What is Economics?

On twitter, I got into a bit of back and forth with two people about economics. In 140 characters, one cannot have a real argument. Instead it is just a series of assertions. One gentleman came down heavily against the idea that economics studies human behavior. It’s all about money, he seems to think. Another person got angry at the claim that “markets work” because, as he pointed out, they fail. I responded, tongue in cheek, “Planes don’t fly. They crash. They kill people and are worthless for transportation.” That set him off a bit more. C’est la vie.

As it happens, I am teaching an online class on economic growth and development. Any econ class, I am convinced, has to start off with the fundamentals. So I start with the question, “What is economics?” I think you may find what I wrote on that question on the class blog interesting. Here it is with some minor edits.

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Economics is what economists do.

Seriously though, economics is about what everybody does. It is the study of human behavior. People have noted regularities and codified them. Economics tries to explain human behavior. And to a limited degree, economics predicts how people will behave.

Humans behave predictably. We just don’t know enough about the specifics of the individual to fully predict how a particular individual will behave at a specific instant in time. However, enough progress has been made in that study that we can predict with some confidence how a person will behave generally. For instance, we know that a person will probably consume less of something if the price goes up.

As opposed to individuals, it is easier to predict overall collective behavior. Our predictions become more accurate as the size of the collective increases. We know that when the price goes up, most certainly consumption goes down. Individual behavior may deviate from that regularity but groups of people will never do.

Economics is “the science of human action based on deductive logic.” It is “not about the amassing of data, but rather about the verbal elucidation of universal facts (for example, wants are unlimited, means are scarce) and their logical implications.”[1]

If there were no people, there would be no economy and no economics. Consider an uninhabited continent with flora and fauna, with lakes and rivers, and minerals and mountains — in short everything except people. Because it has no people, it does not have an economy. But put even one person on it — Robinson Crusoe — and it becomes an economy. Suddenly you can talk about choices and trade offs, about production and consumption, about savings and investments, etc. Everything except one thing: exchange.

Economics is the study of how people behave, individually and collectively, in producing, consuming and exchanging (or trading.)

The focus has to be on human behavior and not on resources. Humans produce, consume and trade. That is what is at the core of this subject. Production requires resources — so the interest in resources is a “derived” interest. Humans attempt to maximize their “satisfaction” by optimally using the resources they have at hand. There are constraints under which this is done. It is a constrained optimization problem. Which means that choices have to be made, both for production and consumption. You cannot have it all. You can eat your cake or have your cake — but not both. Anything we do comes at a cost — which is that we have to forego the opportunity of doing something else.

Economics is the study of opportunity costs.[2] That’s one of the most compact definitions of economics. Economics is the study of humans making choices, individually and collectively. There’s strategic interactions between the choices that people make. Thus game theory is a very important tool used to analyse human choice. Later we will read a bit of game theory.

Paul Samuelson defined it thusly in his famous textbook Economics:

Economics is the study of how people and society end up choosing, with or without the use of money, to employ scarce productive resources that could have alternative uses–to produce various commodities and distribute them for consumption, now or in the future, among various persons and groups in society. Economics analyzes the costs and the benefits of improving patterns of resource use.

Yet, what is economics is not an easy question. Your answer will start to become more general as you understand the subject better. That’s true about all disciplines. For those of you who have a background in computer science (and I don’t mean just a background in knowing how to program), you will be able to appreciate a definition of a program which goes like this:

• A program is a state to state mapping.
• A state is a name to value mapping.

That definition would not make sense at the beginning but with time you will see that it is the most concise, compact and general definition of a program. Definitions are funny like that. Simple words can be defined easily. But an idea cannot be defined so easily. You have to know the idea before its definition makes sense. And an hierarchical collection of abstract ideas — which is what a subject like economics is — is even harder to compactly define before one knows the subject. The best one can do is to examine the subject from various angles (continue to walk around the elephant) and then construct your own definition.

So why, you may ask, did I put that question at the start of this class? It was to show that different people have different conceptions of what something is. And I am pretty sure that whenever we learn something, it changes our understanding of what the subject is about. I hope at the end of this class, you will think differently about what economics is and why it is important.

The Tao which can be named is not the Eternal Tao.

That’s what the ancients in China realized a long long time ago. And back home in India, our ancients put it quite succinctly: neti, neti. Whatever we conceive it to be, it is not that, not that.

Whatever we think economics is, it is probably not that.

NOTES:

[1] What is Austrian Economics? The Ludwig von Mises Institute. Mises.org

[2] Opportunity cost is one of those ideas which if you understand deeply and correctly apply, you can save yourself a lot of mistakes. I dare say that many of the most costly mistakes made by well-intentioned public policy makers is due to their not understanding the idea of opportunity costs.

Here’s a bit about the idea from a previous post, “Casting Spells to Fix the Broken Car” from Dec 2004.

Folk wisdom captures very succinctly the idea that life is about tradeoffs in the saying that one cannot eat one’s cake and have it as well. If you eat the cake, it is gone and you no longer have it. Economists call it opportunity cost. The opportunity cost of eating the cake is not having it; conversely, the opportunity cost of having the cake is that of not eating it.

Remarkable results follow from exploring the idea of opportunity costs. The whole theory of comparative advantage — the fundamental reason why trade is a win-win game — pivots around the idea. One could do worse than to sit and consider opportunity costs whenever one contemplates doing something.

In fact, I would go so far as to claim that economics at its most fundamental is the careful systematic study of opportunity costs. Opportunity costs implies choices and tradeoffs, and is itself the consequence of a fundamental physical characteristic of the universe that we live in. That fundamental fact is that this universe has limits. Each one of us has a limited amount of time and other derivative resources at our disposal.

Economics is about making choices and economic policy is about policy choices. How an economy performs depends on the economic policy choices made by whoever is in charge of making choices.