Home > Uncategorized > Things to consider when reading Mankiw 9th ed. Chapter 1: Ten Principles of Economics

Things to consider when reading Mankiw 9th ed. Chapter 1: Ten Principles of Economics

from Rod Hill and the WEA Textbook Commentaries Project

  1. The definition of economics.

Mankiw begins by defining economics: “Economics is the study of how society manages its scarce resources. In most societies, resources are allocated … through the combined choices of millions of households and firms. Economists therefore study how people make decisions” about working, spending, saving and investing their savings. Economists “examine how the many buyers and sellers of a good together determine the price at which the good is sold at the quantity that is sold.” (p.1)

With this definition, the ‘economic problem’ becomes how to allocate scarce resources efficiently, i.e. putting them to their most valuable uses. This definition also sketches out the framework developed throughout the book: individual households and firms interacting in markets are the basic units of analysis. Government is put in the background in a supporting role.

This definition of economics is stated as fact, apparently not involving any value judgements. In fact, normative choices, that is choices involving values and moral judgements, are inescapable even in deciding how to define economics.

Emily Northrop points out that the assertion that resources are scarce is based on the idea that not everyone’s wants can be met given our limited resources. This is true, but (she writes) “to say that this inability is our fundamental economic problem is a normative choice.” Implicitly, it treats all desires equally, such as “one person’s desire to obtain a subsistence diet with another person’s desire for precious jewellery” (2000, p. 54). No distinction is made between basic needs and wants which arise because of what others have (e.g. ‘keeping up with the Joneses’). Defined in this way, the economic problem can never be solved because resources will always be scarce.

For a different view, Northrop cites John Maynard Keynes, the most influential economist of the 20th century. In an essay in 1930, Keynes described the economic problem as the “struggle for subsistence”, in other words the problem of meeting everyone’s basic needs. He conjectured that this could be achieved within 100 years.

Consider an alternative definition of economics that emphasizes needs, as opposed to wants. In Microeconomics in Context, Goodwin and co-authors (2019, p.20) define economics as “the study of how people manage their resources to meet their needs and enhance their well-being.”

Defining economics in this way leads to an exploration of different questions. What are people’s needs? How can our resources and economic life be organized to meet them? What enhances human well-being?

Such questions do not arise from the standard definition of economics found in Mankiw’s text. That approach implicitly assumes that the pursuit of efficiency will improve well-being by providing people with more and more to consume. (The effects of increased consumption on well-being will be considered in the commentary on Chapter 21.)

  1. Ten Principles of Economics

This set of commentaries deals with microeconomics, so the last three principles dealing with macroeconomics will be ignored. For the rest, mostly brief comments are in order here because more detailed commentary is best placed in the chapters where these ideas are set out in more detail.

(i) People Face Trade-Offs

In illustrating this idea, Mankiw claims that society faces a trade-off between efficiency, “getting the maximum benefits from its scarce resources”, and equality, distributing those benefits “uniformly among society’s members”. He writes: “when the government tries to cut the economic pie into more equal slices, the pie shrinks.” This is explained in just one sentence: “When the government redistributes income from the rich to the poor, it reduces the reward for working hard; as a result, people work less and produce fewer goods and services” (p.2).

As will be explained in the commentary on Chapter 20, this superficially plausible theoretical explanation is too simplistic. Moreover, there is good evidence that high levels of inequality shrink the economic pie, and that policies that reduce inequality can actually increase the size of the pie.

In comparison with other texts, Mankiw’s description of a trade-off between efficiency and equality is unusual. Almost all other texts describe a trade-off between efficiency and equity. As we will see, Mankiw will treat efficiency as one of the final goals that policy makers could attempt to attain. But no one advocates equality of incomes as a final goal; some income inequality is typically considered equitable for a variety of reasons, including the fact that different people have different needs. In that case, attaining greater equity means reducing income inequality to an acceptable level. Does framing the choice between efficiency and the unattractive goal of equality bias the reader’s judgement in favour of efficiency?

(ii) Principle 2: The Cost of Something Is What You Give Up to Get It

Choosing to do one thing necessarily involves giving up the opportunity of doing something else. Every cost in economics is really such an opportunity cost. Rational choice between alternatives requires considering opportunity costs. The textbooks, along with most economic theory, simplify the situation by assuming perfect information about available alternatives (or, that possible outcomes of choices can be described in terms of known probabilities). However, many decisions are made in conditions of fundamental uncertainty, as in the examples given in the next section.

(iii) Principle 3: Rational People Think at the Margin

This principle is useful in deciding whether to have another cup of coffee, but such marginal decisions in a situation of good information apply to only some of the decisions that people make. Many of life’s most important decisions are not taken at the margin. They are also taken in the absence of information about the ultimate consequences. Imagine that you are trying to decide whether to major in economics, in sociology or in accounting. Each choice would result in a completely different life. Or consider a large business firm whose managers are trying to decide whether to make a major investment in a production facility, a non-marginal decision. They simply lack the information about future market conditions to estimate its profitability. Thinking of their decision as a rational weighing of benefits and costs misses the essence of the situation (Keynes, 1936, Ch. 12).

(iv) Principle 4: People Respond to Incentives

People do respond to incentives, but their responses to incentives can be more complex than simple economic theory assumes. For example, some economists, including Mankiw, have advocated paying people to get vaccinated against Covid-19 and some state governments in the United States have experimented with various rewards.

However, psychologists and behavioural economists (i.e. economists who apply psychological research to economic questions) have found that offering monetary incentives can influence how people think about the activity. In this case, some people could conclude that payment is offered because the vaccine is risky; the higher the payment, the higher the perceived risk.

Behavioural economists and others have also found that people motivated by prosocial behaviour, such as donating blood because it benefits others, may reduce that behaviour if offered some monetary reward. Because getting a vaccine benefits others by reducing their chances of getting infected, this could be an issue here as well.

In short, whether and how incentives work depends on the details of the particular situation.

(v) Principle 5: Trade Can Make Everyone Better Off

Mankiw summarizes the principle this way: “Trade between two countries can make each country better off. To see why, consider how trade affects your family.” After pointing out that people specialize in particular kinds of work and trade with others, he writes: “Like families, countries also benefit from being able to trade with one another. Trade allows countries to specialize in what they do best and to enjoy a greater variety of goods and services” (p.6).

Comparing countries to families is fundamentally wrong. It obscures the fact that countries are made up of many different families, some of whom will gain from increased trade and some of whom will be worse off (for example if they lose their jobs because of increased import competition). Economists have no basis for saying that a country as a whole is better off after trade. This necessarily involves a value judgement about the gains and losses in all, about which reasonable people can disagree. (This will be examined further in the Commentaries to Chapters 3 and 9.)

(vi) Principle 6: Markets Are Usually a Good Way to Organize Economic Activity

Mankiw describes a market economy where millions of self-interested firms and households interact, their decisions guided as if by an invisible hand (Adam Smith’s metaphor) to “reach outcomes that, in many cases, maximize the well-being of society as a whole”. He writes: “As a result of these decisions, market prices reflect both the value of a good to society and the cost to society of making the good” (p.7). If governments then alter prices through taxes or other policy measures, they impede “the invisible hand’s ability to coordinate the decisions of households and firms”, adversely affecting the allocation of resources.

As will become clearer later in the book, what Mankiw is describing is an imaginary market economy with very special features that bears no resemblance to the economy in which we live. It’s an economy where no seller has any choice about the price it sets, and no buyer has any bargaining power over the price. All producers in a market sell identical products. Everyone has perfect information. There is no pollution or any other costs (or benefits) experienced by third parties; the buyers and sellers in each market experience all relevant benefits and costs. That’s not a complete list, but it gives a sense of the limitations of the market economy Mankiw has in mind.

Real economies have characteristics quite different from this and these result in a radically different outcome. Joseph Stiglitz of Columbia University (and a recipient of the Nobel Memorial Prize in Economics) writes that “Adam Smith’s invisible hand may be invisible because, like the Emperor’s new clothes, it simply isn’t there; or if it is there, it is too palsied to be relied upon” (1991, p.5).

Yet despite this, Mankiw writes: “One of our goals in this book is to understand how this invisible hand works its magic.” This raises a critical question: Is the theoretical economy in which the invisible hand “works its magic” a useful framework to analyse the real economy? Or is Joseph Stiglitz correct in saying that it is “of limited relevance to modern industrial economies”?

(vii) Principle 7: Governments Can Sometimes Improve Market Outcomes

Mankiw writes: “One purpose of studying economics is to refine your view about the proper role and scope of government policy” (p.9). How will it do that? “As you study economics, you will become a better judge of when a government policy is justifiable because it promotes efficiency or equality and when it is not” (p.10).

In Commentaries on future chapters, we will have to consider carefully how the effects of government policy are analysed and portrayed. Mankiw is saying that these accounts will influence students’ ethical judgements about the role of government in society. Mankiw himself thinks that studying economics tends to make students more conservative. We will see in Commentaries on later chapters why the textbook presentation might indeed have this effect.

REFERENCES

Goodwin, Neva, J. Harris, J. Nelson, B. Roach and M. Torras (2019) Microeconomics in Context, 4th edition, Routledge.

Keynes, J.M. (1936) The General Theory of Employment, Interest and Money.

Northrop, Emily (2000) ‘Normative foundations of introductory economics’, American Economist, 44(1): 53–61.

Stiglitz, Joseph E. (1991) ‘The Invisible Hand and Modern Welfare Economics’, NBER Working Paper No. 3641.

Related commentaries

Commentaries on the Invisible Hand theme

Goodwin – Is efficiency always the goal?

Zaman – Normative Foundations of Scarcity

Zaman – Hunger as the Primary Economic Problem

  1. April 26, 2022 at 1:33 am

    The definition is oblivious to the idea that the Earth is abundant and can supply all our basic needs, at least if we stop abusing it.

    The vehicle of this perception of scarcity is the ‘artificial scarcity’ identified by Jason Hickel in ‘Less is More’ – land is scarce because most of it has been enclosed, employment is scarce because a proportion of us are deliberately excluded from having a livelihood, and so on.

    The non-science (nonsense) of mainstream economics was created when England was suffering an extreme form of artificial scarcity (‘poverty in the midst of plenty’) and it has never moved beyond that, even as its central claims are repeatedly shown to be radically wrong.

    Rather than beat this dead horse yet again, it would be wonderful to see people here attending to far more fruitful re-conceptions offered by Hickel, Kate Raworth in Doughnut Economics and perhaps my own Economy, Society, Nature, for example.

    My definition of economics? The study of how societies provide for their material needs.

    Many societies have found only a limited role for markets. And those with extensive markets need to manage them closely to ensure they are serving the society’s needs, as there is no reason at all to assume they will be efficient and have desirable results. The catastrophic results of the latter assumption are all around us.

    • Meta Capitalism
      April 26, 2022 at 2:26 am

      Post-Keynesians aren’t the only ones who reject scarcity as a basic economic condition. For example, Emily Northrop (2000) questions whether the fundamental cause of scarcity – unlimited wants – is really innate, and argues that it may be merely constructed. She notes that some people manage to resist consumerism and choose different lifestyles embodying simplicity, balance or connection (to the earth and to others). The fact that some are able to do this suggests unlimited wants aren’t innate. In arguing that our wants are constructed, she emphasizes the power of social norms and the power of advertising: some of society’s cleverest people and billions of dollars a year are spent creating and maintaining our wants. (Hill, Rod; Myatt, Professor Tony. The Economics Anti-Textbook: A Critical Thinker’s Guide to Microeconomics (p. 16). Zed Books. Kindle Edition.)

      Northrop also points out that the notion of unlimited wants puts all wants on an equal footing: one person’s want for a subsistence diet is no more important than a millionaire’s want for precious jewellery. This equality of wants reflects the market value system that no goods are intrinsically more worthy than others – just as no preferences are more worthy than others. This is clearly a value judgement and one that many people reject. Yet economics, which unquestioningly adopts this approach, claims to be an objective social science that avoids making value judgements! (Hill, Rod; Myatt, Professor Tony. The Economics Anti-Textbook: A Critical Thinker’s Guide to Microeconomics (p. 16). Zed Books. Kindle Edition. https://a.co/dI1c4r5 )

      Rod Hill’s The Economics Anti-Textbook: A Critical Thinker’s Guide to Microeconomics is one of the best books I have read that debunk many of ME theories. A must read in my view.

    • deshoebox
      April 27, 2022 at 3:26 am

      Economics also ignores the question whether people have rights. Does everyone have an equal an unalienable righrt to enough of everything needed for a safe, healthy, and productive life, for example? What are the implications for economics if this is true? And if you don’t think it’s true that every person has such a right, why don’t you think so?

      • Meta Capitalism
        April 28, 2022 at 1:50 am

        Economics also ignores the question whether people have rights. ~ deshoebox

        Mainstream economics doesn’t ignore rights or the common good a much as it rejects them and obfuscates or delegitimizes moral questions and discussion of moral issues with arguments like the following:

        JUST WORLD THEORY

        On the evening of 10 December 1969, in the grand setting of Stockholm’s Concert Hall, the Dutch economist Jan Tinbergen took his place behind the year’s Nobel laureates in physics, chemistry, medicine, and literature to receive the very first ‘Prize in Economic Science in Memory of Alfred Nobel’. The other Nobel Prizes had all been given every year since 1901. Alfred Nobel himself, a prolific inventor and businessman of genius, would not have created a prize for economics. He wrote in a letter that he ‘hated business with all [his] heart’, and he considered himself a social democrat.1 In the ceremony, the economist Tinbergen was made to stand apart from the other recipients, and was the last to receive his award, after the laureate in literature Samuel Beckett, the Irish avant-garde dramatist, novelist, and poet. Now economics is difficult to master, but Beckett is difficult too. Is economics more like physics or literature? Most Nobel economists would dismiss this question, but let it linger for now.

        The validity of economics would matter less if it were not used constantly to implement courses of social action in the purported interests of ‘efficiency’, often without specifying clearly what the benefits might be and for whom. These policies affect the livelihood and well-being of individuals and nations, as well as large financial and business interests. The arguments of economists are supposed to have a special authority, quite different from the pleadings of other parties: they are the counsel of reason, disinterested and objective. They stand apart from the claims of sectional and private self-interest; and also from those that emanate from metaphysical sources like religious sanction or the people’s will. There is an irony here, which economists rarely acknowledge: they consider private self-interest to be the prime motivator, but not of their own advice. (Offer and Söderberg 2016, 1-2)

        Economics is a cluster of doctrines, not always consistent with each other, which mean to provide a simplified but essentially correct model of social reality. Its claim to authority is twofold: that the theory is compelling in itself; and that it is confirmed by observation or consequences. Theory comes first: its simplified accounts of reality have an elegance, even beauty, that arises from their being at odds with everyday intuitions, while at the same time bringing order to the confusion of experience. Economics is not easy to master, but is easy to believe. Since the 1980s, economic methodologists (scholars who appraise the methods and purpose of economics) have largely been content to leave it at that and to focus on the internal validity of theory, the various ways in which it is meant to hang together and work. The main reason for this focus is that a good deal of economic theory is not borne out by either experience or results. (Offer and Söderberg 2016, 2)

        ‘The great tragedy of science,’ the Victorian biologist Thomas Huxley said in 1870, ‘is the slaying of a beautiful hypothesis by an ugly fact.’ At the risk of being unfashionable, we part ways with present-day methodologists and go back to simpler times, in which theory, to be considered valid, had to accord with experienced reality. Confronting theory with evidence is not simple or easy, and we do not mean to dismiss the many writers who point this out. One of us has tried it himself, confronting George Akerlof’s economic theory of ‘the market for lemons’ (recognized by a Nobel Prize in 2001) with the facts of the historical used-car market, the subject of Akerlof’s article. A key premise was found to be wrong, the theory as stated was not genuinely testable, and some of its predictions were not borne out. Our reason for insisting on reality is that theory is not only about how to understand the world (epistemology), or how the world is constituted (ontology)—it is also about how life should be conducted, that is, theory is ‘normative’. So much hangs on the benefits and sufferings that economics has the power to inflict that we have to insist on asking, ‘Is it true and does it work?’ Other sources of authority can do without that kind of justification: commitment and inner belief have no need for external confirmation. Authority is often resistant to argument and evidence. Officials, priests, prophets, and leaders do not always submit to the test of consequences. But the Enlightenment in Europe and America ordained a quest for truth by means of critical argument and evidence. The sciences abide by this method, and economics, when it aspires to the same esteem, is presumed to do so as well. (Offer and Söderberg 2016, 2-3)

        What are the ‘norms’ that economics lays down? They start from the laudable principle of maximizing well-being, or ‘welfare’. Welfare, however, is defined merely as what individuals want, and only that. That is the principle of ‘methodological individualism’. A social improvement takes place when somebody can get more of what they want, without depriving anybody else. This is a ‘Pareto improvement’ (after Vilfredo Pareto, the Italian economist). When there is no slack, nobody can gain without somebody else losing. We get there by means of exchange: people sell what they want less of (including their labour), and buy what they want more of. Everybody has something to sell. If everyone trades freely, the system achieves a benign equilibrium, which is ‘Pareto efficient’. This was supposedly anticipated in the eighteenth century by Adam Smith as being like the work of an ‘invisible hand’. (Offer and Söderberg 2016, 3)

        In such a system, everyone gets the value of what they can sell, and what they get is what they are due. This imaginary marketplace belongs with a larger set of doctrines, ‘Just World Theories’. The concept comes from social psychology, but is used differently here. The idea is simple: a Just World Theory says that everyone gets what he deserves. If the Spanish Inquisition burned heretics, that was only what they deserved. If peasants were starved and exiled in Soviet Russia, they got what they deserved. Likewise the Nazis and the Jews. Just World Theories are ubiquitous; they are political, religious, ethnic, gendered, and cultural. They justify the infliction of pain. (Offer and Söderberg 2016, 3-4)

        Market liberalism is also a ‘Just World Theory’ of this kind. Milton Friedman, Nobel Prize winner (henceforth, NPW) in 1976 wrote, ‘The ethical principle that would directly justify the distribution of income in a free market society is, “To each according to what he and the instruments he owns produces.”7 In other words, everyone gets what they deserve. The initial endowment of property and ability, and the consequent market outcomes, are both (as Friedman says) ethically deserved. The free market economy is not only efficient, it is also just, a natural order which it is futile to resist. The norm of individual desert justifies the inequalities and hardships of market society. These are the laissez-faire doctrines of nineteenth-century classical liberalism. Not every economist would accept their ethical value, but the assumption that marginal revenue equals marginal product is pervasive in economic modelling. (Offer and Söderberg 2016, 4)

        Market liberalism is radical. If you genuinely believe that the pursuit of individual self-interest maximizes collective welfare, then collective action in any form is likely to be harmful and to reduce welfare. As we shall see, this doctrine is actually the point of departure for a good deal of policy-related economic analysis since the 1970s. It is deeply counter-intuitive, but can it be true? Here is a role for the Nobel Prize, to provide disinterested scientific validation. Self-interest/market-clearing ‘invisible hand’ doctrines are inconsistent with most efforts at organized social betterment, and especially with social democracy. (Offer and Söderberg 2016, 4)

        (Offer, Avner and Söderberg Gabriel. The Nobel Factor [The Prize in Economics, Social Democracy, and the Market Turn]. New Jersey: Princeton University Press; 2016; pp. 1-4.)

  2. Meta Capitalism
    April 26, 2022 at 2:43 am

    Along with Geoff’s book I gave my children Rod Hill’s “The Microeconomics Anti-Textbook: A Critical Thinker’s Guide.” He now has a second edition out. His conclusion sums up the state of ME well.

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