The Online Library of Liberty

A project of Liberty Fund, Inc.

• Introduction
• Part 1: Economics and Ethics
• Chapter 1: Are Economists Basically Immoral? *
• Chapter 2: Economics and Ethics: the Problem of Dialogue *
• Chapter 3: Income and Ethics In the Market System *
• Part 2: Economics and Theology
• Chapter 4: Can Homo Economicus Be Christian? *
• Chapter 5: Economic Scientists and Skeptical Theologians *
• Chapter 6: Christian Theological Perspectives On the Economy *
• Chapter 7: Controlling Stories: On the Mutual Influence of Religious Narratives and Economic Explanations *
• Part 3: Economics, Theology, and Justice
• Chapter 8: Justice, Natural Law, and Reformation Theology *
• Chapter 9: The Concept of Economic Justice In Religious Discussion *
• Chapter 10: The U.s. Catholic Bishops and the Pursuit of Justice *
• Part 4: Economics and History
• Chapter 12: Christian Social Thought and the Origination of the Economic Order *
• Chapter 13: Clerical Laissez-faire: a Case Study In Theological Ethics *
• Part 5: On Teaching and Learning
• Chapter 14: “the Nature of Man”: What Are We After? *
• Chapter 15: Researchers and Degree Purchasers *
• Part 6: Teaching Economics
• Chapter 16: Economics Is a Way of Thinking *
• Chapter 17: Teaching Introductory Economics *
• Chapter 18: Teaching Economics By Telling Stories *
• Chapter 19: Between Sterility and Dogmatism *
• Part 7: Economic Method
• Chapter 20: Ethics On the Road to Serfdom and Beyond *
• Chapter 21: Measures of Wealth and Assumptions of Right: an Inquiry *
• Chapter 22: The Foundations of Law and Economics: Can the Blind Lead the Blind? *
• Part 8: Policy Commentary
• Chapter 23: What Is the Responsibility of Business Under Democratic Capitalism? *
• Chapter 25: An Economic Perspective On Illegal Drugs *
• Chapter 26: Economics, Ethics, and Ecology *

PART 6

Teaching Economics

CHAPTER 16

Economics Is a Way of Thinking*

What do economists know that is both true and important? Not nearly as much as we sometimes pretend. Every profession harbors an inability to appreciate the limitations of its perspective and a tendency to exaggerate its own significance in the larger scheme of things. Since this essay comes from the pen (word processor, actually) of a devout economist, it will probably exaggerate the power and social value of economists’ knowledge. But the critics of economics have lately enjoyed a substantial amount of public exposure in this part of the world. If you want a sample, see “A Consumers’ Guide to Recent Critiques of Economics” in Agenda, the new Australian policy journal.1 A resounding defense of economics can therefore do no harm.

The Heart of the Matter

Why pay heed to economists? What do they know that is worth listening to? The answer differs, of course, among economists. Some know a lot about the form and functions of gross domestic product, labor force data, reserve banks, taxation and expenditure policies of governments, financial institutions and the markets in which they operate, and what economists usually call macroeconomics. Some know a lot about the history of economic systems. Most know a great deal of statistics and mathematics. But I shall emphasize what I think is most valuable in everything that economists know, or that at least the good economists know, with “good economist” circularly defined as one who not only knows it but believes strongly in its applicability and importance. A good economist knows how to employ the economic way of thinking.

Is it presumptuous to speak about the economic way of thinking? Aren’t there several economic ways of thinking? There are surely many ways to think about economic life, at least once we’ve decided exactly what we mean by “economic life” (which turns out not to be all that easy). But there is a particular perspective on human actions and interactions that regularly emerges when economists analyze the world that many economists recognize as uniquely the economic way of thinking. This article will try to explain and illustrate that way of thinking, with teachers of introductory economics especially in mind.

I like to summarize the economic way of thinking in a short sentence that states its basic assumption: All social phenomena emerge from the choices of individuals in response to expected benefits and costs to themselves.

Economizing Actions

It took me many years of practicing with this way of thinking to realize that it actually has two aspects, both expressed in the statement that it offers a particular perspective on human actions and interactions. One aspect of the economic way of thinking focuses on human actions. The other—the more difficult, more useful, and more neglected aspect, I shall subsequently argue—focuses on human interactions.

The former, which I shall call the action aspect, picks up the notion that economics is about economizing. To economize means to allocate available resources in a way that extracts from those resources the most of whatever the economizer wants. Scarcity makes economizing necessary. Anyone with access to unlimited resources does not need to economize. Keep in mind, however, that time is one of those scarce resources—except perhaps, when we are bored and time hangs heavy on our hands. The scarcity of time compels even those to economize who have more money than they know how to spend because they must ordinarily combine their scarce time with the resources their money can purchase in order to obtain what they want. A week in the Islands of the Aegean leaves less time, unfortunately, for lounging on the Left Bank in Paris, no matter how huge your monetary income.

Because scarcity makes economizing unavoidable, everybody does it. We don’t always do it consciously. And sometimes we do it badly, even by our own standards: we allocate our resources in a way that we subsequently come to regret. Most often that occurs because we lacked some relevant information when we made our allocation decision. But information is also a scarce good. If all the relevant information were one of the resources constantly available to us, we would never make mistakes. In the real world, however, we have to sacrifice other goods to acquire additional information. We have to use time and energy that could be employed in some other way to investigate, for example, the characteristics and prices of the various television sets available for purchase. At some point we decide that the results of further investigation probably won’t justify the time and trouble it will take. We stop searching for further information, and we act. But we may turn out to have been wrong. One more telephone call, we learn too late, would have revealed a better deal than the one on which we finally closed.

Marginal Decisions

Economic theory has a pair of bright lights to shine on the economizing process: the concept of the margin and the concept of opportunity cost. Even very young students can learn to interpret their own actions in terms of marginal decisions and opportunity costs, often with a sense of gleeful discovery.

Economizing means making trade-offs. We would like to have more of one thing, but we give it up in order to obtain more of something else. The marginal concept highlights two important but easily overlooked facets of this process. One is that trade-offs don’t have to be all or nothing affairs.

This is important because additional amounts of almost everything become less valuable to us as we acquire more. Water provides a good example. People like to claim that water is “a necessity of life,” and then to draw from this simple “truth” a lot of unwarranted conclusions, such as a city “needs” a specific amount of water and that those who supply water must keep its price very low. The amount of water that people “need,” however, will depend on how much they have grown accustomed to using, and that will depend heavily on how much they have had to pay for it. When water is inexpensive, homeowners maintain large lawns and farmers grow rice in desert areas. When water becomes more expensive, homeowners install water-saving devices in their showers and toilets, set their washing machines at lower water levels, and wash their cars less frequently and without letting the hose run the whole time they’re doing it. Farmers shift from crops like rice to crops that don’t require artificial irrigation.

Housing is another alleged “necessity” that turns out not to be quite what it originally seemed when we look at it through marginal spectacles. The real question is what quality and quantity of housing do people “need.” Once again this will prove to depend largely on what people have grown accustomed to, which will depend in turn on their accustomed income and the price they must pay for housing. Families “need” fewer bedrooms when housing costs more, and fewer bathrooms when the cost of installing plumbing goes up substantially. The sensible economizer, whether a householder or a business decision maker, makes trade-offs by comparing the expected benefits of obtaining an additional or marginal amount with the benefits expected to be lost from giving up (trading off) a small amount of something else. “All or nothing” is the slogan of those who either aren’t thinking carefully or are deliberately trying to stampede others into giving them something they want.

The other aspect of the marginal concept worth nothing is the emphasis it places on the variety of margins or edges along which we can usually decide. When the cost of an option goes up, there are many more ways to react than we initially suppose. What would residents do, for example, if the councils of Auckland or Wellington decided to attack their traffic congestion problems by charging motorists for driving on crowded streets during busy times of the day; perhaps through an automated system of monitoring accompanied by monthly bills? Some few would choose to pay the tolls and drive just as much as before. Most motorists in these cities, however, would search for and discover a variety of margins along which they could adjust their behavior. They would eliminate those single-passenger trips for which they could find good substitutes, such as car pools, walking, consolidation of errands, buses, even the telephone, which is indeed a substitute for a car trip on some margins. We all like to insist that “we are left with no choice” when someone proposes a change in circumstances that is not immediately to our advantage; and we aren’t always lying when we do so. We may just not yet have had sufficient incentive to search for good alternatives.

Opportunity Costs

Marginal thinking directs our attention to incremental benefits and incremental costs and to the variety of directions in which choice can be exercised. The concept of opportunity cost focuses our attention on the ultimately subjective character of all costs. The cost of any action—and only actions, not things, can have genuine costs—is the value of the opportunity that will have to be given up if that action is taken. If the price of seeing a particular movie is $10, the cost of seeing the movie to the individual who is thinking about it will be the value—the subjective valuestatic/, of course—of what he or she would otherwise have been able to obtain with those $10.

If an action does not require the sacrifice of any valuable opportunity, then it costs nothing to take that action. The relevant point for checking on cost is always at the margin, at that position in time and space where the decision maker currently stands. Should you fly or should you drive your own car when you want to travel from Christchurch to Dunedin. Which costs less? You will want to ask about the value of the time you give up when you drive as well as the value of the money you give up when you decide to fly. In calculating the money cost of driving, you do not want to include any costs that are not actually the consequences of this decision. Licensing and insurance costs and a substantial portion of your depreciation costs are not costs of driving your car but costs of owning it. So unless you are going to buy a car specifically to make this trip, you do not want to include the costs of owning as part of the opportunity costs of driving from Christchurch to Dunedin. The only costs relevant to your decision will be the value of the opportunities you give up to follow the course decided upon.

Restaurant patrons who eat food they don’t want because they have already paid for it; householders who refuse to sell a piece of furniture that is only cluttering up their storage space because the best price they can get is so much less than they (foolishly) paid for it; and business firms that consult their research and development costs in determining the best price to set for new products are all paying attention to past expenses, none of which are relevant to current decisions, because they do not represent the value of opportunities that will be forgone.

Will be forgone! Opportunity costs, the only costs relevant to decisions, in addition to being costs of actions and subjective costs to some particular person or persons, always lie in the future. Teachers of introductory economics can do a great deal to clarify their own and their students’ thinking about costs just by keeping in the foreground these three interrelated aspects of costs.

Interactions: Coordinating the Actions of Economizers

The economizing process is so central to the economic way of thinking that many economists have mistakenly concluded that there is nothing more to it. They seem to suppose that interactions among diverse individuals can also be analyzed and understood as an economizing process, in disregard of the fact that economizing presupposes a unified point of view, which implies a single person in command. If the core problem for economic actions is scarcity, the core problem for economic interactions is a multiplicity of diverse and incommensurable projects. The solution to the scarcity problem is economizing; the solution to the problem of diverse projects is coordination.

Our economizing actions occur in societies characterized by extensive specialization. Specialization is a necessary condition for the increases in production that have so increased “the wealth of nations” in recent centuries. But specialization without coordination is the road to chaos, not to wealth. How is it possible for millions of people to pursue the particular projects in which they are interested, on the basis of their own resources and capabilities, in substantial ignorance and disregard of the interests, resources, and capabilities of almost all of the people upon whose cooperation their own projects depend for success? I specialize in writing about economics, which would bring me quickly to the verge of starvation were it not for the cooperation I regularly receive from editors, printers, paper manufacturers, postal employees, bookstores, teachers, and students, not to mention all the farmers, manufacturers, and service workers whose efforts made it possible for editors, printers, paper manufacturers, and all the others to do for me the things I needed done. How do all these activities get coordinated?

That is the “miracle of the market.” One of the economist’s most important tasks is to demythologize this miracle by enabling people to see how and why it occurs. We do that by teaching the process of supply and demand, and by teaching it as a process of continuous, ongoing interaction among suppliers and demanders. This is not an economizing process. Each supplier economizes and each demander economizes, but their interactions cannot appropriately be viewed as an economizing process in which there is something to be maximized, such as wealth or utility. It is an exchange process, and as such it has no maximand. That’s one very good reason for economists to suppress their inclination to pass judgment on market processes, usually by labelling them less or more efficient, and to be content with the sufficiently challenging and important task of explaining how markets work.

Markets and Prices

Successful explanations will focus on changing relative prices, because prices provide both the information and the incentives without which coordination could not occur. When demanders want more than suppliers have made available, competition among demanders tends to raise the price, which simultaneously induces demanders to get along with less and suppliers to provide more. Competition among suppliers tends to lower the price when suppliers want to offer more than demanders are willing to purchase. How quickly and smoothly this will occur is going to depend upon, among other things, the clarity with which relevant property rights are defined and enforced.

When governments try to “fix” prices or otherwise to constrain the terms upon which demanders and suppliers may exchange, both sides will search for other margins along which to further their goals. Rent controls, for example, don’t prevent rents from rising in a situation where there is excess demand; the most they do is prevent the monetary component of the cost of renting from rising. When tenants want more space than owners are willing to make available at legal prices, owners and tenants find alternative ways of negotiating the arrangements they prefer. One acquires proficiency in the art of economic thinking largely by learning to recognize the ingenious ways in which market participants overcome obstacles to mutually advantageous exchanges, obstacles created not only by government but also by ignorance and uncertainty. The great variety of techniques that sellers employ in order to practice price discrimination among their customers provides an endless supply of examples that always fascinate my students.

Explanations, Not Solutions

Skilled practitioners of this art do not so much solve social problems as solve puzzles and mysteries. Social problems don’t have “solutions,” or at least none that can properly be imposed by economists. The subsidies and protections that New Zealand governments once doled out so generously to both agricultural and manufacturing interests had consequences. The economic way of thinking enables one to discern these consequences more clearly and to predict the consequences of alternative policies. Doing so will often clarify the origin of the subsidies and protections, at least for anyone who believes that democratic legislators pay attention to the interests that are paying attention to them. But the economic way of thinking provides no formula for deciding whether the benefits that a policy confers upon one set of people are greater or less than the costs it imposes upon some other set, even when it enables us to assign fairly accurate monetary measures to these costs and benefits.

There are two principal reasons. One is that the value of money itself varies from one person to another, so that while money measures can and do provide a useful way of comparing the costs to some with the benefits to others, they cannot provide an ultimate resolution when interests conflict.

The other principal reason is that some very real costs and benefits slip through the net of the market. Recall the basic assumption of economic theory. All social phenomena emerge from the choices of individuals in response to expected benefits and costs to themselves. When the costs or benefits of actions spill over on to others in such a fashion that the actors do not take them into account in making their decisions, economizing actions are leaving out potentially important data. Economists refer to such spillovers as externalities, and some go on to point to them as evidence of market failure. The latter is a mistake, another instance of economists’ regrettable inclination to pass premature judgment rather than stick to what they do best: explain and predict. The phenomena of externalities offer economists a rich arena in which to practice profitably the economic way of thinking, and there is no good reason for them to declare the whole area off limits to their art by posting the label market failure. Externalities, like all other social phenomena, emerge from interactions that are the product of individuals’ choices, and the economic way of thinking has a great deal to say about their origins and consequences as well as about the probable consequences of changes in the rules of the game that would produce quite different results.

The economic way of thinking remains useful even when we reach what some people think of as the outer boundaries of the market and where the border of government begins. Government measures and institutions are also social phenomena, and as such they are proper grist to the mill of all economists with a courageous faith in the basic assumption.

Learning by Doing

I have found it extremely difficult to discuss such a large topic as the economic way of thinking in such a short space. It ordinarily takes me an entire school term to introduce the economic way of thinking to my students so that it becomes an enduring component of their own thinking. A short piece such as this had to rely on a lot of vague generalities. We teach and learn the economic way of thinking, however, through a multitude of specific applications. That is certainly how I learned it and how I now try to teach it. And as Adam Smith once suggested, there is no better way to learn a subject than by being required to teach it term after term. So go to it, all you teachers of economics. You learn by doing.

CHAPTER 17

Teaching Introductory Economics*

When people who have taken introductory economics courses at the college or university level in the United States are asked what they remember about the course, most of them answer that they remember little except that it was boring.

The baleful influence of these benumbing courses has now extended itself to eastern Europe and the former Soviet Union. When Marxian political economy was purged from the curriculum, American-style economics quickly moved in to fill its place. Much of the world, it would seem, is coming to the conclusion that the content of a standard American introductory economics textbook should be part of the knowledge possessed by an educated citizen in any “capitalist” country. The process has even corrupted the secondary schools, where economics teachers are increasingly expected to anticipate the material their students will encounter in college or university, regardless of whether the students have any intention of taking a higher-level economics course or even pursuing a tertiary education.

Australians who have encountered introductory economics at the university level tend more often to look back favorably on their first course, because so many of them enroll initially with the intention of completing a degree in the discipline. By the time they come to reflect on their overall education, they have been socialized to the ways of the economics profession and consequently recall the first course as a challenging but essential first step toward a satisfying career. But conversations with both teaching economists and their former students in New Zealand, Canada, and the United Kingdom persuade me that extensive dissatisfaction with the first course is by no means confined in the English-speaking world to the United States.

The Problem with Introductory Economics

The problem with the introductory course can be summarized quickly. Its content has evolved on the assumption that everyone enrolling in a first course in economics will eventually go on to earn a specialized degree in the subject, while the degree program itself has been structured on the assumption that everyone who earns a baccalaureate degree in economics will continue to the doctorate. Thus the beginning student is required to learn concepts and techniques that will be almost wholly useless to anyone who doesn’t plan to earn a PhD in economics. How did such an absurd situation come about and why does it persist, especially in view of the fact that so many college and university economics teachers essentially agree with this analysis?

However it came about, the situation persists basically because academia, despite all its radical talk, is one of the most unrelentingly conservative institutions in society. Colleges and universities derive most of their funding not from customers or clients but from taxpayers and philanthropists who rarely have any clear understanding of what goes on in the ivory towers they support. Undergraduate students, even when given an opportunity to influence the curricula to which they will be subjected, are not altogether sure whether they want education or certification, and insofar as they prefer the latter they are for the most part willing to go along with whatever leads to the coveted degree at a tolerable cost. Because the typical academic institution has no genuine owner and hence no residual claimant, no one in a position to effect constructive changes has the appropriate incentives. Higher-level administrators, who are supposed to have a global perspective, don’t want to risk the faculty outrage they would surely encounter if they tried to force changes on departments that have grown comfortable with the status quo.

In economics, the status quo in the introductory course adequately serves the interests of those with the power to control the course’s content: teachers, departmental chairpersons or curriculum committees, textbook authors, and textbook publishers. None of this is the product of a conspiracy. We are caught in a kind of prisoners’ dilemma, where almost everyone prefers an outcome that is, unfortunately, in no one’s interest to bring about. Teachers present what appears in the textbooks, the textbooks offer what the teachers expect, and the teachers expect what has been in the textbooks for as long as they can remember. Paul Samuelson summarized the situation concisely in 1946 when he was trying to predict the lasting impact of Keynes’s General Theory upon thinking in the economics profession: “Finally, and perhaps most important from the long-run standpoint,” he observed, “the Keynesian analysis has begun to filter down into the elementary textbooks; and, as everybody knows, once an idea gets into these, however bad it may be, it becomes practically immortal.”1

Perhaps the best example of a bad idea that has achieved immortality—or possibly an idea that was once good but has grown bad by living too long—is what passes in the textbooks for the theory of the competitive firm. Generations of beginning economics students have dutifully practiced their arithmetic skills by calculating average fixed, average variable, average total, and marginal costs from an arbitrarily constructed schedule of costs and quantities, have plotted these values on a graph, and have learned to say that in the long run under perfectly competitive conditions price will be equal to marginal cost and to average total cost at the latter’s lowest point. The unfamiliarity of the terms and the abstract character of the argument make it difficult for most students to comprehend. The instructor consequently can occupy a great deal of class time with explanations and clarifications that take no time to prepare. And the ease with which examination questions can be drawn from this material compels all students interested in a good grade to attend faithfully upon the entire performance. None of it, however, finds any subsequent application. The whole system seems to be contrived, as Adam Smith long ago observed about the practices of colleges and universities in general, “not for the benefit of the students, but for the interest, or more properly speaking, for the ease of the masters.”2

Individual instructors have very limited power to change the situation. Not only will they have to devise substitute material for whatever standard textbook material they choose to omit. They also risk the criticism of colleagues and even some of their own students for failing to teach material that turns out to be presupposed in the next theory course. Those who are trying to prepare their students for standardized exams have very little freedom to improvise, because the standardized exams sample heavily the examinees’ acquaintance with technical concepts and definitions. Maverick teachers may even acquire a reputation for not teaching a “rigorous” course, in a culture where “rigor” is the most highly-respected virtue and can best be demonstrated by teaching all the conventional theoretical concepts.

So persistence of the situation despite its widely recognized absurdities should not surprise or puzzle us. The difficult question is how we might change it. To answer that question, we must first think about what we want to accomplish. What ought to be the goal in an introductory economics course?

What Should Introductory Economics Aim to Achieve?

Except for students who know when they enroll that they want to specialize in economics, the goal should not be to prepare the students for the next theory course. Most of the general students who enroll in the first course will never take a more advanced theory course in economics. Perhaps a larger proportion would go on to take “intermediate theory” if the first course conveyed more understanding and made less of an attempt to “cover” everything. That word “cover” may say more than the teachers who use it intend to say. To cover means to conceal; our goal should be to discover or uncover, not to cover. Most of the students, general or professional, who do choose to take our intermediate theory courses would probably be better prepared for them if their introductory course discovered or uncovered the usefulness of a few basic concepts than if it tried to anticipate a lot of subsequent technicalities. We should teach the first course in economics as if it is the last course students will ever take in the subject.

Our goal should be to provide students with a few tools that they can use to think more clearly and correctly about the complex interactions that make up a commercial society. This was Adam Smith’s term for a society in which everyone lives by exchanging and everyone is consequently a merchant.3 The term is much more helpful and descriptive than “capitalism.” It focuses attention on what most needs explanation: the processes of exchange that must accompany the division of labor that has made us wealthy beyond the dreams of anyone living two centuries or even one century ago. The citizens of a democracy ought to understand how a commercial society (or a market economy) works, because such knowledge is a powerful antidote to many of the absurd policy proposals that special interests and thoughtless people press upon their governments.

Scarcity and Exchange

The standard introductory economics course does too little by way of teaching students how markets work. It attempts, and fails for the most part even in this limited task, to teach students how academic economists work. One reason is that professional economists have become hung up on the concept of scarcity. Most of them, if asked for the fundamental problem with which economics deals, will unhesitatingly answer “scarcity.” That’s not so much wrong as misleading. It’s true that if there were no scarcity, we would not have to economize. And so we would probably never have extended the division of labor and would never have developed commercial societies. But the genuinely useful light that economics sheds does not fall on the economizing process; it illuminates the process of exchange. Just about everyone knows how to economize, and does so effectively. What people do not know and what economics can explain for them is how millions of economizing people, each one pursuing his or her own interest, manage to cooperate effectively despite the fact they are all substantially ignorant of what others want or can do. The fundamental problem of economics is not so much scarcity as a multitude of interdependent projects that somehow have to be coordinated.

Here is a little exercise with which I often introduced economic theory to my students when I was still captive to the scarcity obsession. A student is taking four courses in the current term and he wants to maximize his average grade across the four courses. He has a limited amount of time to study for final exams. He knows exactly by how much additional study will improve his final grade in each of the four courses. The table presents the grades he can count on receiving if he spends the hours indicated on each subject. How many hours should the student spend studying each subject if he has twelve hours to study? How many hours should he spend on each subject if he has only six hours to study?

I used to ask those questions and let the students play around with the numbers for a while before triumphantly demonstrating that with twelve hours to study, three should be devoted to Chemistry, four to Economics, three to History, and two to Mathematics, because only with this allocation are the gains from the last hour studying each subject equal. For the same reason, with only six hours to study, the student should devote two to Chemistry, three to Economics, one to History, and none at all to Mathematics. I thought that I was capturing my students’ interest at the outset of the course by illustrating the applicability of economic theory to all of life. In fact I was suggesting its essential irrelevance.

Students trying to figure out how long to study for their various courses don’t know in advance what grades their study will secure for them. They are not constrained to studying in increments of whole hours. They are not single-mindedly interested in maximizing their grade-point average. And they obtain no valuable assistance whatsoever in situations like this from knowing the marginal conditions for an optimum. What my exercise demonstrated was that economists have tools that can make simple matters more complicated than they are and complicated matters more simple than they are.

But even if people know how to economize in their private lives without any help from economic theory, do they understand the implications of scarcity for the government sector? Shouldn’t economists continue to emphasize the importance of scarcity to citizens who behave as if the public purse has no bottom? It is certainly appropriate for economists to insist, in season and out, that government-funded projects also have opportunity costs and to call constant attention to the realities of what must be sacrificed to obtain desired goods. The question is how this can be done most effectively. It will not be by drawing production-possibility curves and extracting marginal rates of transformation, because that radically misstates the problem. Except in a dictatorship, no one economizes for society as a whole or for the government sector. In a democracy, public policies emerge from interactions—exchanges!—among optimizing parties: citizens, elected and appointed officials, and interest groups of many kinds. When the marginal benefits and the marginal costs accrue to different parties, an optimizing model just doesn’t fit.

None of this is intended to be a criticism of marginal analysis, but only of its use to illuminate “problems” that it doesn’t actually illuminate. Most of these will be economizing or optimizing problems that have been drastically oversimplified so that we can “solve” them, or that postulate an omniscient dictator, or that people typically manage for themselves quite handily without any formal calculations. Nor am I rejecting all presentations of the logic of optimizing. I spend a lot of time in my introductory courses dealing with the concepts of marginal cost and marginal revenue and the formal logic of net-revenue maximization. But I don’t do so with the intention of helping business decision makers decide how much to produce or what prices to set, because the bare logic of optimization really doesn’t provide much help with such decisions. I want to use the logic of net-revenue maximization to explain or illuminate the enormous variety of pricing policies that we regularly observe. My objective is to explain market processes, interpersonal transactions, patterns of exchange—which is, I maintain, what introductory economics is mostly good for. It’s good for explaining how markets work, which most people do not understand. It is far less useful or illuminating when it tries to explain how individuals optimize.

In The Wealth of Nations, Adam Smith was basically trying to explain how markets work. In order to provide a coherent and persuasive account, he was compelled to explain the formation of relative prices for both final goods and resources, because these prices provide the information and the incentives that coordinate the division of labor. Unfortunately, his theory of “natural” prices contained serious ambiguities and inconsistencies that his classical successors never quite managed to correct satisfactorily. When the science of economics became an academic discipline in the last quarter of the nineteenth century, the professors finally clarified and straightened out the confused and incoherent “classical” theory by developing a general equilibrium theory in which everything determines everything else on the basis of interactions among optimizing resource owners. This system has proved so attractive, so aesthetically satisfying, that many students of economic theory since the neoclassical reformulation never make it back to the issue of how markets work, the issue that inspired the question of relative prices in the first place. That’s why so much of elementary economic theory focuses on the optimization process rather than the process of exchange. As the drunk said when asked why he was searching for his keys under the street lamp despite the fact that he had lost them somewhere else, “The light is better here.” Many professional economists would rather shine a sharp clear light on nothing at all than wander in partial darkness.

Rigor vs. Plausible Stories

As mentioned earlier, the dominant culture in the economics profession values rigor above all other virtues. The emphasis on rigor, besides encouraging us to emphasize optimization over exchange, also prompts us to treat exchange in an overly formal and mechanistic manner. Supply and demand makes up the core of useful economic theory. But if it is to be useful to students in a beginning economics course, supply and demand must be taught as a process rather than as a pair of simultaneous equations. While graphs can be useful aids in teaching supply and demand, they are not useful when they drive out all consideration of actual social transactions. Students don’t learn how markets work by learning how to solve simultaneous equations or to manipulate graph lines.

This implies that teachers of introductory economics must leave behind their lust for rigor when they enter the classroom and must learn to be comfortable with approximations, with uncertainty, and with what is coming to be my favorite phrase: plausible stories. We economists are too quick with the definitive answer, which is usually some variation on “misallocation of resources.” Price controls, agricultural marketing orders, protective tariffs, cartels, restrictive licensing, and a wide variety of government “interferences” always lead for us to a misallocation of resources. This summary judgment is less instructive and less likely to be incorporated into a typical student’s understanding than is a plausible story indicating some of the major effects that will probably follow from this or that event.

Take the case of price controls. Should the government impose temporary price controls after a natural disaster, such as a hurricane? It’s easy to shift an upward-sloping supply curve to the left along a downward-sloping demand curve and to demonstrate that the quantity demanded will exceed the quantity supplied if the price is not allowed to rise. Typical beginning students, however, will be much less impressed by a gap between the demand curve and the supply curve than by the thought of merchants or landlords profiteering at the expense of poor families. When we tell them that price controls allow scarce goods to be used for purposes less valuable than they would be used for if prices were allowed to rise, they are not likely to be much distressed at the prospect. We have to become concrete and specific.

Ask the students what particular goods are likely to be in very short supply right after a hurricane. Write their suggestions on the board and add some crucial ones that they are not likely to think of. Then take several of them in succession. Electric service will probably have been disrupted by the hurricane. How will that affect the demand for ice? How elastic will the supply curve be in response to the increased demand? If the price is not allowed to rise, how will the ice be rationed among those who are clamoring for it? Is this likely to be a fair allocation? Why is it likely to produce a situation where some obtain more ice than they really have any use for while others go without altogether? Why is the supply likely to be more elastic in the longer run than in the very short run? What role does a rising price play in bringing more ice into an area suffering from extensive electrical outages and how does it play that role? How does a rising price encourage people to economize on ice and thus make more available to others? What are some of the substitutes for ice that people will begin using as ice becomes more expensive? How does a rising price encourage those who can economize most conveniently or at the lowest cost to do so?

Plywood provides an excellent case study on which students can exercise their imaginations in dialogue with one another and the instructor. Rising plywood prices provide immediate and effective signals to suppliers, not only of wood products but also of transportation services, to alter their behavior quickly and in ways that will relieve the misery of people in the disaster area. Rising prices also tell potential users of plywood that, at least for now, they should postpone less valuable and urgent projects—in order to save money, from their perspective, but with the benefit to others of freeing plywood for the mitigation and repair of hurricane damage.

I’m learning not to say “That’s wrong,” but to substitute the challenge “Tell us a plausible story about that.” My own “answers” are increasingly presented not as the verdict of science or logic or theory but as a story recommended by its plausibility. Of course, I draw on economic theory to devise and recognize plausible stories. A story will not be plausible if it is inconsistent with the basic assumption of economic theory, which is that all social phenomena emerge from the choices individuals make in response to expected benefits and costs to themselves. While this assumption gives me no clear answer to any actual question, it does alert me to what I should be looking for. What are the relevant benefits and costs? What actions by which individuals could cause the perceived value of these benefits and costs to change (often through changes in their money prices)? What substitutes are available to demanders and to suppliers? Economic theory also reminds me that it is marginal values that matter and that there are many margins on which individuals can pursue the projects that interest them.

My teaching has been significantly altered in recent years by taking to heart Ronald Coase’s trenchant indictment of “blackboard economics.” We are doing blackboard economics whenever we demonstrate, usually with the aid of a blackboard graph, the non-optimal character of a situation and the Pareto superiority of some alternative arrangement, all without paying any attention to what arrangements real people can actually make and the costs of doing so.4 Standing at the blackboard seems to confer upon many economists, at least in their own imaginations, such divine attributes as omniscience, impartial benevolence, and omnipotence. They suppose that they are whispering in the ear of a benevolent and all-powerful despot, to employ James Buchanan’s telling complaint about this way of doing economics.5 When we accept the obligation to tell plausible stories, we stop overpowering our students with blackboard proofs that have genuine policy implications only under the wholly unrealistic assumptions that we are holding at the back of our minds.

The Art of Economics

When we shift to the telling of plausible stories, we also begin to recover the lost art of economics. As David Colander6 has reminded those who like to use the positive-normative distinction, the original classification made by John Neville Keynes and quoted by Milton Friedman in his influential 1953 essay on “The Methodology of Positive Economics” was a three-part one: positive economics, normative economics, and the art of economics. Policy differences among economists are rarely rooted in disagreements either about positive economics or about normative ideals, but in uncertainty about what additional considerations need to be taken into account and how best to do so. Resolving these questions is the task of the art of economics, an art which is indispensable for anyone who wants to apply economics to real-world issues.

It is an art that will always leave some important questions unanswered, if for no other reason than that we can never be sure when we act or recommend action that we have taken everything relevant into consideration. One of the unfair ways in which we economists bully our students is by responding to their objections with, “We’re abstracting from that.” Once we recognize that the art of economics plays an indispensable role in any application of economics, and that this art includes the act of deciding what to take into account and what to leave out of account, we confront the obligation to justify any challenged abstraction. Whether we may abstract from a particular ethical, social, or political consideration in recommending a policy becomes a question for discussion as soon as the abstraction is challenged. We can ask the challenger to construct a plausible story indicating the relevance of the omitted consideration, and we can construct our own plausible story to suggest its irrelevance. But we may not settle the matter by fiat, as we can legitimately do in a piece of “pure” rather than applied analysis.

These examples have all been taken from microeconomics; but the teachers of introductory macroeconomics have been no less guilty of teaching familiar techniques rather than illuminating ones. My colleague Charles Nelson has suggested in conversation that introductory macroeconomics is still obsessed with the Great Depression more than half a century after it ended because our legacy of macroeconomic tools contains so many concepts devised to explain equilibrium at less than full employment. It would be hard to find a better example of searching where the light is good instead of where illumination is required. Nonetheless, introductory macroeconomics teachers who fail to lay solid foundations for subsequent IS-LM analysis will work under the nagging fear that they are not doing their proper job and that they are courting departmental censure. Their job, as conventionally misunderstood, is not to educate the citizens of a democracy, but to begin preparing students for careers as professional economists.

The Dominance of Academic Departments

Perhaps we won’t be able to free our introductory courses from such disabling presuppositions until undergraduate education itself has been liberated from the dominance of academic departments. Departments at leading universities are oriented to their disciplines, which is probably inevitable so long as teaching staff are rewarded primarily for pushing out the frontiers of knowledge in regions controlled by those disciplines. But is it either necessary or desirable that research-oriented disciplines control the content and delivery of undergraduate education? We cannot realistically expect academicians who are narrowly focused on their research interests to reflect thoughtfully on the requirements of a liberal education, or even to care a great deal about general undergraduate education.

An alternative might be semi-autonomous undergraduate colleges within the research universities. It is not certain that such colleges could in the long run escape capture by the research culture of the disciplines while also maintaining high intellectual standards. But the risk might be worth taking. In the long run, as John Maynard Keynes observed in another context, we are all dead.

CHAPTER 18

Teaching Economics by Telling Stories*

I’ve been teaching introductory economics for over 35 years and I think I’ve finally figured out how it ought to be done. That doesn’t mean I now do it right. It’s very hard to teach introductory economics effectively, and I often blow it. But I think I know what I want to do and what I ought to be doing.

What Should We Teach?

If I’m going to persuade you, however, we’ll first have to establish a measure of agreement on why we want students to learn economics in the first place. What is it we hope they will take away from our classes?

Adam Smith began his inquiry into the nature and causes of the wealth of nations by asserting that almost all increases in productivity and hence in wealth could be attributed to the division of labor. Now the division of labor, or specialization, must obviously go hand-in-hand with exchange. Not quite so obviously, the division of labor will extend itself only if exchange can occur at low cost. You won’t specialize in the making of left-handed scissors unless you expect to find, without too much trouble, people who want these scissors badly enough to give you in return enough of what you want to justify your efforts. What this all comes to is that the growth of national wealth presupposes the evolution of an effective, low-cost system to facilitate the quick exchange of innumerable goods, services, and resources among millions of people who don’t even know one another.

Economics, as I understand it and try to teach it, is the discipline that takes as its primary task the explanation of such systems. It explains how people manage to advance the projects in which they are interested by furthering the projects of millions of other people whom they usually don’t even know. Economics, in other words, explains the working of markets.

Why Should We Teach It?

Why is it important that students learn how markets work? It’s not so that they can personally participate more effectively in the market system. I hate to admit this, but I don’t believe that a knowledge of economics is of much help to somebody who wants to get rich. It doesn’t hurt, and it may even convey a slight advantage. But the advantage is very slight. You get rich by knowing something that other people don’t know, or by working hard, or by choosing your parents carefully, or just by being lucky. You don’t get rich by studying economics.

The reason we should want everyone to have a basic understanding of economics, or of how markets work, is political. In a democracy, ignorance and misunderstanding on the part of the public lead to pressure on government to do all sorts of things that interfere with the effective operation of markets. A high level of economic understanding among the members of a society provides protection against many of the foolish things that governments are inclined to do in response to social problems and popular pressure.

That’s the political reason for putting economics into the high school curriculum. Is there an individual reason for learning it if it won’t make the student rich (except for the fact that somebody made it a requirement for graduation and graduation tends to increase lifetime incomes)? I think there is. It clears up puzzles. It explains important and interesting mysteries. People with any sort of intellectual life, or just with a healthy human curiosity about the world in which they live, cannot be comfortable participating in a social system that they don’t understand.

Moreover, social systems that impinge on us daily in important ways seem threatening when we don’t know how they work. They generate alienation and anxiety. So the best reason for anyone to learn economics is that a knowledge of how markets work empowers the knower. Economic understanding is a powerful antidote to the sense of impotence that comes from supposing that “they” must be in control because “we” are not. And if enough people learn good economics because it’s interesting and empowering, they will generate better government economic policy as a spillover benefit.

How to Make It Boring

Unfortunately, as I said at the outset, it is extremely difficult to impart that understanding. If we can rely on the reports from those who have taken courses in economics, most courses are not interesting at all. They are hopelessly boring. They don’t empower anyone; they put everyone to sleep. Why is that? How can a subject that deals with such important problems and processes be so boring?

The root of the difficulty, I have come to believe, is the fact that economics provides no clear and definitive answers to any significant social questions. I’ll say that again, because it’s true, important, and probably a bit surprising coming from someone who makes a good living by teaching economics and even enjoys it: Economics provides no clear and definitive answers to any significant social questions. It provides insight, understanding, a wider comprehension, sometimes even a good bit of wisdom. But it does not provide a clear and definitive answer to any important social question.

Most of the economists I know would not be very happy with that statement. They believe that economics is a worthwhile discipline capable of making important contributions to public policy. I believe that, too. I merely deny that economics can provide clear and definitive solutions to any controversial social problem.

Economics teachers who, despite this fact, insist upon teaching “clear and definitive” answers will end up either teaching arid definitions, whether verbal or mathematical, or trumpeting dogmatisms. And either one quickly becomes tiresome and tedious.

Here are some illustrations of arid definitions: “There are three factors of production: land, labor, and capital”; “In the long run, under conditions of perfect competition, price will be equal to average total cost of production”; “The balanced budget multiplier is equal to the investment multiplier minus one.” For additional examples, consult almost any of the questions that appear on high school Advanced Placement exams in economics. The distinguishing characteristics of this material are that it’s difficult to learn, it bores students, and it does not clarify, much less settle, any important social issue.

Here is a good example of what I call a “trumpeted dogmatism”: “Free trade makes everyone better off.” I call that a dogmatism not because I’m opposed to free trade (I’m the most uncompromising advocate of free trade that I know), but because the statement is both false and unilluminating. If it were true that free trade makes everyone better off, then people would not spend vast amounts of time and money seeking to impose restrictions on free trade. But people do oppose free trade, and very few of them are completely deluded in their belief that free trade will, at least in the short run, make them personally worse off.

Some statements of this sort, while not strictly true, are nonetheless illuminating, because they are useful first steps along the pathway to improved understanding. “Free trade makes everyone better off” is not helpful in this way. It arouses every instinct of resistance, especially among thoughtful students, who have learned that True/False statements containing the word “everyone” are invariably false. We should begin with the truth on this issue: that all persons who engage in voluntary trade expect it to make them better off. That’s a thoroughly defensible statement. And it’s a statement that establishes an important beachhead for subsequent assaults on the myths of protectionism. But notice that it does not by itself demonstrate that the North American Free Trade Agreement is good for the United States or that our government should not impose restrictions on imports from Japan. In order to reach agreement on such important social and political questions, we have to go beyond arid definitions and sweeping dogmatisms to something much more difficult: the telling of plausible stories.

We teach economics effectively, which is to say that we teach our students how markets work, when we help them trace out the probable consequences of selected market actions and market interventions. I’ll present two extended examples to show you concretely what I have in mind.

Stories About Mobile Home Parks

The first example deals with mobile home parks. I start off with a story. Stories are not the same as fictions. Stories are narratives: they recount a series of events, which may be true or fictitious. I prefer true stories, but I also use fictitious ones at times. The one that follows is true. It’s simplified, as all stories have to be, but it recounts events that have actually occurred. Here it is:

I usually present this story to my students through an overhead projector. After they have had a chance to read it, we talk about it briefly to be sure we all understand what’s going on. Then I ask them to write a paragraph that will explain to the aggrieved mobile home owner why he is wrong: why people cannot in fact expect to make money real fast by purchasing a mobile home park and raising the rents. Notice that the letter writer has told a story. When I ask my students to explain in writing why he is wrong, I’m actually asking them to explain why his story is not plausible.

I usually ask them to compare notes when they have finished. Sometimes I collect the answers before we discuss them, sometimes afterward. Sometimes I’ll postpone the discussion to the next class period, after I’ve had a chance to read their “counter-stories” and to prepare stories of my own that take off from or amplify or present more plausible alternatives to the stories they have composed.

But it’s all stories. The stories I like, and to which I will want to introduce my students in the course of this exercise, tell about politicians kowtowing to the NIMBY sentiment and discriminating against people who would like to move to the city in favor of people who are already there; about people who want to live in mobile homes but can’t find sites and who start to bid up the rental rate on sites; about owners of mobile home parks who realize they can get more than they’re currently charging; about park owners who do not raise rents, either because they’re nice guys or because they’re not astute price searchers, who consequently confront long queues of aspiring renters, and who begin discriminating against potential renters on other criteria, such as pet ownership, age, size of deposit, race, and so on; about more astute price searchers who recognize in the below-market rents an opportunity for profit and consequently offer the owner a price beyond what he ever thought his park was worth, which he accepts—after which rents do go up; about the way in which people looking for a good deal bid up the prices of assets that are good deals, so that you can’t buy a good deal unless you know something that almost nobody else knows.

At some point in this festival of stories I raise a new question: What will happen if the city council responds to letters such as this one by legislating ceilings on what owners of mobile-home parks can charge for a site? I may ask them to write an answer; I may ask them to form groups and list probable consequences of such rent controls. What will emerge are stories, which we can examine together for their plausibility. A lot of students will tell stories about the unavailability of sites for people moving into the area. Some will talk about owners who convert their mobile-home parks to other uses when they are denied an opportunity to profit by raising rents. A few exceptionally astute students may talk about mobile home owners who rent or sell their home to someone else at premium prices, because the home has a legal entitlement to a below-market rental rate.

I will be sure that they hear stories about kind and gentle park owners who delayed raising their rents and hence got socked by the city council’s rent freeze, and who now sit and fume about the fact that those who were quickest to take advantage of the shortage are also those who managed to escape the freeze, proving again that no good deed ever goes unpunished; about the follow-up measures that the city council finds itself compelled to adopt: prohibitions on conversion of mobile-home parks to other uses, a commission to hear and arbitrate increasingly bitter and complex disputes between landlords and tenants, and so on.

Almost every major concept in economic theory can find illustration in the stories that emerge from reflection on the implausible tale told by the aggrieved letter writer. At no point do I attempt to draw a clear and definitive conclusion. I do not, however, object to students who draw their own conclusions about the arbitrary and unfair nature of all this, or who notice—as they can hardly help doing—that when legislators make special rules for favored groups, they produce a lot of consequences that no one had anticipated and that few would want.

Stories About Prescription Drugs

So much for my first example. For the second I have chosen an important and controversial public policy issue at this time: government controls on prescription drug prices.

I have learned to begin concretely. Here is one approach. Distribute to the students or display on an overhead projector the following information:

I like to add the following warning:

It’s a very good idea on this project to divide the students into manageable-sized groups and ask them to prepare a report listing the principal factors that enable the pharmaceutical company to charge a price so far above its actual production costs.

The first lesson to be taught is that when we run across a situation we don’t like—“outrageous exploitation of sick people,” for example—we should start by asking how the situation came about and why it persists. What’s actually going on here? That’s an extremely important lesson: for the dinner table, the conference room, the legislative hall, and the faculty lounge as well as the economics classroom. We all have a tendency, especially when we’re filled with indignation, to begin with the conclusions and subsequently to choose the facts that will enable us to reach our preestablished results. That does little to promote understanding; it merely hardens opinions already held. It does not lead to learning. And it fosters debate rather than discussion. Doesn’t it make far more sense to ask why, if the situation is as intolerable as it seems to be, it continues to exist? Social phenomena are not facts of nature, like mountains. They emerge from the choices individuals make in response to the situations they encounter, situations that are in turn largely created by the choices other people make. If we want to change society, we must first understand it. The first step toward understanding how markets work, and the beginning, I would say, of all social understanding, is the recognition that social phenomena are the product of particular choices in response to particular incentives. Incentives matter! To fix any social problem, we must alter the incentives. To do that, we must first discover what they are.

A primary objective of this specific exercise is getting students to see that the persistence of prices that are far above marginal costs requires explanation. We would not expect to find anyone consistently selling for $5.80 a chocolate chip cookie that cost only 10¢ to produce. We would want to know why anyone would be willing to pay that much for a mere cookie, however delicious, and why other people haven’t recognized the opportunity in this situation for huge profits and started to make a competitive cookie whose introduction would bring the price down. The goal is to tell a plausible story.

The story about Foscavir that I prefer marshals four explanatory factors. Given time and a few appropriate hints, your students should be able to come up with a similar list. (Always be generous; find what you’re looking for in what your students say or write, if you can possibly do so.)

• 1. There are no good substitutes for Foscavir for people afflicted with CMV retinitis.
• 2. Insurance pays most or all of the price.
• 3. ABAstra must have a patent on the drug or some other way of preventing anyone else from producing it.
• 4. ABAstra can “justify” its high price and thereby reduce the likelihood of political retaliation by talking about the extremely high cost of developing and testing new drugs and the huge risks involved.

A case study such as this one will give the imaginative and flexible teacher many opportunities to move back and forth between specific applications and the two basic concepts in economics, demand and supply. The first two factors listed above make the demand for Foscavir quite inelastic at low prices. The third factor keeps competition from pushing the price down toward marginal cost. The fourth factor introduces important considerations of politics and even ethics, which should never be dismissed as irrelevant or inappropriate to an economic analysis. We want to understand how markets work, and they do not work in isolation from political and ethical forces.

When members of the class have achieved rough agreement on why the situation exists, only then are they ready to begin thinking about what ought to be done. The teacher’s task at this stage is not to approve or reject any particular proposal but to ask, What will happen if we adopt this or thatproposal? and to assist the students as they attempt to predict the consequences. Predictions in economics should always be offered humbly, and so should criticisms of predictions. Rather than say to our students, “That won’t happen!” we should ask “Is that likely to occur?” The stories we tell can never be more plausible than the assumptions we’re making, and the prediction of social phenomena requires the employment of so many assumptions that we can’t possibly check on the plausibility of all of them. So humility is always in order.

Someone in the class is bound to suggest price controls, for example. “That will create shortages” is a poor rejoinder. “What will happen if we do?” is the appropriate response. Then together teacher and students can begin predicting the consequences of price controls. How will price controls affect the quantity demanded? How will they affect the quantity supplied? And how will they affect the development of new drugs in the long run? The last question is the crucial one. For if demand won’t allow pharmaceutical companies to make anything but losses on unsuccessful drugs, while competition won’t allow them to make anything more than a small profit on most of their drugs, and the law won’t allow extraordinary profits on a few successful drugs, what will provide the incentive for research?

After constructing and evaluating stories that tell how people are likely to respond to various suggested proposals for reform, you could shift gears radically. How should we finance research? Maybe it’s not something we can legitimately expect the private sector to do. You could point out that there are substantial positive externalities associated with pure research and that this creates an argument for at least some government funding. So ask your students to assume that all drug research is going to be funded by the national government, and to figure out how Congress might go about deciding in such circumstances how much money to allocate in total to drug research.

This can be an excellent exercise for driving home the concept of opportunity cost. The cost of more funds for drug research, which means more resources devoted to drug research, is fewer funds and fewer resources for other projects that we also value. After the students have encountered some of the principal difficulties, learning along the way that members of Congress don’t invariably vote for what even they believe is in the nation’s interest if something else is in the interest of their district, ask them to take the next step. Explain how Congress could go about deciding how much of that total to allocate to various diseases. I would expect the subsequent discussion to reveal, among other things, some of the differences between market demand and political demand, or between a demand curve and lobbying pressure. Then ask how the sum allocated to research on a particular disease should be allocated among the various research programs that different groups of scientists want to pursue. The students will come to appreciate through the ensuing discussion that it isn’t necessarily selfish to pursue the projects in which one is personally interested, but that neither can people—not even scientists—be given a blank check to pursue their own interests.

When your students have discovered for themselves how difficult it would be for the political process to allocate research funds in a defensible way, you might ask them to evaluate the following proposal:

I have tried this. The discussion that results is most interesting and instructive, especially because of the many contrary-to-fact presuppositions that students employ, such as that scientists will have to engage in fund raising, which they aren’t very good at (or for which we would say they have no comparative advantage), or that research will only be done on the diseases to which rich people are prone. It usually takes a good while and a bit of prodding for them to discover that this is in fact a description of the entrepreneurial system that we currently use to finance most drug research. You want them to begin reflecting on the role of the entrepreneur in an uncertain world and the way in which the possibility of profit and residual claimancy in an enterprise system places the power to allocate resources in the hands of people with an incentive to assemble and apply the best possible information and the most effective resources.

Only after such an extensive inquiry would you be in a position to ask what would happen if the government imposed price controls on prescription drugs. Price controls would undermine the information and incentive mechanisms of the entrepreneurial system and force the question of funding almost entirely into the political arena, where acceptable criteria for resource allocation cannot be expected to function.

Dialectical Science

How long might it take in a high school economics class to examine in this way the question of prescription drug prices? I don’t know. Not less than a week. Perhaps not less than two weeks. Done carefully, it might take three weeks. And that prompts the obvious objection: “I don’t have time to spend three weeks on the single issue of prescription drug prices.” And of course you don’t. But that’s not what I’m recommending. I’m recommending that you use the issue of prescription drug prices to teach your students how market systems work. You certainly have three weeks for that.

You can’t rush through an economics course and be successful, because economics must be taught dialectically and dialogue takes time. It takes time to find out what the problem is, more time to discover that “the problem” is really several problems, still more time to discern the main outlines of the situation in which the problems arise, additional time to explore possible causes and probable effects. It takes time to set the stage for the telling of plausible stories and more time to spell out those stories and to consider counter-stories. If you don’t have that much time, you don’t have the time to teach economics effectively.

I am not talking now about mere formal or technical economic theory. That can be taught by absolutely anyone with a graduate degree in economics, a standard textbook, and enough indifference to whining students to flunk everyone who refuses to read the textbook and master the theory. Formal or technical theory can be learned by any students with SAT scores high enough to get into college and an instructor who insists that they learn it. But a mastery of the formalities is not the same as really understanding how markets work. I have known dozens of economics students, many of them graduate students, whose command of technical theory would earn them an A grade in an economics course, who were incapable of seeing how this theory illuminated the working of actual economic systems.

I have even begun to suspect that a thorough knowledge of the formal theory is in some instances a barrier to the kind of understanding toward which we ought to be working. The theory, you see, is clear-cut, definitive, and yields precise answers—because it operates exclusively with precise concepts. Those who invest long years in its study develop a fondness for its clarity and—a favorite word—its rigor. Unfortunately, they also often develop a distaste for any economic analysis that lacks the precision and rigor of abstract theory. They don’t want to apply their nice clean concepts to the messy world of real market transactions because that will not yield the clear and definitive result so craved by economists who yearn to be scientists.

I think storytelling is a legitimate form of science. But if those who guard the citadel of Science decide that it’s not, then I will let them have their Science and I’ll stick to storytelling. For it is through the telling and hearing and critical consideration of stories that people come to understand how market systems work.

CHAPTER 19

Between Sterility and Dogmatism*

This paper will try to describe an approach to the teaching of economics that might improve our chances of avoiding both sterility and dogmatism.1 In the course of arguing for the approach, I want to present and defend the heretical claim that economics has a great deal to say about the morality of the market.

Scylla and Charybdis

The sterility with which I am concerned comes from refusing to draw a conclusion until we think we have provided a complete statement of the conditions that must be met for the conclusion to follow rigorously. Economists who behave in this antiseptic fashion give the impression to students that their discipline has nothing of real importance to say about social issues. The opposite danger is dogmatism, which appears when we present conclusions without adequate supporting evidence and argumentation—without just what it takes to produce sterility.

If this account is roughly correct, there may be no channel through which to steer between the rock of dogmatism and the whirlpool of sterility. In that case we would be in urgent need of an alternative route. Sterility and dogmatism, in case they don’t stand self-condemned, are serious impediments to the generation and maintenance of student interest. Interest is essential to learning, because people learn nothing in which they have not first become interested. Threats such as low grades can sometimes stir interest—they induced me to learn the multiplication tables. But threats are far less effective and reliable in nurturing interest than is the belief that valuable insight or understanding lies ahead.

The core of my recommendation is simply that economics be taught with far more attention to social processes. We spend too much time, I believe, on the formal relationships among static variables. We neglect the more interesting and significant issues: What processes created and now maintain these relationships? What subsequent processes can we anticipate as a result of these relationships or the introduction of new factors?

Formal Analysis

Suppose you’re teaching the orthodox “theory of the firm” (or what we oddly call “the theory of the firm” even when the actors are not firms but net-revenue-maximizing black boxes). You show your students when and why marginal revenue lies below demand for a particular seller, and what will happen when marginal revenue and marginal cost are less than price. You derive and display the familiar triangle between the demand curve and the marginal cost curve that results from the seller’s decision to restrict sales to the quantity at which marginal revenue equals marginal cost. What do you do next?

What can be extracted from this set of formal relationships among static variables: demand, price, marginal cost, marginal revenue, quantity? Can we demonstrate waste, inefficiency, non-optimality?

Many of us try. We go through contortions that numb the minds of our students in a largely vain effort to derive some significant conclusion from the analysis without violating our canons of scientific procedure. We would like to demonstrate—rigorously, of course—that an expansion of output to reduce the size of the triangle is a Pareto-superior move. But we need to make some assumptions in order to get to this conclusion, assumptions that are very hard even to state clearly. Zero transaction costs is a favorite. What is there about zero transaction costs or perfect information that makes economists think it will justify policy conclusions? Why don’t we allow zero transportation costs to perform a similar function in our analysis? One can defend any policy conclusion at all if allowed to abstract from everything that would defeat the policy. I believe I could “solve” all the social problems of the world if allowed to assume zero transaction costs. Is it not the case that distinctively social problems are always the result of positive transaction costs, and would disappear if transaction costs were zero?2 What in the world are we doing when we introduce such assumptions in order to draw conclusions? The truth of transaction costs is that they exist, in a multitude of surprising and unexpected forms. They are part of the processes of social interaction. There are all sorts of very real and important costs associated with social transactions that we had tended to overlook before Ronald Coase, or Frank Knight before him, taught us to see why the social world so often fails to meet our expectations.3

Substantive Analysis

The beginning of substantive as distinct from purely formal economic analysis is dissatisfaction. We begin by observing an unsatisfactory state of affairs, or what we suspect to be an unsatisfactory state of affairs, or what someone else says is an unsatisfactory state of affairs. Our formal analysis, with cost curves and demand curves, is a preliminary exercise, an aid to thinking that acquires meaning only when it is put to work on some real, or at least recognizable, social transactions: the marketing of airline tickets, for example, or of restaurant meals, prescription drugs, hardcover and paper-cover books, new textbooks and used textbooks, bachelor’s degrees, foreign automobiles, crude petroleum, long-distance telephone service, or any other price-cost relationship troubling enough to prompt the question: Is this what we want?

Our tools are put to interesting and important uses when we employ them to construct plausible accounts of social processes in response to some kind of dissatisfaction with an observed state of affairs. These accounts can look backward or forward in time. We can try to explain how the observed situation came about; or we can try to predict what will happen if some new factor is introduced, such as a change in the law. This, I submit, is the knowledge we’re after whenever we are trying to evaluate a situation.

Criticism and Inquiry

Suppose, for example, that a student complains about the difference between what the bookstore pays when it buys back used books and what it charges when it resells them. Does the student have a legitimate complaint? We are regularly told that economic analysis cannot answer such questions; but that is a half-truth at best. If economic analysis cannot tell us what ought to be, it can often tell us a good bit of how matters might have come to be. What is the social process through which the gap between buying price and selling price is established and maintained? That is basically what we must know in order to judge whether or not the bookstore is behaving in an unfair or otherwise unacceptable way. And that is precisely the sort of knowledge economics can help us acquire. It is true that no finite account of the process can be guaranteed in advance to settle the question of fairness to any particular person’s satisfaction. But that implies no more than that any inquiry might have to be extended. In what direction? In whatever direction the continuing questions of the dissatisfied inquirer may point us.

A situation cannot be judged satisfactory or unsatisfactory, of course, until it has been compared with alternatives. Economics provides the same kind of assistance here. If our indignant student judges the bookstore’s used-textbook practices unacceptable, the question of an alternative system immediately arises. “What changes would he recommend?” When the recommendation for reform is presented, economic analysis can attempt to anticipate its consequences. Once again the consequences will be a process, and not simply a clearly-defined state of affairs at some future date. The proposed reform can then be evaluated in the light of the flow of consequences anticipated from its introduction. There is again no guarantee that the asserted consequences will convince any particular person that the proposed reform is either desirable or unacceptable. Anyone may want to push the inquiry further. While refusing to decide is in practice itself a decision, in principle economic analysis can continue indefinitely.

Positive-Normative or Simple-Complex?

The claim that economic analysis can never settle normative questions is demonstrably false, since it often does exactly that. It is quite true that economic analysis by itself can never settle normative questions, but economic analysis never exists “by itself.” The knowledge anyone acquires through economic analysis always exists in conjunction with a lot of other knowledge, beliefs, values, assumptions, working principles, and matters taken for granted. Economic analysis presents arguments, and no argument, not even the most respectably rigorous one, will necessarily convince anyone, much less everyone. That’s just as true, however, of so-called positive economics as it is of normative economics.4

Certain kinds of questions are indeed easier to answer than others. Clearly-formulated questions, simple questions, and questions resting upon a broad or deep consensus are easier to answer than carelessly-formulated questions, complex questions, or questions that beg questions. The gulf that so many economists believe they see between positive and normative questions reflects, I think, a misinterpretation. The questions we call “positive” are the ones on which we think we know how to achieve agreement: the clear, simple questions that arise within a well-understood and accepted framework of thought. We label a question “normative” not because it is categorically different from “positive” questions but because we don’t (yet) know exactly how to go about agreeing upon an acceptable answer.

More Misleading Distinctions

Perhaps economists pay so little attention to processes and so much attention to static outcomes at well-defined points in time and space because we find it so much harder to pose questions we can answer definitively when we inquire about processes. That is probably also why we disavow any knowledge of equity but claim expertise on efficiency. We may know less about efficiency than we suppose, however, and more than we realize about equity. Every measure of efficiency is a ratio of values; there is no such thing as technological or objective efficiency. It follows that every measure of efficiency presupposes the appropriateness of particular evaluations, which means, to make a long story short, that every measure of efficiency presupposes the acceptability of some set of entitlements or property rights. Who has the right to value, or to have their valuations counted? An authoritative statement about efficiency rests upon an implicit judgment about equity.

The means-ends distinction is another device we commonly use to confine the questions we ask within manageable bounds. That dichotomy, too, tends to steer us away from the study of social processes into the examination of static conditions: the formal conditions entailing the most effective allocation of given means for the achievement of given ends. In reality, however, neither means nor ends are ever given. We have no ends, but only provisional goals which are going to be means toward the achievement of further goals if we reach them; and those further goals will also be provisional and also really means. We don’t know what we’re after, even though we are highly purposive creatures. We largely find out what we want in the process of trying to get it. And one thing we want is to discover more about the means at our disposal. Our goals change as we approach them. There are no “final goods,” no benefits at the end to be totted up and compared with all the costs in some grand benefit-cost analysis, because benefits often turn into costs and costs into benefits before we get to the end—except that there is no end, unless it’s death, whereupon it’s too late for benefit-cost analysis to serve any purpose. The means-ends dichotomy is a useful simplification. When invoked as a dogma, however, it distorts our perceptions and obscures the important truth that purposive behavior, especially among a society of cooperating persons, is a process and not a problem in pure logic.5

I do not want to be misunderstood. I am prescribing, not proscribing. Economists should and will continue to engage in static analysis, because it stimulates their interest, advances their careers, and also sharpens the tools we use to analyze social processes. My concern is that the prestige and satisfactions of static analysis not deter economists, especially teachers of economic principles, from also using their tools to construct plausible accounts of social processes in response to problematic situations.

Moral Judgments and Social Processes

I want to conclude with the altogether heretical argument that we are seriously underestimating the power of our analytical tool kit and the relevance of our discipline to public policy when we contend that economics has nothing to say about justice or other ethical issues. By making this self-denying claim, we surrender the right to discuss the morality of the market to those who don’t understand how markets work. If economics is practiced exclusively in the formal-static mode, it will indeed have little to say about justice, because justice in large societies characterized by market interactions is far more a matter of process than of outcomes or states. Whether a situation is or is not unjust will depend on the processes that produced it. There is no such thing as an unjust pattern of income distribution; or, if there is, I have yet to encounter a clear and coherent explanation of how it could be recognized. There are, however, unjust actions that distribute income in particular ways. When economists discuss the social processes through which income is allocated, they are, whether they wish to or not, illuminating the morality of those processes.

It is not the outcome but the process itself that enables us to approve or condemn the functioning of the market in particular cases. Outcomes such as poverty, unemployment, or inequality are only relevant as clues or guides to inquiry. I am not merely arguing that this is how we ought to assess the morality of the market; I am contending that this is in fact how we do it, even when we describe what we are doing quite differently. I am thus making an empirical claim, a claim that can be tested by examining the processes of moral reflection and moral discourse in which we regularly engage. Someone who asserts, for example, that great wealth amid grinding poverty is an unjust state is, I believe, putting forward the hypothesis that any such combinations that we observe will be found to have emerged from unjust processes.

To Be Continued

But what constitutes an unjust process? While that isn’t an easy question to answer, neither is it the altogether empty question that so many economists seem to suppose. What processes do we in fact condemn as unjust? What do our actual processes of moral reflection and moral discourse reveal? There is no ultimate answer, of course. There never is, at least not to any human question. Those who practice economics as a humane science, rather than a branch of human engineering, must learn how to be content with less than ultimate answers and with suggestions that are merely plausible.

[* ] Reprinted from Economic Alert 6 (July 1995), by permission of Enterprise New Zealand Trust.

[1. ]Agenda 2, no. 2 (1995): 233-40.

[* ] From Agenda 2, no. 2 (1995): 149-58 (http://agenda.anu.edu.au), reprinted with the kind permission of the journal’s editors and its publisher, The Australian National University College of Business and Economics.

[1. ] P. Samuelson, “Lord Keynes and the General Theory,” Econometrica 14, no. 3 (1946): 189.

[2. ] A. Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (Indianapolis: Liberty Fund, 1981), 764.

[3. ] Ibid., 37.

[4. ] R. Coase, The Firm, the Market, and the Law (Chicago: University of Chicago Press, 1988), 28-29.

[5. ] J. Buchanan, What Should Economists Do? (Indianapolis: Liberty Fund, 1979), 145.

[6. ] D. Colander, “The Lost Art of Economics,” Journal of Economic Perspectives 6, no. 3 (1992): 191-94.

[* ] Unpublished typescript, provenance unknown. Reprinted by permission of Mrs. Juliana Heyne.

[* ] Reprinted from Journal of Private Enterprise (Fall 1986): 14-19, by permission of the publisher.

[1. ] The approach is hardly novel. F. A. Hayek is its most eminent contemporary practitioner, but Adam Smith was working this way in the eighteenth century. I presented an earlier version of these recommendations in March 1986 to students and faculty at Whitman College in Walla Walla, Washington. They might not even recognize the present version, but their questions and comments made a significant contribution to my reformulation of the argument.

[2. ] If all members of every society had “perfect information,” including correct information about what everyone else wanted and how much each would sacrifice to obtain (or avoid losing) what was valued, what kind of social problems could possibly arise? There would be no wars, for example, because with the outcome of any conflict known in advance, the parties would simply settle on the terms that conflict would impose. The price system on which economists lavish so much study (properly, in my view) would be unnecessary in a world of perfect information costlessly acquired by all.

[3. ] The classic reference is to R. H. Coase, “The problem of social cost,” Journal of Law and Economics (October 1960). Knight’s discussion of methods for meeting uncertainty was a much earlier exploration of these themes. Frank H. Knight, Risk, Uncertainty and Profit (New York: Harper and Row, 1965; originally published in 1921), especially part III.

[4. ] Donald N. McCloskey has done much to make this position more acceptable, or at least familiar, in the economics profession. See especially McCloskey, “The Rhetoric of Economics,” Journal of Economic Literature (June 1983).

[5. ] No one has argued more cogently for the position taken in the two preceding paragraphs than Frank Knight. See especially the first two essays in Frank H. Knight, The Ethics of Competition and Other Essays (Chicago: University of Chicago Press, 1976). One of Knight’s most distinguished students, James Buchanan, maintains that Knight himself failed fully to appreciate the limitations that his own arguments place upon the conception of economic activity as essentially maximizing activity.