Common Sense Economics: What Everyone Should Know About Wealth and Prosperity- James Gwartney, Richard L. Stroup, Dwight R. Lee
A Summary (with a little analysis)-
Genius ain't anything more than elegant common sense.
-Josh Billings
This book reinforces nothing but what one faces everyday on the economic front. It is a must read to understand how the "science" of economics functions. It is observed that one tends to undermine things that generally governs the daily life. This book is a reminder that it is not a herculean task to be wise on the economic vanguard, all you got to have is a little common sense about economics.
Introduction- The purpose of the book
This book is designed for beginners, specialists in the subject of economics as well as policy makers who are responsible for bringing ‘actual’ concrete changes in the economy.
For policy makers, this book gives an insight of the ‘larger picture’ which entails political rules and policy.
It highlights how people’s ‘economic illiteracy’ in a Democratic society can result disastrous for the economy of the country.
This books aims at explaining why some nations prosper which usually depends on the common people’ understanding of good economic arrangements.
The link between good political choices and prosperity is highly interlinked. The wonders of understanding common economic principles are very often underestimated.
The importance of understanding how specified principles that govern developed countries can be replicated anywhere is explained in the book.
This book shows in what ways politics and economics are intertwined. The question of whether taxes hurt more than they benefit an economy is answered.
I
Ten key elements of Economics-
Incentives matter-
Firstly, let us make an endeavor to understand what incentive means literally. Incentive is a thing that motivates or encourages one to do something. The author stresses how human nature is intertwined with incentives. Regardless of whether a person is a materialist or an altruist, his/her actions are to a large extent influenced by incentives.
The very crux of why ‘incentive matter’ explains the reason why individuals, business houses and even governments behave the way they do. The basic economic principle of demand and supply reflects how individual incentives result is altering the entire working of the market. While understanding the market behavior one needs to keep in mind the role of ‘time’ and how it affects incentives of suppliers as well as buyers.
‘Incentives’ has a direct influence on political choices as well. The author links the similarity between an individual who goes out for shopping and the ones who are in a voting booth. In both the cases, their behavior is directly affected by incentives. They are guided by the motive of benefitting one way or the other. Incentives play an important role no matter what sort of government structure one has.
There is no such thing as a free lunch-
There is a simple explanation for why there is no free lunch. Though it sounds stereotypical, it is quintessential to understand the fact that our planet’s resources are not infinitely abundant. The constraints in availability of resources make it a must for everyone to earn their own living. This problem is created because even the producer incurs costs for various factors of production. The ‘reality of scarcity’ somehow makes it pertinent that someone has to bear the cost, which makes it compulsory for one to pay for what he/she is demanding.
Decisions are made at the margin-
Making a conscious decision is the manifestation of the entire thinking process. When one’s motive is clear, one takes decisions based upon it. A rational individual will always base decisions on pragmatic grounds. The reason why they are called marginal is because decisions are always based on calculation of either loss or profits in units. Something gets sacrificed at the cost of getting something else. It is necessary to strike a balance between what is viable and what is approachable. Marginal benefits needs to exceed marginal cost. Necessity governs people’s decisions. For instance, in a poverty stricken country more money is expected to be invested in basic necessities than recreational activities.
Trade promotes economic growth-
The benefits of trade are beyond argument. The main emphasis is that both the parties benefit mutually.
Trade facilitates various essential advantages. Firstly, it creates the utility of transferring the good to people who value them more from the people who value them less. We could take the example of medicine manufacturers and its consumers. The manufacturer does not use its produce by it ‘self, the very purpose of its establishment is to hand over them to sick patients. Trade creates utility for all the participants.
Secondly, trade makes specialization possible. This helps in production of goods in economies of scale and ultimately upgrades quality and efficiency. The law of comparative advantage makes it possible for one individual to enjoy different products at the most reasonable price. It is of not pragmatic to produce everything at a higher cost, trade helps in avoiding this problem.
Transaction cost are an obstacle to trade-
Some sort of specialists, often called as middlemen who facilitate trade help in reducing the transaction cost. These middlemen help in overcoming barriers of time and space. At a very nominal charge they deliver the producer’s goods to the consumers. Hence, they help in avoiding too much transaction cost.
Profits direct businesses activities that increase wealth-
Any given country has limited resources. More emphasis needs to be put on productive activities than less productive activities. These resources are determined by geography and their accessibility. Producers need to focus on producing goods that consumers value more. It is obvious that when consumers are willing to purchase something, they are also willing to pay as per the demand of the manufacturer. Otherwise, there would have been no incentive for any one of them, which will lead to a halt in progress.
People earn income by helping others-
Every individual who makes an income is helping other as well. It hardly matter what this individuals’ motive is. But he is providing service to others, and the consumers reciprocate by paying them something in return. High incomes are possible only when one creates utility based products that others benefit from.
The prerequisites for economic growth-
These prerequisites include engagement in trade, investment in technology (including human capital) and sound economic institutions. The evolution of progress can be traced through the development of the above factors. The more advanced these requisites become, the more likely an economy will progress. There is a very proportional relation between progress and the mentioned factors. The economic institutions also determine progress as they create proper grounds for sound economy. Free market is always necessary as it facilitates a platform for innovative ideas. This is very essential for entrepreneurship to flourish.
Role of the ‘Invisible Hand’-
As Adam Smith propounded the idea of ‘Invisible Hand’, he stressed that market prices directs buyers and sellers towards transactions that ultimately promotes general welfare. It is true that modern economy based on private property encourages self-interest but the ‘invisible hand’ of market prices promotes overall prosperity. The presence of market prices avoids the problem of central planning, which has proved to be inefficient after the collapse of the former Soviet Union. It guides the producer as well as the consumer in the best way possible. It is not possible for any individual or central planning authority to obtain information needed for millions of consumers and producers of myriad number of goods, but market prices contain this information that is the best guide for everyone in the market.
Shortsightedness is a major economic deficiency-
There is a tendency of people to ignore the long term consequences as well as the secondary effects of an action. This is highly prevalent in the political arena. The voters often try their best at maximizing the immediate benefits. The secondary effect of an action is not immediately visible. The question of government spending on generating jobs highlights this case. For instance if a government spends a billion rupees in employing 10,000 workers for a project and decides to fund this project by imposing taxes on general people, these taxes will reduce consumer spending and consequently leads to destroying jobs.
Secondary effects are a problem not just for government, but for individuals as well.
II
Seven major sources of economic progress-
Efficient Legal system-
As explained above, it is an established fact that a country can only flourish with free trade, enhancement of industries and the existence of private property. Only an effective legal system can guarantee optimum utilization of these factors. Legal system helps in avoiding uncertainties and arbitration on the part of the players in the market. Property includes ownership of labor services and ideas as well as physical assets such as buildings and land. Private ownership not only helps in prosperity but also makes individuals responsible for their own action. Private ownership encourages wise stewardship, as one feels responsible towards one’s own property. As ‘self-interest’ is at stake, the owner tends to use his/her property for productive endeavors. Private ownership encourages usage of their property in a way that automatically benefits others. Usually private owners focus on conserving their resources for the long term, this leads to planning and consequently systematic growth. It is necessary to understand the incentives that private ownership operates with. When there is a scarcity of these resources, the prices usually soar up which leads to automatic conservation of these resources and also people are encouraged to find better alternatives then.
A legal system that protects private property provides foundation for capital formation and gains from trade which is the mainsprings of economic growth.
Competition- A driving force for pushing innovation and efficient use of resources-
In a free market, consumers tend to play an important role of choosing from the best available alternative. This creates competition for the producers who are compelled to make the best of what resources they have. Competition eradicates inefficient producers. It creates incentives for producers to develop better products, and that also in a lower cost. Complacency in the part of the producer is avoided. As Adam Smith puts ‘it is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner but from their regard to their own self-interest’. This clearly indicates that competition leads to mutual gain to everyone.
Too much regulatory policies that reduce trade also retard economic progress-
The tendency of imposing too many regulations on trade in many countries has resulted in disastrous results. This includes limiting entry of new firms in various businesses. Regulations that give priority to political authority over the rule of law and freedom of contract always undermine gains from trade. This creates the problem of corruption, red tape, and inefficiency. The other problem that rigid government regulations create is fixing of prices by themselves. When they set the price above the market price, consumers are discouraged to purchase them.
Allocating capital-
Allocation of capital into wealth creating projects is a sign of vibrant capital market. It is essential to have mechanisms capable of efficiently using the available resources for a country to realize its potential. Investment in capital needs to be consumption-oriented. The value of the additional output derived from the investment needs to exceed the cost of investment. The country needs to develop mechanisms that encourage saving which usually is used for investment. The country needs to invest its resources in productive endeavors. In the modern economy, the capital market plays an important role.
Private investors such as small business owners, corporate stockholders, and venture capitalist place funds at their own risk. On the contrary, when investment funds are allocated by the governments rather than by the market, an entirely different set of factors come into play. Rather than investing in projects that have more market return, political influence decide here. Former Soviet Union and other eastern European countries highlight the disastrous results. Here, when governments fix interest rates which are lower than the rate of inflation, the wealth of the people also fall. Hence, it leaves less incentive for saving. In countries where governments control capital movements, fix interest rates, and allocate capital on the basis of political rather than economic considerations, inefficiency will surely take over.
The need for monetary stability-
As money is the main means of storing purchasing power for future use, instability in it will create confusion for both lenders as well as borrowers as it creates circumstances that discourage negotiations. Savings and investing will involve very high risks. Hence, gains from specialization, large scale production will be hindered because of the mistrust in the credibility of money. When too much money is supplied in comparison to the supply of goods and services, the value of money declines, and prices increase. This happens when governments print money or borrow too much from central banks in order to pay their bills. Usually the governments have a tendency to blame the greedy businesses, labor unions, big oil companies. This is just a fraud tactic to divert their actions. When there is too much inflation, people will spend less time producing and more time trying to protect their wealth.
Another major problem is that it undermines the credibility and confidence in the government. Hence, the government’s ability to take concrete actions also diminishes. This solely happens because the well being of common people is put in risk. Only when money supply is controlled the price stability can be maintained.
The role of tax-rates-
People are encouraged to produce more when they are allowed to keep more of what they earn. It will also discourage foreign investors from investing in the domestic market and encourage domestic investors to invest abroad. Another disadvantage of high rate of taxation is that people get encouraged to consume tax-deductible goods in place of non-deductible good against their preference as tax-deductible goods will be cheaper. In a nutshell, high tax rates reduce productivity activity, retard capital formation and promote wasteful use of resources.
The advantages of free trade-
The law of comparative advantage comes into play when a country engages in free trade. This means that a country will be selling goods and services that it can produce at a relatively low cost and buying those that would be costly to produce. In this way, when a country produces in bulk it enjoys from the economies of scale. It also is in an advantageous position as it can get a wide variety of goods at the cheapest price possible. International trade also promotes competition in domestic markets and allows the consumers to purchase a wider variety of goods at lower prices. Trade restraints such as tariffs, quotas, exchange rate controls on imports or exports tend to hinder complete advantage from international trade.
The claim that non-economists often argue that import restrictions create jobs is fallacious. The main concern is to generate goods and services that people value, and just creating job does not facilitate this. As free trade fosters competition, when people are allowed to engage in it the producers as well as consumers are benefited. As every country is advantaged over others in producing something or the other, free trade allows the most efficient mode of making the best of what is produced in all countries.
Conclusion- How much does institutions and policies matter?
There is a direct co-relation between prosperity on one hand and the way a country provides secure protection of privately owned property, evenhanded enforcement of contracts, and a stable monetary environment. Government needs to be the facilitator rather than the provider. The institutions and policies need to enhance the above mentioned factors for economic progress. When low income countries get the institutions and policies right, they are able to achieve exceedingly high growth rates and narrow their income gap with the high-income industrial nations. Countries like HongKong, Singapore, Taiwan, Ireland, Chile, Mauritius and Botswana illustrate this point. In the past decades all of these countries have made substantial moves toward economic freedom, and all of them have grown rapidly and achieve substantial increases in income levels and living standards. Without any doubt, if any country wants to strive towards prosperity it needs to provide greater economic freedom.
III
Economic progress and the role of government-
The government has been an integral part of every modern civilization. A good government always engages itself in protective and productive endeavors. It protects people’s lives, liberties and properties. And it produces goods that normally private producers cannot provide.
As the government has the monopoly on the use of legitimate force, it needs to protect the people’s efforts and the profits that it results in. Hence, people are encouraged to engage in productive endeavors. The nature of public goods and the way it is regulated makes it impossible for private businesses to produce them. This is why the government needs to take the responsibility to engage in producing goods that only it can produce compared to the private sectors. For example, building a damn is not feasible for private companies.
Government is not a corrective device-
The misconception that government is a corrective device is widespread. The government is just a medium through which people collectively make choices and carry out activities. Even a democratic government which is based on the will of the majority does not assure the best use of resources. They need to play the role of a facilitator rather than the provider.
The costs of government are not just taxes-
Very frequently politicians fail to mention the entire expenditure they incur. Only taxes are mentioned which is only a partial cost incurred by the government. They tend to miss out on explaining about the ‘opportunity cost’. Three types of costs are incurred by the government. The first one is the loss of private sector output that could have been produced with the resources that are now employed producing the goods supplied by the government. The second cost is the resources expended in the collection of taxes and the enforcement of government mandates. And finally, the cost of price distortions resulting from taxes and borrowing. This creates a gap between what buyers pay and sellers receive. These other costs also need to be considered when analyzing the merits of government programs.
The need for constitutional rules to restrain advantages to special interest groups-
There is a tendency that democratically elected officials favor special interest groups at the expense of the general public. When the government policy is limited to its proper function, it contributes mightily to economic prosperity. We could take the case of a policy that will generate personal gains for the members of the specific groups at the expense of the broader interest of taxpayers or consumers. Hence, constitutional rules need to restrict misallocation of the resources.
Unless restrained by constitutional rules, legislators will run budget deficits and spend excessively-
Budget deficit emerges when government spending exceeds earnings. Then they issue interest earning bonds to finance their budget deficits. These bonds comprise the national debt. Constitutional restraints need to be introduced to prevent the government spending more than what they are willing to tax.
Economic growth is hindered when government is involved to help some people at the expense of others-
Individuals acquire wealth either by engaging in production or by plunder. Government needs to encourage productive activity and discourage plunder. Government in this case needs to act as a neutral force. When the effective law of the land makes it difficult to take away the property of others, few resources will flow into plunder. The quantity of resources directed towards lobbying, political campaigns, and the various forms of “favor-seeking” from the government is rampant in the modern world. The unfair transfer of wealth from tax-payers to well-organized groups and voting blocs has become the business of the modern politics.
Too much cost of income transfers makes it unfeasible-
The need to transfer income is widely recognized in the modern world. But the cost of income transfers is far greater than the net gain to the intended beneficiaries. This failure is explained by the common proposition: this transfer of income does not guarantee the well-being of the recipient in the long run. Moreover, it is a tedious task to identify the right beneficiaries. At times, people modify their behavior just to qualify for being a beneficiary. Apart from making people less productive, people are encouraged to make choices that are likely to make them more prone to adversity.
The unsuitability of central planning-
Market price has been established as being the most efficient medium to cater progress, and central planning contradicts this. Central planning hardly substitutes politics for market verdicts. Even when decisions are made by the general public, it needs to be ratified by legislators. Governments hardly involve in innovative endeavors. Innovative tasks are highly risky because of the unlikelihood of success. Moreover, it is guaranteed that when one is putting his/her own investment they will try to make the best decisions because of the stakes involved. Central planning is not feasible because, they tend to miss out on recognizing problems created by lack of accessibility. Moreover, in this dynamic world where things tend to change very often, the government is sure to look out and amend its plan as per required.
Competition is just as important in government as in markets-
Unlike in the private sector where performance can be monitored, there are no methods to identify performance of the personnel in the government sector. Hence, it is very essential for government enterprises to face competition. To make the best out of the government organizations, private firms should be permitted to compete on a level playing field with government agencies and enterprises. The government cannot act oppressive when citizens have the right to choose from whom to seek services. Competition among decentralized government units- state and local governments will also help promote economic progress.
Need of constitutional rules to bring political process and sound economics in harmony-
Only democratic elections will not ensure economic progress. The government needs to strive to set political rules that encourage self-interest of voters, politicians, and bureaucrats into harmony with economic progress. This makes it necessary for it to keep its role limited and neutral among various sub-groups of citizens.
Things to remember-
Economic prosperity is only possible through private ownership, freedom of exchange, competitive markets, the rule of law, and monetary stability. After these prerequisites are present citizens will be able to “reap what they sow”, and consequently which will lead towards a prosperous economy.
.jpg)
