Introduction to Economic Thinking and Practice
Introduction to Practical Economic Thinking and the Aircraft Armor Problem
Context and Goal: This lecture serves as the second part of lecture one. The primary goal is to introduce the "economic way of thinking" through practical application and examples.
The Case Study of Abraham Wald: - Historical Context: During World War I (as specified in the transcript), Allied forces were suffering heavy losses in aircraft battles. The central problem was determining where to place protective armor on aircraft to improve survival rates. - The Maneuverability-Vulnerability Trade-off: - Adding armor creates a standard economic trade-off. - Extreme Armor: If armor is placed everywhere, the aircraft becomes indestructible but too heavy to fly, essentially becoming a "tank." - Minimal Armor: If armor is removed, the aircraft is highly maneuverable and capable of performing "badass stunts" or winning "dogfights," but it becomes vulnerable to even minor damages. - The Data Set: Engineers and army officials surveyed aircraft that returned from missions and recorded the distribution of bullet holes. - Initial Conclusion: Looking at the data, bullet holes were concentrated on the wings, the tail, and parts of the fuselage. Military professionals concluded armor should be added to these specific areas. - Abraham Wald's Insight: Abraham Wald, an economist and mathematician, disagreed. He famously advised: "Put the armor on the missing bullet holes." - The "Missing Bullet Hole" Logic: - Wald realized the data was biased because it only included aircraft that successfully returned. - Aircraft with bullet holes in the wings, tail, or fuselage survived the hits; therefore, those areas were not fatal. - There were no bullet holes on the engines or the cockpit in the returning planes. - Conclusion: Planes hit in the engines or cockpit did not return at all. These were the fatal hits. Therefore, the areas without bullet holes were the most critical to protect.
Defining the Economic Way of Thinking: The core lesson from the Wald example is that to think economically is to learn how to look for "missing bullet holes"—the solutions that are not immediately visible in the available data.
Formal Definitions of Economics and Scarcity
Simple Definition of Economics: Economics is the study of choices.
Elaborate Definition of Economics: The study of economic agents making choices under scarcity.
Defining Scarcity: Scarcity exists whenever human wants exceed the resources available to fulfill them. - Formalizing the concept of scarcity: \text{wants} > \text{available} - Application to the Aircraft Armor Problem: The problem is economic because you want to armor the whole aircraft, but that option is not available because the plane must remain light enough to fly. The "available" resource is the limited quantity of armor that can be added while maintaining flight capability.
Understanding Unintended Consequences: The Cobra Effect
The Core Advantage of Economic Thinking: It helps in identifying and understanding "unintended consequences"—how plans can backfire in ways the designer did not foresee.
Example: The Cobra Effect in India: - Context: Approximately 200 years ago, New Delhi, India, was under British rule and suffered a severe infestation of poisonous cobra snakes. - The Policy: The British offer a bounty for every dead cobra brought to them, essentially paying people to kill the snakes. - The Result: The infestation actually worsened after the policy was implemented. - The Incentive Shift: Because the bounty paid was higher than the cost of raising a cobra, people began breeding cobras at home to kill them and collect the reward. - The Backfire: When officials discovered the breeding farms, they canceled the bounty program. Consequently, owners of cobra farms released their now-worthless snakes into the wild, increasing the population further.
Friedrich Bastiat’s Philosophy: - Friedrich Bastiat, an economist and philosopher, argued that there is one primary difference between a good economist and a bad one. - The Bad Economist: Only looks at the "visible effect." - The Good Economist: Accounts for both the visible effects and those effects that "must be foreseen."
Unintended Consequences: Mandatory Seat Belt Laws
Standard Logic: Seat belts are mandatory because they reduce the rate of fatalities conditional on a crash occurring.
The Economic Result: Mandatory seat belt laws can lead to a higher total number of traffic deaths.
Behavioral Adjustment and Incentives: - Forcing someone to wear a seat belt reduces the personal "cost" of risky driving because the driver feels safer. - Consequently, individuals engage in more risky driving (e.g., driving faster, texting, or being more distracted).
The Two Competing Effects: 1. Safety Effect: Fewer people die in a specific accident because they are wearing a seat belt. 2. Risk Effect: There are more total accidents because people drive less carefully.
Identifying the Missing Bullet Hole in Traffic Data: - While belted drivers might survive more crashes, their increased risk-taking leads to more collisions with pedestrians and bicyclists who are not protected by seat belts. - This increase in pedestrian/biker deaths often offsets or exceeds the lives saved by seat belts for drivers.
Core Principles of the Economic Way of Thinking
Central Message: "People respond to incentives." All economic analysis is effectively a commentary on this principle.
Structural Components of the Economic Way of Thinking: - Social Phenomena: All social events (uprisings, movies, pandemics) arise from individual actions and the interactions between individuals. - Individual Actions (Economizing/Optimizing Behavior): Based on the assumption of rationality. - Economic Rationality: Individuals are not "insane"; they try to do the best they can given the information available and avoid intentionally harming themselves (i.e., people do not intentionally shoot themselves in the foot). - Interactions (Exchange): Individuals interact to facilitate exchange. - Cooperative order (computers, coffee, software) exists because of a remarkable degree of cooperation driven by exchange. - Specialization (Division of Labor): People specialize in different fields (e.g., environmental economics vs. philosophy) and trade their knowledge, making both parties better off.
Self-Interest vs. Selfishness: - Selfishness: Thinking only about oneself and not caring about others. - Self-Interest: Having clear objectives and pursuing them. This can include the well-being of others. For example, Mother Teresa's charitable work was technically "self-interested" because her personal objectives and interests included helping others.
The Optimization Decision Rule: - Individuals compare their Expected Additional Benefit (EAB), also known as Marginal Benefit (MB), against their Expected Additional Cost (EAC), also known as Marginal Cost (MC). - Decision Threshold: An individual will choose an action only if: - Or alternatively: - In this context, "Benefit" equals the gain, and "Cost" equals the loss or the "sacrifice" of alternative opportunities. - Example: A student watches a lecture because the expected benefit (learning) is judged to be at least as high as the expected cost (loss of time, boredom, or alternate activities).