Starting points for Economics 1


Starting points 1

General assumptions

Copy of on-line economics

Rationality and Self-Interest

Depending on the definition we prefer, we may say that economists are

interested in the allocation of resources, in the nature and causes of the

wealth of nations, or perhaps something else. Regardless, all of those

things depend on the actions and decisions of human beings. So, in order to

get started, economists are going to have to make some assumptions about

human beings, about how human beings act and how human beings decide how to

act. We might turn to psychology for our assumptions — after all,

psychologists are the professionals in the study of the human mind — but

in practice, most economists have not done that. It may be that the

theories of psychologists do not answer the questions economists need to

ask, or that there are many competing psychological hypotheses, or that

economists are stubborn fellows — but, for whatever reason, economists

have not as a rule based their assumptions on psychological views of the

human mind. Rather, most economists have begun from an assumption few

modern psychologists would endorse. The assumption is that human beings are

highly rational and self-interested.

This assumption is especially characteristic of neoclassical economists.

Some non-neoclassical economists do also accept it, but some do not.

Neoclassical economists usually assume, in other words, that human beings

make the choices that give them the best possible advantage, given the

circumstances they face. Circumstances include the prices of resources,

goods and services, limited income, limited technology for transforming

resources into goods and services, and taxes, regulations, and similar

objective limitations on the choices they may make.

I should modify that a little right away. Strictly speaking, neoclassical

economics does not assume that real, concrete human beings are rational and

self-interested. Rather, most economists assume that economic systems work

as if they consisted of rational, self-interested persons. After all, it is

averages that count for these purposes. People are of all sorts; sneaky and

altruistic, smart and dumb, but if the average is a person who is rational

and self-interested, then the system will “act as if” people in general

were rational and self-interested. At least, that is the basis of

“neoclassical” economics: it is assumed that deviations from rational

self-interest are random and will cancel out and so the system will act as

if everyone were rational and self-interested. Accordingly, neoclassical

economics studies an economic system consisting of rational,

self-interested persons.

We should pause a little further over these assumptions before moving on.

They are not particularly common-sense assumptions. We all know of examples

of non-self-interested behavior — of people who give to the church and to

good causes and who sacrifice themselves in other ways — and my common

sense (at least) suggests to me that people are often irrational chumps.

Models in Economics

Of course, the real world of economics is very complex. The allocation of

resources in a market economy is the result of the interaction of thousands

of decisions made by each of hundreds of millions of individual people.

Economics deals with this complexity in part by thinking in terms of

“models.”In a modern economic system, individuals, companies, markets and

even nations are interdependent. A model (of a particular subsystem of the

economic system) is a description of these interdependencies in terms of

mathematics, pictures, a computer programming language, or some similar

descriptive language, together with a theory of the dynamics of the

subsystem. Dynamics is the way the subsystem evolves as time passes.

Models are usually somewhat more complex than theories, and a theory may be

just one part of a model. Like theories, however, models are abstract, and

must ignore some aspects of the system they describe. The term “model” is

sometimes used in two different ways. The most common usage in economics

can be expressed as “a model of.” This is the usage just described: a

“model of” is descriptive. However, we may also hear of a “model for,” as

in “the economy of Taiwan provides a model for all of China to emulate.” In

economics, “model of” is the primary meaning, and nothing more will be said

here about “models for.”

In economics, a model is most likely to take the form of a list of

variables and one or more relationships among the variables. These

variables and relationships describe the interdependence among the people

and activities in the economic system or subsystem, and the way these

activities change as time passes. Examples serve best to make this clear.

In the next few sections, we will illustrate this approach by discussing a

model of a very basic economic concept, the concept of “scarcity.” This

model is one we use in discussing the allocation of resources, so we will

come back to it in studying microeconomics, and it will illustrate the key

role of allocation of resources in modern economics, as well as giving an

example of economic models.


Resources of all kinds are scarce. That simply means that we do not have

enough resources to produce all of the goods and services that anybody

might like to have. It means that we, as a society, must somehow answer

some basic questions: What resources will be used to produce which goods

and services. To answer these questions, and get the resources to the

users, is to “allocate” resources. We would, of course, like to organize

things so that the resources are used for the most urgent and rewarding

kinds of production –that is, we would like to allocate resources


In the Soviet Union[Image] , under the system of economic planning, the

allocation of resources was pretty obvious — the government decided who

got to use which resources. The government “allocated resources” in a way

that anyone would recognize. (They don’t seem to have done it very

efficiently, though). Notice, however, that markets also allocate

resources. This allocation is not as obvious — it goes on while we are not

looking, so to say — so we don’t always think of it as allocation. But it

is allocation of resources, since the bidding and higgling and haggling and

deal-making of the market-place does determine which resources are used for

what purposes.

Fundamental Questions of Economics

The model economy we have been discussing illustrates an important point

about all real modern economies. The model economy faces a menu of choices

among different outputs of gadgets and corresponding outputs of food.

Somehow, they must decide how much food and how many gadgets to produce and

also arrange that the producers of food and gadgets get the appropriate

resources to do the job. But the real world is much more complex than the

model economy. In a modern economic system, people take thousands or even

millions of distinct and complementary roles in the production of many

thousands of distinct goods and services. But they cannot carry out their

distinct tasks without resources. How much resources, and what kind of

resources, should each person have in order to do his or her distinct task?

And how much do each of them get in fact? Many textbooks put the point this

way: any modern economic system must somehow decide the answers to four

fundamental questions:

* What will be produced?

* By what methods?

* Using what resources?

* For whom?

We should recall two points to avoid confusion.

First, decisions on the allocation of resources need not be made by

government or any other authority. Markets, negotiation, or tradition may

determine what resources are available for which task, and markets are

known to have some advantages in doing this job. In general, markets tend

to rationalize the allocation of resources in society; that is, to make the

allocation of resources more rational than it would otherwise be. Of

course, there are important exceptions and qualifications to this rule.

Second, we should not interpret “resources” too narrowly. Natural resources

(i.e. land, water, wild living things and minerals), important as they are,

are not the most important resources. In every economy, labor is the most

important resource both in terms of cost and productivity. Goods and

services produced by past labor, including machinery, buildings,

agricultural biostocks, and the like, — that is, capital goods — are also

very important resources. In economics, “allocation of resources” includes

the allocation of all of these things.

Assumptions: Rationality and Self-Interest

There are two very different issues here. The first issue is that people

are sometimes altruistic. It is hard to avoid the conclusion that people do

sometimes act on ethical values [Image] , and it is hard to see how the

selfishness of the (probable) majority can “cancel out” this

self-sacrifice. It seems that we really have to modify the assumption of

self-interest in order to accommodate the evidence. People often do act on

non-self-interested values — but when they do so they act on their own

values, not those of the government, some philosopher, or (most important)

the observing economist. We might call this assumption “rational

individualism” rather than “rational self interest.” But, as it turns out,

it doesn’t make much difference for the theory [Image] , except to make it

more complicated. We shall avoid the complications here by adopting the

analysis based on self-interest.

What, then, is left of rationality if people are not always

self-interested? A broader (but still neoclassical) neoclassical economics

assumes that people choose in the way that best advances their own values,

altruistic or self-interested as those values may be.

The suspicion that people are often irrational might be easier to deal

with, since it is at least possible that deviations from rationality could

be random and could cancel out. If they are not, then we may be able to

make some adjustments as we go along. In fact, there is a good deal of

evidence that real choices can deviate from rationality in predictable

ways. To the extent that they do, we can understand their choices in two

stages: first, understand what the rational choices would be, and, second,

adjust that for any predictable irrationality. (Some economists will feel

that the second step isn’t necessary, but we can take the first step

together). [Image]

This leads us back to the the distinction of positive and normative

economics. Critics of neoclassical economics sometimes claim that economics

is an apology for self-interest; that economics, like Gordon Gekko, holds

that “greed is good.” This is a misunderstanding. The assumption of

rational self-interest is positive economics, an attempt to describe what

is, not what ought to be.

But is it true? That is the criterion for positive economics.

Assumptions and Critical Reasoning

But the assumptions of rationality and self-interest may not really be

questions of fact. I believe they make more sense if we think of them as

guidelines for critical reasoning in economics.

Take the assumption of rationality, for example. When we observe that other

people disagree with use, or that they do things we would not do in their

place or that we would rather they not do, it is very easy to say that they

are irrational. This is a fallacy, since I could just as easily be the

irrational one — if anybody is irrational — and there could be many other

reasons why we disagree. By starting from the assumption that people are

rational, and trying to explain the disagreements on the basis of

rationality — not irrationality — I protect myself from that fallacy.

Just because I start with the assumption of rationality doesn’t mean I have

to stick with it, and sometimes I don’t; but it proves right more often

than not, so it is the right place to begin a study of economics.

The assumption of self-interest works somewhat the same way. It may seem

very cynical always to try to explain human behavior first in terms of

self-interest — but what is the alternative? When we assume

self-interested motives we are reasoning as follows:

“Self-interested motives are common among human beings.

Joe Smith is a human being.

Therefore, it is probable that Joe Smith’s motives in this particular case

are self-interested.”

Experience teaches us that self-interested motives are indeed pretty

common. There are exceptions, I believe, and that means the rule “Human

beings are self-interested” is a defeasible rule. It’s a good guideline for

critical reasoning in economics, but we have to be aware that there are


I believe almost all modern economists would accept these assumptions as

guidelines for sound critical reasoning in economics, if not as facts.

For now, however, let us look at some less controversial points from the

neoclassical economists, points that will be important for all modern


* the key role of scarcity in economics, and

* the use of models as a means of exploring that and other economic


Summary of Model

The model we have just explored illustrates some basic ideas from

neoclassical economics, ideas which any modern economics will take into


1) that there is scarcity whenever we have to make a choice between

different uses to which resources can be put;

2) that our limited resources and technology set a limit to how much of any

good or service that we can produce, but we can still “trade off” one kind

of good (food in the model) for another (gadgets in the model);

3) that we can increase the production of one good only by diverting

resources from another good, so that we suffer an “opportunity cost,” that

is, the loss of the opportunity to enjoy the other good.

These things have been expressed in terms of symbols — tables of numbers

and pictures — and the same things could be expressed in equations

programming commands. The model described a kind of interdependency

(between production of food and of machinery) and something of the dynamics

of the interdependency (that by producing more machinery, we can shift the

production possibility frontier). In all these ways, it is a good example

of a model, and one sort of thing that we will be trying to do as we

continue in this Hypermedia text.

We understand that the allocation of resources is a social problem in any

modern economy. Any modern economic system must somehow answer the

questions posed by the allocation of resources.

If we are to understand the way in which people respond to this social

problem, we have to make some assumptions about human behavior. The

assumption at the basis of the neoclassical approach is that people are

rational and (more of less) self-interested. This should be understood as

an instance of positive economics (about what is) not normative economics

(about what ought to be). This distinction, positive versus normative

economics, is important in itself and is a key to understanding many

aspects of economics.