Think like an Economist

“Think like an Economist” – Why?

For understanding and appreciating the various policies and regulations and their direct and indirect impact on the natural outcome, one should sometimes “Think Like an Economist”. As we know Economics is a very important discipline and critical in the fields of Fiscal, Commercial and Financial World. It affects and impacts individuals, governments, central banks and business organizations at some or the other levels. And the economic theories and concepts affects and guides all these streams very much.  Strange but true, whether we accept it or not, major fiscal decisions are based on economic theories and no one can be aloof from it. So we must also understand how an economist think and act in the given situation and circumstances.

In fact there is a book “Thinking like an economist” is a book written by N.Gregory Mankiw. It illustrates the different roles of an economist, their differences, various economic models and their uses, the Circular-flow diagram model, the Production Possibilities frontier, the difference between macroeconomics and microeconomics, and the difference between positive economics and normative economics. One may not need to read and understand all these concepts in depth, however, one should know these concepts to practically apply it wherever it has the relation and to understand the changes happening in the economy. And that ultimately affects the prosperity, growth, trade structure, tax structure, social developments, fiscal planning and so on. 

Every field and subject has a unique language, special terminology, concepts and a way of communicating with the outside world. There is a unique thought process that goes behind its theories and policies. The book throws some light into an economist’s way of thinking in detail. In this article we will try to touchbase those areas and concepts.

What are the roles of an Economist?

According to the book “Thinking like an Economist”, an economist performs two major roles in an economy. Let us look at them in slight detail.

The Economist as a scientist

Economics is a social science that makes use of scientific methods to explain how elements in an economy own, use and exchange the scarce resources and benefit from them. Economists make use of actual data, develop and test theories and apply them to explain the behavior of economic participants.

The real world around us is very complex, with an infinite number of participants and economic activities occurring every second, minute, and hour. Economists beautifully simplify this complex maze of transactions and activities for us. For example, economists make use of facts and real-world data to explain complex problems in an economy such as inflation by starting from source. They tell us how the quantity of money affects inflation, which sector or section of the economy is getting affected most, and then lead us to problem-solving.

Economists start by making simplistic assumptions. They may create a small real-world example consisting of just two markets or countries, and just one or two products. Then gradually they develop numerous models on the basis of their simple assumptions. They collect more and more data, analyze them and test them on the models to check their application. And then incorporates the complexity of the situation. Thereafter, they  use a number of equations and diagrams to elaborate and analyse those data and details. And finally they draws conclusios in such a manner that helps us to understand complex issues in a simplistic manner.

But we need to keep in mind that all the data in the economy depends upon the social behavior of its participants. Unlike natural science, this behavior of human participants is dynamic in nature and keeps changing from time to time. Hence economists tend to use historical events as the basis for their assumptions and theories.

Circular-flow diagram model

A Circular-flow diagram model is an economic visual model of macroeconomics that represents the movement of goods, services, and money within the various sectors of the economy. In its simple form, there are two types of decision-makers in the economy that influence the flow of money and that dictate the status of the economy. And these are – households and businesses. Also, there are two types of markets- a market for goods and services, and another market for factors of production i.e. land, labor, capital, and enterprise.

Goods and services flow from manufacturers and service providers to households. Similarly, the households provide factors of production in the form of land, or labor services to businesses for their production processes. The households and businesses interact in the two types of markets mentioned above. The households spend money on the purchase of goods and services. The businesses pay money to the factors of services they use in the form of wages and rent. Therefore, there is a circle formation in the form of the flow of goods and services, services of the factors of production and money in the economy.    

The Production Possibilities Frontier

The Production Possibilities Frontier graphically represents all the combinations of output that manufacturers in an economy can possibly produce, keeping in mind the available technology of production as well as the factors of production.

Example -Problem

Let us take and hypothetical example wherein we have the option to produce only two items – rice and televisions. Labor is the key factor of production is scarce and only 10000 labor hours are available in a week. Producing one ton of rice requires 20 labor hours, whereas producing one television requires 50 labor hours. Therefore, if a producer decides to produce only rice, he can produce a maximum quantity of 500 tons in a week. If he decides to produce only televisions, he can produce a maximum of 200 television sets in a week. So either the producer has to produce only one item. Or else, he may try to come out with an optimum level where he can produce both the items. Such a level at which he gets the maximum advantage.

Example – Solution

The economists use the PPF graph to resolve and suggest in such situations. The PPF graph shows the various combinations of rice and televisions that the producer can produce in a week, given the resource constraint of labor. The model helps us to simplify the complex state of the economy and gives us key points to ponder upon- efficiency, scarcity, trade-offs, opportunity cost, and growth of the economy. We get the most efficient combination of rice and televisions to produce by being at the curve that we denote as the PPF. Any combination that is below or above the curve will mean that there is inefficiency in the economy and the resources are not being optimally used.

We also learn that resources are always scarce and limited, like labor in our example. Also, we always have to face a trade-off between multiple choices in an economy. For choosing to produce more rice, we have to sacrifice the production of televisions. Also, the opportunity cost of producing more rice is the number of television sets that the producer could not produce. The PPF model also explains that either by deploying additional resources or improving the technology of production or both, we can increase our total production. This will lead to the higher economic growth of the nation.

Microeconomics and Macroeconomics

Economists scientifically divide the economy into two categories- Microeconomics and Macroeconomics. Microeconomics has a micro view- it collects and analyzes data of households and businesses, their economic behavior, the theories and policies that impact their choices and decisions, and their interactions in the market.

Macroeconomics has a macro view- it applies science and logic to the broader aspects of the economy such as inflation, unemployment, fiscal and monetary policies, etc. But ultimately it is individuals who make all the decisions in an economy, making microeconomics the basis of all economics.

Thinking Like an Economist

Economists as Policy-maker

Now let us look at the role of economists as policy-makers.

Positive and normative economics

Economists that follow positive economics describe the world as it is actually. They make descriptive claims stating whatever is real and factual. They believe in the “what is “state of economics and do not act as judges of economic occurrences around them.

On the other hand, economists following normative economics make prescriptive statements. They believe in the “what should be” state of economics. They judge the correctness of everything happening around them and prescribe what should actually be happening instead. The interpretations and ideas are subject to the judgment and bias of economists.

Why economists disagree- “Think like an Economist”

Economists around the world disagree on some theory or the other. We can seldom find any policy or theory that all economists will agree upon. Economists tend to disagree with any alternate theory that is opposite of what they believe in. Also, they may have different values and judgments that will change their perceptions and beliefs.

However, there are many propositions and theories in which the majority of economists believe around the world. For example, the majority of them believe that tariffs and import quotas usually tend to lower down general economic welfare. They also believe that minimum wages result in more unemployment among workers who are young and not skilled. Economists suggest a better approach to pollution control. They talk about levying surcharges and taxes on pollution producing businesses rather than putting a ceiling on quantity of pollution generated. Their approach is that imposition is reducing the growth. Here comes the universal contradiction where environmentalists looks other way. There are many such examples in which economists agree with each other. But the number of propositions on which they disagree still outnumber the ones on which they agree with each other.

Thus, by having an idea what and how economists think a common man and businesses can understand the nuances of the subject. It will also help us in understanding the as underline concept driving these policies and the outcome expected.

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Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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