The Fundamental Rules of Economics

In the Russia invades Ukraine thread, @Wincerind said the following:

This struck me as an excellent topic for discussion. Do you believe that there are fundamental rules or laws in economics? If so, what do you think they are? Also, is economics a science? If so, why? If not, why not?

To get things started, I’ll give my answers. Yes, there are fundamental rules to economics. As to whether or not it is a science, that depends on the branch of economics, how ideas are tested, and what claims are made. Some economics is science, a lot isn’t.

As for fundamental rules, Adam Smith came up with three general ones:

  1. Law of self interest
    “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.” - Adam Smith
    People act in their own self interest. This doesn’t mean greed, it means they act with respect to their own goals and values. Recognizing this is the first key to a rational economic order.

  2. Law of Competition
    When people compete in the context of a marketplace, their own self interest is held in check from taking everything by the self interest of others. In a competitive market, the self interest of market participants will cause them to be driven ‘as if by an invisible hand’ towards meeting the needs of others as a condition of reward.

  3. Law of Supply and Demand
    Prices for goods are determined by the supply of the goods and the demand for them. Setting prices too high leaves the seller with unsold goods, while setting it too low results in shortages and unrealized profit. The law of supply and demand says that in a competitive market prices will rise to the point where the supply exactly balances demnd, called the ‘market clearing price’.

Karl Marx had his own three rule formulation:

  1. The General Law of Capitalist Accumulation.
    Real wages are stagnant under capitalism, and the share of national income accruing to labor would fall under capitalism.

  2. The General Law of Declining Profit.
    The rate of profitstrong text falls in an industry when capital accumulation increases.

  3. The General Law of Decreasing Competition:
    Capital accumulation leads to concentration, which leads to less competition,.

I think all of Marx’s rules have been refuted by evidence. Smith’s still hold up as general rules, but may fail in specific applications.

I would add some other common rules or principles widely believed in economics:

Tanstaafl: There are no free lunches. Every choice is a tradeoff.

Value is relative: Goods do not have value. People value things based on their own personal context. Value is not determined by the labor that went into a good.

People respond to incentives. If you change incentives, you change behviour.

Would anyone like to talk about these, or add some of their own?

I would express it more broadly with the concept of opportunity costs.

When you are calculating the cost of a transaction, you have to include consideration that the resources being spent on this transaction will not be available to be spent on another transaction.

So when you are choosing which transactions to make, you need to not only consider your gain from this particular transaction but how the gain of this transaction compares to gains of other transaction you could have made instead.

Bad money drives good money out of circulation - Gresham’s Law

What’s wrong with things like structural econometrics, or Black–Scholes type modelling? There are hypotheses to prove and that need to apply for a model to be valid, but who says that there is no way to test ideas scientifically?

That is definitely an axiom of the Black–Scholes model, for example. So you have to know when it applies.

I think that’s an example of the concept, and a good one. Opportunity costs are critical to any rational decision making.

But Tanstaafl also applies to concepts like believing you can raise taxes or impose tariffs or make other economic decisions that won’t hurt anyone if the changes are small enough. That gets into another rule I almost wrote, which is “Change happens on the margin”.

Some people believe that small changes won’t have negative effects. “You are telling me that if I tax one extra dollar on a $20,000 car it will change anyone’s mind? Nonsense. And we can make millions of dollars!”

The answer is yes, somewhere on the margin you should assume that your extra tax changes behaviour. If there was a free ‘dollar per car’ waiting to be extracted with absolutely no negative costs, it would already be extracted.

No one says that. But if you believe in the model and DON’T test it in a falsifiable way, are you doing science? Or are you using the trappings of science to justify believing in simething you want to believe?

If you have a falsifiable test for a theory, you should definitely do it.

Thanks for starting this thread, it is a good topic to discuss.

I will come with more replies later when I have access to a keyboard :blush:.
For now: these are not fundamental rules. They are gross oversimplifications of human nature. Obviously they contain a nugget of truth, but humans have many more motives than these.
Besides, they are observations, not rules. They do not prescribe behaviour but describe it and as I said, grossly oversimplified.

You probably know the anecdote according to which two economists are taking a walk and pass by a 10$ note lying on the ground. Of course they do not pick it up, because if it was real somebody else would have already done so.
By which I mean to say that somebody has to be the first to come up with anything. Then again, calculating how to extract an extra of one dollar from a 20,000$ car, no more, no less, may be so complicated that it costs more than one dollar, or else it may swing wildly between -50$ and +50$, and that may have all sorts of unforeseen consequences.
I think that is one subject not included yet in the discussion: the unexpected, unforeseen consequences. What is often called butterfly effect. I believe that exists, as do tipping points, and those may be the limits of economics as a science with predictive powers. Of course chaos theory is a science too, but a different kind.

I agree with the general principle, but would amend it:
Prices for goods are determined by what the market will accept.

The high price for a Louis Vuitton hand bag has nothing to do with scarcity. They charge that because there are willing buyers. Scarcity can (and do) lead to higher prices, as with the housing market in some areas. But saying that every transaction is based on the rate of supply and demand does not cover what we see in reality.

As for economics as science, isn’t a general principle n science that what is claimed has to be repeatable/replicable? I see a problem here with part of economics.

“Money is not wealth”.

Don’t confuse ‘economics’ with sensible, successful, well thought out economic planning and execution. Putin is right if you don’t care about the results.

This isn’t actually a law; it’s a definition. When economists say that people act in their own self-interest, what they mean is that they’re defining self-interest to be how people act. Which makes it a lot less useful than it appears. For instance, a real human business owner might do things like deliberately make bad business decisions, purely because he hates his business partner and wants to spite him. This might appear to run contrary to the proposition that he’s acting in his own self-interest, but an economist would then just say that because spiting his business partner is what he wants, and his business decisions accomplish that, they are in his self-interest.

That’s a good insight.

If you could predict the economy from some rules then it becomes advantageous to various parties to act against the rules and incentivise non-traditional economic behaviors. This allows them to jump in and win the pot.

Ergo, the only economic rules that can stay true are those that are too abstract and fundamental to human nature to functionally work against.

For example, Keynesian theory relies on the weak human nature to spend irrationally (money burns a hole in their pockets). But, if you’re a Republican and you want to tank a stimulus policy devised by Democrats then you can talk up to the “ills of inflation” and the like, and convince people to keep their money in their bank account.

Money burning a hole is not a sufficiently fundamental part of human nature. There might be other attributes which are but that one is not.

An economy is probably best thought of like a system of water pipes. Changing the speed of pressure of water at one point in the system will eventually effect all other parts. Figuring out a way to have a limited and targeted effect, from your policy, requires having a very complete and well-proven model of the whole economy. Though, see previous rule. If you can do something for the general good, using that model, then someone else can use the model for personal enrichment.

The OP, like many academic economists, starts with “assume capitalism,” and then uses some of Smith’s insights into that system to project general laws for “economics.” Not all economic systems functioned/function on the laws of capitalist economies. In some societies, charging more for something because the need was greater was a good way to get duffed up and all your stuff taken from you. See “bread riots.” The economist Stephen Marglin wrote an interesting book, The Dismal Science: How Thinking Like an Economist Undermines Community that is worth reading.

Would also note that some non-Marxist economists have demonstrated that each of the “rules” attributed to Marx have in fact been verified. They are not very well stated in the OP, and ignore that Marx was careful to note that because these are not “laws” like the law of gravity but are about people who have choices and options, any such “law” needs to be seen as a tendency that could be affected by many variables. Think of it as “this isn’t necessarily going to happen, but it’s how the smart money should bet.”

Irrespective of what you think the laws are or aren’t, of course it’s a science. Economics is the study of of a particular element of the universe (it’s really a branch of psychology) that seeks to determine truth. That is what science is.

It’s probably in its infancy as sciences go, but it’s science. Ask yourself where physics was in, say, 1700. It was a science, but they didn’t know much yet.

That could absolutely happen in a free market economy.

Indeed it could. The difference is, the capitalist would have the law on their side and the state would uphold that law, unlike a society that refused to recognize the “right” to raise prices because of scarcity.

Well then, isn’t then the science in question psychology. You’re saying economics is a branch, and maybe it is. But I don’t think anyone has claimed that the study of PTSD or bi-polar disorder are their own sciences. They are fields that some researchers in psychology departments devote their time to. Are there sub-departments dealing with economy? Maybe at some Unis. But I don’t have the time to canvas every seat of learning to prove your point.

This is what Google turned up for Cornell, when searching for economy at the psychology dept. It got 52 hits.

Here is what Cornell says about their work in Social and Personality:

Faculty members in the Social & Personality area are interested in understanding how people think, feel, and act in real-world social situations. There is a particular interest in how people make sense of the social world around them, as represented by research programs on judgment and decision making, attribution, self-knowledge, mood and emotion, and stereotyping/prejudice. Frequent topics of inquiry include whether people reach accurate or erroneous judgments about themselves and others, how people arrive at their decisions, how those decisions can be influenced by emotions or factors outside of awareness, and how people decide whether an action or pattern of behavior merits praise or moral condemnation.

All of that can of course be applied to economics. Do you know of any institutions that does so? And I don’t mean a department of Economics, I mean psychology since, according to you, Economics is a branch of Psychology.

Bread riots are illegal in Communist countries, monarchies, and theocracies, too. And they do happen. This is quite separate from whether economics is a science.