Understanding Economics is Easy

In the previous post “Economics and Physics” I briefly explored why the basic explanations of physics are hard to understand and why the basic explanations of economics are easy to understand. Physics is called a “hard science”. I believe it is hard in the sense that advances in physics are made by supremely intelligent people and even comprehending them requires a good deal of training and intelligence.

Physics is also hard in that it is not some soft and squishy, namby-pamby whatever goes kind of nonsense, unlike in some other intellectual enterprises where people just make up stuff as they go along.

Inanimate Objects and Hard Sciences

Unlike physics, economics is not a hard science. It can be variously characterized as a social science, or a behavioral science. Its basic tools are logic and game theory rigorously applied to a set of axioms that relate to how individuals behave. Unlike physics, economics cannot make any precise macro-level predictions. For example, in economics there is no equivalent to the E=mc**2 or the inverse square laws of physics.

Note that equations of physics encapsulate relationships between physical variables. These relationships are just so. They are precise but do not arise out of any logical necessity. Certainly, mathematical tools are useful in the study of physics but that’s just incidental. It is a bit of a mystery why mathematics just happens to apply so neatly to physics.[1]

What makes precise predictions possible in physics is that the objects that it deals with are inanimate. An electron is indistinguishable from any other electron, and all electrons respond to magnetic fields precisely the same way. You’ve seen one electron, you’ve seen all electrons. You’ve seen one carbon atom, you’ve seen all carbon atoms.[2]

Humans are Different

Enough of physics. Now let’s talk about economics. Which means we need to talk about how people act. Here is a list of verities about humans:

1. People are not identical. Each of us is unique in our preferences, abilities, skills, and natural endowments. If humans were all identical, economics would be more like physics.
2. People act purposefully. There’s always a purpose. That purpose is known to the individual, and not to others. At any moment, there are as many purposes as there are people. There are over 7 billion purposes at this very moment.
3. People are rational. This follows from (2) above. They use reason in the ends they choose and the means they use to achieve those ends.
4. People behave strategically. People are not wooden boards. In my favorite Bruce Lee movie Enter the Dragon there’s an instructive scene. Just before a particular fight, Bruce Lee’s opponent demonstrates his toughness by punching a wooden board to bits. Unimpressed, Bruce Lee impassively stares at him and calmly says, “Boards don’t hit back.”[3]
5. People are unpredictable. The unpredictability of people arises from basic human nature. Motives and goals change, preferences change, circumstances change, knowledge changes.
6. People are impatient. Time is the ultimate scarce resource. So they have a time preference. Whatever they want, they’d rather have it sooner than later. To persuade people to have it later, you have to compensate them. That’s the interest rate.
7. People have limited cognitive capacities. They can do only so much with their brains. Thinking is costly and has diminishing returns.
8. People have limited knowledge. They don’t know everything about anything. Acquiring knowledge is costly for people, regardless of how much information they have.[4]
9. People respond to incentives. Rewards and punishments change what people do.
10. People act opportunistically. This is not to say that all people, all the time are immoral, uncaring, unethical and selfish; but that given a chance, many people would free-ride if they could get away with it.
11. People prefer more of something they desire than less of it.
12. People operate at the margins. The next unit of whatever a person consumes (or has access to) provides less satisfaction than the previous unit consumed. That gives rise to the “law” of diminishing marginal utility.
13. People have limited resources to satisfy their wants. Therefore they have to choose what to give up in order to get something else in return. Meaning there are trade-offs.
14. People’s valuation is subjective. The trade-offs that people make differ from person to person because of their differing subjective valuations.

The last two points bring up an important and subtle concept. When you do something, you have forever foregone the opportunity of doing all the other things you could have done instead. That is the concept of “opportunity cost”. Opportunity costs arise from a basic feature of the universe — that time is limited. Furthermore, opportunity costs are subjective.[5]

Are those claims about people true? I think they are. How do I know? Because they happen to be true for me. And I suspect that they are true for you too. We are conscious beings with the ability to reflect and introspect. We cannot explain how consciousness arises but we experience consciousness. Atoms, bricks, and wooden boards don’t.

Societies Cannot be Engineered

Which is why it is possible to successfully engineer a bridge or a building but not a society. Social engineering is doomed to failure, as has been empirically demonstrated by communist and socialists regimes across the world for decades at the cost of enormous human suffering. This is why one of the best ways to ensure poverty is set up a Planning Commission — as India has done for many decades.

Why does planning fail to create wealth? Why does communism fail? Why does socialism fail to deliver the wonders it promises? Economics answers those questions. The beauty of economics is that the answers are accessible to the average 12-year old.

Next time.

References:

1. Talking of mathematics and physics, the trouble is that some economists suffer from physics envy. Not all but some variety of economists envy the mathematics of physics and try to use heavy-duty mathematics to persuade themselves, and delude non-economists into thinking, that economics is a hard science. This has led to the problem of “mathiness” of economics.
   See Paul Romer’s blog post “Mathiness in the Theory of Economic Growth” (May 2015) for more on what he labels mathiness.
2. Why are all electrons the same? One conjecture is that there is only one electron in the universe. What we see as different electrons is just that electron is moving back and forth in the time dimension — as an electron in one direction and a positron in the other.
3. I had first watched Enter the Dragon way back when I was in engineering school, and many times since then. One day out of the blue my mind retrieved that very brief “boards don’t hit back” line as the salient distinction between science and economics: their objects of study differ.
4. Distinguishing between knowledge and information is important. One can get into frightfully confused thinking by conflating the two.
5. 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.