Exploring the Broken Window Fallacy

In 1850, Frederic Bastiat, a member of the French assembly and perhaps the earliest member of the Austrian School (though it had not yet been founded, his contributions to the Austrian School's teachings are central to our way of understanding the economy) wrote an essay titled "What is Seen and What is Unseen". At the time, there was a push by many assemblymen and French citizens to engage in forms of industrial protectionism. The objective of this, they argued, was to give domestic industry time to grow so that it could more suitably compete with foreign industrial interests. In some cases, there were calls to seize or destroy foreign-held factories to allow French industries to use or rebuild them, and at one point M.F Chamans (a fellow politician) argued that if the French government were to burn Paris itself to the ground, then trade would increase rapidly to fund the rebuilding and that such economic activity would make the whole of France better off.

In writing his essay, Bastiat sought to enlighten his countrymen about the real effects of the actions they had proposed. He starts with what is commonly called the Parable of the Broken Window, the bulk of which goes as follows:

Have you ever witnessed the anger of the good shopkeeper, James Goodfellow, when his careless son has happened to break a pane of glass? If you have been present at such a scene, you will most assuredly bear witness to the fact that every one of the spectators, were there even thirty of them, by common consent apparently, offered the unfortunate owner this invariable consolation—"It is an ill wind that blows nobody good. Everybody must live, and what would become of the glaziers if panes of glass were never broken?" 

Now, this form of condolence contains an entire theory, which it will be well to show up in this simple case, seeing that it is precisely the same as that which, unhappily, regulates the greater part of our economical institutions. 

Suppose it cost six francs to repair the damage, and you say that the accident brings six francs to the glazier's trade—that it encourages that trade to the amount of six francs—I grant it; I have not a word to say against it; you reason justly. The glazier comes, performs his task, receives his six francs, rubs his hands, and, in his heart, blesses the careless child. All this is that which is seen. 

But if, on the other hand, you come to the conclusion, as is too often the case, that it is a good thing to break windows, that it causes money to circulate, and that the encouragement of industry in general will be the result of it, you will oblige me to call out, "Stop there! Your theory is confined to that which is seen; it takes no account of that which is not seen." 

It is not seen that as our shopkeeper has spent six francs upon one thing, he cannot spend them upon another. It is not seen that if he had not had a window to replace, he would, perhaps, have replaced his old shoes, or added another book to his library. In short, he would have employed his six francs in some way, which this accident has prevented.

What Bastiat is attempting to say here is that, although we may see the destruction of this window as a benefit to the glazier, and that paying the glazier helps keep him employed. Extrapolating that view to the whole economy, one would be inclined to suggest that such destruction,, in varying forms and functions, actually helps the economy grow and advance over time. The flaw Bastiat seeks to highlight here is that, although this theory holds weight when one looks at all the visible factors, it does not take proper account of what is not seen, namely the events which could have happened had the window not been broken: the shopkeeper could have spent his money another way, and in so doing had both a working window and something else; he could have saved his money, allowing him to better invest in his business in the future or pay for his son's education. Any number of actions could have been performed with those six francs, but his actions are now determined for him by the actions of his son. Because the shopkeeper would not have chosen to fix his window had his son not broken it, clearly that was not his preferred use for that money, and being forced to fix it causes him to gain less utility than he could have.

From this, we clearly see the concept of Opportunity Cost at work, though the term would not be coined for another 60 years. We also see that, although some economists suggest destruction (or destruction by another name, such as War) as a means for growing the economy, such actions merely lock us into a single course of action, which does not provide us the utility yielded by being able to choose for ourselves.

Humans as Rational Actors

Now that we have discussed the underpinnings of general Economics, it would be best to cover the ideas which underpin Austrian Economics specifically, so that we may see how it may differ from other schools and know the basis from which Austrians make economic judgments. Primary among these differences is its approach to human action and how the actions of individuals are determined by the information and economic preferences of those individuals.

In this study, Austrians work from one assumption first and foremost. This is that humans are rational actors,  meaning that they make choices which are rational in relation to their preferences and the information they possess. This means that any person, in any situation where they are faced with a series of choices, will make the choice which suits them best. To put this in terms of our previous post, the choice made is the one with the lowest perceived opportunity cost of action, and as such provides the most utility to the individual making the choice at the time.

There are two points which must be made in order to clarify this point: The first is that people, at all times, in all states of mind, are making rational choices. Regardless of mental or emotional state, a person's choices will always suit their current preferences and provide them the most utility. When a person is angry at someone else and decides to punch him in the face, that represents a rational choice based on his current preferences because, to him, the opportunity cost of not acting on his anger then and there was higher than the cost of further potential violence against him.No action an individual makes is excluded from this principle of rationality, and to suggest such would inherently work against the basis of our premise.

The second point is to remember that when we say rational, we do not mean that all people will make the same choice when faced with the same information. Essentially, "rational" does not mean "agrees with you". To put an example in: Suppose two people each find $100 on the sidewalk. They live in a busy city, and could both use the money, whereas trying to find the person who dropped it would be very hard if not impossible. Now, in this situation, we might think that the rational thing to do would be to keep the money, and go on his way. We may also think that the rational thing would be to at least try to find out who dropped it, since that is a lot of money to just lose. And both would be correct; if one of the people decides to ask nearby people if they dropped the money, and the other decides to fold it back up, put it in his pocket, and walk away, both of them have behaved rationally.

How can this be? Because rationality is not a value judgment of a person's decisions, merely an observation of the process they used to reach that decision. When we say an action is rational we mean that the person making the action took the information available, then considered and weighed it against their preferences to reach the best choice. Oftentimes, claims against the Austrian School's perceptions of rationality are due to confusion on this point; they assume that rational choices are the same for everyone, rather than different from one person to the next based on preference.

Note: I intend to be posting 3 times a week, on Mon/Wed/Fri. That way I can balance this blog with other activities while still being thorough in my posts.

The Twin Laws of Economics

Now that I've outlined Austrian Economics specifically, I figure It would be best to backtrack, and cover the basics of Economics in general, so that any later commentary doesn't breed confusion through the use of unfamiliar terms. In that vein, the best place to start is at the immutable laws which direct our study and analysis. Every science or study has laws which govern the actions of its relevant parts, and many of these overlap. They include The Laws of Gravity, Motion, Thermodynamics, and many others too numerous and specific to go into here. Although Economics shares these (in that the actions we study occur in a universe where these hold true), its nature as a human, or social, science means that it must have laws that deal specifically with the concepts at hand. Many of you will likely have encountered these in the past, as they are usually the first material covered in a basic Economics class, but I would like to provide it here in case someone reading was not fortunate enough to benefit from a a class in Econ before.

Law of Scarcity

Economics, is, at its heart, "the study of the actions and choices people make when faced with inherently scarce resources". This is the clearest and most generally accepted definition of the field, and in it is contained our first law: The Law of Scarcity. Any resource you can think of, no matter what it is, how it is made, or what it is used for, is inherently scarce, in that there is a definitive amount of it in existence, and that amount cannot possibly be enough to satisfy all of the desires people have in relation to it.

To provide an example: We use wood and wood products for a lot of different things in the modern world. From construction, to paper, to starting fires and making sports equipment, many people and businesses need wood to satisfy their wants. Now, imagine that there were an infinite number of trees in the world, and that every time we cut one down, another one would spring up, full grown, right in its place. If this strange phenomenon were to take place, do you think we would consume more wood? Of course we would! Wood would be so plentiful that it would be cheap, if not basically free, and people would find ways to use whatever quantity of wood to do whatever we needed. However, because there are NOT an infinite number of trees, we can only produce so many things from wood, and therefore our ability to produce wood-related goods is limited by the amount of wood we have available.

This is true for EVERYTHING in the world, from water, air, and time to computers and gasoline. Nothing is infinite, and because of that we can't produce everything we want to from a given resource.

Law of Opportunity Cost

The second law which governs our study of Economics is both a corollary of the first law (its truth depends on the truth of the Law of Scarcity), and a law in its own right (due to the significance of the phenomenon it describes). Its name is The Law of Opportunity Cost, and it helps to explain the basic nature of decision making.

Because all resources are scarce, people cannot make all the things they would want to make from a given resource, because there are natural limits on our ability to consume it. Because of this, any time we decide to consume a resource, either directly or by making it into something else, we give up the opportunity to consume it in a different way. This forgoing of a type of consumption, and the utility which we do not gain by forgoing it, is Opportunity Cost. Now, opportunity cost is important to understand, because not having a solid grasp can make economics almost impossible to figure out. When we talk about opportunity cost, we are concerned solely with the cost associated with the highest valued alternative to the method of consumption we chose: we are not concerned with adding up all of the costs of all the other options we had.

Let's go back to wood. One of the most important things we produce from wood is paper, and most of us consume a lot of paper on any given day, in many different fashions. Because of this, a large portion of our consumption of wood is indirect, and is achieved through a consumption of paper. However, by turning all of this wood into paper, we (as a society) forego the option to use more of that wood to do things like build houses and furniture, and this other use is the next best thing we could do with our supply of wood. Although we still use wood to do those things, we do not use as much as we could have, and that means that we have chosen not to gain the utility which those extra houses and furniture could have provided in exchange for gaining the utility that paper provides. In this case, the utility not gained by using wood for construction is the opportunity cost associated with making paper.

It is important to remember that factors beyond money are included in our measuring of utility and opportunity cost, and that anything that can help satisfy a person's wants is considered utility. The opportunity cost of me going to work for $9 an hour, for instance, is the utility I would have gained by using that hour to stay at home and sleep on the couch. The opportunity cost of ordering a chicken sandwich at McDonald's is the utility I would have gained by using that money to buy a hamburger instead. Because of this opportunity cost can be ephemeral or hard to measure, but since most economic calculations do not require a direct or specific measure of opportunity cost beyond defining its existence, this issue has little bearing on its study.

These two laws underpin Economics, and working together set the basis on which all Economic measures and judgments are made, as they serve to describe the setting in which people make decisions. Without these, any sort of economic model or calculation, regardless of how it was achieved, would be ultimately arbitrary or subjective.

Again, feel free to ask any questions or for clarification in the comments!

Outlining the Austrian School

Well, I'm new to blogging, so I guess I will start out simply. The purpose of this blog is to provide insight on current events and historical phenomena, as well as offer economic commentary, through the lens of the Austrian School of Economics. I will also seek to provide an in-depth look at the Austrian School, as I find most people seem to know the Austrian School more through the descriptions of its detractors than its proponents. On that note, I guess I'll start:

The Austrian School of Economics, according to Wikipedia, is "a school of economic thought which bases its study of economic phenomena on the interpretation and analysis of the purposeful actions of individuals." This simply means that an Austrian economist looks to the incentives and choices which an individual faces, and the knowledge on which they base their decisions, to explain larger trends in the economy. This view deviates from more mainstream economic schools which rely on a basis in statistical models or aggregated values to explain these trends. It does so on the basis that the average economic actor is not necessarily concerned with the actions of other actors whose motivations he does not (or cannot) know, but rather on the information which he has on hand regarding his own wants and the resources he has on hand to attempt to satisfy them.

The Austrian School, therefore, also relies heavily on logical deduction and empirical analysis to reach conclusions. The actions of any individuals have consequences, and it is primarily through understanding the rationale of the individual in choosing those actions that we can determine how others will react in turn, thus showing us the greater impact on the economy, in a manner similar to the falling of many small dominoes. Many non-Austrians view this lack of statistic-based study as a hindrance in greater Economic study, but many Austrians favor it because it helps to separate Economics from the "purer" sciences such as Physics or Chemistry, which act on clear natural laws and immutable principles rather than the more muddled incentives and decisions of complex human lives. The Austrian School thus views the more "scientific" view of such schools as the Keynesian School negatively, not because they lack merit, but because they seek to overly simplify the field of economics to the interaction of aggregates and models instead of offering it the intensive look that it deserves as a field of study.

An important point of Austrian thought is that any decision that is made in an effort to direct the economy (such as a policy measure) is subject to unintended consequences (usually negative) due to a lack of complete information, which could easily overshadow the positive effects the policy was meant to generate. This leads to a more reserved approach in crafting economic policy, and more often advocates for allowing natural market forces to correct perceived shortcomings in the economy. Austrians look to the market with such deference because they feel that allowing many individuals to make small decisions, over time, produces a more preferable outcome in the long run than relying on a small group of planners to make big decisions, which may be undertaken with imperfect (or incorrect) information. To summarize this point, I want to end on a quote from notable Austrian economist, Friedrich von Hayek (or F.A. Hayek):

"The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design."

Feel free to comment or discuss, I will attempt to respond as best I can.