3.1.1 The Economy
Economics is supposed to study the economy. Then the immediate question is: what is there in the economy? What makes something economic as opposed to non-economic? At the least, we must discover one thing that animates everything in the economy. If we can find it, we will perforce get a unified economics, something that Debreu (1991) thought was 'out of reach'. Now, here is economics in one sentence:
This treatise stands on the theme that exchange is the one thing that holds together everything in the economy. It may appear rather paradoxical that classical economics intended to be a study of exchange (see Whately 1832), but really failed to become one. It may also seem incredible that neoclassical economics is a study of allocation (see Robbins 1932), which is in may ways contrary to exchange.
3.1.2 Detectives and Fugitives
There are many perplexing paradoxes in economics It is useful to be aware of the paradoxes, and learn how to escape them.
If things were just what they appear to be, there would be no need for science at all. Then the causal relations would be self-evident. No special effort would be needed to discover them. Indeed, the term 'discover' would be meaningless if things were not covered by some disguise that kept their true identities hidden from view.
Scientists are like detectives looking for disguised fugitives. However, the story may be more bizarre. As they said: we have found the enemies and they are us. We ourselves put the disguises on the facts. We prevent ourselves from seeing the naked truth as we fail to observe precisely, and to think causally.
First, the inherent limitation of our sensory organs, unless aided by observational tools, create paradoxes. Natural sciences regularly confront such paradoxes. The earth rotates on its own axis and moves fast in its orbit, but the naked eyes cannot perceive this motion. Again, the unaided eyes cannot see the micro-organisms or distant objects. The sense organs suffer from all kinds of illusions.
Secondly, uncritical intuition about human motives is the commonest source of paradoxes in all social sciences. Economics is full of such paradoxes. If we look and think carefully, we can resolve them.
We look at the same economy that our predecessors studied, but with the help of some tools to remove the factors that tend to hide and distort the essential realities. These tools make the difference. With a few examples, let us learn how to use the tools to remove the illusions and intuitions.
3.1.2.1 Diamond-water Paradox
It may seem odd that highly useful water is cheap, and indeed free, while the rather useless diamond is dear. This may appear odd, but it is not really so. The uncritical mind supposes that the price is based on demand, as linked to a vague sense of usefulness, and forgets to consider the matter of supply. Include supply, and the paradox disappears.
3.1.2.2 Paradox of Hunger amidst Plentiful Food Supply
It may seem paradoxical that a very large number of people starve to death while unsold food piles up in stocks. And the real price of food keeps falling far below cost to make farmers bankrupt despite subsidies.
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People pursue gains,and makeagreementson what and how much to exchange.
To resolve this paradox of hunger amidst plentiful food supply, one needs to remember that food is a traded good, and that those who do not have the income to buy it cannot get it just because it exists. The uncritical mind supposes that food is consumed by the producer. The fact is that 96% of the well-fed people do not produce food, while 92% of the food producers do not eat enough (See Jazairy et al 1994).
The problem is that the simple mind does not consider the relevant facts that have reversed the relation between food production and consumption. Marginal farmers and landless farm workers, as well as traditional foragers and fishermen are starving, because the oversupply of food drives the price down to such low levels that their wages are too low to allow them to keep enough of what they have produced themselves. They need industrial products and a wide range of necessary services, and they just cannot afford to keep the food.
In our detective work, we are about to find that apparently simple premises lead to paradoxical conclusions. We are going to see that much of the previous literature threw away the relevant and wrestled with the irrelevant.
Here is very short list of shocking paradoxes about previous economic theory:
z Everybody believes that demand and supply together determine the price, but this is not so.
z Everybody believes that trade must occur when demand is equal to supply, but it is not so.
z Everybody thinks that economics does study the market or the exchange process, but it does not deal with exchange in any real sense. It studies allocation and mistakes allocation for exchange. z Everybody knows that money is a means of payment, but nobody has ever treated it as such. Everybody treats money as a store of value, but it is irrelevant to money as means of payment. z Everybody thinks that economics cannot be unified, that it must
stay divided between micro and macro. But this is not so. There is simply no need for this division at all.
3.1.2.3.What Determines Price?
The generally accepted idea is that the demand and the supply of a good together determine its equilibrium price. But then one must note that the price of a particular good is measured by the number of units of
another good which pays for it. Thus if 2 apples are paid for by 3 bananas, the price of one apple is 3/2 bananas. The demand for and supply of apples together determine only the quantity of apples to be traded. The price of apple, counted in bananas, cannot be determined by the demand and supply of the apples only.
At the next step, we must note that the number of bananas paid against the apples is also determined by the demand and supply of bananas. Again, if 3 bananas are paid for by 2 apples, the price of one banana is 2/3 apples. Once gain, the demand and supply of bananas alone cannot determine the price of bananas; one must consider the demand and supply of apples too.
Taken together, the price is a relation between the quantities of the two goods that pay for each other. This relation is established by some principle that previous economic theory never considered. That is the relation of equivalence. If 2 apples are to pay fully for the 3 bananas, and the 3 bananas are to pay fully for 2 apples, then the value of 2 apples must be precisely equal to the value of the 3 bananas.
Going one step further, one must see that the equivalence relation is determined by mutual agreement of two traders, both of whom both buy and sell. Thus one agent sells the apples and buys the bananas, while the other buys the apples and sells the bananas. As soon as two people have to agree, a whole new dimension must be examined. Why would anybody agree to sell something if not for profit or gain? And how can both parties gain? Simple and obvious answers to this question lead to results totally unexpected by previous economics.
If we pursue this matter, we end up with the inescapable conclusion that price is determined by agreement of a special type called arbitrage. Among the two traders, at least one must act as an arbitrager to finalize the price, namely the ratio between the quantities to make them of equal value. And arbitrage is something that leaves net profits for the sellers on both sides. We will see that price is determined as a matter of exchange and not as a matter of allocation, meaning that price is not based on either marginal cost or marginal utility.
The above must come as a shock to the readers of the previous literature. If the prevailing theory of price is not valid, what is left? The answer is rather disheartening: not very much is left intact. But the void is filled with something more acceptable.
As we proceed further, we dig deeper and deeper to uncover the essential causal structure underlying the economy. A rigorous formal tool
of analysis is used. This tool helps us identify what is relevant and what is not. Then we see that previous economics overlooked the relevant and pursued the irrelevant.
Historians of thought may use the following example from natural science to see how the problem of relevance arises. Consider Newton's contribution to the discovery of the natural law of gravitation. Everybody ought to have seen that a small apple falls towards a very much larger earth, but everybody overlooked it. Instead, they tried to find some flaw in the apple itself that made it fallible, such as its ripeness that weakened the stem. But the character of apple being ripe or rotten itself was not relevant: its relative smallness was. They missed the essence.
The ordinary observers also did not see the other thing to get a complete picture. The apple is near the earth and falls to the earth, but distant stars do not fall to the earth. It was always easy to see, but somehow people overlooked it.
Next consider the matter of unifying theme from Copernican astronomy. To an ordinary observer, the following events do not seem to be connected at all: (1) the cycle of night and day; (2) the change of seasons; (3) the solar eclipse; (4) the lunar eclipse; (5) the phases of the moon; (6) the change is tides; (7) whether the earth is lying still or not; and (8) whether the earth revolves around the sun or not. Yet if one draws a diagram depicting the sun, the earth, and the moon in their axial and orbital motions, one sees that all of the above phenomena belong to the one and the same mechanism. The connections are not obvious unless a formal tool captures all in one body of a model.
3.1.3 Economics in One Page
If we are able to do economic science at all, we ought to be able to draw a simple diagram and explain how everything in the economy hangs together. Figure-1 below does just that. It shows an exchange with three goods (
x
AB, xBC, xCA). The first subscript indicates theproducer/seller and the second shows the buyer/consumer.
The outer triangle shows the direction in which the goods move. The inner one shows the direction of money payments. Chapter 5 will show how this triangle covers everything in economics.
This is it: this is all of economics.
3.2 Anatomy of an Economy
3.2.1 Economic Anatomy
Economics is unified by the following theme:
The key analytical idea about exchange is that it involves voluntary agreements between free people on what and how much to exchange.
The idea of deliberate agreement compels us to abandon classical economics, in which there is no such thing as agreement, but merely a naturally inescapable equilibrium. Agreement makes the market an institution rather than a mechanism. An institution permits, facilitates, and enforces agreements.
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In isolation, the quantity and kind of each good is determined by the allocation model. When put all of them together, the values and the payments are determined by agreements, within institutional arrangements, and with the help of intermediaries, to permit each participant to achieve gains.
Exchange is the one thing to hold together everything in the economy.
The analytical core of economic science is agreement, not equilibrium.
Agreement involves the freedom of the agents to agree or not to agree. To explain why people agree to exchange one good for another, we must consider the notion of gain. People agree to exchange, because they stand to achieve gains.
If the pursuit of gain is the soul that animates the economy, and agreement among traders is the heart, we need something to give them a body where the heart and the soul can reside. Exchange as a formal construct is that body.
If we pushed this anatomical metaphor further, money would be the blood of the economic body. Unless it circulates to carry the power to pay for purchases, all indirect trades are dead. The main thrust of the analysis is to capture money and see what it does to affect the quantities and kinds of goods to keep them alive or make them dead.
As explained below, the economy is anchored in observations on exchange, which formally serves to unify the analysis. The economy is animated by the pursuit of gain, which culminates in voluntary agreements on what and how much to exchange. Most trades are indirect, and these are kept in operation with the use of fiat money.
3.2.2 Anchored in Observations
Like any proper science, economics must anchor itself in factual observations. Formally, the description of observed exchanges provides that anchor. It makes economic science a study of the kinds and quantities of real output in an exchange.
The empirical anchor compels the analyst to connect one observation to another observation, even though the causal connection is understood in terms of unobservable subjective elements such as preferences, perceptions, and expectations. There is no need to observe these elements, as explanation requires only a stylized set of relations.
It will be very clear that economics is not a study of human behavior. It is a study of output, whose determination involves human actions. Economics explains how the output behaves, but not how humans behave.
3.2.3 Unified by Exchange
Consistent economics is unified by its anchorage in the observed facts of exchange. As explained in detail in Chapter 5, the issues of exchange can be broken down into three parts dealing with value, pensation, and intermediation respectively.
The theory of value studies how the quantities of output are determined. The analysis of output under subsistence by isolated agents can be handled by the existing model of allocation. Fundamental new elements are then introduced to make a transition to output under trade. The key difference is that trade allows additional output that would not be produced under subsistence.
The relation between the quantities of goods that pay for each other is price. A new analysis of price shows how agreements on prices are made in the market through an arbitrage process. The process must be observable at every stage.
The analysis of the structure of output requires a new method. Since one kind of good pays for another kind, including artificial goods, each traded good is a pensation. Pensation theory deals with everything that macroeconomics tried to study.
The market agreements must be understood within the framework of an institution. Then one looks at entrepreneurship, transaction cost, competition, and institutions. The framework lets one separate economic issues from political and cultural issues.
3.2.4 Animated by Gain
The job of the theoretician is to explain the observed patterns of exchange. However, trading activities cannot be explained with the notion of mechanism as applied in natural science. Instead, it requires the subjective notion of intentions which provide the motive for the human actions.
Perhaps the supreme paradox in economics is that the simple idea that people engage in trade to get gains is admitted verbally but denied formally. Sellers are supposed to maximize profit, but in equilibrium, profit is shown to be zero. The paradox arises because the analyst overlooks the transparent manner in which the gain occurs, just as people overlook the transparent largeness of the earth relative to the apple that falls to the earth.
The key is to notice that people sell one kind of good worth one
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Money as a means of payment is the lifeblood of the market economy. Gainful trade is the hallmark of economics.
dollar to buy a different kind of good also worth one dollar. This difference in kind carries the gain. When analyzed formally, this completely changes economics.
At first it seems absurd, but after reflection it seems self-evident that different kinds of goods of equal market value have unequal levels of utility. Thus if one sells apples worth one dollar and buys bananas worth one dollar, one must get more utility from the bananas than from the apples, despite their being of equal dollar value. However, if one buys 1 dollar of apples and also buys 1 dollar of bananas, then the apples and the bananas are of equal utility.
Formally, we must distinguish between allocation and exchange. The former gives no room for gain, but the latter is gainful. This distinction will reveal economic matters that were previously hidden from view. It will resolve the paradoxes. Sections 4 and 5 below explain this.
3.2.5 Instituted by Agreements
The most important change in outlook is that kinds and quantities of traded output are determined by deliberate agreements. Even though the formal expression may look exactly like a mechanical equilibrium, the notion of agreement is distinct from equilibrium in fundamental ways. The analysis of agreements calls for a fundamental rethinking of the foundations of philosophy, of social science, and the worldview of the market as a social institution.
First, the unresolved debate between mechanism and teleology must be resolved. We must recognize that there is really no sound basis to assume that the entire universe must have a single verse, be it either mechanism or teleology. We must acknowledge the existence of diversity. Some objects are inert and they behave mechanically. Other entities are alert and animated, and they act purposefully. There must be tests to determine whether an entity is inert or alert.
An inert object has an immutable nature, which it cannot change from within. An alert being has a mutable character which it can change from inside. For example, it is the nature of chemically pure water to freeze at temperatures below 0 degree Celsius and to evaporate at temperatures above 100 degree Celsius. Water can not refuse to abide by its nature. But a thirsty man has a character. He may drink water when he is thirsty, but he may also refuse to drink when he is thirsty, for