Economics from the Bottom Up

This is the sixth entry in a series of loosely connected posts on economics. Previous entries are here, here, here, here, and here.

NEEDS AND WANTS

What human beings want and what they need are popularly thought to be distinguishable things. Needs are said to be those things that sustain life: food (the minimum daily requirement, with no frills), clothing (just enough to protect us from the elements), and shelter (ditto). Wants are generally thought to be everything else.

But individuals vary in their perceptions of what they need; one person’s need is another person’s luxury. If a rich playboy “needs” a $300,000 Lamborghini, that’s for him to say. Accountants of the soul — moralists who believe that they know how the world should be ordered — will assert that the rich playboy can make do with a $10,000 Kia. But if that’s true, everyone can make do with a $10,000 Kia. And if that’s true, why not a bus token? (Only the older folks will remember those.)

Once the accountants of the soul are loosed, the people are allowed to need (or want) whatever the accountants of the soul approve. Except for those people who are in the good graces of the accountants of the soul. If you suspect that I’m alluding to places like the the former Soviet Union, the former German Democratic (sic) Republic, and the present Cuba and Venezuela, you’re right.

Given that “need” is a loaded word, I use the less-loaded “want.” Thus the rich playboy wants a $300,000 Lamborghini. Whether he needs it is not for economists or accountants of the soul to determine. It’s for the rich playboy to determine as he allocates his available income and wealth to competing products, services, and investment vehicles.

Wants are limitless. I may want a $300,000 Lamborghini (though I am not a rich playboy), a villa on the Mediterranean, and a collection of Rembrandts. Those wants lie far beyond my reach, and the reach of most human beings.

The main attribute of wants, other than their inherent limitlessness, is their vast variety and changeableness. Wants and their ordering can change from minute to minute, depending on what a person was doing a minute ago, what he happens to be doing now, where he happens to be doing it, the conditions in which he is doing it, who or what happens to impinge on his consciousness, how he is feeling (emotionally and physically), and so on. It takes free markets — not command economies run by soul-accountants — to respond to the vast variety and changeableness of wants.

TASTES AND PREFERENCES

A particular want is sometimes referred to as a taste. My taste for ice cream has persisted for more than seven decades. But I may, at various times, want different kinds of ice cream. And I may, at various times, prefer a certain ice cream to, say, chocolate cake, or vice versa.

To take another example, a middle-aged man may have only a residual taste for action movies; that is, he rarely wants to view one, given the alternative ways in which in can use his time and given his recently acquired taste for technical non-fiction books. Yet, twenty years earlier, when he had a strong taste for action movies, the now middle-aged man had no interest in technical non-fiction; it didn’t enter into his thoughts when he pondered whether to watch an action film or do something else.

If tastes represent the kinds of things wanted by a person, preferences are the order in which a person wishes to satisfy those tastes. Preferences, like tastes, change with time (often rapidly), and are also situation-dependent. For example, when I’ve finished eating a large bowl of chocolate ice cream, I’m likely to prefer a glass of cold root beer to another bowl of chocolate ice cream.

The preference for a glass of cold root beer rather than another bowl of ice cream doesn’t necessarily mean that the second bowl of ice cream would give me less satisfaction than the first bowl. It might or might not. But, in the circumstances, I would enjoy a glass of cold root beer more than another bowl of ice cream. (The concept of diminishing marginal utility may apply to particular things at particular times, but it is neither generally true nor a valid reason for redistributing income by force.)

UTILITY AND DEMAND

There are two classic microeconomic constructs that reduce wants, tastes, and preferences to discrete quantities: indifference curves and demand curves.

An indifference curve is said to depict the rate at which a consumer is willing to exchange units of product X for units of other products, while holding constant his level of satisfaction (utility) and his preferences (ordering of wants). Given the rapidity with which preferences can change, I see little utility in indifference curves — except as a pedagogic device.

A demand curve for X can be derived from indifference curves by showing how the amount of X preferred by the consumer varies with the price of X, where (at each price) the consumer chooses the mix of X and other economic goods that maximize his utility. (I use economic goods to stand for products — material items — and services, which require the use of material items but which aren’t material (e.g., a haircut, the use of a credit card to make a purchase).

But an individual’s wants, tastes, and preferences are fuzzy at any given time. So, an individual’s demand for X at any given time is fuzzy — and then it changes, in fuzzy ways.

The summation of all consumers’ demand curves for X yields, in theory, an aggregate or market demand for X at an instant in time — holding constant wants, preferences, income, and the prices of other goods. In other words, the demand for a given economic good is very fuzzy. It may be possible to estimate approximately the demand for a particular economic good for a brief period of time, though the approximation will necessarily come with a range of uncertainty.

SUPPLY: THE SATISFACTION OF WANTS

If demand is one blade of a scissor, supply is the other blade. By supply I mean the ways in which human beings contrive to satisfy at least some of their wants some of the time. Supply comes in three basic forms: individual action, cooperative behavior, and voluntary exchange.

Individual action is just that: what each of us does to satisfy his wants without the help of others, and without recourse to the exchange of one’s resources for the resources of others.  Needless to say, individual action is limited mainly to Robinson Crusoe cases: situations in which a person must fend for himself, to the best of his ability and given the resources at hand.

Cooperative behavior is more relevant to the satisfaction of wants. It is the kind of behavior that wasn’t uncommon in the rural America of decades past, when each farm family operated as an economic unit. The combined efforts of a family — joined at times by neighbors — yielded shelter, food, and (sometimes) clothing, all of which were shared within the family.

To the extent that the family’s efforts failed to yield all of the kinds of food and clothing wanted by the family, it would then turn to voluntary exchange. It would trade some of its products (or labor) in order to acquire things that it could not produce or — this is a key point — could not produce as efficiently as another family or business. Voluntary exchange is of course today’s main mechanism for satisfying wants.

Voluntary exchange in a complex economy is a roundabout process, through which persons with marketable skills (e.g., real accountants) trade their services for monetary income, which enables them to choose from myriad products, services, and investment vehicles.

SUPPLY CREATES DEMAND (BUT NOT VICE VERSA)

Say’s law — popularly rendered as “supply creates its own demand” — is explained by Steven Horwitz in “Understanding Say’s Law of Markets“:

In the passage where he gets at the insight behind the notion that supply creates its own demand, Say writes: “it is production which opens a demand for products. . . . Thus the mere circumstance of the creation of one product immediately opens a vent for other products.” Put another way, Say was making the claim that production is the source of demand. One’s ability to demand goods and services from others derives from the income produced by one’s own acts of production.

Can demand exist without supply? Only if the person who wants something but lacks the wherewithal to pay for it is able to finance his purchase in one of three lawful ways:

  • He may receive a gift of money. But that gift reduces the purchasing power of the giver, either directly as a subtraction from his income or indirectly as a subtraction from his wealth. So the net effect on the demand for all goods may be zero.
  • He may receive a subsidy from government. But the subsidy reduces the purchasing power of the persons who are compelled to finance it through taxes, or the purchasing power persons or companies who are able to borrow less because government borrowing (to finance the subsidy) displaces their borrowing.
  • He may receive credit, either from the seller or a third party. Credit usually will be extended on the basis of the borrower’s prospective future earnings.

The third case is the only one that clearly results in an additional demand for goods. And it is the one in which demand is financed by supply. Demand creates supply only when demand is financed by a claim on the demander’s future supply of economic goods. The ability of a creditor to finance demand rests ultimately on the creditor’s previous production (and sale) of economic goods.

The Keynesian proposition that demand can create supply of thin air, simply by throwing money at unemployed resources, is a fantasy perpetuated by mathematical trickery.

MEANINGLESS AGGREGATION

Are you better off, as a consumer, than you were 5, 10, or 15 years ago? That’s a question which only you can answer. And the answer won’t necessarily depend on your rate of spending today as compared with your rate of spending 5, 10, or 15 years ago. It will depend on how you — and only you — feel about the enjoyment that you derive from your expenditures.

Like you, A and B will derive different kinds and amounts of enjoyment the goods that they buy. And those different kinds and amounts of enjoyment cannot be summed because they are unique to A and to B, just as they are unique to you. If meaningful aggregation is impossible for A and B, how can it be possible for an economy that consists of millions of economic actors and an untold variety of goods and services? And how is it possible when technological change yields results such as this?

GDP, in other words, is nothing more than what it seems to be on the surface: an estimate of the dollar value of economic output. It is not a measure of “social welfare” because there is no such thing.

Social Accounting: A Tool of Social Engineering

Steven Landsburg writes about social accounting here and here. In the first-linked post, Landsburg says:

Economic theory tells us that under quite general hypotheses, the private value of an activity is in synch with its social value. If growing an orange makes you a dollar richer, that’s because growing that orange makes the world a dollar richer. And that’s good, because it encourages people to grow all and only those oranges that are (socially) worth growing.

Here’s my version of the “general hypotheses”: People engage in voluntary exchange if it benefits them. The buyers of an orange is willing to pay the grower $1 for the orange because the benefit derived from the orange is worth (at least) $1 to the  buyer. At the same time, the grower is willing to sell oranges for $1 apiece because he expects (at least) to cover his costs if he sells oranges at that price. (His costs include the interest that he could have earned had he put his money into, say, an equally risky corporate bond instead of land, trees, and equipment.)

Now comes the hard part, which Landsburg skips. Does growing an orange and selling it for $1 really make the world a dollar richer? The buyer of the orange is “richer” (i.e., better off) only to the extent that the enjoyment/satisfaction/utility he derives from the orange is greater than the enjoyment/satisfaction/utility that he would have derived from an alternative use of his dollar. The alternatives include giving away the dollar, buying something other than an orange (maybe something less expensive that yields the buyer as much or more enjoyment/satisfaction/utility), and saving the dollar, that is, making it available for investment in, say, an orange grove.

It may be convenient to add the dollar values of final transactions and call the resulting number GDP (or GWP, gross world product). But adding $1 to GDP doesn’t mean that the world (or the U.S.) is $1 richer for it, even in the scenario described by Landsburg. For one thing, there’s no common denominator for enjoyment/satisfaction/utility, which are personal matters. For a second thing, the marginal gain in enjoyment/satisfaction/utility — the difference between first-best (buying an orange for $1) and second-best (e.g., saving $1) — is also a personal matter without a common denominator. (What’s more, there are many scenarios in which the addition of $1 to GDP makes the world poorer; for example: government entices workers into government service by offering above-market compensation, and then has those workers produce economy-stultifying regulations.)

As for the essential meaninglessness of GDP as a measure of anything, I borrow from an old post of mine:

Consider A and B, who discover that, together, they can have more clothing and more food if each specializes: A in the manufacture of clothing, B in the production of food. Through voluntary exchange and bargaining, they find a jointly satisfactory balance of production and consumption. A makes enough clothing to cover himself adequately, to keep some clothing on hand for emergencies, and to trade the balance to B for food. B does likewise with food. Both balance their production and consumption decisions against other considerations (e.g., the desire for leisure).

A and B’s respective decisions and actions are microeconomic; the sum of their decisions, macroeconomic. The microeconomic picture might look like this:

  • A produces 10 units of clothing a week, 5 of which he trades to B for 5 units of food a week, 4 of which he uses each week, and 1 of which he saves for an emergency.
  • B, like A, uses 4 units of clothing each week and saves 1 for an emergency.
  • B produces 10 units of food a week, 5 of which she trades to A for 5 units of clothing a week, 4 of which she consumes each week, and 1 of which she saves for an emergency.
  • A, like B, consumes 4 units of food each week and saves 1 for an emergency.

Given the microeconomic picture, it is trivial to depict the macroeconomic situation:

  • Gross weekly output = 10 units of clothing and 10 units of food
  • Weekly consumption = 8 units of clothing and 8 units of food
  • Weekly saving = 2 units of clothing and 2 units of food

You will note that the macroeconomic metrics add no useful information; they merely summarize the salient facts of A and B’s economic lives — though not the essential facts of their lives, which include (but are far from limited to) the degree of satisfaction that A and B derive from their consumption of food and clothing.

The customary way of getting around the aggregation problem is to sum the dollar values of microeconomic activity. But this simply masks the aggregation problem by assuming that it is possible to add the marginal valuations (i.e., prices) of disparate products and services being bought and sold at disparate moments in time by disparate individuals and firms for disparate purposes. One might as well add two bananas to two apples and call the result four bapples.

The essential problem is that A and B will derive different kinds and amounts of enjoyment from clothing and food, and that those different kinds and amounts of enjoyment cannot be summed in any meaningful way. If meaningful aggregation is impossible for A and B, how can it be possible for an economy that consists of millions of economic actors and an untold variety of goods and services? And how is it possible when technological change yields results such as this?

GDP, in other words, is nothing more than what it seems to be on the surface: an estimate of the dollar value of economic output. It is not a measure of “social welfare” because there is no such thing.

And yet, Landsburg (among many economists) seems to believe that it’s possible to measure “social welfare,” that is, to measure how much “richer” the world is because of voluntary exchange. (I wouldn’t think of accusing Landsburg or any other economist — Paul Krugman and Brad DeLong excepted — of equating government spending and “social welfare.”)

This isn’t a first for Landsburg. About four years ago he wrote this:

Suppose you live next door to Bill Gates. Bill likes to play loud music at night. You’re a light sleeper. Should he be forced to turn down the volume?

An efficiency analysis would begin, in principle (though it might not be so easy in practice) by asking how much Bill’s music is worth to him (let’s say we somehow know that the answer is $10,000) and how much your sleep is worth to you (let’s say $25). It is important to realize from the outset that no economist thinks those numbers in any way measure Bill’s subjective enjoyment of his music or your subjective annoyance. Only a crazy person would think such a thing, and I’ve never met anybody who’s that crazy in that particular way. Instead, these numbers primarily reflect the fact that Bill is a whole lot richer than you are. Nevertheless, the economist will surely declare it inefficient to take $10,000 worth of enjoyment from Bill in order to give you $25 worth of sleep. We call that a $9,975 deadweight loss.

Landsburg properly denies the commensurability of the two experiences, and then turns around and declares them commensurate. My comment, at the time:

The problem with this kind of thinking should be obvious to anyone with the sense God gave a goose. The value of Bill’s enjoyment of loud music and the value of “your” enjoyment of sleep, whatever they may be, are irrelevant because they are incommensurate. They are separate, variably subjective entities. Bill’s enjoyment (at a moment in time) is Bill’s enjoyment. “Your” enjoyment (at a moment in time) is your enjoyment. There is no way to add, subtract, divide, or multiply the value of those two separate, variably subjective things. Therefore, there is no such thing (in this context) as a deadweight loss because there is no such thing as “social welfare” — a summation of the state of individuals’ enjoyment (or utility, as some would have it).

Prices serve the useful purpose of helping individual persons and firms to move toward maximum utility and maximum profits. (I say “move toward” because the vagaries of life seldom accommodate the attainment of nirvana.) Prices do not — do not — enable the attainment of “efficiency,” that is, the maximization of “social welfare.” They cannot because there is no such thing.

Only a dedicated social engineer could believe that it’s possible to sum degrees of happiness across individuals, or claim that a public project is justified because the costs (imposed on one set of persons) exceed the benefits (enjoyed by a mostly different set of persons).

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Related posts:
Socialist Calculation and the Turing Test
Income and Diminishing Marginal Utility
Greed, Cosmic Justice, and Social Welfare
Positive Rights and Cosmic Justice
Utilitarianism, ‘Liberalism,’ and Omniscience
Utilitarianism vs. Liberty
Accountants of the Soul
Rawls Meets Bentham
The Case of the Purblind Economist
Enough of ‘Social Welfare’
Macroeconomics and Microeconomics
Social Justice
Positive Liberty vs. Liberty
More Social Justice
Luck Egalitarianism and Moral Luck
Utilitarianism and Psychopathy