Sunday, July 22, 2012

How We Develop Basic Economics - Robert P. Murphy

As we discussed above, economic theorists face two huge problems: the objects of their study have minds of their own and it is much harder to perform a controlled experiment in economics than in a natural science such as chemistry. These differences partly explain why the so-called hard sciences enjoy a much better reputation for objectivity and success than the soft sciences, including economics.
However, the economist does have one enormous advantage over the natural scientist: the economic theorist is himself a thinking being, with conscious goals. Because he has an insider’s view of acting in the economy, the economist can more easily understand the motivations and constraints faced by other actors in the economy. In contrast, the particle physicist doesn’t have any idea “what it’s like to be a quark,” and so the physicist must rely exclusively on the familiar empirical techniques to gain insight into the behavior of quarks.
Earlier in this lesson we focused on the important distinction between purposeful action versus mindless behavior, because this difference is key to developing useful economic principles. The economic principles we will develop in this book are all logical implications of the fact that there are other people with minds who try to achieve their own goals. In other words, if we as social scientists decide to commit to the “theory” that there are other minds operating in the world—just as each of us can directly experience his or her own mental awareness—then that “theory” starts spitting out other pieces of knowledge that are consequences of it. You will probably be surprised in Lesson 3 when we show just how much of economics is packed into the simple observation that, “John Doe is acting with a purpose in mind.” Right now we won’t list any of these results, because you should first understand exactly what it is you’ll be doing as you work through Lesson 3.
Rather than looking to physics or chemistry for guidance on how to develop good economic principles, a much better role model is geometry. In standard (i.e., “Euclidean”) geometry, we start with some basic definitions and assumptions that seem reasonable enough. For example, we define what we mean by a point and a line, we explain what we mean by the angle formed at the intersection of two lines, and so forth.
Once we have our starting definitions and assumptions in hand, we can use them to start building “theorems,” which is a fancy word for the logical deduction of the consequences of our original definitions and assumptions. A geometry textbook will start with the most basic theorems, and then use each new result to deduce something even more complicated. For example, early on a simple theorem may run like this: “If we start out with four lines that form a rectangle, then we can draw a new, fifth line that divides the rectangle into two identical triangles.” Once that (very simple) theorem is proved, it can be added to the toolbox, and subsequent, more difficult theorems can invoke this earlier theorem in one of their steps.
The procedure or method of geometry is quite similar to what we’ll do in this book to build up basic economic principles. In the next lesson we’ll define some concepts (such as profit and cost) and show their relation to our basic assumption that events in the social world are driven by purposeful actions. As we go through the lessons, we will continue to add new insights, by building on the previous lessons and by introducing new scenarios where we can apply our earlier results.
At this stage, there are two important observations you should make about the example of geometry First, notice that it doesn’t make sense to ask a mathematician to go out and “test” the theorems in a geometry textbook. For example, consider the Pythagorean Theorem, which is probably the most famous of all geometrical results. The Pythagorean Theorem says that if you have a triangle with a 90-degree angle, and you label each side with a letter, then the following equation will hold:

Once you have seen an actual proof of the Pythagorean Theorem, you understand that it must be true. To amuse yourself, you can take a ruler and a compass (used to measure angles) and “test” the theorem out on triangles that you draw on a piece of paper. However, you’ll find that in practice the theorem won’t appear to be exactly true; you might find that the left-hand side of the equation adds up to 10.2 inches while the right-hand side comes out at 10.1 inches. Yet if you get such “falsifications” of the theorem, and point them out to a mathematician, he will explain that the triangle you were measuring did not really have an exactly 90-degree angle after all (maybe it was 89.9 degrees), and the ruler you used to measure the lines was an imprecise tool, since it only has so many notches on it and in practice you were “eyeballing” how long each line was to some extent. The important point is that the mathematician knows that the Pythagorean Theorem is true, because he can prove it using indisputable, step-by-step, logical deductions from the initial assumptions.
This is a good analogy for how we derive economic principles or laws. We start with some definitions and the assumption that there is a mind at work, and then we begin logically deducing further results. Once we have proved a particular economic principle or law, we can put it in our back pocket and use it in the future to help in proving a more difficult result. And if someone asks us whether the data “confirm or reject” our economic principle, we can respond that the question is nonsense. An apparent “falsification” of the economic law would really just mean that the initial assumptions weren’t satisfied. For example, we will learn in Lesson 11 the Law of Demand, which states that “other things equal, a rise in price will lead to a drop in the quantity demanded of a product or service.” Now if we try to “test” the Law of Demand, we will certainly be able to come up with historical episodes where the price of something rose, even though people bought more units of the good. This finding doesn’t blow up the Law of Demand; the economist simply concludes, “Well, ‘other things’ must not have been equal.”
We now move on to the second important observation you should take away from our discussion of geometry: Just because something is logically deduced from earlier definitions and assumptions (sometimes called axioms), the resulting proposition might still contain important and useful information about the real world. We stress this point because many people think that a field of study can be “scientific” and provide “information about the real world” only if its propositions can, at least in principle, be refuted by experiments or measurements. This requirement is obviously not fulfilled in the case of geometry, and yet everyone would agree that studying geometry is certainly useful. An engineer who sets out to build a bridge will have a much better shot if he has previously studied the logical, deductive proofs in a geometry class, even though (in a sense) all the theorems in the textbook are “merely” transformations of the information that was already contained in the initial assumptions.
The same is true (we hope!) for the economic principles and laws contained in this book. You will not need to go out and test the propositions to see if they’re true, because any apparent falsification would simply mean that the particular assumptions used in the proof were lacking at the time of the “test.” However, you will find that gaining this “armchair knowledge” through careful introspection and logical reasoning, will actually allow you to make sense of the real world in all its complexity. You will do much better navigating the economy, and making sense of its outcomes, once you have mastered the logical (yet un-testable) lessons in this book.

Lesson Recap...

A purposeful action is performed by a conscious being with a mind, who is trying to achieve a goal. Mindless behavior refers to motions in the physical world that are the result of “mere nature” and not the intentions of another thinking being.
The natural sciences include fields such as physics, chemistry, and meteorology. They study the natural world and try to deduce the “laws of nature.” The social sciences include such fields as sociology, psychology, and economics. They study different aspects of human behavior, including our interactions with each other in society.
The natural sciences develop theories that try to predict the behavior of mindless objects with better and better accuracy. They enjoy success because these objects seem to obey a constant set of fairly simple rules, and because in many settings they can perform controlled experiments. In the social sciences, including economics, the objects of study have minds of their own, and controlled experiments are much more difficult to perform. To develop economic principles, the economist relies on his own experience of purposeful action, and deduces the logical implications from it. In this respect economics is closer to geometry than to physics.

Purposeful action: An activity undertaken for a conscious reason; behavior that has a goal.
Keynesian economics: A school of thought (inspired by John Maynard Keynes) that prescribes government budget deficits as a way to lift the economy out of recession and restore full employment.
Budget deficit: The amount the government must borrow when it spends more than it collects in taxes and other sources of revenue.
Austrian economics: A school of thought (inspired by Carl Menger and others who happened to be Austrian) that blames recessions on government interference with the economy, and recommends tax and spending cuts to help the economy during a recession.
Logical deduction: A form of reasoning that starts from one or more axioms and moves step-by-step to reach a conclusion.
Axioms: The starting assumptions or foundations in a deductive system. For example, the method of constructing a straight line between two points could be an axiom in a geometry textbook. Axioms are not proved, but are assumed to be true in order to prove other, less obvious, statements.

If someone sneezes when pepper is thrown in his face, is that a purposeful action?
Does “purposeful action” include mistakes?
Are brain and mind interchangeable terms?
Can we perform controlled experiments to test economic theories?
Would you classify Intelligent Design theory as a natural or social science?

Lessons for the Young Economist

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