Chapter 1 IMPORTANT CONCEPTS IN ECONOMICS

Transcription

1 Chapter 1 IMPORTANT CONCEPTS IN ECONOMICS Ask yourself if there is something that you would like to have but have not been able to afford? Try asking your parents, friends, and even strangers. They will all agree that they have unsatisfied wants. Some of us may think that the very rich have everything. But we cannot be sure they have everything they want. They would probably say there are many things they want but have to do without. The message is simple. On the issues of aspirations, tastes, preferences, desires and feelings, we can only speak for ourselves. And speaking for ourselves, we all have unsatisfied wants. The fact that we all have unsatisfied wants means that we live in a world of scarcity. Scarcity means that in order to get a little bit more of any good, a little bit of some of other good has to be given up. Every time I spend five dollars on a pastrami sandwich, I give up the satisfaction from another bundle of goods that five dollars could buy. A student deciding to study on a Saturday night gives up the satisfaction of going out on a date. No matter how aftluent or poor we are as individuals, scarcity is always present; that is, what we want exceeds what is available. The desire for more utility (satisfaction) is a behavioral consequence of the fact of scarcity. It predicts our behavior in a world in which what people want exceeds what they have. Economic analysis generalizes this behavior as demand for more utility. All of human history is about our search for more utility. Individuals demand only those goods that give them utility or satisfaction. Anything that yields satisfaction to someone is then a good. It could be a physical object (a crystal vase), something to eat (ice cream), an activity (dating), or doing things for others (contributing to boy scouts). In the real world, individuals have diverse preferences, aspirations and values. They go on, day in and day out, learning about alternatives, interpreting them, and choosing those which they expect to make them better off A greedy, rational, calculating "economic person" exists only in some obsolete books. Economics is about much more than just material things. We satisfy wants by acquiring goods. But goods have to be produced. To produce goods we need to use a multitude of things including land, machines, people, raw materials, "gifts" of nature, and time (e.g., to develop a fiiendship). All those things become resources when we S. Pejovich, Economic Analysis of Institutions and Systems Kluwer Academic Publishers 1998

2 4 develop a desire for the goods they help to produce (e.g., oil had been known to American Indians for a long time before it became a resource). That is, resources are created. Once they are created, we search for more of them. In addition to being scarce, resources have alternative uses. I can either work for the government or teach, but I cannot do both at the same time. You can always grow a little bit more food in your yard at the cost of having less lawn. A student could choose to study longer for a test in economics at the cost of giving up a bit of other activities that are also satisfying; a building could be used as a factory or residence; and so on. The point is that whenever we use resources to produce a little more of something, we are, in effect, choosing to produce less of something else. Next time your senator tells you that the state needs another highway, ask what it is that the taxpayers can do without. Every time people decide to buy something, they have less income left for other things; and each time they choose to engage in an activity, they have less time for other activities. When a community decides to produce a few more cigars, it must give up something else that the same bundle of resources (land, machines, people, etc.) could have produced. We could get slightly cleaner air at a cost of reducing the supply of other goods (e.g., cars). We can now define the concept of cost in economics. In a world of scarcity an increment in satisfaction from any good has its cost: the value oj that which is being given up, or the opportunity costs. The concept of opportunity costs explains the nature of human choices. Most human decisions are in terms of the marginal or incremental (more or less of A in exchange for less or more of other things), rather than the total (all or nothing of A). For example, from the standpoint of individual members of a community, the relevant criterion in making a choice on protection from crime, certainly a useful good, is the relationship between the incremental benefits from a little less crime and the incremental costs in terms of other things that have to be sacrificed. The issue is not one of crime or no crime. THE NATURE OF ECONOMICS Given that resources are scarce relative to human wants and are capable of alternative uses, all human societies--yesterday, today and tomorrow- have to resolve two fundamental survival issues: who gets what and who

3 5 does what. The former is about the distribution of goods; each time an individual gets a bit of something, that much less is left for others. The latter is about production and innovation; every time we assign a resource to produce something, we are giving up a bundle of other things the same resource could have produced. Economics seeks to identify circumstances that affect the costs of alternative choices, to analyze their implications for human decisions, and to make verifiable predictions about economic outcome. Economics, then, is the science of choice. It is a positive science; that is, economics does not judge human actions as good or bad, rational or irrational, desirable or undesirable. To say that economics is a positive science means that it is about cognition rather than abstract valuations. Facts and observations have meaning only in the context of a theory, and the theory must be refutable. Economic theories are then generalized propositions of cause and effect. They must explain a wide class of real world events and yield observable propositions. Ad hoc theorizing has no scientific content. INSTITUTIONS AND ECONOMIC PERFORMANCE Recent years have seen a substantial increase in research on the relationship between institutions and economic performance. To incorporate the relationship between institutions and economic performance into a coherent and testable theory, it is necessary to show that (1) institutions have predictable effects on economic performance, and (2) changes in the social and economic conditions of life modify institutional arrangements. The organization of this book reflects those two requirements for the development of a theory. Part two of the book analyzes institutions, property rights, and systems. Part three discusses the effects of alternative institutions on economic behavior. The final section explores the effects of alternative property rights on the choice of business firms, their performance, and incentives to innovate. The book is about the theory of property rights, or--the same thing-- new institutional theory. Like all research efforts, this book reflects its author's understanding of the subject at hand. It is therefore helpful to begin with a few simple propositions in the economics of property rights. 1. The theory of property rights is a positive theory. It separates valuation from cognition. The late professor Karl Brunner focused on this

4 6 point in a number of his papers. He criticized scholars for marketing their own ''values'' to the public as if those values were cognitive statements about our world. The moral disaffection that some such scholars have for the prevailing social arrangements means only that they prefer another state of affairs to the one actually observed. Brunner wrote: The sacrifice of cognition is particularly easy to detect in objections to the market system introduced by discrepancies between one's desires, glorified as social values, and the results of market processes. However, our ability to visualize "better" states more closely reflecting our preferences yields no evidence that this state can be realized. l The problem with abstract values is that they occur in a cognitive limbo. Thus, they provide no useful evidence for analysis. The relevant choice for a community is not between frictionless blackboard models of a "moral" society and the prevailing imperfect system. In a world of uncertainty and incomplete information, the only relevant choice is between imperfect systems. 2. The theory of property rights is a major departure from neoclassical economics. It is not the purpose of the book to denigrate a theory that has made numerous contributions to our understanding of social and economic issues. It is, however, important to understand how and why the theory of property rights differs from neoclassical economics. In the theory of property rights, the incentives effects of the rules of the game replace the maximization paradigm, and the feedback of their consequences on selection processes replaces the assumption of a rational agent who is able to identify the optimal strategy in each situation without any learning process. In fact, neoclassical economics is silent about both the effects of alternative rules on the agents' costs of acquiring the knowledge required to make optimal choices and the effects of new knowledge on prevailing rules. Schotter wrote:... the only institutions existing in [the neoclassical model] are markets of the competitive type in which all information on the economy must be transmitted through the prices formed in these markets. The economy is therefore assumed to have... none of the 1 K. Brunner, "Knowledge, Values, and the Choice of Economic Organization," Kyklos 23 (1970), P. 563.

5 7 many social institutions that are created by societies to help coordinate their economic and social activities by offering information not available in competitive prices The rational expectation theory and the principal-agent model bring the theory of property rights and neoclassical economics close to each other but not together. The rational expectation theory considers the process of adaptation to an optimal solution as a steady trial-and-error process in which the participants are not acquiring new knowledge. The principalagent model defines a contractual relationship between a principal and an agent. The former employs the latter to perform a range of activities on his or her behalf The costs of monitoring the agent being positive, the model seeks to reinstate an optimal solution through a contract that creates incentives for the agent to act in the principal's interest. The problem is that in a world of uncertainty and incomplete knowledge, not all future problems arising between the principal and the agent are pure risk decisions. Thus, the resolution of contingencies arising later between the two cannot depend on a contract but hinges upon the incentive effects of the prevailing rules. Herbert Simon wrote: [New economic theories] are not focused upon, or even much concerned with, how variables are equated at the margin, or how equilibrium is altered by marginal shifts in conditions. Rather they are focused on qualitative and structural questions, typically, on the choice among a small number of discrete institutional alternatives The most critical concept upon which the theory of property rights rests is transaction costs. Given its relative newness, the concept of transaction costs is discussed in some detail in the next chapter. 1 A. Schotter, "Why Take a Game Theoretical Approach to Economics," Economie Applique 36 (1983), p H. Simon, "Rationality as a Process and as a Product of Thought," American Economic Review 68 (1978), p. 6.