ECONOMICS STUDY GUIDE 2020/21

Economics:
1) The social science that studies production, distribution, and consumption of goods and
services. 2) The analysis of behavior and interactions of economic agents and markets.
(Microeconomics) 3) The study of peoples' choices. Macroeconomics: Study of an entire
economy and the issues affecting it.

There are also two different approaches to economics:

Positive economics: describes "what is” (This is the liberal economics of Adam Smith.)
and
Normative economics: which theorizes on "what should be" (This is
Communism/ Socialism, Fascism, Keynesian/Progressivism.)

Economy: 1) a system of trade and industry by which the wealth of a country is made and used:
2) the intentional saving of money or, less commonly, the saving of time, energy, words, etc.:

• Traditional: production/allocation of resources is fixed and based on tradition, ritual, or

climate-based needs. (Tribal economies of barter, early money and trading.) • Market: An
ad-hoc arrangement where producers and consumers trade based on their own needs and
desires. (This is “capitalism.”)
• Command: A central authority sets production and allocation. Consumers have little or no say
in production or distribution. (Communism/socialism, Fascism)

There are still existing traditional economies around the world, but they are increasingly rare.
Most are some form of market economy, although not as complex as the modern capitalist
economy. Command economies can be found in China, Vietnam, Cambodia, Venezuela,
Zimbabwe, North Korea, and Cuba.

THE BASICS
Economics is basically about how people make choices — in what to do, make, buy, consume.
Understanding human nature is as important to good economics as math and computer models.
Traditional economics, however, views people as “rational actors” — people who think through
their decisions. I would suggest that is incorrect. Emotion and perception are often more
important than reality.

Case in point:

The difference between a zero-sum view of economics vs. a positive-sum view of economics.
most people have heard continuously the idea that “the rich get richer while the poor get poorer”
except data going back to the start of the industrial revolution shows this not to be the truth.
Zero-sum models require there to be a static, unchanging amount of wealth. To gain wealth,
someone must lose wealth; this was especially the view when looking at nations as the primary
actor in economics. However, industrialization, innovations in banking, and things like the
creation of the joint stock company have expanded wealth at a steadily increasing rate. However,
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this wealth is not always evenly distributed, and growing differences between rich and poor can
give the impression of the poor “getting poorer”. This is called relative deprivation: the view
that if someone is getting richer faster, you are getting poorer. Compare this to objective
deprivation, where earnings of poorer workers are syphoned off to the wealthy (usually through
taxation.) For example:
Most economists agree that trade and technology have created a positive-sum environment since
about 1600 (which coincides with the massive influx of gold and silver into Europe from the
Spanish mines in South America.)

Central to the study of economics is one particular theory: SUPPLY AND

DEMAND! Supply: the goods and services created for use.

Demand: the consumption or use of goods and services.

Price Equilibrium: The price at which supply meets demand perfectly. Because supply
and demand fluctuate, this means prices naturally fluctuate in a free market.
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The first person to really chart out this idea was Adam Smith, a Scottish philosopher called the
“father of economics” by some. In his book The Wealth of Nations, Smith pointed out that
markets attempt to reach equilibrium in pricing based on the amount of supply and the amount
of demand.

Economists chart this on the supply and demand curves:

When supply rises without a rise in demand (upper left) or demand falls with supply the same,
prices fall to meet equilibrium. When demand increases with no increase in supply (bottom right)
or supply falls but demand stays the same, prices rise.

SHORTAGE: When the supply is not equal to the demand.

SURPLUS: When supply is higher than demand.

The amount of supply and demand sends “price signals” to the market (not literally, of course).
When people want a lot of toilet paper because they’re panicking about something and there’s
not enough to go around, you can charge more.

So what is DEMAND?

Demand relies on three things:

The desire to buy something (you’ve got to want it).
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The ability to buy it (you’ve got to have a way to get it [other than
stealing!].) The willingness to buy it… you actually have to buy it.
If you have all of these things, you have demand. But there is another problem. Most folks don’t
have enough money, time, places to put things and they have to make a choice between what
they might consume. This problem is called:
 Opportunity Cost: This is the cost in money, time, or other value when one chooses a
thing; a Trade-Off.

Another thing plays into demand and the pricing of goods. This is the concept of value (or what
economists call utility ). What makes something valuable? Something rare or scarce, hard to
make, or a necessity would make something valuable, but value isn’t always expensive.

Air, for instance, is highly valuable to life, but doesn’t cost anything. There’s simply too much of
it for the value to matter. Water is a necessity, and in some places clean water is extremely rare
and valuable.

This leads to the concept of the "paradox of value”: that a thing doesn't have to be scarce, and it
doesn't have to be a necessity, to have high value or utility (as in the case of air). The main factor
in utility is often not fixed or measurable, and varies from person to person. This is the idea of
sentimental value. That a thing’s meaning can give it more value than it’s monetary worth. (Say,
a childhood heirloom or a piece of jewelry from a family member.)

SUPPLY:

The other side of the equation is the production of goods and services for the market. First, what
products are there?

GOODS: an item that is economically useful, relatively scarce, and transferable to

others. These are (usually) tangible products. Goods are often broken up into consumer
goods -- which will be used by another person or group, and capital goods -- which are
used to produce other goods.

SERVICES: These are things that are done for a customer — like waiting tables,
creating internet access, or doing a medical exam. There can be overlap with goods, but
mostly this is where someone does something for another.

So the questions are what do you make or what service do you do. Some of this may be simply
seeing a need in the market — people need a car mechanic in your small town, so someone
opens a shops, for instance — but some choose to do something they are skilled in.

SPECIALIZATION and DIVISION OF LABOR

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A long time ago, people had to do pretty much all of the tasks of life — hunt and gather food,
make clothes, find shelter, etc. This takes up a lot of time and people aren’t good at everything.
As a result, people tended to divide labor up amongst their family or tribe members, the father
hunts, the mother makes clothes, the kids gather… As people settled down to farm, as cities
started to develop, this division of labor started to expand. Some families farm, and some fish.
Some trade goods between others. This division of labor was what Adam Smith called
specialization — to be efficient, people tend to do the things they are good at. This increase in
efficiency means people can focus on one or a few things, instead of trying to do everything for
themselves.

PRODUCING STUFF and THINGS

So you’ve figured out what you want to make or do. That’s great…but what do you need to
produce this good or service? Economists break this down into certain categories — what they
call factors of production. These factors are part of the cost of producing a product.

FACTORS OF PRODUCTION:
Factors of production include:
Capital: Capital is the equipment, tools, machinery, robots, transportation, and the
related infrastructure (electricity, running water, what have you) that allow you to make
something or deliver a service.

Land: This isn’t just land (although that would be the case for a farm, say) or a rented
office or building; it can include resources like forests, oil reserves, a waterway or area
for fishing. It would even just be the place you park your butt while working on a
laptop.

Labor: The people that do the work. Maybe it’s just you; maybe it’s a bunch of people
working an assembly line or driving the goods to market. This is sometimes called
“human capital.”

Entrepreneurs: These are the people that decide to actually do it. They’re the idea guys,
the money gals; the people with the vision that drive the business.

PRODUCTION COSTS:

Making things costs money and time. You have materials needed, the people to do the work,
transportation costs. These costs, plus others, set the minimum price — or price floor — for a
good or service. If you cannot sell your product for more than this price floor, it’s not worth
doing (at least for money.)

This means the production costs place a lower limit on the supply/demand equilibrium. Below
this, you are likely to lose producers. It also means there is a maximum amount of things that can
be produced before making another unit is not worth it. Once surplus is so high that people really
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don’t need another unit of the product, cutting the amount made or done is necessary. These are
called margins.

A profit margin is another term for the price floor. Below that, production is not worth it. Some
businesses have very tight profit margins. Restaurants are a classic example where the cost to
make the food and provide the service is almost too high to make it worth doing.

Another “margin” is marginal utility. This is where buying another unit of something simply
isn’t worth it because you’ll never use it. For instance, you could put a TV in every room of your
house. At that point, having a second TV in a room is most likely not worth it; the utility you
would receive is “marginal” or questionable.

Other impacts on production costs are not connected to the production cycle, the act of making
things or giving services. We call these things externalities.

EXTERNALITIES

These can be things like weather events that damage property or slow delivery. They can be theft
or spoilage of material. It can be the loss of labor for whatever reason.

But another is the imposition of regulations on a business. Regulations are rules set by a
government which mandate certain things — like food cleanliness, or safety features on a
workroom floor. It could be “humane treatment” of animals on a farm, or safety or fuel standards
for a car. All of these sets limitations on how you produce, or set requirements on a product that
might be more expensive. (For instance, fuel standards might have been hit years ago for
gasoline car, if the safety standards hadn’t turned the vehicles into giant bloated things.)

The other last (and very common) externality is taxes. Taxation on how many people you hire,
taxes on the materials use, on the goods produces, and on the profits earned all cut in the profit
margin of a business and are often factored into a final price. For instance, raising the minimum
wage on certain businesses with tight profit margins like a restaurant or a motorcycle dealership
means to keep prices down, businesses have to hire fewer people or cut corners in other forms of
production or they go out of business. (McDonald’s, for instance, starting to roll out self-order/
pay kiosks and robotic burger flippers.)

SUBSIDIES: These are government pay-outs to help keep an industry afloat. There have been
subsidies throughout American economic history. The government aided canal and railroad
entrepreneurs because they were seen to be part of the infrastructure (roads…) They aided banks
with government assumption of states’ war debts. They sold land to farmers in the territories and
funded massive settlement drives (Oklahoma, most famously.) They picked winners and losers
during the Great Depression with National Industrial Recovery Administration (later found
unconstitutional.) The defense budget alone subsidizes a host of industries tied to military
equipment. Oil and agriculture (farms) are big recipients of subsidies, mostly to keep prices low
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enough to slow inflation. This leads to the criticism that government picks “winners and losers”
and is unfair to businesses not favored by the political elite.
All of this ties into the effort to keep the economic “healthy”. But what is a “healthy” economy?
Smith and others of his age would have said anything that keeps prices low for customers, yet
provides enough profits and efficiency to keep producers making profit.

More recent views on a healthy economy view the national economy as the central unit of
economics. (This, Smith would call “mercantilism”.) The three things for a health economy for
modern economists is 1) a growing economy (as measured by GDP), 2) low unemployment, and
three, steady prices.

WHAT MAKES FOR A HEALTHY ECONOMY?

Let’s deal with the last point first: Steady pricing. Over time, prices tend to increase with wages.
Keeping prices stable for people is essential to giving them the ability to consume. When prices
go up sharply (we can this inflation), it has the effect of making people’s wages seem lower;
your pay doesn’t go as far as it did. When prices go down sharply (we call this deflation), it’s
great for consumers, but producers can find themselves unable to meet that profit margin we
talked about before and they might stop producing. This last concern is the reason for
government subsidies on food…they simply don’t make enough money on cheap food, but
consumers need cheap food to buy other things.

Low unemployment: this should be obvious. People working means they have income to get
what they need or want. It’s also great for population control: employed people don’t riot, they
don’t commit crimes (as a rule), and they are too busy to cause the people in power too much
trouble. High unemployment not only hurts the person out of work, but the producers whose
stuff they can’t buy (and the governments that can’t get taxes from them.)

Growing the economy: This is the more complex of the three. Just how do we know the
economy is growing or shrinking? Governments do this by taking the total of goods and services
(and the prices of those goods) produced in a year in a given country. This is called the GROSS
DOMESTIC PRODUCT or GDP.

That means that if an American company makes cars in Mexico, those cars are part of the
Mexican GDP, even if the money makes its way back to the United States. So a country’s
companies can profit off of foreign labor, but the “nation’s GDP” suffers. This is a good
barometer for government to gauge a national economy, but it’s not necessarily always a good
indicator of the health of the overall or international economy.

Speaking of international economies…

GLOBALIZATION
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Trade has always been "global". From the spice and silk trades between the Roman Empire and
the Chinese Empire along a route called the "Silk Road", to the trade in -- well, spices and cloth
-- between china and the Italian city states early trade was maybe not "global" but it spanned all
of Europe and Asia.

The Silk Road trade routes from about 500BC until about 1500AD.

With the discovery of America by the Europeans, trade became global as we know it -- with
goods from around the world circling to customers in far-flung locations. Large world-spanning
empires formed — the Spanish and Portuguese first, then the French and British, and to a lesser
extent the Dutch.

(imporant point here!) This trade created a few new techniques for making trade safer for those
who took the risk. These things were the joint stock company, the idea of corporate personhood,
bearer bonds and other forms of “money”, and insurance.

JOINT STOCK COMPANY

We call these corporations or companies, but they are all primarily the same thing: a business
that has people buy “shares” (or stock) in the company to reduce risk to the investors while still
pooling enough money for entrepreneurs to take action. It’s like crowdfunding, but before we
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 Trade routes during the 1600s and 1700s.

called it that. These companies are usually provided the legal fiction that they are “persons” ( or
corporate personhood) around the world for a reason — the investors are often not involved in
the day-today operations of the company and as such should be protected from the malfeasance
or mistakes of the management. If a company officer or worker does something illegal or which
causes damages, the company is charged — not every individual who owns a share of the
company. This further reduces the risk of investing and is essential for the health of investing in
large companies.

Other innovations in bookkeeping, in banking (including the bearer bond — essentially a check
to draw money from a local bank, which would then seek payment from the issuer of the bond),
the practice of charging interest (which had been “immoral” in Catholic society and illegal in
Muslim law, but neither in Jewish practice) became widespread, and lastly, the creation of the
insurance industry. Many of the early trading missions were insanely dangerous: bad ships,
worse navigators, no way to measure longitude, rotting food, weather, pirates — all this made
investing in trade foolhardy. Insurance brokers “gambled” on the return of a vessel and cargo.
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They would charge percentage of the ship, cargo, or both and if the mission succeeded, the
insurer made money. If the mission failed, or there was some kind of loss covered by the
insurance policy meant the insurer paid out.

All of these things was essential to the creation of modern trade or “capitalism”, as Karl Marx
dubbed it.

Trade continued to become more interconnected during the heavy colonization of the 1800s, but
"globalization", as we call it, really gets rolling after WWII and especially after the fall of the
Soviet Union in 1992. By 1999, China was given entry into the World Trade Organization and
became a major player for its cheap labor and raw materials, allowing companies in the rest of
the world to use China to lower their costs.
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GLOBAL TRADE: THE PROS AND CONS

GLOBALIZATION is simply a fancy word for global trade. But not just trade in products and
services, but in cultures. Travel is faster and safer than ever; logistics — the art of getting things
from one place to another — is aided by computerization; communications are global and fast.
All of this means the pace and scale of trade had grown immensely (until the COVID scare) and
this trade has had the effect of pulling billions of people out of abject poverty.
 World poverty rates over the last 40 years. (World Bank, 2020)

A lot of the concerns about globalization come from politicians and pundits who see trade as a
"zero-sum game" -- like the mercantilists that Adam Smith warned us about, these people see
the nation as the most important actor in the economy, and they follow the idea that for one
country to do well, other countries have to do worse; or when the rich get richer, the poor get
poorer. This is simply not true.

Trade is a POSITIVE-sum game; trade and the ability to answer the needs of customers creates
wealth, and the amount of wealth can grow overall. However, that wealth is not evenly
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distributed, just like technology…

“The future is here — it’s just not evenly distributed.”

William Gibson, The Economist, Dec 4, 2003.

We can use pizza as an example. Zero-sum game types would see the pie as fixed in size. If you
got a bigger slice, the other slices would have to be smaller to accommodate for the big piece.
Positive-sum tells us the pie gets bigger or smaller, depending on the amount of wealth being
produced. Everybody's slice can get bigger or small without necessarily affecting the other
slices.

Bigger pie, bigger slices for everyone…but not necessarily evenly sliced.

When goods are imported from, say, Japan customers get access to decent cars and electronics,
or cool anime series, or even cultural things like sushi. Our exports benefit other people similarly
-- what we sell them promotes jobs and wealth creation in our own country, but also can benefit
the customers with things like cultural exchange. (American books, music, and movies promote a
lot of the ideals of the United States...if through a screwed up Hollywood lens.)

The downside is that competition from 7.5 billion people means it’s harder to find a profitable
niche or job for oneself, especially when there’s a couple of million people in Mexico or
Myanmar who are willing to do your job cheaper, if not necessarily better. There is also the
question of fairness. China’s workers are cheap, their raw materials cheaper due to slave labor,
and their environmental rules nonexistent. This lack of externalities places the United States at a
distinct disadvantage from an employment and manufacturing standpoint, and it’s worse for the
overall environment.