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POLICY BRIEF 3 • NOVEMBER 2012 Economists and Res Publica The Virtues and Limits of Economic Analysis By Steven E. Rhoads This policy brief is the third in a series by AEI’s Program on American Citizenship. The program is dedicated to strength- ening the foundations of American freedom and self-government by renewing our understanding of American citizenship. For more information about our work, visit www.citizenship-aei.org. With the possible exception of lawyers, economists are prices coordinate the activities of millions of people in a now the profession with the most influence on public remarkable and typically sensible way. Understanding policy. In the 1960s, when I began working at the US both the principles that drive this outcome and how to Bureau of the Budget, Charles Schultze, an economist apply them to new situations is what allows economists to and then-director of the bureau, tried to ensure that most see themselves as uniquely equipped to design sound pub- of the public policy and program evaluation offices were lic policies. headed by economists. Economic thinking still domi- nates the Office of Management and Budget, the Con- gressional Budget Office, and the General Accounting The Economist’s Toolbox Office, and it is influential in policy and program evalua- tion offices across US agencies and departments. More- Noneconomists usually associate economists and policy over, economic thinking is at the forefront of most public analysis with the macroeconomic questions of inflation, policy schools at our leading universities. Intentional or unemployment, and economic growth. This is understand- not, economists now have a large say in forming the laws able since macroeconomic issues are always in the news and regulations we make as a polity. The question that and economists are generally thought to be the experts in naturally arises is: what are the civic benefits that accrue this area. In the wake of economists’ failure to warn of the from adopting the economist’s view of the world—and, 2008 financial collapse, and their failure to quickly rem- in turn, what are the limitations? edy it, respect for the discipline is not now high. No doubt, economists have a distinctive way of look- Nevertheless, it would be unfair to tar microeconom- ing at the world—one that often runs counter to the ics with the failures of its flashy sister macroeconomics. views of noneconomists. Economists generally agree that, For every government economist using macroeconomics once distributional and equity issues have been sorted out, when making policy recommendations, many others are commercial, capitalist societies best allocate resources in a using applied microeconomics methods such as benefit- way that satisfies most people’s desires. Yet it is not intu- cost analysis. Applied microeconomics deals with the itively obvious that an economic system in which every- allocation of scarce resources between alternative and one can work at whatever they want and wherever they competing ends. For years this was the standard definition want will work better than one that asks our smartest of economics, and most mainstream economists still con- minds to plan the economy. As Nobel laureate Kenneth sider microeconomics to be the more solid of the two Arrow noted, to one unschooled in economics, an econ- branches of the discipline. omy motivated by greed and controlled by no one brings The resource allocation side of economics provides to mind chaos.1 But, in fact, free markets with flexible two types of policy guidance. The first type derives from POLICY BRIEF 3 microeconomic concepts that are not meant to be checkbook knows something of opportunity cost in the comprehensive or conclusive. They are instead things to family context. But in the public policy context, it is eas- be kept in mind, or factors to be weighed against other ily forgotten. Thus, when Congress proclaimed that the relevant factors. Though these concepts are less ambi- discharge of pollutants in navigable waters “shall be elimi- tious, they are not necessarily less useful. Noneconomists nated by 1985,”2 it appeared to ignore the resulting costs can learn much from the concepts of “opportunity cost,” in terms of more air pollution and solid waste disposal, “marginalism,” and “incentives.” since achieving zero discharge in all areas simultaneously The second type of guidance, stemming from is impossible. Similarly, when government reports discuss welfare and benefit-cost economics, is very ambitious. environmental damage from offshore drilling without Appealing to the principles of welfare economics, econo- mentioning tanker spillage of oil which would have to be mists speak with conviction about subjects as grand as the imported if the drilling does not proceed, they are ignoring justifiable objectives of public programs and the appropri- the opportunity costs of a reduction in offshore drilling. ate functions of government in a capitalist system. Exter- nalities help shape economists’ views on appropriate government programs, while benefit-cost economics, the Critics sometimes define economists applied branch of welfare economics, goes even further and advises policymakers about how much money should as those who know the price of be spent on justifiable objectives and functions. everything and the value of nothing. Opportunity Cost. There is much talk these days about government programs that do not achieve their objec- tives. The economist, however, sees a bittersweet quality Economists duel with noneconomists because the in even those programs that do achieve their objectives. latter too often say that costs should never prevent policy The crowd at the groundbreaking for a new community changes that would lead to lives being saved. But “safety recreation center finds it a happy occasion that will soon first” is a good principle only if opportunity costs are rea- make available wholesome sports for the young and sonable. An unending number of hypothetical programs community-building opportunities for senior citizens. could save lives. Take highway safety. We could save lives The economist broods, “Yes, but by spending the money by banning all left turns, by doubling the size of road here and not elsewhere, we give up road improvements shoulders, or by cutting speed limits in half. Even if we that could save two lives a year, the remedial reading pro- did all this, we could save even more lives if we redoubled gram that might raise low-income students’ test scores a the size of road shoulders and cut the speed limit in half full grade, and the larger jail that could reduce our crime once more. Few of us, however, would want to abandon rate. And what about the other recreational opportunities all our other goals so as to save fewer and fewer lives for that local families might enjoy if the tax dollars to pay for any given marginal cost. this center were left in their pockets?” Economists are convinced that many intelligent Critics of the latter line of reasoning sometimes noneconomists do not know how to think about costs. define economists as those who know the price of every- When a local official, for example, explains that city recre- thing and the value of nothing. In economists’ defense, ation policy gives primary consideration to public welfare however, a concern with costs is really a concern with val- but that cost considerations are also important, he suggests ues. Our brooding economist is worrying about recreation- that costs are something other than public welfare forgone center costs precisely because he cares about the victims in other public programs and in the private sector. of road accidents and about disadvantaged children. Added costs leave us with fewer resources available to Marginalism. Marginalism involves understanding that pursue values in other policy areas. In other words, when- most budgeting decisions concern whether we should ever the costs (and benefits) of one program increase, the spend a little more or a little less—not whether we should costs and benefits of some other program decrease. This is address a problem at all. Marginalism means giving up on the opportunity-cost insight—the understanding that the old proverb, “Anything worth doing at all is worth spending and regulatory decisions that use scarce resources doing well.” As we reduce pollution, car accidents, incur costs in terms of forgone alternatives elsewhere. crimes, and fires, reducing them still further becomes This seems so obvious that one wonders why it is more costly. At some point the marginal costs of a pro- worth discussing at all. Anyone who has to balance a gram’s expansion will exceed the marginal benefits, and 2 POLICY BRIEF 3 we will have to settle for less than what interested citizens As seemingly simple as this concept is, it is often or professionals think is necessary if we are to “really” ignored by policymakers. For example, the tens of billions solve the problem. of dollars spent since 1936 on flood-protection projects Some years ago, the president of a religious associa- and disaster-relief programs has not reduced total flood tion wrote that health care is an “essential community damages as expected for the simple reason that the service.” He called it essential because “persons requiring reduced risks of building on flood plains has led to more health care have no options other than to seek health building in those same or adjacent areas. Similarly, a pay- care.”3 But when I visit a physical therapist for treatment roll tax nominally paid by the employer is more likely to of my tennis elbow, I am not near death, nor even in be borne by workers in the form of lower wages than great pain. The treatment I receive may not even help me they would otherwise receive. Although women take get back on the tennis court more quickly.

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