The study of markets in economics is basically the study of the consequences of “just letting things happen”. No direction, no plan by society, no overt choice is being made about “economic system”. People living their lives, and trading with others to get things they want and don’t have. Other people have too much of some things, and are prone to selling stuff they have too much of. Back in the “Barney and Fred” hunting and gathering days we traded. We still trade, but we use money as a medium of exchange, just to make it easier.   Free trade— is a way to get stuff in return for what you’re willing to give up. This is one important pathway to economic growth— specialization and trade.

But, at a more basic level it is “just what people do” without interference by authority. It is not intrinsically “ a good thing” or a “bad thing” to trade. People see something they want but don’t have, and they may be willing to give up something of equal value in order to get it. We barter, or exchange in other ways— but it is just a natural thing to do.

Of course, this “exchange” or “free market” has over time developed lots of support infrastructure (laws that protect people from others who don’t want to exchange, but just want to steal, transportation systems as public goods, that cheapen and encourage trade).

So markets are not good or bad—they are just what happens naturally.

Comparative Statics in Economics: Making Predictions about what will happen in a Market

Economics is a social science that makes and tests predictions about how markets behave (freely trading buyers and sellers). Comparative statics is the name given to the method of comparing one equilibrium to another equilibrium: “what is likely to happen” under some set of circumstances like:

• What will happen to the number of jobs when minimum wages are elevated? What is likely going to happen to the price of Happy Meals or to the stock price of Burger King?
• When there are cold winter storms in Florida, what will happen to the price of oranges? Or to the price of apples grown in Oregon and Washington?
• When taxes are increased on Cigarettes, what will happen to quantity of cigarette smoking in America? To the stock price of pipe tobacco suppliers?
• When there is an increase in the market share of phosphate controlled by the Moroccan government, what will happen to the price of canned corn in supermarkets?

These kinds of questions are answerable through comparative static analysis in economics. Comparative statics tries to examine the direction and size of impact of some single economic event like the cold weather in Florida, a change in the minimum wage law, an increase in the Moroccan market share, etc. Where are we know, where will be after the change works itself through the economic consequences. This kind of analysis examines the impact of only one change at a time. It cannot examine the results of more than one change. This is an important simplifying aspect of economic analysis. It is also a very powerful and disciplined way of analytic thinking[1]. Simple, one-change-at-a-time problems can be addressed using rather simple models of supply and demand in product markets, labor markets, and capital markets. These predictions are very powerful, because they provide a tool for businesses to make simple predictions about the likely impacts of “new events” on their organizations and on their competitors.

These kinds of simple predictions are not detailed. They don’t tells us “how much” price will go up, or if the increase in taxes will generate an increase in store revenues, or not. Sometimes, these more detailed predictions can be approximated by a more exacting specification of the economic model by adding data on specific “elasticities” (eg slopes of the demand or supply relationships) or on the “structure of costs” or on the “type of competitive structure in the supplier industry” (eg perfect competition, oligopoly, etc.). But, even with a more carefully specified economic analysis the predictions about “what will the impact be” are not going to be detailed enough for management action.

What needs to happen next? This is often where additional data from similar situations in the past for the organization can be added. Or maybe historic data from other similar organizations can be used as a guideline or benchmark about the kinds of consequences can be used. One commonly used tool to extend the economic analysis to the more exacting circumstances of the firm is the “scenario analysis”. Here, the analyst creates specific hypothetical scenarios out of assumptions (possibly an optimistic, pessimistic, and mid range scenario). These additional assumptions make it possible to make specific predictions about relevant business impacts (eg revenue, profit, input costs, or whatever the business is interested in projecting) or choices about what to do (lower price or match competitor’s price, invest or not, advertise a little or a lot, etc.). Management can be shown the scenarios built around the economic impact model, facilitating decisions about what to do, and how best how best to do it. The extended economic model using hypothetical scenarios defined by assumptions will frame the discussion that management needs to have.

The analysis of scenarios can also be extended further by doing “sensitivity analysis”. This is done by seeing how the model projections respond to changes in a key parameter whose value we don’t know. For example, how will revenue respond to the assumptions we are making about the loyalty of customers to the competitor’s product? We can create a ‘sensitivity analysis’ by allowing the specified parameter(elasticity of demand of the competitor’s product) to go from the lowest to the highest plausible value (say, -0.50 to -.99) and observe how much impact this parameter variation creates predictions about our revenue impact. Some parameters will be important and sensitive drivers of our predictions, others not so much.

The model and its sensitivity results is not going to tell management what the decision should be. But it should help managers see what assumptions drive the impact (and guide further investment in more data collection) and risks of particular management actions (and guide discussions about how to mitigate the risks).

 

Ethics and Economics

The economic analysis of “what will happen if” some change occurs, can be made using a simple demand-supply prediction of the questions posed earlier, or more specific quantitative impact analysis using scenarios and sensitivity tests. These economic “predictions” are intended to say “what will happen”. The prediction (pick one of the questions posed earlier) may ultimately be proved correct, sort of correct, or not correct at all. Economics is a social science, not exacting like physics or chemistry. It is a social science because it is based on observed (but not inflexible) behaviors of people.

Economics is not about “what should happen” or “what should organizations do”. In doing impact analysis as discussed earlier, the question is not whether Morocco ought to act like a monopolist, but what can we expect them to do when they have more monopoly power? It answers the question of what can we expect to happen when we raise the minimum wage, not whether it is good or bad that we do it.

Essentially economics is a set of theories that help us decide what the impacts of changes are likely to be. When the theories are wrong (yield poor predictions) they are amended or changed. For example, basic supply-demand models (and the theories of self interest that lie behind them) were not doing a good job predicting why firms were not paying some workers what they appeared to be worth. To fill the gap Gary Becker invented the theory of human capital, which predicted that firms that invested in workers need to exploit them (pay them less than they’re worth) in order to recoup investment costs of training. The bigger the investment, the more exploitation to expect. This theory also is a foundation for the prediction that the rather large historic difference in years-with-the-firm between women and men in jobs requiring training would predictably lead to lower wages for females than men, and more qualifications for females relative to men. This is a prediction from the theory, not a normative or ethical proposition. When faced with more competition, U.S. firms may predictably react by outsourcing manufacturing to China, creating large U.S. layoffs of semi skilled workers. Is this the right thing to do? Economics has absolutely nothing to say on this question.

Is this kind of outsourcing ethical? Is Walmart paying the average worker $8.75 an hour (2013 data) fair? Should we let firms pay women CEOs less than their male counterparts. Is it equitable that 0.1% of the people in America have half the wealth? All interesting “normative questions”. Possibly there are compelling arguments to make on these matters. But, such analytic activities are not part of economics.

There is a branch of economics (normative economics) which asks questions about what conditions in markets are conducive to maximum output and maximum social welfare given the scarcities we are endowed with? It is this part of economics that gives us the ideas that market economies with perfectly competitive conditions can produce the most. And, the idea that monopoly power is ‘bad’ because it reallocates resources in ways that cause “less” to be produced by the economy. The whole idea of “market failure” is grounded in this branch of economics, saying that social welfare (aggregate productivity) suffers under situations of market failure. The other idea that is normative in nature is that “diversity” in productive capacity of individuals (and collectives of individuals) provides a basis for specialization and trade, and the gains in productivity that results for everyone. But, these aspects of economic theory are very limited is their attempt to say what is “good” or “bad”, and when this is done it measures value in terms of overall social productivity.

Need and Demand

Demand is what someone (or everyone together) is willing to pay for something. Need is a subjective driver of demand. I might observe that Jane says she “needs” a new car. This is a statement about preferences. It is not an action she takes. She may decide to act on the “need” and wander into a car dealer and decide what kind of car she is willing to pay for—or she may not. On the other hand, her husband might look at the same situation and say that Jane definitely doesn’t ‘need’ a new car. Need is in the eyes of the beholder. Even in a technical field, like health care, the idea of “need” is subjective. You primary care doctor might say you don’t ‘need’ surgery, even though the specialist said you did. The absence of certainly and relevant science in health care situations creates very few absolutes about what is “needed” to deal with a certain situation.

Even if every subjective opinion agreed that “Jane needs a car” there is a problem. How are we going to cope with the fact that a car involves the expenditure of scarce resources to make. It isn’t free. Is Jane going to be willing to forego other things she could have had in order to get a car that she “needs”. Maybe, maybe not. Without solving the problem of scarcity of resources, she will have to be willing to pay or else the “need” she expresses is only a silly fantasy. Maybe her father will pay, or maybe she can convert need into action by some other way. But the fact that there is no free lunch in a society facing scarce resources, will make “need” a moot point, and one that is only a subjective expression of little meaning or consequence.

There is one way in which “need” is actionable, other than someone “who needs a new car” converting that wish into action by “demanding” one in the market.

Sometimes, quite often actually, people with “needs” are blocked from converting that wish into demand because they cant afford to pay (the price is set largely on the basis of the costs of the scarce resources used in producing the product). Because of scarcity IN EVERY SINGLE MARKET PEOPLE & FIRMS THAT WOULD LIKE TO BUY ARE SIMPLY UNABLE TO PULL THE TRIGGER TO BUY BECAUSE THE PRICE IS HIGHER THAN THE VALUE OF THE THINGS THEY COULD BUY WITH THE MONEY IT WOULD TAKE TO BUY. Opportunity cost. In some cases they might even have to borrow to buy it, and give up not only things they could otherwise have today, but things they’d have to give up tomorrow, and next year. They don’t pull the trigger (or they cant’ pull the trigger) on their “need”. They are “priced out” of the market.

This problem of converting want or need into demand is sometimes created by poverty (economic endowment disparities). Monopoly power by suppliers makes this problem more aggravated because the price tend to be set higher.

Sometimes this “unmet need” is acted upon by society, sometimes not. I could say I really need a Lear Jet for my own personal convenience, but society isn’t going to step in in a compassionate way and forgo the “needs of others” in order to get me a plane. Or if Sam “needs” to buy a gun, society is not going to step in and buy them, foregoing what the resources could have otherwise produced. Or your “need” for a higher degree, isn’t necessarily going to be shared by others to the extent that they are willing to give up something they values in order to help you out by paying higher taxes.

But, sometimes society does recognize that important things are being given up by people who are “priced out” of the market, and a collective decision is made to do something about the “unmet need”. So, my need for a plan, and Sam’s need for a gun are unlikely to get many votes from our neighbors to set up a “tax-transfer” program to meet our respective needs. But, if poor single moms are unable to afford to buy a healthy diet for their children, this “need” may be acted upon by society. The “unmet need” is said to rise to a level where voters (the collective) are willing to force some persons to “give up” things so that the poor moms can get the food they “need”.

So some needs are deemed “important and socially actionable” while others are not.

Like sausage making, this is not a pleasant process to watch. Some people’s “unmet needs” are more important than other persons’ unmet needs. Mr Big Wig the “job creator” has “needs for a jet” that are actionable by Congress (acting for the society) by creating various tax code allowances. Important needs for primary care for those poor kids are often not me because of the incentives created by Congress $ Exec in the way we pay doctors.

Solving the “important needs” of those unable to pay are one of the drivers of government decision-making. This problem of “poverty” is one of the sources of market failure, and one of the legitimate roles of government in the market economy.

In the study of health economics, many make assumptions about what care is “needed” in a given situation— and if that care is not “demanded” (eg. sought) the person must be either ignorant, or uninsured, or otherwise limited by access barriers (distance, income, discrimination, etc.). But, this may not always be the case. From the theory of health production we know that people behave differently according to preferences, the scarcity of time, and the scarcity of income. They choose their own target level of health based on these factors, and the result is that health status varies (rather systematically) across people. We can observe this variation and say ” how can people be so ignorant, or why dont we have universal coverage? But, i can guarantee you, even with full knowledge and universal care, the choices of health level will vary, because when it comes down to it, the persons preferences and scarcities matter. They always will. Look elsewhere—scandinavia, Canada, any other place— it is simply naive to ignor the fact that scarcities and preferences vary, and even in places where money is not a barrier—time is scarce, and that scarcity will vary across people— and the result will be that health behaviors and target levels will vary systematically across people. Not because they are stupid or ignorant.

Are all nurses or all doctors similarly healthy? Of course not. Why. The answer is they dont want to be!  The point of this —- be careful with the term “need” for care. What is a “need” for me, may not be a “need” for you. Absolutes are hard to come by in health care. Usually, where you hear people say “she needs that test” what is being said is really — “if i were in her place, i would want that test” —-  but of course, thats the whole point— you are not in her place, nor is she in yours.

[1] It is easy to spot undisciplined and totally groundless reasoning. This occurs when someone creates complex scenarios (some would say realistic) that reach beyond the power of simplifying economic models, or any other analytic device to try to make predictions.