Economists often study politically charged issues, but they try to address these issues with a scientist’s objectivity. Like any science, economics has its own set of tools—terminology, data, and a way of thinking—that can seem foreign and arcane to the layman. The best way to become familiar with these tools is to practice using them, and this book affords you ample opportunity to do so. To make these tools less forbidding, however, let’s discuss a few of them here.

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Young children learn much about the world around them by playing with toy versions of real objects. For instance, they often put together models of cars, trains, or planes. These models are far from realistic, but the model-builder learns a lot from them nonetheless. The model illustrates the essence of the real object it is designed to resemble. (In addition, for many children, building models is fun.)

Economists also use models to understand the world, but an economist’s model is more likely to be made of symbols and equations than plastic and glue. Economists build their “toy economies” to help explain economic variables, such as GDP, inflation, and unemployment. Economic models illustrate, often in mathematical terms, the relationships among the variables. Models are useful because they help us dispense with irrelevant details and focus on underlying connections. (In addition, for many economists, building models is fun.)

Models have two kinds of variables: endogenous variables and exogenous variables. Endogenous variables are those variables that a model tries to explain. Exogenous variables are those variables that a model takes as given. The purpose of a model is to show how the exogenous variables affect the endogenous variables. In other words, as Figure 1-4 illustrates, exogenous variables come from outside the model and serve as the model’s input, whereas endogenous variables are determined within the model and are the model’s output.

To make these ideas more concrete, let’s review the most celebrated of all economic models—the model of supply and demand. Imagine that an economist wants to figure out what factors influence the price of pizza and the quantity of pizza sold. She would develop a model that described the behavior of pizza buyers, the behavior of pizza sellers, and their interaction in the market for pizza. For example, the economist supposes that the quantity of pizza demanded by consumers Q^d depends on the price of pizza P and on aggregate income Y. This relationship is expressed in the equation

Q^d = D(P, Y),

where D( ) represents the demand function. Similarly, the economist supposes that the quantity of pizza supplied by pizzerias Q ^s depends on the price of pizza P and on the price of materials P_m, such as cheese, tomatoes, flour, and anchovies. This relationship is expressed as

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Q^s = S(P, P_m),

where S( ) represents the supply function. Finally, the economist assumes that the price of pizza adjusts to bring the quantity supplied and quantity demanded into balance:

Q^s = Q^d.

These three equations compose a model of the market for pizza.

The economist illustrates the model with a supply-and-demand diagram, as in Figure 1-5. The demand curve shows the relationship between the quantity of pizza demanded and the price of pizza, holding aggregate income constant. The demand curve slopes downward because a higher price of pizza encourages consumers to buy less pizza and switch to, say, hamburgers and tacos. The supply curve shows the relationship between the quantity of pizza supplied and the price of pizza, holding the price of materials constant. The supply curve slopes upward because a higher price of pizza makes selling pizza more profitable, which encourages pizzerias to produce more of it. The equilibrium for the market is the price and quantity at which the supply and demand curves intersect. At the equilibrium price, consumers choose to buy the amount of pizza that pizzerias choose to produce.

This model of the pizza market has two exogenous variables and two endogenous variables. The exogenous variables are aggregate income and the price of materials. The model does not attempt to explain them but instead takes them as given (perhaps to be explained by another model). The endogenous variables are the price of pizza and the quantity of pizza exchanged. These are the variables that the model attempts to explain.

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The model can be used to show how a change in one of the exogenous variables affects both endogenous variables. For example, if aggregate income increases, then the demand for pizza increases, as in panel (a) of Figure 1-6. The model shows that both the equilibrium price and the equilibrium quantity of pizza rise. Similarly, if the price of materials increases, then the supply of pizza decreases, as in panel (b) of Figure 1-6. The model shows that in this case the equilibrium price of pizza rises and the equilibrium quantity of pizza falls. Thus, the model shows how changes either in aggregate income or in the price of materials affect price and quantity in the market for pizza.

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Like all models, this model of the pizza market makes simplifying assumptions. The model does not take into account, for example, that every pizzeria is in a different location. For each customer, one pizzeria is more convenient than the others, and thus pizzerias have some ability to set their own prices. The model assumes that there is a single price for pizza, but in fact there could be a different price at every pizzeria.

How should we react to the model’s lack of realism? Should we discard the simple model of pizza supply and demand? Should we attempt to build a more complex model that allows for diverse pizza prices? The answers to these questions depend on our purpose. If our goal is to explain how the price of cheese affects the average price of pizza and the amount of pizza sold, then the diversity of pizza prices is probably not important. The simple model of the pizza market does a good job of addressing that issue. Yet if our goal is to explain why towns with ten pizzerias have lower pizza prices than towns with only two, the simple model is less useful.

The art in economics lies in judging when a simplifying assumption (such as assuming a single price of pizza) clarifies our thinking and when it misleads us. Simplification is a necessary part of building a useful model: any model constructed to be completely realistic would be too complicated for anyone to understand. Yet if models assume away features of the economy that are crucial to the issue at hand, they may lead us to conclusions that do not hold in the real world. Economic modeling therefore requires care and common sense.

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Macroeconomists study many facets of the economy. For example, they examine the role of saving in economic growth, the impact of minimum-wage laws on unemployment, the effect of inflation on interest rates, and the influence of trade policy on the trade balance and exchange rate.

Economists use models to address all of these issues, but no single model can answer every question. Just as carpenters use different tools for different tasks, economists use different models to explain different economic phenomena. Students of macroeconomics therefore must keep in mind that there is no single “correct” model that is always applicable. Instead, there are many models, each of which is useful for shedding light on a different facet of the economy. The field of macroeconomics is like a Swiss army knife—a set of complementary but distinct tools that can be applied in different ways in different circumstances.

This book presents many different models that address different questions and make different assumptions. Remember that a model is only as good as its assumptions and that an assumption that is useful for some purposes may be misleading for others. When using a model to address a question, the economist must keep in mind the underlying assumptions and judge whether they are reasonable for studying the matter at hand.

Throughout this book, one group of assumptions will prove especially important—those concerning the speed at which wages and prices adjust to changing economic conditions. Economists normally presume that the price of a good or a service moves quickly to bring quantity supplied and quantity demanded into balance. In other words, they assume that markets are normally in equilibrium, so the price of any good or service is found where the supply and demand curves intersect. This assumption, called market clearing, is central to the model of the pizza market discussed earlier. For answering most questions, economists use market-clearing models.

Yet the assumption of continuous market clearing is not entirely realistic. For markets to clear continuously, prices must adjust instantly to changes in supply and demand. In fact, many wages and prices adjust slowly. Labor contracts often set wages for up to three years. Many firms leave their product prices the same for long periods of time—for example, magazine publishers typically change their newsstand prices only every three or four years. Although market-clearing models assume that all wages and prices are flexible, in the real world some wages and prices are sticky.

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The apparent stickiness of prices does not make market-clearing models useless. After all, prices are not stuck forever; eventually, they adjust to changes in supply and demand. Market-clearing models might not describe the economy at every instant, but they do describe the equilibrium toward which the economy gravitates. Therefore, most macroeconomists believe that price flexibility is a good assumption for studying long-run issues, such as the growth in real GDP that we observe from decade to decade.

For studying short-run issues, such as year-to-year fluctuations in real GDP and unemployment, the assumption of price flexibility is less plausible. Over short periods, many prices in the economy are fixed at predetermined levels. Therefore, most macroeconomists believe that price stickiness is a better assumption for studying the short-run behavior of the economy.

Microeconomics is the study of how households and firms make decisions and how these decisionmakers interact in the marketplace. A central principle of microeconomics is that households and firms optimize—they do the best they can for themselves given their objectives and the constraints they face. In microeconomic models, households choose their purchases to maximize their level of satisfaction, which economists call utility, and firms make production decisions to maximize their profits.

Because economy-wide events arise from the interaction of many households and firms, macroeconomics and microeconomics are inextricably linked. When we study the economy as a whole, we must consider the decisions of individual economic actors. For example, to understand what determines total consumer spending, we must think about a family deciding how much to spend today and how much to save for the future. To understand what determines total investment spending, we must think about a firm deciding whether to build a new factory. Because aggregate variables are the sum of the variables describing many individual decisions, macroeconomic theory rests on a microeconomic foundation.

Although microeconomic decisions underlie all economic models, in many models the optimizing behavior of households and firms is implicit rather than explicit. The model of the pizza market we discussed earlier is an example. Households’ decisions about how much pizza to buy underlie the demand for pizza, and pizzerias’ decisions about how much pizza to produce underlie the supply of pizza. Presumably, households make their decisions to maximize utility, and pizzerias make their decisions to maximize profit. Yet the model does not focus on how these microeconomic decisions are made; instead, it leaves these decisions in the background. Similarly, although microeconomic decisions underlie macroeconomic phenomena, macroeconomic models do not necessarily focus on the optimizing behavior of households and firms; again, they sometimes leave that behavior in the background.

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