6 ideas to understand how an economist thinks

Six ideas to understand how an economist thinks about a problem, from opportunity cost to incentives, explained with everyday examples. Note from April 2018.

For some reason, economists are listened to in good times and bad. Especially in bad times. For another reason, a large part of the population has strong opinions on the subject. Which is perfectly logical: economic problems have a concrete impact on people's lives.

Now, do families think like economists? Most likely, yes, at least at the most basic level. The only difference is in language and system.

When a parent advises their child to study because a degree will lead to a better salary, they are intuitively referring to human capital theory. However, having a systematically related technical language allows for order, reduces contradiction, and facilitates learning.

The same applies to any other field of knowledge, from medicine to the craft of making a good piece of art. As knowledge becomes more specialized, common sense loses ground.

To bridge the gap, this first edition presents six ideas that economists have in mind when analyzing a topic. A future edition will include more.

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1- For a sincere economist, everything has a cost

At the heart of economic analysis lies a decision . No matter how spontaneous a person may seem, to a good economist, everyone chooses between at least two options.

When someone does “something,” they inevitably stop doing “something else.” And, of course, that decision comes at a cost.

Suppose your job offers you the opportunity to extend your workday to six hours on Saturdays, paid at the same rate as any other hourly work – let's say – $100. Approximately $2400 per month.

But it turns out that Saturday mornings are the only day he has free to play football. If you decline the job offer, you are revealing that the level of satisfaction from going to play is greater than the additional salary you could receive if you did not reject the offer.

In other words, the net value of playing the Saturday game is—at a minimum—greater than that amount. It could even be a larger amount, but definitely never less. The same applies to an example of decisions where money isn't directly involved (watching Netflix vs. going for a walk). You just have to find a way to put a price on each activity.

The opportunity cost

In short, when a sincere economist evaluates alternatives, they always consider opportunity cost: the best alternative forgone when making a choice or decision. In other words, the value of the best option not chosen. This last point is very important.

If other options were available, and they usually are, the opportunity cost should only be imputed to the best option. Otherwise, if the value of all available options were imputed, any decision would become so onerous as to be prohibitive. Thus, the best option by default would be to do nothing. Which ends up being a contradiction, because doing nothing would also be extremely costly.

2- A good economist does not forget to take into account indirect effects

Suppose you are a benevolent dictator, in charge of a country that is definitely north of the 38th parallel. Like any ruler, you are concerned about the safety of your people, which is why you take actions to guarantee it, forcing a large part of the resources of his country's economy are allocated to the development of a nuclear program, and the rocket that allows the result obtained to be exported far away.

Suppose further that after 10 years he manages to achieve his goal. He invents a new medal, awards it to himself, and celebrates because the development was a complete success.

If the success of the program is measured accounting, that is, by discounting the resources directly used to obtain the greatest feeling of security, perhaps the result will be positive.

However, if the program is measured economically, in addition to discounting the opportunity cost mentioned above, its indirect effects must also be discounted.

For example, the reaction of other powers starting a new arms race, which ends up increasing the price of achieving a sense of security for that country. For the good economist, the movement of one variable (the nuclear program) impacts the movement of many other variables, not just the one that captures the expected result.

Why context complicates analysis

While this point may seem trivial, it's not always understood that way. First, because the effect of a variable's movement depends not only on the variable itself, but also on the context. And studying the context is much more complicated than reading a maxim on Twitter and taking a stance five minutes later.

Second, because the analysis of the context can be partial (the positive effects of the program in the arms sector) or it can be general (the effects generated in the entire economy). Most of the time, a decision does not provide enough time for a general equilibrium analysis, which is why different partial scenarios are used.

But a good economist knows that the overall context is what counts, even when some of its parts are ignored.

3- I don't know what I want, but I want it now

It is unacceptable for a little economist padawan to say something like that. If every decision is costly, then every costly good or action has a value. Now, what determines that value? Some kind of feeling, longing or anguish? In other areas of study, maybe yes.

An inherited object may have a special aura for the family that continues to possess it, but for the analysis of an economist who walks on the bright side of the force, the value of all things lies in their relative scarcity or, in any case, in the information available about the relative scarcity of a thing.

Let's imagine an ideal world of perfect and complete information, unlimited processing capacity, and fully enforceable contracts with zero enforcement costs. In this world, market prices reflect the relative scarcity of one good compared to another. When the world turns out to be more complex than the tools we invent to understand it, prices remain a good source of information for understanding the scarcity of a good, but not the only one.

What information does the price summarize?

But what information determines the price of a good? The forces of supply and demand within a specific institutional context. To briefly summarize: the cost structure of the company that manufactures it, the cost structure of its competitors, the market power of each of these companies, the institutional framework that governs and regulates that market, the purchasing power of customers, their preferences, and various exogenous factors, among others.

As we can see, prices, understood as an information system, are not perfect, but they contain so much information that it is difficult to discard them, at the cost of losing a large part of the analysis. And understanding how scarcity is determined and modified is an essential part of the economist's work.

4- What is desirable in the short term may be bad for the future (and vice versa)

Imagine that every December 24th, Christmas is celebrated in your home. At the Argentine table, that usually means eating a lot, drinking a lot, sleeping little, and getting up the next day to eat even more.

Likewise, for some inexplicable climatic reason, there is usually summer weather at that time, which enhances the caloric diet of nougat, sweet bread, and similar foods.

It's not always like that, but for the purposes of this example, let's consider Christmas dinner as something good. In the short term, it's a feast to be enjoyed. There will be time for dieting the rest of the year.

Let's consider what would happen if a dinner with the same intensity as Christmas dinner were celebrated every three days. Family budgets would decrease due to increased spending, but the income of families employed in the food and Christmas gift sector would increase.

Public health problems would multiply, although the effects would be seen in the long term. And possibly the population would be happier for a couple of years.

Effects that are distributed over time

Thus, the happiness of one generation can be paid for by the next (and vice versa). Without going to extreme cases, the analysis of how different effects of an action or measure are distributed over time is part of the economist's basic toolkit.

The problem, in this analysis, lies in the fact that we all have a preference for the immediate. The reason is simple: the future is uncertain and complex.

The implications and ramifications of this fact have enormous consequences for economic activity. For example, a politician will structure different decisions, both short-term and long-term, depending on whether or not they can be re-elected.

In the case of a company, the incentives to invest (the decision to postpone current spending to bet on a probably greater future income) will require a very different range from that related to daily movements of its business activity, for example, a sporadic or seasonal increase in sales volume.

5- Many discussions and dilemmas are solved by measuring

The boiling point of water occurs at 100˚C. Past that point a change of state occurs. Nothing very new. But now suppose you want to make some tea. If you let the heat do its job, all advice is to remove the kettle at the first boil, at the exact point where the water begins to change.

What does all this have to do with the title? It's that a large part of the discussions about current economic issues are interpreted as changes of state: taxes yes or taxes no, debt yes or debt no, inflation yes or no… and the list goes on among the large number of topics that parade through the afternoon news.

A huge number of problems revolve around how to measure a given economic event and, if possible, how to calibrate the intensity of an intervention to achieve a socially desirable outcome. For this to work, it must be understood that all measurement is a convention.

Measuring: an increasingly cheap convention

The statistics that we read every day arise from a kind of contract on how a certain economic or social fact is defined and captured. If the basis of belief in the suitability of this procedure is not strong, the measurement does not achieve sufficient efficiency, regardless of whether it is correct and faithful to what it tries to capture.

But let's assume there are no problems with that point. Immediately another problem arises: measurement is expensive… although not as much anymore. Generally, those responsible for collecting measurements are official statistical institutes, along with other agencies that produce this type of information. However, in recent years that situation has begun to change.

Technological change has facilitated the digitization of data previously kept on paper, as well as a massive reduction in the cost of its storage and processing. But winds of change are also blowing due to a greater demand for transparency from public institutions, regardless of the level of government or agency.

In short, economists use data , and under this new scenario and with the processing techniques being developed, they use it more and more. Data is the raw material of applied analysis. Theories and models guide the questions, fill the gaps, and provide the basis for interpreting the results. But without data, they are a tool that works in a vacuum, relying on good intentions or fiction.

6- Incentives matter

“I want him to come here because he wants to, not because I'm going to pay him.” “He should have behaved differently, he doesn't see that it is prohibited.” “Taxi drivers never blink when they are about to turn.” Scenes from everyday life that are repeated, calls to duty that appeal to values ​​that not everyone fulfills, culture in general.

On the surface, the economic analyst is often labeled a cynic. Someone who cares little for the values ​​of others, who knows the price of everything and the value of nothing.

Let's see why this isn't quite the case. First, culture matters. If a decision lies at the heart of economic analysis, it is implemented based on the mental model offered by that culture, as well as on the informal institutions (a kind of set of rules) that organize cooperation and exchange.

But it must be noted that they are one more component. Depending on the circumstances, values ​​may not be decisive at an individual level, even though they may be decisive at a collective level (we will expand on this point in the next installment: don't miss it!).

Selfishness and incentives

What is the other element? The selfishness of the person making the decision. Does this mean that economists think that ethical or altruistic behaviors should not be taken into account? No, quite the opposite. An economist would tend to reward this type of behavior if it increased general well-being as a result.

But it is true that economic analysts are blunt when it comes to understanding behavior. It doesn't matter what is said or proposed, but rather what is actually done, and whether that action benefits the person who took it. It is on the basis of this mechanism that incentives matter in economic analysis.

Let's return to an example. It doesn't matter how well an average citizen claims to drive or what the law mandates. What matters is how they actually drive, and what incentives should be provided if they deviate from socially desirable behavior.

On the positive side, a massive education campaign can be carried out (and resources spent massively) so that the average individual with a driver's license in some mysterious way ends up understanding the advantages of heroically blinking before turning or announcing a change of direction. lane, among other things.

Alternatively, he can be penalized indefinitely with fines large and prohibitive enough to make him understand and comply. It all depends on the context and how expensive and effective the various incentives that can be administered are.

Summary, and what's to come

In this first installment, six basic ideas that are present in an economist's toolbox have been presented. Ideas that have been presented without a hierarchical order, but that are present at the base of practically any economic analysis.

They are part of the foundation , they are questionable—as when we talk about selfishness—but they are useful and, for now, they have stood the test of time. Perhaps later they will cease to support the vast edifice of knowledge built upon them, but for the moment they remain the foundation.

But they are not the only ideas. As we promised before, we are missing a second installment (and as many as we conveniently need).

In the next installment of Puente Académico , we'll discuss topics like economic models, which are all flawed, and that's perfectly fine; the underlying problem is culture, but much can still be done; and many other things. Until next time.

Open access, for use and citation

The report is available freely and without charge, under a Creative Commons license (CC BY-NC-SA 4.0):

6 ideas para entender cómo piensa un economista. Informes del Observatorio UNR N.º 43 — Serie Puente Académico N.º 14, abril de 2018. ISSN 2683-9067 / 2683-9091. Autor: Germán A. Tessmer.