What is Economics?

- Why Should I Care?

Environmental destruction, poverty, literacy, democracy, exploration, cultural exchanges, health, leisure, arts, sports… Many social phenomena can be directly influenced by what we produce, how much we produce, who produces it, and where it is produced.

- This Chapter Has 4 Parts

• Economic Systems
• Economics is a Social Science
• Economic Models
• Empirical Verification

Many economists define their field as the study of “optimizing individuals”. Economics is more than that. Economics is about understanding the system that makes stuff.

- What is Economics?

The word economy comes from two Greek words: οἴκος (oikos: "home") and νέμω (nomos: “system of rules”). Therefore, the economy is a system of management for the home, where much production takes place.

This word was coined by Xenophon, a Greek philosopher whose views often criticized those of Socrates. His book Oeconomicus is a manual on what today would be called “Good Housekeeping”. A retired military man, Xenophon appreciated efficiency and order, and felt his peers would appreciate his advice on how to run a household rationally. The word was also used by Aristotle in a three-book series on economic themes.

Economics was originally seen as the study of the system of rules that govern our homes. Historically, a home was a place where many goods and services were produced, such as shelter, meals, clothes, teaching, cleaning, etc. Today, economics is defined in many ways. One definition would be as an academic discipline focussed on material culture, financial institutions and the measurement of wealth and well-being. Another definition would be to see it as a discipline interested in problems of optimization, where individuals and groups of people try to make the most out of their resources. Finally, another definition would be to see economics as a study of systems of production of goods and services.

We will be using all three of these approaches in this text, with a stronger leaning on the third definition.

• Economic Systems

Analyzing systems is an important aspect of this book. So, let’s define what we mean by that. First, what is a system?

A system is a set of components and relationships that operate together to make something. Their operations may also react to other components, or other systems, from the outside. The study of systems is called Systems Analysis or Industrial Dynamics. An economic system is a social institution which deals with the extraction and transformation of resources to produce goods and services for consumers in a particular society.

The economic system is composed of people, social customs, ways of communication, and institutions, with their relationships to natural resources, knowledge, tools, machines and technology.

A system is made of seven components: Inputs, Processors, Outputs, Control, Feedback, Environment, and Boundaries.

1. Inputs: Objects that go into production.
   1. Natural Resources, such as light, water, and minerals.
   2. Transformed inputs, such as lumber, food ingredients, petroleum, and metals.
   3. Intangibles, such as information, art.

2. Processors: What transform inputs into output.
   1. Human Labour, such as hourly-paid workers, family labour, or non-paid labour.
   2. Machines and Equipment, such as appliances, vehicles, manufacturing, computers, and software.
   3. Instruments and Tools, including kitchen utensils, construction tools, and scientific instruments.

3. Outputs: Products that are the outcome of inputs being
   1. Goods are useful transformed objects produced by a system
   2. Bads are unintended secondary productions that are harmful to humans
   3. Services are intangible products meant for consumption
   4. Intermediate Goods and Services are meant to be used as inputs or processors in other production systems.
   5. Final Goods and Services are meant to be consumed by humans
      
      
4. Control: People who decide which inputs and processors to use, and which outputs to produce.
   1. Private sector leadership, including non-profits, small businesses, large corporations. CEOs and managers.
   2. Public sector leadership, including Prime Minister and Cabinet, CEOs and managers of government-owned institutions, city Mayors.
   3. Families and Households who produce inputs and outputs.

5. Feedback: Information relayed to the control function about production quantities, qualities, and other factors
   1. Non-verbal feedback includes lineups at storefronts, empty shelves, excess inventory, rapid wear and tear (ex: road use), congestion, etc.
   2. Informal feedback can be comments made to producers/controllers, word-of-mouth, and social media.
   3. Institutionalized feedback includes surveys, town hall meetings, and focus groups.
   4. Price feedback includes price bubbles, rebates, and liquidation strategies.

6. Environment: Objects outside the system that can affect it
   1. Physical environment includes landscape, climate, weather, and availability of natural resources.
   2. Political environment includes legal regime, political institutions, tax levels,
   3. Social environment includes cultural institutions such as family, religion, language, moral constructs, sports, arts, and culinary habits.

7. Boundaries: Limitations of the system
   1. Demographics are defined as population, which grows with natality, increased life expectancy and immigration.
   2. Technology includes knowledge, competencies, skills, machines, computers, robots, buildings, roads, railways, ports, and other infrastructure.

Summary Table

Economic systems      What produces                         Factories, Farms, and Office Towers

Inputs                         What goes in                             Natural Resources

Processors                   What transform inputs              Workers and machines

Control                        Who decides                             CEOs, Civil Servants, and Politicians

Outputs                       What comes out                        Goods and Bads

Feedback                    What people want                     Comments, Prices, and Lineups

Environment               What surrounds you                  Landscape, Laws, Taxes, and Culture     

Boundaries                  What limits you                         Number of workers and Technology

Exercise: Pizza Dinner

       INPUTS                           PROCESSORS                       OUTPUTS                  OTHER SYSTEM

 

 

 

Consumer

        Flour                                        Cook                                                 Pizza

                                                                                                       Hot _________

                                                                                                         

      Cheese                                       Oven

     _________                              _________                                            Dishes

                                                                                                       Dirty ________

                                                    Electricity

      Pepperoni                              __________

     _________

                                                                                   FEEDBACK

 

                                                                                                              Pepperoni

                                                   More Pizza, Please! But not so much ___________!

 

 

This example shows us how pizza is produced, simple enough. But an economy is a more complex system, since it is the intertwined flow of objects between these individual systems. For example, inputs into pizza making are usually the output of another system, such as the dairy industry. Same for ovens: they were produced by a machine plant, where steel and glass were used as inputs.

On the other end, pizza is an input for other activities. Humans need to eat for energy and biological needs. Humans are also important as labour, in the process of making objects. Food is therefore both an output of the pizza restaurant, and an input for labour in that restaurant. If we were to draw the entire web of these flows, the result would probably be very complicated to actually model everything into the flow chart.

In economics, there are many types of systems we can look at: the producer, the industry, and the regional economy.

The producer, whether it’s a plant that manufactures chairs, or an office where legal services are offered, is the first-level system. Sometimes economists refer to this as the ‘firm’.

Next, you can look at certain sections of the economy, which we call industries. You can look at the banking sector, for example, as a system that operates within a larger context, such as other industries, a political regime, and cultural institutions. The field of micro-economics usually focusses producers and industries.

Finally, you can look at economic systems from a geographical perspective, such as the city-region, the province, or state level. Economies in this regard have inputs and outputs, such as imports and exports, as well as all the other components of a system. The field of macro-economics usually focusses on national-level economies.

What about waste?

An important thing here is that we don’t lose track of both the primary and the secondary productions, both the GOODS and the BADS. Many times, an industrial facility will find a way to reuse, especially if it can resell it, a secondary production. For example, one important waste in the process of making chocolate is called cocoa butter. The famous Swiss company Nestlé was the first to try to make a product with mostly cocoa butter: white chocolate. Instead of throwing the butter out, it becomes an input for another, new product. In this case, a BAD was turned into a GOOD.

 

- In-class Exercise

Think of a company that makes chairs.

Identify 2 examples for each component. List 2 items per component.

Use a dollar sign to identify the output that is sold on a market.

Component	Item 1	Item 2
Inputs	Wood	Leather
Processor	Bandsaw	Labour
Outputs	Chair	Air pollution
Control	Manager	Stockholders
External Environment	Local tree varieties	Local climate for indoor/outdoor needs
Feedback	Client comments	Trade Magazine Reviews
Boundaries	Size of the bandsaw	Quantity of available materials, labour

• Economics is a Social Science

Economics is a social science. This means economists are interested in the study of human behaviour. This also implies that economists use the scientific method to generate knowledge.

Hypothesis + Data = Theory

The scientific method is a widely used research convention that is built on two foundations: theory, and empirical verification of theory (p. 11).

The focus of economics is particular: it is the study of systems of production of goods and services.

Psychology                   is the study of               individual behaviour

Sociology                      is the study of               groups of people

Political Science             is the study of               institutions of power

History                         is the study of               humans over time

Geography                   is the study of               humans over space

Anthropology               is the study of               ancient cultures

Economics                   is the study of               production systems

What disciplines are not sciences? Philosophy, Religion Studies, Literature, Music, Law, Medicine, Engineering, and Business. In most cases, these fields apply scientific knowledge to solve real-life issues, such as technological fields (medicine, engineering). Some fields refer to professional services (law, accounting, business).

Yet other fields concentrate on erudition, analysis, interpretation, and the use of logic, without using the full scientific method to develop their insights (philosophy, music, literature, religion studies).

• Economic Models

One of the unique features of economics is the use of simplified thought experiments, which we call models (p. 12). These models are based on more complex theories, and often rely on deductive logic to help us sort out the complex relationships between economic variables.

Models have 4 parts:

Definitions                   Define variables and objects

Assumptions                Assume certain behaviours, preferences

Hypotheses                  Guess relationships between variables,

IF THEN

Predictions                   Simulate a change to see its effect on the system

Models are usually presented as flow charts, as graphs, or as equation sets.

A model is somewhat similar to a laboratory, but there are no humans directly involved. Models are an artificial, and controlled, environment. This enables the economist to run simulations.

“How does variable D react to a change in variable X?”

Some economists thus liken the modelling technique to testing theory. But the modelling environment remains artificial. The predictions made by models can be very useful, and their logic may seem implacable. But the predictions from models may or may not be confirmed with real-life empirical observations.

• Empirical Verification

Once models are written, they should be tested with real-life observations. This step of the scientific method is called empirical verification. Research methods used by economists include surveys, and available data disclosed by taxpayers to their state.

For example, unemployment data is collected by a monthly telephone survey on a relatively small sample of the population. Another example, income data (GDP) is collected through monthly income tax declarations to the government by citizens and corporations.

As most economic activity can be measured with money, economists are trained at length to analyze quantitative data. This kind of data has its advantages and disadvantages. On one hand, there is lots of data on consumers, investors, institutions, and all sorts of actors in the economy. So, there is lots of data to analyze. On the other hand, keep in mind that most human phenomena may be difficult to quantify, which might give an incomplete picture of the situation. Variables like motivations, personalities, cultural preferences, and cognitive functions, just to cite a few examples, are difficult to include in economics.

Sadly, economists most often cannot use the more powerful research methods such as experiments. We cannot ask the government to slash or raise taxes just to “see what happens”. We cannot trust findings from a laboratory because it is an artificial setting. People would likely act differently with real money in the real world. Also, it would be very expensive to compensate participants of an experiment over long periods of time, to study their behaviour more closely. This said, economists do take advantage of the occurrence of major events, such as a recession, which are said to be natural experiments. There are also subfields of economics which use small scale experiments, or pilot-projects, which does make for some very interesting science.

Also, economists are generally shy to use fieldwork and other more qualitative research methods. The data would be considered anecdotal and difficult to generalize to the whole population.

The most frustrating aspect of all this is that many models actually don’t hold up to the test of real-life data. However, they can still be useful for students to understand basic ideas, and where further research should be conducted.

 

- Think Piece

When you take a plane, or a car, to get somewhere, how important is it to you that you produced carbon dioxide and global warming?

Submit 1 page essay

- Green Policy

This first lesson on economic systems is the cornerstone of changing our economy. Most of our BADS are toxic to humans. Scientists call this pollution. In an ideal world, all of these secondary productions would be either banned, or used as an input to make something else.

This is exactly how nature works. Nature is an economic system. Everything in nature is producing something. Trees produce energy-rich carbon material (wood) and oxygen. The beautiful aspect of nature is that there are no wastes, no BADS. Carbon is biodegradable, so if a tree dies, the carbon goes back to the atmosphere, and the earth, and then probably back to another tree which will grow in its place.

About the air, trees use carbon dioxide (CO²) in the air and turn it into oxygen. That becomes an input for other living mammals, such as humans. When we breathe, our oxygen is transformed into CO², an output, which is an input for trees.

In nature, any living organism that does not create outputs that are beneficial to its environment, as inputs for other organisms, will die. The most successful organisms are those that produce outputs which are perfect inputs for its neighbors. This view of production is part of a more recent branch of study in engineering and science called Biomimicry.

One easy way to implement this in your household is to purchase products where all the waste is both bio-degradable and compostable. Of course, this will eliminate all the waste in your garbage pail, and the plastics in your recycling bin.

Compost is an input for horticulturalists, gardeners, and landscapers. These tradespeople actually pay money for compost, when our cities could (and many do) be providing it for free, by picking up brown bins every week and producing compost in municipal facilities.

Humans should look into these solutions more carefully if they wish to keep growing their population on earth. If we wish to keep having babies, living longer lives, and to keep growing our quality of life, we have to adapt!

- Climate Change Solution

CO2 for sale! Anybody need some CO2? Anybody?

Reducing our BADS across the board is important. However, there is a specific type of production that scientists don’t always designate as pollution because it’s not that toxic to humans. Theses gases actually allow us to exist on Earth.

Nonetheless, the overproduction of greenhouse gases could lead to the demise of the human species. The greenhouse gases (GHG) that keep the earth warm are primarily water vapor (H2O), carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), and ozone (O3). As you know already, our cars and trucks run on fuel, which emit carbon dioxide. Our meat comes from cattle that emit methane. We don’t emit these gases on purpose. They are secondary, and quite useless, productions.

To solve Climate Change, one must take a deep look at the economic systems that produce these particular BADS to either stem their emissions, or to divert them back to the economy as INPUTS. This latter solution is called the Circular Economy.

If we don’t solve Climate Change, a cascade of events will eventually affect many sectors of the economy. If one system is made of seven components, an economy can be seen as an eco-system: a collection of systems that interact and mostly depend on each other. Using Systems Analysis, it is possible to chart and predict the effects of unmitigated climate change on our societies. In the US, the advent of more heatwaves and hurricanes will have a damaging effect on farming, oil refining, electricity grids, and water treatment. A critical report from the US government outlines the sector interactions using a complex systems analysis, to help understand the effects of global warming over the next century (USGCRP, 2018, Ch. 17).

- Democracy Booster

Any political system rests on some type of popular support. Whether it’s a community-based non-profit association, a town, a small country, a federation, or a military regime, anyone who controls the system must be weary of his or her allies, and his or her foes. Support is the key.

When you study the economic system, some parts may seem to be mechanical, and they rightly are, such as the flow of inputs into processors, transforming raw materials into final products. True. However, any change made to the system is guided by feedback, and control mechanisms.

To improve the democratic process, one needs to keep the controllers – the people in charge – accountable to everyone else. You need to design the system so that the controllers have to listen; they need to take feedback into account. One way is to have open, free, elections to choose the people in charge. Another way, may be to have the possibility of changing the people in charge. This is why an organization may have a board of directors, who can replace the Chief Executive Officer (CEO). Still, another way, may be to create incentives that will guide the people in charge to respond to the wants and needs of the many.

Most of our political systems have advantages and disadvantages. It’s up to us to improve these systems so that feedback is not ignored in economic decision making.

- Wrap-Up

Economics is a social science that attempts to understand systems of production of output (goods and services). Those systems produce using inputs, and processors, are subject to feedback and control, and must comply with their environment and boundaries.

Economics uses the scientific method of theory and empirical verification to generate knowledge about what, and how, we produce.

Economics uses a particular kind of theory, called models. These are simplifications of reality and help to isolate specific variables.

These models must be confronted to empirical data to validate their usefulness.

 

- Cheat Sheet with Memory Helper

System:             A set of objects that work together to process inputs into outputs, in a given environment and within boundaries.

Resources:        Objects and services used as inputs to produce final products.

Products:          Goods and Services.

Goods:             Physical, or tangible, outputs of production used as final consumption by people.

Bads:                Outputs that are not meant for final consumption, but can either be waste, or a reusable input for other productions. Also: externality.

Services:           Intangible, or non-physical, outputs of production used as final consumption.

Model:             An artificial, and controlled, environment, allowing the economist to run simulations. The model thus predicts relationships between variables.

- References and Further Reading

Benyus, J. (2005). Biomimicry’s surprising lessons from nature’s engineers. Ted Talks. https://www.ted.com/talks/janine_benyus_shares_nature_s_designs

USGCRP. (2018). Chapter 17: Sector Interactions, Multiple Stressors, And Complex Systems. In Impacts, Risks, and Adaptation in the United States: Fourth National Climate Assessment, Volume II [Reidmiller, D.R., C.W. Avery, D.R. Easterling, K.E. Kunkel, K.L.M. Lewis, T.K. Maycock, and B.C. Stewart (eds.)]. U.S. Global Change Research Program, Washington, DC, USA, 1515 pp.

Forrester, J. W. (1961). Industrial Dynamics. Martino Fine Books; Illustrated edition (Reprinted 2013).

Xenophon. (2012). Oeconomicus. Hardpress Publishing. Available on Amazon.ca.