I have a friend who recently returned to her home in Germany after finishing her studies at Monash. Having spent the last two years modeling profit-optimizing and utility-maximizing behavior, she is now baffled by the habits of her parents.
Apparently, in Germany, it is incredibly easy to get high-quality bike parts online at very low prices. Despite this, her parents continue to go to their local bike shop, which offers a limited range of products at higher prices. Why? Because they like having local shops around where they can talk to a person.
Is This Efficient?
It would be easy to point to this example and say "See! Humans are not calculators!" and justify rejecting economics with a wave of the hand. What’s more, that person may have a point: Suppose her parents had chosen the cheaper and higher quality online product. Firstly, they would have sent a small but crucial reward signal to that particular producer. This signal not only rewards that producer for its efficient business model but also sends an indirect signal to other competitors and entrepreneurs to imitate such efficient behavior.
Similarly, it punishes the inefficient producers that failed to offer similar goods at better prices. This punishment will either encourage the inefficient firm to similarly restructure its production process or, alternatively, it may ultimately be forced to exit the market. This signaling process of trade amongst willing individuals that underlies the ongoing wealth creation of free societies.If it exits, it releases its labor and capital into the wider economy to be taken up by other firms, able to find more efficient uses for them.
Additionally, if they had bought the cheaper part online, they would have had more disposable income left over to be spent on some other good. This, in turn, would reward the firm that produces that other good and so on and so forth. It is this signaling process of trade amongst willing individuals that underlies the ongoing wealth creation of free societies.
But her parents did not choose the cheaper option. It seems that their conduct undermines standard microeconomic theory. However, initial impressions can be deceiving.
At some point in first-year or second-year microeconomics, students are taught that individual utility is subjective: What an individual finds beneficial or costly is entirely up to them. In other words, it is not up to the economist to judge the merit of what people like and don’t like—that’s their decision. All the economist can do is attempt to analyze how they try and maximize their utility given their constraints.
Unfortunately, this lesson is easy to forget. When we see microeconomics as maximizing profits and minimizing costs, we may accidentally absorb the lesson that rational economic behavior involves maximizing income or wealth.
If we recognize that utility is subjective, we must conclude that they are being perfectly rational from an economic point of view.
However, when you really embrace subjectivism and concede that individuals have unique preferences, all sorts of seemingly "non-economic" behavior becomes just as economic as any other. Charity work, altruism, the incredible sacrifices people make for their loved ones, and even the extreme danger one may put themselves in to help another all can be deemed perfectly rational when we acknowledge the subjective nature of preferences.
Let us return to my friend’s parents: They clearly place high value on being able to talk to someone directly about their bike. In fact, their valuation of this service is so high that they would rather build that relationship than pay less for a better quality product. If we recognize that utility is subjective, we must conclude that they are being perfectly rational from an economic point of view.
Is This True for Broader Society?
An alternative line of attack could involve considering social or macro-utility. While the behavior of my friend’s parents may optimize their personal utility, it may not be good for aggregate utility across society: as was argued above, their behavior inhibits the wealth-creating process of free societies as the inefficient firm has been rewarded and the efficient firm has been punished.
In fact, this argument is probably true in terms of the creation of financial wealth. Again though, it does not truly recognize the radical implications of subjectivism. An efficient system is one which optimizes benefits while minimizing costs. But benefits and costs, again, are subjective.
It will make an economic profit if a sufficient number of people prefer to trade with that firm rather than with an alternative.
Suppose you are invited to a party and you are working out whether to go. Some people would immediately decide to go because they just love parties. Others may have the complete opposite reaction, whether it is due to their dislike of crowds and noises or their preference to read a book. If you’re lazy like me, your decision may depend on how long it takes to get there, whether the venue charges admission, whether you’ll have to line up and whether you’ll take public transport or drive. The costs and benefits are determined solely by the individual in question.
Similarly, the determination of whether a firm has an efficient business model is just as subjective and depends entirely on the individual’s perspective. Again returning to my friend’s parents, the financial cost of paying more for the bike part of a lesser technical quality is clearly dominated by the benefit they obtain from developing a relationship with the person in the store. Indeed, from their perspective, the overall experience of purchasing the product from the store, combined with getting the product for their use, is of far greater value than the efficiency achieved from buying online.
So ultimately, they are rewarding what they consider to be the most economically efficient firm. The thing is, their preferred firm will survive if it continues to make an economic profit. It will make an economic profit if a sufficient number of people prefer to trade with that firm rather than with an alternative (that they are aware of). In other words, if that firm continues to make an economic profit, that firm must be efficient from a broader social perspective.
Freedom to Choose
This captures one of the most undervalued advantages of how free enterprises allocate resources: Preferences across society are entirely heterogeneous! Some people prefer online shopping, others prefer interacting with real people. In a free society, both business models can be provided if they are able to attract enough customers to cover their economic costs. We still get an economically efficient outcome, even if that outcome may not be financially efficient.
The incredible social benefits of this freedom are often lost on the bureaucrats and intellectuals who call for the government provision of goods and services. For a host of reasons, government services tend to be delivered with a "one-size fits all" approach, which is often incapable of taking into account the unique needs and desires of population subsets. One need only look at the education system to witness a service delivering almost the same product in almost the exact same way for the last 100 years. It is no coincidence that this industry is dominated by government.
Similarly, government regulations also restrict the freedom to choose. Regulations inevitably inhibit the freedom of entrepreneurs to experiment with how they provide services, while at the same time limiting the choices available to consumers. Ultimately, economics is the study of understanding the allocation of resources in a world with scarcity. One person’s junk may be another’s gold.While some accept such regulation as a necessary evil for the purposes of quality control, not only does this regulation inhibit innovation, it creates a moral hazard problem: Consumers no longer feel any need to investigate the safety of goods and services.
What commentators often don’t realize is that, without such regulations, markets would exist for experts who would inspect or review products for quality and safety. Furthermore, such experts would be legally liable (along with the producer) for any defects found post-inspection.
Moreover, because regulations restrict entrepreneurial choice, they also reduce competition, which would normally be a natural source of quality control. Such regulation also gives power to larger firms who can more easily bear the burden of compliance costs and discourages new entry into markets. All of this inevitably builds up to create a more stagnant economy and society.
Ultimately, economics is the study of understanding the allocation of resources in a world with scarcity. If we want to understand how resources are allocated, we must be able to take into account the unique preferences that guide the incredibly diverse behavior of people in the world. It seems to me that the most obvious way to do that would be to acknowledge that costs and benefits are calculated subjectively. We must never forget that one person’s junk may be another’s gold.