Common Sense Economics: What Everyone Should Know About Wealth and Prosperity

Common Sense Economics: What Everyone Should Know About Wealth and Prosperity

by James D. Gwartney

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Overview

Common Sense Economics: What Everyone Should Know About Wealth and Prosperity by James D. Gwartney

With the global economy recovering from a steep recession, and with that recovery challenging our long-held ideas about what careers and the market can be, learning the basics of economics has never been more essential. Principles such as gains from trade, the role of profit and loss, and the secondary effects of government spending, taxes, and borrowing risk continue to be critically important to the way America's economy functions, and critically important to understand for those hoping to further their professional lives - even their personal lives. Common Sense Economics discusses key points and theories, using them to show how any reader can make wiser personal choices and form more informed positions on policy.

Now in its third edition, this fully updated classic from James D. Gwartney, Richard L. Stroup, Dwight R. Lee, and Tawni H. Ferrarini reflects on the recession and the progress that's been made since the crash; it offers insight into political processes and the many ways in which economics informs policy, illuminating our world and what might be done to make it better.

Product Details

ISBN-13: 9781250106940
Publisher: St. Martin's Press
Publication date: 06/14/2016
Pages: 272
Sales rank: 138,961
Product dimensions: 5.50(w) x 8.20(h) x 1.10(d)

About the Author

JAMES D. GWARTNEY holds the Gus A. Stavros Eminent Scholar Chair at Florida State University and is the director of the Stavros Center for the Advancement of Free Enterprise and Economic Education.

RICHARD L. STROUP is the author of Eco-Nomics and an adjunct professor of economics at North Carolina State University.

DWIGHT R. LEE is coauthor of Getting Rich in America and holds the William J. O'Neil Chair of Global Markets and Freedom at Southern Methodist University.

TAWNI Hunt FERRARINI is the Sam M. Cohodas Professor of Economics and the Director of the Center for Economic Education and Entrepreneurship at Northern Michigan University.

JOSEPH CALHOUN is a lecturer in the Assistant Director of the Stavros Center for the Advancement of Free Enterprise and Economic Education, and a lecturer in the Department of Economics at Florida State University.

Read an Excerpt

Common Sense Economics

What Everyone Should Know About Wealth and Prosperity


By James D. Gwartney, Richard L. Stroup, Dwight R. Lee, Tawni H. Ferrarini, Joseph P. Calhoun

St. Martin's Press

Copyright © 2016 James D. Gwartney, Richard L. Stroup, Dwight R. Lee, Tawni H. Ferrarini, and Joseph P. Calhoun
All rights reserved.
ISBN: 978-1-250-10695-7



CHAPTER 1

PART 1


Twelve Key Elements of Economics


TWELVE KEY ELEMENTS OF ECONOMICS

1. Incentives matter: Changes in benefits and costs will influence choices in a predictable manner.

2. There is no such thing as a free lunch: Goods are scarce and therefore we have to make choices.

3. 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.

4. Trade promotes economic progress.

5. Transaction costs are an obstacle to trade.

6. Prices bring the choices of buyers and sellers into balance.

7. Profits direct businesses toward productive activities that increase the value of resources, while losses direct them away from wasteful activities that reduce resource value.

8. People earn income by providing others with things they value.

9. Production of goods and services people value, not just jobs, provides the source of high living standards.

10. Economic progress comes primarily through trade, investment, better ways of doing things, and sound economic institutions.

11. The "invisible hand" of market prices directs buyers and sellers toward activities that promote the general welfare.

12. Too often long-term consequences, or the secondary effects, of an action are ignored.


Introduction

Life is about choices, and economics is about how incentives affect those choices and shape our lives. Choices about our education, how we spend and invest, what we do in the workplace, and many other personal decisions will influence our well-being and quality of life. Moreover, the choices we make as voters and citizens affect the laws or "rules of the game," and these rules exert an enormous impact on our freedom and prosperity. To choose intelligently, both for ourselves and for society generally, we must understand some basic principles about how people choose, what motivates their actions, and how their actions influence their personal welfare and that of others. Thus, economics is about human decision-making, the analysis of the forces underlying choice, and the implications for how societies work.

The economic way of thinking involves the integration of key concepts into your thought process. The following section presents twelve concepts that are crucial for the understanding of economies, and why some countries grow and achieve high income levels while others stagnate and remain poor. You will learn such things as the true meaning of costs, why prices matter, how trade furthers prosperity, and why production of things people value underpins our standard of living. In the subsequent parts of the book, these concepts will be used to address other vitally important topics.


1. Incentives matter: Changes in benefits and costs will influence choices in a predictable manner.

All of economics rests on one simple principle: Changes in incentives influence human behavior in predictable ways. Both monetary and nonmonetary factors influence incentives. If something becomes more costly, people will be less likely to choose it. Correspondingly, when the benefits derived from an option increase, people will be more likely to choose it. This simple idea, sometimes called the basic postulate of economics, is a powerful tool because it applies to almost everything that we do.

People will be less likely to choose an option as it becomes more costly. Think about the implications of this proposition. When late for an appointment, a person will be less likely to take time to stop and visit with a friend. Fewer people will go picnicking on a cold and rainy day. Higher prices will reduce the number of units sold. Attendance in college classes will be below normal the day before spring break. In each case, the explanation is the same: As the option becomes more costly, less is chosen.

Similarly, when the payoff derived from a choice increases, people will be more likely to choose it. A person will be more likely to bend over and pick up a quarter than a penny. Students will attend and pay more attention in class when they know the material will be on the exam. Customers will buy more from stores that offer low prices, high-quality service, and a convenient location. Employees will work harder and more efficiently when they are rewarded for doing so. All of these outcomes are highly predictable and they merely reflect the "incentives matter" postulate of economics.

This basic postulate explains how changes in market prices alter incentives in a manner that works to coordinate the actions of buyers and sellers. If buyers want to purchase more of an item than producers are willing (or able) to sell, its price will soon rise. As the price increases, sellers will be more willing to provide the item while buyers purchase less, until the higher price brings the amount demanded and the amount supplied into balance. At that point the price stabilizes.

What happens if it starts out the other way: if sellers want to supply more than buyers are willing to purchase? If sellers cannot sell all of their goods at the current price, they will have to cut the price of the item. In turn, the lower price will encourage people to buy more — but will also discourage producers from producing as much, since it is less attractive to them to supply the product at the new, lower price. Again, the price change works to bring the amount demanded by consumers into balance with the amount produced by suppliers. At that point there is no further pressure for a price change.

Remember the record-high gas prices in the summer of 2008? While a lot of people felt the pain of higher prices at the pump, there was no panic in the streets or long lines at the gas pumps. Why? When the higher prices made it more costly to purchase gasoline, most consumers eliminated some less important trips. Others arranged more carpooling. With time, consumers also shifted to smaller, more fuel-efficient cars in order to reduce their gasoline bills.

Furthermore, as buyers reacted to higher gas prices, so did sellers. The oil companies supplying gasoline increased their drilling, developed new techniques such as fracking to recover more oil from existing wells, and intensified their search for new oil fields. The higher price helped to keep the quantity supplied in line with the quantity demanded. Eventually, the prices of both crude oil and gasoline fell as supply expanded.

Incentives also influence political choices. There is little reason to believe that a person making choices in the voting booth will behave much differently than when making choices in the shopping mall. In most cases voters are likely to support political candidates and policies that they believe will provide them with the most personal benefits, net of their costs. They will tend to oppose political options when the personal costs are high compared to the benefits they expect to receive. For example, senior citizens have voted numerous times against candidates and proposals that would reduce their Medicare benefits. Similarly, polls indicate that students are strongly supportive of educational grants to college students.

There's no way to get around the importance of incentives. They are a part of human nature. Incentives matter just as much under socialism as under capitalism. In the former Soviet Union, managers and employees of glass plants were at one time rewarded according to the tons of sheet glass they produced. Because their revenues depended on the weight of the glass, most factories produced sheet glass so thick that you could hardly see through it. As a result, the rules were changed so that the managers were compensated according to the number of square meters of glass produced. Under these rules, Soviet firms made glass so thin that it broke easily.

Some people think that incentives matter only when people are greedy and selfish. This is untrue. People act for a variety of reasons, some selfish and some charitable. The choices of both the self-centered and altruistic will be influenced by changes in personal costs and benefits. For example, both the selfish and the altruistic will be more likely to attempt to rescue a child in a shallow swimming pool than in the rapid currents approaching Niagara Falls. And both are more likely to give a needy person their hand -me-downs rather than their best clothes.

Even though no one would have accused the late Mother Teresa of greediness, her self-interest caused her to respond to incentives, too. When Mother Teresa's organization, the Missionaries of Charity, attempted to open a shelter for the homeless in New York City, the city required expensive (but unneeded) alterations to its building. The organization abandoned the project. This decision did not reflect any change in Mother Teresa's commitment to the poor. Instead, it reflected a change in incentives. When the cost of helping the poor in New York went up, Mother Teresa decided that her resources would do more good in other areas. Changes in incentives influence everyone's choices, regardless of the mix of greedy, materialistic goals on the one hand and compassionate, altruistic goals on the other, that drive a specific decision.


2. There is no such thing as a free lunch: Goods are scarce and therefore we have to make choices.

The reality of life on our planet is that productive resources are limited, while the human desire for goods and services is virtually unlimited. Would you like to have some new clothes, a luxury boat, or a vacation in the Swiss Alps? How about more time for leisure, recreation, and travel? Do you dream of driving your brand-new Porsche into the driveway of your oceanfront house? Most of us would like to have all of these things and many others! However, we are constrained by the scarcity of resources, including a limited availability of time.

Because we cannot have as much of everything as we would like, we are forced to choose among alternatives. There is "no free lunch." Doing one thing makes us sacrifice the opportunity to do something else we value. This is why economists refer to all costs as opportunity costs.

Many costs are measured in terms of money, but these too are opportunity costs. The money you spend on one purchase is money that is not available to spend on other things. The opportunity cost of your purchase is the value you place on the items that must now be given up because you spent the money on the initial purchase. But just because you don't have to spend money to do something does not mean the action is costless. You don't have to spend money to take a walk and enjoy a beautiful sunset, but there is an opportunity cost to taking the walk. The time you spend walking could have been used to do something else you value, like visiting a friend or reading a book.

It is often said that some things are so important that we should do them without considering the cost. Making such a statement may sound reasonable at first thought, and may be an effective way to encourage people to spend more money on things that we value and for which we would like them to help pay. But the unreasonableness of ignoring cost becomes obvious once we recognize that costs are the value of forgone alternatives (that is, alternatives given up). Saying that we should do something without considering the cost is really saying that we should do it without considering the value of the alternatives. When we choose between mutually exclusive (but equally attractive) alternatives, the least -cost alternative is the best choice.

The choices of both consumers and producers involve costs. As consumers, the cost of a good, as reflected in its price, helps us compare our desire for a product against our desire for alternative products that we could purchase instead. If we do not consider the costs, we will probably end up using our income to purchase the "wrong" things — those goods and services not valued as much as the other items we might have bought.

Producers face costs, too — the costs of the resources used to make a product or provide a service. For example, the use of resources such as lumber, steel, and sheet rock to build a new house takes resources away from the production of other goods, such as hospitals and schools. High costs for resources signal that the resources have other highly valued uses, as judged by buyers and sellers in other markets. Profit-seeking firms will heed those signals and act accordingly, such as seeking out less costly substitutes. However, government policies can override these signals. They can introduce taxes or subsidies that help those inconvenienced by the prices that emerge in free and open markets. But such policies reduce the ability of market incentives to guide resources to where consumers ultimately, on balance, value them most highly.

Politicians, government officials, and lobbyists often speak of "free education," "free medical care," or "free housing." This terminology is deceptive. These things are not free. Scarce resources are required to produce each of them and alternative uses exist. For example, the buildings, labor, and other resources used to produce schooling could instead produce more food, recreation, environmental protection, or medical care. The cost of the schooling is the value of those goods that must be sacrificed. Governments may be able to shift costs, but they cannot eliminate them.

Opportunity cost is an important concept. Everything in life is about opportunity cost. Everyone lives in a world of scarcity and therefore must make choices. By looking at opportunity costs, we can better understand the world in which we live. Consider the impact of opportunity cost on work-force participation, the birth rate, and population growth — topics many would consider outside the realm of opportunity-cost application.

Have you ever thought about why women with more education are more likely to work outside the home than their less-educated counterparts? Opportunity cost provides the answer. The more highly educated women will have better earning opportunities in the workforce, and therefore it will be more costly for them to stay at home. The data are consistent with this view. In 2013, 79.5 percent of women aged twenty -five to sixty-four with a college education (or more) were in the labor force, compared to only 64.4 percent of their counterparts with only a high school education and 46 percent of the women with less than twelve years of schooling. Just as economic theory predicts, when it is more costly for a woman to be out of the labor force, fewer will choose this option.

What do you think happens to the birth rate as an economy grows and earnings rise? Time spent on household responsibilities reduces the time available for market work. As earnings rise, the opportunity cost of having children and raising a large family increases. Therefore, the predicted result is a reduction in the birth rate and slower population growth. The real world reflects this analysis. During the past two centuries, as the per capita income of a country increased, a reduction in the birth rate and a slowdown in population growth soon followed. Moreover, this pattern has occurred in every country. Even though there are widespread cultural, religious, ethnic, and political organizational differences among countries, nonetheless the higher opportunity cost of having children exerted the same impact on the birth rate in all cases.

Opportunity cost is a powerful tool and it will be applied again and again throughout this book. If you integrate this tool into your thought process, it will greatly enhance your ability to understand the real-world behavior of consumers, producers, business owners, political figures, and other decision-makers. Even more important, the concept will also help you make better choices.


3. 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.

If we are going to get the most out of our resources, actions should be undertaken when they generate more benefits than costs and rejected when they are more costly than the benefits derived. This principle of sound decision-making applies to individuals, businesses, government officials, and society as a whole.

Nearly all choices are made at the margin. That means that they almost always involve additions to (or subtractions from) current conditions, rather than "all-or-nothing" decisions. The word "additional" is a substitute for "marginal." We might ask, "What is the marginal (or additional) cost of producing or purchasing one more unit?" Marginal decisions may involve large or small changes. The "one more unit" could be a new shirt, a new house, a new factory, or even an expenditure of time, as in the case of a high school or college student choosing among various activities. All these decisions are marginal because they involve consideration of additional costs and benefits.

People do not make "all-or-nothing" decisions, such as choosing between eating or wearing clothes. Instead they compare the marginal benefits (a little more food) with the marginal costs (a little less clothing or a little less of something else). In making decisions individuals don't compare the total value of food and the total value of clothing, but rather they compare their marginal values. Further, we choose options only when the marginal benefits exceed the marginal costs.


(Continues...)

Excerpted from Common Sense Economics by James D. Gwartney, Richard L. Stroup, Dwight R. Lee, Tawni H. Ferrarini, Joseph P. Calhoun. Copyright © 2016 James D. Gwartney, Richard L. Stroup, Dwight R. Lee, Tawni H. Ferrarini, and Joseph P. Calhoun. Excerpted by permission of St. Martin's Press.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

Table of Contents

Preface vii

Part 1 Twelve Key Elements of Economics 1

Part 2 Seven Major Sources of Economic Progress 45

Part 3 Ten Key Elements of Economic Thinking About the Role of Government 105

Part 4 Twelve Key Elements of Practical Personal Finance 171

Acknowledgments 231

Digital Assets, Supplemental Units, and Website 233

Suggested Additional Readings 235

Glossary 237

Index 249

About the Authors 259

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