Thursday, January 10, 2013


Coefficients of elasticity, equilibrium prices, indifference curves, the multiplier, IS/LM curves, the AD/AS model, marginal propensities to consume and save, consumer surplus, deadweight losses, profit maximizing output, utility maximizing equations.   Welcome to Principles of Economics or as Rodney Dangerfield called it in the movie Back to School................fantasyland.    Watch this video.

I taught concepts like these for 31 years as a professor in Ohio before retiring and then teaching at the University of Arizona for 5 more years.  Many of my students, like Rodney Dangerfield in the movie clip above, found it difficult to understand how most of these concepts were relevant to the real world.  After awhile I began to ask the same questions.  So I wrote this blog as an antidote to Principles of Economics as it is currently being taught at almost all colleges and universities.

Monday, April 11, 2011

CHAPTER 1: A PARADIGM is a model of how something works.  Once you have created a correct paradigm in your mind it will help you make better decisions.  For example, is the earth flat or round?  If Columbus had a flat earth paradigm he would have stayed at home.   Your paradigms will also affect what information you believe and what you will ignore.  In psychology this is called CONFIRMATION BIAS. Once formed, paradigms are not easily changed.  People would rather ignore certain facts than have to change an established paradigm.  Facts which do not fit a paradigm create an uncomfortable feeling called COGNITIVE DISSONANCE.  To better appreciate the importance of paradigms you might want to google "Galileo". 

And finally a bad paradigm will result in decisions that do not help solve problems but usually help you create even more. A change from one paradigm to another is called a PARADIGM SHIFT. 

There are three interrelated paradigm shifts suggested in this book.  The first is organizational. The second is moral.  And the third is economic. Most people never experience even one paradigm shift in a lifetime so this is a pretty big challenge for any reader. 

In social organization theory the major competing paradigms are HIERARCHY and SPONTANEOUS ORDER.

Hierarchy is the familiar top-down management model of organizing social activity.  It is usually learned from experience.  For example schools, teams, and firms are all organized this way.  Without a leader disorder would prevail.    

Spontaneous order is based on the concept of  self-organization.  This paradigm is hard to learn by simple observation unless you are unusually perceptive. 

So what exactly is spontaneous order?  The concept can be traced back at least as far as  Mandeville's THE FABLE OF THE BEES through Adam Ferguson's A HISTORY OF CIVIL SOCIETY to the Nobel prize winning economist F.A. Hayek (who coined the phrase).   The most recent term for it is complex adaptive system (CAS).  Read this.  Click on Basic Tutorial and then on Complex Adaptive Systems.

Review Questions:  Consider highway traffic vs. airplane traffic. Why does one have a "controller" and the other not have one?  Is the economy of the United States organized more by spontaneous order or by hierarchy?  Is there a trend?  Is this trend good or bad? 

CHAPTER 2: Spontaneous order is not automatic.  Like highway traffic there must be certain organizational fundamentals.   

First there must be a rule that ties the system together.  For example all drivers in the United States drive on the right hand side of the road and stop on red.  Imagine if only half of the drivers followed this rule.  Or imagine if the rule was constantly changing according to the whims of some  hierarchical planners.   

Next there must be shared information so the indivicual units can make decisions that become self organizing.  For example, blind drivers cannot determine which side of the road IS the right hand side.

And finally there must be a negative feedback loop to eliminate persistent errors.    If you drive on the left hand side of the road and/or ignore red lights you will experience this feedback.  A rule, information, and negative feedback loops are the prerequisites for self-organization.

As children we quickly find out the difference between mine and yours when we try to take another child's toys away from them. As we mature we learn the difference between possessions and property.  This basic concept is the foundation of the philosophy of NATURAL RIGHTS.  The development of this concept has a long history and can be traced from the Stoics to John Locke to Thomas Jefferson to Murray Rothbard.  For simplicity I have left out many links in the chain.  
Look here to gain a better understanding of  natural law and natural rights.  This essay is rather long but well worth your time.

Most pardigms have competition, at least for awhile.  Once the world was thought to be flat and blood letting seemed like a good way to cure disases. The flat world paradigm that presently competes with  natural rights is UTILITARIANISM (Hey, I never said I was unbiased).  According to this philosophy natural rights are secondary to what is good for society.  The catch phrase "the greatest good for the greatest number" just about sums it up.  At least 90 percent of the professional economists in academia and 100 percent of those working for the government are utilitarians.  One reason is job security.  These economists fancy themselves as experts on helping decision makers decide what is the greatest good, therefore they are in demand to give advice.  The other reason is that most of them don't know the difference between a natural right and a positive right.  And worse yet don't care to learn. 


Review Questions:  What are "rights"?  Do people have a right to work?  Do they have a right to an education, to healthcare, to gun ownership? 
CHAPTER 3: The next logical step after learning about natural law and natural rights is to introduce the concept of  PROPERTY.

Property is what you own.  Ownership means exclusive control.  The idea of property evolved as a way to avoid conflicts.  There are four ways to justly obtain your property.  (1) produce it, (2) exchange for it, (3) receive it as a gift, and (4) homesteading (which means being the first to discover it). 

Probably no other concept is more basic to both politics and economics than the idea of property.

Consider your self.  Who owns you?   If you answer "I do" that means you have exclusive control over your actions and implies that you also have exclusive responsibility for what you do.  Are there limits on how you can use yourself?  Should other people be able to sometimes use you for the benefit of society?  These are some of the most basic of all social questions.

Let's read (and hopefully think about) what Hoppe has to say on this subject.

Review Questions:  What is property and why is it so important?  Is there such a thing as "public" property?  How about "intellectural" property?

CHAPTER 4: Next let's turn to the key fundamental concept of MORALITY.

Morality is the difference between right and wrong. 

Some people think that expropriating an individual's property for public use (taxation) is moral under what is called the social contract theory.  Others disagree under natural rights theory.  Until a group of people share a common paradigm about what is right and what is wrong there will always be social conflict. 

EVOLUTIONARY PSYCHOLOGY gives us some insight into how an individual learns morality.  Everyone has a set of morals to guide their behavior but they are not always the same just like everyone can speak and understand a language but not always the same one.  Furthermore there are instincts like envy, the herd mentality, and suspicion of strangers that can compromise morality.  Read this to understand how humans developed a capacity for learning morality and a tendency to rationalize immoral behavior.

Review Questions:   What does morality have to do with economics?  Can you have an economic system without most people adhering to some generally accepted moral principles? 

CHAPTER 5: Moral principles are passed on from generation to generation through education and example. 

As mentioned before, evolutionary psychologists claim that the ability to learn morals, like the ability to learn language, is hardwired into our brains through an evolutionary process. 

But how do we learn what is right or wrong, moral or immoral?  Is it possible to be taught an immoral morality?

Consider the problem of getting from Point A to Point B?  If I follow your directions I will discover if they are right or wrong.  In a similar way, if we assume that the purpose of morality is to improve the quality of our lives (Point B), then we must discover from trial and error what is right and what is wrong (experience).  Or we can rely on a trustworthy source.  Hopefully we won't keep making the same mistakes over and over again. 

This process of discovery is exemplified by English common law.  Let's now turn our attention to the legal framework which codifies a societies standard definitions of right and wrong.  

Read what Bastiat has to say about the LAW.  This is relatively long but definitely worth your time.

Review Questions:  What is the difference between positive law and natural law?  Can a law be immoral?  If so, give an example.  What happens if a society that has lots of immoral laws?  Is theft immoral?  How does taxation differ from theft?  Does public education do a good job of contrasting the opposing paradigms of natural rights vs. the social contract theory?
CHAPTER 6: Paradigms, spontaneous order, natural rights, property, morality, and law.  According to Thomas Jefferson and others, human beings are born with natural rights.  However they are not born with a particular morality.  That must be learned.  Law is the process of enforcing a paticular moral system.  Morality, properly understood, is not subjective.   Spontaneous order is social organization under a moral system of natural rights.  Most people intuitively understand the paradigm of hierarchy but not spontaneous order.

Consider, for example, TAXATION. 

Ownership (having exclusive control) of your own production or what you trade for with other people is a natural right.  Note that natural does not connote good or bad.  That's a question of morality.  CHARITY is voluntarily giving up some of your property for the benefit of another person or group of persons.  Taxation is not charity. 

Taxation requires coercion (as in "your money or your life").  Is it right or wrong to take money, using whatever force is necessary, from some people for the benefit of other people? 

Currently the law comes down on the side of yes it is right and moral.  But since it is not natural for people to give up their money to benefit strangers (like a dam holding back the water from flowing down a river is not natural) this transfer requires construction and maintenance.   And this can get very expensive and complicated as you know if you have ever been audited.

So what does all this have to do with economics?  Let's go there now. 

The paradigm of spontaneous order is at a disadvantage when competing with the paradigm of hierarchy because the former requires a working knowledge of economics which in turn requires some time and effort to understand.  Ready? 

In economics there two major competing paradigms.  They are the KEYNESIAN/NEO CLASSICAL paradigm (hierarchy, utilitarianism, mathmatics) and the AUSTRIAN SCHOOL paradigm (spontaneous order, natural rights, deductive logic). 

Your chances of learning about the second one are slim to none if you take traditional college courses in economics.  When I taught at the University of Arizona I supervised 3 doctoral candidates in economics.  At this late stage in their education none had ever even heard of the Austrian School let alone being able to debate the pros and cons of this paradigm.

So what exactly IS Austrian economics?  Read this.

Review Questions:   What are the basic principles of Austrian economics?  What is the history of Austrian economics.
CHAPTER 7: Economists like to qualify their theories with the "CETERIS PARIBUS" assumption.  It means other things remaining the same.  Of course other things never do remain the same since we live in a complex adaptive system called society that is always changing. 

Mainstream economists also like to express their theories using mathematical models.  This allows them to make precise predictions which of course are invariably wrong since ceteris are never paribus.

A study of history does help but in the end doesn't prove anything.  For example, although everyone agrees there was a Great Depression in the 1930s, Keynesians contend it was caused by capitalism and would have been less severe if there had been more government intervention or at least if it had been used differently.  Austrians believe the Great Depression was brought on by government intervention (Federal Reserve policies) and prolonged by more intervention (FDR's New Deal).

So who is right?  Unlike the hard sciences an appeal to the facts cannot resolve this dispute.   If Galileo had been an economist we would still be debating his theory. 

Nevertheless history cannot be ignored.  Let's take a look at what historians could learn from Austrian School economists.  Read this.

Review Questions:  Did capitalism cause the Great Depression or did government intervention cause it?  Does your paradigm influence your answer? 
CHAPTER 8: Having already explained spontaneous order let's turn to that other non-intuitive concept in economics which is COMPARATIVE ADVANTAGE.  Then I will try to explain in simple non-graphical terms the economist's all purpose tool, SUPPLY AND DEMAND.  But before we study those concepts let me remind you that economics is a controversial subject.  No one expressed the nature of those controverses better than Murray Rothbard.  Let's see what he has to say on this subject.  Since this material is book length I suggest you start by reading only the Inroduction.  Then come back and read more later if the spirit moves you.

Review Questions: Why is economics more controversial than say physics or chemistry?
CHAPTER 9: Economics in a nutshell.  People discovered the economic benefits of specialization and trade.  To facilitate trade they discovered money.  To minimize conflicts they discovered property.  The rest is history.

Every choice involves an OPPORTUNITY COST.  When you choose A instead of B you give up any benefit you may have obtained from B.  Simple enough.  Economists call this problem "scarcity".  In other words you can't have your cake and eat it too. 

When you choose to produce X instead of Y then the value of Y to you is the opportunity cost of producing X.

Every person is an individual therefore opportunity costs vary individually.

Let's say in one hour Smith can produce either 1X or 2Y's. 

Jones can produce either 2Xs or 8Ys.  Stay with me here.

Jones has an ABSOLUTE ADVANTAGE in producing both Xs (2>1) and Ys (8>2).

However Smith has a COMPARATIVE ADVANTAGE in producing Xs because his opportunity cost is lower (2<4).

Jones has a comparative advantage in producing Ys for the same reason (1/4<1/2).  Concentrate now.  This really isn't that hard. 

After specializing according to their comparative advantages Smith and Jones agree to trade 1X for 3Ys.

This is good for Smith because with 2 hours of work he can now have 1X and 3Ys instead of 1X and 2Ys.

This is also good for Jones because in 2 hours of work she can now have 10Ys and 2 Xs instead of 8Ys and 2Xs.

The implications of this simple example are enormous.  Both parties benefit.  It is a win-win game. 

That is why when you trade with someone it is appropriate for both to say thank you.  Mutual benefit.

Comparative advantage is the basis for specialization.  Specialization is the basis for trade.  And trade is the basis for mutually beneficial human relationships. 

In a simple primitive barter economy with only a few products this would be the end of the story. 

But what if there are millions of people and millions of products.  This could get complicated. 

How complicated could it be you ask.  Read this essay and you'll see.

Then read this one.

Review Questions:  If  Mr X has an absolute advantage in producing both A and B can Ms Y have a comparative advantage in producing  either A or B?  Explain. Why dont' we need a Pencil Czar to coordinate the production of pencils?  If we did have a pencil Czar would we have any pencils?

CHAPTER 10: Highly integrated constantly changing economic choices need to be coordinated.  Enter first MONEY and then THE PRICE SYSTEM.  

Money is anything that is generally accepted as a medium of exchange.  Tobaccco leaves, beads, stone monuments, cigarettes, and other items have been used.  People finally discovered the benefits of using gold as money and pretty much stuck with it. 

First there were bags of gold.  Next came gold coins.  Then paper money backed by gold.  Then paper money NOT backed by gold (major change). Then demand deposits.  And most recently electronic fund transfers. 

Prices are determined by supply and demand.  More demand leads to higher prices and more supply leads to lower prices.  If you know the price of any two items you can calculate the opportunity cost of your choices.  For example if product A costs 5 dollars and product B costs 10 dollars then the opportunity cost of 1B is 2As.

But why would product A cost you 1/2 as much as product B.  That's where competition comes into play.  Sellers want the highest price they can get but they know that other sellers will get your business if they charge too much.  On the other hand buyers want the lowest price they can pay but they know that other customers might pay more if they offer too little.  This interplay of forces results in high prices for items when there are relatively more buyers and low prices when there are relatively more sellers.

There's a little more to it than this but you get the general idea.

When demand increases, ceteris paribus, prices rise.  This signals sellers to produce more even if the product costs more to produce.  And vice versa.  When supply decreases, ceteris paribus, prices rise.  This has the effect of rationing some buyers out of the market.  And vice versa. 

Thus prices serve as information so that sellers know when to produce more or less and buyers know when to buy more or less.  All without having a price czar to coordiante these decisions.

Another function of prices is to eliminate wasteful surpluses and shortages.  If there is too much being offerred for sale in relation to the number of buyers, prices fall.  If there is too little being offerred in relation to the number of buyers, prices rise.  And this of course takes place without having an allocation czar.

Think of the price system as the eyes of the drivers who must constantly receive information from their surroundings in order to navigate from Point A to Point B.  

Bastiat once asked this famous question:  How does Paris get fed?   No food czar?  No central plan?  No bureaucrats and agencies to tell people what to produce, how to produce it, and who will get it. 

Review Questions:  If a surplus exists will that cause competition between buyers or sellers.  Will this result in the price going up or down.  How about the same question with a shortage?  Can you think of several examples of government price control?  Does government regulation of prices and production interfere with spontaneous order and therefore create inefficiency and disorder?  If the answer is yes, then why do it? 
CHAPTER 11: Most mainstream textbooks talk about how "we" decide what to produce, how to produce it, and for whom to produce it.  According to METHODOLOGICAL INDIVIDUALISM this is a meaningless question .  A better way to phrase the question is who will produce what for whom and how. 

The first person to produce a new product or produce an old product in a new way is called an ENTREPRENEUR.  The word means risk taker in French but a better description would be discoverer. 

How does one know what products should be produced and how?  The answer is trial and error.  Complex adaptive systems have NEGATIVE FEEDBACK LOOPS.  When an entrepreneur decides to produce a product that costs more to produce than the revenue it brings in he will discover that he has made a mistake.  Remember the role of prices here.  Price>cost make money and produce it.  Price<cost lose money.  Do not produce.   

If he has any money left after this painful lesson he may be able to try again.  Trust me I know about this from experience. 

Of course things are constantly changing.  Once it was profitable (revenue>cost) to produce records and record players.  Now it's not. 

The system is dynamic.  New products and methods of production replace old ones.  This is known as economic development and is both a source of risk and reward for the entrepreneur. 

Profit and loss.  Success and failure.  The carrot and the stick.  The  important point here is  that all this is done without an economic czar.

Review Question:  Did the relavtive inefficiency of the economic system of the old Soviet Union compared to the economic system of the United States have anything to do with using hierarchy to organize economic activity rather than spontaneous order.  If yes, explain.
CHAPTER 12: For those who are interested in more detail there are textbook explanations of elasticity, utility maximizing consumer behavior, profit maximizing business behavior, and other topics.  None of this is necessary to understand how an economic system organizes itself spontaneously.  You have already learned enough to understand this important concept.  We tend to take this marvelous system for granted because it usually works smoothly but like the human body do not mistake smooth for simple. 

One of the mistakes of mainstream economics is to divide the study of economics into macro and micro components exclusively.  What is therefore excluded is the macro-micro connection which is how the individual parts work together in a coordinated and integrated fashion.  In other words, the study of spontaneous order. 

Of course planners have superimposed a partial hierarchy on the otherwise self organizing parts of the system.   So next we need to study the methods and consequences of such policies.. 

Review Questions:  Isn't macro just a large number of micro events?  Does spontaneous order have a macro and a micro component?
CHAPTER 13: The first thing most students are taught in macroeconomics is how to measure aggregates such as total production, total income, unemployment, and the price level. 

They are not of course taught that aggregation is a flawed economic concept.  For example producing more consumer goods does not have the same economic impact as producing more capital goods.  Producing some types of capital goods does not have the same economic impact as producing other capital goods  Yet both add equally to total production, income, and employment. 

The English economist Keynes said it is demand that creates supply.  The French economist Say said that supply creates demand.  That is a fundamental difference in paradigms.  Keynes approved of borrowing and spending to increase current production. Say encouraged saving and investment to increase productivity in the future.    Do you want more now or more later?  Opportunity cost.

Keynes was a central planner which means organization by hierarchy.  Say thought that leaving the economy alone so it could organize itself spontaneously was the best idea.   In the 1930s classical economics based on Says Law began to be replaced by Keynesian economics.  When I studied economics in college during the early 1960s there were no courses in macroeconomics since the professors had learned their economics before Keynes became so popular. 

The purpose of aggregate statistics is to provide information to the central planners so they can try to manipulate the economy in one direction or the other.  In a natural rights/spontaneous order economic system there would be no central planning and therefore this information would not be worth the cost of obtaining it. In other words the Bureau of Economic Analysis would go out of business. 

However if it's statistics you want go to John Williams website to get an unbiased report. 

Review Question:  What would happen if the government suddenly stopped gathering macroeconomic data?  No price indices.  No unemployment rate.  No GDP numbers.