ECONOMIC$
Journalists with little
insight into economics write on economic issues, spread confusion, and let political
bias cloud their objectivity. High
school economics courses are concerned with definitions. Introductory college courses are vast empty
surveys. Economics is either too obscure
or too obvious. 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 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, produce some
products that markets do not, and redistribute income. Political groups try to alter market outcomes by supporting politicians with
money and votes to pass favorable laws and policies.
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 should do is important for sound
economic thinking. This short book can
help you to focus on such economic issues.
I have taught various economics
courses and published numerous 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 a number of 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.