Tuesday, August 14, 2012

Pulling It All Together: What Should Crusoe Do With Himself? - - Robert P. Murphy

Pulling It All Together: What Should Crusoe Do With Himself?

We’re finally ready to explain how Crusoe actually conducts himself. To put it simply, Crusoe will make decisions in order to achieve his most important goals. In the language of economics, Crusoe will act to achieve his highest-ranked preferences; some economists would say Crusoe will “maximize his utility.”

However there is an important caveat. When Crusoe makes a choice, he can’t simply consider the benefits, as he subjectively perceives them. He must also consider the costs. The cost of a particular decision is the value that Crusoe places on the most important goal that he won’t be able to achieve, because of the decision. Economists often drive home the point by using the longer term opportunity cost, which they define as the subjective value placed on the next-best alternative that must be sacrificed because of a choice.

Up till now in this lesson, we have been explaining the nature of the tradeoffs Crusoe faces in his daily decisions. Without realizing the connections between his choices, we wouldn’t be able to make much sense of Crusoe’s actual decisions. For example, let’s reconsider Crusoe’s actions as he ran out of the burning hut. We said that he faced a choice, between grabbing a coconut or grabbing a watch. But actually, we cheated a bit; we zoomed ahead to what we knew the real tradeoff was. In reality, Crusoe had all sorts of options at his disposal. Rather than grabbing the coconut or watch, he could have decided to use his hands to punch himself in the face. Or he could have picked up the coconut, but then hurled it at the burning roof. In fact, we just took it for granted that Crusoe would leave the hut in the first place. He certainly had the option to calmly eat his last coconut before passing out from smoke inhalation.

When we discussed Crusoe’s actions after he foolishly let his hut catch on fire, we didn’t bother considering all of the silly possibilities just mentioned. We knew that Crusoe would first and foremost choose to save his life by running out of the hut, because (we assume) he placed self-preservation very high on his list of preferred outcomes. (It was much much higher than, say, “getting a few minutes more sleep.”) And in that context, we knew that he faced the subsequent decision of grabbing just one item on his way out. We didn’t bother comparing the benefits of rescuing the watch, versus the cost of not being able to punch himself in the face with two free hands. That wouldn’t have been an accurate description of the true cost of his action, because “the joy of face pummeling” is presumably not high on Crusoe’s list of preferences.

Instead, when trying to understand the decision Crusoe really faced, we looked at what the best option was, that he would thereby have to sacrifice because of his decision to grab the watch. In our story, we assumed that Crusoe’s next-best alternative was grabbing the coconut.12 The economist would explain Crusoe’s action in this way: Crusoe decided that the benefits of having the watch outweighed the cost of having one fewer coconut. This is simply using different words to say: The goals Crusoe could achieve with a watch and 99 coconuts, were more important to him than the goals he could achieve with no watch and 100 coconuts.

The other decisions Crusoe makes are more complicated, but the basic principle is the same: Crusoe always chooses the option for which the benefits exceed the costs. For example, when Crusoe decides to work a fifth hour on a particular day, in order to gather more vines, it’s because he considers the benefits to outweigh the costs. In this case, the benefits are (ultimately) the extra pleasure he will get from consuming more coconuts in the future. (Remember that he needs the vines to maintain his pole in good condition, in order to knock down coconuts.) The cost is the value Crusoe places on the most important goal that he now won’t be able to achieve. For example, suppose on his way to cut down more vines, Crusoe sees a pile of perfectly cut vines lying on the ground, the result of a freak lightning strike. In that case, Crusoe might decide to enjoy an extra hour of leisure. That means the cost of his original decision (to spend an hour cutting vines) was the value to Crusoe of having 20 hours of leisure that day, instead of 19.

The last point in this lesson is that all of Crusoe’s actions are guided by his expectations, which is to say his predictions about the future. When Crusoe makes a particular decision, he is really choosing the outcome that he expects will give him more benefits than costs. He very well could be mistaken. For example, Crusoe might spend several weeks collecting branches and other materials, in order to construct a raft. He thinks he will be able to use it to escape to the high sea, where he hopes someone will rescue him. The benefits of this small chance of escape are more important to Crusoe than the leisure he is giving up during the construction of the raft.

However, after many attempts, Crusoe realizes that the ocean won’t let him escape the island on his raft. Unfortunately, he can’t find anything on his island that would serve as a large sail. He realizes with great regret that his efforts on the raft were a complete waste of time. Or more accurately, a complete waste of leisure.

Despite Crusoe’s mistake, as economists we still explain his original choices by saying that Crusoe considered the benefits of getting out to sea to be greater than the cost of many hours of leisure. Even though this wasn’t the true tradeoff involved, Crusoe believed that it was, and it is ultimately Crusoe’s beliefs (and preferences) that guide his decisions.

Lesson Recap...

We can learn many basic economic concepts and principles by studying an imaginary “economy” consisting of just one person. After mastering the tools in a simplified setting, we can apply them to more complicated (and realistic) scenarios involving many people.
One of the most important decisions a person makes is whether to devote time and other resources to the present or to the future. Through saving and investment, people sacrifice current enjoyments but achieve much greater enjoyments in the future.
Economists say that an individual will engage in more and more “units” of an activity so long as the subjective benefits outweigh the costs.

Economize: The act of treating a resource with care because it is scarce and can only satisfy a limited number of goals or preferences.
Consumer goods and services: Scarce physical items or services that directly satisfy a person’s preferences.
Producer goods / factors of production / means of production: Scarce physical items or services that indirectly satisfy preferences, because they can be used to produce consumer goods and services.
Land / natural resources: Factors of production that are gifts of nature.
Labor: The contribution to production flowing from a person’s body.
Leisure: A special type of consumer good that results from using one’s body (and time) to directly satisfy preferences, as opposed to engaging in labor.
Disutility of labor: Economists’ term to describe the fact that people prefer leisure to labor. People only engage in labor because of its indirect rewards.
Capital goods: Producer goods that are produced by human beings; they are not direct gifts from nature.
Income: The flow of consumer goods and services that a person has the potential to enjoy during a specific period of time.
Saving: Consuming less than one’s income would allow; living below one’s means.
Investment: Diverting resources into projects that are expected to increase future income.
Productivity: The amount of output produced by a factor of production in a period of time, often used in reference to labor.
Equilibrium: A stable situation after all disturbances or changes have worked themselves out.
Depreciation: The wearing away or “using up” of capital goods during the course of production.
Marginal utility: A technical economics term referring to the subjective enjoyments of one additional unit of a good or service.
Benefits: The subjective enjoyments flowing from a course of action.
(Opportunity) cost: The benefits of the next-best alternative to a given action.
Expectations: An individual’s forecasts of the future, which involve his or her understanding of “how the world works” and therefore guide current actions.

Lessons for the Young Economist

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