Economics

"The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups."

-- Henry Hazlitt


Introduction...

This one quote simply and powerfully sums up what this module is all about: understanding how economic decisions affect various groups, and how results in the short term may be vastly different than those in the long term. As such, our focus will be to examine fairly large-scale concepts, without delving into those details which, while important to economists, tend to confuse (and bore!) the average reader.

Obviously, economics is not a "hard" science like chemistry or physics, and is not typically advanced through the use of the scientific method. (See our science module.) It is also somewhat different than social sciences like psychology and sociology, as it relies heavily on mathematical, rather than behavioral, models. This makes economics a hybrid science, striving to develop and refine predictive mathematical formulas about personal and social behavior patterns.

Based upon our own research, we believe the following to be true about this field, and important to note prior to any discussion of economic concepts:

  1. Economics is the study of systems that are highly complex and non-linear. This means that economies exhibit many traits common to systems considered to be "chaotic" -- high sensitivity to initial conditions, self-organizing and generally unpredictable. Thus, Adam Smith's "Invisible Hand" and the generally low level of economic predictability can be explained in large part by the basic features of complex systems that are "far from equilibrium."

    One such system is the global environment, which was Smith's inspiration for the Invisible Hand concept and his model for the ways in which economies should function. (It's also the reason he called his book "The Nature and Causes of the Wealth of Nations.")

  2. Economics, psychology and sociology are solidly intertwined, since economic activities are based upon human nature, personal and group psychology, social interactions and cultural considerations.

  3. Political, philosophical and ideological orientations strongly influence perspectives on economic concepts. Thus, it is very important to understand these perspectives before making decisions.

    Example 1: Conservative economists tend to believe that the viability of socialism has been disproven, while some liberal economists feel that socialism may still be viable, but in forms different from the systems that have been tried to date.

    Example 2: Some economists see advertising as a valuable way to reduce costs by creating mass markets, while others see it as a waste of resources that would be better applied elsewhere.

With these ideas in mind, it's easy to see why economics is described as "the dismal science." It's based upon models that economists must label with this qualifier: ceteris paribus -- "all things being equal." In reality, things seldom are.



Key Concepts...


Value and Scarcity
Value is of central importance to the study of economics, because at its core that's what any financial system is all about -- assessing and working to improve the value of a particular product or service. A product provides value by:

  • Helping to produce more or better goods -- improving efficiency,

  • Allowing us to exchange one good for another that we need or want more,

  • Helping us improve our self-image and sense of self-worth.

While the first two examples of value creation are measurable and reasonably objective, the third is very subjective. A large house in a particular suburb has more value to some people than to others, and has nothing to do with efficiency or exchange. Yet, even with equivalent resources, some families are willing to pay for a particular piece of real estate while others are not.

The last piece of the value pie has to do with scarcity. Items that are scarce tend to go up in value versus those that are ubiquitous and easily obtainable. (More on this later in the sections on Supply and Demand and Utility.)

The fact that we value what is scarce is deeply ingrained in both our mental hardware and software: Hardware-wise, scientists have identified a "novelty" gene, which determines our enjoyment (high value) of ideas and activities that are new and different (scarce). On the software side, psychologists use the term "semantic undifferentiation" to describe the process by which words and concepts tend to become meaningless (low value) as they become overused (ubiquitous). (Those in the communications field use the term "wear out" to describe this phenomenon.)

Example: Pick an emotionally "hot" word, such as a curse or one with sexual connotation. Say it over and over. What happens? It starts to become meaningless the more we say it or think it. (This is one of the reasons we become immune to violence and profanity on television. The more we see of it, the less we become shocked. Unfortunately, if we're no longer shocked, we tend to forget that others, especially children, have not yet built up the same "tolerance".)


Rational Self-Interest...
Another basic tenet of economics is that people act out of rational self-interest, trying to maximize their own personal "utility functions". This means that we each try to increase our personal welfare by weighing the costs and benefits of decisions and possible actions as we perceive them.

Rational self-interest is a fairly complex, and sometimes contentious, concept. For one thing, what's rational to person A (e.g., buying a car) may not be rational to person B (who decides to purchase a bicycle). For another, self-interest does not necessarily mean selfish: Self-interest involves improving one's own lot, both physically and emotionally, without necessarily affecting the welfare of others; while selfishness involves personal gain at someone else's expense.

Obviously, rational self-interest is different for different people. It can be affected by one's political and ideological views, morals, social standing, age, experiences, level of self-worth and financial situation. The fact that we all assign different weights to these various factors leads us to assign different costs and benefits to a particular opportunity, explaining why two people can value the same item so differently!


...and the Division of Labor
Adam Smith pointed out that the entire economy benefits from having each individual work to maximize his or her self-interest. The reason has to do with the fact that modern economies are based upon a division of labor, whereby people and organizations are most effective and efficient when doing what they do best. Such a division creates enormous interdependencies which force societal players to work together, rather than selfishly, if positive results are to occur and be sustained. To quote Mr. Smith:

"...man has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love in his favour, and show them that it is for their own advantage to do for him what he requires of them... It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest."

Both modern game theory (Prisoner's Dilemma) and biology (evolutionary stable strategies and "selfish genes") affirm Smith's observations: Social organisms work together, realizing that over the long run it is cooperation, rather than exploitation, which provides the most benefits to the most members.


Supply and Demand
Tied directly to costs and benefits, as well as to scarcity, is the most famous of all economic concepts -- supply and demand. Starting with demand, we will examine the two parts separately and then join them back together.

When economists talk about demand, they don't mean needs or wants, but rather the desire for a product that is backed by the willingness and ability to purchase it. Demand is inversely related to the price of an item: the more something costs, the less demand there will be for it, and vice versa.

Supply, on the other hand, is defined as the willingness and ability of a producer to make an item available for sale at a variety of prices. Supply, too, is related to the price of an item, but unlike demand, it's a direct relationship: the higher the price that a producer can charge for a product, the more of that product he or she is willing to produce.

Supply and demand come together in the marketplace, where buyers and sellers size each other up. Buyers weigh the costs and benefits of an item, and producers try to sell the most number of units at the highest possible price. At the point where buyers are willing to pay the price asked by sellers, who can sell all they can at that price, the market is said to have reached equilibrium. Equilibrium is tantamount to what's known in physics as "neutral buoyancy", since market forces are equal and thus at rest. However, buyers and sellers are not necessarily happy, as the former would still like to pay less and the latter would still like to charge more.

In theory, a laissez-faire (hands off) approach to markets allows for the achievement of equilibrium. However, in many cases, governments and societies have concluded that while efficient, market mechanisms are not always fair or desirable. Thus, subsidies are created that compensate farmers for prices that are too low to provide sustainable incomes; tariffs keep out the goods of other nations to protect domestic industries; and price ceilings are used to reduce the ability of producers to raise prices for particular items (such as apartments).

Such intervention always produces some amount of disequilibrium: farm subsidies and tariffs raise the cost of food to consumers and reduce competitiveness; while rent controls can actually reduce the supply of affordable housing. (Click here to read the Cato Institute's Rent Control Study.) Thus, it is imperative that societies understand the long term effects of market intervention so that they can accurately determine if a.) the medicine will in fact lead to the cure, and b.) the value to the few is worth the collective costs to the many.


Elasticity
In most cases, the relationship of supply to demand is not a straight line -- a 5% increase in price doesn't necessarily lead to a 5% decrease in demand. The way to measure the effect of price on demand is through elasticity: If a small change in price leads to a large change in demand, pricing is considered to be elastic. If a change in price has little effect on demand, pricing is considered to be inelastic. Thus, raising the price of an item with elastic demand, such as yachts, will reduce revenues, while raising the price of inelastic products, such as cigarettes, will increase revenues, since sales volume will go up far faster than product volume will decline (if it declines at all).

Price elasticity is affected by three factors:

  1. The availability of substitutes -- more substitutes mean that people have the opportunity to switch to comparable products that cost the same or less.

  2. The proportion of budgets involved -- goods that account for a larger proportion of someone's discretionary spending will be more elastic, as the effect on their budgets will be more pronounced.

  3. Time -- longer time periods lead to more elasticity. That's because the ability to find or create suitable substitutes, change attitudes or modify behavior increases over time.

Understanding price elasticity is of critical importance to policy makers, since results are highly dependent upon the three factors listed above. Consider the following:

Example: Due to habituation and the absence of substitutes, the demand for illegal drugs remains strong. This means that policies that try to cut supply only end up increasing prices. Thus, dealers become richer, while drug users turn to crime to pay for their increasingly costly habits. The effect on society is far less positive than originally expected.

Thus, it can be seen that creating policies designed to reduce demand for inelastic products such as cigarettes and gasoline require a long term perspective, possibly by seeking alternatives (substitutes) and/or developing impactful education programs (time). Otherwise, the only major effect will be higher profits for the producers and/or the creation of black or "gray" markets.


Equity and Efficiency
In simple terms, equity means doing the right thing, while efficiency means doing things right. A sense of equity develops a concern for fairness and justice, while efficiency involves getting maximum value from minimum resources. Since unregulated economies would strive primarily for efficiency, "the law of the jungle" would most likely rule: Those who couldn't make it would perish. Thus, a desire for equity produces an environment whereby society deems it necessary to "create a level playing field" to help those who are less fortunate, or a "safety net" for those incapable of helping themselves.

From an environmental, health & safety standpoint, the concept of maximum value for minimum impact is commonly referred to as Eco-efficiency. Assuring a "clean" environment for all societal members -- both those of today and tomorrow -- is referred to as Environmental Justice. These concepts of equity and efficiency are integrated to form a broader premise known as Sustainable Development. While there are many definitions of the term Sustainable Development, a commonly accepted one is offered by the Bruntland Commission:

Meeting the needs of today's generations without compromising the ability of future generations to meet their needs.

Financially speaking, assuring a reasonable level of equity carries costs that will ultimately reduce efficiency. Once again, it is up to society to determine the relationship between equity and efficiency that will produce the quality of life that it is collectively seeking.


Utility
While much of life is hard to measure, economists try to do so by using the concept of utility, which is the amount of satisfaction derived from consuming a particular good or service. Utility thus combines quantitative factors such as weight and size, with qualititative considerations such as color or status. There are three dimensions to the concept:

  • Total Utility -- the total amount of satisfaction that an individual receives from all of the units of a particular product consumed in a given period of time.

  • Marginal Utility -- the additional satisfaction received by consuming one more unit of the particular product.

  • Diminishing Marginal Utility -- the fact that as more units of a product are consumed, less additional satisfaction is received from each additional unit.

Example: Let's say you're about to have a turkey dinner, which can be divided into 50 bites. We'll assign a value to the entire dinner of 100. Is each bite worth 2, which is 100 divided by 50? Think about your experiences: The first bite, which is highly anticipated as both a taste sensation and hunger reliever, is worth much more than the last, which no longer thrills the taste buds and may actually provide more food than we need. In reality, bite one may be worth 20, and bite fifty may be worth little more than 0. Thus, there is diminishing marginal utility as we eat our meal. That's because the value, or benefit, of the bite we're about to eat is less than that of the bite that's just left our forks.

The concept of marginal utility, also known as diminishing returns, works for all resources, not just food. Just as an ounce of turkey is worth more to a starving woman than to a satiated one, a dollar is worth far more to a pauper than it is to a prince.


Costs
To an economist, a cost is anything that is given up to obtain something else. Costs result from scarcity: if anything you wanted was easily and abundantly available, there would be little cost involved!

Types of Cost
There are two basic types of costs to be considered when making decisions:

  • Explicit Costs -- These are the visible costs of purchasing something, and are fairly easy to measure. They're the out-of-pocket costs of buying goods and services, measured in dollars or other forms of currency.

  • Implicit Costs -- These are the opportunity costs involved in using resources that don't involve direct payment. They can include factors such as quantity of time (too much or too little), quality of time (with friends, family or boss), effort or aggravation.

Example: The explicit cost of taking the bus may be $1.00, while the explict cost of taking the car (gas and parking) is $2.00. If the implicit costs of taking the bus (waiting, not getting a seat) are much greater than $1.00, and driving has no implicit costs, you'll end up behind the wheel. Thus, decisions that appear irrational when only looking at explicit costs appear very rational when implicit costs are factored into the equation.

Sunk Costs
Sunk costs are costs which occurred in the past and cannot be retrieved. Let's say that the Air Force has spent $3 billion on a new bomber design which new technology has suddenly made obsolete. The $3 billion is a sunk cost. No amount of extra effort or funding can change the current situation. Rather than "spending good money after bad," the best (and sometimes hardest) thing to do is to write it off and move on.

Externalities
An externality is a cost or benefit that the organization which created it doesn't receive or pay for. We'll concern ourselves with negative externalities, which are costs created by an organization but which are paid for by others.

Second hand cigarette smoke is an externality. Non-smokers, who may get sick from the smoke, bear the costs but not the responsibility. Polluters who do not have to pay for the costs of prevention or clean-up have created externalities in the form of pollution and a degraded environment. Thus, government or other third party intervention is usually required to "internalize" the costs and put them on the ledger of the producing party (hence the almost universal agreement to the concept of "the polluter pays").

Externalities make many of our largest and most troubling environmental concerns -- population growth, energy consumption and loss of biodiversity -- hard to visualize and remedy. For example, most people don't think about or pay for the pollution created when they start their cars. By not capturing theses costs and passing them back to the polluters (drivers), we keep the price of fuel artificially low, and continue to create huge amounts of carbon dioxide and other greenhouse gases. A key to solving these problems goes back to the concept of elasticity -- internalize them through the proper combination of pricing signals, education and acceptable substitutes.


Taxes
The way in which societies finance their public undertakings is through taxes. These are compulsory payments by businesses and individuals for which no direct benefit is received. Tax policies strive to be both efficient and equitable. An efficient tax is easy and inexpensive to collect. An equitable tax affects people of similar situations equally (horizontal equity); those of differing circumstances differently (vertical equity); or both.

The way in which taxes are levied is a key determinant in tax policy. There are three ways to relate taxes to individuals:


Tax Rate Progressivity
Income Proportional Tax Progressive Tax Regressive Tax
Rate Amount Rate Amount Rate Amount
$10,000 20% $2,000 15% $1,500 25% $2,500
$50,000 20% $10,000 20% $10,000 20% $10,000
$100,000 20% $20,000 25% $25,000 15% $15,000

From Economics, An Integrated Approach, by B. Davis
  • Proportional Taxes -- All individuals pay the same proportion of their incomes, say 20% as shown above. Since those with higher incomes pay a higher absolute amount, vertical equity exists. If the tax is applied across the board, horizontal equity also exists.

  • Progressive Taxes -- Tax rates increase as incomes rise. Again, vertical equity exists, and as long as people with similar incomes are taxed equally, horizontal equity exists as well.

  • Regressive Taxes -- Tax rates decrease as incomes rise. Since those with higher incomes may still end up paying more even though the proportion is lower, vertical equity can still be met. Once again, if those of equal means are taxed equally, horizontal equity also exists.

From a policy perspective, the development of tax structures must start with clear goals and an understanding of elasticities. Otherwise, revenue goals may not be met due to unexpected consequences.

Example: In 1990 the U.S. government felt that the rich were not paying their fair share of taxes. It was decided that one way to create a highly progressive tax that affected primarily the upper income brackets was to tax luxury goods -- expensive cars, planes and boats. Results were far from anticipated, since legislators didn't factor in price elasticities: The tax made buying luxury items unaffordable, even for the wealthy, who reduced their purchases by more than 50 percent. This led to massive layoffs of lower and middle class workers, since manufacturers couldn't sell or produce more goods. Thus, less tax was actually collected and the people who really paid were those who lost their jobs.


Inflation
Nothing seems to scare economists (and most other people) more than the spectre of inflation. The reason is that inflation signals a decrease in buying power, meaning that money loses it's value: It takes more of it to buy tomorrow what less of it will buy today. If allowed to advance unchecked, inflation can cause signficant social misery and political upheaval: In Germany, the Great Depression led to a huge inflationary spiral that raised prices by a factor of about a trillion. The resulting economic chaos allowed the Nazi Party to topple and then take over the German government.

From a business perspective, there are two types of inflation. Demand pull inflation occurs when the demand for products and services begins to outstrip supply, leading manufacturers to raise prices. Cost push inflation occurs when the cost of raw materials rises, causing manufacturers to pass their extra costs along to their customers and eventually to consumers.

The two are obviously related. If demand for oil increases, producing nations will raise their prices (demand pull). Buyers of oil, who convert it into gasoline, pharmaceuticals and chemicals, will pass their higher prices on to their customers (cost push). If raised high enough, the higher prices will reduce demand and the inflationary cycle will slow.

Another potential cause of inflation is deficit spending by governments. When outflows exceed tax inflows, governments must borrow or print money. The effects are similar: Government borrowing increases the demand for money, raising interest rates and causing inflation. Printing more money means that the money that was around beforehand is now worth less, again leading to inflation.


Growth
Is growth good? Bad? Neither? First, let's define growth from an economic perspective: Growth is an increase in real income, which means that individuals have more real buying power than they did in the past. Thus, true growth doesn't include inflation, which actually causes buying power to decline.

Growth is caused primarily by two factors: population and productivity gains. More people working leads to increases in available financial resources and in demand. Productivity gains stretch the value of a dollar -- the same amount of money today can purchase more or better products and services than it could yesterday. Thus, a reasonable and healthy level of annual growth in the U.S. economy is around 3 percent, with about one-third coming from population increases and two-thirds from productivity gains.

What if growth is faster or slower? Faster growth can lead to inflation, because demand builds faster than available output or productivity can comfortably allow, causing prices to increase. Slower growth can also be problematic: If the population stagnates or productivity falls behind, demand will fall, leading to a depression or recessionary cycle that reduces the overall material quality of life.

Thus, a healthy economy is precariously balanced between growing too quickly and not growing fast enough. Whether or not government intervention is necessary to maintain a healthy economy, or whether it is best left to nature's Invisible Hand, is the major economic question of our time.


Pitfalls

There are a number of pitfalls to avoid when trying to understand statements about economics or the economy. Here are three points to ponder when confronted with economic statistics and conclusions:

  • Ideology -- Good economics thinking is descriptive, and includes only statements of facts. Beware of phrases such as "ought to" or "should be" as they indicate someone's personal feelings rather than descriptions of reality.

  • False Causes -- As described in our sections on statistics and reasoning, it's important not to confuse correlation with causation. Just because two things happen at the same time doesn't mean that one caused the other, or even that they're related at all. Economics is so complex that it's often very hard to tell why business spending increased, why inflation is slowing, etc.

  • Fallacies of Composition and Division -- A fallacy of composition is one in which it is believed that what's good for one person is good for all: If one person waits a year to buy a car, she'll have more money to spend next year. But if everyone waits, the economy will go into a tailspin. Tariffs and subsidies are another example, since helping one small group can actually increase costs for the larger part of society.

    A fallacy of division occurs when it's believed that what's good for the whole economy is good for each of us. For example, low interest rates are generally a sign that a nation's economy is healthy. But for elderly people who live off the interest earned on their savings, declining rates reduce their incomes and thus their standards of living.


Summary...

Economics attempts to explain and predict the effects of policy and other changes on individuals, firms and societies as they interact to increase their wealth. The key tenet is one of scarcity, whereby costs and benefits are calculated based upon the relative supply and demand of goods and services. From an ecological standpoint, the challenge to economists is to ensure that a major externality -- the value of a clean environment -- is properly captured and internalized so that better and more sustainable decisions can be made.

Here is a simple table that you can refer to when analyzing economic proposals or arguments that claim specific economic impacts:


Economics Crib Sheet

  • What group has the most to gain from the proposal, and which groups stand to lose from it?

  • What are the short term effects of the proposal and on which groups?

  • What are the long term effects?

  • What will it cost society as a whole to implement the program?

  • Is the cost worth the benefit?

  • Is the program both efficient and equitable?

  • Has the policy included estimates of price elasticity and do the recommendations reflect these estimates?

  • Have externalities been identified and accounted for?

  • Are statements descriptive and factual, rather than value-laden?

  • Do conclusions based upon projections, correlations or cause-and-effect assumptions make logical sense? Can you determine other reasons for the events described?



References On the Net...

  1. Amos World, "a guide to all things economic, and the home of Mr. Economy"

  2. Commerce Department, Web sites on the economy and statistics

  3. Econ Education Web, at the University of Nebraska

  4. Economics America, Website of the National Council on Economic Education

  5. Essential Principles of Economics, a Web-based education program from Drexel University

  6. WebEc, global resources in economics

  7. The World Bank

 

References Off the Net...
(Clicking on the link will take you to the appropriate catalog page of Amazon.com, where you can learn more about the book and/or order it.)

  1. Bionomics: Economy as Ecosystem, Michael Rothschild (Henry Holt, 1990).

  2. A Concise Economic History of the World, Rondo Cameron (Oxford University Press, 1993).

  3. Ecological Economics: The Science and Management of Sustainability, Robert Costanza, Editor (Columbia University Press, 1991).

  4. Economics: An Integrated Approach, Benjamin Davis (Prentice Hall, 1997).

  5. Economics Explained, Lester Thurow & Robert Heilbroner (Touchstone, 1998).

  6. Economics in One Lesson, Henry Hazlitt (Fox & Wilkes, 1996).

  7. The Economy of Nature, William Ashworth (Houghton Mifflin, 1995).

  8. Energy and the Ecological Economics of Sustainability, John Peet (Island Press, 1992).

  9. Everything for Sale: The Virtues and Limits of Markets, Robert Kuttner (Alfred Knopf, 1996).

  10. Living within Limits: Ecology, Economics, and Population Taboos, Garrett Hardin (Oxford University Press, 1993).

  11. The Origins of Virtue: Human Instincts and the Evolution of Cooperation, Matt Ridley (Viking, 1997).

  12. The Wealth of Nations, Adam Smith.




"Economics is the language we use to talk about the workings and options of our system, but it is not the language in which we appraise the value of the system or decide what elements in it to preserve or change. Politics and morality -- our collective wills and our private value systems -- remain the bedrock of society."

-- Robert Heilbroner & Lester Thurow



©1998 The Center for Informed Decision Making