Knowing Economics

Knowing Economics

by

Sam Choon Yin (2004)

Introduction

It is useful to begin by defining the term ‘Economics’. Essentially, Economics is a subject that helps us to better understand how human beings make choices. Without any doubt, every one of us has to make choices regardless of whether you are young or old, rich or poor. We face a common problem; an economic problem known as scarcity. A relative concept, the problem emerges because the amount of resources we have is not sufficient to meet all of our wants. Income and time are some examples of resources which are limited in supply. With limited resources, a typical individual has to make hard choices and choose the alternative that yields the highest net benefit and forgo the rests. Each of the choices he/she makes brings forth benefit and cost. The latter in Economics is known as opportunity cost, which basically measures the value of the next best alternative forgone.

Assume that you have $17 dollars to spend. The decision you make to purchase a CD worth $17 essentially compels you to forgo watching a movie in the cinema with your friend over the weekend. The opportunity cost of making that decision in this case is the benefit that you may gain from watching the movie. Of course, your decision to purchase the CD allows you to enjoy the benefit which accompanies the item.

To make the wisest choice, it is important that the decision-makers have all the necessary information to assist them. With the information, they would be able to rank the various alternatives according to their net benefits generated. Obviously, a rational individual will select the alternative that yields the highest net benefit. So, if alternative A has the highest net benefit, followed by alternatives B and C, then A is preferred to B and B is preferred to C. Then, the statement ‘A is preferred to C’ should hold as well. The situation however is not as straightforward as it seems. Information for example may not be forthcoming. Even if information is available, the human brain may not be able to decipher all the information. Some information are simply too technical. As a result, individuals are bounded rational who may end up making less than optimal choices. These individuals are said to be satisficing, a term coined by the late Herbert Simon, a Nobel Price Winner for Economics Science. It may also be the case that actions and knowledge are deliberately hidden from you thus disallowing you to obtain ‘non-lemon’ goods. Partly because of these limitations, Economics, in recent years, has been increasingly interfaced with other disciplines like Psychology and Animal Behaviour to better understand how human beings behave and make choices.

Marginal thinking

In Economics, individuals are also assumed to be marginal thinkers. Being a marginal thinker implies that the person thinks incrementally, rather than in totality or in terms of averages. The firms for example decide whether to produce an additional unit of output or not by comparing the additional benefit reaped and the additional cost incurred. The consumers decide whether to purchase one more hamburger or not by comparing the additional (or marginal) benefit of having the hamburger versus the marginal cost incurred. A worker decides whether to work one additional hour or not by comparing the marginal benefit of working (wages) and the marginal cost of working (less leisure). Obviously, the decision makers will choose a particular alternative provided that it yields marginal benefit that is in excess of the marginal cost. In other words, the chosen alternative should ideally yield net marginal benefit that is greater than zero.

Do we think marginally? We do. For example, we feel happier on a particular day after a string of bad days although on the average, the net happiness might still be in the negative territory. Also, we may have the tendency to ignore the good times we had with our friends or relatives in the past such that a recent bad experience could leave scars that are difficult to (or never) heal. A person who thinks marginally therefore ignores the past and focuses on the incremental benefit and cost to help them make choices. What is its implication? The implication of marginal thinking is that seeking improvement on a continuous basis is essential to the economic actors so that they can remain competitive and gain greater acceptability from others. Firms and government for example cannot take it for granted that successes in the past will continue. Past excellence cannot guarantee that they will remain competitive and successful in the near future. They have to keep up with the times.

Three main economic actors

There are three main economic players in a typical country; households, firms and government. The householders are members of the family who make decisions like what to buy, what to invest in and how many hours to work. They are motivated by the intention to maximize their private utility (or satisfaction). Firms are business entities aimed to maximize profits. Since firms are not ‘humans’, they do not make decisions per se. Instead, the persons-in-charged of the firms are the ones who make decisions. In family-owned business, the persons are usually the founders, their relatives and close friends. In public listed corporations, professional managers like the Chief Executive Officers (CEOs) and their directors have the discretionary power in allocating the company resources. It is important that they make decisions aimed to maximise the interest of the owners (or shareholders). In reality, this is often not the case. The executive managers for example may seek opportunities to expropriate company’s funds to pay higher salaries to themselves, furnish their officers with unnecessary electronic gadgets and travel excessively in business trips. This phenomenon is known as the agency problem. Governments, like firms, are not human beings. Accordingly, they do not make decisions. Rather, it is the persons-in-charged of the governments who make decisions. In Singapore, the cabinet members led by the Prime Minister monitor the economic environment and implement the necessary policies to maximize the social welfare. They seek the support from the Members of Parliament (MPs) and other public officials to help them attain this objective. Being elected to office by the voters, the politicians (MPs) are trustees for the public, responsible for the enactment of policies and review them when necessary.

The three main economic actors in a typical country are connected through the circular flow of income model. The model depicts the inter-relationship between the three players. Let’s begin with the firms. Firms are suppliers of goods and services in the country. To assist in their work, householders supply the firms with capital and labour inputs. In turn, the householders are rewarded with income in the form of remuneration, interest and rent. With the income, the householders are able to purchase final goods and services from the firms to maximize their personal utility. The government too make purchases of goods and services produced by the firms say to build public houses, schools, hospitals and road. The government employs public officers (householders) and reward them with remunerations and benefits in kind. The government finances its expenditures through the tax revenue, fees and charges it collects from the households and firms.

Understanding how the consumers, firms and government think and react is useful for their actions can ultimately affect the country’s economy. In Economics, the main macroeconomic indicators are Gross Domestic Product (GDP), inflation rate and unemployment rate. The GDP measures the total value of goods and services produced within the territorial boundary of the nation, usually within a year. Consumers’ decision to spend more and the firms’ decision to invest more can push the country’s national product upward possibly creating higher standards of living for the people. More jobs may be created in the process thus providing the people with income to feed themselves, and the opportunity to use their time more systematically and productively. The unemployment rate - which measures the percentage of the labour force that is unemployed – may be lowered as a result. Otherwise (high unemployment rate), social problems like stealing and kidnapping may become more severe. It is therefore the fiduciary responsibility of the government to see that the country enjoys reasonable growths in the GDP with low unemployment rate. It is also essential that the government maintain the general price level (measured by the inflation rate indicators; the common ones include Consumer Price Index and GDP deflator) at a comfortable level. Higher inflation rate may lower the real value of money or income. The residents in this case are less well off than before simply because lesser quantity of goods and services could be purchased and consumed with other things (like income) remain unchanged.