Think of the most rational person you know. If a friend comes to you with a problem, would you open a spreadsheet document? Would you type Pros at the top of Column A and Cons in Column B? Then I bet you would ask your friend to list all the pros and cons. Maybe you would even ask your friend to assign point values to each item listed. Then you sum up each column. The side with the higher point value would be the answer to the dilemma!
We would describe this kind of rationality as logic or objectivity. Economists assume that, on average and in general, people make decisions rationally. There are exceptions, of course; people who seem to be always irrational or moments in an otherwise rational life when crazy things happen. We know that people aren't always rational. Or at least they don't appear to be rational.
But let me clear what I mean by rational. Remember that economics is all about making choices, such as whether to buy something or not. Rationality means that you would figure out the value of the benefit from the purchase and the value of the cost. Then you would compare the benefit to the cost. If the benefit is greater than the cost, then you would make the buy. If the benefit is less than the cost, then you would not purchase.
Notice how vague the terms benefit and cost are. Benefits and costs will vary from person to person. Benefits and costs may even vary within one person over different periods of time. Emotions can fit under this definition of rational. If our measurement of the benefits includes emotion, we can still act rationally given that we compare that emotional benefit to however we measure the cost. You might call this subjective rationality.
When we see someone acting supposedly irrationally, it may be that we just don't understand how that person is measuring benefits and costs.
Rationality also means that, on average and in general, people make decisions consistently and predictably. Here's an example. How many readers out there like apples better than bananas? Raise your hands and keep them up. There are 20 of you with hands up. Now, how many of you 20 like bananas better than cantaloupes? Keep your hands up. Cantaloupe lovers can put their hands down. OK, there are seven hands left up.
Now, for the rest of you with your hands down, can you make a prediction about these seven people with their hands up? What would you predict these people would answer if I asked if they liked apples better than cantaloupes? You would predict that all seven would like apples better. Why?
You would predict that they would prefer apples over cantaloupes because of the principle of transitivity. If someone likes apples better than bananas and bananas better than cantaloupes, then that person should like apples better than cantaloupes. If A > B and B > C, then A > C. We expect people to act in this consistent and predictable way rather than to answer randomly about fruit preferences. This is another part of rational behavior. When making choices, people do not behave randomly, but instead they make decisions, on average and in general, in predictable ways.
This assumption of rationality is comes from the fact that economics is a social science. As such, economics uses the scientific method. Economists observe human (and sometimes animal) behavior and then ask why does this behavior occur. But different from the physical sciences, it is difficult to conduct economic experiments. Possible, but difficult, and subject to limitations. Almost all economic behavior occurs in real life. It's hard to ask customers in a store to divide into a control group and an experimental group. Therefore, most economic experiments are thought experiments, often reliant on mathematical theory and statistical analysis.
Nevertheless, economists do construct scientific models. There are four parts to a model:
1. assumptions
2. isolation
3. story
4. prediction
Every model begins with some form of the verb to assume. The purposes of the assumptions are to simplify and control the circumstances of the thought experiment. Real life is complex and messy. So, one assumption might be to freeze frame everything, hold everything constant. This eliminates the effects of factors that are beyond the scope of the experiment. For example, we might assume that incomes stay constant while we are studying shopping behavior.
Assuming that everything is held constant, we can then isolate on the factors to be studied. And in many models, especially at introductory levels, we isolate on two things. Why two? Because in economics, everything comes in two's! For example, we might isolate on price (independent variable) and quantity demanded (dependent variable).
A story is a sequence of events, a chain reaction. One thing leads to another. We have isolated on two things in our model and the story begins, "Change one of the things." For example, we might change the price by increasing or decreasing it. Changing the price sets off a sequence of events.
And that sequence of events leads to a conclusion, an ending to the story. Making the same assumptions, isolating on the same two things, and telling the same story, we expect that the ending will always be the same. Therefore, the conclusion becomes a prediction: If these things are true, then we predict that this result will occur.
Economic models help us predict human behavior. A scientific model that accurately predicts real-world behavior is called a theory. Economists never say, "Oh, that sounds good in theory, but it would never work in practice." If it doesn't work in practice—if it doesn't predict real-world behavior—then it isn't a theory. The idea is instead a failed hypothesis.
The basic economic models presented in this blog have been tested by time and do a good job of predicting real-world behavior.
Note to behavioral economists
Advocates of behavioral economics question the assumption of rationality. They criticize many economic models and equations that primarily revolve around benefits and costs measured in money. Behaviorists believe that most economic models assume that all people consistently behave the same way all the time. Predictable behavior based on money might be called objective rationality.
Objective rationality, however, applies only to simple economic models with one or two independent variables. The same models can be expanded by adding parameters and still meet the standards of marginal analysis and transitivity. This is the foundation of subjective rationality.
COPYRIGHT © 2008 by Robert D. Sandman
ALL RIGHTS RESERVED.
Sunday, December 21, 2008
Wednesday, November 19, 2008
Make Your Mind Up Already
When I took Introduction to Marketing, my professor told us that people walk around with shopping lists in their minds. A person says, "If I ever get the money, I will buy . . . ." Then the person names the things on the list: a new car, a boat, a tropical vacation, new dress shoes, a house, and so on. But what if our hypothetical person suddenly came into money through an inheritance or a lottery or big bonus? Our lucky shopper would start buying things on the mental list. And what do you think? Once all the items on the list have been purchased, Super Shopper will be done shopping forever, right?
Of course not. In general, on average, people are never satisfied. Sure, there are some saints on earth who do not crave more goods, but most people have insatiable wants. Notice that I am using the word wants, not needs. Once the lucky shopper buys everything on the mental list, new wants replace the old ones.
Now, a secret. In economics, everything comes in two's. For example, economists make two assumptions about human economic behavior. One assumption is the existence of insatiable wants. The other assumption is related to the definition of market. A buyer and seller come together and make a trade. Product moves in one direction and resources—usually money—move in the other. We have infinite wants, but we also learn at an early age that we cannot have everything we want. There are not enough resources—for example, money—to spend in order to satisfy our infinite wants. Resources are scarce, finite.
So, in general, on average, our wants are infinite, but our resources are scarce.
There are two main examples of scarce resources. Why two? Because in economics, everything comes in two's! One example of a scarce resource is labor, human resources. At any one moment in time, there is a finite number of workers on earth. These workers can produce goods and services, but not enough to satisfy infinite wants.
The other example of a scarce resource is capital. In economics, the word capital means the physical things we use to make stuff. A factory building, an airplane, an office computer are examples of capital equipment. Again, at any given moment in time, there is a finite amount of capital equipment. There is never enough capital to be used to satisfy infinite wants.
What does it mean that we have infinite wants, but scarce resources? It means that we are forced to make choices. We cannot have it all. Instead, we must prioritize which of our infinite wants we will satisfy and which we will sacrifice. As a matter of fact, you already understand the idea that the central economic behavior is making choices. Imagine that, when you go to buy groceries one week, you have less money to spend than usual. As you walk into the store, you say to yourself, "This week I am going to have to economize." You know that you cannot afford to buy everything that you usually buy, so you will have to set priorities. You will have to make choices.
This is what economics is all about, making choices and tradeoffs.. Consumers have to make economic choices. So do managers and so do societies.
Economics scientifically studies choice-making behavior. What do people consider when making their choices? Can we predict what choices people will make?
Keep reading.
COPYRIGHT © 2008 by Robert D. Sandman
ALL RIGHTS RESERVED.
Of course not. In general, on average, people are never satisfied. Sure, there are some saints on earth who do not crave more goods, but most people have insatiable wants. Notice that I am using the word wants, not needs. Once the lucky shopper buys everything on the mental list, new wants replace the old ones.
Now, a secret. In economics, everything comes in two's. For example, economists make two assumptions about human economic behavior. One assumption is the existence of insatiable wants. The other assumption is related to the definition of market. A buyer and seller come together and make a trade. Product moves in one direction and resources—usually money—move in the other. We have infinite wants, but we also learn at an early age that we cannot have everything we want. There are not enough resources—for example, money—to spend in order to satisfy our infinite wants. Resources are scarce, finite.
So, in general, on average, our wants are infinite, but our resources are scarce.
There are two main examples of scarce resources. Why two? Because in economics, everything comes in two's! One example of a scarce resource is labor, human resources. At any one moment in time, there is a finite number of workers on earth. These workers can produce goods and services, but not enough to satisfy infinite wants.
The other example of a scarce resource is capital. In economics, the word capital means the physical things we use to make stuff. A factory building, an airplane, an office computer are examples of capital equipment. Again, at any given moment in time, there is a finite amount of capital equipment. There is never enough capital to be used to satisfy infinite wants.
What does it mean that we have infinite wants, but scarce resources? It means that we are forced to make choices. We cannot have it all. Instead, we must prioritize which of our infinite wants we will satisfy and which we will sacrifice. As a matter of fact, you already understand the idea that the central economic behavior is making choices. Imagine that, when you go to buy groceries one week, you have less money to spend than usual. As you walk into the store, you say to yourself, "This week I am going to have to economize." You know that you cannot afford to buy everything that you usually buy, so you will have to set priorities. You will have to make choices.
This is what economics is all about, making choices and tradeoffs.. Consumers have to make economic choices. So do managers and so do societies.
Economics scientifically studies choice-making behavior. What do people consider when making their choices? Can we predict what choices people will make?
Keep reading.
COPYRIGHT © 2008 by Robert D. Sandman
ALL RIGHTS RESERVED.
Monday, November 3, 2008
Meditate at Lunch
Think for a moment about the last lunch you had. What did you eat? For me it was some pulled pork with barbecue sauce. I made a sandwhich with two pieces of sliced white bread. I also had a golden delicious apple, potato chips, and a glass of milk.
Here is a question. Where did the parts of my lunch come from? The pork and sauce came from a local restaurant. The bread, apple, chips, and milk came from the grocery store. When we purchased the pork or the groceries, we were the buyers. The restaurant or the grocery store were the sellers, who handed the food over. But there's no such thing as a free lunch, right?
In order to take the food, we had to pay money. There at the checkout register, a trade was made. Food flowed from the seller to the buyer and money flowed in the other direction. This is what a market is, a place where buyers and sellers come together and make a trade.
But where did the restaurant get the pork? Probably from a wholesale restaurant food distributor. And notice a subtle shift. The distributor is the seller. Now the restaurant is the buyer. Most people and organizations in the economy play this double role, both buyer and seller. You are a buyer when you are a customer in a store. You are a seller of your labor to your employer. Your organization acts as a buyer through its purchasing department and as a seller through its sales and marketing departments.
In any event, the restaurant buyer and the distributor seller came together and made a trade. The restaurant might have issued a purchase order for a delivery of some number of pounds of pork every few days. After the delivery, the distributor's accounts receivable department sent an invoice to the restaurant. Later, the restaurant's accounts payable department sent a check to the distributor. Buyer and seller came together and made a trade. Food moved from the distributor to the restaurant and money moved the other way.
The wholesale distributor purchased the pork from a processor. Now the distributor was the buyer. In the market, pork moved from the processor to the distributor and money flowed from the distributor to the processor. In a similar way, the processor acted as a buyer and hog farmers acted as sellers.
The pork traveled through a long, complicated supply chain in order to be available in the restaurant when we were ready to purchase it. At every stage in the supply chain, buyers and sellers came together and made a trade. We could describe the same process for the bread that I used to make my sandwich, the apple, the potato chips, and the milk. The food that you ate yesterday and the meals for all the people reading this blog also were delivered by similar supply chains. Same thing for the clothes you are wearing or the computer you are using.
Now comes the miracle of economics, the kind of astounding insight that turned me into an economics jerk. There is no government official or corporate headquarters coordinating all these supply chains and making them work to deliver the products that we want to consume. The supply chains work all by themselves because buyers at each stage are motivated to buy products and sellers are motivated to earn money. This is what the concept of the Invisible Hand is all about.
Imagine for a moment that you are point of light floating in space. Now imagine that the companies from which you purchase goods and services are also floating points of light. Your market trades with them are beams of light connecting you to them. But each of those selling companies also purchase; so, they are connected by beams to many other points of light. Keep going and eventually you can visualize an enormous ball of points of light with many, many beams connecting them in a complicated web.
This connectivity illustrates the Basic Economic Truth: Everything is connected to everything else. So there is something to think about at your next meal. Where did your food come from? What steps did it go through to get to you? How many times did buyers and sellers make a trade? And then tell your friends and family what you're thinking. You'll be an economics jerk!
__________________________
COPYRIGHT © 2008 by Robert D. Sandman
ALL RIGHTS RESERVED.
Here is a question. Where did the parts of my lunch come from? The pork and sauce came from a local restaurant. The bread, apple, chips, and milk came from the grocery store. When we purchased the pork or the groceries, we were the buyers. The restaurant or the grocery store were the sellers, who handed the food over. But there's no such thing as a free lunch, right?
In order to take the food, we had to pay money. There at the checkout register, a trade was made. Food flowed from the seller to the buyer and money flowed in the other direction. This is what a market is, a place where buyers and sellers come together and make a trade.
But where did the restaurant get the pork? Probably from a wholesale restaurant food distributor. And notice a subtle shift. The distributor is the seller. Now the restaurant is the buyer. Most people and organizations in the economy play this double role, both buyer and seller. You are a buyer when you are a customer in a store. You are a seller of your labor to your employer. Your organization acts as a buyer through its purchasing department and as a seller through its sales and marketing departments.
In any event, the restaurant buyer and the distributor seller came together and made a trade. The restaurant might have issued a purchase order for a delivery of some number of pounds of pork every few days. After the delivery, the distributor's accounts receivable department sent an invoice to the restaurant. Later, the restaurant's accounts payable department sent a check to the distributor. Buyer and seller came together and made a trade. Food moved from the distributor to the restaurant and money moved the other way.
The wholesale distributor purchased the pork from a processor. Now the distributor was the buyer. In the market, pork moved from the processor to the distributor and money flowed from the distributor to the processor. In a similar way, the processor acted as a buyer and hog farmers acted as sellers.
The pork traveled through a long, complicated supply chain in order to be available in the restaurant when we were ready to purchase it. At every stage in the supply chain, buyers and sellers came together and made a trade. We could describe the same process for the bread that I used to make my sandwich, the apple, the potato chips, and the milk. The food that you ate yesterday and the meals for all the people reading this blog also were delivered by similar supply chains. Same thing for the clothes you are wearing or the computer you are using.
Now comes the miracle of economics, the kind of astounding insight that turned me into an economics jerk. There is no government official or corporate headquarters coordinating all these supply chains and making them work to deliver the products that we want to consume. The supply chains work all by themselves because buyers at each stage are motivated to buy products and sellers are motivated to earn money. This is what the concept of the Invisible Hand is all about.
Imagine for a moment that you are point of light floating in space. Now imagine that the companies from which you purchase goods and services are also floating points of light. Your market trades with them are beams of light connecting you to them. But each of those selling companies also purchase; so, they are connected by beams to many other points of light. Keep going and eventually you can visualize an enormous ball of points of light with many, many beams connecting them in a complicated web.
This connectivity illustrates the Basic Economic Truth: Everything is connected to everything else. So there is something to think about at your next meal. Where did your food come from? What steps did it go through to get to you? How many times did buyers and sellers make a trade? And then tell your friends and family what you're thinking. You'll be an economics jerk!
__________________________
COPYRIGHT © 2008 by Robert D. Sandman
ALL RIGHTS RESERVED.
Monday, October 27, 2008
Always Stop at Lemonade Stands
Make the lemonade. Set out the cups. Cut a hole in the cardboard to create a cash box. The children at the table have everything they need to sell lemonade—except you. Sellers need buyers. When you stop for a cold drink, you teach the next generation something about how business works.
A lemonade stand is a place to learn about the need to obtain a product to sell. Lemon juice and sugar are raw materials. The neighborhood gang of kids who make the lemonade and staff the table are the labor force. The pitcher, table, and chairs are capital equipment. The kids may even think of the need for some coins in order to make change for the first few customers. This is start-up financial capital. Altogether, raw materials, labor, capital equipment, and financial capital are examples of resources or inputs. This is the supply side of the economy.
A lemonade stand is also a place to learn about selling. The cups of lemonade are the product or output. When you and your neighbors stop at the table, you become customers, the demand side of the economy. Through trial and error over the summer, the kids will learn about the four P's of marketing. product, price, place, and promotion. They will grow to see that being good at selling requires understanding buying behavior.
Just the other day, something new happened. The doorbell rang and there were two neighbor girls. They announced that they were selling lemonade and peach tea at the end of the block and urged me to stop by. This is active lemonade selling as opposed to passive. Very impressive!
A lemonade stand illustrates the black-box model of business. Inputs like lemon juice, labor, and capital equipment flow into a black box. Mysterious production happens inside the box: kids pour juice and sugar into a pitcher and mix them. Then outputs, such as lemonade, flow out of the black box and into the hands of customers.
Flowing back in the other direction is money. Customers pay for the output, lemonade, and the kids use the money to pay for the inputs: buying more lemon juice, maybe paying Mom and Dad rent for the table, and putting the residual in their own pockets.
Thus the lemonade stand becomes a market, a place where buyers and sellers come together and make a trade, lemonade for money. This market behavior happens all over our economy, often without corporate involvement or government oversight. People choose on their own to behave in such a way that the products are available when customers want to buy. On a hot day, there is a table full of kids in your neighborhood selling cold lemonade.
Here are the 52 topics that I will cover in this blog. Come back to read often. Make a comment.
1. Always Stop at Lemonade Stands
2. Meditate at Lunch
3. Make Your Mind Up Already
4. Rationalize All You Want
5. Take a Hike
6. Demand Everything
7. Supply Something
8. Maintain Balance
9. Think Before Controlling Prices
10. Pay Your Share of Public Goods
11. Market Elastically
12. Open the Black Box of Business
13. Choose How Big to Be
14. Count Your Profits
15. Climb the Productivity Hill
16. Plan for the Long Run
17. Build a Better Mousetrap
18. Create Brand Loyalty
19. Give People Choices
20. Play the Game
21. Keep an Eye on the Pendulum
22. Vote in the Economic Democracy
23. Jump into the Labor Pool
24. Ask for a Raise
25. Connect the Dots
26. Set Some Macroeconomic Goals
27. Target Full Employment
28. Stabilize Prices
29. Grow the Economy
30. Share the Macroeconomic Secret
31. Be Skeptical of Data
32. Watch Out for That Quagmire
33. Tax and Spend
34. Trade with a Foreigner
35. Be Fruitful, Multiplier
36. Buy, Buy, Buy
37. Sell, Sell, Sell
38. Find the Balance Point
39. Fight the Cycle
40. Look on the Supply Side of Life
41. Ignore Something Rationally
42. Balance the Budget Cycle
43. Take a Stand on the Debt
44. Barter
45. Take a Wooden Nickel
46. Gaze at the Gold
47. Contemplate Money
48. Create Some Money
49. Manipulate the Money Supply
50. Get Interested in Rates
51. Win with Inflation
52. Get on the Side of the Fed
___________________________________
COPYRIGHT © 2008 by Robert D. Sandman
ALL RIGHTS RESERVED.
A lemonade stand is a place to learn about the need to obtain a product to sell. Lemon juice and sugar are raw materials. The neighborhood gang of kids who make the lemonade and staff the table are the labor force. The pitcher, table, and chairs are capital equipment. The kids may even think of the need for some coins in order to make change for the first few customers. This is start-up financial capital. Altogether, raw materials, labor, capital equipment, and financial capital are examples of resources or inputs. This is the supply side of the economy.
A lemonade stand is also a place to learn about selling. The cups of lemonade are the product or output. When you and your neighbors stop at the table, you become customers, the demand side of the economy. Through trial and error over the summer, the kids will learn about the four P's of marketing. product, price, place, and promotion. They will grow to see that being good at selling requires understanding buying behavior.
Just the other day, something new happened. The doorbell rang and there were two neighbor girls. They announced that they were selling lemonade and peach tea at the end of the block and urged me to stop by. This is active lemonade selling as opposed to passive. Very impressive!
A lemonade stand illustrates the black-box model of business. Inputs like lemon juice, labor, and capital equipment flow into a black box. Mysterious production happens inside the box: kids pour juice and sugar into a pitcher and mix them. Then outputs, such as lemonade, flow out of the black box and into the hands of customers.
Flowing back in the other direction is money. Customers pay for the output, lemonade, and the kids use the money to pay for the inputs: buying more lemon juice, maybe paying Mom and Dad rent for the table, and putting the residual in their own pockets.
Thus the lemonade stand becomes a market, a place where buyers and sellers come together and make a trade, lemonade for money. This market behavior happens all over our economy, often without corporate involvement or government oversight. People choose on their own to behave in such a way that the products are available when customers want to buy. On a hot day, there is a table full of kids in your neighborhood selling cold lemonade.
Here are the 52 topics that I will cover in this blog. Come back to read often. Make a comment.
1. Always Stop at Lemonade Stands
2. Meditate at Lunch
3. Make Your Mind Up Already
4. Rationalize All You Want
5. Take a Hike
6. Demand Everything
7. Supply Something
8. Maintain Balance
9. Think Before Controlling Prices
10. Pay Your Share of Public Goods
11. Market Elastically
12. Open the Black Box of Business
13. Choose How Big to Be
14. Count Your Profits
15. Climb the Productivity Hill
16. Plan for the Long Run
17. Build a Better Mousetrap
18. Create Brand Loyalty
19. Give People Choices
20. Play the Game
21. Keep an Eye on the Pendulum
22. Vote in the Economic Democracy
23. Jump into the Labor Pool
24. Ask for a Raise
25. Connect the Dots
26. Set Some Macroeconomic Goals
27. Target Full Employment
28. Stabilize Prices
29. Grow the Economy
30. Share the Macroeconomic Secret
31. Be Skeptical of Data
32. Watch Out for That Quagmire
33. Tax and Spend
34. Trade with a Foreigner
35. Be Fruitful, Multiplier
36. Buy, Buy, Buy
37. Sell, Sell, Sell
38. Find the Balance Point
39. Fight the Cycle
40. Look on the Supply Side of Life
41. Ignore Something Rationally
42. Balance the Budget Cycle
43. Take a Stand on the Debt
44. Barter
45. Take a Wooden Nickel
46. Gaze at the Gold
47. Contemplate Money
48. Create Some Money
49. Manipulate the Money Supply
50. Get Interested in Rates
51. Win with Inflation
52. Get on the Side of the Fed
___________________________________
COPYRIGHT © 2008 by Robert D. Sandman
ALL RIGHTS RESERVED.
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