Economic Essentials and Economic Errors

Many introductory economics books start by listing some main ideas. For every Essential idea in economics, there is a corresponding Error. Here they are.

Economics is about choosing. Resources are scarce, they have different uses, and we have to choose among those alternative uses. What we call “economics” is ultimately people’s choices and their unintended consequences. The unintended consequences can be positive or negative. Even though you only intend to do a kind deed for a friend when you treat him to a slushie at a gas station, you still help far-off shareholders provide for their retirement security. Even though you intend to help people in dire circumstances by prosecuting “price gougers” who raise prices after a natural disaster, you make people worse off by causing shortages. Economics is involved whenever people choose, and the prosperity people enjoy today is an unintended consequence of letting people make their own choices in the service of their own goals. Every Choice Has a Cost. That cost is your best alternative to whatever you did choose. If you spend $10 on a burger and fries, the cost is the next best thing you could have gotten for that $10. Maybe it was pizza, instead. Maybe you would have put it in a retirement fund and saved it for later. The point is that you gave up something so you could get a burger and fries. If you stand in line for fifteen minutes to get a “free” slice of pizza, that slice of pizza costs you whatever else you could have done in those fifteen minutes, like spend an extra fifteen minutes studying (which would increase your income later) or an extra fifteen minutes at your job (which would increase your income now). Incentives Affect People’s Choices. The economist Steven Landsburg has said that all of economics can be summed up in four words: “people respond to incentives.” Indeed, pretty much everything in economics turns on understanding how people’s incentives change and how people respond to them. People do less of something when it costs them more. They drive less when gas prices rise, for example. Not everyone responds to incentives the same way. Some people (maybe you!) don’t drive less or switch to the bus when the price of gas rises by a few cents, but some people do.

A society’s institutions affect its incentives. Institutions are rules: formal rules are set by governments or written into contracts and constitutions, informal rules are norms of behavior that may not be written down but that might be widely understood (“the man pays on a date,” for example), and their enforcement characteristics. Different rules mean different choices, and different choices mean different outcomes. People Make Incremental Choices. People choose based on the costs and benefits of more or less of something. It’s more of a dimmer switch than a straight on-and-off. Look at your computer’s screen settings. Your decision isn’t “see my screen” or “not see my screen.” It’s “how bright do I want the screen to be?” You adjust it by making it a little bit brighter or a little bit darker. The brighter a screen is, the easier it is to make out the contours of letters and shapes–but at the cost of being a little less comfortable to look at, and maybe it drains your laptop battery more quickly. Or the dimmer a screen is, the less energy it uses–but at the cost of not being able to see as well and, perhaps, giving yourself a little bit of eyestrain. Whether you make your screen a little brighter, a little darker, or don’t change it at all, you make an economic choice. Trade is Cooperation. When people trade, they are working together to help one another achieve their goals, even though they might not know (or care) what the other person’s goals are. Think about the next time you get gas. Maybe you buy it from the Shell station. Shell helps you by providing you with gas. You help other people by specializing in something you do efficiently, like pouring coffee at a coffee shop where a lot of accountants hang out. The accountants, in turn, help Shell by auditing Shell’s financial statements. And just who (or what) is “Shell”? In the case of a multinational corporation like Royal Dutch Shell, it’s everyone who owns stock in Shell, like the company that administers an employer’s retirement plan. You help Shell shareholders have the food, clothing, and shelter they want. A little further down the line, you help everyone who works at Shell. Even if all you meant to do was buy gas for your roadtrip.  People Are Rational. This doesn’t have much more content than just saying “people prefer having more to having less” and “people will do less of something as it gets costlier.” When economists say people are rational, they don’t mean that people’s cognitive processing is efficient or accurate or even that people are particularly thoughtful about their choices. They just mean that people have a pretty good idea of their own interests, and choose what they think are the appropriate ways to satisfy them. Cooperating in Markets is Costly, and Governments Regularly Make it Costlier. Exchange isn’t easy; it is limited by what are called transaction costs. Transaction costs, according to the economist Michael Munger, come in three flavors. There is triangulation, which is finding people with whom to trade. There is transfer, which is moving merchandise and processing payments, and there is trust, which consists of the costs of verifying the integrity of what is being traded. Governments might be able to reduce some of these costs with regulation and rules, but regulation can also make those problems worse.

In markets, entrepreneurs can profit by finding ways to overcome these barriers. Governments are often the source of barriers that make it hard for people to cooperate by attaching all sorts of conditions before people will be allowed to reach an agreement. Joseph (a resident of the US) might be willing to hire Jose (a resident of Mexico) to paint fences, but the US government requires that Joseph and Jose get permission to cooperate. Similarly, Joseph might be willing to put together teams of people to build fences, but the city he lives in might require him to get permission before allowing him to cooperate with people who want to hire him. Profits Tell Businesses They are Helping People While Losses Tell Businesses They Are Wasting Resources. An MBA textbook I’ve used before describes the “art of business” as the art of “identifying assets in lower-value uses and finding ways to profitably move them into higher-value uses.” When someone earns a profit from a particular endeavor, it is an indicator that they have created more value than they have consumed. Similarly, losses show people that they have consumed more than they have created. Choices Have Important Unintended Consequences. It has been said that the road to hell is paved with good intentions. The insight that people respond to incentives leads us to another insight: Our choices have important unintended consequences. These can be positive, as when we help someone pay for their kid’s braces by buying a burger from them. They can also be negative, as when we consign people to less-attractive employment options (or even unemployment) by implementing minimum wages, or when price controls and prohibitions on buying and selling create kidney shortages.

Second, the Errors:

Economics is about money. A lot of people probably think economics is only about the monetary side of life, but you will search in vain for the word “money” in the Nine Essentials above. Economics isn’t about money; economics is much, much broader. Economics is a social science, and we’ll see how we can use some of its basic ideas to study a lot of things people don’t think about when they think about economics–like religion, love, voting, marriage, and crime. It Doesn’t Cost Anything if You Don’t Have to Pay For It. Nope. “Free stuff” isn’t free. When you choose to do one thing, you are choosing not to do another. If you take the time to eat a slice of free pizza, you’re giving up the opportunity to do something else like taking a nap. Frequently, you hear people say that things like education and health care should be “free.” Of course, the time and energy of highly-skilled workers, buildings, land, and so on have alternative uses, so building a hospital and providing health care, or building a school and providing education, is very, very expensive. What they mean is “people should get it for free, but someone else should pay for it.”  Changing People’s Incentives Won’t Change Their Choices. “People aren’t going to stop going to church just because of a small change in their incentives.” Have you ever skipped church because of a snowstorm? Or a pandemic? Sometimes, people hear an economist explain what they think will happen and think the economist is explaining what should happen. This isn’t the case at all. We’re making predictions based on the conviction that people will do more of things that get easier, and less of things that get harder, holding everything else constant. If video games get cheaper, an economist might predict that people will spend less time at church, holding everything else constant. The economist isn’t saying people should spend less time at church. She is pointing out that cheaper video games mean the cost of going to church in terms of gaming time sacrificed has risen, and as something gets more expensive, people will do less of it (again, and crucially, holding everything else constant). Choices Are All or Nothing. This is closely related to #3. Think about people changing their churchgoing in response to changed incentives. A snow flurry probably won’t keep everyone away, but it might be enough to keep some people away. Or “People aren’t going to stop buying gas just because it’s a few cents more expensive.” First, that might be true of a lot of people, but if you can recall times in your life when you’ve been counting pennies because it determined how much gas you could get, you know that at least some people are going to buy less gas because the price is a tad higher. You might have seen a meme where someone says something like “If you think the economy is more important than the environment, try holding your breath while you count your money.” Thinking about it as “the economy” or “the environment” really misunderstands the problem and where the action is. Incremental trade-offs are what matters, and the relevant question is always something like “what are we willing to give up in order to have slightly cleaner air?” Or even more concretely, “what do we have to give up to recycle an aluminum can?” Trade Is Exploitation. A lot of people think every trade has a winner and a loser. This isn’t true. Every trade has two people who win, or else they wouldn’t agree to the trade in the first place. People can always imagine having made a purchase or a sale on better terms, but the fact remains that they enter into trades because they expect to be better off, on net, because of the trade. The idea that “trade is exploitation” is an example of the zero-sum fallacy, which says that if one person is better off, another person has to be made worse off. It’s not the case, and this is one of the cool implications of basic economic analysis. When people can cooperate and exchange, they make themselves better off by making other people better off. This doesn’t mean no one ever makes a mistake. We’ve all ordered something at a restaurant and regretted it. It means, though, that people expect to be better off when they trade, and if they do order something that turns out to be gross, they’re probably not going to order it again. People Are Irrational. In a lot of ways, we are. If you’re a traditional-aged college student and you’re reading this, you probably have a few more years before your brain is fully formed. Furthermore, our minds are infested with cognitive biases. We tend to interpret evidence in ways that support what we want to believe rather than what is actually true. People say they want to provide a safe, comfortable future for their children and grandchildren, and then blow their paychecks on lottery tickets and alcohol. We process information poorly. However, “rational choice” in economics is not a theory of how our minds work. It is, rather, the simple insight that we’re going to do more of the things we like and less of the things we don’t like, all other things equal. Just because many people choose their favorite football teams largely based on cosmic accidents (where they grew up), that doesn’t preclude us from saying that people will demand more tickets to see their favorite teams if those ticket prices go down, nor from saying that those ticket prices are likely to go down, the more games their favorite teams lose. Government Will Fix Problems If We Get The Right People In Power. Adam Smith explained the economic way of thinking by pointing out that societies get bad outcomes because people are responding to bad incentives, not because they are inherently or innately bad. Government officials respond to incentives as well, and in the case of elected officials, we get a lot of explanatory power by assuming that they are overwhelmingly motivated by the desire to get elected and stay elected. This often means supporting politically-popular-but-ultimately-harmful policies that sound good, but that give people dysfunctional incentives. Profits are Greed. Most people think it is vicious to pursue profit and virtuous to eschew it because they think that “profit” is just a charge tacked on to justifiable costs of production by greedy people just looking to skin their customers. This isn’t the case at all. Profit rewards entrepreneurs for making sound judgments about the goods and services people want, and the different ways of providing them. Profit is informative, but it is not decisive; it merely tells you what people do value relative to all the other alternatives. It doesn’t tell you what they should value relative to all the other alternatives, nor that you’re really and truly acting in someone’s best interests when you serve them with what is profitable. If It’s Bad For Someone Who Is Easy To Identify, It’s Bad For All. Every change of every kind makes at least someone worse off relative to some imagined alternative state of the world. If you manage a Dunkin’ Donuts and a Starbucks opens next door, you might be worse off, because you’ll lose some customers. However, Starbucks’s entry means some combination of more coffee and lower prices. Cheaper coffee means customers might be able to buy slightly nicer shoes, or lend to someone who wants to build an apartment complex.

You can replace “Bad” with “Good” and make the same argument. A lot of times, people justify public policies by pointing out how it helps a visible group. Just because something is good for one group doesn’t mean it’s good for everyone. A prohibition on new coffee shops in the neighborhood might be very good for the people who own the coffee shops that are already there, but since they mean less coffee and higher prices, they make coffee drinkers worse off. As a simple matter of math, the value of what coffee drinkers lose because of the restriction is larger than the value of what the coffee shops gain.

Economics has sometimes been described as “the painful elaboration of common sense,” and while I don’t think “painful” is accurate, economics often just applies common sense. People learn not to touch hot stoves or juggle chainsaws for fun. Later,  they then tend to eat better when their incomes rise. This “painful elaboration of common sense” leads us, however, to some surprising results and powerful insights.

This article is based somewhat on this post and this post, both from 2010, as well as Thomas Sowell’s Economic Facts and Fallacies and the “ten principles” or “ten big ideas” or “ten key elements” lists at the beginning of many economics textbooks. I thank Sarah Estelle for comments and suggestions.