Notes on How Economists Think . .

What does economic theory teach that is relevant to thinking about public policy in general and welfare reform in particular? At a very general level, economic theory emphasizes two basic themes. Individuals are rational. Hence, they respond in predictable ways to changes in incentives, for example, to changes in market prices, taxes, and welfare rules. Equilibrium matters. Individuals' responses to an initial change in the incentives they face have feedback effects: their responses to the initial change affect the incentives facing others and induce second, third, and subsequent rounds of responses. Economists focus on the long-run equilibrium implications of this sequence of responses. Economists are most comfortable talking about real markets, such as markets for consumer goods and labor markets, but equilibrium conditions are crucial in metaphorical markets such as marriage markets and political markets. Indeed, many of the much ballyhooed examples of "unintended consequences" of government policies are equilibrium responses to rules, regulations, and policies that should have been anticipated -- the Savings and Loan fiasco is a case in point. I begin by elaborating on these two themes of individual rationality and equilibrium responses, then argue for the importance of gedanken experiments, and, finally, discuss some empirical issues.