observe that swan number 1 is white, swan number 2 is white, and all the rest up to swan number 10,000 are also white, we see a pattern that may prompt us to claim that all swans are white. Of course, if we observe the existence of a black swan, this would disprove our initial claim. Similarly, if we regularly observe that when the price of a good rises, sales of that good will fall, then we might say that this constitutes a general relationship between price and demand. However, if we find cases where price and demand rise together (as sometimes occurs), then this disproves the idea that the relationship between price and demand is fixed. As you can see, empiricism is about real-world evidence. Empirical investigation is often useful in studying relationships between economic variables. If two economic variables seem empirically related to each other (or “correlated,” to use the statistical term) such that they fluctuate together, it might be tempting to think that changes in one variable are causing changes in the other. Sometimes this is true. But two variables may also 1 be related empirically without there being a well-defined causal relationship between them. For example, countries with higher GDP tend to have higher reported levels of cancer. But before we conclude that higher GDP causes cancer, we should consider other possibilities. For example, higher GDP is broadly associated with longer life expectancy, and people living longer are more likely to develop cancer at some point in their lives. Or there may be other factors (including diet, exercise, and a host of other variables) that connect these two observations—cancer and GDP. Economists take seriously the warning that “correlation does not necessarily imply causation.” In other words, the existence of an observable relationship between two economic variables does not imply that changes in one variable cause the changes in the other. BOX 2.1 GRAPHING REVIEW Graphs provide a useful way to explore the relationship between two variables and test specific economic hypotheses. Based on Table 2.1, we might form the hypothesis that unemployment rates tend to be higher when GDP growth rates are lower. We call this a negative, or inverse, relationship—when an increase in one variable is associated with a decrease in another variable (or, vice versa, when a decrease in one variable is associated with an increase in another variable). negative (or inverse) relationship: the relationship between two variables if an increase in one variable is associated with a decrease in the other variable (or vice versa) Table 2.1 Unemployment Rate and Real GDP Growth Rate, United States, 2008–2018 (in Percent) Year 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Unemployment rate 5.8 9.3 9.6 8.9 8.1 7.4 6.2 5.3 4.9 4.4 3.9 Real GDP growth rate -0.3 -2.8 2.5 1.6 2.2 1.7 2.4 2.6 1.6 2.2 2.9 Sources: U.S. Bureau of Economic Analysis and U.S. Bureau of Labor Statistics. Figure 2.1 plots the relationship between unemployment rates and GDP growth rates. Each “data point” on the graph tells us the values of both variables for a specific year. In the graph we have kept the real GDP growth rate on the x-axis and the unemployment rate on the y-axis. So the data point for 2016, for example, indicates that te GDP growth rate was 1.6 percent (by reading across the the x-axis) and the unemployment rate was 4.9 percent (by reading down the y-axis). A visual inspection of Figure 2.1 shows relatively high unemployment rates when GDP growth rates were low or negative. In general, the graph seems to support our hypothesis of an inverse relationship between unemployment and GDP growth, but there are some exceptions. Figure 2.1 Relationship Between Unemployment and GDP Growth Rate, United States, 2008–2018 Sources: U.S. Bureau of Economic Analysis and U.S. Bureau of Labor Statistics. Figure 2.1 can tell us whether our two variables are “correlated,” but we cannot determine whether there is a causal relationship between them. While low GDP growth could cause high unemployment, the causality could potentially be in the opposite direction—that high unemployment causes low GDP growth. Even if the variables seem related in a graph, the relationship could be random, or “spurious.” For example, you may have read stories about how the outcome of sporting events are correlated with the performance of the stock market. But it is highly unlikely that such relationships are causal. The opposite of an inverse relationship is a positive, or direct, relationship. In this case, an increase in one variable is associated with an increase in another variable—or a decrease in one variable is associated with a decrease in another. positive (or direct) relationship: the relationship between two variables when an increase in one variable is associated with an increase in the other variable or a decrease in one variable is associated with a decrease in the other variable A good example of a positive relationship is between the growth rate of GDP and the growth rate of greenhouse gas emissions, such as carbon dioxide and methane. When the economy is growing, greenhouse gas emissions increase as manufacturing industries tend to produce more goods, people tend to fly and drive more, and construction activity tends to increase. The relationship between GDP growth and the growth of greenhouse gas emission is shown in Figure 2.2. In this case, we see a reasonably clear positive relationship—when the economy is growing rapidly greenhouse gas emissions tend to increase. However, as discussed above, we cannot demonstrate causality just by looking at a graph. 3 Figure 2.2 Relationship Between GDP Growth Rate and Greenhouse Gas Emissions Growth Rate, United States, 1991–2015 Source: Greenhouse Gas data from United States Environmental Protection Agency While empirical evidence creates the foundation of economic analysis, a purely empirical investigation is unlikely to explain causation. Furthermore, we often need guidance on how to sift through the often overwhelming amount of empirical evidence available to us. Thus more tools are clearly needed for economists to try to explain, rather than simply describe, economic phenomena. 1.2 RATIONALISM In contrast to an empiricist, a rationalist argues that our senses are not a reliable source of knowledge and instead directs us to look to reason and logic in order to find knowledge. In fact, a dedicated rationalist would argue that observation (and the use of other senses) is simply not necessary. Consider an example. If we accept (as a premise) that all people are mortal, and Joe Bloggs is a person, then logical deduction dictates that Joe Bloggs must be mortal. There is no requirement to wait around for many years in order to empirically observe Joe Bloggs’s death, as logic and reason tell us that if our premise is correct, and our reasoning is logical, then our conclusion must be correct. rationalist investigation: analysis based on abstract thought and the use of logic and reason Much economic analysis uses rationalism. This tool can be particularly useful for determining causation between variables. Economists tend to use a rationalist approach to create theories based on assumptions about economic agents, from which, with careful reasoning, they draw out potential implications for economic behavior. For example, if we start from the premise that individuals are completely rational and fully informed, then we can use logic and reason to predict that they will make a particular choice. This choice is necessarily optimal because the individual has all the relevant information and can weigh this information up in a completely accurate (rational) manner. A rationalist approach to pursuing knowledge can be very useful, but rationalism has its limitations. In particular, if your initial premise is not accurate, then your conclusion is unlikely to be correct. For example, if an individual is not fully informed or fully rational (as is often the case), then that individual’s choice is unlikely to be optimal, even if our use of reasoning and logic seems correct. 1.3 THEORY AND EVIDENCE Most analysis is (or at least should be) a mix of empiricism and rationalism. On one hand, we need reason and logic to make sense of, and to organize, a vast jumble of empirical observations. On the other hand, purely rationalist theorizing without any recourse to empirical evidence is likely to produce misleading and irrelevant lines of analysis. A good economic theory is thus informed by empirical evidence as well as rationalist investigation. Let us now say a little about the nature of economic theory. It should be stressed at the outset that a theory can never be as complex and rich as the reality it seeks to explain, so theory is about simplification. How to simplify is a difficult and somewhat uncertain task. This is one reason there are sometimes competing theories and disagreements within economics. It is important to understand the strengths and weaknesses of particular theories and to be open to considering alternative theories. Theories often give rise to models. A model is an analytical tool that highlights some aspects of reality while ignoring others (in economics, what is ignored is often a portion of the larger historical, social, and environmental context). A model can take the form of a simplified story, an image, a figure, a graph, or a set of equations, and it always involves simplifying assumptions. We look at examples of two basic economic models in Section 2. Other models appear throughout this text. model: an analytical tool that highlights some aspects of reality while ignoring others An important part of many models is the assumption of ceteris paribus, a Latin phrase that means “other things equal” or “all else constant.” In order to focus on one or two variables, we assume that no other variables change. Of course, in the real world, many things are usually changing at the same time. Often, after a basic model is constructed, we can vary the ceteris paribus assumption, to see how changes in other variables will affect the model’s conclusions. ceteris paribus: a Latin phrase meaning “other things equal” or “all else constant” Theories and models essentially simplify reality. Is this justifiable? It is if it gives us greater insight into how things actually work. A model plane, for example, cannot carry passengers or freight, but it can give aerodynamic engineers insights into how a real plane works and help them to design better features for real aircraft. In the same way, simplified models can help economists to understand the working of very complex real-world economies. The question is not whether simplification should occur but whether a particular model’s simplifications are reasonable. 5 Discussion Questions 1. Consider the following examples of investigation. For each one, indicate which mode of investigation it most closely matches, empirical or rational. a) A biologist tries to determine the number of different species of plants found on a plot of rainforest b) Albert Einstein develops his theory of relativity c) An economist measures how GDP varies across countries d) A sociologist examines the impact of movements for equal pay for women on women’s social and economic status e) An economist states that a rise in investment will lead to a fall in unemployment 2. Model building is sometimes compared to map making. If someone asks you how to get to your house, what will you put on the map you draw for them? What if the question asked has to do with the location of the highest point in town, the town’s political boundaries, the public transit system, or how your dwelling links up to the local sewer system? Is it possible for a single, readable map to answer every possible question? Does the goal you have in mind for the map affect what you put on it? 2. DIFFERENT ECONOMIC THEORIES: EXAMPLES OF TWO BASIC MODELS The discipline of economics, like most other areas of academic and public discussion, has a history of varying approaches, beliefs, and conclusions. We will discuss these different approaches in later chapters, but here we present two theoretical models for understanding the economy: the neoclassical model, which has dominated much of standard economics throughout the twentieth century, and the contextual model, which incorporates post- twentieth century advances in economic research. The contextual model is central to this text. These two approaches have some overlap, but they have different scope and emphasis, and can lead to different understandings of economic theory and policy. 2.1 THE BASIC NEOCLASSICAL MODEL The basic neoclassical model is a model of market exchange that—while abstracting away from many real-world factors—portrays some important aspects of markets in a simple way. Neoclassical economics is based on the idea that economies can be thought of as a collection of profit-maximizing firms and utility-maximizing households interacting in perfectly competitive markets. This idea is expressed in terms of formalized assumptions, equations, and graphs. basic neoclassical model: a model that portrays the economy as a collection of profit-maximizing firms and utility-maximizing households interacting in perfectly competitive markets This model can be portrayed in the circular-flow diagram, as shown in Figure 2.3. In this model, the world is simplified to two kinds of economic actors: households and firms—represented by two rectangles. The activity of exchange between the two actors is illustrated using the blue arrows. Households are assumed to consume goods and services with the single (though rather abstract) goal of maximizing their utility (or satisfaction). Firms are assumed to produce with the single goal of maximizing profits. Households are considered the ultimate owners of all resources of land, labor, and capital, called “factors of production” by economists. Households rent the services of these productive factors to firms through factor markets (dark blue arrow from households to firms), receiving monetary payments in the form of wages, rents, interests, and profits (light blue arrow from the firms to households). Firms produce goods and services, which they sell to households on product markets (dark blue arrow from firms to households) in return for monetary payments (light blue arrow from households to firms). The model further assumes that there are so many firms and households involved in the market for any good or service that a situation of “perfect competition” reigns, in which prices are determined purely by forces of supply and demand. circular flow diagram: a graphical representation of the traditional view of an economy consisting of households and firms engaging in exchange utility: the level of usefulness or satisfaction gained from a particular activity such as consumption of a good or service factor markets: markets for the services of land, labor, and capital product markets: markets for newly produced goods and services Figure 2.3 The Circular Flow Diagram for the Basic Neoclassical Model The circular flow diagram is useful in portraying, in a very simplified way, two of the major actors (households and firms) and three of the major activities (production, exchange, and consumption) involved in economic life. However, it is important to recognize that the model leaves out some key actors and activities. 7 For example, while “land” is included as a factor of production, the fact that natural resources can be used up or polluted is not shown. Because of this, the circular flow diagram is a little like a “perpetual motion machine”; the economy it portrays can apparently keep on generating products forever without any inputs of materials or energy. The necessity of resource management activities is not included. Also, the diagram only takes into account flows of goods or resources that are paid for through the market. This ignores unpaid work and free use of natural resources, among other things. The roles of socio-cultural norms and historical factors in influencing economic behavior are also neglected in this model. You will also notice that there is no role for government in this diagram. While this oversimplification has some value, in allowing us to focus only on the workings of specific markets, it limits our ability to present a broader picture that considers the context in which economic activities occur. 1.2 THE CONTEXTUAL MODEL As discussed previously, the traditional circular flow model ignores the environmental and social contexts within which economic activities take place. We therefore need a more inclusive, and more realistic, model than the one presented in Figure 2.3. We present such a model in Figure 2.4. Figure 2.4 Social and Environmental Contexts of Economic Activity Because all economic production requires the input of natural resources and generates some wastes, the economy operates in an environmental context. For example, if we overburden a river with toxic chemicals, the water may not be usable in the future for drinking water supplies. Sometimes economic activity can also generate some positive externalities (unintended spillovers), such as restorative care for farms and rangelands that make them more productive over time. The economy also operates in a social context created and maintained by human beings; this includes history, politics, culture, ethics, and other human motivations. The social context determines what constitutes acceptable economic activity. For example, we do not allow legal markets for human organs or certain drugs. It also determines the relative weight that a society attaches to the different goals discussed in Chapter 1, such as how to identify and assess a potential tradeoff between ecological sustainability and increasing material living standards. As we will see in the discussion of markets in Section 3, much economic activity would become impossible without aspects of the social context such as laws, norms, trust, and honesty. Like the environment, society is also the recipient of both positive and negative outputs from the economy, such as inventions, products, services, and perceptions about what is a “good life”. Some of these may be truly well-being enhancing, while others may run counter to actual well-being. In Figure 2.4, we show the social context as existing inside the environmental context because all human activities—not only those of the economic system—are ultimately dependent on the environmental context. A useful understanding of economics must consider the most critical interactions between the economy and its contexts, showing how the economy is in various ways enabled and constrained by these contexts, and how the environmental and social influences are affected by the economy. The contextual approach presents economic activity as occurring within three spheres: core, public purpose, and business. The core sphere includes households, families, and community institutions. The public purpose sphere includes government and other local, national, and international organizations that seek to enhance human well-being. And the business sphere includes firms producing goods and services for profitable sale. Individuals may move among these three spheres; for example, a woman may be a wife and mother in the core sphere, a volunteer for an environmental group in the public purpose sphere, and a business executive in the business sphere. Thus Figure 2.4 shows the three spheres overlapping. We discuss economic activity in the three spheres in more detail below. Core Sphere The core sphere includes households, families, and community institutions that undertake economic activities, usually on a small scale, and largely without the use of money. Traditionally, economists have focused on the core sphere as consumers and workers, in their interactions with businesses. But important economic activity occurs within the core sphere. For example, the core sphere is the primary site for raising children; preparing meals; maintaining homes; organizing leisure time; and caring for individuals who are sick, elderly, or needy but not in institutions such as hospitals or nursing homes. core sphere: households, families, and informal community groups Conversion of many goods and services (often bought in markets) into forms suitable for final use, such as cooking pasta or planting grass seeds, occurs within the core sphere. Decisions on how to allocate income among consumption, savings or financial investments, are made within the core sphere. So are decisions on allocating time between labor and leisure. As we will see in later chapters, such decisions play an important role in determining economic outcomes. One distinguishing characteristic of the core sphere is that economic activities are rewarded by what it produces instead of earning money. For example, work in a home garden is rewarded with tomatoes, and the reward from good child care is a happy and healthy child. Activities in the 9 core sphere respond not only to wants but also to needs—unlike market activities, which respond to what people are able and willing to pay for, regardless of need. The core sphere is critical for subsistence economies, where extended families and villages may produce for themselves most of what they consume, with little outside trading. Core sphere activities are sometimes described as noneconomic or nonproductive because they generally do not produce goods and services for trade through a market. But this can be misleading. Consider the activity of providing care to family members. According to a 2015 analysis, the estimated economic value of this unpaid labor in 2013 was $470 billion.1 A different study found that the value of unpaid care work by women in the United States was even higher, at $1.5 trillion per year.2 When the core sphere is working effectively to support human well-being, important goods and services are provided to many people, even if the scale of production in each case is quite small. Of course, core spheres can also work inadequately. The requirements of caring for children or elderly and ill people may overwhelm the resources of impoverished families and communities. One extreme example is the situation of families and communities in sub-Saharan Africa trying to care for the large number of children orphaned by HIV/AIDS or by war, without adequate resources to feed and clothe the children, let alone provide for education and safety. There are limits to what can be accomplished within small-scale, largely informal networks of personal relations. The public purpose sphere, with more formal and larger-scale organizations, is uniquely capable of meeting broader well-being needs. The Public Purpose Sphere The public purpose sphere includes government agencies, as well as nonprofit organizations such as charities, religious organizations, professional associations, and international institutions such as the World Bank and the United Nations. They may be as large as a national government or an international scientific organization or as small as a local chapter of the Cub Scouts. The distinguishing characteristic of these institutions is that they exist for an explicit purpose related to the public good—that is, the common good of some group larger than a household or informal community—and they do not aim at making a profit. public purpose sphere: governments and other local, national, and international organizations established for a public purpose beyond individual or family self-interest and not operating with the goal of making a profit We can break down the economic functions of public purpose organizations into two general categories: regulation and direct provision. Regulation. One very basic function of public-purpose organizations is to regulate economic activities—that is, to set the standards and “rules of the game” by which other economic actors “play”—so as to create the legal, informational, and social infrastructure for economic activity. Though many people think of “regulation” entirely in terms of “government regulation,” many nonprofit groups also participate in regulating economic activity, particularly in the area of standard setting. For example, standardized exams like the AP, SAT I or II, GRE, GMAT, or TOEFL are all developed and administered by the Educational Testing Service, which is a large private nonprofit organization. regulation: setting standards or laws to govern behavior Direct Provision. Direct public provision is often used to supply goods or services that cannot be supplied equitably or efficiently by core sphere institutions and businesses alone. Some of the goods and services provided by the public purpose sphere are what economists call public goods. A public good (or service) is a good whose benefits are freely available to all (non-excludable), and whole use by some does not reduce the quantity available to others (non-rival). direct public provision: the supply of goods or services from government or nonprofit institutions public good: a good whose benefits are freely available to anyone, and whose use by one person does not diminish its usefulness to others nonexcludable good: a good whose benefits are freely available to all nonrival good: a good whose use by one person does not reduce the quantity or quality available to others For example, when a local police force helps to make a neighborhood safe, all the residents benefit. Public roads (at least those that are not congested and have no tolls) are also public goods, as is national defense. Some of the larger public purpose organizations, often associated with some level of government, are charged with purposes such as relieving poverty, providing formal health care and education, protecting the natural environment, and stabilizing global financial markets. Religious organizations are other well-known public purpose organizations. Small and large nonprofits exist to promote various causes, ranging from protecting natural resources to providing the homeless with shelter to lobbying for equality based on race and sexual orientation. Some things are provided by the public purpose sphere because, as a society, we believe that everyone should have access to them, regardless of their ability to pay. Public schooling from kindergarten through high school is a primary example. In some instances, public purpose organizations offer goods and services for sale as businesses do, but this is generally not their primary focus. They usually raise much of their support by soliciting monetary contributions or, in the case of governments, requiring such contributions in the form of taxes or fees. Your college or university, if it is operated by a nonprofit or government entity, would be part of the public purpose sphere. For-profit universities, however, would fall in the business sphere. The main strength of public purpose institutions is that (like core institutions) they provide goods and services of high intrinsic value, but (unlike core institutions) they are big enough, or sufficiently well-organized, to take on jobs that require broader social coordination. Unlike in the business sphere, the provision of goods and services itself, and not the financial results of these activities, remains the primary intended focus of public purpose organizations. The public purpose sphere has its weaknesses, of course. Institutions in the public-purpose sphere are sometimes accused of being rigid, slow to adapt, and inefficient because of excessive regulation and bloated bureaucracy. Organizations can lose sight of the intrinsic, common-good goal of providing “public service” and become more focused on increasing their organizational budget. Many current debates about reforms in governments and non-profits concern how incentives for efficiency can be improved without eroding these organizations’ orientation toward providing goods and services of high intrinsic value. 11