I’m just finishing Basic Economics: A Citizen’s Guide to the Economy by Thomas Sowell. The author introduces the book with the following:
What I have learned after many years of teaching and writing about economics is that there are highly intelligent people who want to understand more about the way the economy works, but who have no interest in the paraphernalia of the economics profession. This book is written for such people.
This is a great book to introduce economics, and I recommend you check it out from the library immediately (as a personal finance aficionado how could I suggest you buy it when you can read it for free!?!). The following are some of my notes that I jotted down while reading.
Definition. “Economics is the study of the use of scarce resources which have alternative uses.” – Lionel Robbins. This definition has two key parts: 1) scarcity, and 2) alternative uses of resources.
Without scarcity, there is no economy. When there is an abundance or a plethora of goods (like the Garden of Eden), there is no need to economize or worry about competing for goods and services. Scarcity is when what everyone wants adds up more than there is.
Alternative uses of resources is the second key ingredient. Wood can be made into thousands of different objects, from toothpicks to toboggans. It is up to the economy to determine how much wood should be allocated for each use. Oftentimes, the strength of the economy is tied to the efficiency of this happening.
Prices. This leads directly to the importance of prices. In a capitalist economy, when too many toboggans are made, the toboggan manufacturer has to lower the prices in order to sell (maybe even so low as to sell them for less than it cost to produce). The toboggan manufacturer wants to avoid this, so he or she will reduce the amount of wood purchased in the future. Products that are selling well will pay more for the price of wood, and wood is efficiently allocated for many, many uses this way.
In non-capitalist governments such as socialist or communist governments, the efficiency is often decreased because the free market does not help allocate resources efficiently into alternative uses (the government allocates resources).
Prices are simply messengers conveying basic supply and demand within a society. For example, prices show us that there are not enough beach-front homes for everyone to live in. In this case, demand is high and supply is low, so prices increase. If the government announced a new policy that no home on the Malibu coast could sell for more than $50,000 this would not change the reality that there are more people than beach front homes (even though more people could suddenly afford this option).
In a free market, prices work extremely well as messengers. Companies basically guess what consumers want and the demand for these products allows prices to rise or fall. When Toyota created the Prius, it was a success with consumers and over 2 million cars have been sold from 2001-2010. Compare this to the Plymouth Prowler, of which only 8,100 sold from 1999-2002. During this time, Plymouth incurred such losses that it was taken over by Chrysler.
Without feedback, Plymouth would keep making the same mistakes forever. But free markets provide quick feedback and when a company can’t adapt to the best interest of consumers, it often ends in bankruptcy. While this sounds cutthroat and harsh (especially for the employees of Plymouth), this efficiency is in the best interest of the public because it is the public that allows demand to determine the products that stick around.
Prices can help supplies rise and fall. If there is a crop failure somewhere, other food producers race to get there to beat competitors and take advantage of high prices. While this seems self-serving, it actually ends up helping everyone because competition gets the food to hungry people faster. It is the lack of competition (like the US government agency FEMA) that causes slow response rates similar to what happened after Hurricane Katrina. The picture to the left (taken in the Superdome) is a reminder of the failure of FEMA to help the people of New Orleans in 2005.
Scarcity causes competition. Another benefit of the pricing system is that it prevents direct animosity between competitors. If a Catholic church at one end of town is saving for a new addition, they are directly competing with the Islamic mosque at the other end of town that needs those same materials for their own addition. Luckily, each religious institution, while competing for products, isn’t pitted against each other in the same way they would be if the government was doling out money or supplies.
Incremental substitution. Prices also help serve people’s needs better because of incremental substitution. If the prices of oranges go up, some people will continue to eat the same amount, some will cut back a little, some will cut back a lot, and others will go on to eat another fruit. Not everyone stops eating oranges all at the same time, which would cause mayhem for the economic system.
Economies of scale and diseconomies of scale. What is the price to make something? That depends. If you make one it could cost “x”, but if you make 100,000 of the same thing, the price per unit drops way down (like Henry Ford producing Model T’s, which has revolutionized transportation).
Interestingly, when a company gets too big the company can’t manage all of the working departments as efficiently. Jetblue can move more efficiently and cheaper than the big airlines. This is an example of diseconomy of scale.
Costs and capacity. Costs vary depending on capacity. When reserved seats on an airplane are paid for by 180 people, the remaining 20 people that fly standby pay very little. The tradeoff is saving money for giving up reserved seating. This is the same reason you can score super cheap hotel rooms or cruises during certain times of the year – something I can teach everyone to do!
Specialization. Car dealers make tens of thousands of cars per year but not a single tire. They buy them from Goodyear, a company that can make tires more efficiently. Car dealers also don’t try to run dealerships across the country. They sell cars to people who own dealerships who can determine the price and sell the car more efficiently than the manufacturer because they know their respective markets.
Middleman. Once a company realizes it can outsource a part of the process and save money, a middleman exists. A newspaper company rarely owns their own newsstand. Many companies are terrible at realizing they should outsource –causing them to be outcompeted and they are forced to go under.
In conclusion, I know this was a long article about prices. But prices are fascinating to me and I think few people realize what prices tell us. I also had some great business ideas while writing this article because you start to learn about how companies run.
For example, all you need to for a successful startup is to first recognize an area that a company is not doing efficiently. Then, specialize in that one specific process and prove to them that you are going to save them time or money. There have to be about thousands upon thousands of companies that use this as their primary source of revenue and still thousands more opportunities for this to be done!
Of the four types of prices (consumer goods, labor, borrowing money, services), I’ve pretty much only touched on consumer goods. There’s a lot to learn, but that’s part of the process. If you have recommendations or suggestions, I’d love to hear what you think. Just leave a comment or email me!
~Nick, the Self Taught Economist