What's Economics ?

For a long time I had a derisive stance on the "science" of Economics. As many of you I was listening the pundits on the TV and was astonished all the time by nonsensical statements and just outright lies that defied common sense and my personal experience. Being scientifically slanted as you may suspect it was a normal reaction when I hear blatant contradictions in the economists opinions and failed predictions over and over again...
Couple of months ago I found librivox.org while I was looking for something to listen on the way to work. So I decided to try classic books which I would never have time to read, but always wanted to. So I started with "Wealth of Nations" - Adam Smith, "The Prince" - Machiavelli ... and now many others.
This made me dig deeper up to the point to postpone work on my other projects, but I think it is worth it ;). I hope to transfer this enthusiasm to you too...
I would start this series with some definitional stuff, then I will explore the reason why I changed my opinion about Economics, mind you not about all schools of Economics ;), just some of them. It seems that the TV, cable and gov policy think tanks have been cannibalized by voodoo Economics propagandists, trying to mimic Physics and Math and call it Economics, which was the reason for my initial disguise, but more about that later ... let first define the terms, because that is how a science starts... right?


The term economics comes from the Ancient Greek οἰκονομία (oikonomia, "management of a household, administration") from οἶκος (oikos, "house") and νόμος (nomos, "custom" or "law"), hence "rules of the house(hold for good management)" (Wikipedia definition).

Apart from the apparent etymological meaning which I just mentioned, the biggest confusion (which was also my long held misunderstanding) I think comes from the mixing of the economics ideas : explanation vs purpose i.e. what Economics is versus what Economics ought to be... ;] Let me clarify what I mean.

Positive vs Normative

There is two forms of statements we can use to describe the world of human interaction, which Economics purports to explain.

The first type is the Positive (descriptive) statement which is a statement about what is, this expression has axiomatic sort of quality and does not contain any value judgment. For example "The Sun is a star" is a positive statement. It does not have to be true either, for example "The Sun is made of butter" is still a positive statement.

The other type is Normative (prescriptive) statement which is a statement about what ought to be. Example of normative statement is "It will be better if the Sun was made of honey". As you can see this is value loaded statements it express opinion on what it ought to be.


positive isfactobjectivedescriptivesciencetrue/false
normative oughtvaluessubjectiveprescriptiveartgood/bad


In general the agreement among many of the economists is that Economics should strive for using Positive statements. The reason to want that, if you dwell on it is that Positive statements are less prone to be debatable i.e. there is less chance for people differing on the meaning of the statements. Of cource that is the theory, in reality today mainstream Economics is full of Normative statements.
To clarify the concept let me give you another example :

Positive statement :
According to the law of supply and demand, increasing the minimal wage will cause many people to lose their job. All other things being equal.
Normative statement :
It is not fair for the poor people to receive such a low wage, it does not allow them to support a family, for this reason we must increase the minimum wage.

Do you see the difference. Again don't try to judge the validity of the statements, just try to contemplate what they are describing/prescribing.
The positive statement is making simple observation of the natural phenomena of how the market works, the normative is a value proposition of what is right or wrong.

One thing I snuck under your nose :) is the sub-statement which in economics-lingo is called : Ceteris paribus or caeteris paribus which is a Latin phrase meaning "with other things the same" or "all other things being equal or held constant." In Economics there is no way to make controlled experiments as we do in physical sciences, that is why economists use the Ceteris paribus assumption to make a thought/gedanken experiments.
In fact the principle is implied in almost every economic statement, so keep it in mind.

Let see another example :
"Murder is a sin"
Looks like Positive statement, but is in fact Normative.

Sometimes it is hard to distinguish if a statement is Positive or Normative. To resolve this problem we need a methodology or a framework.

The main goal of Economics is to give us the tools to interrogate the human market interactions in unbiased way, so that we sit on solid ground when we argue our ideas and points of view of how we can improve our well being, instead of going in circles throwing statistics at each other ad infinitum.
Did you see what I did there :), I stated Normative statement using "is" to disguise it as Positive statement.

Marginal utility, Scarcity ...

Marginal utility or said otherwise The law of diminishing returns is simply the idea that people normally value goods less the more they have of them. For example if you are thirsty you value the first glass of water more than the 10th glass ... in fact you will probably don't even care about 10th glass of water.
If you have 5 apples you will value another apple less than if you don't have any apple.

One problem Classical economists had hard time solving was the so called water-diamond paradox i.e.
Why is water so much cheaper compared to diamonds ? Water is invaluable for human survival, diamonds are useless (at least in past, today they are used in some machines, normally man made diamonds) ?
This phenomena can be easily solved with what we now know.
Imagine you own a diamond and you are in the desert slowly dieing of thirst and then miracle a person come by offering you to switch the diamond for a gallon of water. You will grudgingly give up the diamond for the water, to save yourself. This means you value water more than the diamond at this moment of time and place. But what if you were not thirsty at all, what would you do ? ..... Yes I thought that too, you would laugh at him for being such a douche ;).

So marginal utility then is closely related to the problem of Scarcity, the more scarce a good is the higher marginal utility it will have and vs. versa.
Additionaly the time, place, situation, mood ..... etc all play major role in deciding (all other things equal i.e. Ceteris paribus).
The important lesson from our small example which we will will need in a moment is that we value goods on per unit basis not the one class-of-goods vs other i.e. we exchange a specific 1 gallon of water at specific moment in time under specific circumstances i.e. on the margin, we do not evaluate the class of goods all-water vs all-diamonds.
At the moment of decision to exchange we do not compare class-of-apples vs class-of-oranges, but specific apple/s vs specific orange/s.
So we no longer have water-diamond paradox.

Value and Price...

Another great dilemma that confronted and confused great Economists for long time was the formation and measurement of VALUE.
The way to explain value is trough the Price mechanism i.e. the process of formation of price in market economy, the price is the cornerstone of the way we measure the value of economic goods as we will see.
Cost theory of value
Adam Smith the "father" of Economics observed that people normally value goods for two things : how useful they are to them (value-of-use) and how easy is to exchange (value-of-exchange) them for another good. This distinction is merely distinction in kind, but how do we measure the overall value of economic goods ?

The Classical economists ... used in one form or another a theory which we will put under the umbrella of the Cost theory of value. The basic idea is that the final price of good or a service is formed by the cost it took to produce the good.
For example a computer priced at 400$ can be said to have attained this price because it is build of parts and it is sum of the prices of its parts that give us the final value, namely 20$ for the case, 100$ for the hard-drive, 100$ for the screen, 30$ for the video card, 100$ for the motherboard and 50$ for the labor i.e. 100+100+100+50+30+20 = 400. Then to find the price of the screen for example we do the same partition, until we reach to the natural elements from which everything is build. This theory assumes that the basic elements of nature have some sort of intrinsic objective value.
Thus far the theory explain in general terms price formation, but there are some paradoxes and it also couldn't explain all type of prices.
Why for example would a painting, antique and land would command such high prices ? The materials for a painting are very cheap compared to the million dollars some collectors pays for them ! Land is almost unchangeable over long periods of time and still the price can fluctuate a big deal ? and so on ...
The solution which Classics economists proposed was to split the goods in two categories. Now they said the producible goods price is formed by cost of production and the non-producible goods price is mainly influenced by the law of supply/demand and monopoly. So far so good ... but
In the market place the price change constantly every day and every hour ... how to explain that anomaly. To escape from this conundrum they postulated that the price they are talking about are the long-term prices of the goods (natural prices) and the short term price is just a fluctuations on the market caused by supply and demand forces and at "the end of the day" they will tend to the true natural price.
They regarded the goods as having objective value external to the participants. The market is just a tool to discover the natural price.
This seems to solve the problem, so far ... even at the price of very complicated explanation.
But another problem is by explaining the price of computer in the earlier example using cost theory we are treating the Computer as a class-of-goods. But we know that every computer is distinct unit and there are big variations in the prices, even if the configuration is the same in different markets at different times the price will be different i.e. there isn't a single price for the whole class of goods of computers, apples, wheat. The price is always per unit : 1kg, 1 item, 5lb, 3 pairs...
In short cost theory of value can explain satisfactory only long-run "natural" price of reproducible goods.
Another important characteristic of any theory of value is how the prices are imputed. In Cost theory the calculation start from Production goods towards Consumer in the following manner.

Imputation direction: Customer <- Consumer good <- Producer good

Labor theory of value
The next theory is the Labor theory of value. It is a refinement of the Cost-theory. There is no longer intrinsic value of natural elements, but instead the price is the result of human labor.
We can regress recursively like before, but now instead the value comes from the labor exercised to convert those natural commodities to useful goods. I'm oversimplifying alot, there were alot of variations on the above, but for our discussion this will suffice.
Again there is alot of problems with this theory too. It is still circular without end.

What is the cost of labor ? Do you measure it by how hard it is ? How filthy it is ? How many hours it takes ?
How mentally or physically intensive it is ?
Even if you can solve this problem how do you compare 1 hour of doctor work to 1 hour of builder work ?

How does labor cost change over time ?
If the price of the end product fluctuates, does labor cost change, if yes how ? if not why not ?

According to Karl Marx labor is irreduceble element in goods production, in fact it is the major element that should determine the price.
The labor value of commodity is the amount of socially-nececary abstract labor time embodied in that commodity ? But how do you know what is this "social-value" ? Even worse how do you know it in advance to calculate the produced good price ?
Central point in Marx theory is the so called surplus-value, which simply stated is the difference between the sale-price and cost-to-produce the good (also known as value-added). At this point the theory veers outside Economics and enters the land of Politics. Because it insist that this surplus value should be given to the worker (who did the labor) instead of the enterpreneur (who provided the means of production). But in this short article we are mainly interested in a theory that explains how the price forms (Positive), not how the profits should be redistributed (Normative).
Plus redistribution requires some third party to decide how it will be redistributed, which means that the transaction is no longer voluntary exchange between two parties i.e. we can not make a plausable deduction how this will play out, so that we can come up with more succunt theory that have explanatory power, rather than prescriptions what should happen.
Subjective theory of value
The last theory which explained all the inconsistencies of the early attempts is the Subjective theory of value. In the previous two theories the price builds bottom-top, in the Subjective value theory the process is the opposite.
The idea here is that the valuation stems from the person making the decision to buy not from the good itself.
If nobody buys what you produce then the objective value of it is ZERO, it does not matter how much it cost you to produce the good. The only important thing is if there is a buyer ready to buy what you offer.
What this means is what you produced is not an economic-good, if nobody wants it i.e. it is not scarce.
At first it may seem ridiculous, how in the world will you account for all the nuances and problems of the Price mechanism we just discussed, just by subjective valuation ! But if you are just a tad patient, you will see how elegant and truthfull this proposition is.

Let explore what the exact mechanism is then.
Subjective price theory starts with the idea that people have preferences i.e. they prefer some good better than other. Also they prefer more units of a good vs. less units and finally exchange happens at the margin (marginal utility).
By economic-good in Economics we mean something scarce that people desire, but don't have enough of it. If that is not the case then the object or service is not a economic-good
So lets spawn an example of two people that like apples and oranges in different degrees. For exchange to happen there have to be difference in the valuation of goods, as it is almost always the case in free markets.
In the table below we have the preference ranking of the goods of apples and oranges for John and Phil i.e. gradation table from what they like better toward what they like less.
We use brackets to represent what the person does not posses at the moment i.e. John have apples, but does not have orange.

rankJohnPhil
17 apples(5 apples)
26 apples(4 apples)
3(1 orange)(3 apples)
45 apples1 orange
54 apples(2 apples)
63 apples(1 apple)

As we see John values 7 apples more than 6 apples, and 6 more than 5 apples ...etc ... but also 1 orange more than 5 apples.
From his ranking we can deduce that John will be willing to part with 5 apples in exchange of 1 orange (because he values the orange more, left column).
On the other hand from Phil ranking we can see he will be willing to part with his orange for at least 3 apples. What this mean is that voluntary exchange will happen somewhere between 3 and 5 apples for which the orange will switch hands. The other advantageous thing is that both of them will feel better after the exchange because the subjective valuation i.e. it is win-win situation.

This looks like barter on first sight ... but if you think about it nothing changes in our logical deduction if we use dollars instead of apples, because the important thing is that it is matter of subjective preferences.
More astute readers may object that we did not get exact price, but a range between 3-5 apples/dollars, how do we go to shrink this range. Easy we just add more people exchanging on the market to the mix or leave it to the barganing power of John and Phil. This is where the law of supply and demand is born.

Another thing to notice is that to explain the price of the computer example (we had in Cost-theory section) we don't need to refer to the cost of every part of the computer. With the subjectivist approach we get the final price.
Again some may object : But how did the Computer manufacturer got the price for the parts ? Easy the price is subjective. Enterpreneur will only buy the parts if he can make profit. He "projected" for how much probably he will able to sell the final product and bid the prices for the parts accordingly. (We are not interested here is his projection correct, we are only interested that if the valuation is subjective this explains the price formation, along the chain of producers).
What then about the miners of the original materials, like silicon for example. Once more there is no intrinsic value to the material itself. The proof of this is that until anybody knew that silicon can be used for building computer chips, nobody cared about it so the price of silicon was ZERO.
The same goes for the most valuable commodity to date : OIL. Just a century or so ago it was not worth even ZERO, it was nuisance for the farmers.
What about labor ? The answer is the same, if the commodity is not usable, no need to hire people to mine it.

So what else does this scenario explains ?
First and foremost the prices fluctuate constantly, because subjective valuation of people constantly change. Market prices change constantly.
If you just drank a Cola, your preferences for buying another one changed. You probably won't buy another one.
There is no long term natural price, f.e. wheat today is way cheaper than 2 centuries ago (Price of wheat depends on for how much people buy bread. The change of price is a matter of supply/demand which as we saw is phenomena of subjective valuation of people on the market).
Computers are faster and cheaper than decade ago.
Prices of iPhone and Samsung are way higher than no-name phones with similar capabilities, because of branding and subjective perception.
Famous painting are expensive because subjective perception of wealthy persons. People buy numismatic coins and stamps way over the price of the labor and material used to make them.

We do not have the problems that plagued the Labor theory of value of figuring out all the unknowns. Price of labor is valued differently, depending of how much productivity the entrepreneur subjectively think he will make from what the worker will produce. If nobody want to touch filth, then filthy job will be valued more. If there is abundance of office-clerks in given area their job will be less well paid, compared to other region where that may not be the case (because of supply and demand which is a result of subjective preferences and marginal utility).
As we already discussed no longer there is water-diamond paradox when we rely on subjective price formation.
Let's summirize what subjective theory successfuly explained, just to name a few :

And all this explanatory power comes from the idea that valuation is Subjective and people rank their preferences and exchange happens at the margin.


Imputation direction: Customer -> Consumer good -> Producer good

Now the "Customer is always right" parable make sense ;). Classical cost theory on the other hand centers around the busnessmen buying and selling and producing goods with intrinsic objective value.

In mainstream economics the imputation is as follows :

Imputation direction: Customer -> Consumer good <- Producer good

According to them Producer goods do not have independent value ?!

I spend so much time on Value theory, because I think this is the idea that had the biggest influence on the post industrial human history overall.
The initial insights on Value of the classical economists helped spur of the Industrial age.
If you did not have the Marx labor theory of value it is very hard to imagine the whole communist political movement in 20th century.
If you do not have the Subjective theory of value it is hard to imagine the idea of capitalist economy.
I'm finishing this part with interesting fact : Marx published his Capital in 1867. The marginalist revolution which produced the Subjective theory of value started just couple of years later around 1871 (Carl Menger, Jevons and Walras). Had he published his book a decade later. history could have been different, or not :)

Methodology

We've talked about distinguishing between Positive and Normative statements and we saw sometimes it can be tricky.
Discovering the correct economic laws as we elaborated with different Value theories needs even more deliberation.

The question then arises how can we be sure first that we are in the right track and second how we can be sure we compare apples with apples ?
Here lies the hardest nut to crack for Economists i.e. how do you even approach the problem of explaining human phenomena ?
Do you use the tools of sciencies like Physics ? How influential should the use of Statistics be ? Do you abandon this approach alltogheter and go on the road of Geometry and use pure deduction ? Do you combine those approaches ? How ?
The problem is Humans do not behave like homogeneous particles, so that you can apply the methods used in Statistical mechanics. On the other hand if you use pure deduction, how do you apply the rules to do a prediction ?
Does Economics need to predict something or it should just describe things ?
The general solution seems to be that every school picks its own Methodology which is some sort of combination. The problem then is how can you compare their results if they use different Methodologies ?

The true Economics science is Methodology rather than Ideology. But this methodology has implications if you follow trough the logic of it.

We wont bother to decide who is right and who is wrong we will just explore the properties of those Metodologies and try to figure out when are they suitable for use.

One thing to be aware is the difference between Method and Methodology.
Methods are the rules or procedures you use to come to conclusion (f.e. regression of data to fit a curve, induction, deduction ...).
On the other hand Methodology is the way you come up with Methods, the heuristic to decide which Methods to use and which not, how to apply those methods... and so on.

So Methodology is the methods-of-methods, meta-methods.
For example Physics uses Scientific method of making hypothesis and trying to falsify them by experiment (Induction play big role). On the other hand Geometry is based on Axioms which are defined as true statements and via Deduction you prove or disprove hypothesis/theorem (Deduction). So on the basic level a Methodology could be predominately Inductive or Deductive.
As Economics is concerned today's neo-classical economics is heavy Inductive and Normative, on the other hand Austrian economics is predominately Deductive and Positive. Mainstream Economics is heavily reliant on experiments and statistical analysis.
Those are all factors which partake in the formulation of every economic school Methodology.

Up to this point I explored the basic tenets of Economics. I gave you the tools to figure out for yourself what to ascribe as economic thought. Now that we have this basic understanding of ideas and contententions it is time to see some practical results that have came from the science of Economics. When we discuss economics positions there is often much missunderstanding, for that reason in Economics many coloquial words we use in everyday life are redifined and distilled to describe better economic phenomena.

Terminology

Time preference

1000$ chest example.

Competitive advantage

There is two types of economic advantage : absolute and competitive.
Absolute advantage is pretty simple to understand. Let say that USA produces 1000 tonnes of wheat per year for 150$ per tonne and England produces 500 tonnes for 200$ per tonne. We say that USA has absolute advantage because it produces more and cheaper wheat.

Say's law

Capital theory and interest

Business cycle

Economics schools ...

Classical

Neo-classical

Austrian