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Things to consider when reading Mankiw 9th ed. Chapter 1: Ten Principles of Economics

Summary:
From Rod Hill and the WEA Textbook Commentaries Project The definition of economics. Mankiw begins by defining economics: “Economics is the study of how society manages its scarce resources. In most societies, resources are allocated … through the combined choices of millions of households and firms. Economists therefore study how people make decisions” about working, spending, saving and investing their savings. Economists “examine how the many buyers and sellers of a good together determine the price at which the good is sold at the quantity that is sold.” (p.1) With this definition, the ‘economic problem’ becomes how to allocate scarce resources efficiently, i.e. putting them to their most valuable uses. This definition also sketches out the framework developed throughout the book:

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from Rod Hill and the WEA Textbook Commentaries Project

  1. The definition of economics.

Mankiw begins by defining economics: “Economics is the study of how society manages its scarce resources. In most societies, resources are allocated … through the combined choices of millions of households and firms. Economists therefore study how people make decisions” about working, spending, saving and investing their savings. Economists “examine how the many buyers and sellers of a good together determine the price at which the good is sold at the quantity that is sold.” (p.1)

With this definition, the ‘economic problem’ becomes how to allocate scarce resources efficiently, i.e. putting them to their most valuable uses. This definition also sketches out the framework developed throughout the book: individual households and firms interacting in markets are the basic units of analysis. Government is put in the background in a supporting role.

This definition of economics is stated as fact, apparently not involving any value judgements. In fact, normative choices, that is choices involving values and moral judgements, are inescapable even in deciding how to define economics.

Emily Northrop points out that the assertion that resources are scarce is based on the idea that not everyone’s wants can be met given our limited resources. This is true, but (she writes) “to say that this inability is our fundamental economic problem is a normative choice.” Implicitly, it treats all desires equally, such as “one person’s desire to obtain a subsistence diet with another person’s desire for precious jewellery” (2000, p. 54). No distinction is made between basic needs and wants which arise because of what others have (e.g. ‘keeping up with the Joneses’). Defined in this way, the economic problem can never be solved because resources will always be scarce.

For a different view, Northrop cites John Maynard Keynes, the most influential economist of the 20th century. In an essay in 1930, Keynes described the economic problem as the “struggle for subsistence”, in other words the problem of meeting everyone’s basic needs. He conjectured that this could be achieved within 100 years.

Consider an alternative definition of economics that emphasizes needs, as opposed to wants. In Microeconomics in Context, Goodwin and co-authors (2019, p.20) define economics as “the study of how people manage their resources to meet their needs and enhance their well-being.”

Defining economics in this way leads to an exploration of different questions. What are people’s needs? How can our resources and economic life be organized to meet them? What enhances human well-being?

Such questions do not arise from the standard definition of economics found in Mankiw’s text. That approach implicitly assumes that the pursuit of efficiency will improve well-being by providing people with more and more to consume. (The effects of increased consumption on well-being will be considered in the commentary on Chapter 21.)

  1. Ten Principles of Economics

This set of commentaries deals with microeconomics, so the last three principles dealing with macroeconomics will be ignored. For the rest, mostly brief comments are in order here because more detailed commentary is best placed in the chapters where these ideas are set out in more detail.

(i) People Face Trade-Offs

In illustrating this idea, Mankiw claims that society faces a trade-off between efficiency, “getting the maximum benefits from its scarce resources”, and equality, distributing those benefits “uniformly among society’s members”. He writes: “when the government tries to cut the economic pie into more equal slices, the pie shrinks.” This is explained in just one sentence: “When the government redistributes income from the rich to the poor, it reduces the reward for working hard; as a result, people work less and produce fewer goods and services” (p.2).

As will be explained in the commentary on Chapter 20, this superficially plausible theoretical explanation is too simplistic. Moreover, there is good evidence that high levels of inequality shrink the economic pie, and that policies that reduce inequality can actually increase the size of the pie.

In comparison with other texts, Mankiw’s description of a trade-off between efficiency and equality is unusual. Almost all other texts describe a trade-off between efficiency and equity. As we will see, Mankiw will treat efficiency as one of the final goals that policy makers could attempt to attain. But no one advocates equality of incomes as a final goal; some income inequality is typically considered equitable for a variety of reasons, including the fact that different people have different needs. In that case, attaining greater equity means reducing income inequality to an acceptable level. Does framing the choice between efficiency and the unattractive goal of equality bias the reader’s judgement in favour of efficiency?

(ii) Principle 2: The Cost of Something Is What You Give Up to Get It

Choosing to do one thing necessarily involves giving up the opportunity of doing something else. Every cost in economics is really such an opportunity cost. Rational choice between alternatives requires considering opportunity costs. The textbooks, along with most economic theory, simplify the situation by assuming perfect information about available alternatives (or, that possible outcomes of choices can be described in terms of known probabilities). However, many decisions are made in conditions of fundamental uncertainty, as in the examples given in the next section.

(iii) Principle 3: Rational People Think at the Margin

This principle is useful in deciding whether to have another cup of coffee, but such marginal decisions in a situation of good information apply to only some of the decisions that people make. Many of life’s most important decisions are not taken at the margin. They are also taken in the absence of information about the ultimate consequences. Imagine that you are trying to decide whether to major in economics, in sociology or in accounting. Each choice would result in a completely different life. Or consider a large business firm whose managers are trying to decide whether to make a major investment in a production facility, a non-marginal decision. They simply lack the information about future market conditions to estimate its profitability. Thinking of their decision as a rational weighing of benefits and costs misses the essence of the situation (Keynes, 1936, Ch. 12).

(iv) Principle 4: People Respond to Incentives

People do respond to incentives, but their responses to incentives can be more complex than simple economic theory assumes. For example, some economists, including Mankiw, have advocated paying people to get vaccinated against Covid-19 and some state governments in the United States have experimented with various rewards.

However, psychologists and behavioural economists (i.e. economists who apply psychological research to economic questions) have found that offering monetary incentives can influence how people think about the activity. In this case, some people could conclude that payment is offered because the vaccine is risky; the higher the payment, the higher the perceived risk.

Behavioural economists and others have also found that people motivated by prosocial behaviour, such as donating blood because it benefits others, may reduce that behaviour if offered some monetary reward. Because getting a vaccine benefits others by reducing their chances of getting infected, this could be an issue here as well.

In short, whether and how incentives work depends on the details of the particular situation.

(v) Principle 5: Trade Can Make Everyone Better Off

Mankiw summarizes the principle this way: “Trade between two countries can make each country better off. To see why, consider how trade affects your family.” After pointing out that people specialize in particular kinds of work and trade with others, he writes: “Like families, countries also benefit from being able to trade with one another. Trade allows countries to specialize in what they do best and to enjoy a greater variety of goods and services” (p.6).

Comparing countries to families is fundamentally wrong. It obscures the fact that countries are made up of many different families, some of whom will gain from increased trade and some of whom will be worse off (for example if they lose their jobs because of increased import competition). Economists have no basis for saying that a country as a whole is better off after trade. This necessarily involves a value judgement about the gains and losses in all, about which reasonable people can disagree. (This will be examined further in the Commentaries to Chapters 3 and 9.)

(vi) Principle 6: Markets Are Usually a Good Way to Organize Economic Activity

Mankiw describes a market economy where millions of self-interested firms and households interact, their decisions guided as if by an invisible hand (Adam Smith’s metaphor) to “reach outcomes that, in many cases, maximize the well-being of society as a whole”. He writes: “As a result of these decisions, market prices reflect both the value of a good to society and the cost to society of making the good” (p.7). If governments then alter prices through taxes or other policy measures, they impede “the invisible hand’s ability to coordinate the decisions of households and firms”, adversely affecting the allocation of resources.

As will become clearer later in the book, what Mankiw is describing is an imaginary market economy with very special features that bears no resemblance to the economy in which we live. It’s an economy where no seller has any choice about the price it sets, and no buyer has any bargaining power over the price. All producers in a market sell identical products. Everyone has perfect information. There is no pollution or any other costs (or benefits) experienced by third parties; the buyers and sellers in each market experience all relevant benefits and costs. That’s not a complete list, but it gives a sense of the limitations of the market economy Mankiw has in mind.

Real economies have characteristics quite different from this and these result in a radically different outcome. Joseph Stiglitz of Columbia University (and a recipient of the Nobel Memorial Prize in Economics) writes that “Adam Smith’s invisible hand may be invisible because, like the Emperor’s new clothes, it simply isn’t there; or if it is there, it is too palsied to be relied upon” (1991, p.5).

Yet despite this, Mankiw writes: “One of our goals in this book is to understand how this invisible hand works its magic.” This raises a critical question: Is the theoretical economy in which the invisible hand “works its magic” a useful framework to analyse the real economy? Or is Joseph Stiglitz correct in saying that it is “of limited relevance to modern industrial economies”?

(vii) Principle 7: Governments Can Sometimes Improve Market Outcomes

Mankiw writes: “One purpose of studying economics is to refine your view about the proper role and scope of government policy” (p.9). How will it do that? “As you study economics, you will become a better judge of when a government policy is justifiable because it promotes efficiency or equality and when it is not” (p.10).

In Commentaries on future chapters, we will have to consider carefully how the effects of government policy are analysed and portrayed. Mankiw is saying that these accounts will influence students’ ethical judgements about the role of government in society. Mankiw himself thinks that studying economics tends to make students more conservative. We will see in Commentaries on later chapters why the textbook presentation might indeed have this effect.

REFERENCES

Goodwin, Neva, J. Harris, J. Nelson, B. Roach and M. Torras (2019) Microeconomics in Context, 4th edition, Routledge.

Keynes, J.M. (1936) The General Theory of Employment, Interest and Money.

Northrop, Emily (2000) ‘Normative foundations of introductory economics’, American Economist, 44(1): 53–61.

Stiglitz, Joseph E. (1991) ‘The Invisible Hand and Modern Welfare Economics’, NBER Working Paper No. 3641.

Related commentaries

Commentaries on the Invisible Hand theme

Goodwin – Is efficiency always the goal?

Zaman – Normative Foundations of Scarcity

Zaman – Hunger as the Primary Economic Problem

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