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.