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
i. Opportunity Cost
b. Means and ends
1. Means as goods
i. Embedded in Capital
2. Final goods
3. Structure of Production
b. Institutions of prime interest
i. Property Rights
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).
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).
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
Money arises as a means of reducing the costs of exchange. Commodities that come be used as money usually have the following characteristics.
3. Relative scarcity
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.
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"