The Economics You Need

Enrico Colombatto

• Publisher: Routledge
• Year: 2016
• ISBN:
  9781317332688
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

This short book offers a rigorous yet user-friendly introductory guide for students who need to grasp the essential concepts of economics quickly. It provides a serious, clearly understandable and systematic account of the key elements of economics, with a focus on theory and principles.

The Economics You Need provides the ideal introduction for students approaching economics from other academic disciplines, as it uses only a limited amount of economics jargon, and is constructed so that several chapters can be read independently of the others. This book is structured around the premise that a set of theoretical steps are necessary for understanding economics as a way of thinking, rather than as a set of solutions. It also encourages the reader to consider alternatives to common assumptions, to acknowledge the need for value judgements and to foster fresh thinking in an imperfect world.

This engaging primer will be essential reading not only for students of economics, but also for students with a background in disciplines such as politics, international relations and business studies.

1 The economic way of thinking

DOI: 10.4324/9781315658988-2

1.1 On the nature of economics and the importance of methodology

Why should one be interested in economics and what kind of discipline is it? Simply put, economics is important because it offers a powerful set of conceptual tools that help us understand how individuals behave under scarcity, how they strive to improve their well-being without resorting to violence, and how they respond to the conditions and constraints that frame or otherwise affect their choices. In short, economics is about explaining people's behaviour and interactions when they cannot satisfy all their wishes and aspirations, i.e. when they must choose among different options and when they must explore the opportunities offered by cooperation and exchange.

In this light, then, economics is clearly a social science, since individuals operate in a social context defined by other people's actions and by the rules that apply to their community. Moreover, since observing and making sense of what one sees do not involve any form of judgement, economics can be regarded as a value-free discipline with no normative connotations. In other words, the economist's effort to appreciate how people act does not mean that he knows how agents ought to act, or that he is authorised to take action or to command them to change whenever he sees people deviating from his expectations or wishes. Of course, one can evaluate the moral content of individual preferences, as well as of the outcomes that interactions produce. Likewise, and perhaps more importantly, the economist should be aware that moral standards, culture and tradition, historical accidents and prejudice do influence individuals’ preferences and, therefore, choices and human action. Indeed, it would be difficult to understand and explain individual behaviour by assuming that people are just sophisticated robots incessantly busy with developing and comparing streams of quantifiable benefits and costs, and struggling to revise their decisions as new information flows in, or as they realise they have made mistakes. Nonetheless, the very process of understanding and explaining human behaviour is not a moral issue. While a good economic analyst should be equipped with a broad interdisciplinary background that spans law, history, psychology, sociology and statistics, he should also bear in mind that sound economics remains an exercise in logic, rather than in ethics or legislating. Methodological thoroughness is therefore critical, since logic and consistency originate from rigorous reasoning.

In this vein, it seems appropriate to devote the introductory paragraphs of this book to discussing a number of critical methodological issues that tend to be overlooked in textbooks and debates, because they will provide useful guidelines for the following chapters. In particular, we shall begin by highlighting the difference between economics and (economic) policy-making (section 1.2), then we shall examine methodological individualism (section 1.3), the role of time and uncertainty (section 1.4), failures and opportunity costs (sections 1.5–1.7). Section 1.8 concludes with a summary.

1.2 From economics to policy-making

As mentioned above, the essence of economic reasoning boils down to an exercise in consistent deduction based on a set of a priori assumptions about human action. Its purpose is to obtain value-free explanations of human behaviour under scarcity. Economic policy-making is different: although it relies on the same conceptual tools as economics, policy-making focuses on creating and implementing rules enforced by an elite – the policy-makers. It analyses the policy-makers’ purposes and operational features, and it evaluates the results their actions produce. Thus, policy-making cannot ignore economic analysis, since the consequences of rule-making are indeed a matter of human behaviour. However, the prescriptive traits of policy-making raise new categories of methodological questions. In this section, we shall briefly mention two of them: the concept of ‘common good’ and the incentives that drive policy-makers. While the paragraphs below are by no means an exhaustive account of the scholarly debate on these themes, we believe they will suffice to make the reader aware of the potential pitfalls involved.

Since the engine of economic behaviour is the individuals’ efforts to improve their well-being (or their ‘utility’, according to the economics jargon), the role of the self-interest broadly understood – the quest for material and psychic improvement – is apparent. By contrast, the engine of policy-making is the happiness of the community, or the so-called ‘common good’. Regrettably, however, this concept lacks an objective definition and can easily be abused. One can surely agree that given actions or goals are desirable per se and thus contribute to the happiness of a community. For example, there is no doubt that, other things being constant, a free holiday on the Riviera for all the members of a community would have a positive effect on their happiness. Yet, in a world of scarcity, the members of the community might have different views on priorities. For example, the free holiday mentioned would probably be financed with a tax on other goods, and it is not obvious that the consumers of those taxed goods are happy with donating a free holiday to the rest of the population. Put differently, we can easily – and we often do – end up in a world in which the common good means different things to different people.

Absent unanimous consensus, therefore, the policy-maker determined to act needs a rule that legitimises the violation of someone's preferences. Unfortunately, the search for such rule has not produced very persuasive results. Democratic societies usually adopt a rather simple operational criterion: the majority (or super-majority) wins. Yet, this standard amounts to a rather naive form of utilitarianism that draws much of its appeal from populism and expedience: it can hardly provide convincing definitions of good policy-making. More generally, the alternatives to democracy – e.g. absolute monarchy – also fail to gather undisputed agreement. The result is that prudence is in order: the observer/analyst should acknowledge that policy choices frequently involve assumptions about the moral justification of a given political system and that, therefore, policy-making should be regarded with philosophical reserve and a healthy grain of scepticism.

Sadly, the problem of defining the common good in the presence of conflicting interests – the so-called ‘social-choice’ question, according to the economic jargon – is not the only burden aggravating the policy-maker. A second source of issues originates from the fact that policies are implemented by human beings; and like all human beings, politicians, bureaucrats and even the judiciary tend to pursue their own goals, sometimes inspired by commendable altruism, sometimes by greed, vanity, prejudice or ideological biases. Put differently, it may happen that public actors operate in the interest of the community they are supposed to serve. But it might also happen that public actors deviate from this commitment and pursue their own interests, with little or no risk of being held accountable for misbehaviour. More caution is thus in order. Monitoring policy outcomes is a difficult job, and it becomes even more arduous when there is no foolproof method of selecting virtuous policy-makers.

1.3 Methodological individualism and the micro–macro divide

The previous section aimed at underscoring that the major divide between economics and policy-making pertains to the difference between the analysis of individual voluntary action (economics) and the study of the consequences of rule-making in the name of the common good (policy-making). The purpose of this section is to draw attention to the fact that in both cases, the individual remains the actor. This claim is the essence of what is known as methodological individualism, and it explains why the economic observer should always articulate his reasoning in terms of individual behaviour.

Common parlance and academic writing frequently distinguish between the analyses relating to individual agents and those regarding collective units such as a community, a country or a group of countries. According to this line of thinking, the former analyses would belong to the realm of ‘micro-economics’, whereas the latter would be a matter of ‘macro-economics’. For example, according to the traditional textbook view, the study of how an individual interested in buying a car responds to an increase in the price of cars or in his purchasing power is a micro-question. By contrast, the effects of a generalised increase in the propensity to save – say, in response to widely shared fears about living standards in old age − would be a macro-issue.

We do acknowledge that the micro–macro distinction can be useful in order to draw the line between explanations that pertain to individual decision-making and descriptions of what happens when many individuals are involved at the same time, are subject to the same stimuli, exhibit similar reactions and have a countrywide relevance. Yet, we argue that the micro–macro dichotomy is often confusing, since explanations and descriptions are different exercises, rather than two versions of the same logical assignment. After all, decisions are made by individuals, not abstract entities like ‘a group of people’. This is obvious in the absence of constraints: as free individuals, we choose and we bear the consequences of our choices. This remains true when one's actions are limited by laws and regulations, since it is still the individual who decides whether to comply with the rule and, if he does choose to comply, he chooses and operates within the perimeter defined by the rules. It is true that many people make decisions about the same topic at more or less the same time, and that one might call those many people a ‘macro-agent’. Yet, the outcome of these quasi-simultaneous choices is nothing but the algebraic sum of a host of individual choices, even when the individuals influence each other through persuasion or imitation. In other words, one may wonder what happens when several individuals make similar decisions simultaneously – either spontaneously or following orders coming from an authority, as happens in the case of taxation. Still, the answer must originate from the analysis of what each individual member of the group does, which is by definition a micro-question.

Methodological individualism also applies to circumstances in which decisions are formally taken by collective bodies like committees of government officials, corporate boards of directors or the members of a tennis club. If a representative operates according to a clear mandate that originates from a set of individuals, then the content of the mandate is defined by the individuals who have agreed on its substance (i.e., each member of the tennis club). Put differently, delegation is not enough to transform an individual decision into a macro-issue. By contrast, if the mandate is broad, indirect or vague, then decisions originate from the preferences of the members of the collective body and are thus individual (micro-) decisions, once again. For example, an anti-trust agency generally derives its authority from the legislature, which is formed by representatives who refrain from giving specific instructions to the members of the agency. As a result, anti-trust agencies end up being ‘independent’ and reproducing the preferences of the members of their boards, subject to some procedural constraints (collective decisions usually follow the majority-wins criterion). These members are of course individuals, not an abstract, collective body.

To avoid terminological confusion, therefore, one should be aware that there are categories of choices that affect a relatively small number of agents: buying or selling a pound of beef is a typical example. And there are sets of choices that affect a large number of people: that is clearly the case with monetary and fiscal policy. One can surely make a distinction and refer to these two sets of decisions in different ways. Yet, the line between ‘micro’ and ‘macro’ is necessarily arbitrary and – in our view – should be eliminated for the sake of clarity. This is what we plan to do in this book, in which we shall refer to economics when we study the economic way of thinking (the logic of decision-making and exchange in general); to the economics of consumption, of production, of money, of taxation, etc. when we apply the economic way of thinking to specific categories of activities; and to policy-making or government intervention when dealing with the consequences of coercive action carried out by an authority powerful enough to enforce its decisions.

1.4 Time: statics, dynamics and uncertainty

Having examined the nature of economics and the essence of methodological individualism, let us now move on to a third issue, upon which economists have written scores of articles and books: the role of time. Time affects the economic way of thinking from two different perspectives, which have originated the static–dynamic dichotomy and the debate on the role of uncertainty. We shall look at them in turn.

In brief, static analysis refers to situations in which nothing changes: individual preferences are constant, the quantity of resources available and the production techniques do not vary, and the legal context is stable. An observer engaged in static analysis, then, is equivalent to someone watching a photograph and considering whether its composition is agreeable and/or it could be improved upon: are consumers actually spending their money in the best possible way? Are producers using the most effective technique at their disposal? Are they producing the goods that buyers want to buy, or that an eventual social planner would like to see produced? Are there underutilised resources that could be put to better use? Are people's choices influenced by systematic distortions?

More generally, static analysis is useful whenever one wants to investigate the general laws of economic behaviour. After all, there is no need to develop major dynamic insights in order to appreciate that when the price of a production factor increases, entrepreneurs have an incentive to look for other inputs or different production techniques; or that if one considers having a long holiday, the choice between renting an apartment and staying at a five-star hotel depends – say – on how much one wants to spend, how much privacy one cherishes, and how much one is willing to engage in cooking and cleaning.

Nonetheless, reality is far from static and, furthermore, agents operate by evaluating the possible effects of their actions in the future. In other words, a snapshot is not an accurate representation of the real world, and decisions that do not seem immune to criticism in a short-run perspective might be correct if a longer time horizon is taken into account; and vice versa. For example, an individual might find it profitable to invest his time and money in professional education if his working life spans three or four decades, but he could be much less interested if he plans to retire in a few months. Thus, the dynamic aspect – in this case, where the individual is in his career path – is essential. In particular, dynamic reasoning is unavoidable in two broad contexts: when one is interested in examining the extent to which today's behaviour affects opportunities and choices in the future, and when one is interested in exploring how the environment could evolve as a consequence of today's choices. For example, today's decision to borrow money likely affects tomorrow's expenditure, since part of the resources available in the future will be used to pay back the debt. In a similar vein, today's decision to invest in innovative companies and possibly enhance technological progress might create greater wealth and new opportunities tomorrow. In other words, we all operate in order to be better off, now and in the future. Each of us may attribute different weights to the future, but it is clear that the future matters.

Although time is crucial, however, the future is not just the extension of the present, based on the information available at present. The notion of time – and thus the difference between the present and the future – is not an exercise that aims at stretching a past trend into a future trend (extrapolation). In fact, the notion of time includes the idea that tomorrow is intrinsically different from today: our preferences change, the range of products available evolves, production techniques develop in unexpected ways, some companies might go bankrupt and new companies see the light, new knowledge is created and/or acquired, and at least part of it contributes to shaping our new decisions. Trial-and-error processes play an important role, too, since time is also the process through which adaptation and learning unfold. We make mistakes every day and only gradually do we find out what we really want and how to obtain it. Engaging in extrapolation is equivalent to saying that we never learn and that nothing new happens.

In fact, the essence of the future is the presence of uncertainty, not extrapolation. And since economics is about scarcity, the introduction of time amounts to saying that the very notion of scarcity changes continually and that sometimes change is unpredictable: a quick look at the variance characterising stock markets or exchange rates provides plenty of evidence. In other words, one cannot ignore that the playing field changes all the time. Some two centuries ago, the lack of wood was regarded as a major constraint on the future of humankind; in the early twentieth century, the same was true for coal; and some 40 years ago for oil. All those predictions about humanity's future on the basis of these scarcities were exercises in rear-mirror gazing and each prediction has turned out to be false.

Unfortunately, economists have no recipe for neutralising uncertainty and they – like the rest of the world – must learn how to live with instability. Uncertainty is a fact of life, but uncertainty is not always undesirable. Indeed, it seems important to remember that if uncertainty could be elim...