In this lesson you will learn:
Yet before we dive into the deep end, in the present lesson—the last of our “Foundations” section—we will sketch out some of the basic economic truths that apply even in the very simple case of a single person on a remote island. There are a surprising number of conclusions we can draw even in this extremely limited case.
Over the years, many critics have derided this so-called “Robinson Crusoe” economics, named after the shipwrecked mariner in Daniel Defoe’s famous novel.1 Obviously, we are not saying that an isolated person is an accurate description of a modern economy Rather, we are saying that before we can analyze an economy composed of billions of interacting people, we should start with just one person and make sure we understand what makes him tick.
As you will see, in this lesson we are developing general principles about an individual’s purposeful actions in the face of scarcity. These general principles will still hold true, even when Crusoe is rescued and returned to civilization. But to avoid overwhelming students at step one, we are here starting out with the simpler case in which Crusoe is (initially) all by himself and must act to improve his situation, given his circumstances.
At this point we can stop and describe the situation in terms of economic concepts. You probably realized, with Crusoe, why the particular items mentioned in the previous paragraph were relevant to his situation, and would be among the facts that you would consider if you found yourself in Crusoe’s place. In economic jargon, Crusoe took an inventory of the goods at his disposal. That is, he appraised himself of the stockpile of physical items available for his use that exhibited scarcity.
As these examples all demonstrate, Crusoe needs to think through the consequences of his actions whenever his plans involve the rocks, vines, coconuts, and so on. Because these items are scarce, Crusoe might later regret the influence on them, because this will impair his ability to satisfy goals in the future. Items that can help a person achieve his or her goals, and could help the person achieve even more goals if there were more of these items available, are called goods. In contrast, background conditions like gravity and oxygen are not (typically) goods in the economic sense, because no action Crusoe takes will render them less useful to the achievement of his goals. Crusoe doesn’t need to worry about sprinting too fast and thereby “using up all the oxygen,” and he doesn’t face any tradeoffs in relying on gravity when knocking down coconuts with a long stick.2 Further, there aren’t any goals that Crusoe could accomplish, if only he had “more oxygen” or “more gravity” So although oxygen and gravity are necessary for his very life, Crusoe doesn’t have to economize on their use, and hence they are not classified as economic goods.
As with goods in general, the distinction between consumer versus producer goods is in the mind of the acting individual. For example, if the Incredible Hulk should wash up on Crusoe’s island, he might consider the stick a great device for scratching that hard-to-reach spot between his shoulder blades. To the Hulk, the same physical stick would be a consumer good.
The single most important and versatile producer good is Crusoe’s own labor, which is the flow of productive services Crusoe performs with his body. In terms of the logic of economic principles, it would be perfectly sensible to group labor along with other natural resources that provided an indefinite flow of services (with adequate maintenance). However, economists have historically accorded labor special treatment, because labor is the one factor of production that every individual possesses, and also because labor is the one producer good that is required for every production process. When Crusoe devotes his physical efforts toward the indirect satisfaction of goals, he is engaged in labor. On the other hand, if he achieves direct satisfaction of goals through control of his hands, brain, etc., then economists call this leisure. Crusoe will allocate his “body power” among labor and leisure activities, in order to satisfy the goals he considers most important. Historically, economists have referred to the disutility of labor to underscore the fact that individuals directly enjoy leisure, and will only devote some of their scarce time to labor if it allows the achievement (indirectly) of more important ends than the leisure being sacrificed.3
Finally, capital goods are those factors of production that were created by people.4 Every capital good is produced from the combination of (at least one) natural resource and labor. Most capital goods are also produced with the help of (pre-existing) capital goods.5 For Crusoe on his island, examples of capital goods would be a fishing net that he constructs out of vines and his labor, and a shelter that he creates out of rocks, branches, mud, leaves, and his labor.
Income refers to the flow of new consumer goods (and services) that an individual has the potential to acquire during a period of time.6 Saving occurs when someone consumes less than his income; it is “living below one’s means.” Investment occurs when ingredients of production are devoted to future income, rather than immediate consumption.
In Lesson 10 we will discuss in much greater detail the relationship between income, saving, and investment in a modern market economy, in which most exchanges involve money. For now, we quickly illustrate that these advanced concepts have their analogs even in the simple Crusoe economy.
It’s easiest to explain with a numerical example. Obviously the following numbers are chosen for simplicity, and serve only to make the scenario concrete enough so that you can really think through the types of tradeoffs Crusoe faces. In that light, suppose that with his bare hands, Crusoe can find an appropriate tree to climb and knock down 1 coconut per hour. If Crusoe devotes 10 hours per day to work, while leaving the rest for leisure (which includes sleep), that means his raw labor can extract 10 coconuts per day from the natural resources available to him on the island. Fortunately, eating 10 coconuts per day provides enough nourishment to maintain Crusoe in decent health. But working 10 hours per day, with no weekend, is hardly an ideal lifestyle. Besides the grueling schedule, Crusoe knows that if he should ever become sick or injured, he could easily die because of the vulnerability of his hand-to-mouth existence.
After living below his means in this fashion for 25 days, Crusoe has accumulated a stockpile of 50 coconuts. From that point on, he once again resumes eating 10 coconuts per day—he consumes his full paycheck every day, as it were. The main reason Crusoe stopped accumulating additional coconuts is that he discovered their taste begins to suffer five days after being knocked down from the tree. Therefore, Crusoe has settled into a comfortable routine: Every day he picks a fresh batch of 10 coconuts and adds them to one side of his stockpile. During the day, he eats the oldest 10 coconuts from the other side of his stockpile. With this rotation, Crusoe still enjoys a full 10 coconuts (which still taste pretty good) per day, but he also has a savings fund of 50 coconuts that he can draw down in case of emergency. For example, if Crusoe should come down with a tropical illness that makes him unable to work, he has enough saved up to eat for ten days on half-rations.7 Because of his willingness to put in hard work and save its (literal) fruits, Crusoe has greatly enhanced his material position compared to his original situation. Rather than living on the edge of starvation, Crusoe now has a buffer of ten days.
The simple act of saving and accumulating consumption goods is very useful, but Crusoe realizes he can do much better. After surveying the materials at his disposal, Crusoe sets out to invest his savings in a long-range venture, which he expects will permanently increase his future flow of daily income. Relying on his stockpile of 50 coconuts, Crusoe decides to take two days off from climbing trees to knock down new coconuts for the stockpile.
But our hero isn’t taking a much needed vacation! On the contrary, Crusoe spends the first day—all 10 hours—wandering the island, gathering branches of the appropriate length and thickness. The process is slow-going, because when Crusoe spies a good candidate, he needs to use a sharp rock to saw away at the branch, before he can safely snap it off the tree without ruining it.8 During this day, Crusoe eats 10 coconuts, reducing his stockpile down to 40. Even though he has worked all day, he has no new coconuts to show for it. Instead, he has only a collection of sturdy and long branches, which he has transformed from their original shape and location.
During the second day, Crusoe spends another 5 hours using sharp rocks to further prepare the branches. Then he spends 2 hours cutting down vines and bringing them back to camp. Finally, in the remaining 3 hours of the second workday, Crusoe lays the branches on the ground, end-to-end but with a large degree of overlap. Then he uses the vines to tie the branches snugly to each other. At the end of the second day, Crusoe’s stockpile has dwindled to 30 coconuts. But in addition to this (shrinking) stockpile of savings, Crusoe has a new capital good: A long and sturdy pole.
The next day Crusoe takes his capital good out for a spin. He discovers with great satisfaction that in a single hour, his labor power—aided by the new capital good—can yield 5 coconuts. This is such a tremendous boon to his productivity that Crusoe now decides he’s been working too much! Rather than working 10 hours per day gathering food, Crusoe now spends only 4 hours per day knocking them down. This brings in a daily flow of 20 coconuts per day, twice what he was “earning” with his bare hands. Wanting to replenish his stockpile to the fullest amount that still allows for tasty coconuts, Crusoe saves some of his new earnings for a few weeks, until his stockpile has grown to 100 coconuts.9 He once again has five days’ worth of full-rations, except now a “full-ration” means 20 coconuts per day. In the new equilibrium, Crusoe spends 4 hours per day knocking down 20 new coconuts, which he adds to the stockpile. During that same day, he eats the 20 oldest (ripest) coconuts in the stockpile.
Rather than engage in this volatile schedule—seven days of light work with many coconuts, with an eighth day of intense work and no coconuts— Crusoe can smooth things out. In a typical day in the new equilibrium, he can spend 4 hours knocking down 20 new coconuts to add to his stockpile (while of course eating the ripest 20 from the same stockpile of 100). But then he also spends a fifth hour each day working on the preservation of his capital good. This way, after seven days have passed in a typical week, Crusoe will have performed the 7 hours’ worth of labor necessary to restore the pole after it has been worn down from a week of usage.10
In the jargon of economics, we can step back and describe what Crusoe has done. By consuming less than his daily income—by living below his means—Crusoe saved coconuts in order to build up a fund to guard against sudden disruptions in his future income. Moreover, Crusoe then invested his resources into the creation of a capital good that greatly augmented his labor productivity. After the completion of the pole, Crusoe only consumed his net income each day, because he invested enough of his gross income to just balance the depreciation of his capital good.
The classic illustration of this new way of thinking is the so-called “water-diamond paradox.” At first glance, it seems odd that the price of water should be so low—restaurants will serve it for free!—while the price of diamonds should be so high. (Try asking your waiter for a complimentary glass filled with diamonds.) If economists think that the value of goods is ultimately related to humans trying to satisfy their subjective goals, how can diamonds possibly be more valuable than water? After all, you can’t satisfy too many goals if you die of thirst.
But that answer is wrong. That particular coconut will not mean the difference between starvation and nourishment. Indeed, Crusoe still has a stockpile of 99 more coconuts that are not near the fire. At the very worst, all the sacrifice means is that Crusoe will have to settle for eating only 19 coconuts on some particular day (not even necessarily the next day), rather than his normal 20. In fact, Crusoe may simply decide to work an extra 12 minutes at some point11 to knock down 21 coconuts and replace the one lost to the fire.
The general principle is that Crusoe will evaluate goods unit by unit. When he is deciding how valuable a particular coconut is, compared to a particular watch, he considers how his goals will be affected by those particular items. It is completely irrelevant to Crusoe that 100 coconuts are more valuable to him than 100 watches; that’s not the decision he faces as he runs out of the burning hut. No, he has to decide if one coconut is more valuable than one watch. And as we’ve seen, the loss of one particular coconut isn’t devastating at all. It simply means that Crusoe will have to eat a little less at some point, or that he’ll have to work a little more. Economists would say that on the margin the loss of a coconut is fairly insignificant. That’s why it’s perfectly sensible for Crusoe to grab the watch, which he values for sentimental reasons.
Up till now in this lesson, we have been explaining the nature of the tradeoffs Crusoe faces in his daily decisions. Without realizing the connections between his choices, we wouldn’t be able to make much sense of Crusoe’s actual decisions. For example, let’s reconsider Crusoe’s actions as he ran out of the burning hut. We said that he faced a choice, between grabbing a coconut or grabbing a watch. But actually, we cheated a bit; we zoomed ahead to what we knew the real tradeoff was. In reality, Crusoe had all sorts of options at his disposal. Rather than grabbing the coconut or watch, he could have decided to use his hands to punch himself in the face. Or he could have picked up the coconut, but then hurled it at the burning roof. In fact, we just took it for granted that Crusoe would leave the hut in the first place. He certainly had the option to calmly eat his last coconut before passing out from smoke inhalation.
Instead, when trying to understand the decision Crusoe really faced, we looked at what the best option was, that he would thereby have to sacrifice because of his decision to grab the watch. In our story, we assumed that Crusoe’s next-best alternative was grabbing the coconut.12 The economist would explain Crusoe’s action in this way: Crusoe decided that the benefits of having the watch outweighed the cost of having one fewer coconut. This is simply using different words to say: The goals Crusoe could achieve with a watch and 99 coconuts, were more important to him than the goals he could achieve with no watch and 100 coconuts.
The other decisions Crusoe makes are more complicated, but the basic principle is the same: Crusoe always chooses the option for which the benefits exceed the costs. For example, when Crusoe decides to work a fifth hour on a particular day, in order to gather more vines, it’s because he considers the benefits to outweigh the costs. In this case, the benefits are (ultimately) the extra pleasure he will get from consuming more coconuts in the future. (Remember that he needs the vines to maintain his pole in good condition, in order to knock down coconuts.) The cost is the value Crusoe places on the most important goal that he now won’t be able to achieve. For example, suppose on his way to cut down more vines, Crusoe sees a pile of perfectly cut vines lying on the ground, the result of a freak lightning strike. In that case, Crusoe might decide to enjoy an extra hour of leisure. That means the cost of his original decision (to spend an hour cutting vines) was the value to Crusoe of having 20 hours of leisure that day, instead of 19.13
The last point in this lesson is that all of Crusoe’s actions are guided by his expectations, which is to say his predictions about the future. When Crusoe makes a particular decision, he is really choosing the outcome that he expects will give him more benefits than costs. He very well could be mistaken. For example, Crusoe might spend several weeks collecting branches and other materials, in order to construct a raft. He thinks he will be able to use it to escape to the high sea, where he hopes someone will rescue him. The benefits of this small chance of escape are more important to Crusoe than the leisure he is giving up during the construction of the raft.
However, after many attempts, Crusoe realizes that the ocean won’t let him escape the island on his raft. Unfortunately, he can’t find anything on his island that would serve as a large sail. He realizes with great regret that his efforts on the raft were a complete waste of time. Or more accurately, a complete waste of leisure.