Belief in Economics

Economics has been called “the dismal science.” And calling it a “science” at all is arguable. Yet to me it’s the essence of understanding how the world works. As author Tim Harford puts it, economics is really about how people live.

I discovered his book, The Undercover Economist, at a used book sale. It proved a nice surprise.

A key theme is scarcity power. Economic power comes from control of something people need or want. The book starts with an illustration: a coffee kiosk at a busy train station. Coffee is not fundamentally a scarce commodity but, in that location, rushing commuters have no other source for their fix. That gives the kiosk scarcity power; so its prices are steep, and it does a roaring business.

You’d think that means high profits. Not so! The kiosk ekes out only a small profit. How can that be? Well, there’s a supervening scarcity power: the rail authority controlling the space. Vendors must bid for it, so it goes to the one willing to accept the smallest profit after paying the highest rent. So most of the profits from those high priced coffees actually go to the rail authority.

Scarcity power is one way in which markets can be less than perfect. In a perfect market, sellers compete freely, which drives prices down close to costs, minimizing profits and maximizing what economists call “consumer surplus” – the additional amount buyers would have been willing to pay if they had to. Capitalism’s critics love to scoff that this “perfect market” picture is a fantasy. But in fact, many markets do approximate it. A major example is the airline industry, which generates little profit and hence much consumer surplus.

But meantime, a huge cause of markets being less than perfect is government intervention. Government can create scarcity power in many ways – such as protectionist restrictions on imports, or onerous licensing requirements for trades like hairdressers – as if it’s important to protect consumers from bad haircuts. It’s actually existing hair salons that are protected, from competition by upstarts. And of course businesses use political power, and what amounts to bribery, to get such government thumbs on the scales.

But despite all that, don’t forget that no one is really forced to buy anything. Most goods have substitutes, which limits scarcity power. And buyers buy only when they value the purchase more than the money paid (or more than whatever they could buy instead). This leads to Harford’s second key theme – the world of truth. When pricing and purchase decisions are made in a free market, that creates information about what things are really worth; and that, in turn, dictates what is produced, how it’s distributed, and how resources get utilized. The result is economic efficiency, meaning nobody can be made better off without someone else made worse off to an equal or greater degree. Thus, an optimization of aggregate economic welfare.

Having written in 2006, Harford could not directly answer another critique that has since become quite fashionable: debunking the idea of “homo economicus” making choices based on rational calculation of self-interest. Such rationality is another fantasy, we’re told – consumer decisions are subject to a host of weird biases — so market economics supposedly rests on a faulty premise. Yet the answer to this is clear from Harford’s analysis. The point is that people’s money is valuable to them, if only because of all the alternative ways they could spend it. And even if sometimes (or often) individual spending choices might seem irrational, it’s absurd to deny the rationality of purchases in the aggregate. Whatever might be said of a single $4 coffee buy, thousands of them tell us something indisputably true about how coffee is valued in relation to the myriad alternatives – again, “the world of truth” that market economics incorporates.

And, indeed, that’s the only way we can talk about value at all. “Value” has no meaning except insofar as people make choices among alternatives. Any other system for assigning value (like wage and price controls) is bound to be arbitrary and to result in less economic efficiency than people making choices in spending their own money. The market’s truth is the prime means for making the greatest number better off and fewer worse off.

I’m not an economist. But I don’t see economics as a body of abstruse knowledge; it comes down to logic and common sense. However, many people, who say they believe in science, don’t seem to believe in economics (at least not when it gets in the way of policies they favor).

Tags: capitalism, free markets