The simplicity of economic theory
24 March 2015
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Economic Theory
Government and Institutions
24 March 2015
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Economic theory is the science which tries to explain economic phenomena. Just as Newton observed an apple falling from a tree and started searching for an explanation to the phenomenon, which eventually took him to the Universal Law of Gravitation, other thinkers observed the existence of a price for that apple (or the usury for loans), and looked for explanations to these other phenomena. That is the way in which economic theory started taking shape.
Unlike the fall of the apple and other natural phenomena, economic phenomena have their origin in the human individual and their actions. Absent the human being, the apple keeps falling to the ground. In contrast, absent the human being, there is no price for the apple. Economic theory does not make sense unless there are people around.
Because of this, the method for developing economic theory takes (or should take) the human being and their actions, human action, as the starting point. It is not a coincidence that Ludwig von Mises used that name for his magnum opus. The methodology derived from this is named praxeology, and it is one of the main features that differentiate the Austrian School of Economics from other economic schools. The cornerstone on which praxeology rests is arguably the following axiom: the individual acts when they think that the state they will reach as a consequence of their action is preferable to the original state. In other words, when the ‘revenues’ they expect to obtain exceed the ‘costs’ they expect to incur. Starting from this axiom, unprovable but undisputed, theories may be developed to explain different social (not only economic) phenomena that we see around us.
Although the starting axiom may seem simple and intuitive, its application in practice is certainly complex. Firstly, the revenues and costs to which it refers are subjective. Only each concrete individual knows (or thinks they know) the costs to be incurred by carrying out a course of action, and the revenues they may attain as a consequence. However, these costs and revenues are not necessarily of a monetary nature. The motivations for most individuals, if not for all individuals in most cases, have nothing to do with receiving or spending money.
Our motivations are shaped by our religious beliefs, our education, our environment, traditions, and many other factors that shape our hierarchy of values. Thus, the social scientist has to deal with the fact that the fundamental variables driving human action (revenues and costs) are subjective and thus completely out of their grasp. Confronted with the same situation, two individuals act in very different ways. It is not possible to anticipate in which way they will act, because they perceive completely different sets of revenues and costs.
Secondly, when the individual acts, they (subjectively) believe that they will end up in a better state than the starting point. However, we all know that individuals continually make mistakes. So, the individual may actually end up in a situation that is worse than the original one, even from their subjective point of view.
Finally, any individual action (the calculation of revenues and costs that justifies it) depends on the available information and on the, once again, subjective reading of it. With better information, the individual may expect the action to lead to the anticipated results with a higher probability. In turn, the decision to obtain better information is itself an economic action, and as such, it is equally subject to a comparison of anticipated revenues and costs.
As observed, these are large limitations, even unsurmountable, which the social scientist has to confront when they try to explain the social phenomena they observe. Why did Christianity succeed? Why do people marry? Why are there wars? Why are there no completely ‘anarchic’ societies in the world?
All of these are empirical observations of the social reality that we should be able to explain by using praxeology. However, it is very difficult to do that. There are plenty of views with regard to each of the questions, but it is almost impossible to reach a scientific explanation for them.
Fortunately for the Austrian economist, when we try to explain economic phenomena, some simplifications to the general model of human action depicted above are possible. These simplifications allow us the use of praxeology to develop economic theories with high reliability.
The first simplification which can reasonably be made relates to costs and revenues. If we are analysing economic phenomena, we can discard from the model all those revenues and costs that are not expressed in terms of economic goods (be they tangible or intangible, monetary or otherwise). Of course, there is still the possibility of the individual making mistakes, and there will still be lots of individuals considering other types of revenues and costs[1] when making economic decision.
But as these magnitudes are very heterogeneous, the economic scientist may assume that they will not be strong enough to significantly alter the general trends caused by a majority of individuals acting exclusively on the basis of economic costs and revenues. Besides, economic costs and revenues underlie the decision of all individuals, even if most of them will consider other types of revenues and costs. The crux point is that economic costs and revenues are common to all individuals, while other types of costs/revenues are not, so it is very unlikely that these other types will be able to alter the results induced by the former ones.
Therefore, with regard to economic theory, the individual acts when they believe they are going to derive an economical profit from their action. Individuals may still make mistakes, individuals keep reading the information in a subjective way, and each individual is still the only one able to grasp their revenues and costs. But the simplification above is necessary to be able to progress in scientific economics.
Thanks to it, economic actions can be explained by the prices observed by the individual in the market. And, consequently, the market calculation process becomes relevant to explain decisions. Starting from the theory of price, in turn sustained on the theory of value, we can build theories to explain different economic phenomena.
Other subsequent simplifications greatly facilitate the development of economic theory through praxeology. For example, the assumption of the existence of a good generally accepted for exchange (money) considerably eases the market calculation (the use of which has its own costs and revenues), so that it can be assumed that the use of this technique is generalised for economic decisions (even if, once again, there may exist people who do not use it).
As most economic transactions in our society use money, the above simplification does not suppose a large deviation from what actually happens. Of course, there may be non-monetary transactions, but they will not significantly alter the economic theories developed under the assumption that they do not exist.
Another issue of relevance is the model used for the entrepreneur. In the case of entrepreneurs, the exclusive consideration of monetary costs and revenues in economic decisions is very accurate. This simplification underlies, for example, the theory of price control.
Economists are frequently attacked on the ground that they use models for the individual too unreal, which logically lead to absurd theories. It has been shown that this is not the case for Austrian economists, who base their work on the use of praxeology. In this methodology, the starting point is the individual, with all the nuances included in their action: psychological costs and revenues, possibility of mistakes, subjectivity of understanding. The simplification for the Austrian economist does not come from forgetting these issues, but of considering as a first step that they cannot change the general trend induced by price-guided actions. This proxy is accurate, because each of the referred issues are quite specific for each individual, they are not general.
In summary, it could be said that economic theories developed using praxeology have a certain level of ‘noise’, which may be addressed by adding the usual clauses ‘ceteris paribus’ / ‘than otherwise’[2] to the statement of the theorem. In any case, this seems a low price to pay in exchange for the simplification (the ‘simplicity’) that makes possible the development of the economic science.
Unlike the fall of the apple and other natural phenomena, economic phenomena have their origin in the human individual and their actions. Absent the human being, the apple keeps falling to the ground. In contrast, absent the human being, there is no price for the apple. Economic theory does not make sense unless there are people around.
Because of this, the method for developing economic theory takes (or should take) the human being and their actions, human action, as the starting point. It is not a coincidence that Ludwig von Mises used that name for his magnum opus. The methodology derived from this is named praxeology, and it is one of the main features that differentiate the Austrian School of Economics from other economic schools. The cornerstone on which praxeology rests is arguably the following axiom: the individual acts when they think that the state they will reach as a consequence of their action is preferable to the original state. In other words, when the ‘revenues’ they expect to obtain exceed the ‘costs’ they expect to incur. Starting from this axiom, unprovable but undisputed, theories may be developed to explain different social (not only economic) phenomena that we see around us.
Although the starting axiom may seem simple and intuitive, its application in practice is certainly complex. Firstly, the revenues and costs to which it refers are subjective. Only each concrete individual knows (or thinks they know) the costs to be incurred by carrying out a course of action, and the revenues they may attain as a consequence. However, these costs and revenues are not necessarily of a monetary nature. The motivations for most individuals, if not for all individuals in most cases, have nothing to do with receiving or spending money.
Our motivations are shaped by our religious beliefs, our education, our environment, traditions, and many other factors that shape our hierarchy of values. Thus, the social scientist has to deal with the fact that the fundamental variables driving human action (revenues and costs) are subjective and thus completely out of their grasp. Confronted with the same situation, two individuals act in very different ways. It is not possible to anticipate in which way they will act, because they perceive completely different sets of revenues and costs.
Secondly, when the individual acts, they (subjectively) believe that they will end up in a better state than the starting point. However, we all know that individuals continually make mistakes. So, the individual may actually end up in a situation that is worse than the original one, even from their subjective point of view.
Finally, any individual action (the calculation of revenues and costs that justifies it) depends on the available information and on the, once again, subjective reading of it. With better information, the individual may expect the action to lead to the anticipated results with a higher probability. In turn, the decision to obtain better information is itself an economic action, and as such, it is equally subject to a comparison of anticipated revenues and costs.
As observed, these are large limitations, even unsurmountable, which the social scientist has to confront when they try to explain the social phenomena they observe. Why did Christianity succeed? Why do people marry? Why are there wars? Why are there no completely ‘anarchic’ societies in the world?
All of these are empirical observations of the social reality that we should be able to explain by using praxeology. However, it is very difficult to do that. There are plenty of views with regard to each of the questions, but it is almost impossible to reach a scientific explanation for them.
Fortunately for the Austrian economist, when we try to explain economic phenomena, some simplifications to the general model of human action depicted above are possible. These simplifications allow us the use of praxeology to develop economic theories with high reliability.
The first simplification which can reasonably be made relates to costs and revenues. If we are analysing economic phenomena, we can discard from the model all those revenues and costs that are not expressed in terms of economic goods (be they tangible or intangible, monetary or otherwise). Of course, there is still the possibility of the individual making mistakes, and there will still be lots of individuals considering other types of revenues and costs[1] when making economic decision.
But as these magnitudes are very heterogeneous, the economic scientist may assume that they will not be strong enough to significantly alter the general trends caused by a majority of individuals acting exclusively on the basis of economic costs and revenues. Besides, economic costs and revenues underlie the decision of all individuals, even if most of them will consider other types of revenues and costs. The crux point is that economic costs and revenues are common to all individuals, while other types of costs/revenues are not, so it is very unlikely that these other types will be able to alter the results induced by the former ones.
Therefore, with regard to economic theory, the individual acts when they believe they are going to derive an economical profit from their action. Individuals may still make mistakes, individuals keep reading the information in a subjective way, and each individual is still the only one able to grasp their revenues and costs. But the simplification above is necessary to be able to progress in scientific economics.
Thanks to it, economic actions can be explained by the prices observed by the individual in the market. And, consequently, the market calculation process becomes relevant to explain decisions. Starting from the theory of price, in turn sustained on the theory of value, we can build theories to explain different economic phenomena.
Other subsequent simplifications greatly facilitate the development of economic theory through praxeology. For example, the assumption of the existence of a good generally accepted for exchange (money) considerably eases the market calculation (the use of which has its own costs and revenues), so that it can be assumed that the use of this technique is generalised for economic decisions (even if, once again, there may exist people who do not use it).
As most economic transactions in our society use money, the above simplification does not suppose a large deviation from what actually happens. Of course, there may be non-monetary transactions, but they will not significantly alter the economic theories developed under the assumption that they do not exist.
Another issue of relevance is the model used for the entrepreneur. In the case of entrepreneurs, the exclusive consideration of monetary costs and revenues in economic decisions is very accurate. This simplification underlies, for example, the theory of price control.
Economists are frequently attacked on the ground that they use models for the individual too unreal, which logically lead to absurd theories. It has been shown that this is not the case for Austrian economists, who base their work on the use of praxeology. In this methodology, the starting point is the individual, with all the nuances included in their action: psychological costs and revenues, possibility of mistakes, subjectivity of understanding. The simplification for the Austrian economist does not come from forgetting these issues, but of considering as a first step that they cannot change the general trend induced by price-guided actions. This proxy is accurate, because each of the referred issues are quite specific for each individual, they are not general.
In summary, it could be said that economic theories developed using praxeology have a certain level of ‘noise’, which may be addressed by adding the usual clauses ‘ceteris paribus’ / ‘than otherwise’[2] to the statement of the theorem. In any case, this seems a low price to pay in exchange for the simplification (the ‘simplicity’) that makes possible the development of the economic science.
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