Bringing Joy into the 'Dismal Science'

Economist Joe Kalt offers ways to include economic thinking into decision-making

Summary of presentation by
Joseph P. Kalt, Ph.D.
Professor of International Political Economy
John F. Kennedy School of Government
Harvard University

No such thing as a free lunch

Economics is sometimes called the “dismal science” because what some consider its pessimistic view of the world – unlimited wants, and scarce resources.

This conundrum is at the heart of most public policy debates and indeed most of what drives society, said Joseph P. Kalt, Professor of International Political Economy at the John F. Kennedy School of Government, Harvard University.

“The core problem for us human beings and as a society – given that we’re not all the same and we can’t agree unanimously – is facing the challenge of how to allocate our resources: ‘Should we build a new school or a jail? Should we build a new road or a hospital?’ The problem is making those choices as a society and finding ways of using resources that is the best for people.”

In economics parlance, the result of these choices is an “opportunity cost”: The opportunity cost of building a new jail is the new school that could have been built with the community’s resources. In more basic terms, opportunity cost means there is “no such thing as a free lunch,” Kalt said. “You can’t do it all. Somewhere something else is going to give.

“If we did have unlimited resources, we wouldn’t need legislatures to make tough decisions: ‘Should we invest more in highways? Should we invest more in schools or in law enforcement?’ If we had unlimited resources we wouldn’t have to worry about these tough choices.”

Understanding the workings economic principles can help public policy makers, journalists and all citizens make better decisions and resolve the disputes of how to allocate scarce resources. (See Kalt's Power Point presentation here.)

Demagogues and spin

Understanding opportunity costs can be tricky, because many of these trade-offs are not immediately apparent.

“We could invest $500 billion in renewable resources, but then what don’t I have? I have a little less of a lot of things. Somewhere else in the world, there is one less hospital bed, fewer carrots, less steel … It’s so invisible that it creates a difficulty in our public conversation thinking through the choices we face in society,” Kalt said.

“But we know they are real, because journalists cover the fight for these resources every day. The difficulty for reporters is the invisibility of some of these costs.”

Much of what journalists cover is the debate over these resources in city council meetings, county board meetings, school boards, state legislatures and Congress. Invariably, someone will come along and say we can have it all – both the school and the jail, the guns and the butter. This is where understanding economics is critical for journalists, policy makers and anyone else.

“When we don’t understand economics, we leave room for the demagogues,” Kalt said. “The demagogues say, ‘It’s free! It’s a free lunch. You can have your cake and eat it, too.’ A demagogue doesn’t recognize the no free lunch axiom. What makes public policy so hard is there’s no such thing as a free lunch.”

Therefore, understanding economics is the best way to control the demagogues and cut through their spin, Kalt said.

Pleasure and pain

According to the law of demand, as the price of something goes up, people buy less of it. This pattern follows the basic human principle of rational self-interest: “We move toward pleasure and away from pain,” Kalt said. “This doesn’t mean we’re all greedy and want pleasurable things. It means if the price goes up, it becomes more painful to buy, and thus people will move away from pain and buy less.”

So what if the price goes up on an addictive substance, such as narcotics, cigarettes, or oil? If someone is addicted to something, demand response to price spikes is sluggish, or in economic terms, “inelastic.”

But eventually, if the price goes up high enough, even cigarette smokers, heroin addicts and SUV drivers will be forced to cut back. “When the price goes up, in the aggregate it turns out even drug addiction goes down,” Kalt said.

Knowing this basic principle of economics, an anti-drug-crusading politician might try to drive down drug use by beefing-up enforcement against producers and importers, thus driving the price up by restricting supply. “But if you attack the problem solely through this way, you get other problems,” Kalt said. “Increasing the price of drugs, alcohol or cigarettes might have nasty side effects. Sure people will buy less, in the aggregate, but now you’ve got more criminality because you have very desperate people, addicts, breaking into to people’s houses.”

Thus, a strict-enforcement policy can aggravate other social problems and create additional “external costs” such as property loss, the cost of law enforcement and criminal justice – which when all added up might exceed the benefits of a marginal drop in drug use caused by the increase in price.

“What’s going to happen to criminal behavior in the neighborhood if you attack drug use solely though this policy?” Kalt asked. Policy makers and journalists need to keep asking the question. This is another way to control the demagogues, Kalt emphasized.

Carrots and sticks

Raising the price of drugs and cigarettes can create unwanted social costs, but artificially raising the price of other types of products can lower external costs. For example, taxing sulfur emissions from coal-fired power plants has proved an effective way of reducing pollution.

“If you make it more expensive for industry to spit carbon or sulphur into the air, they emit less. Why? Because we are rational, and we are using the law of supply and demand.”

In the past, environmental policy has used quotas and emission prohibitions rather than market-based incentives, such as emission permits that can be bought and sold.

“Over the years we have switched away from the ‘mom and dad’ way of running the economy – ‘Don’t do it,’ or ‘Just say No,’” Kalt said. Instead, the philosophy is, “‘You can do it, but you just have to pay more to do it.’ And this is how we design public policy. Just wagging your finger doesn’t do a lot.”

Communists and kleptocrats

The system of government is critical to the functioning of an economy. The partition of Germany after World War II provided a stark example of two different forms of government. “At the end of 50 years, West Germany was the third or fourth richest nation in the world, and East Germany had to use machine guns to keep people in,” Kalt said.

“Almost everything depends on the government and its policies. The government lays down rules of the game.”

Another stark example of the results of poor governance is Latin America. Geographically, the region has abundant natural resources might seem to be a place ideal for economic development. But corrupt governments and weak civil societies keep the region poor.

“If the rules of the game are set up such that rather than being productive, a society’s best and brightest are devoted to taking resources from the other guy, you can destroy a society,” Kalt said.

If a political party’s sole aim is to maintain a monopoly of power, while extorting the population, as is common in much of the Third World, economies and societies will not develop. In the developed world, similar problems can arise through unchecked lobbying, laws written by industry, and predatory attorneys who live off class-action lawsuits, Kalt said.

“This is why we debate things like tort reform and taxation,” he said.

A major determinant of a productive society is whether it has an independent, nonpolitical courts system, Kalt said.

“The key is the rules of the game: If the rules of the game are set up so we have incentives to be rational and productive; sure enough, we will be productive,” he said. “It’s not a question of big government or small government, but setting up the rules. If those rules channel people into destructive activity, in which you can get more resources by picking up a gun or filing a lawsuit, what happens is you channel your resources into slicing up the pie rather than enlarging the pie.

“In a very deep way what is going on in the world is a tussle over the rules of the game. Are the rules of the game set up to attract capital, or do they encourage people to pick up a gun or file a lawsuit to take someone else’s money? This is why it is so important to create an economic environment that gets the mix right. This is why it’s so important to cover these public policy questions in the newspaper,” Kalt said.

The invisible hand and the heavy hand

If markets are working well, they send signals – through prices – to help people financial decisions. If something becomes scarcer, the price goes up. If price goes up, signals are sent to both consumers and suppliers. This is the “invisible hand” that economist Adam Smith famously so famously described in the 18th century.

But market economies are tough, and a Marxist might say callous, heartless and exploitive. They force people to make the hard choices of allocating resources, and they force people to accept the opportunity costs resulting from their decisions. The communist experiments of the last century attempted to eliminate the callous invisible hand with central planning and the government’s benevolent hand. But the central planners were unable to recreate the prosperity of markets, and the benevolent hand became a heavy hand. The most common image from Soviet Russia was long lines of people outside grocery stores or meat vendors. It could be said that meat lines are the reason the Soviet Union fell and why China survived, Kalt said.

“No one likes high prices, but people like waiting in line even less, because that makes the real price higher. And if you’re third in line, and there are only two pieces of meat, you can’t get it at any price,” Kalt said. “China looked at what happened in the Soviet Union and deregulated all of the food and retail markets. This is the reason China survived.

“Market economies generally work better than anything else because they send signals in a way that don’t require a central planner. That was the Russian problem,” Kalt said.

Command economies such as Soviet Russia could not adequately anticipate the needs and demands of consumers. This was a fatal flaw.

“The market is constantly doing a balancing act,” Kalt said. “The economy is mediating between the various wants and needs of consumers through this balancing act: ‘Do I want more steel or health care?’ It is trading off what consumers want. The consumer is the real driver of the economy, ultimately.”

Market failure

Free markets work well, but they don’t work perfectly, Kalt pointed out.

One of the ways markets can fail is through artificial restrictions in supply, as can happen when cartels conspire to reduce production, thus driving up the price.

“Markets are wonderful, but on the other hand they can get messed up when someone gets control of the supply. They are not violating rules of supply and demand, they are using them in their favor,” Kalt said. “As more and more people turn to using markets, they are also looking for ways to control competition in those markets.”

Free markets can also fail the environment if adequate protections are not set in place. In a totally unregulated economy, no one stops polluters from dumping chemicals into streams, oceans and the air.

“If I’m spitting out chemicals into a river and killing all of the fish downstream, but I am not bearing the costs for killing all of the fish; the costs are external. But I am hurting consumers,” Kalt said. “When you don’t have to bear out all of the costs of your actions, the true social costs are hidden.”

Kalt said it is important that external costs be factored into the market. Environmental laws attempt to address market failure.

Countries with weak environmental laws tend overproduce things because external costs are not factored in. “They are sending the wrong signal that it’s cheaper to produce things in that country, but the producers don’t have to pay for costs of their behavior. The market depends on rules of the game that requires that you bear the costs and consequences of your actions,” Kalt said.

Another way of undermining markets is product “dumping” – for example, when a foreign country subsidizes its own industry in order to sell goods below market price, thus driving out domestic industry. Once the domestic business is destroyed, the foreign company can jack the price back up.

Domestically, markets can fail when mergers eliminate competitors and result in too few competitors or monopolies.

Kalt said there may be other reasons to intervene in markets or even shut them down. “Ethics can and should trump the market,” he said. “Markets can produce all kinds of illicit and illegal things. … We have a whole body of public law about this. It’s why we have the Food and Drug Administration, truth and lending laws, and lemon laws.”

On one hand, but then the other

Kalt said people often complain that economists are ambiguous. The chairman of the Federal Reserve Board is famous for his obtuse statements. There is never a straight simple answer. Issues are usually cast in terms of “on one hand, but then the other.” That is the nature of economics: supply and demand; costs and benefits – there are always at least two counterbalancing elements.

“As a society, we are searching for balancing points,” Kalt said. “Economics is a way of thinking about the world. Economics is what drives so much of society.”

Lack of understanding of economics allows room for demagogues and allows people to be manipulated by them. The loudest voices are often favorites of the media because they capture attention and are entertaining.

“What sells are extreme views and hostility, and yet all of us as citizens need to make informed decisions,” Kalt said. “The shouting and screaming doesn’t make sense. There are things on each side. The challenge for journalists is to frame these issues so we can make better decisions as a society.”