Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Ensuring that intuition doesn’t fail you

Another reason economists like working with models is that often human intuition alone can lead people astray.

Here’s a classic example: the government is going to increase payroll taxes by 10 per cent (these taxes are paid by either the employee or the employer when someone works). A fierce political debate rages between two rival camps:

Camp A thinks that employers should pay the extra tax: Their slogan

is ‘Why should hardworking people have to pay more tax?’.

Camp B thinks that employees should pay the extra tax: Their slogan is ‘Taxing employers is a tax on jobs’.

Who’s right? Both camps have attractive arguments and are arguing for them passionately. Intuition says that employees should prefer employers to pay the tax and vice versa. But intuition is wrong! It makes no difference whether the tax is formally levied on the employer or the employee – the take-home pay of the employee is the same in both cases.

If the employer ‘pays’ the tax, it will pass some of it on to its workers by reducing wages. If employees ‘pay’ the tax, they’ll only be willing to work for a higher wage – which means some of the tax is actually paid by the employer. The eventual outcome is identical in both cases!

This result is counterintuitive – you’d be unlikely to come to this conclusion by sitting down and just thinking really hard. Nonetheless, it’s true and the empirical evidence (the data) supports this conclusion.

The beauty of modelling is that it allows economists to find results that would be almost impossible to find otherwise.


Macro meets micro

Economics is often split into microeconomics and macroeconomics. Microeconomics is the study of individual and firm behavior, and macroeconomics is the study of the economy as a whole. Decades ago they were very different fields with different ways of doing things:

Microeconomics stressed the importance of modelling individuals and firms as optimising agents. This means that when people and companies make choices, they consider all possible options and then choose the one they prefer most. Economists say that individuals maximise their utility and firms maximise their profits.


Macroeconomics used a number of basically ad hoc models in order to explain different aspects of the economy, which was fine for a while until some serious problems soon became apparent. For one, it was just too easy for macroeconomists to ‘explain’ any macroeconomic event by coming up with a new model every time something happened that existing models were unable to explain. So, if they wanted to ‘explain’ why unemployment and inflation rose together in the 1970s all they needed to do was create a model where unemployment and inflation rise together. Want to ‘explain’ why countries go into recession when oil prices rise? No problem, just write down a model where an increase in oil prices leads to a recession. Essentially, it looked like they were cooking the books.

Not happy with this situation, many economists felt that because the economy is made up of millions of interactions between individuals and firms, macroeconomic models should have as their building blocks microeconomic foundations – so macroeconomic models (explicitly or implicitly) should have optimising agents within them. In short, most economists now feel that good macroeconomics should be based on sound so-called microfoundations.