Understanding the assumptions is critical in any analysis, and especially for economics. We all have presuppositions and whether we understand it or not, we each have a worldview which shapes the way we think. At this point I want to cover a few of the assumptions that will be made. In some cases, I will offer analysis and evidence in subsequent chapters; for now, I just want to provide a common frame of reference.
An assumption of methodological individualism is that only individuals make choices, suffer losses, and accrue gains. Of course we often hear that Walmart made a profit, or General Motors suffered a loss. And it’s true that those corporations did suffer losses or receive gains. But the relevant economic actors are always individuals, whether it’s the shareholder who will decide to increase or decrease her capital investment, or the company’s Chief Executive Officer (CEO) who will decide whether to expand or contract business operations in a given market. As the economist Ludwig Von Mises so graphically put it, “the hangman, not the state, executes the criminal.” Other social institutions are also not economic actors— whether the Federal Reserve or the Department of the Treasury. Individual agents will ultimately make decisions (whether as a result of group votes or on their own initiative), and will do so based on the incentives they face. Thus, only individuals choose; societies never do.
The assumption of methodological individualism does not preclude individuals from considering the social implications of their actions. It does not mean that societal norms and values don’t heavily influence the choices individuals make; they often do, and they can be very powerful. Those with a Christian worldview understand that we are both individuals as well as part of the body of Christ. We are individuals created in the image of God and purchased by Christ’s blood, and yet we’re also a social collective with differing gifts that should be in unity as the Godhead is. The point of the assumption of methodological individualism is simply this: social considerations guide individual choices by shaping incentives and values, but at the end of the day, an individual must choose.
Another key assumption of modern economics is that value is subjective. You can think of this as another way of saying “beauty is in the eye of the beholder.” You value an iPod in a certain way, and I may have a different value for it. There is no way to say that your value is correct and mine is false, because my value is always right…for me. But the same goes for you as well. Value is not objective; that is, it is not determined by a standard outside our own thinking. This is often a hard concept to understand, especially when others value things radically different than we may desire. For instance, why are baseball players paid so much, while teachers are paid relatively little? Isn’t teaching a much more socially valuable function? Maybe…maybe not. Who can judge?
Of course Christians have an objective source of truth; truth that can shed light on objective valuation. To the extent that our thinking corresponds to God’s thinking, we can objectively assess valuations. For example, Christians have a strong value for the dignity of life because humans are made in God’s image. Objectively, we know that human life is valued over animal life because we were created in God’s image, and the animals weren’t. We were created to be God’s agents to rule and subdue the earth (including animals). Yet, to claim certainty of how God will value any particular item is problematic. At best we may be able to say that Christians should value one item over another, but then by how much? In the end, we have our individual subjective valuations of what we believe represents God’s objective valuation.
Two additional assumptions seem true by all experience, so we can safely employ them in our analysis. First, people prefer more to less. I prefer six iPods to one iPod, even if I can only use one at a time. I might sell the rest; I may want a fully charged iPod around always. There are a myriad of other reasons to want more. But I usually want more. Yes, one could imagine a world where we all have millions of iPods in our houses and where each additional iPod is a bad thing, but that is not the world we live in and does not describe the economic choices that most of us make. A second similar assumption is that we prefer consumption today to consumption tomorrow. Or, as the character Wimpy in the Popeye cartoon used to say, “I’ll gladly pay you Tuesday for a burger today.” If you have the choice of having an ice cream cone right now or one next year, which do you want? Unless you are very full right at the moment, or for some strange reason don’t like ice cream cones, you’ll take the ice cream today. After all, who knows what tomorrow may bring (James 4:13-14)? Sooner is preferred to later, and we’ll see in chapter 5 that this means that we’ll have to pay more to consume today (interest) if we want to spend money that we don’t have.
The assumptions of methodological individualism (only individual people make choices—organizations don’t) and subjective value (people assign value based on their internal judgments) are key to our understanding of what some economists call acting man (yes, “acting man” includes females also!). Acting man makes choices by considering costs and benefits in action. Acting man continually assesses his current situation, makes plans to improve his situation, and acts based on those plans. His mind imagines a causal connection between means that are within his reach and ends he hopes to achieve.
Hopefully you can see yourself as an “acting man.” You may imagine what you are going to do this weekend. Introspectively, you may think that your weekend would be better if you went on a date or attended a football game. Internally, you consider what you might be able to do to get to go on a date (either ask someone out or communicate your availability) and compare that with the option of using some of your money to purchase a football ticket. In your mind, the benefits of the actions you decide to take to achieve these ends must exceed the costs. Every one of our actions includes an internal (often subconscious) cost/benefit analysis. This goes well beyond how we spend our money. Do I get out of bed this morning? Do I wear green or blue? Even these choices are assessed internally: do the benefits of staying in bed (more sleep) exceed the costs (being late for work or class, or a shorter shower than you like)? If I choose to wear green, it comes at a cost of not being able to wear blue (or red, yellow, or purple). Mentally, we assess whether the benefits of green exceed the benefits of other colors. While we may think “I just felt like green today,” we felt that way as a result of a cost/benefit calculation (perhaps subconsciously). Action implies choice, and choice implies cost/benefit calculation, and subjective cost/benefit calculation is a key part of our internal planning process.
Our internal planning process is not perfect, and often what we imagine will lead to something good is, in fact, quite bad for a variety of reasons. First, we may not have the right means/ends causal framework. In other words, I may think that if I do X, it will lead to Y, but in reality it will lead to Z. When I get Z instead of Y I will be disappointed, and this will guide my future planning process. Second, our plans are ours alone, and God may have other plans that do not agree with ours, such that our plans will be frustrated.
Economic analysis will often use models, which are a simplistic way of viewing the world. While simplistic, these models can provide significant understanding by isolating the important drivers of a market from lesser influences. You will see models employed in subsequent chapters, but for models to be effective, we often have to employ the assumption of ceteris paribus, or “all else equal.” As we change one variable, we assume all other variables stay constant. For example, if we are trying to understand the supply and demand for orange juice, we might assume a freeze in Florida reduces the supply of oranges. In our analysis we’ll hold other things constant, such as the demand to drink orange juice. In the real world, everything is changing simultaneously to a degree, but by assuming ceteris paribus we are able to learn how one economic change influences markets.
Plan coordination is one of the central features of an economic system. We all have plans ranging from what we want to do this weekend, to what we want to do this summer, to what we want to do in our vocation in life. Do I want to go to the concert or invite some friends to go to the movies? Should we go to Hawaii for our family vacation (yes!!) or stay closer to home to save money? Should I become a welder or a computer programmer? To answer each of these questions we must apply economic reasoning, and almost all of our choices are dependent upon the actions of others. If I decide I want to go to the concert, how can I be sure the band will be there? If the band decides to come, how can they be sure their bus driver will go? How can the bus driver be sure there will be gas stations along the way? What about food? When the band arrives, how do I know the concert hall will be open, that the facilities will be clean, or that there will be parking? How will I get to the concert?
You can probably stretch this line of thinking much, much further. The point is that even the simplest of choices usually depends on the actions of many others. How our plans fit in with their plans is crucial to a successful outcome. If the bus driver decides to go on strike just as the band gets on the bus, it may not be possible to get another in time to make your concert date. So how do markets solve these kinds of coordination problems between individuals? Understanding the plans of others is difficult, and the gathering of information is costly.
In our study, we will find that markets help with plan coordination because they are especially effective at transmitting essential information about others’ plans in a very efficient manner. Prices, as well as profits and losses, communicate enough information on the social value of scarce resources to give our plans a chance to succeed. If you want to become a computer programmer, you can see from job listings how much computer programmers are paid today. This will be one input to confirm you are on the right track (or not). If salaries are high and in a rising trend, that may indicate employers are demanding more computer programmers. If you ignore this critical piece of information, or it is not available for some reason, you might not know if your plans to become a computer programmer are compatible with a firm’s need for programmers. If you decide to go ahead and become a computer science major in college, and there is a glut of computer programmers when you graduate, you will have to some degree wasted resources, and your human capital (your talents and abilities) will not be effectively employed. As you develop your understanding of economics, you will learn about those institutions and rules that guide us to more effectively coordinate our plans with those of others. When we do have effective plan coordination, we will use capital and resources wisely. Conversely, when we find institutions and rules that inhibit plan coordination, we will find capital and resources squandered.
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