Introduction to Economics Part 2 - THE LESSON

If there is any economics lesson you need to learn, it is this one. This note is based on LESSON ONE from the book Economics in One Lesson by Henry Hazlitt. A link to the free version is here:

http://jim.com/econ/

Hazlitt's lesson is summed up in this way:

"The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups."

In other words, when you look at an economic policy, you need to not only look for the results you intended to occur, but also any side-effects. This is what is called...

THE LAW OF UNINTENDED CONSEQUENCES

It's not really a law any more than Murphy's Law is a law... it just sort of refers to hidden costs. Unexpected things will happen, like when you take a medicine - you get the effect you want, but there are side-effects as well. The Law of Unintended Consequences simply reminds you that when you pass an economic policy, there will be consequences aside from the ones you intended to occur.

Let's say you're driving down the road and all the sudden you see the edge of a cliff. You think, "Wow, that's really dangerous, the government should put up a barrier there," and you proceed to drive very slowly and cautiously until the cliff side is no longer a danger. About a week later, you come back and find the government has put up a barrier. You are now more at ease, and you don't use as much caution in your driving. The thing is, while the barrier may have reduced the severity of any accident that happened there, the psychological results of the barrier actually increase the likelihood an accident will happen, because drivers will drive less cautiously. This result on the psychology of the drivers is an unintended consequence of adding the barrier. If the drivers overestimate the safety the barrier brings, they may be in more danger because of the barrier than they were if it had not been installed. Thus, when taking such safety measures, all consequences, both intended and unintended, must be taken into account in order to decide what the best course of action is.

THE BROKEN WINDOW

To illustrate the Law of Unintended Consequences in Economics, we have a story! It was first introduced by Federic Bastiat, and later used by Hazlitt. It's the Parable of the Broken Window.

One day a mischievous little boy throws a rock through the window of a baker's shop. The baker, furious, runs out of his shop and yells at the little boy, who immediately runs away. Within seconds a crowd has gathered around the baker's shop, regarding the shattered window with various reactions. After a few minutes, the crowd becomes philosophical.

"Why is he so angry? Does he not realize what a fantastic thing this is? Because of the broken window, a glazier in town will now be employed to fix it. The actions of the little boy have brought stimulation to our town's economy. Far from being a public menace, he is actually a hero."

This is a fallacy, and an all-too common one. The crowd immediately understands the first-order reaction of the broken window - the employment of a glazier. What they fail to recognize is the economic activity which would have taken place had the window not been broken. Perhaps, that very afternoon, the baker had intended to go to the tailor and purchase a new suit. Unfortunately, now that the window has been broken, he can no longer afford the suit. The glazier's business comes at the expense of the tailor. Overall, if we view the town as a system, the entire town is poorer one suit as a result of the little boy's mischief.

This may seem obvious, but you'd be astounded how many economists, politicians, and pundits fail to recognize this fact. When the tsunami hit southeast Asia, there were many pundits around the world who claimed that the tsunami had a bright side, since it would cause economic activity. Since all those villages had been destroyed, they would have to be replaced by new infrastructure, which would employ builders, electricians, plumbers, and all sorts of people. The tsunami was in fact a blessing!

You can't say that the new infrastructure is more valuable than the old because the whole value of the old infrastructure had not yet been extracted. How many cities begin their reconstruction processes by evacuating the population, bombing the cities to the ground, and then starting from scratch? They don't do it because it's not worth it! The only way the claims of these pundits could ever possibly be true is if the tsunami happened to strike at the exact moment the population had wished to dismantle and rebuild their villages anyway. This is the Broken Window Fallacy, and it is very important people recognize it when they hear it.

Now, in any parable, different characters represent different things. By and large, the little boy represents the government. The government runs over, breaks a window, and goes "Oh look, I'm so fantastic, I'm making jobs!" The breaking of the window takes many forms from taxation to minimum wage laws to other controls on the economy. While people may see the bridge constructed by the government, they are unable to see the projects which would have been possible had the government not taxed the population to build the bridge. While people may see the workers making minimum wage, they cannot see the workers who would have been employed if the minimum wage did not exist.

This is why we must constantly look beyond the obvious, visible, direct consequences of an action and recognize the second and third-order consequences.

Thanks for reading! Have a nice day :-)