Let's Think Bigger about "The Economy"

What is “the economy?”

This might seem on its face an esoteric question, but it has ramifications for how we approach public policy questions. This question has special relevance for those of us who conduct cost-benefit analysis, which has been called the “gold standard in applied welfare economics.”

At times, I have referred to cost-benefit analysis as a tool to study how the state can grow or shrink the economy. This has often led to protests from even experienced policy analysts, saying that cost-benefit analysis transcends economics by studying impacts like nonmarket goods such as those with existence value and those generated via externality.

Superficially, these protests are either semantic arguments or misunderstandings of what the undertaking of economics is all about.

In his classic Essay on the Nature and Significance of Economic Science, mid-20th century economist Lionel Robbins puts forth the most commonly-accepted current definition of “economics”:

Economics is a science which studies human behaviour as a relationship between ends and scarce means which have alternative uses.

Robbins describes in his essay that economics is not an exercise in classification (picking out kinds of behavior, like purchases and work), but an exercise in analysis (picking out an aspect of behavior, in particular how human beings behave under conditions of scarcity).

Cost-benefit analysis is so powerful because it attacks the question of how to allocate scarce resources head-on by focusing on a specific question: how do we maximize use of social resources as defined by maximization of social welfare?

Thus, the right way to think about “the economy” is not “the S&P 500” or “gross domestic product,” it is how resources are used to give people more of what they want. Economics is not about increasing jobs or firms or even median income, it’s about maximizing social welfare.

But what does “social welfare” mean? This is where things can get tricky. Some say that maximization of social welfare is equal to the maximization of aggregate social surplus. This is what cost-benefit analysis directly answers. Others argue that welfare is maximized by conferring rights and minimizing inequality, justifying it only by improvement in the lot of the worst well-off. Some argue that welfare is maximized by giving everyone a baseline of basic goods needed to facilitate human development. Still others argue that welfare should be measured by how people assess their own lives.

This ambiguity about the definition of “welfare” has led some down some strange rabbit holes to justify the use of cost-benefit analysis, arguing that cost-benefit analysis’s job is to quantitatively estimate root moral intuitions about what is good for people’s lives. This approach tries to separate people’s desires from their well-being, saying that a desire for certain outcomes in the world do not impact an individual’s well-being and that value can only be defined as that which is directly “experienced” by an individual. Under this point of view, someone cannot “experience” wilderness that is preserved that they do not visit.

This definition of “experience” is arbitrary, though. Do people “experience” a collapsing house across the street from theirs that drives down property values? What about hate speech? The “direct experience” test relies much more on capricious judgment calls by the analyst than simply eliciting willingness to pay for outcomes.

Cost-benefit analysis doesn’t need to provide a comprehensive definition of welfare in order to be of value. The classical definition of welfare as defined as the maximization of social surplus on its own provides policymakers with much more information than they would have otherwise without having to smuggle egalitarian, human development, and subjective well-being considerations into its calculation. Maximization of social surplus can then be balanced against these other goals.

At Scioto Analysis, we ask people to think bigger about what constitutes “the economy.” We ask policymakers to consider the tradeoffs inherent in all policy decisions: that social surplus, poverty, inequality, human development, and subjective well-being all exist in an ecosystem that is characterized by scarcity of resources. The economy is much larger than stocks or GDP, it is about how we use social resources to make lives better.