10 Things You Didn't Know About Economics: Numbers 1-3
The ongoing economic crisis has occurred against a backdrop of flawed economic theory. Much of this faulty thinking on the part of professional and academic economists has been obscured from the general public by the impenetrable jargon and complex mathematics that has become part and parcel of the profession.
However, the profound implications that economic theories have for society's prosperity mandate a solid understanding of the field and its assumptions. So, without further ado, here are 10 big ideas and assumptions in the modern economics profession that you probably didn't know about: numbers 1-3.
1. Economics secretly wants to be Physics
Modern economics is addicted to math. The more complicated, the more arcane and the more inaccessible, the better. Obsession with quantification and turning humans into numbers is understandable to a degree. Things that can be measured, compared and contrasted in an elegant and universal language are more useful than things that are ethereal, esoteric or subjective.
But preoccupation with math becomes destructive. In order to figure out the answer to some question using only math, a bunch of restrictive assumptions need to be introduced, corners need to be cut and huge swaths of human behavior need to be ignored.
For example: suppose we want to understand the impact of a factory on its community. In economics, we would probably look at how much the factory purchases in raw materials, how much it produces, at what price, and how many people it employes, at what wage. So we would design a formula: Raw materials purchased, plus quantity of goods Q times price P, plus number of employees E times the wage W. So it might look something like this:
-RM + Q*P + E*W = B
where B is the total benefit of the factory to the community.
Pretty simple. And that's exactly the problem. What about the relationships, the happiness, sadness, controversies, pollution, psychological, health, cultural or political impact the factory has? Economics tries to deal with such things, but for the most part it either does a poor job (because culture and psychology don't lend themselves very well to mathematical equations), or just ignores them altogether.
2. Economists think you're a computer
Deeply baked into economics is the assumption that people are perfectly rational, and perfectly self-interested. In the real world, any fool knows that people make mistakes, sometimes sacrifice their own benefit for someone else (like their children), make impulse purchases, or waste money on lottery tickets.
Now, surely economists can't be that "irrational" right? See what Milton Friedman, one of the most important economists of the 20th century, has to say about it:
... the relevant question to ask about the “assumptions” of a theory is not whether they are descriptively “realistic,” for they never are, but whether they are sufficiently good approximations for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions.
So the assumptions of the theory are unimportant, as long as the theory predicts reality. This is straightforwardly nonsensical poppycock from an otherwise brilliant man. I can assume that there is a magical spirit in my computer that lights up every time I press the power button--and voila! My theory predicts reality!
However, as we shall see later, much of economics does not, in fact, predict reality. And this naturally has to do with its false assumptions--Mr Friedman notwithstanding.
3. Consumers are all-powerful... no really, they are
The Theory of Consumer Choice says that consumers choose from among a number of different goods and services. They weigh the value of all the goods, and come up with an optimal "mix." They're constrained by their budget, so this mix ends up being the best choice they can make, given the goods available, and given their budget. (This is called "utility maximization.") Sounds pretty simple, right? Not so fast--read on.
The theory doesn't stop there. Since this is economics, everything MUST be quantified to the hilt. So it's not enough to say "people choose a combination of goods based on what they can afford." You have to spell out specific, quantifiable predictions using a mathematical formula and graphs. The Wikipedia article on Consumer Theory shows what I mean.
The absurdity of traditional consumer theory is seen in this analysis by Steve Keen:
In normal consumer theory, the consumer chooses a mixture of, say, 10 chairs and 3 pairs of shoes. For every extra pair of shoes she buys, she must sacrifice 2 chairs because of her budget. From this knowledge we can construct a simple graph with "shoes" on one axis and "chairs" on the other. It's all very simple until we introduce more products--computers, books, music, cars, apples, cigarettes, etc.
Keen's insight is that, if we assume a maximum of 10 units of each product, then if we have just 3 products (chairs, shoes and cigarettes), there are about 1000 different combinations (2 chairs, 1 pair of shoes, and 3 packs of cigarettes... 5 chairs, 2 pairs of shoes and 1 pack of cigs, etc)
If there are just 4 products, we have a whopping 10,000 possible combinations! Let's say the average person has access to just 30 different products. That leads to an incomprehensible 10 million trillion trillion possible combinations! According to Keen, this individual would take 1.6 times the age of the known universe to make a "utility maximizing" choice of just 30 products. Talk about a long shopping trip.