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Macroeconomics 2: Ten Principles of Economics

Economics is the study of the mechanism by which a society allocates its resources. In order to start studying macroeconomics, we must first understand the ten basic principles of economics, as set out by Gregory Mankiw, a well known macroeconomist, and professor at Harvard University. They are further separated into 3 main sections: how people make decisions, how people interact, and how a national economy works as a whole.



In order to get something, we must always give up something else. If you decide to spend $5000 on a great night in Vegas, that is $5000 less that you have to spend on other things, such as a diamond ring for your girlfriend, or college tuition for your kids. Whether that tradeoff is worth it is entirely up to you, as long as you realize that you can't have your cake and eat it too. As a society, we need to make similar types of choices: there is always a tradeoff between efficiency and equity. A society that chooses a high degree of efficiency can seem Darwinian in the cruelest sense, as the relentless pursuit of efficiency simply ignores the suffering of those who are unable to keep up. A society that instead chooses a high degree of equity, or equal distribution of wealth, is much more humane, but will generally suffer from a high degree of inefficiency. For example, we can choose to enact regulations that protect the environment from industrial waste. This comes at a cost, since the cost of enacting, enforcing and abiding by the regulations can be significant. We also face tradeoffs when it comes to the unemployed: most countries choose to provide some sort of social safety net that protects people that are down on their luck. This has an associated cost, not only because it causes a certain degree of moral hazard (it may discourage members of society from seeking work) but also because resources must be allocated toward this safety net, that could otherwise have been used for more productive purposes. This is of course not to say that we should allow industries to recklessly dump toxic materials into the environment, or that we should let unemployed people starve. It is, however, important to understand that these tradeoffs are real, and that policy makers must try to choose the most appropriate balance between efficiency and equity.

Because of the above-mentioned tradeoffs, people in a given situation need some sort of method to determine which course of action produces the most beneficial tradeoff. The cost of one action versus another may not be immediately clear. A good example would be a high school senior trying to make decision whether to go to college or not. When he thinks about the total costs and benefits of a college education, he may consider the fact that a degree will give him a lifetime of great earning opportunities, but it will cost him tuition, books, and other related expenses to get there. One thing he may not even take into account is the time it takes to complete a college degree, and the wages he could collect if he instead chooses to work for 4 years instead of studying. All the things he gives up in order to go to college, are called the opportunity cost of going to college.

A marginal change simply means an incremental change to a pre-planned action. For example, say an airline is planning an extra spring break flight to Cancun. It costs the airline a total of $50,000 to make the flight happen with a 200 seat plane. A bit of simple arithmetic shows us that the average cost per seat is $50,000/200 = $250. It may seem reasonable to conclude therefore, that the airline should not under any circumstances sell a ticket for less than $250. This is not the case however, if you consider the marginal costs in case the flight is underbooked (this year, more students than expected stayed home to study instead of joining in the debauchery in Cancun). It is one hour before flight time, and there are 10 empty seats on the plane, when a young man decides that he has had enough studying and he wants to go to Cancun after all. He rushes to the airport and says he has $200 to pay for the flight. Should the airline sell him the ticket? Even though the average cost per passenger is $250, their marginal cost is simply a bag of peanuts and a soft drink (let's say $1) - the total cost for running the flight will be essentially the same whether this young man is on the plane or not. It certainly makes sense for them to accommodate him. After all, $199 is better than $0.

Most decisions in life are based in some way on a cost and benefit analysis of available courses of action. For example, if the price of tequila rises, the spring break kids may decide that their money will go further if they drink rum, they have an incentive to drink rum rather than tequila. At the same time, since tequila producers see the higher price of tequila as an incentive to produce more of it, they do so. We will see later on in this series, how these market behaviours are a key to understanding how the economy works.



The common view among people is that the United States and China are competitors in some sort of economic tug of war. While there is some truth to this, insofar as some American and Chinese companies compete for the same customers, there is much more to the relationship. To simplify this rather complex relationship, let's look at an example. When you go shopping, you compete against other shoppers, because you may want the same items that they want, at the lowest possible price. On the other hand, imagine that you get sick of all this competition, and decide to economically isolate yourself from all other people. Do you think you would be better off? Probably not. You would have to grow your own food, because you have isolated yourself from the people who produce food. You would have to make your own clothes, because those terrible people at GAP were competing with you. The list goes on. You would have to be completely self sufficient, which in a complex society, is rather difficult. Time is limited, and there are so many areas of specialized knowledge, that you cannot possibly master them all, nor have the time to engage in all of them. Clearly you gain much by your ability to trade with others. Trade allows people to focus on serving a specialized purpose in the economy, such as food production, textile production, home building, computer engineering, etc... By trading with other people, you get access to a much wider variety of goods than you would be able to produce yourself, and at a better opportunity cost (price). The same principle applies to nations. The US and China are friends with benefits, as much as they are competitors. We will examine this further when we look at the principle of comparative advantage.

The well-known economist Adam Smith wrote in 1776:

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... Every individual... neither intends to promote the public interest, nor knows how much he is promoting it... He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it  always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.

What he meant in plain modern English, is that when people look out for their own best interest, they often inadvertantly also achieve the best possible outcome for society. This is by far the best known principle in all of economics, and is the basis upon which all free market economies are built. It identified several centuries ago, the advantages of decentralized decision making. Free markets are the ultimate democratic tool, where every time a market participant decides to purchase a product or service, he or she is casting a vote for it over its competitors. This principle clearly predicted how and why communism would never succeed - central planners interfere with the natural forces of the market, distorting prices - they achieve sub-optimal results and eventually, systemic failure. Central planners failed because they tried to run the economy with one hand tied behind their back - the invisible hand of the marketplace.

As Adam Smith noted, markets are the best way to organize economic activity. The thing about markets is that they still need to follow some rules. Governments need to be there to protect market participants from fraud or other dangerous business practices, and to enforce contracts. Without any rules, we do not have a free market system, but rather anarchy. In order to allow markets to perform their function properly, governments must be on the lookout for two main causes of market failures - externalities and market power. An externality is the impact that one individual, or group of individuals can have on another, without being directly engaged in any market activity. An example of this would be pollution emitted by a factory, which can cause damage to the lives and property of others. Governments can impose regulations directly to such businesses or individuals, or they can ensure that iron-clad property rights take care of such situations. Market power, being the other danger, is the ability of a single economic actor (or small group of actors) to have control of market prices. Examples of market power are monopolies and cartels, which eliminate competition, and thereby disable the invisible hand of the market.



In today's world, it is absolutely staggering how standards of living vary from country to country. People in advanced economies, on average, live far longer and more comfortably than their counterparts in less advanced economies. The main reason behind this is rather simple (although the reasons behind the reason are not). These vast differences are attributable mainly to one variable - productivity. A country's productivity is defined as the amount of goods and services produced by an average worker in an hour. The correlation between a country's productivity and the standard of living enjoyed by its citizens, is striking. There has been a lot of noise made recently about the rise of the "emerging economies" and how they are causing economic stagnation in advanced economies. In fact, it is the slowing growth of productivity in advanced economies that is causing the stagnation (we saw earlier that trade actually benefits everyone involved). Productivity growth has slowed largely due to large government deficits, which crowd out investment. We will learn more about this in follow-up articles.

There have been a number of spectacular cases of inflation throughout history. The cause, each time, was not some mysterious force that robs money of its purchasing power. The culprit, always, is the government's aggressive increase in the supply of money. The reason governments inflate the money supply can differ somewhat from case to case, but generally they happen because of war or other large expenditure that the government cannot afford, so it devalues the currency in order to lessen the debt burden. This can easily get out of control, and when it does, hyperinflation rears its notoriously ugly head.

This relationship is best described by the Phillips curve, named after the economist who discovered it. Although not all economists are convinced that this tradeoff has its basis in reality, a majority do. The explanation for this effect is that prices do not adjust immediately to an increase in the supply of money. It takes time for restaurants to print new menus, or for prices of components to filter through to the consumer market. Prices are said to be sticky. What this means then, is that when a government increases the money supply, it increases the amount that people spend, which provides an incentive for businesses to produce, and thus hire, reducing unemployment. It is important to note that this effect is only temporary, because it only works until all prices, in the economy, including the price of labor (wages) have had a chance to adjust. As prices adjust to the new level of money in the economy, the tradeoff dissipates, and the economy returns back its natural state.

Continue to Macroeconomics 3: Gains from Trade

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