Understanding Economics

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.

Author: Atanu Dey


16 thoughts on “Understanding Economics”

  1. Here is my question:

    Economist regularly fail to predict things like the Housing bubble burst in the US. Back then, some nutcases (like Peter Schiff) who are not economists predicted it exactly. At the same time nobel prize winning economists completely discarded it on television shows. If economic models can’t even predict such big things, I wonder what are they good for? In other words, isn’t the current economic theory just some mathematical model that has nothing to do with reality?

    I would like to have some examples where economic theories have been successful and reasons why they have failed miserably in other occassions.


  2. Fiat currency intrigues me. Fiat currency helps us avoid the complications of Barter system, this much is understood.
    Hence it seems to me that amount of fiat-currency printed/released by a Fed/RBI should be equal to value of goods that its citizens are going to exchange.
    Question1: How can the RBI/Fed print money with such abandon then?
    Question2: How does RBI/Fed go about deciding the amount of money to print?
    Question3: Excess money printing is a mechanism by government to take money out of the hands of citizens’ savings without explicitly calling it tax. Please confirm.


  3. I have a question about free-market philosophy. How does the philosophy of free-market or minimum govt justify govt funding of scientific research and primary education?

    By the way this http://www.quora.com/ is a very good place to answer questions asked by folks world over.


  4. I like the idea of a free market and am aware of the advantages of an incentivized system. Looking at the economic disparities in our society i would like to see you explore some policies or “regulations” enacted the government that are consistent with the idea of a free market economy (without any form of redistribution) and provide a better moral ground to justify a greed based system. Such policies, if any, will help us avoid situations like the sub-prime mortgage crisis which was the result of nothing but pure GREED.


  5. My question is about taxation management.

    We see people being taxed at local, state and Federal govt levels. In some countries, more tax is collected at the lowest level (local) and from that, a portion is sent upward (to the state and federal govts)for their budgets. In India, the reverse is true – taxes at federal level accrue the most income, and the Union govt then disburses some portion of it to the State Govts, who do a similar disbursal to the local governments. I feel that till the East India Company and then the colonial rule, we had the former approach (bottom – up) in India, and then we changed to top -down model which is continuing till date, and may never be allowed to change.

    If the current top down tax collection and disbursal model does not change, then what is the best model to decide who (central/state/local) should get how much tax money for their budgets?Should it be based on population, development need, strategic plan or a formula/equation derived from all these together? What does taxation theory say about the best model to ensure effective disbursal of tax monies across the nation? Thanks in advance.


  6. @VirtualPresence Greed is not a property of a system, but of human beings (atleast some large subset of humans). You cannot have a system that does not take that into account. Greed will always exist, no matter what system you come up with. Greed is not bad in a competitive, fair, accountable framework where it can be channeled into productive activities. Markets are the best system of determining when greed goes too far and companies get punished accordingly. Its only when the framework isn’t fair, or if the accountability mechanism is broken, or when there are distortions from regulators or govt that you have a problem. The problem is that greed is usually one step ahead of regulators, or greed can corrupt regulators, then what do you do? I think we have to live with reactive corrections of excess greed. Most of the time this is ok – like the dot com boom and collapse was not so bad, there was excess greed but it wasn’t too harmful. In the sub-prime crisis, if banks were allowed to fail, in a controller manner, it would not be so bad either. Accountability would apply and the guilty would pay. The problem occurs when the accountability mechanism in markets is interfered with by bailouts, etc. Its important to note though that the main problem in the US right now is not the financial crisis but the upcoming govt balance sheet problem due to over-commitment in entitlement programs. That has different dynamics from greed. If the US balance sheet was in better shape, without pressure from entitlement programs, the sub-prime crisis wouldn’t really be an issue at all. Although, clearly regulators could/should have nipped it earlier.


  7. @Tanno You’ve asked for economic models that would predict the crisis. Minsky is an economist who had models for ponzi debt cycles which would explain and predict the debt crisis. Schiller has behavioral models which predicted the housing bubble and various bubbles born out of irrational exuberance. Didier Sornette while not an economist, uses mathematical models to predict when asset prices will peak. Schiller is not a good example, he is like a broken clock who will be right eventually at some point in time. Raghuram Rajan is another economist who predicted the crisis using his models. There are lots of cases. I think you have to stop looking at business channels for sound advice. They are going to play the game of trotting out the bears when the market is down and trotting out the bulls when the market is going up. Even if they invite an economist, they will likely ask superficial questions, or the anchor will not have the depth to bring out the subtleties of the issues at hand.


  8. @Sambaran The missing link is the interest rate. The Fed will print as much money as is needed to target the interest rate declared in their policy. That interest rate will try to strike a balance between inflation and growth. As you say, if they sacrifice inflation for growth, then it is like a tax on savers because rates are lower than they should be, from an inflation perspective.

    Please see: http://en.wikipedia.org/wiki/Open_market_operation


  9. An issue that I partially have a feel for is: What is money?

    At a somewhat abstract level I see money as a perceived measure of the effort, or a perceived value of the work involved in production of stuff (to use your word :-)). The key word is of course “perceived”. A trade – an exchange of production effort – starts with the perceived value of the other party’s effort. It reaches a central tendency (mean, median, mode) over statistically independent exchanges (i.e. market forces must operate freely). Because money indeed captures the perceived effort – an abstraction – in very concrete terms, it facilitates “storing the effort” and utilising it over distant locations and distant times. If I borrow your effort (i.e. money), then the interest I pay is the part of my effort I return to you to cover your losses of utilising your effort during the period of loan. Seems ok to me so far. My view of money as above seems to fail when I apply it to exchange of – ideas, i.e. intellectual stuff. Perhaps my way of looking at money needs correction, or its application to trading ideas needs correction, or may be I am missing something completely.

    So what exactly is money?

    Warm regards,

    – Abhijat


  10. Hi Atanu,

    I would like to know about market failures. After reading your blog regularly for quite few years now, I think I do understand a bit about market system being better than government controlled economies. But to have the capitalistic market system work properly, you have mentioned that the markets have to be regulated just enough to prevent market failure and increase competition. I would like to know what level of regulations are must, say in the financial sector for example. If you can give some examples of market failures in the history with their possible remedies, it will be really great.



  11. @DJ Let me state an analogy. Prisons are a reactive system meant to rehabilitate individuals who disobey the law but the government doesn’t stop there. There are far too many overt and covert surveillance programs run either by the that proactively snubs criminal activities albeit on a much more macro scale.
    I do realize that it is people who are greedy and those who make up the gov. are also greedy by nature. I do not agree with the statement “greed is not bad” as this brings up an unsolvable question of how much greed is good? (on similar lines to “how much freedom of speech is enough?”)
    In the sub-prime crisis it was taken too far and no amount of controlled failures would have helped the thousands of families on the street. The packaging of loans and offloading repayment worries to others and making money while jacking up the interest rates of the borrower in the process can in no way be anything less than horrendous. When this instrument of making money failed you had the rate adjustment scandal over at libor and the list continues.
    Greed, my friend is like a virus, it mutates and almost always finds a way to succeed.


  12. @VirtualPresence Yes, proactive surveillance is the job of the regulators and the central bank. And, I agree that they weren’t proactive enough. Unfortunately, we had the mistaken ideas of self-regulation dominating the policy makers’ inclinations. That idea is dead for good, thankfully. This should also be the death of Ayn Rand’s philosophy, with her acolyte, Greenspan’s acceptance of the flaws in his belief of self-regulation.

    Other than the regulator’s response (or the lack of it), the major problem with the subprime crisis and the libor scandal, etc is the lack of post-event accountability. Some serious punishments would have led to atleast some measure of deterrence.

    Please don’t take a phrase out of context. My complete point was: “greed is not bad in an accountable framework”. I’m not making the Gordon Gekko argument.

    To some extent you are conflating greed with fraud. Greed can lead to good things, as long as no fraud is committed. And, no undue influence is exercised using money/power, etc. The latter being harder to control/punish. If you disagree, you would like to stamp out all greed? How do you do that?


  13. @DJ I did give it some thought and and almost all alternatives/corrections i could think of with respect to a non greed based system was either a sugar coated version of communism or impractical. I guess it is utterly naive to expect a system with greed but no fraud or a system with greed not being the driving force.
    I’m afraid post-event accountability will not be an effective deterrent with the diverse set of rules each country has. Even when it comes at the cost of human lives (Union Carbide disaster naah massacre) or damage to the ecosystem (the iron dump off the coast of canada so that one corporation could profit more from carbon emission trade).
    Ironically it looks like we can only hope on self-regulation (moral integrity) of people/corporations to not screw up more than they have to… sigh….


  14. Atanu, two of my comments didn’t make it. Not quite sure why. On resubmitting I’m told that I am submitting a duplicate comment. So, something went wrong. Maybe they got labelled as spam, which might not be wrong 😉


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