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Basic Economic Problem

Every generation believes itself to be more intelligent than the ones that went before, and wiser than the ones that comes after it. But economics defies the rule.

Economics is the study of scarcity and how consumers manage it. There are only a limited number of resources such as workers, machines, raw materials, etc. Yet there are any number of different ways in which these resources can be used. On the other hand, consumers only have a limited amount of money – despite having to satisfy lots of needs, wants and desires.

A basic economic problem arises because resources are scarce, whereas the needs, wants and desires of consumers are unlimited. Any resources that are not scarce are called free goods. The text books used to cite the air that we breathe to be a free good – before increasing air pollution worldwide caused clean air to be scarce especially in highly populous urban areas.

Economic choice is how consumers and others decide between different uses of scarce resources; and how efficient they are at producing goods and services. One consequence of economic choice demonstrates that consumers are absolutely not efficient and do not make optimal choices.

This leaves economists with a real imponderable, which they can only determine by means of making forecasts. Just as meteorologists struggle with forecasting the weather – understandably, economists find it really difficult to forecast consumer behaviour. Even Mervyn King former Governor of the Bank of England is sceptical; “Since economic forecasting is so hit and miss, the practice of giving prizes to the best forecasters makes as much sense as it would to award the Fields Medal in mathematics to the winner of the National Lottery.”

Another big issue with forecasts is economic bias. For example, 52% of US workers earn less than $30,000 a year and 73% earn less than $45,000. However, it is very likely that a trained economist compiling a forecast (on consumer behaviour) will earn substantially more than that and will, therefore, not be in a position to map out how consumers on lower incomes will behave. The bias extends further because lower-income earners irrationally shop at the local, more expensive shops; illogically spend more on gambling and foolishly smoke. Coming from a more affluent background a trained economist will recognise these behaviours as sub-optimal and will demonstrate bias in interpreting them.

Rationally the forecaster must assume that average consumers will shop around for cheaper options; will use a fixed percentage of their income on suitably risk-assessed bets and will see smoking as an extravagant luxury. Even recognising the potential bias in advance and making adjustments to the forecasts will not work because future consumer behaviours will defy the logic.

Economists will argue that all forecasts carry disclaimers outlining the assumptions that were made and the potential downsides. In essence we shouldn’t be so infatuated with forecasts but, therein, lies another dilemma.

If consumers don’t study the forecasts they are uninformed, but when they do they are misinformed!!

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