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How to think like an economist

Written By: Jason Shafrin - Jun• 05•06

Economists are a peculiar brand of individuals.  They often think more quantitatively than researchers from other social sciences, but also are fond of never giving a straight answer.  If you wonder how economists view most problems, I will give a basic framework to use.  

1. Identify the parties involved
2. Identify the incentives of each of the parties involved
3. Analyze the costs and benefits of a policy change for each group, and approve the policy if the sum of the benefits less the costs exceeds that of any other alternative policy.

Here is an example:

On the Public Citizen website, the non-profit public interest group calls for ‘better SUVs.’  To quote:

Americans want safe, fuel-efficient SUVs, but today these vehicles are costing lives on the road and money at the pump. New research shows that SUVs pose serious risks to children and families, and that SUV owners in the U.S. each spent $350 extra on gas in 2002 – together more than $9 billion – over what they would have paid if SUVs were as efficient as cars. Automakers have the technology to improve fuel economy, but choose instead to bulk up the weight and acceleration of SUVs, costing SUV owners and other motorists lives and money.

Sounds like a great policy…but let’s look at this proposal from an economist’s point of view:

1. Identify the parties involved
Consumers (sub-divided between those who purchase SUVs and those who do not), Automobile companies, and the government

2. Identify the incentives of each of the parties involved
For consumers, having a safer, more fuel efficient SUV would be great.  The safer and more fuel efficient the better.  From the firm’s point of view, however, it is more costly to make a safer and more fuel efficient SUVs while keeping all the other features the same.  Producers could increase fuel efficiency and decrease acceleration in order to maintain the cost.  Now we must decide whether or not consumers are willing to pay for added fuel efficiency or safety; we must decide whether consumers want to sacrifice acceleration for fuel economy.  If consumers are demanding more safety and fuel efficiency, an economist would believe that car companies would produce these cars to maximize their profits, and if not, they will produce the same SUVs as they do now. 

3. Analyze the costs and benefits of a policy change
Let me assume that Public citizen would wish for the government to mandate minimum safety and fuel efficiency standards for all SUVs.  Those who want higher quality cars and are willing to pay for the quality improvement would likely benefit.  With the added regulations, the cost of SUVs would rise and some individuals would be priced out of the SUV market.  Assuming firms were maximizing profits before the new regulation, the automobile company would now be earning less money.  There are other aspects of this policy that various economic specialties would look at:

  • Political Economy: How would consumer and automobile lobbying groups affect how stringent the requirements were?
  • Public Economics: Public Citizen claims that SUVs pose a safety risk on other drivers.  This is an externality on consumers who decide not to purchase an SUV.  Most public economists would recommend a safety tax on SUVs to take into account the additional safety costs SUVs pose on car drivers.  Similarly, if SUVs use a lot of gas which pollutes the environment, a gas tax would be appropriate to curb the pollution externality from the use of fossil fuels.
  • Industrial Organization: Is the car market competitive?  If not, should the government regulate the market in order to increase supply to consumers?  What are the beneficial and harmful effects of this legislation.
  • Finance: How would the regulation affect an automaker’s short-term and long-term profitability?

As you can see, economists are fond of complicating problems, but do so in order for us to realize that what seems to be a simple policy change may have an unintended effect on other parties in society. 



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