John Maynard Keynes once wrote that economics “is a method rather than a doctrine, an apparatus of the mind, a technique of thinking which helps its possessor to draw correct conclusions.” In other words, economics doesn’t provide answers in and of itself. It is an approach that points us what to look for — all the important incentives impinging on the issues we are analyzing. Economics is a framework to help organize the information and judgments we must provide, which helps us see what each depends on and how much it depends on them, disciplining our understanding and choices. But it does not itself provide the information we require or make the judgments involved.
Economics’ “incentives matter” approach focuses attention on what I describe as “the rule of rational choice.” In a nutshell, it says that whatever the choice or action being considered, an individual will do “it” (make the choice) if and only if the marginal expected benefits to the decision-maker exceed the marginal expected costs to the decision-maker. But since a vast range of variables can change those marginal expected benefits or marginal expected costs, that means there is no one “right” choice. regardless of those variables. In other words, the right answer (part a) to most general questions of what should be chosen or done is “it depends.”
Consider the impact of incorporating uncertainty. A decision that is good in some states of the world can be very bad if alternative states of the world arise. For instance, the Japanese post-WWII strategy of production on a large scale, intending to export worldwide, worked very well because it occurred after a large change in technology, particularly for mass production, economic growth was strong, and tariffs and other trade barriers were dramatically lowered. But what if the world had moved back to increasing protectionism and slow growth? It would have been a very poor choice. Again, the initial answer to what should be done in an uncertain world is “it depends.” Then, done right, it opens up the most interesting part of the analysis — what it depends on and how important the various considerations are.
Alternatively, think of the demand and supply curves not as typically shown in economics textbooks — well-defined and known — but as relationships surrounded by clouds of indeterminacy. At the time real-world producers must decide their price and output plans, they do not, in fact, know what the demand curve will be, a typically unnoticed-but-false assumption snuck in by drawing a specific, implicitly assumed-to-be-known, demand curve at the beginning of the analysis.
Without such a well-defined demand curve, known in advance, a producer cannot actually know how much total revenue will change for an additional unit of output (the marginal revenue, which microeconomics books assume producers will adjust output until it equals marginal cost). With uncertainty, marginal cost can’t be known in advance, either. Many unanticipated things could change it, from disasters to health problems for workers to accidents to hacking attacks to changes in government policy. As a result, the neat MR = MC equation of economics principles texts can no longer tell a producer what to do in order to successfully maximize his profits, as Armen Alchian pointed out long ago in his “Uncertainty, Evolution, and Economic Theory.” And I can still remember what he said to my graduate school class in summarizing this point: “I have been an economist long enough to recognize that ‘I don’t know’ is an intellectually respectable answer.”
Consequently, as Paul Heyne noted in his The Economic Way of Thinking textbook, economists know far more about what not to do, because some choices are clearly inferior to other options, than what to do, which requires we know the absolutely best choice in a situation. For example, economists know that treating sunk costs (things that were already committed to or have already happened, and so will not be changed as result of a choice) as if they are relevant to current choices will make us worse off in virtually every circumstance, so we shouldn’t do that. We know not to expect higher returns from bearing risks that appropriate diversification can eliminate, since those risks can be eliminated by portfolio management. But telling people what not to do to avoid making themselves worse off by certain choices is quite different from telling them what is the best choice, beyond the “buy low, sell high” level of specificity.
Thinking of economics in terms of such real-world issues, however, stands sharply at variance with objective exams typical of economics principles courses.
On such exams, there are typically unique, correct answers to virtually all questions. But that is only because all the necessary information to find a single correct answer is almost always provided in the questions. There is no guarantee of that in the real world, where decision-makers typically do not begin with all the necessary information for a single “right” answer to be determined. We not only lack at least some of the information we need (particularly because the future is uncertain), but we also know a great deal of information that may or may not be relevant to a particular decision, and we need to determine which, as a prelude to the actual analysis.
In other words, by simply providing all the relevant information (and only relevant information), typical objective economic exams skip the initial real-world step of asking yourself, “What do I need to know to answer this question,” or “What do I need to know, or make judgements about, that I do not yet know,” or “What information, from the vast ocean of it we swim in, can I ignore as irrelevant for this question?” But those sorts of questions about what the most appropriate choice depends on are frequently necessary to arrive at useful real-world judgments.
I have observed an ironic implication in my students. When they are guessing at objective exam answers, they virtually never pick “it depends” or some version of “we cannot determine the answer from the information provided.” That is because such answers are very unlikely to be the “correct” answer when all the information to determine that answer is almost always provided in the exam question. And yet, some version of “I don’t know” or “it depends” is the most likely correct answer at the beginning of most real-world applications.
Because of how important it is to recognize the initial questions which must be asked to move toward large numbers of real-world judgments, I have modified my exams to force students to confront those issues on occasion.
Sometimes that involves failing to give students enough information in a question to determine a single, correct answer. That would make “none of the above” or “there is insufficient information provided to determine a correct answer” the correct answer to the question. Other times, I will provide students with information relevant to some issues, but not the issue addressed by a problem. In that case, the first real-world step would be to recognize that such information is unrelated to the question at hand (like billions of bits of data we are exposed to every day) and so can be safely ignored, before moving on to tackling the question with the information that is relevant to it.
To help students understand this point, I also use classroom examples to illustrate the prevalence of such “it depends” answers to real world issues.
For example, I often pick a student in class who has a younger sibling still living at home. I specify that my student takes half an hour to mow the lawn at home, but their sibling takes an hour. With that information given, I then ask the student who is the lower-cost lawnmower.
They almost always reply with the “obvious” answer that they are the lowest cost lawn mower because they can do it faster. At that point, I tell them that is the wrong answer, despite how obviously it appeared to be correct. In fact, I didn’t provide them enough information to determine the answer. What is missing is the value of the alternative uses of the two siblings’ time, since it is not the time, but the value of the alternatives given up in that use of time, that is the relevant cost. In economics lingo, my student confused absolute advantage with comparative advantage. My student, who is twice as fast at mowing the lawn would actually be the higher-cost lawn mower whenever the opportunity cost of the time in question (the value that could be created for others in the same amount of time as it takes them to mow the lawn) is more than double that of their younger sibling.
I often also go through an extended example involving the opportunity cost of going to a particular meeting of my course. Over and over, I ask if something is a relevant opportunity cost of going to that class meeting, presenting it in a way that students think conveys an obvious right answer, then showing them that the “right” answer (at least part a) is actually “it depends.”
Should you count the cost of driving to campus? It depends — what if you would have come to campus even if you weren’t going to attend my class? Should you count the cost of one day’s parking? It depends — if you have an annual or semester pass, that is a sunk cost that should be ignored, but not if you have to pay each day. Should you count the cost of one day’s worth of insurance coverage? It depends — do you pay for insurance every six months or by the mile? Should you count depreciation? It depends — some depreciation is based on age of the vehicle and other depreciation is based on wear and tear. If you are leasing a vehicle and every mile over a certain amount at return costs you twenty cents, should you include the twenty-cents-a-mile as a relevant cost of driving to campus? It depends — will you end up over or under the mileage cap? Should you count the cost of gas? This one seems the most obvious, but in fact, it, too, depends — what if someone else, like dad, is paying your gasoline bill?
There are plenty of other questions where “it depends” is the first part of getting to many real-world answers or judgements that will face students. So confronting such questions, whether on exams or in class, helps develop student abilities to do accurate real-world analysis. Given that economics training is not useful if it cannot be used in that context, that is an important-but-underdeveloped skill among students. Just how important it is can be seen by noticing how many people stand to gain by being able to fool others into making worse decisions or recognizing that every “free lunch” offered by politicians involves at least one necessary but unasked question (“Who will be forced to pay for it, and what will be the effects of that imposition?”). As a consequence, I would like to convince my fellow economics professors to spend a bit more time on such issues, because the real-world benefits to students can be very large, even if there is a small cost of developing new questions to nurture and then test those skills.
The post It Depends—Is This an Economics Exam or the Real World? was first published by the American Institute for Economic Research (AIER), and is republished here with permission. Please support their efforts.