Economists tend to relate to the subject of research with scientific objectivity (Mankiw, 2015). They develop theories, accumulate evidence and then analyse them in an attempt to prove or disprove the theoretical concepts. The main tools of the economist (and other scientists) are theory and observation, but, in contrast to the natural sciences, in economics it is almost impossible to set up an experiment to confirm or deny a new concept. In order to somehow compensate for the absence of the possibility of carrying out laboratory experiments, economists are paying close attention to natural experiments offered by life. An important role in the process of economic experiments and economic research belongs to assumptions and economic models.
Very often, economists are asked to explain the current economic events. Why, for example, the unemployment rate is particularly high among young people? Sometimes economists are asked to recommend measures to improve the economic situation. What should the government do to improve the level of life of young people? When economists try to explain the structure of the world, they act as scientists. When they try to change it, they become policy makers.
Economics studies the mechanisms by which society distributes its available scarce resources. And no matter how complex and multifaceted economic theory, it can be brought down to three main ideas: 1) examine the principles according to which people make decisions; 2) explore the forms of human interactions; and 3) analyze the factors and trends affecting the economy as a whole. The four principles of decision-making by individuals include: 1) people compromise; 2) the cost of something is the cost of what person has to give up to get what he wants; 3) rational people think the terms of marginal changes; 4) the person responds to stimuli (Mankiw, 2015).
Circular flow model is an economic model showing the flows of goods, services and money between households and firms. Its basic assumption is the assumption that in the economy there are two types of decision-making entities – households and firms. Firms produce goods and services, using labor, land and capital (buildings and machinery), i.e. the factors of production. Households own the factors of production and consume all the goods and services produced by firms. The model schematically shows the organizational structure of the economy. Households and firms interact in the two main markets. In the market of goods and services the households act as buyers and firms as sellers; households purchase goods and services that are produced by firms. In the market of factors of production, households offer factors of production that are acquired by the firms and used for the production of goods and services. The circular flow model is a simple way to organize all the transactions in the economy, concluded between households and firms.
Internal arrows represent the flow of goods and services among households and firms. Households sell labor, land and capital to firms in the market of factors of production; firms use them for the production of goods and services, which, in turn, are acquired by households in their respective markets (Beggs, 2016). Thus the factors of production flow from households to firms and goods and services flow from firms to households. External arrows represent cash flows. Households use money to buy goods and services from firms. Firms use part of the revenue to pay for the factors of production, such as wages. The rest is the profit of the owners of firms, who are at the same time the members of the households. Thus, the money spent on the purchase of goods and services flow from households to firms and money income in the form of wages, rent and profit comes from firms to households.
An independent economic actor is an individual, a firm, a government or a society as a whole; it has the ability to use labor, land and capital. Independent economic actors are assumed to be rational but it happens that their actions require coordination. The structure of economic mechanism of modern national economy includes: the market, the competition of all economic actors (within the sector and cross-sectoral), the commercial independence of enterprises (self-financing, self-management and financial incentives), the system of free contracts, free pricing, and state regulation. Market and free pricing are the ways for the economy to coordinate society’s independent economic actors. By means of markets buyers and sellers interact with each other in order to purchase and sell goods; it is an instrument that coordinates their independent objectives. Free pricing determines the specific proportion of commodity exchange and by balancing supply and demand on the market ensures the coordination of economic actors (Mankiw, 2015). If market and free pricing fail, state takes measures for correction and changing the reproduction of social capital.
Gross Domestic Product (GDP) is the most common tool for assessing the country’s economy. “Gross” means that by means of GDP the entire production is estimated, regardless of its purpose. Production can be directed to the immediate consumption, investment in new fixed assets or the replacement of depreciated fixed assets. “Domestic” means that GDP estimates production in the territory of one country.
There are many ways to measure GDP. Generally, the following formula is used for this:
GDP = consumption expenditure + gross investment + government spending + (exports - imports)
Or briefly: GDP = C + I + G + (X - M) (Thangavelu, 2015)
Most often, GDP is measured on a quarterly or year basis. On the basis of the factors prevailing in the economy, central banks and other institutions reduce or increase the forecasts of its growth. In order to evaluate the quality of life GDP per capita is commonly used.
The Consumer Price Index (CPI) is a price index, which is calculated for a specific group of goods and services, determining the composition of the consumer basket per capita of the country and is calculated for a specific time period. The consumer price index is a ratio of total consumer basket of the base year, estimated at the current year’s prices, to the consumer basket in the base year, estimated at base year prices. The consumer price index is one of the most common price indices, which plays an important role in the economy, since it is a basis for the recalculation of wages, social benefits and other payments, which must be done by the organizations regularly and automatically, for example, every quarter, or every year.
It should be noted that the CPI is an imperfect measurement of the cost of living since includes only the products that are used by the consumer for his personal needs and that are included in the fixed consumer basket. It does not reflect the changes on the market (and namely that the companies start to offer new goods and services that are absent in the consumer basket), as well as changes in quality of the goods and services that are being offered. Another problem is substitution bias, i.e. that CPI does not reflect changes in prices (the number of goods and services purchased by the consumers changes as the price for them changes). Besides, the methodology of calculating the CPI differs from country to country because the consumer basket consists of different products there.
References
Beggs, J. (2016). The Circular-Flow Model of the Economy. About.com Education. Retrieved 1 February 2017, from http://economics.about.com/od/economics-basics/ss/The-Circular-Flow-Model.htm
Mankiw, N. (2015). Principles of economics (7th ed.). Stamford, CT: Cengage Learning.
Thangavelu, P. (2015). How To Calculate The GDP Of A Country. Investopedia. Retrieved 1 February 2017, from http://www.investopedia.com/articles/investing/051415/how-calculate-gdp-country.asp
