Friday, December 5, 2008

How to build an efficient economy - Part I

Whether or not you believe a free market is the best means of benefitting the most people, a proper understanding of a free market is critical to economic understanding. Last month, I laid out where I'm coming from in my approach to economic theory. Below is a list of the basic assumptions we need to start with before we can determine effective policy:


1) The resources we have at our disposal are scarce - nothing that we have (as individuals or worldwide) is in infinite supply.
2) Humans are flawed (both individually and as a race). They want (and occasionally need) more of a given resource than is available to them.
3) Individuals (and individual states) place different values on a given resource. People (and states) are unique. They have different goals, desires and needs. It follows that they will value things differently.
4) An economy simply provides a means of allocating resources. The health of an economy is simply a measure of its efficiency in directing resources to those who most value them.
5) No economy is going to operate with perfect efficiency. There is no humanly possible way to allocate resources to those who need them most with 100% precision.

The above list states the reality of our condition on earth. We cannot change these rules by legislation any more than we can change legislate away gravity. Most often, the attempt is to change (or ignore) rule #2, but we cannot change human nature. Number 5 seems to be cast aside frequently - especially when it comes to necessities like energy or medicine.

It is my hope to put some flesh on these bones, to at least create an understanding of free market principles. Economics may seem cold and uncaring - that's because it is. Physics doesn't care about anyone, but we can use it to our benfit - provided we understand its laws. Biology doesn't care about anything, but when we understand it, we can use it for healing.

Likewise, Economics doesn't care who needs what, but by understanding the rules, we can build an economy that provides health and wealth for as many people as possible.

7 comments:

  1. I know it sounds loserish for one author of the blog to pat another on the back (mutual reinforcement and all that...), but I seriously hope people are reading this stuff. This is what we really need: good, clear economic thinking--teach 'em how that market works!

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  2. Another thing to keep in mind is that there are externalities that cannot easily be seen for years or decades. For example, a chemical company could make their products and pollute the land around them for years but be able to sell their product at a much lower price if they didn’t have to worry about these effects. These sort of consequences/externalities are not taken into account when the goods are bought unless there is regulation. Because a pure market economy assumes a purely rational and totally self interested parties. However, externalities/effects on others, such as pollution should be taken into account. Especially, for those who believe that they should do onto others as you would have done on to you.

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  3. Anon: I don't believe I made an argument that there should be zero regulation, at this point, I'm merely laying groundwork for developing sound economic policy. Any policy that pretends that we live in a world other than that described above is going to have negative consequences.

    I do agree that pollution is something to be concerned about - and I'd certainly like to touch more heavily on that subject at some point.

    I will mention, however that the law of diminishing returns ways heavily on issues such as pollution.

    To continue with the air quality example, as requirements become stricter (approaching 100% purity), the costs will become greater - and the benefits become negligible.

    Often times, people tend it ignore this - and act as if there are no costs - and that any amount of particulate matter in the air is just as dangerous as if you were breathing directly from a smokestack.

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  4. Also John, I never said that you said that you were in favor of no regulation. I was just want to make the case that some regulation is very sensible and rational. I don’t think anyone wants absurd regulation such as to the point that we have no heat or electricity for example. However, we must recognize that there are externalities in a pure market economy that need to be accounted for because the a pure market economy doesn’t take account for them properly.

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  5. I hear you - and greatly appreciate your comments - the main point of this post was to set a starting point.

    I'll be fleshing things out over the next several weeks. I figured that was easier both to write and to read if I built from an extended series of shorter posts than one giant ramble :)

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  6. Not the other anonDecember 8, 2008 at 8:05 PM

    1) Agree
    2) Disagree -- I don’t think I want more petrol than is available to me. Neither do I want a baseball signed by Ty Cobb.
    3) Agree
    4) This shows a fundamental flaw in humanity also. We don’t necessarily direct the resources to those that “value” them most, but to wherever we can get the things most valuable to us. If a loaf of bread costs me 10 cents to make and sell, to whom am I going to sell it? To the one that will pay $1? Or to the one that can pay only 11 cents?
    5) Again, an economy is not going to direct resources where they are needed (or even where those resources are wanted). There are vast areas of the world where people are in desperate need of HIV medication, nevertheless people die.

    I think this write-up would be better if you were more careful with the terms want, value and need. Also, please define them.

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  7. NTOA:
    1) Nothing to really answer since we agree on this
    2) Regarding oil, unless you consume no plastics, don't drive and generate all of your home energy from other resources, you DO use more than is available to you. At some point in the next week or two, you will likely exchange something of value (in this case money), that could be used to acquire other goods and services. In economics, this is referred to as "opportunity cost". You are foregoing some other opportunity to fill your gas tank.
    As far as the Ty Cobb baseball, this is really an example of item #3 - even though there is little or nothing you would forgo to acquire said item, there are more individuals who place some value on Ty Cobb baseballs than exist in the world.
    Also while you do not particularly care about Ty Cobb, you do place some value on the resources that make up the baseball. That value is not likely very high since leather, string (and ink) are relatively abundant items.
    3) We agree here
    4 & 5) I think you misunderstood these points. I was not saying anything about what we (the US, individuals, or world states) do, I was simply explaining what economies do. 4) stated that we measure an economies health based on how efficiently resources are allocated to those who value them the most. A good (or healthy) economy maximizes that efficiency - placing valuable resources are placed in the hands of those who value them the most - and with as little waste as possible. 5) stated that no economy can perfectly allocate those resources. There will always be individuals who are unable to aquire resources they value highly - regardless of what policies are in place. Your comment regarding HIV simply indicates that economies in those areas of the world are functioning poorly. This does nothing to refute #5 - it is an example of an unhealthy economy (as defined in #4). It would certainly be worthwhile to take a look at the economies of African nations and determine the reasons for such gross inefficiency.

    Your point about defining "need, want and value" is well taken. For purposes of this series, you can take them to mean the same thing - what is an individual willing to give up to obtain a particular good or service. In otherwords, what "opportunity cost" is acceptable.

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