Economics 101, My Way

From time to time we have commenters here who have had the misfortune to take an economics class or two, or even worse, to have majored in economics. The brain damage is not irreversible, in many cases. Let's see if we can offer some healing, by starting over. We'll begin with microeconomics. Although the major controversies of the day focus on macroeconomic issues, the faith-based macroeconomic orthodoxy is built on the faith-based microeconomics taught in the first semester.

So here's a transaction: B buys something from A. Your EC101 professor will ask you to accept several ostensibly "simplifying" assumptions about this event.* One of the most important is that all of the costs and benefits to humanity (usually labeled as "society") are captured in the transaction. In other words, B gets a product and A gets money, they're both happy, and that's all we need to worry about: the world is now better off. Exceptions to this supposed rule are called "externalities," which are an example of an unusual situation called "market failure," but we'll worry about those later, in specialized sub-disciplines such as environmental economics.

Alas, it's the first day of class, and you have already been lied to. Every single transaction, even the most mundane, has externalities. In fact, the externalities overwhelm the transaction itself, in every case. Markets always fail: this is not a special case or a minor adjustment to be considered later. It's fundamental, i.e., the theory is false, it does not describe reality.

Consider an ordinary trip to the grocery store. B gets in her car and drives to the Stop & Shop, emitting from her tailpipe CO2, oxides of nitrogen, and hydrocarbon vapors which condense into ultrafine particles. The latter cause inflammation in the lungs and bloodstreams of the passersby who inhale them, causing respiratory and cardiovascular damage, increasing their risk of heart disease, and shortening their lives. There's more of course, but let's get her into the store.

B loads her shopping cart with some Hungry Man dinners, boxes of cereal, bottles of soda and milk, some ground chuck and a pot roast, a bag of potatoes, etc. Plain old groceries. You already know that producing this food involved such activities as destroying tropical rain forest to grow forage for cattle, feeding antibiotics to livestock thereby creating antibiotic resistant bacteria, depleting topsoil, polluting waterways with fertilizer runoff and pesticides, shipping stuff long distances by plane, truck and rail thereby emitting air pollution and causing other kinds of damage such as bothering neighbors with a lot of noise, crashes in which people are injured and killed, destruction of communities to build roads, etc.

But wait, there's more! B is going to feed this stuff to herself and her family. The choices she makes will have a huge effect on their health. For example, the sodas have a lot of calories with little nutrition, and a high glycemic index. They'll tend to make her and her kids fat and diabetic. You could say that's her choice and her problem, but it's not her kids' choice. Furthermore if you do make that claim, you are ignoring that a not inconsiderable part of the price of the products pays for advertising which has persuaded her to buy them, using sophisticated techniques of psychological manipulation.

Another assumption your professor asked you to make is the assumption of perfect information: that B knows all about the stuff she is buying. But the only reason she even has a chance to know what's in the food is because of a law that requires the manufacturers to put the ingredients, and some nutritional information, on the label. But B probably doesn't know enough to interpret this information meaningfully, even so.

After B gets home and her family eats the stuff, the packaging ends up in a landfill. The paper and cardboard means that forests were destroyed and converted into tree plantations, and sulfuric acid was discharged into rivers. You probably know all about the plastics but don't forget that some of those plastic bags end up blowing away, landing in the ocean, and ultimately circulating in a vast gyre in the middle of the Pacific Ocean -- a sea of biologically inert, forever dead petrochemical waste.

I could go on. You can think of more stuff for yourself. But the point is, the assumption is not simplifying, and the theory built upon it does not illuminate the world or guide us toward understanding. It is simply wrong. Externalities absolutely overwhelm every economic transaction. The dollars that change hands in the transaction itself are trivial. To start out thinking about it in any other way is to make a fool of yourself.

Next: Public goods






* That's already sort of odd. When we do science, we don't generally make assumptions that we know to be false. Sometimes we make assumptions that might be true, which we call hypotheses, and we test them. If they turn out to be wrong, we discard them. Scientists sometimes build models which they know are simplified, but they test them to see if they make accurate predictions, so they can figure out what data are essential and what can be ignored. Economists, however, do not do this. Their models manifestly do not make accurate predictions, but they stick with them anyway.