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Two Elementary Ideas for Basic Economic Reasoning

Summary:
This term I am teaching my HIstory of Price Theory course, a course I enjoy teaching tremendously.  But two lessons emerge from both the classical economist and the early neoclassical economists that I think would ensure clear thinking.  Ironically, this might actually be exemplified in the writings of Frank Knight on value and price theory, and thus in his price theory.  And, those two lessons can be simply stated as: (1) solve for the equilibrium, and (2) always remember we are part of the equilibrium.  How do I understand these two lessons?  First, if we freeze all the data and we freeze time, work through the logic and let the story go to its completion and determine the optimality conditions.  This exercise in logic is essential, and to repeat, it is a huge mistake in economic

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This term I am teaching my HIstory of Price Theory course, a course I enjoy teaching tremendously.  But two lessons emerge from both the classical economist and the early neoclassical economists that I think would ensure clear thinking.  Ironically, this might actually be exemplified in the writings of Frank Knight on value and price theory, and thus in his price theory.  And, those two lessons can be simply stated as: (1) solve for the equilibrium, and (2) always remember we are part of the equilibrium.  How do I understand these two lessons?  First, if we freeze all the data and we freeze time, work through the logic and let the story go to its completion and determine the optimality conditions.  This exercise in logic is essential, and to repeat, it is a huge mistake in economic reasoning to cut the story off too short -- read to the end of the story, so all the equilibrium conditions are fulfilled.  As I said, solve for the equilibrium.  But the second lesson, which is equally important, is never begin your analysis in the end!  This is why the technique of simultaneous equations has serious shortcomings in doing good economics.  It has great strengths too -- no doubt -- but by construction it obscures the second lesson evidenced in the practice of the great price theorists from Marshall to Alchian.  The equilibrium conditions we worked to solve, emerge from the behavior of actors within the system -- from their weighing of alternatives, from their choices on the margin, from their imaginations of better deals to be struck, from their creative and clever actions.  As I said, we are part of the equilibrium.  This also true, as my teacher Bob Tollison used to stress, for economists seeking to propose Pareto improving changes in the rules of the game. Change is indeed possible, and in fact, change (as Hayek stressed) is what sets in motion the "problem" that economic theory must address.

These two elementary ideas to my mind explain both why equilibrium properties are critical for disciplining thought, and why understanding the mechanism of the price system requires that we reflect on disequilibrium dynamics and the adaptations and adjustments that must be made along multiple margins for us to understand the coordinative properties of the price system and the market economy.  And, once you understand these two lessons, then you can see in the great practitioners how one avoids both the intellectual error of cutting the story off to soon, and beginning the story with the ending.  Instead, like a good mystery story, we must follow the economic story to its end, but the plot twists and turns in the story invokes in us intellectual awe and admiration for the beautiful logic unearthed in our explorations of the mystery of the mundane (from Adam Smith's woolen coat to F. A. Hayek's market for tin to Milton Friedman's pencil).

Basic Economic Reasoning follows from the fact that we imperfect beings live in an imperfect world, and we face the situation of scarcity. The reality of scarcity means we face trade-offs in our choices, since we cannot do everything we want and any time, we must prioritize in our choices, and this means we must negotiate those trade-offs.  In order to negotiate those trade-offs we rely on institutions that emerge to provide mental aids to us.  Within the context of the market economy, those institutions are property rights, prices, and profit-and-loss.  And, this is true for all actors in the system.  The underlying realities at any given time are determined by the existing state of technology, the fixed preferences of the relevant actors, and current resource availability. The induced variables of the market are relative prices, profit-and-loss statements, and the existing pattern of resource ownership.  In equilibrium the induced variables will perfectly reflect the underlying variables. But how that dovetailing comes about through the working out of economic forces is the purpose of market theory and the analytics of the price system.

Peter Boettke
Peter Joseph Boettke (January 3, 1960) is an American economist of the Austrian School. He is currently a University Professor of Economics and Philosophy at George Mason University; the BB&T Professor for the Study of Capitalism, Vice President for Research, and Director of the F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics at the Mercatus Center at GMU.

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