ECONOMIC$
Journalists with little insight into economics write on economic
issues and spread confusion, and may have political bias that clouds their
objectivity. High school economics
courses are too concerned with definitions.
Introductory economics courses in college tend to be vast empty
surveys. Economics seems either too obscure
or too obvious to many. This little
introduction to economics is meant to get the interested reader off on the
right foot.
The foundation of human society is the production and
consumption of valued goods and services that sustain life and make it worth
living. The major theme of economics is
that markets provide these goods and services.
Governments provide a legal structure defining property rights, pass
laws to influence how markets work, provide some products that markets fail to
produce, and redistribute income.
Political groups use politics
to alter market outcomes, supporting politicians with money and votes to
pass laws to their advantage.
The basic rule of government economic policy should be “Do no
harm” but the power of lobby groups to short circuit efficient market outcomes distorts
policy. The role of government in
economics is critical and grasping the scope of what the government can do is
important for sound economic thinking. This
short book can help you to focus on such economic issues.
I have taught numerous economics courses and published a number
of scholarly articles, a textbook on international economics, instructor
manuals, student workbooks, book reviews, and newspaper articles. I have done consulting work for energy
companies and government agencies. I
have given seminars at numerous universities worldwide. Take a look at my textbook International
Economics.
Economics is the study of the production and
distribution of goods and services through the market system. Economics explains how prices or relative value of goods and services are determined. Economics strives to helps us understand how
the world works. Sound economic thinking
exposes the limits of government policy and defines the role of government
in the economy. The basic lesson of
economics is that free trade and
investment are beneficial. Economics explains why people save, firms
invest, and how the economy grows.
Economics also explains how to control the spillovers of industrial
activity, how to control pollution.
Economics will not make you rich but it might help you find a
wise investment. Economics will help you
understand politicians as they pass laws to get your financial support and
vote.
Economics will help you understand and predict market
changes. Why is gold, useful only for
jewelry and a few industrial purposes, expensive while water, essential for
life, cheap? What will happen to the
price of oil over the coming years, or for that matter
next week? When will there be a sale on
new cars? These are examples of
questions that economics can help answer.
Goods and services are produced and consumed in markets. Goods are scarce physical objects such as
cars, shirts, gas, and wine. Services
are valuable things produced directly by other people such as haircuts, doctor
visits, or economics consulting. Goods
and services have to be produced and compensation is required to keep people producing.
One side of the market for a good or service is supply that
sums up potential production at various prices.
As price increases, the quantity supplied increases. Anything that affects production shifts
supply. Higher wages decrease supply and
lower input prices raise supply.
The other side of the market is demand based on prices as
well as incomes and tastes of potential buyers.
Everyone is a potential buyer of everything but many goods and services
are beyond most consumers because of prices, limited budgets, location, and
timing. Price is most critical in
determining demand.
Supply and demand are the two sides of a market. Together supply and demand determine price
and quantity produced and consumed.
Changes demand and supply affect price and quantity. Increased income, for instance, raises demand
leading to higher prices and more quantity.
Improved technology increases supply leading to lower prices and more quantity.
Labor, capital, and natural resources are three general types of
inputs in production on the supply side.
Firms have to pay owners of these inputs to hire them into 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 households. Everyone would like a higher wage but the
labor market determines your wage.
People with their own business pay themselves a wage.
Capital refers to the machinery, equipment, and structures used in
production. Capital has to be produced
and is valuable because it contributes to the production of revenue. Firms pay rent for the capital input
hired. Even if a firm owns a machine, it
could rent it to another firm. People
own most of the capital in a capitalist economy although the government also
owns and manages capital.
Natural resource inputs such as oil, lumber, and iron are
derived from the earth. Some natural
resource inputs require production but the point is their foundation in 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
the buying firms. Either people or the
government may own natural resources.
Income is distributed through input markets. Payments to labor, capital, and natural
resources are the components of household income. The government uses various schemes to
redistribute this income. Redistribution
of income is the 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, and markets are interrelated by
price effects. For instance, an increase
in the price of gas will raise the demands and prices for bicycles and mass
transit. Prices send signals about what
to produce, what can be afforded, which inputs to buy, where to invest, and how
many hours to work.
Sound intimidating? The
economic system is beyond description but markets work constantly to distribute
goods and services. The newspaper is
delivered, the hamburger is served, the TV cable hooked up. The entire economy is too much to fully grasp
but economics boils it down to a simple picture.
Households, firms, and governments in different countries trade
with each other. When something is
cheaper in another country there is arbitrage from the cheap to the more
expensive location. The rule of
arbitrage is "buy low, sell high" and the result is a profit. Trade results in cheaper goods and services
for both trading partners. Production becomes
more efficient and countries do not waste valuable resources making products
that other countries make cheaper.
Industries that have to compete with imports, however, want protection
from imports with tariffs and quotas. A
tariff is a tax on imports and a quota a limit on the quantity that can be
imported. These political devices help protected
industries but hurt everyone else in the economy. Protected industries become lazy since they
do not have to compete as well and fall below world class.
There is a fear that other countries are better at making
everything but comparative advantage or relative efficiency determines
production. There will always be plenty
for every country to produce since relative efficiency is all that is required
for gains from trade. China might be
better than Japan at making toasters and cars but Japan might be relatively
better at making cars.
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, does not
benefit when Hyundai invests in an automobile plant.
The exchange rate translates prices from one currency to
another and determines the domestic prices of exports and imports as well as stocks
and bonds for investment. Governments
may want to “fix” their exchange rate to please one group or the other but the
exchange rate is best determined in a free market. The level of the exchange rate determines the
direction of some international trade, tourism, and investment, and high
variation in the exchange rate alters behavior of international traders and
investors.
The saying is to save for a rainy day. People 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.
Firms invest in capital to become more productive. Funds for investment are either from profit
not paid to the owners of the firm, from the sale of new stock, or from
borrowing. Investing this year helps
produce more revenue over the coming years. Saving and investing determine the future
productivity of the economy.
The two sides of the credit
market are then saving and investment, in other words 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 or
the cost of a loan. It is very important
to remember that the credit market, not the government, determines the interest
rate. The government makes the news by
setting the discount rate that it
charges banks to borrow but market forces determine where it can set the
discount rate.
The government controls the money supply. The growth of the money supply determines
inflation. Higher inflation translates
into a higher nominal interest rate that
people pay to borrow or earn on savings.
The more important real interest
rate determined by credit market forces is the nominal interest rate less
inflation.
The economy as a whole might also save or lend
internationally. One country might be a
lender, the other a borrower. Reasons
for lending and borrowing internationally are the same as for the domestic
credit market.
Countries grow through trade and investment, but some countries stay
poor largely as a result of corrupt governments. Petty dictators cheat and steal to build
villas in other countries. If their
country has scarce natural resources like oil, the rulers are supported by
their customers. Honest government
officials are relatively rare worldwide.
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 job of
government is to settle disputes over property rights.
Governments use taxes and subsidies to influence various
activities. With a tax, you pay the
government. With a subsidy, the
government pays you. Certainly everyone
would prefer a subsidy to a tax, leading to political wrangling. Politicians accept political support in votes
or cash to enact taxes and subsidies.
Governments also create monopoly power with franchises and
licenses. A legal monopoly is the
only firm able to produce a particular good or service. Monopoly power is nice to have because you
can set the price that maximizes profit with no competitors that might take your
customers. Electric utilities are legal
monopoly franchises. The government regulates
the electric companies trying to mimic a competitive market. The government receives taxes and political
support in exchange for the political franchise. This unholy alliance between business and
government creates inefficiency.
Taxis, doctors, electricians, airport slots, cable service, and
beauty salons are examples of monopoly power granted by government licenses and
franchises. Monopoly power means the
restriction of competition. The value of
a government license or franchise can be high and firms are willing to pay
lawmakers to seize or maintain monopoly power.
Some industries that were franchised and regulated by the
government have been "deregulated" during the past 20 years. These industries include banking, trucking,
airlines, and telecommunications, and all now produce better services at more
competitive prices than under franchised regulation.
Macroeconomics is concerned with managing the economy. Lots of analogies to vehicles are used in
macroeconomics, including "accelerators," "brakes,"
"fine tuning," "takeoff," and "soft
landing." The desired illusion is
that the macroeconomic managers are in control.
Presidents take credit for economic expansions when they have nothing to
do with it. Congress passes economic
recovery packages that are primarily needed to recover from previous recovery
packages.
The ultimate macroeconomic plan was a series of Five Year Plans
in the ex Soviet Union. The plans sound
good on paper but the socialist system collapsed under sustained poverty and waste.
People have different ideas about how much the government should
manage the economy but two things at least are certain. First, any plan should allow for market
incentives. Second, running the
government requires taxes that lower income.
In the final analysis, a macroeconomy
can hardly be managed and does not need to be.
Markets provide the adjustment mechanisms to adjust the economy to
imbalances such as unemployment, recession, bad weather, and high energy
prices.
Out of a sense of fair play some income can be redistributed but
the iron law of incentives is that charity hurts the recipient who loses
the incentive to help themselves.
Welfare systems create a permanent underclass and the “safety net”
becomes more of a hammock.
There are good jobs, however, involved with managing the macroeconomy. These
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 that their main
concern is their own well being but that should be clear.
Pollution is a spillover created along with some products. A good deal of pollution is caused by energy
sources including coal, oil, and gas.
Pollution is a cost that is external to the firm or household producing
it. The cost of pollution has to be paid
by people outside the firm.
Solving pollution is costly.
For instance, pollution from generating electricity could be eliminated
but your electricity bill would perhaps 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 how much is paid and who pays.
Remember that markets work but there remains
room for disagreement on political issues.
It is always worth the effort to try to separate economics from
politics. Economics focuses on the costs
and benefits of an issue. These ideas should
help you begin to think in economics.