Money. Essential yet still vastly unknown. Have you ever wondered where it came from, how it worked and how countries managed it? Taking a course in economics is long and expensive - this series of articles, named EE for Economics Explained will give you the fundamentals of economics clearly and effectively. Stay tuned for the next article!
Session 1: Fundamentals
Before delving into the complex and passionate world of economics, we must first establish the rules our journey will follow. Take them as guidelines for the economic world: the whole theory of economics revolves around them.
Keep in mind that economics is a vast field; this article is merely an introduction to the most important parts of it. In-depth studies of specific topics will be put in the following articles.
A) Definition
A formal definition of Economics would be :
"Economics is the study of scarcity and its implications for the use of resources, production of goods and services, growth of production and welfare over time, and a great variety of other complex issues of vital concern to society"
-From Arts-Science
Scarcity means that resources are limited: we do not have an unlimited amount of oil, food or land, for example.
We can reduce this definition to :
"the study of how society manages its scarce resources"
-From Principles of Economics, Mankiw (eighth edition)
B) How individuals behave
Society as a whole is made of individuals: population, government and States are all individuals interacting. Because economics is the study of society and that society is a group of individuals. we start our inquiry by making assumptions for individuals.
People are rational
In Economics, we assume that people are rational, meaning that they will always pick the best option for them. Rational people weigh the costs and benefits before taking an action.
Concretely, this means that, for example, when two ice creams of the same quality are available at different prices, the customer will go for the cheapest.
People have to make trade-offs
Every day, everybody faces choices, which implicate different levels of sacrifice: for example, a student studying economics for an hour "sacrifices" a potential hour spent studying maths.
To choose the outcome of these trade-offs, people must weigh the costs and benefits of each outcome before making a choice. To choose an outcome, as people are rational, benefits must outweigh the costs.
People react to incentives
Incentives are the prospects of either gains or "punishments".
For example, when oranges are more expensive, people will eat less of them - the higher cost is a prospect of "punishment" (the cost ruins a little bit the satisfaction of buying the orange). On the other side, orange farmers hire more people to try to cultivate more oranges - the extra profits are prospects of gains.
This rule may seem obvious, but beware: it is absolutely essential. We already saw above that markets are hugely impacted by incentives; in fact, not only markets are impacted, but also public policies.
Example of incentives with public policies
For example, take the seatbelt.
To reduce the alarming number of car accident deaths, governments made seatbelts mandatory. However, even though the number of deaths by car accidents did lower, statistics show that there was a significant increase in the number of car accidents. Wearing a seatbelt made people less careful while driving and provoked more car accidents. This is an example of an undesired side-effect of incentives and why they are at the very heart of public policies.
Incentives are how rational people make decisions; this is thus, in economics, how everybody makes decisions.
C) How individuals interact
Now that we saw how individuals behave, let's take a look at how they interact with each other, notably internationally.
Trade generally benefits everyone
You probably heard that China is a competitor of the United States, to the extent that both produce goods like toys, clothes, cars etc. This would therefore imply that in this constant battle, someone loses while the other one wins. However, this is often not true: Trade generally makes everyone better off.
Take your family. When your older sibling looks for a job, she is competing against all the other workers of the other families for the job. When you go buy food, you are also competing against other families to find the best apples at the cheapest price possible. Each family is competing against each other - a bit like countries. But does that mean that each family should isolate itself from trade? If everyone did so, every family would have to grow its own food, manufacture its own clothes etc. Obviously, in this case, everyone is better off with trade, for the simple reason that trade allows people to specialise in a field, producing more and better quality goods. Trade ensures people have access to a greater variety of goods at low costs. Competitors are, in fact, also partners.
Markets are GENERALLY a good way to organise economical activity
A market is a group of buyers and sellers of a particular good or service.
A market's primary goal is to allocate those resources effectively: this is called the equilibrium, which is the price and quantity sold that takes into account all benefits and costs of the good/product. We'll look closer at the equilibrium later on. In a market, the buyers try to get the cheapest price possible (to save money), while the sellers try to sell at the most expensive price possible (to make profits).
The study of a specific market is called "microeconomics"
A market economy is an economy that bases itself on a set of markets held by firms and households. Put into simpler words, a market economy is when the government only has limited control over the economy and lets people interact with each other freely.
Examples market economy
An example of a (former) country not having a market economy is the URSS. It centralised its economy so that the government decided what was produced, how much and when without the population interfering with it. On the other hand, the US are a great example of market economy, where people freely interact with each other in markets.
At first sight, market economies seem dangerous: people make decisions on a particular market guided by their self-interest, not seeing the big picture - one would think that this wouldn't work well. However, as many economists have observed, market economies often do work, and well! They seem "guided by an invisible hand", as Adam Smith, a famous economist, observed.
Disclaimer: the invisible hand alone is NOT a good way for a country to function. We'll see why on the next point.
Smith's observation comes with a set of consequences: whenever governments intervene in market economies - this can be taxes, quotas, restrictions... - the invisible hand doesn't work as well. In a 100% efficient market where goods are sold at a price that satisfies both buyers and sellers, a tax will bother both sides, the buyers buying fewer goods as they are more expensive and sellers producing less because of the lower benefits.
Public policies interventions are sometimes good
If governmental intervention in markets is so bad, why even bother with one anyway? The invisible hand will take care of the economy, and everyone will be better off.
The first reason is that the invisible hand works only under a few conditions. It needs governments to enforce laws on property rights: farmers won't grow pineapples if they think they will be stolen, and people won't work unless they are assured to be paid at the end of the month.
The second reason is that the invisible hand has limits. Although we saw that the invisible hand was effectively managing markets in most cases, there are still a few cases where the market is experiencing market failure, which is when it fails to allocate resources effectively among buyers.
Two factors can explain this phenomenon.
First, externality. It is when the impact of an action affects the well-being of another person. Consider pollution. Factories might harm the health of the surrounding people, but the invisible hand might fail to take this cost into account, as people in the market are not directly affected by this pollution. It will then give a false equilibrium that didn't take into account the cost of pollution.
Second is the threat of monopolies. A monopoly is when someone or a group of people have a huge impact on a market - they are able to control it. This will be at high risk of market failure as that person/group of people will be able to influence prices on the market. Take your railway company. In every country, there are extremely few railway owners: in France, there is one major company, SNCF, which owns most trains and railways. If it suddenly increased its prices, all the French people who are forced to take the train to go to work will be forced to pay. This is of course a case of market failure where someone abuses her power.
D) How the Economy as a whole behaves
Individual decisions and interactions between groups of people make together the "economy". In economics, the study of a whole economy is called "macroeconomics". Let's take a closer look at how it works:
Standards of living is ability to produce goods and services
What makes a country poor, and another country rich? The answer is simple: productivity.
Productivity is the quantity of goods and services produced for each unit of labour input.
In the UK, thanks to an ordered economy and technology, each UK worker's productivity is much higher than a Blangadeshis', who doesn't have access to those tools and can produce less. Public policies, when trying to raise standards of living -which is basically the goal of any politician- are actually trying to find a way to increase productivity. This goes through improving the education system, developing access to technology, creating better transportation systems...
Printing too much money raises prices
The phenomenon of increase of prices is known as inflation - I'm pretty sure you already heard that word somewhere. Inflation is one of the most critical points for governments: it can bring instability and poverty all over the country.
It is when central banks (that are more or less under the control of governments) print money that prices go up. Printing more money devaluates it: as you still have the same amount of resources but more units of money, every single unit will be valued less.
If you didn't understand how inflation works
Imagine that, in a country named Loriane's, there are 100 units of Lorianes, the currency used there.
The Loriane's government decides, following the Covid pandemic, to print 100 more units of currency and distribute it amongst the population.
Now, there are 200 units in the economy and everyone is richer. However, the resources are just the same as before (remember, we have scarce resources), and must be distributed in markets where buyers and sellers agree to a certain price (remember, buyers want to save money and sellers want to make profit).
What happens then? Take the apple sellers: they still have a limited number of apples, while apple buyers have more money. Every buyer will then be willing to spend more money buying delicious apples - the price goes up, as the sellers try to sell at the highest price possible and buyers are willing to do so.
This is a simplification; however, the overall inflation scheme could be resumed into:
Printing money
People more money
People want to spend their money
Prices go up (inflation time!)
Inflation is often pictured as a horrible phenomenon that must be avoided at all cost. This is not true - a little bit of inflation is healthy for an economy; it is high amounts of inflation that will be a problem. Inflation will have an article on its own; stay patient!
Governments have to choose between inflation and unemployement
Unemployment is when someone is looking for a job, but can't find any. It is of course an important social and economical issue for governments.
Unemployment is closely linked to inflation. Their cycle is as follows:
Governments print money
Richer now, people want to spend their money on goods and services
Firms hire more people to sustain this demand
Over time, inflation occurs (remember that we printed money in 1.)
We see that to improve employment, the government can print money, causing inflation. Employment often happens much faster than inflation - there is typically a 1 to 2 years gap between those two phenomena.
Now, you have all the knowledge needed to start thinking like an economist! We still need to take a look at the tools and graphs economists use; don't worry, it will come gradually on the following articles.
The following articles will each focus on a specific topic of economics, but they will all go along those rules.
If you have a specific topic (graphs of demands/offer, inflation, unemployment...) that you want the next article to be on, do not hesitate to put it in the comments!
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