1 the nature and scope of economics -...

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1 The Nature and Scopeof Economics

1.1 Economics as a Social Science 4

1.2 “Economic Man” 9

Rationality 9Human Goals – The Self-Interest Assumption 12Ignorance and Uncertainty 16

1.3 Market and Nonmarket Interactions 16

1.4 Allocation by Prices – The Market System 18

1.5 Behavior within Organizations 20

1.6 Positive and Normative Analysis: “Is” versus “Ought” 20

1.7 Elements of the Economic System 21

Decision-Making Agents in the Economy 21Scarcity, Objects of Choice, and Economic Activities 22

1.8 Microeconomics and Macroeconomics 23

SUMMARY 23

QUESTIONS 24

EXAMPLES

1.1 The Ecologist, the Economist, and the Statistician 61.2 Earnings of Male College Graduates, by Field 81.3 Rational Drivers? 101.4 Rational Malingering? 111.5 “Irrational Exuberance” 111.6 Selfish Economics Students? 141.7 Selfish Economics Profs? 151.8 Crime as an Economic Choice – “Three Strikes” 161.9 Bidding for Faculty Offices 181.10 When Do Economists Disagree? 21

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4 1. THE NATURE AND SCOPE OF ECONOMICS

Economics concerns decisions – choices among actions. Every action has its pros andcons, pluses and minuses, benefits and costs. Are you thinking about taking up tennis?The game may trim your figure and improve your disposition, but will take time fromyour studies and could damage your joints. How about dropping out of college to takea job? You would likely earn more money now, but earn less later in life. Similarly inbusiness and government. Whether it’s a small action, as when your neighborhoodmarket sets its price for potatoes, or a big one, as when Congress decides on declaringwar, almost always there are valid arguments for and against. Faced with such opposedconsiderations, how should individuals, firms, or governments make decisions? Eco-nomics shows how to determine the best action, through a systematic assessment of thecosts and benefits.

Few decisions are made in a vacuum. Other people are likely to react. Thinking likean economist means taking these reactions into account. A law firm that raises its billingrates may find customers switching to another provider of legal services – so the higherprice might not increase profit after all. Or imagine that Congress, aiming to widen use ofthe Internet, were to require Internet service providers (ISPs) to charge very low prices.Before concluding that this is a good idea we would need to know how the ISPs wouldreact. They might provide access at those low prices. Or they might reduce the qualityof service, so that consumers find busy signals when trying to connect. (Althoughthis might seem a rather wild example, something similar occurs when rent-controllegislation freezes apartment rents during a period of general price inflation. Such aprice freeze makes landlords less willing to supply and to maintain rental housing.)

Economics has been called the “dismal science.”1 That’s probably because economistsare often messengers bringing bad news; for example, that a superficially appealingproject or scheme may not be such a great idea once all the consequences are taken intoaccount.

Table 1.1 lists a number of individual and social problems, together with somepurported “solutions.” Also shown are possible bad consequences that an economistmight point out. Can you add other possible objections? And on the other side, can youthink of counterarguments that might rebut these objections?

Proponents of plans and projects tend to overlook possible flaws, while opponentstend to ignore the evidence in favor. Because people committed to one side of a questiongenerally do not want to listen to contrary arguments, thinking like an economist – tryingto impartially weigh the pros and cons – may not make you popular. But it is likely toimprove your private decisions, enhance your prospects of business success, and makeyour views on social issues more balanced.

1.1 ECONOMICS AS A SOCIAL SCIENCE

Economics is a science. Like other sciences it consists of explanations (theories) thathelp us understand and make valid predictions about the real world, together with theempirical evidence for and against them. More specifically, economics is a social science.Its subject matter is the interplay of choices made by living beings. Economics addresses

1 Not a gay science . . . no, a dreary, desolate, and indeed quite abject and distressing one: what we mightcall, by way of eminence, the dismal science.

– Thomas Carlyle (1795–1881)


1.1 ECONOMICS AS A SOCIAL SCIENCE 5

Table 1.1 Finding solutions to social problems

Problem SolutionPossible adverseconsequences

1. Our country’s steelproducers are threatenedby competition fromimports.

Impose a tariff on importedsteel.

a. The price of steel will rise,so steel-using industries willhave higher costs and willhave to raise prices toconsumers.

b. Foreigners, because theywill be selling less steel tous, will buy fewer of ourcountry’s exports.

2. Apartment rents are rising,putting decent housingout of reach for the poor.

Freeze apartment rents. a. Landlords will skimp onupkeep and repair ofapartments.

b. In the longer run, fewerrental units will beconstructed.

3. Women’s wages are lowerthan men’s.

Adopt “comparable worth”laws requiring equal pay formen and women doingcomparable jobs.

a. Employers will become lesswilling to hire women.

b. Costly bureaucratic andjudicial proceedings will beinvolved in setting wages.

4. Commercial fishing for tunakills large numbers ofdolphins.

Require domestic fisheries touse special nets that letdolphins escape.

a. Consumers will have to paymore for tuna.

b. Foreign fisheries, notsubject to our laws, will takeover more of the tuna trade.

5. Medical costs are veryhigh.

Require government to pay ashare of medical bills,especially for the poor.

a. Doctors’ bills and hospitalcharges will rise even morethan they have previously.

b. Taxes will have to go up.6. Many people are addicted

to drugs.Toughen enforcement ofnarcotics laws.

a. Street prices of narcotics willrise, forcing addicts to stealto feed the habit.

b. Huge financial stakes in thenarcotics trade will lead tomore corruption of thepolice and judiciary.

7. Many people are addictedto drugs.

Abandon enforcement ofnarcotics laws.

Increased availability andlower prices of narcotics willincrease usage andaddiction.

questions such as: Will a reduction in the capital gains tax make the stock market rise?Will higher tariffs make consumers better off? Will increased prison terms reduce crime?Will easier divorce improve the status of women? Will a high-price (meaning low volumeof sales) strategy lead to more profit for a firm than a low-price strategy?

A cynic might deny that economics is a science. Here is a possible complaint:“Economists always disagree with one another. That doesn’t give me much confidencethat economics has arrived at scientific truth. Furthermore, if economists can scientif-ically predict financial and commercial events, why aren’t they all rich?”



It’s easy to exaggerate the disagreement among economists. Controversy makes news;consensus rarely does. The great majority of economists agree that price controls leadto shortages, that free trade improves the international division of labor, and that un-controlled printing of money will bring about inflation.2 What is more important, dis-agreement is essential if a science is to advance. In astronomy the heliocentric hypothesisof Copernicus challenged Ptolemy’s 1,000-year-old geocentric model. In chemistry thephlogiston theory of combustion was superseded by Lavoisier’s oxidation theory. Andin biology creationism was countered by Darwin’s theory of evolution. It is not univer-sal agreement that characterizes science, but rather willingness to examine the evidence.All important issues of economics – for example, how taxes affect incentives to work,whether trade unions raise workers’ wages, whether stronger copyright laws promotecreativity – are under continuous re-evaluation in the light of the evidence. Economistsmay continue to disagree, perhaps because the problems are complex or the investigatorsinsufficiently skilled, but unresolved issues persist in any living science.

Engineers, despite having well-validated theories and a vast amount of evidence asto strength of materials, commonly add a huge safety factor (50 or even 100%) beforebuilding a bridge or a dam. And even so, bridges still collapse and dams wash away.In Los Angeles during the 1994 earthquake, reinforced freeways designed to withstandan even more severe jolt than actually occurred nevertheless collapsed. As anotherexample, meteorology is certainly a natural science, yet meteorologists hardly evenclaim to predict the weather for more than a week or so ahead. If economists predictingthe extent of unemployment or forecasting the rate of inflation were permitted as widea safety factor as engineers or meteorologists, they would rarely be seen as going very farastray.

EXAMPLE 1.1 THE ECOLOGIST, THE ECONOMIST, AND THE STATISTICIAN

In 1990 the ecologist and popular author Paul Ehrlich sent a check for $576.07 to theeconomist Julian L. Simon. It was a payoff on a bet made 10 years previously. Ehrlich,though not an economist, had made startling economic predictions in his 1968 best-seller The Population Bomb. Take, for example, his opening sentences: “The battleto feed all of humanity is over. In the 1970s hundreds of millions of people are goingto starve to death.”

Ehrlich’s predictions utterly failed. Despite an “oil crisis” in mid-decade and againtoward the end, overall the 1970s were a decade of remarkable economic growth.Yet the author continued to be highly acclaimed. In books, speeches, and articlesthat received worldwide attention he prophesied that accessible supplies of manykey minerals would be nearly depleted by 1985.

Meanwhile the economist Julian L. Simon had been predicting just the reverse forthe 1970s and 1980s: continuing improvements in human well-being, and lower pricesfor raw materials. Simon challenged Ehrlich to back his contrary forecast with hardcash, and Ehrlich accepted the challenge. The result was a 1980 bet about whether theprices of five important metals – chrome, copper, nickel, tin, and tungsten – would,after allowing for inflation, rise or fall by 1990. The economist let the ecologist choosethe specific commodities. Once again, the economist Simon was proved right and

2 Scientific consensus need not imply general agreement about policy, however. See the section on “Positive versusNormative Analysis” below.


1.1 ECONOMICS AS A SOCIAL SCIENCE 7

Ehrlich wrong. The 1980s were also a decade of prosperity, and raw materials pricesgenerally fell. The ecologist had to pay off on the bet.

Ehrlich’s analytic error was to look only at the demand side, and specifically atgrowing world population (more mouths to feed). Julian Simon, with his better eco-nomic understanding, also considered the supply side. More people mean moremouths, but also more hands and brains. Simon also took account of other favorableeconomic trends such as greater liberalization of national economies and increasedinternational trade.

So the predictions of economic analysis were vindicated. Nevertheless, PaulEhrlich continued to publish highly popular books forecasting, as mistakenly asbefore, environmental doom in the near future. Just as regularly, up to his death in1998 Julian Simon was providing sound analysis and well-validated economic fore-casts, culminating in his volume The Ultimate Resource (2nd ed., Princeton UniversityPress, 1998). But none of his books were best-sellers.

What was going on here? An economic interpretation might be that these twoauthors were supplying different commodities. Julian Simon was supplying correcteconomic analysis. Paul Ehrlich was and is in a different business, rather comparableto horror-story writers such as Stephen King. Evidently, at least when it comes toselling books, the demand for horror stories far exceeds the demand for soundeconomic analysis.a

A later exhaustive and careful study by the Danish statistician Bjorn Lomborg (TheSkeptical Environmentalist, Cambridge University Press, 2001) has updated Simon’sresults. Initially intending to refute Simon’s analysis, Lomborg found his research in-stead confirming it. Despite rising world population, per capita incomes have main-tained their upward trend and real prices of important resources have continued tofall.

As a rather strange sidelight, upon publishing these results Lomborg became thetarget of personal attacks that reached an extraordinary level of intensity. At one ofhis public presentations a cream pie was dumped on his face and clothing. He waseven accused of “intellectual dishonesty” by a scientific body with official standing inDenmark. Ultimately, all the charges were conclusively refuted, and the improperlymotivated proceeding against Lomborg was dismissed. (Which does not necessarilymean, of course, that all of Lomborg’s estimates and forecasts will ultimately proveto be correct.)

One possible lesson: sound economic analysis can sometimes be riskier than youmight think!b

a For a detailed history of the Ehrlich-Simon wager see John Tierney, “Betting the Planet,” New YorkTimes Magazine, December 2, 1990.

b A summary of the Lomborg controversy is provided in Jim Giles, “The Man They Love to Hate,”Nature, v. 423, May 15, 2003.

The cynic’s second challenge to economists – “Why aren’t you all rich?” – soundscrass. But economists, of all people, cannot dismiss it. First of all, as the precedingExample showed, correct economic analysis need not have greater market appeal thanincorrect but psychologically appealing assertions. More generally, scientific knowledgein any field does not guarantee riches. If Michael Jordan had studied the aerodynamicequations governing the motion of spheroidal missiles, would that have improved hisbasketball point scores? This argument shouldn’t be pressed too far, though. After all,



what’s the use of economics (or of aerodynamics, for that matter) if not the practicalresults obtained? So it’s reasonable to expect that better understanding of economicsand markets would lead to more wealth. Although most people can hardly match the lifeachievements of geniuses like Tiger Woods in sports or Bill Gates in business, trainingin economics ought to increase income. And, as the next Example shows, apparently tosome extent it does.

EXAMPLE 1.2 EARNINGS OF MALE COLLEGE GRADUATES, BY FIELD

The table shows median annual earnings for men with bachelor’s degrees, byselected fields, for the year 1993 – the latest year for which such data have beenpublished. Only selected fields are shown here, and the ranking is among thoseselected fields. (The source also tabulates earnings for women graduates, but thefemale tabulation unfortunately omits economics.)

Median annual earnings for men, by selected fields, 1993

Field 1993 earnings Rank

Engineering $51,600 1Mathematics 50,500 2Pharmacy 50,500 3Physics 50,400 4Economics 48,100 5Accounting 47,800 6Nursing 43,500 7Business, other 43,000 8Political science and government 41,600 9Psychology 40,700 10Biological/life sciences 39,600 11Sociology 38,800 12History 38,300 13English language and literature 37,600 14Education 34,500 15Visual and performing arts 32,100 16Social work 30,600 17Philosophy, religion, and theology 29,700 18

Source: Table 5 in Daniel E. Hecker, “Earnings of College Graduates, 1993,” MonthlyLabor Review, December 1995.

In this tabulation, economics is the best-paying social science degree, ranking justbelow a high-earnings group that includes engineering, physics, mathematics, and (sur-prisingly perhaps) pharmacy. (Though not shown in this tabulation, pharmacy is ac-tually the top-ranking field for women.)

One cannot be sure that these high incomes are due specifically to educational prepa-ration. To earn a degree in engineering, math/stat, or physics you have to be pretty smartto begin with, and perhaps that applies also to economics. Also, the life styles associatedwith different occupations may be attractive or repellent. Higher pay may be needed toinduce people to become bill collectors or hangmen, and conceivably economics suffersfrom a mild version of such distaste. Perhaps the category of philosophy, religion, and


1.2 “ECONOMIC MAN” 9

theology ranks at the very bottom of the tabulated wage distribution because manypeople find such employment to be a noble activity, a “higher calling.” (How suchnonpecuniary considerations influence occupational wage patterns will be studied inChapter 12.) Overall, it seems reasonable to conclude that studying economics does payoff, to some extent, in terms of higher income.

What about the other social sciences? Sociology, anthropology, political science, so-cial psychology, and sociobiology also attempt to explain behavior. The boundariesbetween economics and these other sciences are indistinct, in part because economicreasoning has shown itself to be of value in those fields as well. Anthropologists useeconomic techniques to analyze the foraging choices and birth-spacing decisions ofprimitive peoples. Political scientists use cost-benefit analysis to predict how manycitizens will cast ballots and which way they will vote. And sociobiologists, on thehypothesis that economically sound strategies are more likely to survive the test ofevolutionary selection, employ economic analysis to explain, for example, why someanimals choose to defend territories while others do not. (This book will be illus-trating economic principles with instances drawn from these and other related socialsciences.)

Although the boundaries may be indistinct, economics has a central core. First,on the individual level of choice economists generally postulate “economic man,”3 ahypothetical being whose decisions are based upon the rational pursuit of self-interest.Second, economics concentrates upon one type of human interaction: market exchange.In this book we necessarily emphasize the “narrow economics” associated with thesecore ideas. But there is a “broad economics” that goes beyond them. Economists canand do attempt to take account of irrational and nonselfish behavior. And economistscertainly devote effort to studying nonmarket interactions, ranging from family relationsto violent conflict.

However, first steps first. We must begin with the central core of economic reasoning.

1.2 “ECONOMIC MAN”

The term “economic man” is frequently used in a derogatory sense, as an implicitcriticism of economic reasoning. Since people are not always rational and not alwaysself-interested, economics is, critics allege, built on bad foundations. But the economistdoes not contend that rational and self-interested behavior are universal and absolutefacts. Rather, they constitute a working hypothesis, whose validity in any context canonly be assessed only by its usefulness. Does that assumption help us understand whatactually happens in markets and elsewhere?

RationalityRational behavior has at least two meanings in common use. The first meaning refersto method, the second to result. When speaking of method, rational behavior is actionselected on the basis of reasoned thought rather than habit, prejudice, or emotion. Whenspeaking of result, rational behavior is action that is effective in achieving desired goals.The two meanings differ. Good methods can sometimes lead to bad results. (“The best

3 Note: “economic man” includes “economic woman”!



laid schemes o’ mice and men/Gang aft a-gley” – Robert Burns.) And the seeminglyinferior methods available to animals, even some with tiny brains, often work very well.A human being chasing a fly with a swatter often loses the contest. But in general, weexpect that considered thought leads to better action.

Everyone behaves irrationally to some extent – out of passion, thoughtlessness, men-tal defect, or just plain perverseness. So how can rationality be assumed in economics?Assuming rationality is justified only if doing so helps predict how people will behave.Economists find that for the most part, though not literally always, the assumption ofrationality does work.

Operating a motor vehicle involves many decisions, among them how aggressivelyto drive. It might seem that driving aggressively is always irrational, but that dependsupon one’s ends. A rational person values safety, but also values other goals such assaving time and avoiding inconvenience.

EXAMPLE 1.3 RATIONAL DRIVERS?

Airbags reduce, on average, the severity of auto injuries and the risk of death frommotor accidents. But given that additional safety margin, it might well be rational formotorists to drive more aggressively!

Is such an adaptation observed? Steven Peterson, George Hoffer, and EdwardMillner examined statistics collected by the state of Virginia about fatal two-caraccidents in 1993.a In 30 such accidents, one car was equipped with an air bagand the other was not. The accident reports identified in each case the supposed“initiator,” the party driving more aggressively. The table indicates that in 22 ofthe 30 accidents (73%) the initiators drove cars with airbags, although only 50% ofthe cars involved in accidents were equipped with airbags. So, the indications are,having an airbag increased the likelihood of a driver initiating an accident.

Two-car accidents with/without airbags (Virginia, 1993)

With airbags Without airbags

Number of cars 30 (50%) 30 (50%)Number of “initiators” 22 (73%) 8 (27%)

Source: Adapted from Peterson et al., p. 262.

Any single bit of evidence such as this can only be indicative, not conclusive. Andeven if entirely valid, these results do not necessarily imply that regulations requiringairbags are inadvisable. Although drivers of airbag-equipped vehicles may indeedbe more inclined to take risks, the increased aggressiveness may not entirely cancelout the overall beneficial safety effect of airbags.

a Steven Peterson, George Hoffer, and Edward Millner, “Are Drivers of Air-Bag-Equipped Cars MoreAggressive? A Test of the Offsetting Behavior Hypothesis,” Journal of Law and Economics, v. 38(October 1995).

For a person receiving disability pay, the rational choice of when to return to workdepends upon the costs and the benefits. What would you expect to happen if disabilitybenefits were increased?



EXAMPLE 1.4 RATIONAL MALINGERING?

Under U.S. federal regulations, each state’s workmen’s compensation program re-imburses injured workers at a certain “replacement ratio” (usually around 2/3 ofpre-injury wages) up to a specified maximum. For a rational decision-maker, thehigher the compensation for remaining on disability status, the less the incentiveto return to work. Bruce D. Meyer, W. Kip Viscusi, and David L. Durbin examined a“natural experiment” testing whether changes in incentives had any visible effectupon the return-to-work decision.a

In 1980 the state of Kentucky raised its maximum weekly benefit from $131 to $217 –by about 66%. In 1982 the state of Michigan raised its maximum from $181 to $307 – byabout 70%. (Other provisions of the states’ compensation arrangements were largelyunchanged.) Crucially, these adjustments impacted only upon relatively high-wageworkers, those with incomes big enough to benefit from the higher compensationcaps.

If remaining on disability status were purely a medical matter, higher payoffs wouldnot have affected returning to work. But taking monetary incentives into account, arationally calculating high-wage worker would be more likely than before to remainon disability status. In contrast, low-wage workers, unaffected by the higher cap ondisability payments, had no financial incentive to defer returning to work.

After the change in regulations in Kentucky, the median duration of temporarytotal disabilities for high-wage workers rose from 4 to 5 weeks, while remaining at3 weeks for low-wage workers. Similarly in Michigan, the median duration for high-wage workers rose from 5 to 7 weeks, while the low-wage median remained constantat 4 weeks. So both high-wage and low-wage workers responded in ways consistentwith the rationality assumption.

COMMENT

We ought not jump to the conclusion that workers who chose to remain longeron disability status were malingering. It may well be that family responsibilities andother financial needs had previously induced some workers to return to work tooearly, before their injuries were fully healed.

a Bruce D. Meyer, W. Kip Viscusi, and David L. Durbin, “Workers’ Compensation and Injury Duration:Evidence from a Natural Experiment,” American Economic Review, v. 85 (June 1995).

Despite these and many other examples of rational choices being made even in some-what unexpected contexts such as automobile driving, one often hears about “irrational”behavior – even from so eminent an economist as the Chairman of the Federal ReserveBoard.

EXAMPLE 1.5 “IRRATIONAL EXUBERANCE”

On December 5, 1996 Alan Greenspan, the chairman of the Federal Reserve Board,expressed concern that the high level of stock prices represented “irrational exu-berance.” And indeed, by historical standards, the stockmarket was extraordinarilyhigh. At the beginning of 1980 the Dow Jones Industrial Index had stood at about800. A decade later it had risen to about 1,800 and by December 1996 to around 6,900.Although the market dipped a bit after Greenspan’s remark, by the beginning of theyear 2000 it reached almost 11,000.



Stock prices can be said to be “too high” or “too low” only in relation to actualand anticipated corporate earnings. In his book Irrational Exuberance (PrincetonUniversity Press, 2000), the economist Robert Shiller contended that not only werestock prices historically high, but the price-earnings ratio (P/E) also far exceeded allhistorical levels. According to his data, the inflation-adjusted P/E, whose previoushigh had been around 32 (just before the 1930s Depression), had reached an un-precedented 44 in the year 2000 (as estimated visually from Figure 1.2 in the Shillerbook).

But other analysts maintained that the unusually high stock prices reflected on-going favorable economic developments such as the computer revolution, whichpromised continued gains in productivity. Also important, though less often men-tioned, were the reduced risks of cataclysmic war after the collapse of the SovietUnion. Along with that, there was an improved climate of opinion for private busi-ness, owing to the declining appeal of communist and socialist ideologies.

So at the time it was not so clear whether the stockmarket levels were “irrational.”The table here indicates that the Dow Jones Industrial Index did indeed movedownward for some years after the publication of Shiller’s book in 2000, but itrecovered almost all the lost ground by early 2004. Whether stockmarket levels of8,000 or 10,000 or whatever are truly “irrational” is something all investors (includingthe authors of this book!) would really like to know.

Dow JonesDate (January) industrial index

2000 10,9402001 10,8872002 9,9202003 8,0532004 10,544

Human Goals – The Self-Interest Assumption“Economic man” is supposed to be not just rational but also self-interested. Who candoubt that self-interest, though certainly not the only human goal, is an importantaspect of what humans seek in life? Adam Smith said: “It is not from the benevolence ofthe butcher, the brewer, or the baker, that we expect our dinner, but from their regardto their own interest.”4

Traditional “narrow economics” does not inquire into the origins of our goals inlife, our tastes or preferences. In one society individuals may protect children but eatcattle; another society may protect cattle but permit infanticide. Often, however, people’sgoals and preferences do have analyzable sources. Psychologists explain them in terms ofprimitive instincts, as reinforced or suppressed by socialization. Anthropologists analyzehow culture helps determine individual purposes; sociologists examine the role of classor of other group identifications. Sociobiologists explain human tastes and preferencesas the product of evolution through natural selection. Partly stimulated by this line

4 The Wealth of Nations (1776), Book I, Chapter 2.



of scientific work, “broad economics” has begun to study the cultural and biologicalsources of preferences. As one example, teenage boys take more risks than do teenagegirls, as evidenced by the higher auto accident rates (and correspondingly higher autoinsurance premiums) for young males. Male risk-taking may make biological sense,since males must compete harder with one another to gain the attention of the oppositesex.5 (Biological and other possible sources of preferences will be discussed in moredetail in Chapter 3.)

Another question is whether tastes and preferences are stable. In analyzing taxes onalcohol, economists usually assume that the craving for alcohol, a taste, will be constant.If so, taxing alcohol makes drinking more costly but will not affect the underlyingdesire to drink. As a matter of historical fact, however, the taste for liquor has beenknown to change dramatically. Around 1850 the remarkable temperance campaignof Father Matthew in Ireland cut the consumption of spirits in that country from12,000,000 to 5,000,000 gallons per annum. (But only temporarily!) And think of thefashion industries – their very existence is based upon ever-changing tastes. What isfar more important, many of the crucial social changes in human history have beendue to shifts in people’s goals for living. Economic analysis may trivialize fundamentalvalues and goals by suggesting that they are mere arbitrary “tastes.” From the prophetsof ancient Israel to the ministries of Jesus and Mohammed to the recent decline inreligious belief in the West, the changes in the kinds of rewards that people seek fromlife have enormously affected human societies. Economists have mostly not attemptedto explain these important determinants of human behavior.

Self-interest is the human goal attributed to “economic man.” But benevolence(“wishing well” to others) certainly exists,6 and malevolence (“wishing ill”) as well.For biologically evident reasons, people are mainly benevolent toward their own chil-dren, or at any rate to close kin. Yet people also extend very large sums, in the formof charity, to strangers. Economists for the most part do not attempt to explore theunderlying sources of such behavior. Nevertheless, economists would assert that, if itwere cheaper to be benevolent (for example, if tax deductions for charitable givingwere to become more generous), more benevolence would be elicited. And even thoughthere is a biological explanation of parental aid to children, economists would stillpredict that greater financial inducements would induce even more assistance to one’soffspring.

It has been alleged that this emphasis upon self-interest makes economists moreselfish than they would otherwise be. Perhaps economics students are being “taught tobe selfish”!7

5 See Paul H. Rubin and Chris W. Paul II, “An Evolutionary Model of the Taste for Risk,” Economic Inquiry, v. 17(October 1979).

6 Indeed, Adam Smith also said:

How selfish soever man may be supposed, there are evidently some principles in his nature, whichinterest him in the fortune of others, and render their happiness necessary to him, though hederives nothing from it, except the pleasure of seeing it.

This is the opening sentence of The Theory of Moral Sentiments (1759).7 This allegation has been made even by economists: Robert H. Frank, Thomas Gilovich, and Dennis T. Regan,

“Does Studying Economics Inhibit Cooperation?” Journal of Economic Perspectives, v. 7, 1993.



EXAMPLE 1.6 SELFISH ECONOMICS STUDENTS?

In a study at George Washington University the economists Anthony M. Yezer, RobertS. Goldfarb, and Paul J. Poppena examined two questions: (1) When asked abouthypothetical situations, do students in economics courses report they would bemore selfish than before they took the course, as compared with students takingnon-economics courses? (2) When the actual behavior of students is observed, areeconomics students in fact more selfish?

Table A compares the self-reported unselfishness of students in economicsversus noneconomics classes. Each student was asked to state the percentchance that, after receiving a bill containing a substantial error in his/her favor,he/she would voluntarily ask to be charged the correct amount due. The samequestion was asked at the beginning of the course (“Before”) and at the end(“After”).

Table A Results of survey question (self-reportedhypothetical “unselfish” actions)

Before After

Two economics classes 53.4% 50.0%Two noneconomics classes 52.5% 53.8%

Source: Calculated from Yezer, Goldfarb, and Poppen, “Question 2,” inTable 1, p. 181.

Though the difference is small, these data do provide some slight support for thecontention that economics instruction led to an increase in student selfishness – asself-estimated for such a hypothetical situation.

The investigators then went on to conduct a much more significant experiment,this time with real money. Envelopes containing $10 in cash were “lost” in economicsand noneconomics classrooms. Each envelope was addressed and stamped, andalso contained a message to the effect that the money was in repayment of a loan.Since the envelopes were already addressed and stamped, an unselfish person hadonly to seal the envelope and drop it in a mailbox. A selfish person could just keepthe money.

The investigators left 32 envelopes in economics classes and 32 in noneconomicsclasses. See Table B for the results.

Table B Results of “lost letter” experiment

Returned Not returned

32 letters in economics classes 18 (56%) 14 (44%)32 letters in noneconomics classes 10 (31%) 22 (69%)

Source: From description in Yezer, Goldfarb, and Poppen, p. 181.

Table B shows that, when it came to real decisions with real financial stakes in-volved, fewer economics students acted selfishly. The self-estimated hypotheticalsurvey reported in Table A, which appeared to indicate the contrary, may have shown



only that economics students are more frank in admitting they might sometimes be-have selfishly.

a Anthony M. Yezer, Robert S. Goldfarb, and Paul J. Poppen, “Does Studying Economics Discour-age Cooperation: Watch What We Do, Not What We Say or How We Play,” Journal of EconomicPerspectives, v. 10 (Winter 1996).

So, it appears, studying economics does not make a person more selfish. However,economics instruction may make the student more willing to admit that he or she will,in certain circumstances, act selfishly. What about economics professors?

EXAMPLE 1.7 SELFISH ECONOMICS PROFS?

In a number of academic professional associations the dues schedules rise withincome. But members are permitted to fit themselves voluntarily into the appropriateincome category (the “honor system”). David N. Laband and Richard O. Beil studieda number of professional associations using this procedure.a

A member of the American Economic Association (AEA) in 1994 who placed himselfor herself in the lowest dues category (declared income less than $37,000) would paydues of $50, whereas self-placement in the highest category (declared income greaterthan $50,000) required dues of $70. For the American Sociological Association (ASA),the dues structure ran from $34 at the bottom end (for income less than $15,000) to$180 at the top (for income greater than $50,000). For the American Political ScienceAssociation (APSA) the comparable numbers were $65 (for income less than $30,000)and $125 (for income greater than $70,000).

Were the self-placements into dues categories truthful? The authors tested thisby sending a separate questionnaire asking members of each association abouttheir incomes during the year. The questionnaires had no obvious connection withprofessional dues, but replicated the income categories in members’ annual billingstatements.

It was found, for example, that in responding to the questionnaire only 3% ofAmerican Economic Association members indicated that they fell into the lowestincome category. But when it came to paying dues, 25% placed themselves in thatcategory. So evidently, many members “cheated.” Somewhat similar results werefound for the other associations.

One way of comparing the different professional associations is to calculatewhat the “true” average dues payment would have been, if members of eachassociation had placed themselves in the correct categories as indicated by theindependent questionnaire. Some of the relevant averages are indicated in the table.

Average dues liabilities and payments in 1994/95

“True” dues Actual duesliability payments Actual/true

AEA $67.74 $62.83 93%ASA $147.60 $112.52 78%APSA $105.15 $96.05 91%

Source: Laband and Beil, pp. 96–97.



Although in percentage terms the economists appear to be relatively truthful (and,to that extent, unselfish), the comparison in the table is perhaps biased. Since theAEA is considerably cheaper than the ASA and APSA, the temptation to cheat isless. Still, it is at least doubtful whether economists are any more selfish than otheracademics.

a David N. Laband and Richard O. Beil, “Are Economists More Selfish than Other ‘Social’ Scientists?”Public Choice, v. 100 (1999), pp. 85–101.

Ignorance and UncertaintyTo say that people are rational is not to say that they are all-knowing. Almost all decisionsare subject to uncertainty. A consumer may not be aware of the quality of the goodsoffered for sale, a job-seeker may not know which employer would be willing to paythe highest salary, a computer manufacturer may be unsure about what products itscompetitor may bring to market, a politician may be doubtful whether the public willapprove of a proposed policy.

Much of this book deals with decision-making under uncertainty. How much shouldone be willing to pay as an annual premium for fire insurance? Should a person choose asafe but lower-paying job over a risky one offering higher rewards? Which stocks shouldan investor buy?

As a subtler point, individual decision-makers should take into account the behaviorof others. A person who thinks a stock is underpriced ought to ask why other investorslet that stock’s price get so low. Moreover, any one person should recognize that othersmay attempt to take advantage of his or her own ignorance. Later chapters will analyzehow these considerations affect the terms of insurance contracts, the prices of assets,and the employment contracts that firms offer.

1.3 MARKET AND NONMARKET INTERACTIONS

We all need food. But there are many ways to go about getting it. Someone who wantsbread from the baker can work at a job and earn the price of a loaf. An alternativewould be to steal the bread. As still another option, consumers might try to persuadebakers that it is their charitable duty to give away bread. Or consumers might organize apolitical movement aimed at forcing bakers to do so. “Narrow economics” concentratesupon the first of these interactions, that is, upon voluntary exchange through the market.For the most part, crime has been left to sociology, the techniques of persuasion topsychology, and the uses of state power to political science, and. But “broad economics”goes beyond these boundaries.

EXAMPLE 1.8 CRIME AS AN ECONOMIC CHOICE – “THREE STRIKES”

Crime sometimes does pay. It may be entirely rational, though certainly not ethical,for a criminal to steal rather than work if he feels the gains are worth the risks. Con-ventional criminology, a field historically dominated by sociologists, has regardedcriminals as “deviant” individuals who do not make rational choices. According tothis traditional view, the solution to crime lies on the psychological level – for exam-ple, improving the mental health of potential lawbreakers, or providing them with


1.3 MARKET AND NONMARKET INTERACTIONS 17

better role models. Economic analysis, without necessarily denying that criminalsare psychologically “deviant” in some ways, suggests that even criminal activity willrespond to incentives.

Imprisonment can reduce the crime rate in two main ways: incapacitation or de-terrence. Incapacitation does not involve rationality: a person in jail is simply notin a position to commit crimes against the public. Deterrence, in contrast, operatesthrough the potential lawbreaker’s calculation of the costs versus the benefits ofcriminal activity. So a deterrence policy implies at least some degree of rationalityon the part of potential law-breakers.

This distinction became crucial in the debate over “three strikes” laws – pro-posals to sentence habitual criminals to life imprisonment. If incapacitation is theimportant consideration, “three strikes” laws are seriously flawed. The propensityto commit crimes is known to decrease with age, so such laws would fill the prisonswith relatively aged inmates who would not be committing offenses anyway. But ifdeterrence matters most, the threat of being put away for life might discourage evenyoung criminals.

A study by Steven Levitt attempted to separate the two effects.a Using data forthe period 1970–1992, he examined how the number of crimes in one statisticalcategory such as assault responded to arrest rates in another category such as bur-glary. Given that a large number of lawbreakers commit both types of crimes then, ifincapacitation is the main force at work, a higher arrest rate for assault would reduceboth assaults and burglaries. But if deterrence is the predominant influence, a higherarrest rate for assault should lead criminals to commit fewer assaults – but just asmany (or maybe even more!) burglaries and other crimes.

The evidence suggested that deterrence was more important than incapacitationin reducing the crime rate. In fact, deterrence alone explained about 75% of the over-all impact of higher arrest rates on crime. The study therefore provides some supportfor “three strikes” laws, though of course the effect on crime rates is not the onlyconsideration in evaluating such legislation. (Another element that needs to beweighed are the costs of building more prisons and dealing with a larger inmatepopulation.) Recent evidence from the states of Washington and California tends toconfirm that, in those states as well, the higher incarceration rates associated with“three strikes” have reduced the number of offenses.

In another study, the same author asked why juvenile crime rates rose much morethan nonjuvenile rates in the period 1978–1993.b (In that period the adult arrest ratefor murder fell by 7%, but the juvenile arrest rate rose by an extraordinary 177%!)The main explanation, he concluded, was that in the period of study the averagejuvenile punishment rate per crime – already lower than the adult rate – fell byaround 20%, whereas the adult punishment rate rose by about 60%. He also notedthat the crime rate falls sharply in the year that an age cohort moves out of the (morelenient) juvenile justice system and into the (more severe) adult system.

a Steven D. Levitt, “Why Do Increased Arrest Rates Appear to Reduce Crime: Deterrence, Incapaci-tation, or Measurement Error?” Economic Inquiry (July 1998).

b Steven D. Levitt, “Juvenile Crime and Punishment,” Journal of Political Economy (December 1998).

So it appears that economic analysis can be usefully applied to crime as one formof nonmarket behavior. Charity is another. A third form of nonmarket interaction,sometimes not too far removed from crime, is politics. The economic approach topolitics will be covered in Part Seven of this book.



Market interactions have two crucial characteristics: they are mutual and they arevoluntary. Among the possible nonmarket interactions, charitable giving is voluntarybut is a unilateral rather than a mutual transaction. Theft, of course, is involuntary onthe part of the victim.

But is the market interaction really voluntary? Can a poor person refuse a job thatpays low wages but will at least put food on the table? Isn’t he just a “wage slave”?Or suppose a highwayman threatens his victim, “Your money or your life!” Isn’t heoffering a voluntary deal? Then how can criminal extortion be distinguished frommarket exchange?

The explanation of these puzzles rests upon the concept of property. The highway-man is proposing a market deal: he will refrain from murder, in exchange for money.But under our legal system each person has property in his or her own life. The seem-ingly voluntary transaction proposed by the highwayman is based on his seizing powerover something to which he has no legal title – the victim’s life. As for the wage slavecontention, it is true that a rich person can buy more of what he or she wants than cana poor person. This may or may not be inequitable, but poor people are not enslaved.Their working capacity is their own property, and they can bargain with alternativeemployers for the best available terms. Slaves cannot market or trade their labor, for itis not legally theirs to sell.

1.4 ALLOCATION BY PRICES – THE MARKET SYSTEM

Consider the allocation of seats in your economics classroom. Some seats are moredesirable than others. One possible rule is first come first served. Or the professor couldmake the assignments on any basis he or she preferred. Or the students might elect acommittee to work out the assignment. In less friendly situations such as rock concerts,good seating might depend on your ability to jostle and trample others. All of the aboverepresent nonmarket ways of apportioning a scarce resource. On the other hand, rightsto seats might be assigned by a market technique, for example, by an auction.

EXAMPLE 1.9 BIDDING FOR FACULTY OFFICES

William J. Boyes and Stephen K. Happel reported on how the College of Businessat Arizona State University, upon moving to a new building, dealt with the prob-lem of assigning faculty offices.a The Management Department gave first choiceto the most senior professors. The Finance Department followed a first come firstserved rule: a sign-up sheet was posted outside the Chairman’s office, and choiceswere awarded in order of signing up. The Statistics Department used a randomizingdevice – rolling dice.

The Economics Department chose to hold an auction. (The financial proceeds,which turned out to be around $3,200, went to a fund supporting graduate studentscholarships and dissertation research.) The single highest bidder paid $500 for theright to have the first choice of offices available.

COMMENT

The auction led to some adverse publicity. A number of citizens felt that the profes-sors were auctioning off public property for their own benefit. The complaint wasunwarranted, since the offices were not being sold to the detriment of the taxpayers.What was being sold was only the right to choose ahead of other professors. Also,


1.4 ALLOCATION BY PRICES – THE MARKET SYSTEM 19

the proceeds were not used for the benefit of the bidders but for the benefit ofgraduate students. Once this was made clear, opposition dissipated.

a William J. Boyes and Stephen K. Happel, “Auctions as an Allocation Mechanism in Academia: TheCase of Faculty Offices,” Journal of Economic Perspectives, v. 3 (Summer 1989).

The key feature of markets is price – the terms on which goods are exchanged. Toacquire a commodity buyers must be willing to pay the market price, while successfulsellers are the ones willing to give up control of the good in exchange for the samemarket price.

Market prices ration goods and resources to consumers. As the preceding discussion hasshown, there are other ways of rationing: first come first served, dictatorship, violence,lottery, and so on. But price has one feature these other methods lack: the commoditiesgo to those individuals with the highest willingness to pay. Economists do not claim thatthis principle is necessarily ethically attractive. Among other things, wealthier peopleare able to pay more. So anyone who has acquired wealth, even unethically, has thepower to buy lots of desired goods. On the other hand, all other conceivable methodsfor rationing goods and resources might also be subject to objection on ethical grounds,perhaps more so. Setting ethics aside, it is “efficient” (in a sense to be made more explicitin the chapters that follow) for goods and resources to end up in the hands of thosemost willing to pay.

From the point of view of sellers or providers, prices guide production. Whenever thecurrent market price of a commodity exceeds its cost of production, producing more ofthe good becomes profitable. Not only are current producers likely to increase output,but new providers will have an incentive to enter the industry. In consequence, moregoods will be provided precisely where consumers’ willingness to pay is highest. Thisis the principle that Adam Smith called “the invisible hand.”8 Even if a person seeksonly private advantage, he or she is led to serve the public by producing those goods orservices that others most desire.

Perhaps this idea, that self-interested motivations can lead to actions that end uphelping other people, seems obvious. Yet many people, in Adam Smith’s day and inours, believe that the only way to help others is by intentionally “doing good.” Moresophisticated individuals appreciate, as did Adam Smith, that in helping others tradecan be more effective than charitable aid.

Still, it is not immediately evident just how self-interested behavior manages to avoidmutual harm or even total chaos. Los Angeles is fed by converging food shipments fromall corners of the earth – without any benevolent dictator to make sure that the Kansasfarmer, the New England fisherman, and the Florida orange grower deliver food to thecity. Though no one is ordered to do so, and none of these suppliers need be motivatedby any particular love and concern for Angelenos, the city is fed. Why? Because Kansasfarmers simply find it more profitable to ship their wheat to Los Angeles than to eattheir crops themselves, and similarly for all the others.

Adam Smith put it this way: “in civilized society [man] stands at all times in need ofthe cooperation and assistance of great multitudes, while his whole life is scarce sufficientto gain the friendship of a few persons.”9 How can a person who has only a few friends

8 Adam Smith, The Wealth of Nations, Book IV, Chapter 2.9 Adam Smith, The Wealth of Nations, Book I, Chapter 2.



nevertheless get the assistance of multitudes? The answer lies with the invisible handof self-interest, which leads an individual to work for the good of persons practicallyunknown to him. The market system leads us all to work for the good of one another.The result is an orderly economy that meets people’s needs and desires without anyonehaving planned for it to do so. (Ironically, it was the “planned economies” of CommunistChina and Soviet Russia that had difficulty keeping the grocery shelves stocked.)

1.5 BEHAVIOR WITHIN ORGANIZATIONS

Though traditional “narrow economics” has concentrated on the study of markets,one of the directions in which “broad economics” has moved has been to examinebehavior within organizations. Within organizations, to some extent at least, resourcesare allocated not by exchange but by command. Government is the most prominentexample. American congressmen enact legislation without buying one another’s votes.(But, as will be seen in Chapter 17, “log-rolling” represents a kind of exchange of votesamong members of a legislature.) In the executive branch, the President is empoweredby law to direct the activities of the subordinate officers of government. Similarly withinbusiness firms, managers exercise authority over the actions of subordinates.

Yet “economic man” is also at work within organizations. In democratic politicalsystems, voters are likely to support the candidate regarded as most likely to improvetheir well-being. Politicians are likely to adopt positions that maximize their careerprospects. Within firms, managers are notoriously interested in their compensationpackages. And when a Board of Directors fires a CEO, the usual reason is inadequateperformance in terms of maximizing shareholder income.

1.6 POSITIVE AND NORMATIVE ANALYSIS: “IS” VERSUS “OUGHT”

In its scientific aspect economics is strictly positive. It answers questions such as “Isthis theory (explanation) really true of the actual world?” But economics also has anormative aspect, dealing with questions such as “Should this policy be adopted?”Given an objective, economists can use their knowledge of “what is true” to analyze theproblem and suggest ways of achieving “what ought to be done.”

Adam Smith had in part a normative purpose in writing The Wealth of Nations. Heopposed the then politically dominant mercantilists,10 favoring instead the policy hecalled “natural liberty” – free trade among nations, and laissez faire within. This bookis less concerned with normative issues (policy recommendations) than with positivematters (scientific understanding). Looking at the positive aspect, Adam Smith’s evenmore fundamental thesis was that the economy follows objectively determinable laws.In early times, some people thought the planets were pushed in their courses by angels.Newton showed how the principle of gravity explains planetary motions. Similarly, toexplain the universe of economic behavior, Smith put forward the idea of the marketsystem as a mechanism, driven by the self-interest of participants, yet integrated so thateach is led to serve the desires of others.

The distinction between positive and normative analysis sheds new light upon thequestion raised earlier about disagreement among economists. Economists may disagree

10 The mercantilists believed that national well-being required the accumulation of gold and silver. To achieve thisend, they recommended regulations to encourage exports and discourage imports.


1.7 ELEMENTS OF THE ECONOMIC SYSTEM 21

on policy issues because they seek different normative goals. One might be more con-cerned with social equality, another with individual freedom. Even complete scientificunderstanding will not resolve such philosophical conflicts. But often disagreementamong economists is over means rather than goals: not over what to do, but how to doit. Scientific progress in positive economics will, over time, tend to eliminate this sourceof disagreement.

EXAMPLE 1.10 WHEN DO ECONOMISTS DISAGREE?

In the early 1990s several surveys of economists collected opinions on a variety ofimportant positive and normative issues. The table here summarizes results for sixquestions, which we have classified as either positive or normative.

Agreement among economists

Generally Agree with Generally Index ofProposition agree provisions disagree consensus

POSITIVE ISSUESA minimum wage increasesunemployment among young andunskilled workers.

56.5% 22.4% 20.5% 36.0

A ceiling on rents reduces the quantityand quality of housing available.

76.3% 16.6% 6.5% 69.8

The cause of the rise in gasoline pricesthat occurred in the wake of the Iraqiinvasion of Kuwait is the monopolypower of the large oil companies.

11.4% 20.3% 67.5% 56.1

NORMATIVE ISSUESThe distribution of income in theUnited States should be more equal.

48.5 24.4 26.7 21.8

Antitrust laws should be enforcedvigorously to reduce monopoly powerfrom its current level.

34.9 36.9 27.6 7.3

The level of government spendingrelative to GNP should be reduced.

35.6 19.03 44.6 −9.0

Note: The column labeled “Index of consensus” was constructed by comparing “Generally agree”with “Generally disagree,” subtracting the smaller of these from the larger. (“Agree with provisions,”the middle position, was omitted.)Source: Adapted from Richard M. Alston, J. R. Kearl, and Michael B. Vaughan, “Is There a Consensusamong Economists,” American Economic Review, v. 82 (May 1992), pp. 204–5.

COMMENT

Notice that the “Index of Consensus” among economists is quite high for the positiveissues, but considerably less so when it comes to normative issues of public policy.

1.7 ELEMENTS OF THE ECONOMIC SYSTEM

Decision-Making Agents in the EconomyThere are three main types of economic decision-makers: individuals, firms, and gov-ernments.



Individuals are the basic units of a society. The consumption decisions of individualsare discussed in Part Two of the text, and their resource-supply decisions in Part Four.Actually, recognizing the mutual support and cohesiveness of the family, economistssometimes consider the household to be the effective consumption unit. Except whereotherwise specified, the individual here will be understood as making decisions for hisor her family or household.

Business firms are artificial units. Every firm is ultimately owned by or operated forthe benefit of one or more individuals. Surprisingly, this fact is often overlooked. Onehears it said, for example, that “we should tax corporations, not the people.” But taxeslevied upon a corporation must ultimately come from the pockets of human beings.The company’s owners will likely earn lower profits, its workers may have to foregowage increases, its customers may pay higher prices. At the same time, of course, thetax revenues might be used in ways that benefit other people. (As usual, every choiceof policy involves both costs and benefits.) The firm is best regarded as an aggregationof individuals gathered together for the purpose of production, for converting resourceinputs into desired outputs. The market supply decisions of firms will be discussed inPart Three, and their resource demand decisions in Part Four.

Governments are also economic decision-makers. The most important activity of agovernment is to set the legal framework within which the entire economy works. Likefirms, governments are artificial groupings. Unlike firms and individuals, governmentshave the legal right to take property without consent (as by taxation). Furthermore,government decision-making is determined by political rather than market processes,a topic that will be examined in Part Seven.

Modern economies have still other decision-making units. Trade unions and cartelsare organizations of sellers in markets. And there are also voluntary associations such asclubs, foundations, and religious institutions, through which individuals combine forcollective consumption choices.

Scarcity, Objects of Choice, and Economic ActivitiesThe source of all economic problems is scarcity. People’s desires can never all be satisfied.Even if all material commodities were present in unlimited quantities, we would haveinsufficient time to enjoy them all. And, in addition, we all desire intangibles such aspower, love, and prestige. There can never be enough of these. Scarcity is what forcespeople to make economic decisions – where to work, what to produce, how much tosell – with a view to obtaining what we most desire.

The objects of economic choice are called commodities or goods. These terms areusually understood to include not only merchandise but also services. Services representa flow of benefits over a period of time, which might be derived either from physicalgoods (e.g., the shelter provided by a house) or else from human activities (e.g., theentertainment provided by concert performers).

Consumption is the ultimate economic activity, and in a sense the explanation for allthe others. In their consumption decisions, individuals choose the goods they like best,given their incomes and the prices they face.

Production by individuals and firms is a second economic activity. Production trans-forms resources into consumable goods. The process of production can modify physicalform, as in the conversion of leather and human labor into shoes, but not necessarily so.Moving goods over space (shipment of oranges from Florida to Maine) and over time


SUMMARY 23

(storing potatoes after harvest to distribute consumption over the year) are also formsof production.

Of course, to be economically rational, production should represent conversion froma less desired to a more desired configuration. Burning an antique Chippendale chairfor heat is production, but would normally be ill-advised. (Yet a person in danger offreezing to death might find the conversion from chair to warmth highly advantageous.)

The third main economic activity is exchange (to be discussed in Part Five). For theindividual, exchange, like production, is also a kind of conversion – a sacrifice of someobjects for others. But from the social point of view, exchange is distinguished fromproduction by the fact that the totals of commodities are unaffected. Trade neithercreates nor destroys goods and services, but only reshuffles them among the differentdecision-making agents in the economy.

1.8 MICROECONOMICS AND MACROECONOMICS

A distinguished professor of logic, deploring the division of his subject between deduc-tive reasoning and inductive reasoning, once declared: “In our textbooks on deductionwe explain all about logical fallacies; in our textbooks on induction, we then committhem.” Economic theory has a similar split. In much of microeconomics we explain howand why the Invisible Hand operates so well, how and why self-interest leads people toserve one another in a spontaneous system of productive cooperation. But macroeco-nomics examines why the system of coordination of economic activity through marketsmay sometimes break down.

Microeconomics concentrates on equilibrium in particular markets, presuming anequilibrium of the market system as a whole. But, it seems, the overall equilibriumof the market system is not always robust. Economic activity may become disrupted,with consequences such as inflation or large-scale unemployment. Macroeconomicsinvestigates how and why such disruptions occur.

For some time starting with the “Keynesian” ideas of the 1930s, macroeconomistsattempted to develop modes of reasoning largely independent of any microeconomicfoundation. Some theorists even dismissed classical microeconomics as obsolete orirrelevant. It is now generally recognized that the study of microeconomics is necessaryeven for a proper understanding of macroeconomics. However, it may be that suchan understanding will require employing “broad economics,” and in particular takingaccount of imperfect rationality.

SUMMARY The core of economic analysis deals with the rational and self-interestedbehavior of individuals and firms, as they interact with one another through marketexchange. Rational behavior is the appropriate choice of means for achieving givenends, which requires comparing the benefits and costs (advantages and disadvantages)of all the available courses of action. Economists do not ordinarily ask why people areself-interested or why they have specific desires, but instead treat these as facts to bestudied by the other social sciences.

Individuals can try to satisfy their desires in a number of ways, for example bypersuasion, by force, by theft, or by calling upon government assistance. But economics



mainly studies market relations, in which people seek to achieve their aims throughvoluntary exchange.

Economic thinking has, however, moved outward from this central core. In an attemptto achieve more complete understanding of reality, “broad economics” applies economicmethods of analysis to nonmarket interactions such as crime and politics. It also attemptsto allow for non-self-interested actions (such as benevolence in the family) and for thefact that humans sometimes deal with one another in ways that seem irrational.

Adam Smith’s principle of the Invisible Hand shows how persons who are interestedonly in their own welfare are nevertheless led to cooperate with one another throughmarket exchange. The market economy is an unplanned yet integrated arrangement,whose functioning follows scientifically determinable laws.

The main decision-making agents in the economic system are individuals (possiblyacting on behalf of their families or households), firms, and governments. Individuals arethe only agents who consume. Though individuals may also produce goods and services,in modern economies production mainly takes place through business firms – artificialagents created by individuals for that purpose. Production transforms the physical shape,location, or availability of commodities. Exchange reshuffles the existing goods andservices among the economic agents to better accord with individual desires.

Economics has both a positive and a normative aspect. From the positive or scientificpoint of view, economics attempts to explain what the real world is like. In its normativeaspect economics studies questions of policy, for example, how large a fraction of thetax burden should be borne by the rich. Although scientific progress in economics tendsto eliminate disagreements among economists on positive matters, when it comes tonormative issues unanimity can never be expected. The reason is that economists, likeother citizens, diverge in the policy goals they seek to achieve. This book concentratesupon the positive aspect of economic analysis.

QUESTIONS†The answers to daggered questions appear at the end of the book.

For Review†1. a. In what respects can economics be considered a science?

b. Give an example of a prediction that modern economic science can confidentlymake.

c. What predictions has economics not yet been able to make?†2. a. What is rational behavior?

b. Give examples of rational and irrational behavior.c. Can the economist’s postulate of rationality be useful even when irrational elements

strongly influence behavior?

3. Does the economist assume stable preferences? Give an example of a change in prefer-ences that has had important economic effects.

†4. Does the economist assume that everyone is selfish? Give an example of unselfishbehavior that has important economic consequences.

5. Market transactions are said to be both mutual and voluntary. Give an example of anonmarket interpersonal transaction that is not voluntary and an example of one thatis voluntary but not mutual.


QUESTIONS 25

6. What are positive issues in economics? What are normative issues? Give an example ofeach.

†7. a. How does the Invisible Hand lead self-interested individuals in a market economyto cooperate?

b. Would self-interested behavior lead to voluntary cooperation in a monastic econ-omy where all income was equally divided?

c. In a dictatorship where the political authorities confiscated the lion’s share?d. In an economy with no property, so that any person could try to seize whatever he

or she needed from other people?

8. “The principle of the Invisible Hand asserts that self-interested behavior on the part ofresource-owners leads inevitably to chaos.” True or false, and why?

9. What is the difference between production and exchange?

For Further Thought and Discussion

1. Jack Vance, in his novel Wyst: Alastor 1617, described a planet whose economy wasbased upon egalism, a system in which all resources are shared and accumulation ofprivate property is considered a crime. In this self-styled utopia, theft is considered avirtue, as it prevents anyone from accumulating private property. Would you like to livein such a society? What would be the advantages and disadvantages?

†2. a. Other things being equal, would you expect the murder rate to be lower in juris-dictions applying capital punishment?

b. If the income-tax exemption granted for each child were increased, would youexpect the birth rate to rise?

†3. The psychiatrist T. S. Szasz argues that mental illness is the result of rewarding people fordisability. Not only is the patient motivated to become “ill,” but there is a financial ad-vantage to the healing professions in declaring personal problems to be “illnesses.” Howcould mental illness be made less “rewarding”? Would doing this reduce mental illness?

4. If government were to increase relief payments to the unemployed, would you expectunemployment to rise?

5. Explain why some individuals are wealthy (in a position to consume a great deal in theproduct market) and others are poor.

†6. If the Invisible Hand leads individuals to serve their own interests by serving others,why are some people led to a life of crime? Why do some corrupt politicians find itadvantageous to serve themselves at the expense of their constituents? Why are dictatorsmotivated to seize power? [Hint: Does the principle of the Invisible Hand apply to allkinds of social interactions, or does it hold only when individuals interact in a particularway?]

†7. Would an effectively enforced law requiring drivers to wear seat belts tend to reducedriver deaths? Pedestrian deaths?

†8. Dr. Samuel Johnson said, “There are few ways in which a man can be more innocentlyemployed than in getting money.” But the French writer Charles Baudelaire declared“Commerce is satanic, because it is the basest and vilest form of egoism.” What do youthink each had in mind?

9. Classify each of the following statements or propositions as either positive or normative.(Does the classification “positive versus normative” have any bearing upon truth orfalsity?)a. Smoking in enclosed public spaces should be banned.b. Prohibiting smoking in public places would reduce the demand for cigarettes.



c. Legislation to limit the places where smoking is permitted would be opposed bythe tobacco industry.

d. Nonsmokers’ rights to breathe clean air are more important than smokers’ rightsto pollute the air.

e. Antismoking laws will have no effect on sales of cigarettes because smokers willlight up just as much as before but confine their puffing to legal areas.

10. It may become possible to predict the place and time of earthquakes, weeks oreven months before their occurrence. Some influential writers have argued that suchpredictions should be kept secret, or even that investigations leading to such predictionsshould be banned. Allegedly, the panic caused by predicting an earthquake would bemore damaging than the earthquake itself. What does this view imply about individualrationality? Would you favor or oppose a ban on earthquake prediction?

11. According to traditional economic analysis in which all economic agents have perfectinformation about market opportunities, a worker who is unemployed can get a jobpromptly simply by agreeing to accept a lower wage. In a sense, any unemploymentwould be voluntary.a. Suppose that employers do not know whether a particular worker will be a good

match for the firm without interviewing the worker. How do you think this wouldaffect the unemployment rate?

b. Suppose that some workers prefer to be temporarily unemployed rather than receivea pay cut. Consider a company that faces a drop in demand, and needs to pay itsemployees less. Do you think it matters whether price levels are stable, or whetherthe economy is in a period of rapidly rising prices (so that each dollar is worth lesseach year in terms of the real goods and services it can command)?

1 the nature and scope of economics -...

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