Six Economic Concepts Everyone Should Know
Updated: Sep 1, 2021
This past week, I submitted the manuscript that I had been working on for two years, Law and Economics: Private and Public (with Todd Zywicki and Tom Miceli) to West Academic Publishing. To celebrate, I am now posting six economic concepts that I believe everyone would benefit from understanding. As always, I welcome your comments, including, perhaps especially, your thoughts on other concepts that I should have included in this short list. Here’s my list: (1) opportunity cost; (2) rationality; (3) marginality; (4) the nirvana fallacy; (5) rent; and (6) comparative advantage.
Opportunity cost: I often tell my students that this is the single most important economic concept. The others listed here, and many more, derive from it. The real cost of anything—a good, service, or activity—is not fully captured in the price. The price signifies one part of the opportunity cost, namely the relative value of the financial commitment required, which you can weight against other opportunities for that value. But opportunity cost is more comprehensive; it also includes the forgone use of the necessary resources for the chosen activity, such as time and energy, on alternative activities that you might have pursued. The cost of attending a four-year college or university is not four times tuition plus room and board (even discounted to present value). Rather it is that plus the four years of time and energy you might have spent doing something else: working, honing another skill, starting a business, or vocational training. In our information economy, college often is a wonderful investment for those who can manage the cost and who have the needed acumen and drive. But for many individuals, other pursuits might prove more fruitful. One of the great challenges, of course, is making effective predictions with limited information, especially at such a young age. This brings us to the next concept.
Rationality: This might be the most contested concept in all of economics. Economists tend to define rationality narrowly; detractors from economics tend to ascribe a broader meaning. Economists equate rationality with the cost-effective pursuit of desired objectives, taking the objectives themselves as given. Economists have no particular skill, or comparative advantage (see #6 below), in identifying the goals or aspirations that individuals hold. Empirically these are incredibly varied and wide ranging. Just as one man’s trash is another man’s treasure, one person’s strong desire (consider jumping from a plane or swimming with sharks) might be another person’s worst fear. Rationality casts no judgment on such choices; it simply means that whatever a person (and yes, we can expand more broadly to the animal kingdom) elects to pursue, she or he will do so up to the point at which the marginal cost equals or exceeds the marginal benefit. Before getting to marginality, let’s briefly touch on what some detractors claim economists mean by rationality.
Some say that economists insist that individuals have complete information about all choices, can assess that information effortlessly and without cost, and can therefore make decisions that unerringly result in a higher level of personal wealth, satisfaction, or utility. There are three major problems with such claims. First, no actual economist believes this. Second, this definition actually contradicts rationality since the acquisition and processing of information are costly activities. Instead, economists understand that individuals will acquire information rationally, meaning based on a cost-effective assessment given its likely value (once more, on the margin). And third, nothing in economics implies that people are devoid of heuristic biases that potentially influence information processing in ways that thwart personal utility maximization. (People also hold values in conflict with pure wealth maximization). The influential literature on behavioral economics is fascinating. It nonetheless remains important to recognize that exposing heuristic biases and costly information processing is not in conflict with the economist’s understanding of rationality.
Marginality: This one stumped even the great Adam Smith! Smith could not fathom why water, essential to human existence, held a nominal value, whereas diamonds, an inessential luxury, held a high value. The answer rests on marginality. Alfred Marshall credited this concept to Austrian Economist Friedrich von Wieser. Prices of goods or services are not a function of abstract notions of essentiality or value; rather they reflect the cost of procuring the next unit as compared with the last at the point at which the market remains willing to pay. In a competitive market, price is determined at the point at which demand and marginal cost meet. (Non-competitive markets get a bit more complicated.) Although Smith observed water as abundant, with a marginal cost close to zero, diamonds, which were highly desirable but had to be mined (and were then cartelized, but that’s another story), commanded a much higher price.
Marginality is highly relevant to law and public policy. Most of the time, most individuals are not affected by most legal rules. If the state lowered the penalty for first degree homicide, the overwhelming majority of people still would not commit it. As with the price of a commodity, changing any legal rule affects only the behavior of those people “on the margin” with respect to that rule. The conduct of those who are “infra-marginal,” meaning beyond the reach of the change in price or change in rule will not be affected by such changes. (Per Nobel Laureate Gary Becker, a change in a rule can be viewed as a change in the price of the prohibited activity). This is at least true of those who are “rational,” meaning capable of incorporating such cost adjustments in their decision calculus concerning planned activity. Not everyone is rational in that sense, and, not surprisingly, the legal system also focuses attention on how to respond appropriately.
The nirvana fallacy: Economists experience some frustration when commentators identify a defect or problem in an institution and claim that it should be abandoned or replaced without carefully considering the merits of actual alternatives. The nirvana fallacy, traceable to Economist Harold Demsetz and Nobel Laureate Ronald Coase, is assuming that the failure of institutions to perform flawlessly implies that they should be abandoned or changed, without first employing a comparative analysis to determine if the proposed fix will ameliorate or exacerbate the claimed problem.
Not infrequently, Donald Trump evokes this fallacy. This past week he did so by condemning our criminal justice system, following the tragic act of terror in New York City, as a laughingstock. See here. Part of the problem is Trump’s failure to recognize that such impediments to the more rapid administration of justice as due process, the right to counsel, and the like, are critical features, not pesky bugs to be swatted away. Even setting that aside, Trump appears unburdened by any depth of understanding as to how alternative systems of criminal justice actually operate, and thus as to whether the changes he imagines to our admittedly imperfect system would actually improve the administration of justice.
Rent: Contrary to some popular accounts, rent, including the pursuit of it, is not invariably problematic. Rent is a rate of return on economic activity above the opportunity cost of the assets used in that activity. That’s a bit technical, so here’s an example. Let’s say that overall, the economy yields a predicable 4% rate of return on productive assets, including labor and capital. Imagine that a clever entrepreneur develops some new product that will be highly profitable, or recognizes that a machine used in one industry, where it earns the standard 4% return, can used more productively elsewhere, thereby earning a 20% return. Either by creating something new that’s highly valued, or by redeploying assets more effectively, an entrepreneur can earn more from the relevant factors of production than the standard rate of return. When she does so, she pursues a rent. This pursuit, by the way, is not only good for her, making her wealthier, it is also good for the economy in that it moves assets to where they are more highly valued, thereby creating societal wealth. Over time, rents tend to flatten. Imagine a lumpy blanket. Capital flows to the lumps, where the rents are, and over time as more resources go there, prices come down, bringing the return in line with the overall economy (or opportunity cost), as newer lumps emerge elsewhere.
So what’s the problem? Another way to procure rents involves political “rent seeking.” This means lobbying for protection against competition, such as barriers to entry or restrictive tariffs. This rent seeking activity is not wealth producing. To be sure, it makes the beneficiaries wealthier, but at a cost borne by others, typically in a zero, or even negative, sum way. For practical political reasons, those who incur such costs are often unlikely to bear the expenses necessary to block the rent. (Think opportunity cost!).
In general, we can say that all else being equal, political rent seeking is undesirable, whereas the private market pursuit of rents is desirable. On the other hand, all else is rarely equal. (Think nirvana fallacy!) Sometimes the pursuit of political rents helps to forge coalitions necessary to enact beneficial legislation. We can make rent seeking more costly, but doing so might also make getting the legislation we desire more costly. One’s view is likely affected by ideology, or how one sees the political process in general. One thing is certain: eliminating rent seeking is impossible. The goal then should be channeling it productively
Comparative Advantage: This final concept is closely tied to opportunity cost. Imagine that one of two persons is absolutely better at two relevant activities, such as practicing law and typing up briefs. Despite the lawyer’s absolute advantage in both (and her assistant’s corresponding absolute disadvantage), the two can improve their situation though specialization and exchange. This is captured in the grammatically challenged, yet economically insightful, phrase: “more better.” Although the lawyer is absolutely better at practicing law and typing as compared with her assistant, she is more better at practicing law given the higher opportunity cost to her (but not to her assistant) of typing. In a well-functioning economy, absolute advantage matters less than comparative advantage.
I hope you’ve enjoyed my survey of these economic concepts. Your comments are most welcome.
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