After a brief foray into film school, I planned on heading into political science/international relations, but ended up studying economics. I think my posts here will follow a similar pattern: one about a movie, a quick detour through some political thoughts, and now: economics.
Economics broadly consists of two different fields: micro and macro. A lot of people have had to take these in school, but if not, they still sound like self-defining words. Micro is small, so that must be the study of individuals or firms, or maybe industries, and macro is the study of the whole economy. Yeah? Well… not quite. Or at least, they ought not be defined as such.
Microeconomics: the behavior of individuals and firms, governments, industries, and how they interact with one another. Basically this includes almost everything. All graduate micro courses can have a section on “general equilibrium”, which is, by definition, economy-wide.
Macroeconomics: the study of emergent phenomenon that arises due to the choices of individuals, firms, et al. Within this still somewhat broad concept, Arnold Kling has a particular focus that I’d like to emphasize: economic activity consists of sustainable patterns of specialization and trade.
By “emergent phenomenon”, I mean phenomenon that are unplanned side-effects of agents (that is, individuals, firms, et al) pursuing their own ends. This might be more broad than I want, but I think some examples will make my meaning clear. An example: in recessions, workers find themselves laid off and unable to find work. Firms find their sales dropping and are forced to cut their workforce, despite the loss in output and thus profit. As a nation, we are producing fewer goods than we were previously. Put like this, it almost seems absurd: there are workers who would work for money, and would buy goods with that money. There are firms who would sell goods should consumers (ie, workers) want to buy them, and who would hire workers to produce them. So why don’t they?
Thinking of macroeconomics as “about the whole economy” doesn’t provide any obvious answers to this questions. Maybe it’s because unemployment went up? But that only happened cause sales went down and firms had to fire people! Well then, it’s because sales are down! We’re in a recession after all! Well, sales are only down because the former workers don’t have jobs and so can’t buy things. The circularity here is obvious, but I think that trying to understand this as “the whole economy” leads almost directly to this circularity.
So, here’s another way. The economy is based upon an almost infinite web of connections: firms hire a number of workers, all of these workers spend their wages at a wide array of other firms, these firms employee workers, etc etc. I tend to buy the view that economic systems can be modeled as if agents are optimizers: firms optimize profit, and workers/consumers optimize their well-being (which can, of course, include promoting the well-being of others. It doesn’t require selfishness). For consumers, this means trading some of their free time to a firm–that is, they go to work–in exchange for wages that let them obtain food, shelter, clothing, computers, books, ipods, and whatever else they think will make them better off.
So, how does this help us think about “the economy”, and explain the persistent unemployment in recessions? The general “firms” that I keep talking about aren’t really general at all. Some of them sell sporting goods, some of them import French wine, some of them mine the silica that gets used in computers. Why do these firms do these specific activities? Entrepreneurship and the profit motive, generally. Potential entrepreneurs can look around their city (or the internet, or elsewhere) and envision a firm meeting some untapped demand. Over time, they may take on new projects, or shed less successful ventures, or outsource non-core activities, and otherwise evolve. In the end, though, we are left with an economy of relatively specialized firms.
But that’s not all! A worker is not a worker is not a worker: a teacher and an accountant and a fashion designer could not readily perform one another’s job. Firms are not the only ones specializing; workers do too. So, in the end, we are left with a country full of a huge number of divergent firms and differentiated workers, all performing different tasks. Because those firms are producing goods demanded by the others–the fashion designer needs an accountant, and the teacher needs clothes–people are able to trade their labor at work for money to trade for the goods they want. Patterns of specialization and trade!
Of course, Kling’s definition includes one extra word: sustainable patterns of specialization and trade. As long as the fashion designer and teacher and accountant are all producing goods and services that the others desire, these patterns are sustainable. There comes a point, however, where this isn’t true. Fax machines are less needed in the age of email; SUVs declined in popularity as gas prices rose; and Milli Vanilli’s music doesn’t sell like it used to. The firms supplying these declining goods fire workers. These unemployed workers buy fewer goods from elsewhere, leading to more layoffs. In the end, we get the same result: declining output, rising unemployment, and a recession.
Thinking of “the economy” in terms of patterns of specialization and trade encourages insight and implies an explanation. Thinking of macroeconomics as “the economy” in a free-standing sort of way doesn’t, and can impede understanding.