Journalists with minimal insight into economics and political agendas
write on economics, spreading confusion.
High school economics courses define a few terms providing little
insight. College principles courses tend
to be vast empty surveys. As a result,
economics seems either obscure or obvious.
This introduction to economics is meant to get you on the right foot
toward understanding the depth and focus of economics.
The foundation of human society is the production and
consumption of goods and services that sustain life and make it worth
living. The major theme of economics is
that markets efficiently provide these goods and services. During the past century living standards rose
remarkably worldwide due to increased specialization and trade worldwide.
The role of government is to provide the legal structure for
property rights, produce some products where markets fail, pass laws to
influence markets, and redistribute income.
Political groups try to alter
market outcomes in their favor by supporting politicians to pass laws
and policies favorable to the group.
Support comes in the form of money and votes. Lobby groups try to short circuit market
outcomes with government policy favoring their members.
There is plenty of room for disagreement over the role of
government in economics. Grasping the
scope of what the government can do is important for sound economic
thinking.
Economics is the study of the production and
distribution of goods and services through the market system. Economics studies the prices and outputs of
goods and services. Sound economic
thinking defines the role of
government in the economy and exposes the limits of government
policy.
The basic lesson of economics is that there are benefits of free commerce, free trade, and free
investment. Economics explains why
people save, why firms invest, and why the economy
grows. Two important issues for the
whole economy remain unemployment and inflation. Economics explains how to control the
negative spillovers of industrial production.
Economics will not make you rich but might help you make wise
investments. Economics will help you
understand why politicians pass laws to get the support and votes of various
political groups. Economics will help
you understand and predict market changes.
Economics can answer some puzzling questions. Why is gold, mainly for jewelry, expensive
while water, essential for life, is cheap?
What will happen to the price of oil over the coming years? How soon will there be a sale on that new car
you want? Which industries can be
expected to grow? These are examples of
questions that economics can answer.
Markets produce and distribute goods and services. Goods are scarce physical objects such as
cars, shirts, gas, and wine. Services
include haircuts, doctor visits, and investment consulting provided directly
from one person to another. Goods and
services are produced, requiring payments for the required machines, labor, and
energy.
One side of a market is supply
that sums up potential production at various prices. As the price rises, the quantity supplied
increases. Higher wages decrease
supply. Lower energy prices raise
supply.
The other side of a market is demand, the amount purchased at various prices. As the price rises, the quantity demanded
falls. Incomes and tastes of potential
buyers affect demand. Everyone is a
potential buyer of everything but many goods and services are beyond most
consumers because of price, limited budgets, location, or timing.
Supply and demand are the two sides of a market. Together supply
and demand determine price and output. Changes demand and supply affect price and
output. Increased income, for instance,
raises demand leading to a higher price and more output. Improved technology increases supply leading
to lower prices and more quantity.
Higher wages reduce supply, raising price and lowering output.
Labor, capital, and natural resources are the three general inputs for production. Firms pay owners of these inputs to hire them
for their production processes. In the economy,
firms are input buyers and households are input sellers.
Everyone sells their labor
and receives a wage. Labor supply comes from individuals or
households. Everyone would like a higher
wage but the labor market determines the wage.
People with their own businesses effectively pay themselves a wage.
Capital refers to the machinery,
equipment, and structures for production.
Capital has to be produced and is valuable because it contributes to the
revenue from sales. Firms pay rent for the capital input
hired. Even if a firm purchases a
machine, it could rent it to another firm.
People own most of the capital although the government also owns capital
for production.
Natural resource inputs such as energy,
lumber, and iron are derived from the earth.
The foundation of natural resource inputs is land, air, or water. Natural resources inputs have to be paid for
by the firms using them in their production processes. Owners of the natural resources sell them to
firms for production. Either people or
the government can own natural resources.
Input markets distribute income.
Payments to labor, capital, and natural resources are the components of
household income. The government uses
various schemes to redistribute income, a basic issue of political economy.
Markets for products and inputs are the two sides of the
economy. People are demanders in the
product markets and suppliers in the input markets. Firms are suppliers in the product markets
and demanders in input markets.
Prices for products and inputs are determined in markets. Markets are interrelated by price and output
effects. For instance, an increase in
the price of gas will raise demands and prices for bicycles and mass
transit. Prices send signals such as
what to produce, what can be afforded, which inputs to buy, where to invest,
and how many hours to work.
This all sounds intimidating.
The economic system is complicated to say the least but markets
constantly distribute goods and services.
The newspaper is delivered, the hamburger served, the TV cable hooked
up. The working of the entire economy is
too much to grasp but economics boils it down to supply and demand.
Households, firms, and governments across countries trade with
each other. When a scare good or service
is cheaper in another country, arbitrage
traders buy it in the cheap location and transport it to the expensive
location. The arbitrage rule "buy
low, sell high" results in profit.
Trade leads to more goods and services for both trading partners. With trade, production becomes more
efficient. Countries do not waste
valuable resources making products that other countries make better or cheaper.
Industries competing with imports want protection with tariffs and quotas provided by the
government. A tariff is a tax on
imports. A quota is a limit on the
quantity that can be imported. These government
devices help the protected industries but hurt everyone else. In the long term, protected industries become
inefficient and cannot compete.
Politicians provide tariffs and quotas in exchange for money and votes.
There is concern that other countries are better at making
everything with wages that are too low or environmental regulations that are
too weak. China might be better than
Japan at making appliances while Japan might be better at making cars. There will always be plenty of goods and services
for every country to produce since relative efficiency is all that is required
for gains from trade. Comparative advantage is the relative
efficiency that determines production in a market system.
International investment is vital for economic growth. Investment naturally flows across borders as
industries look for better locations for production. Some countries become international lenders
while others become borrowers.
Governments want to limit international investment due to political pressure
from the firms that have to compete with the foreign investment. General Motors, for instance, is hurt when
Hyundai invests in a new automobile plant.
The exchange rate
translates prices from one currency to another.
The level of the exchange rate determines the direction of international
trade, tourism, and investment. High
variation in the exchange rate discourages international traders and investors.
The exchange rate sets domestic prices of imports and foreign
investments. Governments may want to
“fix” their exchange rate to please some group in the economy. Governments can undervalue a fixed exchange
rate to help their export industry, essentially transferring purchasing power
to foreign consumers. The exchange rate
is best determined in a free market.
People and households save
so they can spend later. People save for
college for their children, a new car, retirement, or to pass it along to their
offspring. Saving provides money now that
is not spent on consumption.
Firms invest in
capital to become more productive. Funds
for investment are either from profit not paid to owners of the firm, from the
sale of new stock, or from borrowing.
Investing this year helps produce more revenue over the coming
years. Investing requires money now that
is not spent on consumption.
Saving and investing determine the future of the economy. Saving and investment interact in the credit
market. The two sides of the credit
market are saving and investment, supply and demand. Together saving and investment determine the
price and quantity of credit.
The price of credit is the interest rate, the return to saving and the cost of a loan. The credit market, not the government,
determines the interest rate. The
government only sets the discount rate that it charges banks to borrow. Market forces determine where the government
has to set the discount rate.
The government also controls the money supply. The growth rate of the money supply
ultimately determines inflation. Higher
inflation translates into a higher nominal interest rate that people pay to
borrow or earn on savings. The real
interest rate is the nominal interest rate less inflation. If the inflation rate is 8%, a nominal
interest rate of 10% implies a 2% real return to lending or cost of borrowing.
The economy as a whole might save or lend internationally. One country might be a lender, and the other
a borrower. Reasons for lending and
borrowing internationally are the same as in the domestic credit market.
Countries grow through trade and investment but some stay
poor. The cause of poverty more often
than not is a corrupt government. Petty
dictators cheat and steal. If their
country has scarce natural resources like oil, the rulers are supported by
their customers. Honest government
officials are relatively rare.
Governments define and enforce property rights. If anyone
could drive your car there would be little incentive for you to work to pay for
it. Without private property rights,
people would not work and the economy would collapse. An important function of government is to
settle disputes over property rights.
Governments use taxes
and subsidies to influence
economic activities. With a tax, people
pay the government. With a subsidy, the
government pays people. Certainly
everyone would prefer a receiving a subsidy to paying a tax, leading to
political wrangling. Politicians accept
cash and votes to enact taxes and subsidies.
Governments also create monopoly power with franchises. A legal
monopoly is the only firm able to produce a particular good or
service. Monopoly power allows the
seller to set the price that maximizes profit with no competitors to take your
customers. Electric utilities are legal
monopolies. The government regulates the electric utilities
trying to mimic a competitive market.
The government receives taxes and political support in exchange for the
franchise. This unholy alliance between
business and government creates inefficiency.
Taxis, doctors, electricians, airport slots, cable service, and
beauticians are examples of government franchises and licenses. Monopoly power restricts of competition. The value of a government license or
franchise can be high and firms are willing to pay lawmakers.
Some industries that were franchised and regulated by the
government have been deregulated during recent decades. These industries include banking, trucking,
airlines, and telecommunications. These
deregulated industries now produce better services at more competitive prices
than under franchised regulation.
environmental economics
Pollution is a spillover created along
with some products. Most pollution is
caused by energy sources
including coal, oil, and gas. Pollution
is a cost that is external to
the firm producing the good or service.
The cost of pollution has to be paid by people outside the firm.
Solving pollution is costly.
Pollution from generating electricity could be eliminated but
electricity bills would triple. People
want clean air but not that much. There
are various ways to control pollution but they all have costs that consumers
have to pay. The political process of
environmental laws determines who pays how much.
Remember that markets work but room for disagreement
remains on political issues. It is worth
the effort to separate economics from politics.
Macroeconomics is concerned with managing the economy.
Analogies to vehicles in macroeconomics include accelerators, brakes,
fine tuning, takeoff, and soft landing.
The desired illusion is that the government macroeconomic managers are
in control. Presidents take credit for
economic expansions when they have little or nothing to do with it. Congress passes economic recovery packages
primarily to recover from previous recovery packages.
The ultimate macroeconomic plan was the series of Five Year
Plans in the ex Soviet Union. While the
plans sound good on paper, the socialist system collapsed under continued
poverty and inefficiency.
People have different ideas about how much the government should
manage the economy but two things are certain.
First, any plan should stress market incentives. Second, the government requires taxes that
lower output.
The economy can hardly be managed and does not need to be. Markets provide adjustment mechanisms for
imbalances such as unemployment, recession, bad weather, and rising energy
prices.
Out of a sense of fair play some income can be
redistributed. The iron law of economics is that charity
hurts the recipient who loses the incentive to help themselves. Welfare systems create a permanent underclass,
the proverbial safety net becoming a a hammock.
There are good jobs, however, in managing the economy. Government bureaucratic jobs perpetuate
themselves. Politicians are elected if
they can make you think they can do something for you. Macroeconomic managers and politicians would
never admit their main concern is to maintain their own well being.