A while ago a non-economist friend who had read my book “Transforming India” said that as he did not understand economics would I write a book explaining some of the basic concepts of economics? It would be a “prequel” to the “Transforming India” book. That sounded like a good idea and over the last couple of months, I have spent some time on such a book. The working title is “Understanding Economics.” Not the most brilliant title but that will change to something more attractive by the time it is ready for publication.
To be entirely honest, I find writing pretty hard. The empty page (or screen, as it happens in this case) is forbidding and I usually hit a brick wall. I feel that there’s nothing to explain — until someone asks a question. So here’s your chance: if you have a question in mind, I would be delighted to address it. Since crowd-sourcing is all the rage these days, why not crowd-source the book? I say let the crowds (all three of you who read this blog) ask the questions and I will do the answering.
One of the things that I want to do with the book is to explain what economic models are. As you know, economists do it with models. A few months ago I was explaining to a 12-year old kid that models help us understand the messy world around us. We cannot comprehend the complicated world unless we strip it of all its rich details and create a model which we can hold in our heads and think systematically about it. We proceed slowly, taking the next step cautiously only after we are sure of our mental footing.
Going too fast when working with models is definitely a bad idea. Patience is absolutely essential. The kid was, as all 12-year olds are, very impatient. He wanted to know it all right now. Sorry, kid, I said, we have to proceed methodically. I gave him his first real lesson in economics model building. Here it is, for the record.
“Consider an economy which produces and consumes only corn,” I began.
“That’s it? How on earth can anyone survive on corn alone?” he objected.
“Remember we are building a model. We make up the world any which way we like. In this world, the only thing produced and consumed is corn. And the only thing you need to produce corn is — guess what — corn, since that’s all that there is in our model world. If you have some corn, you produce more corn. You don’t need land, or labor, or anything else. Just corn,” I said.
“Without land, you cannot grow corn,” he said firmly.
Yes, in the real world you cannot grow corn without seed corn, land, water, sunshine and labor. But in the model we have at hand, all we need is seed corn. How much is produced depends on how much seed corn you have. Now comes the constraint. You cannot consume more corn than your total production of corn. You can however consume less than your production — in which case you have what we call “savings.”
What do you do with your savings? You invest it. So the “investments” come from that part of your production that you save. From your investment comes the next period’s production. Another word we can use here is “capital.” Capital gets produced by not consuming all your production and saving some of it.
“Yeah, yeah,” said the 12-year old. “I want to know about exchange rates, and the use of technology, and about balance of payments. I want to know how the GDP growth rates depend on aggregate demand and how to control inflation. I am not sure how you can talk about unemployment and how subsidies for the trading sector can affect it with this silly thing about corn and how it grows without labor and technology.”
“I was coming to that,” I said. “But you have to have patience. Slowly we will enrich the model and when it is done, you will see that every bit makes sense.”
Part of the problem, you see, is that people are too impatient. They want it all and they want it now. The great unnoticed evil is that of instant gratification. Here we will take our own sweet time and gradually develop the story.
“What have you learned so far?” I asked.
“It seems that without production there can be no consumption. And that without saving there can be no production either. That there is a trade-off between consumption now and consumption later. If we consume all our corn this period, there can be no production next period. I also figure that if you are too short-sighted, you suffer in the long run,” said the kid.
He’s a smart cookie even though he’s impatient. Remember, I said, there’s no such thing as a free lunch.
“So what’s next,” said the kid.
“Exciting things,” I said. “Next we are going to introduce labor as an input to production. And tractors. Would you like that — tractors? We will introduce labor and tractors so that we can figure out how technology helps us produce more corn.”
“But when will we start producing more interesting stuff than corn?” he said.
“In due course we will produce a zillion different things. And trade with other nations — which don’t exist at all right now in our make-believe world. In time our model will become rich enough that everything you care to consider will be in it. Gradually we will have our world produce more than just corn. And we will see how the terms of trade change when we produce both corn and tractors. Of course you cannot run tractors without fossil fuels. We will figure out how natural resources influence the production of stuff. Then we will see how governments affect the whole enterprise of production and consumption. We will talk about the production of shoes and ships, and sealing wax and kings,” I said.
“Yes, kings,” I replied. “Or at least their contemporary equivalents. Politics and politicians. We will talk about markets and market failures. About other models of human behavior such as the prisoner’s dilemma and the tragedy of the commons. Later we will talk about the theory of the second best. By the time we are done, you will know why some nations fail and why some other nations succeed. You will know what the secret sauce is and why.”
“Whatever,” said the 12-year old.
Update Nov 30: The follow up to the comments to this post is here “Understanding Economics — Follow up.”