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Economic Principles:
How the Market Works

Economic Principles: How the Market Works

Chapter 2: The Social Animal

Methodological individualism as our way of understanding
Rationality: examples in consumption choice, production choice and politics
Definition of economics a la Robbins
Something is missing: the role of exchange (social animal)
Economics is not mechanics: uncertainty and subjectivity

To be remembered:

• Methodological individualism

• Rationality

• Unintended consequences of human actions

• Catallaxy

• Economics (definition)

Bibliography:

Lionel Robbins, The Nature and Significance of Economic Science

Kirzner, The Economic Point of View

Mises, Human Action

Marx and Engels, Communist Manifesto

Political science book

Hayek, 1945 piece

Buchanan: What should economist do

Where to start?

As explained in the introductory lecture, economics aimed at understanding the path to progress. How do we do that? Where do we start?
The question is not easy to answer since, as was noticed, social phenomena are complex phenomena . In that chapter we will reflect on the appropriate method to study complex phenomena.
The method that we will be following throughout the course relies on one essential belief: Progress is not something that happens mechanically, it is at least in part a matter of choice . For that reason, it is essential to understand how individuals make choices; to understand the logic of choice. But do choices follow any logic?

The postulate of rationality

There exists surely many ways to look at actual behaviour of men and women. When looking at the behaviour of a consumer, a producer, a member of the parliament, a bureaucrat, the economist sees the expression of a rational choice . He assumes that those men and women have goals they wish to reach and behave accordingly. In other terms, the economist believes that those individuals have an understanding of their environment and, on the basis of that understanding, make the best use of the resources they have. Here by �best use� is meant, �the use, which, in the view of the actor, will lead to a situation that he prefers to the one he is now, and that he prefers to all the other situations he thinks are reachable�.

Let us illustrate that way of looking at things with a simple example : It is Saturday morning, what will you do? The economist assumes that you will choose among all the possibilities that you perceive as available (doing some sport with your friends, reading your economic class's notes, doing some shopping, staying in bed�) the one that you prefer, not necessarily because it is the most enjoyable (studying economics is not always great fun!), but because it best serves your multiple desires.

Now, of course, the choice is not always a simple one, if only because you might have conflicting desires (e.g., to rest in bed and to be wealthy). We will come back on those conflicts later and on the fact that they can generate inconsistencies between choices made at different points in time. This, however, does not mean that we are not rational. Our assumption of rationality does not make the individual an alien from outer space. It does not rule out surprise, regret and other kinds of mistakes. The only thing it rules out that is the possibility that an individual having to choose between A and B, both being available at the same cost, chooses B even though he prefers A.

How do we go from rational choice to social phenomena: Methodological individualism

As said earlier, the economist believes that progress is, al least partly, a matter of choice. More generally, the economist attempts to understand the phenomena he observes around him as the consequence of individual choices, of human actions. Not only development, but also unemployment, growth, wars, inflation, the size of families, the size of cities, scientific progress, the availability of better health can be explained by the use of that method.

Specialists of methods (epistemologists, or philosophers of science) have given a name to qualify that method which consists in trying to understand a phenomenon by looking at individual choices: they call it methodological individualism . Methodological individualism and the principle of rationality, together with subjectivism on which we will come back in the next chapter, constitute the pillars of the method that we will be using.

May be the better way to illustrate what methodological individualism is all about is to take an example from outside economics. You will find below an abstract from a book that belong to another social science: political science .

Not each and every scholar of social phenomena uses methodological individualism. Karl Marx , for instance, believed that the development of our societies had little to do with human action. Indeed, to use his own terminology, capitalists as well as proletarians are not masters of their future. Their struggles can in no way modify the course of history. At most it can speed up things, but everything is already written. Marx' denial of human action is what makes his understanding of the working of a society so different and incompatible with ours. (See quotes at the end)

Unintended consequences

Some might think that I am exaggerating the role of purposeful human action in the evolution of our economies and more generally of our society. They will object that we, as human being, are influenced by our education, our family background, by tradition, by advertising and by the media. We imitate more than we act in an original fashion.

Without denying the fact that we receive many influences, it is important to underline the following two points:

Some of the things that are imposed on me result of others' action. Such is the case, for instance, of technological progress. We don't �choose it�, but someone, somewhere, is responsible for that innovation which is now �impose� on me.

Institutions, tradition like languages are indeed not �designed� by anyone in particular, and in that sense they are not the result of one particular action. But they are the fruits of the combination of many individual actions. In the language of economics we say that they are unintended consequences of individual actions .

This notion of unintended consequences is an essential one. May be the most essential one in economics. The market , for instance, has not been invented by anyone. Nonetheless it did not come by chance. Its development was not something that could not be avoided; something that came �naturally�. It was, and still is, the unintended consequences of many purposeful efforts undertaken by many to improve their living.

The concept of unintended consequence of individual actions is not an easy one to grasp and we will have to come back to it because most debates in political economy gravitate around that concept. For now, it is enough to note that the acceptance of methodological individualism does not mean that human beings control everything. As I told you earlier, things are more complex than that, and to understand what is going on we must acknowledge that complexity�

A definition of economics

To come back to something simpler, it might be the right time, after having discussed at relative length what economics is all about and how we do it, to propose a definition of that field of inquiry. There exist many definitions in the literature, and this diversity proves how difficult it is to come up with a satisfying answer. I will give one of the most often quoted; a definition that was proposed by an English economist in the 1930s by the name of Lionel Robbins.

Economics, he wrote, is the science that study human behaviour as linking given ends with scarce resources having alternative uses.

That definition is in line with some of the remarks made above:

It makes clear that economics uses methodological individualism because it starts with the study of human behaviour.

It correctly underlines the fact that we have to make choices: resources are scarce but can be put to many uses and we have to choose which one best fit our ends.

But the definition forgets some important features. In particular, it does not stress what I will call �the knowledge problem�, and it does not mention the best tool available to fight scarcity: trade.

Knowledge and trade

Robbins's definition tells us implicitly that the main problem the economic actor is facing�and economics is therefore studying�is the problem of scarcity : We have limited resources and many ends we wish to reach. Consequently we are forced to choose. For instance, you have 24 hours in one day (time is the most scarce resource!) and many things you would like to do. Therefore you will have to allocate those 24 hours among many possible uses.

Robbins is perfectly right when he stresses the importance of scarcity. But the problem faced by an individual is broader than that because, before thinking about how to allocate given but scarce resources, one must find out about those resources. Indeed, in many real life situations, the tough part is not to choose among alternatives; it is to identify the alternatives. This is what will be referred to as the knowledge problem : resources are not �given� to us, and finding out about existing resources, discovering new resources, discovering that an object so far considered as useless can in fact helps to satisfy a need: this is the crucial problem, this is what smart decision making is all about.

You might think that I am here being picky. I am not. If economics was just a scarcity problem, economics would be entirely about computation, evaluation. But economics is about the discovery as much as the exploitation of new opportunities and for that reason it relates to art as much as to computation. The art of entrepreneurship , as we will see in the next chapters, is the engine of progress.

Now, because each one of us knows so little about resources, trade is a wonderful tool to deal with the knowledge problem. Without trade the economic agent is like Robinson Crusoe on his desert island: he tries to deal with scarcity as best as he can, but he can count only on his limited knowledge about existing resources, and he must do everything, even those things he does not know how to perform well. Without trade, economics as a science would probably have never developed. Actually it would have been unnecessary. For economics is mostly concerned with interaction, and in particular with exchange.

Economics or Political Economics?

Adam Smith put it in a crude way when he noticed that we have never seen dogs trading bones. Indeed trade is the main feature of human societies. It is also, as we will explain in the next chapter, the main source of development. Through exchange we become wealthier, and, I believe, better.

But exchange requires some rules. The rules of interaction that prevail in a society are for that reason utterly important for economic life. This is the point where politics enters the picture. We are not talking here about daily politics, but about those general rules that define a sphere of power for every member of the society. What are you allow to do as a citizen? What can you own? What can you trade? What are your rights and duties? Who can you trust? From the answers given to those questions greatly depends the solution that can be applied to the knowledge problem, and therefore to the scarcity problem.

This is why some economists have suggested that we abandon the term �economics� and choose another name. Buchanan suggested that we come back to the terminology used in the 19 th century. At that time a usual name for a textbook was �A treaty in Political economics �. Hayek suggested that economics be renamed � catallaxy �, a new word based on the Greek verb �catallaktein� which meant �to exchange�, but also �to admit in the community�, or �to transform an enemy in a friend�. A nice goal indeed!

Marx:

Workers have no choice. They are alienated:

�The more merchandises the worker creates, the more he becomes himself a mere merchandise. The devaluation of men increases in direct proportion to the increase value of goods.� Marx, Manuscripts of 1844

Capitalists have no choice either. They must accumulate capital, and the rate of profit is always decreasing. Even though they are the oppressor, they also are alienated, and the process of concentration is driving more and more capitalists towards poverty. Individuals are caught in an evolution they cannot stop. The revolution can only precipitate that evolution.

� Hitherto, every form of society has been based, as we have already seen, on the antagonism of oppressing and oppressed classes. But in order to oppress a class, certain conditions must be assured to it under which it can, at least, continue its slavish existence. The serf, in the period of serfdom, raised himself to membership in the commune, just as the petty bourgeois, under the yoke of the feudal absolutism, managed to develop into a bourgeois. The modern laborer, on the contrary, instead of rising with the process of industry, sinks deeper and deeper below the conditions of existence of his own class. He becomes a pauper, and pauperism develops more rapidly than population and wealth. And here it becomes evident that the bourgeoisie is unfit any longer to be the ruling class in society , and to impose its conditions of existence upon society as an overriding law. It is unfit to rule because it is incompetent to assure an existence to its slave within his slavery, because it cannot help letting him sink into such a state, that it has to feed him, instead of being fed by him. Society can no longer live under this bourgeoisie , in other words, its existence is no longer compatible with society.

The essential conditions for the existence and for the sway of the bourgeois class is the formation and augmentation of capital; the condition for capital is wage labor. Wage labor rests exclusively on competition between the laborers. The advance of industry, whose involuntary promoter is the bourgeoisie , replaces the isolation of the laborers, due to competition, by the revolutionary combination, due to association. The development of Modern Industry, therefore, cuts from under its feet the very foundation on which the bourgeoisie produces and appropriates products. What the bourgeoisie therefore produces, above all, are its own grave-diggers. Its fall and the victory of the proletariat are equally inevitable."

From the Communist Manifesto, chapter 1; Bourgeois and Proletarians, (Marx & Engels, 1848). Emphasis added.