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Limitations of the Economic Way of Thinking

The noted ecological writer Bill McKibben began a recent article for Audubon magazine with the following suggestion for a thought experiment:

Let’s assume, for the duration of this article, that to you trees are vertical stalks of fiber, that a forest carries no more spiritual or aesthetic value than a parking lot, that woodland creatures are uninteresting sacks of calories, and that the smell of sunbaked pine needles on a breezy June afternoon merely matches the scent that comes from those conifer-shaped air fresheners that dangle from your rearview mirror.

Let’s assume, in other words, that you’ve done something rotten and God has turned you into an economist.

McKibben does not really believe that the economist’s way of thinking is as crude as this implies, but his remarks draw a smile because economists have, in fact, acquired a reputation for knowing “the price of everything and the value of nothing”–Oscar Wilde’s definition of a cynic.

As a long-time teacher of economics and even the author of a textbook titled The Economic Way of Thinking, I am not about to repudiate the perspective that economists employ in explaining the world they study. It is a powerful perspective and a highly useful one. Discussion of social issues would be vastly improved and public policy would be much sounder if more people understood the economic way of thinking and put it to work.

What exactly is the economic way of thinking? It is a perspective on human decisions and social transactions. I like to summarize it as the view that emerges from the presupposition that all social phenomena result from interactions among the choices that individuals make after calculating the expected benefits and costs to themselves. This perspective is very useful when employed to explain the working of the largely impersonal network of transactions that we call the market system or simply the economy.

Problems of Price and Value

Markets work best when exchange transactions can be arranged and carried through at low cost. Transaction costs decline rapidly when money prices are attached to all the alternatives under consideration, because these prices provide all parties with a common denominator for comparing values. Grocers can decide much more easily what to stock, for example, and customers can decide what to buy, by comparing price tags, which enables them to cooperate very effectively. When prices are not attached to alternatives, cooperation becomes more difficult. How can we compare the value of the better housing people will enjoy as a result of lower timber prices with the value of the amenities preserved when a forest is left standing, without placing some kind of dollar value on the latter as well as the former? Economists have acquired their reputation for knowing the price of everything and the value of nothing, in large part, by trying to explain a system in which relative prices are used as reflections of relative values and by trying to infer relative prices when markets do not provide any.

As long as economists use prices merely as the best available measure of values for selected purposes, the reputation is undeserved and unfair, but some people–not just professional economists–do conflate price and value. Doing that amounts to a failure to recognize a major limitation of the economic way of thinking. The Gross Domestic Product as measured by government statisticians is not identical to the Gross National Welfare. Some of what contributes to the former makes no contribution to total welfare or even makes it less. If the crime rate increases and homeowners buy security systems, the price of the security systems gets added to the Gross Domestic Product. If air pollution requires houses to be painted more often, the prices of the additional paint and painters’ services are counted in the gdp. If a man divorces his wife and subsequently hires a housekeeper, the wages of the housekeeper will contribute to the gdp, although the unpriced work of the wife did not.

Moreover, the fact that one person was willing to pay a higher price for a good than another does not prove that the first valued the good more highly. The first may simply have valued money less than the other at the margin, which means, given the relative amounts of money and other goods that each commanded when making decisions.

Most economists are so afraid of contaminating their analysis with value judgements that they will freely admit, even insist, that economic theory cannot decide whether one set of arrangements is better or more in the public interest than another. Many of these same economists fail to see, however, that the economic way of thinking also cannot determine whether one set of arrangements is more efficient than another. Claims that rent controls or protective tariffs promote inefficiency, if they mean anything definite at all, mean that rent controls and protective tariffs reduce the size of the potential Gross Domestic Product. That may be an interesting and important claim, but it is not as significant as the claim that they are inefficient. And the latter claim has no foundation in economic theory.

Efficiency refers ultimately to valuations. (The term technical efficiency is a meaningless combination of words.) Because prices and values are not the same, the economic way of thinking cannot pronounce on the relative efficiency of alternative arrangements. It is often said that rush-hour urban traffic is inefficient because it is made up predominantly of single passenger vehicles. That is an insupportable claim. Those who drive alone rather than forming a car pool or taking the bus are implicitly showing that they place a higher value on the benefits relative to the costs of driving alone than of any available alternative. For people with the appropriate values, the most efficient way to commute to work could be in solemn procession, carrying candles and chanting psalms.

Effective Coordination with Millions of Others

The economic way of thinking has at least one other major limitation, a limitation that is also closely related to the connection between economic theory and market systems. The problem begins with the fact that economic theory is a defense of market systems. While many, perhaps most, economists would vigorously dispute that last sentence, they are being disingenuous. Economic theory shows how millions of people, pursuing the infinitely varied projects that interest them, coordinate their activities effectively with millions of other people, although they know next to nothing about the projects that interest those other people. The economic way of thinking shows how social processes that look like recipes for chaos (and that have often been so described) produce actual cooperation and advance the purposes of those who participate in these processes. Adam Smith invoked a semi-theological metaphor to characterize this process: the invisible hand. Because economic theory explains the working of the invisible hand, it is in a very basic sense a defense of market systems. It does not defend every aspect of such systems, but it certainly tends strongly to demonstrate to anyone willing to pay attention that markets work a lot better than most people suppose and that proposed substitutes for market systems, such as socialism, are the true recipes for chaos.

However, the economic way of thinking exaggerates the achievements of markets by overlooking their subversive effect on other forms of human relationship. Adam Smith noted that in a society characterized by extensive specialization, people stand “at all times in need of the cooperation and assistance of great multitudes.” That certainly describes us. We depend upon multitudes of other people, most of whom we do not know and never think about, to provide the food, clothing, shelter, medical care, and other goods that enable us to live in comfort and health.

This dependence on others has one feature that deserves more attention than it usually receives: The dependence is characterized by extraordinary freedom because we rarely have to depend on specific others. If we do not like the product or the terms on which it is offered, we can take our business to someone else. We have lots of choices, and choice means freedom for each of us: genuine independence despite our dependence on “the cooperation and assistance of great multitudes.”

Communities of Exceptional Thinness

That is not an unmixed good. It produces a society in which people barely know, if they even know at all, most of the people with whom they interact. The market functions very well even when the transactions that make it up are between people with no personal knowledge of one another. In fact, this is a major source of the market’s effectiveness as a system for increasing the cooperative production of wealth. Specialization is the prime source of wealth; the degree of specialization is limited by the number of people with whom we can exchange at low cost; and we could not exchange with very many people if exchange always required personal knowledge of those with whom we are trading. It is not that market transactions are inherently impersonal but that markets have so extended the range of our transactions that we necessarily do most of our exchanging with people whom we cannot possibly know personally.

Reflect for a moment on the role of money in this scheme. Most of us feel vaguely uneasy selling to friends or buying from friends for money; it seems somehow cold and impersonal. At Christmastime we give our friends gifts that we have taken the trouble to choose, and which they must then sometimes take the trouble to exchange for something that better suits their situation. We do not just give them money and let them choose for themselves. Why? Because money is impersonal. And that is its great virtue. The evolution of money has facilitated impersonal transactions and thus has vastly expanded our ability to exchange at low cost with people all over the globe.

The corollary is that money creates communities in which very little is actually shared and that these communities, through their effectiveness in enabling us to further the projects in which we are interested, become the principal communities in which we participate. Monetary exchange so dominates our social transactions that we have come to reside primarily in communities of exceptional thinness. We cannot love our neighbors because we do not even know their names, which we have never had occasion to learn because we are in no way dependent on them, and we are not dependent on them because it is so much easier to consult the Yellow Pages when we find ourselves in need of assistance.

Even that is not all bad. How many of us want to live in a village where people all know one another? We have become strongly attached to the privacy that the market system makes possible. But we do incur costs for this: crime, isolation, loneliness, anomie, a sense of impotence in the face of social problems, festering inequities that both market and government are too impersonal to overcome. While some of us are in a position to belittle these costs, they are serious burdens for others.

The costs are unanticipated side effects of markets, part of the price we pay for the enormous wealth and personal liberty that markets create. They are not effects of the economist’s way of thinking, but the economic way of thinking has proved itself surprisingly blind to these costs, which is why I have emphasized them in discussing limitations of the economic way of thinking.

A Free, Prosperous, and Just Society

As already stated, I am a devoted practitioner of the economic way of thinking. I am also, as anyone can readily infer from this essay, a staunch defender of markets. Nothing in this essay should be interpreted as a call to replace either one. I would prefer that we learn to celebrate their strengths. I ask only that we do so with a clear consciousness of their limitations. Market systems and the economic way of thinking are necessary but not sufficient conditions for the nurture of a free, prosperous, and just society.

We must also learn to nurture social institutions about which economics can say relatively little that is interesting or important, face-to-face institutions as distinct from the largely impersonal institutions that respond to monetary signals. These are often the very same institutions that the market system tends over time to displace: the family, the church, and the neighborhood.

The operative word is displace, not replace. The market cannot be a complete substitute for the family, but it can and does provide family members with attractive opportunities that make participation in family activities less important. Time spent eating dinner together becomes too costly to prolong when the television set is calling.

Consider how the automobile, a favorite gift of the market system, has altered the role of churches in the lives of many who think of themselves as faithful “churchgoing people.” The mobility created by the automobile enables people to worship more easily at a church that suits them, which often means a church that imposes on them no uncomfortable demands and where they need not stay long enough to develop any serious responsibilities.

And who really needs the neighborhood? Why concern oneself with the neighborhood school when an efficient real-estate market makes it so easy to transfer residence to where the neighborhood school is more satisfactory?

The market is a faithful servant in America today, providing more and more of the good things that we want. That is no reason to cripple it. It is reason, however, to think more carefully about what we want.