Economics is a curious discipline, at once simple and complex. It is simple because it tells a story that nearly everyone already knows through experience. By this, I do not necessarily mean all the specific economic concepts that require technical language: production, distribution, consumption, supply, demand, credit, debit, capital, labor, etc. We can get into all that later. No, what is simple about economics is how it tells the story of rational human behavior.
Each individual has goals; things they want to obtain or do. They are compelled to take actions to achieve those goals. Here we encounter a problem, which is formally called the economic problem of scarcity. Simply put, we live in a world of scarce resources, which means that we might not be able to do everything we want to do, and we certainly can’t do it all at the same time. While we might have unlimited goals, or ends, we are limited in achieving them by scarce resources, or means. I currently have several goals: I want to read about 20 books, build a garden, get a dog, go on a trip, learn guitar, buy a new house, have a kid, and write this article. I am limited in the ends I can achieve by my scarce resources of time, money, concentration, and energy.
Since I can’t do everything at once, if I want to do something I must necessarily give up something else. This is called opportunity cost: the cost of any activity measured in terms of the next best opportunity forgone. In choosing to write this article I am forgoing other goals that I could be using my time resource to achieve, like practicing my guitar skills or procreating. If I go out and buy a purebred German shepherd puppy tomorrow, that is money that I will not be able to save for a down payment on a house.
Individuals are therefore forced to make choices and rank their goals. The choices are called trade-offs. There is no such thing as a “perfect” economic action or a “perfectly bad” one; there are only trade-offs. If a president signs a bill that has an effect of increasing employment in some field there will necessarily unintended negative consequences implicit in the opportunity cost. They may be misallocation of resources needed in other sectors, or inflation brought on through credit expansion; these are the trade-offs.
With all the possible ends and trade-offs how do economic decisions get made? The answer resides in a vital component of economic thinking:
Incentives matter. People respond to incentives.
When economic agents (individuals) apply means to ends and evaluate costs they respond to incentives when making choices. An obvious example of this is why people work. The opportunity cost of working is some degree of freedom in one’s daily activities. This is compensated by wages which afford a greater degree of possible ends (like getting an Xbox, or not starving to death) than would be otherwise available. Without monetary incentives that expand the opportunity to pursue ends, nobody would work.
Most often economics focuses on monetary incentives. The incentive of a higher salary earned by physicians is what inspires individuals to take on the miasma of opportunity costs known as “medical school”. Incentives, however, are more than just about money. Even though they were identical in price at their respective launches, the video game Halo: Reach sold almost 3 million more units than did L.A. Noire within the first month of release. Halo’s massive online multiplayer community and placement in a decade-long franchise provided greater incentives for gamers to purchase it.
Every action or policy that manipulates an economy should be judged in the ways it sets up an incentive scheme. Some policies actually incentivize immoral behavior. The period of the 1920s in the United States is infamous as a time of gangsters, thugs, smugglers, and bootleggers. As the sale and consumption of alcohol was criminalized, those people involved in the alcohol trade were afforded no protection of theft and fraud under the law, and thus resorted to murder and extortion where they otherwise would not have. Prohibition produced an incentive to commit crime that was not previously there. This type of incentive is called a perverse incentive because it results in an unintended negative consequence. Those people who championed prohibition wanted to incentivize people to avoid drunkenness and all of the negative social consequences therein, but what they got was actually more crime and social degradation.
This brings us to the problems created when different individuals with different incentives and goals must interact with each other. Because we live in a social world, my own goals have an affect on and are affected by the goals of someone else. This is called the multiplicity of goals; your goals and my goals may be different and even incompatible. In order to reduce our opportunity costs we must have some way of coordinating activities. A market is a social phenomenon that emerges from individual actions and interactions as a means of coordinating activity.
Incentives are one way to show how socialism and communism are poor ways of coordinating the activity of individuals. In its pure theoretical form, communism seeks to create a classless society in which there is no economic hierarchy of individuals. There is no wealthy class, nor is there an impoverished class, everyone is made economically equal. In practice, the lack of the profit motive disincentivizes people from working hard or innovating to make more money. As a result, the threat of force was needed to keep people working, resulting in tyranny and poverty.
The best way to coordinate activity is to allow individuals to pursue their own ends by engaging in voluntary arrangements with other people. This will never result in a perfect society, there will always be trade-offs, but this is due to the problem of scarcity, not because of simply not having the perfect economic framework. A free market economy emphasizes the primacy of the individual in making his or her own decisions on how to best use resources, and this results in the greatest prosperity for everyone.
The next article explores the most important rule that one needs to follow to be a good economist, whether amateur or professional.