Economics in Minutes

by Niall Kishtainy

  The law of demand

  A basic ‘law’ of economics is that when the price of a good rises, people demand less of it, and when the price falls people buy more. Although this prediction is a fairly robust one, like any law stated in the abstract, assumptions are used that may not always hold up in practice. For example, a showroom slashing the price of its cars might lead to queues around the block. But what if people were unsure about the quality of the cars? A lower price might signal that the cars were of low quality, leading to fewer not more buyers.

  In addition, there are other factors beyond the price of a good that can affect demand for it: consumer tastes might alter or changes in the price of goods that are close substitutes for it might affect demand. There are some special kinds of goods, such as goods which are consumed in order to display one’s wealth (so-called conspicuous consumption, see Conspicuous consumption) for which demand may actually increase when the price goes up.

  Elasticity of demand

  People respond differently to changes in prices for different goods. Suppose, for example, that the price of jam rises: consumers might easily switch to marmalade, leading to a fairly large fall in the demand for jam. Demand for jam is thus sensitive to changes in prices – what economists call elastic demand. In contrast, consider a village only served by a single bus: a rise in the bus fares might not affect demand very much. Here bus travel is said to be price inelastic.

  Goods that are necessities, or those for which there are few substitutes, tend to be inelastic, while those that are luxuries or are easily substitutable tend to be elastic. In the short term, demand tends to be more inelastic, but over time consumers may adjust to price changes. In the 1970s, the oil-producing countries attempted to keep the price of oil high to earn themselves large revenues. In the long run, however, consumers reduced their demand for oil by switching to more fuel-efficient cars.

  Giffen goods

  If the price of laptops increases, one would expect people to demand less of them. However, economic theory also allows that a price increase might generate more, rather than less, demand. A price increase has two effects that may contradict each other: a higher price makes consumers shift spending towards other, cheaper goods, but in addition, the price increase reduces consumers’ purchasing power, cutting real income. Some goods, such as laptops, tend to be demanded less when income falls. Another category of good known as inferior goods are demanded more as income falls. ‘Giffen goods’ are inferior goods with such a strong income effect that when the price goes up overall more of the good is demanded. Poor households spending most of their income on a basic staple suffer a large fall in real income if the price of the staple rises. Households may respond by cutting out non-essential items like meat or sugar, and spending even more on the staple. Some have claimed that during the Irish famine of the 19th century, potatoes were such a Giffen good.

  Paradoxically, demand for a Giffen good rises as its price increases, since this reduces consumers’ ability to spend on alternative goods.

  General equilibrium

  If the price of petrol rises, consumers tend to demand less of it. They may use their cars less and buy bicycles, and as a result, the price of bicycles rises and resources shift towards the manufacture of bicycles as new producers enter the market. In this way different markets are connected, and a shock in one may ripple through the rest.

  Often we tend to think of markets in isolation: we talk about the price of cars that brings supply into line with demand: what economists call partial equilibrium. General equilibrium theory considers the possibility of equilibrium across the whole economy, taking account of the linkages between markets. One might imagine that completely unfettered free markets would lead to muddle and instability – why would one expect that any kind of order would arise? General equilibrium theory has shown that under certain conditions there are prices that bring about equilibrium in all markets. However, whether these conditions actually hold in practice is another matter.

  The invisible hand

  In the 18th century, Scottish economist and philosopher Adam Smith famously wrote: ‘It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.’ If I am hungry, the butcher supplies me with meat and in buying it from him I provide him with his living.

  The ‘invisible hand’ was Smith’s metaphor for the way in which free markets spontaneously satisfy people’s wants. No coordinating organization orders the butcher to supply meat at a particular spot, or tells the hungry person to turn up there for his dinner. Supply is made equal to demand by prices, so that everyone who wants to buy something at that price can obtain it. A fundamental tenet of much of economics is therefore that the result of people acting purely in their own self-interest will not be chaos, but rather social good. Much deep economic thought is concerned with the way in which the invisible hand works, and the conditions in which it might fail.

  Pareto efficiency

  Economists want to do more than just explain economic outcomes: they also want to assess how desirable they are. The standard they apply is Pareto efficiency, named after the Italian economist who devised the concept.

  Suppose Tom has two packets of crisps and two packets of sweets. He likes crisps, but is indifferent to sweets. Jane has two packets of crisps, and likes both crisps and sweets. If Tom gave Jane the sweets, she would be better off and he would not be worse off: this would be a Pareto improvement. The original allocation of goods was ‘Pareto inefficient’ because they could be reallocated to make someone better off without hurting anyone else. When all such reallocations are made, society achieves Pareto efficiency, the state in which it is not possible to make anyone better off without hurting someone. Market exchange takes place when both buyer and seller stand to gain, and much of economics is concerned with uncovering the conditions in which free markets lead to Pareto efficiency.

  From any point along the Pareto efficiency curve it is impossible to make one person better off without hurting the other.

  Market efficiency and the welfare theorems

  Adam Smith claimed that a system of free markets spontaneously leads to a socially desirable allocation of goods (see The invisible hand). Without any central organization, the right goods and services get produced and end up in the hands of those who can put them to best use. It’s as if all the buyers and sellers, workers and employers are guided by an ‘invisible hand’. In the 20th century, economists investigated this idea mathematically, deriving ‘welfare theorems’ that set out conditions under which free markets lead to social good.

  Their criteria for social good was Pareto efficiency (see Pareto efficiency): an allocation is said to be Pareto efficient if no further reallocations of goods can be made to benefit at least one person while hurting no one. One of the welfare theorems states that under certain conditions any allocation of goods arrived at through the action of free markets is Pareto efficient. The catch is that the conditions are so stringent that they are unlikely to hold in the real world.

  Market failure

  Under certain conditions, markets can give rise to efficient allocations of goods (beyond which it is impossible to make a person better off without hurting someone else). When such conditions are not met, market failure arises. One condition for efficiency is competition: no buyer or seller should be able to influence the price of a good. So one market failure is lack of competition: if a monopoly controls the bread market, it can raise the price and supply less, creating an inefficiency. Another efficiency condition is that a market outcome only affects those participating in it: your purchase of a bunch of bananas doesn’t affect me, but suppose you buy a drum kit, forcing me to wear earplugs? Your action had an unintended consequence that was not taken into account in the price you paid for the drums. Economists call this kind of failure an ‘externality’.

  Market failure is used to justify government intervention: for example, so-called ‘anti-trust
’ policy deals with monopolies, while certain kinds of taxes can be used to offset externalities.

  An important aim of public policy is to correct market failures

  Externalities

  Suppose a car factory is located upriver from a fishery. The factory buys materials and labour, sells its cars and turns a profit. But a by-product of its production is a chemical that is released into the river. It flows down to the fishery and kills some fish. The impact of the chemical on the fishery is an externality: the factory creates a cost to the fishery that is not taken into account of in the market. When the factory decides how many cars to make it looks at the cost of materials and the price of cars – the lower output of fish doesn’t enter into it. So the market has failed to bring the costs and benefits faced by the factory into line with those for society as a whole: the ‘negative’ externality can be seen as the factory producing ‘too many’ cars. Conversely, markets have a tendency to undersupply ‘positive’ externalities. Bees pollinate crops, but the beekeeper only considers the price of honey, not the benefit from his bees to the neighbouring farmer. Relative to the potential benefit overall, the beekeeper has ‘too few’ hives.

  The tragedy of the commons

  Picture a traditional village in which people make a living from the sale of wool, grazing their sheep on a collectively owned common pasture. The village prospers and more sheep are put to graze. But soon there are so many sheep that the grass is eaten faster than it can grow back. Eventually, the ground is bare and no sheep can be supported on it – the villagers’ livelihood disappears.

  This ‘tragedy of the commons’ comes about because when individual owners graze their sheep, they don’t take account of the fact that this reduces the grass available to other villagers’ sheep. Here the grass is a common resource: no one can be excluded from using it, but one person’s use reduces that for others. The combined effect of the villagers’ actions is self-defeating – if they could agree to limit the number of sheep, perhaps using taxes or quotas, their livelihoods could be protected. This is what lies behind governments’ attempts to regulate common resources such as water, roads and fish.

  The Coase theorem

  Suppose that John takes up the trombone and his neighbour Jack can’t stand the din. The trombone gives pleasure to John, but imposes a cost on Jack. This cost isn’t reflected in the market and so John isn’t made to face the full cost to society of his hobby. Economists say that John creates a negative externality. In 1960, economist Ronald Coase proposed a theorem suggesting that markets can solve the problem.

  Suppose that the pleasure from the trombone is worth £1,000 to John, and the annoyance to Jack is equivalent to £2,000. Jack could pay John £1,500 to stop playing. Both John and Jack are made better off. This assumes that John had an initial right to play the trombone. It could be that Jack has the right to peace and quiet, in which case John could attempt to pay him to allow trombone playing. In either case, the theorem says that parties should be able to bargain their way to a solution. In reality, however, the theorem might not work: bargaining is often too costly to bring a solution.

  Public goods and free riding

  Ten residents of a street each place a value of $100 on the installation of streetlights: overall, they would get a benefit of $1,000. So if the cost of the lights was less than $1,000, it would be beneficial to install them, with each resident contributing to the cost.

  But streetlights are a special kind of good known as a public good: no one can be excluded from using them, and one person’s use does not reduce their availability to others. Why, then, would a resident admit to valuing streetlights at all and contributing to their installation? It would be more rational for him to feign indifference, knowing that once the streetlights were installed he would still benefit because he couldn’t be excluded from their use. If all the residents ‘free ride’ in this way, no contributions are made and the streetlights don’t get installed. Free riding means that markets cannot supply public goods: one of the main roles of government is to invest in socially beneficial public goods such as national defence.

  The second best

  Economists espouse the benefits of free, well-functioning markets. When a market fails, then the first response is often to propose that an intervention should be made to correct the problem. The theory of the second best shows that the situation is more complex.

  Suppose we were worried about a firm monopolizing the steel market. Monopolies tend to drive up prices and restrict output compared to the social ideal, so we might suggest intervention from an ‘anti-trust’ agency to break the firm into smaller competitors: steel output would rise and prices would fall. But suppose there is another market failure: the firm pumps gases that damage nearby crops. The firm doesn’t take account of this cost – if it did it would produce less steel. So one market failure – lower output arising from the monopoly – offsets the other failure of pollution costs arising from overproduction. Correcting just one failure – the monopoly – might worsen the situation, because even more crops would be damaged.

  Arrow’s impossibility theorem

  In any society, some people might want extra resources to go to schooling, and others may want it spent on roads. When making collective decisions, societies must grapple with the problem of such conflicting desires. Arrow’s impossibility theorem shows that logically there is no procedure for making such decisions that simultaneously satisfies a small number of reasonable criteria for fairness. One of these properties is that there is no ‘dictator’: no single person who determines society’s decision. Another is that if every individual preferred schools to roads, then society as a whole should prefer schools to roads. The theorem states that these, and other apparently sensible criteria for fairness, are inconsistent.

  Consider a voting system that met the second condition: as a result there would be a dictator – a single vote would always determine the outcome. The theorem is powerful and disturbing: even the most transparent voting systems are likely to be bedevilled by inconsistency and paradox.

  Risk and uncertainty

  Economic life is imbued with risk. A trader’s portfolio might lose value or go through the roof, a worker might be laid off or get a raise. Risk refers to situations in which there are a set of known events that will occur with measurable probabilities, such as the different outcomes on a roulette wheel.

  Much economic analysis uses this idea: firms and individuals calculate expected returns from different courses of action and then choose the one with the highest return. For example, a firm believes with a high probability that there will be large market demand next year: it therefore decides to launch a new product. Uncertainty refers to situations in which future events do not have a known probability and so expected returns can’t be calculated. Uncertainty pervades all economies: for example, it is impossible to know what new kinds of technologies might exist a decade from now. This means that in reality a great deal of economic decision-making about the future is driven by hunches rather than calculations.

  Risk aversion

  Suppose I offer to give you £1,000 if a coin toss comes up heads, but nothing if it comes up tails. Because both heads and tails outcomes occur with a probability of one in two, we can say that the expected value of the coin toss is £500. Knowing this, suppose that I now give you a choice between taking the gamble or receiving £490 immediately?

  According to economics, if you take the £490 you are said to be risk averse: you are willing to accept a lower pay-off in order to avoid a risky gamble in which you may end up with nothing. This is because the pain of a loss exceeds the pleasure of a gain: you would probably refuse to play a game in which I paid you £100 if a coin came up heads, but you paid me £100 if it came up tails. Risk aversion explains the existence of insurance markets: risk-averse individuals pay a premium to an insurer each year to avoid the possibility of facing a larger loss.

  Insurance

  Sophie buys household insurance, and yet
she has never been burgled. Why does she continue to pay? She does so essentially because she seeks to avoid risk. With insurance she ends up with less wealth in the event that she doesn’t get burgled, but if she is burgled, the insurance company makes up the losses. Insurance transfers wealth from the outcome in which she is not burgled to the one in which she is. Without it, she will end up with a higher return in the first outcome, a lower return in the second. The expected returns – wealth in each outcome weighted by the probability of the outcome – are the same with or without insurance, but still, because she hates risk she takes out the policy. The company, meanwhile, can insure her by insuring large numbers of people: it is hard to predict whether Sophie herself will be burgled, but one can make a reasonable prediction about how many out of 1,000 people will be. The company can therefore ensure that the total premiums paid will cover the total amount paid out.

  The principal–agent problem

  Markets may not work properly when some people have more information than others. For example, the owner of a building firm wants to maximize his profits, but this depends on the efforts of his employees. This is known as the principal–agent problem: an outcome that is important to the owner (the principal) depends on the actions of the workers (the agents). However, the agents have more information than the principal about their own actions. The owner of the building firm can’t monitor the effort of all the bricklayers and carpenters scattered across various building sites.