Some people would rather rub a raw onion in their eye then try to understand economics. That is unfortunate because the basics of economics are not that hard to understand. The fact is that you and I and everyone else use economics every day of our lives. It is liberating to understand why economic things happen, in the same way that it is liberating to know why a car takes longer to stop on ice or gravel. The essence of politics is the use of economic law to manipulate the behavior of citizens to the will of the politicians. Political motivations become more understandable in that light, though no more moral or justified.
Economics is merely an attempt at understanding the basic laws that work in our lives. It seeks to define and simplify our knowledge of the forces that affect us so we can make appropriate decisions. We similarly use the physical principles of gravity, momentum and force every day of our lives. In both economics and physical sciences, there are relatively few laws, which can be applied in understanding very complex systems. Unfortunately, many modern economists actually add confusion and complexity by repudiating simple economic laws, substituting complex macro-economic theories, mathematical models and personal policy preferences.
With that said, the basic laws of economics are truly straight forward and powerful, and arise from the way that humans act and make decisions. Because the logic of human choice hasn’t changed, the economic laws that governed ancient societies are the same ones that govern our lives today, as well as all future civilizations of any time. We can relate to historical characters from any place on the globe because they acted like we do. Their wisdom and their follies are reflected in our experiences today. All that has changed over time is the technology we use to satisfy our needs and wants.
One of the key concepts in economics is that incentives matter. Humans take specific actions to achieve specific goals. If the incentives change, it will affect the means and the ends chosen by the actors. Related to this is the idea that choices are made at the margin. The law of diminishing marginal utility implies that the higher the quantity of a good a person has, the lower the marginal utility, or value, the next available unit holds for that person. If you are dying of thirst in a desert, you would pay almost any price for the first cup of water. You wouldn’t value the fifth cup nearly as much because your thirst would be quenched. You would value the 1000th cup of water much less because you can’t carry it and it does you little good. It’s marginal utility is very small.
The fact that the current market price for a good is $1 doesn’t mean that everyone is willing to pay a dollar. Some people would have a higher marginal utility and be willing to pay more, while others wouldn’t buy it unless it was cheaper. It only means that, at that price, the number of buyers at the margin, those willing to pay at least $1, are about equal to the number of sellers at the margin, those willing to supply it for $1 or less.
This is typically stated as economic laws of supply and demand. If the price of a specific good is lowered, buyers will be enticed to purchase more. We see this in every day life as retailers so often use discounts and sales to move inventory. If the price is raised, the quantity demanded will be less. On the other side of the coin, suppliers are in business to make profits. It will be difficult to make a profit if prices are too low, and very little will be supplied. As prices increase, it becomes easier to earn money, thus suppliers produce more, and new competitors are drawn to the market. Supply increases with increasing prices.
The incentives for buyers and sellers are at odds, and for every good in a particular market at a point in time, there will be a price where the number of willing buyers about equals the number of willing sellers. Any price above that point will produce an excess of sellers, a glut of goods. Any price below it will produce an excess of buyers, a shortage of goods. That simple relationship is one of the most powerful keys to understanding economic phenomena, whether it is Hurricane Katrina shortages or gluts of labor, more commonly called unemployment. Prices, demand and supply are all mutually dependent and reflect the market environment at a particular time. Imposing an artificial limitation on any of them will have inevitable unintended consequences, often very powerfully.
With this understanding, it is possible to comprehend the bulk of the phenomena occurring in society, and in politics, on a day to day basis. There is a lot more to it, of course. A very important aspect of economic laws and concepts from an overall point of view is that they can help to understand why an economy progresses or regresses over time.
The laws of comparative advantage and division of labor are related and work together in determining the level of productivity and prosperity of an economy. Comparative advantage means that any person, organization or geographic region has specific advantages, whether that is because of natural resources, innate skill, education and any number of other characteristics. If the actors concentrate on those things that they are most productive at and pay other people to do the things they less productive at, everyone will be better off overall. A typical example may be an attorney who may have better secretarial skills than any secretary available. But since attorney’s make a much higher hourly rate than secretaries, the attorney will be better off by doing attorney work than secretarial work. The secretary likewise would probably be better off leaving attorney work to the attorney and concentrating on the areas where relative skills are the highest.
Division of labor is the recognition that everybody has only 24 hours a day. It takes a great deal of time and effort and the right tools to be highly productive in any endeavor. Nobody cannot develop all of the skills and purchase all of the tools needed to be highly productive at all types of activities. People or geographic regions that try to be self sufficient will lead a very poor, difficult life and work very long hours.
A surgeon may be very good with his hands, but will probably hire someone to do his plumbing, carpentry, auto repair and so on. He could probably develop some low level of competence in each of those areas, but in order to do that, he would probably sacrifice very valuable time at which he is most productive. In an advanced society, there is a strong tendency toward specialization because it leads to higher productivity and a higher standard of living.
Because people who specialize are generally more productive, they have more income with which to buy the goods and services of other people. Most people in modern society outsource most of their requirements to other people or businesses. They outsource their food requirements to grocery stores and farmers. They outsource their automobile needs to car manufactures. They outsource their homebuilding needs to experienced carpenters, and so on. By building a high level of competence in one area, you are able to trade with others for the things for which they have built a high level of competence. That is what trade is all about. We outsource our requirements to others who are more highly qualified in those areas, and thus, both sides reap the benefit.
If you define progress in society as that state of affairs where people have to work less hard for less hours in order to provided for themselves and their families, then the higher the level of division of labor and the more people can apply their comparative advantage, the more quickly they will progress to a higher level. The wealth of a society comes from people producing more than they consume. Over time, that wealth can be used for capital investments that enhance the productivity of participants, and thus, further raise their income and standard of living. Societies that restrict trade and inhibit capital accumulation and specialization are those that remain in perennial status of less developed countries.
The laws of economics hold many important lessons on a day to day basis. You can try to disobey them, but it is similar to disobeying the law of gravity. You can step off a tall building and think you won’t fall, but your funeral will be just as sure as if you realized you would fall and die. The most critical lesson that economics can give is that actions have consequences. Good intentions and powerful politicians don’t make a bit of difference. The more we can gauge the true consequences without sentimentality or blinders, the more likely we are to make decisions which avoid the pitfalls and lead us to our goals, as individuals and as a society.