What is Economics?
Economics is a broad field of study. That breadth leads to difficulties of concise definition. However, some common definitions include:
- Economics is the study of how people choose to use resources[1]
- Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses[2]
- Economics is the social science that studies the production, distribution, and consumption of goods and services[3]
These definitions emphasise the key elements of economics – people, resources, and choices – but the simplicity of the definitions belie the range of topics that come within the ambit of economic analysis. While economics is frequently associated with the big issues of the national economy, and international trade, it is equally present in individual industries (industry regulation, health, education), markets (electricity, water, greenhouse gas emissions), implementation of legislation and regulation (Resource Management Act). In general, you will find economics in any field of human activity.
Let’s take the example of greenhouse gas (GHG) emissions referred to above – what can economics tell us about controlling these emissions? First of all, the basic problem is defined outside an economic framework – in this case GHG emissions are causing the world’s temperature to rise, with this increase in temperature being considered a bad thing.
A non-economic response to this problem may be to decree that all GHG emissions must be reduced by (say) 2 per cent per year for the next 10 years. However, this takes no account of the benefits of the emitting industries, the cost of reducing GHG emissions in any given industry, or whether reductions in GHG emissions are even possible.
In contrast, an economic response may be to ask: “How do we reduce GHG emissions at the least cost?”[4] “Least cost” may refer to an individual firm, an industry, the country, the whole world, or all of these entities. Likewise, the “cost” may include the effects on society of a reduction in employment opportunities if firms have to close and reduced availability of goods for consumption, as well as the financial cost of upgrading equipment or changing technological processes.
A typical answer to this question would be to place a tax on GHG emissions. This tax would create incentives for emitters of GHG’s to reduce their emissions. As the tax was increased, more effort would be applied to changing lifestyles and production processes so that emissions of GHG’s are reduced.
What is less obvious here is that the level of GHG abatement will differ across industries. Those industries that can change their production processes at low cost will do so, and avoid the tax. Other industries (for example, a coal fired power plant) may find it very expensive or impossible to reduce GHG emissions. These industries will need to pay the tax, and pass on some or all that tax to consumers of their products by way of increased prices.
Ultimately, the cost of goods with high embodied GHG emissions will be higher than similar goods with low embodied GHG emissions. That price differential will then encourage consumption of the goods with low embodied GHG emissions.
In some cases, firms may not be able to pass on the cost of the tax due to competitive markets for their products. In this case, the profits of firms with low GHG emissions will be higher, enabling those firms to prosper, while firms with high GHG emissions will do less well due to the tax imposition. Effectively, production of the goods with low embodied GHG emissions will be encouraged, while production of goods with high embodied GHG emissions will be discouraged.
We would expect the cost of the solutions to be less than the long-run cost of the tax, otherwise firms would be better off by simply paying the tax. Therefore, firms will not put in abatement measures in place unless their (long-run) cost is less than the tax. This ability to choose abatement mechanisms ensures the total investment required across the whole economy to achieve the GHG target is minimised – which, in turn, maximises the amount left over for investment or consumption elsewhere in the economy.
It also means that as the cost of (or tax on) GHG emissions increases, the number of available abatement strategies increases. This is because it becomes worthwhile to utilise more expensive solutions in order to avoid the tax on GHG emissions.
How does the economic approach outlined above differ from the non-economic approach of requiring all industries to reduce emissions by 2 per cent per year? Firstly, not all industries can reduce their emissions – this approach would force some businesses to close. Secondly, some businesses could only reduce emissions at enormous cost – a cost far higher than the tax referred to above. Thirdly, there is no incentive for business to reduce GHG emissions any faster than the 2 per cent per year, even if they could easily do so. In contrast, a tax would continue to encourage abatement as long as the cost of doing so is less than the tax. Finally, it would require an army of administrators to ensure that everyone complied.
There are many economic principles in the above example. These include:
- the initial problem is placed in value terms (costs and benefits)
- the proposed solution created an incentive for market participants to change their behaviour
- the incentive used was ‘price’
- the solutions put in place by the market participants will depend on the price of the solution relative to the price of the tax on GHG emissions, and will lead to responses that are appropriate for each firm or industry.
Overall, the economic response to the problem is to create a set of incentives which lead market participants to change their behaviour such that the desired outcome is achieved. A key part of this process is allowing market participants to choose a solution appropriate to their own situation, rather than imposing a “one size fits all” solution on everyone.
[1] http://www.vanderbilt.edu/AEA/students/WhatIsEconomics.htm
[2] Lionel Robbins (1932, 2nd ed., 1935). An Essay on the Nature and Significance of Economic Science, London: Macmillan
[3] http://en.wikipedia.org/wiki/Economics
[4] Economists may pose a range of questions about this issue, including “Should we even worry about global warming?” This question is not meant to belittle global warming, but to encourage people to rank the importance of global warming relative to other issues (such as sanitation and access to clean water) that face the global population.
