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The economics you need


T H E E C O N O M I C S YO U NE E D

This short book offers a rigorous yet user-friendly introductory guide for
students who need to grasp the essential concepts of economics quickly. It
provides a serious, clearly understandable, and systematic account of the key
elements of economics, with a focus on theory and principles.
The Economics You Need provides the ideal introduction for students
approaching economics from other academic disciplines, as it uses only a
limited amount of economics jargon, and is constructed so that several chapters
can be read independently of the others. This book is structured around the
premise that a set of theoretical steps are necessary for understanding economics
as a way of thinking, rather than as a set of solutions. It also encourages the
reader to consider alternatives to common assumptions, to acknowledge the
need for value judgements and to foster fresh thinking in an imperfect world.
This engaging primer will be essential reading not only for students of
economics, but also for students with a background in disciplines such as
politics, law, international relations, and business studies.
Enrico Colombatto is Professor of Economics at the University of Turin,
Italy, where he teaches ‘Foundations of Policymaking’, ‘International
Economics’, and ‘Growth and Development’. He is the head of research at

IREF (Institut de Recherches Économiques et Fiscales, Luxembourg) and a
Senior Fellow at GIS (Geopolitical Information Service, Liechtenstein).


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TH E E CON O M IC S
Y O U N EE D

Enrico Colombatto


First published 2016
by Routledge
2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN
and by Routledge
711 Third Avenue, New York, NY 10017
Routledge is an imprint of the Taylor & Francis Group, an informa business
© 2016 Enrico Colombatto
The right of Enrico Colombatto to be identified as author of this work
has been asserted in accordance with the Copyright, Designs and
Patent Act 1988.
All rights reserved. No part of this book may be reprinted or
reproduced or utilised in any form or by any electronic,
mechanical, or other means, now known or hereafter
invented, including photocopying and recording, or in any
information storage or retrieval system, without permission in
writing from the publishers.
Trademark notice: Product or corporate names may be trademarks or
registered trademarks, and are used only for identification and
explanation without intent to infringe.
British Library Cataloguing in Publication Data
A catalogue record for this book is available
from the British Library
Library of Congress Cataloging in Publication Data
Names: Colombatto, Enrico, author.
Title: The economics you need / Enrico Colombatto.
Description: Abingdon, Oxon ; New York, NY : Routledge, 2016.
Identifiers: LCCN 2015040251 (print) | LCCN 2015042933 (ebook) |


ISBN 9781138963108 (hardback) | ISBN 9781138963115 (pbk.) |
ISBN 9781315658988 (ebook)
Subjects: LCSH: Economics.
Classification: LCC HB171 .C764 2016 (print) |
LCC HB171 (ebook) | DDC 330--dc23
LC record available at http://lccn.loc.gov/2015040251
ISBN: 978-1-138-96310-8 (hbk)
ISBN: 978-1-138-96311-5 (pbk)
ISBN: 978-1-315-65898-8 (ebk)
Typeset in Bembo
by Saxon Graphics Ltd, Derby


C ONTE NT S

List of figures
Acknowledgements
Introduction
1

The economic way of thinking
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8

2

ix
xi
xiii
1

On the nature of economics and the importance of methodology 1
From economics to policy-making 2
Methodological individualism and the micro–macro divide 3
Time: statics, dynamics and uncertainty 5
Failures: social justice, transaction costs, externalities 7
Exchange, opportunity costs and surplus 11
Free lunches and the surplus 14
Summing up 16

The economics of consumption
2.1 Price takers, price makers and market power 18
2.2 Why does the demand curve slope downward? 19
2.3 Demand curves are imaginary and partial 21
2.4 When the demand curve moves 22
2.5 Preliminary conclusions 24
2.6 Intertemporal consumption and the rate of interest 25
2.7 Tampering with the future 27
2.8 From the demand curve to the consumer’s surplus 28
2.9 The cost of living 32
2.10 A word on happiness 36

18


CONTENTS

3

The economics of production and growth
3.1
3.2
3.3
3.4
3.5
3.6
3.7
3.8

4

38

What can the economics of production tell us? 38
Production functions, technologies and productivity 38
Some words of caution 41
From traditional production theorising to growth 43
The world of the firm: owners and managers 44
Productive entrepreneurs: who are they and what do they need? 46
The alternatives: planners, bureaucrats and non-profit organisations 48
The consequences for growth 51

Cost theorising and supply curves

55

4.1
4.2
4.3
4.4
4.5
4.6

Total costs and cost-efficiency 55
Fixed, sunk and variable costs 58
Average costs 60
Marginal costs and supply curves 63
Cost efficiency and supply 66
Supply curves for the industry and competitive price setting:
the short run 67
4.7 Supply curves for the industry: the long run 70
4.8 Do externalities justify tampering with supply curves? 71
5

Competition and its enemies

74

5.1 Where do prices come from? 74
5.2 On competition as usually understood 77
5.3 Ideal output and the fair sharing of the surplus 78
5.4 Antitrust intervention 80
5.5 An introduction to free competition 82
5.6 Three categories of barriers 83
5.7 Fair profits and rightful profits 84
5.8 Profits, quasi-rents and normative rents 86
5.9 Rent-seeking 87
5.10 Rent-seeking: how much does it cost and why can’t we get rid of it? 88
5.11 So, what have we learned? 89
6

Taxation and regulation

91

6.1 On the role of government 91
6.2 On tax targeting, tax collecting and tax paying 91
6.3 The irrelevance of tax collection 92

vi


CONTENTS

6.4 An extension to non-competitive contexts 94
6.5 The social losses of taxation in the goods markets 95
6.6 Efficient taxation and elasticities 98
6.7 An extension to the labour market 100
6.8 On efficiency, retroactive taxation and legal monopolies 101
6.9 On proportional, progressive and regressive taxation 102
6.10 On regulation: what you see … 104
6.11 … and what you don’t see 106
7

Money and banking

109

7.1 On the birth and nature of commodity money 109
7.2 From commodity money to banknotes and cheques 110
7.3 Modern banking and bank credit 111
7.4 The relationship between credit and basic money 114
7.5 Getting closer to the real world: monetary aggregates 116
7.6 Getting closer to the real world: central banking 117
7.7 Getting closer to the real world: fiat money 117
7.8 On the economics of fiat money 118
7.9 The nature of monetary policy and the economics of inflation 119
7.10 A note on the rate of interest 120
8

International trade
8.1
8.2
8.3
8.4
8.5
8.6
8.7

9

123

The benefits from trade 123
Why do people fear free trade? 125
Who trades what? The theory of comparative costs 127
Agglomeration 128
The role of institutions 129
Intra-industry trade in manufactured goods 131
Trade patterns and trade statistics revisited 132

Exchange rates

134

9.1
9.2
9.3
9.4
9.5

An introduction to exchange rates 134
Simple exchange-rate economics: the gold standard 135
Devaluation under a gold standard: the short run 135
Devaluation under a gold standard: the long run 136
Deflation, trade imbalances and capital movements under a
gold standard 137
9.6 Paper money and flexible-exchange rates 138

vii


CONTENTS

9.7 Competitive devaluations, capital movements and the strength
of a currency 140
9.8 Paper money and flexible-exchange rates: forward markets 141
9.9 Paper money and flexible-exchange rates: arbitrageurs at work (I) 143
9.10 Paper money and flexible-exchange rates: arbitrageurs at work (II) 145
9.11 Fixed-exchange rates 148
9.12 Currency boards 150
9.13 Monetary unions 151
10 On growth, poverty and crises

154

10.1 Basic concepts 154
10.2 What do we mean by growth? The issues of measurement
and aggregation 155
10.3 What makes the difference between stagnation and growth?
Innovation! 158
10.4 Technological progress: science and engineering 159
10.5 Skills, entrepreneurship and investments: why institutions matter 160
10.6 Preliminary conclusions: what have we learned about growth? 162
10.7 What about poverty? 164
10.8 Business cycles, booms and crises 166
10.9 Final remarks 169
Glossary
Index

172
181

viii


FIGURE S

1.1
1.2
1.3
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
3.1
3.2
4.1
4.2
4.3
4.4
4.5
4.6
4.7
4.8
4.9
4.10
4.11
5.1
5.2
6.1
6.2
6.3
6.4
9.1
9.2

Alicia would like to sell Y and buy X
Bob would like to sell X and buy Y
Alicia and Bob exchange
The demand curve
The demand region
Movements of the demand curve
Movements along/of the demand curve
Consumer’s surplus
Consumer’s surplus
Changes in consumer’s surplus
Changes in consumer’s surplus
The production function
The production–possibility frontier
The total-cost curve
Average cost curves
Average costs
Marginal costs
The supply curve of the firm
Desirable supply
Industry supply curve: the short run
Competitive equilibrium
Shifts in the supply curve
Long-run changes in industry supply
Subsidised supply
Pricing under perfect competition (a) and monopoly (b)
The perfectly competitive industry
Equilibrium after a tax on a good or service (a) and (b)
Taxes in the labour market
The deadweight loss of taxation
The role of the elasticities (a) and (b)
The effects of a devaluation
The exchange rate and the money supply

13
14
14
20
22
23
24
29
30
34
36
39
53
56
61
62
64
65
66
68
69
70
71
72
76
78
93
95
96
99
137
139


FIGURES

9.3 The exchange rate and productivity
9.4 Forward exchange rates and expectations
9.5 Spot and forward exchange rates
9.6 Arbitrage when interest rates differ
9.7 Arbitrage after a change in interest rates
10.1 Catching-up
10.2 Slowing-down

x

140
143
145
146
147
163
164


AC KNOWLE DGEMEN T S

I am grateful to many friends and colleagues for having read parts of this book.
In particular, Stefano Adamo, Fabio Bagliano, Emiliano Brancaccio, Claudio
Campanale, Christine Henderson, Paul Lewis, Henry Manne (†), Mario
Pagliero, Simone Pellegrino, Mario Pezzino, Ben Powell, Valerio Tavormina,
Larry White who offered valuable suggestions, criticisms, and helped me
improve the substance and the presentation of these chapters.


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INTRODUC T I O N

Economics studies how people behave and interact in order to improve their
well-being in an environment characterised by scarcity. While economics as a
field of study dates only to the eighteenth century, humankind has always been
confronted with economic problems, as long as labour has been necessary for
survival and the supply of resources has been smaller than the demand for
them. Over the long course of human development, we have made huge
progress, by learning to make the right choices, to cooperate, and to take
advantage of our talents and intuitions in order to produce increasingly large
amounts of goods and services. As a result, we have been remarkably successful
in alleviating the scarcity constraint, avoiding starvation, and enhancing both
our life-expectancy and our well-being.
Certainly, this development has not always been a smooth process. Many
mistakes have been committed, especially when groups of individuals have
resorted to fraud and violence to force other individuals to go against their
preferences and their beliefs, or when looting has been more profitable than
working. Yet, it is indisputable that most people today enjoy standards of living
that would have been unimaginable even one or two centuries ago.
It is also true that interest in economic matters has increased significantly
among all layers of the population in recent years. Why has this happened? On
the one hand, our ambitions have risen: we expect our living standards to
increase steadily, and we are interested in knowing how to make these
expectations come true. On the other hand, we become increasingly concerned
when we suffer setbacks, and when we feel we have fallen victim to economic
mismanagement and are missing opportunities. More generally, we have come
to appreciate that the fight against scarcity is not just a matter of happenstance
and good luck. Humankind is by no means condemned to stagnation or even
disaster, should the natural resources at its disposal be depleted. Rather, we are
now aware that alleviating scarcity depends on our ability to avoid wastages,
and to create new wealth through technological progress and entrepreneurship.
Since the eighteenth century, we also have learned that human behaviour in
the presence of scarcity follows fairly regular patterns which can be studied and
explained, and the consequences of which go beyond what the uneducated


I N T RO D U C T I O N

observer might at first glance perceive. Certainly, the economic interactions in
which most people engage today are considerably more complicated than those
in which the average individual engaged in the eighteenth century, yet the
insights inherited from the founders of modern economics remain valuable.
Loyal to this early heritage, our purpose is to investigate and help the reader to
understand the key categories of economic actions, in all of their complexity:
savings, consumption, production, competition, regulation, money, specialisation,
currency trade, and booms and busts. As the reader will see, economic actions
can be explained by individuals’ efforts to improve their conditions, and the
process through which they strive to reach their goals has always been a matter
of opportunity costs, a synonym for exchange driven by choice.
The purpose of The Economics You Need is to guide the reader through this
journey into the world of economic thinking, a world which can appear
complicated, but which need not be hopelessly complex. With the aim of
untangling some of these complexities, we have done our best to keep our
story simple, but not simplistic. This explains why the reader will find no maths
and no footnotes, and only a few straightforward figures. Thus, no previous
technical skills are required to understand the ideas developed in these pages.
Since we have preferred to give priority to the fundamental concepts and
mechanisms that characterise the economic mental framework, we have made
use of simple examples to illustrate the passages that are less intuitive. Hence,
we have avoided lengthy references to the complex situations that characterise
the real world, situations that would have forced us to engage in lengthy
digressions, and that would have certainly necessitated risky forays into other
disciplines. Likewise, we have also decided to avoid the debates regarding the
goals and nature of economic policy-making, because these debates lie beyond
economics, strictly speaking. In other words, this book will help the reader
learn how economists think and what kind of tools they use. Evaluating the
merits of choice and the desirability of the results is clearly important, but it is
an entirely different exercise, and should not be confused with economics.
Economics explains and is a value-free science.
The lessons in this book will also train the reader to resist a variety of
common temptations. He or she will learn that economics is not an exact
science, and that economists have no magic wands. When mechanics or
scientific formulae are applied to human interaction, disaster can easily
follow. Thus, prudence is in order: a good economist is one who uses
common sense, asks the appropriate questions, realises that many phenomena
are too complex to be explained by the right equation or the right model,
and thus, that he must be open to the suggestions offered by other disciplines
– history, psychology, philosophy and political science. Moreover, he will
also recognise that human beings are neither clones nor angels, and that when
unfettered human interaction fails to provide a desirable answer to an
economic problem, resorting to government intervention is not necessarily
the best solution. Policy-makers are also human beings: they are fallible, they
xiv


I N T RO D U C T I O N

respond to the incentives generated by the world of politics, and sometimes
they are less altruistic than might be desirable.
That said, our efforts to clarify and simplify economic processes have not
come at the cost of rigour. Although economics is not a hard science, its essence
is logical consistency and its arguments depend upon precise usage of
terminology, because ambiguity leads to confusion and contributes to blurring
the essence of the concepts. Rigour is therefore necessary, in terms of content
and of organisation. With regard to content, our quest for rigour explains why
we offer the reader a method that can be applied more or less systematically.
With regard to organisation, rigour means, for example, that the analysis of
price formation must be preceded by the study of demand and supply; and that
the origin and nature of the business cycle is unintelligible without previous
knowledge of how individuals can act rationally and yet fall victim to systematic
mistakes. Thus, our chapters follow a traditional sequence: after an introduction
to some preliminary methodological issues, we deal with consumers’ behaviour
and the world of production (Chapters 2–4); we then move on to studying the
interaction between consumers and producers in Chapter 5 (market structure),
the features of government action in Chapters 6 and 7 (taxation, regulation and
money), and we conclude by examining the interaction among different
countries (international trade and exchange rates) and the long-run picture
(growth, poverty and crises).
The Economics You Need offers an agile and easy-to-read account of what
economics is and of how problems should be framed following the economic
way of reasoning; our inquiry into these matters is enriched by offering the
reader provocative thinking and new insights into current and relatively wellknown topics. It is hoped that it will provide readers with a deep enough
knowledge of the key economic concepts and issues that they will be able to
analyse the world around them with more discerning eyes, reframing ideas and
debates within a consistent economic perspective and eventually forming their
own visions.

xv


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1
THE EC ONOMI C W A Y
OF THINKIN G

1.1 On the nature of economics and the importance
of methodology
Why should one be interested in economics and what kind of discipline is it?
Simply put, economics is important because it offers a powerful set of conceptual
tools that help us understand how individuals behave under scarcity, how they
strive to improve their well-being without resorting to violence, and how they
respond to the conditions and constraints that frame or otherwise affect their
choices. In short, economics is about explaining people’s behaviour and
interactions when they cannot satisfy all their wishes and aspirations, i.e. when
they must choose among different options and when they must explore the
opportunities offered by cooperation and exchange.
In this light, then, economics is clearly a social science, since individuals
operate in a social context defined by other people’s actions and by the rules
that apply to their community. Moreover, since observing and making sense of
what one sees do not involve any form of judgement, economics can be
regarded as a value-free discipline with no normative connotations. In other
words, the economist’s effort to appreciate how people act does not mean that
he knows how agents ought to act, or that he is authorised to take action or to
command them to change whenever he sees people deviating from his
expectations or wishes. Of course, one can evaluate the moral content of
individual preferences, as well as of the outcomes that interactions produce.
Likewise, and perhaps more importantly, the economist should be aware that
moral standards, culture and tradition, historical accidents and prejudice do
influence individuals’ preferences and, therefore, choices and human action.
Indeed, it would be difficult to understand and explain individual behaviour by
assuming that people are just sophisticated robots incessantly busy with
developing and comparing streams of quantifiable benefits and costs, and
struggling to revise their decisions as new information flows in, or as they
realise they have made mistakes. Nonetheless, the very process of understanding
and explaining human behaviour is not a moral issue. While a good economic
analyst should be equipped with a broad interdisciplinary background that
1


T H E E C O N O M I C WAY O F T H I N K I N G

spans law, history, psychology, sociology and statistics, he should also bear in
mind that sound economics remains an exercise in logic, rather than in ethics
or legislating. Methodological thoroughness is therefore critical, since logic and
consistency originate from rigorous reasoning.
In this vein, it seems appropriate to devote the introductory paragraphs of
this book to discussing a number of critical methodological issues that tend to
be overlooked in textbooks and debates, because they will provide useful
guidelines for the following chapters. In particular, we shall begin by
highlighting the difference between economics and (economic) policy-making
(section 1.2), then we shall examine methodological individualism (section
1.3), the role of time and uncertainty (section 1.4), failures and opportunity
costs (sections 1.5–1.7). Section 1.8 concludes with a summary.

1.2 From economics to policy-making
As mentioned above, the essence of economic reasoning boils down to an
exercise in consistent deduction based on a set of a priori assumptions about
human action. Its purpose is to obtain value-free explanations of human
behaviour under scarcity. Economic policy-making is different: although it
relies on the same conceptual tools as economics, policy-making focuses on
creating and implementing rules enforced by an elite – the policy-makers. It
analyses the policy-makers’ purposes and operational features, and it evaluates
the results their actions produce. Thus, policy-making cannot ignore economic
analysis, since the consequences of rule-making are indeed a matter of human
behaviour. However, the prescriptive traits of policy-making raise new
categories of methodological questions. In this section, we shall briefly mention
two of them: the concept of ‘common good’ and the incentives that drive
policy-makers. While the paragraphs below are by no means an exhaustive
account of the scholarly debate on these themes, we believe they will suffice to
make the reader aware of the potential pitfalls involved.
Since the engine of economic behaviour is the individuals’ efforts to improve
their well-being (or their ‘utility’, according to the economics jargon), the role
of the self-interest broadly understood – the quest for material and psychic
improvement – is apparent. By contrast, the engine of policy-making is the
happiness of the community, or the so-called ‘common good’. Regrettably,
however, this concept lacks an objective definition and can easily be abused.
One can surely agree that given actions or goals are desirable per se and thus
contribute to the happiness of a community. For example, there is no doubt
that, other things being constant, a free holiday on the Riviera for all the
members of a community would have a positive effect on their happiness. Yet,
in a world of scarcity, the members of the community might have different
views on priorities. For example, the free holiday mentioned would probably
be financed with a tax on other goods, and it is not obvious that the consumers
of those taxed goods are happy with donating a free holiday to the rest of the
2


T H E E C O N O M I C WAY O F T H I N K I N G

population. Put differently, we can easily – and we often do – end up in a
world in which the common good means different things to different people.
Absent unanimous consensus, therefore, the policy-maker determined to act
needs a rule that legitimises the violation of someone’s preferences.
Unfortunately, the search for such rule has not produced very persuasive
results. Democratic societies usually adopt a rather simple operational criterion:
the majority (or super-majority) wins. Yet, this standard amounts to a rather
naive form of utilitarianism that draws much of its appeal from populism and
expedience: it can hardly provide convincing definitions of good policymaking. More generally, the alternatives to democracy – e.g. absolute monarchy
– also fail to gather undisputed agreement. The result is that prudence is in
order: the observer/analyst should acknowledge that policy choices frequently
involve assumptions about the moral justification of a given political system
and that, therefore, policy-making should be regarded with philosophical
reserve and a healthy grain of scepticism.
Sadly, the problem of defining the common good in the presence of
conflicting interests – the so-called ‘social-choice’ question, according to the
economic jargon – is not the only burden aggravating the policy-maker. A
second source of issues originates from the fact that policies are implemented
by human beings; and like all human beings, politicians, bureaucrats and even
the judiciary tend to pursue their own goals, sometimes inspired by
commendable altruism, sometimes by greed, vanity, prejudice or ideological
biases. Put differently, it may happen that public actors operate in the interest
of the community they are supposed to serve. But it might also happen that
public actors deviate from this commitment and pursue their own interests,
with little or no risk of being held accountable for misbehaviour. More caution
is thus in order. Monitoring policy outcomes is a difficult job, and it becomes
even more arduous when there is no foolproof method of selecting virtuous
policy-makers.

1.3 Methodological individualism and the micro–macro divide
The previous section aimed at underscoring that the major divide between
economics and policy-making pertains to the difference between the analysis
of individual voluntary action (economics) and the study of the consequences
of rule-making in the name of the common good (policy-making). The
purpose of this section is to draw attention to the fact that in both cases, the
individual remains the actor. This claim is the essence of what is known as
methodological individualism, and it explains why the economic observer
should always articulate his reasoning in terms of individual behaviour.
Common parlance and academic writing frequently distinguish between the
analyses relating to individual agents and those regarding collective units such
as a community, a country or a group of countries. According to this line of
thinking, the former analyses would belong to the realm of ‘micro-economics’,
3


T H E E C O N O M I C WAY O F T H I N K I N G

whereas the latter would be a matter of ‘macro-economics’. For example,
according to the traditional textbook view, the study of how an individual
interested in buying a car responds to an increase in the price of cars or in his
purchasing power is a micro-question. By contrast, the effects of a generalised
increase in the propensity to save – say, in response to widely shared fears about
living standards in old age − would be a macro-issue.
We do acknowledge that the micro–macro distinction can be useful in order
to draw the line between explanations that pertain to individual decisionmaking and descriptions of what happens when many individuals are involved
at the same time, are subject to the same stimuli, exhibit similar reactions and
have a countrywide relevance. Yet, we argue that the micro–macro dichotomy
is often confusing, since explanations and descriptions are different exercises,
rather than two versions of the same logical assignment. After all, decisions are
made by individuals, not abstract entities like ‘a group of people’. This is
obvious in the absence of constraints: as free individuals, we choose and we
bear the consequences of our choices. This remains true when one’s actions are
limited by laws and regulations, since it is still the individual who decides
whether to comply with the rule and, if he does choose to comply, he chooses
and operates within the perimeter defined by the rules. It is true that many
people make decisions about the same topic at more or less the same time, and
that one might call those many people a ‘macro-agent’. Yet, the outcome of
these quasi-simultaneous choices is nothing but the algebraic sum of a host of
individual choices, even when the individuals influence each other through
persuasion or imitation. In other words, one may wonder what happens when
several individuals make similar decisions simultaneously – either spontaneously
or following orders coming from an authority, as happens in the case of
taxation. Still, the answer must originate from the analysis of what each
individual member of the group does, which is by definition a micro-question.
Methodological individualism also applies to circumstances in which decisions
are formally taken by collective bodies like committees of government officials,
corporate boards of directors or the members of a tennis club. If a representative
operates according to a clear mandate that originates from a set of individuals,
then the content of the mandate is defined by the individuals who have agreed
on its substance (i.e., each member of the tennis club). Put differently, delegation
is not enough to transform an individual decision into a macro-issue. By contrast,
if the mandate is broad, indirect or vague, then decisions originate from the
preferences of the members of the collective body and are thus individual
(micro-) decisions, once again. For example, an anti-trust agency generally
derives its authority from the legislature, which is formed by representatives
who refrain from giving specific instructions to the members of the agency. As
a result, anti-trust agencies end up being ‘independent’ and reproducing the
preferences of the members of their boards, subject to some procedural
constraints (collective decisions usually follow the majority-wins criterion).
These members are of course individuals, not an abstract, collective body.
4


T H E E C O N O M I C WAY O F T H I N K I N G

To avoid terminological confusion, therefore, one should be aware that
there are categories of choices that affect a relatively small number of agents:
buying or selling a pound of beef is a typical example. And there are sets of
choices that affect a large number of people: that is clearly the case with
monetary and fiscal policy. One can surely make a distinction and refer to these
two sets of decisions in different ways. Yet, the line between ‘micro’ and
‘macro’ is necessarily arbitrary and – in our view – should be eliminated for the
sake of clarity. This is what we plan to do in this book, in which we shall refer
to economics when we study the economic way of thinking (the logic of
decision-making and exchange in general); to the economics of consumption,
of production, of money, of taxation, etc. when we apply the economic way
of thinking to specific categories of activities; and to policy-making or
government intervention when dealing with the consequences of coercive
action carried out by an authority powerful enough to enforce its decisions.

1.4 Time: statics, dynamics and uncertainty
Having examined the nature of economics and the essence of methodological
individualism, let us now move on to a third issue, upon which economists
have written scores of articles and books: the role of time. Time affects the
economic way of thinking from two different perspectives, which have
originated the static–dynamic dichotomy and the debate on the role of
uncertainty. We shall look at them in turn.
In brief, static analysis refers to situations in which nothing changes:
individual preferences are constant, the quantity of resources available and
the production techniques do not vary, and the legal context is stable. An
observer engaged in static analysis, then, is equivalent to someone watching
a photograph and considering whether its composition is agreeable and/or it
could be improved upon: are consumers actually spending their money in the
best possible way? Are producers using the most effective technique at their
disposal? Are they producing the goods that buyers want to buy, or that an
eventual social planner would like to see produced? Are there underutilised
resources that could be put to better use? Are people’s choices influenced by
systematic distortions?
More generally, static analysis is useful whenever one wants to investigate
the general laws of economic behaviour. After all, there is no need to develop
major dynamic insights in order to appreciate that when the price of a
production factor increases, entrepreneurs have an incentive to look for other
inputs or different production techniques; or that if one considers having a long
holiday, the choice between renting an apartment and staying at a five-star
hotel depends – say – on how much one wants to spend, how much privacy
one cherishes, and how much one is willing to engage in cooking and cleaning.
Nonetheless, reality is far from static and, furthermore, agents operate by
evaluating the possible effects of their actions in the future. In other words, a
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snapshot is not an accurate representation of the real world, and decisions
that do not seem immune to criticism in a short-run perspective might be
correct if a longer time horizon is taken into account; and vice versa. For
example, an individual might find it profitable to invest his time and money
in professional education if his working life spans three or four decades, but
he could be much less interested if he plans to retire in a few months. Thus,
the dynamic aspect – in this case, where the individual is in his career path
– is essential. In particular, dynamic reasoning is unavoidable in two broad
contexts: when one is interested in examining the extent to which today’s
behaviour affects opportunities and choices in the future, and when one is
interested in exploring how the environment could evolve as a consequence
of today’s choices. For example, today’s decision to borrow money likely
affects tomorrow’s expenditure, since part of the resources available in the
future will be used to pay back the debt. In a similar vein, today’s decision to
invest in innovative companies and possibly enhance technological progress
might create greater wealth and new opportunities tomorrow. In other
words, we all operate in order to be better off, now and in the future. Each
of us may attribute different weights to the future, but it is clear that the
future matters.
Although time is crucial, however, the future is not just the extension of the
present, based on the information available at present. The notion of time –
and thus the difference between the present and the future – is not an exercise
that aims at stretching a past trend into a future trend (extrapolation). In fact,
the notion of time includes the idea that tomorrow is intrinsically different
from today: our preferences change, the range of products available evolves,
production techniques develop in unexpected ways, some companies might go
bankrupt and new companies see the light, new knowledge is created and/or
acquired, and at least part of it contributes to shaping our new decisions. Trialand-error processes play an important role, too, since time is also the process
through which adaptation and learning unfold. We make mistakes every day
and only gradually do we find out what we really want and how to obtain it.
Engaging in extrapolation is equivalent to saying that we never learn and that
nothing new happens.
In fact, the essence of the future is the presence of uncertainty, not
extrapolation. And since economics is about scarcity, the introduction of time
amounts to saying that the very notion of scarcity changes continually and that
sometimes change is unpredictable: a quick look at the variance characterising
stock markets or exchange rates provides plenty of evidence. In other words,
one cannot ignore that the playing field changes all the time. Some two
centuries ago, the lack of wood was regarded as a major constraint on the
future of humankind; in the early twentieth century, the same was true for
coal; and some 40 years ago for oil. All those predictions about humanity’s
future on the basis of these scarcities were exercises in rear-mirror gazing and
each prediction has turned out to be false.
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Unfortunately, economists have no recipe for neutralising uncertainty and
they – like the rest of the world – must learn how to live with instability.
Uncertainty is a fact of life, but uncertainty is not always undesirable. Indeed,
it seems important to remember that if uncertainty could be eliminated, we
would be living in a frozen world: progress would no longer take place and our
efforts to find ways of improving our well-being would be pointless. With
regard to policy-making, therefore, the concept of time indicates that even
when they are perfectly designed and executed, constraints will hardly generate
the expected results, since the context within which they apply is no longer the
context within which they were conceived. This might be less relevant when
considering rules derived from fundamental principles, such as the right to
private property or to physical integrity, but it might be a source of unpleasant
surprises when analysing some categories of ordinary law-making, such as
banking regulation, monetary policy, public expenditure or trade barriers. In
all these cases, therefore, prudence is required: not only can legislation provoke
undesirable effects, but it can also modify the outcomes occurring in the
spontaneous passing of time – technological change and economic growth, for
example – and not necessarily for the better.

1.5 Failures: social justice, transaction costs, externalities
Regrettably, the consequences of the search for the comforting feelings of
stability and perfect design are not limited to the neglect of time and uncertainty.
With a few exceptions, economists have not been able to resist the temptation
to identify what an ideal economic system should look like, to compare that
ideal with reality, and to suggest policies that would bridge the gap and make
all participants better off. Indeed, this attitude has become increasingly popular
and – unfortunately – has been accompanied by almost unlimited faith in the
virtues of government intervention. As a result, most contemporary economics
is no longer an attempt to explain human behaviour under scarcity constraints,
but rather a preliminary step towards active, top-down intervention in order to
improve people’s well-being. What are the foundations of this benign attitude
towards regulatory intervention?
It is indeed recognised that in a context characterised by spontaneous
interaction – the free market – resources are used in the way people value
most. In other words, nobody doubts that contracts must be respected and
neither cheating, nor violent physical aggression is allowed. At the same time,
however, there is a wide consensus on the presence of various categories of
shortcomings attributed to the unfettered working of the (free-)market
mechanism. To each of these ‘market failures’ corresponds a justification for
government interference, the foundations of which deserve some attention. In
this section, we shall briefly discuss three issues that are frequently mentioned
in current debates. Additional controversial points will be mentioned in the
next chapters.
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The first criticism of free-market economics originates from the notion of
social justice. According to this argument, individuals are not altruistic enough
and, thus, they forget that justice requires that all members of society – even
the less affluent ones – have a positive right to enjoy at least a minimum amount
of goods and services, such as food, shelter, health and education. As a result, it
may happen that the distribution of income generated by spontaneous
interaction does not fulfil the requirements of a just social order and that some
mandatory redistribution is desirable. The debate on the meaning of social
justice is thus critical, since the content with which the term ‘social justice’ is
infused determines the features and extent of redistribution of income and
wealth. Nonetheless, the analysis of social justice pertains to the domain of
philosophy, where the debate over this concept has been intense for many
centuries and shows no sign of approaching an end. We thus feel justified in
contenting ourselves with alerting the reader to the problem and not pursuing
the debate or taking sides.
A second category of criticisms relates to the fact that there exist situations
in which individuals do want to cooperate and interact, but that the cost of
doing so is prohibitively high. When this happens, opportunities to improve
everybody’s well-being are missed. These costs are called ‘transaction costs’, a
term used to describe the expenses that are incurred in order to complete a
transaction, but that do not imply a transfer of resources from the buyer to the
seller of the good or service being exchanged. In other words, transaction
costs help to explain why some transactions do not take place despite their
desirability and might thus justify efforts to bring about the results that would
take place if transaction costs were lighter or absent. For example, the cost of
establishing liability for faulty products might discourage buyers from
exchanging. In this context, no-fault liability enforced by the legislators puts
the burden on those who are presumably better informed about the nature of
the product and eliminates the cost of bargaining. The search for these desirable
outcomes is the core of two economic sub-disciplines that go under the names
of ‘institutional economics’ and ‘law and economics’. The former focuses on
the design of appropriate rules and norms with a view to reducing transaction
costs, while the latter examines suitable assignments of property rights, so that
transactions would no longer be necessary and at least some transaction costs
could be avoided.
Certainly, institutions and property rights are of great importance: they affect
economic behaviour and play a critical role in shaping the nature of government
intervention. Yet, things are not so simple and a word of methodological
prudence could be useful. Suppose that John would like to have dinner in a
restaurant he likes in Buenos Aires. Yet, John is currently in Europe. Not
surprisingly, the cost of flying across the ocean and the time it takes to go and
come back will probably make that dinner too expensive: although the owner
of the restaurant will pocket $50, the fact that John has to spend some $3,000
– the airfare and the value of his time, plus the cost of the meal – means that
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