A. Formally, economics is the study of the allocation of scarce resources, but its reach goes well beyond that. Economics permeates all areas of society. It’s the reason people buy what they buy, the reason things cost what they cost, the reason governments regulate, control, and supply some things, and why companies control and supply other things. Economics is about human behavior and the study of economics is a matter of solving puzzles; ascertaining why things are the way they are in the world.
II. The genesis of Economics
A. The first economists advised kings as to why their subjects hoarded coins. They pondered why some countries traded in some things and not others. The first economists explored these puzzles and out of this exploration, the study of economics was born.
III. The Central Tools of Economics
A. In economics, the best way to understand big puzzles is to break them down into smaller, more accessible puzzles. When analyzing the immensely complicated world in which we live, economists begin by looking several key puzzles: Where does a market exist? What are prices doing? What’s competition doing? Do we have a monopolist or do we have a lot of competitors running around? B. Prices are messengers. Prices are signals that tell producers about the demand of their product or service. If the price is too high, the consumer won’t buy something and the producer will be signaled to lower the price. C. Competition helps reduce pricing. If the price is too high the consumer will seek a lower price elsewhere from another producer. This leads to competition between producers for the consumer’s money and ultimately to lower prices. D. In the end, the price of something will always be tied to the cost of producing it, but not necessarily reflective of only the cost of production. Some products might be priced much higher than the cost of their production. This can be the result of increased demand for that product.
E. Demand is the consumer side of a transaction. Demand measures how much people want something and prices are the currency with which demand is measured. The more someone is willing to pay for a product, the higher the intensity of demand for that product.
F. Higher prices can signal to the consumer that a product is extremely desirable and thereby create a trend or fad. The housing bubble crisis was an example of a trend where prices did not accurately communicate demand or cost of production. Consumer speculation led to the purchase of housing as an investment. As a result, prices for housing exceeded both demand and cost of production. As the prices kept increasing and increasing, consumers borrowed more and more money to afford the ever-increasing prices. And banks lent more and more money to satisfy the ever-increasing demand for loans. In the end, the bubble burst and our economy was sent into a tailspin.
G. QUESTION: Why didn’t economists “catch” the housing bubble before it was too late?
1. People were not just buying houses to live in them; they were buying house because they were afraid that if they didn’t buy the house the house would go up in value and they wouldn’t be able to afford the same house later on. They were, in a sense, speculating in housing even as they were also living in it.
2. Speculation is difficult for economists to explain or predict because it’s about the psychology of the consumer and not the economics of the transaction. The price ends up having little to do with actual demand for the product and certainly has very little to do with the actual cost of the assembly and the inputs.
3. The tools of economics cannot accurately measure or account for speculation.
H. Arbitrage and markets are the other central tools in the economist tool belt. Arbitrage is the simultaneous purchase and sale of an asset in order to profit from a difference in the price. A market is a collection of entities engaged in arbitrage. Competitive markets are the foundation of economics. A competitive market has healthy arbitrage between plenty of buyers and sellers. This leads to competition and drives pricing down.
A. Not everything is sold on a competitive market and many of the things we depend on are sold in non-competitive markets. Examples of this can be seen in:
1. Non-profits involved in healthcare, education, and providing goods to impoverished peoples.
2. Governments that supply services like national defense, national parks, public schools, and firefighters. 3. Business monopolies like Apple holding critical patents on iPads.
B. Airlines are a prime example of a business monopoly.
1. Airlines can have exclusive access to certain routes.
2. Thus, an airlines can set the prices for providing service on this exclusive route any way it deems fit.
3. Airlines maximize profits by using economy of scale to their advantage, i.e. splitting big costs into many parts.
4. When airlines set prices according to maximum profits and not according to demand, they might price buyers out. This is called a deadweight loss. A deadweight loss is an inefficiency in a market due to pricing that exceeds actual cost. Empty seats on popular route are a sign of deadweight loss.
C. To further maximize profits monopolies, like airlines, find ways to control arbitrage.
1. Airline tickets are non-transferrable and non-refundable, thus they cannot be resold or re-priced as demand shifts. 2. Airlines also practice price discrimination. They can change the prices for their product to maximize profit, e.g. to cover costs, a set number of tickets are sold at a high price, once these tickets have sold the price can be lowered to sell the rest of the seats. 3. Price discrimination maximizes profit and reduces deadweight loss.
1. Monopolies don’t always keep all of their profits. Governments can regulate or tax monopolies to siphon off some of their profits. 2. Monopolies need a way to limit competitors’ access to their market. 3. Governments play a critical role in creating and sustaining monopolies by selling exclusive access to markets. Monopolies often spend money in the hopes of receiving exclusive access to a market. This is called rent-seeking. Governments or more specifically politicians have much to gain from rent-seeking practices.
V. Political Incentives
A. Politicians spend an enormous amount of money on election campaigns. A politician running for president will spend roughly 1 billion dollars. Monopolies can provide large amounts of capital to finance political campaigns through rent-seeking donations.
B. QUESTION: Are you keeping track of big business and government interaction? C. Candidates spending money on political campaigns or monopolies spending money to seek out exclusive market access are examples of a “pay all auction.” In a traditional auction, only the winner pays. In a pay all auction, everyone pays. Lobbying is a form of the pay all auction.
A. Economics is the seamless web that connects all interactions in our world.
B. Prices are messengers that go back and forth from buyer to seller and vice-versa coordinating supply and demand.
C. Competition is what happens in a market with free and open exchanges between buyer and seller
D. A monopoly has a market to itself. It doesn’t have to set prices based on costs, supply, or demand. It can create deadweight losses or maximize profits via price discrimination. E. Governments are key to creating and sustaining monopolies. Often times, monopolists provide capital to politicians or governments for access to a market. F. However, in the 21st century, there is little room for the traditional monopolist to operate. The Internet has created a global economy. In many cases, previously protected markets are now open for competition. In the Internet age, prices have now become messages about countries and their roles in the world. G. New economic models have sprouted in the developing world. China and India are both very successful economic powers, yet they operate very differently from each other and from the traditional capitalist economy. Understanding how these new economic models work and what it means for the future of economics is an important area of study for the next generation of economists. H. More generally, economics is a tool for the modern human to use. A better understanding of economics will lead to a better understanding of almost everything in the world.