Introduction to Economics
Economics is the study of how a society uses its resources to produce output that it desires. In the beginning, people were hnters and gathers, organized as family units, and as larger groups, who expended most of their energy to survive. Through the millennia, people learned to organize and specialize, so that they could create products and services beyond those needed to survive.
Although economics can be a complex science, it is based upon a few simple principles. The primary principle is the efficient allocation of scarce resources. Since every economy has only so much of what are called the factors of production — labor, land, and capital — the greatest wealth generated by any society will be achieved through the most efficient and fullest utilization of its resources.
Adam Smith noted in his 1776 publication The Wealth of Nations that people act naturally in their self-interest, which he called the invisible hand, and that the economy can be organized to take advantage of this self-interest. This requires that the people have the freedom to act and to own the factors of production, and to enjoy the profits or suffer the losses of their activities.
Adam Smith also noted the advantages of the division of labor, where the production of goods or services is decomposed into simpler steps, where a person specializes to perform each step, thereby gaining proficiency in accomplishing the task. This increased productive efficiency over craftsmanship, where the worker would perform all the tasks required to provide the good or service.
In deciding how much of a product or service to provide, economics offers the tools of marginal analysis, which is the ratio of the marginal benefit over the marginal cost of providing an additional benefit. Marginal analysis is necessary because the cost of producing a good or service depends on the quantity produced. Within limits, economies of scale reduce the cost of production, where the cost of producing an additional unit is slightly less than the cost of the previous unit. However, demand, and the prices that people are willing to pay, declines with increasing supply. Hence, there will be a point, known as the supply-demand equilibrium, where the cost of producing an additional unit = the price that people are willing to pay for that unit.
Why Study Economics?
Economics is a science most pertinent to most people. It is the science of the economy and how it works, and its principles apply to every economy, regardless of the type and regardless of the culture of the people composing that society. Its principles apply to capitalist, communist, and socialist countries. Its principles apply to Americans, Europeans, Russians, Chinese, Africans, everyone. It applies to the largest economies down to the smallest economies. Its principles apply to cultures within cultures, such as the 400 remaining tribes of the Amazon rainforest, or the almost 3000 tribes in Africa. Its principles apply to the Roman Empire, to ancient Athens, to the Mesopotamians, to the Aztecs and the Maya, to all of civilized history.
Psychology is the study of individual behavior, sociology is the study of how members interact in society, and economics is the study of how society uses it scarce resources to produce products and services most desired by people. Economics applies to all people and all societies because ultimately what people do is based on their biology, and that biology has not changed significantly over history or across cultures. While there are endless variations of cultures, the underlying principles remain the same.
The study of economics can help a society to achieve its maximum wealth. It also increases understanding of business cycles and the effect of government policies, and how those policies affect the business cycle, which can be enormously beneficial to both business people and investors.
Knowledge of economics even allows people to choose the best political organization of their society to achieve the greatest economic wealth. For instance, history has shown repeatedly that communism simply never works because it is a well-established principal that people work for their own self-interest and not for the common good. It is clear that any political organization that does not heed economic principles is doomed to failure, and society will suffer as a result.
By understanding economics, you can understand the news better: why the stock market goes up and down, why the economy goes up and down, why government policies work or don’t work, and, and most importantly, what motivates people.
And because news becomes history, you can also understand history better. For instance, although the Black Death was a terrible scourge to the people of the mid-14th century, killing almost half the population in some places, it turned out to be a blessing for the peasants who survived, because labor became a more scarce resource, allowing the peasants to demand higher wages and better living conditions from their masters.
By understanding economics, you can invest better. The economy moves in cycles. Although the stock market is up and down every day, it tends to move in trends that mirror the economic cycle. The stock market usually starts rising when the economy reaches a nadir, then continues to ascend with the economy, reaching a peak right before the economy reaches a peak. When the government is printing money, stock prices tend to increase, because people buy assets, to protect themselves against inflation and because the Federal Reserve uses that new money to buy Treasuries, causing the investors who held those Treasuries to use their additional money to reinvest elsewhere, usually for a higher return, such as in the stock market, especially in the low interest rate environment that usually prevails when the Federal Reserve increases the money supply. So when the Federal Reserve implemented their policy of quantitative easing, which increases the money supply, the stock market increased significantly, especially between 2012 and 2014. This was not the only factor, of course, but it is a reasonable assumption, given that interest rates were close to 0%, leaving stocks as a major alternative for reinvestments. On the other hand, when the money supply contracted in the 1930s, the Great Depression ensued. One factor contracting the money supply was that banks started to fail, causing people to panic, to withdrew their money and hoard their cash. This reduced the velocity of money, causing the economy to contract. When people hoard cash, it is as if the money does not exist, since it is not being spent, so, with fewer customers, many businesses fail, causing the economy to cascade downward. This was not the only cause of the Great Depression, of course, but it was a prominent one.
You can also understand politics and policies better. One cardinal characteristic of every economy is that there are always certain groups of people who profit off of the rest of the population, which is why they are wealthy. In communist countries, dictators control the country, so they rule the country in the interest of themselves and their benefactors. The Russian government, for instance, is not so much a government as it is a network of criminals, who control the government to maximize their own wealth, even though they impoverish everyone else. And because there is no rule of law there, it would be idiotic to invest in any Russian company, at least without understanding that there is an enormous amount of risk in such an investment. This also explains why Russia, by far the largest country in the world, is an economic midget, with the Gross Domestic Product less than that of little South Korea. In democracies, the wealthy cannot dictate, but they can influence politicians with money, and those politicians often pass legislation that benefits political donors at the expense of everyone else, then they try to justify their actions with specious arguments. A prominent way that democracies allow the wealthy elite to profit at the expense of the masses is by placing most of the tax burden on income earned from work, while taxing income that accrues mostly to the wealthy — investments and inheritances — less. Taxing work less will promote work and increase economic growth by increasing the labor supply.
Economics can provide a blueprint for how the economy can be improved. It can even improve the political process of selecting capable and honest leaders. Especially in democracies, economic knowledge allows people to evaluate politicians and their proposed policies, to prevent their bamboozlement by demagoguery. For instance, although Hugo Chavez was democratically elected in Venezuela, the people were hoodwinked into believing that communism would provide a better standard of living for everyone, when, in fact, the exact opposite happened. Without understanding how an economy works, Chavez literally destroyed Venezuela with his policies, creating years of poverty and stress for millions of Venezuelans, even though there is enough natural resource wealth in Venezuela to enrich everyone there.
Understanding economics allows you to avoid political hoodwinking. For instance, politicians often argue that the rich should get most of the tax breaks because they help to stimulate the economy. But if you knew economics, then you would know that it is consumption that drives the economy, and that the marginal propensity to consume, which is the proportion of income received by individuals that is spent for consumption, is inversely related to wealth. In other words, poor people spend much more of their income for consumption than wealthy people do, since they need to spend simply to live, so it stands to reason, that giving tax breaks to the poor will stimulate the economy much more than giving tax breaks to the wealthy, and it will reduce the need for government handouts. Giving tax breaks to the wealthy simply increases government debt, which is amply evidenced by the continually growing federal debt since the enactment of the Tax Cuts and Jobs Act at the end of 2017.
By understanding policies better, you can choose better politicians. In the present world of so much fake news, understanding economics allows you to discern what policies are better than others, and what policies are being presented by politicians to benefit their political donors. By understanding this, you can help thwart the role of money and fake news in elections. In fact, I use simple economic principles to construct the best possible tax policy for any economy at any time, which I explain in my book Trickle-Up Economics.
In most sciences, knowledge is advanced by forming a hypothesis to explain observations or experimental data, designing experiments to test the hypothesis, then either accepting the hypothesis if the experiment confirmed it, modifying it with new information from the experiment, then retesting it, or even outright rejecting the hypothesis if the experiment contradicts it.
But testing most economic hypotheses through experiments is infeasible, given the scale of economics and the difficulty of manipulating the economy to test specific hypotheses. Therefore, economics largely depends on statistical analysis of economic events, including the construction of economic models to make testable predictions. These models are further complicated because of externalities, and the asymmetric information and imperfect rationality of market participants.
Although economics is a science, most of its principles are gleaned, not from experiments, but from observing how the world works, by forming hypotheses of cause and effect, then seeing if the hypotheses accounts for a wide variety of economic data. Deductive reasoning is used to abstract the principles yielding the greatest understanding of economics, by making predictions that can be tested or observed. Additional information may modify parts of the hypothesis if contradicted by the new information or if it does not adequately describe observed results, or the hypothesis may even be rejected if unsupported by the evidence. As a successful hypothesis gains evidence, it eventually becomes a theory, or even a law or principle, where the confidence of its veracity is high.
Theoretical economics uses mathematical models based on these principles to simulate the economy, continually adjusting mathematical parameters to more closely mimic reality. The confidence in a principle increases with the accuracy of its predictions and by how well it coheres with other well-established scientific principles.
Because the economy is complex, there are many deviations from predicted outcomes, which must be resolved through statistical analysis. Economists try to abstract the essential principles by simplifying the economy, so that cause-and-effect relationships can be more easily determined. In any case, it is understood that because all causes cannot be accounted for, there will be some variation in the outcomes of even the simplest models.
Policy economics is the application of economics to formulate government policies to achieve particular goals. Because of the many uncertainties in economics or because of the inability to quantify parameters, there is often a trial-and-error method of achieving economic goals. First the desired goal must be clear. Then, it must be determined what policy options are available to carry out the goal. Once decided, the policy should be implemented, and then evaluated to measure its success.
People may differ in what they consider to be the most desirable economic goals, but a few economic goals are widely accepted as being desirable, and these include:
- Economic growth, since this allows more goods and services to be produced that can improve the standard of living.
- Full employment, since labor is one of the factors of production, and less than full employment implies the economy is not producing maximally. Furthermore, the quality of life for the unemployed will be low.
- Economic efficiency, since this allows the maximum production of desirable goods and services for the least of limited resources.
- Price level stability, since it is difficult to plan economic or business projects or anything else involving a large amount of capital without stable prices. Even falling prices can wreak economic havoc.
- Equitable distribution of income, so that no one suffers extreme poverty.
- Economic security, which provides for people unable to take care of themselves, such as the chronically ill, disabled, or anyone else unable to earn an income.
Positive and Normative Economics
A distinction is sometimes made between the study of the economy and what its goals should be.
Positive economics focuses on facts and cause-and-effect relationships without regard to economic goals. It strives to understand how the economy works and why it works the way it does. Normative economics, on the other hand, seeks to use positive economics to formulate the most desirable policy objectives and how to achieve them.
So, for instance, positive economics observes the inverse relationship between the cost of labor and the demand for labor. Normative economics, on the other hand, would use that fact to argue that there should be no minimum wage laws, since this lessens the demand for labor and decreases economic efficiency by reducing economic output.
The main problem with normative economics is that economics is more complex than economic arguments. So, for instance, while the argument for eliminating minimum wage laws to increase employment seems plausible, it may be contraindicated by macroeconomic arguments. For instance, because the marginal propensity to consume is inversely proportional to wealth, paying low-income workers higher wages would help to stimulate the economy because they would spend more of their increased income than wealthier people do with their pay raises, which would stimulate the economy, while also raising the standard of living for low-income workers.