Economics in Minutes

by Niall Kishtainy

  ECONOMICS IN MINUTES

  NIALL KISHTAINY

  First published in Great Britain in 2014 by

  Quercus Editions Ltd

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  Copyright © Quercus Editions Ltd 2014 Text by Niall Kishtainy Illustrations by Tim Brown Design and editorial: Pikaia imaging Design assistant: Kathryn Brown

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  CONTENTS

  Introduction

  Markets, efficiency and fairness

  Money and finance

  Firms and industry

  Income, unemployment and inflation

  Economic policy and the government

  The international economy

  Society and the economy

  Growth and development

  Glossary

  Introduction

  What makes some societies richer than others? Why do banks crash? How high should taxes be? These are questions that economists try to answer, but often disagree about. To the layman, economics can seem an obscure language – one filled with jargon and complicated mathematics. And economic news can be bewildering, as share prices soar and crash, and the economy lurches from crisis to crisis. In fact, underneath the specialist terminology, much economics comes down to some fairly simple principles. This book will give you a flavour of theories about how the economy works and how it should be managed.

  What actually is economics? The term was used by the Ancient Greeks and comes from a Greek word meaning ‘management of the household’. Nowadays, economics encompasses much more than this, but households and individuals have always been building blocks of the economy. People make decisions about what to buy with their incomes and how much to work. In doing this they encounter a basic economic fact of life: resources such as food, electricity or time are limited and choices have to be made about what to consume and what to produce. It is people who make these choices, so explanations of human behaviour are a central part of economics – what makes a consumer buy a new computer, a businessperson build a factory, and a worker accept a job in a far off city?

  Most economists think of their subject as a science: they try to uncover general laws that govern economic phenomena, such as trends in unemployment – just as physicists look for laws that explain the acceleration of a rocket. But finding laws of human behaviour is much harder than explaining the path of a rocket. This is why economists disagree so much, for example on whether the government should spend more money to pull the economy out of recession, or on the levels at which public debt is sustainable. This book demystifies the complex vocabulary in which these debates are conducted, boiling down economic concepts into accessible explanations that will hopefully make the important and influential ideas of economics easier to understand.

  Economic man and rationality

  At its core, economics is a theory of human behaviour. Economists see people as rational beings that respond with consistency and logic to economic variables such as prices and interest rates, and even to things like the weather, which can affect the economy. What this boils down to is that people make decisions in a way that maximizes their economic pay-off – they will always buy the car or coat that is exactly in line with their preferences, at the lowest price possible.

  Economics’ version of rationality requires people to be able to gather and assess information – for example, the prices and characteristics of different goods – and to then calculate the best decision with ease. In reality, far from being cold, rational calculators, people are often capricious and emotional, and may at best make economic decisions that are ‘good enough’ or based on plausible rules of thumb rather than a thorough reckoning. Nevertheless, economists see rationality as a useful simplification and use it as a basis for most of their theories.

  Scarcity

  Resources are finite – at any point in time there is only so much wheat, coal or cement to go around. Resources can be used in myriad ways: cement could be used to build new homes or renovate factories, wheat may be processed into various foods and consumed by different people. New houses, better factories and more nutrition are all worth having, but because resources are finite, we cannot have them all: how to choose between them is a fundamental question of economics.

  Economists see the problem in terms of trade-offs: competing options each have costs and benefits, but the best will be that which maximizes overall benefits over costs. The analysis of the trade-offs inherent in allocating scarce resources is the essence of modern economics: British economist Lionel Robbins described it as ‘the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses’. Economists have come to believe that the market offers a powerful way of deciding between these uses.

  Utility

  Economics posits an underlying logic to human behaviour: whether it be a purchase of food or a choice about savings, all decisions are aimed at maximizing ‘utility’. If I prefer strawberries to bananas I am said to gain more utility from strawberries than bananas, perhaps quantified as a utility of ‘four’ compared to ‘two’. Maximization of utility is the sole aim of rational economic man, and while economics is often thought of as the study of money, money is simply needed to buy things, and the utility generated is the driver of behaviour.

  Utility is subjective: strawberries add to my well-being but reduce that of someone who dislikes them. Early theories saw utility as a scale like money: someone with a utility of four was twice as happy as someone with a utility of two. But because it is impossible to directly observe, economists now think of it as a ranking – we can say someone gains more utility from strawberries than bananas because we see his choice, but cannot really measure how much absolute utility they provide.

  Preferences

  Economics views well-being in terms of the extent to which a person’s preferences – his or her desires for one thing rather than another – are satisfied. But because resources are scarce, there is a limit to the extent to which people’s preferences really can be satisfied. Individuals experience this in facing a ‘budget constraint’: they can only sate their desires up to the amount of money that they have to buy goods. In doing so they are said to maximize their utility or well-being.

  Of course, it is hard to observe a person’s full set of desires, and for this reason economists tend to think in terms of what they call ‘revealed preference’: if we see a person spending her money on jeans when she could have afforded a skirt then we infer that she prefers jeans to skirts. From this starting point, economics attempts to explain how individuals respond to a loosening or a tightening of their budget constraint as a result of changes in pric
es and incomes.

  Opportunity cost

  In everyday thinking, the cost of going to a university consists of tuition fees plus the cost of food, rent and so on. Economists instead prefer to think of the true cost of choosing one option as the opportunity which had to be given up as a result: so in this example, the opportunity cost of going to university is getting a job. The biggest cost of university is likely to be the money that could have been earned, and many of the direct outlays made by a student – food and rent – would still need to be made in employment and might even cost more.

  The concept of opportunity cost helps to determine if resources are being put to best use. Suppose that a firm bases its operations in a building that it owns in the centre of town. It may pay no rent for its offices, but may be giving up the opportunity of earning a large rental income by leasing out the centrally located building and locating its staff in a cheaper suburban building.

  Substitutes and complements

  Different kinds of chocolate bars are what economists call substitutes – they all satisfy the same basic want, so that if the price of one bar increases, people will buy less, and buy more of another kind instead. In contrast, some goods are consumed jointly, compact discs and CD players, for example. If the price of compact discs rose, the demand for CD players would fall. Economists call these kinds of goods complements.

  Many goods are of course unrelated – in the sense that when the price of one changes, the demand for the other is unaffected (tuna and computer games, perhaps). Goods may have degrees of substitutability and complementarity: for example, two brands of orange juice may be substitutable, but butter and margarine are less so. Substitutability is considered by competition authorities when they assess the extent to which a firm might be monopolizing a market: a firm controlling the butter market would be less able to raise prices if consumers could switch to margarine.

  Normal and inferior goods

  Suppose you get a pay rise. Feeling richer, you increase your consumption of your favourite beer. In this case, the beer is what is known as a normal good: consumption of it rises with income, and if your income fell you would consume less of it.

  But now you are richer, you also drink less of that cheap brand of cider you used to consume. In this case, the cider would be an inferior good – you consume less of it as your income rises, more of it when poorer. Luxury goods like caviar or sports cars can be thought of as a special type of normal good for which consumption increases by proportionately more than income when income rises.

  Of course, a good may sometimes be normal and sometimes inferior depending on the level of a consumer’s income. If I get a pay rise I might drink more beer, but if I then win the lottery, I might ditch the beer completely and only ever drink champagne.

  Income and substitution effects

  Picture a student who spends his money on nothing but chips and cola – then, because of a bumper potato harvest, the price of chips falls. This affects the student’s spending in two ways. Firstly, the price of cola in terms of chips has risen: for every can of cola the student buys he has to give up more chips than before. He buys less cola but more bags of chips. This is what economists call the substitution effect. Secondly, because chips are cheaper, the student’s purchasing power has risen – in a sense his income is now larger. He may well decide to buy both more chips and more cola. This is the income effect.

  Economists break down changes in demand as a result of price changes into these effects. The overall impact on the student’s consumption of chips is clear: both the income and the substitution effects point towards him buying more. But the impact on his consumption of cola is ambiguous: the substitution effect means he buys less but the income effect makes him buy more.

  Consumer surplus

  While a woman is out shopping, she sees exactly the right-sized wardrobe for her bedroom. She would be willing to pay £250 for it, but the price is just £100. As a result, the woman enjoys a consumer surplus of £150 – the difference between what she would be willing to pay and what she actually pays.

  At very high prices, only a few of these wardrobes would be sold to those with high ‘willingness to pay’. At a price of £100, those individuals gain a large consumer surplus, but if a total of 500 wardrobes sold across the whole market is ranked by surplus, the 500th will be sold to someone willing to pay exactly £100 – for more to be sold the price would have to be lower, inducing people with a ‘willingness to pay’ below £100 to buy one. Adding up the consumer surplus of each buyer gives us the total consumer surplus across the entire wardrobe market. Economists believe this is a measure of economic well-being: when it is high, consumers’ desires are being satisfied well.

  Engel’s law

  The 19th-century German economist Ernst Engel identified a basic pattern in the relationship between food expenditure and income. He argued that as income rises, people increase their spending on food by a smaller amount, so the proportion of income allocated to food falls. Someone tripling their income overnight would be unlikely to triple their consumption of food, unless they had started off in poverty.

  The law implies that the poor spend a higher proportion of their income on food – very poor families living in developing countries often spend most of their income on basic staples. Contrast this with a consumer in a rich nation, whose income is spent on a complex basket of goods – housing, travel, holidays, entertainment – within which food may be just a modest share. Engel’s law highlights the vulnerability of the poor to increases in the cost of food – if most of their income goes on food, they may not be able to adequately feed themselves when prices rises.

  Time and discounting

  Economic decisions are not just about whether to buy, but when to. If I am impatient, I may borrow money to buy a television today. If I am patient, however, I will wait until I have earned the money myself. Economists call people’s level of impatience their time preference. Although some are more patient than others, in general people prefer a television today to a television in a month. People are said to ‘discount’ the future.

  People who discount at a high rate are likely to save less, and consume more today. This is related to the idea of an interest rate. £100 in a year’s time is viewed as worth less than £100 today, so if I lend someone £100, I will ask for more than £100 to be returned to me in a year. If I expect to receive £100 in one year, then I would want to know the ‘present value’ of this amount. This would be the amount that I would have to lend out at interest today to be paid back £100 in a year, and would be less than £100.

  Labour supply

  Decisions about how much to work can be thought of as a choice between consumption and leisure. How does a worker respond to an increase in her wages? Intuitively one might think that she would work more: an hour of leisure has become more costly in terms of the wages lost, and therefore the consumption that she must give up, so she takes less leisure time and works more.

  But with a higher wage, the worker has become richer: she can afford more leisure, and so may therefore work less. It is possible that the second effect might outweigh the first, in which case the overall effect of the higher wage has been to make the worker work less. And this outcome is not just a theoretical possibility: over the last couple of centuries the length of the working week in the industrialized world fell even as wages were rising considerably. As workers got richer, they used their greater wealth to take more leisure.

  The paradox of value

  Why is it that a glass of water, so vital to life, is worth hardly anything, whereas a diamond, which has no practical use, is so valuable? This is the so-called paradox of value, discussed by philosophers and economists down the ages, and perhaps most notably by the 18th-century Scottish economist Adam Smith. The paradox can be resolved with the concept of ‘marginal utility’.

  Utility is the pleasure or well-being from the consumption of a good such as a grape (see Utility). Marginal utility is the pleasure that is ga
ined from an extra unit of consumption, so if I eat five grapes the marginal utility is the extra pleasure I received from the fifth grape. Marginal utility tends to decline: the fifth grape probably gave me less extra utility than did the first. Because diamonds are so scarce, their marginal utility is very high and they therefore have a high value. In contrast, because water is readily available in most parts of the world, the marginal utility of an extra drop is much lower.

  Supply and demand

  In a free market, the price of a good is determined by supply and demand. The market price of wheat emerges through the interaction of the supply of wheat by farmers and the demand for it from flour mills and food manufacturers: when the level of supply is equal to the level of demand the market is said to be in equilibrium.

  In equilibrium, the market is at rest, because all the mills wanting to buy wheat at the prevailing price can find a farmer willing to sell some, and all the farmers wanting to sell wheat can find a flour mill willing to buy some. Often, however, markets get thrown out of equilibrium: perhaps a sudden drought lowers wheat supply below demand, leading to a shortage. The power of the free market is in its ability to correct this: because there are too many mill owners chasing too few bushels of wheat, farmers can increase their prices without losing sales. The higher price chokes off demand and stimulates supply, until the market returns to equilibrium.