The Uncertainty Of Economics: Exploring The
Dismal Science
By Andrew Beattie
When speaking or reading about economics, you've probably heard someone drop the phrase the
dismal science. If you did not know what this phrase meant, you may have dismissed it as a clever
joke, or, harboring a secret passion for experimental observation and beakers, you may have been too
shy to question how on earth any science could be dismal. Looking at what the dismal science is and
why it carries such a depressing name, however, may help you better understand why you may face
uncertainty and contradictions in your investing endeavors.
Origins
The phrase "dismal science" was coined by Thomas Carlyle in response to Thomas Malthus' beliefs
that the exponential population growth would outpace the linear growth of the world's food supply,
resulting in a global famine. Malthus didn't foresee the leaps in science, such as the development of
fertilizer, that have allowed the earth to support many more people than was previously imagined.
Still, one of the fundamental concepts of economics is the principle of scarcity - the idea that there
will never be enough for everyone. That dreadful outlook is one of the reasons economics is
considered a dismal science.
Why Economics Isn't Really a Science
In addition to the blunder of Malthus the phrase dismal science refers to the unreliability of
economics in comparison to conventional sciences such as mathematics, physics or biology. Most
sciences work through an initial explanation of a proposed phenomenon (also known as a
hypothesis). The scientist then forms a model to test and scrutinize this hypothesis until only the
important variables remain. These variables are repeatedly tested to determine whether they are the
causes of the end result. If in fact a variable can be isolated and determined as the sole cause, then the
theory underlying the hypothesis is referred to as a law. (Please keep in mind that this is a gross
simplification of the scientific method.)
Economics, like science, aims to explain certain phenomenon, but for many reasons economics
cannot fulfill the criteria of the experimental model. To better understand the constraints on the study
of economics, let's take at look at what the methods of science demand:
Scientific Method Example - Car Door Experiments
So let's say we're studying the phenomenon of why my hand hurts when I slam it in my car door. For
me to use a scientific approach I would form a hypothesis. Suppose my theory is that it's because I'm
wearing an Investopedia T-shirt. To test this theory, I create a model to test different scenarios and
variables. This model involves slamming my hand in the door while wearing different shirts,
including my Investopedia T-shirt. I eliminate factors (variables) that don't affect the result (my pain)
and I continue testing other variables until I am left with one that is the cause of my pain: the fact that
I'm smashing my hand in a car door.
After several hairline fractures, I've figured out that the real reason my hand hurts is not because of
the T-shirt I'm wearing, but because a slamming car door on my hand translates into pain through my
nerves. So, a law has been formed: the Andrew Law, which states that if I slam my hand in a car door
with "X" amount of force, my hand will absorb "Y" amount of energy causing my nerves to relay "Z"
amount of pain to my brain (a gross simplification).
The Uncertainty of Economics
Economics cannot ascertain any clearly defined laws because in the market some unidentifiable
factor always may be influencing a particular event or phenomena. It's nearly impossible to isolate
any given variable in economics, so the dismal science is mainly based on theories.
These theories may contradict each other, like efficient market hypothesis (EMH) and behavioral
finance, but they may be proven true in certain cases or even at the same time. Furthermore, when
studying economics, evidence often turns out to be coincidence more than a fact.
Typically, these unreliable characteristics are a result of three specific things that economists cannot
control:
Un-testable Economy
Unlike other scientists, economist don't have special laboratories where they can create isolated
models to test their hypotheses. A vacuum of the economy just doesn't exist and cannot be created.
Because of this, economists can't verify or prove their hypotheses as easily as other scientists. For
instance, when Sir Isaac Newton had to repeat his tests for the existence of gravity, all he needed to
do was find more apples to drop from different trees. For my law, all I needed to do was wear
different T-shirts (and eventually stop slamming my hand in the door). For an economist to test a
theory, he or she has to appeal to different governments to implement a specific change in the
economy or, even worse, wait for them to do so under their own accord and then take the necessary
measurements.
Homo Economicus
Aside from the many different assumptions that economists make when debating their theories,
probably the most hotly debated one is the idea of homo economicus, or the rational human. Nearly
all economic theories assume that people are rational at all times, that they always prudently allocate
their resources in a predictable manner that is beneficial. Unfortunately, this doesn't always hold
water in the real world. People will gamble even though the odds are against them; they will forget to
go to the supermarket with a calculator to see if the 32 oz. can of soup is cheaper than the 16 oz. can,
and they don't routinely analyze the opportunity cost of different goods.
Blind Man's Bluff
Imagine you were blind with a deck of cards laid in front of you and someone expected you to be
able to sort out the three of hearts. We know that there is a one-in-52 chance of being right and that,
if the cards are randomly sorted, there is no scientific methodology that can help you improve those
odds. However, if you pull the right card, you might attribute it to anything: the way you reached out,
how many breaths you took, the twitch in your right eye - anything.
Once again you are stuck slicing and applying variables, but you can't repeat the test with any kind of
consistent controls. This is similar to economics: the number of testable variables is enormous due to
the sheer size of the economy. As a result, there has been little success not only in predicting
phenomena but also in proposing reasons for why observable things happen. The economy can't be
controlled like a math equation or a science experiment, and there are simply too many variables to
test with any sort of reliability and verifiability.
The Bottom Line
So there you have it. Next time you see someone dropping the phrase "dismal science" you can check
if he or she uses it correctly; furthermore, you know that the person using the term could not possibly
predict or explain market events with any smug confidence.
Economics Basics
By Adam Hayes, CFA
Economics is a field of study that has become increasingly relevant in our globalized, financialized
society. The economy is part of our collective conscious and a buzzword that links personal finances
to big business and international trade deals. Economics deals with individual choice, but also with
money and borrowing, production and consumption, trade and markets, employment and
occupations, asset pricing, taxes and much more. What then is the definition of economics? One way
to think of it is the study of what constitutes rational human behavior in the endeavor to fulfill needs
and wants given a world with scarce resources. In other words, economics tries to explain how and
why we get the stuff we want or need to live. How much of it do we get? Who gets to have more?
Who makes all this stuff? How is it made? These are the questions and decisions that economics
concerns itself with.
As an individual, for example, you constantly face the problem of having limited resources with
which to fulfill your wants and needs. As a result, you must make certain choices with your money –
what to spend it on, what not to spend it on, and how much to save for the future. You'll probably
spend part of your paycheck on relative necessities such as rent, electricity, clothing and food. Then
you might use the rest to go to the movies, dine out or buy a smartphone. Economists are interested
in the choices you make, and investigate why, for instance, you might choose to spend your money
on a new Xbox instead of replacing your old pair of shoes. They would want to know whether you
would still buy a carton of cigarettes if prices increased by $2 per pack. The underlying essence of
economics is trying to understand how individuals, companies, and nations as a whole behave in
response to certain material constraints.
Adam Smith (1723 - 1790), is often considered the "father of modern economics." His book "An
Inquiry into the Nature and Causes of the Wealth of Nations" (1776) was the first fully elaborated
attempt to understand why some nations prospered while others suffered widespread poverty. He
famously argued that individuals working for their own self-interest could nonetheless create a stable
and well-provisioned society through a mechanism he called the invisible hand of the market. (See
also: 'Adam Smith and 'The Wealth Of Nations.')
Smith, however, was not the first to write on economic matters. Other scholars of what was then
known as political economy wrote prior to "The Wealth of Nations," but Adam Smith was one of the
first to identify the unique economic changes that accompanied the birth of industrialization and
capitalist production. Smith’s work was followed by David Ricardo’s "Principles of Political
Economy and Taxation" (1817) and later by Karl Marx in "Capital" (1867). Each of these authors
sought to explain how capitalism worked and what it meant for producers and workers in the
capitalist system. (See also: What is the difference between Communism and Socialism?)
In the late 19th century, the discipline of economics became its own distinct field of study. Alfred
Marshall, author of "The Principles Of Economics" (1890) defined economics as a social science that
examines people's behavior according to their individual self-interests. He wrote, "Thus it is on one
side the study of wealth; and on the other, and more important side, a part of the study of man." In
the early 20th century, however, there was a push toward legitimizing economics as a rigorous
science alongside the physical sciences like chemistry and physics. As a result, mathematical models
and statistical methods were brought to the forefront along with a number of strong assumptions that
are needed to make those models work. For example, modern mainstream economics makes the
assumption that human beings will always aim to fulfill their individual self-interests. It also assumes
that individuals are rational actors in their efforts to fulfill their unlimited wants and needs. It also
makes the claims that firms exist to maximize profit and that markets are efficient. This school of
economics, which has come to dominate both the academic field of economics as well as the
practical application of economic theory in policy and business, is known as neoclassical economics.
(See also: The Difference Between Finance And Economics.)
The bulk of this tutorial will concern itself with this line of neoclassical economic theory. Other
strands of so-called “heterodox” economics have sprung up to challenge the mainstream model, and
other social sciences such as psychology and sociology have added valuable insight to the
mechanical models of pure economics. Sometimes rejected as fringe elements, mainstream
economics is today increasingly tolerant of some these ideas and even go so far as try to incorporate
alternative theory into its own. Some of these will be examined briefly at the end of this tutorial.
First, we start our tutorial with a brief overview of what economics is and go over some basic
concepts before proceeding.
Economics Basics: What Is Economics?
By Adam Hayes, CFA
In order to begin our discussion of economics, we first need to understand some important concepts.
For instance, what is the economy anyway? When we hear that “the economy is growing” or that
“the economy is doing poorly,” what does that mean? At the most abstract level, the economy is a
system that exists to produce and provide people in a society with the goods and services they need
to live and do what they want. The size of this system can grow as the population gets larger or as the
existing population gets wealthier. Economists often measure the size of the economy with metrics
such as gross domestic product (GDP), which measures the value of all the goods and services
produced by a country in a year.
Types of Economic Systems
Types of economic systems are defined either by the way that stuff is produced or by how that stuff
is allocated to people. For example, in primitive agrarian societies, people tend to self-produce all of
their needs and wants at the level of the household or tribe. Family members would build their own
dwellings, grow their own crops, hunt their own game, fashion their own clothes, bake their own
bread, etc. This self-sufficient economic system is defined by very little division of labor and is also
based on reciprocal exchange with other family or tribe members. In such a primitive society, the
concept of private property didn’t typically exist as the needs of the community were produced by all
for the sake of all.
Later, as society developed, economies based on production by social class emerged such as
feudalism and slavery. Slavery involved production by enslaved individuals who lacked personal
freedom or rights and existed as the property of their owner. Feudalism was a system where a class of
nobility, known as lords, owned all of the land and leased out small parcels to peasants to farm, with
peasants handing over much of their production to the lord. In return, the lord offered the peasants
relative safety and security including a place to live and food to eat.
Capitalism emerged with the advent of industrialization. Capitalism is defined as a system of
production whereby business owners (capitalists) produce goods for sale in order to make a profit
and not for personal consumption. In capitalism, capitalists own the business including the tools used
for production as well as the finished product. Workers are hired in return for wages, and the worker
owns neither the tools he uses in the production process nor the finished product when it’s complete.
If you work at a shoe factory and you take home a pair of shoes at the end of the day, that’s stealing
even though you made them with your own hands. This is because capitalist economies rely on the
concept of private property to distinguish who legally owns what.
Capitalist production relies on the market for the allocation and distribution of the goods that are
produced for sale. A market is a venue that brings together buyers and sellers, and where prices are
established that determine who gets what and how much of it. The United States and much of the
developed world today can be described as capitalist market economies.
Two alternatives to capitalist production are worth noting.
Socialism is a system of production whereby workers collectively own the business, the tools of
production, the finished product, and share the profits – instead of having business owners who retain
private ownership of all of the business and simply hire workers in return for wages. Socialist
production often does produce for profits and utilizes the market to distribute goods and services. In
the U.S., worker coops are an example of socialist production organized under a broader capitalist
system.
Communism is a system of production where private property ceases to exist and the people of a
society collectively own the tools of production. Communism does not use a market system, but
instead relies on a central planner who organizes production (tells people who will work in what job)
and distributes goods and services to consumers based on need. Sometimes this is called a command
economy.
Scarcity
Scarcity, a concept we already implicitly discussed in the introduction to this tutorial, refers to the
tension between our limited resources and our unlimited wants and needs. For an individual,
resources include time, money and skill. For a country, limited resources include natural resources,
capital, its labor force and its level of technology. If scarcity didn’t exist, economics wouldn’t matter
since everybody would be able to provision all of their needs and wants at all times, and for free.
Because, however, our resources are limited in comparison to all of our wants and needs, individuals,
firms, and nations have to make decisions regarding what goods and services they buy or produce
and which ones they must forgo. For example, if you choose to buy one new video game as opposed
to two old games, you must give up owning a second game of inferior technology in exchange for the
higher quality of the newer one. Likewise, a company that produces video games must decide how to
allocate its workforce, time, and money to produce a small number of high quality games or a large
number of lower quality products. Because of scarcity, people, firms, and nations must all make
decisions over how to allocate their individual resources. Economics, in turn, aims to study why we
make these decisions and how we allocate our resources most efficiently.
Macro and Microeconomics
Macro- and microeconomics are the two main vantage points from which the economy is studied.
Macroeconomics looks at the economy on a national and international level. It examines total output
of a nation (GDP) and the way the nation allocates its limited resources of land, labor supply and
capital. Macroeconomics is concerned with international trade, a nation’s fiscal and monetary policy,
the level of inflation and interest rates, national unemployment, and more.
Microeconomics studies the level of the individual and the firms within the economy. Analyzing
certain aspects of human behavior, microeconomics shows us how individuals and firms respond to
changes in price and why they demand what they do at particular price levels. Microeconomics tries
to explain how and why different goods command different values, how individuals make financial
decisions, and how individuals best coordinate and cooperate with one another.
Micro- and macroeconomics are intertwined; as economists gain understanding of certain
phenomena, they can help us make more informed decisions when allocating resources. Many people
believe that the micro foundations of individuals and firms acting in aggregate constitute
macroeconomic phenomena.
Economics Basics: Supply and Demand
By Adam Hayes, CFA
Supply and demand is perhaps one of the most fundamental concepts of economics and it is the
backbone of a market economy. Demand refers to how much (quantity) of a product or service is
desired by buyers. The quantity demanded is the amount of a product people are willing to buy at a
certain price; the relationship between price and quantity demanded is known as the demand
relationship. Supply represents how much the market can offer. The quantity supplied refers to the
amount of a certain good producers are willing to supply when receiving a certain price. The
correlation between price and how much of a good or service is supplied to the market is known as
the supply relationship. Price, therefore, is a reflection of supply and demand.
The relationship between demand and supply underlie the forces behind the allocation of resources.
In market economy theories, demand and supply theory will allocate resources in the most efficient
way possible. How? Let us take a closer look at the law of demand and the law of supply.
A. The Law of Demand
The law of demand states that, if all other factors remain equal, the higher the price of a good, the
less people will demand that good. In other words, the higher the price, the lower the quantity
demanded. The amount of a good that buyers purchase at a higher price is less because as the price of
a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally
avoid buying a product that will force them to forgo the consumption of something else they value
more. The chart below shows that the curve is a downward slope.
A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation
between quantity demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1 and
the price will be P1, and so on. The demand relationship curve illustrates the negative relationship
between price and quantity demanded. The higher the price of a good the lower the quantity
demanded (A), and the lower the price, the more the good will be in demand (C).
B. The Law of Supply
Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain
price. But unlike the law of demand, the supply relationship shows an upward slope. This means that
the higher the price, the higher the quantity supplied. Producers supply more at a higher price
because selling a higher quantity at a higher price increases revenue.
A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation
between quantity supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and the
price will be P2, and so on. (To learn how economic factors are used in currency trading, read Forex
Walkthrough: Economics.)
Time and Supply
Unlike the demand relationship, however, the supply relationship is a factor of time. Time is
important to supply because suppliers must, but cannot always, react quickly to a change in demand
or price. So it is important to try and determine whether a price change that is caused by demand will
be temporary or permanent.
Let's say there's a sudden increase in the demand and price for umbrellas in an unexpected rainy
season; suppliers may simply accommodate demand by using their production equipment more
intensively. If, however, there is a climate change, and the population will need umbrellas yearround, the change in demand and price will be expected to be long term; suppliers will have to
change their equipment and production facilities in order to meet the long-term levels of demand.
C. Supply and Demand Relationship
Now that we know the laws of supply and demand, let's turn to an example to show how supply and
demand affect price.
Imagine that a special edition CD of your favorite band is released for $20. Because the record
company's previous analysis showed that consumers will not demand CDs at a price higher than $20,
only ten CDs were released because the opportunity cost is too high for suppliers to produce more. If,
however, the ten CDs are demanded by 20 people, the price will subsequently rise because,
according to the demand relationship, as demand increases, so does the price. Consequently, the rise
in price should prompt more CDs to be supplied as the supply relationship shows that the higher the
price, the higher the quantity supplied.
If, however, there are 30 CDs produced and demand is still at 20, the price will not be pushed up
because the supply more than accommodates demand. In fact after the 20 consumers have been
satisfied with their CD purchases, the price of the leftover CDs may drop as CD producers attempt to
sell the remaining ten CDs. The lower price will then make the CD more available to people who had
previously decided that the opportunity cost of buying the CD at $20 was too high.
D. Equilibrium
When supply and demand are equal (i.e. when the supply function and demand function intersect) the
economy is said to be at equilibrium. At this point, the allocation of goods is at its most efficient
because the amount of goods being supplied is exactly the same as the amount of goods being
demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the current economic
condition. At the given price, suppliers are selling all the goods that they have produced and
consumers are getting all the goods that they are demanding.
As you can see on the chart, equilibrium occurs at the intersection of the demand and supply curve,
which indicates no allocative inefficiency. At this point, the price of the goods will be P* and the
quantity will be Q*. These figures are referred to as equilibrium price and quantity.
In the real market place equilibrium can only ever be reached in theory, so the prices of goods and
services are constantly changing in relation to fluctuations in demand and supply.
E. Disequilibrium
Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*.
1. Excess Supply
If the price is set too high, excess supply will be created within the economy and there will be
allocative inefficiency.
At price P1 the quantity of goods that the producers wish to supply is indicated by Q2. At P1,
however, the quantity that the consumers want to consume is at Q1, a quantity much less than Q2.
Because Q2 is greater than Q1, too much is being produced and too little is being consumed. The
suppliers are trying to produce more goods, which they hope to sell to increase profits, but those
consuming the goods will find the product less attractive and purchase less because the price is too
high.
2. Excess Demand
Excess demand is created when price is set below the equilibrium price. Because the price is so low,
too many consumers want the good while producers are not making enough of it.
In this situation, at price P1, the quantity of goods demanded by consumers at this price is Q2.
Conversely, the quantity of goods that producers are willing to produce at this price is Q1. Thus,
there are too few goods being produced to satisfy the wants (demand) of the consumers. However, as
consumers have to compete with one other to buy the good at this price, the demand will push the
price up, making suppliers want to supply more and bringing the price closer to its equilibrium.
F. Shifts vs. Movement
For economics, the "movements" and "shifts" in relation to the supply and demand curves represent
very different market phenomena:
1. Movements
A movement refers to a change along a curve. On the demand curve, a movement denotes a change
in both price and quantity demanded from one point to another on the curve. The movement implies
that the demand relationship remains consistent. Therefore, a movement along the demand curve will
occur when the price of the good changes and the quantity demanded changes in accordance to the
original demand relationship. In other words, a movement occurs when a change in the quantity
demanded is caused only by a change in price, and vice versa.
Like a movement along the demand curve, a movement along the supply curve means that the supply
relationship remains consistent. Therefore, a movement along the supply curve will occur when the
price of the good changes and the quantity supplied changes in accordance to the original supply
relationship. In other words, a movement occurs when a change in quantity supplied is caused only
by a change in price, and vice versa.
2. Shifts
A shift in a demand or supply curve occurs when a good's quantity demanded or supplied changes
even though price remains the same. For instance, if the price for a bottle of beer was $2 and the
quantity of beer demanded increased from Q1 to Q2, then there would be a shift in the demand for
beer. Shifts in the demand curve imply that the original demand relationship has changed, meaning
that quantity demand is affected by a factor other than price. A shift in the demand relationship
would occur if, for instance, beer suddenly became the only type of alcohol available for
consumption.
Conversely, if the price for a bottle of beer was $2 and the quantity supplied decreased from Q1 to
Q2, then there would be a shift in the supply of beer. Like a shift in the demand curve, a shift in the
supply curve implies that the original supply curve has changed, meaning that the quantity supplied
is effected by a factor other than price. A shift in the supply curve would occur if, for instance, a
natural disaster caused a mass shortage of hops; beer manufacturers would be forced to supply less
beer for the same price.
Economics Basics: Utility
By Adam Hayes, CFA
We have already seen that a primary focus of economics is to understand behavior given the problem
of scarcity: the problem of fulfilling the unlimited wants of humankind with limited or scarce
resources. Because of scarcity, economies need to allocate their resources in such a way that
everything ends up where it ought to. Underlying the laws of demand and supply is the concept of
utility, which represents the advantage, pleasure, or fulfillment a person gains from obtaining or
consuming a good or service.
Utility, then, is used to explain how and why individuals and economies aim to gain optimal
satisfaction in dealing with scarcity. The idea of utility as a guiding force of human action is not new,
and was established in economic theory in the 1700’s and 1800’s in Europe and especially in
England thanks to thinkers such as Adam Smith, John Stuart Mill, and Jeremy Bentham who
believed that people are driven to find pleasure and avoid pain. The viewpoint that people maximize
utility, known as utilitarianism, has been taken up by the field of economics, but also criticized by
some who claim that pleasure and freedom from pain are not the only goals that matter in life.
Utility is an abstract theoretical concept rather than a concrete, observable quantity. The units to
which we assign an amount of utility (known as utils), therefore, are arbitrary, representing a relative
value. Total utility is the aggregate sum of satisfaction or benefit that an individual gains from
consuming a given amount of goods or services in an economy. The amount of a person's total utility
thus corresponds to the person's level of consumption. Usually, the more that a person consumes, the
larger his or her total utility will be. Marginal utility is the additional bit of satisfaction, or amount of
utility, gained from each extra unit of consumption. For example, from eating just one more cookie.
Although the total amount of utility gained usually increases as more of a good is consumed, the
marginal utility usually decreases with each additional increase in the consumption of a good. This
decrease demonstrates the law of diminishing marginal utility. Because there is a certain maximum
threshold of satisfaction, the consumer will no longer receive the same pleasure from consumption
once that threshold is crossed. In other words, total utility will increase at a slower pace as an
individual increases the quantity consumed. For example, the pleasure of eating the first cookie is
much greater than the pleasure received from eating the tenth or eleventh cookie in a sitting.
Moving on from cookies, let us now consider a chocolate bar. Say that after eating one chocolate bar
your sweet tooth has been completely satisfied. Your marginal utility (and total utility) after eating
one chocolate bar will be quite high. But if you eat more chocolate bars, the pleasure of each
additional chocolate bar will be less than the pleasure you received from eating the one before probably because you are starting to feel full or you have had too many sweets for one day. In fact, if
you were to eat 5 or more chocolates, you may begin to experience pain and not pleasure.
This table shows that total utility will increase at a much slower rate as marginal utility diminishes
with each additional bar. Notice how the first chocolate bar gives a total utility of 70 but the next
three chocolate bars together increase total utility by only 18 additional units.
The law of diminishing marginal utility helps economists understand the law of demand and the
negative sloping demand curve. The less of something you have, the more satisfaction you gain from
each additional unit you consume; the marginal utility you gain from that product is therefore higher,
giving you a higher willingness to pay more for it. Prices are lower at a higher quantity demanded
because your additional satisfaction diminishes as you demand more.
In order to determine what a consumer's utility and total utility are, economists turn to consumer
demand theory, which studies consumer behavior and satisfaction. Economists assume the consumer
is rational and will thus maximize his or her total utility by purchasing a combination of different
products rather than more of one particular product. Thus, instead of spending all of your money on
three chocolate bars, which has a total utility of 85, you should instead purchase the one chocolate
bar, which has a utility of 70, and perhaps a glass of milk, which has a utility of 50. This combination
will give you a maximized total utility of 120 but at the same cost as the three chocolate bars.
Economics Basics: Elasticity
By Adam Hayes, CFA
We’ve seen that the demand and supply of goods react to changes in price, and that prices in turn
move along with changes in quantity. We’ve also seen that the utility, or satisfaction received from
consuming or acquiring goods diminishes with each additional unit consumed. The degree to which
demand or supply reacts to a change in price is called elasticity.
Elasticity varies from product to product because some products may be more essential to the
consumer than others. Demand for products that are considered necessities is less sensitive to price
changes because consumers will still continue buying these products despite price increases. On the
other hand, an increase in price of a good or service that is far less of a necessity will deter
consumers because the opportunity cost of buying the product will become too high.
A good or service is considered highly elastic if even a slight change in price leads to a sharp change
in the quantity demanded or supplied. Usually these kinds of products are readily available in the
market and a person may not necessarily need them in his or her daily life, or if there are good
substitutes. For example, if the price of Coke rises, people may readily switch over to Pepsi. On the
other hand, an inelastic good or service is one in which large changes in price produce only modest
changes in the quantity demanded or supplied, if any at all. These goods tend to be things that are
more of a necessity to the consumer in his or her daily life, such as gasoline.
To determine the elasticity of the supply or demand of something, we can use this simple equation:
Elasticity = (% change in quantity / % change in price)
If the elasticity is greater than or equal to 1, the curve is considered to be elastic. If it is less than one,
the curve is said to be inelastic.
As we saw previously, the demand curve has a negative slope. If a large drop in the quantity
demanded is accompanied by only a small increase in price, the demand curve will appear looks
flatter, or more horizontal. People would rather stop consuming this product or switch to some
alternative rather than pay a higher price. A flatter curve means that the good or service in question is
quite elastic.
Meanwhile, inelastic demand can be represented with a much steeper curve: large changes in price
barely affect the quantity demanded.
Elasticity of supply works similarly. If a change in price results in a big change in the amount
supplied, the supply curve appears flatter and is considered elastic. Elasticity in this case would be
greater than or equal to one. The elasticity of supply works similarly to that of demand. Remember
that the supply curve is upward sloping. If a small change in price results in a big change in the
amount supplied, the supply curve appears flatter and is considered elastic. Elasticity in this case
would be greater than or equal to one.
On the other hand, if a big change in price only results in a minor change in the quantity supplied, the
supply curve is steeper and its elasticity would be less than one. The good in question is inelastic
with regard to supply.
Factors Affecting Demand Elasticity
There are three main factors that influence a good’s price elasticity of demand:
1. Availability of Substitutes In general, the more good substitutes there are, the more elastic the
demand will be. For example, if the price of a cup of coffee went up by $0.25, consumers might
replace their morning caffeine fix with a cup of strong tea. This means that coffee is an elastic good
because a small increase in price will cause a large decrease in demand as consumers start buying
more tea instead of coffee.
However, if the price of caffeine itself were to go up, we would probably see little change in the
consumption of coffee or tea because there may be few good substitutes for caffeine. Most people in
this case might not willing to give up their morning cup of caffeine no matter what the price. We
would say, therefore, that caffeine is an inelastic product. While a specific product within an industry
can be elastic due to the availability of substitutes, an entire industry itself tends to be inelastic.
Usually, unique goods such as diamonds are inelastic because they have few if any substitutes.
2. Necessity As we saw above, if something is needed for survival or comfort, people will continue
to pay higher prices for it. For example, people need to get to work or drive for any number of
reasons. Therefore, even if the price of gas doubles or even triples, people will still need to fill up
their tanks.
3. Time The third influential factor is time. If the price of cigarettes goes up $2 per pack, a smoker
with very few available substitutes will most likely continue buying his or her daily cigarettes. This
means that tobacco is inelastic because the change in price will not have a significant influence on
the quantity demanded. However, if that smoker finds that he or she cannot afford to spend the extra
$2 per day and begins to kick the habit over a period of time, the price elasticity of cigarettes for that
consumer becomes elastic in the long run.
Income Elasticity of Demand
Income elasticity of demand is the amount of income available to spend on goods and services. This
also affects demand since it regulates how much people can spend in general. Thus, if the price of a
car goes up from $25,000 to $30,000 and income stays the same, the consumer is forced to reduce his
or her demand for that car. If there is an increase in price and no change in the amount of income
available to spend on the good, there will be an elastic reaction in demand: demand will be sensitive
to a change in price if there is no change in income. It follows, then, that if there is an increase in
income, demand in general tends to increase as well. The degree to which an increase in income will
cause an increase in demand is called the “income elasticity of demand,” which can be expressed in
the following equation:
If EDy is greater than 1, demand for the item is considered to have a high income elasticity. If EDy is
less than 1, demand is considered to be income inelastic. Luxury items usually have higher income
elasticity because when people have a higher income, they don't have to forfeit as much to buy these
luxury items. As an example, consider what some consider a luxury good: vacation travel. Bob has
just received a $10,000 increase in his salary, giving him a total of $80,000 per year. With this new
higher purchasing power, he decides that he can now afford to go on vacation twice a year instead of
his previous once a year. With the following equation we can calculate income demand elasticity:
Income elasticity of demand for Bob's air travel is 7, which is highly elastic.
With some goods and services, we may actually notice a decrease in demand as income increases.
These cases often involve goods and services considered of inferior quality that will be dropped by a
consumer who receives a salary increase. An example may be the decrease in going out to fast food
restaurants as income increases, which are generally considered to be of lower quality that other
dining alternatives. Products for which the demand decreases as income increases have an income
elasticity of less than zero. Products that witness no change in demand despite a change in income
usually have an income elasticity of zero. These goods and services are considered necessities and
are sometimes referred to as Giffin Goods.
Another anomaly in elasticity occurs when the demand for something increases as its price rises.
We’ve learned that if the price of something goes up, people will demand less – but certain luxury or
status items may be demanded because they are expensive. For example, designer label clothing or
accessories or luxury car brands signal status and prestige. A work of art, a personal chef, or a
diamond ring all may be in high demand precisely because they are expensive. These types of goods
are referred to as Veblen Goods.
Economic Basics: Competition, Monopoly and
Oligopoly
By Adam Hayes, CFA
Economists make the assumption that there are a large number of different buyers and sellers in the
marketplace for each good or service available. This means that we have competition in the market,
which allows price to change in response to changes in supply and demand. For example, if the price
of a good is very high and some firms are making extra profits in that sector, other firms will be
induced to start producing that same good – in competition with the others – which will increase
supply and reduce the selling price. Furthermore, for almost every product there are substitutes, so if
one product becomes too expensive, a buyer can choose a cheaper substitute instead (recall the
section on elasticity). In a market with many buyers and sellers, both the consumer and the supplier
have equal ability to compete on price.
Adam Smith in the 18th century recognized that competition between producers is crucial for the
invisible hand to keep an economy efficient. Smith imagined a primitive society with only two
products: beaver and deer. A hunter can produce only one type of game and therefore must choose
whether to hunt for beaver or deer each day. If given the same effort, a deer sells for twice as much
as a beaver, people will switch from beaver production to hunt deer instead. The result is more deer
and less beaver, so the profit rates for deer begin to decline as beaver increases. Smith predicted that
in a world of competition, the profit rates for all industries will converge to the same rate of profit,
since if it becomes more profitable to be in a certain line of business, new companies will pop up to
exploit that difference – pushing it back in line in the process.
Economists call this assumption about competitive producers perfect competition. Perfect
competition is characterized by many buyers and sellers, many products that are similar in nature
and, as a result, many substitutes. Perfect competition means there are few, if any, barriers to entry
for new companies, and prices are determined by supply and demand. Thus, producers in a perfectly
competitive market are subject to the prices determined by the market and do not have any leverage.
For example, in a perfectly competitive market, should a single firm decide to increase its selling
price of a good, the consumers can just turn to the nearest competitor for a better price, causing any
firm that increases its prices to lose market share and profits. Take for example corn farmers. Many
hundreds of farmers all produce an identical product: corn. Buyers do not care which farmer sells
them their corn, and so buyers’ only concern is the price of corn. Therefore, the lowest priced corn
seller will sell the majority of corn. If a corn seller cannot compete because his cost of production is
too high, he will be forced to find ways to lower his costs or risk going out of business.
Monopoly and Oligopoly
In some industries, however, we find that there are no good substitutes and there little competition. In
a market that has only one or few suppliers of a good or service, the producer(s) can control price.
Consequently, consumers do not have much choice.
A monopoly is a market structure in which there is only one producer and seller for a product. In
other words, the single business is the entire producer in the industry. Entry into such a market can be
restricted due to high costs or other impediments, which may be economic, social or political that
keep potential competitors out. For instance, a government can create a monopoly over an industry
that it wants to control, such as electricity. Another reason for the barriers against entry into a
monopolistic industry is that oftentimes, one entity has the exclusive rights to a natural resource. For
example, in Saudi Arabia the government has sole control over the oil industry. A monopoly may
also form when a company has a copyright or patent that prevents others from entering the market.
Pfizer, for instance, had a patent on Viagra. Most economists agree that monopolies are inefficient
since without competition, they can keep prices artificially high.
In an oligopoly, there are only a few firms that make up an industry. This select group of firms has
control over the price and, like a monopoly, an oligopoly has high barriers to entry to keep out
potential competitors. The products that the oligopolistic firms produce are often nearly identical and,
therefore, the companies, which are competing for market share, are interdependent as a result of
market forces. Assume, for example, that an economy needs only 100 widgets. Company X produces
50 widgets and its competitor, Company Y, produces the other 50. The prices of the two brands will
be interdependent and, therefore, similar. So, if Company X starts selling the widgets at a lower
price, it will get a greater market share, thereby forcing Company Y to lower its prices as well. In
certain cases, types of oligopolies (for example cartels) are illegal.
Economics Basics: Production Possibility Frontier,
Growth, Opportunity Cost and Trade
By Adam Hayes, CFA
So far, we have gone over key topics of economics that have focused generally on microeconomic
phenomena. Here, we turn to more macroeconomic matters that occur on the level of national
economies.
Production Possibility Frontier (PPF)
In the field of macroeconomics, the production possibility frontier (PPF) represents the point at
which a country’s economy is most efficiently producing its goods and services and, therefore,
allocating its resources in the best way possible. There are just enough apple orchards producing
apples, just enough car factories making cars, and just enough accountants offering tax services. If
the economy is not producing the quantities indicated by the PPF, resources are being managed
inefficiently and the stability of the economy will dwindle. The production possibility frontier shows
us that there are limits to production, so an economy, to achieve efficiency, must decide what
combination of goods and services can and should be produced.
Let's turn to an example and consider the chart below. Imagine an economy that can produce only
two things: wine and cotton. According to the PPF, points A, B and C – all appearing on the PPF
curve – represent the most efficient use of resources by the economy. For instance, producing 5 units
of wine and 5 units of cotton (point B) is just as desirable as producing 3 units of wine and 7 units of
cotton. Point X represents an inefficient use of resources, while point Y represents the goals that the
economy simply cannot attain with its present levels of resources.
As we can see, in order for this economy to produce more wine, it must give up some of the
resources it is currently using to produce cotton (point A). If the economy starts producing more
cotton (represented by points B and C), it would need to divert resources from making wine and,
consequently, it will produce less wine than it is producing at point A. As the figure shows, by
moving production from point A to B, the economy must decrease wine production by a small
amount in comparison to the increase in cotton output. However, if the economy moves from point B
to C, wine output will be significantly reduced while the increase in cotton will be quite small. Keep
in mind that A, B, and C all represent the most efficient allocation of resources for the economy; the
nation must decide how to achieve the PPF and which combination to use. If more wine is in
demand, the cost of increasing its output is proportional to the cost of decreasing cotton production.
Markets play an important role in telling the economy what the PPF ought to look like.
Consider point X on the figure above. Being at point X means that the country's resources are not
being used efficiently or, more specifically, that the country is not producing enough cotton or wine
given the potential of its resources. On the other hand, point Y, as we mentioned above, represents an
output level that is currently unattainable by this economy. But, if there were a change in technology
while the level of land, labor and capital remained the same, the time required to pick cotton and
grapes would be reduced. Output would increase, and the PPF would be pushed outwards. A new
curve, represented in the figure below on which Y would fall, would then represent the new efficient
allocation of resources.
When the PPF shifts outwards, we can imply that there has been growth in an economy.
Alternatively, when the PPF shifts inwards it indicates that the economy is shrinking due to a failure
in its allocation of resources and optimal production capability. A shrinking economy could be a
result of a decrease in supplies or a deficiency in technology.
An economy can only be producing on the PPF curve in theory; in reality, economies constantly
struggle to reach an optimal production capacity. And because scarcity forces an economy to forgo
some choice in favor of others, the slope of the PPF will always be negative; if production of product
A increases then production of product B will have to decrease accordingly.
Trade, Comparative Advantage and Absolute Advantage
Specialization and Comparative Advantage
An economy may be able to produce for itself all of the goods and services it needs to function using
the PPF as a guide, but this may actually lead to an overall inefficient allocation of resources and
hinder future growth – when considering the benefits of trade. Through specialization, a country can
concentrate on the production of just a few things that it can do best, rather than dividing up its
resources among everything.
Let us consider a hypothetical world that has just two countries (Country A and Country B) and only
two products (cars and cotton). Each country can make cars and/or cotton. Suppose that Country A
has very little fertile land and an abundance of steel available for car production. Country B, on the
other hand, has an abundance of fertile land but very little steel. If Country A were to try to produce
both cars and cotton, it would need to divide up its resources, and since it requires a great deal of
effort to produce cotton by irrigating its land, Country A would have to sacrifice producing cars –
which it is much more capable of doing. The opportunity cost of producing both cars and cotton is
high for Country A, as it will have to give up a lot of capital in order to produce both. Similarly, for
Country B, the opportunity cost of producing both products is high because the effort required to
produce cars is far greater than that of producing cotton.
Each country in our example can produce one of these products more efficiently (at a lower cost)
than the other. We can say that Country A has a comparative advantage over Country B in the
production of cars, and Country B has a comparative advantage over Country A in the production of
cotton.
Now let's say that both countries (A and B) decide to specialize in producing the goods with which
they have a comparative advantage. If they then trade the goods that they produce for other goods in
which they don't have a comparative advantage, both countries will be able to enjoy both products at
a lower cost. Furthermore, each country will be exchanging the best product it can make for another
good or service that is the best that the other country can produce so quality improves. Specialization
and trade also works when several different countries are involved. For example, if Country C
specializes in the production of corn, it can trade its corn for cars from Country A and cotton from
Country B.
Determining how countries exchange goods produced by a comparative advantage ("the best for the
best") is the backbone of international trade theory. This method of exchange via trade is considered
an optimal allocation of resources, whereby national economies, in theory, will no longer be lacking
anything that they need. Like opportunity cost, specialization and comparative advantage also apply
to the way in which individuals interact within an economy.
Absolute Advantage
Sometimes a country or an individual can produce more than another country, even though countries
both have the same amount of inputs. For example, Country A may have a technological advantage
that, with the same amount of inputs (good land, steel, labor), enables the country to easily
manufacture more of both cars and cotton than Country B. A country that can produce more of both
goods is said to have an absolute advantage. Better access to quality resources can give a country an
absolute advantage as can a higher level of education, skilled labor, and overall technological
advancement. It is not possible, however, for a country to have an absolute advantage in everything
that it produces, so it will always be able to benefit from trade.
Economic Basics: Measuring Economic Activity
By Adam Hayes, CFA
One important part of macroeconomics is measuring the economy. Knowing if the economy is
growing and by how much is an important metric for policy makers, financial professionals,
corporate strategy and everyday citizens. Here we will bring up just a few of the most important
measures of economic activity at the national level.
Gross Domestic Product (GDP)
Gross domestic product, or GDP, is one of the main indicators used to measure a country's economic
activity. It represents the total aggregate dollar value of all goods and services produced in a country
each year, and is often equated with the size of the economy. GDP is often measured quarterly, but
expressed as an annualized figure. For example, if 3rd quarter GDP is reported to be up 3%, this tells
us that economy has grown by 3% over the last year starting from the 3rd quarter.
GDP is tabulated either by adding up what everyone working within a county (citizens or noncitizens) earned over the course of a year (the income approach), or else by adding up what everyone
spent (expenditure method). In theory, both measures should arrive at roughly the same total since
your spending is somebody else’s income.
The income approach, which is sometimes referred to as GDP(I), is calculated by adding up total
compensation to employees, gross profits for incorporated and non-incorporated firms, and taxes less
any subsidies and government transfers (such as welfare checks). The expenditure method is the
more common approach and it is calculated by adding up total consumption (C), investment (I),
government spending (G), and the net difference between imports and exports (X-M). Sometimes
economists express this as the GDP equation, where Y is the national income, or GDP.
Y = C + I + G + (X - M)
Consumption is typically the largest GDP component in the economy, consisting of private
expenditures on the wants and needs of a nation’s citizens. Investment is what businesses spend on
things like equipment purchases or new construction of factories. Government spending includes
items such as salaries of civil servants and government contractors, purchase of weapons for the
military, and any investment expenditure by a government. Exports are the goods produced in a
country but sold abroad, and imports are goods produced abroad but purchased here.
When the economy is healthy and growing, you will typically see steady increases in a county’s
GDP. If GDP falls, the economy is contracting. Investors worry about negative GDP growth, which
is one of the factors economists use to determine whether an economy is in a recession. The rule of
thumb is that two consecutive quarters of shrinking GDP is the signal for a recession.
Unemployment
The unemployment rate measures how many people in a country are out of work. It is the share of
the labor force that is jobless, expressed as a percentage. Unemployment generally rises or falls in
response to changing economic conditions, making it a lagging indicator. When the economy is in
poor shape and jobs are scarce, the unemployment rate will rise. When the economy is growing at a
healthy rate and jobs are relatively plentiful, it can be expected to fall.
To calculate the unemployment rate, the number of unemployed people is divided by the number of
people in the labor force, where the labor force consists of all employed and unemployed people. The
ratio is expressed as a percentage. This represents the so-called headline unemployment figure, or U3
unemployment. Some have criticized this measure for not accurately reflecting the employment
picture of a country. This is because it includes people who are working part time but would rather
work full time, and more importantly because it excludes people who are no longer looking for work
– and therefore are no longer considered in the labor force. Some discouraged workers that have
given up looking for work would probably like to work but have lost hope. A more inclusive
unemployment measure that includes discouraged and part time workers is the U6 unemployment
figure, and this is typically quite a bit higher than the headline rate.
Unemployment in a growing economy is never actually zero percent. This is because some people
choose not to work (voluntary unemployment), some are in between jobs (frictional unemployment),
or some skilled workers find their skills are no longer in demand (structural unemployment). Full
employment is a situation where all available workers in the labor force are being used in the most
efficient way possible. Full employment embodies the highest amount of skilled and unskilled labor
that can be employed within an economy at any given time. Any remaining unemployment is
considered to be frictional, structural, or voluntary. In the contemporary United States, the headline
unemployment rate associated with full employment has been around four to six percent.
Inflation
Inflation measures the change in the price levels of goods and services in an economy over time.
Inflation is defined as a sustained increase in the general level of prices for goods and services in a
country, and is measured as an annual percentage change. Under conditions of inflation, the prices of
things rise over time. Put differently, as inflation rises, every dollar you own buys a smaller
percentage of a good or service. When prices rise, and alternatively when the value of money falls
you have inflation.
Inflation can be caused for a number of reasons, but what is important to understand is that a rate of
inflation that is too high or too low is bad for economic stability. Typically an inflation rate between
one and four percent annually is ideal. If inflation rises too high, the prices of things in an economy
can surge even if wages don’t catch up. In extreme cases, hyperinflation can wreck a nation’s
economy. At the same time, if price levels decline, in what is known as deflation, people may stop
spending money and companies may halt investments. They anticipate that things will be cheaper
tomorrow, so why spend today? This mindset can lead to a dangerous deflationary spiral that can also
wreck an economy.
Measuring inflation is a difficult problem for government statisticians. To do this, a number of goods
that are representative of the economy are put together into what is referred to as a market basket.
The cost of this basket is then compared over time. This results in a price index, which is the cost of
the market basket today as a percentage of the cost of that identical basket in the starting year. These
measures are commonly the consumer price index (CPI) and the producer price index (PPI).
Economics Basics: Alternatives to Neoclassical
Economics
By Adam Hayes, CFA
While mainstream neoclassical economic theory has been dominant over the past century, some
criticisms have been leveled at this school of thought. Some argue that the strong assumptions made
that people are all hyper-rational, all-knowing, utility-maximizing beings is simply wrong. Critics
have referred to these hypothetical rational individuals as a different species altogether, homo
economicus. Other critics claim that the assumptions about efficient markets and equilibrium given
supply and demand do not reflect reality either. Here we briefly give an overview of some alternative
or supplementary ways that people theorize about the economy and economic activity.
Imperfect markets
An imperfect market refers to any economic market that does not meet the rigorous standards of a
hypothetical perfectly (or "purely") competitive market, as established by equilibrium models. An
imperfect market arises whenever individual buyers and sellers can influence prices and production,
or otherwise when perfect information is not known to all market actors. Situations can arise in
which too few sellers control too much of a single market, or when prices fail to adequately adjust to
material changes in market conditions. It is from these instances that the majority of economic debate
originates. For example, when there is too much stuff for sale and not enough demand, we experience
a recession as price levels must decline.
Imperfect markets also exist when there are information assymetries. Neoclassical economics
assumes that all buyers and sellers have perfect information – that they know everything that there is
to know about the items in the market and about the intentions of all other market participants. In
reality, however, producers of goods or other sellers tend to have much more information than
buyers. For example, a company selling shoes might cut costs and use cheap materials that cause
them to be of inferior quality. Unless they inform consumers, buyers probably do not know about
these potential defects. Similarly, the seller of a used car will know that it is likely to be a pile of junk
sooner than later, while a buyer must trust the word of the seller.
One proposed solution to imperfect markets has been government intervention to prop up prices and
stimulate demand. Free market economists believe there is no role for governments in the market, but
some schools of thought such as the Keynesians believe that government spending is not only
important but necessary during economic crises.
Behavioral Economics
Behavioral economics was developed in the late 1970’s by psychologists who understood that people
often fail to behave rationally in financial situations, although in predictable ways. They found that
people were not always utility maximizing and that their economic behavior could be manipulated.
One key finding by the social psychologists Amos Tversky and Daniel Kahneman (who later won the
Nobel prize in economics), for example, showed that rather than being risk averse as neoclassical
assumptions would predict, people are instead loss averse. In other words, people are more hurt by a
loss than the utility they receive from an equivalent gain – losing $100 hurts more than the pleasure
of finding $100. They recognized that human emotions play a role in economic behavior.
Behavioral economics has been a hot area of research over the past few decades by psychologists and
economists alike, and has established a set of dozens of cognitive and emotional biases and heuristics
that are surprisingly common and predictable.
Economic Sociology
While behavioral economics seeks to explain deviations from rational behavior by studying the
phenomena that occurs within individual human minds, economic sociology seeks to explain this by
shifting the level of analysis up to the role that social norms, expectations, values and beliefs play on
economic action. For example, neoclassical economics states that as utility maximizers, if we know
that we could get away with stealing something and would never get caught that we will. However,
we are socialized to recognize that theft is immoral, and therefore the majority of people will never
steal even if they know they won’t ever get caught.
Another key theory to emerge from economic sociology is the concept of embeddedness, which
suggests that economic activity is embedded in a network of social relationships, both weak and
strong. For example, you might do business with somebody because you like them as a person
instead of searching for the best possible service at the best possible price. Or, people may prefer to
do business with people of similar ethnic, racial, religious, or cultural backgrounds. Embeddedness
also tells us that depending on the composition of a social network, the social norms and rules of
behavior can change with regard to economic transactions. For example, it may be considered taboo
to haggle on a price with a close friend, but perfectly acceptable with a stranger. Tastes and
preferences can be influenced by friends as well as acquaintances and are not entirely developed on
one’s own.
Heterodox Economics
In addition to the above theories, there are strands of economic thought that are considered
heterodox, or that challenge mainstream beliefs within the discipline of economics. While this
tutorial is not the place to elaborate on these, it is worth noting some of the dominant schools of
heterodoxy.

Marxism Adherents of this theory argue that the ideas developed by Karl Marx about
capitalism as a system are correct – that capitalism is doomed to fail due to a number of
structural contradictions and that socialism is one solution to these problems.

Institutional economics asserts that people and organizations are not rational, but subject to
bounded rationality, whereby people simply do not have the time or brain power to find out
all the information they need to make economic decisions. Therefore, they accumulate the
best information at hand and make a best effort to achieve a satisfactory outcome.

Austrian economics believes in completely free markets without any government
intervention. Individuals each function according to their own self-interest, but that these
individuals need not be utility maximizers and each have their own tastes and preferences.
Importantly, macroeconomic phenomena cannot be explained by aggregating these individual
actions.

Post-Keynesian economics developed from the work of the economist John Maynard Keynes
believe in the importance of aggregate demand and effective demand. These economists also
believe that money is endogenous, meaning that it is created from within the commercial
banking system and is not simply created by central banks externally.
Economics Basics: Conclusion
By Adam Hayes, CFA
We hope that this tutorial has given you some insight to the economy and the. Let's recap what we've
learned in this tutorial:

Economics is best described as the study of humans behaving in response to having only
limited resources to fulfill unlimited wants and needs.

Scarcity refers to the limited resources in an economy. Macroeconomics is the study of the
economy as a whole. Microeconomics analyzes the individual people and companies that
make up the greater economy.

The Production Possibility Frontier (PPF) allows us to determine how an economy can
allocate its resources in order to achieve optimal output. Knowing this will lead countries to
specialize and trade products amongst each other rather than each producing all the products
it needs.

Demand and supply refer to the relationship price has with the quantity consumers demand
and the quantity supplied by producers. As price increases, quantity demanded decreases and
quantity supplied increases.

Elasticity tells us how much quantity demanded or supplied changes when there is a change
in price. The more the quantity changes, the more elastic the good or service. Products whose
quantity supplied or demanded does not change much with a change in price are considered
inelastic.

Utility is the amount of benefit a consumer receives from a given good or service.
Economists use utility to determine how an individual can get the most satisfaction out of his
or her available resources.

Market economies are assumed to have many buyers and sellers, high competition and many
substitutes. Monopolies characterize industries in which the supplier determines prices and
high barriers prevent any competitors from entering the market. Oligopolies are industries
with a few interdependent companies. Perfect competition represents an economy with many
businesses competing with one another for consumer interest and profits.

Economists measure economic activity in a nation using gross domestic product (GDP), the
rate of unemployment, and inflation.

Alternatives to the mainstream theory of economics includes imperfect markets, behavioral
economics, heterodox economics, and economic sociology.
Explaining The World Through Macroeconomic
Analysis
By Reem Heakal
When the price of a product you want to buy goes up, it affects you. But why does the price go up? Is
the demand greater than the supply? Did the cost go up because of the raw materials that make the
CD? Or, was it a war in an unknown country that affected the price? In order to answer these
questions, we need to turn to macroeconomics.
TUTORIAL: Economics
What Is It?
Macroeconomics is the study of the behavior of the economy as a whole. This is different from
microeconomics, which concentrates more on individuals and how they make economic decisions.
Needless to say, macroeconomy is very complicated and there are many factors that influence it.
These factors are analyzed with various economic indicators that tell us about the overall health of
the economy.
Macroeconomists try to forecast economic conditions to help consumers, firms and governments
make better decisions.

Consumers want to know how easy it will be to find work, how much it will cost to buy
goods and services in the market, or how much it may cost to borrow money.

Businesses use macroeconomic analysis to determine whether expanding production will be
welcomed by the market. Will consumers have enough money to buy the products, or will the
products sit on shelves and collect dust?

Governments turn to the macroeconomy when budgeting spending, creating taxes, deciding
on interest rates and making policy decisions.
Macroeconomic analysis broadly focuses on three things: national output (measured by gross
domestic product (GDP)), unemployment and inflation. (For background reading, see The
Importance Of Inflation And GDP.)
National Output: GDP
Output, the most important concept of macroeconomics, refers to the total amount of goods and
services a country produces, commonly known as the gross domestic product. The figure is like a
snapshot of the economy at a certain point in time.
When referring to GDP, macroeconomists tend to use real GDP, which takes inflation into account,
as opposed to nominal GDP, which reflects only changes in prices. The nominal GDP figure will be
higher if inflation goes up from year to year, so it is not necessarily indicative of higher output levels,
only of higher prices.
The one drawback of the GDP is that because the information has to be collected after a specified
time period has finished, a figure for the GDP today would have to be an estimate. GDP is
nonetheless like a stepping stone into macroeconomic analysis. Once a series of figures is collected
over a period of time, they can be compared, and economists and investors can begin to decipher the
business cycles, which are made up of the alternating periods between economic recessions (slumps)
and expansions (booms) that have occurred over time. (For more, see High GDP Means Economic
Prosperity, Or Does It?)
From there we can begin to look at the reasons why the cycles took place, which could be
government policy, consumer behavior or international phenomena, among other things. Of course,
these figures can be compared across economies as well. Hence, we can determine which foreign
countries are economically strong or weak.
Based on what they learn from the past, analysts can then begin to forecast the future state of the
economy. It is important to remember that what determines human behavior and ultimately the
economy can never be forecasted completely.
Unemployment
The unemployment rate tells macroeconomists how many people from the available pool of labor
(the labor force) are unable to find work. (For more about employment, see Surveying The
Employment Report.)
Macroeconomists have come to agree that when the economy has witnessed growth from period to
period, which is indicated in the GDP growth rate, unemployment levels tend to be low. This is
because with rising (real) GDP levels, we know that output is higher, and, hence, more laborers are
needed to keep up with the greater levels of production.
Inflation
The third main factor that macroeconomists look at is the inflation rate, or the rate at which prices
rise. Inflation is primarily measured in two ways: through the Consumer Price Index (CPI) and the
GDP deflator. The CPI gives the current price of a selected basket of goods and services that is
updated periodically. The GDP deflator is the ratio of nominal GDP to real GDP. (For more on this,
see The Consumer Price Index: A Friend To Investors and The Consumer Price Index Controversy.)
If nominal GDP is higher than real GDP, we can assume that the prices of goods and services has
been rising. Both the CPI and GDP deflator tend to move in the same direction and differ by less than
1%. (If you'd like to learn more about inflation, check out our Tutorial: All About Inflation.)
Demand and Disposable Income
What ultimately determines output is demand. Demand comes from consumers (for investment or
savings - residential and business related), from the government (spending on goods and services of
federal employees) and from imports and exports.
Demand alone, however, will not determine how much is produced. What consumers demand is not
necessarily what they can afford to buy, so in order to determine demand, a consumer's disposable
income must also be measured. This is the amount of money after taxes left for spending and/or
investment.
In order to calculate disposable income, a worker's wages must be quantified as well. Salary is a
function of two main components: the minimum salary for which employees will work and the
amount employers are willing to pay in order to keep the worker in employment. Given that the
demand and supply go hand in hand, the salary level will suffer in times of high unemployment, and
it will prosper when unemployment levels are low.
Demand inherently will determine supply (production levels) and an equilibrium will be reached;
however, in order to feed demand and supply, money is needed. The central bank (the Federal
Reserve in the U.S.) prints all money that is in circulation in the economy. The sum of all individual
demand determines how much money is needed in the economy. To determine this, economists look
at the nominal GDP, which measures the aggregate level of transactions, to determine a suitable level
of money supply.
Greasing the Engine of the Economy - What the Government Can Do
Monetary Policy
A simple example of monetary policy is the central bank's open-market operations. (For more detail,
see our Tutorial: The Federal Reserve.) When there is a need to increase cash in the economy, the
central bank will buy government bonds (monetary expansion). These securities allow the central
bank to inject the economy with an immediate supply of cash. In turn, interest rates, the cost to
borrow money, will be reduced because the demand for the bonds will increase their price and push
the interest rate down. In theory, more people and businesses will then buy and invest. Demand for
goods and services will rise and, as a result, output will increase. In order to cope with increased
levels of production, unemployment levels should fall and wages should rise.
On the other hand, when the central bank needs to absorb extra money in the economy, and push
inflation levels down, it will sell its T-bills. This will result in higher interest rates (less borrowing,
less spending and investment) and less demand, which will ultimately push down price level
(inflation) but will also result in less real output.
Fiscal Policy
The government can also increase taxes or lower government spending in order to conduct a fiscal
contraction. What this will do is lower real output because less government spending means less
disposable income for consumers. And, because more of consumers' wages will go to taxes, demand
as well as output will decrease.
A fiscal expansion by the government would mean that taxes are decreased or government spending
is increased. Ether way, the result will be growth in real output because the government will stir
demand with increased spending. In the meantime, a consumer with more disposable income will be
willing to buy more.
A government will tend to use a combination of both monetary and fiscal options when setting
policies that deal with the macroeconomy.
The Bottom Line
The performance of the economy is important to all of us. We analyze the macroeconomy by
primarily looking at national output, unemployment and inflation. Although it is consumers who
ultimately determine the direction of the economy, governments also influence it through fiscal and
monetary policy.
Overview: Economic Catastrophes
Since the 1930s economists have split their domain into two parts, into microeconomics and
macroeconomics. The difference between microeconomics and macroeconomics is in the
problems with which each is concerned. Microeconomics focuses on the "What?" and "For
Whom?" questions. It examines how a society decides to produce the bundle of goods and
services it does (the "what" question), and who gets these goods and services (the "for whom"
question). It explores how various systems of incentives and ways of making decisions (such as
"dollar voting" or various forms of political voting) work to solve the "what" and "for whom"
questions. Central in much of this examination is the concept of economic efficiency.
Microeconomics asks whether the bundle that a society produces is the bundle that has the
highest value to that society, and if it does not, what changes would increase that value.
Macroeconomics deals with topics of inflation and unemployment. This selection of readings
introduces you to macroeconomics by looking at extreme episodes, the hyperinflation in
Germany after the First World War, and the massive unemployment in the United States during
the 1930s. It also describes how the methods used in macroeconomics differ from those used in
microeconomics.
After you complete this unit, you should be able to:





Explain how microeconomics differs from macroeconomics in topics and in the way it
simplifies its theory.
Define what a recession is.
Explain what a hyperinflation is, and how people change behavior in order to cope with
it.
Explain who gains and who loses from inflation or deflation.
Explain what is meant by partial equilibrium analysis.
Sketch what happened to production, unemployment, and prices during the Great Depression.
A Case of Inflation
In the early 1920s Germany experienced one of the most severe inflations of all
time.1 The inflation was not apparent in 1920, but began showing up in 1921.
Thereafter it got steadily worse until it came to an abrupt halt at the end of 1923.
At its worst in the second half of 1923, prices rose more than fivefold each
week.
Some idea of the magnitude of this catastrophe can be seen in table below.
During 1920 and early in 1921 the signs of inflation were mixed. The price of
food was increasing, but the price of dollars in terms of marks (the mark was the
name of the German currency) was dropping, and so were the prices of products
bought from the United States. However, the signs of inflation were
unmistakable in the next year, from mid 1921 to mid 1922. In this period prices
increased about sixfold—that is, it took six marks at the end of the period to buy
what one mark would have bought at the beginning. But this rapid inflation,
greater than any yearly inflation in the history of the United States, was only a
prelude for what was to happen.
MEASURES OF GERMANY HYPERINFLATION
Percentage Change in Various Measures of Inflation
Dates
Internal Prices
Price of Dollars
Cost of Living*
Feb 1920
to May
1921
4.6%
-37.2%
39.2%
May
1921 to
July 1922
634.6%
692.2%
417.9%
July 1922
to June
1923
18094%
22201%
13573%
381,700,000,000%
560,000,000,000%
July 1923
to Nov
854,000,000,000%
20 1923
*food until June 1923, thereafter based on all items. These data were
calculated by the Statistical Bureau of the Reich. All data are from The
Economics of Inflation: A Study of Currency Depreciation in Post-War
Germany by Costantino Bresciani-Turroni (Augustus Kelley), pp. 30, 33,
35-6.
From the middle of 1922 until the middle of 1923, prices increased by over 100
times. Measured by the price of food, prices were 135 times higher at the end of
the period than they were at the beginning. Measured by how many marks it
took to buy a dollar, prices were 222 times higher. Yet even this horrid inflation
was mild compared to what happened from July to November of 1923, when
prices increased by somewhere between a million and a billion times their
previous level.
The rapid increase in German inflation can be seen in the postage stamps that
were issued during this period. (See the picture below.) In 1920 the highest
valued stamp issued was for four marks. In 1923 the denominations were
changing so rapidly that the post office could not design new stamps fast
enough and resorted to using old dies and then overprinting them with new
values. The highest value reached in 1923 was for 50 billion (50,000,000,000)
marks. A great many of these stamps must have been issued and bought, though
not necessarily used, because very few of the almost 200 varieties of stamps
issued from 1921 to 1923 have more than minimal collector's value. Also,
stamps that were postally used during the period have a higher collector's value
than stamps that were never used, a pattern that is quite unusual.
Inflation hurts some people but helps others by redistributing wealth and
income. Buyers, for example, are hurt by higher prices, but offsetting this is the
gain that the producers get from the higher prices. People on fixed incomes will
suffer, as will creditors, who are owed fixed amounts of money in the future. On
the other hand, those making fixed payments, such as most debtors, will benefit.
The German hyperinflation illustrates the redistribution that inflation causes in a
dramatic way. It eliminated the value of all life insurance policies and all
savings left in banks. When life insurance policies were paid in 1923, the value
of the check was usually worth much less than the stamp used to post the letter.
The hyperinflation eliminated all debts that existed prior to 1921. For example,
the value of German mortgages in 1913 measured in U.S. dollars was about $10
billion; in late 1923 these mortgages were worth only one U.S. penny.
By 1924 the inflation had radically redistributed the wealth of Germany. The
segment of society that was hit the hardest seems to have been the middle class.
The poor had little wealth to lose while the rich were often able to get their
wealth into forms not adversely affected by inflation. Wealth held in foreign
bank accounts, gold and precious metals, and land maintained value.
If redistribution were the only effect of inflation, one could argue that it is not a
serious problem. Since for every loser there is a winner, society as a whole may
break even (if this redistribution is not seen as being too "unfair"). However,
inflation also makes ordinary decisions more difficult to make, and it causes
people to change their behavior. The changes in behavior, which cause social
losses, are again dramatically illustrated in a hyperinflation.
Coping with a situation in which prices could double in a day meant changes in
the way people organized their financial affairs. Wages were paid daily or
several times a day, and the whole family would immediately go out and spend
the money before it lost value. In The Black Obelisk, a novel set in 1923, Erich
Maria Remarque describes this practice:
"Workmen are given their pay twice a day now—in the morning and in the
afternoon, with a recess of a half-hour each time so that they can rush out and
buy things--for if they waited a few hours the value of their money would drop
so far that their children would not get half enough food to feel satisfied."2
Getting rid of money was the key to financial survival since it lost its value so
quickly.
Merchants eventually found that they could not mark up prices as fast as they
were rising.
"So they left the price marks as they were and posted (hourly) a new
multiplication factor. The actual price marked on the goods had to be multiplied
by this factor to determine the price which had to be paid for the goods. Every
hour the merchant would call up the bank and receive the latest quotation upon
the dollar. He would then alter his multiplication factor to suit and would
perhaps add a bit in anticipation of the next quotation. Banks had whole
batteries of telephone boys who answered each call as follows: '100 milliarden,
bitte sehr, guten Tag.' Which meant: 'The present quotation on the dollar is 100
billion marks, thank you, good day.'"3
The great inflation led to a large waste of society's resources. Just coping with
the rapid change required resources—the extra bank clerks that Bopp mentions
are but one example. Talented people no longer tried to earn money by
productive activity, but sought ways to stay ahead of inflation, an activity
unlikely to have any social benefits. Fortunes were made by those who
speculated on the continued worsening of inflation. People who borrowed
heavily almost always did well.
People dislike inflation because it redistributes in ways they consider unfair,
because it forces them to take actions to protect themselves, and because it
makes decisions more difficult to make. Decisions to buy, sell, or invest are
based on a person's knowledge of what normal prices are and this knowledge of
normal prices is based on remembering past prices. With inflation, a person
must remember not only past prices, but also the dates of those past prices, and
then must try to compute what their present equivalents would be. Because our
mental capacity to handle large amounts of information is limited, and because
inflation requires us to handle more information in order to make decisions,
inflation, even when it is perfectly predicted, reduces our ability to make good
decisions. People like stable prices because they minimize the cost of making
economic decisions.
The German hyperinflation came to an abrupt end in November of 1923. The
man who received credit for this achievement was named Hjalmar Schacht, the
new currency commissioner of the Weimar Republic. In his autobiography he
mentions a little poem that indicated his popularity among common folk:
"Wer hat die Mark stabil gemacht,
Das war allein der Doktor Schacht."
This can be loosely translated as:
Who could make the mark stable?
Only Hjalmar Schacht was able.
He was less popular with those who borrowed heavily on the assumption that
prices would continue to rise. Stabilization led to large losses for them, and in
some cases unmade huge fortunes that inflation had built.
The German hyperinflation is an example of a major economic catastrophe, one
that cries out for explanation. Did some defect in the economic system cause
this disaster? Was it accidental, due to an unlikely combination of
circumstances? Was it due to error on the part of government policy makers?
Can a society take steps to insure that a similar disaster does not happen to it?
These are important questions, questions that economists have spent years
studying. However, the German hyperinflation is an example of only one type
of economic disaster. Another type was illustrated in the United States during
the 1930s.
1
Those interested in trivia may enjoy knowing that Hungary had an even worse inflation in
1945 and 1946 and seems to hold the world record for the biggest inflation.
2
Translated by Denver Lindley (New York: Harcourt, Brace-World Inc, 1957) p. 262.
3
Karl R. Bopp, "Hjalmar Schacht: Central Banker," The University of Missouri Studies, Vol
XIV, No. 1, Jan. 1, 1939 p. 13.
Copyright Robert Schenk
A Case of Unemployment
The decade of the 1930s saw the Great Depression in the United States and
many other countries. During this decade large numbers of people lived in
poverty, desperately in need of more food, clothing, and shelter. Yet the
resources that could produce that food, clothing, and shelter were sitting idle,
producing nothing.
At the worst point of the Great Depression, in 1933, one in four Americans who
wanted to work was unable to find a job. Further, it was not until 1941, when
World War II was underway, that the official unemployment rate finally fell
below 10%. This massive wave of unemployment hit before a food stamp
program and unemployment insurance existed. There were few government
programs designed to help the poor or those in temporary difficulty. Further,
most wives did not work, so if the husband lost his job, all income for that
household stopped. An equivalent rate of unemployment today would cause less
economic hardship because of the variety of programs (often inspired by the
Great Depression) that cushion unemployment and poverty.
Many people date the beginning of the Depression at October 24, 1929, Black
Thursday, the day the stock market crashed. This was indeed a traumatic day for
those who owned stock as sales volume broke all records. But the decline in
overall stock prices was only about 2.5%, from 261.97 to 255.39 as measured
by the New York Times index of 50 stocks. Most of the decline still laid in the
future; the market hit bottom on July 7 of 1932 when the Times index was only
33.98, a decline of over 89% from its high of 311.90 of September 19, 1929.
However, economists date the Depression somewhat differently. First, they
usually make a distinction between recession and depression, and they use the
concept of recession much more than they use the concept of depression. A
recession is a period in which economic activity is receding or falling, while a
depression is a period in which it is depressed below some level. In the picture
below, which shows a path of economic activity through time, the period from a
to b is the period of recession. At time a the economic activity is peaking, and
there is a trough at time b. After b the economy is in a recovery or expansion
stage. (Some economists call the period from b to c the recovery and the period
after c the expansion phase.) Which period is best called a depression is less
clear since one must first decide which level provides the measure of normalcy.
One could consider the period from a to c the depression because after c the
economy is above its previous high point, but there are other options that make
as much sense.
The period that is called the Great Depression contained two periods of
recession. The first began in August of 1929 (two months before the stock
market crash) and ended in March of 1933. (These dates have been chosen by
the National Bureau of Economic Research, a nonprofit organization that
sponsors a great deal of economic research. They are based on the analysis of a
large number of economic time series, and do contain some subjective
elements.) In the first recession the value of goods and services that the
economy produced fell by about 42% (but only by 36% once the effects of price
changes are eliminated). The recovery in the four years that followed was slow
and not completed by the time the second recession began. In this recession
lasting 13 months from May 1937 until June 1938, output fell by 9% (but only
6% when the effects of changes of prices are eliminated).1
The three graphs here show the effects of these two recessions on output (Gross
National Product or GNP), unemployment, and prices. Note that prices fell
considerably from 1929 to 1933, but not afterwards despite the very large levels
of unemployed resources. As a result of this fall, those who kept their jobs and
received the same pay in 1933 as in 1929 were much better off in 1933 than
they were in 1929. Another group that should have benefited from the decline in
prices was creditors because the real value of what was owed to them increased
as prices fell. However, many debtors could not pay because of the poor
business conditions, so not all creditors actually benefited from the deflation.
People perceive the 1930s as a period in which business failures were very high,
and they were when one compares them to what happened in the 1940s and
1950s. During the years 1930 to 1933, the annual failure rate was 127 for every
10,000 businesses. In contrast, failure rates in the 1950s were between 40 and
50, and for the 1940s they averaged only 23. However, during the years 1925 to
1929, a period usually considered prosperous, the failure rate averaged 104.
There was one segment of business that was unusually hard hit during the
Depression, the banking industry. The table below shows the number of banks
each year and the number of bank suspensions. A bank suspension indicates that
the bank closed during the year, but it does not mean that the bank failed. Some
banks closed only temporarily. Nonetheless, the total number of banks fell by
about one third during five years, either through merger, failure, or voluntary
liquidation. This process was not invisible to the public. The most dramatic
banking crisis in the history of the United States took place in early 1933. In one
of his first acts as president, Franklin Roosevelt declared a banking holiday and,
as a result, no banks were open from Monday, March 6 to Monday, March 13.
The drastic reduction in bank suspensions in 1934 reflects both new policies and
the enactment of legislation to insure banks.
Numbers of Banks and Bank
Suspensions
1929
Number as of
12-31
24,633
1930
22,773
1350
1931
19,970
2293
1932
18,397
1453
1933
15,015
4000
1934
16,096
57
Year
Suspensions
659
Data are from Banking and Monetary
Statistics, Board of Governors of the
Federal Reserve System, 1943, pages 18
and 283.
The high unemployment rates of the 1930s made those who had jobs both
thankful that they had jobs and fearful that they could lose them. Those who
could not find jobs often took to the roads—thousands of men regularly rode the
rails. The numbers in skid rows increased greatly, and other homeless set up
homes in shantytowns throughout the nation that became known as
"Hoovervilles." Because the Depression caused so much suffering, it is not
surprising that it caused major changes in the political structure in the United
States.
From the Civil War until the Depression, the Republican party was the
dominant political party—it generally controlled the House of Representatives,
the U.S. Senate, and the Presidency. In the elections of 1930, the Democrats
took control of the House of Representatives, and after the 1936 elections they
outnumbered the Republicans 331 to 89. Only once in the next fifty years did
Republicans capture a majority in the House. After the Republicans lost control
of the Senate in 1932, they regained a majority in only six of the next fifty
years. In the same year of 1932, Franklin Roosevelt was overwhelmingly
elected, defeating Herbert Hoover with a total of 22.8 million votes to 15.8
million. Along with the change in dominant political party has come a change in
what Americans expect from government. Only a limited understanding of
American politics is possible without understanding the effects of this period;
the shadow of the Depression dominated American political life for decades.
Finally, the Depression was more than an American affair. Many other nations,
though not all, experienced a similar decline, though the severity and timing
differed from country to country. For example, Britain hit its trough in the third
quarter of 1932, while France did not reach its low point until April of 1935.
The questions that the Great Depression raises are similar to those that the Great
Inflation raised. What caused this disaster? Was it caused by some defect in the
economic system of the United States or the world? Was it caused by some
accidental occurrence of unlikely events? Was the government in any way
responsible for it? Can a society take steps to insure that such an event does not
happen to it? Why was the Depression international in scope? Finally, is there
any relation between what happened in Germany in 1921-1923 and what
happened in the United States in 1929-1940?
1
Data are from Geoffrey H. Moore, Business Cycles, Inflation, and Forecasting, (Cambridge,
Mass: Ballinger, 1980), page 440. Other sources will give slightly different numbers.
Copyright Robert Schenk
Different Tools
Both microeconomics and macroeconomics start with the assumption that
people respond to incentives (or as economists are more likely to say,
individuals are self-interested and make decisions on the basis of costs and
benefits).1 But the different topics they address require different simplifying
assumptions. As a result, macroeconomic theory appears to be somewhat
different from microeconomic theory.
To understand the methods used in both, one must first realize that theory is a
creation of the human mind. It is our attempt to impose order on the world
around us. Theory is like a map. A good map shows how pieces of geography fit
together, but omits large amounts of detail. It simplifies the world so that our
minds can use the information it contains.
Economic reality is more complex than any human mind can completely
understand. To be useful, economic theory must give us a simplified picture of
this reality. In microeconomics the usual way to simplify is to use partial
equilibrium analysis. Partial equilibrium analysis assumes that we can look at
part of the system in isolation, ignoring the rest. Strictly speaking, this
assumption is rarely if ever true. What happens to the apple market may affect
the orange market, and these effects may in turn come back to affect the apple
market. But indirect effects of this sort are often small enough to ignore,
especially when one does not worry about the adjustment process.
Microeconomics usually begins with the assumption that the economy is at
equilibrium, that is, all markets clear. It then investigates properties of this
equilibrium.
In macroeconomics, however, these indirect effects are interesting and
important because economists have found that problems visible in one set of
markets very often have their origin in another set. The human mind, however,
cannot work through the interactions of the millions of markets that make up a
real economy. If the economy had only three of four markets, the patterns of
interaction would be simple enough to understand. Economists create this
simple economy of only a few markets by combining together, or aggregating,
many thousands or millions of markets that microeconomics looks at separately.
Microeconomics also aggregates, but not in the drastic way macroeconomics
does. Although the prefix micro suggests that microeconomics deals with small
units, such as individual consumers and sellers, it does not. It does discuss how
idealized individuals act, but only to use the results for predicting what groups
will do. And in discussing what groups do, it aggregates. Thus economics does
not predict what Adrienne Hrycyk will do if the price of apples increases by
10% due to a bad harvest. It does predict that consumers as a group will buy
fewer apples. Individual behavior involves many variables and price may not be
the most important. When groups become large enough, the special
circumstances of each individual tend to cancel out, and the role of price
dominates all other factors.
However, macroeconomics does not just lump together all the buyers or sellers
of one product: it lumps together completely separate markets. It combines
millions of markets into a few—often just two, three, or four. In a sense
economists replace apples, oranges, cars, and haircuts with a composite good
and discuss the market for goods and services, and they replace accountants,
lawyers, masons, and waitresses with a composite item and discuss the labor
market. This procedure may seem extreme, but economic measurements such as
rates of inflation and unemployment make sense only if this procedure is
accepted.
A recital of problems does not tell us anything about their causes. To examine
causes, we need theory to interpret the facts. Unfortunately, in macroeconomics
there remains a substantial amount of disagreement among economists about
what theory organizes the facts best. Topics of macroeconomics are usually
more controversial than topics in microeconomics.
1
This statement was not true fifty years ago when microeconomics and macroeconomics were
seen as two separate branches of economics. Since then much effort has gone into uniting them
by giving macroeconomics a foundation in microeconomics.