Some people would rather rub a raw onion in their eye then try to understand economics. That is unfortunate because the basics of economics are not that hard to understand. The fact is that you and I and everyone else use economics every day of our lives. It is liberating to understand why economic things happen, in the same way that it is liberating to know why a car takes longer to stop on ice or gravel. The essence of politics is the use of economic law to manipulate the behavior of citizens to the will of the politicians. Political motivations become more understandable in that light, though no more moral or justified.
Economics is merely an attempt at understanding the basic laws that work in our lives. It seeks to define and simplify our knowledge of the forces that affect us so we can make appropriate decisions. We similarly use the physical principles of gravity, momentum and force every day of our lives. In both economics and physical sciences, there are relatively few laws, which can be applied in understanding very complex systems. Unfortunately, many modern economists actually add confusion and complexity by repudiating simple economic laws, substituting complex macro-economic theories, mathematical models and personal policy preferences.
With that said, the basic laws of economics are truly straight forward and powerful, and arise from the way that humans act and make decisions. Because the logic of human choice hasn’t changed, the economic laws that governed ancient societies are the same ones that govern our lives today, as well as all future civilizations of any time. We can relate to historical characters from any place on the globe because they acted like we do. Their wisdom and their follies are reflected in our experiences today. All that has changed over time is the technology we use to satisfy our needs and wants.
One of the key concepts in economics is that incentives matter. Humans take specific actions to achieve specific goals. If the incentives change, it will affect the means and the ends chosen by the actors. Related to this is the idea that choices are made at the margin. The law of diminishing marginal utility implies that the higher the quantity of a good a person has, the lower the marginal utility, or value, the next available unit holds for that person. If you are dying of thirst in a desert, you would pay almost any price for the first cup of water. You wouldn’t value the fifth cup nearly as much because your thirst would be quenched. You would value the 1000th cup of water much less because you can’t carry it and it does you little good. It’s marginal utility is very small.
The fact that the current market price for a good is $1 doesn’t mean that everyone is willing to pay a dollar. Some people would have a higher marginal utility and be willing to pay more, while others wouldn’t buy it unless it was cheaper. It only means that, at that price, the number of buyers at the margin, those willing to pay at least $1, are about equal to the number of sellers at the margin, those willing to supply it for $1 or less.
This is typically stated as economic laws of supply and demand. If the price of a specific good is lowered, buyers will be enticed to purchase more. We see this in every day life as retailers so often use discounts and sales to move inventory. If the price is raised, the quantity demanded will be less. On the other side of the coin, suppliers are in business to make profits. It will be difficult to make a profit if prices are too low, and very little will be supplied. As prices increase, it becomes easier to earn money, thus suppliers produce more, and new competitors are drawn to the market. Supply increases with increasing prices.
The incentives for buyers and sellers are at odds, and for every good in a particular market at a point in time, there will be a price where the number of willing buyers about equals the number of willing sellers. Any price above that point will produce an excess of sellers, a glut of goods. Any price below it will produce an excess of buyers, a shortage of goods. That simple relationship is one of the most powerful keys to understanding economic phenomena, whether it is Hurricane Katrina shortages or gluts of labor, more commonly called unemployment. Prices, demand and supply are all mutually dependent and reflect the market environment at a particular time. Imposing an artificial limitation on any of them will have inevitable unintended consequences, often very powerfully.
With this understanding, it is possible to comprehend the bulk of the phenomena occurring in society, and in politics, on a day to day basis. There is a lot more to it, of course. A very important aspect of economic laws and concepts from an overall point of view is that they can help to understand why an economy progresses or regresses over time.
The laws of comparative advantage and division of labor are related and work together in determining the level of productivity and prosperity of an economy. Comparative advantage means that any person, organization or geographic region has specific advantages, whether that is because of natural resources, innate skill, education and any number of other characteristics. If the actors concentrate on those things that they are most productive at and pay other people to do the things they less productive at, everyone will be better off overall. A typical example may be an attorney who may have better secretarial skills than any secretary available. But since attorney’s make a much higher hourly rate than secretaries, the attorney will be better off by doing attorney work than secretarial work. The secretary likewise would probably be better off leaving attorney work to the attorney and concentrating on the areas where relative skills are the highest.
Division of labor is the recognition that everybody has only 24 hours a day. It takes a great deal of time and effort and the right tools to be highly productive in any endeavor. Nobody cannot develop all of the skills and purchase all of the tools needed to be highly productive at all types of activities. People or geographic regions that try to be self sufficient will lead a very poor, difficult life and work very long hours.
A surgeon may be very good with his hands, but will probably hire someone to do his plumbing, carpentry, auto repair and so on. He could probably develop some low level of competence in each of those areas, but in order to do that, he would probably sacrifice very valuable time at which he is most productive. In an advanced society, there is a strong tendency toward specialization because it leads to higher productivity and a higher standard of living.
Because people who specialize are generally more productive, they have more income with which to buy the goods and services of other people. Most people in modern society outsource most of their requirements to other people or businesses. They outsource their food requirements to grocery stores and farmers. They outsource their automobile needs to car manufactures. They outsource their homebuilding needs to experienced carpenters, and so on. By building a high level of competence in one area, you are able to trade with others for the things for which they have built a high level of competence. That is what trade is all about. We outsource our requirements to others who are more highly qualified in those areas, and thus, both sides reap the benefit.
If you define progress in society as that state of affairs where people have to work less hard for less hours in order to provided for themselves and their families, then the higher the level of division of labor and the more people can apply their comparative advantage, the more quickly they will progress to a higher level. The wealth of a society comes from people producing more than they consume. Over time, that wealth can be used for capital investments that enhance the productivity of participants, and thus, further raise their income and standard of living. Societies that restrict trade and inhibit capital accumulation and specialization are those that remain in perennial status of less developed countries.
The laws of economics hold many important lessons on a day to day basis. You can try to disobey them, but it is similar to disobeying the law of gravity. You can step off a tall building and think you won’t fall, but your funeral will be just as sure as if you realized you would fall and die. The most critical lesson that economics can give is that actions have consequences. Good intentions and powerful politicians don’t make a bit of difference. The more we can gauge the true consequences without sentimentality or blinders, the more likely we are to make decisions which avoid the pitfalls and lead us to our goals, as individuals and as a society.
Yes, division of labor, specialization, and excess production (I guess what Raymond calls production with savings, though I call it production with investment) have improved the lot of mankind. It’s amazing how many Americans know who the bimbo of the day is dating than know these important facets of economics. As a social conservative, I’m saddened that the people championing those ideals have done such a poor job of explaining economics, and the relative strengths of our system (and the required conditions for our system to continue to succeed, such as integrity).
As President Bush gave his farewell speech, I was struck with the thought that history may find that the greatest black mark on his term was this economic meltdown, and his inability to keep the Federal Reserve from creating it. No one seems to understand that yet, but it was many years before conventional wisdom found the link between the Great Depression and constrictive monetary policy. The sooner we figure it out (and I’m not sure the Fed is following through on their promise to create more money to the extent some thought), the better.
Hi Dan M,
Thanks for this – very useful. I’m aware of the concepts you mentioned, but it’s nice to know exactly which such ‘rules’ are upheld by the Austrian school.
That said, can you go a little further and explain in simple terms for me how you feel the laws of comparative advantage and diminishing returns lead to:
a) the rise of the nation state
b) war between nations
c) the demographic transition, in which birth rates in advanced economies fall off with increasing prosperity.
It would be interesting to see which if any additional factors (hidden laws) you may need to introduce to generate these explainations.
- Dan W
Hi Dan W,
The article was not meant to be a comprehensive listing of every economic law or concept, but rather a discussion of how few relatively simple laws can help to understand human phenomena. With that said, I think that economic concepts can easily help to understand even things like the formation of states and the causes of war.
Economizing behavior is important to economic understanding. People will choose behavior that is the least cost to them, not necessarily in terms of money, but in terms of everything they have to forego, the idea of opportunity cost. People will do what gets them what they want with the least effort.
The concepts of human action, the idea that humans use means to attain ends, are related to economizing behavior in understanding how states arise and how wars are started. There is a difference between legitimate means and illegitimate means. Libertarian tradition holds that it is illegitimate to use violence or the threat of violence as a means to attaining ends. The exception is in defense against someone using violence against you. Those who stand opposed to the libertarian tradition assert that it is legitimate to use aggressive force and coercion as means to their ends.
Thus, there are two basic methods of achieving your goals. One is the use of markets and free and open trading, where both parties agree and exchange is voluntary. The other is the political means. It is the use of force, violence and/or coercion to get what you want. The political means is the abrogation of markets. Exchange is involuntary, usually under the threat, actual or implied, of the use of force.
In that sense, political means are the dismissal of economic laws, the belief that one is not bound by them. That belief is incorrect and, in the end, the people always pay the price of the mistakes of the anointed elite.
Nation states can arise from the desire of the people of a country to protect themselves against the force of other potential aggressors. That gives the government of the nation a certain amount of legitimacy in the eyes of the people. It is, in effect, the hiring of others for the service of defense. That, in itself, is an economic decision to the extent that it is truly voluntary, and the service itself is truly defensive and not offensive. To that extent it may be legitimate.
The problem with nation states is that power is rarely, if ever, limited to legitimate purposes. Lord Acton stated, “And remember, where you have a concentration of power in a few hands, all too frequently men with the mentality of gangsters get control. History has proven that. All power corrupts; absolute power corrupts absolutely.”
Some people, in their economizing behavior, discover that it is often easier and more profitable for them personally to use political power for gain than it is to compete in markets for goods, capital and labor. They use illegitimate means to achieve their goals. In that case, it is always a zero sum game or a negative sum game, someone wins and someone, or many, lose. The power is used to manipulate market relationships by restricting prices or activities of market participants to the benefit of the politically connected, or the direct stripping of property rights from the victim.
The gangster mentality is prevalent in all modern states, the idea that they have the right to coerce others to comply with their dictates. Wars are the use of force between the gangsters in different states. The gangster uses what means he has available, whether legitimate or not, to force the enemy to comply. They are economic phenomena to the extent that they use means to attain ends. The results of wars are always economic phenomena. The costs of war and the costs of states’ abuse of citizens rights always, without exception, follow the laws of economics. Kings, governors, presidents and parliaments can never break the economic laws. They can only break their people upon them, and they often do.
To the extent that people are free to trade within and between nation states, they will benefit from division of labor and comparative advantage. To the extent that trade is restricted, they will not reap their benefits, nor those from any other economic law. Those states that most restrict trade hurt their own people to the greatest extent. You will find that some of the highest tariff walls are built around poverty stricken nations, in the disastrously mistake assumption that they protect against outsiders.
As far as demographic transition from high birth rates in developing regions to low birthrate in developed regions, it seems pretty apparent to me that there are quite fundamental economic phenomena at work. In a poor society, lack of sanitation, lack of health care, poor nutrition and a host of other factors contribute to a high mortality rate among infants and people of all ages. Poor families depend on the work of offspring to contribute to the welfare of the family. That is why child labor is prevalent in poor countries. It has nothing to do with labor laws. Manual labor without the benefit of capital improvements necessitates children helping to provide. The net result of families needing helping hands, along with the expectation that many of those helping hands will not live long enough to support the family, is that many children are born to make up for the expected losses. It is cultural, but it is based on economic reality.
As a nation transitions to a higher level of wealth, families don’t have to struggle for existence. It is easier to provide for the needs of the family without the children needing to work. As the level of health improves, many more children survive into productive adulthood. Fewer children are born per family because they are not needed for survival. As the physical needs are satisfied, the incentives are re-prioritized. Child labor is not prevalent in developed countries, not because there are child labor laws, but because families are well off enough to want better for their children. They send them to school rather than to work. Large gaggles of children are a burden to families when they are not contributing, but rather only consuming. The incentive is for fewer children and smaller families, so they can provide a better standard of living for their families. This, again, is all based on recognizable economic incentives, which may or may not become embedded in cultural norms.
This phenomenon of large families is a fact of life in Amish communities in America for the very same reason that it occurs in developing countries. The Amish shun many of the modern advances in productive capacity and comforts of modern life. Thus, they require many helping hands to make the family function successfully. They seem to be very happy with this situation, but none the less, the conclusion must be that they are acting economically in having large families.
Dan M, thanks for the detailed reply.
Regardnig nation-states, I think common defence is well down the list in terms of the dynamics of their formation. Note that I used the term nation-state, rather than just state. A nation is a cultural entity, implying shared language and cultural heritage. In general it is the cultural self-similarity of populations which binds them together against neighbouting, culturally dis-similar populations. Think for example of the huge differences between the dutch speaking and french speaking populatins – their language differences (and further back, their racial differences) are the main reasons why we have holland and france, not some arbitrary decision long ago to form a collective defense pact. The free flow of information and trade withni a cultutally similar region then makes it easier for a state to be imposed on top of the nation, which may indeed be driven by a need for common defence, or driven by the powerful few binding together those elements of the population which are likely to stay bound, to further their own power.
So here, I suggest that issues of culture and race trump ‘economic behaviour’.
Moving to war, this once again is often as a result of cultural differences in addition to conflict over resources. When in the heat of battle, men are more easily motivated by a deep and irrational cultural or racial hatred of the enemy, than they are by the desire to take from him his riches. After all if you die in battle, who cares whether the enemy was rich or not.? This is not rational behaviour.
Finally demographics. What is the main reason for population decline in the PIGS (south european) countires? Prosperity is one factor, but these countries are poorer than north europe but exhibit higher population decline. The theory is that this has more to do with the outdated attitude towards women in these nations than it does with prosperity. Because women in these countries are expected to stay in the home once they have children, the young women in these countries, who want to join the workforce, either don’t have children of wait until they are in their late 30s to have them. This is the main reason for their decline. Again, while the woman’s decision here is a rational economic behaviour, the cultural attitude that forces an either-or choice between work of children, is not rational. Hence, the population decline of PIGS nations cannot be fully accounted for by economizing behaviour.
Would you accept that cultural, sprititual and inter-racial aspects of human nature and behaviour are not rational, but still have huge and often very subtle effects on how events develop, which can trump the economising behaviour you speak of?
Hi Dan W,
I strongly agree with you that cultural, spiritual, inter-racial and many other factors in human behavior have great effects on events. I think that interpretation of words and definitions is blocking the way to understanding again, however. The economic behavior I am speaking of is the very basic idea of human action. Humans use means to attain ends. In that sense, there really is no irrational behavior.
Everyone has certain assumptions about reality that form the basis of their understanding and actions. Those assumptions may be true or they may be false. The more false assumptions held, the harder the individual will have in dealing with life’s opportunities. Those assumptions are the result of our learning and experience throughout our lives, which includes cultural, family, educational and many other sources. Sometimes one shocking experience can drastically change our assumptions, possibly ingraining false impressions that affect the rest of our lives. When someone does something that we think is irrational, it is only because we do not know what assumptions the seemingly irrational person is using. Their belief system is very different than our own.
An insane person still uses means to attain ends. The assumptions embedded in his brain are, for some reason, no longer in touch with reality, but to the extent he makes choices, he still uses the same process that everyone else does. He tries to get what he wants but in seemingly bizarre ways.
When I talk about behavior that is least cost to people, it really has little to do with money. As you say, people with similar cultural backgrounds generally aggregate together. That is why our cities have a “Chinatown”, a “Little Italy”, Swedish neighborhoods and so on. Those people make the decision to live with each other because they don’t have to waste time getting other people to understand their tastes, their language, their customs or any other shared trait. They share those traits because their assumptions about reality were formed under similar circumstances.
That is what makes the push for diversity everywhere with everybody so misguided. It is not a bad thing to have Italians live in an Italian neighborhood. It makes their lives easier. It is comforting to have someone to talk to who knows what you mean and relates to the same things you do.
Problems arise between cultures, races, sexes, etc, only when one tries to impose their values onto the others. That is the difficulty in countries with strong national cultures. The French expect everyone to act like Frenchmen, he Germans like Germans, etc.
The United States has been called the melting pot because so many people came from so many different places. For a very long time, they were each allowed to have their own culture. Nobody imposed an “American culture” on them. It was more of a live and let live atmosphere. That was not always the case everywhere, but it was the general rule. It is much less the rule now, when strong national government imposes its will on all people, regardless of culture, of likes, dislikes, or assumptions about reality and about the future.
Imposing a centralized vision upon an entire nation is the way to make for discord, disunity, misunderstanding and hatred. People don’t act like the planner thinks they should, and force and coercion is necessary to impose sameness and orthodoxy. Not everybody wants to pay the same price to attain wealth, status, possessions, religious beliefs, or any other facet of a complex society.
War results primarily from the elite politicians of a society trying to impose their will on foreign people. The ordinary people never start a war. They can be whipped up into support of the effort through propaganda, altering their assumptions about reality. In almost all cases, wars are fought by the politicians for the benefit of the politicians. The people are used only as pawns. In each case, the politicians use means to attain ends. We may not agree with those ends. We may think they are evil. We may recognize that the politicians are lying to the people for support. We, as outsiders, may recognize that the means that they use may be doomed from the beginning. We may think that the decisions of a Hitler or a Stalin were not rational. They were, however, using means to attain ends, the very same way that we decide to drive a car to get groceries.
In the sense that I am describing economic behavior, there is no exception at any time. It is the result of being human, of using human logic and making decisions. The laws of economics derive from that logic, and thus, they always apply, whether a monetary market is involved or not.
Mother Theresa worked among the poor in Calcutta for a reason. She believed she was better off doing that than anything else she could imagine. And she was right.