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” Accessed January 4, 2014. http://data.worldbank.org/indicator/ TG.VAL.TOTL.GD.ZS. World Trade Organization. 2014. “Annual Report 2014.” Accessed April 1, 2015. https://www.wto.org/english/res_e/ booksp_e/anrep_e/anrep14_chap10_e.pdf. 568 References This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Index INDEX A AARP, 433 absolute advantage, 444, 460 Accounting profit, 157 accounting profit, 181, 242 acquisition, 256, 270 actual rate of return, 407, 423 Adam Smith, 12, 39, 245 additional external cost, 291 additional external costs, 278 Adverse selection, 391 adverse selection, 396 Affirmative action, 342 affirmative action, 347 Affordable Care Act (ACA), 381, 394, 433 Age Discrimination in Employment Act, 342 Agriculture and Food Research Initiative (AFRI), 309 Aid to Families with Dependent Children (AFDC), 361 Alfred Marshall, 73 Allocative efficiency, 36, 229 allocative efficiency, 42, 206, 231, 292 American Federation of State, 335 Anthony Downs, 431 Anti-dumping laws, 478 anti-dumping laws, 488 Antitrust Division of the Justice Department, 245 antitrust laws, 257, 270 asymmetric information, 383, 396 average cost, 166 average cost curve, 264 average profit, 170, 181 Average total cost, 169 average total cost, 181 average variable cost, 169, 181 B bar graph, 502 Barriers to entry, 216 barriers to entry, 231 Behavioral economics, 147 behavioral economics, 150 behavioral economists, 385 bilateral monopoly, 337, 347 biodiversity, 288, 291 Bipartisan Campaign Reform Act (BCRA), 431 bond, 404, 423 bond yield, 409, 423 bondholder, 404, 423 bonds, 409, 523 break even point, 196, 209 budget constraint, 29, 42, 135, 141, 512 budget constraint (or budget line), 135, 150 budget constraint line, 357 budget line, 511 bundling, 262, 270 C Capital, 159 capital gain, 405, 423 cartel, 244, 250 Celler-Kefauver Act, 258 certificate of deposit (CD), 408, 423 ceteris paribus, 52, 64, 75, 86 checking account,
407, 423 circular flow diagram, 16, 23 Civil Rights Act of 1964, 340 Civil Rights Act of 1991, 342 Clayton Antitrust Act, 258 Clean Air Act, 280, 283, 285 Clean Water Act, 280 coinsurance, 390, 396 collateral, 387, 396 collective bargaining, 330, 347 collusion, 244, 250 command economy, 18, 23 command-and-control regulation, 280, 291 common market, 488 common markets, 483 common resources, 312 comparative advantage, 13, 37, 42, 445, 475 competition, 303 competitive market, 341 complements, 55, 75 Compound interest, 420 compound interest, 423 concentration ratio, 258, 270 constant cost industry, 205 constant returns to scale, 176, 181 Constant unitary elasticity, 114 569 constant unitary elasticity, 127 consumer equilibrium, 140, 150 consumer surplus, 71, 75, 471 consumption, 134 consumption budget constraint, 35 copayment, 390, 396 copyright, 218, 231 core competency, 13 corporate bond, 404, 423 corporate governance, 406, 423 corporation, 404, 423 cosigner, 387, 396 cost, 35 cost-plus regulation, 266, 270 County and Municipal Employees (AFSCME), 335 coupon rate, 409, 423 cross-price elasticity of demand, 123, 127 CTC, 362 D David Ricardo, 444 deadweight loss, 72, 75 debit card, 408, 423 decreasing cost industry, 205 deductible, 396 deductibles, 390 demand, 47, 75, 304 demand and supply diagram, 71 demand and supply models, 98 demand curve, 47, 52, 75, 111, 113, 237, 241, 469 demand curves, 261 demand schedule, 47, 75 democracy, 436 Deposit insurance, 389 deregulation, 219, 231, 267 derived demand, 323 differentiated product, 250 differentiated products, 237, 243 diminishing marginal productivity, 168, 181 diminishing marginal utility, 136, 150, 510 Discrimination, 338 discrimination, 347 diseconomies of scale, 177, 181 disruptive market change, 486, 488 diversification, 414, 423 570 Index dividend, 405, 423 division of labor, 12, 23, 455 Dodd-Frank Act, 268 Dow Jones Index, 412 dumping, 458, 488 Dumping, 478 duopoly, 246, 250 E earned income tax credit (EITC), 361, 375 economic efficiency, 39 Economic profit, 157 economic profit, 181 economic surplus, 72, 75 economic union, 488 economic unions, 483 Economics
, 10 economics, 23 economies of scale, 13, 23, 181, 181, 456 Economies of scale, 174, 217 ecotourism, 285 effective income tax, 371, 375 efficiency, 71 elastic demand, 109, 127 elastic supply, 109, 127 Elasticity, 108 elasticity, 127 elasticity of savings, 124, 127 Entrepreneurship, 159 entry, 204, 209 Equal Employment Opportunity Commission (EEOC), 342 Equal Pay Act of 1963, 342 equilibrium, 51, 71, 75, 86, 242, 383, 467 equilibrium price, 51, 75, 384 equilibrium quantity, 51, 66, 75 equity, 414, 423 estate tax, 372, 375 European Union, 483 European Union (EU), 70 excess demand, 51, 75 excess supply, 51, 75 exclusive dealing, 262, 270 exit, 204, 209 expected rate of return, 407, 423 Explicit costs, 157 explicit costs, 181 export, 452 Exports, 21 exports, 23 external benefits (or positive externalities), 314 external costs, 278 externality, 277, 291 F face value, 409, 423 Factor payments, 165 factors of production, 57, 75 factors of production (or inputs), 181 Federal Deposit Insurance Corporation (FDIC), 408 Federal Reserve Economic Data (FRED), 402 Federal Trade Commission, 245 Federal Trade Commission (FTC), 387 fee-for-service, 391, 396 financial capital, 93 financial capital market, 387 financial capital markets, 383 Financial capital markets, 402 financial intermediary, 407, 423 firm, 37, 59, 156, 181, 242, 248, 303, 403, 437 firms, 236 first rule of labor markets, 320, 347 fiscal policy, 15, 23 fixed, 160 fixed cost, 181 Fixed inputs, 160 fixed inputs, 181 fossil fuels, 288 four-firm concentration ratio, 270 Francine Blau, 338 free rider, 310, 310, 314 free trade, 479 free trade agreement, 488 free trade agreements, 483 function, 493 fungible, 147, 150 G gain from trade, 448, 460 game theory, 245, 250 Gary Becker, 341 General Agreement on Tariffs and Trade (GATT), 482, 488 George Psacharopoulos, 305 globalization, 21, 23, 261, 370, 444, 475 good, 48 goods and services market, 16, 23 This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Great
Depression, 444 Great Recession, 363 Gross domestic product (GDP), 21 gross domestic product (GDP), 23, 289 growth rate, 497 H Health Care for America Now (HCAN), 433 health maintenance organization (HMO), 391, 396 Herfindahl-Hirschman Index (HHI), 259, 270 high yield, 409 high yield bonds, 423 High-income countries, 470 high-income countries, 479 I immigrants, 343 imperfect information, 383, 396 imperfectly competitive, 236, 250 Implicit costs, 157 implicit costs, 181 import quotas, 466, 488 Imports, 21 imports, 23, 452 Income, 354, 371 income, 375 income effect, 143, 150, 513 income elasticity of demand, 123 income inequality, 375 increasing cost industry, 205 index fund, 414, 423 indifference curve, 509 inelastic demand, 109, 127 inelastic supply, 109, 127 inequality, 354 infant industry argument, 476 inferior good, 54, 75, 123, 142 Infinite elasticity, 113 infinite elasticity, 127 initial public offering (IPO), 405, 423 inputs, 57, 75 Insurance, 388 insurance, 396 intellectual property, 219, 231, 314 Intellectual property, 306 Interest and dividends, 165 interest rate, 93, 103, 523 Index 571 international externalities, 288, 291 international trade, 457, 486 International Trade Commission (ITC), 438 intertemporal choices, 41 intertemporal decision making, 95 intra-industry trade, 455, 460 invisible hand, 40, 42 J Joan Robinson, 438 John Maynard Keynes, 16 junk bonds, 409, 423 K key input, 118 kinked demand curve, 248, 250 L Labor, 159 labor market, 16, 23, 86, 386 labor markets, 365 labor-leisure budget constraint, 357 labor-leisure diagram, 515 Laurence Kahn, 338 law of demand, 47, 75, 94 Law of Diminishing Marginal Product, 162 law of diminishing marginal utility, 32, 42 law of diminishing returns, 35, 42 law of supply, 48, 75 legal monopoly, 217, 231 leviathan effect, 177 line graphs, 498 liquidity, 407, 423 living wage, 90 lobbyists, 433 Logrolling, 435 logrolling, 440 long run, 160, 181 long-run average cost (LRAC) curve, 175, 181 long-run equilibrium, 205, 209 Lorenz curve, 366, 375 loss
aversion, 147 low-income countries, 470, 479 M Macroeconomics, 14 macroeconomics, 23 marginal analysis, 32, 42 marginal benefits, 286 marginal cost, 166, 181, 194, 224, 266 Marginal cost, 169 marginal cost curve, 286 marginal cost curves, 281 marginal cost of labor, 328 marginal product, 161, 181 Marginal profit, 226 marginal profit, 231 marginal rate of substitution, 510 marginal revenue, 191, 209, 224 marginal utility, 136, 150, 510 Marginal utility per dollar, 138 marginal utility per dollar, 150 market, 19, 23, 261, 392 market economy, 19, 23, 37, 303 market failure, 280, 291 market price, 237 market share, 258, 270 market structure, 188, 209 marketable permit program, 283, 291 maturity date, 409, 424 maximizing utility, 139 median, 498 median voter theory, 436, 440 Medicaid, 356, 363, 375 Medicare, 433 merger, 256, 270 Michael S. Clune, 344 Microeconomics, 14 microeconomics, 23 Midpoint Formula, 111 Midpoint Method, 109, 112 minimum resale price maintenance agreement, 262, 270 minimum wage, 90, 103, 475 model, 16, 23 Mollie Orshansky, 354 monetary policy, 15, 23 money-back guarantee, 385, 396 monopolistic competition, 236, 250 monopoly, 216, 231, 263 monopsony, 328, 347 Moody’s, 410 Moral hazard, 390 moral hazard, 396 municipal bond, 404 municipal bonds, 424 mutual funds, 414, 424 N National Academy of Engineers, 309 National Academy of Scientists, 309 National Association of Insurance Commissioners, 393 National Education Association, 335 National Institutes of Health, 309 national interest argument, 481, 488 National Labor-Management Relations Act, 336 National Venture Capital Association, 403 natural monopoly, 217, 231, 244, 264 Natural Resources (Land and Raw Materials), 159 near-poor, 360, 375 negative externalities, 433 negative externality, 277, 291 negative slope, 495 non-rival, 310 nonexcludable, 310, 314 nonrivalrous, 314 Nontariff barriers, 467 nontariff barriers, 488 normal good, 54, 75 normal goods, 123, 142 normative statement, 42 normative statements, 39 North American Free Trade Agreement (NAFTA), 473, 483 O occupational license, 396 occupational licenses, 386 oligopoly, 236, 250 Oligopoly, 244 opportunity
cost, 29, 42, 445, 453, 473 opportunity set, 42, 513 Organization of Petroleum Exporting Countries (OPEC), 247 output, 247 Oxfam International, 470 P partnership, 405, 424 572 Index patent, 218, 231, 306 Patient Protection and Affordable Care Act (PPACA), 381, 394 Pension insurance, 389 perfect competition, 188, 209 perfect elasticity, 113, 127 perfect inelasticity, 113, 127 perfectly competitive firm, 188, 189, 205, 220 Perfectly Competitive Labor Market, 322 perfectly competitive labor market, 347 perfectly elastic, 237 Pew Research Center for People and the Press, 63 pie chart, 501 pie graph, 501 pollution charge, 281, 291 pork-barrel spending, 434, 440 positive externalities, 303, 314 positive externality, 277, 291 positive slope, 495 positive statement, 42 positive statements, 39 poverty, 354, 375 poverty line, 354, 375 poverty rate, 354, 375 poverty trap, 357, 375 predatory pricing, 219, 231, 263 premium, 396 premiums, 388 present discounted value (PDV), 523 present value, 409, 424 price, 31, 47, 52, 75, 248 price cap regulation, 266, 270 price ceiling, 68, 72, 75 price control, 72, 75 price controls, 68, 100, 434 Price elasticity, 108 price elasticity, 127 price elasticity of demand, 108, 127 price elasticity of supply, 108, 127 price floor, 68, 73, 76 price taker, 188, 209 price takers, 236 prisoner’s dilemma, 245, 250 private benefits, 303, 314 private company, 405, 424 private enterprise, 19, 23, 181 private insurance, 389 Private markets, 277 private rates of return, 305, 314 producer surplus, 72, 76, 471 product differentiation, 237, 250 production, 156, 181 production function, 160, 181 production possibilities frontier (PPF), 33, 42 production possibility frontier (PPF), 289, 446 production technologies, 172, 181 Productive efficiency, 36, 206 productive efficiency, 42, 242, 292 productivity, 450 Profit, 165 profit, 189 profit margin, 171, 194 profit-maximizing, 239 profits, 247 progressive tax system, 371, 375 property rights, 284, 291 protectionism, 466, 470, 488 Protectionism, 473 public company, 405, 424 public good, 309, 314 Public policy, 372 Q
supply schedule, 49, 76 surplus, 51, 76 T tariff, 432 Tariffs, 458 tariffs, 460, 466 tax incidence, 120, 127 Technology, 159 technology, 303 Temporary Assistance for Needy Families (TANF), 361 theory, 16, 23 thick market, 384 thin market, 384 time series, 500 total cost, 182 total costs, 190 total product, 182 total revenue, 190, 224 total surplus, 72, 76 total utility, 135, 150 trade secrets, 219, 231 trademark, 218, 231 tradeoffs, 39 traditional economy, 18, 23 Treasury bond, 404, 424 Tying sales, 262 tying sales, 270 Tyler Cowen, 313 U U.S. Census Bureau, 54 U.S. Department of the Treasury, 404 underground economies, 20 underground economy, 23 Unemployment insurance, 389 Unitary elasticities, 109 unitary elasticity, 127 usury laws, 98, 103 utility, 32, 42, 135, 509 utility maximizing, 385 utility-maximizing, 430 utility-maximizing choice, 142 V value chain, 456, 460 variable, 160, 494 variable cost, 182 Variable costs, 167 Variable inputs, 160 variable inputs, 182 Venture capital, 403 venture capital, 424y, constructed a system to explain a set of forces that would guide social and economic behavior. In The Theory of Moral Sentiments [1759] he showed the need for justice and a system of morality. In An Inquiry into the Nature and Causes of the Wealth of Nations [1776] he describes the role of self-interest and markets. In a third book that was destroyed at his request at the time of his death, he describes the need for a system of jurisprudence. Two sets of students’ notes have been used to show these basic arguments in Lectures on Jurisprudence [1762-63 and 1766 published in 1978]. Smith describes a social system that requires morality, markets and jurisprudence to guide and constrain individual action in a social context. 1.4.1.3 COORDINATION OF EFFORTS Once humans use the division of labor and specialization, it is necessary for them to coordinate their efforts. They must interact on a variety of levels. Society is a complex set of interactions among groups and individuals. These interactions give rise to social institutions. The study of these interactions and institutions is “social science.” Human interaction can be studied from a variety of perspectives. Sociology, political science,
law, history, psychology, religion, anthropology and economics are examples of social sciences. These are often studied as separate disciplines. However, we should remain aware 20 they are all interrelated perceptions of human behavior. While economics specializes in the study of the processes that coordinate human behavior as it allocates scarce resources to satisfy unlimited wants, its relationship to other 1.4.1 Social Interaction social sciences should not be overlooked. 1.4.2 ECONOMIC ACTIVITIES John Stuart Mill [1806-1873] divided economic activities into three categories: production, distribution and exchange. It may be helpful to think of an economic system as a process that begins with a set of inputs (or resources) that are used for production that must be distributed for ultimate consumption. (Mill, Principles of Political Economy, The Colonial Press, 1900) In Figure I.1, the economy is shown as a process of altering a set of inputs to satisfy individual wants. In this example, the steps in the economic process are production, distribution and consumption. Input or Resources [Land, labour, capital and entrepreneurial ability or energy, matter, time and tech] Production Distribution or Allocation Figure I.1 Consumption The ability of goods and services to satisfy wants is called “utility.” 1.4.2.1 PRODUCTION Production is the process of altering inputs to increase their ability to satisfy human wants. Inputs are sometime called “factors of production” or resources. Typically, economists will categorize inputs as land, labor and capital. Superficially, labor is defined as human effort used to produce goods that satisfy human wants. An input that is a “gift of nature” is referred to as 21 1.4.2 Economic Activities “land.” Capital is usually considered as an input that is produced by labor but is used for the further production of goods and services. Entrepreneurial ability was the last category of inputs to be added as a factor of production in market oriented economies. It is usually associated with the process of creating and innovating of new processes. The taxonomy of inputs, its relation social structure and the nature of economics will be considered more carefully later in the text. 1.4.2.2 DISTRIBUTION Distribution usually describes the process of allocating the goods and services that have been produced. Societies have used market exchange, reciprocity, eminent domain, inheritance, theft and philanthropy to distribute goods and services. The primary means of
distribution or allocative mechanisms that are used in most societies are market exchange, reciprocity and eminent domain. MARKET EXCHANGE Market exchange involves a quid pro quo, i.e. an exchange of private property rights between individual agents. The terms of the exchange are clearly specified: “I will give you this if you will give me that.” The goods to be exchanged are clearly specified, as are the terms of the exchange. The participants in the exchange do not need to know each other: they only need to know the terms of the exchange. The information requirements are quite low. In many cases, the exchange may be made easier by social institutions. Laws that protect buyers and sellers may facilitate the exchange. Trust may be an important element as well. 22 1.4.2 Economic Activities RECIPROCITY Reciprocity is a system of obligatory gift giving: I will do you a favor or give you a gift, but you are then obligated to do an unspecified favor or give me a gift at some (possibly unspecified) point in the future. Reciprocity requires a sense of community. Kinship ties or membership in the community is needed so that the obligation of returning a favor is enforced by social forces. If a friend helped you move apartments one weekend and then helped you fix your car the next weekend, your refusal to help that person would have social repercussions. Your common friends might come to regard you as a freeloader. Social pressure may induce you to return the favor. EMINENT DOMAIN Eminent domain is a redistribution of private property rights through the authority of some organization. The individual is required to give up their claims to private property by an authority. Usually the process of eminent domain is legitimized by government, religion or some other authority. PHILANTHROPY The act of giving a gift with nothing expected in return is called philanthropy. This is an important method of distribution in blood drives and the donation of organs for transplantation. INHERITANCE AND THEFT Inheritance is the process transferring private property rights from a dead person to an agent. The form that the inheritance laws take may greatly influence the accumulation of wealth in a society. Theft is the process of transferring property rights by illegitimate force. Few societies can function if theft is widely used. 23 1.4.2 Economic Activities 1.4.2.3 CONSUMPTION The end purpose of economic activity is to provide goods and services that can be consumed by individuals to satisfy needs
and wants. Modern, neoclassical economists generally do not like to use the word “needs.” The use of the word “wants” is an attempt to take subjective judgment out of the analysis. 24 2 The Problem of Provisioning 2 THE PROBLEM OF PROVISIONING 2.1 INTRODUCTION Society is confronted with a finite set of resources and a given state of technology at any given point in time. As a result, there is a finite amount of goods and services that can be produced in that time frame. Given human desires and need for food, clothing and shelter, it is not always possible to produce everything that every one would like to have. When individuals want more than can be produced they have the economic problem of scarcity. The problem of scarcity might be resolved by reducing individuals wants or by increasing the output of goods and services. If the solution is to reduce wants, which wants should be eliminated and which should be retained to be satisfied? The individual would necessarily be required to make a choice. If the solution was to produce more goods, which goods should be produced and how are they to be produced? Again, the individual must make choices. In modern, neoclassical, economic analysis (we will call this “orthodox” economics), the problem is structured so the wants are taken as given and the problem is to produce the goods that satisfy the greatest wants. Scarcity requires that the individual or agent make choices. An individual in isolation (Defoe’s Robinson Crusoe before Friday) would have to make choices since time and resources are limited. It would be necessary to choose whether time was to be spent catching fish, gathering coconuts, reading or building shelter. If the choice were to catch fish, he/she would have to choose between making a net, a fishing pole or trying to catch fish by hand. The choice to spend an hour fishing implies that that hour cannot be used to gather coconuts. The sacrifice of coconuts is called “opportunity cost.” 25 2.1 Introduction Even Robinson Crusoe’s world of isolation did not last long. When Friday came to the island, it became necessary to decide who did what and who got what. It is necessary to coordinate the preferences and activities of Crusoe and Friday. Since the story of Robinson Crusoe was written by an Englishman, Daniel Defoe (1659-1731), Crusoe is dominant and he has a greater influence on the
decisions than Friday. In 1719, the perspective of an English writer was that aboriginals of various lands were subordinate. Still, it is necessary to coordinate their activities. 2.2 SOCIAL INTERACTION In a society, the behavior of the individuals must be coordinated through social interaction. This social interaction takes many forms ranging from cooperation to competition. In the process of resolving the allocation problem through social interaction, a set of institutions, organizations, beliefs, principles, perspectives and commonly held values are created. Society, guided by these values, perceptions and beliefs and constrained by institutions, technology and resource endowment, must solve the problem of provisioning. The specific uses of goods and resources must be determined. These choices involve which resources to use, which goods to produce, who will bear the costs and who will benefit. The basic problem is the coordination of the choices and behavior of individuals. Finding a way to protect the autonomy of the individual while coordinating their behavior to provide for the commonweal has been an important goal of most great writers on social topics. 2.3 SPECIALIZATION Specialization and the division of labor are two important forms of social 26 2.3 Specialization interaction that allow two or more individuals to do what an isolated individual cannot do. Both are means to increase the production of goods and services. Specialization is the case where an individual (firm, organization or country) focuses on the production of a specific good (or group of goods). It can increase the amount of goods that can be produced. It also requires some form of social institution to coordinate the process. If one individual produces food and the other clothing, the two individuals must interact if both are to have food and clothing. This interaction may be facilitated through an institution such as the market or a transfer based on kinship, marriage, religion or government authority. Plato suggests that the city-state is a social construct that is used to facilitate specialization and to improve the welfare of the members of that state. In The Republic, Plato [427-347 B.C.] suggests specialization as an explanation of the origins of the city-state. Plato describes a conversation between Socrates and a group of students. They are pondering the nature of justice. They conclude that justice is each person doing that which they are best suited to do. The person best suited to be a baker should be a baker: the person best suited to be a shepherd should be a shepherd. Once individuals specialize, the city-state arises to facilitate the transfer of goods and the
necessary interactions among the individuals. [The Republic, Book II] Plato tries to identify the characteristics of the ideal society. One of the focal points is justice that is achieved by “each person doing what they are best suited to do.” Social interaction is required because each person depends on the other members of the community. He devises a meritocracy that is lead by philosopher kings. To prevent nepotism and greed from influencing these philosopher kings, Plato does not allow the philosopher kings to hold private property rights, all of their property is held in common. 27 2.4 Division of Labor 2.4 DIVISION OF LABOR The division of labor is another form of social interaction that allows individuals to do what the isolated person cannot. In the division of labor, the production of a good is broken down into individual steps. One person then performs one step in the process. No single person produces the good alone. The actions of each individual in the production process must be coordinated. In modern industrial societies, production often takes place in a business firm. “Management” is regarded as the process of coordinating the activities of the individuals within the production process. A specific application of microeconomics to the process of production within a firm is called “managerial economics.” Adam Smith [1723-1790] in the Wealth of Nations proposes that the division of labor is one of the major elements that contribute to economic growth (the increased ability to produce goods and services) [The Wealth of Nations, page 1]. The division of labor is the process of dividing a task (work) into its component parts. Smith argues that the division of labor increases production through improved dexterity, saving time in moving from one task to another and improvements in tools. Smith cautions about the effects of unrestrained use of the division of labor, “In the progress of the division of labor, the employment of the far greater part of those who live by labor, that is, of the great body of the people, comes to be confined to a few very simple operations, frequently to one or two. But the understandings of the greater part of men are necessarily formed by their ordinary employments. The man whose whole life is spent in performing a few simple operations, of which the effects too are, perhaps, always the same, or very nearly the same, has no occasion to exert his understanding, or to exercise his invention in finding out expedients for removing difficulties which never occur. He naturally loses, therefore, the
habit of such exertion, and generally becomes as stupid and ignorant as it is possible for a human creature to 28 2.4 Division of Labor become….But in every improved and civilized society this is the state into which the laboring poor, that is the great body of the people must necessarily fall, unless government takes some pains to prevent it. [Smith, Wealth, p 734-735] of Nations Smith, a professor of moral philosophy, constructed a system to explain a set of forces that would guide social and economic behavior. In The Theory of Moral Sentiments [1759] he showed the need for justice and a system of morality. In An Inquiry into the Nature and Causes of the Wealth of Nations [1776] he describes the role of self-interest and markets. In a third book that was destroyed at his request at the time of his death, he describes the need for a system of jurisprudence. Two sets of students’ notes have been used to show these basic arguments in Lectures on Jurisprudence [1762-63 and 1766 published in 1978]. Smith describes a social system that requires morality, markets and jurisprudence to guide and constrain individual action in a social context. 2.5 COORDINATION OF EFFORTS Once humans use the division of labor and specialization, it is necessary for them to coordinate their efforts. They must interact on a variety of levels. Society is a complex set of interactions among groups and individuals. These interactions give rise to social institutions. The study of these interactions and institutions is “social science.” Human interaction can be studied from a variety of perspectives. Sociology, political science, law, history, psychology, religion, anthropology and economics are examples of social sciences. These are often studied as separate disciplines. However, we should remain aware they are all interrelated perceptions of human behavior. While economics specializes in the study of the processes that coordinate human behavior as it allocates scarce resources to satisfy unlimited wants, its relationship to other social sciences should not be overlooked. 29 2.6 Economic Activities 2.6 ECONOMIC ACTIVITIES John Stuart Mill [1806-1873] divided economic activities into three categories: production, distribution and exchange. It may be helpful to think of an economic system as a process that begins with a set of inputs (or resources) that are used for production that must be distributed for ultimate consumption. (Mill, Principles of Political Economy, The Colonial Press, 1900) In Figure
I.1, the economy is shown as a process of altering a set of inputs to satisfy individual wants. In this example, the steps in the economic process are production, distribution and consumption. Input or Resources [Land, labour, capital and entrepreneurial ability or energy, matter, time and tech] Production Distribution or Allocation Figure I.1 Consumption The ability of goods and services to satisfy wants is called “utility.” 2.6.1 PRODUCTION Production is the process of altering inputs to increase their ability to satisfy human wants. Inputs are sometime called “factors of production” or resources. Typically, economists will categorize inputs as land, labor and capital. Superficially, labor is defined as human effort used to produce goods that satisfy human wants. An input that is a “gift of nature” is referred to as “land.” Capital is usually considered as an input that is produced by labor but is used for the further production of goods and services. Entrepreneurial ability was the last category of inputs to be added as a factor of production in market 30 oriented economies. It is usually associated with the process of creating and innovating of new processes. The taxonomy of inputs, its relation social structure and the nature of economics will be considered more carefully later 2.6.1 Production in the text. 2.6.2 DISTRIBUTION Distribution usually describes the process of allocating the goods and services that have been produced. Societies have used market exchange, reciprocity, eminent domain, inheritance, theft and philanthropy to distribute goods and services. The primary means of distribution or allocative mechanisms that are used in most societies are market exchange, reciprocity and eminent domain. MARKET EXCHANGE Market exchange involves a quid pro quo, i.e. an exchange of private property rights between individual agents. The terms of the exchange are clearly specified: “I will give you this if you will give me that.” The goods to be exchanged are clearly specified, as are the terms of the exchange. The participants in the exchange do not need to know each other: they only need to know the terms of the exchange. The information requirements are quite low. In many cases, the exchange may be made easier by social institutions. Laws that protect buyers and sellers may facilitate the exchange. Trust may be an important element as well. RECIPROCITY Reciprocity is a system of obligatory gift giving: I will do you a
favor or give you a gift, but you are then obligated to do an unspecified favor or give me a gift at some (possibly unspecified) point in the future. 31 2.6.2 Distribution Reciprocity requires a sense of community. Kinship ties or membership in the community is needed so that the obligation of returning a favor is enforced by social forces. If a friend helped you move apartments one weekend and then helped you fix your car the next weekend, your refusal to help that person would have social repercussions. Your common friends might come to regard you as a freeloader. Social pressure may induce you to return the favor. 2.6.2.1 EMINENT DOMAIN Eminent domain is a redistribution of private property rights through the authority of some organization. The individual is required to give up their claims to private property by an authority. Usually the process of eminent domain is legitimized by government, religion or some other authority. PHILANTHROPY The act of giving a gift with nothing expected in return is called philanthropy. This is an important method of distribution in blood drives and the donation of organs for transplantation. INHERITANCE AND THEFT Inheritance is the process transferring private property rights from a dead person to an agent. The form that the inheritance laws take may greatly influence the accumulation of wealth in a society. Theft is the process of transferring property rights by illegitimate force. Few societies can function if theft is widely used. 2.6.3 CONSUMPTION The end purpose of economic activity is to provide goods and services that can be consumed by individuals to satisfy needs and wants. Modern, neoclassical economists generally do not like to use the word “needs.” The use 32 of the word “wants” is an attempt to take subjective judgment out of the analysis. 2.6.3 Consumption 2.6.4 COORDINATION, COMPETITION AND COOPERATION Each society must develop a set of social institutions (behavioral patterns) to coordinate the activities of production, distribution and consumption. There is a wide range of forms these institutions may take depending on the physical environment, state of technical knowledge, social values and other factors. These institutions and behavioral patterns may rely on competition, cooperation or some combination. Market systems tend to focus on competition while other systems may have a larger role for cooperation. A bicycle race is a useful metaphor. In a road race the riders cooperate in the peleton (the large group of riders in
a bicycle race) by drafting (using the rider in front to reduce the wind drag). When a group breaks away from the peleton, they typically form a pace line and each shares the work of riding in front of the group. Eventually, the structure of the pace line disintegrates and the riders compete in a sprint to the finish or they fall back into the group. The race is a mixture of cooperation and competition. Joan Robinson argues that an economic system “… requires a set of rules, an ideology to justify them, and a conscience in the individual which makes him (sic) strive to carry them out.” (Robinson, p 13) Production, distribution and consumption are interrelated. What to produce is influenced by what individuals want to consume. What people want to consume is influenced by the distribution process and what can potentially can be produced. This coordination may come in the form of cooperative activities, such as the creation of a business firm. The firm usually organizes production internally as a cooperative process but must compete externally. Alternatively, 33 the coordination of activities may be accomplished by competition or some 2.6.4 Coordination, Competition and Cooperation combination of cooperation and competition. 2.7 TECHNOLOGY Technology is knowledge about how resources, individuals and social organization can be used to accomplish objectives. Technology is more than a set of skills to do things. It is a perspective about the relationships between humans and their world. Technology is the sum total of the ways in which human societies interact with natural and built environments. Humans seek to understand these interactions and develop technology by combining and reorganizing existing technologies. In economics, technology is the knowledge about the use of scarce resources to produce goods and services that satisfy human wants. The knowledge about how we do things, “technology,” is not limited to machines. The discovery of a calendar or the realization that crops can be planted on a three field rotation may be as important as the invention of the padded horse collar, the steam engine or the PC. Knowledge about the use of organizational structure to achieve an objective is, in a sense, a form of technology. The values and structure of society are connected to the state of technology. Society is shaped by technology and at the same time is an important force in the determination of the course of technological change. This relationship between technology, society and the individual can be driven by curiosity and/or material gain. Technological change is pervasive. During some periods of history, technology changes at a slow pace. At other times, the
rate of change is more rapid and more dramatic. During the medieval period, technological change was slow. With the development of mechanical clocks, the plague, moveable 34 2.7 Technology type, gunpowder, new techniques in art and other innovations, the “Renaissance” (usually thought of as the 14th-17th centuries) was a period of dramatic change. During the 17th and 18th centuries, the “age of Enlightenment” was fueled by technological change. The “Industrial Revolution” (which is often dated as about 1750) is another term used to identify a period of rapid technological change. Each of these periods involves changes in ideas, values, knowledge and social institutions. Each altered economic and social processes. There are opposing views as to the process of technological change. One view is the Thomas A. Edison perspective. In this case, technological development is driven by profits. If a technology is profitable, it will be invented. The other view is that technology is a self-generating process. New technology is the result of old technology(ies) being recombined in new ways and used for new purposes. In the second view, profits cannot create the development of technology but determine its uses. What an individual perceives as a resource is influenced by the nature of technology. In the 18th century, obsidian was an important resource among the inhabitants of the western United States: uranium was not. In the 21 st century, obsidian is not normally regarded as a very important resource while uranium has become a resource. Factor endowment may influence the direction that technology develops. In a society with an abundance or arable land and a shortage of labor may produce (and consume) different goods and seek different technologies to produce them. In the Edison view, the light bulb was invented because there was a demand for it and it could be developed and produced for a profit. In the second view, it is not possible to invent high-pressure steam engines, even 35 2.7 Technology though they may be profitable, until the technology of metallurgy develops metals to contain the higher pressure. Either view supports the argument that technology builds upon itself. The creation of an internal combustion engine depended on its connections to cannons, oil, Maybach’s spray carburetor, levers and gears. Each of these in turn depended on other technologies. When Daimler and Maybach built the automobile, it was the result of a series of connections between technologies that had been developed by many
people over a long period. (see Burke, Connections, pp 175-183) It is useful to think about technological change as a process. First, a piece of knowledge emerges or an “invention” occurs. Second, some one finds an application for the new knowledge (innovation) and uses it. Third is the process of dissemination, i.e. the use of the idea is spread through out the social system. Each stage of technological change may produce or require significant changes in values and social institutions. Changes in social structure or the natural environment may encourage technological change. Technology and the social system are interconnected. Technology has a strong influence on the structure of society and individual behavior. The Industrial Revolution may be thought of as a fundamental change in technology of production that altered society. The development of the mechanical clock was driven by the clergy’s desire to satisfy the institution of prayers at specific times of the day. The perception of and taxonomy of inputs or resources was influenced by social structure. Land was associated with the nobility and the clergy while labor was associated with the serfs. As trade developed, a merchant class arose and became associated with capital. 36 2.8 Economic Decisions 2.8 ECONOMIC DECISIONS In a simple taxonomy, individual behavior may be influenced by rules (command), intuition, emotion, habit, reason or some combination. Philosophers and psychologists have struggled with the issue of fate and freewill. The issue has not been resolved. It is not likely that it will be resolved here. The question for economics is to try to understand and explain how humans try to resolve the problems of provisioning and allocation. 2.8.1 RULES If behavior is constrained or influenced by rules, rules of thumb or habits, the nature of those rules and the process by which the rules evolves is of interest to economists. If the agent’s decision is constrained, the nature of those constraints is of concern. Rules may by implicit or explicit. Explicit rules often take the form of law and maybe imposed by governments or organizations. Generally, explicit rules are conscious creations and must be communicated and enforced. Social groups may also use explicit rules. Business firms, churches, and other organizations may explicitly impose rules. Implicit rules may also be important constraints. Implicit rules are not consciously created but must still be communicated. Certain types of behavior are expected and influenced by such social constructs as “manners,” mores, custom, rules of thumb and traditions.
These rules are short cuts to problem solving. If over time a particular problem is always or nearly always resolved by a specific approach, that approach becomes a habit or rule of thumb. These rules and habits provide ready made solutions that do not have to be derived by reason or intuition. 37 2.8.2 Intuition 2.8.2 INTUITION In recent years, there has been a growing interest in the interrelationship between psychology and economics. Daniel Kahneman (Nobel Foundation prize winner) has explored intuition and reason as thinking and decision processes. (Kahneman, pp 1449-1475) According to Kahneman, intuition can be powerful and accurate, requires practice and is “ rapid and effortless.” The reasoning process provides a check on the intuitive process. 2.8.3 REASON AND RATIONAL BEHAVIOR Orthodox, modern economic analysis is generally regarded as the study of alternative uses of resources to achieve objectives. At a technical level, economic analysis is used to evaluate rational decisions. Rational behavior that the agent has identified an objective or goal and has evaluated all feasible alternatives to select the alternative that best achieves the objective. 2.8.4 INFORMATION Within any economic system, the agents must have information and there must be a set of incentives to encourage appropriate actions. Whether the economic system primarily uses market exchange, reciprocity, eminent domain or some other allocative mechanism, the agents must have information about preferences, inputs, technology and alternatives. In different economic systems, the decisions may be made by different agents. In a planned economic system, some type of planning authority would necessarily have to have information about the preferences of the members of the systems, all inputs, all technology and all alternatives that are feasible. This is an enormous requirement. In a market-oriented system based on 38 2.8.4 Information exchange between individual’s, the information requirement is altered. Individuals only need to know about their own preferences and feasible alternatives. What is required is a social system that provides for voluntary exchanges between agents with appropriate information. In the 1920’s and 30’s there was a debate (The Socialist Calculation Debate) about the ability of socialist systems to acquire necessary information. One side of the debate lead by the Austrians (Ludwig von Mises (1881-1973) and Friedrich Hayek (1899-1992)) argued that it would be impossible for a centrally planned economy run by rules to have the necessary information to function. Oscar Lange (
1904-1965) and Abba P. Lerner (1903-1982) argued that if planners were cost minimizers, the appropriate information could be calculated. This is a simplistic description of the Socialist Calculation Debate but emphasizes the importance of information to the functioning of an economic system. In the Socialist Calculation Debate, Austrians argued that command economies could not be successful because there was insufficient information to guide decisions in the economic process. They believed that each individual had information about their preferences and what they were capable and willing to do. Markets were seen as the social institution that could provide information about relative values through the voluntary, exchange interactions of individuals. The market system was the process that provided the information for the agents to make decisions. The Austrians argued that the command system had no process by which information would be revealed. Lange accepted this criticism and suggested, “market socialism” as an alternative. Incentives are the forces that encourage or induce agents to behave in particular ways. Duty, authority or self-interest may guide an agent’s 39 behavior. Since neoclassical economics is based on a consequentialist ethic that is expressed through markets, the incentive provided by self-interest is perceived as dominant. Other incentives may be equally as important. Smith believed that self-interest would be constrained by systems of morality and 2.8.4 Information jurisprudence. 2.8.5 RATIONALITY AND INFORMATION The allocation of scarce resources requires both information and incentives for the agents. Information about the objectives and feasible alternatives is necessary if “rational choices” are to be made. A rational choice requires that the alternative that “best” satisfies the objective be selected. This requires criteria to evaluate each alternative with respect to the objective. Based on the objective, set of alternatives and the method of evaluation, the optimal or best alternative can be selected. There are three fundamental steps to the process of making “rational” economic choices: • Identify the objective of the agent. Identify all feasible alternatives that are related to the objective. • • Develop the criteria to evaluate each feasible alternative with respect to the objective. 40 3 Introduction to Ways of Knowing 3 INTRODUCTION TO WAYS OF KNOWING Knowledge about economic phenomena is imperfect. The problem of knowing is not unique to economics. An understanding of the methods by which knowledge is accumulated aids in the identification of potential biases and weaknesses of any discipline or field of study. Academic disciplines, like individuals, can benefit from introspection. By examining
our values, objectives, and methods of achieving those goals, we better understand ourselves, consider other perspectives and hopefully improve the discipline. The study of methodology and epistemology provides a process by which this introspection of economics as an academic discipline can proceed. Any understanding of the methods used in economics requires some introduction to a few important contributions to the literature on the process of knowing. It is a fundamental part of cultural literacy in a world dominated by ”science” and the “scientific method.” A brief summary of some of the basic concepts and major contributors is presented here. There is a long history of various approaches to the study of the economy. These approaches are not self contained, isolated bits of knowledge: they are extensions of and reactions to earlier approaches in economics and other fields. The process of “knowing” is difficult. Two questions that should be paramount are: What do I know? How do I know what I think I know? Epistemology is the study of the origin, nature, methods and limits of knowledge. There are several approaches to the study of processes that contribute to knowing: the history of science and the sociology of knowledge are two closely related fields. Methodology is one aspect of epistemology. 41 3 Introduction to Ways of Knowing Methodology is generally seen as the system of values, beliefs, principles and rules that guide analysis within a given discipline. The methodology(ies) that prevails within a discipline plays a major role in the nature of questions that are asked as well as the answers that are offered. There is a large and growing body of literature on methodology in philosophy and the sciences (both natural and social). This trend has also influenced economics. Many economists have participated in the explorations into methodology and epistemology. One explanation for a renewed interest in methodology in economics is that the basic processes created to explain the development of market systems and mature industrial economies may need to be adjusted if there are significant structural changes in the economy. The study of the history of economic thought and methodology adds the questions of “What do I believe?” “Why do I believe what I believe?” One of the most difficult tasks in any discipline is to understand the nature of knowledge and the process by which it is acquired within the discipline. In this matter, economics is no different from any other body of knowledge. The methods used to study the phenomena influence the phenomena we select to study and the conclusions we draw. 3.1 FACTS, INFORMATION, KNOWLED
GE AND WISDOM In any period of history, there is a problem of determining the nature of what we think we know. Facts, information, knowledge and wisdom are not the same things. It is possible to engage in long arguments about the meaning of these words. (For our purposes, we will accept facts in the spirit of its Latin roots. Factum is something done: factus is done: facere is to do.) Sometimes 42 3.1 Facts, Information, Knowledge and Wisdom data may be considered as facts. Facts alone do not tell us much. It is the organization of those facts into patterns that provides information. The recognition of patterns is aided by the way in which facts are ordered. Categorization (taxonomy) of facts is necessary to establish the relevant patterns and relationships. Information may also include the communication of those facts. Knowledge implies an understanding of the nature of relationships (system of causation) among the facts and information. Wisdom is more complicated and suggests a system of values and the judgment to evaluate and apply knowledge. Wisdom requires a system of ethics. The definitions of facts, information, knowledge and wisdom used here are superficial and subject the reader’s interpretation. 3.2 HYPOTHESES, THEORIES, LAWS AND MODELS A hypothesis is a proposition or set of propositions that is an attempt to explain an event or class of phenomena. It is usually thought of as provisional and a guide to further investigation. Hypotheses can be tested but never proven. Hypothesis testing requires the analyst to try to disprove the hypothesis. If it can be shown to be false, then it can be rejected. If it cannot be shown to be false then it is accepted as not yet proven false and may be retained until proven false. It is possible to reject a true hypothesis as false: this is a Type I error. It is also possible that a hypothesis is retained as probably true even when it is false: this is a Type II error. It is not possible to reduce these errors to zero. A theory is an explanation about a class of phenomena. Webster’s Dictionary defines a theory as a “as a coherent group of general propositions used as principles for explaining a class of phenomena.” Usually a theory is considered as more reliable than a hypothesis. Theories are used to establish 43 3.2 Hypotheses, Theories, Laws and Models relevant patterns in data and to explain the relationships within those patterns. Newton’s theory of gravity or Einstein�
�s theory of relativity are examples of explanations of relationships between masses or the relationships between energy and matter. Theories are used to make sense out of data and information. “Without theory facts are meaningless.” (Alfred Marshall) The term law is used to represent a widely accepted premise or theory about a particular causal relationship. It is more widely accepted than a theory. In economics some writers refer to a “law of demand.” (The belief that demand functions are inverse relationships between price and quantity that will be bought at each price, individuals buy more of a good at lower prices.) In economics, a model is a simplification of various relationships among economic variables and is used to explain or predict economic phenomena. It is a way to represent or call attention to a relevant order or pattern in a set of data. It is of necessity an abstraction and includes only the most important aspects of a relationship. The nature of a model is dependent on the elements it is constructed of and the purposes it’s anticipated use. If two groups are given the task of making a model airplane but one of the groups is given paper and the other clay, their models will not look alike. Both models will be abstractions from reality. The elements of reality that are modeled may be different. The shape of a wing to give lift is an important feature. The color of the insignia on the rudder may not be significant (unless you are trying to demonstrate how air craft are identified by different insignia). Which model is “best?” A paper model of an airplane may be useful to demonstrate the idea of flight to a third grade class. A clay model might be best in a wind tunnel to test aerodynamics of a 750 mph wind. In economics, models built using individuals may not be useful in describing the economic behavior of multinational corporations. 44 3.2 Hypotheses, Theories, Laws and Models Models using land, labor and capital may not ask and answer the same questions as models that are built with energy, matter, time and technology. Models may take many forms: narrative, visual/graphic, tabular, mathematical, Cartesian graphs are some of the forms that may be used to present models. 3.3 FOUNDATIONS OF “SCIENCE” Jacob Bronowski contends there are three creative ideas central to science. These are the ideas of: 1) order, 2) causes and 3) chance. (Bronowski 1978) ORDER Bronowski states that,
“Science is not an impersonal construction.” (Bronowski. p 13) This human construction of knowledge begins ordering of things and events or phenomena. Aristotle saw order in the “nature of things.” Things fall to the earth because it is in their nature to do so. Bronowski mentions that one of the contributions made by the philosophers of the Middle Ages is that there is a hierarchy to the system of order. (Ibid. p 23) The notion of order is implicit in the classification of phenomena. Taxonomy (the art and/or science of identification, naming and categorization of phenomena) is fundamental to the process of science and the acquisition of knowledge. To classify events or things requires the recognition of the way in which things are alike or different. Taxonomy implies observation of the phenomena and some recognition of specific characteristics. Science looks for order or regularities among sets of facts. Order or regularities are patterns that are repeated in data or facts. Facts or data are 45 3.3 Foundations of “Science” usually collected by empirical methods. Observation is a typical method of collection. If we watch a “magician” or a group of witnesses to a crime testify, we understand that what we observe is not always what is. It is important to be very careful about what we see as facts. Different sets of “facts” can lead to very different questions and conclusions. Different “facts” or data can be collected about the same set of events. The taxonomy or the categorization of facts may lead to the recognition or belief that these facts are related in particular ways. A different taxonomy may result in the perception of different patterns When inputs are categorized as land, labor, capital and entrepreneurial ability, the order recognized may be different to a set of inputs categorized as energy, matter, time and technology. Depending on the patterns (order) perceived within the data, different questions may be asked. CAUSES Bronowski argues that both DA Vinci and Newton were great inventors and mechanics. They both recognized patterns of order in the universe and were able to describe these patterns. The difference, according to Bronowski, is that while DA Vinci was interested in variety and infinite adaptability, Newton was focused on unity and the singleness of nature. (Bronowski, p 24) Bronowski comments: “We could say that the Middle Ages saw nature as striving towards its own inner order: and that the Scientific Revolution overthrew this
order and put in its place the mechanism of causes. … On the one hand, all science, and indeed all thinking starts from and rests upon the notions of order: what marks the Middle Ages is that their order was always a hierarchy. And on the other hand what marks the scientific view is not that it turned to the mechanism of causes, but that it saw the world as a mechanism at all – a machine of events.” (Bronowski, p 25) 46 3.3 Foundations of “Science” Understanding how one fact is related to another fact is the recognition of causes. The recognition of order, regularities or patterns in a set of fact, raises the question as to the nature of the patterns. There are at least five possibilities: 1) event A may be caused by event B: A = fa(B) 2) event B may be caused by event A: B = fb(A) 3) events A and B may be caused by some (unobserved event C): B = fbc© and A = fac© 4) event A may be caused by some interaction between events B and C: A = fh(B, C) 5) events A and B may be the result of coincidence Statistical analysis is the typical method used to manipulate and analyze data. Many technical tools can be used to describe and relate the facts in data sets. Averages, median, mode, range, domain, variance, standard deviation and other measures are descriptive statistics. Correlation, analysis of variance and regression can be used to relate different aspects (variables) in the data set. The strength of the relationships that are recognized in the data set can the tested using t-scores, F-ratios, Chi Square and other methods. At the end of the day, none of these methods can prove causation: they can only show correlation. The concept of causation depends on a theory (or hypothesis) about the relationship between the variables. Statistical methods allow a test of the hypothesis or theory. The hypothesis cannot be proven it can only be disproven and the hypothesis rejected. Statistics can be used as evidence to support or reject a perception of causation. 47 3.3 Foundations of “Science” CHANCE If the world of events were truly a machine subject to the law of causes, events would be deterministic. Bronowski argues that the recognition of the law of chance is central to the method of science. It adds “statistical law” to the concept
of “causal law.” (Bronowski,. p 82) Causal law states that event B is caused by event A and therefore, event B will follow event A 100 time out of 100 occurrences of event A. Statistical law is based on the notion that event B will “probably” follow event A. The process is described as one where: “We look for a trend or systematic difference. But the line of this trend will itself be blurred by the unsteady hand of chance or random fluctuation. We cannot get rid of this random scrawl. But we can from it determine a measure of random variation, and use that to draw round the trend an area of uncertainty. If the area is small enough by standards which are agreed between us, then the trend is established, and we know the limits within which it is likely to lie. (Bronowski, p 92) The concept of probability provides the method by which observations of an extraordinarily complex world can be interpreted. It gives us information and knowledge that may not be “true” but is useful. In a complex world, there may be many reasons for a lack of certainty in causes. There may be other hidden or unrecognized forces that influence the relationship between event A and event B. If event A results in event B 90% of the time we may believe that A “causes” B. If the occurrence of A results in event B 30% of the time, other “causes” of B may be more important. Probability is a key idea in the understanding of causes. Statistics provides the means to state that with 95% confidence (or some other percentage) event A is correlated with event B. USEFULNESS AND “TRUTH” Knowledge held at any time may be “true” or “not true.” Knowledge that is true may or may not be useful. Knowledge may be useful whether it is “true” 48 3.3 Foundations of “Science” or not. Before the Copernican Revolution, a common belief was that the Earth was a stationary center of the universe. This was the Ptolemaic system attributed to Claudius Ptolemy [127-151 AD], a Greek mathematician and astronomer who lived in Egypt. In this system, the sun, stars, planets and moon circled the Earth in repeated patterns. Complex models were constructed to explain and predict the paths of the objects. These models worked with
reasonable accuracy and were useful to plan for seasons, planting of crops, and to prepare for floods. The models were useful, but “wrong.” New information obtained through observation and measurement showed there were simpler explanations for the paths of the celestial bodies. The Copernican or heliocentric view gained dominance. Galileo [1564-1642] verified the Copernican system with a new technology (the telescope). Johann Kepler [1571-1630] improved on Galileo’s findings and calculated equations to explain the elliptical orbits of the planets about the sun. As we accept “new knowledge” about the cosmos and subatomic matter, we replace old truths with new truths. 49 3.4 Explanation, Prediction and Storytelling 3.4 EXPLANATION, PREDICTION AND STORYTELLING Explanation and prediction are two of major objectives of science. These two goals are not symmetrical: it is possible to explain an event or phenomenon without being able to predict the probability of its occurrence: at the same time, it is possible to predict an event without being able to explain its nature or causes. Mark Blaug identifies two problems that arise from the “Symmetry Thesis.” First is the problem: “the history of science contains a number of theories which appear to explain natural phenomena, without however predicting them even in a statistical sense.” (Blaug, 1986, p 274) Darwin’s theory of evolution is cited as an example. Second is the problem: “…science, and particularly social science, abound in rules-of-thumb that yield highly accurate predictions about both natural and social events despite the fact that we may have absolutely no idea why these rules-of-thumb work as well as they do. (Ibid.) Whether explaining or predicting, science places value on precision and rigor of the process. However, one should avoid using the same criteria to evaluate scientific models with different objectives. It is also necessary to avoid attempts at precision and rigor that are not possible. Thomas Mayer cautions economists (the warning applies to all disciplines): “...we should draw a much sharper distinction that is usually done between two types of economic theory. One, formalist theory is abstract theory that is concerned with high-level generalization and looks towards axiomization. The other, empirical science theory focuses on explaining past observations and predicting future ones. While both are perfectly legitimate, applying the criteria appropriate to
one to evaluate the other generates confusion and misunderstanding. (Mayer’s book)...is a plea for a more modest economics that recognizes the inherent difficulty of making precise and indubitable statements about the actual world, accepts that there is a trade-off between rigor and relevance. I certainly agree that one should be as rigorous as one can be: I just oppose trying to be as rigorous as one can not be.” (Mayer, p 50 3.4 Explanation, Prediction and Storytelling 7) An emphasis on rigor and precision may result in attempts to develop theories or models that are esoteric and of little interest to anyone other than the scientist-author. In addition to explanation and prediction, science and the stories of science also create, shape and transmit individual and social values. Often this is an unintended effect rather than a conscious objective. The study of the evolution of methods in a discipline, such as economics, will hopefully create a greater awareness of this role and a greater understanding of one of the important effects. 3.5 LOGIC Several processes can be used in the discovery, creation and justification of knowledge. Instinct, intuition, abduction, deduction, induction and authority are examples of sources of knowledge. Appeals to authority as a justification for acceptance of knowledge is common but is not a reliable source. Instinct, intuition and introspection were once of great importance, but are not often seen as credible as “science” when seeking justifications for “knowledge” in Western, industrial societies. Research in the cognitive sciences and behavioral economics has recently been investigating intuition as a means of decision- making. Daniel Kahneman (a psychologist) received the Nobel in economics for work in cognitive processes and intuition in economic decisions. However, most discussions of methods in science place primary emphasis on inductive and deductive processes. 51 3.5.1 Deductive Reasoning 3.5.1 DEDUCTIVE REASONING Aristotle (384-322BCE) is usually credited with formalizing syllogistic or deductive reasoning. Deductive reasoning is a process that starts with a set of premises (or a priori truths) or general principles and through rules of logic, “deduces” a conclusion about a specific case. There are usually two premises: a major premise and a minor premise. If the general principle or major premise were that all the water in the lake was safe to drink, then deductive reasoning would conclude that a specific glass of water from the lake (the minor premise
is the water is from the lake) is safe to drink. The internal logic could be correct but if either of the premises were false, correct deductive logic would not yield true conclusions. 3.5.2 INDUCTIVE REASONING Francis Bacon (1561-1626) is credited with formalizing inductive reasoning. J.E. Creighton argues that Bacon’s Novum Organum was to replace Aristotle as the preeminent guide to the process of acquiring knowledge. “Bacon did for inductive logic what Aristotle did for the theory of the syllogism. It is of course, incorrect to say, as has sometimes been said, that Bacon invented the inductive method of reasoning. … What Bacon endeavored to do was to analyze the inductive procedure, and to show what conditions must be fulfilled in order that truth may be reached in this way.” (Bacon, pps vii-viii) Inductive reasoning is the process of inferring information from empirical observations. If several glasses of water were taken from a lake and each glass of water was shown to be safe to drink, it might be “inferred” that the water in the lake is safe to drink. Because all the water in the lake was not (and possibly could not) be tested there is some probability that all the water in the lake is not safe to drink. Empiricism is rooted in the inductive process 52 3.5.2 Inductive Reasoning and is based on empirical observations. Statistical inference is an application of the inductive method. While inductive methods are useful, there are pitfalls to avoid. Observations might be incomplete or the interpretation of the observation(s) could be incorrect. The selection of which phenomena to observe and the sequencing of the “facts” can alter the conclusions reached. The application of inference and inductive methods requires judgment and caution in the interpretation of data. 3.5.3 ABDUCTIVE REASONING Abduction is a creative process from which hypotheses arise. Abduction is similar to induction. The differences are that abduction is less formal process that consists of a combination of intuition, experience, observation, deductive reasoning and generates hypotheses which could be wrong. Abduction is the insight that occurs with less conscious formal reasoning than either induction or deduction. It is the purpose of inductive and deductive reasoning to test the hypotheses that emerge from the process of abduction. 3.6 EPISTEMOLOGY AND ECONOMIC M
ETHODOLOGY Epistemology is the study of the nature and limits of knowing. Economists are confronted with an ocean of facts and data that are reputed to support a plethora of theories and laws that purport to be the “truth” about economic behavior. Any discipline, whether it is economics, physics, biology or …, advances because someone questions the received wisdom: both extensions of ideas and new ideas that are created as reactions against result from questions about the received wisdom. If a scientist, economist or practitioner of any discipline has the “truth,” their only task is to make sure others accept 53 that “truth.” A bit of humility about what one thinks they know is not a bad thing. A quick survey of some of the basic ideas in epistemology provides an 3.6 Epistemology and Economic Methodology enlightened humility. 3.6.1 A TAXONOMY OF KNOWLEDGE Joel Mokyr classifies knowledge as propositional and prescriptive knowledge. Mokyr, an economic historian, relates the problem of human knowledge to economic growth and the economic problem. Propositional knowledge is “..knowledge (that is to say beliefs) about natural phenomena and regularities.” (Mokyr, p 4) Prescriptive knowledge is instructional or knowledge about techniques about how to do something. (ibid) 3.6.1.1 PROPOSITIONAL KNOWLEDGE In Mokyr’s taxonomy, propositional knowledge (Ω) can take two forms. He describes these as (1) “the observation, classification, measurement, and cataloging of natural phenomena.” And (2) “the establishment of regularities, principles and ‘natural laws’ that govern these phenomena and allow us to make sense of them.” Mokyr’s characterization of propositional knowledge is: “Science, as John Ziman has emphasized, is the quintessential form of public knowledge, but propositional knowledge is much more: the practical informal knowledge about nature such as the properties of materials, heat, motion, plants and animals: and intuitive grasp of basic mechanics (including the six ‘basic machines of classical antiquity: the lever, pulley, screw, balance, wedge and wheel): regularities of the ocean currents and the weather: and folk wisdom in the ‘apple-a-daykeeps-the-doctor-away’ tradition. Geography
is very much a part of it: knowing were things are is logically prior to the instructions of how to go from here to there.” (Mokyr, p 5) He argues that for the economic historian what matters is the collective knowledge of what society, as a whole, knows (the union of all statements of such knowledge). Confidence and consensus about knowledge as well as 54 3.6.1 A Taxonomy of Knowledge access to and transmittal of that knowledge is of great importance to how propositional knowledge is used. Mokyr characterizes the development of new propositional knowledge as “discovery, the unearthing of a fact of natural law that existed all along but was unknown to anyone in society.” (Mokyr,, p 10) 3.6.1.2 PRESCRIPTIVE KNOWLEDGE Prescriptive knowledge (λ) is the knowledge about how to do something: it is technique or instructional knowledge. This prescriptive knowledge is defined as “sets of executable instructions or recipes for how to manipulate nature.” (Mokyr,, p 10) The addition to this prescriptive knowledge is called an “invention.” Prescriptive knowledge is not right or wrong it is successful or unsuccessful. Mokyr argues that the industrial revolution and the associated economic growth began when prescriptive knowledge came to be based on proportional knowledge. Individuals can learn to do things without knowing why they work. Once you know why techniques (prescriptive knowledge) work, (propositional knowledge), it is easier to invent improvements to old techniques and develop of new ones. 3.6.1.3 AN EXAMPLE Knowledge about baking includes an understanding of the effects of altitude, leavening, moisture, temperature, gluten and a host of other phenomena on cakes. This knowledge is propositional knowledge. A cake can be baked by someone in San Francisco with a recipe (prescriptive knowledge) and no knowledge about the effects of altitude on cakes. The recipe will work as long as person doesn’t try to bake a cake in Santa Fe, NM (elevation 7200 feet). To modify the recipe so it will work at the new elevation requires propositional knowledge. The development of new recipes (λ) requires some proportional knowledge (Ω). 55 3.6.2 BRIEF SURVEY OF EPISTEMOLOGY Karl Popper [1902-1994] is the primary architect of falsification as a
3.6.2 Brief Survey of Epistemology method of science. In his The Logic of Scientific Discovery, 1934, he outlines the basic approach taken in what is called the scientific method. He proposes that scientific knowledge grows through a process of making hypotheses abut the nature of problems and the falsification or testing of those hypotheses. Popper argues that it is the duty of every scientist to try to disprove or reject his or her hypotheses. If a hypothesis cannot be rejected by empirical evidence, it may be retained as “probably true.” All knowledge then is probabilistic: it has not yet been falsified. The process is subject to what statisticians call Type I and II (or alpha and beta) errors. Type II errors occur when a false hypothesis is accepted as “true.” When a “true” hypothesis is rejected as false a Type I error has occurred. Thomas Kuhn [The Structure of Scientific Revolutions, 2cd ed, 1962,1970] offers another explanation for the evolution and change of scientific thought in the “hard sciences.” His explanation is often applied to economics and social sciences. Kuhn used the concept of “paradigms” and paradigm shifts to explain the process. The term, paradigm, is often used and abused in discussions. Kuhn’s approach is essentially a “truth by consensus” which is contained in the paradigm. This paradigm (and its associated “truth by consensus”) is practiced until there are “anomalies” or problems that the existing paradigm cannot explain. Then an alternative paradigm with greater explanatory powers replaces it. He argues that a science operates within a paradigm. This paradigm is characterized by, • the “community structure of science’ • or the “disciplinary matrix” which consists of symbolic generalizations (deployed without question), • shared commitments to a set of beliefs and a set of values. 56 3.6.2 Brief Survey of Epistemology The members of the science use this paradigm to resolve anomalies. When an anomaly of major significance or a large number of anomalies cannot be explained, the paradigm must be questioned and a new paradigm for that science developed. In this manner “science progresses.” Imre Lakatos’ method is expressed in his book, Proofs and Refutations, [Cambridge University Press: Cambridge, 1976]. Lakatos’ approach, while in the tradition of one of
his teachers, Karl Popper, is critical of both Popper and Kuhn. He advocated a more sophisticated form of falsification of “groups of theories” and combined it with “scientific research programmes (SRP’s)” which were more specific than paradigms. Lakatos’ SRP consists of two elements, the “hard core, protective belt” and the “positive heuristic.” (Pheby, John, Methodology and Economics: a Critical Introduction, M.E.Sharpe, 1988,, p 56) The hard core is constructed of “basic axioms and hypotheses” that are accepted without question and is used as a defense mechanism. The positive heuristic is the body of theories and problems that drive the research programmes. (Pheby, p 56) Kuhn’s approach can be contrasted with that of Karl Popper and Imre Lakatos. Popper saw the advancement of knowledge as the result of the falsification of testable hypotheses. Those hypotheses that were not disproved were accepted as “probably true.” Lakatos took the middle ground. Rather than falsifying a hypothesis or the whole paradigm, he felt that the process was based on “scientific research programs.” A school of economic thought may represent a paradigm (in a Kuhnian sense) or a scientific research program (in a Lakatian sense). A more extreme view is expressed in Paul Feyerabend’s book, Against Method (Verso: London, 1988, originally published by New Left Books, 1975). He advocates an approach to science that has been called “theoretical 57 3.6.2 Brief Survey of Epistemology anarchism.” Feyerabend argues that the “success of science cannot be used as an argument for treating yet unsolved problems in a standardized way” and scientific achievements can “be judged only after the event.” (Feyerabend, p 2) Feyerabend’s approach to the methodology of science is radically different because of his objectives. He claims his purpose is “humanitarian not intellectual” in that he wants “to support people not advance knowledge.” He is “against ideologies that use the name of science for cultural murder.” (Feyerabend, p 4]) While he does not disavow the title of “theoretical anarchist,”
he does provide insights into the evolution of science and knowledge. Feyerabend summarizes some of his insights: “Neither science nor rationality are universal measures of excellence. They are particular traditions, unaware of their historical grounding.” (Feyerabend, p 231) “Yet it is possible to evaluate standards of rationality and to improve them. The principles of improvement are neither above tradition nor beyond change and it is impossible to nail them down.” (Feyerabend, p 248) “Science is a tradition among many and a provider of truth only for those who have made the appropriate cultural choice.” (Feyerabend, p 256) “The entities postulated by science are not found, and they do not constitute an ‘objective’ stage for all cultures and all of history. They are shaped by special groups, cultures, civilizations: and they are shaped from a material which depending on its treatment, provides us with gods, spirits, a nature that is a partner of humans rather than a laboratory for their experiments, or with quarks, fields, molecules, tectonic plate. Social monotony thus implies cosmic monotony - or ‘objectivity,’ as the latter is called today.” (Feyerabend, p 260) Science (and economics) is not free from ideology. It is necessary to understand the prevailing ideology in a culture, society, group or corporation in order to interpret one’s own perspective. Imagine a luxury train, the Orient Express. You find your way to the club car and find a billiard table. You shoot the cue ball down the table (parallel to the tracks) in the direction the train is 58 3.6.2 Brief Survey of Epistemology coming from at the same speed the train is traveling. You perceive that the ball is rolling toward the other end of the table. To some one observing the train pass by, as they peer into the window they perceive that the cue ball is stationary and that the table, you and the train are moving away from the point where the ball is fixed. Your perspective determines your interpretation of the event. 3.6.3 MILTON FRIEDMAN Milton Friedman [1912-2006] is one of the best-known economists of the 20th century. His article, “The Methodology of Positive Economics” in Essays in Positive Economics [1953] was one of the most important influences
on economic thought. In this important piece, Friedman sets the standards for normative and positive economics as well as influencing several generations of economists. He argues that positive economics is “independent of any ethical position” and its task is to provide “a system of generalizations that can be used to make predictions about the consequences of any change in circumstances:” it deals with “what is.” (Friedman, p. 4) Normative economics is dependent on positive economics and deals with “what ought to be.” Friedman argues that economics can be a positive science. The structure of this positive science, like all positive sciences, consists of two parts: first, is a language and second, is a “body of substantive hypothesis designed to abstract essential features of complex reality.” (Ibid. p. 7) According to Friedman, language is a set of tautologies whose primary function is to organize and classify empirical material to facilitate our understanding. This language has no substantive content. This component or element in positive science may be evaluated by formal logic to determine if it is consistent and 59 3.6.3 Milton Friedman complete. Empirical or factual evidence and presumably the use of the language will reveal how well the analytical filing system functions. (Ibid.) The body of “substantive hypotheses” or theory is primarily to yield “valid and meaningful (i.e. not truistic) predictions about phenomena not yet observed.” (Ibid.) The only test of the validity of the hypotheses or theory is its “predictive power for the class of phenomena it is intended to ‘explain.’” If there are alternative hypotheses that may be chosen, Friedman suggests two criteria: simplicity and fruitfulness. Simplicity is an echo of the work of William Ockham [1285-1347 (49?)] or Ockham’s razor. Fruitfulness reflects the precision of predictions as well as their relevance for wider or more generalized applications. A more “fruitful” set of hypotheses would also suggest additional lines of research. The validity of a theory cannot be evaluated on the basis of the reality of the assumptions, rather a “…hypothesis can be tested only by the conformity of its implications or predictions with observable phenomena: but it does render the task of testing hypotheses more difficult and gives greater scope for confusion about the methodological principles involved. More than other scientists, social scientists need to be
conscious about their methodology.” (Friedman, p 40) 3.6.4 DEIRDRE MCCLOSKEY Of all the individuals whose views on methodology have been discussed, Friedman and McCloskey are the only writers who can be identified as “economists.” McCloskey’s book, The Rhetoric of Economics, (University of Wisconsin Press: Madison, 1985) has gained widespread attention among economists. McCloskey argues that the method economists claim to follow is not the method that they follow in practice. Most economists, as well as individuals in most other disciplines, claim to follow the “scientific method” of falsification (i.e. hypothesis testing), usually in the format expressed by some 60 3.6.4 Deirdre McCloskey integration of Popper/Lakatos/Kuhn. McCloskey charges that as a result of attempts to create and follow a modern science, “modernism” has become a dominant theme. According to McCloskey, modernism is a “word that can be fully defined only in use.” (McCloskey, 1985, p 5) She points out that modernism is not limited to economics but is also present in philosophy, architecture, music, and politics. This list can be expanded to include management, accounting and a multitude of other fields. While it may not be possible to give a precise definition of modernism, it is possible to characterize its nature. Some of its characteristics are identified in the following quotes about modernism: “knowledge is to be modeled on the early twentieth century’s understanding of certain pieces of nineteenth-century and especially seventeenth-century physics.” (McCloskey, 1985, p 5) (Presumably, Comte, Descartes and Newton are the seventeenth century physicists in the reference.) It is the “notion that we can know only what we cannot doubt and cannot really know what we can merely assent to.” (McCloskey, 1985, p 5) It includes the belief that “only falsifiable hypotheses are meaningful: the evidence is consistent with the hypothesis: of tastes one ought not, of course, to quarrel.” (McCloskey, 1985, p 6) “Modernism views science as axiomatic and mathematical and takes the realm of science to be separate from the realm of form, value, beauty, goodness, and all
unmeasurable quantity.” (McCloskey, 1985, p 6) It is “functionalist and given to social engineering and utilitarianism, the modernist is antihistorical, uninterested in cultural or intellectual traditions.” (McCloskey, 1985, p 6) McCloskey advocates the use of classical rhetoric to advance economic theory through the same methods used in literary criticism. Rhetoric, which includes the use of fact, logic, metaphor and story, provides the criterion and framework that guides the development of science. Deirdre McCloskey argues that, 61 3.6.4 Deirdre McCloskey “(E)conomists do not follow the laws of inquiry their methodologies lay down.” (McCloskey, 1983, p 482) Rather, “Economists in fact argue on wider grounds and should. Their genuine workaday rhetoric, the way they argue inside their heads or their seminar rooms diverges from the official rhetoric.” (McCloskey, 1983, p 482) McCloskey proposes that the development of “knowledge” about economic relationships and behavior is pushed forward by “rhetoric.” The many dimensions of rhetoric emerge from quotes McCloskey chooses from Wayne Booth. Rhetoric is: “the art of probing what men believe, rather than proving what is true according to abstract methods.” “the art of discovering good reasons, finding what really warrant assent, because any reasonable person ought to be persuaded.” “careful weighing of more-or-less good reasons to arrive at more-or less probable or plausible conclusions - none too secure but better than would be arrived at by chance or unthinking impulse.” the “art of discovering warrantable beliefs and improving those beliefs in shared discourse.” not to “talk someone else into a preconceived view: rather it must be to engage in mutual inquiry.” (McCloskey, 1983, pp. 482-483) McCloskey argues that, “Each step in economic reasoning, even the reasoning of the official rhetoric, is metaphor. The world is said to be ‘like’ a complex model, and its measurements are said to be like the easily measured proxy variable to hand.” (McCloskey, 1983 p 502) Even “...mathematical theorizing is metaphorical and literary.”
(McCloskey, 1983, p 505) In If You’re So Smart, published in 1990, McCloskey argues that, “Like other arts and sciences, that is, economics uses the whole rhetorical tetrad: fact, logic, metaphor, and story. Pieces of it are not enough. The allegedly scientific half of the tetrad, the fact and logic, falls short of an adequate economic science, or even a science of rocks or stars. The allegedly humanistic half falls short of an adequate art of 62 3.6.4 Deirdre McCloskey economics, or even a criticism of form and color.” (McCloskey, 1990, p 1) To consider the rhetoric and storytelling of economics does not mean that economics is or should be without method. Rhetoric provides a framework and criterion that guides the development of economic theory. It is rhetoric that makes theory more relevant, identifies the ethical content and increases flexibility in the evolution of economic knowledge. 3.7 WHICH METHODOLOGY IS “CORRECT?” Which of the methodological arguments is “correct” and should be followed? There is not a universally accepted answer in any academic discipline nor among those who study the philosophy of science. To understand and contribute to any field of knowledge, it is necessary to be aware of the methodology(ies) that have guided the development of accepted ideas, hypotheses, theories, concepts, tools, values and ideologies that are used within that discipline. Ignorance of methodology dooms an individual to perpetual training and re-training rather than opening the door to education. Methodological problems apply to all knowledge including Newtonian mechanics, the theory of relativity and quantum mechanics as well as economics. In economics, the methods used and ideological preconceptions of individual economists and schools of thought help to explain many of the differences in explanations of problems and policies advocated. Modern economic theory has a long tradition of following a “modernist” methodology characterized by a strong faith in empiricism and rationalism. Within modern economics, knowledge is believed to be advanced by inductive or empirical investigations that can verify (or fail to falsify) “positive” concepts, hypothesis, theories or models developed by deductive or rationalist logic. 63 3.7 Which Methodology is “Correct?” Normative economics (or the study of what “ought to be”) is seen as distinctly separate from positive economics. When economics is studied as a process of provisioning
, normative and positive issues become interrelated. 3.8 THE STANDARD VIEW OF THE SCIENTIFIC METHOD The process by which knowledge is acquired is often called the “scientific method.” There are several variations of the way in which the scientific method are characterized, but the steps usually are: 1) recognition of a problem 2) creation of a hypothesis about the nature of the problem 3) collect relevant data to test the hypothesis 4) propose a solution to the problem 5) act on the proposed solution or policy to solve the problem 6) monitor the results of the policy: collect and analyze data on the application of the policy 7) make adjustments in the hypothesis and solutions as needed. The first step in the so-called scientific method requires an integration of positive and normative issues (normative and positive aspects of economics was discussed under the section on Milton Friedman). The recognition of a problem is a recognition of a deviation between what should be and what is. If my shoes do not hurt my feet (a positive statement), I probably don’t think about my shoes. If my shoes hurt my feet (a positive statement) and I think they shouldn’t hurt my feet (a normative statement), I recognize a problem. If there is unemployment (positive statement) and believe there should be unemployment (normative statement), a problem is not recognized. If there is unemployment and think that there should not be unemployment, a problem is recognized. 64 4 Individuals and Community 4 INDIVIDUALS AND COMMUNITY A community is made up of a group of individuals. One of the characteristics of a community is that there is an intersection of a set of shared values and objectives held by the individuals. Social institutions (embedded patterns of behavior within a society) represent these shared values. Only under rare circumstances would a group of individuals have the same set of shared objectives. Because they are individuals, it is probable that some of their objectives will be different and conflict or compete. It is necessary for the community to have a set of social institutions to coordinate competing values and ends. Social institutions both arise from human behavior and influence their behavior. Traditions, mores, customs and more formal institutions (such as laws), define the range of choices. Markets are also a social institution. A voluntary contract between two individuals is a social mechanism to coordinate activities. Markets require a social infrastructure. Trust, expectations about buyers and sellers providing information (no fraud, deceit or duress), obligation to fulfill contracts and expectations that individuals will do no harm
to others, facilitates the operation of markets. Adam Smith (1723-1790) points out that markets are subject to abuse: People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. It is impossible indeed to prevent such meetings, by any law which either could be executed, or would be consistent with liberty and justice. But though the law cannot hinder people of the same trade from sometimes assembling together, it ought to do nothing to facilitate such assemblies, much less to render them necessary.(Smith WN, p 128) Participants in markets may also use formal institutions (law, regulations) to benefit themselves: 65 4 Individuals and Community The interest of the dealers, however, in any particular branch of trade or manufactures, is always in some respects different from, and even opposite to, that of the public. To widen the market and to narrow the competition, is always the interest of the dealers. To widen the market may frequently be agreeable enough to the interest of the public: but to narrow the competition must always be against it, and can serve only to enable the dealers, by raising their profits above what they naturally would be, to levy, for their own benefit, an absurd tax upon the rest of their fellow-citizens. The proposal of any new law or regulation of commerce which comes from this order ought always to be listened to with great precaution, and ought never to be adopted till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention. It comes from an order of men whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it. (Smith WN, p 250) 4.1 INSTITUTIONS Douglass North argues that Institutions are the rules of the game in a society or, more formally, are the humanly devised constraints that shape human interaction. In consequence they structure incentives in human exchange, whether political, social, or economic. Institutional change shapes the way societies evolve through time and hence is the key to understanding historical change. (North, 1990, p 3) North expands “human exchange” to include human interactions that include “political, social or economic” phenomenon. Human exchange is interpreted as “human interaction on social, political and economic levels
.” North’s broader definition will be used in this chapter even though the term “exchange” is quite specific: Exchange involves a quid pro quo, i.e. an exchange of private property rights between individual agents. The terms of the exchange are clearly specified: “I will give you this if you will give me that.” The goods to be exchanged are clearly specified, as are the terms of the exchange. (Chapter 2, p 15) North identifies the roles of these institutions: 66 4.1 Institutions • • • • “Institutions reduce uncertainty by providing structure to everyday life.” (North, p 3) “Institutions include any form of constraint that human beings devise to shape human interaction. Are institutions formal or informal? The can be either, and I am interested both in formal constraints – such as rules that humans beings devise – and informal constraints – such as conventions and codes of behavior.” (North, p 4) “Institutional constraints include both what individuals are prohibited from doing and, sometimes, under what conditions some individuals are permitted to undertake certain activities.”(North p 4) “A crucial distinction in this study is made between institutions and organizations. Like institutions, organizations provide a structure to human interaction. (North, pp 4-5: North points out that organizations are considered as one of the players or actors while institutions are the underlying rules of the game.) “Institutions are a creation of human beings. They evolve and are altered by human beings:... Integrating individual choices with the constraints institutions impose on choice sets is a major step toward unifying social science research.” (North, p 5) North refers to some institutions as “conventions and codes of conduct.” Traditions, customs, mores, rules of thumb are other examples of implicit institutions that are part of the rules of the game. These habitual patterns of behavior or embedded rules may arise spontaneously. Individuals seek solutions to problems. When they find something that works (or provides a reasonable solution), they learn to try the same approach when the same or new problems arise. These institutions become short cuts to analyzing and devising new solutions for every new problem. These implicit institutions may be transmitted to others in a variety of ways. Custom and traditions are the most obvious. It is possible to create codes of conduct that may be communicated through religious beliefs. Religious law and jurisprudence are common to
almost all societies. In 67 4.1 Institutions societies that depend on interpersonal relationships, these implicit institutions may be dominant in influencing behavior patterns. In cases where the community becomes complex, the effects of social values on individual choices may be weakened. If implicit social institutions are weakened, force of law (formal explicit institutions) may be used to encourage some behavioral patterns and discourage others. Adam Smith had a manuscript on jurisprudence destroyed at the time of his death (1790). Copies of students’ notes on Smith’s lectures on jurisprudence (1762-63, 1766) were found and published as Lectures on Jurisprudence (LJ). In these notes, Smith describes the role of law within a society. The two traditions of common law and the Napoleonic code provide the framework for the legal systems in most Western industrial countries. Common law is based on stare decisis: i.e. laws emerge over time on the basis of precedence. As society, technology, relationships, environment and other features of society change, laws are modified. The Napoleonic code (dates from 1804) is based on Roman Law. It establishes a clear legal framework on issues of property, inheritance, the family and individual freedom. Both approaches provide formal rules of the game and may be considered as an explicit, formal institution. The relationship between the legal and economic system is well established. John R. Commons (Legal Foundations of Capitalism, 1924) and Richard Posner (The Economic Analysis of the Law, 1973, sixth edition 2003) are foundations for two traditional approaches to law and economics. 4.2 INSTITUTIONS AND COSTS The provisioning process and the allocation process both involve the ownership of resources and goods as well as the mechanisms by which the 68 4.2 Institutions and Costs rights of ownership are transferred. With in a society, the transfer of ownership of goods is not with out costs. In the case of eminent domain, there are costs (opportunity costs) to the authority that defines and enforces the transfer of ownership of goods (property rights). Individuals who are affected by eminent domain incur costs as well. There are also costs of using exchange. These costs are the effort (sacrifice) of individuals to obtain information about goods, other individuals who are willing to enter a contract and the effort to negotiate the contract or terms of exchange. Social institutions and organizations are a social response to reduce the costs of exchange and eminent domain. Social institutions also
facilitate and enforce reciprocity. The costs of using exchange are referred to as “transaction costs.” (see Coase, “Nature of the Firm”. 1937) The institutions define the rules of the game: provide individuals with information and some degree of certainty in their social interactions. This reduces the time and effort (transaction costs) that individuals devote to the allocation problem. Institutions and organizations are human creations that are intended to solve problems. It should be noted that these human creations might be intentional and explicit or unintentional and implicit. As in all human endeavors, some attempts are more successful than others: i.e. some institutions are more successful at achieving objectives than others. Institutions arise as solutions to a given set of problems. Should the elements of the problem change (the actors, agents, technology, information, other institutions), the institutions may need to adapt. However, any set of institutions is correlated with the interests of particular individuals. Some of these individuals benefit from the particular structure while others are not. Those who benefit from a particular institutional structure have a vested 69 4.2 Institutions and Costs interest in preventing changes in the institutions. These vested interests may use their positions and power to prevent institutional change and to work to alter institutions (particularly explicit institutions such as law) in their interests. Consequently, the institutions that are prevalent at any point in time may lag behind environmental, technological and social changes. Patents, copyrights, regulations of communication industries (radio, television, newspapers, internet and the like) determine the behavior of the agents and firms in those industries. George Stigler (1911-1991) described a “capture theory of regulation.” (Stigler, 1971, Published first in 1962 with Claire Friedland) He argues that when an industry is regulated, it is in the interests of that industry to capture the regulatory agency and influence its policies. The communication industries have a greater incentive to influence the policies of the Federal Communications Commission (FCC) than the average person. Recent actions by the FCC have allowed greater concentration of news media. Companies that publish music have more interest in the laws regarding the ownership (copyrights) and royalties to music than the public: the “Napster” incident on downloading music files from the Internet is an example. The insurance, pharmaceutical, hospital and medical industries have more interest in the social institutions that influence the delivery of health care than individuals. Health insurance emerged in the mid 1930’s as a solution to
the problems of random, catastrophic health care costs and how hospitals and doctors would receive financial payment. The insurance and health care providers (doctors, pharmaceutical, hospitals and insurance industries and firms) have a vested interest in maintaining the system that maintains their sources of revenue. 70 4.2 Institutions and Costs The vested interests have an incentive to shape the formal and informal institutions that relate to their activities. 4.3 MORALITY, JUSTICE AND A STABLE SOCIETY Institutions reduce the costs of the allocation process. Additionally, justice, an orderly society, tranquility, security, peace are objectives that are commonly held in many societies. Adam Smith (1723-1790) is used to express these ideas here since he is generally regarded as one of the first writers to advocate a system based on morality, markets and law. He wrote the Theory of Moral Sentiments in 1759 to describe his view of the role of sympathy and empathy in human behavior. He argues that justice is essential for an orderly society. On the first page of Theory of Moral Sentiments, Smith writes: How selfish man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it, except the pleasure of seeing it. Of this kind is pity or compassion, the emotion which we feel for the misery of others, when we see it, or are made to conceive it in a very lively manner. That we often derive sorrow from the sorrow of others, is a matter of fact too obvious to require any instances to prove it: for this sentiment, like all the other original passions of human nature, is by no means confined to the virtuous and humane, though they perhaps may feel it with the most exquisite sensibility. The greatest ruffian, the most hardened violator of the laws of society is not altogether without it. (Smith, TMS, p 47) Smith continues on the role of society in the formation of individual values: Were it possible that a human creature could grow up to manhood (sic) in some solitary place, without communication with his (sic) own species, he could no more think of his own character, of the propriety or demerit of his own sentiments and conduct, of the beauty or deformity of his (sic) own mind, than of the beauty or deformity of his (sic) own face. All these are objects which he cannot easily see, which naturally
he does not look at, and with regard to which he is provided with no mirror which can present them to his view. Bring him into society, and he is immediately provided with the mirror which he wanted before. It is placed in the countenance and behavior of those he lives with, which always mark when they entered into, and when they disapprove of his 71 4.3 Morality, Justice and a Stable Society sentiments: and it is here that he first views the propriety and impropriety of his own passions, the beauty and deformity of his own mind. (Smith, TMS, p 204) Smith continues: It is thus that man, who can subsist only in society, was fitted by nature to that situation for which he was made. All the members of human society stand in need of each other’s assistance, and are likewise exposed to mutual injuries, Where the necessary assistance is reciprocally afforded from love, from gratitude, from friendship, and esteem, the society flourishes and is happy. All the different members of it are bound together by the agreeable bands of love and affection, and are, as it were, drawn to one common centre of mutual good offices. But though the necessary assistance should not be afforded from such generous and disinterested motives, though among the different members of society there should be no mutual love and affection, the society, though less happy and agreeable, will not necessarily be dissolved. Society may subsist among different men, as among different merchants, from a sense of its utility, without any mutual love or affection: and though no man in it should owe any obligation, or be bound in gratitude to any other, it may still be upheld by a mercenary exchange of good offices according to an agreed valuation. Society, however, cannot subsist among those who are at all times ready to hurt and injure one another. (Smith TMS, p 166)... Society may subsist, though not in the most comfortable state, without beneficence: but the prevalence of injustice must utterly destroy it.... Justice, on the contrary, is the main pillar that upholds the whole edifice. If it is removed, the great, the immense fabric of human society, that fabric, if I may say so, to have been the peculiar and darling care of nature, must in a moment crumble into atoms. (Smith TMS, p 167) As society cannot subsist unless the laws of justice are tolerably observed, as no social intercourse can take place
among men (sic) who do not generally abstain from injuring one another: the consideration of this necessity, it has been thought, was the ground upon which we approved the enforcement of the laws of justice, by Smith recognizes that beneficence and morality cannot be the only mechanism that creates order in society. He argues that: This disposition to admire, almost to worship, the rich and the powerful, and to despise, or, at least, to neglect persons of poor and mean condition, though necessary both to establish and maintain the 72 4.3 Morality, Justice and a Stable Society distinction of ranks and the order of society, is, at the same time, the great and most universal cause of the corruption of our moral sentiments. That wealth and greatness are often regarded with the respect and admiration which are due only to wisdom and virtue: and that the contempt, of which vice and folly are the only proper objects, is often mostly unjustly bestowed upon poverty and weakness, has been the complaint of moralists of all ages. (Smith TMS, p 126) Smith is not the only writer to argue the importance of justice and morality in the proper functioning of society. Plato, Aristotle, St Thomas, and a host of writers argue the role of justice. At the same time, most recognize that beneficence and cannot be the only motivating force in society. The need for morality is based on biology and ecology: Joan Robinson argues: A society cannot exist unless its members have common feelings about what is the proper way of conducting its affairs, and these common feelings are expressed in ideology. (Robinson, p 3) The biological necessity for morality arises because, for the species to survive, any animal must have, on the one hand some egoism-a strong urge to get food for himself (sic) and to defend his means of livelihood: also-extending egoism from the individual to the family- to fight for the interests of his mate and young. On the other hand, social life is impossible unless the pursuit of self-interest is mitigated by respect and compassion for others. A society of unmitigated egoists would knock itself to pieces: a perfectly altruistic individual would soon starve. There is a conflict between contrary tendencies, each of which is necessary to existence, and there must be a set of rules to reconcile them. Moreover, there must be some mechanism to make an individual keep the rules when they conflict with his immediate advantage. (Robinson, p 4)... Since the egotistic
impulses are stronger than the altruistic, the claims of other have to be imposed upon us. The mechanism by which they are imposed is the moral sense or conscience of the individual. (Robinson, p 5)... But observe, it is the honesty of other people that is necessary for my comfort. (Robinson, p 6) Justice and concern for others is an important objective that is often reflected in the golden rule: “Do unto others as you would have them do unto you.” Or to quote Ivan Hill, 73 4.3 Morality, Justice and a Stable Society Men of many ages have considered the Golden Rule to be the fundamental moral imperative. Confucius once was asked, ‘Is there one word which may serve as a rule of practice for all of one’s life?’ He answered, ‘Is not reciprocity such a word? What you do not want done to yourself, do not do to others.” (Hill, p 4) A just and moral society where humans can live in a peaceful environment is an objective held by many philosophers through the ages. Perhaps for some, the history of conflict and war casts doubt on a human objective of justice. Alternatively, perhaps conflicts and wars occur because of feelings or injustice. Tradition, customs, mores, and other social institutions are mechanisms through which individuals acquire common values. The size of one’s family, forms of marriage, responsibility for children or parents, expectations about disposal of wastes, use of resources, obligations to care for less fortunate people, trust, theft, voting, creativity, duty to family (country, etc) attitudes about stewardship, are examples of values that may be generally held by the members of a community. These values influence the choices that individuals make. 4.4 AGENTS A decision also implies the existence of an agent. An agent is an individual who has the authority to evaluate, select, and act on alternatives to achieve an end. The agent may act for themselves or on the behalf of a principal. Agents choices may be based on intuition, habits (rules of thumb, institutions), explicit rules or reason. Any decision implies that there is an end, objective, or goal that an agent wishes to achieve. Humans seek means to achieve ends. As suggested above, decisions based on reason must have an objective. Intuition as a method for making decisions also implies that a result is desired. Rules and habits (or 74 4.4 Agents social institutions) arise because
there is some desired end to be accomplished. The question is what is the origin and nature of the objectives. Both the ends and means may be influenced or constrained by resource endowment, technology, or social institutions (such as customs, traditions, markets and law). In the case of an agent or agents representing a principal, there may be a conflict or incompatibility among their objectives. This is referred to as the principal/agent problem. The agent has a conflict of interest. A stockbroker acts as an agent for an investor: a doctor may act as the agent for a patient. The lawyer acts as an agent for her client, the principal. The goal or end of the investor may be to maximize earnings on their assets. The end or objective of the stockbroker may be to maximize their commission. In the short run, the broker may sacrifice the earnings of the investor to maximize commissions. Hopefully, in the long run the broker will recognize that the short term strategy will result in the loss of the investor as a client. The principal must have some knowledge and information regarding the agent’s behavior. In a complex world, this does not always happen. Enron is an example of the principal/agent problem. The interests (ends) of the CEO and management (the agents) were inconsistent and had priority over the goals of the stockholders (principals). In a complex world where it is difficult for principals to have information to evaluate all the action of the agents, a code of conduct or code of ethics may be important as a means to get the agent to act for the principal. The Hippocratic oath is a social institution to insure the physician acts in the principals interests. Accountants and lawyers are other examples of professions that rely heavily on codes of ethics to resolve conflicts between the principal and agent. 75 4.5 Organizations and Agents 4.5 ORGANIZATIONS AND AGENTS Organizations are another way that the cost of economic activities. North distinguishes between institutions and organizations. Both provide structure to human interactions. Ronald Coase (1910-) sees both as mechanisms to reduce the costs of transferring ownership. (Coase, 1937) The crucial difference is that institutions are part of the rules of the game and organizations are participants in the game. The firm (or any organization) arises because there are costs to using the “pricing mechanism.” What the prices are have to be discovered. There are negotiations to be undertaken, contracts to be drawn up, inspections to be made, arrangements
to settle disputes, and so on. These costs have come to be known as transaction costs. Their existence implies that methods of co-ordination alternative to the market, which are themselves costly and in various ways imperfect, may nonetheless be preferable to relying on the pricing mechanism (market? Author’s question), the only method of co-ordination normally analyzed by economists. It was the avoidance of the costs of carrying transactions out through the market that could explain the existence of the firm, in which the allocation of factors came about as the result of administrative decisions. In the “Nature of the Firm” I argued that in a competitive system there would be an optimum of planning since a firm, that little planned society, could only continue to exist if it performed its co-ordination function at a lower cost than would be incurred if co-ordination were achieved by means of market transations and at a lower cost than this same function could be performed by another firm.... I argued in “The Nature of the Firm” that the existence of transaction cost leads to the emergence of the firm. (Coase 1995, p 8-9) The firm (or any organization) comes into existence to create a small “planned society” and to use administrative decisions to allocate resources because it would be more costly to use market exchange. Firms (or organizations) may be for profit, not-for-profit, cooperatives, sole proprietorships, partnerships or corporations. There are many ways of categorizing organizations. 76 4.5 Organizations and Agents Within a firm the CEO, Board of Directors, shareholders, Vice-President of Marketing, Vice-President of Production and the assembly line workers may have competing objectives that will be resolved by authority, contract, or some other social institution. There are managerial techniques that might be used to coordinate the activities of the diverse groups in a firm. In a family, the parents may have different ends than the children. There are parental “instincts,” love and social expectations as well as laws that insure the parents act in the child’s interests. Within an organization, the principal/agent problem becomes important. Usually a manager (CEO) makes administrative decisions that affect many other groups. Their administrative decisions may be guided by general policies and guidelines established by a Board of Directors who in turn is constrained by the shareholders (or owners). The objectives of the shareholders may or may not be reflected by the decisions of the manager. The manager may
have a different set of objective and the shareholders may or may not have information (or control) over the decisions of the manager. Kenneth Lay and the management of Enron is an example of the principal/agent problem. 4.6 OBJECTIVES An objective, goal or end is something that an individual or group of individuals hopes to achieve. There may be many alternatives that will potentially achieve the end or goal. Some alternatives have a higher probability of success. The alternative that is selected, through reason, rules, habits or intuition, is the means. It is not always clear how humans create their objectives or ends. One hypothesis is that they are capable of thought and can imagine alternative states or conditions. If the alternative state is perceived as preferable to the 77 4.6 Objectives existing state, the alternative state becomes an end. This process necessarily requires a subjective valuation or ranking of alternative states or conditions. I am hungry. I can perceive or imagine myself not being hungry. Not being hungry is preferable to being hungry so the objective or end is to reach the preferred state. The mind is capable of recognizing an incongruity between what is and what I imagine can be. I may seek the means to satisfy my hunger through reason. Intuition, rules or habitual patterns of behavior may also suggest means of satisfying my hunger. Many substances will satisfy hunger. Geographic differences and resource endowment may alter what people choose to eat. Inuit people eat whale and sea lion. In the southwestern United States pinto beans, corn and chili peppers are favorites. In France, escargot is a delicacy. Individuals often develop a “taste” or preference for a food they ate as a child. As a result, we often think of foods as representing different social of ethnic groups. Italian, Chinese, Mexican, Indian are examples of ethnic foods that represent different social groups from different locations. Hunger is a physiological stimulus so it is easy to recognize the incongruity between being hungry and not being hungry. Other events are more complex. I have shelter that is adequate (a 700 square foot shelter that has plumbing and heat) but can imagine a larger house (3000 square foot with a den and multiple bathrooms) that I would prefer. If the 700 square foot house is adequate, why is the larger house preferred? Is it because I perceive that my neighbors (the community) associate the bigger house with status? Do the values of the community influence my preferences? If my objective or end was to acquire status, the large house
was the means to achieve that end. If my objective was to have enough room for a large family, the large house may be the means to achieve that end. To the casual observer the acquisition of a large house may incorrectly be seen as the desired end. 78 4.6 Objectives Economics is a study that is based on scarcity of the means to achieve objectives. As a result, choices must be made on the relative values that are placed on the competing objectives. To repeat from above, Warren Samuels argues that the “economy is a process of valuation…. That to behave and to choose is to engage in valuation and thereby to participate in the social, or socioeconomic, valuation process.” [Samuels p ix] He goes on to point out that, “the economy encompasses more than the market…” and “that other nonmarket valuational processes exist.” These valuational processes are used to choose among competing ends, or objectives. 4.7 ECONOMIC OBJECTIVES Justice, respect from others and creativity are not easily measured. Income, quantities of goods and prices are more easily measured. There are many complexities in measuring incomes, quantities of goods and prices. In spite of measurement problems, individuals tend to focus on phenomena that can be ranked or associated with a magnitude (or number). This is particularly a problem when quantifiable objectives are to be traded off for non- quantifiable objectives. Examples include an individual who sacrifices a larger salary for a job with more activities that are creative or to remain near a personal relationship. The appreciation of environment or wildlife may be sacrificed for jobs or timber production. Economic objectives are complex linkages. Utilitarianism is the philosophical foundation of modern economics. The perceived objective is to maximize the utility or welfare of the members of society. In a simplistic world, the welfare or utility of the community is the sum of the utilities or each member of that society. Therefore, if each individual maximizes their utility it will maximize the utility of the group. The maximization of each individual’s 79 4.7 Economic objectives utility is consistent with the maximization of the utility of society. This view requires a social mechanism or institution to coordinate or constrain the behavior of individuals. The constraints may be social institutions such as moral rules, mores, customs, laws, or the market. Since it is not possible to measure utility, welfare or happiness, utility is connected to variables that can be measured. In orthodox economics, a person
’s utility is a function of (or determined by) the quantity of goods and services they consume. Since utility can’t be measured and is a function of the quantity of goods, an increase in the quantity of goods consumed is assumed to increase utility or welfare: more goods are preferred to fewer goods. As a result, economic growth, producing more goods (as measured by gross domestic product) becomes a perceived objective. The inability to measure utility also leads to the use of price as a proxy. The price of a good is perceived as an indicator of its value. Relative prices are seen as information that can be used to rank the worth or value of goods. The inability to measure utility directly leads to a focus on quantities of goods and their relative prices as a substitute. This process often leads to ignoring or minimizing the importance of non-market objectives. If prices are distorted by lack of information or imperfections in the social institutions, the rankings based on relative prices may be misleading. In the modern world our objectives and behavior may be altered by advertising. Fashion and fads popularized in the media also shape our objective and the means we choose to achieve them. 80 5 Criteria for Evaluation 5 CRITERIA FOR EVALUATION Individuals must make choices about their objectives (or ends) and the alternatives (means) they choose to achieve those objectives. To make these choices, it is necessary to value or prioritize ends and means. The process of ranking and the ultimate selection of priorities require criteria to value the alternatives. Both ends and means can be ranked on the basis of tradition. Communities often develop traditional solutions to economic problems. In some societies, the solution to the problem of food acquisition may be hunting. Hunting a given specie or species of animals provides a workable solution given technology, natural and built environments. Religion and other social institutions may develop to support these solutions. Use of tradition and institutions (and rules of thumb) to choose ends and means is a way of minimizing the use of analysis and reasoning to make choices: there are a set of ready-made choices. These traditional ends and means are created and evolve as workable solutions to problems. In many cases, traditional solutions may be very effective. However, traditions by their nature persist over time (tend to maintain the status quo) and may become less effective as circumstances change. When natural or built environments change society may still cling to the traditional solutions in the face of declining success. Religion, the vested interests, desire for the
old ways and human resistance to change are examples of forces that inhibit the search for new solutions. The ranking of ends and means by tradition may lag behind the changes in knowledge, technology and environmental circumstance. If traditions and existing institutions result in increasingly less successful results, new solutions that are more consistent with individual values and expectations may emerge. 81 5.1 Criteria to Evaluate Ends and Means 5.1 CRITERIA TO EVALUATE ENDS AND MEANS The evaluation and ranking of both ends and means requires the application of ethical principles. At another level, the choices of means to achieve a given end may appear to be based on efficiency. Ethics is the study of the process by which an objective (and/or the means used) is judged “right or wrong.” Efficiency is a measure of the extent to which an objective is achieved. Efficiency can only be used to evaluate the means used to achieve a goal or end. Ultimately, efficiency rests on a foundation of ethics. An immoral objective can be achieved “efficiently.” Nazi Germany sought “efficient” means to achieve the annihilation of an ethnic group. Modern, neoclassical economics is often perceived as a study of efficiency with in the context of a very specific ethical system: “utilitarianism.” 5.2 ETHICS Ethics is the branch of philosophy that studies the nature of “right and wrong” and the criteria used to evaluate the moral questions about ends, choices, means and behavior. Albert Schweitzer is quoted, “In a general sense, ethics is the name we give to our concern for good behavior. We feel an obligation to consider not only our own personal well-being, but also that of others and of human society as a whole.” (quoted in Hill, p 4) Humans tend to rationalize and justify their values, beliefs and behavior: they like to think that what they believe and do is “the right thing to do.” For our purposes, there are two broad approaches to judging right and wrong. One approach is to judge the moral quality of an end or action based on duty. This is called deontological ethics. The second approach is to judge the rightness or wrongness with regard to the consequences or outcomes of 82 actions. This approach is referred to as axiological ethics. A third approach is teleological ethics that presumes that each person or community has some unique purpose and that the moral objective should be the attainment of that 5
.2 Ethics purpose. DEONTOLOGICAL ETHICS In deontological ethics, right and wrong are judged on “duty.” Individuals often engage in activities and make choices that are based on a sense of duty. These duties may be based on tradition, expectations or more formal rules. The rightness of behavior is can be seen as compliance with these rules. It should be noted that these rules may be implicit or explicit. The belief that individuals have an obligation to tell the truth, not to kill, to vote or to serve their country are examples of rules that specify duties. In an exchange relationship the seller (or buyer) may have a duty to provide information to the buyer (or seller). AXIOLOGICAL OR CONSEQUENTIALIST ETHICS Right and wrong (or goodness and badness) of an act (or choice) is based on the value of the outcome of that act (or choice) in axiological ethics. One subset of axiological ethics is consequentialist ethics. In consequentialist ethics, the consequences of actions determines what an individual ought to do and will do. Utilitarianism is a consequentialist ethic that provides the ethical foundation of orthodox microeconomics. Neoclassical economics is based on Utilitarianism, a system of ethics that was formalized by Jeremy Bentham [1748-1832]. Bentham believed that seeking pleasure (happiness, satisfaction, welfare or utility) and avoiding pain determined what individuals do and should do. It is based on the goal of maximizing the welfare or utility of the people “whose interests are of concern.” The rightness or wrongness of a choice is based on the outcome or the utility that results from that choice. If the total utility of the group is 83 5.2 Ethics increased, the choice was “right.” If utility is decreased, the choice was unjustified by this ethical standard. In the Introduction to the Principles of Morals and Legislation (1789), Bentham makes the following observations. “Nature has placed mankind under the governance of two sovereign masters, pain • and pleasure. It is for them alone to point out what we ought to do, as well as what we shall do.” (Bentham, Principles, Chapter I) • “By utility is meant that property in any object, whereby it tends to produce benefit, advantage, pleasure, good, or happiness or to prevent the happening of mischief, pain, evil, or unhappiness to the party whose interest
is considered: if that party be the community in general, then the happiness of the community: if a particular individual, then the happiness of that individual.” (Ibid.) “The interests of the community then is, what? --the sum of the interests of the • several members who compose it.” (Ibid.) The consequentialist ethic of Utilitarianism and neoclassical economics is based on the maximization of each individual’s utility. It provides the criteria that are used to judge what we should do and it is the stimulus that directs what we do. The interest or welfare of the community is the sum of the interests of individuals therefore the sum of individuals’ utilities is the community or social welfare. Anything that increases the utility or welfare of an individual or society is perceived as ethically correct. Bentham tried to create a method to calculate the utility or welfare of a community: a “felicific calculus.” His approach required that each individual’s utilities be independent other individuals utility functions so that they could be added. This process is a form of “reductionism,” the overall system is simply the sum of its parts. Bentham considered seven characteristics of each act to calculate the consequences. These included: intensity (of pleasure or pain), the duration, the certainty, propinquity (nearness in place or time), fecundity (capacity to produce similar results), purity and the extent or number of persons affected. Bentham argues the process is to “Sum up all the values of all the pleasures on the one side, and those of 84 5.2 Ethics all the pains on the other. The balance if it be on the side of pleasure, will give the good tendency of the act upon the whole, with respect to the interests of that individual person: if on the side of pain, the bad tendency of it upon the whole.” (Bentham, p 39) Bentham’s utilitarianism is a benefit-cost analysis of pleasure and pain. If the pleasure associated with an act exceeds the pains associated with that act, the act is justified by consequentialist ethics. In economics, finance, accounting and policy analysis, benefit/cost analysis is often used in decision making: if the benefit/cost ratio exceeds one, the project is justified. The difference between Bentham and modern benefit/cost analysis is that Bentham’s approach is much broader. In modern benefit/cost analysis, prices
of goods are substituted for pleasure and pain. Only market pleasures (utiltity) and pain (cost) are used in the analysis. Pleasure and pain encompass emotional and non-market values held by individuals. 5.3 EFFICIENCY Efficiency is a measure of the extent to which an objective has been achieved. If an objective is immoral or unethical, efficiency can still be used to evaluate the extent to which the objective is met. Consider the construction of ovens. If an oven is “too small”, there is inefficiency in the loss of energy because the door is opened and closed more frequently. If an oven is “too large” it is inefficient in heating too much space. The choice of using a toaster oven or a full size oven is a judgment about their efficiency at different tasks. If the task were to dispose of human bodies during genocide, efficiency would be important in determining the size of the ovens even though the objective is clearly immoral. It is possible to have objectives that are unethical or wrong and still achieve those objectives with different degrees of efficiency. If an objective were good, moral or ethically correct, then greater efficiency would be 85 5.3 Efficiency desirable. If the objective is immoral or bad, then greater efficiency is not necessarily desirable. If there are alternative means to achieve an ethical objective, the means may have different levels of efficiency. It is also possible that the different means will be more or less ethical than others. In this case, it may be necessary to judge between an efficient less ethical means and a less efficient more ethical one. The idea of efficiency was borrowed from physics. Energy efficiency is often measured as: % efficiency = useful energy produced total energy used x 100 Mechanical efficiency is defined as: % efficiency = output power input power X 100 In economics, efficiency can be thought of as a ratio of outputs to inputs. The resources used in production are the inputs and the goods (and services) that are produced are the output. Efficiency is not in and of itself an objective. It is possible to efficiently pursue immoral objectives. It is also possible to pursue ethical ends with unethical means. Several variations of efficiency are relevant in economics: technical efficiency, allocative or economic efficiency and Pareto efficiency. These concepts of efficiency are straightforward: the difficulty lies in measurement of output, value of outputs, inputs and the value of inputs. In neoclassical microeconomics, utilitarian ethics is the foundation of the concepts of efficiency. Relative prices of inputs and outputs are used as
proxies or surrogates for relative values. Again, remember the warning of Oscar Wilde: 86 5.3 Efficiency “A cynic is someone who knows the price of everything and the value of nothing.” Price and value are not the same thing, but prices may be used as an approximation of value. Prices may not reflect all the benefits or costs associated with a choice. They may be distorted in a variety of ways: exchange may not be voluntary: agents may engage in deception, institutions may be inconsistent with technical and environmental circumstances, regulations and other problems. 5.3.1 TECHNICAL EFFICIENCY One of the functions of an economic system is to coordinate the production of goods (and services). The technical efficiency of a productive process is the ratio of the outputs (or resources used) to the input (of goods and services). If an economic system produced two goods: Xebecs (Q X) and Yawls (QY), the output could be measured as QX + QY. The inputs would be the sum of the resources used (Land ®, labor (L) and capital (K)). Efficiency can be expressed as: Technical efficiency = = output input 5.3.2 PRODUCTION POSSIBILITIES FUNCTION Efficiency as a market phenomenon can be illustrated using a production possibilities model. (Sometimes called a Production possibilities function, production possibilities curve, production possibility frontier, PPF or transformation function). The PPF is a model that identifies all the production alternatives that are possible for two goods given a set of inputs and a state of technical knowledge. Using the equation from above: 87 5.3.2 Production Possibilities Function • Output is QX + QY or the quantity of good X (xebecs) plus the quantity of good Y (Yawls), there are alternative quantities of QX and QY that can be produced. By limiting the outputs to two goods, the model can be constructed in two-dimensional space (on a graph). If three goods are considered, the model requires a thee-dimensional space. Inputs are: R (natural resources) + L (labor) + K (capital), these resources are • finite and given at any point in time. The state of technology is the information the agents have about the various ways • of producing different quantities of goods X (xebecs, or QX) and Y (yawls, or QY). If all inputs and the best technology available were allocated to the production
of xebecs (QX), a finite quantity could be produced. In Figure 5.1 this is shown at point G on the X axis when 32 units are produced. Since no inputs are allocated to the production of yawls (QY), none are produced. If the agents decided that some yawls were desired, they would have to take some of the inputs from the production of xebecs to use in the production of yawls. Since all the inputs (and best technology) were used to produce 32 xebecs in our example, any reallocation of inputs from the production of xebecs to yawls would require a sacrifice, or the production and availability of fewer units of xebecs. This can be shown as a move from point G (Q X = 32: QY = 0) to point F (QX = 31: QY = 10). The production of 10 units of yawls requires the sacrifice of 1 units of xebecs (32-31=1). The inputs that are least effective in producing xebecs would be reallocated to the production of yawls. The sacrifice of xebecs would be minimized. (You would not shift the best resources to produce xebecs into the production of yawl: that would maximize the sacrifice.) At point A (QX = 0: QY = 53), all inputs are allocated to the production of yawls so no xebecs are produced. Resources can be reallocated from the production of yawls to produce xebecs: the first five units of xebecs can be produced by sacrificing the output of 3 yawls. Again, the least effective inputs in the production of yawls would be shifted to the production of xebecs. This can be shown as a movement from point A to point B. Sacrifice of one good to produce more of the other is called “opportunity cost.” We can locate other 88 5.3.2 Production Possibilities Function output alternatives along the PPF: points A, B, C, D, E, F, G all represents alternative outputs of xebecs and yawls. Any point that lies on the PPF is an output alternative that represents a combination of QX and QY that can be produced given inputs and technology. Any output combination inside the PPF is possible but, would not be
the maximum amounts of X and Y that could be produced. Output combinations that lie outside the PPF are not attainable or feasible given the inputs and technology available. The output combination at point H (QX=16: QY=20) is clearly not efficient: more X or Y or both can be produced given the inputs and technology. (Remember, R, L, K and technology, inputs are fixed.) Resources can be reallocated to produce more xebecs (a move to point E), to produce more yawls (point C) or more of both (any point in the triangle HEC. Any output combination that can be shown as a point on the PPF can be considered as “technically efficient.” Any output combination that falls inside the PPF is technically inefficient: there are unused inputs or inputs are not being used for the most appropriate purpose. Clearly there is a problem: there are an infinite number of output combinations (any point on the PPF) which are technically efficient. There are also an infinite number of output combinations that lie inside the PPF that are technically inefficient. If we expand the model to include the ratio of output to inputs, an increase in technical efficiency could be the result of: an increase in the output of either good while the other good and inputs are held • constant • • • an increase in both goods while inputs are held constant a decrease in the inputs while the output is held constant an increase in output and a decrease in inputs. A movement from a point inside the PPF to a point on the curve is can be regarded as an “increase in efficiency.” An improvement in technical 89 5.3.2 Production Possibilities Function knowledge can also be regarded as an “increase in efficiency” since the same output combination could be produced with fewer inputs. The technological improvement can also be envisioned as a shift of the PPF, more output can be produced if the same quantities of inputs are used. This is shown in Figure 5.2. There are an infinite number of technically efficient solutions to the allocation problem. However, there is only one allocation that achieves economic or allocative efficiency. ALLOCATIVE OR ECONOMIC EFFICIENCY Since Xebecs (good QX) and Yawls (good QY) are not the same things, it does not make sense to add them together (case of adding apples and oranges, QX +QY). If the values of the two
(or more) goods were known or there were an acceptable proxy for the value, it would be possible to add their values. Remember that one of the tasks of the economic process is to allocate resources to their highest valued use. Technical efficiency is a prerequisite for allocative efficiency. Economic or allocative efficiency takes into account the value of both the inputs and outputs. Economic efficiency is measured by a ratio of the value of the output to the value of the inputs. Value is a complex notion and market prices are often used as an indicator of exchange value. (Remember the warning of Oscar Wilde: “A cynic is some one who knows the price of everything and the value of nothing.”) Lacking a better proxy for value, price is often used. If the price of good X (PX) and good Y (PY) are proxies for their value and the wage or price of labor (WL or PL) and capital (PK or %) were proxies for their values then allocative or economic efficiency might be represented as: Allocative efficiency = value of output value of input = 90 P Q + QY.3.2 Production Possibilities Function Given the original PPF as line RA. An improvement in technology that impacts only the production of xebecs can be seen as a shift from RA to RB. An improvement in technology that influences only the production of Yawls would be a shift from RA to HA. Technology that impacts the production of both goods would be a shift from RA to HB. These outward shifts are sometimes called “economic growth.” A change in inputs could also be shown as shifts in the PPF, a decrease in inputs would shift the PPF inward toward the origin. An increase in inputs would shift the PPF outward. A QX B Quantity of Xebecs A B Figure 5.2 Allocative efficiency is not only influenced by the quantities of the goods produced and quantities of the inputs used, but the relative values of the inputs and outputs are also important. The benefits or value of an alternative can be expressed as PXQX +PYQY. The costs of the alternative could be expresses as PLL + PKK. Given a set of inputs and technology the solution that achieves allocative efficiency is the highest valued output possible given the inputs and prices. Given inputs and a state of technology, the alternative sets of outputs are shown by the production possibilities function. If all inputs are used to produce Yawls (good Y
, or QY), a maximum of 53 units can be produced. If the inputs are reallocated to produce 5 Xebecs (good X, or QX), it will be possible to only produce 50 yawls. At the output shown by point C, 16 units of xebecs and 40 units of yawls are produced. If all inputs are used to produce Xebecs (QX= 32 at point G), a maximum of 32 units of X can be produced. Given technology and inputs, all possible output combinations are shown by all points that lie along and inside the line ABCDEFG. A change in inputs or technology will shift the production possibilities frontier. A B 53 50 ) Y Q 40 ( 30 20 10 C H D E F G 5 16 Quantity of Xebecs (QX) 24 29 32 Figure 5.1 91 5.3.2 Production Possibilities Function Using the same production possibilities function as in Figure 5.1, allocative efficiency can be described in Figure 5.3. In this example, the optimal output alternative is that with the highest value. Since value cannot be measured directly, neoclassical economists use market price as an approximation of value. In order for market price to be a reasonable approximation, exchanges must be voluntary exchanges of goods with exclusive property rights. If the price of xebecs were $4 and the price of yawls were $2 the “value” of each alternative identified in Figure 5.2 can be calculated. Alternative A is worth $106, alternative B is worth $120, C is worth $144, D is worth $156, E is also “valued” at $156. The output at alternative F is worth $144 and at G is worth $128. These calculations can be seen in Table 5.3. The highest valued output, based on market prices will lie on the PPF between alternatives C (valued at $156) and D (also $156). If the prices of the goods are accepted as the value of the goods, the calculation of each alternative are shown in Table 5.1 If the price of good Y should rise to $3.50 (and the price of X stay at $4) the alternative with the “highest value” is at point C as shown in Table 5.2. The alternative that is allocatively or economically efficient is dependent on a set of prices that measures value. We will explore the ability of the market to
accurately reflect values of outputs. It is also important to note that there are many things that humans value that cannot be expressed as a market price. 92 5.3.2 Production Possibilities Function The PPF is determined by the finite quantity of inputs and technology. If the price of xebecs is $4 (PX=$4) and the price of yawls is $2 (PY=$2), at point A the “value” of good X is 0 and the “value” of good Y is $106, the “value” of the output (given prices) is $106. At point B the value of the output of good X is $20 ($4x5 units X), the value of good Y is $100 ($2x50 units Y). The value of output of good X and Y is $120. At D and E the value of the output is $156. Some where between alternatives D and E on the PPF the value of the output will reach a P maximum. It is where the slope of the PPF is equal to X. P Y Any alternative inside the PPF will be valued at less than the maximum value. 53 50 ) Y Q 40 ( 30 20 10 ($106) ($120) A B ($144) C ($104) H ($156) D ($156) E ($144) F ($128) G 5 16 Quantity of Xebecs (QX) 24 29 32 Figure 5.3 93 5.3.2 Production Possibilities Function Table 5.1 Allocative Efficiency and Value of Output QX PX Value of output of X QY PY Alternative (PX QX) Value of output of Y (PY QY) Value of output (PXQX + PYQY4.00 $0.00 53 $2.00 $106.00 $106.00 5 $4.00 $20.00 50 $2.00 $100.00 $120.00 16 $4.00 $64.00 40 $2.00 $80.00 $144.00 24 $4.00 $96.00 30 $2.00 $60.00 $156.00 29 $4.00 $116.00 20 $2.00 $40.00 $156.00 31 $4.00 $124.00 10 $2.00 $20.00 $144.00 32 $4.00 $128.
00 0 $2.00 $0.00 $128.00 16 $4.00 $64.00 20 $2.00 $40.00 $104.00 94 5.3.2 Production Possibilities Function Table 5.2 Allocative Efficiency and Value of Output QX PX Value of output of X QY PY Alternative (PXQX) Value of output of Y Value of output (PYQY) (PXQX + PYQY4.00 $0.00 53 $3.50 $185.50 $185.50 5 $4.00 $20.00 50 $3.50 $175.00 $195.00 16 $4.00 $64.00 40 $3.50 $140.00 $204.00 24 $4.00 $96.00 30 $3.50 $105.00 $201.00 29 $4.00 $116.00 20 $3.50 $70.00 $186.00 31 $4.00 $124.00 10 $3.50 $35.00 $159.00 32 $4.00 $128.00 0 $3.50 $0.00 $128.00 16 $4.00 $64.00 20 $3.50 $70.00 $134.00 95 5.3.3 Pareto Efficiency 5.3.3 PARETO EFFICIENCY At a technical level, economics provides a set of tools to aid in choosing among competing alternatives. In 1906 an Italian, French, Swiss, engineer, sociologist, economist Vilfredo Pareto (1848-1923) introduced the concept of Pareto optimality as a means to undermine the role of utilitarianism in economics. Instead, it became the foundation for what is now called benefit cost analysis and its derivative measures of allocative performance such as rate of return on investment and cost effectiveness. Consider a community of individuals. Your task is to choose an alternative to maximize the welfare or utility of the group. If there were an alternative that would improve the welfare (or increase the utility) of at least one person in the group without making any one worse off (decrease their welfare or utility), you should choose to that alternative. However, if all the alternatives that would make at least one person better off would also make at least one other person worse off, you cannot know if that alternative would improve the wellbeing (utility) of the group
. Pareto efficiency is the condition where all alternatives that would increase the welfare of at least one person without decreasing the welfare of others have been exhausted. There is nothing that can be done to improve the welfare of anyone without making someone else worse off. In the PPF model (Figure 5.4), Pareto efficiency exists at any point on the PPF once you have attained that point. 96 Given the PPF, point H is not Pareto efficient: more X (Y) can be produced with no sacrifice of good Y (X). A move to any output combination identified in the triangle HEC is a Pareto improvement; some one (or everyone) is better off and no one is any worse off; this area is Pareto Safe. A move to any point in the Pareto Safe area is a Pareto improvement or is Pareto superior. Once on the PPF (point D for example) any change to improve the welfare of an individual (or group) who prefers good Y, would make those who prefer good X “worse off.” To increase the quantity of Y, from point D to point C, would require that less X would be produced. A B 53 50 ) Y Q 40 ( 30 20 10 5.3.3 Pareto Efficiency C H D E F G 5 16 Quantity of Xebecs (QX) 24 29 32 Figure 5.4 Pareto efficiency can be used as a criterion to decide whether to chose an alternative. If a choice makes some one better off and no one any worse off, it is a choice that will increase the achievement of the goal or end of maximizing the utility or welfare of the group. This can be “Pareto Safe,” i.e. the output can be altered so someone is “better off” and no one is worse off. Any change that increases the welfare of one person or persons that does not reduce the welfare of another is a “Pareto improvement” or Pareto Safe and will clearly increase the welfare or utility of the community. Any alternative that results in a greater utility of at least one person and no decrease in the utility of anyone can be referred to as “Pareto superior.” The problem is that this criterion tends to support the status quo. Almost all choices that increase the utility of an individual or group will make others worse off. Since a Pareto efficiency criterion is very restrictive
, Pareto Potential is may be used. This is the same as the benefit/cost criterion. Pareto potential holds that if a choice or alternative makes one person or 97 5.3.3 Pareto Efficiency group better off but others are worse off, if the “winners” or those who gain can hypothetically reimburse those who are “losers” (or are worse off) and still be better off, the alternative will increase the utility of the group. In a more simplistic way, the benefits associated with the choice exceed the costs. PARETO POTENTIAL, BENEFIT/COST AND MARGINAL ANALYSIS The Pareto potential criterion for decision making is the foundation of analysis that use benefit/cost, cost effectiveness and rate of return for decision making. Marginal Analysis The process of making decisions is like the proverb “The longest journey begins with the first step.” Or like the question posed by Albert Camus (1913- 1960) about the individual deciding each day about suicide or continuing life. The individual taking a journey must make the decision about taking the first step before they decide on the second. In Camus’ case, one must decide not to committee suicide before you tackle the rest of the day. Decisions in economics are always made at the “margin.” A decision to change one variable will cause a change in some other related variable. An act or choice will have benefits and costs associated with that act. An increase in the production of xebecs may require a reduction in the production of Yawls: the benefit is more xebecs, the cost is fewer yawls. A change in the price of a good will change the quantity sold, a change in the quantity sold will change the total revenue collected. The change in total revenue caused by a change in units sold is called marginal revenue. The marginal concept is applied to a wide variety of relationships. In principles of economics, these are usually described as a “one unit” change in the variables. The Greek letter delta, D is used to identify a change calculated by 98 5.3.3 Pareto Efficiency subtraction. In other cases, a derivative (d) or partial derivative (∂) will be used to denote a change that approaches 0. The use of marginal is applied to many economic relationships. In fact, the early period of the development of microeconomics (
mid to late 19th century) was called the “marginalist revolution.” Below are some definitions of several useful marginal relationships. Marginal Cost (MC) MC is defined as the change in Total Cost (TC) or variable cost (VC) caused by a one unit change in the quantity produced, output (Q). MC represents opportunity cost. MC = ΔTC ΔQ = ΔVC ΔQ Equation 5.3 Marginal Benefit (MB) MB is defined as the change in total benefit (TB) caused by a one unit change in quantity consumed (Q). MB = ΔTB ΔQ Equation 5.4 Marginal Utility (MU) MU = ΔTU ΔQ Equation 5.5 MU is the change in utility caused by a change in quantity consumed (Q) CHOICE AND MARGINAL ANALYSIS 99 5.3.3 Pareto Efficiency If Pareto Potential or the Benefit/Cost criteria are to be used for decision- making, the rule is quite simple: if the benefits associated with a choice (or alternative) exceed the costs associated with that choice, then the choice will increase net benefits. If the costs of an alternative exceed the benefits of that alternative, then that alternative is not a good choice. EXAMPLE BENEFIT/COST USING MARGINAL ANALYSIS Using the example PPF presented in Figure 5.5 (Same PPF as in 5.1, 5.3, 5.4 ) Consider the PPF in Figure 5.5: Xebecs are priced at $4 (PX= $4) and yawls are $3.50 (PY = $3.50). If the initial output were where QX= 16 and QY = 20, which is represented at point H. At these prices, the output of xebecs is “worth” $64 and yawls are worth $70. The “value” of the output alternative identified at point H is $134. Original allocation is at H (QX=16, QY=20); PX = $4 and PY = $3.50 Alternative E (C, D or any choice in triangle HEC) has no MC, the output of X or Y or both X and Y increases so the MB is positive. The B/C ratio of any alternative is grater than one, the MB>MC. If production were at point D (Q
X=24, QY=30), a choice of alternative C would result in QX=16, QY=40, 8 units of X are traded for 10 units of Y. Six fewer units of X at $4 each is a MC of $24. The MB is 10 additional units of Y at $3.50 each or $$35. The MB>MC, The B/C ratio >1, the net benefits will increase by $11 by selecting alternative C over D. Alternative C is worth A B 53 50 ) Y Q 40 ( 30 20 10 C H D E F G 5 16 Quantity of Xebecs (QX) 24 29 32 Figure 5.5 100 5.3.3 Pareto Efficiency Ranking of Alternative H with Alternative E If alternative E were chosen over alternative H, 13 additional units of xebecs would be produced (29-16=13). This is the marginal benefit (MB) of the choice of reallocating resources from alternative H to E. If xebecs were valued at $4 each, that would be a MB of $52 in monetary terms. This can be viewed as a move from row H to row E in Table 5.3 Table 5.3 Allocative Efficiency and Value of Output QX PX Alte rnat ive A 0 $4.00 B 5 $4.00 C 16 $4.00 D 24 $4.00 E 29 $4.00 F 31 $4.00 Value of output of X (PXQX) $0.00 $20.00 $64.00 $96.00 $116.00 $124.00 QY PY 53 $3.50 50 $3.50 40 $3.50 30 $3.50 20 $3.50 10 $3.50 Value of output of Y (PYQY) Value of output (PXQX + PYQY) $185.50 $175.00 $140.00 $105.00 $70.00 $35.00 $185.50 $195.00 $204.00 $201.00 $186.00 $159.00 This reallocation of resources would not reduce the output of yawls, so the marginal cost of the reallocation is 0. Since the MB > MC, the reallocation or inputs to move the output alternative from H to E would be an improvement in the achievement of the objective (producing the
highest valued output). The output of xebecs and yawls at point E is $186 (134 + 52: the value of the output at H added to the MB of reallocation of inputs) The relative prices of xebecs and yawls are irrelevant since the marginal cost (MC) is zero. Any increased production of xebecs at any positive price would be a Pareto improvement. A reallocation to point D, C or any output combination that lies in the triangle HEC would be a Pareto improvement (or Pareto superior to the allocation at point H). 101 5.3.3 Pareto Efficiency Ranking of Alternative E with Alternative F If the current output were at point E (Q X= 29 and QY = 20), and alternative F (QX= 31 and QY = 10) is considered. The marginal benefit (the benefit associated with reallocating resources to point F) would be an additional 3 units of xebecs (31-29=3). At $4 each this is a MB of $12 in monetary terms. However, the reallocation of resources from H to F requires a sacrifice or MC of 10 units of yawls (20-10=10). At a price of $3.50 the MC is $35 in monetary value. The MC = 35: MB = 12. A reallocation of inputs to move from point E to point F would be trading $12 for $35: not a good idea. Ranking of Alternative E and Alternative D A reallocation of resources from alternative E to alternative D would result in an increased output of 10 yawls. At a price of $3.50, the MB is $35. This reallocation reduces the output of xebecs from 29 to 24, a marginal cost of 5 units of xebecs. At $4 each this is a MC of $20. Since the MB > MC (35 > 20), the reallocation of inputs from the production of the output at point E to point B is justified by our benefit/cost criterion. Notice that the net gain to society is $15, so point D is “worth” $15 more than the output at point E. D is “valued” at $201 and E is “valued” at $186 (186 +15 = 201). Can a reallocation of inputs from the production of the output at
point D to point C be justified using the Pareto potential criterion? Complications This analysis is simplified. There are a number of questions. When the “winners” gain more than the losers, the reallocation is justified. The winners can hypothetically reimburse the losers but the reimbursement may never occur. The alternative at point C is preferable to that at point D. The net marginal benefit of a reallocation form D to C is $3. The individuals 102 5.3.3 Pareto Efficiency who have a preference for xebecs are “worse off” (losers) Those who prefer yawls are “better off” (winners). Can the redistribution of benefits from one group to another be justified on ethical grounds? Consider a reallocation of water from storage behind a dam to a free flowing river. Irrigators and power users may incur significant costs while the fishermen and white water rafters gain. A tax cut clearly benefits some individuals but may impose costs on others. There may be no mechanism by which the losers can be compensated by the winners. Another issue is that if the move from D to C involves fewer xebecs and more yawls. The increase in yawls might cause the price for yawls to fall while the decrease in xebecs could feasibly result in a price increase for xebecs. If the winners of an action can hypothetically compensate the losers and still be better off, the benefits exceed the cost of the action. The benefit/cost ratio is greater than one and is justified by the Pareto Potential criterion. There are still ethical questions involved. 5.3.4 SOME PRACTICAL ETHICS The ideas of justice and ethics are often considered a matters of individual preference and therefore impossible to evaluate. What I consider just, someone else may perceive as unjust. It has been a perplexing problem that has been addressed by philosophers over the ages. Plato and Aristotle both were concerned with justice. Adam Smith saw justice as a necessary requirement for a civil society. Ethics is important. One of the approaches that is applicable in economics is the “veil of ignorance” as described by John Rawls. “It is assumed, then, that the parties do not know certain kinds of particular facts. First of all, no one knows his place in society, his class position or social status: nor does he know his fortune in the distribution 103 5.3.4 Some
practical ethics of natural assets and abilities, his intelligence and strength, and the like. Nor, again, does anyone know his conception of the good, the particulars of his rational plan o life, or even the special features of his psychology such as his aversion to risk or liability to optimism or pessimism. More than this, I assume that the parties do not know the particular circumstances of their own society. That is, the do not know its economic or political situation, or the level of civilization and culture it has been able to achieve, the persons in the original position have no information as to which generation they belong. These broader restrictions on knowledge are appropriate in part because questions o social justice arise between generations as well as within them, for example, the question of the appropriate rate of capital saving and of the conservation of natural resources and the environment of nature. There is also, theoretically anyway, the question of a reasonable genetic policy, In these cases too, in order to carry through the idea of the original position, the parties must not know the contingencies that set them in opposition, They must choose principles the consequences of which they are prepared to live with whatever generation they turn out to belong to.” (Rawls, P 137) Individuals must be prepared to be placed in a society and no matter the circumstances, say “That’s fair.” 5.3.5 EFFICIENCY AND ETHICS (AGAIN!) If the objective is to maximize the welfare or utility of a group, an alternative with a benefit/cost ratio that exceeds 1 will increase the utility of that group. The winners can hypothetically reimburse the losers and still be better off. If the hypothetical reimbursement is not actually made, the distribution of wealth, income and the level of goods that each person can potentially consume will be altered. Some people are better off and other people are worse off. This change in relative welfare of individuals is an ethical question, not one of efficiency, although it often masquerades as a question of efficiency. Consider a case of a society. Under the present conditions, there is a distribution of income and wealth that results in different individuals consuming differed quantities of goods. These individuals probably have 104 5.3.5 Efficiency and ethics (again!) different preferences and derive different levels of utilities from the given good. A tax cut will make some people better off: they pay fewer taxes. Since the government has less revenue, they must cut some programs: grants for low income students to attend college, road construction
, etc. Students, employees at universities, movie theaters near the university, trucking companies, and consumers who must pay higher prices because it costs more to transport goods may be worse off. Taxpayers with lower taxes, firms where these taxpayers spend their increased incomes and workers who are hired by the firms are better off than before. If the benefits exceed the costs, the winners could hypothetically reimburse the losers. If the reimbursement is not actually made (which it probably will not), there is an ethical question about taking from one group to benefit another. 105 6 Introduction to the Rules of the Game and Economics Systems 6 INTRODUCTION TO THE RULES OF THE GAME AND ECONOMICS SYSTEMS Whether a society emphasizes the use of exchange, reciprocity or eminent domain to allocate resources, “Any economic system requires a set of rules, an ideology to justify them, and a conscience in the individual which makes him strive to carry them out.” (Robinson, p 13) This set of rules includes informal institutions and values held by individuals as well as formal law. The structure of the rules of the games shapes the society’s economic system. Neoclassical microeconomics does not often explicitly consider the nature of these rules and their relation to economic behavior. 6.1 ECONOMIC SYSTEMS Societies that fail to meet minimum subsistence requirements for its members become relics of the past. Ideally, an economy will produce more than necessary for subsistence and apply the additional output to improving the lives of the members of society through development and/or economic growth. The ideas of “progress,” economic development and economic growth came with the development of the commercial world that replaced the feudal society of the medieval world. An economic system consists of a matrix of social institutions (law, political institutions, religion, etc), agents (individuals or actors), organizations (corporations, unions, charitable org, not-for-profit firms, etc) and society. The principles, beliefs and values held by individuals are included in the structure of society. The function of an economic system is to coordinate the activities of agents in the processes of provisioning and allocation. Nonmaterial 106 6.1 Economic Systems characteristics of life (social stability, low crime rates, a sense of community, etc) are related to the economic processes and should be included. Robert Heilbroner identifies thee basic types of economic systems. These are classified as markets, command, and tradition. In practice, most economies are a mixture
that includes elements of all three. However, the economic system is usually classified by the dominant approach. Markets and command exist in traditional economies. Tradition and markets exist in command economies. Western industrial societies categorized as “market- oriented” economies rely primarily on exchange, but contain elements of tradition and command. In market economies tradition is important to such decisions regarding values, expectations about behavior (trust, loyalty, etc.), fashion, preferences about housing, choices about occupations and geographic preferences. Command is also found in market economies as regulations and laws regarding the allocation or resources and goods. 6.1.1 TRADITIONAL ECONOMIES Traditional economic systems are based the repeated use of solutions that have worked in the past. Solutions to problems in the processes of production, distribution and consumption are embedded in the customs, mores and cultural patterns of social life. These solutions have been established through trial and error: those activities that result in adequate production and an acceptable distribution are retained and used often without question. Agents in traditional societies may engage in exchange transaction but these are peripheral to the provisioning and allocation problems. The traditional economic system tends to be found in non-industrial societies that are engaged in hunting, gathering, pastoral, or basic agriculture. Often these are subsistence economies: there is little or no growth or 107 6.1.1 Traditional Economies progress. The aboriginal culture in Australia is an example of an economy that has flourished for thousands of years (40,000 years by some estimates) as a traditional economy. Traditional economies tend to depend upon a deontological ethic. Duties to other members of the family, tribe or clan and “reciprocity” are the primary allocative mechanisms. The forms of production that individuals engage in are based on the processes that have worked in the past. Social institutions, such as religion, may evolve to reinforce the traditional ways. These societies must communicate behavioral expectations to each new generation. The most important form of knowledge may be contained in stories and myths. Mythology and story telling are important aspects of the creation and communication of cultural values. Webster’s Encyclopedic Unabridged Dictionary of the English Language gives one of the definitions of myth as: “an unproved collective belief that is accepted uncritically and is used to justify a social institution.” Keen and Valley-Fox describe myths as: “… an intricate set of interlocking stories, rituals, rites and customs that inform and give the pivotal sense of meaning and direction to
a person, family, community or culture.” (Keen, p xii) Mythology is one of the processes by which cultural values and expectations about behavior are transmitted from generation to generation. Even in modern societies, stories are fundamental to the process of creating, and perpetuating culture in societies. Reciprocity is often a key element in traditional economies. Remember that reciprocity is based on duty and involves obligatory gift giving: I do you a favor and both you and I (and other members of society) expect that you will return some unspecified favor at some unspecified time in the future. It 108 6.1.1 Traditional Economies requires a sense of duty, social values and a community to enforce reciprocation. Social institutions give structure to the values, duties and expectations about economic behavior. In many societies, reciprocity becomes an important element of the social process. In a ranching community Rancher Smith goes to the other ranchers and says: “I need some help branding my calves next Tuesday, I’d appreciate some help.” On Tuesday, the ranchers show up at Rancher Smith’s place and help with the task. If Rancher Jones does not come to help, it may be for a good reason. However, if he or she is perceived as shirking his or her duty, it may be difficult for Jones to get neighbors to help with future tasks. Similarly, if everyone helps Rancher Smith but then at some point in the future Rancher Smith does not reciprocate by helping someone else fix his or her fence, then Rancher Smith may find it difficult to get anyone to help in the future. There is a community that expects that the other members will help when needed and will reciprocate in the future. The community must communicate the willingness of its members to participate in mutual aid and to sanction members who do not fulfill their obligatory duties. Notice that the substance of the event is different if Rancher A says: “I’ll pay you $10 per hour to help me brand my calves.” Shifting the process from reciprocity to a market exchange significantly alters the relationships and the nature of the event. In the case of reciprocity, there is a sense of community. The relationship between the members of the community may be of value in and of itself. Blood and organ donations are examples. Moving a good or activity into a market transaction may significantly alter its meaning or value. A market exchange can
take place between anonymous individuals. As communities become larger, more complex and social relationships are altered: tradition may be less useful as an allocative mechanism. It is more 109 6.1.1 Traditional Economies difficult for the members of the community to communicate the extent to which the members fulfill their duties. Social pressure to enforce obligations of reciprocity and duty may become less effective since each person has more relationships that may be more valued. Another weakness of a traditional economy is that it does not adapt quickly to changes in technology or the environment. So long as there are no (or few) changes in the environment, technology or external forces, the traditional economy is stable or static. However, if there are sudden changes in the environment, the traditional solutions may no longer suffice. Droughts, desertification, over hunting specific animals are examples of events that traditional societies may not be able to deal with. Native Americans in the plains developed societies that were dependent upon the bison. Their economies, social structure, politics and religions were based on bison. With the advent of Europeans, firearms, railroads and a demand for hides, the bison were hunted almost to extinction. Many of the native societies found it difficult to adapt to a system without bison. Whaling, fishing, hunting, agriculture based on single (or limited) crops are other examples of the difficulty that traditionally based economies have in adapting to change. 6.1.2 COMMAND ECONOMIES Eminent domain is the primary allocative mechanism used in a command economy. An economic system based on command requires an agent or organization with the authority to make allocation decisions. This authority may be based on religion, military strength, political position, birth or wealth. Command economies often rely on traditions as part of the allocative process. This traditional process is subordinated to eminent domain. The Roman society is an example of a command economy. Fascist Germany, the 110 6.1.2 Command Economies former Soviet Union and Maoist China are other examples of attempts to use command. These economies are often thought of as “planned economies.” During World War II many allied countries relied on command systems to coordinate the war effort. In both traditional and market economies command may play a significant role. In modern, market economies there are regulations and laws that mandate particular actions, behavior, production techniques and/or characteristics of products. A command economy requires an overall objective or goal for the governing body: individuals’ goals become subordinate. Since command economies are often represented by
nation states, these can be thought of as national goals. Some organizations act as small communities with organizational goals and use command and eminent domain as the primary allocative mechanism. During the medieval era, the Church and the secular state both operated as command economies that were interrelated. In the modern industrial world, the multinational corporation uses a command system internally: its decisions are made administratively. Goals may include: • • • • • • • • • • • economic growth, full employment, industrialization, military strength, conquest, acquisition of specie (gold/ silver), land, political control religious conversions control over markets where they sell, control of resources, 111 • or any thing else that the governing authority chooses. 6.1.2 Command Economies One of the important questions in a command economy how the overall objective is selected. It may be an administrative choice. The authority may simply select the objective. If this is the case, the intentions of the authority become crucial: are they benevolent or not? In some cases, it may be possible to have the objectives of the members of the community reflected in the overall objective. Market socialism in the former Yugoslavia is an example. The task of the command system is to coordinate individual behavior with the national or organizational goal. A command system relies on administrative decisions that flow from the authority down. This requires that the decisions be communicated to the individuals and enforced. This may require a complex system of rules and institutions to communicate and create the appropriate incentives to act on that information. The authority that is responsible for the administrative decisions that are imposed on the members of the organization or state, must have information about the goals, the members of the community, the availability of inputs, all potential technologies, all alternative outputs and potential distribution patterns. This is an enormous information requirement that was debated in the “socialist calculation debate.” One of the strengths of a command system is that it can alter its objectives quickly. In a wartime economy, it may be useful to be able to command the allocation of resources into the development and production of munitions and military hardware. The weakness of a command system is that the authority would need an enormous amount of information about individuals’ preferences and the production requirements of all goods and services. Command systems may also be flawed by the nature of the authority that may or may not be 112 benevolent. Another major problem of a command system is the loss of 6.1.2 Command Economies individual autonomy. 6.1.3 MARKET Market based economies depend on individual exchange
contracts that occur in the context of a social contract. An exchange contract is based on quid pro quo, “I will give you this if you give me that!” The nature of the goods (include money) to be exchanged as well as the conditions and time is clearly specified. It is necessary that both parties engage in the contract or exchange voluntarily. If the exchange is voluntary, the presumption is that a person would engage in the exchange if and only if they are better off or no worse off after the exchange. Therefore, a voluntary exchange results in Pareto improvements and ultimately a Pareto superior solution to the allocation problem. Neoclassical microeconomics uses “supply and demand” as a representation of a market. The demand function represents the behavioral patterns of the buyers (both actual and potential) of a specific good. The supply function represents the behavior of actual and potential sellers (producers) of a good. The strength of market system is that is capable of quickly adapting to changes in preferences and technology. The information required by any one agent is minimal. The weakness is that when exchanges are not voluntary or property rights are attenuated (weakened), outcomes may be less than optimal. Neoclassical microeconomics tends to be a study of contracting and voluntary exchanges between individuals. The context in which these contracts 113 6.1.3 Market occur is usually “the market.” The structure of the markets is perceived to influence the behavior or the individuals who participate in voluntary exchanges or contracts. In its most ideal form, the market is characterized as “pure competition.” In pure competition, there are a large number of buyers and sellers, none of which can influence the price or the behavior of others: they can only contract to exchange goods (and money). The purely competitive market is characterized by goods that are homogeneous: i.e. buyers perceive these goods as identical or perfect substitutes. Buyers have no preference for one seller’s good over another’s. The exchange or contract is made on the basis of price. In this way, sellers compete for buyers by lowering the price to the minimum they will accept. Buyers compete to purchase by offering the highest price they are willing to pay. In a market such as this the equilibrium price: the price at which the last (or marginal) unit is exchanged will optimize the welfare of the buyers and sellers. In the least desirable market form, a seller has a monopoly where there is
only one seller of a good. The effects of market structure on the behavior of buyers and sellers are an important topic in neoclassical microeconomics that is covered in Part II of this text. The social context of economic behavior is often not made explicit. People perceive that individual exchange in competitive markets is the only consideration. This leads to the perception that the government and community have little or no role in economic activity. Many laissez faire advocates fail to recognize that economic behavior is a part of social behavior. Friedrich A. Hayek (1899-1992) is a well-known advocate of the market system. He identifies the social infrastructure that must exist to support individual market exchange. The following quotes are long because they are important and must be considered in the context of Hayek’s ideas: 114 6.1.3 Market While it would be an exaggeration, it would not be altogether untrue to say that the interpretation of the fundamental principle of liberalism as absence of state activity rather than as a policy which deliberately adopts competition, the market, and prices as its ordering principle and uses the legal framework enforced by the state in order to make competition as effective and beneficial as possible-and to supplement it where, and only where, it cannot be made effective-is as much responsible for the decline of competition as the active support which governments have given directly and indirectly to the growth of monopoly. It is the first general thesis which we shall have to consider that competition can be made more effective and more beneficient by certain activities of government than it would be without them. With regard to some of these activities this has never been denied, although people speak sometimes as if they had forgotten about them. That a functioning market presupposes not only prevention of violence and fraud but the protection of certain rights, such as property, and the enforcement of contracts, is always taken for granted. Where the traditional discussion becomes so unsatisfactory is where it is suggested that, with the recognition of the principles of private property and freedom of contract, which indeed every liberal must recognize, all the issues were settled, as if the law of property and contract were given once and for all in its final and most appropriate form, i.e., in the form which will make the market economy work at its best. It is only after we have agreed on these principles that the real problems begin. (Hayek, pp 110-111) Hayek continues: If I am not mistaken, the main headings under which the measures required to insure an effective competitive order ought
to be considered are the law of property and contract, of corporations and associations, including, in particular, trade-unions, the problems of how to deal with those monopolies or quasi-monopolistic positions which would remain in a otherwise sensibly drawn-up framework, the problems of taxation, and th problems of international trade, particularly, in our time, of the relations between free and planned economies. As far as the great field of the law of property and contract are concerned, we must, as I have already emphasized, above all be aware of the error that the formulas of “private property” and “freedom of contract” solve our problems. They are not adequate answers because their meaning is ambiguous. Our problems begin when we ask what ought to be the contents of property rights, what contracts should be enforceable, and how contracts should be interpreted or, rather, what standard forms of contract should be read into the informal agreements of everyday transactions. (Hayek, pp 112-113) 115 Adam Smith also saw a positive role for government. As implied in the quotes from Hayek, it is the content of the laws of property and contract that is crucial. It is important to identify the role of the state in structuring the allocative process that society depends upon. 6.1.3 Market 6.1.4 ROLE OF GOVERNMENT One of the major controversies is the proper role of government (and the use of command) within a market based economic system. Many of the issues in this controversy are ideological in nature and result in the existence of different “schools of economic thought.” The Chicago School and the Austrian School of economic thought argue that the role of government in the economy should be minimized. (Hayek taught at the University of Chicago and was an Austrian economist.) The American or “Old” Institutionalists and much of Neoclassical microeconomics (in the Cambridge tradition) sees a more positive or active role for government in many areas. The French Physiocrats [led by Francios Quesnay, 1694-1774] advocated a minimal role for government. Jacques Claude Vincent de Gournay [1712-1759] is usually credited with the phrase laissez faire, laissez-passer! Some advocates of an extreme laissez faire doctrine argue that there is no or almost no role for government. Most argue for limited government action in the economy. Others, such as Adam

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