A First Look at Economics
2. What is economics?

Economics, it's now plain, is not just about money and material "stuff", as Paul seems to think.

True, economists have a few things to say about money, the stuff in your pocket---though it turns out that the stuff is a small part of money. And they have a great deal to say about the size of what they call the "output" of a company or a nation. That sounds like stuff---though it turns out that it involves all sorts of non-stuff like educational services and national defense. But economists are much more interested in the larger question of how human beings behave (which is never just about money) and how human communities organize the production and distribution of their goods and services (which is never just about material stuff). So economists have a lot to say about "supply and demand," yes, but also about freedom, justice, equality, and fairness.

In fact, some of the greatest economists have made fundamental contributions to political and ethical philosophy-the study of freedom, justice, and other values. Some of them are living and working on these issues today: Milton Friedman (b. 1912), James Buchanan (b. 1919), Kenneth Arrow (b. 1921), Amartya Sen (b. 1933), Nancy Folbre (b. 1949). Add oldsters such as Adam Smith, John Stuart Mill (1806-1873), Karl Marx (1818-1883), Vilfredo Pareto (1848-1923), Charlotte Perkins Gilman (1860-1935), Friedrich Hayek (1899-1992), Joan Robinson (1903-1983) and you see that economics is political philosophy as much as. . . money and stuff.

You do not need to memorize all these names, right now. Some of them you will encounter again in due course. At the end of this course you should be able to associate the names of six or seven prominent economists with a few key ideas. At this juncture, you could jot down in your notes that despite their sometimes profound intellectual differences, Milton Friedman, Amartya Sen, Adam Smith, and Karl Marx are each interested in the social and political implications of economic theory.

One eye of the economist is fixed on individual behavior, another on societal or communitarian organization and outcomes. That's why. If you come upon a one-eyed economist you should know that he does with one eye the work of two. Economic science works best when both eyes-the one that's fixed on the individual and the other one, looking at society-are working simultaneously. A little off balance, but charming. Economists try to understand individual behavior as part of a larger social system and they try to understand the larger social system by studying individual-level behavior. The dual focus-seeing individuals as part of society, and seeing society as made up of individuals-makes economics a social science.

The science-word begs for a definition. For example, many economists-including McCloskey, 1964 to 2006-define their subject as "the study of how people choose to employ scarce resources to produce and distribute goods and services." "Resource," by the way, does not mean as it often does in non-economic talk "natural resources," like coal or timber or land. It means merely "anything you can use to achieve an end," in other words, a means. This "study of how people choose" is the famous (and to some, the infamous) "means and ends" definition of economics we spoke of in the Preface for Students. The means and ends definition can be divided into three big questions: what, how, and for whom.

• The what question is about what people choose to produce. Do they choose to build ships, grow grain, or explore the universe? What mix of products do people want? What, in other words, are their ends?
• The how question is about how people choose to produce things. Do they want to rely on lots of human workers, or do they prefer heavy machinery and advanced technology? Do they want to rely exclusively on free enterprise or do they also want some government participation? What means do they use? What resources, in the economist's sense?
• The for whom question is about who gets the products and services that are produced. In other words, how will the economy's output (and the incomes derived from its production) be distributed? How will the economy determine the levels of workers' wages, business owners' profits, moneylenders' interest, and other forms of income?

Each of these questions-what, how, and for whom?-implies a choice. In fact, each entails a whole set of choices: choices by each individual about what to buy and what to do for a living; choices by each business about what to produce and how to produce it; and choices by entire communities (local, national, and international) about how to organize and regulate these production and distribution activities.

The emphasis on choice reflects the economist's awareness of resource scarcity. Were it not for scarcity we would not need to choose one thing over another. We could just have it all. If cars and hamburgers and houses fell costlessly from the heavens, there would be no need to decide if, how, or for whom to produce them. But scarcity exists. Everyone has a "want list" of things they want to acquire in order to improve their own life or the lives of others. Yet their resources (time, energy, talent, money) are limited. So they have to choose. If they choose to have more of X, they must sacrifice some of Y. Look at that again: choosing more of X means you have to have less of something, call it Y. It's the heart of economics, the idea of "opportunity cost," that is, the opportunity to get more of Y that you give up by actually getting more of X. Even rich people are forced to choose. That is, even Bill Gates faces scarcity. Should the rich person sponsor a new wing for the local art museum or set up a foundation to help feed the world's hungry? With the same resources, or means, she can't do both. This is scarcity.

When people want more than they can get from their available resources, scarcity forces them to make choices.

Study a few more hours or go to a movie? Buy a paperback book or order a pizza for two? We spend our life making choices based on scarcity and opportunity cost. Marriage, for example, involves in most cultures choosing one partner over numerous other potential partners. If you prefer a partner with high earning potential, or high earning potential coupled with physical beauty and your family's religion-you will experience scarcity and opportunity cost firsthand.

Concept Check 1: When economists say that every person's time is a scarce resource, what exactly do they mean? What seems to be the economic definition of a "scarce resource"?

Not all economists are thrilled with the "means vs. ends" definition of economics and its emphasis on choice. Some, as we mentioned in the Preface to Students, prefer a definition of economics that focuses more on the social systems or circumstances in which economic decisions and outcomes are forced rather than chosen. Following the abolition of slavery in the United States, free African American farmers worked under a legal system of unequal power called "tenancy." Tenant farmers did not own the resources they worked with; they leased them from a landlord at a price of one-fourth or even one-half of their annual revenue. The tenant system was especially horrible during times of drought, flood, or general economic downturn. Institutionalist and radical economists reject an approach to economics that relies exclusively on "choice" on grounds, for example, that tenant farmers did not choose to be poor and exploited. Such economists do not entirely reject scarcity and choice. But they believe that economics ought to have a more realistic historical and sociological grounding.

A Three-Minute History of Economic Thinking, Ancient Times to 1950

Economics first appeared prominently in the writings of the ancient Greek philosopher Aristotle (384-322 B.C.). In his economic thinking Aristotle was mainly concerned with the management of a household. The word "economics" is actually a composite of the Greek words oikos, which means house, and nomos, which means law or rule. To Aristotle economics meant something like what we call "home economics." He did not in fact have much to say about household economy, which was the work of women and slaves. But he developed an ethical perspective on the economic affairs of a household in relation to other households. One household trades with another in a market. In his discussion of markets Aristotle spoke of a "just" price, and was unhappy with profit and merchants and charging interest on loans. His aristocratic disdain for markets was gigantically influential in Western thinking. (Confucius [c. 551-479 B.C.) in China held rather similar views, with similar long-lasting effects on his culture.)

Fast forward to around 1700. Surprisingly little happened to economic thinking in the intervening twenty centuries. St. Thomas Aquinas (c. 1225-1274 A.D.) excused merchants, but clung to Aristotle's disapproval of charging interest and to the notion of a just price. But political thinkers in the seventeenth and eighteenth centuries viewed a nation as a kind of household, and what they called "political economy" was a study of the workings and governance of the national household. They were creeping towards economics, the householding on a national scale that Aristotle neglected. Many believed that a nation acquired wealth by exporting goods to other nations and thereby accumulating gold, a view that became known as mercantilism. Mercantilism (accent the "can") survives today in efforts by some governments to "protect" their domestic industries from foreign competition. We show why it doesn't make a lot of sense, but the mercantilists like Thomas Mun (1571-1641) were at least focused on the economy, instead of simple disdaining it. The aristocratic cum Christian distaste for anything to do with markets and profit was breaking down.

A group of French economists in the mid-1700s took the next step, seeing that free trade was good if profit was. But these so-called physiocrats also believed that a nation's wealth came only from agricultural production. That, too, is a mistake. Their ideas survive today in the U.S. and European Union farm programs, with their notion that agriculture is the foundation of economic prosperity.

Adam Smith (1723-1790), a Scottish ethical philosopher, set the economic conversation on a different and more fruitful track. In 1776, after 25 years of study, he published a book titled An Inquiry into the Nature and Causes of the Wealth of Nations. Though the book caused some stir at the time---the American Revolution was going on (Smith supported the Americans)---it became much more influential over the decades and centuries since. Many consider it to be one of the most important books ever written.

Dismissing the mercantilist position and amending the physiocrats, Smith advocated a policy of free trade inside and outside a country. For the first time someone got the accounting of national income almost completely right. The purpose of an economy, Smith said, is consumption, not exports. And consumption is made possible by labor in industry as much as in agriculture. In an earlier and equally distinguished book, The Theory of Moral Sentiments (1759), he had extolled the importance of a full set of virtues as an engine of ethical and social order, and of personal fulfillment. He emphasized in that book temperance among the virtues, and planned to write a book on "jurisprudence," that is, the theory of criminal and property laws, emphasizing the virtue of justice. In The Wealth of Nations he emphasized a third virtue, the virtue of prudence (wise self-interested action), and showed how it could provide the foundation for economic order and progress in a market-based economy.

Self-interest in Smith and in most Western ethical thinkers before his was seen as a virtue. Smith and Aquinas and others had warned of course that someone who attends only to prudence is a bad person, and a throng of bad people will create a bad society. But Smith argued---and this is what makes him unusual in the history of ethical philosophy---that a balanced prudence, or wise self-interest, may lead to good for society as a whole, through unintended consequences. By contrast, a butcher who out of compassion gives free meat to the poor will soon go out of business. His lack of prudence may end by hurting himself, his family, and the poor, who end up with no meat at all. But Smith did not advocate ruthless selfishness, "greed is good," or any such Wall-Street motto. He advocated bourgeois, that is, middle class, virtues.

Smith's vision was revolutionary. It justified taking economic power from princes and bureaucrats and letting the market work, the policy called laissez faire (a French phrase, pronounced "lay-zeh fair," meaning literally "let to do" --- that is, let [the market] be). It provided the ideology for the capitalism of the nineteenth and twentieth centuries and for the recent pro-market revolutions in Eastern Europe and the former Soviet Union.

Some were doubtful of Smith's theories. Karl Marx (1818-1883) stressed what he saw as the "exploitation" inherent in market capitalism. He popularized the very word "capitalism," meaning an economic system in which workers are legally free to sell their labor services yet generally not free to own or control the products of their labor. Marx saw capitalism as a dynamic and progressive system in comparison to slavery, feudalism, and other pre-modern modes of production. Like many other economists he overemphasized accumulation of capital as a source of high national income. He held out hope for a higher form of economy, a socialist or communist one, in which workers would finally gain control over the processes and products of their labor and thus realize what Marx saw as the highest form of human freedom: freedom from class exploitation.

Despite Marx's vigorous arguments, the mainstream of economic thinking in the 19th and early 20th centuries remained optimistic about market capitalism, as it came to be called. Scholars worked to refine their understanding of the determinants of market prices and the distribution of income. They invented such notions as demand and supply curves, elasticities, and opportunity costs - all of which advanced their understanding of market economies and are among the subjects we treat here.

The contentment among mainstream economists was shaken by the Great Depression of the 1930s. In many countries, and especially disastrously in the United States and in Germany, thousands of empty factories and long lines of people desperate for jobs showed a market economy derailed. Marx's prediction of capitalism's ultimate collapse seemed for a while to have been accurate, and many intellectuals became socialists. A well-known British intellectual, John Maynard Keynes (1883-1946; rhymes with "brains") helped to prevent a massive defection of economists to Marxism (and to fascism, the glorification of the state). He persuaded economists and political leaders, in Britain and to some degree in the United States, that a market economy could be made to work if guided at the national and international level by government. In truth someone else showed how to do it. That honor goes to Abba Lerner (1903-1982), a British-born migrant to the United States and a professor at Roosevelt University in Chicago, who had worked with Keynes. Economists and policymakers around the world began to study what Lerner called "functional finance": how governments could stabilize their economies through the raising and lowering of taxes or expenditures. These so-called Keynesian policies became common, at least in declaration. In practice, especially in the United States, government spending was ruled by war and peace, not boom and bust.

The effectiveness of Keynesian stabilization policies remains an unsettled issue. Some economists support them while others are skeptical or opposed. Research on the nature and effectiveness of markets continues within the laissez faire framework of Adam Smith. And there are economists who maintain that Marx was basically right after all. The ultimate question, you see, goes right back to old Aristotle: is an economy a household to be managed or a market to be left alone?