In analyzing economic behavior, economists tend to have a common approach -- even though they make make very different policy prescriptions. That is, it may be said that there is an "economic way of thinking" that characterizes the way in which economists approach and analyze economic problems and that distinguishes economists from other social scientists. [N.B. Some argue that student performance in economics is directly linked to the ability to develop and utilize the economic way of thinking.]
We can identify five principal characteristics of economic thinking that are essential to the economic approach:
1. Scarce goods have a cost -- there are no free lunches.
In order to acquire an economic (scarce) good, one must give up something (usually, money or effort or both) -- i.e., one must pay a cost. The cost of many scarce goods is direct and thus obvious (as with private goods sold in the market). Other goods and services, especially public goods, do not have such an obvious cost.
For example, consider public elementary education, which at first glance appears to be "free" to students. Note that providing public education requires scarce resources (for buildings, teachers' salaries, books and supplies), which are obtained from tax revenues. Thus the community (taxpayers) bears the direct costs of providing public education. If the scarce resources involved were not used to produce elementary education, they could be used to provide other goods (public and/or private). Hence, the community forgoes (gives up) other scarce goods in order to provide public education (this is also true with respect to "free" pizza delivery, "free" medical care, etc.).
Consider again our elementary-school students. May we at least say that public education is free for them, thanks to the subsidy provided by the community? From an economic perspective, the answer to this question is "no." If something is truly free, you can have it without sacrificing anything (like clean air in the old days before industrial pollution). But elementary school students must give up (forgo) their time -- time in which they could have been playing, watching TV, etc. Thus, the students themselves do bear a cost -- albeit nonmonetary and indirect -- in attending school: the forgone opportunities associated with attending school. (cf., high school students and forgone wages.)
This kind of cost is referred to by economists as opportunity cost. The notion of opportunity cost is one of the most fundamental concepts in economics. Formally, the opportunity cost of using resources in a certain way is the value of what these resources could have produced if they had been used in an alternative way (note time as a basic and very scarce resource).
As in the example of elementary school students, the "value of what these resources could have produced" need not be monetary -- it may instead refer to the individual's subjective evaluation of the satisfaction associated with the activity forgone. Parkin defines opportunity cost as "the best alternative forgone;" a more cumbersome definition is "the highest-valued alternative that must be sacrificed because one chooses an option is the opportunity cost of the choice."
Hence, if you have a choice among competing alternative activities (e.g., A, B, and C), you will bear an opportunity cost once you choose a particular option. For example, if A is most highly ranked and C is least highly ranked, the opportunity cost of choosing A is the satisfaction that you gave up by not choosing the next-best alternative, B (examples: study vs. going to the movies, going to your 8 o'clock class vs. sleeping in, whether or not to go to college). This concept of opportunity cost is very helpful in understanding and analyzing human behavior, including behavior that we might not ordinarily consider as being "economic" (e.g., fertility).
The more general point here, in the context of the economic way of thinking, is that the provision of a scarce good or engaging in a particular activity always involves a cost: we must give up other goods or other activities in order to have the scarce good or engage in the activity in question. Thus, economic goods are not free.
2. Decision makers choose purposefully; therefore, they will economize ("rationality").
Since resources are scarce, individuals have an incentive to be efficient and avoid wasting valuable resources in the pursuit of their own personal objectives. Formally, economists view individuals as attempting to maximize their satisfaction (utility) subject to resource constraints (limited income, time, talent).
Economizing behavior results directly from purposeful decision making. Economizing individuals will seek to accomplish an objective at the least possible cost. When choosing among goods or activities that yield equal benefit, an economizer will select the cheapest option. Likewise, when choosing among alternatives of equal cost, economizing decision makers will select the option that yields the greatest benefit (satisfaction or utility). Note the importance of marginal analysis.
Purposeful choosing implies that decision makers evaluate the benefits and costs of different alternatives. This implies that decision makers have some knowledge on which to base their evaluations. As noted above, utility serves as the basis for these evaluations, where utility is the subjective benefit or satisfaction that an individual expects from the choice of a specific alternative. Note that since utility is subjective, rational individuals may differ in their evaluations of different activities.
3. Incentives matter: human choice is influenced in a predictable way by changes in economic incentives.
As the personal benefits from choosing a particular option increase, other things equal, an individual will be more likely to choose the option. Conversely, as the costs associated with choosing an activity or a good increase, a person will be less likely to choose the option. [Note that this assumes the existence of substitutes; cf., perfect and imperfect substitutes, coke vs. pepsi.]
For society, then, this postulate implies that as an option is made more attractive, more people will choose it; whereas making an option more costly will result in fewer people choosing it. Thus, for example, improving the quality of food in dormitories would, in this view, increase the number of students who wished to live in dormitories; whereas increases in the cost of dorm living relative to living off campus would reduce the number of students who wanted to live in dorms. Proposals for tax cuts, welfare reform, harsh penalties for drug dealers, and numerous other policy changes are based in large part on the view that incentives matter.
This basic economic concept provides a powerful tool with which to analyze various types of human behavior -- both noneconomic as well as economic. The economic way of thinking emphasizes that changes in incentives exert an important and predictable influence on human decisions.
4. Information, like other resources, is scarce; hence, even purposeful decision makers will not always have perfect information when they choose.
Rational decision makers recognize that it is costly to obtain information and make complex calculations. Although additional information to improve one's decision-making capabilities is valuable (its marginal benefit is positive), often this potential benefit is less than its cost (MB < MC). Thus, the sensible consumer will conserve on limited resources used to acquire information, as he or she conserves on scarce resources in other uses.
5. Economic actions often have secondary (indirect) effects in addition to their immediate, direct effects.
In economics as elsewhere (drinking gets you high, but leads to a hangover; bitter aspirin -> headache relief; lovemaking may result in pregnancy; 3 strikes and you're out -> clogging the courts), there are secondary effects that take time to develop and that may be quite different from the initial direct effect. The centerpiece of Bob Dole's economic proposal is a tax cut which, initially, will reduce government revenues and hence contribute to a bigger budget deficit; however, the Dole-Kemp view is that ultimately the tax cut will stimulate greater economic activity and hence higher tax revenues.
The economic way of thinking asks, "In addition to the initial result of this policy, what other factors have now changed? How will future actions be influenced by the change in economic incentives that resulted from implementation of this policy?"
Good economic thinking demands that we recognize the longer-range secondary effects as well as the immediate, readily identifiable consequences of economic change. Further, it's important to recognize that the adjustment process through which secondary effects emerge takes time.
© 1996 David Shapiro
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