Tuesday, 24 March 2015

The Simplicity of Economic Theory

By Fernando Herrera-González

Economic theory is the science which tries to explain economic phenomena. Just as Newton observed an apple falling from a tree and started searching for an explanation to the phenomenon, which eventually took him to the Universal Law of Gravitation, other thinkers observed the existence of a price for that apple (or the usury for loans), and looked for explanations to these other phenomena. That is the way in which economic theory started taking shape.

Unlike the fall of the apple and other natural phenomena, economic phenomena have their origin in the human individual and their actions. Absent the human being, the apple keeps falling to the ground. In contrast, absent the human being, there is no price for the apple. Economic theory does not make sense unless there are people around.

Because of this, the method for developing economic theory takes (or should take) the human being and their actions, human action, as the starting point. It is not a coincidence that Ludwig von Mises used that name for his magnum opus. The methodology derived from this is named praxeology, and it is one of the main features that differentiate the Austrian School of Economics from other economic schools.  The cornerstone on which praxeology rests is arguably the following axiom: the individual acts when they think that the state they will reach as a consequence of their action is preferable to the original state. In other words, when the ‘revenues’ they expect to obtain exceed the ‘costs’ they expect to incur. Starting from this axiom, unprovable but undisputed, theories may be developed to explain different social (not only economic) phenomena that we see around us.

Although the starting axiom may seem simple and intuitive, its application in practice is certainly complex. Firstly, the revenues and costs to which it refers are subjective. Only each concrete individual knows (or thinks they know) the costs to be incurred by carrying out a course of action, and the revenues they may attain as a consequence. However, these costs and revenues are not necessarily of a monetary nature. The motivations for most individuals, if not for all individuals in most cases, have nothing to do with receiving or spending money.