The source material for each principle in this summary is drawn directly from Common Sense Economics. Below, I outline twelve key principles from the book, supplemented with my explanations and examples. For a deeper understanding, I highly recommend purchasing the full book.
- Incentive matter: Changes in benefits and costs will influence choices in a predictable manner.
- When people think of incentives, they often envision monetary rewards. While monetary rewards do play a role in decision making, nonmonetary factors also exist. When one can accurately assess the benefits and costs of a course of action, behavior becomes predictable.
- Consider the individual who is faced with the choice of accepting overtime on Christmas Eve to earn additional income. Perhaps this individual has a father on his deathbed, who is expected to pass within the coming day. The nonmonetary reward of having a final moment with his father will likely take priority over the monetary gain.
- Or take another example. Rebecca is offered a substantial raise for her outstanding work, but another competitor is offering her equal pay for fewer hours worked as well as a better office environment. Assuming there are minimal obstacles to switching jobs, Rebecca’s choice to switch becomes obvious.
- There is no such thing as a free lunch: Goods are scarce and therefore we have to make choices.
- While the supply of goods and services is limited by time and cost, demand is effectively limitless. Since we can’t have everything we want, we must choose among alternatives. Economists refer to this dilemma as opportunity cost. In every decision made, we choose to give up doing something else. It is also true that choosing to forego making a decision is, in and of itself, a decision.
- Take John. He wants to learn guitar but he’s on a budget. He can pay for the guitar, but he won’t be able to afford tickets to a show he wants to see. Here, an opportunity cost emerges. Now imagine John already owns guitar and wants to practice on Friday night to improve his skills, but he’ll have to miss spending the night out with friends. Another opportunity cost.
- Occasionally a politician will dubiously claim that a service or good they wish to provide is free. For example, assume a congressman seeking re-election promises his constituents free healthcare. This sounds nice at face value but ignores the hidden costs and scarce resources that must be allocated to satisfy these promises. Governments may be able to shift costs, but they cannot eliminate them.
- Decisions are made at the margin: If we want to get the most out of our resources, options should be chosen only when the marginal benefits exceed the marginal cost.
- Any individual presented with multiple options should only ever choose that which reflects the greatest benefit. The difficulty here is that, in many cases, the differences are razor thin. Over the long run, correctly identifying the greatest benefit compounds success. This is a fundamental premise of sound decision making.
- An example of this principle in action is demonstrated by a man faced with the choice of purchasing food or investing in his skillset. To a starving man, the marginal (additional) value of satisfying his hunger through the purchase of food far outweighs the costs of investing in his skillset. As he nears satiety, the marginal benefit of additional food falls. Eventually the man gets to a point of overeating. In this case, continuing to eat becomes a marginal cost (assuming famine is not on the horizon) while investing in his skillset becomes a rather attractive benefit. After all, the more skilled the individual, the better equipped he is to provide himself with necessities.
- Trade promotes economic progress.
- Absent coercion, trade is driven by expectations of personal gain. This means that in any voluntary transaction where each party is giving something in order to receive something, the foundation is mutual gain. There are three primary benefits of trade.
- First, trade reallocates goods from people who derive less marginal benefit to those who derive greater marginal benefit. In other words, trade raises the value of a good even when nothing new is produced. For example, if Sally has a no musical talent and suddenly inherits a rare guitar, the instrument has little subjective value to her. On the other hand, if she brings the guitar to a collector, the collector may be willing to spend several hundred dollars to acquire the guitar. In this case, both parties walk away with something they want.
- Second, trade allows each of us to specialize more fully in the things we do best relative to cost, enabling larger production and consumption levels. Several hundred years ago this was not the case. Limited trade meant that an individual was largely responsible for providing all of their own needs. The explosion of trade since then has led to increased specialization and productivity. One can now purchase what would otherwise be costly to produce on one’s own while providing a larger quantity of goods or services. This is known as the law of comparative advantage and can be applied not just to the individual but to businesses and nations as well. Produce what you produce best, and trade for the rest.
- Third, trade enables economies of scale. A business that achieves lower per-unit costs by adopting large scale production methods is said to achieve an economy of scale. This level of cheaper output is only achievable thanks to the broad consumer bases made possible through trade. Amazon is one example of an economy of scale in today’s consumer market. Its infrastructure investments have high fixed costs. As sales volumes increase due to a growing consumer base, these fixed costs are spread over a larger number of units, reducing the cost per unit. Even when new fixed costs are introduced to meet demand, the long-term trend in cost per unit generally remains downward sloping.
- Transaction costs are an obstacle to trade.
- Any resources spent to execute a transaction are called transaction costs. The higher these costs, the greater the limit on our productive capacity as well as any gains accrued through trade. A pernicious example of transaction costs acting as an obstacle to trade is the tariff – a government-imposed tax on imports often enacted with the sole purpose of benefiting a special interest. In this case, the American consumer pays a higher fee for imported goods. For some, the rise in prices will be too great an obstacle and the transaction will never take place.
- Sometimes one transaction cost is absorbed to reduce what would otherwise be higher transaction costs. Such an example is a broker. If I want to purchase a high-end sports car but don’t know where to begin my search or how to negotiate, I could hire a broker to act as the middleman and handle all aspects of the transaction. One cost to reduce many higher costs.
- Prices bring the choices of buyers and sellers into balance.
- There is an inverse relationship between the price of a good or service and the quantity demanded. Economists refer to this as the law of demand. A rise in price means the good or service is more expensive. Buyers respond by purchasing fewer units. Conversely, a rise in price means greater revenue, encouraging sellers to supply more. Economists refer to this as the law of supply. It is important for buyers and sellers to be able to distinguish between a change in demand and a change in supply.
- When placed on a graph, the demand curve intersects the supply curve at an equilibrium price. This point reflects a market in balance. The exact number of goods and services brought to market is equal to the amount of demand. This market clearing price dictates there will be neither surplus (excess supply) nor shortage (excess demand). For both the buyer and the seller, the marginal benefit of the transaction exceeds the marginal cost.
- Financial markets are a perfect example of supply and demand in action. At any given moment, the price of a stock reflects the current equilibrium price of supply and demand. Buyers are willing to purchase the stock because they believe it will rise in value while sellers are unloading shares for any number of reasons, such as short-term liquidity needs. Over time, changes in the expectations of a stock’s future performance will affect its equilibrium price (i.e. current market value), causing the price to fluctuate.
- Profits direct business toward productive activities that increase the value of resources, while losses direct them away from wasteful activities that reduce resource value.
- Value is created when the factors of production – land, labor and capital – are combined through entrepreneurship to generate goods and services that customers want. Profits and losses then signal whether the goods and services offered by a business are the best use of these scarce resources. Since free-market competition forces producers to bid resources away from alternative uses, poor allocation of resources cannot be sustained if the market does not value the product. On the positive side, business failures release resources that can be directed toward other potentially wealth-creating projects.
- A firm’s profit can be expressed as total revenue less total cost. Simply put, a firm will only earn profit if it can produce a good or service that consumers value more than the cost of the resources needed for its production. For example, if I purchase raw materials and combine them into a pile of debris, buyers are highly unlikely to accept any price that isn’t a discount to my initial costs. If instead I craft a beautiful sculpture, I should be able to fetch a price above my initial costs and thus earn a profit. In short, when a product is valued by the consumer, the price paid often exceeds the sum of its parts. Economies promote economic progress when they consistently transform the factors of production into goods and services consumers value more than alternative uses.
- People earn income by providing others with things they value.
- Differences in ability and skillset influence the income one can earn in a free market economy. People who earn high incomes do so because of their ability to provide others with things they value more than their cost. In other words, if you want to earn a high income, determine how to help others get what they value.
- It’s important to remember the law of supply and demand still applies here. If one develops a skillset that is valued but in high supply, earning a high income might require performing your skill better than all other suppliers or equally well but at a lower cost. Alternatively, if you identify a skillset that allows you to provide unique value, the opportunity for a high income rises substantially. This is what successful entrepreneurs do.
- Production of goods and services people value, not just jobs, provides the source of high living standards.
- While employment is crucial for providing individuals with income and purpose, the true measure of a society’s prosperity lies in its ability to produce valuable outputs efficiently. Efficient output translates to higher living standards over time through increased output, quality, and affordability of goods and services. In short, doing things better.
- Higher output means that more goods and services are provided with the same resources, allowing society to meet a broader range of needs and wants. Better quality results from efficient production methods encouraging innovation and refinement over time. Improved affordability emerges as competition drives producers to provide products cheaper than their competitors.
- Compare the average cellphone today to one from decades ago and you can see all three components in action. Cellphones are owned by nearly everyone today compared to less than .1% in the late 1980s. The Motorola MicroTAC, for example, was $3000 and had no utility beyond making phone calls, was also 9 inches long, and double the weight of the average iPhone today.
- Economic progress comes primarily through trade, investment, better ways of doing things, and sound economic institutions.
- Having already discussed trade and better ways of doing things, I’ll focus on investment and sound economic institutions here. Investments in physical capital (e.g. tools or machines) and human capital (e.g. education or training) improve our ability to produce. Each investment works synergistically with the other. Workers produce more with better machines just as a chainsaw is more effective in the hands of an expert than a first timer.
- Improvements in economic organization, or social innovation, additionally promote growth. Economic organization here refers to the ways in which human activities are organized and the rules under which they operate. A free-market economy operating under a political and legal framework that protects the rights of individuals and their property, enforces contracts, and settles disagreements is necessary for rapid economic progress. Without this framework, incentive structures for providing value to others deteriorate and competition becomes corrupted, driving up costs and slowing growth.
- Vaclav Havel, the former President of Czechoslovakia and the Czech Republic, once said, “when a communist regime takes over a country, it is as if time stops.” Havel is reflecting on the sad reality that communist regimes often lead to stagnation in societal progress, economic development, and personal freedoms. A modern example of this is Cuba, where many people still live in structures dating back to the 1960s or drive vintage cars manufactured as far back as the 1950s.
- The “invisible hand” of market prices directs buyers and sellers toward activities that promote the general welfare.
- The invisible hand referred to here is the price system. Despite the self-interested nature of human beings, any actions taken for one’s gain are directed by the invisible hand to promote the goals of others through trade. At the population level, this principle drives prosperity.
- No individual or central-planning authority has the omniscience to consider all information needed to coordinate the actions of all buyers and sellers acting in the economy. And yet a free market system, where individuals act on their needs and wants freely, achieves this.
- A simple example is the standard farmer’s market, where local farmers come together at a self-coordinated time to bring produce to market. Buyers from all backgrounds come to purchase these products, seeking to satisfy their wants and needs. At no time could a single authority accurately determine how many of each good, and at what price, producers should bring to market because it is impossible to know which buyers will come to market and how many of each item they will desire.
- Too often long-term consequences, or the secondary effects, of an action are ignored.
- Henry Hazlit stated it succinctly when he said, “Economics is haunted by more fallacies than any other study known to man.” The reason for this is that many economists often evaluate only the immediate, direct consequences of a proposed course of action rather than considering the longer-term and indirect effects. Additionally, they may myopically evaluate the consequences for a single group rather than the population at large.
- One such fallacy is the known as “spread the work” schemes. Union leaders suggest that there is limited work available at a given time, and so systems must be considered to spread this work among the largest number of people. This leads to arbitrary subdivisions of labor which raise production costs and reduce productivity. While employment technically increases among the special groups that fight for the right to work certain jobs, society as a whole suffers from reduced labor efficiency and a lower standard of living. The same principle applies to proposals to shorten the work week.
In the next series, I will discuss the seven major sources of economic progress.