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Economic thinking

September 6, 2018 · 0 comments

Economics is often portrayed as a dismal science. It seems to be about a small group of experts talking mostly about monetary policy. I want to argue that this is not true and that there is an elegant, natural and simple interpretation that admits far-reaching applications.

Finite thinking

First, we introduce finite thinking. Finite thinking is a kind of thinking that takes into account that resources are finite, or more generally, that entities in the real world have to obey the constraints of the real world.

When you are thinking about how to spend the $10 in your wallet, you carefully weigh different options against each other. You are performing finite thinking. But if you know that you are carrying around plenty of money, you no longer think of it as a scarce resource and, thus, no longer think finitely.

This applies to time management as well. If you have plenty of time, you cease to think of time as finite and tend to slack off. But if there are only two hours left until the deadline, you start to think finitely and try to use the remaining time as wisely as possible.

A more subtle example is this: When a thief robs a bank and escapes, the police could throw their hands in the air and say that he must have already left the country. Or, they acknowledge that the speed of his vehicle is not infinite and that he must be somewhere within a certain radius around the bank.

Economical thinking is nothing other than finite thinking: Anyone and anything that interacts with reality is subject to certain constraints. To think economically means to factor in these constraints.

Infinite thinking

It is instructive to look at its counterpart, which is infinite thinking. Here, it is implicitly assumed that a resource is available in an infinite amount. At first, this seems abstruse and not how people think at all because it clearly defies the basic truths of reality. But in fact, this mode of thinking is commonplace and pervades all aspects of life. It can also be very useful.

When buying groceries, most people do not take a close look at the price nor do they sum up the total amount in their heads. They pick the products they planned to buy and then pay the cashier the amount that is asked of them. Even though they are not aware of it, they implicitly assume that they have an infinite amount of money. However, if the resulting total is exorbitantly high, finite thinking kicks in and people start looking closer.

A wonderful example of infinite thinking is the efficient market hypothesis. It states that stock price immediately reflects all publicly available knowledge about a company. Even though it has the words “efficient” and “market” in it and is clearly about economics, it has nothing to do with economical thinking. For it to be true, every trader must have access to all relevant information at all times, react instantaneously to changes and make decisions completely rationally. To acknowledge that this can’t be true is to apply finite thinking. This opens the door to a more precise model of the stock market, that, for example, takes into account basic human instincts.

Which other areas are prone to infinite thinking although finite thinking would be more appropriate?

For the most part of human history, we have seen air as an infinite resource. A forager did not quantify the carbon dioxide that his bonfire emitted into the air, neither did the industrialist when burning coal. The more advanced our technology becomes, the more we impact we have on the environment and the greater the pressure to switch from infinite thinking to finite thinking. This mental shift happened in cities such as industrial London, which suffered from air pollution. On a global scale, we have seen this happening when the ozone layer was threatened by CFCs.

Telling a young person that they have all the time in the world is essentially an encouragement to think infinitely. If they took this advice to heart, which they rarely do, they would end up postponing major life decisions or pursuing unrealistic plans. A much better strategy is to accept time as a finite resource and make the best of it.

In any given moment, we can only pay attention to a small range of phenomena. It is impossible for us to simultaneously observe everything that is happening around us. You cannot play on your smartphone and watch traffic at the same time. People who claim to be good multi-taskers often think of their attention as infinite.

We sometimes tend to treat other human beings as though they had an infinite amount of self-control, knowledge and wisdom. This is how children commonly view their parents. It is obviously not the case, but it is much easier to see them as perfect beings rather than to deal with their flaws and deficiencies.

Consider books. We can easily acknowledge that we only have a finite amount of time. But we often ignore the logical conclusion — that we can only read a finite number of books. This leads to long ever-increasing reading lists that we believe “we will get to eventually”. But once you realize that you have to be selective about the books you read, you start thinking economically. You make a list of absolute must-read books, start to prioritize important books over unimportant ones and you pay more attention to what books get recommended often.

Conspiracy theorists are particularly guilty of infinite thinking. To establish a secret world order, you would need an infinitely good coordination structure, infinitely strong-willed individuals and an infinitely clear plan that everybody adheres to without question. Positing an unrealistic structure like this is way more convenient than to recognize the complexities of modern societies.

In health care, the idea that a human life is invaluable is widespread. If a human life is at risk, any amount of money, risk and effort seems to be justified to save it. And this is a sentiment that health professionals in direct contact with patients undoubtedly should have. But from a planning perspective, it is irreconcilable with reality. And worse: if you adopted this mindset, you could actively cause harm by making decisions that don’t prevent as much suffering as they could.

A politician who understands that the size of the front page of a newspaper — and thus, public attention — is limited, can enact unpopular legislation in the shadow of a major newsworthy event. In constrast, a politician who thinks infinitely implicitly believes in a supernatural force that makes every citizen in his country instantly aware of his legislation. Unlike his colleague, he is not going to see this opportunity 1.

In lightning chess, players have only a few seconds for their next move. Since this implies a limited number of possible thoughts, you can assume that your opponent won’t (and can’t!) play an overly complicated strategy.

If finite thinking is better in so many cases, why do we have infinite thinking at all? It is a mechanism to abstract away details to see the bigger picture. Without it, we would have to take into account all real constraints at all times, which would quickly overwhelm us. So, infinite thinking itself is the product of the limitations of human computational power. It is indispensable for us and it is so common that we are not even aware of it. However, you should not overdo it either. The key is to view the world at the level of abstraction that is suitable for the particular application.

Economics

So far, we have focused on different kinds of thinking. What does this have to do with economics?

Economics and its concepts arise when you think finitely about something. You ask yourself: What happens if you take into account the fact that a system has to obey the constraints of reality? The dynamics that arise as a consequence are the economics of that system.

In the public eye, drug cartels tend to be viewed as ideal constraint-free entities that exist outside the laws of reality. But people who actively fight them know better: They see them as ordinary organizations with mundane elements such as a hierarchical order of command, management of resources, establishment of trade routes, a distribution network for the end product — all while they have to follow the laws of supply and demand. All of these aspects make them vulnerable and make them seem less almighty.

We tend to think of the law system as an impeccable ideal that transcends the rules of the real world. We believe that when a new law is introduced, it immediately changes how people interact. We also believe that it automatically enforces itself at all times since “It is THE LAW!”.

When you spell it out like this, it seems ludicrous, but these are implicit assumptions we make all the time — unless we focus our attention on the law itself.

The reality is far less spectacular. The main reason the law works is because there is a general consensus that you should abide by the law. If we did not have that, anarchy would break loose and law enforcement would be futile. Also, the law is only enforced because there are flesh and blood people who enforce it. This leads to an economics of law enforcement: There is only a finite number of police officers who drive finitely fast cars. As a consequence, if there is too much crime, a choice has to be made where to enforce the law and where not.

There is an important practical ramification: If you think infinitely about the law, you will think that cutting spending for police will not influence the degree to which the law is upheld. This can result in a significantly higher response time and staff shortages. If spending is cut too much, it may be that your own house is being burgled, but nobody is there to help you.

The standard interpretation of economics is the study of the best allocation of finite resources. This is compatible with our interpretation. The main difference is that we don’t define it through actors and goods in an external reality, but through different modes of thinking. This allows for an understanding of economics that is universally applicable since it can cover anything you can think about.

We need to think in ideals to navigate the world. But when these ideals touch reality, they are subjected to its constraints. Then, economics is born.

  1. This can arguably be a good thing. 

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