The Economics Book (DK) (Part 1)

The book serves to give a better understanding on economics theories. The power of economics is felt everywhere. Economics is what moves countries. It is not just about numbers and graphs/charts. The subject is more of an art than science as it is driven by the rational/irrational behavior of humans. ‘The Wealth of Nations’ by Adam Smith in 1776 kicked start modern economics. Soon came the market economy. This is generated separated into macroeconomics and microeconomics. A hands off approach is known as laissez-faire. Others such as Karl Marx believed in state intervention. Neoclassical economics occurred in the 19th century. There are many other schools of thought now.

In economics, hope and faith coexist with great scientific pretension and also a deep desire for respectability. – John Kenneth Galbraith

The first lesson of economics is scarcity: there is never enough of anything to satisfy all those who want it. The first lesson of politics is to disregards the first lesson of economics. – Thomas Sowell

Economics is, at root, the study of incentives: how people get what they want, or need, especially when other people want or need the same thing. – Steven D Levitt

Let Trading Begin (400BCE to 1770 CE). Trading, even barter trading occurred a long time ago. Plato and Aristotle wanted to come up with a normative (moral implications) approach on an economy. In the 15th century, governments started to monitor fiscal surplus/deficits, imports/exports, taxes. In the 17th century, the stock exchange was established. In the 18th century, economics became a lot more scientific. This was when the macro-economy was born.

Property Should Be Private (Property Rights). Aristotle believes that private property will give people the incentive to trade and get rich. There are three different beliefs here. The first is that everything is common and that everyone can use them. The second is that the property be held and used collectively. The third is that property is private and that people can do as they choose. 3 reasons against public property (no one will maintain it, people have little incentive to trade, people will be selfish). Government can take over private property as well but usually the home owner will be compensated with the market price.

It is clearly better than property should be private, but the use of it common; and the special business of the legislator is to create in men this benevolent disposition. – Aristotle

What Is A Just Price? (Markets and Morality). Some believe that prices are a function of supply and demand. In the past, it is believed that sellers get to fix their prices. The moral issue is that the seller gets excessive profits and deceive customers. Thomas Aquinas believed in a ‘just price’ setting. There are different views to this, depending on whether you are for government intervention.

No man should sell a thing to another man for more than its worth. – Thomas Aquinas

You Don’t Need to Barter When You Have Coins (The Function of Money). Kublai Khan used money in the 13th century. Money is ever-present in today’s society. It is hard for barter to work in the long term. ‘Money is transferable and deferrable’. There are two types of money: commodity (example gold coins) and fiat money (paper money).

Make Money from Money (Financial Services). It started off from the Medici family in the 14th century. The initial tools were to finance trade in commodities. The next was to open many branches, managed by different partners. The last was to accept customer deposits. Long ago, banks already dealt in foreign currencies. The economics of banking include lending wisely, gathering deposits, spreading risks to earn economics of scale. Banks must be careful to avoid ‘a run on the bank’ situation. Bills of exchange were developed to guarantee delivery of goods. Derivatives brought about the financial crisis of 2008. Banks engage in ‘network externalities’, meaning that they collaborate with each other to get more information. Co-operatives started (example is Grameen Bank, Rabobank). Bank failures can have serious implications on the economy. That is why regulation is in place to prevent them from going under.

A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain. – Mark Twain

Money Causes Inflation (The Quantity Theory of Money). Jean Bodin came up with this idea. An increase in money supply increases inflation levels. This is because as people become richer, there is too much money circulating and not enough goods, leading to inflation. Real and nominal side of the economy emerged. People chase ‘real money’, not ‘nominal money’. MV=PT ‘P is the price level’; ‘T is the transactions that take place’; ‘M is the supply of money’; ‘V is the velocity of money (a constant)’. However, recent research has proven that velocity is not constant. V affects output and employment. A rise in interest rates will lead to rise in V. Quantitative easing is when central banks print money and buy government debt. This helps to reduce interest rates.

Inflation is always and everywhere a monetary phenomenon. – Milton Friedman

Protect Us From Foreign Goods (Protectionism and Trade). Limiting import of goods causes more money to be retained in an economy. Some believe in a free market, some believe in protectionism. There was causing that money outflow will lead to currency devaluation. Thomas Mun concluded that how the trade and payments balance out matters. His idea was to import and then value-add on the product before exporting it. Adam Smith believed the wealth of all nations as a whole mattered. Nowadays, many people believe in free trade. Hence, the FTAs signed between countries. Protectionism is quite rare nowadays.

The Economy Can Be Counted (Measuring Wealth). William Petty attempted to measure national income and GDP. He wanted to quantify different countries’ performances. GDP is the total value of all the goods and services exchanged for money within a country in a particular period. Other indicators have emerged, such as GPI (Genuine Progess Indicator), HPI (Happy Planet Index).

Let Firms be Traded (Public Companies). The purpose of the stock market was for more efficient capital allocation and diversification of risk. The East India Company was one such example.

Wealth Comes from the Land (Agriculture in the Economy). Wealth stems from production and the output of the farmer. Manufacturing can also produce surpluses. Theodore Schultz also believed in the power of agricultural development, especially in poor countries. Henry George believed that land should be held in common. However, Adam Smith believed more in labour than in land.

If we knew the economics of agriculture we would know much of the economics of being poor. – Theodore Schultz

Money and Goods Flow Between the Producers and Consumers (The Circular Flow of the Economy). The circulation of money is very important. The ‘multiplier effect’ was introduced in the economy. That is why government stimulus package is crucial. Quesnay believed in low tax and investing in equipment to generate more money. Macroeconomic performance via income accounting was born (income and expenditure flow). The classical model focuses on three factors: land, labor, and capital.

Private Individuals Never Pay for Street Lights (Provision of Public Goods and Services). Public good (hard to prevent someone from benefitting, by enjoying it you can’t diminish someone’s else enjoyment, can’t stop non-payers from using them). Government has to step in to provide these. Problem of ‘free-riding’. Non-excludability and non-rivalry.

Where the riches are engrossed by a few, these must contribute very largely to the supplying of the public necessities. – David Hume

The Age of Reason (1770 to 1820). A fresh approach of looking at the economy was needed. Adam Smith was central to this development. He believed in a free market, capitalism, with a limited role for the state. This was also the period of Industrial Revolution. David Ricardo was also very influential. He showed how less productive countries could benefit from free trade. The relationship between supply and demand was established.

Man is a Cold, Rational Calculator (Economic Man). Individuals are all self-interested and want to maximize well-being. Yet, they want to minimize cost in achieving the above. Cost-benefit analysis. People are rational. This is how behavioral economics comes about.

The Invisible Hand of The Market Brings Order (Free-Market Economics). Man, even without his knowledge, acts in the wider interests of society. This is known as laissez-faire (leave business alone) economics. When demand for a product exceeds supply, people will bid up the price. Suppliers will see this opportunity and compete to supply more products. This will eventually reach equilibrium. Same works for employment: also based on the invisible hand. However, recent criticisms to his theory is that market might only produce products for the rich and fair prices may change in times of scarcity. Innovation and competition can help lower prices. Consumption is the sole end and purpose of all production’ – Adam Smith. There are two types of labor ‘productive’ and ‘unproductive’. Division of labor results as there are more specializations. As there is more capital, there can be more savings in the economy. Later on, neoclassical economics emerged. Maths was used to seek a solution on how prices can reach equilibrium. Keynesian economics believed in government intervention. This debate has carried on till today.

The Last Worker Adds Less to Output than the First (Diminishing Returns). This is the diminishing marginal returns theory. It explains not only why it costs more to produce more, but also why countries struggle to get richer if their population expands without improvements in technology.

The earth’s fertility resembles a spring that is being pressed downwards where the effect of additional weights will gradually diminish. – A R J Turgot

Why do Diamonds Cost More Than Water? (The Paradox of Value). Hardly anything can be exchanged for water. However, a diamond doesn’t serve much uses but is worth a lot as it is in limited supply. Diminishing marginal utility. Water is abundant, but diamonds are scarce. One extra diamond has a high marginal utility and so commands a much higher price than an extra cup of water.

Make Taxes Fair and Efficient (The Tax Burden). Tax allows the transfer of happiness from one group to another. Efficiency means both effectiveness in collection and maximizing tax revenues. Fairness needs to be taken into account when designing a policy. In the past, people believed that only agriculture was value adding. Modern tax suggests final tax to goods sold to customers. Taxation on market failures is also common.

Divide Up Pin Production, and you get More Pins (The Division of Labour). Focusing on a task can mean more speed and skill. Therefore, leading to higher productivity. Although a division of labour might lead to poor job satisfaction. It is good to specialize in something. Nowadays, companies like to outsource certain parts of the process.

Every expansion of the personal division of labour brings advantages to all who take part in it. – Ludwig von Mises

Population Growth Keeps Us Poor (Demographics and Economics). Thomas Malthus argued that population growth puts a strain on resources. Social and economic reforms are very common. ‘Mathusian trap: higher living standards are always choked off by population growth.’ However, this is not true in modern society. People are becoming increasingly affluent. Technology and productivity has improved, leading to better standards of living.

Meetings of Merchants End In Conspiracies to Raise Prices (Cartels and Collusion). Competition drives down prices. Monopolies set prices by restricting output. Oligopoly is when a few suppliers collude. This is how cartels are formed. It is possible to use legislation like anti-trust laws to counter this. Small cartels are easier to manage. There is the possibility of self-interest in a cartel. A famous cartel is the OPEC. There is usually an enforcer in a cartel. Cartels are not common as it is hard to maintain.

Economists have their glories, but I do not believe that antitrust law is one of them. – George Stigler

Supply Creates its Own Demand (Gluts in Markets). Jean-Baptiste Say didn’t believe it was possible to over produce. Once a product is made, it creates a market for other products. This is the flow of money. People will have to spend the money that they eventually earn. ‘Supply creates its own demand’. Overproduction is very rare. On the other hand, Keynes believes that growth only comes with increased demand. He believed that if people saved money, it would no longer be in circulation. This would lead to a decrease in demand for goods, causing unemployment.

Borrow Now, Tax Later (Borrowing and Debt). It makes no difference whether the government borrows or taxes now. Borrowing is deferred tax. People are indifferent to the method used. This is the Ricardian equivalence (debt neutrality). The modern debate is that borrowing and taxes occur at different rates and timing. Life expectancy matters as well. It predicts that if government uses fiscal stimulus measures and spend more now, the people will receive heavy tax in the future. Therefore, people are indifferent now. This is not true. ‘There is a limit to which governments can borrow and tax’.

The Economy is a Yo-Yo (Boom and Bust). Under consumption and over production are the causes of economic turbulence. The economy is cyclical in nature. How to fuel the boom. People will get richer during a boom. However, when the supply exceeds demand then it will force companies to cut prices. This will lead to a downturn. Government intervention can help cool a heated economy.

Universal competition or the effort to always produce more, and always at a lower price…has been a dangerous system. – Jean-Charles Sismondi

Trade is Beneficial for all (Comparative Advantage). Time is essential. Make what you are good at doing best only. The others will make the reminder of the products. Then trade to exchange these goods. Setting price floors and restricting imports lead to deadweight losses. You will profit by doing what you are best at. Whether you are capital intensive or labor intensive, you will have an edge if you trade. Protectionism normally doesn’t work. It appears that those countries which have cut tariffs have achieved better growth.

Industrial and Economic Revolutions (1820 to 1929). Capitalism started. There was a shift from agriculture to industralisation. The supply and demand curve was developed. Marx believed in less of a market economy, but rather one where production is owned by workers and there was no private property.

How Much Should I Produce, Given The Competition? (Effects of Limited Competition). Duelling duopolies. The Nash equilibrium is making an optimal decision when you not know what the opponent will do or react. This is an example of game theory. The optimal output for a duopoly is more than a monopoly but less than perfect competition.

Phone Calls are Dearer Without Competition (Monopolies). A monopoly is generally defined as having more than 25% of market share. The problem of a monopoly existed almost 2000 years ago. John Stuart Mill believed that collusion is more common than a pure monopoly. Monopolies push up prices by limiting supply. The monopoly market can also enter the labor market. Monopolies produces deadweight losses and less consumer surplus. Sometimes, a monopoly can lower the price and also achieve greater revenue. They also have to advertise less as they are already quite large. They can engage in predatory pricing. Most countries have natural monopolies running the utilities. For some natural monopolies, fixed costs are so high that forcing them to lower their price might lead to losses. This is when the government needs to step in.

Whatever renders a larger capital necessary in any trade or business, limits the competition in that business. – John Stuart Mill

Crowds Breed Collective Insanity (Economic Bubbles). Bubbles occur when there is speculation, causing prices to veer from the fair value. This is dangerous as bubbles will eventually burst. “Let the buyer beware” is good advice. ‘Crowds breed collective insanity’. Never underestimate the power of mass media.

Let the Ruling Classes Treble at a Communist Revolution (Marxist Economics). Some places have planned economies. Marx believed in a different economic system. Feudalism was born. Communism will be brought about by revolution. He believed capitalism will eventually hit a downfall. Bourgeoisie vs the proletariat. Those who held production were ‘the ruling party’. He felt that a commodity’s value depends on the labor necessary. Companies will want to pay as little wages as possible. They will also seek to improve technology in the company. This often leads to less human involvement or a poor work environment. The ruling class will tremble once the working class have a revolution. Capitalism believed in the formation of monopolies. Socialism is when the majority of the people have the power. Marx believed in moving a planned economy based on common ownership. Modern society has proven Marx wrong. Death of communism.

The proletarians have nothing to lose but their chains. They have a world to win. Working men of all countries, unite. – Karl Marx

The Value of a Product Comes From the Effort Needed to Make It (The Labor Theory of Value). A certain amount of effort is needed to convert a raw material to a finished good. Marx had his labour theory of value. ‘All commodities, as values, are realized human labour.’ – Karl Marx. Ultimately a value of a good must be derived from the labor costs. Value is determined by the normal amount of labour we expect its production to take. Marx believed in seeing the fruits of your labor and going through the whole process, not just a tiny step of the process.

Prices Come From Supply and Demand (Supply and Demand). Value can be derived from the previous chapter. It needs to be fair for both the consumer and producer. The supply and demand curve was formed. ‘The Marshallian Cross’. The equilibrium is the intersection between the supply and the demand. Firms are price takers (assumption). There is a need to separate fixed and variable costs. Prices are not the only factor that affects demand. Customer tastes and preferences also matter. Producers can entice demand by advertising and giving promotions. Short term products need more price alterations to achieve equilibrium.

In every case the more of a thing is offered for sale in a market the lower is the price at which it will find purchasers. – Alfred Marshall

You Enjoy the Last Chocolate Less Than the First (Utility and Satisfaction). Consumers will only buy more of something if the price falls as they don’t enjoy as much utility from the subsequent purchases. Too much of a useful thing would be no use. Law of diminishing marginal utility. Alcohol is different. The more of which is consumed, the more people enjoy it. People make decisions based on risk appetite and not really their DMU.

When the Price Goes Up, Some People Buy More (Spending Paradoxes). These are Giffen goods. Demand rises when price rises. It has to be an inferior good, where people buy less of it when their income increases. This is because there are other sources/alternatives around. Substantially a large percent of their spending is on the product. No alternatives currently to the product. There is need to outweigh the substitution effect.

A System of Free Markets is Stable (Economic Equilibrium). Leon Walras attempted to establish equations for the general market equilibrium. This is similar to Newton’s three laws. The sum of all excess demand in an economy equals zero. His work builds on the supply and demand graph. The whole economy is interlinked. His equation was reduced to just price and quantities. Flaws in the model. His equations were too technical for most to understand. John von Neumann exposed flaws in his model. Arrow and Debreu, in the 1950s, derived conditions in which Walras’ model would hold. Partial equilibrium analysis is the basic.

The equilibrium re-establishes itself automatically as soon it is disturbed. – Leon Walras

If you Get a Pay Rise, Buy Caviar not Bread (Elasticity of Demand). Changes in income alter the level of demand. This is how the elasticity of demand came about. When prices for bread changes, demand doesn’t vary much as there are few substitutes. Other more expensive items might be more price-elastic. Engel’s law ‘demand for food is income-inelastic’. Demand for expensive items grew as quickly as the increase in income. Inferior goods are those when demand falls when prices increase.

Firms are Price Takers, Not Price Makers (The Competitive Market). This is due to perfect competition. There are a large number of firms. Every firm is selling the same product. There are no barriers to entry. An opportunity for excessive profit will drive more firms to enter the market. There is almost no industry in reality which can fit this model. The world is dynamic and not as flat and static as Marshall’s model.

Make One Person Better Off Without Hurting the Others (Efficiency and Fairness). Pareto efficiency. Pareto believed in ‘ordinal utility’ or relative happiness, rather than ‘cardinal utility’ or absolute happiness. ‘No one can be made better off without hurting someone else’ This is Pareto optimality or Pareto efficiency. Everyone is assumed to know what they want and want to trade to maximize their own utility.

The Bigger The Factory The Lower The Cost (Economies of Scale). Fixed costs is the same, variable costs is reduced. Average cost decreases. Specialization in labor and investment in machinery can aid this process.

The Cost of Going to The Movies is the Fun You’d Have Had at the Ice Rink (Opportunity Cost). This is known as opportunity cost. True cost include both direct costs and opportunity costs.

Economics brings into view that conflict of choice is one of the permanent characteristics of human existence. – Lionel Robbins

The value of something was determined by what had to be given up in order to get it. – Friedrich von Weiser

Workers Must Improve Their Lot Together (Collective Bargaining). There are more employees than workers, therefore they hold the balance of power. Therefore, workers need to act together to fight for their rights. There are unions present to help them with it. However, those jobs that are protected by the Union enjoy better benefits than those which are not covered by the Union.

If a group of workmen concert together, and send representatives to conduct the bargaining on behalf of the whole body, the position is at once changed. – Beatrice Webb, Sidney Webb

People Consume to Be Noticed (Conspicuous Consumption). Rich like to purchase expensive goods to flaunt their wealth and status. This is known as ‘Conspicuous Consumption’. Expensive goods or branded goods are also known as ‘Veblen Goods’.

Economic behavior is driven by psychological factors. – Thorstein Veblen

Make the Polluter Pay (External Costs). Government can step in and force polluters to pay. These are known as negative market externalities. This idea came from Arthur Pigou and the tax is known as ‘Pigouvian tax’. Governments use this to reduce carbon emissions. However, how much to tax can be big issue.

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