Sunday, October 7, 2007

Introduction and the First Lesson: Incentives Matter

Hi everybody. This is the first post on my new blog about economics. People have told me I should have a radio show, or lobby Congress or the President, or run for office myself. So I did the next, most effective thing which will doubtlessly reach millions of people overnight--I started a blog.

Throughout this blog you will see me use humor on occasion, or what I call humor, but it doesn't mean that what I say is not to be taken seriously. Which is to say that what I say should be taken seriously, even if I use humor. Which is a roundabout way of mentioning the seriousness of not saying what I'm thinking when I use humor. Or something.

Before I get into today's lesson, I'd like to explain what economics is and why it is so darn important. A quick definition taken from some other economist who probably won the Nobel Prize or something:

Economics is the study of the allocation of scarce resources which have alternative uses.

"What? I thought economics was about money. Or business. Or something."

Nope, economics does not necessarily concern itself with money, or markets, or businesses, or government, or stocks, or banks, or any of the other things you may immediately think of when you hear the term "economics."

Now a resource is a thing which can be used as an input into a process to get a certain output. Like putting gasoline into a car. The resource is gas, the output is an engine that runs. Some important points to note here, which explain how gasoline is an economics thing, is that 1) gasoline has other uses and 2) gasoline is scarce.

Think about it. If a certain resource were infinite, what need would there be to economize? We'd all have enough. Demand would be satisfied everywhere. But resources are scarce. Breathable air is scarce, oil is scarce, healthcare is scarce, education is scarce, food is scarce, DVD players are scarce. Just because something is in abundance doesn't mean it's not scarce. Scarce means "less than infinite," or "finite" in other words. Part of the problem of economics is getting a limited resource to the largest number of people, or satisfying as much demand for that resource as possible.

And gasoline can be used for other things. It can be used to fuel other peoples' cars instead of your own, or it can be used in lawn mowers, or for entertainers to set their farts on fire. Gasoline isn't the only resource with alternative uses. Wood, steel, plastic, time, space, and even human beings themselves have alternative uses. Another part of the problem of economics is putting resources to their most valued use first, rather than putting them to a use that isn't as valued.

So, now you see how economics is not just about money, or markets, or things of a financial nature. It is about any scarce resource that has alternative uses, and how it can be allocated.

Why is this important? Don't we elect politicians so we don't have to worry about this kind of thing? Shouldn't we leave this to the experts? Yes and no. Some things belong in the hands of politicians because politicians are best able to handle those particular things, but a great many things are best left to people to decide. I don't say this because of some political ideology or philosophical notion of rights, but simply because it's more economical. You'll understand more as this blog goes on.

Back to why economics is important: Because people starve to death. Governments have committed genocide and gone to war. People go without the health care they need to survive or the education they need to get a job or the basic necessities they need to get by. Because single mothers don't make enough to raise a family. All from bad economic policies put into place, or economic problems ignored or exacerbated by the government.

Economics is not, and should not, be the concern only of rich people living comfortable lives, because when bad economics is put into action the people on the margin are the ones who suffer first, and who suffer the worst. An inadequate education system is much harder on a single mother than on a Senator's son who will wind up in an Ivy League university. Rampant inflation is far worse for blue collar workers living paycheck to paycheck than it is on the CEO of Viacom. (which is not to say that all business owners are rich, most of them are not and many of them make less money than those they employ)


I hope you're not too bored, and you're still with me, because now that I have my intro out of the way I can start the first lesson. And since you were nice enough to read this far (you didn't skip ahead, did you?) I'll make it as brief as possible. Here's the lesson: incentives matter. Corollary: so do constraints.

I should probably add a little meat to those bones, huh? What is an incentive? It's a thing that leads people to do...things. For instance, the incentive to avoid starvation will make you eat food. The incentive to avoid being killed will make you not run with the bulls in Pamplona. The incentive to have a higher material standard of living will make you go for a job that pays more money, even if you're already quite comfortable where you are. That one incentive is the incentive from which most other incentives flow--that is, the incentives that matter in economics--because it is the incentive to make ourselves better off (meaning having a higher material standard of living) which drives the economy. It's how enough food is brought into cities to feed a million people a day, it's how gas is brought to the gas station, it's how drugs are invented. Somebody followed their incentive to engage in a trade that made themselves better off. And as a side effect, it made somebody else better off too.

You worked for your boss. He got your production (whether you produce cars, insurance, or just mopped floors, it's the same principle), and you got his money. Your incentives were coordinated so that you each were better off. You valued the wage more than the time and effort it took to earn it, and he valued your output more than the money he paid you for it. Without incentives, nobody would go to work, eat, sleep, poop, or bring food to grocery stores.

If all of this seems stupidly simple, and a waste of time to even cover, then consider that many very intelligent, educated, and powerful people have put into place economic policies which totally ignore the importance of incentives. The Soviet Union, for instance, was a country that existed many moons ago. From 1917 to 1991, if memory serves me right. The economy was wholly owned and controlled by the government under a system called "communism," and there was no such thing as privately owned property. Everybody worked to support everybody else, not for themselves. Really. By removing the profit motive (a very important incentive in economics) nobody really felt like doing work. The only incentives that existed under this system were the incentive to avoid starvation, jail time, or execution. Over time the Soviet authorities realized they needed to provide incentives to get people to do things, so they started giving better apartments and things like refrigerators and tvs to their top performers.

Basically, millions of people in the Soviet Union wound up starving to death, and those that lived through the whole thing lived in horrible poverty. It was a country that could put a man into space but couldn't feed its people. This isn't to harp on the Soviet Union (I am a Russophile, after all), merely their economic system.

That was just one really horrendous and obvious example of how incentives matter. There are other policies or economic systems which also ignore incentives, but few if any are as bad as communism was (and still is, in countries like Cuba and North Korea), so it's great to use as a clear example. Starvation drives the point home better than do higher costs for sugar, doncha know.

"Didn't he say something about constraints?"

Yes I did, and this will be quick. Well, I'll try to make it quick. Constraints are the opposite of incentives. Incentives lead us toward something (earning more money, eating, going to work, buying things) and constraints drive us away from things. An example is how the higher tax on gasoline (currently 46 cents per gallon I think) adds to the price of gasoline, making us buy less gas and drive less than we would if the tax on gasoline were just a normal sales tax. Basically, incentives lead us to things that would make us gain, while constraints drive us away from things that would make us lose.

This isn't to say that constraints are worse than incentives, they are just different. I, personally, prefer a system of laws where there are constraints in place that keep guys with pantyhose on their heads from breaking into my apartment and stealing my HD DVD player ($233 at Amazon with free shipping, you can't beat that). A penalty for something is a constraint, and jail time or having your balls tased by a rookie cop counts as a penalty. It would make that panty-headed guy lose. He'd lose his time and his freedom, both of which are of value to him because he could use those resources to gain. Either with a job, finding coins on the street, or just walking through a park and enjoying the day.

Boy, I haven't talked about scarce resources with alternative uses and how they can be allocated much, have I? Never fear, I just wanted to set the groundwork by talking about the most fundamental thing in economics, the importance of incentives and constraints, since they are what guide human behavior and without human behavior, an economic model is just a plan.

Until next time..........


roberto teixeira said...

I'm a software engineer who happens to also be an enthusiast of economics. I am most certainly not an economist.

I've already subscribed to your feed. Hope to read more and more from you -- hopefully you'll eventually stop using fixed-width fonts, though, as I have a lot of trouble reading long texts in Courier in the computer screen. Other than that, carry on! :-)

Jacob Oost said...

Whoa, a comment! I had no idea anybody was even reading this. Gee, a fan, I'll have to update more often.

And I like courier. I wrote one and a half novels in courier. :-P