1.3: Economic Reasoning and Analysis

Learning ObjectiveS

1. How do economists reason?
2. What is comparative static?
3. What assumptions are commonly made by economists about human behavior?
4. What do economists mean by marginal?

What this country needs is some one-armed economists.

—Harry S. Truman

Economic reasoning is rather easy to satirize. One might want to know, for instance, what the effect of a policy change—a government program to educate unemployed workers, an increase in military spending, or an enhanced environmental regulation—will be on people and their ability to purchase the goods and services they desire. Unfortunately, a single change may have multiple effects. As an absurd and tortured example, government production of helium for (allegedly) military purposes reduces the cost of children’s birthday balloons, causing substitution away from party hats and hired clowns. The reduction in demand for clowns reduces clowns’ wages and thus reduces the costs of running a circus. This cost reduction increases the number of circuses, thereby forcing zoos to lower admission fees to compete with circuses. Thus, were the government to stop subsidizing the manufacture of helium, the admission fees of zoos would likely rise, even though zoos use no helium. This example is superficially reasonable, although the effects are miniscule.

To make any sense of all the effects of a change in economic conditions, it is helpful to divide up the effects into pieces. Thus, we will often look at the effects of a change in relation to “other things equal,” that is, assuming nothing else has changed. This isolates the effect of the change. In some cases, however, a single change can lead to multiple effects; even so, we will still focus on each effect individually. A gobbledygook way of saying “other things equal” is to use Latin and say “ceteris paribus.” Part of your job as a student is to learn economic jargon, and that is an example. Fortunately, there isn’t too much jargon.

We will make a number of assumptions that you may find implausible. Not all of the assumptions we make are necessary for the analysis, but instead are used to simplify things. Some, however, are necessary and therefore deserve an explanation. There is a frequent assumption in economics that the people we will talk about are exceedingly selfish relative to most people we know. We model the choices that people make, presuming that they select on the basis of their own welfare only. Such people—the people in the models as opposed to real people—are known as “homo economicus.” Real people are indubitably more altruistic than homo economicus, because they couldn’t be less: homo economicus is entirely selfish. (The technical term is self-interested behavior.) That doesn’t necessarily invalidate the conclusions drawn from the theory, however, for at least four reasons:

1. People often make decisions as families or households rather than as individuals, and it may be sensible to consider the household as the “consumer.” Identifying households as fairly selfish is more plausible perhaps than identifying individuals as selfish.
2. Economics is mostly silent on why consumers want things. You may wish to make a lot of money to build a hospital or endow a library, which would be altruistic. Such motives are not inconsistent with self-interested behavior.
3. Corporations are expected to serve their shareholders by maximizing share value, thus inducing self-interested behavior on the part of the corporation. Even if corporations could ignore the interests of their shareholders, capital markets would require them to consider shareholder interests as necessary condition for raising funds to operate and invest. In other words, people choosing investments for high returns will force corporations to seek a high return.
4. There are good, as well as bad, consequences that follow from people acting in their self-interest, and it is important for us to know what they are.

Thus, while the theory of self-interested behavior may not be universally descriptive, it is nonetheless a good starting point for building a framework to study the economics of human behavior.

Self-interested behavior will often be described as “maximizing behavior,” where consumers maximize the value they obtain from their purchases, and firms maximize their profits. One objection to this economic methodology is that people rarely carry out the calculations necessary to literally maximize anything. However, that is not a fatal flaw to the methodology. People don’t consciously do the physics calculations to throw a baseball or thread a needle, yet they somehow accomplish these tasks. Economists often consider that people act “as if” they maximize an objective, even though no explicit calculation is performed. Some corporations in fact use elaborate computer programs to minimize costs or maximize profits, and the field of operations research creates and implements such maximization programs. Thus, while individuals don’t necessarily calculate the consequences of their behavior, some companies do.

A good example of economic reasoning is the sunk cost fallacy. Once one has made a significant nonrecoverable investment, there is a psychological tendency to invest more, even when subsequent investment isn’t warranted. France and Britain continued to invest in the Concorde (a supersonic aircraft no longer in production) long after they realized that the project would generate little return. If you watch a movie to the end, even after you know it stinks, you haven fallen prey to the sunk cost fallacy. The fallacy is attempting to make an investment that has gone bad turn out to be good, even when it probably won’t. The popular phrase associated with the sunk cost fallacy is “throwing good money after bad.” The fallacy of sunk costs arises because of a psychological tendency to make an investment pay off when something happens to render it obsolete. It is a mistake in many circumstances.

Casinos often exploit the fallacy of sunk costs. People who lose money gambling hope to recover their losses by gambling more. The sunk “investment” to win money may cause gamblers to invest even more in order to win back what has already been lost. For most games like craps, blackjack, and one-armed bandits, the house wins on average, so that the average gambler (and even the most skilled slot machine or craps player) loses on average. Thus, for most, trying to win back losses is to lose more on average.

The way economics performs is by a proliferation of mathematical models, and this proliferation is reflected in this book. Economists reason with models. Models help by removing extraneous details from a problem or issue, which allows one more readily to analyze what remains. In some cases the models are relatively simple, like supply and demand. In other cases, the models are more complex. In all cases, the models are constructed to provide the simplest analysis possible that allows us to understand the issue at hand. The purpose of the model is to illuminate connections between ideas. A typical implication of a model is “when A increases, B falls.” This “comparative static” prediction lets us determine how A affects B, at least in the setting described by the model. The real world is typically much more complex than the models we postulate. That doesn’t invalidate the model, but rather by stripping away extraneous details, the model is a lens for focusing our attention on specific aspects of the real world that we wish to understand.

One last introductory warning before we get started. A parody of economists talking is to add the word marginal before every word. Marginal is just economists’ jargon for “the derivative of.” For example, marginal cost is the derivative of cost; marginal value is the derivative of value. Because introductory economics is usually taught to students who have not yet studied calculus (or can’t be trusted to remember it), economists avoid using derivatives and instead refer to the value of the next unit purchased, or the cost of the next unit, in terms of the marginal value or cost. This book uses “marginal” frequently because we wish to introduce the necessary jargon to students who want to read more advanced texts or take more advanced classes in economics. For an economics student not to know the word marginal would be akin to a physics student who does not know the word mass. The book minimizes jargon where possible, but part of the job of a principled student is to learn the jargon, and there is no getting around that.

KEY TAKEAWAYS

• It is often helpful to break economic effects into pieces.
• A common strategy is to examine the effects of a change in relation to “other things equal,” that is, assuming nothing else has changed, which isolates the effect of the change. “Ceteris paribus” means “other things equal.”
• Economics frequently models the choices that people make by assuming that they make the best choice for them. People in a model are known occasionally as “homo economicus.” Homo economicus is entirely selfish. The technical term is acting in one’s self-interest.
• Self-interested behavior is also described as “maximizing behavior,” where consumers maximize the net value they obtain from their purchases, and firms maximize their profits.
• Once one has made a significant nonrecoverable investment, there is a psychological tendency to invest more, even when the return on the subsequent investment isn’t worthwhile, known as the sunk cost fallacy.
• Economists reason with models. By stripping out extraneous details, the model represents a lens to isolate and understand aspects of the real world.
• Marginal is just economists’ jargon for “the derivative of.” For example, marginal cost is the derivative of cost; marginal value is the derivative of value.