Learning ObjectivesBy the end of this section, you will be able to do the following:
- Interpret a circular flow diagram
- Explain the importance of economic theories and models
- Describe goods and services markets and labor markets
John Maynard Keynes (1883–1946), one of the greatest economists of the 20th century, pointed out that economics is not just a subject area but also a way of thinking. Keynes, shown in Figure 1.5, famously wrote in the introduction to a fellow economist’s book: “[Economics] is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct conclusions.” In other words, economics teaches you how to think, not what to think.
Milton Friedman is an American economist who was awarded the Nobel Prize in Economics in 1976. His book, A Monetary History of the United States, co-authored with Anna Schwartz, highlights the connection between the fluctuation of the money supply and economic activity. As a result of this and his other scholarly contributions, Friedman is considered the founder of the macroeconomic school of thought known as Monetarism.
Another influential 20th century economist is Friedrich Hayek. Hayek is noted for his many contributions to modern economics. Hayek shared the 1974 Nobel Prize in Economics for his work on the business cycle. The Austrian approach pioneered by Hayek argues that business cycle fluctuations occur due to changes in credit as a result of central bank monetary policy.
Economists see the world through a different lens than anthropologists, biologists, classicists, or practitioners of any other discipline. They analyze issues and problems with economic theories that are based on particular assumptions about human behavior, that are different than the assumptions an anthropologist or psychologist might use. A theory is a simplified representation of how two or more variables interact with each other. The purpose of a theory is to take a complex, real-world issue and simplify it down to its essentials. If done well, this enables the analyst to understand the issue and any problems around it. A good theory is simple enough to be understood, while complex enough to capture the key features of the object or situation being studied.
Sometimes economists use the term model instead of theory. Strictly speaking, a theory is a more abstract representation, while a model is a more applied or empirical representation. Models are used to test theories, but for this course we will use the terms interchangeably.
For example, an architect who is planning a major office building will often build a physical model that sits on a tabletop to show how the entire city block will look after the new building is constructed. Companies often build models of their new products, which are more rough and unfinished than the final product will be, but can still demonstrate how the new product will work.
A good model to start with in economics is the circular flow diagram, which is shown in Figure 1.6. It pictures the economy as consisting of two groups—households and firms—that interact in two markets in the goods and services market, firms sell and households buy and in the labor market households sell labor to business firms or other employees.
Of course, in the real world, there are many different markets for goods and services and markets for many different types of labor. The circular flow diagram simplifies this to make the picture easier to grasp. In the diagram, firms produce goods and services, which they sell to households in return for revenues. This is shown in the outer circle, and represents the two sides of the product market (for example, the market for goods and services) in which households demand and firms supply. Households sell their labor as workers to firms in return for wages, salaries, and benefits. This is shown in the inner circle and represents the two sides of the labor market in which households supply and firms demand.
This version of the circular flow model is stripped down to the essentials, but it has enough features to explain how the product and labor markets work in the economy. We could easily add details to this basic model if we wanted to introduce more real-world elements, like financial markets, governments, and interactions with the rest of the globe (imports and exports).
Economists carry a set of theories in their heads like a carpenter carries around a toolkit. When they see an economic issue or problem, they go through the theories they know to see if they can find one that fits. Then they use the theory to derive insights about the issue or problem. In economics, theories are expressed as diagrams, graphs, or even as mathematical equations. (Do not worry. In this course, we will mostly use graphs.) Economists do not figure out the answer to the problem first and then draw the graph to illustrate. Rather, they use the graph of the theory to help them figure out the answer. Although at the introductory level, you can sometimes figure out the right answer without applying a model, if you keep studying economics, before too long you will run into issues and problems that you will need to graph to solve. Both micro and macroeconomics are explained in terms of theories and models. The most well-known theories are probably those of supply and demand, but you will learn a number of others.
This section may include links to websites that contain links to articles on unrelated topics. See the preface for more information.