In his Principles
of Economics, Carl Menger tells us that his goal is to “reduce the
complex phenomena of human economic activity to the simplest elements that can
still be subjected to accurate observation, to apply to these elements the
measure corresponding to their nature, and constantly adhering to this measure,
to investigate the manner in which the more complex economic phenomena evolve
from their elements according to definite principles (46-7).” To create a
theory of the economy, we must first identify what are our most
basic categories of theoretical objects and the attributes of these objects. As a theory of economics is a fundamental component of a more general social
theory, the human agent is our fundamental unit of analysis. As such, we begin
by identifying fundamental attributes of the human agent and the implications
of these attributes both for the individual alone as well as for interaction
between agents.
By identifying the
objects and attributes of interest to economic theory, we identify the minimal
extent of a domain of interest. The goal of theory is to compress a significant
amount of information into a minimal set of general objects. In doing so, we
develop a language and structure that we can continually reference while
telling a story about the world around us. Theory allows us to tell stories
with scientific precision. A brief skeleton of this theory includes:
1. Human Agents
a.
Action
i. Opportunity Cost
ii. Profit
iii. Uncertainty
iv. Entrepreneurship
b.
Means and ends
i. Goods
1.
Means as goods
a.
Labor
b.
Capital
i. Physical
ii. Land
iii. Social
c.
Technology
i. Embedded in Capital
2.
Final goods
3.
Structure of
Production
c.
Knowledge
i. Preferences
ii. Strategy
iii. Expectations
1.
Institutions
a.
Rules
i. norms
ii. laws
b.
Institutions of prime
interest
i. Property Rights
1.
Exchange
2.
Money
3.
Prices
When you tell a story
about a family member, you employ your theory and language from that theory in
your telling of the story. The story evidences your theory of the family member.
Likewise, these terms and the structure they comprise will allow you to begin
telling your own story about current events and will even inform the narrative
of your own life. By the time you have finished, you will know that you have
absorbed these concepts simply in light of the new way that you see the world
and the new language that you use to describe it.
We will review key
terms one at a time and will later investigate many of these features as we develop
our theory.
1. Human agents
The economy is
comprised of real-life human beings. Social theory abstracts from the
particular features that are not shared by all agents. Our agents interact with
the environment. In order for this occur, agents themselves need some theory of
the environment. They need a mental model that represents what the agents
believe to be the logic of the environment. This allows them to predict the
effects of their action and, therefore, to act with the intention of
transforming to their liking the future state that they will inherit.
Our agents are
ecologically rational. Although a theoretical agent is herself a high level
abstraction, agents do not reason only by means of high level abstraction. They
relate their thought processes to the webs of objects that comprise their
reality (Gigerenzer 2008). Most decisions are made using heuristics – rules of
thumb – that allow the agent to arrive a decision for action by use of a
limited amount of information. The ability to reduce the sensing and
computation required for decision making down to the attributes of one or a few
elements in the environment have been shown to be efficient (Gigerenzer and Goldstein 1996) – i.e., cost minimizing in light of payoffs. These rules
comprise a significant portion of agent knowledge.
Agents do not act in isolation.
They interact with others, exchanging both resources and knowledge. Models used
by agents to interact with their environment must therefore include other
agents. Agents that interact with one another must employ shared or
interlocking mental models in order for their actions to lead to coherent
outcomes (Koppl, Kauffman, Felin, and Longo 2015).
a. Action
All agents act. Action exists so long as intervention into the
current state of affairs by the agent in question is possible (Mises 1949, 13). Absent
intervention, some series of future states are expected by observing agents and
necessarily implied by the logic that governs the physical world. Action is aimed at affecting the future. By acting the agent casts his vote for the
future. If he intervenes, the agent hopes to replace the future states that he
would otherwise inherit with some other array of future states that he expects
he will prefer.
i. Opportunity cost
Any particular action must be chosen over other possible
actions. The action that a person would otherwise perform had he not performed
the action he chose is the agent’s opportunity cost. It is the next best course
of action that he would have taken. It is possible that, in hindsight, the opportunity
cost of an action actually exceeds the value gained from the action. This
represents a loss (negative profit).
ii. Profit
At a fundamental level, profit is a feeling of gain or
improvement. It is a purely psychical phenomenon that arises from perception of
improvement of one’s state (Mises 1949, 11-29). The drive for profit motivates all action. This is
true whether a person chooses to intervene in the world or to continue act as
he has always acted. At the time of action, a person chooses the action that
one believes will promote a state of the world that the agent perceives as the
greatest improvement.
Profit takes a concrete form as monetary profits. Monetary
profits allow for the comparison of revenues and costs, enabling the
entrepreneur to calculate the value generated by her labor and to compare this
value to other uses of her time. We know that an increase in wealth leads to a feeling
of gain. Even for the ascetic who has developed an indifference to material
wealth, a windfall profit can be donated to a charitable end that he values and
would certainly be viewed as a positive development.
iii. Uncertainty
All action occurs under conditions of uncertainty. There exists
no perfect model of the future. Those models that better predict the future enable
action that is more profitable than models that promote agent ends in a
relatively costly manner. Profits are evidence that the model guiding the action
of an agent or the operation of a firm has proved successful at overcoming uncertainty
in the process of providing consumers with the goods they desire.
One element of uncertainty that entrepreneurs face in the market
lies in the developing tastes of consumers. When an entrepreneur brings an
innovation to market, he cannot know for sure whether or not consumers will
value the product enough to make its production possible. Thus, uncertainty
exists not only in light of objective circumstances that could potentially be
definable beforehand, but also in light of the inherent subjectivity of the
human agent. There is no perfect way to gauge the course that consumer
preferences will follow or whether or not those preferences can be guided in a manner
that yields monetary profit for a market entrepreneur.
iv. Entrepreneurship
Entrepreneurship is action that is aimed at profit. Thus, all
action is entrepreneurial, though not all action succeeds in its aims. More
commonly, we refer to market entrepreneurs when we use the word entrepreneur. These
entrepreneurs seek monetary profit greater than can be earned by the average
return on investment in the market, often referred to as the risk-free rate of
return. This excess profit we refer to as economic profit. In a competitive
environment, market entrepreneurs tend to compete away economic profits in
light of available information. Economic profits accrue to those market entrepreneurs
who successfully confront uncertainty. These entrepreneurs enlarge the extent
of human knowledge in a manner that serves the wants and needs
of others.
b. Means and ends
All action implies
opportunity cost. Some ends are chosen at the cost of others. The use of some
means to attain a given end precludes the use of other means to attain that
end. This use may also enable the later use of some means or acquirement of
some ends that otherwise would not be available. Likewise, it may preclude the
later use of some means or acquirement of some ends. Thus, means and ends are
integral to action and imply opportunity cost entailed in action.
i. Goods
Carl Menger defines a
good in his Principles:
Things that can be placed in a causal
connection with the satisfaction of human needs we term useful things.
If, however, we both recognize this causal connection, and have the power
actually to direct the useful things to the satisfaction of our needs we call
them goods (52).
A thing is a good if
the following prerequisites are met:
1.
A human need [desire]
2.
Such properties as render
the thing capable of being brought into a causal connection with the
satisfaction of this need [desire].
3.
Human knowledge of
this causal connection.
4.
Command of the thing
sufficient to direct it to the satisfaction of the need [desire]. (52)
A good is an entirely
subjective category of object. Humans act to attain goods. Agents expect that a
good will aid in the fulfillment some desire. Action to attain a good requires knowledge of
how and the resources required to acquire the good. If a person finds herself
sick, she may desire a medicine that she believes will heal her sickness. The
medicine is good because it will bring the woman a state that she prefers over
the state she would otherwise inherit without the medicine. If the woman learns
that the medicine is actually poison, she will correctly treat it as a bad if
she values her health.
We may also conceive
of the state desired as a good. We may call this a state-good. The state may be
associated with objects that are goods, such as the medicine that the women
hopes will heal her ailment and bring her to a state of good health. Or the
state-good may simply represent a reordering of one’s surroundings. If I
rearrange the furniture in my house to create more useable floor space or to
change the functionality of a given area, I acquired a unique good, but this
good is solely a state-good as no new object has actually been acquired that
can be deemed a good. I have increased my contentment (removed uneasiness) in
light of the change.
A good may lose its
goods character if a change occurs that prevents the fulfillment of the four
requirements described above. It is possible that an object or state may be treated as a good when
“attributes . . . are erroneously ascribed to things that do not really possess
them” and when needs or desires “are mistakenly assumed existent (53).”
There are many ways
that we may categorize goods. As economics studies human action in terms of
means and ends and in light of opportunity cost, analysis will continue with
this schema.
1. Means as goods.
When goods are used as
means of acquiring other goods, they are often referred to as productive
factors. These are intermediate goods whose value is derived from what they
produce, not their consumption. Productive factors are, as the classical
economists argued, land, labor and capital where land is a special form of
capital.
a. Labor
At its core, labor is
action. In relationship to production, we say that labor earns a wage. Labor is
contracted by some organizer of activity – an entrepreneur – and paid a wage. Labor
tends to be paid the value of its revenue product. If labor is underpaid, it
can migrate to a new firm who will still realize a profit by paying it
marginally more than it earned at the previous firm, so long as the wage paid
is less than or equal to the value of labor – its marginal revenue product. If
it is overpaid, the company paying it will incur losses that inhibit its
function in the long run.
b. Capital
i. Physical Capital
Capital is any asset
that might be used in a manner that generates revenue. Instances of capital
include trucks, homes, roads, computers, among many other objects. Often,
capital embodies technology, as is the case in each of the capital-objects just
referenced. An incomplete list of technology embodied in a computer include circuits,
micro-processors, graphics cards, and cooling systems. Capital serves as a
means to some end, whether that end is the production of other goods, as is the
case of a computer for a professional programmer, or the consumption of
entertainment, as is the case of a computer for a person who watches movies on
it. The value imbued to the functions of capital in light of competing uses
generate capitals price. In the case of productive capital, the price tends
toward the discounted value of the sum of revenues that the capital is expected
to earn. In the case that capital is itself consumed for the direct realization
of utility, the price of capital in equilibrium represents the discounted value
of the utility that is expected to be realized by the user.
The revenue earned by
capital is a rent. In equilibrium this rent is equal to the value of the
capital’s marginal revenue product, which is a way of saying that the price of capital
tends to match the value that the capital generates.
ii. Land
Land is a special form
of capital. Land receives its own category as it is the fundamental unit upon
which all activity is dependent. Resources come from land. Productive activity
must occur on land. Space is limited, and so must be put toward one of many
competing uses. Classical economists referred to the revenue derived from
ownership of the land, by virtue of the value of the land’s use, as a rent.
Within a competitive market, excess rents are competed away so as to reflect
the market rate of return. In reality, rents tend to accrue to land by virtue
of its inherent scarcity as well as increasing efficiency in use. This leads to
a tendency for the price of land to increase over time. Though, over short
periods of time – i.e., decades – the value of land fluctuates, its value will
increase so long as population increases or efficiency of production that
depends upon the land increases. These rents accrue to owners who bear the
costs that arise due to uncertainty. Defined in this manner, land’s rent is a
manifestation of profit.
iii. Social Capital
Of all concepts in
economics and the study of society, social capital is one of the most complex .When
we observe social capital, we observe particular instances of social
organization. There are many phrases we may use to describe instances of social
capital: institutions, firms, networks of affiliation, shared language, etc…. Social
capital is very often non-transferable as it is embedded in interaction (Granovetter 1985; Lewis and Chamlee-Wright 2008) . Eugene cannot sell his friendship with
Samson. Neither can a successful entrepreneur perfectly transfer the confidence
that he has developed among venture capitalists. Nor can the particular, and often private, language
or mode of interaction within a club or firm be learned costlessly or without a
minimal level of consent among some members. Social capital is embedded in the
web of relationships, formal and informal, in which we continually participate.
It provides a medium of communication that promotes convergent actions and expectations
between players who participate in common and overlapping sets of social
capital.
c. Technology
Technology is embedded
in capital. For physical capital, technology is like a blueprint that describes
the organization of different physical components and the functions that emerge
from this organization. In social capital, technology is the abstract
description of organization. French as it is spoken represents social capital.
The language, as discussed without reference to a particular organization, is
itself technology. The technology is embedded in social capital when it is
shared and used to coordinate activity.
2. Final Goods
Final goods are goods that are consumed. If a woman purchases an apple
for consumption, it is, in its original form, a final good. It is possible that
a good may fulfill the requirements of both an intermediate and a final good. An
apple purchased for use in an apple pie is an intermediate good upon
creation of the pie, and part of a final good upon the pie's consumption. Similarly, a
computer that is used both for work and for entertainment is an intermediate
good when used for work and a final good when used for entertainment.
3. Capital structure
a. Order of a good
Capital structure is a
formal description of the arrangement of economic goods. We can describe a good
by its order: its position in the process of production. Final goods are always
of the first order. Intermediate goods are always of the second order or
higher. We call capital a higher order good (say machinery) when it is used to
produce another good. But if that same good is consumed with expectation that
consumption will improve the welfare of the agent consuming it, then the good
is a first order good. Thus, if a man derives pleasure from destroying a piece of
machinery, its use to this end is as a final good. There is nothing intrinsic
about the order of a good. It is a description relative position in the
structure of production.
b. Network structure
Capital structure can
be described in terms of a network. Firms tend to employ higher order goods to
produce lower order goods. A firm does not exist in isolation, but is embedded
in a network of other firms. As was the case with the pencil, resources flow
from their source point to firms that transform and combine them. Along each
step of the way, revenues earned by firms must at least cover the costs of
operation. The structure of production is continually transforming as changes
in profit margins, whether due to changes in demand and supply of inputs and outputs or changes in strategies
employed by firms, drive reconfiguration in the network.
c. Knowledge
Humans attempt to
understand the world by identifying objects within it and their attributes,
including their relationships between one another, and process that transform
these objects.
i. Mental Model
The mental model is a
personal ontology (Hayek 1955; Johnson-Larid 1980; Denzau and North 1994). “Ontology” comes from the Greek root, meaning, “existence”. Acting
men and women attempt to create a simplified representation of their reality,
existence with which they are concerned, in their minds. In some cases, this may
be a detailed representation. Such is often the case with scientific models. More
often, the representation is simplified in light of the costs of acquiring new
information. For example, when asked which city has more residents, respondents
typically choose the city with which they are more familiar (Goldstein and Gigerenzer 1999). This is known as the recognition heuristic. It is imperfect,
but it works better on average than guessing, and therefore economizes on
information in regard to answering the question. An agent’s mental model is
likely to include some mixture of detailed representation and simplified rules
that guide decision-making.
1. Rationality and Preferences
Rationality contains
two components. One is the representation of reality. In regard to the agent,
this is the mental model. The other component is a selection mechanism. In a
particular circumstance, the rule chooses the end selected in light of the
environment. Selection also occurs at a higher level. It is this higher level
selection that is most significant to the pattern of behavior exhibited by an
agent. Mises (1949, 19) refers to this as the agent’s “ultimate end”: the
fulfillment of “some desires of acting man”. While any particular action may
fulfill a particular desire, the pattern of actions exhibited by a human agent
reflect the ultimate ends of that agent.
Rationality includes
the process of learning. As agent knowledge changes, so too does the expression
of preference. Changes in knowledge can affect preferences in one of two ways.
Either the agent, in light of new knowledge, realizes that his former
preferences are inferior, and so adopts new desires. Or the agent realizes that
she could more efficiently fulfill her preferences. In either case, we will
observe a change in the pattern of actions for a learning agent. In the first
case, the ends implied by the pattern of action change, in the second, the
costs incurred by action are, for the sensing agent, reduced.
3. Strategy
Agent knowledge expresses itself as strategy. Just as the pattern of
agent action may reflect changes in regard to ends, so too can a change imply a
change in strategy. Strategy aims at producing some end efficiently (Nelson and Winter 1982). A change
in strategy represents, at least on the margin, a change in the process of production,
if not a change in the end produced altogether. Strategy is significant in our discussion
of firms as strategies that are more efficient at producing a given end are
more likely to survive so long as that end provides profit to the agent
employing the strategy.
4. Expectations
Agents form expectations according to their knowledge. Agents build
models of the world in order to be able to predict their environment and
interact with it in the future. They extend the logic implied in their mental
models into the future. If an agent believes that there will be an increase in
demand for some product tomorrow, he will expect that the product will increase
in price. If he believes that the price does not sufficiently represent this
increase in demand, he can himself express this demand by investing in the
product and its production with expectation of profit when he sells it at a
higher price.
1. Institutions
Institutions structure
interaction between agents, either formally or informally. Agents who
participate in an institution acquire duties and rights according to roles and/or
offices filled by the agent (Searle 2005). Institutions make interaction between
agents more predictable for each involved.
a. Rules
Rules constrain and guide agent action. Agents interact by adhering to a
common rule structure. Rules that are shared may be implied or explicit. Violation of
either of these types of rules may be returned with disapproval by other
agents, and in extreme cases, overt punishment. Punishment takes the form of
imposition of costs on the violator where either benefits received by the
violator are reduced or some cost must be paid directly.
i. Norms
Norms are rules of behavior that are commonly observed within a group,
but that are not necessarily identified explicitly. When students wait in a line
in the cafeteria, they do not need to be told that it is a rule that they do
so. They confirm to the pattern of behavior that they observe. Failure to
comply with the pattern may lead to conflict – i.e., if a woman steps ahead of you in line, you,
and maybe others as well, will probably express your discontent toward her.
ii. Laws
Laws are rules of behavior that are codified and backed by the use of
force. Law enforcement, in its ultimate instance, is performed by the state. This
is the network of institutions that share a monopoly on the legitimized use of
coercion. When I walk on the right side of the sidewalk, I follow a norm. When
I drive on the right side of a road that is managed by the state, I follow a
law that evolved from a norm. No one can justifiably punish me with a ticket or
the threat of physical force if I fail to walk on the right side of the sidewalk.
If I violate the law that governs the use of a state owned highway, I will find yourself paying a
stiff penalty.
b. Institutions of
interest
Some institutions are of special interest to the study of social economy.
The most fundamental is a system of property rights. Upon this depend the
institutions of exchange, money, and money prices.
i. Property rights
Assumed in our
analysis is an organization of ownership described as private property. Menger
describes property rights:
The entire sum of goods at an economizing
individual’s command for the satisfaction of his needs, we call his property.
His property is not, however, an arbitrarily combined quantity of goods, but a
direct reflection of his needs, an integrated whole, no essential part of which
can be diminished or increased without affecting realization of the end it
serves.” (76)
Having a property
right ensures an agent’s command over the object owned and the attributes over
which he has rights. In our model of the economy, as well as in real life,
agents are empowered by their ownership of goods. When an agent owns a good,
that good is under his control. Thus, property ownership provides a space for a
property owner to experiment with the use of goods at his disposal.
1. Exchange
Exchange occurs between owners of property. In an exchange some quantity
of a good is exchanged for some quantity of another good. So long as coercion
is not involved, that which an agent receives in an exchange is valued more
highly by him than that which is given up.
The earliest exchanges were barter exchanges. Goods could only be traded
directly for other goods. Imagine that our agent wanted a good, good C, but could not find a party
that was willing to accept the good that he was able to offer, good A. That agent
would have to exchange the good in his possession for a good, good B, that was desired
by a party willing to offer the good originally desired. This is costly as our
agent would have to spend time learning what goods each trading partner desired
and perform a series of exchanges if he finds that he must iterate the process.
2. Money
Money arises as a
means of reducing the costs of exchange. Commodities that come be used as money
usually have the following characteristics.
1. Durability
2. Divisibility
3. Relative scarcity
4. Saleability
5. Portability
These characteristics allow money to serve as
1. A
medium of exchange.
2. A
store of value.
3. A
common unit of account.
4. A
standard of deferred payment.
Money significantly
reduces the cost of exchange and allows for value of goods to be measured in a
common unit. These are, money prices.
3. Prices
Prices denominate in a given currency allow agents
to compare the value of goods. So long as the supply and demand for money are
relatively stable, prices rise and fall in light of changes in demand for and
supply of the good in question. Prices promote the development of more accurate
expectations. Agents can look at past transactions and objectively measure
their profitability. Likewise, agents can estimate future revenues and costs in
an attempt to engage in business that is profitable and avoid business that is
unprofitable.
When the price of a
good rises due to an increase in demand for it – a willingness of the average
consumer to pay more for some quantity of the good – sensing entrepreneurs are
incentivized to produce more of the good. Likewise if the price falls due to a
fall in demand, sensing entrepreneurs are incentivized to produce less of it. As
with price of other goods, the price of money is affected by factors of supply
and demand for money. Suppose the price of money, money’s average price in
terms of other goods, rises. More money will be produced. If the price falls,
less money will be produced.
Adapted from "Formulating a Framework for Economic Analysis"
