Economics is often thought of as a dull science. When most people hear the word “economics,” they immediately think of terms such as interest rates, inflation, unemployment, or other equally unexciting concepts. Economics, however, is considered a social science and is a fascinating combination of science and art used to predict behavior.
Economics, although often associated with finance, can be used to predict presidential elections, courtroom verdicts, love, war, crime, sporting events, and even your dog's behavior. The conventional use of economics (interest rates, inflation etc.) is really just one small use for economics. Economists believe that behavior is not hard to predict, on average, because people will act in their own self-interest and do what is best for them.
The science side of economics comes from looking at data, using equations or applying theory. The art side comes from forecasting the outcomes based on the scientific facts. Because the art side of economics requires opinions, educated guesses, and other less scientific bits and pieces of information, economists rarely agree. In fact, there is an economist's joke that says if you laid all the economists end to end, they would never reach a conclusion! While there are certainly many areas where economists disagree, there is one thing they all agree on and that is the power of incentives.
People respond to incentives in ways that benefit them the most. Understanding economics comes down to remembering that one phrase. In fact, the father of modern economics, Adam Smith, wrote more than two hundred years ago, "It is not from the benevolence of the butcher, or the baker, that we expect our dinner, but from regard to their own self interest."
Economists believe that people, acting in their own self-interest, implicitly use a cost-benefit analysis for all decisions. Costs do not necessarily mean dollars. They can be measured in terms of time, risk, aggravation, work, and many others. Sitting in rush-hour traffic, for example, is a very big cost of living in a big city. Regardless of how they are measured, economists believe that if costs outweigh the benefits, the behavior stops. On the other hand, if benefits outweigh the costs, the behavior continues. Why do people sit in rush-hour traffic? Evidently, the benefits of living in the city are still greater.
As another example, assume speeding is a problem on a particular highway in your state. How do you use economics to get drivers to slow down? You simply increase the cost of speeding. There are many costs to speeding, with the potential for car wrecks and bodily injury being among the highest. However, if you add the potential for traffic fines, you've added to the cost of speeding. If you increase speeding fines significantly to a point where the costs outweigh the benefits, people act in their own self-interest and slow down.
If speeding tickets were only $10, for example, many would feel that moving faster from point A to point B is well worth the risk of losing $10. If they are caught speeding, they would feel the benefits outweighed the costs, pay the fine, and continue to speed. However, if you keep increasing the fines, at some point, the dollar amount of the risk is too great, the costs outweigh the benefits, and drivers will slow down. Now it should make sense why speeding tickets are so expensive. People value their time and have a great self-serving interest to drive fast. Smaller fines do not produce the desired results.
Of course, what is expensive to one may still be cheap to another. For any given level of traffic fines, there will still be those who feel it is worth the risk and continue to drive fast. For these people, other negative incentives (disincentives) will work too. Suspended licenses, jail time, community service work, and a host of others can all be used to further decrease the average highway speed. Which method or methods to choose for the greatest results, the least cost, or other reasons is a question for the art side of economics.
Raising speeding fines is one way to reduce the number of traffic deaths. What about using safety equipment? Would you predict that more or less traffic deaths would occur as more and more cars come equipped with side airbags? Most jump to the immediate conclusion that the number of traffic deaths will decrease. It seems logical but the answer is not that easy.
It’s true that the number of deaths would decrease if all other factors remained constant or “ceteris paribus” to use a favorite Latin phrase by economists. The term literally means “with other things the same," and usually interpreted in English as "all other things being equal."In other words, as long as more cars are not sold as a result of the new safety equipment, as long as drivers continue the same driving habits and so on, then we could expect the number of traffic deaths to decrease. However, the addition of side air bags changes more than just the safety. They change the cost of speeding and therefore change the incentives to drivers.
Economists would argue that the number of traffic deaths might actually increase with the addition of side airbags. The reason is that air bags may reduce fatalities but the number of accidents may increase. If the additional accidents result in more deaths than the lives saved by the side airbags, the total number of deaths will obviously increase. But why would economists guess an increase in the number of accidents?
Airbags give drivers the incentive to accept more risk. With side air bags, cars are safer and people therefore have the incentive to take more risk, which includes driving faster. Even if they don't drive faster, people have the incentive to do other things involving more risk with a safer car. They may reach for a CD lying on the floor, dial a cell phone in heavy traffic, change lanes excessively, or catch a quick glimpse in the rearview mirror to apply lipstick while driving down the highway. The more that these kinds of activities occur, the more accidents will occur.
What makes economists so sure that people will actually drive faster or less cautiously just because side air bags are added? That's the self-serving side of human nature that economists are very aware of. If that's hard to accept, sometimes it helps to solve economic questions by considering negative incentives rather than incentives.
For example, a distinguished economist, Armen Alcian, from UCLA used the following creative and extreme example to show how laws requiring seatbelts actually increase tailgating. He argued that a law requiring a long spear mounted on the steering wheel and aimed at the driver’s heart would immediately reduce the number of tailgaters. But if the spear is removed, the tailgaters reappear. Using the same line of reasoning, if seatbelts are added, drivers are now safer just as when the spear is removed, and are willing to accept a little more risk. Accepting more risk is accepting more accidents.
Economists would agree that drivers, on average, would drive less cautiously as side airbags become standard. Applying this simple economic theory is the science side of economics. However, nothing has been said about the net effects of traffic deaths. While drivers may be less cautious and cause more accidents, airbags, on the other hand, will save more lives. Will the addition of airbags increase or decrease the number of traffic deaths each year? That is another question for the art side of economics and the sole basis of whether they should become standard equipment or not.
So while standard air bags may initially seem like a good idea, economists are not so quick to agree. Further, incentives can be tricky things. Sometimes, incentives set off a chain reaction of events that are difficult to track and can sometimes yield the opposite effect. In economics language, when a decision yields an unexpected outcome, it is known as an unintended consequence and examples abound in the field. For example, in 1989, the Exxon tanker Valdez created one of the worst oil spills in U.S. history. As a consequence, many coastal states pursued legislation that placed unlimited liability on tanker operators. The idea, of course, was similar to increasing speeding fines. Operators now had a disincentive to be more careful and the states felt they found an elegant solution for reducing the chances of costly oil spills for the future. It was an obvious solution. Obvious, and wrong.
True economic forces prevailed and the self-serving interests of corporations were apparently underestimated. The oil-importing corporations simply hired foreign ships to deliver the oil to the U.S. and escaped the laws holding their fleets to the newly established unlimited liabilities. Rather than seeing reliable U.S. ships on the horizon, the coastal states saw shady independent operators with less than satisfactory ships and questionable insurance. Rather than decrease the chances of an oil spill, their legislation actually increased it – an unintended consequence for sure.
This is why the art side of economics is so important – and difficult. In order to make sound judgments, you must be able to trace all of the secondary effects through the economy to ensure that any particular decision will have the correct impact. Regardless, once you discover how a particular incentive will affect people, you simply need to rationalize how people will respond, carefully trace out the secondary effects, and you are on your way to understanding economics.
For most people, money is a powerful incentive and is the primary incentive used when speaking about economics in the conventional sense. If the government wants people to buy homes, they lower interest rates. Lower interest rates mean that housing costs are reduced; when price is reduced, people have the incentive to buy. If they want to encourage savings, they can raise interest rates. Higher rates provide an incentive to keep your money in the bank. Why the government would want you to buy houses or save money will be discovered later in this course. How they go about doing it is a question for the art side of economics.
It all comes down to applying the correct incentive to achieve a desired response. You may respond better to money but your dog probably prefers T-bones. The power of incentives is the foundation for all economic principles. As you will learn, the seemingly trivial number we call an interest rate provides a powerful financial incentive. By tracking interest rate changes, we can predict what people will do, how financial markets will react, and where money will flow. It’s a small number that provides powerful, predictable paths you can be sure investors will follow. Understanding where those paths lead can generate valuable investment ideas.
While interest rates provide the incentive for you to take specific courses of action, no matter which action you choose, there are opportunity costs that must be accounted for.