Mic 1.1

The standard model of market economics, specifically 'X' marks the spot where supply meets demand, was formalized by Alfred Marshall, in the last part of the 19th and early part of the 20th centuries. Its roots, however, lay in what is known as the 'Marginalist Revolution' of the 1870s. This shifted the focus of economics from the production and distribution of wealth among social classes - owners of capital, labour and natural resources - towards the atomized individual consumer (2.0 Demand) and producers (3.0 Supply). Microeconomics was born. Before examining that model, and how it came to be, certain key economic concepts will first be introduced.

General

1. Opportunity Cost, Scarcity & Relative Prices

It is assumed in micro that human wants, needs and desires always exceed the available means to satisfy them, i.e., scarcity is a permanent condition. Such wants, needs and desires (as well as the means to satisfy them), are not just physical and/or financial, but also psychic. Put another way, scarcity is a permanent human condition and choice between both means and ends must be made.

An excellent expression of the infinity of wants, needs and desires can be found in Abraham Maslow's "Need Hierarchy". Maslow (1908-1970) proposed that human beings reach fulfillment through satisfying a series of needs beginning with basic physiological ones like food, water and shelter and rises to increasingly abstract ones like love, self-esteem and personal expression. Only when primitive needs are satisfied can the individual progress up to higher levels in the hierarchy. Thus only the person reaching self-actualization will fully utilize one's potential. Put another way, once lower needs are satisfied, higher needs rise to consciousness and demand attention. They can be just as pressing as physical ones. Furthermore, ongoing satisfaction of lower needs is required to maintain the process, i.e., basic needs must be continuously satisfied.

How to satisfy infinite wants, needs and desires subject to scarce resources requires a choice between alternatives, e.g., a pensioner choosing between food or medicine. The choice of the best alternative, however, implies that the next best alternative is not chosen. Put another way, the cost of choosing one alternative possibility is the next best alternative foregone. This is called 'opportunity cost'. All economic costs are opportunity costs serving to distinguish economics from accounting or business costs.

i - Monetary vs. Real Cost

Monetary units (dollars, cents, francs, marks, pounds, yen, etc) are useful in determining economic or opportunity cost but they do not necessarily reflect 'real cost'. Monetary cost refers to the price paid on a market. Real cost, on the other hand, includes costs that are not necessarily reflected in market price, i.e., they are externalities or rather external to market price. A number of factors can lead to a difference between monetary and real cost. Thus real or opportunity cost includes the value of time involved in purchasing a good or service. If one works at an hourly job, one is paid a wage per hour that when multiplied by the number of hours worked equals one's income. This income does not, however, allow for the cost of getting ready for and re-creating after work and commuting both to and from work. Accordingly, the 'real' wage per hour would account for such external costs. Similarly, the market price of gasoline may not reflect costs associated with polluting the environment and contributing to so-called 'global warming'. Such additional costs are paid by society as a whole and are called 'external costs', i.e., external to market price. They must be included to calculate the real, economic or opportunity cost of a good or service. This is another example of the difference between economics and accounting cost. Carbon credits and other tradeable pollution permits are innovative ways to reconcile the two.

ii - Relative Prices

Assuming market price does reflect real cost we can determine the opportunity cost of different goods and services by calculating 'relative price'. Relative price is the ratio of one price to another. For example if the price of a Coke is $1.00 and chewing gum $0.50 the relative price of Coke is $1.00/$0.50 or 2, i.e. you could buy 2 packs of chewing gum for the price of one Coke.

There are, of course, thousands if not millions of different goods and services all with different and changing market prices. Accordingly, relative price is usually expressed in terms of the price of a standard 'basket' of goods and services measured by a 'price index' over time. Thus we divide the monetary price of a good or service by the price index. The resulting 'relative price' tells us how much of the standard basket we must exchange to buy the given good or service.

In the micro theory of supply and demand, price means 'relative price'. Thus when the price of a good or service falls, we do not mean its monetary but rather its relative price to other goods and services, i.e. it's opportunity cost declines. In macro theory concern focuses on the aggregate price level rather than the prices of specific goods or services.

The question of relative 'international' prices is even more complicated. One widely used way of measuring 'purchasing power parity' in different countries is the 'Mac Index' which measures the number of hours of work required to buy a 'Big Mac' in different countries.

2. Expectations, Futurity & The Price Bargain

Time plays a critical role in economic analysis. In fact there are two distinct forms of analysis based on time: static and dynamic. Static analysis involves an economic variable or phenomena in a specific fixed moment in time. Dynamic analysis involves analysis through time, that is from the past to the present, or from the present into the future.

Two great economists enhanced economic understanding of Time. John Maynard Keynes introduced the concept of 'expectations'. Over time people's changing expectations of what tomorrow will bring causes their actions to change today. Similarly, John R. Commons introduced the concept of 'futurity' meaning people live in the future but act in the present. The difference between what we plan to do tomorrow and what we actually do today in expectation of tomorrow introduces a constantly changing dynamic to economic analysis, especially macroeconomic analysis. For example, if we expect interest rates will fall tomorrow, we hold off borrowing money today. But when tomorrow does comes and interest rates do not fall our plans must be changed.

Another important concept introduced by Commons is the 'price bargain'. Essentially Commons noted that the evolution of the concept of property has led away from the idea of tangible physical property towards increasingly intangible property specifically the buying and selling of the 'expectation of profits'. Thus business assets such as 'good will' and intellectual property are playing an ever increasing role in the so-called 'knowledge economy'. For further information please see Chapter VII: The Price Bargain from Common's seminal 1924 work "The Legal Foundations of Capitalism".

3. Analytic Geometry, Calculus & Symbolic Equations

When Western Civilization was young Art, Science & Technology were one. In the sixth century B.C.E., a quasi-mystical figure named Pythagoras, none of whose writings have survived, sat in the southern Italian sun at the Greek colony of Kroton plucked a string and thought. What he thought was that there was a cognate relationship between mathematics (number) and Matter/Energy. And with this thought began the Western tradition of Art, Science & Technology.

With respect to Art, Pythagoras set the standard for music, poetry and therefore drama. He also arguably founded the first experimental Science – music. Both Aristotle and Plato accepted his „numeric‟ findings implicitly as fact. The Pythagorean Theorem and his other practical discoveries were applied as Technology especially in architecture and construction. Arguably he established Harmony as the first episteme of Western Civilization. For the ancient Greeks balance, harmony, proportion and resonance were everything. This sense is captured by the ancient Greek word kosmos – the right placing of the multiple parts of the world (Hillman 1981, 28). Harmony is inherent in the music of the spheres, i.e., astronomy, and in the design of cities:

In temples and public buildings, the ancient Greeks used the proportions of the human body. According to Marcus Vitruvius in the 1st century B.C.E., the Doric column represents the proportions of a warrior; the Ionian, those of a matron; and, the Corinthian, those of a maiden. It was Protagoras the Sophist (485-410 B.C.E.), who began his work Truth with the statement: "Man is the measure of all things - of things that are, that they are, of things that are not that they are not" (Internet Encyclopedia of Philosophy 2002). It is from this sentiment that Renaissance humanism arose. Man, not God, was the measure of all things and Man was mutable, God was not.

But beyond the human lay the universal forms of the circle, square, triangle and variations, e.g., the parabola. Captured in Euclid’s Elements, two-dimensional space was reduced to the mathematics of such universal forms – their balance, harmony, proportion and resonance. Archimedes moved the cognitive relationship between number and nature into the three-dimensional world of volume. Measuring different forms of space was resolved by the Greeks through ‘exhaustion’ whereby one considers the area measured as expanding to account for successively more and more of the required space. In astronomy this method was extended to the celestial motion of the stars and planets. In effect, motion to the ancient Greeks was geometric exhaustion applied, step by step, through time. Ancient Greek mathematics was thus essentially concerned with spatial relationships finding its fullest expression in Euclidian and Archimedean geometry and the astronomy of Ptolemy. Geometry is arguably a unique mathematical contribution of Western European civilization. Algebra came from the Arabs via the Persians arguably via India

Descartes - analytic or co-ordinate geometry abscissa, ordinate - horizontal, vertical, + - 4 quadrants of which we will use only 1 (+, +)

In the 1670s, what was known as ‘the geometry of infinitesimals’, i.e., geometric exhaustion, achieved a breakthrough with the simultaneous invention of ‘the calculus’, independently by Newton (1643-1727) and Leibniz (1646-1716). Calculus provided a true mathematics of motion – changing spatial position through Time expressed in algebraic rather than geometric terms. This breakthrough was then extended by Newton in his three laws of motion which arguably served as the foundation stone of modern natural science. By the middle of the 18th century, in France, ‘scientific’ engineering emerged with a requirement for formal training using both differential and integral calculus. It was, however, Leibnitz's terminology that was adopted. Thus what for Newton was a 'fluxion' is today a 'derivative', e.g., 1st and 2nd order derivatives, the rate of flow and the change in the rate of flow - the mathematics of motion. This mathematic innovation were propelled by funding by the military and navigational needs of the Western European States. The military funded many of Galileo's experiments with canons and canon balls. Similarly the Tudor monarchy in Britain vigorous supported development of mathematical navigational aids.

Symbolic equations

4. Demand, Supply & Markets

A Market involves Demand for and Supply of a good or service. With respect to Demand, all things being equal, the higher the price of a good or services, the smaller the quantity demanded. This is the Law of Demand. Among other things the law reflects the substitution and income effect of a price increase on the quantity of a good demanded by consumers.

i - Substitution Effect: when the price of a good increases it does so relative to all other goods. Although each good is unique it has substitutes - other goods that will serve almost as well. As the opportunity cost of a good rises, people will tend to buy less of it and more of its substitutes.

ii - Income Effect: when the price of a good rises, all things being equal, it rises relative to income. Faced with a higher price and an unchanged income, the quantity of at least some goods and services must decrease.

The demand curve (and schedule) shows the relationship between the price of a good or service and the quantity demanded. In effect the curve shows consumers' 'willingness to pay' and 'ability to pay' to obtain a given quantity of a good or service. All things being equal, the demand curve will be downward sloping reflecting the law of demand: the higher the price, the lower the demand; the lower the price, the greater the demand. Assuming other prices remain constant and other factors do not change, there will be movement along the demand curve as the price of the good or service changes.

The demand curve can, however, shift, if other prices or other factors change (P&B 4th Ed Fig. 4.9; 7th Ed.Fig 3.8).

A shift in the demand curve can result due to changes in:

i - Price of Related Goods or Services;

ii - Income;

iii - Expected Future Prices;

iv - Population; and,

v - Preferences.

Supply

All things being equal, the higher the price of a good or services, the greater the quantity supplied. This is the Law of Supply. The supply curve (and schedule) shows the relationship between the price of a good or service and the quantity supplied by producers. In effect, the curve shows the minimum price producers' will accept to provide a given quantity of a good or service. All things being equal, the supply curve will be upward sloping reflecting the law of supply: the higher the price, the greater the supply; the lower the price, the less the supply. Assuming other factors do not change, there will be movement along the supply curve as the price of the good or service changes.

The supply curve can, however, shift, if other factors change (PB 4th Ed Fig. 4.10; 7th Edition Fig.3.9). A shift in the supply curve can result due to changes in:

i - Price of Factors of Production;

ii - Price of Other Goods;

iii - Expected Future Prices;

iv - Number of Suppliers; and,

v - Technology.

Markets

Markets are any arrangement that enables buyers and sellers to get information and to do business with each other. Put another way, markets are where demand meets supply. Markets can be described by reference to, in addition to other things:

- whether they are geographic or commodity-based;

- whether or not they are in equilibrium and, if so, what type of equilibrium;

- their sensitivity to change (elasticity) in prices and incomes; and,

- whether or not anyone - consumer, producer or government - can influence price or, more generally, the terms of trade or exchange.

In a market, price acts as a regulator of the quantity of goods and services demanded and supplied. If the price is too high, consumers will demand less than producers are willing to supply. If the price is too low, consumers demand more than producers are willing to supply (P&B 4th Ed Fig. 4.8; 7th Ed Fig. 3.7).

5. The 'Es' of Economics

i - Efficiency

Efficiency plays many roles in economics. Consider. First, allocative efficiency implies that all factors in production and all commodities in consumption are in their best use and receive their opportunity cost.

Economic choice involves how to satisfy infinite human wants, needs and desires subject to scarce resources. It requires a choice between alternatives, e.g., a pensioner choosing food or medicine. The choice of the best alternative, however, implies that the next best alternative is not chosen. Put another way, the cost of choosing one possibility is the next best alternative foregone. This is called 'opportunity cost'. All economic costs are opportunity costs even those not expressed by market prices. This distinguishes economic from accounting or business cost.

For allocative efficiency to exist three conditions must hold:

(i) Consumer Efficiency: when consumers cannot increase utility by reallocating their budgets;

(ii) Producer Efficiency: when firm cannot reduce cost by shifting the input mix;

(iii) Exchange Efficiency: when all gains from trade have been exhausted. Gains to consumer is called consumer surplus (P&B 4th Ed. Fig. 12.12; 7th Ed Fig 12.12b) which measures the difference between what consumers are willing to pay and what they actually pay for a given quantity of a good or service. Gains to producers are called producer surplus (P&B 4th Ed. Fig. 12.12; 7th Ed Fig 12.12b)which measures the difference between what they are willing to accept and what they actually receive for a given quantity of a good or service.

Second, in production efficiency refers to the ratio of outputs to inputs. To measure efficiency one must therefore be able to calculate both inputs and outputs. This is most easily done in the production of goods rather than services, especially in manufacturing, e.g. cars produced per worker.

Technical efficiency is achieved when it is not possible to increase output without increasing inputs. Economic efficiency occurs when the cost of production for a given output is as low as possible. A secondary consideration is that such output is sold at a price sufficient to compensate all factors of production at their opportunity cost, i.e., no excess or economic profit or rent is earned. Thus all economically efficient solutions are technically efficient but not all technically efficient solutions are economically efficient, that is, something may be technically efficient but uneconomic. It cannot pay its own way, e.g., space exploration and the military.

It is also important to distinguish between technical and functional obsolescence. Equipment becomes technically obsolete when newer equipment can do the job more efficiently, e.g. the Pentium CPU made the 486 and 386 technically obsolete but they can still do the job for which they were intended. Functional obsolescence occurs when old equipment cannot do the job.

ii - Effectiveness

In some goods and most services especially those produced by government, neither inputs nor outputs can be readily calculated and hence efficiency cannot be determined. Accordingly, a less stringent test - cost effectiveness - is applied. Surrogates or proxy indicators of inputs and outputs are used. For example, the “recidivism rate” per parole officer (percentage of repeat offenders) can be used as an imperfect proxy for output rather than the more difficult to measure concept of “rehabilitation” measured in human, social, and/or economic terms. Similarly, average salary per parole officer can be used as a crude surrogate for inputs rather than the more difficult to measure opportunity cost of relevant financial, human, information, and physical resources in alternative applications, e.g., early education rather than later incarceration.

iii - Elasticity

Elasticity refers to the sensitivity of one variable to a one percentage change in another. Economic theory recognizes three principal types:

a) income elasticity of demand (P&B 4th Ed, Fig 5.8; 7th Ed not displayed) - with all prices constant refers to the percentage change in the quantity of a commodity demanded compared to a one percent change in income;

b) price elasticity of demand (P&B 4th Ed. Fig. 5.8; 7th Ed Fig 4.3) or supply (P&B 4th Ed. Fig. 5.11; 7th Ed Fig.4.8) - refers to the percentage change in the quantity of a commodity demanded or supplied compared to a one percentage change in its price. The amount demanded or supplied can increase:

i) more than proportionately, i.e. elasticity is greater than one - at the extreme a horizontal demand or supply curve is perfectly elastic - a small increase in price results in a large change in the quantity demanded or supplied;

ii) proportionately, i.e. elasticity is equal to one (unitary elasticity); or,

iii less than proportionately. i.e. elasticity is less than one (inelastic) - at the extreme, a vertical demand or supply curve is perfectly inelastic - any change in price results in no change in the amount of the commodity demanded or supplied; and,

c) elasticity of substitution or cross-elasticity (P&B 4th Ed Fig. 5.7; 7th Ed Fig. 4.6) in production refers to the percentage change in the amount of an input substituted for another in response to a change in their relative prices. Similarly, the cross-elasticity in consumption of one commodity substituted for another by a consumer in response to a change in their relative prices can be calculated.

iv - Employment

While popular discussion focuses on employment with respect to labour in fact all factors of production are subject to employment, underemployment and unemployment. In manufacturing the concept of capacity utilization captures employment of physical plant and equipment, i.e., what percentage of potential output – 24/7 - is actually produced. Similarly ‘undeveloped’ refers to natural resources not yet employed in the production process.

In the case of labour there is the concept of the labour force defined as all persons aged between 15 and 65. Then there is the related concept of the participation rate, i.e., what percentage of the labour force has or is actively seeking employment. There is season unemployment, e.g., in the ski industry; cyclical unemployment which follows the business cycle; and, structural unemployment often reflecting the effects of technological change such as afflicted the Maritime provinces of Canada with the shift from sail to steam powered vessels late in the 19^th century.

There is also the concept of the ‘natural rate’ of unemployment which varies between countries due to structural and policy factors such as the generosity of unemployment insurance programs. Thus traditionally the Canadian (P&B 4th Ed Fig 21.6; 7th Ed Fig. 21.2 different) natural rate of unemployment has been higher than the U.S.A. (P&B 4th Ed Fig 21.7; 7th Ed not displayed)

v - Equilibrium

Equilibrium is a condition which once achieved will continue indefinitely (P&B 4th Ed Fig. 4.8; 7th Ed Fig. 3.7)unless one of the variables is altered. In the case of markets, the equilibrium price 'clears' the market, that is the quantity demanded by consumers equals the quantity supplied by producers.

More generally, economic theory recognizes four types of equilibrium:

a) general equilibrium: which refers to a condition when the entire economy is under perfect competition. It is a static state where all prices are at their long run equilibrium, individuals are spending income to yield maximum satisfaction, and the demand and supply factors of production are equated throughout the economy;

b) stable equilibrium: which refers to a condition which once achieved continues indefinitely unless there is a change in some underlying conditions. Changes in economic conditions will be followed by reestablishment of the original equilibrium. Example: a ball resting at the bottom of a cup; shake it and the ball moves; stop shaking and it returns to the bottom of the cup; and,
c) unstable equilibrium: which refers to a condition which once achieved will continue indefinitely unless one of the variables changes and then the system will not return to the original equilibrium. Example: a ball resting on the top of an overturned cup - shake it and the ball falls off never to return to the same place; and,

d) multiple equilibria: which refers to the condition in which more than one equilibrium exists. This is particularly true in developmental economics where a developing country may find itself in a stable equilibrium but one that is not optimal for its economic growth and development. The unaided market cannot move the economy to the preferred outcome.

vi - Equity

The economic concept of equity evolved out of English legal history. At the same time that the Common Law began another unique Anglosphere legal institution emerged – Equity. With the Norman Conquest of 1066 all rights and privileges of the previous regime were abrogated by right of conquest. In effect William the Conqueror had carte blanche to shape a kingdom without accounting for pre-existing feudal rights and obligations. Unlike other European kingdoms, it was his exclusive unqualified and personal domain. He was absolute Sovereign. Nonetheless, what he conquered was a patchwork of Angle, Saxon, Jute, Danish, Viking and Celtic settlements, regions, laws and languages. The new King divided up his new Property, after accepting fealty, to a new Anglo-Norman aristocracy. The new local rulers, while subject to the King, also, in effect, inherited rights and privileges acceded to traditional rulers under local legal systems. Some were honoured and survived to become incorporated into Common Law.

William’s new subjects, however, soon brought to his attention (and that of his successors) inequities in a supposedly unified kingdom. At the extreme, in one jurisdiction theft of a loaf of bread cost a hand; in another, two days in the stocks hit by rotten vegetable and insults thrown by one’s neighbours. It was not guilt or innocence they cried but fairness of punishment before the King. This is arguably the root of Equity – a separate and distinct strand of jurisprudence parallel to the Common Law of precedent.

Over time responsibility for hearing calls for mercy was transferred to the King’s Lord Chancellor and a court of his own – the Court of Equity also known as the Court of Conscience or of Morality. In fact until Sir Thomas More (a lawyer) became Chancellor in 1529, all had been men of the cloth. Two aspects of Equity played a critical role in the Sovereign’s ability to control his vassals. These were trusts and tenant-landlord disputes. Trusts (from which modern charities and financial trusts evolved) generally concerned widows and orphans left to the mercy of a local lord. The most famous is Lady Marion of the Robin Hood legend who was an orphan and ward of the King. With respect to tenant-landlord disputes, Equity balanced the feudal local lords by judiciously connecting the King to his subjects. This was called the ‘rent bargain’ by J. R. Commons. It stabilized the social system of post-Conquest England.

While Magna Carta (1215) and subsequent developments increasingly limited the King, Equity and Common Law continued to develop as parallel systems of courts with precedence given to Equity. It was not until 1873 in the United Kingdom that the two systems of courts merged. Nonetheless the two strands of Anglosphere jurisprudence continue to this day in all Common Law countries with Equity retaining precedence.

The economic concept of Equity arguably derives from legal Equity. In fact the Chancellor of the Exchequer (who in Canada we call 'the Minister of Finance') exercised a concurrent jurisdiction in Equity with the Lord Chancellor’s Court. There are two economic definitions of Equity, each reflecting its historical roots.

First, there is Equity as the capital of a firm which, after deducting liabilities to outsiders, belongs to the shareholders. Hence shares in a limited liability corporation are also known as equities. This links back to the historical treatment of trusts under Equity.

Second, there is Equity as ‘fairness’. While often used with reference to taxation it is a general economic concept. With respect to taxation Equity has three dimensions: horizontal, vertical and overall burden. Horizontal Equity refers to ‘like treatment of like’. Vertical Equity refers to ‘unlike treatment of unlike’. Overall Equity refers to the accumulated impact of all forms of taxation. Crudely, it is the difference between earned and disposable income after all taxes – income, excise, sales, et al.

Equity is also applied in a number of market interventions by government, e.g., minimum wage and rent control. Examples of government intervention for reasons of equity will be discussed in the next lecture in this series.

vii - Excludability

Excludability and rivalrousness are characteristics of a private good. If I buy a car I can exclude others from using it by lock and key. I alone extract its utility. Similarly, if I am driving no one else can, i.e., driving is rivalrous in consumption/production.

On the other hand, public goods are non-rivalrous in consumption, i.e. my consumption does not reduce the amount available to you. If I watch a fireworks display it does not reduce the amount available to you. Similarly, public goods are non-excludable, i.e. a user cannot be easily prevented from consuming a public good. This creates the ‘free-rider’ problem. Extending the fireworks example, while I may not be willing to pay to enter the stadium but I can still watch the display from the balcony of my apartment at no charge.

Allowing for externalities (discussed below) there is in fact a spectrum of goods ranging from pure private to pure public in nature.

viii - Expectations

See 2. Expectations, Futurity & The Price Bargain

ix - Externalities

Until now we have assumed that market price includes or 'internalizes' all relevant costs and benefits. This means the consumer captures all benefits and the producer pays all the costs. An externality refers to costs and benefits that are not captured by market price for whatever reasons, i.e., they are external to market price.

In effect, the market demand curve reflects only marginal private benefits (MPB) of consumers but not the external benefits accruing to society. When such external benefits are added, vertically, we derive the marginal social benefit curve (MSB) inclusive of both private and public benefits.

Similarly, the market supply curve reflects only marginal private costs (MPC) but not costs external to the firm’s accounting, e.g., pollution, that society must pay. When such social costs are added, vertically, to the supply curve we derive the marginal social cost (MSC) curve inclusive of both private and public costs.

Put another way, the market 'X' solution is superseded by a social ‘X” marking the spot. It is generally up to government to correct the miscalculation of private agents to generate a new socially optimal equilibrium (P&B 4th Ed. Fig. 18.8; 7th Ed Fig. 16.7).

7. "Let Us Assume" & ceteris paribus

Another expression often used by economists is 'let us assume'. Consider the joke about the economist, mathematician and physicist marooned on a desert island with crates of canned food and no can opener. The physicist says: I can start a fire an blow the top off". The mathematician says: "And, I can calculate the trajectory of the food so we can catch it." The economist says: "Let us assume we have a can opener". Laugh, laugh, laugh, stupid economist.

But consider. The physicist has no equipment to measure the energy content of the fuel for the fire and cannot determine the temperature at which the can will blow. The mathematician cannot, therefore, determine when the can will blow and what will be the trajectory of the food. The economist, on the other hand, looks for a sharp rock to act like a can opener.

One of the most important and regularly used assumptions of economics is ceteris paribus or 'all other things being constant'. Thus in analyzing a given economic phenomenon economist usually begin by assuming all other factors or forces are held constant and thus remain the same as the phenomenon under investigation emerges.

Ceteris paribus is a Latin expression meaning 'all other things being equal'. This is a critical assumption used in economic analysis. For example, if the price of a good or service changes, analysis of its effect would be difficult, if not impossible, if, for example, the price of substitutes changed at the same time. To determine the effects of a price change, economists assume all other prices remain constant (in the first round).

8. Economics as a "Science"

Economics is a 'social science'. However, it is to paraphrase economist Herbert Simmon, a science of the artificial ruled by human not natural law. Scire

The natural, experimental, instrumental sciences are different. They are subject to the laws of Nature and rather than generating certainty or belief generate doubt. In fact Descartes’ famous dictum ‘I think, therefore I am’ could more accurately be restated as ‘I doubt, therefore I am’. They are based on the experimental instrumental method, or, as originally called ‘experimental philosophy’. This, however, requires controlled experimental conditions – hold all factors constant then measure the effect of a change in one, then repeat the experiment to confirm the results. With respect to the social or human sciences we arguably engage in uncontrolled experiments, those for which replicability of results is simply not possible.

Like physics, however, Economics has its ‘Standard Model’, i.e., a generally accepted theoretical model of reality. It is, as will be seen, a truly elegant model satisfying ’ requirement of a science in that it uses deductive logic based on a set of key assumptions whose conclusions are subject to geometric and mathematical proof. In effect it atomizes the economy into the individual consumer and firm. The resulting paradigm led philosopher of science Thomas Kuhn to single out Economics among all the social sciences as best approximating ‘normal science’. Like physics, it is taught in geometric, mathematical and deductive terms using standardized textbooks in first and second year university courses around the world from Adelaide, Beijing, Budapest, Cambridge, Cape Town, Moscow, Paris, Saskatoon, Stockholm to Washington D.C.

The Standard Model was developed during the last quarter of the 19th and first quarter of the 20th centuries particularly in the hands of Alfred Marshall (1842-1924) at Cambridge University (Marshall 1920). Alternatively known as the Marshallian, Neoclassical or Perfect Competition Model, it fulfils Descartes’ requirement of a science in that it uses deductive logic from a set of key assumptions whose conclusions are subject to both geometric and mathematical proof. There are a number of limitation that flow from this description.

a) Limitations

First, economics is not, like physics and chemistry, an 'experimental science'. Its theories and conclusions can not be directly tested by experimentation. There is no such thing as 'replicable laboratory conditions' in economics; the conditions under which economic activity takes place are constantly changing, evolving and cannot therefore be duplicated.

The best that can be done is to compare the predictions of an economic theory or model with statistical or other 'empirical' evidence. Empirical evidence is derived from direct observation or experimentation, not theory or deduction. As experimentation is not really possible in economics, empirical evidence is limited to observation.

Second, as a 'social' science, economics carries values; it is not 'value-free' as are, relatively speaking, the natural and engineering sciences. A bridge stands or falls depending upon the laws of physics which are, at least on our plane of existence, constant and unchanging. Economic theories, however, stand or fall depending upon the changing historical, cultural and technologic conditions of society. Truth is therefore relative rather than absolute.

Third, the inherent limitations of the social sciences in general, highlights the fact that 'science' is more than just experimental science, i.e. use of the experimental method. Science, in general, means an organized and systematized body of knowledge. How knowledge is collected, organized and systematized varies between the natural and engineering sciences, the social sciences and humanities, and the arts. Each way of 'knowing', i.e., ways of accumulating knowledge, varies between these three primary forms of knowledge in contemporary society.

b) Induction & Deduction

To gain knowledge, economics uses two forms of logic: induction and deduction. Induction involves reasoning from the particular to the whole. Deduction involves reasoning from given premises or assumptions to a conclusion. Different schools of economic thought have traditionally emphasized one or the other. Thus the English,l French and German Historical School and the American Institutionalist School relied on inductive reasoning. The Anglo-American Marginalists, the Austrian School, Lausanne School and Swedish School making up the Neoclassical relied on deduction. Keynes, in contrast, synthesized the two poles of economic thought, using both inductive and deductive reasoning in his methodology. In this course, deductive logic will be the primary engine of analysis. Given a set of assumptions deduce a conclusion.

c) Positive vs. Normative

Reflecting the binary nature of economics as a 'social' 'science', two types of statements and questions can be made. The first involve: What is? Such statements or questions are called "positive", i.e. they involve no value judgment. The second involves: What should be? Such statements and questions are called "normative", i.e. they involve a value judgment. For example, it is a positive statement to say that about 20% of Canadian live in poverty. It is a normative statement to say we should, for reasons of 'equity' (see Equity below), increase welfare allowances to help them.

d) Observation & Measurement

Economists observe economic phenomena such competitiveness, size of firms, concentration of economic activity, employment, wages, interests rates, prices and taxes. Such observations produce 'empirical evidence' - both statistical and descriptive.

Some phenomena are subject to statistical measurement through government agencies such as Statistic Canada or by private agencies such as trade associations. Statistical measures are, however, subject to limitations. Thus unlike the experimental sciences where strict physical and technical factors limit the ability to measure a phenomenon, in all the social sciences there are technical AND social limitations. Consider the Census. The Census is something that North American economists rely on for in-depth measurement of a range of economic phenomenon including the census of the population (age and other demographic characteristics as well household expenditures and consumer capital goods), and the census of business enterprise.

While there are all kinds of technical limitations to the Census, e.g. does it ask a question in such a way so as to elicit a meaningful answer, there are also social limitations. In continental Europe, for example, the Census of Population is not very reliable because of traditional suspicion of government, i.e. many, many people simply do not answer or will even lie. Similarly, different companies use different accounting methods and when they answer the Census of Business they do not necessarily answer in the same way.

The bottom line: numbers have quality. They are collected using inherently imperfect methodologies. They have parents who have their own agendas and preconceptions about what they will find or what they want to find. In the physical sciences, this last point is often referred to as: experimenter expectations. However, what distinguishes social scientific statistical evidence from that in the natural & engineering sciences is that every bit is mediated by human beings from marketing survey to data manipulation. In the natural & engineering sciences statistical data is derived from instruments that once calibrated generate evidence without further human mediation and then data manipulation takes place.

For a more detailed assessment of the methodological problems associated with economics and all the social sciences please see my: The Great Social Science Schism: Tales from the Methodological Woods as well as A Flawed Ideology. Also: Boulding, K.E., The Limitations of Mathematics: An Epistemological Critique, Seminar in the Application of Mathematics to the Social Sciences, University of Michigan, December 15, 1955.

e) Model Building in the Sciences of the Artificial - Ideology

Heidegger argues that the essence of the contemporary world is objectivity resulting from the triumph of representation in Art during the Renaissance and in Science with Descartes in the 17th century. (The graphic space in which this course is conducted is 'Descartian Space' made up of the X and Y axis.) In effect, it is our ability to model or imitate nature, especially using mathematics including geometry that brings certainty of knowledge and perspective. Through representation everything in and of the world is brought before us from the perspective of object. We call them "models", "simulations", et al. The result is that we live in “The Age of the World Picture” (Heidegger 1938). This iconic conclusion is visible in the contemporary Natural & Engineering Sciences where confirmation through picture or graph makes "seeing believing'. Scientist do not watch a cascade of numbers as in the film The Matrix (Wachowski & Wachowski 1999) but rather they "read" their graphic representation as "lived" in a virtual reality. In Polanyi‟s terms we indwell in our representations. They can become more real to the observer than that which our native senses tell us. This is arguably one cause of the current 'Great Recession', i.e., the so-called 'quants' on Wall Street believed their complex math models were reality. The quality of the data (see Keynes, Chapter 12), among other things, make this impossible. Furthermore, in the Natural & Engineering Sciences the Laws of Nature are assumed fixed while in the Social Sciences including economics, human laws constantly change and evolve.

An economic model is a description of some selected aspects of the economic world, for example, supply and demand. While induction is sometimes used, that is collecting empirical evidence, and then building a model of the whole from specific information, often deduction is used. A set of assumptions or premises are made and conclusions deduced from them. One thing both inductive and deductive model building share in common is 'reductionism'. Reductionism is the simplification of a given phenomenon by ignoring, eliminating or simply holding certain aspects related to the phenomenon constant. A model thus tries to explain how certain variables will react to changes in other selected variables, but not all possible variables. The world is simply to complex to be 'fully' modeled.

There is, however, another approach to organizing economic knowledge: taxonomy. A taxonomy is a classification scheme. Examples include the National Accounts and all of its sub-divisions. Important concepts and phenomena are identified and evidence is sought to fill the slots. There is not necessarily, however, a functional relationship between categories. We know each is important but not how they relate to each other.

In fact Economics is an Ideology. Ideology has many meanings today but was coined simply enough by Condillac during the French Revolution to mean ‘the science of ideas’. Separation of Church and State was critical to both American and French Republican Revolutions. Creation of a secular science of ideas to counter the awe and mystery of religious and metaphysical thought and ritual was part of a revolutionary agenda designed to overthrow of an Ancient Regime of subordination by birth. In this sense ideology is ‘secular theology’, i.e., an explanation of the way the world works without reference to any god. In this regard the word 'theory' literally means a god's eye view. And unlike the Natural & Engineering Sciences, a contemporary definition of Ideology is: A systematic scheme of ideas, usu. relating to politics or society… and maintained regardless of the course of events" (OED, 4).

With the collapse of Communism there is arguably only one Ideology still standing - Market Economics in which everything has a price – kidneys, children, the environment, everything. It is, however, arguably split into two antagonistic schools of thought. One, the Austrian School of the ‘vons’ - von Mises & von Hayek, believes in the supremacy of the market with limited if any government and no public intervention. The other, the Keynesian School, believes in a regulated marketplace and public intervention to correct externalities to market price. This is called macro-economics. Both are ideologies, not natural science.

The perceived misuse of ‘new’ knowledge is known as ‘the problem of dirty hands’. Originally coined to describe physicists spawning the atomic bomb, there are lots of dirty hands to go around. Biology gave birth to eugenics and its demon child, the Holocaust with the smiling, all-knowing biologist greeting the condemned at the gates of Auschwitz. Economics too must accept paternity for its own devil spawn, the Market/Marx Wars, which, for half a century, threatened mutually assured nuclear destruction of the human race because of an ideological dispute over private property. Even the Arts must accept responsibility. In Nazi Germany, all modern means of artistic expression - from literature, music, painting and sculpture to radio, television and the motion picture - were harnessed in the service of a cause so evil that colour film of the Nuremburg Rallies has never been released to the public by the American Government. What in scratchy black and white is ancient history is to the modern eye a symbol of the power of Art to serve evil in living colour. Then there is the ‘Agitprop’ practiced by Lenin’s Commissar of Enlightenment consolidating the revolution before Stalin took over and displaced it with socialist realism and the gulag. Art is no more summum bonum – all good - than physics, biology or economics.

f) Testing

Having constructed a model of some economic phenomenon, economist then attempt to test its predictions against empirical evidence including statistical evidence and descriptive observation. If the predictions accord with the evidence, the model or theory is held to be true; if not, it is rejected.

In fact, however, some theories in economics simply cannot be tested, for example, the theory of revealed preference developed by Paul Samuleson. In essence, this theory says the preferences of consumers is revealed by their actual behaviour in purchasing goods and services. However, it is simply not possible to track a large number of consumers over time holding all other things fixed, for example, income and education which affects taste.

Furthermore, much of the statistical evidence collected by agencies such as Statistics Canada does not precisely fit the theoretical definitions used by 'academic' economists. Accordingly, much effort is put on 'massaging' available data to more effectively fit the definitions of the theory. This exercise can go too far.

In many ways, economic models and theories are accepted not because the have been tested (because often they cannot be tested with available measurement technology). Rather, they are accepted because they are 'believable'. An instance were the mathematics of it all may exceed any testability is 'New Growth Theory'.

Like other ‘new’ forms of economics such as the New Institutionalism (Coase 1992), New Economic History (North & Thomas 1970), New Economic Geography (Krugman 1983; Martin & Sunley 1996) and the New Economics of Science (Dasgupta & David 1994), New Growth Theory appears, at least to this observer, as an exercise in re-calibrating the Standard Model to include descriptive, empirical, institutional and historical evidence previously excluded because of its qualitative rather than quantitative nature.

While welcomed, the professional urge remains to fabricate such new evidence into quantitative proxy indicators to be plugged into mathematical models. Romer thus calls for more sophisticated mathematical modeling without expectation of testing because “these kinds of facts tend to be neglected in discussions that focus too narrowly on testing and rejecting models” (Romer 1994, 19-20). So much for Positivism in econometrics!

Beyond admitting additional sources of evidence, new growth theory introduces the concept that technological change involves non-rival ‘ideas’ that can “be stored in a bit string” (Romer 1996, 204), implicitly referring to computer programs, a form of soft-tooled knowledge. His concept, however, presents, to my mind, a confusion between information (measurable) and knowledge (immeasurable) and a failure to acknowledge the distinction between the short-run and long-run with respect to intellectual property, i.e., between knowledge residing in the private domain in the short-run but entering the public domain in the long-run.

With respect to information and knowledge, the ‘bit’ abstracts from content and fails, as has been demonstrated, to provide a homogenous unit measure of knowledge, or what Kenneth Boulding called ‘the wit’ (Boulding 1966, 2). With respect to intellectual property, in the short-run technical knowledge is rivalrous and excludable to the degree that copyrights, patents and other state-sponsored intellectual property rights provide protection. In the long-run, however, all intellectual property rights expire and knowledge enters the public domain. Given new technical knowledge is continually being copyrighted and patented, one faces an ever moving horizon between rivalrousness and non-rivalrousness, a horizon that can never be reached. Or, put in terms of Lord Keynes’ famous aphorism: “In the long run we are all dead” (Keynes 1924).

Macroeconomic

a) Unemployment

- while focus on Labour, in fact, all factors of production subject to unemployment

definition (PB 4th Ed. Fig. 21.6, 21.7; 7th Ed not displayed)

- rate, seasonal, cyclical, structural

- discouragement and underemployment

- lost income and production as well as serious personal and social problem

b) Growth

Economic growth refers to growth in income and production per person. It is important to note that economic growth is a means, not an end. Growth allows human beings to live more satisfying lives, to reach higher and higher up the 'needs hierarchy'. Unfortunately, we live in a time in which a 'value inversion' seems to exist. We often hear it said that "the end does not justify the means". In fact, with respect to economic growth "the means justifies the end". For example, if we look at various higher values in human society like education (as opposed to skills training) or the arts, today government and private support is justified not because these are considered as ends-in-and-of-themselves but rather because they contribute to economic growth. There are a number of reasons for this value inversion especially in the political process.