Wednesday, September 05, 2007

The Trouble with Economics

Is that too many people misuse its theories. Actually, that's the trouble with people and their habit to pass off overly stretched analogies as arguments. However, 'the trouble with people' is a little too cynical for my tastes. Misanthropy is best left to Nilu and the dictator. (I'm repaying your link love in kind, dictator). Hence, the title of the post.

So why do I say this? Exhibit 1. Niranjan Rajadhyaksha argues that school children should have more choice and specialization in the subjects that they study. He brings in David Ricardo and the theory of comparative advantage in the picture. He draws his conclusions by presenting an analogy with the situation his daughter faces at school.Why is this analysis and analogy flawed? Many reasons - economic, empirical, educational, practical and philosophical. Let's deal with the flaw in the economic logic of the argument in this post.

What does the theory of comparative advantage say? Essentially, that firms/countries should focus on what they do best. The classic example that Ricardo considered is that of the trade of cloth and wine between England and Portugal. England produces cloth more efficiently than wine and Portugal produces wine more efficiently than cloth. Also, Portugal produces both the products more efficiently than England. The result from the analysis is that Portugal should produce enough wine to meet both countries' demands and no cloth at all and England should produce cloth for both countries's demands, but no wine at all. It is a very strong argument in support of free trade and specialization. Mr Rajadhyaksha argues that similarly, his daughter, who his apparently not too keen on art, should not be made to study art as a compulsory subject and should instead be allowed to specialize - possibly to leverage her comparative advantage. (some B-school jargon was bound to creep in).

Ricardo's theory is one of the most insightful in the entire field of classical and neoclassical microeconomics but it makes certain assumptions, namely

1) There is free trade of goods (explicit)
2) There is no trade of labour or capital, i.e factor inputs (explicit)
3) The demand for the traded products is reasonably similar (implicit, because what is actually being measured is the opportunity cost)

Here, the 'good' that his daughter will specialise in is a certain level of competence in a field or a subject. It is thus safe to assume that the free trade assumption holds true. However, the second and the third assumptions are not true. The factor inputs in this case are aptitude and capital (the investment into the education to gain these skills) and on the individual level, capital can easily be traded. The situation will hence move towards absolute advantage. The product that her daughter, or anybody for that matter, will get in return for their skills is money. Money has a high demand almost universally. The same is not true for the product traded in return - i.e skills.

Mr Rajadhyaksha is fortunate that his daughter has a disliking for the visual arts and a preference for the more conventional subjects. What if it was the other way round? What if, in addition, Mr Rajadhyasha belonged to a less privileged socio-economic segment. The economy places a high premium on numerical and verbal skills and lesser on the visual arts. It then makes more sense for his daughter to focus on math and science rather than pursuing the visual arts, even though her 'comparative advantage' lies in the visual arts. If you are a better artist as well as a better computer engineer than I am (absolute advantage), in the given economic environment it makes more economic sense for you to become a computer engineer even though you are a better artist than you are a computer engineer (comparative advantage). In terms of economic opportunity cost, the area in which you have a 'comparative advantage' may be very different from the area in which you have a comparative avantage in terms of pure aptitude or skills. The unnecesary introduction of Ricardo shows a failure to 'think it through' at best, and shallow intellectual show-offism at worst.

With reference to the misuse of economic theories, everyone would do well to remember what a cetain Mr Neelakantan Rajaraman once said - and I quote him verbatim - "Economics is the result of the human condition, not the other way round." Instead of superficial impositions of economic theories by presuming their a priori correctness in all situations, one must strive to fully analyse the actual situation and see if it has any implications on the nuances and assumptions of the theory itself. At the very least, one must strive to avoid this tendency to name-drop when one writes. Ricardo may have been right Mr Rajadyaksha, but if you ignore the foundations on which his theory is built, you may turn out to be absolutely wrong. And you will not fool us simply because because you mention Ricardo.

For the other reasons detailing why that article says too little too callously , readers must wait with bated breath for the next post.

4 comments:

confused said...
This comment has been removed by the author.
confused said...

Ritwik,

Well argued. However, you ignore one thing: the difference between her abilities as an artist vis-a-vis as a computer enginner. If she is a middling artist and a bad ccomputer engineer, it makes sense for her to focus on the latter. However, if she is an absolute genius as an artist, compputer enginerring would be less renumerative.

zen babu said...

Confused,

You're right. In the example that you mention, the opportunity cost of being a computer engineer becomes higher than the opportunity cost of being an artist. Exactly how much of a genius she would need to be for your condition to be satisfied would be decided by the demand for artists and art vis-a-vis the demand for computer engineers.

By ignoring this all important external factor of maket demand, and fudging 'comparative advantage' to mean comparative advantage in terms of intrinsic skils rather than oportunity costs, Niranjan Rajadhyaksha heavily trivialised the issue. Not to mention, ofcourse the high-handed "this is where the principles of economics come in". Severe irritation comes when one sees such flights of ideology being passed off as sound economic logic.

doubtinggaurav said...

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