Journalists with little insight into economics write
on economic issues, 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. Regardless, 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 by 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.