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Tuesday, October 10, 2023

8 More Ideas on Thinking like an Economist

To avoid fallacies about economics, we need to learn how economists view the world.

Image Credit: NASA - Flickr | CC BY-NC 2.0

In my previous essay “8 Ideas That Will Teach You to Think Like an Economist,” I discussed eight fundamental principles of economic thinking. In this follow-up, I aim to introduce eight additional principles and perspectives that further explain the economic way of thinking.

1) Well-Intended Actions Can Have Unintended Consequences

Economic thinking shows us that bad results can occur even if one’s intentions are noble. In their book The Economics of Public Issues, Roger LeRoy Miller, Daniel Benjamin, and Douglass North explain how while the FDA tries to prevent Type I errors—pharmaceuticals being released too early and, hence, being unsafe for human consumption—the unintended consequence of the required additional testing could result in Type II errors—people’s needless pain, suffering, and even death because the drug was safe but delayed.

Another example of an unintended consequence is that the improved safety of football helmets has increased the number of concussions (more safety leads to more risk-taking, a phenomenon known as moral hazard). Economists have also studied race car driving. Robert Tollison and Adam Pope showed how the “Peltzman effect” applies to NASCAR. Specifically, the increased safety regulations have led to more accidents on the track and have made it more dangerous for both drivers and spectators.

In addition, economic thinking allows us to critically examine the negative effects of public health policy. For example, the COVID-19 hospital restrictions affected the elderly and people whose primary language is not English. Hospitals allowed most parents to visit their young children in isolation due to a COVID-19 diagnosis; however, they had a different policy for elderly and non-English speaking adult patients. The intention was to protect people but the unintended consequence was that isolated older adults and ethnic minorities experienced an emotional toll and loneliness that had detrimental health effects. Furthermore, for those not proficient in English, healthcare professionals may have misunderstood what the patient was trying to communicate, potentially leading to a misdiagnosis or unnecessary discomfort or suffering. Of course, patients dying alone was another cost borne by family members.

2) The Importance of Property Rights

As Aristotle said, “That which is common to the greatest number has the least care bestowed upon it, everybody is more inclined to neglect the duty which he expects another to fulfil.” In other words, when everyone owns something, nobody truly owns it. This is known as the “tragedy of the commons.”

Typically, I introduce this topic by asking students to rub underneath their desks. I usually get the hesitant look and some students tell me that they will not do that. They assume there is gum or some other unpleasant items under their desks and usually they are correct. Because desks are not the students’ private property, they do not have the same incentive to take care of them as they would if it was their own desk in their bedroom.

The classic example is sheep eating grass on an open pasture not owned by anyone—a common resource good. In technical terms, it is a resource that is “nonexcludable” and “rivalrous in consumption.” Once the grass is gone, there is no personal incentive to replant the grass.

An interesting example of property rights and incentives considers endangered animals. Some say the best thing for an endangered animal is to be on a restaurant menu. This shocks and offends some people, but the logic is compelling. Animals that are sold in the legal marketplace are owned. Ownership incentivizes people to not only slaughter the animal for eventual sale but also to breed the animals so that there will be more to serve at restaurants. In an adjacent avenue, endangered animals native to Africa saw their numbers increase when placed on private Texas ranches that allowed hunting. The ranch owners charged hunters thousands of dollars for the experience of an African safari, and they also had an incentive to limit the number of animals killed to allow for ample reproduction.

3) The Diamond-Water Paradox and Why Athletes, Singers, and Movie Stars Are Wealthy

Economists tried to explain why water, a necessity for survival, was priced so inexpensively in comparison to diamonds, primarily used as jewelry. The puzzle stemmed from a lack of comprehension of marginal utility, which was resolved by the Marginal Revolution in economics. Initially, economists suggested that since the total utility of water was significantly greater than that of diamonds, the price of water should logically be higher. What they didn’t realize is that price is related to marginal utility, not total utility. Utility is just another term for benefit and “marginal” means the one additional. In most situations, the marginal utility of diamonds is higher. In other words, usually, people are willing to spend thousands of dollars for a diamond ring but not for a bottle of water even though water is essential for them to live. To illustrate this point, consider the scenario of an individual stranded in a desert with $1,000; in such a dire situation, they would willingly part with this money for a single bottle of water because, at that moment, the marginal utility of that bottle of water is extremely high—it is the value of their life.

Similarly, famous professional athletes, actors, and singers get paid far more than teachers, firefighters, and nurses—people who shape and save lives. However, it is not the importance of the job that determines pay. The pool of individuals possessing the skills to become the next professional athlete, Hollywood celebrity, or pop music star is relatively scarce compared to those who can become the next teacher, firefighter, or nurse. It is not easy to become the latter, but it is easier and more realistic.

Furthermore, consumer demand plays a pivotal role. If I were to give a lecture at the San Jose Shark Tank (the SAP Center), it is unlikely that people would flock to attend, including my own family! In contrast, thousands of people want to watch NHL hockey games or their favorite band in concert.

4) The “This Will Save American Jobs” Fallacy

In the classic book Economics in One Lesson, Henry Hazlitt reminds us that the errors in economic analysis result from looking at the short-run effects of a policy, not the long run, or by looking at the effects on only one group, not all groups.

Some claim that importing products harms the American economy and that “buying American” will protect American jobs; however, these are technically incorrect. While some Americans would benefit from trade barriers or the “buy American” philosophy, other Americans would lose their jobs.

As an example, let’s consider my vehicle, a Honda Pilot, which most people would consider a Japanese car. However, it was built in Lincoln, Alabama by American workers. Furthermore, when my Pilot requires servicing, I do not take it to Japan; I take it to my local Honda dealership in California where Americans work. Even if my Pilot had been built in Japan, it still would have needed to be shipped to the United States and unloaded by American workers at the Port of Los Angeles or San Francisco. If we do not import, that eliminates the jobs of those port workers.

Additionally, when politicians advocate for trade restrictions or tariffs to help “save American jobs,” this increases the prices of imports and, due to less competition, domestic product prices rise. Consumers would now spend more on the foreign car they want or have to settle for a domestic car that is relatively cheaper but still more expensive than it would be with free trade. Consequently, Americans will have less money to spend on other American goods and services.

5) Consequences of Interfering with the Price System

Prices serve as signals to both buyers and sellers, directing them to adjust their consumption and production behaviors. In a free market, prices help to efficiently allocate limited resources. Problems arise when politicians interfere with the price system to protect consumers by setting price ceilings or price floors. Even though these measures aim to prevent the “exploitation” of consumers or shelter agribusiness from low prices, price ceilings lead to shortages while price floors lead to surpluses.

6) The Importance of the Rules of the Game

Economics can be defined as the study of how people behave given certain institutional arrangements. This is just a formal way of saying that society’s rules affect human action. Some countries are rich while others are poor. It is not necessarily because the people in the poor countries are lazy or because their country lacks natural resources. Rather, these factors are influenced by the systems in place (i.e., institutions), primarily the economic system.

The classic example is to compare and contrast North Korea and South Korea. These two countries have similar geography, culture, and language. However, economically (and in many other ways), North Koreans are far worse off than South Koreans. The satellite image of the two countries at night demonstrates the difference—there are many lights in South Korea but not in North Korea. North Koreans do not hate electricity and South Koreans are not afraid of the dark. Rather, there is no reliable power in much of North Korea so only the privileged authoritarian politicians and bureaucrats enjoy consistent lighting.

Another interesting observation is that some individuals who immigrate to the United States become entrepreneurial successes when they were not in their native country. Primarily, this is because we have better institutions—more economic freedom. In other words, countries with economic systems that make it easier to become the next “shark” on Shark Tank, allow private property and profits, and have a judicial system that enforces property rights do better than those with little economic freedom—i.e., those with central planning, no secure property rights, punishing taxes and regulations, and no incentives to become an entrepreneur.

7) Competition is Dynamic, Not Static

Competition is an ever-evolving process. Businesses constantly strive to excel in producing goods and services. Either several coexisting firms in the market or a single dominant firm emerges. Neither outcome is inherently superior or inferior as the market is in a constant state of flux.

A firm can rise to the top or even eliminate its competitors by demonstrating superiority in its practices and better catering to consumer desires. Alternatively, a firm may gain market dominance or become the sole entity in an industry due to special privileges granted by the government, gaining a true monopoly.

The standard perfect competition narrative assumes a static situation. An alternative and better perspective views the economy as dynamic, suggesting that if a firm does not receive special privileges from the government, its rise to the top or success in eliminating competitors indicates that it must be good at what it is doing. Moreover, it is essential to recognize that it is consumers who elevated the firm to the top, and even if a firm becomes the “lone wolf,” it cannot force customers to buy its product or service.

8) Two Ways to Gain Wealth

In his book Seven Deadly Economic Sins, James Otteson distinguishes between two ways of acquiring wealth: extraction and cooperation. If someone uses force to take something from another, that is extraction—it is a zero-sum game. However, when a person voluntarily pays a seller for a good or service, that is cooperation—a positive-sum game. In the cooperation scenario, consumers win—they wanted the good or service more than their money—and the seller wins by earning income.

When entrepreneurs amass substantial wealth or when small business owners run profitable businesses that allow them to buy expensive items, it is the result of them helping (i.e., giving people what they need or want) thousands or millions of consumers. A private business’ success does not involve forcibly extracting money from customers unless it has an unfair advantage due to a government-granted privilege.

Conclusion

As the Austrian economist Ludwig von Mises stated, “Economics deals with society’s fundamental problems; it concerns everyone and belongs to all. It is the main and proper study of every citizen.” The economic way of thinking reveals that good intentions do not always yield favorable outcomes and that interfering with the market process can lead to negative unintended consequences.

Many people have strong opinions about economic and public policy, but they do not always understand the economic implications of those opinions. Hopefully, this essay has shined a light on an economic reality and has given readers an incentive to further their economic education.


  • Ninos P. Malek is an Economics professor at De Anza College in Cupertino, California and a Lecturer at San Jose State 
    University in San Jose, California. He teaches principles of macroeconomics, principles of microeconomics, economics of social issues, and intermediate microeconomics. His previous experience also includes teaching introductory economics at George Mason University.