What should everyone know about economics?

Answer by Jeremy Arnold:

10 Common Economic Myths Revisited

Some great answers already given by Balaji Viswanathan and Roshan Cariappa. But, as they focused more on the academic fundamentals, I thought I'd have some fun by attacking some common myths and misconceptions.

So, here we go:

Myth #1: Central banks are the problem.

Without demand, all a central bank can do is "push on a string". And demand itself is simply people wanting things. If the broader part of a population (or its government) is willingly to recklessly pursue things that they can't afford, you have a cultural problem, not an economic one. Focusing on the supplier doesn't tend to accomplish much. You have to deal with the root: the addiction itself.

Myth #2: Debt is always bad.

As the old saying goes, "it's the dose that makes the poison". Debt is necessary for a healthy economy. It's just a question of proportion. This holds true on both the commercial and household side. If everyone is saving and no one is borrowing, you're going to have some serious growth problems. "Know your limits and play within them." But we need to play up to those limits, if playing prudently.

Myth #3: Superpower status comes from good policy.

History confirms that past superpowers reached their zenith through one or more of the following means: luck, slavery, theft, war, fraud, or tribute. Skill and efficiency can definitely create significant advantages, but not at the scale that was seen in the "glory days" of empires and hegemons. No country that plays by modern rules will ever ascend those heights again.

Myth #4: Western governments can just print spending money.

A government can't just call up their central bank and get a boatload of money printed up to line the public coffers. Central banks can purchase government bonds, but must do so through the secondary market. Central banks can also create money in the sense of increasing the reserves of the banks in their network, but it's up to those banks to multiply that money through fractional reserve banking. When they do, that benefits the economy on a whole, not the government itself.

* I'm only speaking to the West. Governments in a limited number of other places that have no arms-length central banks can print-and-spend (also true for the UK, in a limited sense).

Myth #5: Fractional reserve banking is bad, and unnecessary.

As with debt, this is a question of proportion. A reserve ratio of 3% is probably a terrible idea. But the basic concept of how the system works is simply inarguably positive. There is no credible alternative. Here's why: if money doesn't multiply, modern banks don't exist. (It would leave them without the ability to collect interest or make profits.)
 

Myth #6: The stock-market is beatable.

While this is more finance than economics, I thought it was worth including. The idea of "beating the market" is used in a very imprecise way by a lot of casual investors. People sometimes forget the simple fact that the whole point of an "exchange" is that a deal is being made between two (or more) parties, not with the market itself. For me to buy a stock, the current holder has to be willing to sell it at the quoted price. How convinced am I that I know more about the proper value of the stock than they do?

* The only way to truly "beat a market" would be to short an index fund. I get that some folks use the expression to mean that their custom picks outperform a given index fund, but it's a silly way of saying it.

Myth#7: Rich companies pay the most taxes.

Who writes the tax codes? Politicians. And their favour is intensely courted by lobbying firms that represent large corporations. The end result is a lot of deductions, discounts, and exemptions for the largest players. In some countries, this is also true on a personal level. As Warren Buffet famously shared, his marginal tax rate is less than his secretary's. The truth is that the heaviest proportional burden is always borne by the meat of the middle-class.

Myth #8: Academic economics is all about science.

Math is a language that allows us to describe the functions of a given system. Science is the investigation into the dynamics of that system. The truth is that there are a good number of economists out there who really don't understand much about the practical world that their models describe. They're just math wizards. As such, their work is of limited utility to casual readers.

* No, not all economists are guilty of this. It's hard to say what percentage are. Many are brilliant in the practical sphere. But I think the broad point is still fair. How can a PhD-level expert understand things like Black-Scholes and derivative volatility models and yet not understand the basic principles of systemic risk and over-leveraging? The written record proves that a whole lot of them didn't see 2008 coming.

Myths #9: Bubbles are sure opportunities for profit.

Just because you spotted an error in pricing, doesn't mean that you're going to profit off of it. Naked emperors can be surprisingly resilient when the trumpet-blower isn't a market-mover like Mr. Buffet. Bubbles tend to burst at arbitrary speeds. Take a stock like Amazon for example. It's currently valued at $152bn in market cap. When compared to revenues, this is quite reasonable. Except that stock prices have no correlation to revenues — they need to be tied to the expectation of future profits. Amazon has no profits, and its CEO has quite literally built his business model around the premise of making no profits. You can short their stock all you want in protest, but as Keynes wisely observed, "the market can stay irrational longer than you can stay solvent."

* Yes, I know that they expect to make profits in a day to come, once they've monopolized their key markets. Which is fine, except that the world has changed and that day isn't coming. (At least, never to the tune of repaying $152bn in stock value.)

Myth #10: Outsourcing makes rich countries poorer.

Getting more done with less means more overall wealth. That isn't really up for debate. The problem is that this model demands that displaced workers be migrated to higher-value jobs. That isn't happening. But that's not a flaw in the economic theory. It just reflects a broken sociopolitical system. 

Note: None of my points are really controversial. If they sound like it, it's largely because of the fuzzy economic narratives present in a lot of mass-media sources. I'd be happy to have my reasoning challenged in the comments. If you'll be respectful, I'll be patient (and willing to be wrong).

Note 2: For those looking for a more detailed understanding of the technical bits, see the comment string with Steven Ford below.

What should everyone know about economics?

What should everyone know about economics?

What should everyone know about economics?

Answer by Roshan Cariappa:

These are the ten principles of Economics, as listed by Gregor Mankiw, in his fascinating book, Principles of Macroeconomics

A. How people make decisions

1. People face trade-offs: "There is no such thing as a free meal." To get one thing that we like, we usually have to give up another thing that we like,

Micro economic: A student deciding whether to study Economics or Psychology.

Macro economic: If the Defence budget increases, there will be a decrease in other budget heads, such as Education or Healthcare.

2. The cost of something is what you give up to get it: As a result of point 1, we tend to compare costs and benefits of our choices. So, the Opportunity Cost of an item is what you give up to get that item.

Micro economic: A student deciding whether to go to college or take up a job.

Macro economic: If the government decides to buy more ballistic missiles for the army, it probably could have built a new metro station at that cost. 

3. Rational people think at the margin: Individuals and firms make better decisions by thinking at the margin. A rational decision-maker takes an action if and only if the marginal benefit of the action exceeds the marginal cost.

Micro economic: So, most often, it's not a choice between blowing off your exams or studying 24 hrs a day, but whether you spend an extra hour revising concepts instead of watching TV. 

Macro economic: The government does not forego a budget for Education in lieu of its spending on Defence. Rather, decisions are closer, say between increasing the number of schools by x% versus increasing the number of fighter planes by y%.

4. People respond to incentives: People make decisions by comparing costs and benefits, their behavior may change when the costs or benefits change.

Micro economic: When the price of apples rises, people eat fewer apples. When the price of pears decreases, they consume more pears.

Macro economic: If the government decides to subsidize the price of fuel, then auto manufacturers have less incentive to build fuel efficient cars.

B. How people interact

5. Trade can make everyone better off: 'Competition' in economics is not like a sports contest, and can make everyone better. 

Micro economic: We do not, generally, grow our own food or build our houses. Instead, we hire experts to do it for us.

Macro economic: A country exports goods/services that are in abundance and imports goods/services that are scarce. Ex: India exports coffee and imports oil.

6. Markets are usually a good way to organize economic activity: In general, the idea is to have less regulations and allow demand-supply to take its natural course in terms of pricing. (However, it is rarely as simple.)

In a market economy, the decisions of a central planner are replaced by the decisions of millions of firms and households.

Adam Smith describes an "invisible hand" of the marketplace, which guides self-interest into promoting general economic well being.

Micro-Macro economic: If a family's average consumption of broccoli increases, the price of broccoli will go up. (As against, the Dept. of Agriculture fixing the price of broccoli. Essentially, such a decision will not be flexible to demand-supply.)

7. Governments can sometimes improve market outcomes: Sometimes the invisible hand fails (called a market failure).

It maybe due to an 'externality', which is the impact of one person's / institution's actions on the well-being of an outsider.
Ex: If a chemical factory does not bear the entire cost of the smoke it emits, it will likely emit too much. Here, the government can raise economic well-being through environmental regulation. (An externality can be beneficial as well. For instance, a remarkable scientific discovery which causes the Govt. to increase funding for research).
 
Another possible cause is 'market power', which refers to the ability of a single person / institution to unduly influence market prices.
Ex: Suppose that everyone in town needs water but there is only one well. The owner of the well has market power—in this case a monopoly—over the sale of water. The well owner is not subject to the rigorous competition with which the invisible hand normally keeps self-interest in check.

This calls for government intervention. The government can promote efficacy and equity. That is, enlarge the economic pie or change how the pie is divided.

C. How the economy as a whole works

8. A country's standard of living depends on it's ability to produce goods and services: The reason that living standards in the US are better off in, say, Ethiopia – 'productivity'.

To boost living standards, policymakers need to raise productivity by ensuring that workers are well educated, have the tools needed to produce goods and services, and have access to the best available technology.

9. Prices rise when the Government prints too much money: In Germany in January 1921, a daily newspaper cost 0.30 marks. Less than two years later, in November 1922, the same newspaper cost 70,000,000 marks. All other prices in the economy rose by similar amounts. This episode is one of history’s most spectacular examples of 'inflation', an increase in the overall level of prices in the economy.

Because high inflation imposes various costs on society, keeping inflation at a low level is a goal of economic policymakers around the world.

10. Society faces a short-run tradeoff between Inflation and Unemployment: Simply put, the two are inversely proportional (explained by the Philip's curve), meaning a decrease in inflation will, in the short term, cause an increase in unemployment.

When the government reduces the quantity of money, for instance, it reduces the amount that people spend. Lower spending, together with prices that are stuck too high, reduces the quantity of goods and services that firms sell. Lower sales, in turn, cause firms to lay off workers. Thus, the reduction in the quantity of money raises unemployment temporarily until prices have fully adjusted to the change.

===

Note- The following I have come to realize with my romance with economics:
a. It is good to assume, people are selectively rational
b. There is no clear cause-effect. Generally, there are several underlying causes. (Economics is the only field in which two people can win the Nobel Prize for saying totally contrasting things.)

===

I have quoted/reproduced information from the book only because it is extremely lucid and interesting. This book first kindled my interest in economics. I implore anyone who wants to understand economics and the world in general to read the book.

Also, you might want to check out Irwin A Schiff's – How an Economy Grows and Why It Doesn't. Another fascinating read!

PS – This answer has been selected for an essay contest. You can vote here- What should everyone know about economics?

What should everyone know about economics?

What should everyone know about economics?

What should everyone know about economics?

Answer by Balaji Viswanathan:

EDIT: This answer is now featured in Business Insider: The 10 Things In Economics That Everybody Should Know

I have studied economics in B-school and have built a few economic tools in my startup. Here are the top 10 things you need to know in economics:

  1. Economics has two main streams – Microeconomics and Macroeconomics. Micro deals with customer behavior, incentives, pricing, margins, etc. Macro deals with broad economies and larger things such as interest rates, Gross Domestic Product (GDP) and other  stuff you see in the business column of a newspaper. Micro is more useful for the managers and macro is more used by investors. Except for points 2 & 3, I will cover macroeconomics in other points.
  2. Law of Supply & Demand: This is the founding block of economics. Whenever supply of something increases its price decreases and whenever supply decreases price increases. Thus, when you have excess production of corn, food prices decrease and vice versa. Think of this intuitively. You will find its applications in 1000s of places. 
  3. Marginal Utility: Whenever you have more of something its use for you diminishes. Thus, a $100 would be more valuable when you earn $1000/month than when you earn $1 million/month. This is widely used in setting up prices.



     

  4. Gross Domestic Product (GDP): This is the fundamental measure of the size of an economy. This is conceptually equal to the sum of incomes of all people in the country or sum of the market value of all goods & services produced in that country. Right now US is the biggest economy in terms of GDP at around $14 trillion. That means, $14 trillion of value is produced in the US every year.
  5. Growth rate: The growth of an economy is commonly measured in terms of GDP growth rate. Since GDP is a measure of national income, this growth rate is a rough proxy for how an average person's income grows every year.
  6. Inflation: You already know that the price of most products now are higher than in your grandfather's time. Inflation (measured in percent) is measure of how much a bunch of products have increased in price from last year. In mature economies, annual inflation is around 2% – that means on an average the prices of stuff goes up by 2% every year. The fundamental role of central banks is to manage this rate and keep it to a low positive number. Here are  the 100 year inflation numbers in the US.


  7. Interest Rates: When you loan money to somebody, you expect something extra in return. This excess is called the interest. Interest rate is a positive number that measures how much excess you will get. There are bunch of rates here. In the short term, this rate is usually set by the Central Banks. Right now it is close to zero. In the long term, this is set by the market and is dependent on inflation and the long term prospects of the economy. The mechanisms in which the central banks control the short term rates is called monetary policy.
  8. Interest Rates vs. Inflation vs. growth: There exists almost an inverse relationship between interest rates & growth and interest rates also can affect inflation directly. Thus, when you increase interest rates inflation tend to come down, along with growth. One is good and other is bad. Thus, the constant tension on setting the interest rates. In the US, Federal Reserve sets the short term rates making it one of the most watched economic news.
  9. Fiscal Policy: Government can control the economy in a big way by adjusting its expenditure. The group of mechanisms using expenditure form the fiscal policy. When government spends more it can lead to more demand and that means more price increase. This means both high growth and high inflation. And it works in the reverse too. Thus, governments try to spend more during periods of low growth & low inflation and cut spending during periods of high growth & high inflation.
  10. Business cycle: Economies have their periods of booms and bust in cycles of approximately 7 years long. At the start of the cycle it is a boom, then it gets to the top, then there is a contraction leading to a recession (period of negative growth and/or increasing unemployment) and finally followed up with an expansion.


Bonus:
1. Opportunity Cost: When you do an activity, you tend to equate how good the activity is when compared to the alternatives. For instance, when you are working hard a Friday night on a project, you might be thinking "man, I should be doing something else." The alternative (in this case, partying with friends) has a high value, and thus your present project better be attractive. This value of the alternative is termed as an "opportunity cost" – value of what you give up. Thus, if you quit a $120K/year paying job to do a startup, your opportunity cost of doing startup is $120K/year. Your payoff should be higher than what you give up. Hat tip: Charles Phan

2. Comparative Advantage:  You are running your tech startup and one day a client asks you whether you can build a website for them. Should you offer to build the website for them, or should you pass up the opportunity to a friend? How do you decide? A rational person might calculate how much time they will take to build the website, and whether they can use that time to earn more building their current startup product. Then, he/she might calculate whether the friend might be able to build the site more efficiently.

If the friend can build it more efficiently and you have a lot in your plate, you will pass up the opportunity. This is called the theory of comparative advantage. Your friend has an advantage here and it makes no sense for you to take up that business. Nations, businesses and people should do only those things they are better at and leave the rest to others. Hat tip: Aaron Klemm

Also see: Balaji Viswanathan's answer to How does the stock market work?

Balaji Viswanathan's answer to What should everyone know about investing?

Balaji Viswanathan's answer to What should everyone know about accounting?

What should everyone know about economics?

What should everyone know about economics?

What should everyone know about economics?

Answer by Noh-Joon Choo:

Bill Gates: “This knowledge would help everyone as investors and citizens. Watching is a worthwhile 30 minutes investment.”

Andrew Ross Sorkin, The New York Times: “Forget Econ 101. Take a look at the lessons in Dalio 101.”

Sal Khan, Khan Academy: “Explains macroeconomics in a practical way.”

Paul Volcker, Federal Reserve Chairman (1979-1987): “Ray Dalio’s ‘template’ may be unconventional but it casts strong light on how the economy actually works.”


What should everyone know about economics?

What should everyone know about economics?