In Section I of this book, I defined economics as that approach to understanding behavior that starts from the assumption that people have objectives and tend to choose the correct ways of achieving them. I went on to add several additional elements--the assumption that objectives were reasonably simple, the definition of value in terms of revealed preference, and the idea that the different things we value are all comparable. In Section II, I used economics to analyze individual behavior in order to show how prices and quantities are determined in a simple economy. The connections between the two sections may not always have been obvious; while Section II applied the ideas discussed in Section I, I usually did not bother interrupting the analysis to point out what assumption or definition was being applied where. Since we are now at a sort of halfway point, finished with the analysis of a simple economy and about to launch ourselves into a sea of complications, this is a convenient place to look back at what we have done and trace out some of the connections.
The central assumption of rationality--the assumption that people tend to choose the correct means to achieve their objectives--has been applied throughout Section II. The approach used over and over again was first to figure out what a rational person would do--how he could best achieve his objectives--and then to conclude that that is what people will do.
In the analysis of production, for example, we first figured out which good it was in the individual's interest to produce, then concluded that that was the good he would produce. We went on to figure out how much it was in his interest to produce, given his preferences, and again concluded that that was what he would do. Similarly, in the analysis of consumption, the demand curve was equal to the marginal value curve because the individual took the actions that maximized his net benefit. In the analysis of trade, each individual only made those exchanges that benefited him, and two individuals continued to trade as long as any exchanges that benefited both of them remained to be made.
One part of the assumption of rationality discussed in Chapter 1 was that people have reasonably simple objectives. This too has been used, although rarely mentioned, several times in Section II. Consider, for example, the discussion of budget lines and indifference curves in Chapter 3. Throughout that discussion, I assumed that the only reason someone wanted money was for the goods it would buy. In discussing the location of the optimal bundle, for example, I argued that the individual would spend his entire income--that, after all, is what money is for (the possibility of saving for future consumption did not come up, since we were assuming a static world in which each day was just like the next). But one could imagine an individual who liked the idea of living below his income--forever--and so chose to buy fewer goods than he might, while accumulating an ever-increasing pile of money. That may seem irrational to you, but remember that we have no way of knowing what people should want. Economics deals with the consequences of what they do want. I ignored the possibility of such behavior not because it was irrational in the normal sense of the word but because it violated the assumption that individual objectives were reasonably simple.
I again assumed that one desired money only for what it could buy when I discussed income effects and substitution effects; I asserted, as you may remember, that if your income doubled and the prices of everything you consumed also doubled, you would be in the same situation as before. But suppose that at some point in your life, you fell in love with the idea of being a millionaire. What you wanted was not a particular level of consumption but the knowledge that you "had a million dollars." Doubling all incomes and prices would make it considerably easier for you to reach that goal. Here again, I assumed such situations away on the grounds that they would violate my assumption of reasonably simple objectives.
The definition of value in terms of revealed preference was also used in Section II. One could argue that it is revealed preference, not rationality, which implies that demand curves are equal to marginal value curves; your values are revealed by how much you choose to consume at any price--your demand curve. The principle of revealed preference and the assumption of rationality are closely connected; if we did not believe that people tended to choose the actions that best achieved their objectives, we would have a hard time deducing their objectives from the actions they chose. To say that you value an additional apple at a dollar means that given the choice between the apple and some amount of money less than a dollar, you will choose the apple; given the choice between an apple and some amount of money larger than a dollar, you will choose the money. From that, it follows that you will keep increasing your consumption of apples until you reach the point where the marginal value of an apple is equal to its price. Since you do that at any price, the graph of how much you buy at any price is the same as the graph of your marginal value at any quantity. The demand curve and the marginal value curve are identical.
Revealed preference appeared again in the derivation of consumer surplus. Later in Chapter 4, the combination of consumer surplus and rationality was used to prove that a profit-maximizing theater owner would sell popcorn at cost. The argument depended on the assumption that consumers would correctly allow for the price of popcorn in deciding how much they were willing to pay for a ticket. In classroom discussions of the popcorn problem, I find that students are frequently unwilling to accept that; they believe that consumers (irrationally!) ignore the price of popcorn and simply decide whether or not the movie is worth the price. Perhaps so. The applicability of economics to any form of behavior is an empirical question. What I demonstrated was that if the assumptions of economics apply to popcorn in movie theaters, then the obvious explanation of why it was expensive had to be wrong.
The assumption of rationality was used yet again in the popcorn problem, applied this time to the theater owner rather than to his customers. If the theater owner's rational policy is to sell popcorn at cost, then rationality implies that that is what he will do. The observation that theater owners apparently sell popcorn for considerably more than it costs them to produce it provides us with a puzzle. One may, of course, conclude that economics is wrong. In Chapter 9, I hope to persuade you that there are more plausible solutions to the puzzle.
One more economic idea was discussed in Section I--comparability, the idea that none of the goods we value is infinitely important in comparison to the others. While comparability was never mentioned in Section II, it was implicit in the way in which we drew up the tables and figures of Chapters 3, 4, and 5. Imagine drawing an indifference diagram for two goods, a "need" A on the horizontal axis and a "want" B on the vertical axis. Since no amount of B could make up for even a tiny reduction in A, the indifference curves would have to be vertical. But vertical indifference curves imply that you are indifferent between a bundle consisting of 5 units of A and 5 of B and a bundle consisting of 5 units of A and 10 of B--which is inconsistent with the assumption that you value B. It is possible to analyze such a situation--but not with indifference curves.
I have now shown you some examples of how the assumptions of Section I were used in the analysis of Section II. The same assumptions will continue to be applied throughout the rest of the book; just as in Section II, I will only occasionally point out which assumptions go into which arguments. One of the things I have learned in writing this book is that economics is considerably more complicated than I thought it was. In such an intricately interrelated system of ideas, pointing out every connection whenever it occurs would make it almost impossible to follow the analysis. Much of the job of tracing out how and where the different strands are connected you will have to do for yourself.
That is not entirely a bad thing. It has been my experience that I only really understand something when I have figured it out for myself. Reading a book, or listening to a lecture, can tell you the answer. But until you have fitted the logical pattern together yourself, inside your own head, what you have read or heard is only words.
This brings us to the end of the first half of the book. The second half will be devoted to expanding and applying the ideas worked out so far. In Section III, I will introduce a series of complications to our simple model. The first, in Chapter 9, is the existence of the firm, an enterprise that serves as an intermediary between the ultimate producers and the ultimate consumers, buying productive services from the individuals who own them and selling consumption goods. Next, in Chapter 10, I drop the assumption that we are dealing with markets in which each individual producer and consumer is too small a part of the whole for his decisions to have a significant effect on market price; this will get us into discussions of monopoly and related complications --including, in Chapter 11, the complications of strategic behavior and the attempt to use game theory to deal with them. In Chapters 12 and 13, I add time and uncertainty to the analysis, bringing the world we are analyzing noticeably closer to the one we live in. Finally, having expanded the theory to include most of the essential complications of a real economy, I use it in Chapter 14 to answer one of the questions that economists are frequently asked--how the distribution of income is determined in a market economy.
Section IV begins by making explicit the criteria of "economic welfare," "efficiency," "desirability," and the like that have been introduced, or at least suggested, in the discussion of consumer and producer surplus. I then go on to show how such criteria can be used to judge alternative economic arrangements. Expanding on that subject, and on the results of dropping our normal assumption that prices are free to reach their supply/demand equilibrium, I will discuss the effects of various interferences in the workings of the market, some touched on already in earlier chapters.
At the end of Chapter 17 ("Market Interference"), you may be left with the impression that the market is a perfect mechanism for satisfying our desires and that there are no legitimate arguments for interfering with its natural workings. In Chapter 18, I attempt to dispel that impression by discussing market failures--ways in which failures of the market to conform to assumptions we have made (often implicitly) in our analysis may result in its failure to function as we would expect and wish. This chapter is an expansion of a point made in Chapter 1--that rational behavior by individuals does not necessarily produce rational behavior by groups.
By the end of Section IV, all of the essential ideas of the course will have been covered. Section V consists of a series of chapters applying those ideas. A few of the applications will be conventional ones, such as the analysis of the effects of tariffs in Chapter 19 and the discussion of inflation and unemployment in Chapter 23. More of the applications will be of the sort that I find especially interesting--using economics to analyze the dating/sex/marriage market of which most of us are a part, for example, or to explain why people in Chicago keep their houses warmer than people in Los Angeles, or to analyze the economics of theft.
The book ends with a final chapter in which I discuss how economics is done, what economics is good for--why, aside from passing a course, you should want to learn what I want to teach--and what economists do.