Lecture Series: Macro-Economics without Math

Let me talk about what economics is not. It is not about money, finance, investments, etc. These things are definitely a part of economics and a sound application of classical economic theory can help you excel at finance and investments. But as a description of the field, this would be insultingly narrow.

Economics in a sentence is “The study of human decision making and resource allocation under the constraint of the scarcity of resources”. Choices such as what to buy at the market, where should a business invest, what should a government do, etc. Each word of the description is key. This field of social science studies human decision making as it is, not as it ought to be. Precisely because of this, arguments such as “if everyone thought economically, the world would be a bad place” and “economic forces are corroding our morality” are pointless. I know these are not exact quotes but you get the gist of it. Economics does not describe how things ought to be, it simply describes how humans do make decisions and allocate resources. The latter part of the description is just as important. If resources were not scarce, economics would not exist. After all, it is a field describing the allocation of resources. If there was no scarcity, in other words, if resources were infinite, then everyone could have to their heart’s content everything they want. Governments would be able to provide universal basic income while doubling the military size. Corporations would be able to share buybacks, invest in factories, and give generously to charity, and so on.

I want to clarify that the “people” I am talking about are not normal people. They are a construct oft referred to as “the economic person”. This person behaves in particular ways such as having all the economic information in the world up to date, behaving in a perfectly rational way while evaluating choices, etc. These are big assumptions which are obviously not true but they can help us make surprisingly accurate judgements, and even predictions, of an economy. Another clarification I would like to make is the economic person is not necessarily a person. It can be an actual person or anything that faces person-like constraints and choices such as a firm or a government.

Next time, we will talk about some fundamental assumptions in classical economics.

In this lecture, we discuss the idea of an economic model.

In general, a model is a representation of reality. That representation can take various forms, such as maps, graphs, equations, description, etc. and can have various purposes such as display, manipulation, understanding, etc. Economic models usually take the form of graphs and equations and the primary reason to construct them is to understand an economy* and often predict its future behaviour as best as possible.

The ultimate goal of an economist is to construct a mathematical model (aka equations and graphs) that perfectly describes every action in an economy and predicts its future behaviour. Alas, that is a task that has not been achieved in the past 250 years of economic history. But many models have been constructed for understanding particular parts of the economy, some of which have been remarkably successful. As far as possible, I will keep the math to a minimum. But often, some math is worth a thousand words (really) and I will use it.

*I said “an economy” and not “the economy” because economics can analyse any system with actors who follow the common assumptions and this system is an economy. “The economy” is often used by media to refer to the national or global economy.

Note: The past two decades have seen an ascendance of the fields of Behavioural economics which borrows heavily from behavioural psychology and often from other scientific fields. The seminal work in this field has been done by Amos Tversky and Daniel Kahneman. Narrative economics as a sub-discipline has also been on the rise. These two fields point to many flaws in conventional economics and try to suggest solutions. However, in this series, I will stick to the conventional.

Next up, we discuss the fundamental assumptions made while constructing an economic model.

In this lecture, we discuss the assumptions made to construct an economic model. These often make the models less accurate and precise but without them, it would be a hopelessly complicated task to model the economic world.

Assumptions

1)Scarcity: Already discussed earlier, I would say this is a perfectly accurate assumption in most economic systems. There have always been fewer resources than the sum of human wants in all of economic history and will reasonably be so in the future. To clarify, the idea of scarcity is functional. This means that if a resource is scarce or not depends on how much people want it. A billion widgets are scarce if people want three billion widgets while a local stream of potable water is sufficient for a village of 100 and may not be so for a city of a million.

2)Tradeoffs: This derives directly from the assumption of scarcity. Since the set of human wants, at an individual level or as an aggregate, is always greater than the resources available, we must make choices about what we want. There are many ways to quantify tradeoffs and we will look at some of those. How these choices are made gets us to point

3)Maximising utility: Every economic actor maximises their own utility, be it a person, corporation, or a government. This means that the actor makes tradeoffs to use their resources in a way that gives them maximum benefit. A person might want to save a thousand dollars and buy that Zara dress. Alas, she doesn’t have money both and goes for the Zara dress since she believes that will be more useful. A government might want to buy more jets and expand welfare payments but due to the limited revenue, it may decide to increase welfare and forgo the jets since it gets more total utility that way.

4)Rational expectations: At its simplest, this means that any economic person is a mathematical machine perfectly suited to calculate problems to maximise his own utility from the resources and information he has. He/She has no emotional, experiential, or social bias that may cloud the judgement of best utility.

5)Perfect Information: This means that every economic person has perfect up-to-date information about all events and transactions made in an economy. They will know every purchase, every economically relevant event ( even seemingly non-economic things such as policy change or weather that might affect the economy). Of course, in an economy larger than a neighbourhood, this is not fully true but with the increasingly fast transmission of information, it is truer than ever for the world as a whole.

Note: While assumptions 1 and 2 have little to no distorting effect on our models since they are mostly true, and while 5 is true as well, the validity of 3 and 4 is not total. In fact, people don’t always maximise utility and they are never fully rational. They have other motives such as community, loyalty, altruism, etc and biases such as anger, persuasion, etc that render these assumptions doubtful. However, at a macro-economic level, they can still help construct models that are remarkably accurate, flexible, and have predictive power.