Economics 101 --part 1 (a reader's question answered -- at length)
January 9th 2011 14:40
In discussing economics, even at the lowest, most trivial level, it’s important to realize that the subject really isn’t a science. It’s not only not a science, it’s not even a soft science. Oh, it uses graphs and calls things “laws” and some stuff really does seem like universal truth – but about the best you can say for economics is that it’s psychology with a scorecard. If you read the work of well known economists, the also seems to be a measure of theology thrown in, and the same set of facts can be used to justify different beliefs.
This isn’t intended as a real introduction to economics, just as an answer to a question from a reader, so if anybody would like to offer corrections or emendations, feel free. Everything that follows is gross over-simplification. Unfortunately, it sometimes seems as if everything is.
Our current understanding of economics probably starts with Adam Smith, circa 1770. Smith described the Law of Supply and Demand, and the invisible hand of the market. Basically, he observed that prices fluctuate with supply of a product and the demand for that product. In an agrarian society, the supply of a crop will balance the demand for that crop – buyers and sellers can reach an agreement on a fair price. But suppose there’s a drought, and the potato harvest is very poor. If there aren’t enough potatoes to go around, farmers will raise the price and only those people who are willing to pay the higher price will buy, and other people will go hungry, or find something else to eat. The same rule applies if there is a bumper crop, and farmers have more potatoes than anybody wants. The farmers will lower their price in the hope of finding somebody who will take the excess off their hands.
Lots of factors can affect both supply and demand, but the adjustments in price happen naturally enough. A farmer with small, funny looking potatoes won’t be able to charge as much as a farmer whose potatoes look good. A magazine article warning that potatoes are fattening will reduce the demand. The key point is that prices go up and down, adjusting to botht eh supply of a product and the demand for it, to find a natural level. If the economy is bad, and people can’t afford to buy things, prices will go down, and eventually the price will be low enough for people to buy stuff, and then, once there’s enough demand for a product, prices will go up again, and everything works out. It’s true that occasionally people starve to death, but the market will correct itself sooner or later.
Skip ahead to the 1920s and John Maynard Keynes, who found a flaw in Smith’s work. While Keynes agreed that the market is self correcting most of the time, there are situations where it can’t fix things on its own. That’s what happened during the Great Depression. People were starving for lack of food, but instead of planting more crops, farmers were cutting back, because nobody could afford to pay for the food they had. There were too many people with no money at all, and nothing to trade. In this case, demand fell because there were too few people who could afford to buy, and supply fell because in the absence of demand, nobody could afford to produce anything. The market wasn’t able to correct itself.
Keynes solution was simple – the government should step in and create demand. He wrote that while, under normal conditions, the government should have a balanced budget, when things got really bad, it should run at a deficit, and one way or another, distribute money so that people could buy things again. When people were buying, then farmers would start growing more crops, and hire more workers, who would have money to buy things, and the whole cycle would produce more growth. The farmer might sell enough potatoes to buy a new tractor, and then International Harvester and John Deere might add another production line, and maybe go to a restaurant to celebrate, and so on. Done properly, the economy would start running on its own again, the government could collect enough in taxes to pay off its debt, and get out of the business of running the economy. So, in answer to one of the questions asked, there is no term “demand side” economics, it’s called Keynesian, or neo-Keynesian since, after World War II, a number of economists tried to align Keyenesian theories with traditional ideas. Among them was Paul Samuelson, the texbook author, whose introductory text was for a long time the best selling book on the subject, and the way the baby boomers learned economics, if they learned it at all.
Supply Side Economics came later, and has so many names behind it that it’s hard to give credit to just one person. It was the idea that economic growth could be stimulated by reducing restrictions on manufacturers – lowering taxes and reducing regulations. There’s little solid documentation of the theory working, and yet it’s the basis for a great deal of political argument, as in “job killing taxes” and “job killing regulations”, and the request by Congressman Darrell Issa sent letters to corporate leaders asking what regulations they would like changed. Supply Side Economics is an outgrowth of Say’s Law: "A product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value." According to this notion, supply determines demand, rather than the other way around.
The flaw in Supply Side economics should be obvious, unless you have a vested interest in not noticing what’s wrong. Aside from the obvious historical observation that the tax cuts and reduction in regulations that we’ve seen under recent Republican administrations haven’t ushered in a time of economic Eden, there’s a simple thought experiment that should cover the situation. Assume you have a store with 10 customers and 1 cashier, and the cashier is fully utilized. Obviously, you’re not going to hire a second cashier. Now suppose they change the rules, so that you don’t have to pay the payroll taxes on a new hire – you can have a second cashier at a lower price – are you going to hire anybody? Change regulations – the second cashier doesn’t get a lunch break. Still no new hire. The simple reality is that you’re not going to hire anybody if there’s no profit in it. But suppose you get 10 new customers. Then, you’ll add a cashier even at full price. The reality is that supply side remedies only work over a narrow range – so that you might hire somebody a bit sooner than otherwise, say when you have 5 new customers instead of 10 – but they’re of no value when the economy hits a trough and nobody has any money.
This happened during the Great Depression. There was an increased demand for food – people were literally starving to death. Under conventional theory, this should have lead to an increase in production – but instead it resulted in a reduction in crop planting, and farmers deserted their farms. What was missing was money. The people might be starving, but they had lost their jobs and homes, and had nothing to pay for food. The farmers weren’t able to recover their costs for seed, for labor, for fuel for tractors or feed for horses – so they couldn’t increase production. It was only when the government created jobs, the WPA, CCC and others, that there was any sign of economic recovery, and it took the greatest deficit spending program in history, World War II, to induce full recovery.
This isn’t intended as a real introduction to economics, just as an answer to a question from a reader, so if anybody would like to offer corrections or emendations, feel free. Everything that follows is gross over-simplification. Unfortunately, it sometimes seems as if everything is.
Our current understanding of economics probably starts with Adam Smith, circa 1770. Smith described the Law of Supply and Demand, and the invisible hand of the market. Basically, he observed that prices fluctuate with supply of a product and the demand for that product. In an agrarian society, the supply of a crop will balance the demand for that crop – buyers and sellers can reach an agreement on a fair price. But suppose there’s a drought, and the potato harvest is very poor. If there aren’t enough potatoes to go around, farmers will raise the price and only those people who are willing to pay the higher price will buy, and other people will go hungry, or find something else to eat. The same rule applies if there is a bumper crop, and farmers have more potatoes than anybody wants. The farmers will lower their price in the hope of finding somebody who will take the excess off their hands.
Lots of factors can affect both supply and demand, but the adjustments in price happen naturally enough. A farmer with small, funny looking potatoes won’t be able to charge as much as a farmer whose potatoes look good. A magazine article warning that potatoes are fattening will reduce the demand. The key point is that prices go up and down, adjusting to botht eh supply of a product and the demand for it, to find a natural level. If the economy is bad, and people can’t afford to buy things, prices will go down, and eventually the price will be low enough for people to buy stuff, and then, once there’s enough demand for a product, prices will go up again, and everything works out. It’s true that occasionally people starve to death, but the market will correct itself sooner or later.
Skip ahead to the 1920s and John Maynard Keynes, who found a flaw in Smith’s work. While Keynes agreed that the market is self correcting most of the time, there are situations where it can’t fix things on its own. That’s what happened during the Great Depression. People were starving for lack of food, but instead of planting more crops, farmers were cutting back, because nobody could afford to pay for the food they had. There were too many people with no money at all, and nothing to trade. In this case, demand fell because there were too few people who could afford to buy, and supply fell because in the absence of demand, nobody could afford to produce anything. The market wasn’t able to correct itself.
Keynes solution was simple – the government should step in and create demand. He wrote that while, under normal conditions, the government should have a balanced budget, when things got really bad, it should run at a deficit, and one way or another, distribute money so that people could buy things again. When people were buying, then farmers would start growing more crops, and hire more workers, who would have money to buy things, and the whole cycle would produce more growth. The farmer might sell enough potatoes to buy a new tractor, and then International Harvester and John Deere might add another production line, and maybe go to a restaurant to celebrate, and so on. Done properly, the economy would start running on its own again, the government could collect enough in taxes to pay off its debt, and get out of the business of running the economy. So, in answer to one of the questions asked, there is no term “demand side” economics, it’s called Keynesian, or neo-Keynesian since, after World War II, a number of economists tried to align Keyenesian theories with traditional ideas. Among them was Paul Samuelson, the texbook author, whose introductory text was for a long time the best selling book on the subject, and the way the baby boomers learned economics, if they learned it at all.
Supply Side Economics came later, and has so many names behind it that it’s hard to give credit to just one person. It was the idea that economic growth could be stimulated by reducing restrictions on manufacturers – lowering taxes and reducing regulations. There’s little solid documentation of the theory working, and yet it’s the basis for a great deal of political argument, as in “job killing taxes” and “job killing regulations”, and the request by Congressman Darrell Issa sent letters to corporate leaders asking what regulations they would like changed. Supply Side Economics is an outgrowth of Say’s Law: "A product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value." According to this notion, supply determines demand, rather than the other way around.
The flaw in Supply Side economics should be obvious, unless you have a vested interest in not noticing what’s wrong. Aside from the obvious historical observation that the tax cuts and reduction in regulations that we’ve seen under recent Republican administrations haven’t ushered in a time of economic Eden, there’s a simple thought experiment that should cover the situation. Assume you have a store with 10 customers and 1 cashier, and the cashier is fully utilized. Obviously, you’re not going to hire a second cashier. Now suppose they change the rules, so that you don’t have to pay the payroll taxes on a new hire – you can have a second cashier at a lower price – are you going to hire anybody? Change regulations – the second cashier doesn’t get a lunch break. Still no new hire. The simple reality is that you’re not going to hire anybody if there’s no profit in it. But suppose you get 10 new customers. Then, you’ll add a cashier even at full price. The reality is that supply side remedies only work over a narrow range – so that you might hire somebody a bit sooner than otherwise, say when you have 5 new customers instead of 10 – but they’re of no value when the economy hits a trough and nobody has any money.
This happened during the Great Depression. There was an increased demand for food – people were literally starving to death. Under conventional theory, this should have lead to an increase in production – but instead it resulted in a reduction in crop planting, and farmers deserted their farms. What was missing was money. The people might be starving, but they had lost their jobs and homes, and had nothing to pay for food. The farmers weren’t able to recover their costs for seed, for labor, for fuel for tractors or feed for horses – so they couldn’t increase production. It was only when the government created jobs, the WPA, CCC and others, that there was any sign of economic recovery, and it took the greatest deficit spending program in history, World War II, to induce full recovery.
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Comment by dr db karron
What do I need to know to seem intelligent, besides wiping the drewel from the corners of my mouth every once and a while when it starts to drip on the tablecloth.
K.I.S.S. and dew tel Prof U !