Value is of central importance to the study of economics, because at its core that's what
any financial system is all about -- assessing and working to improve the value of a
particular product or service. A product provides value by:
- Helping to produce more or better goods -- improving
- Allowing us to exchange one good for another that we need or
- Helping us improve our self-image and sense of self-worth.
While the first two examples of value creation are measurable
and reasonably objective, the third is very subjective. A large house in a particular
suburb has more value to some people than to others, and has nothing to do with efficiency
or exchange. Yet, even with equivalent resources, some families are willing to pay for a
particular piece of real estate while others are not.
The last piece of the value pie has to do with scarcity.
Items that are scarce tend to go up in value versus those that are ubiquitous and easily
obtainable. (More on this later in the sections on Supply and Demand and Utility.)
The fact that we value what is scarce is deeply ingrained in
both our mental hardware and software: Hardware-wise, scientists have identified a
"novelty" gene, which determines our enjoyment (high value) of ideas and
activities that are new and different (scarce). On the software side, psychologists use
the term "semantic undifferentiation" to describe the process by which words and
concepts tend to become meaningless (low value) as they become overused (ubiquitous).
(Those in the communications field use the term "wear out" to describe this
Example: Pick an emotionally "hot" word, such as a curse or one with sexual
connotation. Say it over and over. What happens? It starts to become meaningless the more
we say it or think it. (This is one of the reasons we become immune to violence and
profanity on television. The more we see of it, the less we become shocked. Unfortunately,
if we're no longer shocked, we tend to forget that others, especially children, have not
yet built up the same "tolerance".)
Another basic tenet of economics is that people act out of rational self-interest, trying
to maximize their own personal "utility functions". This means that we each try
to increase our personal welfare by weighing the costs and benefits of decisions and
possible actions as we perceive them.
Rational self-interest is a fairly complex, and sometimes
contentious, concept. For one thing, what's rational to person A (e.g., buying a car) may
not be rational to person B (who decides to purchase a bicycle). For another,
self-interest does not necessarily mean selfish: Self-interest involves improving one's
own lot, both physically and emotionally, without necessarily affecting the welfare of
others; while selfishness involves personal gain at someone else's expense.
Obviously, rational self-interest is different for different
people. It can be affected by one's political and ideological views, morals, social
standing, age, experiences, level of self-worth and financial situation. The fact that we
all assign different weights to these various factors leads us to assign different costs
and benefits to a particular opportunity, explaining why two people can value the same
item so differently!
...and the Division
Adam Smith pointed out that the entire economy benefits from having each individual work
to maximize his or her self-interest. The reason has to do with the fact that modern
economies are based upon a division of labor, whereby people and organizations are most
effective and efficient when doing what they do best. Such a division creates enormous
interdependencies which force societal players to work together, rather than selfishly, if
positive results are to occur and be sustained. To quote Mr. Smith:
"...man has almost constant occasion for the
help of his brethren, and it is in vain for him to expect it from their benevolence only.
He will be more likely to prevail if he can interest their self-love in his favour, and
show them that it is for their own advantage to do for him what he requires of them... It
is not from the benevolence of the butcher, the brewer, or the baker, that we expect our
dinner, but from their regard to their own interest."
Both modern game theory (Prisoner's Dilemma) and
biology (evolutionary stable strategies and "selfish genes") affirm Smith's
observations: Social organisms work together, realizing that over the long run it is
cooperation, rather than exploitation, which provides the most benefits to the most
Supply and Demand
Tied directly to costs and benefits, as well as to scarcity, is the most famous of all
economic concepts -- supply and demand. Starting with demand, we will examine the two
parts separately and then join them back together.
When economists talk about demand, they don't mean needs or
wants, but rather the desire for a product that is backed by the willingness and
ability to purchase it. Demand is inversely related to the price of an item: the more
something costs, the less demand there will be for it, and vice versa.
Supply, on the other hand, is defined as the willingness
and ability of a producer to make an item available for sale at a variety of prices.
Supply, too, is related to the price of an item, but unlike demand, it's a direct
relationship: the higher the price that a producer can charge for a product, the more of
that product he or she is willing to produce.
Supply and demand come together in the marketplace, where
buyers and sellers size each other up. Buyers weigh the costs and benefits of an item, and
producers try to sell the most number of units at the highest possible price. At the point
where buyers are willing to pay the price asked by sellers, who can sell all they can at
that price, the market is said to have reached equilibrium. Equilibrium is
tantamount to what's known in physics as "neutral buoyancy", since market forces
are equal and thus at rest. However, buyers and sellers are not necessarily happy, as the
former would still like to pay less and the latter would still like to charge more.
In theory, a laissez-faire (hands off) approach to
markets allows for the achievement of equilibrium. However, in many cases, governments and
societies have concluded that while efficient, market mechanisms are not always fair or
desirable. Thus, subsidies are created that compensate farmers for prices that are too low
to provide sustainable incomes; tariffs keep out the goods of other nations to protect
domestic industries; and price ceilings are used to reduce the ability of producers to
raise prices for particular items (such as apartments).
Such intervention always produces some amount of
disequilibrium: farm subsidies and tariffs raise the cost of food to consumers and reduce
competitiveness; while rent controls can actually reduce the supply of affordable housing.
(Click here to read the Cato Institute's Rent Control Study.) Thus, it is
imperative that societies understand the long term effects of market intervention so that
they can accurately determine if a.) the medicine will in fact lead to the cure, and b.)
the value to the few is worth the collective costs to the many.
In most cases, the relationship of supply to demand is not a straight line -- a 5%
increase in price doesn't necessarily lead to a 5% decrease in demand. The way to measure
the effect of price on demand is through elasticity: If a small change in price
leads to a large change in demand, pricing is considered to be elastic. If a change in
price has little effect on demand, pricing is considered to be inelastic. Thus, raising
the price of an item with elastic demand, such as yachts, will reduce revenues, while
raising the price of inelastic products, such as cigarettes, will increase revenues, since
sales volume will go up far faster than product volume will decline (if it declines at
Price elasticity is affected by three factors:
- The availability of substitutes -- more substitutes
mean that people have the opportunity to switch to comparable products that cost the same
- The proportion of budgets involved -- goods that
account for a larger proportion of someone's discretionary spending will be more elastic,
as the effect on their budgets will be more pronounced.
- Time -- longer time periods lead to more elasticity.
That's because the ability to find or create suitable substitutes, change attitudes or
modify behavior increases over time.
Understanding price elasticity is of critical importance to
policy makers, since results are highly dependent upon the three factors listed above.
Consider the following:
Due to habituation and the absence of substitutes, the demand for illegal drugs remains
strong. This means that policies that try to cut supply only end up increasing prices.
Thus, dealers become richer, while drug users turn to crime to pay for their increasingly
costly habits. The effect on society is far less positive than originally expected.
Thus, it can be seen that creating policies designed to
reduce demand for inelastic products such as cigarettes and gasoline require a long term
perspective, possibly by seeking alternatives (substitutes) and/or developing impactful
education programs (time). Otherwise, the only major effect will be higher profits for the
producers and/or the creation of black or "gray" markets.
Equity and Efficiency
In simple terms, equity means doing the right thing, while efficiency means doing things
right. A sense of equity develops a concern for fairness and justice, while efficiency
involves getting maximum value from minimum resources. Since unregulated economies would
strive primarily for efficiency, "the law of the jungle" would most likely rule:
Those who couldn't make it would perish. Thus, a desire for equity produces an environment
whereby society deems it necessary to "create a level playing field" to help
those who are less fortunate, or a "safety net" for those incapable of helping
From an environmental, health & safety standpoint, the
concept of maximum value for minimum impact is commonly referred to as Eco-efficiency.
Assuring a "clean" environment for all societal members -- both those of today
and tomorrow -- is referred to as Environmental Justice. These concepts of equity
and efficiency are integrated to form a broader premise known as Sustainable
Development. While there are many definitions of the term Sustainable Development, a
commonly accepted one is offered by the Bruntland Commission:
Meeting the needs of today's generations without
compromising the ability of future generations to meet their needs.
Financially speaking, assuring a reasonable level of equity
carries costs that will ultimately reduce efficiency. Once again, it is up to society to
determine the relationship between equity and efficiency that will produce the quality of
life that it is collectively seeking.
While much of life is hard to measure, economists try to do so by using the concept of
utility, which is the amount of satisfaction derived from consuming a particular good or
service. Utility thus combines quantitative factors such as weight and size, with
qualititative considerations such as color or status. There are three dimensions to the
- Total Utility -- the total amount of satisfaction that
an individual receives from all of the units of a particular product consumed in a given
period of time.
- Marginal Utility -- the additional satisfaction
received by consuming one more unit of the particular product.
- Diminishing Marginal Utility -- the fact that as more
units of a product are consumed, less additional satisfaction is received from each
say you're about to have a turkey dinner, which can be divided into 50 bites. We'll assign
a value to the entire dinner of 100. Is each bite worth 2, which is 100 divided by 50?
Think about your experiences: The first bite, which is highly anticipated as both a taste
sensation and hunger reliever, is worth much more than the last, which no longer thrills
the taste buds and may actually provide more food than we need. In reality, bite one may
be worth 20, and bite fifty may be worth little more than 0. Thus, there is diminishing
marginal utility as we eat our meal. That's because the value, or benefit, of the bite
we're about to eat is less than that of the bite that's just left our forks.
The concept of marginal utility, also known as diminishing
returns, works for all resources, not just food. Just as an ounce of turkey is worth
more to a starving woman than to a satiated one, a dollar is worth far more to a pauper
than it is to a prince.
To an economist, a cost is anything that is given up to obtain something else. Costs
result from scarcity: if anything you wanted was easily and abundantly available, there
would be little cost involved!
Types of Cost
There are two basic types of costs to be considered when making decisions:
The explicit cost of taking the bus may be $1.00, while the explict cost of taking the car
(gas and parking) is $2.00. If the implicit costs of taking the bus (waiting, not getting
a seat) are much greater than $1.00, and driving has no implicit costs, you'll end up
behind the wheel. Thus, decisions that appear irrational when only looking at explicit
costs appear very rational when implicit costs are factored into the equation.
- Explicit Costs -- These are the visible costs of
purchasing something, and are fairly easy to measure. They're the out-of-pocket costs of
buying goods and services, measured in dollars or other forms of currency.
- Implicit Costs -- These are the opportunity costs
involved in using resources that don't involve direct payment. They can include factors
such as quantity of time (too much or too little), quality of time (with friends, family
or boss), effort or aggravation.
Sunk costs are costs which occurred in the past and cannot be retrieved. Let's say that
the Air Force has spent $3 billion on a new bomber design which new technology has
suddenly made obsolete. The $3 billion is a sunk cost. No amount of extra effort or
funding can change the current situation. Rather than "spending good money after
bad," the best (and sometimes hardest) thing to do is to write it off and move on.
An externality is a cost or benefit that the organization which created it doesn't receive
or pay for. We'll concern ourselves with negative externalities, which are costs created
by an organization but which are paid for by others.
Second hand cigarette smoke is an externality. Non-smokers,
who may get sick from the smoke, bear the costs but not the responsibility. Polluters who
do not have to pay for the costs of prevention or clean-up have created externalities in
the form of pollution and a degraded environment. Thus, government or other third party
intervention is usually required to "internalize" the costs and put them on the
ledger of the producing party (hence the almost universal agreement to the concept of
"the polluter pays").
Externalities make many of our largest and most troubling
environmental concerns -- population growth, energy consumption and loss of biodiversity
-- hard to visualize and remedy. For example, most people don't think about or pay for the
pollution created when they start their cars. By not capturing theses costs and passing
them back to the polluters (drivers), we keep the price of fuel artificially low, and
continue to create huge amounts of carbon dioxide and other greenhouse gases. A key to
solving these problems goes back to the concept of elasticity -- internalize them through
the proper combination of pricing signals, education and acceptable substitutes.
The way in which societies finance their public undertakings is through taxes. These are
compulsory payments by businesses and individuals for which no direct benefit is received.
Tax policies strive to be both efficient and equitable. An efficient tax is easy and
inexpensive to collect. An equitable tax affects people of similar situations equally
(horizontal equity); those of differing circumstances differently (vertical equity); or
The way in which taxes are levied is a key
determinant in tax policy. There are three ways to relate taxes to individuals:
Tax Rate Progressivity
From Economics, An Integrated Approach, by B. Davis
- Proportional Taxes -- All individuals pay the same
proportion of their incomes, say 20% as shown above. Since those with higher incomes pay a
higher absolute amount, vertical equity exists. If the tax is applied across the board,
horizontal equity also exists.
- Progressive Taxes -- Tax rates increase as incomes
rise. Again, vertical equity exists, and as long as people with similar incomes are taxed
equally, horizontal equity exists as well.
- Regressive Taxes -- Tax rates decrease as incomes rise.
Since those with higher incomes may still end up paying more even though the proportion is
lower, vertical equity can still be met. Once again, if those of equal means are taxed
equally, horizontal equity also exists.
From a policy perspective, the development of tax structures
must start with clear goals and an understanding of elasticities. Otherwise, revenue goals
may not be met due to unexpected consequences.
In 1990 the U.S. government felt that the rich were not paying their fair share of taxes.
It was decided that one way to create a highly progressive tax that affected primarily the
upper income brackets was to tax luxury goods -- expensive cars, planes and boats. Results
were far from anticipated, since legislators didn't factor in price elasticities: The tax
made buying luxury items unaffordable, even for the wealthy, who reduced their purchases
by more than 50 percent. This led to massive layoffs of lower and middle class workers,
since manufacturers couldn't sell or produce more goods. Thus, less tax was actually
collected and the people who really paid were those who lost their jobs.
Nothing seems to scare economists (and most other people) more than the spectre of
inflation. The reason is that inflation signals a decrease in buying power, meaning that
money loses it's value: It takes more of it to buy tomorrow what less of it will buy
today. If allowed to advance unchecked, inflation can cause signficant social misery and
political upheaval: In Germany, the Great Depression led to a huge inflationary spiral
that raised prices by a factor of about a trillion. The resulting economic chaos
allowed the Nazi Party to topple and then take over the German government.
From a business perspective, there are two types of
inflation. Demand pull inflation occurs when the demand for products and services
begins to outstrip supply, leading manufacturers to raise prices. Cost push
inflation occurs when the cost of raw materials rises, causing manufacturers to pass their
extra costs along to their customers and eventually to consumers.
The two are obviously related. If demand for oil increases,
producing nations will raise their prices (demand pull). Buyers of oil, who convert it
into gasoline, pharmaceuticals and chemicals, will pass their higher prices on to their
customers (cost push). If raised high enough, the higher prices will reduce demand and the
inflationary cycle will slow.
Another potential cause of inflation is deficit spending by
governments. When outflows exceed tax inflows, governments must borrow or print money. The
effects are similar: Government borrowing increases the demand for money, raising interest
rates and causing inflation. Printing more money means that the money that was around
beforehand is now worth less, again leading to inflation.
Is growth good? Bad? Neither? First, let's define growth from an economic perspective:
Growth is an increase in real income, which means that individuals have more real buying
power than they did in the past. Thus, true growth doesn't include inflation, which
actually causes buying power to decline.
Growth is caused primarily by two factors: population and
productivity gains. More people working leads to increases in available financial
resources and in demand. Productivity gains stretch the value of a dollar -- the same
amount of money today can purchase more or better products and services than it could
yesterday. Thus, a reasonable and healthy level of annual growth in the U.S. economy is
around 3 percent, with about one-third coming from population increases and two-thirds
from productivity gains.
What if growth is faster or slower? Faster growth can lead to
inflation, because demand builds faster than available output or productivity can
comfortably allow, causing prices to increase. Slower growth can also be problematic: If
the population stagnates or productivity falls behind, demand will fall, leading to a
depression or recessionary cycle that reduces the overall material quality of life.
Thus, a healthy economy is precariously balanced between
growing too quickly and not growing fast enough. Whether or not government intervention is
necessary to maintain a healthy economy, or whether it is best left to nature's Invisible
Hand, is the major economic question of our time.
There are a number of pitfalls to avoid when trying to
understand statements about economics or the economy. Here are three points to ponder when
confronted with economic statistics and conclusions:
- Ideology -- Good economics thinking is descriptive, and
includes only statements of facts. Beware of phrases such as
"ought to" or "should be" as they indicate someone's personal feelings
rather than descriptions of reality.
- False Causes -- As described in our sections on statistics and reasoning,
it's important not to confuse correlation with causation. Just because two things happen
at the same time doesn't mean that one caused the other, or even that they're related at
all. Economics is so complex that it's often very hard to tell why business spending
increased, why inflation is slowing, etc.
- Fallacies of Composition
and Division -- A fallacy of composition is one in which it is believed that
what's good for one person is good for all: If one person waits a year to buy a car,
she'll have more money to spend next year. But if everyone waits, the economy will go into
a tailspin. Tariffs and subsidies are another example, since helping one small group can
actually increase costs for the larger part of society.
A fallacy of division occurs when it's believed that what's good for the
whole economy is good for each of us. For example, low interest rates are generally a sign
that a nation's economy is healthy. But for elderly people who live off the interest
earned on their savings, declining rates reduce their incomes and thus their standards of
Economics attempts to
explain and predict the effects of policy and other changes on individuals, firms and
societies as they interact to increase their wealth. The key tenet is
one of scarcity, whereby costs and benefits are calculated based upon the relative supply
and demand of goods and services. From an ecological standpoint, the challenge to
economists is to ensure that a major externality -- the value of a clean environment -- is
properly captured and internalized so that better and more sustainable decisions can be
Here is a simple table that you can refer to when analyzing
economic proposals or arguments that claim specific economic impacts:
Economics Crib Sheet
- What group has the most to gain from the
proposal, and which groups stand to lose from it?
- What are the short term effects of the proposal and on which groups?
- What are the long term effects?
- What will it cost society as a whole to implement the program?
- Is the cost worth the benefit?
- Is the program both efficient and equitable?
- Has the policy included estimates of price elasticity and do the
recommendations reflect these estimates?
- Have externalities been identified and accounted for?
- Are statements descriptive and factual, rather than value-laden?
- Do conclusions based upon projections, correlations or
cause-and-effect assumptions make logical sense? Can you determine other reasons for the
References On the Net...
World, "a guide to all things economic, and the home of Mr. Economy"
Web sites on the economy and statistics
Econ Education Web,
at the University of Nebraska
Website of the National Council on Economic Education
Principles of Economics, a Web-based education program from Drexel University
resources in economics
The World Bank
References Off the Net...
(Clicking on the link will take you to the appropriate
catalog page of Amazon.com, where you can learn more about the book and/or order it.)
Economy as Ecosystem, Michael Rothschild (Henry Holt, 1990).
Economic History of the World, Rondo Cameron (Oxford University Press, 1993).
Economics: The Science and Management of Sustainability, Robert Costanza, Editor
(Columbia University Press, 1991).
Integrated Approach, Benjamin Davis (Prentice Hall, 1997).
Explained, Lester Thurow & Robert Heilbroner (Touchstone, 1998).
One Lesson, Henry Hazlitt (Fox & Wilkes, 1996).
The Economy of Nature, William Ashworth (Houghton Mifflin,
the Ecological Economics of Sustainability, John Peet (Island Press, 1992).
for Sale: The Virtues and Limits of Markets, Robert Kuttner (Alfred Knopf, 1996).
Limits: Ecology, Economics, and Population Taboos, Garrett Hardin (Oxford
University Press, 1993).
of Virtue: Human Instincts and the Evolution of Cooperation, Matt Ridley (Viking,
The Wealth of
Nations, Adam Smith.