Everything you need to know about economics.
Learn the foundations of economic theory and how it affects your daily life.
Did you snooze through economics in college? You are probably not alone. However, economics is more than just a collection of uninteresting numbers; it plays an essential and intimate role in our daily lives.
Everything we engage with, from the clothing on our backs to the screen on which we're reading this text, is the consequence of a series of economic transactions culminating in a product in our hands.
In these summaries, you will understand how economics shapes our lives and how it has evolved over the last few centuries. An in-depth look at the history of economics will help you grasp how our society has been shaped by its laws and practices.
Furthermore, you will receive a crash lesson on the specific forces that determine economic behavior and the knowledge required to assess a country's financial health.
In the overview below, you will also discover:
Why we shouldn't be concerned about why and how sumo wrestlers cheat;
why a plane made of solid gold may not be worth that much;
Spending less at the grocery shop can result in a pink slip for the cashier.
1. Economic theory has several applications, although it is most commonly employed in economic studies.
If you've read the book Freakonomics (as many millions of people have), you've seen how economics can be utilized in situations that aren't directly related to "the economy."
For example, the book's authors use the economic theory of rational choice to explain why sumo wrestlers may cheat, assuming that each person's decisions are designed to yield the greatest possible outcome.
But why would a sumo wrestler cheat? Imagine two sumo wrestlers competing in a match. They are best friends. However, since one has already qualified for the next round, it is reasonable for him to lose on purpose to enhance the likelihood that his companion progresses.
This is only one example. In truth, economic theories have been employed to explain various events.
And, while interesting, we should recognize the most crucial application of economics: understanding the economy. Indeed, one of the most fundamental aspects of economics is how money helps economic systems function.
Money is a measure of what society owes you, typically due to your labor.
On the other hand, money transfer is a method by which money is freely distributed. In welfare programs, for example, cash is typically shifted from those who have it to those who do not meet basic requirements such as shelter and food.
Money can be spent on goods and services created by organizations that use a specific combination of labor (people) and capital (machines and tools required for production).
Your mobile gadget, for example, was created through this combination: its processors were conceived by workers (labor) and then manufactured with the assistance of machines (capital).
Rather than a sumo wrestler's problem, these types of relationships are central to economic theory.
2. The capitalist economy has dramatically altered From medieval village blacksmiths to multinational corporations.
The advantages and cons of capitalism are a current topic. Indeed, in recent years, an intellectual battle has raged, with assertions like "Capitalism is in crisis" and "Capitalism creates jobs" being thrown back and forth.
But what exactly constitutes capitalism?
One of the most prominent early definitions of capitalism is in Scottish economist Adam Smith's landmark work, An Inquiry into the Nature and Causes of the Wealth of Nations, published in the 18th century.
Smith defines capitalism as a system of natural liberty in which the primary goal of political and economic systems is the accumulation of profit. One of Smith's significant contributions to capitalism was his relationship between rising productivity and the division of labor.
To demonstrate this, he investigated pin manufacture. He discovered that when a worker was assigned a specific but well-defined job in the manufacturing process, such as forging metal or forming molds, his particular expertise enabled him to work more productively than if he attempted to manufacture a finished pin from start to finish himself.
These discoveries distinguish Smith's book as a seminal account of a capitalist system, and its impact can still be seen today. Yet, much has changed since the seventeenth century!
Economic actors and institutions differ dramatically from those in Smith's world. Businesses were previously owned by people directly involved in the production process, such as the village blacksmith or butcher.
Today, many corporations are held by shareholders who are virtually entirely disconnected from the day-to-day operations of their businesses.
Market conditions have also altered. During Smith's period, most marketplaces were regional or national at their largest. As a result, most enterprises were small. Globalization has made markets transnational and permitted the expansion of massive multinational enterprises.
3. Trade policies and boom-and-bust cycles help us understand how our economic system was formed.
We have witnessed how much the global economy has transformed over the previous few centuries. But what circumstances contributed to this change?
Notably, the politics of powerful Western nations throughout the Industrial Revolution resulted in tremendous economic expansion in these countries.
During the Industrial Revolution, from the late 1700s to the early 1800s, the governments of the United States and the United Kingdom pursued protectionism through industrial tariffs.
If foreign corporations sought to sell their products to US or UK consumers, they would have to pay additional levies or fees, increasing the cost of their items. As a result, homegrown products became more affordable and widespread.
Meanwhile, these same governments compelled Latin American and Asian countries to sign free-trade agreements, which allowed highly competitive Western products to enter these markets.
This mismatch in historic trade policy has resulted in the current economic situation, with Western economies being the richest and most developed.
Then followed the Great Depression, which prompted governments to take greater control of the economy.
On October 24, 1929, the US stock market crashed unexpectedly, reeling the economy. Confidence collapsed, and only some people wanted to invest. This resulted in a long-lasting economic depression, with millions of people worldwide experiencing significant unemployment and poverty.
Faced with dire circumstances, governments strove to better control the economy, aiming to influence it to ensure citizens had enough to survive or, better yet, prosper.
The US Social Security Act of 1935 was one such intervention, establishing an old-age pension and unemployment insurance. Even if people could not work, they would not be left impoverished.
Workers in Western countries gradually became more economically comfortable due to such protections, and with few exceptions, they continue to be so today.
4. The Neoclassical School, which emphasizes limited economic involvement, dominates contemporary economic philosophy.
When you watch the news, you'll frequently see two economists fighting about whose theory should lead government economic policy. But why are there so many different perspectives?
The study of economics has been divided into numerous schools of thought, owing to the inherent complexity and difficulty of understanding the workings of any economy.
Let us look at some of the most prominent schools of economic thought.
The Neoclassical School, first developed by economists in the 1870s, is the preferred theory among most modern economists. It focuses on individual players and supports intervention only when markets fail.
As the name implies, the Neoclassical School is based on two primary principles of the Classical School, which originated around the time of Adam Smith.
The first premise is that economic players, whether enterprises, producers, or consumers, are motivated by self-interest.
As actors pursue their goals, the competition between them will result in the best possible outcome for everyone. For example, if every automobile manufacturer competes for the most sales of the same model, the price will reduce, resulting in more sales for merchants and lower customer prices.
The second assumption is that markets self-equilibrate; that is, markets will restructure to an optimal level following an external shock, such as an oil crisis or war. This indicates that markets, in most situations, should not be messed with because they are self-sufficient.
The Neoclassical School differs from the Classical School in that it believes a product's worth is determined by its production cost and consumer valuation.
Assume an airplane built of solid gold is for sale. According to the Classical School, the plane's high production cost would result in a very high value. However, no airline would buy such a heavy, useless jet since it could not fly! According to the Neoclassical School, the plane's value would be significantly lower.
5. Keynesian economists emphasize the need for government spending during difficult economic times.
But if the market works so well, as Neoclassical economists claim, why are so many people out of work? Here's where the Keynesian School comes in.
According to the Keynesian School, long-term unemployment and things that cannot be sold, such as our solid gold airplane, violate the Neoclassical belief in markets' self-equilibrating potential.
If a commodity remains unsold for an extended time, Keynesian economists argue that the money ordinarily used to consume such a product must have been spent elsewhere. Usually, the money will have been saved. When people save money rather than spend it, they withdraw cash from the economy, contributing to unemployment.
Imagine two workers working at a supermarket with three customers. If the three customers save a third of their wage rather than spend it all, the effect would be the same as if the supermarket only had two customers.
However, a supermarket requires only one working employee with only two clients, leaving the other unemployed.
To prevent unemployment, Keynesian economists argue that the government should act to preserve economic investment.
When investors and consumers save money, overall expenditure goes down. This reduces income since consumer spending is effectively the income of other employees.
To compensate for this, the government should invest in the economy when total investment is low, such as during financial crises when people hesitate to spend money. Ideally, This government action will help prevent income declines and even a recession.
The government might invest in infrastructure projects such as airport construction and roadway improvements to do this. Such projects would supply people with labor and wages, allowing them to spend money on goods and services while creating jobs for others.
Now that we've covered the various schools of economic theory, the next overview will look at how to assess an economy's health.
6. a country's economic health indicators are GDP and GDI.
Countries compete against one another in global markets, much as individuals do on a sports field. Some countries are regarded as economic powerhouses, while others struggle. However, how do we know just how well a country succeeds economically?
The most common indicator of a country's economic health is its Gross Domestic Product, or GDP.
GDP is the monetary value of everything a country produces over a certain period of time. It specifically accounts for added value, the difference between the finished product's and intermediate inputs' values.
For example, a bakery generates $150,000 in revenue. Over the course of a year, the baker had to purchase $100,000 in baking ingredients or intermediate inputs. The extra value is $50,000.
Another key indicator of economic health is Gross Domestic Income, or GDI, the sum of citizens' income in a single country.
GDI, unlike GDP, cannot be used to compare countries because the cost of living in each country varies. An iPod might cost $200 in the United States but only $150 in India. Thus, even if India and the United States had similar GDIs, their levels of wealth would be different.
To utilize GDI to compare nations, economists established the idea of purchasing power parity (PPP), which assesses a currency's purchasing power about the price of specific items. It then asks, "How many of these goods can I buy with my income in my country?"
From 2009 to 2013, India's PPP conversion factor was 0.3, which means that if you swapped US dollars for Indian rupees, you would need just 30% of the money in India to buy milk as you would in the United States.
7. GDP growth alone is insufficient; a government must invest to maintain a healthy economy.
Now that we know GDP is one of the most important indices of economic health, what can we conclude about a country's economy based on GDP growth? Very little.
GDP growth is sometimes an accurate indicator of a country's economic prosperity.
Consider Equatorial Guinea, which had its GDP grow at an annual rate of 18.6 percent between 1995 and 2010. That is more than double China's GDP growth rate of 9.1 percent over the same period.
However, no one mentions Equatorial Guinea as a growth superstar, whereas many people have enthusiastically referenced the "Chinese economic miracle." Why is this?
Equatorial Guinea's small population of 700,000 people contributes to this. More importantly, the small country's GDP growth differed in increasing productivity. Instead, finding a vast oil deposit in 1996 resulted in a surge of international investment.
Economic development is a better indication of financial health since it represents a country's economic growth due to increased productive capabilities or the ability to organize and modify production activities. Some indicators of financial development include the purchase of new machines or the improvement of communication infrastructure.
Another useful indicator of economic development is the share of investment in GDP. When enterprises in a country spend more profits on fixed capital or the machinery and facilities that enable production, this is a positive indicator of the country's development potential.
One excellent example of such an investment is computer numerical control (CNC) devices. These machines may be programmed to translate models into finished products and are far faster than equipment that requires manual operators.
If a corporation invests in machines that enable faster production, it can manufacture and sell more things in less time.
8. When a country has more "have-nots" than "haves," its economy is not in good shape.
The goal of equality is inherent in human nature, and people intuitively shun circumstances in which a few individuals claim all of the resources we jointly require to survive.
Indeed, our shared past is replete with instances where individuals battled for equality. One devastating example is the French Revolution, which had the motto "Liberty, equality, fraternity or death."
It's a good thing people instinctively seek equality because inequality is terrible for the economy.
Inequality in a country frequently leads to political and social instability, which may deter potential investors. Consider the investments made in Austria and Somalia in 2011. Despite its enormous population, the severely unstable state of Somalia received $100 million, while Austria, a stable electoral democracy, received $10 billion.
High inequality also suggests restricted social mobility or the ability of individuals to move up the social hierarchy. When just a few people can afford an expensive, high-quality education, they will get top employment. Those who cannot afford a proper education, even if they are better qualified for a job, will never have the opportunity to compete, which harms the economy.
One method for measuring inequality is to utilize the Gini coefficient, which evaluates the degree to which the actual distribution of income differs from an optimum (or equal) distribution.
The lower the Gini coefficient, the more evenly money is divided. A value of "0" indicates a perfect distribution. As values approach "1," fewer and fewer people have practically everything, while the others have nothing.
Gini coefficients in most industrialized countries range between 0.3 (in Italy) and 0.5 (in the United States), putting them in the middle.
The following summary will examine how governments might use data like inequality metrics to determine how to better support the economy.
9. A country's government can impact market prices through fiscal and monetary policies.
Even though economists generally believe that the economy functions best when left alone, there are specific circumstances that necessitate government intervention.
In a perfectly free market, there would be no taxes. However, a government must first obtain funding if it needs to build a road. So, who will pay for the road?
A government might levy taxes on the people to ensure that they have enough money to build a road and that everyone pays their fair amount.
Or what if a corporation has no competitors in its market segment? These natural monopolies most commonly emerge in industries where the cost of entry is too high for competition to gain a foothold, such as electricity, water, or public transit. In this instance, the government must intervene to enforce fair practices, such as setting price limits or otherwise meddling with the market.
There are two basic ways for a government to influence the market.
The first is based on budgetary policy. Governments have the option of increasing or decreasing spending, as well as raising or lowering taxes. Fiscal policy includes promoting highway expansion and other public works projects with public cash.
The second approach involves monetary policy. A government can directly impact the amount of physical currency in circulation, modify interest rates on loans from the central bank, or do both.
If a government cuts interest rates for borrowing money from the central bank, the overall cost of borrowing falls. This encourages businesses to take out loans at the new, lower interest rate, allowing them to invest more affordably in new fixed capital, such as machines, or recruit new employees.
With a better understanding of how a government might intervene in the market, the final review will look more closely at our current global economy.
10. Financial instruments thought to be intelligent later proved poisonous, contributing to the financial catastrophe.
You may think of a bank as merely a location to deposit your paycheck or open a savings account. Today's banks, however, are far more diverse.
In truth, there are two types of banks.
The first is a commercial or deposit bank, which deals directly with customers. Deposit banks, such as Germany's Sparkasse and America's Bank of America, provide a safe haven for people's money.
The second is an investment bank whose primary goal was to assist companies (rather than people) in raising capital from investors. Investment banks include Goldman Sachs and the now-defunct Lehman Brothers, which were crucial in the 2008 financial crisis.
Since the 1980s, investment banks have been increasingly focused on developing and selling new financial products, with disastrous outcomes.
Asset-backed securities (ABS) are one type of financial innovation that played a significant part in the economic crisis.
An ABS consolidates many debts, such as mortgages or student loans, to create a more significant bond, making it more appealing to investors.
Combining these obligations makes the bonds appear secure. Combining thousands of mortgages lets you be confident that most people can make their payments. Some may default, but these defaults will be covered by additional secured payments.
At least, that was the plan.
Many ABSs were overvalued and posed a rising concern as more people defaulted on their loans. This resulted in a devaluation of ABSs and other comparable financial products. As the situation became apparent, many banks that traded ABSs could not sell them, resulting in massive losses that cascaded across the global economy.
11. Company downsizing, technical breakthroughs, and economic crises contribute to unemployment.
Although we currently spend the majority of our time at work, we spend significantly less time in the office than laborers did less than two centuries before.
Until the nineteenth century, people often worked 70 to 80 hours weekly. Today, such figures are substantially lower: in Greece, the average person works roughly 40 hours per week, compared to 35.6 hours in Germany.
Nonetheless, work continues to consume a significant percentage of our waking hours. This has important ramifications because work significantly impacts our psychological and physical well-being.
Some vocations, such as construction labor, are physically demanding and sometimes hazardous. Working long hours can leave people exhausted and ill. Furthermore, our psychological well-being is determined, at least in part, by how much we enjoy our jobs; those who are content are happier than those who are not.
Being unemployed is far more stressful than having a lousy job. Economists classify unemployment into three categories.
Frictional unemployment arises "naturally" when businesses close or employees leave for a new or better opportunity. Frictional unemployment refers to the time a potential worker spends between jobs.
Technological unemployment arises when machines replace workers, as happened during the Industrial Revolution when hand textile weavers were replaced by steam-powered machines. This type of unemployment persists today as technology advances and physical labor is rendered obsolete.
Then, there's cyclical unemployment, produced by a drop in labor demand due to external events, such as the Great Depression. People may wish to work yet are still looking for it.
While these disparities do little to lift the spirits of the unemployed, they help us understand how best to tackle unemployment.
12. A firm rarely makes decisions independently because several actors have voting rights.
When you pick how to spend your money, such as by purchasing a new home, a car, or even an ice cream sandwich, you are effectively making your own decision.
Companies' spending decisions, on the other hand, are typically significantly more complex.
Unlike people, corporation decisions are affected by shareholders and management. Many corporations are held by many stockholders.
However, only a few corporations have an individual shareholder with enough shares to determine the company's future, such as Sweden's Wallenberg family, which owns 40% of Saab, a car and aviation manufacturer.
In contrast, business managers have effective control since they are more intimately involved in daily decision-making. Of course, this can lead to problems when shareholders' and managers' interests diverge.
A manager seeks status, which is favorably related to the size of the organization she leads. In contrast, shareholders prioritize profit over status, which is only sometimes tied to a company's size. More enormous profits indicate more significant rewards for shareholders and, consequently, a better probability of survivability because a company with high profits is less likely to face a liquidity crisis.
Conflicts of interest such as these can lead to disagreements between shareholders and management.
Governments and even workers can have an impact on corporate decision-making. Workers can organize into trade or labor unions to fight for higher salaries or better working conditions.
Some firms are also partially owned by governments. The German government owns a 25% share in Commerzbank, the country's second-largest bank, giving the federal government direct influence over the bank's corporate decisions.
13. International trade is becoming increasingly vital to developed and developing countries.
Have you ever noticed how easy it is to find a can of Coca-Cola anywhere in the world?
This is because international trade involves the movement of capital, goods, and services across international borders. In fact, worldwide trade has grown considerably during the last 50 years.
In the early 1960s, international trade accounted for 12% of global GDP, but by 2010, it had climbed to as much as 29%.
The following examples demonstrate how international trade affects markets and services.
First, many technology businesses outsource services like customer care contact centers and software development to low-wage countries.
Second, manufacturing has become a global enterprise, accounting for up to 69% of international merchandise trade in 2010.
Finally, international commerce has enabled emerging countries to play a more significant part in the global economy. China, for example, accounted for only 0.8 percent of global manufacturing in 1980 but 16.8 percent by 2012.
Participation in the global economy, of course, requires money, which can come from various sources.
Some money comes from the trade surplus, which occurs when a country exports more than it imports. However, the opposite can also happen: a country may face a trade deficit.
To pay for trade deficits, countries might use investment income, which is money generated by the country's financial investments overseas, such as profits from foreign company shares held by its inhabitants.
Another alternative is to seek funding through international aid or grants from other countries. If the funds are insufficient to finance trade deficits, countries may be forced to borrow more money or sell assets, such as bonds.
As we move forward, globalization will only increase the importance of international trade.
Final Summary
The economy has altered dramatically during the last 300 years. Not only have economic actors evolved, but so have the structures of corporations and global trade, making us more intertwined than ever before. Understanding the structure of our societies and the complicated relationships between countries requires a fundamental understanding of economics.