10 Economic Ideas Everyone Should Know - dummies

10 Economic Ideas Everyone Should Know

By Sean Masaki Flynn

Here is a list of ten economic ideas that all informed people should understand and be ready to use to evaluate the policy proposals made by politicians, pundits, and the media. Some of these ideas aren’t true in all situations, but because they’re usually correct, be wary if some guy wants you to believe that they don’t apply to a particular situation. Chances are that he’s wrong.

Self-interest can improve society and the economy

The idea that self-interest can improve society is basically Adam Smith’s famous invisible hand. If all economic transactions in a society are voluntary on the parts of all parties involved, then the only transactions that will take place are those where all parties feel that they’re being made better off. This concept doesn’t mean that charitable acts are bad for society. Rather, it means that even philanthropy is generated by self-interest: People give because they enjoy helping others, so both givers and the people they help are better off.

In addition, this concept motivates entrepreneurs to find ways to produce products you like at prices you like. Sellers must fear your power of choice — your right to walk away from any offer that you don’t consider advantageous.

Free markets require regulation

Economists firmly believe that voluntary transactions in free markets tend to work toward the common good. But they also believe that nearly every participant in the marketplace would love to rig the system in his or her own favor.

Adam Smith was quick to argue that for markets to work and serve the common good, the government has to fight monopolies, collusion, and any other attempts to prevent a properly functioning market in which firms vigorously compete against each other to give consumers what they want at the lowest possible price. Government intervention may also be necessary to deal with asymmetric information, public goods, and externalities.

Economic growth relies on innovation

The only way to have sustained economic growth and widespread increases in living standards is to invent more efficient technologies that allow people to produce more from the limited supply of labor and physical resources. To that end, societies should promote education and set up institutions such as patent rights, competitive markets, and copyright laws to promote innovation and increases in efficiency.

Freedom and democracy make us richer

Very good moral and ethical reasons exist for favoring freedom and democracy. But a more bottom-line reason is that because they promote the free development and exchange of ideas, free societies have more innovation and, consequently, faster economic growth. And they attract foreign investment.

Education raises living standards and the economy

Not only do educated people produce more as workers — and get paid higher salaries — they produce innovative new technologies. Sustained economic growth and higher living standards are possible only if you educate your citizens well. You have, of course, other good reasons for getting an education, including the ability to appreciate high art and literature. But if all you care about is rising living standards, work hard to promote education in science and engineering, sectors where revolutionary technologies are created.

Intellectual property boosts innovation and the economy

People need incentives to take risks. One of the biggest risks is leaving a secure job to start a new business or develop a great new idea. Intellectual property rights, such as patents and copyrights, guarantee that you’ll be the only one making money off your hard, innovative work. Without this assurance, few would be willing to take the risks necessary to provide new technologies and products.

Weak property rights cause all environmental problems

Environmental problems stem from poorly defined or nonexistent property rights that allow polluters to ignore the costs that they impose on others. Therefore, economists favor the creation and enforcement of property rights systems that force people to take all costs into account. People always need to do some polluting. After all, even if you don’t want gas-guzzling SUVs causing lots of pollution, you probably still want ambulances and fire trucks to operate even though they, too, pollute the environment. The difference is that the benefits to society outweigh the costs of pollution in the case of the emergency vehicles.

Strong property rights are the key to ensuring that people weigh the complete costs and benefits of causing pollution. Property rights force people to take into account not only personal costs but also the costs that their actions impose on others.

International trade is a good thing for the economy

Opening your country to international trade means opening your country to new ideas and innovations. Competition causes local businesses to innovate to match the best offerings of companies from around the world.

Throughout history, the richest and most dynamic societies have been the ones open to international trade. Of course, what economists have in mind when they think of the benefits of international trade is free trade, where companies compete across borders to provide people with the best goods and services at the lowest prices. Economists strongly condemn the government subsidies and trade restrictions that impede free trade and that try to rig the game in one country’s favor.

Government can provide public goods

Economists view the existence of public goods as one of the most important justifications for government intervention in the economy. Although private philanthropy can provide some public goods, many are so expensive that they can be provided only if the government uses taxes to fund them. Consequently, public goods are typically government-provided.

Private firms can provide goods and services only if they can at least break even doing so. To break even (or make a profit), whatever a firm is selling has to be excludable, which means that only those paying for the good or service receive it.

Some goods and services are not excludable. For instance, a lighthouse provides warning services to all ships in the vicinity regardless of whether the ships’ captains pay the lighthouse keeper. The private lighthouse quickly goes bankrupt because only a few captains are fair-minded enough to pay for the service. Goods and services that are not excludable are called public goods because they’re essentially open to the public and can’t be kept private.

Because private firms can’t make a profit producing public goods, you typically need governments to provide them. Governments can force people to pay for public goods. They do this by levying taxes and using the tax revenues to pay for public goods, such as national defense, police departments, lighthouses, public fireworks displays, basic scientific research, and so on.

Preventing economic inflation is easy

High rates of inflation are caused by the government’s increasing the money supply too rapidly. A growing economy always has a growing demand for money because with more stuff to buy, you need more money with which to buy it. To keep the overall level of prices constant, increase the money supply at the same rate that demand is increasing. If the supply of money increases faster than the demand, the value of money falls, creating an inflation.

In other words, you need more money to buy the same amount of stuff as before, so prices go up. The way to prevent an inflation is to make sure that the government increases the money supply at the same rate that the demand for money increases. Modern central banks such as the Federal Reserve Bank in the United States can do this quite easily, so there’s no excuse for high rates of inflation.