Economics is the study of how we allocate resources—not only tangible resources like food, clothing, and money, but also intangibles like time, effort, and knowledge. To understand this process, economists begin by examining incentives: the driving forces behind our decisions. By understanding how we respond to incentives and the psychological instincts that steer us, we can better understand how market forces work and how governments and firms can use incentives to foster a healthy economy.
In Naked Economics, bestselling author Charles Wheelan strips away the complexity from some of the most powerful theories in economics, allowing readers with little or no background in the subject to understand many of the field’s most fundamental concepts. He skips over the more technical, mathematics-based aspects of the discipline and concentrates instead on the logical pieces of how and why people behave in certain ways, how markets function, and how governments can design incentive systems that encourage healthy economies.
We’ll structure our discussions by walking through different aspects of markets one by one:
Let’s start by exploring some basic economic concepts:
A market is a collection of billions of separate transactions that form a complex economy in which people can earn and spend money to fund their lives. A capitalist market allocates resources by matching supply with demand, thereby directing resources to where they will be most productive. In doing so, a market improves society by increasing opportunities for people to make income and increasing the variety of goods available to consumers.
When a sale is made, firms and individuals connect and maximize their utility against each other. “Utility” can be thought of as happiness, and maximizing it means making yourself as well-off as possible. In a sale, firms look to make as much money as possible, while individuals look to satisfy a need or desire by purchasing something.
In a capitalist economy, meeting points between sellers and buyers are regulated by prices, which reflect the supply and demand for any item on sale: how much of something is available and how much people want to buy it.
When sellers and buyers settle on a price that reflects a balance between supply and demand, they’ve set the market price for that particular thing, where its price encourages enough demand from buyers to generate an acceptable amount of profit for the seller. There is often a complex process involved in arriving at that price: In general, when prices increase, fewer people buy that thing, so the demand drops relative to its supply. If demand drops enough, vendors respond by lowering the price. But when the price drops, people start buying that thing again, which increases demand, which in turn increases prices again.
Self-interested incentives power the economy. Firms produce goods in order to make money for themselves, and people work to earn an income for themselves. In general, such incentives help the economy work well—in the pursuit of personal income, people and firms produce goods and services that benefit others. However, there are situations where incentives can cause problems:
A government makes a capitalist market possible. Though many people, including many politicians, talk about how much better the market could operate if there were little or no government of markets (or society), the fact is, countries without strong governments have almost non-existent markets in which it’s difficult to conduct even simple transactions. A government provides a number of essential things that allow for a functioning economy:
However, if a government sets too many rules or gets too involved in managing an economy’s operations, it can destroy an economy. Too many regulations can stifle growth and increase prices for consumers by requiring firms to go through excessive and often unnecessary steps to do business, such as licensing and paperwork. In general, a government should allow the private sector to provide goods and services whenever possible, only stepping in when the private sector would be unable to provide the same level of quality.
Too much government can also lead to distorted incentives for individuals and firms. For example, high taxes encourage tax evasion, discourage work, and sometimes even foster a black market. All of these actions hinder a properly functioning economy.
Financial markets are markets specifically designed for moving and managing money. This includes stock and bond markets as well as insurance markets. What other markets do for tangible goods, financial markets do for capital—essentially, they direct it to where it can be the most productive, which, in general, is where it’s earning the highest return.
Financial markets satisfy four basic needs that people have in an economy:
In order to properly evaluate the strength of an economy, economists must first figure out how to measure economies. There are several markers of economic health that they look at, but the primary one is an economy’s gross domestic product, or GDP. GDP summarizes the value of all the goods and services an economy produces. It’s the number that people generally refer to when they talk about a country’s growth: If you say the U.S. grew 3 percent this year, what you mean is that the U.S. produced 3 percent more goods and services this year than it did last year.
In addition to GDP, there are some other numbers that economists often refer to in order to judge how an economy is faring. These include:
Recessions are periods of time during which an economy’s GDP shrinks. They’re generally caused by a shock to the system—something unexpected and bad happening. Shocks might be the bursting of stock market or real estate bubbles (when exorbitant price increases are followed by sudden and devastating losses), a steep rise in oil prices, or a combination of such causes.
Because all parts of modern markets are interconnected, the failure of one part of the economy can quickly cause other parts to fail as well. For example, if your income suddenly drops because of a stock market correction, you will respond by spending less money. Your decreased spending makes other people’s income decrease, who then respond by also spending less money, which spreads the pain throughout more and more sectors of the market.
When this kind of slowdown reaches banks, the entire economy can quickly freeze up. When banks stop lending money because they fear people caught in a downward economic cycle can’t pay it back, businesses can’t operate. This is what happened during the financial crisis that began in 2007. Homeowners took on more debt than they could finance in order to pay for new homes, fueling a property bubble. When property prices fell, people unable to honor their loans found they couldn’t sell their homes for enough money to cover their outstanding mortgages, and the resulting wave of foreclosures devastated investment banks. When Lehman Brothers, a major investment bank, declared bankruptcy, the global financial market froze as panicked banks stopped lending people money.
To counter recessions, governments can change their fiscal policies or their monetary policies to encourage businesses to begin investing and consumers to start spending, so that the economy becomes self-sustaining again.
Fiscal policies: A government can encourage spending by injecting money into the economy, either by cutting taxes or by creating stimulus programs that put money directly into the hands of consumers and businesses.
Monetary policies: A government controls the supply of money in an economy by increasing or decreasing short-term interest rates. Cutting interest rates allows consumers to buy more things and allows firms to invest. Raising interest rates puts a brake on the economy by raising the cost of money itself, making it harder for individuals and businesses to borrow capital.
A government can decrease interest rates to heat up an economy, but it must be careful that it doesn't go too far and cause inflation—a continuous rise in prices. When interest rates are low, people borrow more money, and with more money running through an economy, prices for goods typically rise.
If, however, a government errs on the opposite end of the spectrum with interest rates that are too high, it can tip an economy into recession. When interest rates are high, borrowing money becomes expensive and people and firms stop taking out loans. Consequently, individuals stop spending money on big-ticket items, like homes, education, or home improvement projects, and businesses invest less and hire less, which decreases the number of jobs available.
The concepts we’ve reviewed so far relate to how an economy functions in general, and typically within the borders of one particular country. We’ll now look at how people, firms, and governments of different countries can interact with each other globally in an international market, buying and selling not only goods and services but also currencies. We’ll then discuss how international trade can benefit standards of living throughout the world.
The international market operates similarly to domestic markets, except on a global scale. The global nature of the international market adds complexity to business transactions, not only because of the logistics of buying and selling goods and services from far-away regions, but also because different countries have different rules, regulations, taxes, and currencies.
A currency is the unit of money a country uses to conduct its business. Different countries have different currencies—for example, the United States has the dollar, Mexico has the peso, and Japan has the yen. Each country also has its own governmental institutions that create and manage its currency.
A physical piece of currency is just a piece of paper or a coin, but it represents an amount of purchasing power that can be used for goods and services. To evaluate a currency’s purchasing power, economists determine how many goods and services it can purchase from a hypothetical “basket of goods” that includes a broad range of things for sale. Economists call comparing purchasing power across countries purchasing power parity (PPP). PPP can be an effective way of comparing the strength of different countries’ currencies.
People can trade or sell currencies for other currencies. Currencies behave just like any other item that can be traded or sold—their values rise and fall according to the laws of supply and demand. The price at which you can purchase one currency using another currency is called the exchange rate.
Today, most economies have floating exchange rates. This means that currencies are traded on foreign exchange markets (similar to stock markets but for currencies) and their values fluctuate against each other based on what traders are willing to pay for them. So, if a firm wants to, for example, change its dollars into yen, it would use the foreign exchange market to trade its dollars for yen at a price set by the supply and demand of each currency in the market.
Currencies can strengthen or weaken against each other, reflecting which one is more valuable to traders at any given moment. For example, if last week, one dollar equaled one pound, but this week, two dollars equals one pound, then the dollar has weakened against the pound: Each dollar can buy fewer pounds (in this case, one dollar would only be able to buy half a pound). If, however, this week one dollar equals two pounds, then the dollar has strengthened: Each dollar can buy more pounds.
The strength or weakness of a country’s currency has direct effects on importers and exporters:
Overall, a currency responds to supply-and-demand market forces: A country with a healthy economy will often have a strong currency, since a strong economy attracts investors who purchase that country’s currency in order to conduct business in and with the country. This increases demand for the currency, driving up its price.
Currencies also respond to governmental policies, such as interest rates. A government might adjust the strength of its currency in order to manufacture some short-term benefits, such as propping up their exporters by purposefully weakening their currency.
To a large extent, the world is economically interdependent. Exports have increased from 8 percent of global GDP in 1950 to 25 percent today, meaning that countries are trading many more of their goods and services abroad. The increase in international trade is often called globalization. Overall, international trade makes all the countries involved richer and raises their standards of living, be they rich or poor to start with.
International trade allows poor countries to escape poverty. In fact, for a poor country to become a rich country, it must engage in international trade; there has never been a country in modern history that developed without doing so.
International trade helps poor countries in several ways:
Although the benefits to international trade are enormous overall, this isn't always true on an individual level. Sometimes, people lose their jobs due to economic or technological advances brought on by international trade and end up with a permanently lower standard of living. If this happens, people sometimes decide globalization is the source of their problems and rebel against it, demanding protectionist policies to shield themselves from foreign competitive pressures.
When a government institutes protectionist policies, it puts up barriers to trade. These can be in the form of taxes, tariffs, quotas, regulations, or sanctions. These barriers keep foreign goods and services out of a country, thereby protecting the country’s own industries from competition. However, domestic firms protected from competition have few incentives to innovate, increase productivity, or lower prices, and consequently, economies with many protectionist policies in place typically grow stagnant and expensive for consumers.
Economics is the study of how we allocate resources—not only tangible resources like food, clothing, and money, but also intangibles like time, effort, and knowledge. To understand this process, economists begin by examining incentives: the driving forces behind our decisions. This study makes up the field of behavioral economics, a relatively recent branch of economics, and one of the most applicable to our everyday lives.
By understanding the psychological instincts that steer us and how we respond to incentives, we can better understand how market forces work and make more informed decisions about how to spend or use our own resources. Additionally, governments and firms can use this information to design incentives that foster a healthy economy.
In Naked Economics, bestselling author Charles Wheelan strips away the complexity from some of the most powerful theories in economics, allowing readers with little or no background in the subject to understand many of the field’s most fundamental concepts. He skips over the more technical, mathematics-based aspects of the discipline and concentrates instead on the logical pieces of how and why people behave in certain ways, how markets function, and how governments can design incentive systems that encourage healthy economies.
We’ll structure our discussions by walking through different aspects of markets one by one:
A market is essentially a collection of billions of separate transactions that form a complex economy in which people can earn and spend money to fund their lives. A capitalist market functions cohesively not because a centralized authority tells it what to do, but because each transaction works together efficiently. The paradox of the market is that while individuals use the market to increase their own individual well-being, in the process, they increase everyone else’s well-being also.
In this chapter, we’ll explore some basic ideas underpinning capitalist markets:
A capitalist market is essentially a way to allocate resources. Because there’s a finite supply of anything that’s worth having—almond butter, clean water, spin classes, computer repair-people—we are faced with a basic problem of how to determine fairly who gets what, how much of it they get, and at what price they get it. Instead of determining these things through a centralized authority who doles out resources (as in a communist economy), a market allows individuals to decide these things for themselves: how much to pay and to charge for any particular thing that’s for sale.
By matching buyers with sellers, a market directs resources to where they will be most productive. For example, when diners start ordering more tuna in a particular restaurant, that restaurant’s manager will start ordering more of it to sell. This has knock-on effects: The tuna distributors respond by delivering more tuna, the fishermen on the other side of the globe start catching more tuna in place of, say, sole and invest in equipment more appropriate to tuna-fishing to help them do so, which causes equipment makers to increase production of tuna nets, and so on. In each step, money and resources are diverted to where they’re most useful through the simple mechanics of market demand.
In general, the market improves the lives of everyone involved in its transactions by increasing opportunities for more people to make income, and by increasing the variety of goods available to consumers. For example, a neighborhood corner store might stock coffee, cereal, pasta sauce, newspapers, and paperback novels. The production of each of these items involved a complex set of interactions between people from every corner of the globe, not only providing city dwellers with culinary and reading options but also providing an income for a vast array of people: Everyone benefits.
There are different ways to measure how markets improve peoples’ lives, but the most obvious is that markets reduce poverty by enabling people to earn incomes and improving their overall standards of living. As just one example, the technological and medical advances made possible by the market-driven pharmaceutical industry have seen us control diseases like polio, typhoid fever, and whooping cough. Over the course of the 20th century, average American life expectancy rose from 47 years to 77 years, while infant mortality dropped by 93 percent.
Sometimes, people object to capitalist economies by arguing that people can only improve their lives through the market by taking resources away from someone else. This mistaken belief is based on the idea that a market is a zero-sum game: one in which someone can only win if someone else loses.
A capitalist economy is not a zero-sum game. It’s a positive-sum game: When certain segments of a market become richer or more productive, they make other segments richer and more productive also. This happens not only through exchanges of money, but also through intangible benefits due to improved standards of living: For example, successful pharmaceutical companies enable people all around the globe to enjoy healthier lives.
Further, when certain people find jobs, this doesn't mean that other people then have no jobs (a position put forward by the lump of labor theory, which mistakenly holds that there are a finite number of jobs to go around). On the contrary—in general, jobs create more jobs. If you get a job, you have money to spend, which supports someone else’s job. Again, everyone benefits.
This fact is proved by data. In the latter half of the 20th century, millions of women and immigrants entered the workforce. If the number of jobs had remained unchanged in response to this influx of workers, the unemployment rate would have skyrocketed. However, the unemployment rate stayed low. The U.S. economy produced millions of new jobs and entire new industries. While there are some short-term job losses with the rise of new industries (which we’ll explore in Chapters 12-13), overall, more jobs are created than lost.
Economics is based on the assumption that incentives drive the market. This means the incentives of both individual people and also individual firms, each of which are working to benefit their own particular well-being.
In the following section, we’ll explore how:
We’ll then explore some ways in which incentives can work poorly, distorting the market instead of allowing it to function properly.
The first assumption of economics is that people will do what they can to maximize their utility. “Utility” can be thought of as happiness, and maximizing it means making yourself as well-off as possible.
Utility means different things to different people. Different people have different priorities, and when you maximize your utility, you’ll balance life’s competing influences differently than other people will. People make different decisions based on how they prioritize the following dichotomies:
Whatever a person's individual priorities, a capitalist market allows her to make decisions to satisfy them. And in the same way that the market, in general, maximizes the productivity of its resources, individuals will do the same. As an example, George Clooney would surely have been an excellent car salesperson. But his unique resources—his looks and charisma—could be more productive, and earn him a higher income, being put to use as an actor. He therefore maximized his utility by choosing the career he did.
Although economics assumes that people do things to make themselves better off, this doesn’t mean that they always succeed at these efforts. Sometimes people do things that feel like a good idea but actually harm them. This is often because people don’t consistently act rationally to better themselves. Instead, they act emotionally, and in doing so, make several common mistakes:
(Shortform note: For an in-depth discussion of how and why people misunderstand risk and probability, read our summary of Fooled by Randomness.)
The second assumption of economics is that firms work to maximize their own utility, which typically means profits. They must make choices when doing so, designed to meet the desires of their potential customers while competing with other firms offering similar products. Some of the choices they face include:
For each of these choices, firms must balance how to best allocate their own resources—time, money, assets, knowledge, and labor. Each firm will balance these resources depending on its unique situation. For example, in the United States, labor is expensive but machinery is relatively affordable for firms, so you’ll see a landscaping company hiring a small team of people to work complex, efficient machines like ride-on mowers. In other parts of the world, the opposite is true: Machinery is unaffordable but labor is cheap, so you might find a large team of people cutting a lawn by hand, using sickles.
Prices are the mechanisms through which people and firms decide how much each can benefit from the market and from each other. Firms and individuals connect when a sale is made. Prices regulate these connections, and reflect the supply and demand for any item on sale: how much of something is available and how much people want to buy it.
When sellers and buyers settle on a price that reflects a balance between supply and demand, they’ve set the market price for that particular thing, where its price encourages enough demand from buyers to generate an acceptable amount of profit for the seller. There is often a complex process involved in arriving at that price: In general, when prices increase, fewer people buy that thing, so the demand drops relative to its supply. If demand drops enough, vendors respond by lowering the price. When the price drops, people start buying that thing again, which increases demand, which in turn increases prices again.
When setting prices, vendors must anticipate demand and try to set their prices to best encourage and capitalize on it. They must strike a balance: Too much demand, and they run out of supply. Too little demand, and they sit on unsold supply.
Because of the constant adjustments sellers make to find an item’s market price, most markets are self-correcting; that is, when supply and demand get out of line with each other, market pressures, fueled by prices, generally push them back into place.
Some industries adjust almost instantaneously to these influences of supply and demand, driven by real-time changes in buyer preferences. The stock market is one such industry: For any company, there will be a finite number of shares for sale (supply) and a certain number of buyers (demand). As the number of buyers fluctuates, the market price for those shares adjusts automatically.
However, most industries don’t react so directly to customer demand, and instead determine prices through company decisions. Company executives try to predict customer demand and how it will affect profits. In doing so, they try to find a price high enough to make a profit but low enough to encourage demand. For example, if a company offers a shirt for $10, they may sell out of it but only net a small profit off each shirt. However, if they charge $100, they may make a large profit off each shirt, but they may sell very few of them, resulting in a warehouse full of unsold shirts and an overall profit loss.
Prices are driven by what people want to buy, and in a free market, this is more of a reflection of scarcity than of importance or need. For example, people pay high prices for diamonds, which are scarce, even though they can’t sustain life—but water, without which we can’t live without, is practically free because it is plentiful.
Prices only reflect one aspect of what people actually pay for something. There are subtle costs involved in any transaction that the listed price either reflects or is discounted by. For example, an expensive pair of shoes in a store near your office might not actually be more expensive to you than the cheap shoes in a shopping mall an hour’s drive away, if you have to give up paid working time to go get the “cheaper” shoes. Similarly, a “free” ticket to a play isn’t truly free if you have to stand in line for eight hours to obtain it.
There are additional, societal, costs to an item as well. These costs are even more subtle and harder to quantify. The cost of a car isn't merely its price tag—it’s also the price your children will pay to clean up the pollution your car produces. We’ll discuss how governments are involved in managing and accounting for these types of costs in Chapters 3-4.
The last point we’ll discuss regarding incentives is how incentives can sometimes work poorly. In general, self-interested incentives help an economy work well—in the pursuit of personal income, people and firms produce goods and services that benefit others. But sometimes, incentives drive people to do things that harm the economy or to behave poorly. This happens either when people misunderstand incentives or when well-meaning incentives produce unintended consequences. The following sections examine some ways incentives can go wrong in both the private and public sectors.
Corporate America is riddled with competing and misaligned incentives, which commonly manifest in one of two ways:
Each of these is discussed below.
The Principal-Agent Problem
The principal-agent Problem is when two people who are working together in an employer/employee dynamic have differing goals, leading to problems for the long-term stability of a company.
When a company (a principal) employs someone (an agent), they often have differing motivations. The principal wants to make money off their customers, but the agent might want to make money off the company (over and above a salary). For example, a fast-food restaurant wants to profit from food sales, while a cashier might want to pocket the money from the transaction for herself. (This is one reason some fast-food restaurants tell customers that if they don’t get a receipt, their meal is free—it ensures that cashiers are running transactions through the register.) These misaligned incentives exist at the higher levels of the corporate world, too: Executives have an incentive to, for example, use company money for corporate cars, jets, and vacations.
Misaligned incentives can influence important business decisions, which can have serious repercussions for a company’s future. For example, CEOs have a strong incentive to engineer corporate mergers, since running a larger company brings them personally more status and income. Unfortunately, two-thirds of such mergers don’t increase the value of either company involved, and one-third actually decrease it. Thus, while the CEOs benefit, the shareholders they supposedly work on behalf of don’t.
The principal-agent problem also manifests when an employee takes risks with company money assuming that if those risks go bad, the employee herself won’t shoulder the consequences; the company will. This is partly what drove the housing bubble leading up to the financial crisis of 2008—tens of thousands of investment bankers buying up shaky loans at the investment firm’s expense.
Solutions to the principal-agent problem can create their own problems of distorted incentives. For example, corporations often try to align their employees’ interests with their own by offering stock options, whereby an employee is given the option to sell a certain number of shares in their company if the share price rises above a particular price. The thinking is that employees will then work to increase the market value of the company. However, this only incentivizes top executives to artificially drive up a stock’s short-term price so that they can cash out when the value is high. If the measures they took to drive up that price ultimately weaken a company, well, that’s someone else’s problem.
Even when two parties working together have very similar incentives, the principal-agent problem can still arise: for example, when you contract with a real estate agent to sell your home. It benefits you both to sell the house at a good price, but with one caveat—your realtor is incentivized to price your home a little low and move it quickly so she can move onto selling the next home, while you’re incentivized to price it high and wait longer for a better offer.
The Communal Resource Problem
Individual incentives can also create problems in markets built around communal resources. Communal resources are finite resources of which everyone uses a piece, but no one in particular owns—such as fish in the ocean. Systems based on such resources distort incentives because personal incentives rarely align with the incentives of the larger group, and often, people have incentives to cheat the system. For example, while it benefits all fishermen as a group when each individual fisherman limits her catch (because if everyone limits their catch, the fish supply will last forever), it benefits each individual to catch as many fish as she can before the other fishermen do (which depletes the fish supply and destroys the resource for everyone).
Usually, the only solution to problems of common resources is governmental regulation ensuring that no one party is able to take more than their fair share. However, such incentives have to be designed properly or they exacerbate the problem. For example, when Massachusetts tried to slow the depletion of fish stocks off the Cape Cod coast by imposing an overall, aggregated limit of how many striped bass could be caught by all fishermen collectively, it incentivized each fisherman to catch as many as she could as early in the season as she could, depleting fish stocks even faster.
Contrastingly, the coastal community of Port Lincoln in Australia established more effective incentives to protect their local lobster population: The community created licenses that set quotas for each individual fisherman, rather than for the group as a whole, thus allowing each operator to catch lobsters throughout the season without the fear that others will top out the quota first. Fishermen can also sell their licenses, turning them into a retirement plan—a license purchased for $2,000 in 1984 might sell today for close to $40,000. This gives individual fishermen a personal stake in the industry and therefore an incentive to protect it; their license will only be valuable if the lobster stock remains healthy. These regulations have enabled generations of fishermen to make a living.
This leads us to consider the role of government in setting incentives, for as the above examples illustrate, sometimes problems can arise when individuals act in their own self-interest. It’s then that the government must step in to regulate.
To create good policies that address societal or market-based problems, lawmakers must harness incentives wisely to direct peoples’ behavior in the desired way. This is difficult, and lawmakers often either ignore incentives or wrongly predict how incentives will change a person’s behavior. They therefore create policies that have unintended consequences, worsening the very problems they’re trying to solve—or creating brand new problems.
For example, Mexico City tried to solve their smog problem by ruling that all cars had to stay off the streets on one day every week. The government enforced the law by regulating license plates: Plates ending in, for example, 5 couldn’t be driven on Mondays. However, instead of limiting their driving habits, people simply bought second cars with different license plates. The ultimate effect of the policy was more cars on the roads, not fewer.
This isn't to say that governmental intervention always gets it wrong. When done properly, restrictions can produce their intended results. For example, London also tried to reduce traffic in the city center by charging a congestion fee for all drivers entering a certain perimeter. The regulation worked well, lowering traffic by 15 to 20 percent.
Use a Broad Brush
Why did the London example work while the Mexican efforts didn’t? It might be because the Mexican restrictions were too narrowly focused on one particular segment of the market—cars with certain license plates—which made the restrictions easy to skirt, while the London fees applied to all vehicles that entered the city center during certain hours, making the restrictions much more difficult to avoid. In general, broad restrictions are more successful because there are fewer exceptions within them that people can manipulate.
Another benefit of broad restrictions is that when responsibilities are spread among many people, each person’s responsibility is small, reducing the incentive to evade it. For example, if everyone is charged a small fee to cross a bridge, no one really minds. But if only, say, silver cars are charged a fee, and it's a high enough fee to subsidize everyone else, then people will simply switch from driving silver cars to cars of other colors.
While incentives in a capitalist economy may not always get it right, they mostly do. Capitalism may be a flawed option, but it’s better than the others available.
Take, for example, communism, where production is separated from self-interest. In a communist economy, a company offers and prices goods based on instructions from a central authority. Additionally, that central authority pays firms a predetermined set price, which the firms receive no matter how many goods they produce or sell. In such a system, where firms and people aren’t rewarded for hard work, people work less and don’t bother innovating or becoming more efficient: They have no incentive to act otherwise. A striking illustration of this was the state of East German car manufacturers at the time of the fall of the Berlin Wall; they were operating so inefficiently that the cars they produced were worth less than the steel they contained.
You don’t have to descend into full communism to see how ignoring self-interest creates perverse incentives. The American public school system ties wages to seniority and rigorous certification rules rather than to performance, even though seniority and certificates have not been shown to benefit students. Because such a system doesn’t reward performance, it creates a process of adverse selection, whereby the most talented individuals select themselves out of the field, since their talents won’t be properly rewarded in that industry.
Communal resources are finite resources of which everyone uses a piece, but no one in particular owns—such as fish in the ocean. Systems based on such resources distort incentives because personal incentives rarely align with the incentives of the larger group.
Describe a time you operated in a market based on communal resources. (This doesn’t have to be a traditional, capitalist market—did you ever divide up communal chores between roommates or pitch into a project at work that involved many people but had no clear leadership?)
What kinds of problems did you or other members of your group encounter in dividing up responsibilities or the resources of your communal asset? (For example, did one person take more than their fair share of communal food, or did someone shoulder more responsibilities than others?)
How might these problems have been better managed or avoided entirely?
Now that we’ve explored some basic concepts of economics, let’s look at the role governments play in markets.
A government makes a capitalist market possible. Though people, including many politicians, sometimes speculate about how much better the market could operate if there were little or no government control of markets (or even society), the truth is, countries without strong governments have almost non-existent markets in which it’s difficult to conduct even simple transactions. For example, businesses find it almost impossible to operate in Somalia, where a lack of government means there’s little infrastructure or protection against criminals.
In this chapter, we’ll explore the different ways a government can facilitate a functioning market economy. We’ll also explore the ways it can destroy one: Government intervention in the economy isn’t always beneficial.
The most essential thing a government does to benefit the economy is provide laws and infrastructure that allow businesses to conduct transactions. Without a set of rules that everyone involved in a market agrees to, and which can be enforced, a market can’t smoothly operate (or operate at all). Laws and regulations allow people to trust complete strangers in situations where they otherwise wouldn’t be able to. This is why you can, for example, give your money to a bank teller and feel confident you’ll see that money again later. Your transactions with other individuals are protected as much as with firms: You can send an online payment to a person on the other side of the world and feel comfortable that you’ll receive the, say, necklace you ordered—and they’ll feel comfortable they’ll receive your payment.
Without established property rights enforced by the government, you could spend your time, money, and other resources growing a crop of wheat, only for someone else to come to your farm and harvest it for themselves—and you would have no legal recourse against them.
Property includes intangible things as well as tangible ones, like ideas (protected by copyright laws, patent laws, and trademark laws). In order for an economy to produce anything of value, ideas must be protected—if a firm develops, for example, a new medication, and other firms are allowed to simply copy their formulation and sell it for their own profit, the first firm will have no incentive to create the medication in the first place.
Property rights can also include even more complicated notions of “property.” For example, do you own the right to enjoy a quiet night’s sleep, or does your neighbor own the right to leave her barking dog in her yard all night? Noise ordinances and other such regulations can help resolve these disputes.
One of the most important responsibilities of a government is building and maintaining goods that everyone benefits from:
The private sector wouldn’t be able to provide these goods because of the “free rider” problem, which is what happens when something expensive is paid for by one person but then enjoyed by all.
For example, if a clothing company realized it needed paved roads for its delivery trucks to reach customers, and it decided to fund those roads itself, then it would be at a disadvantage against its competitors, who’d get to use the road, too, but at no cost to them—meaning they’d be able to conduct business without the debt of the road-building project weighing them down. Because of this inherent competitive disadvantage, the clothing company would never bother to create the roads in the first place, and therefore all companies would remain worse off, unable to easily transport items. A government, paid for by taxes, is the only fair solution to such problems.
A government prevents a capitalist economy from devolving into a fully polarized structure in which some people reap all the rewards and others reap none. To do so it redistributes some wealth from the richest to the poorest citizens. This doesn’t mean directly taking cash from wealthy people and handing it to poor people, but instead, taxing people who have excess funds in order to pay for safety-net programs that help people in financial need. These programs include unemployment payments, food stamps, and the like.
Decisions you make affect other people, even when those other people didn’t have a say in your decision. For example, if you buy a large, gas-guzzling car, there are social costs:
Economists call this an externality, or the difference between the cost of something to one individual and the cost of it to the wider society. Governments manage externalities by passing regulations to limit the damage that one person’s decisions might have on another person’s quality of life. This task falls to governments rather than individuals because a government’s reach is wide, while an individual has only a narrow perspective on the world and is either unable to see how her decisions affect other people or unable to do anything about it.
A government can manage externalities through either regulation or taxes. Regulations ban certain things in order to protect a large number of people from the personal decisions of a few: For example, zoning boards in local governments sometimes ban ugly buildings or ones that block views. However, a government can’t ban too many things or it will become authoritarian, infringing on people’s freedom to choose how to live. For this reason, governments often use taxes to discourage unwanted behavior.
Taxes are effective because they increase the private cost of something that has social costs. Increased private costs deter people from doing or buying certain things. For example, increasing the cost of driving a heavy, gas-guzzling vehicle by adding a fuel tax will encourage people to buy more fuel-efficient cars. Taxes also limit those behaviors to individuals willing to pay more for them.
Taxes have other benefits as well:
While a government must establish rules that allow for a functioning economy, if it sets too many rules, or gets too involved in managing economic operations, it can destroy an economy in a number of ways:
Taxes can distort incentives.
Each of these ideas is explored below.
One major way that a government can steer an economy wrong is by misdirecting resources. While a market directs resources according to where market demand indicates they’re needed, a government directs resources according to how individuals in power want them to be directed. These individuals often have motives that don't align with the movies of the rest of society.
For example, in the early 1990s, the federal government funded the building of a high-speed particle accelerator. The best building spot for the accelerator would have been Illinois, which already had much of the necessary scientific infrastructure built because of previous projects. However, the government chose to locate the accelerator in Texas, not for practical reasons but because the President at the time, George W. Bush, hailed from Texas and wanted the prestigious project built there. Because there was no existing infrastructure or expertise in that area, the price of the project skyrocketed and work was ultimately halted—after the government had spent over $1 billion on it.
When governments direct resources to pet projects because of a personal preference, taxpayers lose in two ways:
Governments can also interfere with an economy’s operations by implementing too many regulations. Regulations are a subtle way of directing resources and money, and they can raise the cost of doing business in various ways—for example, through excessive licensing requirements or paperwork. When businesses incur extra costs because of regulations, they typically raise their prices, making goods and services more expensive for consumers.
For example, regulations ensure that lawyers are well-educated, so that consumers can be sure to hire qualified legal help. To a degree, this is a good thing for consumers, because it protects them from unqualified lawyers. However, the educational standards for lawyers are exorbitant, requiring many years of school and ongoing certifications, and are not necessary for the majority of legal work that many consumers need advice on—much legal work is simple paper-filing, not complicated prosecutions. As a result, lawyers are very expensive, and sometimes consumers can’t afford them. Consumers would be better off if they were allowed to choose between lawyers of differing levels of credentials.
Regulations can also stifle growth by propping up specific industries. They are often used by these industries to protect their incumbents. Such incumbents are called special interest groups: groups that influence governmental policies. Special interest groups promise politicians votes in return for policies that benefit them, but that don’t necessarily benefit the rest of the economy. An example would be corn farmers, who pressure politicians into imposing corn-sourced ethanol requirements in gasoline, purportedly because ethanol makes gas more environmentally friendly. Even though the scientific evidence for the benefits of ethanol is scant, politicians continue to promise ethanol regulations and ethanol subsidies because corn farmers make up a powerful voting block.
Regulations supported by special interests have a number of negative effects on an economy:
1. They prop up industries that couldn’t otherwise sustain themselves (like the ethanol industry detailed above).
2. They waste taxpayer money on projects that don't benefit most taxpayers (such as funds for local museums paid for by federal dollars).
3. They erect barriers to people trying to enter an industry, which makes it harder for qualified people to offer their services. For example, the training and certification regulations for teachers haven’t been shown to raise teacher performance, but do serve to protect existing teachers from competition. In fact, most new certification laws that are introduced exempt existing teachers—if such laws were truly necessary for the benefit of students, all teachers should be subjected to them.
4. They raise prices for consumers, without providing additional benefits. For example, in many states, people wishing to become manicurists have to complete stringent licensing requirements, not because consumers regularly get injured from pedicures, but because existing nail salons want protection from incoming immigrants offering cheaper prices. Such regulations deliver few benefits to consumers but allow existing salons to keep their prices high.
5. They prevent creative destruction, which is when markets destroy an existing system when creating a new one. For example, the rise of streaming services destroyed the business model of retail video-rental stores. Creative destruction is a natural part of an economy, and regulations that prevent it by protecting industries from being destroyed or altered also prevent companies from innovating in ways that benefit consumers.
Taxes are an important source of income for a government, enabling it to provide the services needed to run an economy. However, if taxes are not well-designed, they can harm an economy by distorting people’s incentives in a number of ways:
1. In order to avoid taxes, rich people often try to exploit tax code loopholes, moving their money to different investments or even to a different location—states or countries—with laxer tax laws. Tax avoidance acts as a drag on productivity in an economy, since it directs business activity away from productive pursuits and instead toward tax evasion. This type of activity also exacerbates inequality because in general, only rich people can afford accountants who can exploit the tax code.
2. By taxing income, a government essentially punishes work, which can discourage people from working. The effects of this can be seen when married couples are lumped together under the same tax bracket: The earner who pulls in less income will end up paying a much higher tax rate than she would pay by herself, making her efforts significantly less financially rewarding. Since these second earners are typically women, such taxes discourage women from staying in the workforce. This can have a tangible effect on workforce participation; after the 1986 tax reforms addressed this issue in the U.S., women’s participation in the workforce increased threefold.
3. If tax rates get so high that the people being taxed feel they’re unfairly treated, they’ll create a black market to conduct their business. This can be a real problem in some high-tax countries; for example, experts estimate that a shadow economy in Norway expanded from 1.5 percent of gross national product in 1960 to 18 percent of it by the end of the 20th century. Further, when people drop out of the official economy and stop paying taxes, everyone else’s taxes rise, which then encourages more people to move into the black market, and it becomes a downward spiral.
Some economists argue that since taxes punish work (as well as discourage investment by taking away some of the future returns of a firm investing in a business), they should be reduced to almost zero. These economists argue that such tax cuts would encourage such economic growth that they would pay for themselves, because the smaller taxes recouped from the increased economic growth would more than equal the larger taxes taken from smaller economic growth.
Unfortunately, this belief is based on a misunderstanding. It’s true that cutting taxes and rolling back regulation can encourage productivity, but such cuts will only pay for themselves if they’re swinging the tax rates from one extreme to another. For example, if tax rates are set at 95 percent of income, that economy is probably slow-growing (such high rates remove almost all incentives to work hard or invest in businesses). If those taxes get reduced to 5 percent, that economy is likely to take off to such an extreme that the government will end up raking in much higher revenues.
However, in a country like the United States, where tax rates are relatively low—and certainly lower than many other developed countries—a further tax cut isn't going to pay for itself. Instead, it will simply deprive the government of revenue that it could use to keep the economy running smoothly, defend the nation, educate children, and so on.
Therefore, the answer to how much the tax rate should be falls somewhere in the middle of two extremes, leaving the door open to debate.
Unfortunately, examining all the pros and cons of various methods of taxation does not produce the ideal tax that will effectively encourage the right kind of actions all the time. Different approaches will always result in conflicting incentives for different facets of the market, and will always prioritize a solution to one problem over another.
For instance, the problem of rich people cheating the tax code could be solved if a government used a flat tax instead of a progressive tax. A flat tax sets one rate that affects everyone equally, while a progressive tax takes a larger percentage of rich people’s incomes than poor people’s (which is why rich people try to manipulate their incomes through creative accounting).
However, a flat tax (also called a regressive tax) has its own drawback: It falls harder on poor people than on rich people. For example, at a flat tax rate of 25 percent, a person earning $40,000 a year has to pay $10,000 while a person making $400,000 has to pay $100,000. It’s much harder for the poorer person to live on her resulting net income of $30,000 than it is for the richer person to live on her net income of $300,000.
There are also negatives to using taxes to incentivize good behavior or to manage externalities. For example, taxing large cars might encourage people to buy smaller cars, but it carries its own sets of unfair consequences:
It can be hard to know where to draw the line between too little and too much governmental involvement in the economy, but a good place to start is with this guideline: Governments should never provide goods or services unless there is a compelling reason to do so. In general, a government should act as a provider of last resort for any goods or services, allowing the private sector to provide these things instead whenever possible.
This is because a government is a monopoly, meaning it has no competition (at least, within its own country). Monopolies are generally bad for an economy because they lead to inefficiencies: If you have guaranteed customers, you have few incentives to work hard to attract or keep those customers.
However, there are some situations in which a monopoly is a better option for a particular good or service—for example, if competition might lead to decreased quality as firms compete for customers on price. For this reason, agencies dedicated to public health or safety, such as the Department of Motor Vehicles, should stay in the hands of the government; if private companies were to issue driver’s licenses to less-safe drivers in order to get their business, unsafe drivers on the roads would harm society as a whole.
Another reason justifying governmental monopoly is if it provides a service that private firms would not be able to because of logistics, technology, or profits. In America’s early days, this justified the government providing a postal service—no private firm had the delivery infrastructure to reach every corner of the country, nor the incentive to do so, as delivering to remote, rural areas wasn’t profitable. However, today, private firms such as FedEx and UPS have proven that these issues are no longer relevant, and the postal service no longer needs to be a governmental provision.
One way a government can combine the oversight of a monopoly with the efficiency of the private market is to act as a mediator; it can oversee government programs but hand the operation of those programs over to private firms. Done well, this can allow for the best of both worlds—the government can keep an eye on quality, while firms can compete on price and efficiency in order to win governmental contracts. This is the way that many roads are built: Governments field bids and assign the work to the company best positioned to complete the work properly.
The next elements of economics we’ll discuss are information and human capital: Any economy is driven in large part by these two major influences. In these two chapters, we’ll explore how each element affects individuals, businesses, and the functioning of an economy.
Information, and who has access to it, has an outsized influence on how smoothly an economy runs. A free flow of information allows for easy and smart transactions. Information imbalances—when one party knows more than the other party in a transaction—put one party at a disadvantage to the other: Markets generally favor the party who has more information.
To counter information imbalances, people and businesses will try to glean information about what they’re buying from indirect sources. This process affects how people and businesses interact with each other.
You’re often at a disadvantage when you make a purchase because the business selling you a product knows more about its quality than you do. You won’t be able to fully judge its quality until after you’ve purchased it—for example, you won’t know if you like a burger until after you’ve paid for it and eaten it. The burger company, however, knows ahead of time what the quality of their burger is; they know how they’ve made it and how other people before you have reacted to it.
To counter this inherent disadvantage, people seek information in a number of ways:
Sometimes, businesses can be at a disadvantage because they have less information about a transaction than their potential customers. This is not such a problem for companies selling goods like shoes because the habits and preferences of their customers don’t affect them much beyond that individual sale.
However, an imbalance of information can be a significant problem for companies that forge a long-term relationship with a customer, such as insurance companies, which may be affected for many years by the lifestyle choices of their customers. For example, a life insurance company is exposed to more financial risk from a customer who skydives than from one who does not, and it benefits the company to know which customers have such habits.
Such companies can counter their information imbalances by either:
Demanding information: In certain situations, a company might refuse to offer services to a customer unless they have more information. Life insurance companies are a good example of this. They typically require health exams of their potential clients to set a client’s fee structure appropriately, based on their overall health and life expectancy.
Structuring their services to encourage customers to reveal information: A company can’t always demand proof of a customer’s health—for example, health insurance companies are sometimes not legally allowed to. This puts the health insurance company at a significant disadvantage when it comes to setting prices for their plans: If the company offers cheap insurance, and their customers need lots of medical care, the company won’t be able to cover their costs. But if it offers expensive insurance, not enough people will sign up to make the company self-sustaining.
If the insurance company knew which customers are generally healthy and which customers will likely require lots of care, they could offer cheap plans to the healthy people and expensive plans to the sicker people. Naturally, however, the sicker people aren’t going to volunteer this information. So, insurance companies allow their customers to self-select by offering different plans with different deductibles. A deductible is a predetermined out-of-pocket expense that an insured person pays before her insurance kicks in. A person with a $5,000 deductible will pay $5,000 in medical expenses before insurance takes over; a person with a $100 deductible will pay only $100 before insurance kicks in.
Deductibles encourage customers to be honest about how much medical intervention they’re likely to need in the near future. Cheaper insurance plans have higher deductibles. They attract people who anticipate needing few or no medical interventions in the near future and are therefore willing to take the risk of a one-time high medical expense (in this example, having to pay $5,000 if they, say, break their arm) in order to pay overall lower insurance rates. Expensive plans with low deductibles attract people who anticipate going to the doctor more often and don’t want to keep paying high healthcare costs out-of-pocket—for example, an elderly person who has ongoing health problems might want her insurance to kick in after just $100 of out-of-pocket expenses, and will pay a higher annual rate for that benefit.
Another situation where information imbalance can put a business at a disadvantage is when they interview people for a job: People aren’t always honest in job interviews. In order to figure out what a job candidate might not be telling them, interviewers try to glean information from related sources they think might reveal something useful. Sometimes this can be relatively innocuous, like when an employer thinks a candidate who went to a good school is a good candidate, assuming that the school vetted her. Sometimes, though, this can lead to discrimination, where one party, afraid of what they don’t know about the other party, assumes something based on information that is somewhat related but may or may not be correct in this specific instance.
This is called statistical discrimination, or rational discrimination, and it can lead to discrimination for what appear to be logical reasons. For example, studies show that when an employer wants to avoid hiring someone with a criminal history, she is less likely to hire black men if her company doesn’t conduct criminal background checks as part of the employment process. However, if the company does conduct criminal background checks, her discrimination disappears, and she is as likely to hire black men as other demographics. The theory supposes that with a lack of real information, she relies on related information to try to make informed guesses—in this case, the fact that more black men have criminal backgrounds than other demographics, leading her to believe she is less likely to hire an ex-con if she avoids all black men.
Governments can also be at an information disadvantage: Individuals know more about their own lives than they’ll let on to the government when remaining silent gives them an advantage. Well-intentioned policies often fail as a result.
For example, in the 1990s, Yale University experimented with a scholarship structure that allowed students to borrow money for their education and pay it back not with a typical payment schedule, but from a percentage of their future earnings. The idea was that students who went on to become, for example, highly paid doctors would subsidize the educations of those who went on to become, say, social workers in low-income areas. In this way, people would not be discouraged from choosing careers devoted to helping others—careers that generally don’t pay well—because of the need to pay back expensive college loans.
Unfortunately, the experiment failed and had to be discontinued because the students knew more about their future plans than did the people running the scholarship, and they selected themselves either into or out of the plan depending on whether or not it would benefit them. Those who planned to go on to high-paying careers recognized that the percentage structure would disadvantage them later, and therefore they opted for other, more traditional loans. The only people left who wanted the scholarship were those who planned to go into low-paying industries, because they recognized that the percentage structure would benefit them later. Without the high earners to subsidize the low earners, the scholarship couldn’t sustain itself.
The second market influence we’ll explore is human capital. Your human capital is the sum of what makes you valuable and marketable as an individual. It’s your intelligence, athletic ability, education, and work experience. It’s also less quantifiable traits like charisma, work ethic, creativity, and honesty. It’s what you would be left with if all of your wealth and assets were stripped away from you: What would you be able to use to rebuild your life if that happened? People who’ve invested heavily in their education and training have more human capital than do, for example, high school dropouts with addiction problems.
As with other items for sale, the price of a person’s human capital (the income they can command for their skills) reflects the capital’s scarcity, not its inherent value. For example, a civil servant who helps raise people out of poverty might make less than a star basketball player. This is a reflection of the fact that there are many civil servants working with that same skill set, while there are only a few basketball players who excel to that level.
Economies with higher levels of human capital are stronger than those with lower levels, for a number of reasons:
We’ll explore each of these reasons below.
Human capital creates wealth for everyone, not just for the individual who has the capital, due to the way it supports entire economies. Economists estimate that 75 percent of our modern economy is driven by personal resources like education, training, health, and skills, not physical resources like oil and steel.
This accounts for the striking correlation between economic wealth and human capital in any given country, while there is a decided lack of correlation between economic wealth and natural resources in a country. For example, Japan and England—countries with lots of human capital—are among the richest countries in the world despite having relatively few deposits of natural resources. Conversely, Nigeria has enormous oil deposits but its citizens have a comparatively low standard of living because they don’t have as much education or access to job training—things that would increase their human capital.
Further, and to a large degree, poverty is caused by a lack of human capital more than by a dearth of jobs. A lack of jobs is often a reflection of a society filled with people with low human capital, who don’t have the skills and education needed to contribute to the economy and create jobs.
One of the most difficult problems that poor countries face is high birth rates but few resources to properly care for their populations. While many people think that high birth rates cause a country to be poor, the causality actually runs in the other direction: Poverty causes people to have large families. This is not only because the cost of raising children is cheaper in poor countries, but also because those children are less likely to reach adulthood for a variety of reasons (malnutrition, disease, and violence being just a few), so parents have more kids as insurance.
When parents start accumulating human capital—through education or work experience—the cost to raise kids increases, both because parents start investing in their children more and also because raising children takes time that could otherwise be spent making money (opportunity costs). Further, as a country gets richer, the likelihood that each child will survive increases, which lessens the pressure for parents to have more children.
Consequently, when a population starts accumulating more and more human capital, its birth rate starts to decrease. This usually has a positive cyclical effect of then allowing parents to accumulate even more human capital (as they can spend their time and resources on things like education and work instead of caring for children), which encourages parents to have fewer children again as they start to feel more secure in the futures of the children they do have. Countries caught in such a positive cycle increase their overall standards of living, as parents with smaller families increase their financial stability.
Therefore, the best way to control population growth is to increase human capital, which leads to economic opportunity. The proof of this can be seen across the developing world, where increased education and economic opportunities (especially for women, who often drive the family planning decisions), have led to fertility rates decreasing to or dropping below replacement rates of 2.1 births per woman.
How an economy uses its human capital determines how efficiently it turns inputs into outputs—which in turn determines productivity. Inputs include time, money, labor, materials, and other resources. Outputs are tangible goods like cars, clothes, and houses, as well as intangible goods like health care and computer programming. Productivity rises when we can get more outputs out of fewer inputs. For example, a factory worker who makes a lamp in 10 hours is more efficient than one who makes the same lamp in 30 hours. A farmer who gets 100 bales of hay from a field is more efficient than one who gets only 15 bales from it.
Productivity depends upon human capital: A labor supply that is capable, educated, and healthy. Countries that have ready supplies of these kinds of workers, especially for skilled work, can offer productivity that lesser-developed countries can’t rival. This is why warnings from politicians about other, lesser-developed countries stealing domestic jobs en masse are mostly overblown. When deciding where to locate a factory, firms must take into account productivity as well as labor costs: A worker who costs half as much as a domestic worker but produces only a tenth as much is not a good bargain.
Further, productivity—and productivity growth—is what makes a country rich. Productivity growth explains why a typical American household needed 1,800 hours of labor to amass its annual food supply in 1870, while today, it only needs about 260 hours of labor. When goods become cheaper in terms of the work-hours needed to purchase them, consumers can afford more items, and their standard of living rises.
Human capital goes a long way toward explaining economic inequality. By almost any measure, America is unequal and is growing more so: In 2004, the bottom fifth of American households in terms of income distribution earned only 2 percent more than they did in 1979 (inflation-adjusted), while the top 20 percent of Americans saw their income increase by 63 percent in the same time frame.
This divergence corresponds with a divergence in the levels of human capital at either end of the economic spectrum and an economy that increasingly rewards skilled workers (those with human capital). Almost every industry has shifted toward a need for computer skills, which has decreased the need for low-skilled workers but increased the need for high-skilled ones. For example, automatic teller machines have made many bank tellers redundant, but at the same time, have created jobs for computer programmers who design the machines.
However, because computer training and other such capital-building investment is often unaffordable for those at the very bottom of the social-economic ladder, they get shut out of the fastest-growing segments of the economy, leading to increased inequality between the upper and lower echelons of society.
Economists have traditionally argued that inequality is an acceptable part of a healthy economy for two reasons:
However, economists are starting to question the absolute truth of these assumptions. People don’t actually react to inequality in a way consistent with these assumptions, because the assumptions don’t take into account certain aspects of human nature.
On the first point, there may be a level of inequality at which differences in income are no longer motivating, but are instead de-motivating. When poor people feel so disenfranchised that they don’t believe they can climb out of poverty, they start to reject some basic market foundations, such as the rule of law or property rights. A breakdown of the foundations of the economy benefits no one, as it creates problems of lawlessness and inefficiency that become a drag on the economy as a whole, affecting everyone.
On the second point, economists are starting to acknowledge that a person judges her wealth based not only on the absolute value of it, but also on its relative value in comparison to people around her. This means that economists are misjudging what constitutes “success” and misunderstanding what makes people satisfied with their lives. For example, a person earning $100,000 a year when everyone around her earns $75,000 will be happier than a person earning $200,000 when everyone around her earns $300,000, because the first person feels she’s earning more than her peers while the second person feels she’s earning less than her peers. Therefore, while it might seem on paper that the person earning $200,000 is better off than the person earning $100,000, the actual people involved may not feel the same way.
Thus, economists are starting to agree that a certain level of inequality might do more harm than good to an economy, because people react negatively to it emotionally and might therefore behave negatively as well.
Your human capital is the sum of what makes you valuable and marketable as an individual—your intelligence, athletic ability, education, and work experience, as well as your charisma, work ethic, creativity, and honesty.
Think about your human capital. What personal traits set you apart from other people and allow you to earn an income?
What kinds of human capital are vital to your industry, and why?
What additional human capital might you be able to accumulate in order to make yourself more valuable to your company or industry? How might you accumulate it? (For instance, could you take a class in a marketable skill?)
Information, and who has access to it, has an outsized influence on how smoothly an economy runs. A free flow of information allows for easy and smart transactions, while information imbalances put one party at a disadvantage to the other.
Think of a time when you had to make a purchasing decision but didn’t have a lot of information about the item or service you were buying. How did you try to obtain information that could help you? Did the information influence your purchasing decision? (For instance, did you look at online reviews for the item or service, find those reviews were negative, and decide not to buy the item?)
If you are in a similar situation in the future, what are some other ways you could seek more information to help you make a decision?
Think of a time when you had to sell someone else something (either an item or your services), and the other person felt hindered by a lack of information. How did you convey the information you felt the other person was looking for? (For instance, did you send them an email outlining all relevant information about your service?)
If you are in a similar situation in the future, what are some other ways you could impart information to the other person to help them make a decision?
We’ll now turn our attention to financial markets: markets specifically designed for moving and managing money. This includes stock and bond markets as well as insurance markets. What other markets do for tangible goods, financial markets do for capital—essentially, they direct it to where it can be the most productive, which, in general, is where it’s earning the highest return.
Financial markets service some basic human needs, which we’ll explore below. We’ll then discuss a common misbelief about financial markets, which is that you can “get rich quick” using them. Finally, we’ll briefly look at some basic investing guidelines.
Financial markets satisfy four basic needs that people have in an economy:
The most basic use of financial markets is to allow us to raise capital, either by borrowing money or by selling stocks. In either case, financial markets allow us to raise money for things we couldn’t afford otherwise—for a price, of course. Financial markets allow us to:
Financial markets allow us to store our excess money so we don’t have to use it as soon as we earn it. While we may take this for granted, consider that throughout most of human history, people couldn’t do this with their precious resources: They’d have to eat their harvest or their hunted animals soon after they’d acquired them, or they'd lose them to rot.
Financial markets also help us store our money safely, protecting it from theft. It’s harder for a robber to steal your money from a bank or from the stock market than from a shoebox under your bed.
Additionally, financial markets protect us from another, more subtle, thief: inflation. If you store your money in a shoebox, it will lose value over time, while if you invest it, it will (usually) keep up with inflation, or even grow faster than it.
Financial markets also give us opportunities to put our excess money to use and make it profitable, by connecting us with people who are looking to borrow money. This is essentially what we do when we, for example, buy stocks: We allow a firm to borrow our money to invest it in their business, on the assumption that we can profit off of it later.
Life, and business, is full of risks. Financial markets can help protect individuals and firms from the effects of bad luck, using:
Financial markets also enable another basic human instinct: the urge to speculate—to bet on price movements. You can bet against future prices for just about anything: commodities, corporate earnings, federal interest rates, and so on.
Speculation can, at times, lead to system-wide problems, which is what happened with the aforementioned credit default swaps in the 2000s. Credit default swaps can be used not only to hedge against risk in your own transaction, but also to bet on another person’s transaction. For example, you can bet on someone else’s chances of defaulting on their mortgage. When this gets out of control, so that thousands of these “bets” are riding on certain transactions, the effects of those transactions are multiplied. Thus, when people started defaulting on their poorly-structured mortgages in 2007, their losses were amplified throughout the market.
Because the stock market allows for speculation, some people think of it as an investor’s version of Las Vegas. However, there are far more differences between those two markets than there are similarities:
Financial markets such as the stock market have a reputation for allowing people to “get rich quick” by betting big on a stock that pays unexpectedly large returns. Unfortunately, this reputation is misleading. Although it certainly can happen occasionally—just as gambling in Las Vegas can occasionally make a person wealthy—the unremarkable truth is that get-rich-quick schemes usually fail because they hit two realities:
First, it’s unlikely that you know more than other investors about any particular stock. If you’re looking to bet on a stock that will increase in value significantly more than other stocks, you’re essentially looking for an undervalued stock that no one else has noticed—in a world filled with people constantly looking for these kinds of things. Not only are you competing with investors with decades of experience and training, but you’re also competing with supercomputers programmed to seek out pricing imbalances. The chance of you outsmarting them all is small.
The main reason you can’t outsmart other investors is that all information you can make trading decisions with is available to the public. In order to outsmart other investors, you’d have to have access to information about a company that other people don’t, such as yet-unrevealed test results for a new medicine. However, it’s illegal to trade on information that’s not available to the public, so even if you had access to such knowledge, you’d be unable to act on it.
Large, sudden price movements are driven by unanticipated occurrences, such as a company unexpectedly announcing that it missed its sales targets, or suddenly becoming the target of a criminal investigation. The paradox is that these events drive stock price changes because they’re unpredictable, which means—importantly—you can’t predict them any better than anyone else can.
Second, get-rich-quick schemes violate a fundamental principle of economics: that everyone, not just you, is looking to maximize their utility. In the same way that you want the stocks you hold to have a high value, other people also want the stocks they hold to have a high value. People don’t make money by underestimating the value of their stocks; if the stock is strong, they’ll price it accordingly. Therefore, if a company has a good chance of succeeding in its industry, its stock will typically reflect that, and you are unlikely to discover a stock priced low that is actually worth a lot.
Again, everyone in the market has access to the same data. Therefore, in general, stocks are priced to accurately reflect all the available information pertaining to them, and it isn’t possible to maintain long-term success by buying and selling undervalued and unnoticed stocks.
The purpose of this book isn't to detail investing strategies, but even still, there are a few guidelines you should know before making investment decisions:
(Shortform note: For a more in-depth discussion about smart investing, particularly through index funds, read our summary of The Simple Path to Wealth.)
Financial markets’ reputation as a way to “get rich quick” is misleading, because first, all information you can make trading decisions with is available to the public, and second, while you’re trying to maximize your utility (your happiness), everyone else is doing the same.
Describe a time you used financial markets to invest or speculate in a way that you hoped would earn you a quick return. What was the ultimate result of your speculation?
If you were successful, why do you think this was? (For example, was it because of good luck or because you had information before other people did?) Do you think you could consistently repeat your results in the future? Why or why not?
If you weren’t successful, why do you think this was? (For example, was it because of bad luck or because other people had information you didn’t have?) What might you do differently in the future to produce a different outcome?
Sometimes, an economy functions well: It grows at a healthy rate that allows many people to earn a good living. But sometimes, it suffers a period of stagnation or contraction, when people find it harder to survive or to thrive within the market. Every economy generally goes through periods of growth punctuated by periods of recession in what economists call the “business cycle.”
In these chapters, we’ll explore how economists measure the health of an economy, what causes an economy to fall into recessions, and how governments can respond to recessions to fix them (or better yet, to prevent them).
In order to properly evaluate the strength of an economy, economists must figure out how to measure economies in a way that allows for effective comparison. There are several markers of economic health that they look at, but the primary one is an economy’s gross domestic product, or GDP. GDP summarizes the value of all the goods and services an economy produces. It’s the number that people generally refer to when they talk about a country’s growth: If you say the U.S. grew 3 percent this year, what you mean is that the U.S. produced 3 percent more goods and services this year than it did last year.
To properly measure the wealth of a country, you must also consider its population, which is why economists often look at GDP per capita—the GDP of a country divided by its population— rather than simply GDP. If you don’t consider population, you can end up with misleading numbers. For example, India has a GDP of $3.3 trillion while Israel’s GDP is $201 billion. Without taking population into consideration, you might say that India is the wealthier country. However, because India’s population is so much larger than Israel’s (over a billion compared to several million), the GDP per capita works out to be approximately $2,900 in India and $28,300 in Israel, indicating that Israel’s population is better off.
While GDP does a good job of showing an overall picture of an economy’s health, it misses a number of important factors that determine whether or not an economy is functioning well and if the people operating within that economy are happy:
In addition to GDP, there are some other numbers that economists often refer to in order to judge how an economy is faring. These include:
Recessions are periods of time during which an economy’s GDP shrinks. They’re generally caused by a shock to the system—something unexpected and bad happening. Shocks might be the bursting of stock market or real estate bubbles (when exorbitant price increases are followed by sudden and devastating losses), a steep rise in oil prices (each of which preceded, respectively, the Great Depression of 1929, the financial crisis of 2007/2008, and the United States’ recession of 1973). Often a combination of causes leads to recession: For example, the American slowdown beginning in 2001 was sparked by the “dotcom bubble” of overinvestment in technology stocks, and was later exacerbated by the terrorist attacks of September 11.
Because all parts of modern markets are interconnected, the failure of one part of the economy can quickly cause other parts to fail as well. For example, if your income suddenly drops because of a stock market correction, you will respond by spending less money. Your decreased spending makes other people’s income decrease, who then respond by also spending less money, which spreads the pain throughout more and more sectors of the market.
When this kind of slowdown reaches banks, the entire economy can quickly freeze up. Our economy is very much based on credit: Many of the most basic business transactions require individuals and firms to borrow money from banks. When they can’t—because banks no longer feel confident lending out money, fearing that people won’t be able to pay it back—businesses can no longer invest or conduct business with each other, and individuals can’t borrow money to pay for things like houses, cars, or college. Everything grinds to a halt.
This is essentially what happened during the financial crisis that began in 2007. First, homeowners leveraged themselves highly: They took on more debt than they could finance in order to pay for new homes, fueling a property bubble. They did so on the understanding that if they found themselves unable to repay their mortgages, they could simply sell their houses and pay off the debt. However, this strategy could only work if home values continued to rise, and when the property bubble burst and home values dropped, people found themselves unable to pay their mortgages and also unable to sell their homes for enough money to cover their debts.
The resulting wave of foreclosures devastated investment banks. These banks were not only highly leveraged with mortgages but also with the credit default swaps we discussed earlier, which amplified the effects of homeowners defaulting on their mortgages. Lehman Brothers, a major investment bank, declared bankruptcy, and the global financial market froze as panicked banks stopped lending people money.
To counter recessions, governments can change their fiscal policies or their monetary policies to encourage businesses to begin investing and consumers to start spending, so that the economy becomes self-sustaining again.
Through its fiscal policy, a government encourages spending by injecting money into the economy. It can do so by cutting taxes, which allows people and businesses to keep more of their income and then (ideally) spend it. It can also do so by creating stimulus programs that put money directly into the hands of consumers and businesses. For example, stimulus packages might mail checks directly to individuals or allow firms to apply for no-cost loans, or they may fund programs that create jobs, such as infrastructure projects like road-building.
Through its monetary policy, a government controls the supply of money in an economy. The Federal Reserve (the “Fed”) is the governmental agency in charge of monetary policy in the U.S. and is the world’s most powerful agency when it comes to affecting the economy, both domestic and global. Its monetary policy is the most powerful tool it has.
Monetary policy controls the amount of money in a market by increasing or decreasing short-term interest rates. Cutting interest rates allows consumers to buy more things and allows firms to invest because borrowing is cheaper. Raising interest rates puts a brake on the economy by raising the cost of money itself, making it harder for individuals and businesses to borrow capital.
The Fed uses these mechanisms to pull the economy out of recessions and also to prevent recessions from happening in the first place by keeping the economy growing at a healthy clip. Importantly, a healthy clip means growing not too fast and not too slow, and it can be difficult to strike the right balance.
When an economy grows too slowly, production outstrips demand. People don’t buy goods that firms produce, so those goods sit idle in warehouses or on lots, with no buyers. Unemployment rises because firms don’t need to hire workers if there are no transactions happening. The Fed can prevent this by decreasing interest rates and therefore making money cheaper to borrow, which encourages people to spend it.
Some people (often politicians) advocate for continually decreasing interest rates so that consumers and businesses can spend and invest all they want. However, there are limits to the speed an economy can grow. Firms can only produce items at a certain pace—a pace that depends on the availability of labor, factories, time, and other resources. Problems can arise when an economy is pushed faster than this pace. When consumers have easy access to cheap capital, they flood the marketplace with demand for items. When firms can’t keep up with demand, the market becomes unbalanced, with demand exceeding supply. As we discussed earlier, when demand exceeds supply, prices rise.
This leads to inflation: a continual and somewhat rapid increase in prices of almost everything in an economy, including both goods and services. To understand why inflation is so problematic, think of it not as prices increasing, but as the purchasing power of each dollar decreasing. This means that if you have $100, you might be able to buy four shirts today, but a month from now, you might only be able to buy two shirts.
Inflation leads to all sorts of problems:
Consequently, the Fed aims to set interest rates at a level that encourages growth but doesn’t allow inflation to set in.
On the other end of the spectrum are persistent price decreases. On the one hand, price decreases are an expected part of a healthy economy: As we discussed earlier, productivity can lead to increased purchasing power because goods are relatively cheaper in terms of how many work-hours it takes to purchase them. This is overall a good thing, allowing people to buy more with their money.
On the other hand, prices that are continually falling are terrible for an economy. This is called deflation, and it’s as destructive to an economy as inflation.
Deflation is a danger during recessions, making them much harder to recover from. When wealth drops after an economic shock, people start spending less on goods and services. When demand decreases because of this, prices drop. At a certain point, price drops perpetuate themselves: People postpone purchases knowing prices will drop further (why buy a television today if it will be cheaper next month?), which causes prices to drop even further, and so on.
The negative effects of this are significant. Decreased demand for goods and services leads to fewer jobs needed to produce them, so unemployment rises. House prices drop, leading to a decrease in wealth for households and an increase in foreclosures, as people can’t sell their homes for enough to pay off their mortgage. People caught between unemployment and decreasing asset values (such as homes) are unable to repay loans, and banks, scared of future defaults, stop making new loans, which again freezes the economy.
To make matters worse, monetary policy is often unable to stop deflationary cycles in the same way it can stop inflationary cycles. Once a government drops interest rates to zero—doing so to encourage people to borrow seemingly cheap money that they can then spend, boosting the economy—it can’t go any further. However, rates of zero may not be enough to make borrowing money actually cheap and spark spending. This is because, during deflation, your money gets stronger (the opposite of what happens during inflation, when your money gets weaker).
In other words, if you have $10, you might be able to buy two shirts today, but three shirts next month. This also means that if you borrow $10 today (two shirts worth), you’ll be paying back a more expensive $10 next month (three shirts worth). Thus, even with an interest rate of zero, it can be quite costly to borrow money. In a stagnant economy, people will not borrow expensive money, and lending shuts down, bringing the economy down with it.
Japan suffered through many years of deflation in the late 1990s and early 2000s, underscoring how difficult it is to break the cycle. When America flirted with deflation in 2007, the Fed lowered interest rates until they were no longer helpful, and then resorted to some creative ways to encourage spending—it allowed banks to borrow from the government anonymously so as not to burden them with the stigma of being in financial trouble, and eased certain regulations to make borrowing easier. In other words, it did whatever it could to inject money into the economy to stave off a deflationary cycle. This seems to be the only way to stop deflation: to flood the market with money by doing “anything short of dropping bank notes out of helicopters,” as one economist put it.
The concepts we’ve reviewed so far relate to how an economy functions in general, and typically within the borders of one particular country. We’ll now look at how people, firms, and governments of different countries can interact with each other globally in an international market, buying and selling not only goods and services but also currencies.
International markets operate similarly to domestic markets, except on a global scale. The global nature of the international market adds complexity to business transactions, not only because of the logistics of buying and selling goods and services from far-away regions, but also because different countries have different rules, regulations, taxes, and currencies.
A currency is the unit of money a country uses to conduct its business. Different countries have different currencies—for example, the United States has the dollar, Mexico has the peso, and Japan has the yen. Each country also has its own governmental institutions that create and manage its currencies.
In this chapter we’ll examine currencies, and how the international market uses them to function, covering:
A physical piece of currency is just a piece of paper or a coin, but it represents an amount of purchasing power that can be used for goods and services. To evaluate a currency’s purchasing power, economists determine how many goods and services it can purchase from a hypothetical “basket of goods” that includes a broad range of things for sale in any given country.
In theory, we can determine the values of currencies against each other by comparing how many goods and services each can purchase. This is called purchasing power parity (PPP).
For example, if 50 American dollars buy the same exact goods and services in the U.S. as 750 rand (R) do in South Africa, we can calculate that $50 is worth about R750 (and that $1 is worth about R15).
Economists and government officials use PPP to compare the relative strengths of different currencies and, in a related vein, the relative strengths of different economies. So, for example, if someone living in Israel earns 100,000 shekels a year, how much would she have to earn in American dollars in order to have the same standard of living in the U.S.?
To determine this, economists compare the prices of a hypothetical basket of goods in both countries to see which currency can purchase more goods. The basket of goods includes both tradable and non-tradable items: For example, it might include televisions (tradable, because you can sell and ship a television to another country) and haircuts (non-tradable, because you can’t ship a haircut overseas).
So, for instance, if you buy a dinner in India for the equivalent of 10 American dollars (converted into rupees), and that same dinner would cost you 40 American dollars in New York, this indicates that the dollar is stronger than the rupee, as it can buy more items priced in rupees. (In other words, the $40 that would buy you dinner in New York will buy you dinner, dessert, movie tickets, and a hat when you exchange the dollars for rupees and use them in India.)
While PPP can give us a rough estimate of the strength of one currency in comparison to another, this correlation can differ significantly from the currencies’ official exchange rates. For instance, with our dinner example above, this measure of PPP does not necessarily mean that an Indian rupee is “officially” worth exactly one-fourth of an American dollar.
This is because official exchange rates and PPP take into account different types of goods. Official exchange rates are highly influenced by trade, and because you can't trade non-tradable items, it's hard to factor them into the rate. However, as mentioned above, PPP does factor in non-tradable goods. Given that nontradable goods account for more than 3/4 of goods in a modern economy, it follows that PPP calculations would be very different from exchange rates.
Currencies can be traded or sold for other currencies. Currencies behave just like any other item that can be traded or sold—their values rise and fall according to the laws of supply and demand. The price at which you can purchase one currency using another currency is called the exchange rate.
There are several ways that a country can determine the value of its currency and its exchange rate:
The gold standard is the most straightforward way to assign value to a unit of currency. With this method, a country pegs its currency to a specified amount of gold. A government stores a reserve of gold, and you can trade a physical unit of currency for a specified amount of physical gold.
The gold standard has a few advantages:
However, the gold standard is an outdated method of valuing currency—no developed nations use it anymore. This is because it has a significant disadvantage: It can rob a government of the tools it needs to ward off recessions. A government using the gold standard can’t increase or decrease the amount of money in its economy through the fiscal policies that we discussed earlier; it’s beholden to the amount of gold in its coffers. Therefore, it has limited power to influence the flow of capital within its market.
Further, when an economy runs into trouble, foreigners who own that country’s currency lose faith in that currency, and often prefer to redeem it for gold rather than hold onto the currency itself, which they fear will lose value. When many foreigners do this simultaneously, they can drain a country’s gold reserves.
In order to protect its gold reserves, the country has to raise interest rates (because higher interest rates offer more value for investors who own that currency, they encourage people to hold onto the currency instead of trading it in for gold). Unfortunately, this is the exact opposite of what an ailing economy needs—as we discussed above, one of the most powerful things a government can do to fix a recession is to lower interest rates. Raising rates only puts a further brake on the economy, which makes it harder for that country to climb out of its financial troubles. This is essentially what happened in the early 1930s during the Great Depression in America, and it led to ever-increasing unemployment.
Today, most economies have floating exchange rates. This means currencies are traded on foreign exchange markets (similar to stock markets but for currencies) and their values fluctuate against each other based on what traders are willing to pay for them, instead of against something tangible like gold. So, if a firm wants to, for example, change its dollars into yen, it would use the foreign exchange market to trade its dollars for yen at a price set by demand in the market. (A firm might change dollars into yen for a variety of reasons—for example, if a Japanese company sells its product in America for dollars, and then wishes to pay its Japanese workers in yen, it will need to exchange those dollars for yen.)
Floating exchange rates are more flexible than the gold standard, because if a country needs to adjust its interest rates or to print more money, it can do so without the constraints of maintaining a physical gold reserve. The fact that the U.S. used floating exchange rates in 2007 to value its currency (instead of gold) allowed it to stave off the worst of the financial crisis with aggressive monetary policy adjustments.
However, this flexibility leads to a disadvantage as well: Firms conducting international business trust the system less, knowing that a government can adjust the value of its currency at any time.
Fixed exchange rates operate similarly to the gold standard in that they peg a currency to something else that has a stable value—in this case, instead of gold, they peg a currency to another country’s currency. Argentina did this in 1991, pegging its peso to the American dollar. To do so, it kept a reserve of U.S. dollars in its vaults, and it committed to only printing more pesos if it had dollars to back them up.
Unfortunately, a fixed exchange rate runs into the same problem that the gold standard faces: A country using this system can’t adjust its own monetary policy based on its real-time needs, because in order to keep its currency pegged to the other country’s, it must mirror the other country’s monetary policies. Therefore, when Argentina fell into a recession in the late 1990s, its government couldn’t cut interest rates or do anything else to stop the downward spiral. The system was unsustainable, and in 2001, Argentina defaulted on its debts—the largest default in history. The country was only able to move forward after unpegging its currency from the dollar.
Currencies can strengthen or weaken against each other, reflecting which one is more valuable to traders at any given moment. For example, if last week, one dollar equaled one pound, but this week, two dollars equals one pound, then the dollar has weakened against the pound: Each dollar can buy fewer pounds (in this case, one dollar would only be able to buy half a pound). If, however, this week one dollar equals two pounds, then the dollar has strengthened: Each dollar can buy more pounds.
The strength or weakness of a country’s currency has direct effects on importers and exporters. In general, a weak currency hurts importers and benefits exporters. To illustrate: If the dollar is weak, meaning it can buy fewer pounds, then an American trying to buy goods priced in pounds can buy fewer of them. Foreign, imported goods become expensive.
At the same time, a British person wanting to use pounds to purchase American goods can buy more of those goods. American exported goods become cheap for the rest of the world.
In contrast, a strong currency works in the opposite direction, helping importers and hurting exporters. So, if the American dollar strengthens against the British pound, so that dollars can buy more pounds, Americans buying imported British goods can purchase more of them, helping importers. However, the goods of American exporters become more expensive in Britain, so that the strong dollar hurts exporters’ sales.
Overall, a currency responds to supply-and-demand market forces: A country with a healthy economy will often have a strong currency, since a strong economy attracts investors who purchase that country’s currency in order to conduct business in and with the country. This increases demand for the currency, driving up its price.
However, currencies can also be affected by governmental policies. A government might adjust the strength of its currency in order to manufacture some short-term benefit, such as propping up their exporters by purposefully weakening their currency. To manipulate its currency, a government can do several things:
It can adjust interest rates: In general, higher interest rates attract investors because they promise more return for their investment. When more people invest in currency, it raises demand for it, strengthening the currency. Alternatively, lower interest rates attract fewer investors, creating decreased demand and therefore weakening a currency.
It can directly purchase or sell its own currency: To strengthen its currency, a government might start buying it up, trying to create scarcity. Conversely, to weaken the currency, a government might start selling it on the market. Britain tried this technique (unsuccessfully) in 1992, buying pounds to stop its currency from being devalued. Unfortunately, this isn't an effective technique, because a government’s efforts to buy or sell a currency are usually insignificant in comparison to the wider market forces—if countless investors are selling a currency, a government trying to buy it back won’t make a material difference to its price.
It can print money: If a government starts printing money, driving up inflation and weakening the purchasing power of each unit of currency, it can drive down the value of that currency on the market. A country might do this if it gets into a lot of debt with another country and wants to devalue that debt. For example, say America owes China $1 trillion (and it does)—if the Fed doubles the number of dollars on the market so that each dollar now has half its purchasing power, then America’s debt gets cut in half.
Now that we’ve discussed currencies, we’ll look at international trade in general, and how it can be used to improve living standards around the world. We’ll also look at what countries generally need to thrive economically.
To a large extent, the world is economically interdependent. Exports have increased from 8 percent of global GDP in 1950 to 25 percent today, meaning that countries are trading many more of their goods and services abroad. The increase in international trade is often called globalization.
Overall, international trade makes all the countries involved richer and raises their standards of living, be they rich or poor to start with. It does so by:
International trade also allows poor countries to escape poverty. In fact, for a poor country to become a rich country, it must engage in international trade; there has never been a country in modern history that developed without doing so.
International trade helps poor countries in several ways:
Sometimes, rich-world social advocates object to what they see as negative effects of globalization that the poor world suffers, and try to impose regulations intended to counter these ills. However, people in the rich world have different priorities than people in the poor world, and sometimes what the rich world sees as problematic, the poor world may not. When rich world activists impose their own values on the developing world, they can create problems rather than solve them.
For example, rich-world people often object to the low wages paid to factory workers who produce goods for international firms in developing countries. However, while these wages might be low in comparison to Western wages, they’re often high relative to local wages, and people in poor countries are often happy for the work because they don’t have many other options.
When people in rich countries boycott goods made by certain factories because of their working conditions, causing those factories to close, the people who worked in them often end up worse off—they can’t simply go work for another factory if there aren’t any other factories. For example, in 1993, American legislation proposed banning imports from countries using child labor. In response, Bangladeshi textile factories stopped hiring children. Unfortunately, Bangladesh was not developed enough for all former child workers to either go to school or be taken care of by financially stable families, and many of those now-unemployed children ended up either homeless, in poorer-paying jobs, or being forced into prostitution.
A better way to improve working conditions in foreign factories is to encourage more trade, not less. When a country’s overall GDP rises, its standards of living improve, and people eventually have the ability to demand higher standards for themselves. However, if they’re kept poor, they can’t get to that place.
People from rich countries also try to impose their environmental concerns on poor countries. However, people in poor countries are concerned first and foremost with survival, which means they’re not going to care about certain things that people in rich countries have the luxury of caring about, like pollution. For example, people in poor countries would prefer to have functioning factories even if those factories pollute the air. In another example, the insecticide DDT has been banned from most developed countries because it’s so destructive to the environment. However, in some poor countries, it’s still in use because it’s one of the most effective ways to prevent malaria. Malaria kills more than a million people in developing countries every year, and is a far more pressing and immediate problem for those populations than the long-term effects of DDT.
Again, the best way to improve environmental conditions in the long run may be to increase trade. Countries that get richer start caring about the environment more and have more resources to solve or mitigate problems. However, governments of developing countries should make sensible development decisions while they’re growing in order to avoid future problems—for example, they should build cleaner power plants now so that they don’t have to be retrofitted later to lower emissions.
If rich world governments truly want to help environmental problems, they could help fund these kinds of projects, rather than trying to set regulations that developing countries won’t benefit from and therefore won’t abide by (such as bans on imports from countries who engage in non-environmental practices).
Although international trade benefits a country as a whole, sometimes it doesn’t benefit certain individuals within that country. Some people will lose their jobs because of foreign competition: For example, a shoemaker from Vermont might not be able to compete with an influx of cheaper shoes from China. In these cases, some people can end up with a permanently lower standard of living.
A government can help soften these effects for the people who suffer them. It can:
When people lose their jobs because of foreign competition, they sometimes demand protectionist policies to shield themselves from those foreign competitive pressures. Protectionist policies are barriers to trade, and can be in the form of taxes, tariffs, quotas, regulations, or sanctions. These barriers keep foreign goods and services out of a country, thereby protecting the country’s own industries from competition. Protectionist policies do save some local jobs, but at steep costs:
International trade isn’t the only thing that countries need to thrive economically (although it certainly helps; one study found that during the 1970s and 1980s, developing economies that were open to trade grew by 4.5 percent annually while those closed to trade grew by only 0.7 percent). We’ve already discussed some of the other things any economy needs to succeed:
Additionally, there are some other factors that have proven important to the economic development of certain countries:
Fortunate geography: The majority of countries classified as “rich” by the World Bank lie in temperate zones, with the exception of only Hong Kong and Singapore. Economists posit that high temperatures and heavy rainfall, common in the tropics, inhibit food production and spread disease, which means that countries located in tropical regions have problems of basic survival to contend with that other countries don’t. For example, New Yorkers don’t have to worry about malaria, and can therefore focus their energies on other things.
To counter this fundamental problem, rich-world governments could offer incentives to firms to address the kinds of problems tropical countries face. Britain attempted this in 2005 by encouraging pharmaceutical companies to compete to develop vaccines for poor-world diseases, and by committing to purchase a certain number of doses of the “winning” vaccine.
Limited natural resources: Earlier, we discussed the fact that human capital has more influence on a country’s success than a wealth of natural resources. This works in two ways: Not only does human capital allow for more innovative investments, but evidence also suggests that having a wealth of natural resources can actually be detrimental to a country’s development—consistently, countries with a rich endowment of natural resources like minerals or oil are poorer and less advanced. Economists believe this is because of three reasons:
Democracy: Consistently, economies in countries with democratic political systems are stronger and more resilient than those in countries led by authoritarian governments. Democracy acts as a check against ill-thought-out monetary policies that might benefit only a ruling elite, such as the appropriation of private property and capital.
Peace: National security provides a safe place for firms to conduct business. Companies can’t effectively produce and trade goods if they have to worry about armed combatants destroying their assets or killing their workers.
Equality for women: Countries that allow their female population to be educated and to work develop better than those who don’t. Not only is it poor policy to bar half your working-age laborers from working, but women also tend to act more responsibly with their wages, spending their money on nutrition for their families, medicine, and housing, rather than drinking and smoking, which is what men often spend their wages on (studies of how men and women spend windfalls of income in developing countries back this up). For this reason, foreign aid administrators have found their funds do more good for a country when they’re given to the female head of a household rather than the male.
Sometimes, rich-world social advocates object to what they see as negative effects of globalization that the poor world suffers and try to impose regulations intended to counter these ills. Unfortunately, though well-intended, these “solutions” often make problems worse, not better.
Describe a time you boycotted goods from a developing country, or saw others doing so, because of social advocacy. (For example, did you ever avoid a product because of news about poor factory conditions or a bad environmental record?)
What is a better way you could aid in the welfare of people in the developing world? (For example, could you contribute to organizations that work to improve living conditions in developing countries?)
There are many different flavors of capitalism: Some allow for more of a free-for-all, while others are more concerned with minimizing capitalism’s drawbacks. In each country, people must decide for themselves what kind of market they want, weighing their priorities and voting for governments that support those priorities. In doing so, governments and their people must consider several basic questions:
How will we maximize our utility? In general, as a population’s wages go up, people start to work longer hours. At some point, though, people start to decide that time is more important than additional money, and they start to work fewer hours. Each country—and each person within it—must decide for themselves where they want to draw that line: For example, will we end up working 50 hours a week and earning a lot of income, or will we decide we prefer to work 30 hours a week and enjoy what we can of our lesser income? Will we derive more utility (happiness) from listening to vintage records or walking in the park than working so that we can buy more records and a house closer to the park?
How do we slice up the pie? Some countries, like the United States, value a market that doles out large rewards to those who can grab them, but also tolerates harsh inequalities. Other countries, like those in Europe, discourage inequality but as a result, stifle overall growth. For example, regulations protecting workers from being fired only discourage firms from hiring in the first place, resulting in higher unemployment rates and a great percentage of people working part-time or gig-by-gig. Every country needs to decide where on the spectrum of economic freedom they want to operate, and how much inequality they’re willing to tolerate.
How will we use incentives to encourage good behavior? What punitive fees will we tolerate in order to ensure long-term desirable outcomes? For example, will we continue to subsidize car travel by making it cheap to own and drive a car? Or will we accept so-called “green taxes” that increase the costs of using non-renewable resources, bringing them more in line with their actual, overall costs to society as a whole (such as environmental costs)?
How will we manage externalities? How will we determine which elements of our society should be protected from market forces to maximize people’s overall happiness? How do we balance the desires of people who oppose strip malls because they’re “ugly” with those of people who want them because they provide easy, affordable shopping?
How do we manage risk in the financial markets? Figuring out fiscal and monetary policies that will consistently deliver healthy, sustainable growth is an ongoing challenge for governments. As different pieces of the economy become more integrated, they must adjust their techniques. For example, while classic economic theory advocates letting struggling businesses fail, in practice, when the government let the investment firm Lehman Brothers fail in 2008, the entire economy almost failed with it. Governments must continue to study how to allow the market to punish wrongdoers without punishing everyone else as well.
How will the world eradicate poverty? How can the rich world help governments in the poor world establish institutions that support a thriving market economy?
There’s no ultimate right answer for every economy, and each country might experiment with a number of approaches before finding one that suits its needs. In the end, the process of finding the right solutions to economic challenges is inherently ongoing, as solutions that work today might not satisfy tomorrow’s evolving priorities.
The first assumption of economics is that people will do what they can to maximize their utility. “Utility” can be thought of as happiness, and maximizing it means making yourself as well-off as possible.
At what level of income will you be happy to spend more time outside of work, enjoying the fruits of your labor rather than pursuing more income? What specific factors will determine when your income becomes sufficient for you?
For which quality-of-life improvements would you give up some income? (For example, would you accept a smaller paycheck for a shorter commute, or more time to exercise?) How much would each of these improvements be worth to you, and how might you determine their value?
Make a list of some things that bring you happiness. Think about how much time you spend on each item. How might you adjust your time to devote more energy to the things you enjoy?