Economics is really about people
(Introduction to Economics, Lesson 3)
Far from being about money, Economics is very much about people. In fact, it might very well be viewed as a branch of psychology. The decisions people make, the way people make decisions, the motivations behind their decisions and the factors and influences that affect their decisions — all these matters are fundamental to Economics.
It is sometimes said that Economics is the study of humans in the everyday business of life. It’s about how humans go about meeting their needs and pursuing their desires and ambitions. Another useful definition is that Economics is the study of human behaviour in relation to the use and allocation of resources. These are not universally-accepted definitions, but think about it and you’ll realise that there’s a great deal of psychology involved in pretty much everything Economics gets involved in.
What is the market price of a house? Well, ultimately that depends upon the decisions made by individual humans. It depends on the decision made by the owner as to how much they are prepared to sell it for. It depends on the decisions made by prospective buyers as to how much they are prepared to pay for the house in question. It depends on decisions made by bank managers as to how much they are prepared to lend to the prospective buyers.
Revenues, profits, production levels, advances in technology, inflation rates, GDP, tax receipts, demand, educational standards — these all depend on the cumulative effects of decisions made by millions of individuals. The state of the markets, the state of the nation and the state of the human species as a whole depend rather precariously on the decisions of millions of individual human beings.
When studying how people behave and trying to predict the future, it is important for economists to remember that humans are not entirely rational creatures. The question of how rational or irrational people are is at the heart of many issues in Economics. Sometimes, people follow clear, logical patterns of behaviour, but they also have the capacity to be irrational and illogical. Humans, as we know, can be moody and sulky, flippant, irresponsible and reckless.
The failure to understand that Economics is fundamentally about human psychology, is at the heart of people’s misunderstandings about Economics.
Economics is a science, but economic choices and thus economic theories are always at the mercy of human psychology. People change. Human beings are capable of changing, adjusting and adapting. That’s why we’re such a successful species! This also means, however, that economic theories can sometimes have a limited shelf-life.
For a time, people may behave in a predictable way and, consequently, a particular economic theory may prove useful for a while — but, one day, people may start to behave in a different way and a new theory may be needed to predict future behaviour. This doesn’t mean that the original theory was wrong or that it wasn’t useful at all — only that it may not be accurate for all time.
For example, you might have a theory that house prices follow a ‘bubble’ pattern of several years of rapidly rising prices, followed by a sudden drop (the bubble bursts!) and then the whole cycle starts again.
The reason this pattern may occur is that, when house prices rise, people often imagine that prices will continue to rise. They may believe that there is easy money to be made by buying houses and then selling them for a profit later on. The chance of easy money sees lots of people clambering to buy houses and this does indeed cause prices to rise further.
Then, having paid a lot for their houses, some people start to struggle to make their mortgage payments. People start to realise that house prices have become ridiculously high and that people can’t really afford such high prices. A degree of panic sets in — and house prices suddenly collapse as people scramble to sell property before prices fall even further.
This theory about how house prices behave may appear to be correct — for some time — but, if people start to recognise this pattern, they’ll start to realise that rapidly rising house prices are often a precursor to a collapse. This knowledge makes them more cautious about buying property in the first place. They’re no longer willing to pay so much for a house. As a result of such forward-thinking, the house prices bubble may never occur in the first place.
So, people change. They adjust their beliefs and their behaviour and economic theories have to adjust in turn. This doesn’t mean, however, that the economists who came up with these theories were incompetent or that Economics is not a valid, scientific discipline. Economics is a science. We study patterns, but these are not the immutable patterns of physics — they are patterns of human behaviour and subject to change as humans change and adapt to the changing world they live in.
By recognising and remembering that Economics is a branch of psychology, we can avoid getting stuck with economic theories that, whilst they may have proved very useful in the past, no longer fit the way people are behaving now or how they are likely to behave in the future.
So, Economics is, in many ways, a branch of psychology. Understanding people helps us understand our economy. What is, perhaps, even more interesting, however, is how studying our economy can help us understand more about people.