Economics in Minutes

by Niall Kishtainy

  Which comes first, economics or culture? If you sell your old stereo to a friend, you might offer him a knock-down price because there is an expectation that friends do each other favours. You probably also exchange gifts with friends. Such behaviours affect the allocation of economic resources, but seem to be culturally driven. Economists view individuals as rational profit maximizers – but if so, why don’t they try to get the best ‘price’ out of their friends and waste less money on presents? Austrian economist and anthropologist Karl Polanyi argued that economic organization is determined by a society’s culture and social norms rather than by economic rationality, particularly in traditional societies. Even in modern economies, culture influences economic life. A conventional economist might argue that beneath the apparently culturally driven behaviour lies hard-nosed economic calculation: I help you only so that you help me, and what really matters is still profit and return. Polanyi, on the other hand, argued that customs are entirely distinct from the pursuit of profit.

  Institutions and property rights

  The buying and selling of goods requires property rights, and if people don’t have confidence that such rights will be respected, economic activity is likely to be hampered. Analysis of the fundamental prerequisites for economic life, including these rights, is essential to understanding the creation of wealth. Property rights are what economists call an institution – a ‘rule of the game’ that governs the economic activities of individuals, firms and governments. These rules can be formal laws and regulations or informal social norms and customs.

  Institutional economists have tended to stress the importance of property rights as essential to creating incentives to trade, to invest and to innovate. Political instability and rapacious governments damage property rights. At the same time, the rise of the state has gone with the growth of markets. So identifying the mix of institutions that brings prosperity is a difficult and as yet uncompleted task, and what helps in one country or era may be a hindrance in others.

  Marxist economics

  For Karl Marx, capitalism was a dynamic and innovative economic system, an advance on the earlier feudal economy. However, he argued it contained flaws that would eventually lead to its collapse. Under capitalism, capital owners hire workers, and Marx said that the value of a good resides in the labour used to make it. For capitalists to earn profit, they must extract a surplus above this value – hence workers get exploited through low wages and the threat of unemployment. Profits are also driven by technology and the division of labour: under capitalism the worker no longer produces a rug in his cottage, but spends his days loading spools onto factory looms. This is ‘alienated labour’: capitalist work saps people’s creativity and undermines human connection. Marx predicted that conflict between workers and capitalists would eventually lead to the overthrow of capitalism and establishment of communism. Despite the collapse of the communist states, elements of Marx’s thinking and his linking of the economic, social and political spheres remain influential to this day.

  The labour theory of value

  Until the 19th century, it was believed that the value of goods came from the labour used to make them: a chair that took 50 hours of labour was worth ten times as much as a stool that took five. Even the value of goods made in factories could be traced to labour. A factory-made chair is produced by machines operated by people. The machines are made by other labourers, and the iron used to make the machines is produced by still others. The labour theory of value became closely associated with Karl Marx – he asked how profits were possible if the value of goods came from labour. Marx argued that capitalists were able to exploit the workers and squeeze a surplus out of them (see Marxist economics).

  From the 19th century, economists moved on from the labour theory of value. It was seen that a dress that took ten hours to make was not necessarily worth five times more than a diamond that took two hours to cut. Value was determined by people’s desires, and in the market by supply and demand.

  Central planning

  With the advent of communism, economic thinkers began comparing the workings of socialist and market-based systems. A long-standing tenet of economics was that market prices lead to an efficient allocation of resources: if lots of people want bicycles, the price of bicycles will rise, encouraging more production. In socialist systems, central planners decide what should be produced. Some argued that they, too, would be able to bring about an efficient allocation of goods, essentially replicating what markets do while reducing their inequities. The Austrian economist, Ludwig von Mises denied this possibility – only through interplay of supply and demand in markets could prices emerge reflecting society’s true valuation of different goods. The sheer complexity of economies with thousands of different goods and services would be too much for any central planner, he argued, and the result would be large inefficiencies and errors in matching what people wanted with what was produced. This was certainly one of the problems that the communist states eventually ran into.

  The social market

  When Tony Blair came to power in Britain in 1997, there was much talk of a ‘Third Way’, a middle ground between left- and right-wing approaches to economic management. In fact, the attempt to create a synthesis of left and right goes back to the immediate postwar period, when economists proposed the model known as the social market economy.

  Subsequently established in many European countries, the social market combined private enterprise with government provision of goods and services such as health and schooling. The state also created ‘safety nets’ – unemployment benefits, pensions and other payments aimed at mitigating the social impact of markets. Many governments had tax policies that redistributed wealth from the rich to the poor. The idea was to harness the productive, dynamic aspects of capitalism, while tempering them with socialist principles of equality and fairness. Today, most European economies combine markets with state intervention.

  Trade unions

  The textbook model of a labour market involves millions of workers making their own contracts with millions of employers. However, with the rise of industrial capitalism, the employers often become large corporations. An important function of trade unions is to increase workers’ bargaining power against these powerful employers. By negotiating collectively, and agreeing not to compete with each other, workers can achieve better pay. Employers may even prefer to deal with unions, as it simplifies setting wages and conditions. The role of unions is more complex than this, however, as they mediate other interactions between workers and employers.

  Unions have come in for criticism from some economists, who argue that while they ensure higher wages for union members, they shut out non-unionized workers and create unemployment. In recent decades, many governments attempted to reduce the power of unions, believing them to be an impediment to the modernization of economies.

  Shortages and rationing

  In properly functioning markets, supply equals demand. There are no shortages: anyone willing to pay the market price can obtain the good. In contrast, Hungarian economist Janos Kornai showed why shortages arise in centralized economies.

  In standard markets, firms are subject to ‘hard budget constraints’ – they must earn enough revenue to cover costs. This ensures they produce as efficiently as possible, making as much as they can with the smallest inputs. Kornai argued that in centrally planned economies, firms face ‘soft budget constraints’: if they make losses, they get bailed out by the state. As a result, they don’t have an incentive to economize on inputs or produce in quantity. As they eat up inputs without increasing production, shortages emerge, until eventually consumers are forced to queue for goods. Even in capitalist economies, not all budget constraints are hard: some firms considered ‘too big to fail’ are still bailed out by the taxpayer, as some banks were in the wake of the 2007–8 financial crisis.

  Economic liberalism

  Two of the dominant economic thinkers of the 20th century were Friedrich Hayek (op
posite) and John Maynard Keynes. They stood on opposite sides of an intellectual fault line: Hayek believed in the supremacy of the market, while Keynes argued that governments would need to step in when markets failed.

  Hayek was a radical economic liberal – he equated markets with freedom itself. Interference with markets by the state was an attack on freedom, which would lead to increasing political control and to totalitarianism. Hayek also defended markets on the grounds that they were a better way of coordinating individuals than any kind of central planning. People make decisions in an environment of uncertainty and on the basis of localized knowledge, and their behaviour influences prices, so the prices that emerge in markets are a distillation of all this disparate information about local conditions. In this way ‘spontaneous order’ emerges. Hayek argued that a central planner could never collect and interpret all this information.

  Conspicuous consumption

  Suppose that Jane buys a new coat. Standard economics assumes that Jane has a stable set of desires for goods and services – when properly satisfied these contribute to his well-being. He bought that particular coat because winter was drawing in and he liked the design. Jane’s desire is self-contained: it is not connected to the judgements of others.

  But if Jane had chosen an Armani coat in order to display his wealth to others, he would be engaging in what American economist Thorstein Veblen called conspicuous consumption. Now his desire for the coat is connected to other people’s perception of it, namely that it tells them about Jane’s own ‘high status’. A status good has to be something that Jane can own, but others can’t – as countries get richer and more people can afford Armani coats, Jane might have to start buying yachts in order to continue to communicate his status. Veblen argued that because of this, conspicuous consumption is wasteful.

  Family economics

  Microcredit projects in developing countries frequently focus on offering small loans that allow women to start up businesses, based on the idea that mothers are more likely to invest wisely.

  Economic analysis traditionally starts with the individual and the firm, but individuals are also members of families. Family economics uses economic principles to analyse people’s decisions about marriage, having children and the distribution of resources within families. Marriage can allow people to pool resources, divide up their labour into different household tasks and share market risks. Different family members may have different preferences about how resources should be used. Studies have found settings in which mothers give greater weight to spending on children than fathers do. This drives policy initiatives in developing countries aimed at giving mothers greater control of family resources: it is hoped that these enhance the nutrition and education of children. Family economics also studies fertility behaviour, distinguishing between child ‘quantity’ and ‘quality’. If there is a high future return to education, parents may have fewer children but spend more on their education, choosing quality over quantity. Broader changes in the economy can alter this trade-off.

  Gender

  Over time, female earnings have lagged behind male earnings, as shown in this graph of earnings ratios in Canada from 1976-2011.

  Standard economics says little about gender: economies consist of interactions between firms and rational, genderless individuals. Recently, however, some economists have begun to consider the role of gender in more detail. They argue that the usual starting point of ‘rational economic man’ can’t address the discrimination and power imbalances faced by women. What’s more, existing ways of measuring the economy don’t properly take the contribution of women into account. Women carry out a lot of work within households, caring for children and relatives, cooking and cleaning, and so on. Because this work is usually not paid for in a formal economic transaction, it is not counted in national income. Macroeconomic policies can also affect men and women differently: cutbacks often hit women hardest, especially if health or education cuts increase their responsibilities in the home. GDP is only a partial measure of economic progress, the critics argue: human well-being is dependent on a broad range of factors, including the position of women in society.

  Social capital

  Traditionally, when economists talk about capital they mean physical things – conveyor belts, electricity pylons, lathes – that along with labour can be used to produce goods. More recently, however, economists have begun to talk about social capital – broadly speaking, the connections between individuals that create social networks and trust. Like machines, social capital acts as an input into production, with large amounts of social capital allowing for more economic activity.

  The market exchange and information sharing that make up economic life depend on social capital: without trust, even the most basic economic activity would be difficult. Belonging to social networks allows individuals to learn about market opportunities and jobs, and to coordinate with each other. Economists have tried to measure social capital and link it to national economic fortunes, but the idea can also be criticized: some argue that it is a hopelessly vague concept that cannot provide a robust explanation of economic performance.

  Economic reform

  Economic activity can take place in all sorts of economic systems, from free market to state-run to communist. Economic reform includes a host of actions by governments to change, and hopefully improve, the nature of their economic systems. A famous example is the ‘shock therapy’ reform that followed the fall of communism in Eastern Europe, in which countries were rapidly subjected to market forces. African nations, too, underwent similar reforms. These changes had mixed results, and later reform programmes have broadened to encompass changes in the legal and political institutions required for markets to work. Even advantageous reforms can get derailed – they often threaten the privileges of politically powerful people, such as industrialists who might lose from opening up to international competition. The distribution of costs and benefits from a valuable reform may not be known, so to minimize the risk of ending up on the losing side people may oppose it. Such problems make economic reform one of the most complex and uncertain types of government action.

  Growth and the sources of growth

  One of the founders of economics, Adam Smith, entitled his magnum opus The Wealth of Nations, and the differences that make some countries rich and others poor remain a major preoccupation of the discipline. Today, economists wrestle with the problem by searching for the causes of growth.

  Growth is simply the rate of expansion in a country’s output. Over time, even small differences in this rate can lead to big gaps in living standards: over 30 years a country growing at 4 per cent per year would be one-third richer than one starting from the same point but growing at just 3 per cent. For poor countries, a small growth disparity might make the difference between having the resources to immunize children against diseases or not. In simple terms, economies grow when more inputs – capital, labour and skills – are put into production, and when new technologies make the inputs more productive. Understanding how this happens, and why it happens more easily in some countries than others, is a holy grail of economics.

  Living standards and productivity

  Living standards rise when economies become more productive. Suppose that a new technology allows workers to produce more each day: the economy generates more resources to go round, wages rise and living standards improve. Productivity improvements can be driven by the capital and labour available in a country. Suppose that a country is scarce in labour compared to capital – wages are high, but the prices of machines and fuel are low. This will encourage businesses to install machines, and as these machines are improved, the economy becomes more productive. Some argue that this is what happened during Britain’s Industrial Revolution.

  Another factor behind productivity improvement is market size. When markets are large, cost advantages can be reaped through the mass production of standardized products, a factor that was critical to the early growth of the America
n economy. Competition, too, helps productivity – when firms are in competition they look for ways of being more productive.

  Economic convergence

  In the mid-1950s, American economist Robert Solow devised a theory of economic growth which predicts that over time countries’ living standards converge: poor countries will catch up with the rich. The idea is that the lower starting point of poor countries actually allows them to grow faster. When a country has little capital – factories, roads and machines – extra investment has a big impact on growth. When a country is rich and already has a large capital stock, the same extra investment has a much smaller impact on growth. Over time, then, as countries get richer they grow more slowly.

  Like all theories, Solow’s depends on simplifying assumptions – a crucial one is that all countries have access to the same stock of technology. In practice, there are all sorts of economic, political and social barriers to accessing the latest technologies. Some countries, such as South Korea and other Asian nations have managed to catch up with the industrialized West, but for many convergence remains a chimera.