Stableness
13-05-2004, 16:22
HOW PEOPLE INTERACT
The first four principles discussed how individuals make decisions. As we go about our lives, many of our decisions affect not only ourselves but other people as well. The next three principles concern how people interact with one another.
Principle #5: Trade Can Make Everyone Better Off
You have probably heard on the news that the Japanese are our competitors in the world economy. In some ways this is true, for American and Japanese firms do produce many of the same goods. Ford and Toyota compete for the same customers in the market for automobiles. Compaq and Toshiba compete for the same
customers in the market for personal computers.
Yet it is easy to be misled when thinking about competition among countries. Trade between the United States and Japan is not like a sports contest, where one side wins and the other side loses. In fact, the opposite is true: Trade between two countries can make each country better off.
To see why, consider how trade affects your family. When a member of your family looks for a job, he or she competes against members of other families who are looking for jobs. Families also compete against one another when they go shopping, because each family wants to buy the best goods at the lowest prices. So, in a sense, each family in the economy is competing with all other families.
Despite this competition, your family would not be better off isolating itself from all other families. If it did, your family would need to grow its own food, make its own clothes, and build its own home. Clearly, your family gains much from its ability to trade with others. Trade allows each person to specialize in the
activities he or she does best, whether it is farming, sewing, or home building. By trading with others, people can buy a greater variety of goods and services at lower cost.
Countries as well as families benefit from the ability to trade with one another. Trade allows countries to specialize in what they do best and to enjoy a greater variety of goods and services. The Japanese, as well as the French and the Egyptians and the Brazilians, are as much our partners in the world economy as they
are our competitors.
Principle #6: Markets Are Usually a Good Way to Organize Economic Activity
The collapse of communism in the Soviet Union and Eastern Europe in the 1980s may be the most important change in the world during the past half century. Communist countries worked on the premise that central planners in the government were in the best position to guide economic activity. These planners decided what goods and services were produced, how much was produced, and who produced and consumed these goods and services. The theory behind central planning was that only the government could organize economic activity in a way that promoted economic well-being for the country as a whole.
Today, most countries that once had centrally planned economies have abandoned this system and are trying to develop market economies. In a market economy, the decisions of a central planner are replaced by the decisions of millions of firms and households. Firms decide whom to hire and what to make. Households decide which firms to work for and what to buy with their incomes. These firms and households interact in the marketplace, where prices and self-interest guide their decisions.
At first glance, the success of market economies is puzzling. After all, in a market economy, no one is looking out for the economic well-being of society as a whole. Free markets contain many buyers and sellers of numerous goods and services, and all of them are interested primarily in their own well-being. Yet, despite decentralized decisionmaking and self-interested decisionmakers, market economies have proven remarkably successful in organizing economic activity in a way that promotes overall economic well-being.
In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, economist Adam Smith made the most famous observation in all of economics: Households and firms interacting in markets act as if they are guided by an “invisible hand” that leads them to desirable market outcomes. One of our goals in
this book is to understand how this invisible hand works its magic. As you study economics, you will learn that prices are the instrument with which the invisible hand directs economic activity. Prices reflect both the value of a good to society and the cost to society of making the good. Because households and firms look at prices when deciding what to buy and sell, they unknowingly take into account the social benefits and costs of their actions. As a result, prices guide these individual decisionmakers to reach outcomes that, in many cases, maximize the welfare of society as a whole.
There is an important corollary to the skill of the invisible hand in guiding economic activity: When the government prevents prices from adjusting naturally to supply and demand, it impedes the invisible hand’s ability to coordinate the millions of households and firms that make up the economy. This corollary explains why taxes adversely affect the allocation of resources: Taxes distort prices and thus the decisions of households and firms. It also explains the even greater harm caused by policies that directly control prices, such as rent control. And it explains the failure of communism. In communist countries, prices were not determined in the marketplace but were dictated by central planners. These planners lacked the information that gets reflected in prices when prices are free to respond to market forces. Central planners failed because they tried to run the economy with one hand tied behind their backs—the invisible hand of the marketplace.
Principle #7: Governments Can Sometimes Improve Market Outcomes
If the invisible hand of the market is so great, why do we need government? One answer is that the invisible hand needs government to protect it. Markets work only if property rights are enforced. A farmer won’t grow food if he expects his crop to be stolen, and a restaurant won’t serve meals unless it is assured that customers will pay before they leave. We all rely on government-provided police and courts to enforce our rights over the things we produce.
Yet there is another answer to why we need government: Although markets are usually a good way to organize economic activity, this rule has some important exceptions. There are two broad reasons for a government to intervene in the economy—to promote efficiency and to promote equity. That is, most policies aim either to enlarge the economic pie or to change how the pie is divided.
Although the invisible hand usually leads markets to allocate resources efficiently, that is not always the case. Economists use the term market failure to refer to a situation in which the market on its own fails to produce an efficient allocation of resources. One possible cause of market failure is an externality, which is the impact of one person’s actions on the well-being of a bystander. For instance, the classic example of an external cost is pollution. Another possible cause of market failure is market power, which refers to the ability of a single person (or small group) to unduly influence market prices. For example, if everyone in town needs water but there is only one well, the owner of the well is not subject to the rigorous competition with which the invisible hand normally keeps self-interest in check. In the presence of externalities or market power, well-designed public policy can enhance economic efficiency.
The invisible hand may also fail to ensure that economic prosperity is distributed equitably. A market economy rewards people according to their ability to produce things that other people are willing to pay for. The world’s best basketball player earns more than the world’s best chess player simply because people are willing to pay more to watch basketball than chess. The invisible hand does not ensure that everyone has sufficient food, decent clothing, and adequate health care. Many public policies, such as the income tax and the welfare system, aim to achieve a more equitable distribution of economic well-being.
To say that the government can improve on market outcomes at times does not mean that it always will. Public policy is made not by angels but by a political process that is far from perfect. Sometimes policies are designed simply to reward the politically powerful. Sometimes they are made by well-intentioned leaders who are not fully informed. One goal of the study of economics is to help you judge when a government policy is justifiable to promote efficiency or equity, and when it is not.
The first four principles discussed how individuals make decisions. As we go about our lives, many of our decisions affect not only ourselves but other people as well. The next three principles concern how people interact with one another.
Principle #5: Trade Can Make Everyone Better Off
You have probably heard on the news that the Japanese are our competitors in the world economy. In some ways this is true, for American and Japanese firms do produce many of the same goods. Ford and Toyota compete for the same customers in the market for automobiles. Compaq and Toshiba compete for the same
customers in the market for personal computers.
Yet it is easy to be misled when thinking about competition among countries. Trade between the United States and Japan is not like a sports contest, where one side wins and the other side loses. In fact, the opposite is true: Trade between two countries can make each country better off.
To see why, consider how trade affects your family. When a member of your family looks for a job, he or she competes against members of other families who are looking for jobs. Families also compete against one another when they go shopping, because each family wants to buy the best goods at the lowest prices. So, in a sense, each family in the economy is competing with all other families.
Despite this competition, your family would not be better off isolating itself from all other families. If it did, your family would need to grow its own food, make its own clothes, and build its own home. Clearly, your family gains much from its ability to trade with others. Trade allows each person to specialize in the
activities he or she does best, whether it is farming, sewing, or home building. By trading with others, people can buy a greater variety of goods and services at lower cost.
Countries as well as families benefit from the ability to trade with one another. Trade allows countries to specialize in what they do best and to enjoy a greater variety of goods and services. The Japanese, as well as the French and the Egyptians and the Brazilians, are as much our partners in the world economy as they
are our competitors.
Principle #6: Markets Are Usually a Good Way to Organize Economic Activity
The collapse of communism in the Soviet Union and Eastern Europe in the 1980s may be the most important change in the world during the past half century. Communist countries worked on the premise that central planners in the government were in the best position to guide economic activity. These planners decided what goods and services were produced, how much was produced, and who produced and consumed these goods and services. The theory behind central planning was that only the government could organize economic activity in a way that promoted economic well-being for the country as a whole.
Today, most countries that once had centrally planned economies have abandoned this system and are trying to develop market economies. In a market economy, the decisions of a central planner are replaced by the decisions of millions of firms and households. Firms decide whom to hire and what to make. Households decide which firms to work for and what to buy with their incomes. These firms and households interact in the marketplace, where prices and self-interest guide their decisions.
At first glance, the success of market economies is puzzling. After all, in a market economy, no one is looking out for the economic well-being of society as a whole. Free markets contain many buyers and sellers of numerous goods and services, and all of them are interested primarily in their own well-being. Yet, despite decentralized decisionmaking and self-interested decisionmakers, market economies have proven remarkably successful in organizing economic activity in a way that promotes overall economic well-being.
In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, economist Adam Smith made the most famous observation in all of economics: Households and firms interacting in markets act as if they are guided by an “invisible hand” that leads them to desirable market outcomes. One of our goals in
this book is to understand how this invisible hand works its magic. As you study economics, you will learn that prices are the instrument with which the invisible hand directs economic activity. Prices reflect both the value of a good to society and the cost to society of making the good. Because households and firms look at prices when deciding what to buy and sell, they unknowingly take into account the social benefits and costs of their actions. As a result, prices guide these individual decisionmakers to reach outcomes that, in many cases, maximize the welfare of society as a whole.
There is an important corollary to the skill of the invisible hand in guiding economic activity: When the government prevents prices from adjusting naturally to supply and demand, it impedes the invisible hand’s ability to coordinate the millions of households and firms that make up the economy. This corollary explains why taxes adversely affect the allocation of resources: Taxes distort prices and thus the decisions of households and firms. It also explains the even greater harm caused by policies that directly control prices, such as rent control. And it explains the failure of communism. In communist countries, prices were not determined in the marketplace but were dictated by central planners. These planners lacked the information that gets reflected in prices when prices are free to respond to market forces. Central planners failed because they tried to run the economy with one hand tied behind their backs—the invisible hand of the marketplace.
Principle #7: Governments Can Sometimes Improve Market Outcomes
If the invisible hand of the market is so great, why do we need government? One answer is that the invisible hand needs government to protect it. Markets work only if property rights are enforced. A farmer won’t grow food if he expects his crop to be stolen, and a restaurant won’t serve meals unless it is assured that customers will pay before they leave. We all rely on government-provided police and courts to enforce our rights over the things we produce.
Yet there is another answer to why we need government: Although markets are usually a good way to organize economic activity, this rule has some important exceptions. There are two broad reasons for a government to intervene in the economy—to promote efficiency and to promote equity. That is, most policies aim either to enlarge the economic pie or to change how the pie is divided.
Although the invisible hand usually leads markets to allocate resources efficiently, that is not always the case. Economists use the term market failure to refer to a situation in which the market on its own fails to produce an efficient allocation of resources. One possible cause of market failure is an externality, which is the impact of one person’s actions on the well-being of a bystander. For instance, the classic example of an external cost is pollution. Another possible cause of market failure is market power, which refers to the ability of a single person (or small group) to unduly influence market prices. For example, if everyone in town needs water but there is only one well, the owner of the well is not subject to the rigorous competition with which the invisible hand normally keeps self-interest in check. In the presence of externalities or market power, well-designed public policy can enhance economic efficiency.
The invisible hand may also fail to ensure that economic prosperity is distributed equitably. A market economy rewards people according to their ability to produce things that other people are willing to pay for. The world’s best basketball player earns more than the world’s best chess player simply because people are willing to pay more to watch basketball than chess. The invisible hand does not ensure that everyone has sufficient food, decent clothing, and adequate health care. Many public policies, such as the income tax and the welfare system, aim to achieve a more equitable distribution of economic well-being.
To say that the government can improve on market outcomes at times does not mean that it always will. Public policy is made not by angels but by a political process that is far from perfect. Sometimes policies are designed simply to reward the politically powerful. Sometimes they are made by well-intentioned leaders who are not fully informed. One goal of the study of economics is to help you judge when a government policy is justifiable to promote efficiency or equity, and when it is not.