02 National Accounting

The Economist’s Toolkit: Models and Assumptions

We concluded last time by establishing the economist’s role as a scientist. A key part of this role is the use of models. To understand a complex world, we must simplify it. This is the role of assumptions.

Economists make assumptions to distill complex realities into manageable models. The world is too noisy to analyze in its entirety; we must filter out what is less relevant to focus on the core mechanisms. The art of scientific thinking lies in choosing the right assumptions, those that simplify without distorting the essential question at hand.

Models are Maps

Think of an economic model as a map. A map is, by definition, an incorrect simplification of reality. But its usefulness depends on the question you’re asking. To find your way around Zurich, you need different maps for navigating municipalities versus city streets.

For navigating London’s subway, the schematic Tube map is far superior to a geographically accurate street map. It intentionally distorts distance and location to make the system understandable. It’s “wrong,” but it’s useful. Economic models are the same: we knowingly make simplifying assumptions (e.g., “the world has only two countries”) if they help us answer a specific question clearly.

In any model, we distinguish between two types of variables:

• Endogenous Variables: The outcomes we want to explain. Their values are determined within the model.
• Exogenous Variables: The inputs we take as given. Their values are determined outside the model. This creates a clear cause-and-effect structure: exogenous variables drive the endogenous outcomes. To isolate these effects, we often employ the ceteris paribus assumption, “all other things being equal”, changing only one exogenous variable at a time to see its impact.

Our First Model: The Circular-Flow Diagram

This is a visual model of the macroeconomy that shows how money and resources flow between its key actors: households and firms.

In its simplest form, we have two actors and two markets:

1. Households: Own the factors of production (labor, land, capital) and consume goods and services.
2. Firms: Use factors of production to produce goods and services.
3. Market for Goods and Services: Where firms sell and households buy.
4. Market for Factors of Production: Where households sell (e.g., their labor) and firms buy.

This creates two loops: an inner loop of real things (labor flows to firms, goods flow to households) and an outer loop of money (firms pay wages, households spend on goods). The key insight is that total income must equal total expenditure. It’s like measuring the flow of blood in the body; it doesn’t matter where you measure it, the flow rate is the same.

We can make this model more realistic by adding other key actors:

• Government: Collects taxes and makes government purchases.
• Financial System: Channels savings from households into investment for firms.
• Rest of the World: Engages in trade (exports and imports) and international capital flows.

Even in this complex model, the fundamental identity holds. This gives us three ways to measure the total economic activity, or Gross Domestic Product (GDP).

Our Second Model: The Production Possibilities Frontier (PPF)

The PPF is a graph showing the maximum combinations of two goods an economy can produce given its available technology and factors of production. It’s a powerful tool for visualizing core economic concepts.

The PPF illustrates:

• Efficiency: Any point on the frontier (like A and B) is efficient; the economy is getting the most from its resources.
• Inefficiency: Any point inside the frontier (like D) is inefficient (e.g., due to unemployment).
• Impossibility: Any point outside the frontier (like C) is currently unattainable.
• Trade-offs & Opportunity Cost: Moving from A to B requires giving up 200 computers to gain 100 cars. The opportunity cost of those 100 cars is 200 computers. The bowed-out shape reflects increasing opportunity cost, as resources are not equally suited for producing both goods.
• Economic Growth: A technological advance (an exogenous shock) shifts the frontier outward, making previously unattainable points (like G) possible.

The Economist as Policy Advisor

Economists play a dual role. When explaining the world, they are scientists. When trying to improve it, they are policy advisors. This distinction is captured by the difference between positive and normative analysis.

• Positive Statements: Descriptive claims about how the world is. They are testable with data.
  • Example: “An increase in the minimum wage will cause a decrease in employment among the least-skilled.”
• Normative Statements: Prescriptive claims about how the world ought to be. They involve value judgments and cannot be tested.
  • Example: “The income gains from a higher minimum wage are worth more than any slight reductions in employment.”

This course focuses on positive analysis, understanding the mechanisms of the economy.

Why do economists disagree?

Disagreements arise from two sources:

1. Differences in Scientific Judgments: Economists might use different models (maps) or have different positive theories about how the world works.
2. Differences in Values: They may have different normative views about what policy should accomplish.

A KOF-NZZ survey of Swiss economists shows broad consensus on many positive issues (e.g., 92.6% agree that property rights and free competition are central to well-being). Disagreement is much stronger on normative questions, like whether income should be distributed more evenly (39.6% agree, 34.5% disagree).

Measuring a Nation’s Income: National Accounting

To analyze the economy, we first need to measure it. Macroeconomics is the study of the economy as a whole, aiming to explain economy-wide phenomena like why average income differs across countries, why prices sometimes rise rapidly (inflation), and why economies experience booms and busts (business cycles).

The most important statistic in macroeconomics is Gross Domestic Product (GDP).

The Measurement of Gross Domestic Product (GDP)

GDP measures two things at once: the total income of everyone in the economy and the total expenditure on the economy’s output of goods and services. For an economy as a whole, income must equal expenditure, because every transaction has a buyer and a seller. Every dollar of spending by a buyer is a dollar of income for a seller.

Definition: GDP is the total market value of all final goods and services produced within a country in a given period of time.

Let’s break this down:

• “…Market Value…”: To add up different items (apples, cars, haircuts), GDP uses their market prices. This values output at what people are willing to pay.
• “…of All…”: GDP aims to be comprehensive, including all items produced and sold legally in markets. It excludes most non-market activities, like household production (mowing your own lawn isn’t counted, but hiring a gardener is). It also often excludes the black market.
• “…Final…”: GDP only includes the value of final goods, not intermediate goods. This is to avoid double-counting. The value of the tires is already included in the final price of a car. We count the car, not the tires and the car.
• “…Goods and Services…”: GDP includes both tangible goods (food, clothes) and intangible services (haircuts, financial advice).
• “…Produced…”: GDP measures current production. The sale of a used car is not included in GDP because the car was not produced in the current period; it’s a transfer of an existing asset.
• “…Within a Country…”: GDP measures the value of production within the geographic confines of a country, regardless of the nationality of the producer.
• “…in a Given Period of Time.”: GDP is a flow variable, measured over an interval of time, typically a quarter or a year.