Chaper 2: The essence of economics

Economics is a social science. We are concerned with people and their happiness. Our job is to help people get along, support one another, and to benefit from one another in the realm in which they exchange money. Our intentions are like that of a therapist, or a priest (the good kind). The therapist helps you manage your personal relationships. A priest helps you manage your relationship with the gods. Economists study how people interact in the places where things are bought and sold, helping people understand the consequence of their actions, striving to ensure that every transaction benefits both buyer and seller, and doing what they can to create a world where everyone becomes richer and happier at the same time (if not always in the same degree).

When I was a student economics was describes as, “the study of the allocation of scarce resources.” This definition was not very helpful, as it made economics seem like a quartermaster charged with rationing what little food was left to his soldiers. Instead, I came up with my own definition. It is still far from perfect, but after it is taken apart and elaborated upon it will suffice.

Economics is the study of how

  1. people interact with strangers and acquaintances
  2. through commerce and government
  3. to create a more prosperous and meaningful life,
  4. with a particular interest in making self-interest and social-interest harmonious

(2.1) people interact with strangers and acquaintances

Money rarely changes hands between intimates. Lovers don’t buy and sell dates from one another, and spouses don’t agree in advance how their income will be shared. Mothers are loved by children for the love they receive, not by the size of their allowance. We do favors for friends because we care for them, not in expectation that they will soon return the favor (if we are real friends, that is).

Our intimates are few compared to the number of strangers and acquaintances we pass each day. Yet most of the food you eat is provided by strangers! When strangers meet, you can bet that money will change hands. The potatoes grown to make your french fries were not produced out of a sincere concern for your happiness, but to make the farmer money. We don’t buy french fries at McDonalds because we know and love the farmer; we buy them because we French Fries are tasty. The people who defend us in court do it mostly for the money. Bailey Norwood only teaches this class because it is his job (though he does love his job). Even in places where camaraderie between strangers is at its most intense—think college football—lots of money are being paid and received. We all love Mike Gundy for what he has done for our football program, and we know he loves OSU, but he is not family. He is our champion, but he is paid handsomely.

When strangers interact, money changes hands, and an economist is watching.

(2.2) through commerce and government

Although money does pass between father and child, friend and friend, most exchanges of money takes place in the marketplace (commerce) and government. We go so far as to recommend that one “not mix business with pleasure.” This separation between intimates and the marketplace seems both deliberate and desired. Roughy a third of all the money Americans make are paid to governments through taxes, so economists are keen to make sure this money is well-spent. Consider for a moment where most of a household’s after-tax income goes to: the home. It is not unusual for one to purchase a house at a price over twice her annual income. She borrows this money and then steadily pay it back over, say, twenty years. Who do they borrow the money from? Their parents? Rarely. Friends? Almost never. Strangers, who work at a bank? Almost exclusively. There are strangers who are willing to give us a huge sum of money because they have confidence that it will make them money. Why do they trust us? Aren’t they scared we will take the money and neglect to pay them back? No, because laws are written such that if we do not pay back the loan the bank can take ownership of the house and sell it. If we refuse the leave the house, the police will make us. Laws about property and contracts are the prime reason it is so easy for us to obtain a mortgage.

One cannot separate the study of government from commerce, as a particular form of government is necessary before commerce can thrive. As we saw in the previous chapter, a nation’s wealth—including the amount of food—is highly dependent on the political system.

What economists rarely study is how customs and culture change over time. That is largely the domain of sociologists and anthropologists. Economists are paying more and more attention to culture, but the bulk of what is called economic theory concerns commerce and government.

(2.3) to create a more prosperous and meaningful life

What does it mean to be prosperous? Making a lot of money is a big part of it, because with money people can buy many of the things they value—but I didn’t need to tell you that, did I? It is thus not surprising that economics was born with the publication of a book titled The Wealth of Nations, by Adam Smith. Economists devout much resources to learning how to help nations out of a recession and to help developing nations gain in wealth. It would be a mistake, though, to believe that economists definition of “wealth” concerns only those things that are bought in the marketplace.

As chicken manure leaves the fields and enters Oklahoma streams, rivers, and lakes, economists say that citizens are less wealthy, even if the number of their dollar bills does not decline. Many people value environmental purity, and even if they never visit a lake but are “merely sad” at learning of the pollution, an economist will say that is equivalent to a reduction in wealth. Some people even become happier as they give some of their money to other people. We know that people give time to charity, fund charitable projects, and enter monasteries because there are some things more important than buying more toys. The fate of lottery winners is not encouraging to those who believe money buys happiness.

When I was first taught economics it was described as the study of the allocation of scarce resources. How humans deal with their unlimited wants in the presence of limited resources. Indeed, economists usually describe people as wanting more “stuff” regardless of how much they already have. Our desires are never satisfied. Or are they? This is a matter of semantics. We all know there are monks who renounce all possessions, so at first glance it may seem that some people’s preferences can be satiated. What if this monk could give away, for free, food to the hungry? Or what if he could magically provide houses for the homeless, comfort for the lonely, medicine for the sick? Surely, he would do so, so this monk does want more “stuff”, he just wants other people to be the ones to enjoy it, and then he gets happiness from their joy.

Humans are never fully satisfied with their wealth, but of course we want other things like close friends and to see our generosity benefit the world. The Onion once did a farce on our unsatiated desires, and though it was meant to be funny, it speaks worlds about our true desires.

Video 1—The Onion on our unlimited wants and needs

What is a “meaningful life”? It varies across people, and when one becomes an economist it is like taking a vow to avoid judging the tastes of other people. If one person is happier renouncing all possessions and becoming a Franciscan monk, while another is happier spending all their time accumulating money and boasting of their riches, we respect their choices and wish them the best. If someone is happier eating large amounts of fatty food than enjoying a long and healthy life, that is their choice and the economist views this little different than preferring vanilla over chocolate ice cream. There are limits to this, of course. People will probably be happier in the long-run if they stop doing heroine today instead of next year, and sometimes people do not have the proper information to make an informed choice. The point is that we try as hard as possible not to impose our preferences onto other people, so long as their actions do not impact the happiness of others.

Figure 1—Economists are not like Carol Gaither

Oklahoma State University is fortunate to have the most famous agricultural economist in the world: Jayson Lusk. In his book The Food Police Lusk describes why he believes organic foods provide no real benefit to consumers. This is information he believes is backed by science and important, and he works hard to communicate this information to the public. At the same time he has no desire to force people not to buy organic food, and he would never support government policies that would impede with consumer freedom to buy organic food or farmer freedom to grow and sell organic food. This is why he is a helpful economist: he wants to inform the public, not coerce them.

Figure 2—Jayson Lusk is a helpful economist

(2.4) with a particular interest in making self-interest and social-interest harmonious

Humans can be very altruistic. We are an ultra-social animal, and cannot prosper without each other. At the same time we are individuals who want the freedom to work for their own benefit. Yes, we live in herds, like armies of ants or a hive of bees, but we are slaves to no queen. As individuals we only consistently work hard where it benefits us directly, but as a society if we profit at the expense of others we destroy each other. It is for this reason that a society only really prospers if people are paid for their work, and the people who pay them benefit from their work also. It is for this reason that economists are captivated by the notion that it is relatively easy to design an economy where people work for their own self-benefit and for the benefit of others at the same time. After all, every time a buyer and seller make an exchange they are both made better off. Otherwise the exchange would not have taken place. In this way, strangers can perhaps benefit each other more than friends and family!

Consider a non-agricultural example. Our financial system is such that a large bank can take great risks, and if the risks results in large profits they get to keep it all, but if they incur large losses the government—the taxpayers, that is—bails them out. This is an undesirable system because it results in excessive risk taking, where small profits are funneled to a few people but large costs are imposed on society. The bankers are only being rational. The incentives are such that to not take such risks would to be to leave money on the table. Although it is rational for the bankers to take these risks, it is not rational for citizens to encourage this by continually bailing them out. Such a system takes an economy from one financial crisis to another.

(2.4.a) Farm for profit so that I will be fed

Now to an agricultural example, where the absence of property makes it in the self-interest of the individual to produce little food, which is not in the interest of society. This same story took place in colonial America and twentieth century China. Let us hope no people have to repeat this mistake.

Video 2—Pilgrims and property rights

Podcast 1—Planet Money podcast on China and property
Access here

The lesson is simple and clear. If you want people to produce food, all you have to do is to let them make profits by doing so. Often other people benefit us more not by sacrificing themselves for us, but in pursuing their own self-interest. In these cases, self-interest and social-interest are harmonious. This obvious but profound remark was made most clear in the book that gave birth to economics: The Wealth of Nations, by Adam Smith.

Quotation 1—Adam Smith on where food comes from

Now that you have seen the role of capitalism (meaning private property and free markets) in providing abundant food, consider humans’ greatest achievement, an achievement largely resulting from capitalism and the technologies resulting from capitalism. Despite a much larger world population, the price of agricultural products (and thus the price of food) is much lower compared to the past. This triumph of enterprise over resource scarcity is greater than The Iliad, the Renaissance, and the Great Wall of China combined.

Figure 3—Agricultural product prices and population growth since 1900(N1)

In the last 100 years the only famines to take place were due to political factors, not insufficient harvests, and every year more people are brought out of poverty. In 1990 43% of the world lived in extreme poverty; today that number has fallen to 21%. What is the source of this achievement? Technology, certainly. But also capitalism: private property and free markets!

Quotation 2—Capitalism and poverty

Most of the credit [for world poverty reductions ]...must go to capitalism and free trade... the biggest poverty-reduction measure of all is liberalizing markets to let poor people get richer. That means freeing trade between countries...and within in them.
—The Economist. "Towards the end of poverty." June 1, 2013. Page 11.

Now that we have injected the word “capitalism” into the discussion, we should pause and consider exactly what we mean. “Capitalism” means different things to different people. Those on the far-political-left who criticize capitalism usually define it as a system where a few wealthy people exert so political power that they are basically “calling the shots”, allowing them to gain in wealth by oppressing and exploiting others. For instance, the Koch Brothers today are considered by the political-left to have gained most of their wealth by polluting the environment.

However, when economists say “capitalism” we simply refer to an economy where the government protects private property, and where people are allowed to sell their property and buy other people’s property at whatever prices they negotiate.

If an economy has private property and free markets, but a few wealthy individuals nevertheless control policy, economists don’t call this capitalism but “crony-capitalism”. Few are more vocally opposed to crony-capitalism than economists. So you will find that economists join the conservatives in promoting private property and free markets, but we also join the liberals in opposing excessive political influence by rich people.

Video 3—Crony-capitalism is where rich people like Jesse Lauriston Livermore don’t stop for red lights
See details and comment on this video here

(2.4.b) The buffalo and the cow

One of the best illustrations of how property can harmonize self- and social-interest, consider the fate of the buffalo and the cow. The former almost went extinct, the latter never came close. Why?

People once hunted and killed almost every buffalo, leaving few to breed and secure their offspring for the future. Yet we never came close to killing all the cattle. The difference is due to the fact that cows are owned by someone, and the farmer who reserves a heifer from being slaughtered so that she can reproduce receives the benefit. She did not receive the money today from slaughtering the heifer, but in the future she will receive even more money from the heifer’s offspring. The rancher took ownership of the calf because she owned the heifer.

From Kitchen Sink at DASNR of OSU

It is a different story for the buffalo. Yes, a hunter could decide not to kill a female buffalo, so that she can reproduce and ensure buffalo populations in the future. However, it is almost certain that it will be some other hunter that benefits by killing the female buffalo’s offspring. So the hunter with the female buffalo in his cross-hairs has no personal incentive to let her live, even if it is in society’s benefit that buffalo reproduce. This is a case where the hunter’s self-interest and the interests of society are not aligned.

By Sarah Afshar (Own work) [CC BY-SA 4.0 (], via Wikimedia Commons

There are many solutions to the buffalo problem. One could make it illegal to kill the buffalo, or one could give people ownership of the buffalo. Once it is someone’s property it will be cared for. The same can be said for African elephants. When they are not owned by anyone they can only be protected by making hunting them illegal and punishing poachers. Another solution that has worked very well in some reasons is to give specific communities ownership of the animals, allowing them to decide how many elephants will be killed each year. Because these communities make handsome profits from tourism, they are focused on leaving many males and females unmolested, so that they may breed.

(2.4.c) Why nothing should be free

In 1985 Uzbekistan, part of the Communist Bloc, natural gas to heat people’s homes and fuel their stoves was given to its citizens for free. Matches to light the stoves however were scarce. So people either had to go without their stoves when no matches were available or ... leave their stoves burning 24/7. They often chose the latter. This was rational for the individual, as leaving the stoves on continually did not increase their utilities bill. This was highly irrational for their society though, for the gas that was given away for free may not have had a retail price but it did have a cost. The gas that was wasted could have been exported for revenues, used to power factories that produced goods, or stored for future consumption. The wasted fuel could have been used to raise money to buy matches, or even run a match factory. It also costs money to extract and deliver the gas, and those costs were real, as they required labor and inputs that could have been used to produce something else. So while the household paid no extra money by leaving their stoves burning all day and night but the society as a whole was essentially burning money.(S1)

In public domain at Wikimedia Commons

This is why nothing should be given away for free. It causes the individual to treat the good or service as if it is costless to produce and in infinite supply, when reality there is never the case. In order for self-interested individuals to use resources in a way that is rational from a social perspective, it must pay a price at least equal to its cost.

(2.4.d) Shipping prisoners

Britain used to ship some of its prisoners to Australia, and ships were initially paid per person they transport. People can be cruel, and it costs money to ship prisoners humanely, so it is unfortunate but not surprising to learn that many ship captains cared for their prisoners so poorly that few arrived in Australia alive. The Britain government and public was shocked to discover this fact, and decided that what was in the ship captain’s self-interest was not in Britain’s self-interest.(K1)

By Bookhout, Edward, engraver Darley, Felix Octavius Carr, 1822-1888 , artist [Public domain], via Wikimedia Commons

Designing a new system where self-interest and social-interest were aligned was easy. Instead of paying ship captain a specific amount for each prisoner transported regardless of whether they arrived alive, they paid each captain a specific price for each prisoner that arrived alive. This new system apparently fixed the problem, as ship captains began to care for their prisoners much better, regardless of whether the captains were naturally benevolent or malevolent people.

A final motivation

Even if one does not care to understand how people interact with strangers and acquaintances through commerce and government to create a more prosperous and meaningful life, with a particular interest in making self-interest and social-interest harmonious, the fact is that the world does consider it a worthy subject. An educated person is expected to understand basic economics.

So integrated is economics with modern life that sometimes one must understand it just to understand jokes like the following on television!

Video 4—Another reason why we learn economics (to get jokes like this one on TV)


(K1) Kestenbaum, David. September 10, 2010. “Pop Quiz: How Do You Stop Sea Captains From Killing Their Passengers?” Planet Money [podcast]. Accessed December 16, 2014 at

(R1) Radiolab [podcast]. December 12, 2014. “Buttons Not Buttons.”

(S1) Seabright, Paul. 2004. The Company of Strangers. Princeton University Press: Princeton, NJ.