by Judy Jones
MIXED ECONOMY: Another term for economic reality, the “mixed economy” is the middle ground between the free market (the good guys) and the planned economy (the bad guys). When you look around a country like the United States and see the government manipulating the price and availability of money and energy, legislating a minimum wage, and so on, you have to conclude that ours is not really a free market. But neither is it a centrally planned economy. Grudgingly, economists have decided that what it is is a mixed economy, a kind of economic purgatory they will have to endure while they pray for ascension to the free market.
OPPORTUNITY COSTS: The idea behind the old line “I could’ve had a V8.” In economics, there is a cost to using your resources (time, money) in one way rather than another (which represented another opportunity). Think of it this way: There is an opportunity cost associated with your studying economics instead of a really useful subject like podiatry.
PRODUCTIVITY: Another of the big words in the field, productivity, simply defined, is a measure of the relationship between the amount of the output and that of the input. For example, when you were in college, if it took you two days (input) to write your term paper (output) and it took your roommate one day to hire someone to write his term paper, your roomie’s productivity was twice yours—and he probably got a better grade.
PROFIT: To get a firm grasp of profit and its counterpart, loss, you might consider the biblical quotation, “What does it profit a man if he gain the world but lose his soul?” For an economist, the correct way to answer this question would be to calculate the revenues received from gaining the world and subtract the costs incurred by losing one’s soul. If the difference (known as “the bottom line”) is a positive number, you have a profit.
SUPPLY AND DEMAND: Supply is the amount of anything that someone wants to sell at any particular price; demand is the amount that someone wants to buy at any particular price. Economists have a lot of fun making you guess what happens to the relationship between supply and demand when the amounts or the prices change. More on this game later.
VALUE ADDED: A real comer in the world of economics, the value added is a measure of the difference of the value of the inputs into an operation and the value of the product the operation yields. For example, when Superman takes a lump of coal and compresses it in his hands, applying superforce to turn the coal into a perfect diamond, the value added, represented by Superman’s applied strength, is significant. The term explains how wealth is created; it’s also what people use to justify all those hours they put in on the super pullover machine.
VALUE-ADDED TAX: Like the name says, a tax on the value added. At each stage of the value-added chain, the buyer pays, and the seller collects, a tax based on the value of the services added at that stage. The tax is rebated on exports and paid on imports. The VAT is a lot like a sales tax in that it’s a tax on consumption (as opposed to income) and the consumer pays in the end, but it’s less direct. All Western European countries have it, but in the United States the mere mention of a possible VAT, which does tend to hit the poor harder than the rich, is considered grounds for lynching the nearest politician.
Eco Think
Now that you can talk like an economist, the next step is to learn to think like one. The good news here: Economics is a closed system; internally it is perfectly logical, operating according to a consistent set of principles. Unfortunately, the same could be said of psychosis. What’s more, once having entered the closed system of the economist, you, like the psychotic, may have a hard time getting out.
THE FOUR LAWS OF SUPPLY AND DEMAND: Economics as physics—something like the laws of thermodynamics brought to bear on the study of wealth. Basically, these four laws say that when one thing goes up, the other thing goes down, or also goes up, or vice versa, depending. When demand goes up, the price goes up; when demand goes down, the price goes down; when supply goes up, the price goes down; when supply goes down, the price goes up.
THE THEORY OF PERFECT COMPETITION: If the four laws of supply and demand are economics as physics, this is economics as theology. The theory holds that firms always seek the maximum profit; that there is total freedom for them both to enter into and to leave competition; that there is perfect information; and that no business is so large as to influence its competitors unduly. It is, according to economic dogma, a situation in which neither firms nor public officials determine how resources are allocated. Rather, the market itself operates like an “invisible hand” (see “Adam Smith,” on the next page). And if you buy that one, there’s this bridge we’d like to talk to you about.
THE PRINCIPLE OF VOLUNTARY EXCHANGE: Comes under the heading how-to-make-even-the-simplest-idea-sound-important; also known as people buying and selling to get what they want.
THE THEORY OF COMPARATIVE ADVANTAGE: The basis for much of our thinking about international trade. Most simply, it says that everyone’s economic interests are served if each country specializes in those commodities that its endowments (natural resources, skilled labor, technology, and so on) allow it to produce most efficiently, then trades with other countries for their commodities. The classic example: Both England and Portugal benefit if England produces woolens and Portugal produces port and the two countries trade their products—rather than both countries trying to produce both products. Once you’ve arrived at an understanding of the theory of comparative advantage, the next thing to think about is how it is that Japan—without natural resources, native technology, or capital—ever became dominant in steel, cars, motorcycles, TVs, and Nintendo. The answer may tell us more about the theory of comparative advantage than it does about the Japanese.
THE THEORY OF RATIONAL EXPECTATIONS: Maintains that people learn from their mistakes. It is illustrated by the story of the economics professor who was walking across the campus with a first-year economics student. “Look,” said the student, pointing at the ground, “a five-dollar bill.” “It can’t be,” responds the professor. “If it were, somebody would have picked it up by now.”
THE THEORY OF REVEALED PREFERENCE: Another of those laws that stipulate how people are supposed to behave. According to this one, people’s choices are always consistent. In other words, once you have revealed your preference for a pepperoni pizza over a Big Mac, you’ll always choose the pizza, provided it’s available. Reduce it to this level, and it’s easy to see the limits of the theory.
ECONOMIES OF SCALE: At the heart of manufacturing strategy since the days of Henry Ford. The principle is a simple one: With big factories using long production runs to make a single commodity, you can reduce manufacturing costs. In addition, the more you repeat the same operation, the cheaper it becomes. Following this principle, American factories have turned out some very cheap goods, indeed.
THE PHILLIPS CURVE: Had everything going for it. Based on data compiled in England between 1861 and 1957, this theory held that when inflation goes down, unemployment goes up, and vice versa. For politicians, it was an invaluable guide: If you had too much unemployment, you let inflation go up and— presto!—down went unemployment. If inflation was raging out of control, you put a few people out of work and down went inflation. All in all, a handy little tool. Then along came stagflation, which combined high unemployment with high inflation, and the Phillips curve turned into the Phillips screw.
EcoPeople ADAM SMITH (1723-1790)
The first economist, this Adam Smith was an actual person, not some contemporary telejournalist’s pseudonym. His historic book, An Inquiry into the Nature and Causes of the Wealth of Nations (1776), propounded the idea that competition acted as the “invisible hand,” serving to regulate the marketplace. His theories, some of them derived from observations he made while visiting a pin factory, would prompt skeptics to ask, “How many economists can dance on the head of a pin?” DAVID RICARDO (1772-1823)
With Malthus (see next page), a leader of the second generation of classical economists. Early on, Ricardo made a fortune in the stock market when he ought to h
ave been going to school. He next gravitated to economics, where his lack of education, naturally, went undetected. In his most famous work, The Principles of Political Economy and Taxation (1817), he advanced two major theories: the modestly named Ricardo Effect, which holds that rising wages favor capital-intensive production over labor-intensive production, and the theory of comparative advantage (see “EcoThink,” page 130). THOMAS MALTHUS (1766-1834)
A clergyman who punctured the utopianism of his day by cheerfully predicting that population growth would always exceed food production, leading, inevitably, to famine, pestilence, and war. This “natural inequality of the two powers” formed, as he put it, “the great difficulty that to me appears insurmountable in the way to perfectability of society.” Malthus’ good news: Periodic catastrophes, human perversity, and general wretchedness, coupled with the possibility of self-imposed restraint in the sexual arena, would prevent us from breeding ourselves into extinction.
JOHN STUART MILL (1806-1873)
A child prodigy, Mill learned Greek when he was three, mastered Plato at seven, Latin and calculus by twelve; at thirteen he digested all that there was of political economy (what they called economics back then), of Smith, Malthus, and Ricardo. For the next twenty years he’d write; in 1848 (noteworthy also for the publication of the Communist Manifesto and a passel of revolutions) he published his Principles of Political Economy, with Some of Their Applications to Social Philosophy. A couple of critics complained that the book was unoriginal—calling it “run-of-the-Mill”—and that Mill’s mildly Socialist leanings (he argued for, among other things, trade unions and inheritance taxes) were antithetical to the Spirit of England. Many more, though, appreciated his making the distinction between the bind of production and the flux of distribution—how, while we can produce wealth only insofar as the soil is fertile and the coal doesn’t run out, we can distribute it as we like, funneling it all toward the king or all toward the almshouse, taxing or hoarding or, for that matter, burning it. Sociopolitical options took a seat next to economics’ abstract—and absolute—laws, and ethics eclipsed inevitability. Mill would be revered as a kind of saint (and Principles serve as the standard economics textbook) for another half century. JOSEPH SCHUMPETER (1883-1950)
An Austrian who came to America in the early Thirties and whose best-known work was published a decade later, Schumpeter is remembered today as the man who argued that government should not try to break up monopolies, that, in fact, a monopoly was likely to call into existence the very forces of competition that would replace it. This dynamic, labeled the “process of creative destruction,” is now much brandished by more conservative political and economic observers, who use it to explain to old industries why it’s OK for them to go out of business. “Don’t think of it as bankruptcy and massive unemployment,” the rationale goes. “Think of it as ‘creative destruction.’” JOHN MAYNARD KEYNES (1883-1946)
The most influential economic thinker of modern times, known to his close friends and intimates as Lord Keynes (remember to pronounce that “kanes”). Pre-Keynesian economists believed that a truly competitive market would run itself and that, in a capitalist system, conditions such as unemployment would be temporary inconveniences at worst. Then along came the Great Depression. In 1936 Keynes published his major work, The General Theory of Employment, Interest, and Money (now known simply as The General Theory) in which he argued that economics had to deal not only with the marketplace but with total spending within an economy (macroeconomics starts here). He argued that government intervention was necessary to stimulate the economy during periods of recession, bringing it into proper, if artificial, equilibrium (the New Deal and deficit spending both start here). Keynes’ system, brilliant for its time, has proved less valuable in dealing with modern inflation, and has been considered officially obsolete ever since Richard Nixon declared himself a Keynesian back in 1971. Later, however, Ronald Reagan’s supply-side economists set Keynes up in order to knock him down again in an uprising known in economics circles as “The Keynes Mutiny.” JOHN KENNETH GALBRAITH (1908-)
One of the first (and certainly one of the tallest) New World economists to give a liberal twist to the field’s dogma. In his The New Industrial State (1967), Galbraith, a Canadian, argued that the rise of the major corporation had short-circuited the old laws of the market. In his view, such corporations now dominated the economy, creating and controlling market demand rather than responding to it, determining even the processes of government, while using their economic clout in their own, rather than society’s, interests. More traditional economic thinkers have agreed that Galbraith is a better writer than he is an economist.
Five Easy Theses
Even though economies are always in flux, economic theories aren’t built to turn on a dime. As a result, it doesn’t take long for even the most hallowed hypothesis to stand exposed as just another version of the emperor’s new clothes. Here, for the record, a few items we’ve recently found balled up on the floor of the emperor’s closet.
THE LAFFER CURVE: A relic of the Reagan years, this was Economist Arthur B. Laffer’s much-applauded hypothesis, rumored to have been first sketched on the back of a cocktail napkin, stating that at some point tax rates can get so high—and the incentive to work so discouraging—that raising them further will reduce, rather than increase, revenues. The converse of this theory, popularly known as supply-side or trickle-down economics, maintains that a government, by cutting taxes, actually gets to collect more money; this version has been widely credited with creating the largest deficit in American history—before the current one, of course.
KONDRATIEFF LONG WAVE CYCLE: Obscure theory dating from the Twenties and periodically enjoying a certain gloomy vogue. Nikolai Kondratieff, head of the Soviet Economic Research Center, postulated that throughout history capitalism has moved in long waves, or trend cycles, which last for between fifty and sixty years and consist of two or three decades of prosperity followed by a more or less equivalent period of stagnation. Kondratieff described three such historical cycles, and when economists dusted off his graphs and brought them up to date in the 1960s and 1970s, they found his theories to be depressingly accurate. According to their predictions, we were all in for another twenty years with no pocket money. The Russians, by the way, weren’t thrilled with Kondratieff’s hypothesis, either, since it implied that the capitalist system, far from facing impending collapse, would forever keep bouncing back like a bad case of herpes. Sometime around 1930, Kondratieff was shipped off to Siberia and never heard from again.
ECONOMETRICS: Yesterday’s high-level hustle. Econometrics used to mean studies that created models of the economy based on a combination of observation, statistics, and mathematical principles. In the Sixties, however, the term referred to a lucrative mini-industry whose models were formulated by computer and hired out to government and big business to help them predict future trends. Government, in fact, soon became the biggest investor in econometrics models, spending millions to equip various agencies to come up with their own, usually conflicting, forecasts—this, despite the fact that the resulting predictions tended, throughout the Seventies, to have about the same record for accuracy as astrology. Today, econometrics models are still expensive and still often wrong, but they’re accepted procedure and nobody bothers making a fuss about them anymore.
MONETARISM: One of two warring schools of thought that feed advice to politicians on how to control inflation. Monetarists favor a laissez-faire approach to everything but the money supply itself; they have misgivings about social security, minimum wages, and foreign aid, along with virtually every other form of government intervention. They stress slow and stable growth in the money supply as the best way for a government to ensure lasting economic growth without inflation, and they insist that, as long as the amount of money in circulation is carefully controlled, wages and prices will gradually adjust and everything will work out in the long run. Monetarism owes much of its appeal to one of its
chief proponents, Nobel Prize–winning economist Milton Friedman, whose theories are generally acknowledged to have formed the backbone of Prime Minister Margaret Thatcher’s economic policy in Britain (as well as Ronald Reagan’s here). Liberal critics say Friedman owes his own appeal to the fact that he looks like everyone’s favorite Jewish uncle.
NEO-KEYNESIANISM: Monetarism’s opposite number, a loose grouping of economists who are less inclined to wait for the long run. The neo-Keynesians argue that there are too many institutional arrangements—things like unions and collective-bargaining agreements—for wages and prices to adjust automatically. They maintain that the best way for a government to promote growth without inflation is by using its spending power to influence demand. Who wins in the monetarist/neo-Keynesian debate seems less important than the fact that each side has found someone to argue with.
Action Economics
So much for theory. Although no self-respecting economist ever dispenses with it entirely, there are areas of economics in which interpreting—or inventing—economic gospel takes a backseat to delivering on economic promises. That is, to keeping things—money, interest and exchange rates, deficits— moving in what’s currently being perceived to be the right direction. Here, contributor Karen Pennar explains what some of those promises (and some of those directions) are. Come to terms with them and you’ll be ready to queue up for her tour of the markets, stock and otherwise, where action turns into hair-raising adventure. THE FEDERAL RESERVE BOARD
