I have a friend who recently returned to her home in Germany after finishing her studies at Monash. Having spent the last two years modelling profit optimising and utility maximising behaviour, she is now baffled by the habits of her parents. Apparently, in Germany, it is incredibly easy to get high quality bike parts online at very low prices. Despite this, her parents continue to go to their local bike shop, which offers a limited range of products at higher prices. Why? Because they like having local shops around where they can talk to a person.
Stories like this are often the basis of criticising the underlying logic of economics. Someone could point to this example and say ‘See! Humans are not calculators!’ and justify rejecting economics with a wave of the hand. What’s more, that person may have a point: Suppose the parents had chosen the cheaper and higher quality online product. Firstly, they would have sent a small but crucial reward signal to that particular producer. This signal not only rewards that producer for its efficient business model, but also sends an indirect signal to other competitors and entrepreneurs to imitate such efficient behaviour. Similarly, it punishes the inefficient producers that failed to offer similar goods at better prices. This punishment will either encourage the inefficient firm to similarly restructure its production process, or alternatively, it may ultimately be forced to exit the market. If it exits, it releases its labour and capital into the wider economy to be taken up by other firms, able to find more efficient uses for them. What’s more, if they had bought the cheaper part online, they would have had more disposable income left over to be spent on some other good, which in turn would reward the firm that produces that other good and so on and so forth. It is this signalling process of trade amongst willing individuals that underlies the ongoing wealth creation of free societies. But her parents did not choose the cheaper option. At first glance, it seems that such conduct undermines the logic of free enterprise. However, initial impressions can be deceiving.
At some point in first year or second year microeconomics, we are taught that individual utility is subjective: What an individual finds beneficial or costly is entirely up to them. In other words, it is not up to the economist to judge the merit of what people like and don’t like – that’s their decision. All the economist can do is attempt to analyse how they try and maximise their utility given their constraints. Unfortunately, this lesson is easy to forget. When we see microeconomics as maximising profits and minimising costs, we may accidentally absorb the lesson that rational economic behaviour involves maximising income or wealth. However, when you really embrace subjectivism and concede that individuals have unique preferences, all sorts of seemingly ‘non-economic’ behaviour becomes just as economic as any other. Charity work, altruism, the incredible sacrifices people make for their loved ones and even the extreme danger one may put themselves in to help another all can be deemed perfectly rational when we acknowledge the subjective nature of preferences. Returning to my friend’s parents, they clearly place high value on being able to talk to someone directly about their bike. In fact, their valuation of this service is so high that they would rather build that relationship than pay less for a better quality product. If we recognise that utility is subjective, we must conclude that they are being perfectly rational from an economic point of view.
An alternative line of attack could involve considering social or macro-utility. While the behaviour of my friend’s parents may optimise their personal utility, it may not be good for aggregate utility across society: as was argued above, their behaviour inhibits the wealth creating process of free societies as the inefficient firm has been rewarded and the efficient firm has been punished. Indeed, this argument is probably true in terms of the creation of financial wealth. Again though, it does not truly recognise the radical implications of subjectivism. An efficient system is one which optimises benefits while minimising costs. But benefits and costs, again, are subjective. Suppose you are invited to a party and you are working out whether to go. Some people would immediately decide to go because they just love parties. Others may have the complete opposite reaction, whether it is due to their dislike of crowds and noises or their preference to read a book. If you’re lazy like me, your decision may depend on how long it takes to get there, whether the venue charges admission, whether you’ll have to line up and whether you’ll take public transport or drive. The costs and benefits are determined solely by the individual in question. Similarly, the determination of whether a firm has an efficient business model is just as subjective and depends entirely on the individual’s perspective. Again returning to my friend’s parents, the financial cost of paying more for the bike part of a lesser technical quality is clearly dominated by the benefit they obtain from developing a relationship with the person in the store. Indeed, from their perspective, the overall experience of purchasing the product from the store, combined with getting the product for their use, is of far greater value than the efficiency achieved from buying online. So ultimately, they are rewarding what they consider to be the most economically efficient firm. The thing is, their preferred firm will survive if it continues to make an economic profit. It will make an economic profit if a sufficient number of people prefer to trade with that firm rather than with an alternative (that they are aware of). In other words, if that firm continues to make an economic profit, that firm must be efficient from a broader social perspective.
This captures one of the most undervalued advantages of how free enterprises allocate resources: Preferences across society are entirely heterogenous! Some people prefer online shopping, others prefer interacting with real people. In a free society, both business models can be provided if they are able to attract enough customers to cover their economic costs. We still get an economically efficient outcome, even if that outcome may not be financially efficient. The same logic explains how some people much prefer hand crafted furniture, even though it may not be as precise as a factory made chair. There is something intrinsically valuable to the consumer in the time and effort that one person dedicated to making that object. It would be wrong to describe such products as economically inefficient, even though we know there are more financially efficient substitutes available.
Ultimately, economics is the study of understanding the allocation of resources in a world with scarcity. If we want to understand how resources are allocated, we must be able to take into account the unique preferences that guide the incredibly diverse behaviour of people in the world. It seems to me that the most obvious way to do that would be to acknowledge that costs and benefits are calculated subjectively. We must never forget that one person’s junk may be another’s gold.