Saturday, June 27, 2009

My take on why economics matters

I wrote this essay two years ago for no particular reason. I just noticed this one in one of my folders and felt like posting it here as it is!


Why Economics Matters?

Economics as a subject is very rich and diverse in context. It covers issues beginning from the Stone Age to the agricultural society to the present day society. One way or the other, every activity we do is related to economics. From a layman who does not have knowledge of economics to a planner or a freedom activist, everyone uses economics concepts to make choices and decisions.

People make decisions at the margin, i.e. constrained by budget or resources, they make decisions so that the expected outcome is as close to optimality as it can get. This simple concept of making decisions at the margin is what economists call opportunity cost, the cost of the next best alternative forgone. By taking decisions at the margin, say sorting out expenditures out of a weekly paycheck, people first prioritize necessities and then limit consumption and recreation expenditures within the horizon of their budget. In doing so, they try to consume, invest, and save in such a way that their choices are optimal, at least to them.  A simple concept like opportunity cost helps unravel a logical foundation and reasoning for human actions. This is economics at daily use at the individual level.

Economics is always in use in business and commerce. A simple concept of equilibrium of demand and supply helps an entrepreneur decide whether an investment will be profitable or not. The entrepreneur knows that when quantity demanded of a commodity or service outstrips quantity supplied, then there is a chance to reap profits by producing that commodity or service. Meanwhile, through concepts like decreasing, constant, and increasing returns to scale economics helps provide answers to questions like why only a handful of firms exist in an industry or why a monopoly firm deliver goods at a lower price. It also answers why consumers tend to benefit if there are many firms competing with each other to produce similar or differentiated goods. Through concepts like increasing returns to scale, transportation cost and preferences for product diversity, economics helps explain why industries tend to cluster in one location and why they produce slightly differentiated products. This is economics at daily use at the industry level.

Economics is a vital tool to managing an economy at the macro level. Economics helps indentify if and why there is an investment gap in an economy. It helps answer why it is appropriate to have varying tax rates contingent on income level. It helps to measure progress or downslide of an economy and sometimes correctly predict the causes of such a change. It unravels the secret of why excess money supply is bad and why depreciation of currency is sometimes good for an economy dependent on exports. If an economy is overheated (say with investment), then economics tells us how to cool down the situation through either upping interest rate and tax rates or limiting government expenditure and money supply or both. This is economics at daily use at the national level.

Economics is used to answer sources and causes of historical events like the industrial revolution, which changed the trajectory of material progress of humanity. Economics provides answers to more intriguing questions like why industrial revolution occurred in England, why not in Africa, and why at a specific period in history. Economics helps measure the relative prosperity of nations (GNP per capita). It provides answers to questions like why there is persistently high level of poverty in sub-Saharan Africa, and why the East Asian Tigers continue to prosper while the African nations stagnate or even perform worse. By looking at the amount of natural, labor and capital resources and cost of trading, economics helps explain why countries tend to produce and export a limited range of commodity, in which they have comparative advantage, and why the countries engage in international trade. Moreover, it unearths answers to conundrums like the tragedy of commons. Economics uses an eclectic combination of mathematics, statistics, behavioral science, and simple human reasoning to find appealing and convincing reasoning to these problems. This is economics at use in the history and at the international level.

As engaging as it sounds, economics is by no means a clear, uncontroversial subject. For a given topic, especially in macroeconomics, there are many opposing views, which are correct in their own right. The ideological difference between Keynesians and Monetarists over small versus big government is as lively today as it was after the Great Depression. This ideological difference is still raging on issues like taxation, regulation, and foreign aid among others. Meanwhile, other heterodox schools of thought – institutional, Marxist, socialist, feminist, Austrian, supply-side economics- have their own explanation for major events in the economy. They hardly converge on methodology and mechanism, which give rise to diverse views, correct in their own right, making economics ever engaging.

Economics is not a perfect science. Events like the Great Depression, stagflation in the 80s and recent financial meltdown are all unprecedented events. They rarely occur and sometimes economists are unable to predict them ex-ante. However, they search for and provide answers ex-post. This helps policymakers to be aware of causes and consequences of occurrences of such events so that if symptoms of such nature appear again, they could take remedial measures preemptively. This means that economics as a subject is always in a continuum and is never complete. The more we learn about economics and how it matters to the world, the more we realize that there is something more to learn; circumstances change, so does variables affecting the economy and their roots and explanation. However, whatever we learn from economics as it continuously evolves, it helps us better fathom a problem by identifying sources, causes, and consequences. Economics matters because its laws, theories, and concepts rule our lives. Economics matters because it helps optimize the use of scarce resources, and make choices and decisions at the margin so that productivity and efficiency are as close to optimal level as it can get.