A Primer on How to Think about the Economy

“Economics is based on the concept of human action as purposeful behavior.”

These are the words of economist Per Bylund, whose new book How to Think about the Economy: A Primer (2022) offers a friendly introduction to economic thinking.

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The central insight of the book is that people act rationally, that is, for purposes or goals. This may seem obvious, but it often causes confusion. For example, it does not mean that people are always successful in achieving the goals they strive for, or that their goals are “reasonable” in the eyes of others. Rather, it means merely that people act to try to achieve what they value. In other words, “value” (in this economic sense) is subjective. Furthermore, it also means that as a discipline the methodology of economics is individualist. Why? Because groups do not act–only individuals do. Writes Bylund:

People may choose to act in concert, but those are individual choices…That four people collaborate to lift and move a piano does not mean that the group lifted the piano but that four people coordinated their individual efforts toward that common end.

This insight clarifies another confusion. Many people believe that economics promotes free markets. But economic analysis is in fact a neutral discipline—it cannot tell us whether we “ought” to make one choice compared to another, or promote one policy relative to another. Instead it makes us aware of the trade-offs involved in the choices we make. Bylund makes this point by noting that economics no more “promotes” free markets than physics “promotes” free-fall. Rather, economic reasoning cannot do without the free-market model, just as the reasoning of physics cannot do without the free-fall model.

Moreover, because economic methodology is individualist, data regarding the overall (or “macro”) economy—data like “GDP,” “the unemployment rate,” “aggregate demand,” etc.—are of limited value when it comes to grasping the underlying workings of the economy, the “whys” of exchange. Bylund demonstrates this with the following example:

Let’s say Adam offers Beth an apple and Beth gives Adam a quart of milk in return. There are two ways we can analyze this exchange. One is to study it empirically by observing the exchange in real life and collecting “objective,” that is, measurable data before, during and after the exchange.

But the problem with this method is that the “objective data” do not tell us why the apple shifted from Adam’s into Beth’s possession. All it tells us is that one person (Beth) has an apple and that another person (Adam) has milk. But because we can understand the exchange in terms of rational choice, we can in fact know why the trade occurred. Because people act with an end or purpose in mind, we know that Adam and Beth traded because they both believed that the trade would leave them better off. Simply put, we can say why the trade occurred and not merely that a trade occurred.

Note, furthermore, the concept of pricing that this example introduces. Prices are the exchange ratios of various goods and services, and they are determined by the subjective value of individuals. Beth’s and Adam’s subjective preferences regarding milk and apples set the exchange ratio—or price—between the two goods: in this case, the “price” of one apple was one quart of milk.

While this illustration involves a direct exchange of goods (“barter”), we can also conduct indirect exchanges using money, which serves as a medium of exchange in the modern economy.

To facilitate this, money must retain its value. Periods of inflation (increasing the money supply) or deflation (reducing the money supply) can result in sand being dumped into the gears of exchange, which causes trade to slow down. Nevertheless, even though increasing the money supply generally causes prices to rise, it does not necessarily follow that there is a one-to-one correspondence between the rise in its supply and the subsequent rise in prices. As Bylund notes, a “doubling of the money supply will not double all prices.” Why? “Because people do not react in the same way or at the same time to the doubling of their cash.” If someone buys, say, three bananas and suddenly his cash doubles, it does not necessarily mean he will buy six bananas. Perhaps the extra cash will be spent on another good, or simply be put in the bank.

Furthermore, this also helps illuminate why economic prediction is a risky business. People are not like pieces on a checkerboard that can be easily controlled and anticipated. Rather, people have free will. They act to achieve their desired ends, which change relative to the opportunities and trade-offs that spontaneously emerge in light of billions of others doing the same. Economic forecasting looks at a snapshot of the economy at a single moment in time (and typically an old moment, as economic data are generally available only after the fact rather than in real time) and projects it forward. But the economy is not a snapshot, it is a process of billions of individuals acting in concert with each other. Hence the difficulty of forecasting what the economy might do a year from now, or even a month from now.

But these are merely a sampling of issues the reader will encounter in How to Think about the Economy, and for anyone wondering where to begin, it is an ideal introduction to the subject.

This article was originally published on FEE.org. Read the original article.