A physicist, a chemist, and an economist are stranded on a desert island. A can of beans washes ashore. They debate how to open it. The physicist says, “let’s smash the can open with a rock,” The chemist says, “let’s build a fire and heat it first.” The economist says, “Let us assume we have a can opener…”
The best place to start in understanding economics is by understanding an economic view of well-being. To an economist, people are made better off when their preferences are satisfied. People are rational utility-maximizers (i.e. they know what they want and they set about getting it as efficiently as possible).
For a great many things this works very well. Suppose we’re trying to figure out how much you are going to spend on food, and how much you are going to spend on travel. In real life, of course, you have more than two options, but to simplify (and make it possible to graph) for now we’re going to assume that your money is spent between food and travel. I’m going to use graphs and intuition so that we can avoid doing too much math (if you’d like to see the math just ask and I’ll put it in the comments).
Here the amount of Food you choose to buy is represented on the vertical axis, and the amount of Travel you buy is represented on the horizontal axis. The mysterious blue line represents that rate at which you would willingly trade food for travel. The technical name for the blue line is an indifference curve. In theory, you are indifferent to any combination of food and travel that appears on the line. Notice that the line curves. When you’re spending a lot on food, you’d be willing to trade quite a bit of food money for a little bit more travel. Conversely, if you’ve been spending a lot on travel and don’t have much food, you’d be willing to trade a lot of travel for not that much food. This is a result of the principle of diminishing marginal utility. For any good, like travel, each additional unit is still good, but it’s not as good as the last. If you’ve ever eaten too much pizza you probably understand diminishing marginal utility intuitively, The first slice is good, the second not quite as good, and so on until you’ve overeaten and the joy (utility) you take from the last slice is actually negative, since it causes a stomachache. (Eating the last slice is irrational, so for now let’s assume human beings don’t do things like that).
Economists assume that more of any given good is better. So while when you have lots of money for food, you’d willingly trade it for travel, what you’d really like is to have more of both. There is no satiation. The only thing that stops you from increasing both food and travel to infinity is your budget. In general, the market sets prices for food and travel. It doesn’t matter if you’ve gone out for dinner every night for the past week, the price for dinner tonight (at any given restaurant and for any given meal) will be the same as if it’s the first time you’ve gone out in a year. This means that the budget constraint (the red line) does not curve. The number of good meals out at restaurants that the market requires you to give up in order to get more travel stays constant, so we have a budget constraint with a constant slope that stretches from spending all your money on food to spending all your money on travel.
Okay, now let’s put it all together. On this next graph we have multiple blue indifference curves. Because more is always better, indifference curves to the northeast (upper right) are better than those to the southwest (lower left). Indifference curves don’t ever cross, and are assumed to be everywhere.
Points A (lot’s of food, not much travel) and B (lots of travel, not much food) are both within the budget constraint. (Economists assume you will spend all of your budget. Think of savings as just being another category in the budget, a sort of ‘future spending’ category that also gets traded off with current food, travel, etc.). Although you’d be equally happy with either A or B, point C is better. Here you’ve moved to a higher indifference curve, and so increased your overall utility while staying within your budget. In general, economists argue that you will maximize your utility when the rate at which you are willing to trade off one good for another is equal to the rate at which the market makes you trade off one good for another. This is represented on the graph as point C, where the indifference curve is tangent to the budget line.
Economists think about social welfare in terms of individual utility functions. Each individual wishes to have more of the bundle of goods they have chosen. (We thought just about trading food for travel, but in reality we trade off lots of different goods in order to form a unique bundle of goods). This can be accomplished either by increasing individual income, or by making goods cheaper; both of these have the effect of moving the budget constraint up and to the left, and so allowing the consumer to reach a higher indifference curve.
All of this is very useful up to a point. It is a bad idea to try to tell people how they should make choices between eating out at a fancy restaurant and saving up for a long vacation. Not only does the market overall not work as well this way, but it’s an unnecessary restriction of individual liberty. This is the reason many economists argue that benefits to the poor should be provided in the form of cash, rather than through a myriad of programs. So instead of SNAP (food stamps) and a housing voucher, recipients of aid could choose how much money to allocate to food and how much to housing.
We run into problems once some of these assumptions are used beyond the basic case of an individual choosing among goods. This is probably the primary problem in economics, the extension of simplifying assumptions designed to clarify one point on to another topic, where those assumptions no longer simplify and enlighten, but instead lead to wrong and often harmful conclusions.
The assumption that individuals always want more and are made better off by getting it is challenged by the hedonic treadmill theory in psychology; the idea that people usually adjust their happiness to their level of material well-being. The subjective happiness effects of buying a new car or new house last no longer than a year or two. The effects for other material goods are even smaller. Travel can actually have relatively long-lasting effects because of the memories formed and the socialization experience. In general, socializing and spending times with friends has a much, much stronger link to individual happiness than any level of material well-being.
There is also an assumption buried in the model that preferences are stable, i.e. that people know what they want, and while it may change slowly over the years, its mostly stays the same. Of course, if this is true, then companies are wasting billions of dollars on advertising to try to get people to want things they didn’t want before. In reality, advertising works. It’s tough to argue that one is better off if you satisfy a preference that was induced by an advertisement. You would have been better off if you’d just never seen that ad. Even in the absence of advertising, there are still good reasons to doubt that human beings have stable preferences, in part simply due to the conditions of uncertainty under which we must make decisions.
Finally, although diminishing marginal utility does imply that there should be a somewhat equitable distribution of resources ($100 dollars is worth more to someone who makes $10,000 a year than someone who makes $100,000), looking at social welfare through the lens of individual utility functions tends to ignore the distribution of resources. Things like the median income and the level of inequality matter not simply for the material well-being that goes along with it, but for the ability to fit into society.
It’s worth pointing out that many economists know this, and are working to correct some of the problems in standard economic theory. (Amartya Sen is a great example). And again, it’s not that there aren’t clear uses to indifference curves, budget constraints, and utility functions. They explain individual micro-economic behavior remarkably well. They’re worth knowing. It’s just also crucial to know their limits.