Belief in Economics

UnknownEconomics 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. Unknown-1That 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. imagesCapitalism’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. images-1It’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.

images-3Having 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.Unknown-2

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).

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17 Responses to “Belief in Economics”

  1. Henshaw Says:

    The problem with economics is that it sometimes work counter to how people think. Price control seem like a good idea. Wage controls seem like a good idea. But they’re not.

  2. rationaloptimist Says:

    Thanks. It’s that often people don’t think ENOUGH. If you think a little, price controls may sound good. But if you think some more, then you realize why it’s not such a good idea after all.

  3. WhamaJama Says:

    I am an economist. I, too, admire the discipline. However, I am experienced enough to know that it is far from infallible or purely rational. However, let’s discuss one point briefly. Creating scarcity is not an objective of government regulation. It may well be a consequence, but it is surely not the objective. Regulation is intended to ensure markets perform under a fair set of rules. Even the most ardent free-marketer of all, Milton Friedman, realized government regulation was absolutely necessary:

    “But we cannot rely on custom or on this consensus alone to interpret and to enforce the rules; we need an umpire. These then are the basic roles of government in a free society: to provide a means whereby we can modify the rules, to mediate differences among us on the meaning of the rules, and to enforce compliance with the rules on the part of those few who would otherwise not play the game.” Capitalism and Freedom, Chapter 2, 1962.

    One rule is that contracts be enforceable. Another might be that products are safe and reliable. And so on. The desire to ensure airlines operate safely, or that hairdressers receive some basic accreditation, may reduce the supply of such services but they do serve to ensure that planes do not crash so often or that your haircut does not expose you to a prior customer’s lice.

    It also clear that political parties and their policies are not economically based and sometimes not, therefore, consistent or logical. When Democrats support trade barriers or minimum wage laws, or Republicans oppose immigration reform or any tax increase, they usually fail to acknowledge the inherent weakness of their position economically. That is a failing of our political system. As the leaders of government are ultimately products of politics small and large, this indicates to me that we have a broken system. Economics has a role to play, but a better educated, ethical, and healthy populace is much more important.

  4. rationaloptimist Says:

    Free market advocates are often portrayed, by opponents, as urging zero regulation. But (as I keep saying) nobody does. Just as laws bar individuals from acts that harm others, so should businesses be so restricted. Government intervention should aim to make markets more free, but too often do the opposite, because of special interest influence. Protecting us from lice does not require an elaborate licensing scheme for hairdressers.

  5. Lee Says:

    It is not just the regulation of fraud and other harms.

    Free-market economics often replies on a supposition that the parties have the information needed to make economically rational decisions. However, when I am buying something complicated, it is not possible for me to personally evaluate each and every subpart for its performance, durability, disposability, etc. I don’t even have time with every purchase of something complicated to read a complete expert evaluation of all these subparts; to learn the necessary technical terms to properly understand the information; etc.

    Instead, I am dependent upon some organization to set minimum standards. It is possible that a corporation could fill this role, as does Underwriters Listed in some markets. However, if it is just one company that fills this role then there are concerns regarding monopolistic powers. It is multiple companies then I am being asked to make a choice among rating companies, where I will generally not have the expertise to distinguish the best from the worst. Don’t get me wrong — I don’t need a full-time nanny — with some tweaks this could become a workable enough solution.

    The best solution I have found so far is a hybrid one. Rather than having some monopolistic organization (de jure or de facto) pick the best product for me, as was common in communist countries, and rather than having a wild west that prohibits only frauds and harms, I am happy to have government set some sort of minimal standards in important areas, leaving the rest of the decision making process to me. That leaves only the decision as to when and where government should set those standards. It easily could be that government should get out of the hair stylist regulation business… I am ignorant in this matter.

  6. frank S. Robinson Says:

    The market has a built-in regulatory feature: business that do not satisfy customers do not survive. MOST businesses understand this, and MOST try hard to satisfy. You can make money by ripping people off . . . but not for very long.

  7. Herb Van Fleet Says:

    “If all economists were laid end to end, they would not reach a conclusion.” — .George Bernard Shaw

  8. bruce Says:

    Indeed the worst offenders for not meeting customer demand are the companies that the government has decided are their pet projects. Those companies no longer must succeed by satisfying customers.Their success is granted by government intervention.
    Stifling competition and hence promoting monopolistic practices.
    Practices the government has by regulation or unartful law proscribed.
    As you say companies work tirelessly to make money and they make money by selling to the larger public. The larger public buys what is the best bargain balanced by best product. You just can’t depend on people you have ripped off coming back to you.

  9. Mayuresh Says:

    Some economists even argue that economics is a rational science and not an empirical one. But sometimes I believe that there could be no rational science as such, as there are “unintended consequences” which are almost certain and economists will always keep on rationalizing their partial understanding of things.

    BTW, thinking ENOUGH is a good rationalization practice.

  10. frank S. Robinson Says:

    “Thinking ENOUGH” is indeed rational in everyday life problems. One can overthink. It can be better to make a decision and act. But when it comes to (macro) economic problems, the intuitive answer may not be the right answer.

  11. Lee Says:

    FSR writes: “The market has a built-in regulatory feature: business that do not satisfy customers do not survive.”

    I do not understand this. How do I know whether a new business is genuinely trying vs. is fly by night? That a fly-by-night business subsequently goes bankrupt does not get me my purchase price back. On the other hand, if I should buy my important purchases from well established businesses only, then how do we expect that new businesses with genuinely good products will ever achieve any sort of market share?

    When government (or UL type organizations) set a minimum standard for usability (not just preventing harms and frauds) new businesses have a chance of getting customers. If it is the wild west of “buyer beware”, won’t new businesses have a credibility problem that makes it very hard to overcome the established businesses?

  12. rationaloptimist Says:

    Yet new businesses do manage to gain a foothold and prosper, all the time. The main reason is that it’s fundamental to the human character to assume another is probably trustworthy, unless shown to be otherwise.
    Here’s a perfect example: out of the blue I got an e-mail recently from a guy in Tanzania selling coins. He was smart enough to realize that, what with all the Nigerian scams etc., nobody in an advanced country was going to trust a coin offer from Tanzania. BUT he was also smart enough to realize that customers in advanced countries ARE likely to be trustworthy. So the deal was: he sends the coins, THEN you send payment. I ordered. He didn’t know me, yet he sent the coins, on trust. And I sent payment (in fact before I even found time to open the package and check the coins, because I just assumed they would be what he advertised).
    Indeed, MOST of the world’s commerce happens on a basis of assumed trust.
    So when a new business opens, the assumption is that it will be trustworthy enough that it will supply what it purports to offer. How many times have YOU gone to eat in a restaurant without prior proof that you will get decent food and not be poisoned? Even, indeed, in foreign countries (where regulation may be dubious or nonexistent)?
    Yes, once in a while, you get burned, by a rascal taking advantage of this system. But that is truly a small price to pay for the stupendous benefits to consumers of the basic system.

  13. Mayuresh Says:

    But do you think that market/business/money/competition is a solution to all problems?

    Why can market NOT produce *great* things? e.g. commercialization of technologies do work but the core scientific principles and core inventions are produced largely by the non-profit organizations and academicians. I do not say Governmental organizations can do it. I know broken window fallacy. But I do not think that only profit could be *a motive that can lead ground for* all time great discoveries and inventions. Do you have any examples?

    Do you think that the language we speak, which has played a key role in developing our intelligence, which is at the root of all great products in market now, was produced by selfish/profit motives by our ancestors? Or the motive was exactly opposite – altruistic? If altruism had been so disastrous, evolution of human brain would have rejected this emotion.

    Are you a fan of Ayn Rand?

  14. Herb Van Fleet Says:

    For a mind blowing take on how the economy actually works, check out Ha-Joon Chang’s “23 Things They Don’t Tell You About Capitalism.”

    For example, “Thing 1: There is no such thing as a free market — Pace the glorification of the free market in recent years, this is largely a mythical animal. This is not just because of government interference, it is often because the private sector doesn’t want to be free, regardless of what it says. Even when we could hypothetically free up markets, we frequently wouldn’t be better off it we did.”

    For a good review, and a teaser for what’s in store if you read the book, (which I have) check out Ian Fletcher’s review at http://www.huffingtonpost.com/ian-fletcher/a-review-of-ha-joon-chang_b_840417.html

  15. rationaloptimist Says:

    To Mayuresh: 1. No, of course I don’t think the market “is a solution to all problems.” But, forgive me, the question is very silly. Saying it’s “not a solution to all problems” tells us nothing about any particular problems.
    2. Can the market produce great things? See my post on Steve Jobs! I am typing this using things he, in the private sector, totally innovated, and I do think they are pretty darn great.
    3. No, I do not think language was produced by a profit motive. Again, the point frankly strikes me as silly and irrelevant. Language developed because it helped humans accomplish many things.
    4. No, I am not a fan of Ayn Rand.
    To Herb: “The free market is a myth.” How many times must I answer this old chestnut? In fact, I answered it in the very post you are commenting on. No, we don’t have perfectly free markets. No, humans are not totally rational actors. But none of that means that to the extent we could make markets more free (and act more rationally) it would not be a good thing.

  16. Mayuresh Says:

    4. Good! 🙂 Neither me. I thought you were thinking on the lines of rational selfishness by her.

    2. Correct me if I am wrong – Mac OS X is influenced by Unix/C which was developed in Bell Labs. Bell labs is private, but unix/C is not motivated by profit. Unix is open source. Without C, there would have been no other higher level programming language than assembly level. Same thing with keyboards and touchscreens – Steve Jobs successfully commercialized them.

    1. I mean economic problems only. I am also not an economist. But, I wonder why you do not declare yourself an economist. I have seen so many people who for writing an article; self-proclaim as economists.

    3. The point is quite relevant. Free markets are fuelled by competition and create huge economic inequality. Economic inequality is further disastrous. A competition than co-operation among people takes us to debate rational-selfishness Vs self-sacrifice. So my question – what produced language and other important things that shaped humanity – competition or co-operation?

    I hope this discussion is not becoming an exchange of arguments. 🙂 🙂 🙂 Seriously, when people from diverse cultural backgrounds from distant geographical areas discuss with different view points – there are chances of misunderstandings.

  17. rationaloptimist Says:

    Market critics portray opponents as though having a maniacal belief that nothing in human life matters except markets. Just like some attack the idea of “scientism,” a supposed belief that science answers everything. No such absurd beliefs are actually held by any actual persons. These kinds of arguments do not help us in understanding the very real ways in which market economics — and science! — do enable us to advance human welfare.
    Yes, markets operate by people seeking to advance their own self-interests. Adam Smith showed us how all those efforts at self-interest, when combined, actually serve the interests of society as a whole. Yes, inequality does result. But without the motivation of people to achieve their own advancement — by providing goods and services others want to buy and willingly pay for — we would all be equal — equal in poverty.
    You may call me an economist if you like.

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