Economics in Minutes

by Niall Kishtainy

  Barriers to entry may also be legal: governments may confer exclusive rights on single firms to supply certain goods and services. When there are no barriers, firms can enter markets easily and compete. Sometimes the threat of entry alone may be enough to induce existing firms to charge more competitive prices: such markets are said to be contestable.

  Patents

  Patents grant exclusive rights over use of new technologies to their inventors. Economists normally think of such monopolistic situations as a bad thing because they lead to higher prices for consumers. The economic rationale for patents, however, arises from the fact that inventions have large ‘spill-over’ effects. Suppose that a firm invents a new kind of packaging to keep food fresher. Knowledge about this becomes available to other firms and they soon start to use similar packaging. The original invention creates benefits that spill over to other firms, and the benefit of the packaging to society as a whole is larger than the benefit accrued to the firm that invented it. The implication is that without encouragement, too few new inventions will be made relative to the high potential social gains. By making new inventions the property of their inventors, patents provide strong incentives for firms to invent new technologies. If competing firms want to use the technology immediately, they must pay the inventor, but after a certain period, the invention can be freely used.

  Taxing corporations

  The taxation of firms is often a vote winner for politicians – it seems fairer and less painful to impose heavy taxes on large, impersonal corporations than on individual wage earners struggling to support families. But this apparently persuasive idea depends on an assumption that might not always hold. Sometimes disparagingly called the ‘flypaper theory of taxation’, this is the idea that like a fly landing in the glue, the burden of taxes ‘sticks’ wherever it is imposed.

  Formally, a corporation pays its own taxes, but who ‘really’ pays them? Consider a tax on an airline. This hits the firm’s profits and it may respond by raising airfares, so consumers end up footing the bill. The tax reduces potential returns from investment, so the firm doesn’t expand its fleet as much as it had planned. It offers fewer flights, leading to still higher airfares and the lay-off of some of its workers. This is just one demonstration of the way that taxes ripple around the economy and have all sorts of unintended consequences.

  Advertising

  Advertising is a pervasive feature of modern economies in which a huge variety of brands are offered to a large pool of consumers. What function does it serve? In much economic theory consumers are assumed to have all the information they need. In reality, however, they need to be informed about the prices of goods, their different features and even about where to buy them. Advertising provides this information. When consumers make informed decisions, markets work well: firms are subject to competition and prices are kept low.

  Of course, a lot of modern advertising conveys little concrete information, but it can still inform consumers in an indirect way: when the quality of different brands is hard to ascertain, large advertising outlays can signal that a firm has confidence in its product. Advertising’s many critics argue that all it does is generate new desires for the market to satisfy. What’s more, enhancement of brand loyalty may actually hurt competition if consumers become less willing to switch between sellers.

  GDP and its components

  This map shows the nominal GDP of the world’s nations in billions of US$.

  Gross Domestic Product (GDP) is a key measure of a nation’s income. It is the value of all goods and services produced in a country over a period of time. A country with a large overall GDP might still be considered poor if its population is very large, so an important measure of living standards is GDP per person (GDP divided by population). This provides a very rough indication of the amount of goods and services consumed by individuals.

  GDP can be divided into different kinds of spending, such as consumption, investment and the purchase of goods and services by the government. Because every purchase involves a buyer paying a seller, it can also be broken down into the different incomes that get paid when businesses produce goods and services – these include wages and profits. As well as absolute and relative levels of GDP (between countries), economists are also concerned with the rate at which it grows, and hence how quickly living standards are rising.

  Real versus nominal GDP

  Suppose that a nation’s Gross Domestic Product (GDP) rises by 10 per cent in one year. This might be because the output of goods and services in the country went up by 10 per cent. But it could also mean that the prices that we use to value the goods rose by 10 per cent while the actual output didn’t rise at all. Often, growth in national income is the result of a combination of rising output and rising prices. Nominal GDP is expressed in money terms without adjustment for the impact of changing prices. Real GDP measures the actual goods and services produced.

  If GDP rises by 10 per cent purely due to a rise in prices, then real GDP has stayed constant. In terms of actual goods and services available, the economy has got no richer. Economists calculate real GDP by computing the level of output at the prices of a particular fixed year. This removes the impact of price changes on the GDP number.

  Japanese GDP, 1991–2011

  In Japan during the 1990s, prices increased faster than output, so nominal GDP outpaced real GDP. In the 2000s prices lagged behind output so real GDP growth was faster than nominal.

  The circular flow of income

  An economy can be thought of as a circular flow of income and spending between households and firms. Firms and households meet in two markets: that for goods and that for production inputs such as labour. In the goods market, money flows from households to firms as households make purchases. For example, when Pete spends 50p on bread, his payment for the bread becomes part of the bakery’s revenues. In the market for inputs, money flows the other way as firms buy from households: the bakery needs labour, so it uses Pete’s 50p to help pay its workers. In turn, the wage is used to buy another good and the circle is completed.

  This way of thinking about the economy is fundamental to the calculation of national income. It shows that national income can be thought of in two ways: as the total output of goods or as the total income earned in an economy. The simple example given above just looked at wage incomes, but the circular flow also includes profits and rent.

  Investment

  When economists discuss investment, they mean spending on capital that allows the economy to produce more goods in future. Capital includes machines and infrastructure, but also spending on the creation of skills through education and on knowledge through research and development. Investment is central to economic growth – only through greater productive capacity can the economy expand – but the amount of investment that is desirable is a more complex question than it might first appear. Investment fosters growth, but it can mean less consumption today.

  Investment is affected by all sorts of variables. Because it usually involves borrowing from savers, the interest rate is an important factor. When rates are high, investors need to earn high returns from their investments to repay their loans and make a profit, so some projects become economically unviable. When interest rates are low, more projects are worthwhile and investment is stimulated.

  Consumption

  When you buy a shirt, get a haircut or eat a burger, you are consuming part of the output of the economy. Economists think about consumption at the level of individuals, studying how people choose what to buy given the prices of products and the income available to them. At the level of the overall economy, consumption takes up a major share of a country’s national income.

  Various explanations of the level of consumption have been put forward. British economist John Maynard Keynes said that when people receive extra income they consume a fraction of it and save the rest. If their income was zero, they would still consume some small amount, using savings or borrowing. Other theories look at how
people decide between consumption today or in the future. When consumers take a forward-looking approach, higher income today doesn’t necessarily translate into higher consumption: if they believe that the increase is temporary, they may save the extra income for a rainy day.

  Government spending

  Government spending makes up a large part of GDP in modern economies. Even in market economies like the US and UK, it is in the order of 40 per cent of national income. Historically, as economies have developed, governments have undertaken a wider range of tasks of increasing complexity. Provision of state education broadens, the government supplies more kinds of health services, and the welfare system provides for the unemployed, infirm and elderly.

  Government spending on areas such as defence, hospitals, libraries and the education system all go into GDP. The other big category of government outlays encompasses welfare payments such as pensions and unemployment benefits: economists call such payments ‘transfer payments’. Unlike the payment of a nurse’s salary, for example, they are not made in exchange for any economic output. They merely transfer spending power from one set of people to another, and for this reason they are not included in GDP.

  Aggregate demand and supply

  Aggregate demand is the relationship between the price level and output demanded. Aggregate supply links the supply of output with price. Together they determine the output and price level in an economy. At low prices, aggregate demand is high as consumers’ purchasing power is enhanced. Low prices also cut real interest rates, stimulating investment. Many economists believe that aggregate supply is unaffected by prices in the long run: this is because potential output depends on the actual capital, labour and technology available for making goods. In the short run, it is possible that higher prices might stimulate supply, but this can’t be sustained.

  The aggregate demand relationship can shift: an oil windfall might increase demand at every price level. In the short run, this may increase output, although in the long run because aggregate supply is unaffected the only impact is higher price levels. If supply is not influenced by prices, then the only way to achieve higher output in the long run is through investment.

  Higher aggregate demand may stimulate output in the short run, but may be felt later in higher prices.

  Boom, bust and depression

  Over several decades, an economy demonstrates a trend rate of growth, but from year to year growth fluctuates around this trend. In some years growth is below trend, in others it is above it. As a result, the economy naturally goes through sequences of booms and busts, known as an economic cycle. The more technical term for a bust is a recession, a period of falling output over a period of months or longer. Serious recessions, known as depressions, may last for years and see sharper falls in output and larger rises in unemployment.

  Economic cycles can take on different shapes: sometimes reference is made to V-shaped cycles, featuring a sharp decline and recovery, and W-shaped cycles, when the economy declines and recovers, then falls back again in a so-called ‘double-dip’ recession. Much economic thinking has gone into explaining economic cycles and into devising policies that can help to moderate them – in particular, to avoid recessions.

  Unemployment and its costs

  The unemployment rate is perhaps the economic variable that worries people the most, and it is probably the most politically sensitive. An obvious point is that unemployment causes great suffering: people who are out of work experience economic hardship and unhappiness. Sometimes unemployment is quite fleeting, as people move between jobs: it is people who are unemployed for long periods of time who suffer the most.

  High unemployment also means that resources are lying idle. During recessions, machines and factories also tend to be underused because of weak demand, but unemployment usually gets the most attention. So when a high rate of unemployment persists over time, society loses out on goods and services that could have been produced if people had jobs. People who find themselves out of work for long periods of time can also get into a vicious cycle whereby their skills become obsolete and their morale is undermined, making it even harder to get back into work.

  The natural rate of output

  Often governments try to engineer short-term boosts in output and reduce unemployment, but many economists believe that economies have ‘natural’ levels of output and employment that apply over longer timescales. One idea associated with the concept is that governments can’t push output and employment above the natural level for very long without generating inflation.

  Anything that affects the ability of the economy to produce goods and services will cause the natural rate to change over time. Higher supplies of the basic inputs of production – labour and capital – will enhance economic capacity and cause it to rise. A greater stock of skills among workers will also do this. Over time, technological progress also has a huge impact on an economy’s natural rate of output. Institutional features of markets can also influence the natural rate: one of the drivers of economic policy in the 1980s was the idea that reducing market regulation would make it easier for firms to produce.

  Frictional and structural unemployment

  Unemployment can persist when old industries close down, leaving workforces unsuited to new jobs.

  Unemployment has multiple causes. When economies go into recession large numbers of workers lose their jobs, but unemployment exists in healthy economies too, in a form called frictional unemployment that results from people switching jobs and careers. Because the labour market doesn’t immediately match workers to jobs, it is said to have ‘frictions’.

  Economies are in a constant state of flux. Firms invent new products and stop selling others: when compact disks went on sale, tape cassettes rapidly became obsolete. Workers making cassettes were laid off, but in a growing economy they would be able to find new jobs in other sectors – perhaps working for compact disc manufacturers. However, the workers would still need some time to search for and secure new employment. The shift can sometimes take time, with workers in regions dominated by declining sectors often struggling to find new employment opportunities. Economists call this kind of more persistent unemployment structural unemployment.

  The Phillips curve

  In the 1950s, New Zealand-born economist Bill Phillips identified an inverse relationship between inflation and the rate of unemployment. When inflation was high, unemployment was low and when inflation was low, unemployment was high. The explanation for this relationship was that when the economy was booming and lots of people were in work, demand would be high, and this high demand for goods and services would push up price levels. Conversely, when unemployment was high and the economy was in a downturn, demand for goods would be weak and prices would fall.

  Through much of the postwar period, economists took the Phillips curve to mean that there was a stable long-term trade-off between unemployment and inflation. By regulating economic activity through fiscal and monetary policy, it was believed that the government could effectively ‘pick a point’ on the Phillips curve, choosing a bit less unemployment and a bit more inflation, or vice versa.

  Stagflation

  Stagflation was a term used to describe the twin ills of the 1970s: persistent inflation and unemployment. At the time, much economic thinking was based on the Phillips curve, which suggested that high inflation coincides with low unemployment (see The Phillips curve). During the 1970s, however, unemployment and inflation rose together, contradicting the Phillips curve.

  New theories, notably those of Milton Friedman (see Monetarism), tried to explain this by denying that the Phillips curve really held in the long run. Economists had believed that by spending more money the government could boost the economy, driving down unemployment and pushing up inflation. Friedman argued that higher inflation would lead workers to realize their real wages were lower and make them less willing to work. Labour supply would fall and the economy would return to the previous level of unemployment, now at a hi
gher rate of inflation. According to this view, the only way to sustain the lower level of unemployment was through ever-higher inflation.

  In a situation of stagflation, unemployment and inflation rise together, as seen in the Australian economy during the 1970s.

  Hysteresis

  Economists often think in terms of a natural rate of unemployment (see The natural rate of output) – a rate that corresponds to an economy’s long-run level of output given its capital, the state of its technology and so on. The economy fluctuates around this natural rate: during a recession the rate of unemployment temporarily drops below it, and later reverts to it. Here, the natural rate is stable and is not affected by today’s actual level of unemployment.

  In a situation of ‘hysteresis’, this is no longer the case: high current unemployment pushes up the long-run natural rate. Unemployment is then more than just a short-term problem of idle resources – workers who will later get redeployed when the upturn arrives – it is much more serious, because it damages the economy’s underlying productive capacity. One way in which this might happen is that when workers are unemployed for a length of time, their skills and motivation can deteriorate so much that they become unemployable.