NOTE: FIGURES ARE NOT REPRODUCED IN THESE PAGES ACCESSED WITH THEM BACK IN 1998.FOR FIGURES GO TO THE ACTUAL COPY OF ENCYCLOPEDIA BRITANNICA.
Starting points 1
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,
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
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
* 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
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
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.