Friday, March 22, 2024

What is economics?

A post on LinkedIn drew my atention to an ABC story about economics which has various economists talking about how economics must change. It focuses particularly on the views of one, Nobel laureate Angus Deaton. 

The thrust of the argument is that standard economics has made the rich richer and consigned millions in advance economies back into poverty. It cites Amartya Sen as suggesting that Lionel Robbins definition (the allocation of scarce resources among competing ends) was a wrong turn. 

While it is easy to agree with that proposition, that wasn't where the evil really entered. The first thing to remember is that economics is a science, it seeks to describe what will happen when certain economic relations are put in place. The first essential economic question as framed by Adam Smith is simply "How much is there?" Under the title The Wealth of Nations this is what Smith set out to describe. His conclusion is that open trading nations with functioning domestic markets would be wealthier nations. Robbins is not unaware of this definition of economics - in An Essay on the Nature and Significance of Economic Science he refers to it as the "material definition".

That is accurate so far as it goes, and certainly was more accurate than the mercantilist approach of maximising exports while minimising imports. But Smith didn't address the second essential question of "Who gets what and why?" This is where Robbins work comes in. 

Now it transpires that the concept of "efficiency", which ordinarily means that the most output possible is generated given the amount of inputs available, has a different meaning in (some) economics. A market is said to be efficient if no one can be made better off without making someone else worse off. More accurately this could be described as "allocative efficiency". We can see how it relates to the other definition because it adds the important caveat - there is no point in making more output if it is output nobody wants.

But there is a slight of hand used in this definition of efficiency. It is subject to the Kaldor-Hicks criterion that an outcome is more efficient if someone who is made better off could compensate a person who is made worse off. This then comes down to simple benefit-cost analysis. 

This seems perfectly reasonable - if the compensation actually occurs. But it almost never does. What is worse is that some economists argue against any such transfer because of what it does to incentives. If those who are made better off have to compensate those who are made worse off, those being made better off won't try as hard and so we won't get improved efficiency. 

How this works into policy is NOT the fault of economists. A physicist can describe the pathway of a projectile, but someone else decides to fire it. A chemist can describe a reaction that results in an explosion, but someone else decides to mix the chemicals.

Economics describes how certain decisions about the relations between people (let's call them institutions) determine how much "stuff" there is and how it is distributed. Economists have accurately described how a highly artificial market that represents no real world market would allocate resources to meet their definition of efficiency. In doing so they make no statement about how these markets give greaterr weight to the preferences of individuals based on their initial endowment. They make no claim that the allocation does anything more than provide to each person as much of what they prefer that rhey can afford.

There are, unfortunately, economists who have gone beyond being scientists to being pundits. These are the economists who try to impose policy positions based on the assumption that the outcome of their theory is what policy makers want. Unfortunately policy makers are easily seduced by words like "efficiency", using it as they do as an ordinary English word not the economists definition.

Similarly we ecounter real problems with the word "productivity", especially labour productivity. This is defined by the ABS as total GDP divided by the number of hours worked. Immediately we see an issue. If we assume that not all workers are equally productive - i.e. deliver the same amount of output per hour - and that employers will first employ those who are more productive, then increased workforce participation rates and decreased unemployment would each REDUCE labour productivity. What is a perfectly reasonable way to measure productivity of an individual is a very poor way of measuring the productivity of a nation. 

One of the greatest evils to befall economics was Milton Friedman's The Methodology of Positive Economics. His starting point was a delineation by John Neville Keynes in The scope and method of political economy betweeen:
  • positive science - a body of systemetized knowledge concerning what is;
  • a normative or regulative science - a body of systemetized knowledge relating to criteria of what ought to be, and concerned therefore with the ideal as distinguished from the actual; and
  • an art - a system of rules for the attanment of a given end. 
Friedman argued that normative economics involved taking an ethical stand (deciding on what ought to happen) and that the economist should only be concerned with "what is". However, he took a markedly different view to the positivists in not being concerned with whether what was being described in economics was real; he favoured an instrumentalist view that the only value of theory was that it made accurate predictions, not that it described reality. 

More recently micro-economists realise they are studying a normative science in the sense that Keynes used it - they are describing idealised markets, not real markets. Yet introductory textbooks still refer to Friedman's model of a positive science. 

That economists predominately still use the neo-classical model and its three axioms of methodological individualism, methodological instrumentalism and methodological equilibration is, however a problem. Each of these axioms cannot be accepted. Individual preferences are shaped by their society and are ever changing, this is the insight of institutional economics. Individuals are not perfect calculating machines that can therefore be expected to act on their preferences, this is the insight of behavioural economic. Finally the economic system is never in equilibrium and studying based on the idea that it can ever do so is pointless, this is the insight of Austrian economics.

But even where economists do a better job of describing "what is" it is still only information for decision makers, just as climate science is just information for decision makers. 

Life is what happens while you are busy making other plans JWL

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