Journalists with little insight into economics and their own political agendas write on economics spreading confusion. High school economics courses define some terms but provide little insight. College principles courses are vast empty surveys. Economics seems simultaneously obscure and obvious. This introduction is meant to get you started on toward understanding 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 worldwide due to increased specialization and trade.
The role of government is to provide a legal structure of property rights, produce some products when markets fail, pass laws to influence markets, and redistribute income. Political groups try to alter outcomes in their favor by supporting politicians to pass favorable laws and policies. Support comes as 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 has the potential to do is important for sound economic thinking.
Economics is the study of the production and distribution of goods and services through markets. 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 the benefits of free commerce, trade, and investment. Economics explains why people save, why firms invest, and why the economy grows. Two important issues for the economy are 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 laws politicians pass 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?
Markets produce and distribute goods and services. Goods are scarce physical objects such as cars, shirts, gas, and wine. Services are things people do for others including haircuts, doctor visits, and investment consulting. 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 price rises, the quantity supplied increases. Higher energy prices raise quantity supplied for instance.
The other side of a market is demand, the quantity purchased at various prices. As price rises, the quantity demanded falls. Incomes and tastes of potential buyers affect demand. Limited budgets, location, and timing affect demand as well.
Supply and demand are the two sides of a market. Together supply and demand determine price and output. Changes in 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.
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.
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.