PRINCIPLE #5: TRADE CAN MAKE EVERYONE BETTER OFF
You have probably heard on the news that the Japanese are our competitors in the
world economy. In some ways, this is true, for American and Japanese firms do
produce many of the same goods. Ford and Toyota compete for the same customers in the market for automobiles. Compaq and Toshiba compete for the same customers in the market for personal computers.
Yet it is easy to be misled when thinking about competition among countries.
Trade between the United States and Japan is not like a sports contest, where one side wins and the other side loses. In fact, the opposite is true: Trade between two
countries can make each country better off.
To see why, consider how trade affects your family. When a member of your
family looks for a job, he or she competes against members of other families who
are looking for jobs. Families also compete against one another when they go
shopping, because each family wants to buy the best goods at the lowest prices. So,
in a sense, each family in the economy is competing with all other families.
Despite this competition, your family would not be better off isolating itself
from all other families. If it did, your family would need to grow its own food,
make its own clothes, and build its own home. Clearly, your family gains much
from its ability to trade with others. Trade allows each person to specialize in the
activities he or she does best, whether it is farming, sewing, or home building. By
trading with others, people can buy a greater variety of goods and services at
lower cost.
Countries as well as families benefit from the ability to trade with one another.
Trade allows countries to specialize in what they do best and to enjoy a greater variety of goods and services. The Japanese, as well as the French and the Egyptians and the Brazilians, are as much our partners in the world economy as they are our competitors.
PRINCIPLE #6: MARKETS ARE USUALLY A GOOD WAY TO ORGANIZE
ECONOMIC ACTIVITY
The collapse of communism in the Soviet Union and Eastern Europe may be the
most important change in the world during the past half century. Communist
countries worked on the premise that central planners in the government were in
the best position to guide economic activity. These planners decided what goods
and services were produced, how much was produced, and who produced and
consumed these goods and services. The theory behind central planning was that
only the government could organize economic activity in a way that promoted
economic well-being for the country as a whole.
Today, most countries that once had centrally planned economies have abandoned this system and are trying to develop market economies. In a market economy, the decisions of a central planner are replaced by the decisions of millions of firms and households. Firms decide whom to hire and what to make. Households decide which firms to work for and what to buy with their incomes. These firms and households interact in the marketplace, where prices and self-interest guide their decisions.
At first glance, the success of market economies is puzzling. After all, in a market
economy, no one is looking out for the economic well-being of society as
a whole. Free markets contain many buyers and sellers of numerous goods and
services, and all of them are interested primarily in their own well-being. Yet,
despite decentralized decisionmaking and self-interested decisionmakers, market economies have proven remarkably successful in organizing economic activity in a way that promotes overall economic well-being.
In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations,
economist Adam Smith made the most famous observation in all of economics:
Households and firms interacting in markets act as if they are guided by an “invisiblehand” that leads them to desirable market outcomes.
One of our goals in this book is to understand how this invisible hand works itsmagic.
As you study economics, you will learn that prices are the instrument with which the invisible hand directs economic activity. Prices reflect both the value of a good to society and the cost to society of making the good. Because households and firms look at prices when deciding what to buy and sell, they unknowingly take into account the social benefits and costs of their actions. As a result, prices guide these individual decision makers to reach outcomes that, in many cases, maximize the welfare of society as a whole.
There is an important corollary to the skill of the invisible hand in guiding economic activity: When the government prevents prices from adjusting naturally to supply and demand, it impedes the invisible hand’s ability to coordinate the millions of households and firms that make up the economy. This corollary explains why taxes adversely affect the allocation of resources: Taxes distort prices and thus the decisions of households and firms. It also explains the even greater harm caused by policies that directly control prices, such as rent control. And it explains the failure of communism. In communist countries, prices were not determined in the marketplace but were dictated by central planners. These planners lacked the information that gets reflected in prices when prices are free to respond to market forces.
Central planners failed because they tried to run the economy with one
hand tied behind their backs—the invisible hand of the marketplace.
PRINCIPLE #7: GOVERNMENTS CAN SOMETIMES IMPROVE
MARKET OUTCOMES
Although markets are usually a good way to organize economic activity, this rule
has some important exceptions. There are two broad reasons for a government to
intervene in the economy: to promote efficiency and to promote equity. That is,
most policies aim either to enlarge the economic pie or to change how the pie is
divided.
The invisible hand usually leads markets to allocate resources efficiently.
Nonetheless, for various reasons, the invisible hand sometimes does not work.
Economists use the term market failure to refer to a situation in which the market
on its own fails to allocate resources efficiently.
One possible cause of market failure is an externality. An externality is the impact
of one person’s actions on the well-being of a bystander. The classic example
of an external cost is pollution. If a chemical factory does not bear the entire cost of the smoke it emits, it will likely emit too much. Here, the government can raise
economic well-being through environmental regulation. The classic example of an
external benefit is the creation of knowledge. When a scientist makes an important discovery, he produces a valuable resource that other people can use. In this case, the government can raise economic well-being by subsidizing basic research, as in fact it does.
Another possible cause of market failure is market power. Market power
refers to the ability of a single person (or small group of people) to unduly influence market prices. For example, suppose that everyone in town needs water but there is only one well. The owner of the well has market power—in this case a
monopoly—over the sale of water. The well owner is not subject to the rigorous
competition with which the invisible hand normally keeps self-interest in check.
You will learn that, in this case, regulating the price that the monopolist charges
can potentially enhance economic efficiency.
The invisible hand is even less able to ensure that economic prosperity is distributed fairly.
Amarket economy rewards people according to their ability to produce
things that other people are willing to pay for. The world’s best basketball
player earns more than the world’s best chess player simply because people are
willing to pay more to watch basketball than chess. The invisible hand does not ensure that everyone has sufficient food, decent clothing, and adequate health care.
A goal of many public policies, such as the income tax and the welfare system, is
to achieve a more equitable distribution of economic well-being.
To say that the government can improve on markets outcomes at times does
not mean that it always will. Public policy is made not by angels but by a political
process that is far from perfect. Sometimes policies are designed simply to reward
the politically powerful. Sometimes they are made by well-intentioned leaders
who are not fully informed. One goal of the study of economics is to help you
judge when a government policy is justifiable to promote efficiency or equity and
when it is not.
PRINCIPLE #8: A COUNTRY’S STANDARD OF LIVING DEPENDS
ON ITS ABILITY TO PRODUCE GOODS AND SERVICES
The differences in living standards around the world are staggering. In 1997 the
average American had an income of about $29,000. In the same year, the average
Mexican earned $8,000, and the average Nigerian earned $900. Not surprisingly,
this large variation in average income is reflected in various measures of the quality of life. Citizens of high-income countries have more TV sets, more cars, better nutrition, better health care, and longer life expectancy than citizens of low-income countries.
Changes in living standards over time are also large. In the United States,
incomes have historically grown about 2 percent per year (after adjusting for
changes in the cost of living). At this rate, average income doubles every 35 years.
Over the past century, average income has risen about eightfold.
What explains these large differences in living standards among countries and
over time? The answer is surprisingly simple.
Almost all variation in living standards is attributable to differences in countries’ productivity—that is, the amount of goods and services produced from each hour of a worker’s time. In nations where workers can produce a large quantity of goods and services per unit of time, most people enjoy a high standard of living; in nations where workers are less productive, most people must endure a more meager existence. Similarly, the growth rate of a nation’s productivity determines the growth rate of its average income. The fundamental relationship between productivity and living standards is simple, but its implications are far-reaching. If productivity is the primary determinant of living standards, other explanations must be of secondary importance.
For example, it might be tempting to credit labor unions or minimum-wage laws
for the rise in living standards of American workers over the past century. Yet the
real hero of American workers is their rising productivity. As another example,
some commentators have claimed that increased competition from Japan and
other countries explains the slow growth in U.S. incomes over the past 30 years.
Yet the real villain is not competition from abroad but flagging productivity
growth in the United States.
The relationship between productivity and living standards also has profound
implications for public policy. When thinking about how any policy will affect living standards, the key question is how it will affect our ability to produce goods
and services. To boost living standards, policymakers need to raise productivity by ensuring that workers are well educated, have the tools needed to produce goods and services, and have access to the best available technology.
In the 1980s and 1990s, for example, much debate in the United States centered
on the government’s budget deficit—the excess of government spending over government revenue. As we will see, concern over the budget deficit was based
largely on its adverse impact on productivity. When the government needs to
finance a budget deficit, it does so by borrowing in financial markets, much as a
student might borrow to finance a college education or a firm might borrow to
finance a new factory. As the government borrows to finance its deficit, therefore,
it reduces the quantity of funds available for other borrowers. The budget deficit
thereby reduces investment both in human capital (the student’s education) and
physical capital (the firm’s factory). Because lower investment today means lower
productivity in the future, government budget deficits are generally thought to depress growth in living standards.
PRINCIPLE #9: PRICES RISE WHEN THE GOVERNMENT PRINTS TOO
MUCH MONEY
In Germany in January 1921, a daily newspaper cost 0.30 marks. Less than two
years later, in November 1922, the same newspaper cost 70,000,000 marks. All
other prices in the economy rose by similar amounts. This episode is one of history’s most spectacular examples of inflation, an increase in the overall level of
prices in the economy.
Although the United States has never experienced inflation even close to that
in Germany in the 1920s, inflation has at times been an economic problem. During
the 1970s, for instance, the overall level of prices more than doubled, and President Gerald Ford called inflation “public enemy number one.” By contrast, inflation in the 1990s was about 3 percent per year; at this rate it would take more than 20 years for prices to double. Because high inflation imposes various costs on society, keeping inflation at a low level is a goal of economic policymakers around the world.
What causes inflation? In almost all cases of large or persistent inflation, the
culprit turns out to be the same—growth in the quantity of money. When a government creates large quantities of the nation’s money, the value of the money
falls. In Germany in the early 1920s, when prices were on average tripling every
month, the quantity of money was also tripling every month. Although less dramatic, the economic history of the United States points to a similar conclusion: The high inflation of the 1970s was associated with rapid growth in the quantity of money, and the low inflation of the 1990s was associated with slow growth in the quantity of money.
PRINCIPLE #10: SOCIETY FACES A SHORT-RUN TRADEOFF
BETWEEN INFLATION AND UNEMPLOYMENT
If inflation is so easy to explain, why do policymakers sometimes have trouble ridding the economy of it? One reason is that reducing inflation is often thought to cause a temporary rise in unemployment. The curve that illustrates this tradeoff between inflation and unemployment is called the Phillips curve, after the economist who first examined this relationship.
The Phillips curve remains a controversial topic among economists, but most
economists today accept the idea that there is a short-run tradeoff between inflation and unemployment. This simply means that, over a period of a year or two, many economic policies push inflation and unemployment in opposite directions.
Policymakers face this tradeoff regardless of whether inflation and unemployment both start out at high levels (as they were in the early 1980s), at low levels (as they were in the late 1990s), or someplace in between.
Why do we face this short-run tradeoff? According to a common explanation,
it arises because some prices are slow to adjust. Suppose, for example, that the
government reduces the quantity of money in the economy. In the long run, the
only result of this policy change will be a fall in the overall level of prices. Yet not
all prices will adjust immediately. It may take several years before all firms issue
new catalogs, all unions make wage concessions, and all restaurants print new
menus. That is, prices are said to be sticky in the short run.
Because prices are sticky, various types of government policy have short-run
effects that differ from their long-run effects. When the government reduces the
quantity of money, for instance, it reduces the amount that people spend. Lower
spending, together with prices that are stuck too high, reduces the quantity of
goods and services that firms sell. Lower sales, in turn, cause firms to lay off workers.
Thus, the reduction in the quantity of money raises unemployment temporarily
until prices have fully adjusted to the change.
The tradeoff between inflation and unemployment is only temporary, but it
can last for several years. The Phillips curve is, therefore, crucial for understanding many developments in the economy. In particular, policymakers can exploit this tradeoff using various policy instruments.
By changing the amount that the
government spends, the amount it taxes, and the amount of money it prints,
policymakers can, in the short run, influence the combination of inflation and
unemployment that the economy experiences. Because these instruments of monetary and fiscal policy are potentially so powerful, how policymakers should
use these instruments to control the economy, if at all, is a subject of continuing
debate.
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