The much-misunderstood basic principles of economics

Listening to our media intellectuals can be hard on the head at the best of times, especially when it comes to intellectual things. No academic discipline is more often misunderstood and more often mischaracterized than economics.  My complaint here is not that commentators don’t understand money theory or derivatives, it’s that they don’t (or more likely won’t) get the basic principles correct.

The first principle of economics is not “homo economics,” i.e., it is not the assumption that human beings act rationally. The first principle of economics is scarcity, which means, as the everyday sense of the word suggests, that wants are unlimited and resources are limited. In consequence, all of us must choose between the things we want and prioritize when we want them.

Notice that scarcity is not an assumption open to debate; it’s a perennial, empirical fact about the human condition.  Argue all you want, then, about whether and how much this or that person should want or should have, the fact remains that we’ll always have to choose between toiling for our supper and eating it.

(As an aside, this last remark should suggest that the basic insight about scarcity is ultimately biblical: the writers of the Old Testament mythologized this insight in the exodus from the Garden of Eden. No more will Adam feast upon the abundant fruits of the Earth.  From now on, he’ll have to till the soil for his meals and build his own shelter. But this is a topic for another day…)

The corollary of the principle of scarcity—and the second principle of economics—is that people respond to incentives.  Responding to incentives is what economists mean when they talk about human beings “acting rationally.”  In other words, acting rationally (i.e., the much-ballyhooed homo economicus) does not mean that everyone behaves is a sober and reflective manner, calculating every move like little the Gary Kasparovs of their everyday lives.  Not at all; it simply means that we adjust to the world around us by making tradeoffs between the things we want to do and the things we can, based on the time and money we have. It’s a deceptively simple premise, which is likely why it’s misunderstood.

This notion of rational action, moreover, should put the lie to pseudo-argument against economics that some people act irrationally, and even the seemingly stronger argument that empirical evidence has been dug up to show that people don’t respond optimally to incentives.

It should be obvious that the first claim is a red herring.  That people don’t act rationally—where what’s rational is determined in accordance with some unspecified criterion—for the simple reason that economics makes no such assumption.  In fact, it would be amateurish to assume something as counter-intuitive as “everyone is a perfectly rational agent.”

The second is no less irrelevant, but it can seem like a more potent objection, because the notion of “optimal choices” does speak to the economic principle of responding to incentives. The problem with the objection, however, is that it supposes complete information or perfect analytical powers on behalf of actors.  It’s obvious that no one has complete information and (probably) none of us is perfect at picking the right course of action. So sure, people may be shown to consistently invest their money in the wrong place, for example.  But this only means we tend—when we do in fact tend—to make predicable miscalculations about our interests, not that we’re not forced to make such calculations in the first place.

In other words, the existence of sub-optimal choices doesn’t speak against the basic fact that people do respond to incentives.  If the price of cheese goes up, we may start eating bread instead or the reverse. Is this a wise tradeoff?  I don’t know.  The important thing is, however, that we respond in predictable ways, even when those responses could be construed as suboptimal (and thus irrational).

Now, none of this should be taken to mean that economics and economists are beyond reproach (so please spare this strawman rebuttal).  Even economists will admit that macroeconomics, for example, is a nebulous business.  But let’s be clear about the fundamentals so we know what we’re criticizing, instead of indulging in the same tired canards over and over again.

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