Ten Principles of Economics - Part 3. Economics is the study of how society manages its scarce resources. In most societies, resources are allocated not by a single central planner but through the combined actions of millions of households and firms. Economists therefore study how people make decisions: how much they work, what they buy, how much they save, and how they invest their savings. Economists also study how people interact with one another. | CHAPTER 2 THINKING LIKE AN ECONOMIST 23 are not actual human bodies and no one would mistake the model for a real person. These models are stylized and they omit many details. Yet despite this lack of realism indeed because of this lack of realism studying these models is useful for learning how the human body works. Economists also use models to learn about the world but instead of being made of plastic they are most often composed of diagrams and equations. Like a biology teacher s plastic model economic models omit many details to allow us to see what is truly important. Just as the biology teacher s model does not include all of the body s muscles and capillaries an economist s model does not include every feature of the economy. As we use models to examine various economic issues throughout this book you will see that all the models are built with assumptions. Just as a physicist begins the analysis of a falling marble by assuming away the existence of friction economists assume away many of the details of the economy that are irrelevant for studying the question at hand. All models in physics biology or economics simplify reality in order to improve our understanding of it. OUR FIRST MODEL THE CIRCULAR-FLOW DIAGRAM The economy consists of millions of people engaged in many activities buying selling working hiring manufacturing and so on. To understand how the economy works we must find some way to simplify our thinking about all these activities. In other words we need a model that explains in general terms how the economy is organized and how participants in the economy interact with one another. Figure 2-1 presents a visual model of the economy called a circular-flow diagram. In this model the economy has two types of decisionmakers house-holds and firms. Firms produce goods and services using inputs such as labor land and capital buildings and machines . These inputs are called the factors of production. Households own the factors of production and consume
