Seth Godin has a daily blog where he writes about many topics. A lot of the topics have to do with the world we live in. Yesterday he posted a blog titled Economics is messy in which he claimed there were “a lot of myths in the intro to economics course.” I respect Godin’s blogging, but his understanding of economic principles leave a lot to be desired.
Below is a point-by-point economic demythification of his points:
1. Rational decisions
Human beings make rational decisions in our considered long-term best interest.
Actually, behavioral economics shows us that people almost never do this. Our decision-making systems are unpredictable, buggy and often wrong. We are easily distracted, and even more easily conned.
Every time we assume that people are profit-seeking, independent, rational actors, we’ve made a mistake.
Humans might factor their perceived long-term interest into their cost-benefit calculation, but humans don’t posses a crystal ball to foresee their long-term best interests. Instead, humans make decisions based on what they perceive will be best for them. In hindsight, this could be determined irrational, but at the time of the decision they convinced themselves they were making a rational choice. People aren’t rational actors in the sense that rationality is perfect. Humans act in their perceived best interest whether their perceptions are perfect or imperfect.
And let’s not get started on the phrase “behavioral economics shows.” All behavioral economics shows is that a lab can create results in-line with researcher’s desires. To quote the Mises Institute, “Human beings are not viewed as necessarily rational because they act and choose as they will. Researchers view human beings as rational only if they obey certain axioms or models of the researchers. This implies that researchers almost surely will uncover irrationality because human behavior rarely coincides with a model.”
2. The Free Market
The free market is free.
The free market only works because it has boundaries, rules and methods of enforcement. Value is created by increasing information flow and working to have as many contributing citizens as possible.
That’s wrong, the free market is free. “Boundaries, rules, and methods of enforcement” are created by the state.
In an actual free market, value is created by improving another person’s life. It doesn’t matter about information flow, what matters is that the person who desires a product is supplied that product. If more than one person supplies it then the person who creates the superior product, or offers the lowest price, will win the business. It’s up to the participants in the business transaction to decided if it’s a worthwhile exchange by weighing their perceived costs and perceived benefits.
Additionally, boundaries are unenforceable. In a free market, a monopoly is impossible. If Supplier A and Supplier B collude to charge higher prices to their customers, without barriers to entry (i.e. state-sanctioned business licenses), Supplier C will undercut the price and take the profits. Because of this fear, both A and B don’t collude and they compete for the lowest price. The state’s rules, enofrcement, and boundaries, are the only thing interfering with the free market.
3. Profit Demonstrates Value
Profit is a good way to demonstrate the creation of value.
In fact, it’s a pretty lousy method. The local water company clearly creates more value (in the sense that we can’t live without it) than the handbag store down the street, and yet the handbag store has a much higher profit margin. That’s not because of value, but because of mismatches in supply and demand, or less relevant inputs like brand, market power and corporate structure.
Profit is often a measure of short-term imbalances or pricing power, not value.
I hope we can agree that a caring nurse in the pediatric oncology ward adds more value than a well-paid cosmetic plastic surgeon doing augmentations. People with more money might pay more, but that doesn’t equate to value.
The best way to measure value created is to measure value, not profit.
This is the most mind-boggling statement of them all. Profit is the only way to demonstrate value.
Value is subjective. What I deem valuable, say skis for going to the mountains, has no value to a person residing in Miami. Does that mean paying $300 is overvalued? To me, no. To someone in Florida that has no use for skis? Probably.
Water Diamond Paradox
Let’s put it another way. Say you’ve been lost in the desert for three days. You have no food, no water, and no shelter, all you have is $1,000. A diamond salesman comes along who’s selling diamonds for $10 each. You say, “I don’t want stinking diamonds, I just want water!” He shakes his head and says he’s sorry, all he has are diamonds. A bit later a water truck arrives. The water salesman is selling glasses of water for $500 each. A cup of water for $500! Since you’re near your death-bed you buy two glasses of water and guzzle them down. Seems unfair right?
If you hadn’t been dying of thirst you probably would’ve bought 100 diamonds for $10 each. But at that point in time you didn’t care. What you cared about was being alive. What is valuable to you changes based on your circumstances. The only way that water truck is in the desert is because that $1,000 for two glasses provides enough money (enough profit) for the water salesman to drive around in the desert all day.
4. The Purpose of Society
The purpose of society is to maximize profit
Well, since profit isn’t a good measure of value created, this isn’t at all consistent. More important, things like a living wage, sustainability, fairness and the creation of meaning matter even more. When we consider how to advance our culture, “will it hurt profits?” ought not to be the first (or even the fifth) question we ask.
Maximizing profit is the purpose of society. Here’s the definition of an entrepreneur from the Library of Economics and Liberty, “An entrepreneur is someone who organizes, manages, and assumes the risks of a business or enterprise. An entrepreneur is an agent of change. Entrepreneurship is the process of discovering new ways of combining resources. When the market value generated by this new combination of resources is greater than the market value these resources can generate elsewhere individually or in some other combination, the entrepreneur makes a profit.”
By maximizing the resources around her, the entrepreneur is able to improve society as a whole. She acts because there is a profit to be made. So, “will it hurt profits?” is a question to be asked because making a profit means combining goods to maximize the value to society.
5. Stock Prices
The price of a stock represents the value of the company.
It turns out that the price of a stock merely reflects what a few people decided to trade it for today. Tomorrow, it will certainly be different, even if nothing about the company itself changes.
There’s very little correlation with how the traders come to value a company in the market and how much value a company actually creates.
I’d agree. This is a myth.
Although, I’m not sure how many people believe a stock represents a company’s value. After a stock is entered onto the stock market, like through an IPO (initial public offering), the company isn’t the thing being traded. A stock is being traded, which is a different commodity than the company itself. Thus, a stock doesn’t determine the value a company creates, it merely reflects the perceived value of the stock.
6. A Company’s Purpose is to Maximize Long-Term Shareholder Value
The only purpose of a company is to maximize long-term shareholder value.
Says who? Is the only purpose of your career to maximize lifetime income? If a company is the collective work of humans, we ought to measure the value that those humans seek to create.
Just because there’s a number (a number that’s easy to read, easy to game, easy to keep track of) doesn’t mean it’s relevant.
This goes back to the definition of value. A company’s main purpose is to maximize profits, which in turn maximize efficiency for society. If a company is consistently innovating themselves then it is able to provide the best product to society. The maximized profit is society giving the company recognition of an efficient service.
Economics Isn’t Messy, Humans Are
The post “Economics is messy” had an underlying tone implying capitalists are evil, and the only people who create value are those who are stuck in the trenches. Although I want to see people with less money grow richer, the way Godin portrayed his points was far from sound economic thought.
Economics isn’t a messy subject. Economics is about creating something better for society, having society agree with the value, and improving the world around us. The study of humans is a messy subject because humans act in their own self-interest without perfect information. Understanding economic principles is important. Making a profit is about creating value for society, value which helps us live in a more efficient world each and every day.