Economics

A Beginner's Guide

James Forder

• Publisher: Oneworld Publications
• Year: 2016
• ISBN:
  9781780746401
• Topic: Volkswirtschaftslehre
• Subtopic: Wirtschaftstheorie

Markets, models, mechanisms and monopolies… most of us understand that economics is important, but what exactly is it – and what do economists do?In this fresh and engaging introduction, Oxford University's James Forder skilfully presents the key concepts crucial to mastering the subject. Combining theory with dynamic, real-life examples, he shows us why economics matters and how it shapes our world. Economics: A Beginner's Guide is the perfect introduction for anyone wishing to understand and interpret economic problems, both past and present.

1

Economics: the short version

There are four ideas which are crucial to economics. One is the idea of ‘rational action’, or of the ‘rational actor’, which is always at the centre of discussion, but sometimes misunderstood. Then there is the issue of what economic ‘models’ are and what they are for. Understanding those is essential simply for seeing how economists go about their business. Then there are two more substantive ideas which are essentials – the idea of ‘comparative advantage’ and of the ‘price mechanism’ and what it does. Between them, these ideas provide quite a bit of insight but they are also in one way or another the foundation of much more economic analysis. Beyond that, they also illustrate both the kind of metaphor used, and insights about how economic analysis can be related to aspects of a wider vision of economic society.

Rational action and the definition of economics

Economics is, as has often been said, whatever economists do. That is not much help, though, to anyone who does not know what they do. We might expect economics to be the study of the economy, and that is how it started, even if the originators of that study would not have had quite the same idea of ‘the economy’ that we do. A lot of study of the economy goes on in government and think-tanks, and the people doing it are certainly economists. In university teaching and research there is much less of that than might be expected. The study of ‘economics’ has moved on from studying actual economies – or simply moved away from it, perhaps.

Another possibility would be to say that economics is the study of markets, or ‘behaviour in market settings’. Actual markets are probably studied even less often than actual economies. If we say it is the study of ‘abstract markets’, then that again risks conveying nothing useful since it just raises the question of how we go about doing that.

As things stand, and if we think of what people do when they study economics, I would say that the best short definition is that economics is the study of rational behaviour and its consequences. That does not capture everything economists do – there are some issues where questions of rationality do not really arise. And there are economists who specifically set out to study non-rational, or incompletely rational behaviour. What they say about it, though, is always that they are addressing a limitation of conventional economics, and that is a clue about what it is that economists mainly do.

That obviously raises a question about what is meant by ‘rational behaviour’. All it really means is behaviour that is properly and effectively directed at some clearly defined objective, within the limits of what those concerned know or could work out. Very often in economics, the objective will be put in terms of maximizing something – maximizing profit is a likely example. So, a producer might be said to choose their price with the objective of maximizing profit. Then the point of emphasizing that they are behaving ‘rationally’ is merely that the price is well chosen to achieve the goal being pursued.

Almost anything might be the quantity to be maximized – along with profit, or personal wealth or welfare, there could be exam performance and museum attendance. Or the goal could be to minimize something – casualties, pollutants, spelling mistakes.

HOMO ECONOMICUS

Economists are often mocked – or sometimes condemned – for the idea of ‘homo economicus’, which means something like a stylized, ruthlessly calculating, selfish creature which does exactly what is required to pursue its own interests. Some critics say that the idea supposes we are dealing with a person who has no kinds of feeling for other people, no sense of responsibility, or obligation. There are two answers to that. One would be that there is an aspect of people, or some situations in which people find themselves, where that sort of view is very realistic. The idea of ‘homo economicus’ is just a label to say that we are thinking about that aspect of a problem. The second response is to say that we can treat the ruthlessly calculating individual as having all manner of concerns for other people, or social obligation. Charity workers who are trying to maximize the amount of money they raise could be ‘ruthlessly calculating’ about how they do it. In an extreme case, health workers who expose themselves to the risk of deadly disease can be thought of as fitting the picture of ‘homo economicus’. They are certainly not selfish, but they are doing everything they can to achieve a goal.

So, narrow self interest has nothing to do with it. It does not really matter whether we say the health workers are pursuing their ‘self interest’ and that self interest benefits others, or we say that they are maximizing something else. So long as we understand what we are talking about, the idea of ‘homo economicus’ serves perfectly well.

Some of those obviously do not initially look like problems in economics. But the idea is that the same kind of analysis can be used for them all. The student who wants to maximize exam performance has to balance studying time, the advantages of spending a long uninterrupted period working on a topic, with the problem of losing concentration; and the amount of time spent, all told, with the necessity of getting enough sleep and perhaps even doing the washing. The profit-maximizing producer has to balance the costs of different suppliers with the quality of their supplies or the reliability of their delivery, and perhaps the number of people employed actually doing the work, and the number of those required to supervise them. The cases all have the aspect of there being some goal to be pursued, various ways of pursuing it, and a problem to work out which is the best.

It can also be that the goal in question is stated as achieving a balance between things – like having enough beer for the weekend without its being too difficult to carry home. Or we might be stealing the most gold we can from the bank without taking so long about it that there is too much risk of the police showing up. In those sorts of cases we can always devise a mathematical formula linking the various goals so that we can think strictly of maximizing or minimizing the value of that formula. But the maths is not necessary to an appreciation of the character of the problem.

Similarly, almost anybody or anything might be doing the maximizing. It could be a company or a person; the person might be acting as a consumer, or a worker, or an employer. Or it could be an Oxford college, or a government, or a tennis club, or anyone or anything with the capacity to form objectives and take decisions about achieving them. Any of these, then, might be the ‘economic agent’ under discussion – that is not a spy who is careful with money, but simply whoever is making the decisions to be analysed.

A reaction to that is that people are not rational, even in this limited sense (nor are companies, countries, tennis clubs, and the like). People have whims and fancies, inconsistent desires, emotional reactions, weakness of the will. They also, we might add, reason badly, send regrettable emails when they are drunk, and just get it all wrong. Maybe that is true, but there are two responses. One is that in order to learn how much behaviour might be rational, we have to understand the outcomes of such behaviour. One of the fun aspects of economics is finding ways of looking at things which suggest that seemingly strange behaviour might in fact be a rational reaction to the circumstances agents are in.

I would place more weight on a different response. That is to say that the question of whether behaviour is rational is secondary to the fact that it is rational behaviour that is being studied. Perhaps some economists actually believe people are always strictly rational, although they are crazy if they do. More importantly, the irrationality of humans does not make the character of rational action uninteresting.

That definition also brings two other ideas quite easily into focus. One is the question of scarcity. An alternative definition of economics is that it is the study of reactions to scarcity. That has a great deal of merit, and the point is that to make the problem an economic problem, something must be in short supply. There must be something that needs to be rationed, or we are anxious to conserve, or that, one way or another, we wish we had more of it. Indeed, problems of scarcity do set the scene for many arguments in economics. But it is because resources are scarce that the problems of rational action are interesting ones. If they were not scarce we would not need to maximize what we can make out of them. These resources are then related to another recurring theme in discussions of the essentials of economics – that is, the role of incentives. Again it would be possible to think in terms of defining economics in these terms – it could be ‘the study of incentives and their effects’. In that case, we think of the gold thieves as considering the benefits of taking more gold and the costs of getting caught and how these things determine how much gold they take. If we change the incentives – by making the penalties stiffer, for example – no doubt someone’s behaviour will change. But again, most of the time, the incentives are interesting because they are amongst the characteristics of a problem that shape rational responses to it. So, again, it is the study of rational action and its consequences that is at the heart of the subject.

The idea of a model

One much-mocked aspect of economics arises from the use of ‘models’. So, what is a model? It is a collection of assumptions. That’s it. The mockery arises from the mistaken idea that models should be thought of as attempts at accurate descriptions of reality. It would be hard to get further from the truth. Models seek to capture an aspect of a problem, and put it under a bright light. A model is not a description of reality – it is not really a description of anything. Sensible models are designed to highlight some aspect of behaviour in an enlightening way, and good models succeed in doing so. We could think of them as being a bit like poems. No one ever asks ‘is the poem true?’ or ‘are its assumptions accurate?’ Rather, the poem invites the reader to see things in certain ways. Whether a poem is any good turns on what the reader feels is gained from looking at things that way. But it is insight, or understanding, or appreciation, that is at issue, not accuracy, or conformity with the details of the world, or testability.

So, here is a model. It is one that is often characterized as ‘more advanced’ in introductory textbooks, but there is no good reason for that. We assume that second-hand cars of a certain brand and type come in two qualities – good cars and bad cars. The ‘good’ ones are known by their owners to be reliable, whereas the ‘bad’ ones are known to be prone to breakdowns – they are all of the same brand and type so that is all there is to it. However, this ‘proneness’, we assume, is learned by experience – it is not discovered by inspection of the vehicle. There are owners of cars who would like to sell them – half of whom know they have good cars, and half know they have bad ones – and there are potential buyers of them, but they each wish to buy or sell only if they can do so at a price which is appropriate to the quality of the car. We assume that a seller of a good car would be willing to sell it for $6,000, and a seller of a bad car for $2,000. Buyers would, equally, be willing to pay $6,000 for a car they know to be a good one, or $2,000 for one they know to be a bad one. Or, we shall assume, if they know that there is a 50-50 chance as to what type it is, they are willing to pay $4,000. And, to make this properly a matter of analysing rational action, we assume that all concerned have highly developed reasoning powers about all aspects of the problem, including the market circumstances and each others’ opportunities, objectives, and capabilities.

There is probably a temptation to stop there (or perhaps it came earlier) and start thinking about which of these assumptions is ‘reasonable’ or ‘plausible’. It is better not to get involved in that at this stage. The one point that might be worth making is that all of those assumptions can safely be regarded as false. If there are some strange car markets where some of them are true, they are not important enough to be worth worrying about, and there are surely none where all those assumptions are true. So, the question of whether this model is ‘realistic’ is settled: it is not.

Never mind for now. At this point, the model has been stated, and we are moving on to consider what can be learned from operating it. So, first suppose – hypothetically – that all the potential sellers seek to sell their cars and the buyers know that is happening. Since there is then a 50-50 chance of any particular car being a good one, a buyer will be willing to pay $4,000.

The problem there is that the sellers of good cars are not willing to sell for that price. That means the buyers can be sure that it will not be true that all the potential sellers seek to sell their cars – here it is the logic of the model that tells us that the initial hypothetical supposition cannot be correct. Ind...