Trying to understand what economics is about by studying definitions is like trying to learn to swim by reading an instruction manual. Formal analysis makes sense only once you have some practical experience. In this section we discuss two economic issues to show how society allocates scarce resources between competing uses. In each case we see the importance of the questions what, how, and for whom to produce.
Microeconomics and Macroeconomics
Many economists specialize in a particular branch of the subject. Labour economics deals with problem of the labour market as viewed by firms, workers, and society as a whole. Urban economics deals with city problems: land use, transport, congestion, and housing. However, we need not classify branches of economics according to the area of ??economic life in which we ask the standard questions what, how, and for whom. We can also classify branches of economics according to the approach or methodology that is used. The very broad division of approaches into microeconomic and macroeconomic cuts across the large number of subject groupings cited above. Microeconomic analysis offers a detailed treatment of individual decisions about particular commodities.
For example, we might study why individual households prefer cars to bicycles and how producers decide whether to produce cars or bicycles. We can then aggregate the behaviour of all households and all firms to discuss total car purchases and total car production. Within a market economy we can discuss the market for cars. Comparing this with the market for bicycles, we may be able to explain the relative price of cars and bicycles and the relative output of these two goods. The sophisticated branch of microeconomics known as general equilibrium theory extends this approach to its logical conclusion. It studies simultaneously every market for every commodity. From this it is hoped that we can understand the complete pattern of consumption, production, and exchange in the whole economy at a point in time.
If you think this sounds very complicated you are correct. It is. For many purposes, the analysis becomes so complicated that we tend to lose track of the phenomena in which we were interested. The interesting task for economics, a task that retains an element of art in economic science, is to devise judicious simplifications, which keep the analysis manageable without distorting reality too much. It is here that microeconomists and macroeconomists proceed down different avenues. Microeconomists tend to offer a detailed treatment of one aspect of economic behaviour but ignore interactions with the rest of the economy in order to preserve the simplicity of the analysis. A microeconomic analysis of miners 'wages would emphasize the characteristics of miners and the ability of mine owners to pay. It would largely neglect the chain of indirect effects to which a rise in miners 'wages might give rise. For example, car workers might use the precedent of the miners 'pay increase to secure higher wages in the car industry, thus being able to afford larger houses which burned more coal in heating systems. When microeconomic analysis ignores such indirectly induced effects it is said to be partial analysis.
In some instances, indirect effects may not be too important and it will make sense for economists to devote their efforts to very detailed analyses of particular industries or activities. In other circumstances, the indirect effects are too important to be swept under the carpet and an alternative simplification must be found.
Macroeconomics emphasizes the interactions in the economy as a whole. It deliberately simplifies the individual building blocks of the analysis in order to retain a manageable analysis of the complete interaction of the economy.
For example, macroeconomists typically do not worry about the breakdown of consumer goods into cars, bicycles, televisions, and calculators. They prefer to treat them all as a single bundle called 'consumer goods' because they are more interested in studying the interaction between households 'purchases of consumer goods and firms' decisions about purchases of machinery and buildings.
Because these macroeconomic concepts are intended to refer to the economy as a whole, they tend to receive more coverage on television and in the newspapers than microeconomic concepts, which are chiefly of interest to those who belong to the specific group in question. To give an idea of ??the building blocks of macroeconomics, we introduce three concepts, which you have probably read about in the newspapers or seen discussed on television.
Cross domestic product (GDP) is the value of all goods and services produced in the economy in a given period such as a year.
GDP is the basic measure of the total output of goods and services in the economy.
The aggregate price level is a measure of the average level of prices of goods and services in the economy, relative to their prices at some fixed date in the past.
There is no reason why the prices of different goods should always move in line with one another. The aggregate price level tells us what is happening to prices on average. When the price level is rising, we say that the economy is experiencing inflation.
The unemployment rate is the percentage of the labour force without a job.
By the labour force we mean those people of working age who in principle would like to work if a suitable job were available. Some of the landed gentry are of working age but have no intention of looking for work. They are not in the labour force and should not be counted as unemployed.
Already we can see two themes of modern macroeconomic analysis. Society reveals, both through statements by individuals and by the policy pronouncements of politicians who must submit themselves for re-election by the people, that it does not like inflation and unemployment. Yet for most of the 1970s economic interactions within and between national economies led to substantial inflation rates. In the 1980s, most Western economies faced sharp rises in the aggregate unemployment rate. Macroeconomists wish to understand how interactions within the economy can lead to these outcomes and whether government policy can make any difference.
1. Economics analyses what, how, and for whom society produces. The central economic problem is to reconcile the conflict between people's virtually unlimited demands with society's limited ability to produce goods and services to fulfil these demands.
2. The production possibility frontier shows the maximum amount of one good that can be produced for each given level of output of the other good. It depicts the trade-off or menu of choices that society must make in deciding what to produce. Resources are scarce and points outside the frontier are unattainable. It is inefficient to produce within the frontier. By moving on to the frontier, society could have more of some good without having less of any other good.
3. Industrial Western countries rely extensively on markets to allocate resources. The market is the process by which production and consumption decisions are co-ordinated through adjustments in prices. The role of prices is central to this definition.
4. In a command economy, decisions on what, how, and for whom are made in a central planning office. No economy relies entirely on command, hut there is extensive planning in many Soviet bloc countries.
5. A free market economy has no government intervention. Resources are allocated entirely through market.
Demand, Supply, and the Market
Society has to find some way of deciding what, how, and for whom to produce. In Chapter 1 we said that Western economies rely heavily on markets and prices to allocate resources between competing uses. We now examine markets in greater detail. The ideas discussed in this chapter are central to economic analysis and must be mastered by anyone who wishes to understand how our own society solves the basic economic problems.
The framework of analysis is very general. It can be applied to the market for motor cars, labour, haircuts, or even footballers. In each case, the interplay between demand (the behaviour of buyers) and supply (the behaviour of sellers) determines the quantity of the good that is produced and the price at which it is bought and sold.
In Chapter 1 we defined markets in a very general way as arrangements through which prices guide resource allocation. We now adopt a narrower definition.
A market is a set of arrangements by which buyers and sellers are in contact to exchange goods or services.
Some markets (shops and fruit stalls) physically bring together the buyer and the seller. Other markets (the London Stock Exchange) operate chiefly through intermediaries (stockbrokers) who transact business on behalf of clients. In supermarkets, sellers choose the price, stock the shelves, and leave customers to choose whether or not to make a purchase. Antique auctions force buyers to bid against each other with the seller taking a passive role.
Although superficially different, these markers perform the same economic function. They determine prices that ensure that the quantity people wish to buy equals the quantity people wish to sell. Price and quantity can not be considered separately. In establishing that the price of a Rolls-Royce is ten times the price of a small Ford, the market for motor cars simultaneously ensures that production and sales of small Fords will greatly exceed the production and sale of Rolls-Royces. These prices guide society in choosing what, how, and for whom to purchase.
To understand this process more fully, we require a model of a typical market. The essential features on which such a model must concentrate are demand, the behaviour of buyers, and supply, the behaviour of sellers. It will then be possible to study the interaction of these forces to see how a market works practice.
The Role of the Market
Markets bring together buyers and sellers of goods and services. In some cases, such as a local fruit stall, buyers and sellers meet physically. In other cases, such as the stock market, business can be transacted over the telephone, almost by remote control. We need not go into these details. Instead, we use a general definition of markets.
A market is a shorthand expression for the process by which households 'decisions about consumption of alternative goods, firms' decisions about what and how to produce, and workers 'decisions about how much and for whom to work are all reconciled by adjustment of prices.
Prices of goods, and of resources, such as labour, machinery and land, adjust to ensure that scarce resources are used to produce these goods and services that society demands.
Much of economics is devoted to the study of how markets and prices enable society to solve the problems of what, how, and for whom to produce. Suppose you buy a hamburger for your lunch. What does this have to do with markets and prices? You chose the cafe because it was fast, convenient and cheap. Given your desire to eat, and your limited resources, the low hamburger price told you that this was a good way to satisfy your appetite. You probably prefer steak but that is more expensive. The price of steak is high enough to ensure that society answers the 'for whom' question about lunchtime steaks in favour of someone else.
Now think about the seller's viewpoint. The cafe owner is in the business because, given the price of hamburger meat, the rent and the wages that must be paid, it is still possible to sell hamburgers at a profit. If rents were higher, it might be more profitable to sell hamburgers in a cheaper area or to switch to luxury lunches for rich executives on expense accounts. The student behind the counter is working there because it is a suitable part-time job, which pays a bit of money. If the wage were much lower it would hardly be worth working at all. Conversely, the job is unskilled and there are plenty of students looking for such work, so owners of cafes do not have to offer very high wages.
Prices are guiding your decision to buy a hamburger, the owner's decision to sell hamburgers, and the student's decision to take the job. Society is allocating resources - meat, buildings, and labour - into hamburger production through the price system. If nobody liked hamburgers, the owner could not sell enough at a price that covered the cost of running the cafe and society would devote no resources to hamburger production. People's desire to eat hamburgers guides resources into hamburger production. However, if cattle contracted a disease, thereby reducing the economy's ability to produce meat products, competition to purchase more scarce supplies of beef would bid up the price of beef, hamburger producers would be forced to raise prices, and consumers would buy more cheese sandwiches for lunch. Adjustments in prices would encourage society to reallocate resources to reflect the increased scarcity of cattle.
After the market
The election of Bill Clinton marks, in part, a disenchantment with both the rhetoric and reality of market economics. During his campaign, the president-elect repeatedly disavowed the tax-and-spend policies of his Democratic forebears, but his speeches nonetheless celebrated the positive role that government can play in the economy. Now Mr. Clinton has said he will soon arrange a summit meeting of businessmen and economists - America's best and brightest - to help him revive the economy. And his administration will create an Economic Security Council, whose task for the moment remains obscure, but whose name evokes a sense of purpose and a country under siege. After years of being told by George Bush that the economy was fine - and where it was not, free enterprise would provide - all this was undoubtedly what a large number of voters wanted to hear.
Fashion seems to be swinging back towards state activism in many other parts of the rich world, too-odd as that may seem, coming so soon after the communist alternative to market capitalism was exposed as a fraudulent wreck. Has market capitalism, the ideology that triumphed in the 1980s, had its day?
Learn from the poor
Thankfully, not in the developing countries - whose governments tested the limits of economic activism in the 1970s and early 1980s with results they and their electorates are unlikely to forget. In Asia and Latin America, the market remains very much in vogue, with increasingly impressive results. Consider Mexico. Or look at the fastest-growing region in the world: southern China. It is not just going capitalist, but is doing so entirely without the benefit of shrewd oriental planning or coordination. Nobody is more surprised than China's government by the power of free enterprise.
In the rich world, however, things look different. A weariness with the economics of the 1980s does appear to have set in. America's choice of Mr. Clinton - not to mention its flirtation with the profoundly anti-market Ross Perot - is only one sign of this. In Britain, too, the idea of ??"partnership between industry and government" (a weary cliche in the 1970s, which no minister would have dared utter in Margaret Thatcher's day) has again been taken up with enthusiasm. What is worse, it forms part of a bold new go-for-growth "strategy".
Elsewhere in Europe, pro-market forces are meeting stronger opposition. The Community's +1992 programme started from a belief in competition as a spur to efficiency. Moreover, it harnessed European integration to the cause of economic freedom, by aiming to merge markets through deregulation. These ideas are now being questioned. The deregulatory push of the single-market experiment is increasingly seen as a threat. In a scary alliance, Europe's rightist xenophobes and leftist interventionists are making common cause.
The seemingly endless stalemate in the GATT talks, whatever the eventual outcome, reflects the same mood (see page 81). Even in the 1980s, mind, the case for free trade was never accepted so widely or unquestioningly as was the case against ambitious domestic intervention. Ronald Reagan and Mrs. Thatcher instinctively preferred "fair" trade to free, a distinction that the philosophers of market capitalism, ever since Adam Smith, have regarded as utterly misconceived. On trade, then, the shift from conservative economics is not one of economic doctrine, but one of attitude.
Lately governments have seemed less willing to pursue a forgiving and co-operative approach to trade reform - an approach that is the next best thing to an unshakeable belief in open markets, and which, in practice, can work nearly as well. In much of the industrialised world, but especially in America and Europe, trade reform is increasingly seen as another species of deregulation - that is, an abdication of the state's responsibility to manage the economy in the national interest. The Uruguay round of GATT talks can still be rescued, and probably will be; but this may prove a hollow victory if living by the GATT's rules continues to be seen as a sign of weakness.
Despite all this backsliding, the idea that the next few years will expunge what was learnt and achieved in the 1980s is a wild exaggeration. Mr. Clinton is indeed a new Democrat; his proposals for greater state intervention are far more intelligent than those of his predecessors. Europe's single-market programme has already achieved a great deal. Eventually, though not without further squabbles, the Uruguay round will lower many trade barriers. And not even John Major's panic-stricken government is likely, say, to renationalise Britain's telecommunications industry - or not for the moment, anyway. The extent of the transformation wrought in the 1980s is best gauged by today's left-of-centre parties: all call for change, but none wants to return to the policies of the 1970s.
That is reassuring. Nonetheless, the challenge for the state in the rest of this decade will be to meet the popular demand for action without delivering, as bold interventionist governments have in the past, a crushing disappointment. In this, as in much else, America will set the example for others to follow.
As he prepares for government, the most important thing for Mr. Clinton to do is curb his appetite for advice. Least of all should he listen to businessmen. For perfectly understandable reasons, they want just one thing from government: preference. Every industrialist invited into the White House will make a persuasive case for special assistance. New industries seek subsidies and protection from competition so they can establish themselves in the market. Their slogan is: invest in tomorrow. Old industries seek the same, to avoid the need for retrenchment. Their slogan is: export goods, not jobs.
It would be nice to help them all; but, as Adam Smith pointed out more than 200 years ago, you can not extend preference to everybody. Each measure of assistance puts a tax on other producers and on consumers at large. A little bit of "industrial policy" is fairly harmless, merely a zero-sum game; but too much of it becomes negative-sum, because firms that can not prosper unaided are kept alive by taxes (explicit or implicit) on firms that can. That holds the economy back. The same is true of measures (such as trade protection) that pretend to tax foreigners and cost America nothing. Europe's consumers and non-farm producers are the principal victims of the EC's common agricultural policy; in the same way, Americans will suffer most if Mr. Clinton embarks on a more "realistic" trade policy. Therefore go easy on the advisers.
After special pleading, the biggest trap for Mr. Clinton's new government is macroeconomic policy. The new president will be told by many (including some of the country's best and brightest economists) that the budget deficit is no cause for concern-even that, in the interest of spurring short-term growth, a bigger deficit is needed. Instead of listening too closely, Mr. Clinton should notice one simple fact. America had a big budget deficit throughout the 1980s - a decade which, on his view, ended in a "crisis of competitiveness". So he should need no persuading that "expansionary" fiscal policy does not raise an economy's long-term rate of growth. It actually does the opposite, by fuelling inflation and / or raising long-term interest rates. These are the enemies of capital accumulation, and economies grow richer chiefly by accumulating capital.
Mr. Clinton has emphasised his concern with America's long-term prospects. That focus is dead right. Another way of putting it - though some Democrats will find the words unpalatable - is that enduring growth and competitiveness depend upon supply, not demand. A bigger budget deficit would spur demand, but at the cost of undermining future supply. If Mr. Clinton really does care about long-term prosperity, his first goal will be to ensure that in four years the budget deficit is much smaller than today. And the right time to start a gradual programme of budget reductions is now.
To become the first supply-side Democrat in the White House, Mr. Clinton then needs to channel his interventionist energies into areas that his predecessors left largely unexplored. The president-elect has already identified many of them. He has promised to improve the quality of public education, to reduce the cost of health care (though it would be pointless to do this merely by shifting the burden from individuals to firms), and to promote investment in infrastructure. In all three areas, the case for government action is strong. Equally, though, an intelligent interventionist will understand that in getting these policies right, market forces, judiciously applied, are not the enemy, but an indispensable ally.
In addition, a supply-side Democrat would turn his attention to the tax system. Let us hope that Mr. Clinton's promise to raise taxes on the rich and lower them on the immense "middle class" was only cynical electioneering - for such a promise has nothing to do with growth, and precious little to do with "fairness". A supply-side Clinton would think of tax reform as a way to promote saving, and hence investment; that suggests moves towards a progressive expenditure tax-ie, an income tax levied only on the part of income that is spent.
The market is dead. Long live the market
By any standards, this would be an ambitious agenda for domestic policy over the next four years. It would also be a distinctively Democratic agenda. And in its way - though Mr. Clinton might choose not to boast about this - it would be an entirely pro-market agenda. If Mr. Clinton succeeds, it will not be by killing market capitalism, but by giving it a new lease of life.
The greatest difficulty the new president will face in following such a course is in persuading himself, his political allies and the American electorate of the need for patience. The supply-side policies that await a leader with energy and a sense of mission pay their political dividends only slowly, over a span of many years; that is why awaiting is usually all they do. Unfortunately, Mr. Clinton seems to be in a quick-fix mood, promising action to "kick-start" the economy; as his planned summit shows, he is inviting pleas for special assistance, and talking of urgent new initiatives in trade and industrial policy. This is the claptrap that politicians, out of panic or conviction, have peddled many times before. America voted for change. It is entitled to nothing less.
Business Organization and Behaviour
Having analysed demand we turn now to supply. How do firms decide how much to produce and offer for sale? Can a single theory of supply describe the behaviour of a wide range of different producers, from giant companies such as ICI and Shell to the self-employed ice cream vendor with a van?
For each possible output level a firm will wish to know the answer to two questions: how much will it cost to produce this output and how much revenue will be earned by selling it. For each output level, production costs depend on technology that determines how many inputs are needed to produce this output, and on input prices that determine what the firm will have to pay for these inputs. The revenue obtained from selling output depends on the demand curve faced by the firm. The demand curve determines the price for which any given output quantity can be sold and hence the revenue that the firm will earn. Figure 7-1 emphasizes that it is the interaction of costs and revenues that determines how much output firms wish to supply.
Profits are the excess of revenues over costs. The key to the theory of supply is the assumption that all firms have the same objective: to make as much profit as possible. By examining how revenues and costs change with the level of output produced and sold, the firm can select the output level which maximizes its profits. To understand how firms make, output decisions we must therefore analyse the determination of revenues and costs.
We introduce two essential concepts in the theory of supply, marginal cost and marginal revenue. Although later chapters give a more detailed analysis, these concepts form the framework for the economist's approach to supply. Finally, because the assumption of profit maximization forms the cornerstone of this approach, we discuss the plausibility of this assumption and examine alternative views of what firms 'aims might be.
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