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Economic thinking – how to think like an economist

June 11, 2011

There’s a certain essence of what it means to think like an economist. When made comprehensible, economic thinking can be incredibly powerful and useful in understanding the world, in making personal decisions, in formulating business strategies, or in choosing national policy. Developing your ability to make these evaluations more effectively is the objective of this course. Once you learn to think like an economist, you will never be quite the same again.
To think like an economist is to view the world from the 6 foundation principles of economic thinking.
Principle number 1: People respond to incentives. No premise is more central: If you reward a behavior, people will do more of it and more intensely; if you penalize it, they’ll do less of it. If you tax cigarettes more, people will smoke less. If you offer free breakfast, people will line up around the block.
Principle number 2: There is no such thing as a free lunch. It sounds silly, but that expression captures a lot of economic thought. When economists look at the world, they see an unavoidable imbalance between the wants we have on one hand and the limited resources we have on the other. A fundamental reality is that there is always going to be scarcity: Any use of time or limited resources for one purpose is an opportunity forever gone to use them for another. More of anything always means less of something else; and it’s that option that you had to give up that economists call opportunity cost.
Principle number 3: No thing is just one thing; there are always at least 2 sides to every interaction. I recently read a column arguing that it was unethical for those of us who had jobs in a period of economic difficulty to continue spending when others are unemployed. But the reality is that every dollar of my expenditure is a dollar of income coming in for someone else. If there’s less total spending, there’s also by de􀂿 nition less total income.
Principle number 4: The law of unanticipated influences. We can see this with a concept from chaos theory called the butterfly effect. In chaos theory, hypothetically, a butterfly on one side of the world can flap its wings and, through a chain of causation that’s totally unpredictable, cause a hurricane on the opposite side of the world. This is true in economics: No event ever takes place in a bubble; a change in any one part of an economic system is going to have ripple effects, often in far removed places. The 1979 embassy takeover in Tehran, Iran, resulted in an increase in dental costs in the United States. How does that happen? There was fear that there might be war in the Middle East, which could result in the disruption of financial markets. People turned to gold and silver as a hedge against this uncertainty, which impacted the costs of dental fillings and X-ray film. Butterfly effects are real: We are often impacted by things we cannot anticipate or control.
Principle number 5: The law of unintended consequences. In our interconnected world, our actions are always going to have multiple consequences. A number of cities have installed red light cameras, which take a photograph of the license plate of any car that enters an intersection after the light has turned red. The intended purpose, of course, was to reduce the number of intersection accidents. The cameras achieved this, but they also increased the number of rear-end accidents caused by people slamming on their brakes to avoid the cameras.
Principle number 6: No one is, and no one ever can be, in complete control. If you apply an incentive to some subset of 6 billion complexly interrelated people, whose interactions are totally unforeseeable and have unintended consequences, and then predict the 􀂿 nal result, that would be monumental. To go further and try to control that outcome would be utterly impossible. When economists approach any problem, they are grounded in a paradigm defined by these 6 principles. At face value, they are simple, but they can be applied in endless contexts. Their richness comes not from the complexity of the vision but from their adaptability to so many different situations.

The 3 core analytic concepts in economics are rationality, marginal analysis, and optimization.
Economists believe in rationality: They build extraordinarily complex models on the assumption that humans are fundamentally rational in their behavior. People will choose strategically rather than randomly. In principle, making rational decisions means following 4 simple steps: First, clarify the objective. Second, identify all possible alternative paths to achieve the objective. Third, evaluate carefully the payoffs from each of those alternatives. This is where economic thinking can help a lot—developing tools to help you understand how to put value on difficult things. Fourth, select the best option and implement your decision (i.e. 4-step problem-solving approach/thinking). In our world of scarcity, evaluating alternatives is all about valuing the opportunity costs. Rationality says that you should always choose
the option with the highest net payoff; to knowingly choose anything worse would be irrational. The presumption of rationality works 2 ways: It helps us with the prediction and the description of behavior, and it also gives us a way to evaluate after the fact and draw conclusions about values. The concept of strategic decision making and rationality as both an objective for and a description of human behavior is fundamental to economic thinking (i.e. strategic rational decision making).
The second core concept is marginal analysis. Economists tend to look carefully at sequences of small changes made on the margin, because most of the choices we make in life are not all-or-nothing decisions; most of them involve marginal trade-offs. A little more of one thing inevitably means a little less of another. If we woke up tomorrow and gas prices had doubled, how would that affect automobile usage? As the marginal value changes, more of something makes the marginal value fall; less of something makes the marginal value rise. At high gas prices, some trips would not be worth it, but others certainly still would be. Thinking like an economist means we reject claims that a change in price is going to make things stop altogether. People adjust on the margin until the value of the last trip taken reflects the new, higher costs of driving.
The third core concept is about optimization in the equimarginal principle. This means figuring out the best attainable allocation given a set of constraints. Imagine yourself on a new TV reality show. You’re 􀃀 own by
helicopter deep into the wilderness, with nothing but the clothes on your back. You’re given 4 chits that you get to exchange for units of food or units of shelter. If you think like an economist, you’re going to realize that
survival is not about either food or shelter; it’s about the best attainable combination of the two. Gorging on food while freezing to death is not a good strategy; basking in warmth and comfort while starving to death is not
either. The optimal solution is to find the balance between food and shelter that will make the marginal value of each of them equal; hence the name “equimarginal principle.”
Applying the concepts of rationality, marginal thinking, and optimization in a world proscribed by the 6 foundation principles means you are thinking like an economist. Complex econometric models are based on these essential ideas. Thinking like an economist means being aware of the incentives you face and, perhaps more importantly, the incentives those around you face. It means anticipating what’s strategically rational for them, and how that will affect your options. It means focusing on the margin, on trade-offs, and on adjustments to find the optimal balance. The question is always how much? And of which?
Source: Thinking like an Economist: A Guide to Rational Decision Making. Randall Bartlett, Ph.D. PUBLISHED BY:
THE GREAT COURSES: Corporate Headquarters: 4840 Westfi elds Boulevard, Suite 500. Chantilly, Virginia 20151-2299
Phone: 1-800-832-2412; Fax: 703-378-3819., 2010. at 3-8.


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