The Basics of Economics with Paul Samuelson

Paul Solman: I’ve done numerous interviews with Paul Samuelson over the years. Invariably, he was funny, imaginative and deep. Particularly memorable was a long session on the basics of economics about 10 years ago, in his office at MIT, which helped concretize my own understanding of the economic fundamentals.

We’re sharing a few transcripts of our Samuelson interviews here on the Making Sen$e this week, beginning with our session on the basics. Teachers should feel free to make whatever use of them they wish.

Here, then, is the first part of the “basics” interview —- by perhaps the greatest economics textbook writer of all time, remember. The subjects: scarcity; trade-offs; opportunity cost. Read the transcript:

SOLMAN: Scarcity. Why do economists talk about scarcity, since we’re the most abundant economy in history?

SAMUELSON: Well, human wants and human needs are pretty much insatiable. If we were condemned, you and I, to go back for a day and live in 1850 — it’s only 150 years ago, that was the peak of Queen Victoria on the throne, great progress being made — and if we were put down in the aristocracy, we would feel incredibly deprived. Once you’ve been in Paree, World War soldiers, how do you get them back on the farm? You think, if you ask people, what would it take to make you happy economically, they say, a 25% increase in pay. And they’re right. For about three months. [LAUGHTER]

SOLMAN: So humans are insatiable.

SAMUELSON: Well, yes, and it’s not just frivolous needs. I’m talking about the good life, I’m not talking about the celebrity good life. I’m about to go off to Florida. That will be for a working winter, quasi-vacation. That’s not an inordinate demand, but right now, it’s beyond the means of 80% of people in the most prosperous nation in the world, and make no mistake about it. Some others have been catching up toward us, but when you go to the University of Pennsylvania tables, that call it as it is, we still, in America, are number one, with the next guys being Canada and Western Europe. Japan is not even with America. So in order to have a long life, to have the opposite of Thomas Hobbes’ jungle, where life was short, nasty and brutish, it takes more than the best that modern science and technology can provide.

SOLMAN: People say economics is the study of trade-offs. Is opportunity cost the way you measure trade-offs?

SAMUELSON: Well, opportunity cost is a very important part of it. It’s not easily understood until after you understand it, and then it is obvious. For example, back in the 1970’s, my bank paid me 3% interest, but I could get a money market account at Fidelity paying me 18% interest. Now why 18%? It was because inflation was proceeding at about 18%. There was really no remuneration at all. Three percent was a good return at your local bank, compared to another local bank, but you were giving up something more valuable. There was nothing criminal or illegal about the banks, but that shows you what opportunity cost is.

SOLMAN: In other words, the difference between the two interest rates.

SAMUELSON: Yes. One famous example, told in every economics class, is about the lawyer who’s the best typist in town. He’s a better typist than his own secretary. But he would be crazy to be typing up his legal briefs because he’s displacing billable time, $100 an hour, to be doing what is paid about $12 an hour, at best.

So economics is a choice between alternatives all the time. Those are the trade-offs. I hate the expression, there’s no such thing as a free lunch, because it’s untrue. We’re all mammals, we all had a free lunch [from our parents] or we wouldn’t be here. But when somebody gives you an offer that’s too good to be true, almost always it is too good to be true. There are no easy pickings. That would be a more accurate, less dramatic statement than there’s no such thing as a free lunch.

SOLMAN: Because there are always costs associated with what you’re not doing.

SAMUELSON: Right, yes. But life is full of free lunches that come from increases in productivity.

SOLMAN: So if I attend a football game, say, then what am I foregoing?

SAMUELSON: Well, you could have been at the Nutmeg Ballet [in Connecticut] or you could have been at a nightclub. We all have choices to make, and every choice involves giving up something else.

SOLMAN: We took the liberty of bringing two editions of your book, in which you define opportunity cost. One starts with Robinson Crusoe.

SAMUELSON [reading]: “Thus, Robinson Crusoe pays no money to anyone, but realizes that the cost of picking strawberries is the sacrificed, and that word is italicized, amount of raspberries he might otherwise have picked for the same time and effort. Or it is the sacrificed amount of foregone leisure.”

At this point, however, you may well say, ‘now I’m totally confused. First I learned that price is a good measure of true social costs in the marketplace. Now you tell me that opportunity cost is the right concept. Can’t you economists make up your minds?’

Actually, there is a simple explanation. In well-functioning markets, price equals opportunity cost. Meaning that the proper way to price out and charge us for things is to charge us what those resources could otherwise have produced. This is a lesson the Soviet Union never learned at all, and the rest is history.

SOLMAN: Why is price equal to opportunity cost?

SAMUELSON: Because in a perfectly good supply and demand of many people on each side of the market, the price is at the marginal cost of the resources needed to produce it, and that cost comes from what you could otherwise have produced with those resources.

Time is our ultimate scarcity. Isaac Newton can give us more electricity, but he can’t give us more than 24 hours of the day of time. And so we’re constantly having to sacrifice alternate activities to get the one that pleases us most. And if you know somebody who makes bad decisions in life, old high school chum, you’ll find that they constantly neglect to consider what the alternative costs are of each thing that they do, so that they’re living a life of, from their own viewpoint, mistakes, and economics can help you sort out those things, hopefully.

By the way, there is no scientific way of deducing proper tastes. You can’t argue about taste. I happen to like olives, you hate them. You like a martini, I don’t go for that. But once you’re human, you develop a pattern of tastes and of needs and desires, and in order to maximally fulfill those, this is a matter of selfishness, but it’s not a matter of meanness toward others, within the resources that are yours. The problem of choice involves foregone opportunities. And so opportunity cost prevails, even if the ordinary person on the street doesn’t use that terminology.

SOLMAN: And getting back to my football game?

SAMUELSON: Instead of going to two athletic events a week, you could have been studying a home correspondence course in computers, and you would be on your way to the high executive ranks and cushy retirement [LAUGHTER] at an early age [LAUGHTER] in Florida. That’s the example of opportunity cost and maximal choice.

And that’s precisely what the government bureaucrats have in mind when they construct index numbers of cost of living. They try to work out how people actually spend their money and, in a time of inflation, how much you would have to give in extra income to get the same level of overall satisfaction as in a previous period, and that increase in income is the index number of the inflation that’s taken place between the first date and the second.

SOLMAN: But it’s very hard to do that, isn’t it? Calculate one’s own opportunity cost, that is?

SAMUELSON: Yes. And remember this, life is not this one event, it’s the steady state. Very few people would not go to an attractive athletic game once in six months, but very people would go every night. And the whole art of personal home economics is working out the sustainable schedule, so you don’t hate yourself in the morning. [LAUGHTER] You’re doing the things that you want to do, but you’re doing it with diversification. It’s the same principle, diversification, in taste satisfaction, that you have in [an investment] portfolio, which you don’t put all your eggs in one basket. Don’t invest all your money in General Motors, give Ford and Chrysler a little, and don’t put it all in the automobile industry. Well, similarly, however good caviar is, man does not live by caviar alone, nor does woman. [LAUGHTER]

SOLMAN: So you’d have to do a bunch of things to satisfy your tastes more broadly.

SAMUELSON: Right. It’s the simultaneous general equilibrium, as economists’ lingo puts it.

SOLMAN: So in other words, if I were to sit down and try to come up with this kind of calculation, I can do it and get some kind of approximation, but since every one of these things is on the margin, because of substitution with other things I might be doing and diminishing returns, it’s almost an impossible calculation.

SAMUELSON: Right. But you mustn’t become too tied up in the calculation. I don’t know if you play billiards. But if you are a great billiard player, I’m sure you are not a master of Newtonian dynamics and the angle of incidence of the ball off the cushion is equal to the angle of its entrance. We all do these things by forming habits, good and bad habits, and it doesn’t require self-conscious deliberation. If you worry about, do you sleep with your beard above the sheet or you sleep with the beard below the sheet, you won’t be able to sleep at all. [LAUGHTER] So there are many learned wise fools.

SOLMAN: But what do you do, then? What does economics teach you to do? When you’re talking about cost benefit analysis of this sort, and I’m wondering if I’m wasting four hours by spending them at a football game, how does an economist tell me to go through that calculation, however generally, so that I won’t hate myself in the morning?

SAMUELSON: Well, there are certain obvious things. The human ego is an ostrich: denial. You do self-destructive things that you realize are self-destructive, and the good advisor — the good counselor, the good parent, and also the, the imperfect human being improving himself, herself — uses some thought processes, and then, finding a pattern, doesn’t seek for the very very best. Seeking for the very very best meal in life is a miserable existence. What you want is what Herbert Simon, the great Carnegie Tech psychologist/economist, says is to satisfice, get a good sustainable solution. That’s better than seeking endlessly for the very best.

SOLMAN: But does it help to think in these terms so that, even if I’m not going to be able to exactly cost out how much it would be worth to me to do the alternatives to attending the game — read the newspaper, take a nap — at least it helps my decision-making.

SAMUELSON: Well, let me say, I think it helps us, in our health problems, to be observant of our own condition, to be thoughtful, but also not to think that we’re the doctor. It certainly helps you, in investing for your life-cycle security, to do that. And a lot of the evils of life are self-inflicted, from wrong decisions. You formed a smoking habit when you’re in high school and you can’t break away from it and you die of lung cancer at 37, instead of at 77.

SOLMAN: So it does make sense to think through “opportunity cost”: what you’re foregoing.

SAMUELSON: Yes. And more than that. The people who do this in life are the survivors, and the people who don’t do this in life are the ones who cease to have the voting power.

SOLMAN: So it pays, in the long run, to try to do this kind of cost benefit analysis about your decision-making and what the opportunity cost of any given decision is.

SAMUELSON: Up to a point. To become too obsessed with getting the exact best best best is to move into the land of diminishing returns. You want to do the best you can on the basis of the information that you have. Be thoughtful, don’t be in denial, but don’t sweat it [LAUGHTER] beyond that.

SOLMAN: Because then, of course, there’s an opportunity cost to spending the time making the calculation.