Economics Basics

I'll try to explain here the basics of how economies work, using examples as much as possible. First, though, I want to mention something that I think causes difficulties. It has to do with the way we normally perceive the world. Most people see situations as win or lose. A game where someone wins and someone loses is called a zero-sum game (1 + -1 = 0). Team sports are generally of this type. Politics and wars are, too. Economics is not, or at least, shouldn't be if the markets are functioning well and typical market failures are controlled (see below). In the world of economics, everyone wins. I hope the following introduction will show that.

Supply and Demand
Yup, everyone's heard of it somewhere. Supply and demand is at the root of everything in economics, from transactions at a local shop right on up to complex financial derivatives. If you understand S&D, you're a lot closer to understanding economics. Let's have a look with an example.

Let's pretend you open a factory that makes widgets. You can produce 1000 per month. You set your price to $10 per widget. When the product catches on, you start to sell out of widgets. Soon, people want to buy more widgets than you can produce: demand now outstrips supply. You have three options: keep increasing delays in delivery times of your widget, increase the price per widget to bring the quantity demanded in line with supply, or increase the supply of widgets so it matches demand.

Let's say you decide you can afford to take on a second loan to expand the factory's capacity. In the meantime, however, you still have back orders and angry customers. Once again, you can set up a waiting list or you can raise the price. Creating a waiting list may seem the "fairer" option, but is it really? You will obviously benefit more from raising the price, but I will argue that your customers will, too. Here's why: those who really want the widgets and are willing to pay more will do so. Those who don't want them as much will not. In this way, the widgets go to the customers who want them most.

"Yeah, the rich ones" you say. Well, that may be true at first, but let's move on to the next logical conclusion: if you make more money, you will be able to expand to produce more widgets, pay the loan off more quickly, and have lower costs. This will allow you to drop the price. In fact, if you are producing as many widgets as the market will consume, you may find that cutting the price helps sell more, making more efficient use of the factory, and making customers happy. Making people wait will mean the price will stay high forever, fewer people will be able to get your widgets, and you will make less money. Who benefits from that? No one, of course. By the way, higher profits also mean more money to hire more workers (job creation!) and expand your factory further. This is how economic growth generates wealth and jobs.

Competition
What's to stop you from just leaving the price high and collecting huge profits from your wildly successful product? You guessed it: competition. Sooner or later, someone will see the money you're making and decide they want in on that. They will enter the market and sell widgets at a lower price than you do. You will be forced to lower your prices in response. You may also (or as an alternative) better the quality of your product, brand it and advertise it more, etc. In any case, you will have to work harder to get and keep your customers. This is not so great for you, but very good for customers. This is why most countries have "anti-trust" laws to break up monopolies (markets dominated by one company) and oligopolies (markets dominated by just a few firms that might work together to keep prices high). "Oligopolistic competition," as this is called, is the first of the three main "market failures."

Market failures
There are three scenarios in which markets do not provide optimal results. One is scarcity power, when monopolies or oligopolies run things (as described above). These quite often dissolve themselves, as newcomers challenge the older firms' dominance.

Some areas are hard to break into, however, so this is harder. The aircraft industry is an example. The technology, expertise, risks, and huge sums of money needed to design, build, and test aircraft are prohibitive. This is partly what prompted European governments to get together to create a rival (Airbus) to Boeing. Only with government support could they get it running. In the meantime, government support for the two companies is theoretically forbidden, and they keep suing each other with accusations of receiving support. It's quite amusing for us consumers, because all that fighting ensures we get better, cheaper aircraft. Another situation where scarcity power can be abused is in areas like cable TV, telephones, railroads, and ports. It usually doesn't make sense for a city to have several competing ports, for example. The one port (or even two, it doesn't matter much) then has the power to dictate the terms of access to the city. In all these situations, some form of government regulation or even control is required.

The other two areas are asymmetric information and externalities. The former just means that one side in a transaction knows more than the other. Knowing more doesn't always help. Let's say you just bought a new car 3 months ago and have just seen one you like even more. You'd like to sell your car, but just can't get a decent price for it. Why? You know the car is in perfect condition, but the buyer doesn't. She will probably assume there is something wrong with it if you want to sell it again so fast. Even if she believes you, the fear of buying a lemon is too great. No one will pay you more than 75-80% of what you paid for the perfectly good car just 3 months ago. You're therefore either stuck with your car for a while or you will have to shell out more of your savings (or borrow more) to buy the other one. This is technically a market failure, because the price you got for the car did not reflect its true value. Here it was below value, in the monopolies section the price was usually above value.

This can all work the opposite way, of course, with you getting a good price while selling a piece of junk that looks nice. Another example is insurance. In this case, the seller can't know how healthy you are (not exactly, anyway) or how likely you are to burn down your house for the money. Low-risk people then end up overpaying, high-risk ones underpaying. This is why insurance companies spend loads assessing risk, which in turn is party of the reasony why health insurance in America is so expensive.

Externalities are costs or benefits that flow outward to others. One example of a negative externality is pollution. A factory that dumps waste into a river pays nothing for the disposal. People and wildlife downstream, however, pay dearly. The factory has externalized the cost. This, obviously, must be regulated.

There are also positive externalities. Fixing up your home, for example, can make your neighborhood nicer and improve the value of other homes. You get much of the benefit, but you pay all the costs. Your neighbors benefit some, too, but pay nothing. This is why home improvement is sometimes subsidized. It is also why parks are often run by the city and why rules are enforced there. Everyone enjoys the park, but no one has to take care of it. If no one took responsibility for it (i.e. the government), it is very unlikely the park would stay nice for long. Taxes ensure that everyone helps out covering the costs to maintain the park. Another solution would be charge an entry fee to the park.

These are examples of public goods. Roads and sidewalks are other examples. It's hard to restrict access to the sidewalk, so they pretty much have to be built and maintained by a government and paid for by taxes. A patchwork of privately-owned sidewalks, or sidewalks with toll booths, would be silly and wasteful.

That's it. Believe it or not, a large chunk of economics boils down to these concepts (supply, demand, pricing, competition, and market failures). My last point: the flip-side of these market failures is government failure, which I haven't discussed here. Basically, though, if government is involved in an area that is not a market failure, chances are it is going to make things worse. Both sides of this are discussed with frequency by myself and my colleague, Michael Mohr, in this blog.

For more information on these concepts, I encourage you to read a book I've drawn upon heavily for ideas and example: The Undercover Economist by Tim Harford. It's an entertaining read for folks who don't know all that much about economics. For those who are a bit more economically inclined and have an international outlook, I recommend International Political Economy by Thomas Oatley.