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Cambridge University Press
0521818648 - Price Theory and Applications - Decisions, Markets, and Information - by Jack Hirshleifer, Amihai Glazer and David Hirshleifer
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1. THE NATURE AND SCOPE OF ECONOMICS

Economics concerns decisions - choices among actions. Every action has its pros and cons, pluses and minuses, benefits and costs. Are you thinking about taking up tennis? The game may trim your figure and improve your disposition, but will take time from your studies and could damage your joints. How about dropping out of college to take a job? You would likely earn more money now, but earn less later in life. Similarly in business and government. Whether it's a small action, as when your neighborhood market sets its price for potatoes, or a big one, as when Congress decides on declaring war, almost always there are valid arguments for and against. Faced with such opposed considerations, how should individuals, firms, or governments make decisions? Economics shows how to determine the best action, through a systematic assessment of the costs and benefits.

Few decisions are made in a vacuum. Other people are likely to react. Thinking like an economist means taking these reactions into account. A law firm that raises its billing rates may find customers switching to another provider of legal services - so the higher price might not increase profit after all. Or imagine that Congress, aiming to widen use of the Internet, were to require Internet service providers (ISPs) to charge very low prices. Before concluding that this is a good idea we would need to know how the ISPs would react. They might provide access at those low prices. Or they might reduce the quality of service, so that consumers find busy signals when trying to connect. (Although this might seem a rather wild example, something similar occurs when rent-control legislation freezes apartment rents during a period of general price inflation. Such a price freeze makes landlords less willing to supply and to maintain rental housing.)

Economics has been called the "dismal science."¹ That's probably because economists are often messengers bringing bad news; for example, that a superficially appealing project or scheme may not be such a great idea once all the consequences are taken into account.

Table 1.1 lists a number of individual and social problems, together with some purported "solutions." Also shown are possible bad consequences that an economist might point out. Can you add other possible objections? And on the other side, can you think of counterarguments that might rebut these objections?

Proponents of plans and projects tend to overlook possible flaws, while opponents tend to ignore the evidence in favor. Because people committed to one side of a question generally do not want to listen to contrary arguments, thinking like an economist - trying to impartially weigh the pros and cons - may not make you popular. But it is likely to improve your private decisions, enhance your prospects of business success, and make your views on social issues more balanced.

1.1 ECONOMICS AS A SOCIAL SCIENCE

Economics is a science. Like other sciences it consists of explanations (theories) that help us understand and make valid predictions about the real world, together with the empirical evidence for and against them. More specifically, economics is a social science. Its subject matter is the interplay of choices made by living beings. Economics addresses questions such as: Will a reduction in the capital gains tax make the stock market rise? Will higher tariffs make consumers better off? Will increased prison terms reduce crime? Will easier divorce improve the status of women? Will a high-price (meaning low volume of sales) strategy lead to more profit for a firm than a low-price strategy?

A cynic might deny that economics is a science. Here is a possible complaint: "Economists always disagree with one another. That doesn't give me much confidence that economics has arrived at scientific truth. Furthermore, if economists can scientifically predict financial and commercial events, why aren't they all rich?"

It's easy to exaggerate the disagreement among economists. Controversy makes news; consensus rarely does. The great majority of economists agree that price controls lead to shortages, that free trade improves the international division of labor, and that uncontrolled printing of money will bring about inflation.² What is more important, disagreement is essential if a science is to advance. In astronomy the heliocentric hypothesis of Copernicus challenged Ptolemy's 1,000-year-old geocentric model. In chemistry the phlogiston theory of combustion was superseded by Lavoisier's oxidation theory. And in biology creationism was countered by Darwin's theory of evolution. It is not universal agreement that characterizes science, but rather willingness to examine the evidence. All important issues of economics - for example, how taxes affect incentives to work, whether trade unions raise workers' wages, whether stronger copyright laws promote creativity - are under continuous re-evaluation in the light of the evidence. Economists may continue to disagree, perhaps because the problems are complex or the investigators insufficiently skilled, but unresolved issues persist in any living science.

Engineers, despite having well-validated theories and a vast amount of evidence as to strength of materials, commonly add a huge safety factor (50 or even 100%) before building a bridge or a dam. And even so, bridges still collapse and dams wash away. In Los Angeles during the 1994 earthquake, reinforced freeways designed to withstand an even more severe jolt than actually occurred nevertheless collapsed. As another example, meteorology is certainly a natural science, yet meteorologists hardly even claim to predict the weather for more than a week or so ahead. If economists predicting the extent of unemployment or forecasting the rate of inflation were permitted as wide a safety factor as engineers or meteorologists, they would rarely be seen as going very far astray.

EXAMPLE 1.1 THE ECOLOGIST, THE ECONOMIST, AND THE STATISTICIAN

In 1990 the ecologist and popular author Paul Ehrlich sent a check for $576.07 to the economist Julian L. Simon. It was a payoff on a bet made 10 years previously. Ehrlich, though not an economist, had made startling economic predictions in his 1968 best-seller The Population Bomb. Take, for example, his opening sentences: "The battle to feed all of humanity is over. In the 1970s hundreds of millions of people are going to starve to death."

Ehrlich's predictions utterly failed. Despite an "oil crisis" in mid-decade and again toward the end, overall the 1970s were a decade of remarkable economic growth. Yet the author continued to be highly acclaimed. In books, speeches, and articles that received worldwide attention he prophesied that accessible supplies of many key minerals would be nearly depleted by 1985.

Meanwhile the economist Julian L. Simon had been predicting just the reverse for the 1970s and 1980s: continuing improvements in human well-being, and lower prices for raw materials. Simon challenged Ehrlich to back his contrary forecast with hard cash, and Ehrlich accepted the challenge. The result was a 1980 bet about whether the prices of five important metals - chrome, copper, nickel, tin, and tungsten - would, after allowing for inflation, rise or fall by 1990. The economist let the ecologist choose the specific commodities. Once again, the economist Simon was proved right and Ehrlich wrong. The 1980s were also a decade of prosperity, and raw materials prices generally fell. The ecologist had to pay off on the bet.

Ehrlich's analytic error was to look only at the demand side, and specifically at growing world population (more mouths to feed). Julian Simon, with his better economic understanding, also considered the supply side. More people mean more mouths, but also more hands and brains. Simon also took account of other favorable economic trends such as greater liberalization of national economies and increased international trade.

So the predictions of economic analysis were vindicated. Nevertheless, Paul Ehrlich continued to publish highly popular books forecasting, as mistakenly as before, environmental doom in the near future. Just as regularly, up to his death in 1998 Julian Simon was providing sound analysis and well-validated economic forecasts, culminating in his volume The Ultimate Resource (2nd ed., Princeton University Press, 1998). But none of his books were best-sellers.

What was going on here? An economic interpretation might be that these two authors were supplying different commodities. Julian Simon was supplying correct economic analysis. Paul Ehrlich was and is in a different business, rather comparable to horror-story writers such as Stephen King. Evidently, at least when it comes to selling books, the demand for horror stories far exceeds the demand for sound economic analysis.^a

A later exhaustive and careful study by the Danish statistician Bjorn Lomborg (The Skeptical Environmentalist, Cambridge University Press, 2001) has updated Simon's results. Initially intending to refute Simon's analysis, Lomborg found his research instead confirming it. Despite rising world population, per capita incomes have maintained their upward trend and real prices of important resources have continued to fall.

As a rather strange sidelight, upon publishing these results Lomborg became the target of personal attacks that reached an extraordinary level of intensity. At one of his public presentations a cream pie was dumped on his face and clothing. He was even accused of "intellectual dishonesty" by a scientific body with official standing in Denmark. Ultimately, all the charges were conclusively refuted, and the improperly motivated proceeding against Lomborg was dismissed. (Which does not necessarily mean, of course, that all of Lomborg's estimates and forecasts will ultimately prove to be correct.)

One possible lesson: sound economic analysis can sometimes be riskier than you might think!^b

^a For a detailed history of the Ehrlich-Simon wager see John Tierney, "Betting the Planet," New York Times Magazine, December 2, 1990.
^b A summary of the Lomborg controversy is provided in Jim Giles, "The Man They Love to Hate," Nature, v. 423, May 15, 2003.

The cynic's second challenge to economists - "Why aren't you all rich?" - sounds crass. But economists, of all people, cannot dismiss it. First of all, as the preceding Example showed, correct economic analysis need not have greater market appeal than incorrect but psychologically appealing assertions. More generally, scientific knowledge in any field does not guarantee riches. If Michael Jordan had studied the aerodynamic equations governing the motion of spheroidal missiles, would that have improved his basketball point scores? This argument shouldn't be pressed too far, though. After all, what's the use of economics (or of aerodynamics, for that matter) if not the practical results obtained? So it's reasonable to expect that better understanding of economics and markets would lead to more wealth. Although most people can hardly match the life achievements of geniuses like Tiger Woods in sports or Bill Gates in business, training in economics ought to increase income. And, as the next Example shows, apparently to some extent it does.

EXAMPLE 1.2 EARNINGS OF MALE COLLEGE GRADUATES, BY FIELD

The table shows median annual earnings for men with bachelor's degrees, by selected fields, for the year 1993 - the latest year for which such data have been published. Only selected fields are shown here, and the ranking is among those selected fields. (The source also tabulates earnings for women graduates, but the female tabulation unfortunately omits economics.)

In this tabulation, economics is the best-paying social science degree, ranking just below a high-earnings group that includes engineering, physics, mathematics, and (surprisingly perhaps) pharmacy. (Though not shown in this tabulation, pharmacy is actually the top-ranking field for women.)

One cannot be sure that these high incomes are due specifically to educational preparation. To earn a degree in engineering, math/stat, or physics you have to be pretty smart to begin with, and perhaps that applies also to economics. Also, the life styles associated with different occupations may be attractive or repellent. Higher pay may be needed to induce people to become bill collectors or hangmen, and conceivably economics suffers from a mild version of such distaste. Perhaps the category of philosophy, religion, and theology ranks at the very bottom of the tabulated wage distribution because many people find such employment to be a noble activity, a "higher calling." (How such nonpecuniary considerations influence occupational wage patterns will be studied in Chapter 12.) Overall, it seems reasonable to conclude that studying economics does pay off, to some extent, in terms of higher income.

What about the other social sciences? Sociology, anthropology, political science, social psychology, and sociobiology also attempt to explain behavior. The boundaries between economics and these other sciences are indistinct, in part because economic reasoning has shown itself to be of value in those fields as well. Anthropologists use economic techniques to analyze the foraging choices and birth-spacing decisions of primitive peoples. Political scientists use cost-benefit analysis to predict how many citizens will cast ballots and which way they will vote. And sociobiologists, on the hypothesis that economically sound strategies are more likely to survive the test of evolutionary selection, employ economic analysis to explain, for example, why some animals choose to defend territories while others do not. (This book will be illustrating economic principles with instances drawn from these and other related social sciences.)

Although the boundaries may be indistinct, economics has a central core. First, on the individual level of choice economists generally postulate "economic man,"³ a hypothetical being whose decisions are based upon the rational pursuit of self-interest. Second, economics concentrates upon one type of human interaction: market exchange. In this book we necessarily emphasize the "narrow economics" associated with these core ideas. But there is a "broad economics" that goes beyond them. Economists can and do attempt to take account of irrational and nonselfish behavior. And economists certainly devote effort to studying nonmarket interactions, ranging from family relations to violent conflict.

However, first steps first. We must begin with the central core of economic reasoning.

1.2 "ECONOMIC MAN"

The term "economic man" is frequently used in a derogatory sense, as an implicit criticism of economic reasoning. Since people are not always rational and not always self-interested, economics is, critics allege, built on bad foundations. But the economist does not contend that rational and self-interested behavior are universal and absolute facts. Rather, they constitute a working hypothesis, whose validity in any context can only be assessed only by its usefulness. Does that assumption help us understand what actually happens in markets and elsewhere?

Rationality

Rational behavior has at least two meanings in common use. The first meaning refers to method, the second to result. When speaking of method, rational behavior is action selected on the basis of reasoned thought rather than habit, prejudice, or emotion. When speaking of result, rational behavior is action that is effective in achieving desired goals. The two meanings differ. Good methods can sometimes lead to bad results. ("The best laid schemes o' mice and men/Gang aft a-gley" - Robert Burns.) And the seemingly inferior methods available to animals, even some with tiny brains, often work very well. A human being chasing a fly with a swatter often loses the contest. But in general, we expect that considered thought leads to better action.

Everyone behaves irrationally to some extent - out of passion, thoughtlessness, mental defect, or just plain perverseness. So how can rationality be assumed in economics? Assuming rationality is justified only if doing so helps predict how people will behave. Economists find that for the most part, though not literally always, the assumption of rationality does work.

Operating a motor vehicle involves many decisions, among them how aggressively to drive. It might seem that driving aggressively is always irrational, but that depends upon one's ends. A rational person values safety, but also values other goals such as saving time and avoiding inconvenience.

EXAMPLE 1.3 RATIONAL DRIVERS?

Airbags reduce, on average, the severity of auto injuries and the risk of death from motor accidents. But given that additional safety margin, it might well be rational for motorists to drive more aggressively!

Is such an adaptation observed? Steven Peterson, George Hoffer, and Edward Millner examined statistics collected by the state of Virginia about fatal two-car accidents in 1993.^a In 30 such accidents, one car was equipped with an air bag and the other was not. The accident reports identified in each case the supposed "initiator," the party driving more aggressively. The table indicates that in 22 of the 30 accidents (73%) the initiators drove cars with airbags, although only 50% of the cars involved in accidents were equipped with airbags. So, the indications are, having an airbag increased the likelihood of a driver initiating an accident.

Any single bit of evidence such as this can only be indicative, not conclusive. And even if entirely valid, these results do not necessarily imply that regulations requiring airbags are inadvisable. Although drivers of airbag-equipped vehicles may indeed be more inclined to take risks, the increased aggressiveness may not entirely cancel out the overall beneficial safety effect of airbags.

^a Steven Peterson, George Hoffer, and Edward Millner, "Are Drivers of Air-Bag-Equipped Cars More Aggressive? A Test of the Offsetting Behavior Hypothesis," Journal of Law and Economics, v. 38 (October 1995).

For a person receiving disability pay, the rational choice of when to return to work depends upon the costs and the benefits. What would you expect to happen if disability benefits were increased?