Summer ‘10

Woods

Some Key Notions

All of the basic principles of economics are founded on the immediate reality of ‘scarcity,’
whether of resources (aka, ‘factors
factors of production’)
production or information (knowledge). While
this is intuitively obvious, it is too often ignored (the following quotation as been taken
from the opening paragraphs of the Nineteenth Century, French economist‘s Frédéric
Bastiat’s essay: What is Seen and What is not Seen (1850):

In the department of economy, an act, a habit, an institution, a law, gives birth not only to an
effect, but to a series of effects. Of these effects, the first only is immediate;
immediate it manifests itself
simultaneously with its cause - it is seen. The others unfold in succession - they are not seen:
seen it
is well for us, if they are foreseen.
foreseen Between a good and a bad economist this constitutes the
whole difference - the one takes account of the visible effect;effect the other takes account both
of the effects which are seen,
seen, and also of those which it is necessary to foresee.
foresee Now this
difference is enormous, for it almost always happens that when the immediate consequence is
favourable, the ultimate consequences are fatal, and the converse. Hence it follows that the bad
economist pursues a small present good, good which will be followed by a great evil to come, while
the true economist pursues a great good to come, - at the risk of a small present evil. evil

In fact, it is the same in the science of health, arts, and in that of morals. It often happens, that
the sweeter the first fruit of a habit is, the more bitter are the consequences. Take, for example,
debauchery, idleness, prodigality. When, therefore, a man absorbed in the effect which is seen
has not yet learned to discern those which are not seen, he gives way to fatal habits, not only by
inclination, but by calculation.

This explains the fatally grievous condition of mankind.

mankind Ignorance surrounds its cradle:
cradle then its
actions are determined by their first consequences, the only ones which, in its first stage,
stage it can
see. It is only in the long run that it learns to take account of the others.
others It has to learn this lesson
from two very different masters - experience and foresight.
foresight Experience teaches effectually, but
brutally.
brutally It makes us acquainted with all the effects of an action, by causing us to feel them; and
we cannot fail to finish by knowing that fire burns, if we have burned ourselves. For this rough
teacher, I should like, if possible, to substitute a more gentle one. I mean Foresight.
Foresight For this
purpose I shall examine the consequences of certain economical phenomena, by placing in
opposition to each other those which are seen, and those which are not seen. [www.bastiat.org/en/
twisatwins.html]

This quotation and the concepts upon which it rests provide the foundation for economics
as a decision science and provide insights into how the decision-process may be
structured

The fundamental ideas of economics are based on ‘decision-making’ – whether these decisions
are made by individuals or households, businesses or the government. The decision-
makers’ choices are limited by the ‘prices’ of the goods and the individual’s or
businesses’ levels of ‘income.’

1
Note, in a perfect world, ‘the levels of government expenditures’ too would be limited by their
current tax receipts. Clearly, there are instances of emergencies, when it is necessary for
individuals, businesses and governments to go into debt and borrow against future
incomes or tax revenues.

Each and every choice or decision, involves trade-offs – if I want more of A, given my current
income (Yd) and the current price of A (PAt0) and the prices of all other goods and
services (POG&St0) – I must sacrifice some of the ‘other goods and services).

More abstractly, such decisions involve making choices at the moment (t0) [what do I need or
what makes me ‘satisfied
satisfied’ right now]; OR over some number of future periods … (t0 →
tn) [what will give me the greatest level satisfaction over that future period].

The consideration of decisions taken at different points in time requires the explicit
recognition of the ‘time-value
time-value of money,’
money and the relationship between time, levels of
information (knowledge) and certainty/uncertainty, degrees of risk, and potential pay-
offs associated with the decision.

Levels of Information (or Knowledge)

-------│→ -------------------------------------------------------------------- →│-------
(t0) Levels (or Degrees) of Certainty/Uncertainty (tn)
More Less

Degrees of Risk
-------│→ -------------------------------------------------------------------- →│-------
(t0) Potential Payoffs (tn)
Lower Greater

Notice:
Notice There is a direct (positive) relationship between information/certainty and time; and an
inverse (negative) relationship between risks/payoff and knowledge/certainty and time.

All of this means that ‘interest rates’ become an essential ingredient in making a choice
between how scarce resource