What people get wrong about Economics

Having done a year of economics I now feel imminently qualified to pronounce judgement upon it and upon those who criticise it. There are a lot of things said about economics, the economy and economists by those outside the profession that is wrong, or at least misguided. I was guilty of many of these pronouncements in years gone by. The record will be set straight. In a follow up article I will discuss what I still or now think is wrong with the discipline.

There are two criticisms that I would like to answer and a point I would like to clarify. First, I would like to discuss the charge that economics is dependent on the rational agent hypothesis, which is a plainly false hypothesis, and that economics is therefore bunk. As part of this analysis I will address the claim that economics assumes everyone is a selfish dickhead. I will also address the complaint that the economist’s notion of ‘utility’ is an inaccurate term that introduces an unacceptable amount of bias into economic models.

Second, I would like to counter the accusation that all economists are bastards who care nothing for altruism, the environment, people or common decency, being fixated instead on ‘production’. This is absolutely wrong. Economists, especially academic economists, care deeply about these issues and, in my opinion, do more to effect real change than any other social science. Rather, this charge should be levelled at business interests that exploit the language of economics to make claims that no economist worth his papers would ever countenance, such as Tony Abbott’s claim that the Carbon Tax damages the economy.

Finally, I would like to clarify the difference between production and productivity, as the terms are grossly misused in the public discourse, leading to a range of problems.

You will oft here it mentioned that economics assumes people are rational, which is wrong, and so the whole discipline is a big waste of time. Certainly people are not rational, we know because economists, specifically behavioural economists (notably Daniel Kahneman) went to pains to prove it. People are in fact predictably irrational. One famous example is the lotto, which economists refer to as the idiot tax because the odds of making money are so far outweighed by the odds of losing money. A more articulate example is the following from Economist Daniel McFadden:

‘You go to your car dealer seeking a model that has a sound system you want. He says it will take 3 days to get that exact model, but you can drive away right now with one that has a better sound system and costs $300 more. Most buyers will choose to pay a little more and take their new car now. However, if the dealer said that no car is available right now, and he can get the model you want in 33 days, but a model costing $300 more with a better sound system in 30 days, most buyers will choose to wait the 33 days and get the exact model they want. This is hyperbolic discounting at work. Rational consumers with consistent intertemporal evaluation should treat the trade "$300 for an attractive but unneeded accessory versus 3 days" the same whether it is executed right now or executed in 30 days.’

Yet importantly, these cases of irrationality are almost invariably marginal, and are irrelevant to the bulk of economic activity. Certainly we can think of various hypothetical, rare and or contrived situations in which people are a bit crazy. But when you buy a bag of rice at the supermarket your behaviour will be extremely rational. You will trade off price and quality and the price and quality of substitutes (like pasta or bread) to come to a decision about which option maximises your utility. Economics explains these situations extremely well. It has a very rich and deep understanding of incentives, disincentives, prices, expected utilities, information, coordination, market access etc that allows it to make very precise predictions about the economic outcomes one might expect from certain conditions. This understanding means economics can tell us a great deal about the bulk of economic activity, and can help us design good policy for many situations. For the most part, it is everyday economic activity that policymakers and individuals are interested in, not marginal, rare, contrived cases.

It should also be noted that economists are quite adept at modelling irrational behaviour as well as rational behaviour, but that they often don’t need to because the economic notion of rationality is not quite as strict as the psychological or philosophical one. Economics merely assumes that individuals will act to satisfy their preferences. That is a rather weak assumption. I challenge you now to think of common cases where people do not act to satisfy their preferences. The lotto, cited earlier as irrational behaviour, is clearly a case of rational behaviour under the preferences definition, even if it is idiotic. Altruism can also be handled by the preferences assumption without compromising the assumption that the individual is inherently self-interested. Here we see that economics is not trying to make everyone into a greedy, heartless bastard. An individual can have a preference for altruism, and will act to satisfy it. However, if they merely claim to have a preference for altruism and actually do not, economics will call them on their bullshit, because it is action that defines the person.

Let us turn now to the second criticism I often hear of economists, namely, that we are all bastards. The fundamental issue here seems to be me to be that people think economics comes embedded with certain values. In particular, that the market is always right, and that nothing is as important as growth. But this is not the case. Economics is a thoroughly apolitical body of knowledge. It is not left or right wing, pro or anti government. Its methods and perspectives can be used to advance nearly any agenda. An economist can easily declare that a situation is both inefficient and the best course of action. Their models will not, however, allow them to pretend that a situation is actually efficient when it is not. No judgement is passed on the goodness or badness of efficiency. Indeed, any value set can be plugged in to economics to produce a range of outcomes. Some outcomes however, to a rational mind, will appear obviously poor. Venezuela’s current regime of price controls, for example, does not produce a good outcome. Economics will only show the outcomes—shortages, a lack of incentives for foreign investors, a lack of incentive to work, better equity etc—but it will not say that these things are good or bad.

Certainly economics is concerned with the operation of markets, and because markets have been shown to lead to very efficient and just outcomes given certain conditions, economists tend to have a bias towards markets. But it was economists who came up with the concept of market failure; and very few economists would declare that governments are unnecessary. I would go further to claim that most economists are actually very much in favour of government and recognise the need to steer markets to ensure they produce not only an efficient but also a humane outcome. Economists recognise that markets do not produce equitable outcomes, merely efficient ones. Government and morality is required to balance these competing requirements. This lesson is typically learnt in first year.

The people who give economics this bad name are people who use its language to make pronouncements that a proper economist knows are untrue. My favourite example is Prime Minister Abbott’s insistence that the Carbon Tax is hurting Australia’s economy. This is absolutely false. The Carbon Tax, as I have written elsewhere, is a so-called Pigovian tax that corrects an externality. An externality is an aspect of a transaction that is not incorporated into the price at the heart of that transaction. Pollution is the textbook example of a negative externality—people who buy energy, for example, don’t pay for the pollution coal burning produces, but it is still there. In the case of pollution, it is a very real feature of our economy. Clean air, water and soil are resources. As they deteriorate they affect the productivity of factors exposed to them. Fisheries produce smaller catches, farms weaker crops, cities less robust workers. These negative productivity effects have a value—a dollar value. The cost of offsetting these effects is what Pigovian taxes aim to determine and introduce into the market transaction. In the case of the Carbon Tax, polluters pay a fee to pollute to offset the damage they are doing to other productive assets downstream. Thus, to say that the Carbon Tax hurts the economy is to fundamentally misunderstand what the economy is. If you do not price pollution you are simply borrowing from the future. At some point you will have to pay. A carbon tax simply makes this cost present and manageable. It allows market actors to optimise their consumption.

When people say that policies like the Carbon Tax (or often the minimum wage, but that is a bit more complex) are bad for the economy, what they really mean is that they are bad for business. But the economy is comprised of both producers and consumers. Most free market economists are very much in favour of the little guy—the consumer. This is very frequently overlooked by the Marxists who think market economists are in league with big corporations when the case is actually the opposite. So next time you hear someone who sounds like an economist expounding dastardly views, check that they are actually an economist, and not a charlatan.

I turn now to the final point I wanted to address: the misuse of the term productivity. Recently I’ve heard a lot of commentators, notably the Australian treasurer, Joe Hockey, and the conservative commentator Niall Ferguson, suggest we need to work more to boost productivity. The term is here used incorrectly. What they mean is ‘produce more’—this is something else entirely. Productivity means doing more with less. The photocopier, for example, was a productivity enhancing devise because one secretary could now do the work of an entire typing pool, often in less time. Working more is actually detrimental to productivity because a worker’s effectiveness declines as they become fatigued. Working longer hours only has beneficial effects for an industry’s competitiveness if the labour is contributed voluntarily. But this is no different to reducing wages (which might be what Hockey and Ferguson actually want to say but know it would be unpopular).

The whole point of productivity enhancing reforms and innovations is that they should allow for the same level of production with fewer inputs. The gains can then be captured either as higher wages or fewer work hours. Productivity gains are basically the essence of economic development. Increasing production, by contrast, is only worthwhile if you have something to pay for (like a national debt). But if your macro fundamentals are solid working harder is pretty silly, and the argument that first world nations need to work harder to compete with China and other low cost nations is silly. (As a gentle aside, cutting executive salary would drive down the costs of Western firms significantly, making them much more competitive in the services sector without compromising the wages of lower ranking staff).

I would like to make one more point about productivity to close off this piece. Our thinking about productivity and production when it comes to finite resources is a little misguided. Certainly you can increase the production of the mining sector. You can also certainly increase its productivity (digging out more rocks with less effort). But at some point you are going to run out of rocks to dig up. When thinking about economic growth and the standard of living, the only thing really of relevance is increasing in productivity in non-finite areas. The photocopier mentioned earlier is a good example, as is the bicycle. Both create economy wide improvements in productivity that last, essentially, forever. Such innovations put the economy on a permanently higher plane. Digging up resources, by contrast, increases the economy temporarily—until the resource runs out. The benefits of these activities thus need to invested in things that will produce long term productivity gains (like infrastructure or R&D) if they are to be anything more than a loan from future generations.

So in summary, economists aren’t partisan bastards who only see the worst in people. Economics is not rendered useless by its reliance on the assumption of rationality. And productivity is not the same as production.