The Scope of Economics 

Economics divides itself up into two major subfields; microeconomics and macroeconomics.  The traditional way of explaining this is subdivision is to use the analogy of the trees and the forest.  Microeconomics is about the trees, macroeconomics is about the forest.  Micro’s main focus is how markets (and those people and institutions that make-up markets) interact, much the way one tree may interact with another (or even how a tree may interact with a bird).  Micro econ endeavors to see how prices influence the economics behavior of individuals, how prices are determined in different market conditions (competitive, monopoly and so forth) and whether markets outcomes serve the interest of society.  Macro econ looks at the economy as a whole, is it expanding or contracting?  Are all the available resources being put to use?  The core issues are growth, recession and inflation. 

Rational Self-interest 

Since this course is micro we will be concentrate our attention on markets and how they work.  We start our analysis at the individual member of society.  One of the things that we do in all the social sciences is to try to model human behavior.  We build these models to try to answer the question:  why do people behave the way they do?  We economists tend to answer this question in a fairly simple way (our critics...which includes more than a few economists who we will study a later in the quarter…say too simple).  We argue that people are rationally self-interested.  What do we mean by this? 

We say that when people are confronted with a choice, as they must be when scarcity exists, they tend to weigh out the costs and benefits of all the alternatives.  The choice that has the most net benefit (or least net cost if there are no net gains to be had) is the one they will select.  This weighing out process is called rational.  Please note that rational doesn’t necessarily mean sane.  If the voices tell me to go up on the rooftop and shoot my fellow students, I may rationally weigh out the cost of being imprisoned or killed against the benefit of quieting these very annoying voices.  But, whatever I rationally decide, I’ve got a sanity problem, so rational means to compare costs and benefits and maximize the gain or minimize the loss. 

The next problem is to determine how costs and benefits are assessed.  In other words, when we say costs, benefits, and net gain, what do we mean?  Do we mean the costs to you or me?  Do we mean the benefits to Harry or Mary?  Do we mean the net gain (or loss) to society or to the individual?  We economists say that the individual will weigh those costs, benefits, and net gains or losses in terms of their individual interests.   

What is an interest?  It is an aspiration or goal that an individual has.  I may have a goal to be rich; therefore, my choices will be weighed out in terms of how they affect my goal.  I won’t donate my time to the local church; instead I will work overtime to gain recognition by the company.  Or, I may want to be thought of as generous.  In this case, I would donate my time to the local church rather than work overtime.  Ask yourself why you chose to sign up for this class.  Did you do it to understand more about the economy?  Did you do it because society needs more people to understand economics?  Did you do it because you don’t want to commute or because society needs fewer cars on the road?  Why doesn’t everyone take this class? 

We economists would argue that all of you signed up for this course for a variety of reasons, all of which could be boiled down to the idea that each of you were following your own rational self-interest.  To the economist, when you decided to take this class you weighed out the costs and benefits in terms of how it furthered you towards some goal that you have chosen.  How you have come up with this goal may or may not be something economics can address.  If your goal is to be wealthy, you may have signed up for this class in order to advance yourself towards that goal.  After all, getting a degree is a common characteristic of wealthy people.  But, you may want to be rich in order to prove that your father was wrong when he called you worthless, or you may want to be rich because you like expensive stuff.  These latter areas are more the field of psychology or sociology.   They may be very important questions, but traditional economics do not address these questions in any great depth. 

However, there is a new a growing field within economics called behavioral economics that very directly tries to answer these questions.  They do this by focusing on the very times and places where people seem to be behaving the least rational.  There is a very extensive body of literature devoted to one of the most economically devastating irrational events, the financial bubble.  A bubble is when people speculate that the price of some asset is going to increase to the points where those prices lose all connection with reality (rationality).  The 1929 stock market crash was one of the most famous, but we just recently experienced one centered on technology stocks called the dot com bubble.  Robert Schiller’s Irrational Exuberance would be a good place to start reading about this. 

For the rational self-interest assumption to hold we also need to take into account information.  When one makes a rational decision they are basing it on the best information that they have available at the time.  If the information is flawed then the decisions are flawed (as programmers say…garbage in garbage out).  You seek information all the time when making a decision.  Before to decide to go to a movie you might check out the newspaper for a review or recall a friend’s comment about the movie.  If you make a decision without accurate information you are likely to make a wrong decision (on that doesn’t further your goals).  The recent accounting scandals were all about information.  Businesses were hiding expenses and exaggerating income so that people would pay more for the stock of the company. 

This is a good point to digress a bit about institutions in order to reinforce this concept.  In the 1980s the way top management was paid changed from salaries to salaries plus stock options.   This represents an institutional change.  How did it change how a firm operated?  First, a stock option is the ability to buy a stock in the future at a set price.  For example, a chief financial officer (CEO) of a firm might get a contract that pays him or her $500,000 a year (salary), but added to that would be the ability to buy a 10,000 shares of stock in the company for $5.00 a share.  If the firm’s stock were to increase to $55.00 a share he or she would be able to buy the stock from the company at $5.00 and sell it for $55.00 for a gain of $500,000 thereby doubling his/her income.  This was thought to be good by those hiring CEOs because most stockholders would want to see there share prices increase.  But what this system has done is build in an incentive to overstate the income and understate the losses of the firm.  This is exactly what Eron did and Kenneth Lay made a fortune through “exercising his options.”   

This also had an interesting impact on how firms made decisions.  Recall that the rational decision maker weighs out costs and benefits as the impact his or her interests.  In this case what was the interest of top management?  They benefited greatly if the buyers and sellers of stock market deemed their choices good.  Speculators in stocks tend to look at the short term rather than long term.  This means that the firm will also tend to take a short term view of the world.  They will look for investments that pay off in the short term and not concern themselves with the longer term.     

Does this matter?  In a word: yes.  Look at your own investment behavior.  If you new you were going to die in the next six months would you stay in school?  For some of you the answer would be yes, or others, no.  For those who said no, they would say that the opportunity cost of staying in school (traveling, skiing, hiking, spending time with friends and family) is greater than the benefits (learning, reading econ textbooks, listening to brilliant lectures…).  Quite rational, don’t you think?  So some significant number of you would stop investing in education because you moved from long term thinking to short term thinking.  The same criticism has been aimed at businesses in the U.S. 

You should also note that rational self-interest does not mean greedy.  To those who rank wealth higher than their other interests might be greedy, but simply because you decide to take a job that pays $8.00 an hour instead of one that pays $7.00 an hour does not make you greedy.  You’re just behaving in your rational self-interest.  However, it is interesting to note that during the just mentioned financial bubbles, greed plays a significant role. 

Efficiency 

How does this rational self-interested behavior influence social outcomes?  Does it result in good things or bad things? We will be addressing these questions for the rest of the class.  But for this week, let’s figure out how we will evaluate those outcomes. Because economics is concerned with the material well being of society, our evaluation can be fairly straightforward.  We don’t have to worry about individual fulfillment, happiness, enlightenment, etc.  The main concern we have is whether or not we’re getting the most value from our resources.  If we are, then we are efficient; if we aren’t, then we are inefficient.   

We can break down this evaluation into two sub-categories.  The first one is whether we are fully and sustainably using our resources or not.  If we are, then we are productively efficient.  If we are not, then we are productively inefficient.  When there are idle resources, particularly labor, we are not getting all the material goods that we might if those resources were being put to use.  Therefore, we are being productively inefficient.  One of the most striking examples of productive inefficiency in the twentieth century was a period called the Great Depression.  It started in 1929 and lasted until 1941.  At its worst, up to one-third of the working age population was idle.  That’s a lot of stuff that simply didn’t get produced.  

In the 1990s, we were experiencing an economic boom with very low unemployment rates; hence we were fairly productively efficient.  But, we were worried (we economist are never happy – we can see a dark cloud in any silver lining) that we were trying to produce too much and this might lead to inflation.  That’s right.  Trying to make too much is also productively inefficient.  You can think of productive efficiency as Goldilocks efficiency: not too cold, not too hot, but just right. 

We can also end up making too much now and hurting our ability to produce something later on.  Suppose that you were back on your island and found a pond with 100 fish in it.  Now suppose that one member of your group is a wildlife biologist who knows that this type of fish cannot successfully reproduce at a population under 80.  You would be very foolish to catch more than twenty fish a year.  So if you caught more than 20 fish you are depleting this resource to the point if will not sustain itself, again you are productively inefficient. A society should not use its resources to the point where it overuses them.  A classic example is the way that nineteenth century European-Americans hunted (overused) buffalo to the point where they almost became extinct.  Some argue the same thing is happening with salmon today.  But in this case, the Northwest is overusing the habitat where salmon spawn.  Global warming would be another example. 

The second category of efficiency is allocative.  Allocative efficiency is when a society is producing those goods that are most wanted by that society.  In the period right after World War II, the U.S. experienced a baby boom.  During such a period as this, should the society make more baby diapers or more Geritol?  If the answer turns out to be more Geritol, that society is allocatively inefficient.  These days, as those boomers start aging, what is the allocatively efficient choice? 

This kind of efficiency is pretty important.  After all, one of the reasons that the Communist countries gave up on socialism was that they were very allocatively inefficient.  People were always standing in line for things that the society had somehow neglected to produce.  Things like shoes, bread, automobiles and housing were chronically in short supply.  

However, some argue that they gave up one inefficiency for another.  (They say if you put two economists in a room, three opinions will come out.)  In the “bad old days” a person in a Communist country couldn’t find shoes, but they always had a job.  Now that they have tried to move their system to a capitalist one, there are shoes, but they can’t afford them because jobs are so hard to find.  In an efficient economy, there should be shoes and jobs. When a society is both productively efficient (fully utilizing all its resources) and allocatively efficient (to make those goods it really wants the most), it is considered economically efficient. 

Conclusion 

The big deal here is to get you to realize that an economic system not something that is just simply "is" but something we have control over.  But we need some way to evaluate it.  Efficiency is one of our measuring sticks.  At this juncture in history the market system (more specifically capitalism) has the best track record for achieving efficiency.  This is one of the reasons that we no longer have a cold war.   The socialist nations could not keep up with the incredibly productive capitalist economies.  

This is not to say that the market system or capitalism is perfect.  As you will see, we economists think there are several imperfections, called market failures, which should be addressed.    We’ve already talked about the command system of communism being allocatively inefficient.  The same could be said about the traditional system.  Were the slaves of Egypt best served by building the Pyramids?   Traditionally, men and women are not allowed to do whatever they are best at.  Even today if a woman is good at carpentry she is unlikely to easily find success in her field because she is fighting tradition.  The same could be said for male nurses.  But in pure market systems the gender of the carpenter means little; what counts is the value of her/his product.