Forget about the Economists… Economics 101

Given that this is an economy blog, it seems the headline is, at least, challenging. After all, economists are held in high regard, as the experts in the scientific field of economy. They have all those complex formulas to explain, predict and plan the economy, haven’t they? They have after all studied the field, act as counselors for the governments, tell us what’s wrong and give us advice in troubling times where the complexity of economic events become overwhelming, do they?

This is not an academic journal, so it would be off the mark to argue about all those „scientific“ claims made by most economists. One of my former co-workers, a Scotsmen, once told me the phrase that “common sense is not very common.” I have to agree. So, this article is based on common sense and how it helps to understand economy.

Since most of us have too much to do to get the daily chores done and to make a living, we have little time to spend understanding fancy phrases and economic babble. And if I had the choice to watch, say Jon Stewart, or read John Maynard Keynes, in my spare time, I would sure switch on the TV and throw the “General Theory” into the bin. Guessing that most of my fellow citizens would do the same, it is no wonder, that economic science rests in an ivory tower guarded by a huge army consisting of terms and phrases that the “common” man does not even know how to spell let alone knows what they really mean. You remember the story of the emperors clothes?

Mind, I am not saying that economy is useless. In fact is is much to important to leave it to the scholars in the ivory towers. Economics is about the essence of our lives and therefor “essential” to all of us. I promise I will try to keep fancy words at a minimum, and where I use them I will explain them.

Well than, let me start with some explanations. Economics as a term is derived from ancient Greek oikonomia – which basically means the rules of the household as oikos is the house and nomos means law. Because we all live in households, and all have, at least some, rules how to run it, we all are engaged in economics. In short, economics is your and my everyday struggle to survive. No need for fancy phrases here so far.

The first question that comes to my mind when I consider this would be, why do I have to struggle to survive anyway? I mean, wouldn’t it be cool to survive without any effort? Indeed, that would be cool. Yet, we as humans have a lot of empirical (another fancy word meaning “by collecting historical data”) evidence that we can not survive by doing nothing. Men has always dreamed about such an environment and we call it paradise. Alas, reality looks different. Question is, what keeps us from being in paradise? Ok, I don’t mean the angel with the sword. There are two things that keep us from the kind of paradise described above. First, scarcity and second uncertainty about the future. Think of all the basic ingredients a human being needs to survive. Air to breath, food to eat, water(well that would be very basic) to drink and, given the absence of a natural fur, shelter.

If you are still with me (which means probably that Jon Stewart is not on the program yet) I ask my next question. Which things of the list above are scarce? Well air is not, unless you are a scuba diver trapped in a wreck 30 feet below the surface of the Atlantic with a half empty bottle of air. Food is sure scarce, even if you have a well equipped fridge with bulks of your favorite Alfredo style Lasagna. The same goes for beverages. While there is no need to search for ways to get air, you can just breath, you need to find ways to get food and drink, and shelter. You have to spend time to get those vital things (unless you still live with your parents that is).

Good, we now know that some stuff we need is scarce and we have to do something to get it. But, why do we have to do something at all? Because, we do not know the future. If we would know everything that will happen in the future, we would not act at all. If I was hungry, and knew that in 2 minutes a roasted chicken would fly into my mouth, why bother to think about going out to hunt? Yet, I am pretty uncertain this would happen ever. Omniscience (well, remember my promise about fancy words), which means to know everything of the past and the future, would prevent us from doing things. Or, to say it in another way, we only act because we are uncertain about the future.

Now, what is action? Action is what we do to achieve our goals. What we do is using means we have at hand, or think we have at hand, to get us closer to the goal we desire to achieve. Wew, starts getting complicated, doesn’t it?

Let me give you an example. If you are hungry, and you are not a masochist, you probably have the desire to feel full, as hunger is a painful feeling. Now, we know that probably not much roasted chicken fly through your kitchen within the next minutes. But, you know there is some bread, tuna, salad and mayonnaise there of which you could produce (hey you are a producer) a tuna sandwich, eat it and fight that painful hunger. So homo economicus, that is you, starts acting. You take your means – bread, tuna, salad, mayonnaise and your skills in preparing those yummy sandwiches of yours- and employ them to make that great product which will be consumed by you and, hopefully, brings you the desired satisfaction -feeling full.

You just encountered one of the economic rules (remember economics means rules of the household) “Humans act, that is they purposefully employ means, to achieve what they desire”.

We have already scratched the surface of another rule when we talked about the difference between air and the other vital things. It is the rule of subjective value. Subjective means, that it is always you, or more accurate, the individual, that gives value to an item. Air has no value to you, as you do not have to act (that is purposeful employing means to achieve ends) to get it. It is abundant in a normal environment. Remember the scuba diver (he is still trapped in that wreck)? To him air is pretty valuable, don’t you think? He probably would put a lot of effort into getting more. To him air is a good.

Another important rule we have here. Goods are things that have a value to individual humans. For something to be a good, it must be a means that an individual can use to achieve what he/she desires and it must be scarce. Bottom line, whether something is a good or not, depends on its usability for individual men. Another word for usability is utility.

Before I close this first short excursion to “common sense” economics another example tho show that something is a good only, if it has a utility for individuals.

Oil was the pest of every piece of land until only a hundred years ago. Whenever a farmer encountered those black, ugly, stinking springs on his land he was probably going to curse, even if he was a puritan(not meant offensive). Oil was not only worth nothing, yes it has been used in ancient warfare to ignite enemy ships, but this was long forgotten, oil was seen as bad luck if you had it on your property. Why? Because no one had any use for it until a guy named Rockefeller showed up and invented a way to make stuff called kerosene out of it. Now Kerosene was pretty useful. You could use it in lamps (can you imagine to have only daylight, how boring nights, especially in winter, must have been…uhm), and some people even experimented with it to build engines that might one day drive coaches without the need for horses which would be called cars or automobiles(which is a bad name because they do not drive by themselves as the name suggests).

All of a sudden, a good rose out of a totally useless thing like oil. And today, we tend to believe, with good reason, that our civilization might fall, if oil vanished.

Economics is not about complex equations in an ivory tower, but about human ingenuity to transfer the natural resources man finds into something useful.

8 comments to Forget about the Economists… Economics 101

  • thanks for your common sense.

    I would assume that you realize that not all academic economists are stuck in model building. What you describe is the economics of Ludwig vom Mises in “Human Action” and the Austrian school of economics.

    I heartily agree with you that most of contemporary economics is a pathetic mixture of mathematical games and political posturing. That is why modern economics is so dismal, rather than being the robust explanation of human phenomena that it should be.

    I look forward to more of your common sense.

  • You’re spot on, Norbert! Economicss is simple, common sense!

    After some thirty years of teaching the “dismal science” I am writing a book on economics geared to readers who want to know how it all works.

    I discuss and illustrate the basic ideas without the math and graphs and charts yet make the subject as plain as day.

    Supply and demand is key, of course, since it’s been proven so many times. Everything is limited! (Even air – have you ever been to Houston or L.A. or Shanghai or any of a thousand spots on the globe on a “bad air day?”)

    So is the fact that mankind wants as much of anything as possible.

    That leads to an assumption about human nature.

    That, in turn, results in people having to make choices about everything, from tuna salad sandwiches to their form of government.

    The book, “Economics Without Widgets”, is written in everyday English that anyone can understand. (With he right publisher it can be translated into a gillion different languages!)

    It’s designed as a help to existing textbooks – not as a replacement. It’s just common sense.

  • As others have said before, one of the first lessons we learn about economics is that it is the study and understanding of the”scarcity” of goods and services meant to satisfy human needs and wants. If by some miracle, we were to have enough (or a surplus), there would be no need to study economics, at all.

    Just as mathematics is generally based on four basic functions (addition, multiplication, substraction, and division)-in order to truly understand economics at its basic level, one has to learn about scarcity and how that relates to concepts such as “supply and demand.”

  • Dirk

    Norbert,

    A couple thoughts came to mind reading your piece.

    First, humans generally act because they are certain about the future. For example, if you don’t eat, you may lose weight and look better, but eventually you’ll starve. So most people eat- although there are a few who have warped body image that overwhelms their sense of self-preservation and develop eating disorders. And consider investors- the greater the uncertainty in a market, the greater the unwillingness of them to invest to enter it, wouldn’t you agree?

    Second, there is a difference between what people desire and what they should have. For example, a big house is really nice, but on the other hand the cost to keep it heated, cooled, maintained (not to mention mortgage and taxes) is higher. So lots of people built big houses (and the ones I see currently being built are bigger than ever!), though many now regret it.

    Third, your last point of substitutionary technology and choices is huge. Oil is a good example, but I think solar is perhaps better. Without humans, all you have is sand and sun, with them- solar panels that can create electricity for billions of years. But this change creates risk for investors.

    What makes economics more complex than it should be, in my opinion, are, then, three factors-

    1. The opinions of those who believe we are running out of raw materials- air, metals, clean air, land, oil, etc. and thus we need to constrain economic growth;

    2. The opinions of those who believe that these shortages require rationing, and therefore, societal/governmental oversite of economic choices;

    3. The combined effects of 1 and 2 on monetary policy and interest rates. In the old days, an inventor could ask the King for support, and if the King felt they were smart, he’d give them support with no interest and no concern about running out of goods. Yet, today, when an inventor looks for support he’s often asked to promise repayment of money, with interest, and personally guaranteeing repayment. This has the effect of holding down innovation and creativity, and providing advantage for government-sponsored inventors and entrenched technology.

    I feel we fell into this latest economic crash for the same reason we have previous ones- Fed monetary constriction. Now, if we really are running out of scarce goods, then let’s put it on the table. If we really do need government to make our choices for us, let’s put it on the table. And if we don’t believe technology and human innovation can overcome the first two issues, then let’s put it on the table.

    But I think that kind of Scarcity Paradigm, Government Rationing worldview is just as warped as those with severe eating disorders…

  • Wew,

    Never thought i get so much so well balanced comments so fast.

    Regarding the headline, Dan mentions, this was an eye catcher to get people start reading. :-)

    I know that economists are not all, maybe not even in majority, a crowd of useless scholars in an ivory tower.

    My idea of the series of articles I am planning is to give a congruent step by step introduction into economics to help evaluate current events from, agreed, one economic point of view. What I like to show is, that this view does not contradict itself and is deductable to the very basic axioms about human beings.

    Ok, now I have outed myself for any other economist reading this :-)

    Thanks Stephan for the credits from a pro.

    Dirk, you might want to reconsider your statement, that man act because he is certain about the future. I agree, that we have some good experience of what would happen if we would not eat, but we are at least a bit uncertain about what exactly will happen, so we take actions, compare the results with where we wanted to be, adjust and act again. This is basically what i meant. In that sense we can never be sure about (1) the outcome of our actions (2) the next step we will take.

    In terms of the raw materials, I agree. A thing becomes a good when at least one human has a need for it. And, more important, goods are produced. Even raw materials have to be dug out, or extracted or grown, i.e. produced. I would think that in that sense we are not endangered to ran out of raw materials. We have a thread with the current goods we use to achieve things, like oil used to produce energy etc.

    The challenge is not new and I am a positive thinking guy. So I would say we have to come up with something better suited with our goals. If we do not like to breath polluted air, than we better find a way to produce what we think we need by means that do not require to pollute.

    I would also question if we can decide what others ought to have. But that is another issue even though it palys a significant role when it comes to your point 3, that is rationing and regulation.

    One of my favorite intial arguments against rationing is that it might extend the time we can use a certain good, but it can not invent anything to replace the goods that become too scarce to be used efficiently.

    Or in short Planning copes with what is, inventing with what is not…yet.

  • Raymond

    Scarcity — deficient in quantity or number compared to demand.

    People under the old Socialist economy of the Soviet Union
    endured shortages of food supplies.
    The central planners had the resources of the soviet state at their disposal yet they could not solve chronic shortages, for such a basic need. The ideology of an egalitarian society
    was applied to the Soviet economy by it’s central planners with disastrous results.

    But that’s because their economy does not have the profit-seeking( loss-avoiding) entrepreneurs utilizing private property to respond to demand– signaled by price.

    The central planners had no market feedback mechanism to guide their production— Freely fluctuating market prices.

    Prices aligns production with consumption in the market economy. So a rising price for a good, say brown rice, signals to entrepreneurs that profits are available in producing brown rice. Consumers let them know if their methods are sound if they’re making profits.
    Profits attract new entrants into the market. To the extent that new entrants borrow from the limited pool of savings, their demand for the money will naturally raise the price of borrowing (rates).
    Potential entrants to brown rice production will judge their chance for profit by comparing the now higher Price of money versus the anticipated price of brown rice in the market. As the new supply begins to fill the market demand, the Price for brown rice falls signaling lower profits and discouraging further production. The crucial economic calculations that entrepreneurs routinely perform functions as an efficient allocator of resources. Motivated by profit making (and loss avoiding) and guided by Price signals from the market.

    A function that cannot be duplicated by central planners nor central bankers.

  • Excellent post, Raymond! Correct me if I’m wrong, but I seem to recall that this was indeed a key argument made by Mises: that central planners could never effectively regulate and act on supply-and-demand more efficiently than a free market economy.

  • Norbert Haag

    Raymond is basically right. Just one remark to clarify this argument a bit more and strenghten it. What makes socialist economy, that is central planned economy, impossible is not the lack of consumer prices, but mainly the lack of prices for capital goods.

    To produce brown rice, to take your example, several “factors fo production” are needed.All sort of machinery, conveyor belts, energy, labor you name it. Before you can start producing your brown rice you need to go to the market to buy all these things. On the market you compete with all other entrepreneurs who want to produce something and need those things you like to buy too. The combined market prices you will have to carry tells you if you can produce at a profitable margin. Or better, you believe you can.
    Because factors of production are not specific to the brown rice market, Iron for your brown rice machinery can be used for other stuff as well, you actually bid against other products and their demand.

    That way the market prices of the factors of production you need for your brown rice factory, reflect the preference of other uses compared to your product. If a huge desire for say cars is in the market, than the price for iron will rise maybe even to a range where you can not compete for it anymore. This way the market achieves to shift the factors of production to the place where they are valued most and therefor adjusts the production of any good to the demand.

    There can never be a market price for factors of production in a socialst or planned economy, because there is only one owner. For a price to come into existens there must be a transaction between 2 parties. One that wants to sell and one that wants to buy. If both agree on a price, than the one that sold benefits and the one that bought benefited too, else, no transaction would have taken place.

    The absence of a market of the factors of production and therefor the inability to distribute them according to the demand is why planned economies can not work.

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