A simple lesson in economics.
Written by Kerry S. Doolittle   
Wednesday, 12 May 2010

    Many people view the subject of economics as a great mystery, difficult to unravel and understand by ordinary mortals, on par with advanced calculus or astrophysics.  They hear terms like GDP and recession and inflation with only a vague sense of the meaning.  In college I took the upper level macro and micro economic classes in the same quarter with a total load of 20 hours including an honor’s political science class.  Classmates and professors alike considered me insane to take these classes together and prophesied that I was ruining my grade point average.  Instead, I made four A’s.  I could not understand why my classmates believed economics was difficult.  Quite the contrary, economics is comparable to basic math.

 

    Just as math begins with very basic principals (2 + 2 = 4), then develops formulas (a2 + b2 = c2) which are always true, economics does the same thing.  The only difference is that math deals with the behavior of numbers and economics deals with the behavior of people. 

    If you are thinking that predicting human behavior is an inexact science because everyone is an individual with different tastes, opinions, attitudes, you are correct with regard to predicting an individual’s behavior.  However, when predicting the behavior of people as a group, the science becomes much more exact, and the larger the group the better the predictions.  The reason for this is simple.  While there will always be the individual exceptions (the serial killer, the mentally ill, the anti-social, etcetera) within the group, everyone else is a rational human being with the same basic needs, drives, and desires: food, shelter, companionship, security. 

    Let me give you a basic lesson in economics.  At the foundation, economics is all about the balance of supply and demand.  This balance can be discussed with reference to a single product or service, or with reference to all of the products and services in a particular market place.

    First principal: all resources are finite. 

    The supply has a limit which economics refers to as scarcity.  That limit for any particular item, like crude oil, may increase if a new source is found, or decrease if a fire destroys a warehouse.  The supply may be artificially manipulated if someone  has control over a sufficiently large portion of the supply, e.g. OPEC restricting its output of crude oil.  The term monopoly refers to someone having control over the entire supply, or a sufficiently large portion that the remaining supplies are inconsequential. 

    A monopoly is a bad situation in economic terms because of the artificial manipulations.  In a monopoly choices are not made based on the usual human needs and competition for resources, but for other considerations unique to the monopoly.  Why does OPEC restrict production?  One reason may be to drive up the price of oil which presumably increases profits, but if that were the real reason, why not do that all the time?  The motivating reason is often political, forcing the U.S.A. to change some foreign policy for example. 

    Quiz:  What is the biggest monopoly everyone must deal with regularly?  I will give you the answer later.

    Second Principal:  Price functions as the allocator of scarce resources. 

    This second principal is really the heart of economics.   Remember, in economic terms all resources are scarce in terms of being finite.  In this case scarcity does not mean that the supply is very limited like a rare mineral.  It just means that the supply is not unlimited.  A fair market price is defined as the price at which a willing buyer who is not compelled to buy and a willing seller who is not compelled to sell will make the exchange.

    The principal is simple.  As a price goes higher more people are willing to sell (increasing supply), but fewer people are willing to buy (decreasing demand).  At a very high price the available supply greatly exceeds the available demand, meaning much of the supply would sit on the shelf unsold.  In this condition, competition to sell the product drives the price down.  Conversely, as a price goes lower, more people are willing to buy (increasing demand), but fewer people are willing to sell (decreasing supply).  At a very low price the available demand greatly exceeds the available supply, which means that a lot of people who want the item cannot find the item to purchase, the shelves are empty.  In this condition, competition to buy the product drives the prices up.

    You see this effect of competition every day.  When high definition televisions first appeared in the stores, the prices were very high.  The available selection was limited because it was a new technology and manufacturing was just beginning.  Factories could produce new televisions at a certain rate.  At the same time demand was very high because a lot of people wanted these new televisions with better pictures.  But, as the technology continued to improve, and other manufactures began producing high definition televisions the supply steadily increases and the demand shifts to the every newer products, with the result that prices steadily falls.

    We see price function as an allocator at our local gas station.  When the available supply of gasoline drops because a hurricane shuts down a refinery, the price at our local gas station goes up.  When the available supply of gasoline increases, the price at our local gas station goes down. 

    The reverse is also true of demand for gasoline.  When the summer vacation travel season begins as schools close for the summer, we usually see the price of gasoline increase.  The same is true for heavily traveled holidays like Thanksgiving.  But, when the holiday is over, and travel drops back to the normal level, the price of gasoline also drops. 

    You no doubt experienced this phenomenon, and if you were the traveler felt like you were being gouged by the greedy gas stations and oil companies.  I certainly understand the feeling because as a traveler, you need to buy the gasoline and have no choice but to pay the higher prices.  But I have a couple of bones to pick with that statement.  First, the word greedy is a character assessment which has no place in economics.  Second, you do have a choice.  Would you still take the trip if the price of gasoline is $5.00 per gallon? $25.00 per gallon? $100.00 per gallon?  At some point you will decide the trip is not worth the cost.  Third, you are feeling as an individual.  Back up and think about the results from the group perspective.

    Because we anticipate the price increase, many of us will fill up early in the week before the holiday begins and the prices spike up.  The travelers may have to fill up again during the holiday, but was able to minimize the total cost of fuel for the trip by planning ahead.  Also, not everyone travels during the holiday, and they can choose to wait until after the holiday when prices come back down before filling up their gas tanks.  You are now thinking so what, these are still individual results.  Not true.  The cumulative effect of these individual choices is to allocate a larger supply of gasoline during the holidays for the travelers who need it by reducing the demand for gasoline over the holidays by those who can do without for the duration.  It also spreads out the purchases of gasoline over a longer period, including the days before and after the holiday, thereby allowing the gas stations to re-fill their tanks more often to keep up with the increased demand. 

    Allocation of scare resources is all about making more of the supply available to those who need it more, and less to those who need it less.  In the example of holiday travel, the price increase discourages those who do not need to purchase gasoline during that period so that more is available to those who do need to purchase gasoline. 

    What happens if price is not allowed to perform this function of allocation?  Ask anyone driving a vehicle in the late 1970's.  OPEC reduced the oil supply, the available supply of gasoline suddenly dropped significantly.  The result was to put a lot of upward pressure on the price at a time when the economy was already suffering.  Politicians decided to implement price controls to mollify their constituents who did not want to pay higher prices.  The result was long lines at gas stations, stations which ran out of gasoline, and limits on how much gasoline a driver could purchase at one time.  Anyone who needed a lot of gas had to make frequent, time consuming waits at multiple stations.  This story has two morales.  One, political interference with the function of price has bad consequences of its own.  Two, price comes in more than one form.  In this case, instead of price functioning through dollars, the most efficient means, price functioned through time, i.e. how long you were willing to wait depended on how badly you needed the gasoline.

    Third Principal: Supply and Demand will always mover toward equilibrium, i.e. the price at which supply equals demand. 

    In a free market the price will never be completely static, but at equilibrium the price will be stable.  Any change in either the supply or demand will cause the price to move up or down toward the balance point. 

    This principal is the basis for the basic economics graph with which everyone is familiar.  The vertical axis measures price.  The horizontal axis measures quantity.  Supply is represented by a line sloping upwards from left to right.  At any given price point, a certain supply is available.  At a higher price point, a greater supply is available, i.e. more people are willing to sell.  At a lower price point, a lesser supply is available, i.e. more people keep their supply to themselves.  Demand is represented by a line sloping downwards from left to right.  Again, this is the reverse of supply.  As the price drops, demand increases, and as the price goes up, demand decreases.  The point at which the Supply line crosses the Demand line is the equilibrium price, the point at which supply and demand are balanced.

    Now this is the part that some think is tricky, but it is really simple.  Let us say our graph represents the supply and demand and price of crude oil.  What happens if the supply or demand changes?

    If suddenly a new oil field starts producing in Alaska, the supply of crude oil on the open market increases.  With the new competition on the market, oil suppliers will accept a lower price to sell their oil.  If they do not, consumers will buy elsewhere at a lower price and the stubborn supplier will sell less oil, losing money.  On our graph, the entire line for supply drops and shifts to the right on the graph, indicating that a greater supply is available for the previous price points.  The result is that the point at which the supply and demand lines intersect represents a lower equilibrium price and a greater quantity.  If the supply suddenly drops because of an oil embargo by foreign producers, the result is just the opposite.  The entire supply line rises and shifts left on the graph indicating that a lower supply is available and requires a higher price.  The intersection of supply and demand shifts to a higher dollar value and a lower quantity.

    Changes in demand results in the reverse conditions.  If demand drops, the demand line shifts down and to the left resulting in a lower price and smaller quantity.  If demand increases, the demand line shifts up and to the right resulting in a higher price and greater quantity. 

    In the real world, a lot of measuring of prices, sales, supplies and uses goes in to determining exactly where the supply and demand lines appear on the graph for any given product or service.  The graphs are used to predict what will happen if changes occur.  On the other hand, every day, every one of us are practicing economics when we decide to buy two candy bars because the store is having a sale, and decide whether we want to buy a new television with the latest technology, or if we prefer to pay less and get last year’s model.  Some people will pay the higher price to get it now, others will wait until the prices come down. 

    Now for the advance lesson.

    For the last couple of years our country has been in a recession (or depression depending upon whether you are using political or economic definitions).  What does that mean in terms of what we just learned?  When you hear the words “The Economy”, it generally refers to the combined totals of all goods and services in the marketplace.  The marketplace can be your local community, your state, your country or the entire globe.  In most cases, the news is referring to our national economy or marketplace.  Have you heard the term G.D.P. or Gross Domestic Product?  This is the Economy, the total of goods and services in the national marketplace.

    To say that the Economy is in recession simply means that the total dollar value of all those goods and services, based on the equilibrium prices, has dropped or is continuing to drop.  Some may say the Economy is shrinking.  In your individual circumstances that may mean that you are making less income, the value of your home dropped, the costs of the goods you buy has increased, and the supply of those goods have decreased.  You have fewer choices and those choices cost more. 

    Why are we in a recession now and what will it take to get out of it?  Those can be very complex questions because everything in the Economy is intertwined, and changing one little thing can affect a whole lot of other things.  In the greatest oversimplification, the supply of money has dramatically decreased, and only an increase in the supply of money will turn things around. 

    Money is, after all, just another product although it happens to be the product used to measure the value of other products.  When the value of money changes, the value of everything else changes.  That sounds really complicated, but think of it like this.  You measure a football field with a yard stick, three feet long.  The football field is 100 yards long.  What happens if the yard stick shrinks and is only two feet long.  The football field is now 150 yards long.  If the yard stick grows to four feet, the football field is now only 75 yards long.  The yard stick is the dollar.  The football field is any product, and the length of the football field is the cost of that product.  You will note that the actual size of the football field did not change, only the size of the yard stick.  That demonstrates that the actual value of the product relative to other products does not change just because the value of the dollar changes, but the effective cost of the item changes when measured by dollars.

    If the cost of money drops (i.e. you get more dollars for the same value, hence a longer yard stick), the cost of goods goes down.  If the cost of money goes up (i.e. you get fewer dollars for the same value, hence a shorter yard stick), the costs of goods go up. 

    If you are confused, re-read that while remembering that cost and value are not the same thing.  A gallon of gasoline has a certain value because it will carry your vehicle a certain distance.  That value does not change when the cost of that gallon goes up or down. 

    What is the cost of dollars measured against?  Well it could be measured against anything, but how about in terms of your labor or time.  Are you earning more or less dollars now than three years ago?  If you are earning less, the cost of money has increased.  In terms of necessary goods, if the cost of milk and bread has increased, then the cost of money has increased because you have to expend more labor to earn more dollars to buy the same amount of milk and bread.

    We do not have to measure value or costs in terms of dollars.  For example, if a gallon of milk costs $5.00 and a dozen eggs costs $2.50, then a gallon of milk equals two dozen eggs.  Before money was invented or widely available, the exchange of goods was made in just this fashion called bartering, in which one physical product was traded for another physical product. 

    When the supply of money decreases, the price of money rises, making the yard stick shorter (i.e. you get fewer dollars for the same relative value) and the cost of goods effectively rises.   When the supply of money increases, the price of money drops, making the yard stick longer, and the costs of goods effectively drops.

    Why has supply of money decreased dramatically?  The ever increasing national budget and national debt is absorbing more of the available supply of money.  Increasing taxes are taking dollars out of the hands of the private economy.  With less money, the private economy produces fewer goods and services.  Since the economy is the total value of those goods and services, the economy is contracting or shrinking.  Employers cut back on their use of labor, so unemployment increases, meaning individuals are producing less, earning less, further reducing the supply of money circulating around the Economy. 

    How do we turn it around?  In academic, not political, terms, we simply have to increase the supply of money available to the Economy to stimulate economic growth and increase employment.  The easiest way to do that is for the government to reduce spending, reduce the national debt, and reduce the tax burden on the private economy.  These three things make more real money available.  I recognize that politically that is far from a simple task, but politics do not alter economics.  Politicians merely interfere with economics, which I postulate always results in adverse outcomes.

    Consider this idea in terms of your personal household budget.  If your income decreases your reaction will be to reduce spending.  That is a rational response.  Government does not act rationally.  Despite the recession the federal government has increased spending and raised taxes, exactly the opposite of sound economic and fiscal policy.  This is not unproven theory.  Three times under Kennedy, Reagan and Bush taxes were cut with a result that revenue to the government actually increased because of the expansion of the economy resulting from the stimulation of an increased money supply.  When President Obama was running for office, he was asked point blank since it has been shown that cutting taxes increases revenue and raising taxes reduces revenue, does he still intend to raise taxes and why.  Essentially the answer was yes because it is not about raising revenue.  What then is it about?  In President Obama’s administration, tax policy is about social engineering.

    I kept politics out of this lesson thus far.  My point here is not to argue about politics on the basis of political ideology or agenda, but to view political decisions through economic consequences.  You may well feel that a national health care program is a desirable political goal for whatever reasons you personally hold.  I can take the position that health care is not a legitimate function for the federal government.  That is not the point.  Economically the question is simply can we as a nation afford such a program.  No matter how noble or desirable the goal may be, if we cannot afford it, then the economic consequences will be devastating.  The annual federal budget deficit continues to increase.  The national debt continues to increase.  The one thing I have not heard is any plan to reverse this trend within some reasonable time frame so that the debt can eventually be paid off.  I believe a lot of people simply assume that the debt will never be paid off and will continue to grow indefinitely.  The problem is that outcome is not economically possible.  See what is happening in Greece right now.  At some point, the bill comes due, and then what?

    Now the answer to the quiz, the biggest monopoly with which everyone of us deal almost daily is the federal government.  We do not have multiple national governments competing with each other to provide us with national defense and administration of the judiciary and legislature.  We have no control over the cost (beyond the ballot box) of the national government because its simply determines how much it wants to charge, and has the authority to use guns to enforce payment. 

    Because the federal government is a monopoly, the founding fathers limited the scope and authority of the federal government in favor of leaving the bulk of the power in the states.  The states are in competition.  Current trends have people leaving states like New York, Michigan and California for reasons of higher taxes, greater regulations on business, higher costs of living, and higher unemployment.  If a state wants to experiment with a health care system and higher taxes to pay for it, people can decide whether to move into or out of that state.  If the federal government experiments, some people may be able to move out of the country, and poor people may flock into the country for the free services, but the rest of us will be trapped here bearing the burden.  Worst of all, if the experiment fails the consequences will be harsh.  Europe can bail out Greece, but who can or will bail out the U.S.A.? 

    I do not expect that a lot of people will find this article, much less read to the end.  Thank you.  I hope you have been entertained or educated or challenged to think or all of the above.