Journalists with little
insight in economics write on economic issues spreading confusion. College
principles courses tend to be vast surveys. As a result, economics seems either
obscure or obvious. This introduction to economics is meant to start you on the
right foot toward understanding the depth and focus of economics.
The foundation of human life is production and consumption of
goods and services that make it possible. The major theme of economics is that
markets provide these goods and services. During the past century living
standards rose remarkably worldwide due to increasing specialization and trade.
The role of government is to provide the legal structure for
property rights, produce public goods when markets fail, and redistribute
income. Political groups try to alter
market outcomes in their favor supporting politicians who pass laws favorable
to the group. The support is 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 exposing the limits of government policy.
The basic lesson of economics is the benefits of free trade and free investment.
Economics explains why people save and
firms invest, and why
the economy grows. Two issues for the economy are unemployment and inflation.
Economics will not make you rich but might help you make wise
investments. Economics will help you understand why politicians pass laws favoring
various 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 decades? How soon will there be a
sale on that new car you want? Which industries will expand?
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 consulting provided directly between people. Goods
and services are produced requiring payments for the inputs of labor, machines,
and energy.
One side of a market is supply
that sums up 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 for the amount purchased at various prices. As the price
rises, the quantity demanded falls. Incomes and tastes of potential buyers shift
demand. Everyone is a potential buyer of everything
but many goods and services are beyond most consumers due to price, budgets,
location, or timing.
Supply and demand are the two sides of a market together determining price and quantity.
Changes in demand and supply affect price and output. Increased income 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.
markets
for productive factors
Labor, capital, and natural resources are the three general factors of production. Firms pay
owners of these inputs. In the economy, firms are input buyers and households
are sellers.
People sell their labor
and receives a wage. Labor
supply comes from individuals or households. While everyone would like a higher
wage, the labor market determines wages. People with their own businesses pay
themselves a wage.
Capital refers to the machinery,
equipment, and structures in production. Capital has to
be produced and is valuable because it contributes to firm revenue. Firms pay rent for capital input. Even if a
firm owns 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
resources, lumber, and iron are derived from the earth. The foundation of
natural resource inputs is land, air, and water. Natural resources are paid by
the firms using them in their production. Owners of the natural resources sell
them to firms for production. Either people or the government can own natural
resources.
The factor 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 factors are the two sides of the
economy. People are demanders in the product markets and suppliers in the factor
markets. Firms are the opposite, suppliers in the product markets and demanders
in factor markets.
Prices for products and factors are determined by markets.
Markets are interrelated by price and output effects. For instance, an increase
in the price of gas will raise demands for bicycles and mass transit. Prices
send signals for what to produce, what can be afforded, which inputs to buy,
where to invest, and how many hours to work.
The economic system is complicated with markets constantly
distributing goods and services. The news is delivered, a hamburger served, the
internet provided. Economics boils this 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, arbitragers 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
as countries do not waste valuable resources making products that other
countries make at lower cost.
Industries competing with imports want protection with tariffs and quotas of the government. A tariff
is a tax on imports, and a quota a limit on the quantity imported. These
government policies help the protected industries but hurt consumers of the
good or service. Protected industries are inefficient and cannot compete with politicians
providing protection in exchange for money and votes.
There is concern that other countries have lower wages or weak
environmental regulations with unfair trade. 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. Relative
efficiency is all that is required to gain from trade. Comparative advantage is the relative efficiency that determines
efficient production.
International investment is vital for economic
growth naturally flowing across borders as industries look for better locations
for production. Some countries become international lenders, and others borrowers. Governments limit international investment
due to political pressure from firms competing with the foreign investment.
General Motors, for instance, is hurt when Hyundai locates a new automobile
plant in the country.
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 trade and investment.
The exchange rate sets domestic prices of imports and foreign
investments. Governments may fix their exchange rate to please bankers or
investors. 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
now so they can spend later. People save for college for their children, for a
new car, for retirement, or to pass wealth to their descendants. Saving is money
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 representing
ownership in the firm, or from borrowing. Investing this year helps produce
more revenue next year. Investing requires money now that is not spent on
consumption.
Saving and investing determine the future of the economy
interacting in the credit market. The two sides of the credit market are saving
as saving and investment as 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 rate that it charges banks that need to borrow. Market forces
determine this federal funds 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% leaves a
2% real interest rate.
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. Some stay poor more
often due to a corrupt government. Dictators cheat and steal. If their country
has scarce natural resources like oil, the rulers take the profits for
themselves. Honest government officials are rare.
Governments define and enforce property rights. If anyone could drive your car there would be
little incentive to work and 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. Everyone would prefer a receiving a subsidy to paying a
tax, leading to political issues. 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. A monopoly sets price to maximize
profit with no competitors. Electric utilities are franchise monopolies. The
government regulates the utilities
receiving taxes and political support in exchange for the franchise. This
unholy alliance between business and government leads to inefficiency.
Taxis, doctors, electricians, airport landing slots, cable
service, and beauticians are other examples of government franchises and
licenses. Monopoly power restricts competition. The value of a license or
franchise can be high with firms willing to pay lawmakers for the favor.
Some industries that were franchised and regulated by the
government have been deregulated over recent decades. These include banking,
trucking, airlines, and telecom. These deregulated industries now produce
better services at more competitive prices than when franchised.
environmental
economics
Pollution is a negative spillover produced
along with some outputs. Most pollution is caused by energy sources including coal, oil, and gas and by mining of
minerals. Pollution is a cost external
to the firm producing the good. The cost of pollution has to
be paid by others outside the firm.
Solving pollution is costly. Pollution from generating
electricity could be eliminated but electricity bills would at least double.
People want clean air but not to that extent. There are various ways to control
pollution but they all have costs consumers would have
to pay. The political process of passing and enforcing environmental laws
determines who pays how much.
Remember that while markets work there is room for disagreement on
political issues. It is worth the effort to separate the politics from the
economics.
Macroeconomics is concerned with managing the entire economy. Analogies to driving vehicles include
accelerators, brakes, fine tuning, takeoff, and soft landing. The desired
illusion is that the government macromanagers are in
control. Presidents take credit for economic expansions when they have little to
do with it. Congress passes economic recovery packages 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 sounded good on paper, the
socialist system collapsed with 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 cost someone.
The economy can hardly be managed. 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
only create a permanent underclass as the safety net becomes a hammock.
There are good jobs, however, in maromanaging
the economy. Government bureaucratic jobs perpetuate themselves. Politicians
are elected if they can make you think they can do something for you. Macroemanagers would never admit their main concern is to
perpetuate their own well being.