6. If you want a financially comfortable retirement, then start saving as soon as possible in order to receive maximum benefit from compound interest.

6. If you want a financially comfortable retirement, then start saving as soon as possible in order to receive maximum benefit from compound interest. Interest is the rate of return earned on an investment. Compound interest, which is interest earned on previously earned interest, is most effective when you have a long time horizon. Regular savings, even when invested at modest rates of return, can result in large sums of money in the future. This concept is explained more fully in Chapter 5 (Personal Investments).

5. Money does not buy happiness.

5. Money does not buy happiness, at least not when people have their basic needs and wants met.

There is a distinction between standard of living and quality of life. Standard of living is the value of the goods and services available to an individual, group, or country. Quality of life is the degree of satisfaction in a person’s life. Quality of life is not the same as the standard of living because it considers things in addition to material possessions and wealth.

As discussed in Chapter 1, economics is the study of how scarce resources are allocated to satisfy seemingly unlimited needs and wants. No matter how many material possessions people have, it seems they always want more. Surveys suggest that income and the material possessions it can buy do not buy happiness, however.

There are a tremendous number of wealthy people in the world who are unhappy and unfulfilled. It is okay to want more money and the things that it will buy. Just do not count on money and material possessions providing you with happiness and fulfillment. This concept is explained in Chapter 1 (What is Economics?).

See Kluger, Jeffrey. “No Price Tag on Happiness.” TIME. September 8, 2003 and Chatzky, Jean. “Money Can’t Buy It.” TIME. October 6, 2003.

4. Economists do not have the solutions to all the world's problems. However, economists point out that many of our economic and social policies are p

04. Economists do not have the solutions to all the world's problems. However, economists point out that many of our economic and social policies are poor choices. Herbert Stein, an economist who spent almost fifty years working in Washington, D.C., expressed this point in the preface to one of his books : “Economists do not know very much... Other people, including the politicians who make economic policy, know even less about economics than economists do.”

Stein, Herbert. Washington Bedtime Stories: The Politics of Money and Jobs. New York: The Free Press, 1986, p. xi.

3. Politicians use economists as hired guns.

3. Politicians use economists as hired guns. Consequently, the economic analyses politicians provide to the public are usually incomplete and one-sided. Rather than using professional economists to help develop social policy, politicians often ask them to support existing opinions, without objective analysis.

A story from state politics provides an example. Wisconsin state legislators considered an increase in the minimum wage in the late 1980s. Tommy Thompson was then the governor of Wisconsin. Rather than asking staff economists to provide him with a complete analysis of the issue, however, Thompson instructed them to develop arguments against the proposal.

Another example involves economist Gregory Mankiw, who was the Chairman of President George W. Bush’s Council of Economic Advisers from May 2003 to February 2005. When Mankiw was questioned in February 2004 about the outsourcing of American jobs to foreign countries, his response was an attempt to explain the economic perspective on trade. When countries specialize and trade, some jobs that were previously done by American workers must now be done by foreign workers. Thus, outsourcing (to the extent that it represents specialization) is good for the American economy. This is not a politically popular opinion, however. Mankiw was told by the administration to retract his comments, even though similar ideas still appear in his and hundreds of other economic textbooks.

2. Correlation does not imply causation.

2. Correlation does not imply causation. If two variables move together, it may not be the case that one variable caused the other variable to change. This is a common mistake in all areas of research, not just economics.

A Latin phrase expresses a similar concept. Post hoc, ergo procter hoc translates as "it happened after, so it was caused by".

An extreme example to illustrate this point involves the sunrise. If a person wakes up before sunrise every day for many years, it does not imply that if the person oversleeps, then the sun will not come up. The person arising does not cause the sun to rise.

Similarly, just because a person is a country leader when the economy does especially well or poorly, it does not imply the leader is responsible for the economic performance. The leader indeed may influence the economy. The correlation does not imply it, however. One needs to look closely at the actions of leaders to determine how much credit and blame they deserve.

Politicians, such as the President of the United States, probably receive more credit and blame than is justified for economic events that occur during their years of service.

Political publicists, sometimes called spin doctors, use favorable correlations to trumpet the great value of their candidates while ignoring correlations that put their candidates in an unfavorable light.

1. People tend to readily accept information that supports their current beliefs and may be hypercritical of evidence that contradicts those beliefs.

1. People tend to readily accept information that supports their current beliefs and may be hypercritical of evidence that contradicts those beliefs. This idea is expressed in the following quotation by Bertrand Russell:

If a man is offered a fact which goes against his instincts, he will scrutinize it closely, and unless the evidence is overwhelming, he will refuse to believe it. If, on the other hand, he is offered something which affords a reason for acting in accordance to his instincts, he will accept it even on the slightest evidence. (Russell, Bertrand. Roads to Freedom.)

One of the benefits of a college education is the opportunity to examine alternative perspectives on a variety of issues.

Important Concepts in Understanding Macroeconomics

Important Concepts in Understanding Macroeconomics
1. People tend to readily accept information that supports their current beliefs and may be hypercritical of evidence that contradicts those beliefs.
2. Correlation does not imply causation.
3. Politicians use economists as hired guns.
4. Economists do not have the solutions to all the world's problems. However, economists point out that many of our economic and social policies are poor choices.
5. Money does not buy happiness.
6. If you want a financially comfortable retirement, then start saving as soon as possible in order to receive maximum benefit from compound interest.
7. Most economies rely heavily on markets to allocate resources and products because they are usually more efficient than systems that rely heavily on tradition and command.
8. Markets are not perfect. Market failures occur when the marketplace fails to provide socially desirable outcomes.
9. Governments can improve some market outcomes.
10. The primary distinction between traditional conservatives and traditional liberals is the difference in their attitudes toward government.
11. Traditional conservatives believe government, and thus taxes, should be relatively small.
12. Traditional liberals believe government, and thus taxes, should be relatively large.
13. The three primary macroeconomic policy goals are economic growth, low unemployment and low inflation.
14. Increased trade with the rest of the world and investments in physical capital, education, and technology are the keys to increased productivity and economic growth.
15. Relatively high rates of unemployment and inflation reduce economic growth and result in a lower standard of living than would occur in their absence.
16. Unemployment occurs when there is not enough spending in the economy.
17. Inflation occurs when there is too much spending in the economy.
18. The government plays an active role in managing the economy by using monetary and fiscal policies to influence the amount of spending in the economy.
19. Monetary policy is the Federal Reserve System's use of the banking system to alter the money supply and interest rates to influence overall spending in the economy.
20. One of the most powerful people in the world in the chairman of the Board of Governors of the Federal Reserve System.
21. Fiscal policy is taxation and government spending.
22. Fiscal policy has a large political bias because politicians are reluctant to increase taxes or cut spending on constituents.
23. The U.S. political system is biased toward fiscal irresponsibility.
24. The public debt is the accumulation of federal budget deficits over time.
25. Entitlement programs, such as Social Security, Medicare, and Medicaid, will become an increasing portion of federal government spending unless modifications are made.

Trade Adjustment Assistance

Trade Adjustment Assistance – A Closer Look
Trade adjustment assistance (TAA) is a federal program that provides financial assistance to those injured by import competition. Economists argue that trade is beneficial to society. It allows people to specialize in producing things they do relatively well. For example, we do not grow many bananas in the United States. It is easier to buy them from other countries. Trade allows us to use our resources to produce other goods and services. Some people object to trade, however. For example, if you are an American banana farmer, you might argue that your are harmed when American consumers buy bananas from other countries. It is harder for you to sell your bananas if consumers have the option to buy them from, say, Costa Rica. Trade adjustment assistance provides money to people (for example, American banana farmers) who are harmed by the availability of cheap products from foreign countries. The idea is to make American consumers better off (by being able to buy cheap foreign products) without harming American workers too much.
Web Sites with Additional Information about Trade Adjustment Assistance:
• U.S. Labor Department – Trade Adjustment Assistance Fact Sheet
http://www.doleta.gov/programs/factsht/taa.htm
• TAA Centers
http://www.taacenters.org/

The Economic Perspective on Trade

Economists believe trade can make everyone better off. Trade is the exchange of goods and services for other products, money, or other compensation. Everyone involved in an exchange transaction can benefit from it. One of the ways a person or country can become wealthy is to trade a lot.

Different opinions about trade create some of the strongest economic controversies. For centuries, however, economists have argued that trade is a primary source of wealth and prosperity and is beneficial to all trading partners.

One of the greatest benefits of trade is that it allows specialization. Specialization is concentration on the production of particular goods and services. If a person or country engages in trade, then it no longer needs to produce everything it needs or wants. Instead, it can focus its energies on activities it does especially well and trade for the other things it needs or wants.

Three of the basic needs in life are food, clothing and shelter. If people are especially skilled at making clothes, for example, they can then make more clothes than they need and trade the extra clothes for other things, such as food and shelter. Similarly, people who are skilled at growing food can trade food for clothes and shelter. People who are skilled at building houses can trade them for food and clothes. When people specialize and trade, it is possible for everyone to benefit.

Consider the following simple example of the benefits of specialization and trade. Suppose two people, Robinson Crusoe and Friday, are stranded on an island. They can survive with the rags they wear and by scavenging for food, but both would prefer to have a new set of clothes each month and to eat cultivated food every day. While working for a month, suppose Crusoe can make two sets of clothes (shirts and trousers) if he spends all his available time making clothes. Alternatively, if Crusoe spends his time cultivating food, the best he could do is grow enough food to feed one person for two weeks. If Crusoe splits his month’s labor between the two activities, he could make one set of clothes and grow enough food to feed one person for one week.

Suppose Friday has a different set of talents. While working for a month, suppose Friday can make only one half of a set of clothes (just the trousers, perhaps) if he spends all of his available time making clothes. Alternatively, if Friday spends all his time cultivating food, then he could grow enough to feed two people for a month. If Friday splits his month’s labor between the two activities, then he could make one quarter of a set of clothes (half a shirt, perhaps) and enough food to feed one person for the entire month.


Output if his labor for the entire month is devoted to making clothes Output if he equally splits his labor for the month between making clothes and growing food Output if his labor for the entire month is devoted to growing food
Robinson Crusoe 2 sets of clothes
(no food is grown) 1 set of clothes and food for one person for one week food for one person for two weeks
(no clothes are made)
Friday 1/2 of a set of clothes
(no food is grown) ¼ of a set of clothes and food for one person for a month food for two people for a month
(no clothes are made)
Table 1. Specialization and Trade Allow an Economy to Produce and Consume More Output Than in the Absence of Trade.


If Crusoe and Friday do not trade, then they must produce their own food and clothing. Depending on how he allocates his labor, Crusoe could make two sets of clothes and no cultivated food, one set of clothes and enough food for one week, no new clothes and enough food for two weeks, or another similar combination . Depending on how he allocates his labor, Friday could make one half set of clothes and no cultivated food, one quarter set of clothes and enough food to feed one person for one month, no new clothes and enough food to feed two people for the entire month, or another similar combination. In the absence of trade, neither person is able to have a new set of clothes each month and enough cultivated food for the entire month.

If Crusoe and Friday specialize and trade, however, then each person can have a new set of clothes each month and enough cultivated food to satisfy their needs. This occurs if Crusoe completely specializes in making clothes and Friday completely specializes in growing food. Every month Crusoe would make two sets of clothes and Friday would grow enough food to feed two people for the entire month. If Crusoe trades one set of clothes for a month’s supply of food, both men have a new set of clothes each month and enough cultivated food to satisfy them every day. Because of their different skills in making clothes and growing food, it is impossible for them to obtain this level of satisfaction in the absence of specialization and trade.

A similar argument can be made for trade between countries. What complicates it from a social policy standpoint, however, is that the process of specialization requires a country to shift resources into activities that a country does relatively well (such as manufacturing computers or other high technology equipment) and shift resources away from activities that another country may do relatively better (such as manufacturing steel, textiles, or furniture). The country as a whole benefits from the availability of cheaper foreign products. Some individuals lose their jobs, careers, and way of life in the process, however. The government attempts to lessen the hardships imposed on these individuals by providing them with financial assistance, education, training, and help in finding new jobs. Trade adjustment assistance is a federal program that provides financial assistance to those injured by import competition.

Trade is another area where people ignore tradeoffs. Workers and politicians often decry the loss of American jobs to manufacturers in foreign countries. Keeping those jobs in the United States typically results in higher prices for the products or higher taxes to provide government subsidies to those industries, however. If foreigners produce a product more cheaply than Americans, the way to convince consumers to buy the American product is to raise the price of the foreign products through import taxes, or to lower the price of the American product through tax-funded subsidies. Politicians typically only discuss part of the issue when they say they will protect American jobs. They usually fail to mention the costs to consumers and taxpayers.

The benefits of specialization and trade are explained more fully in module 11 (The Evolution of Trade Theory).

Trade Adjustment Assistance is explained more fully here.

Footnote: As Crusoe devotes more time to one activity, he must sacrifice what he could have produced in the other activity with that time.

The Economic Perspective on Incentives

Economists believe incentives always matter. An incentive is something that induces a particular behavior or action. Price changes are incentives because they usually alter consumer behavior. An increase in the price of a product normally causes people to buy less of it. If beef becomes a lot more expensive, for example, many people buy less beef and more of a substitute product, such as chicken or fish.

Not everyone believes in the power of incentives. In the 1970s, the price of gasoline quadrupled as a result of manipulations of the world oil market by the Organization of Petroleum Exporting Countries (OPEC). At the time, American consumers bought over 90 percent of their automobiles from the three major U.S. auto producers: Chrysler, Ford, and General Motors. Economists predicted the rapid increase in gasoline prices would cause consumers to want more fuel-efficient cars. The heads of the American automobile companies ignored the fact that incentives matter, however. Chrysler, Ford, and General Motors continued to manufacture large, gas-guzzling automobiles without providing consumers the option of an American-made fuel-efficient car. Japanese automobile producers, however, were eager to sell their compact, fuel-efficient cars to American consumers. Throughout the 1980s, Japanese car companies gained an increasing share of the U.S. automobile market. It is unlikely that American automobile companies will ever regain all of the shares of the automobile market they lost to foreign producers after oil prices increased dramatically in the 1970s. Japanese brands, such as Honda and Toyota, are firmly entrenched in the U.S. car market. This occurred because the highly educated business leaders of some of the largest American corporations ignored a basic economic principle. Incentives always matter.

If society uses appropriate incentives, then people’s behavior can be altered. Economists use incentives when designing social policies. If society wants more of something, it should subsidize it. If society wants less of something, then it should tax it.

A subsidy is monetary assistance from the government to promote an activity deemed advantageous to the public. For example, the government subsidizes lunches in public schools. Public school cafeterias provide nutritious meals to students at low or no cost. This is because society believes it is beneficial for all students to have access to a balanced diet, at least on school days, even if families have difficulty affording it.

A tax is a charge (usually of money) imposed by the government on people or property. For example, in cases where the government can measure pollution emissions, it sometimes charges a pollution tax. Companies that generate more pollution pay more in pollution taxes than those that pollute less. This creates an incentive for businesses to find methods of operation that are cleaner for the environment.

Other examples of taxes used to alter social behavior are the excise taxes on cigarettes and alcohol. These are called sin taxes because they are designed to discourage the consumption of these “sinful” products. An excise tax is levied on a particular product. Other products that are typically subjected to excise taxes are fuel, hotel rooms, cable television, and telephone service.

Subsidies and taxes are important components of social policy.

The Economic Perspective on Costs

Economists also have a different perspective on costs than many other people. Most people consider the cost of something to be the amount of money paid to acquire it. Economists prefer to consider opportunity costs. The opportunity cost of something is what is sacrificed or foregone when a choice is made.

Most people consider the costs of attending college to be the amounts paid for tuition, books, and similar expenses. When economists consider the costs of college, however, they think about the opportunity costs. The opportunity costs of college include everything that is foregone, sacrificed, or given up in order to attend college. The monies paid for tuition and books are certainly given up when one goes to college. Yet there are many other sacrifices, too. The time devoted to college could have been spent at a job. Whatever income could have been earned at that job is also given up when one attends college full-time.

If the annual cost of tuition and books is $20,000 and a person quits a job that pays $30,000 per year in order to attend college, then economists would say the true costs, or opportunity costs, are $50,000 rather than the $20,000 most people consider.

A similar argument can be made about the costs of war. Most people think about the bombs, missiles, and other munitions used. It is also expensive to transport troops and equipment to the battleground, particularly if it is halfway around the world. When calculating the costs of war, however, economists also include the sacrifice of what else military personnel could do with their time and effort. This is especially relevant to the men and women who lose their lives and reservists who, in the absence of war, would be productive in the civilian sector of the economy.

The Economic Perspective on Tradeoffs

A tradeoff is an exchange of one thing in return for another. Economists often express the concept of tradeoffs as “there is no such thing as a free lunch.” Even if one person does not pay for lunch, someone incurred the costs of growing, preparing, and serving the food.

Economists believe tradeoffs always exist and that they should be explicitly considered when making choices. Others, including many politicians, frequently ignore tradeoffs.

To illustrate how people ignore tradeoffs, consider the Tax Reform Act of 1986, which was designed to generate the same level of revenue for the federal government by increasing the federal taxes levied on businesses when it decreased individual income taxes. Many people reveled in this perceived reduction in their taxes. Economists have a different perspective, however. If corporations are required to pay more in taxes, then the money to pay these higher taxes must come from somewhere. This is a tradeoff. Corporations could obtain additional income for their increased taxes by charging higher prices for their products, by paying workers less in wages and salaries, or the taxes could result in reduced corporate profits.

If product prices increase, then the increase in corporate income taxes is partially borne by consumers. Similarly, if the change in tax structure causes businesses to pay workers less (or to increase their pay more slowly), then workers are bearing part of the burden of the increased corporate income taxes. If the taxes result in lower corporate profits, then stockholders receive less when those profits are distributed to them as dividends. More than half of all Americans own stock. To the extent that people are consumers, workers, and stockholders, they are still paying for the taxes, even though the structure changed. Economists argue that people should not have been quite as excited about the change in the tax structure since it resulted in higher product prices, slower wage increases, and reduced dividend income.

Oliver Wendell Holmes, the former Justice of the United States Supreme Court, said, "Taxes are what we pay for a civilized society." Regardless of how we structure taxes, ultimately they must be paid by members of society. Remember, there is no such thing as a free lunch!

Economic Perspectives

This module introduces the economic perspectives and provides examples of how economists think about a few issues. It also highlights the most important ideas in macroeconomics. The remainder of this blog is devoted to justifying and explaining these concepts.

Economics is an important field of study because it provides different perspectives that may be beneficial

Economists have a different perspective on social issues than many other people, including some leaders of business and government. This lack of understanding of economic principles leads to the implementation of many social policies that are poor choices. This module provides a few examples of the different way economists view issues and then outlines important concepts to remember in order to understand macroeconomic policies.

To introduce the alternative perspectives of economists, consider four things: tradeoffs, costs, incentives, and trade.

The Economic Perspective on Tradeoffs
The Economic Perspective on Costs
The Economic Perspective on Incentives
The Economic Perspective on Trade

Economic Perspectives - Learning Objectives

After studying this module, you should be able to:
• explain the economic perspective on tradeoffs, costs, incentives and trade.
• define a tradeoff, opportunity costs, incentives, a subsidy, a tax, and trade.
• explain Trade Adjustment Assistance (TAA).
• list and explain the 25 concepts that are important to remember when studying macroeconomic policies.

Economic Perspectives - Topics

Click on the hyperlinks below to go to a portion of the blog devoted to that topic:

Economic Perspectives - Learning Objectives
Economic Perspectives
The Economic Perspective on Tradeoffs
The Economic Perspective on Costs
The Economic Perspective on Incentives
The Economic Perspective on Trade
Trade Adjustment Assistance

Important Concepts in Understanding Macroeconomics:
1. People tend to readily accept information that supports their current beliefs and may be hypercritical of evidence that contradicts those beliefs.
2. Correlation does not imply causation.
3. Politicians use economists as hired guns.
4. Economists do not have the solutions to all the world's problems. However, economists point out that many of our economic and social policies are poor choices.
5. Money does not buy happiness.
6. If you want a financially comfortable retirement, then start saving as soon as possible in order to receive maximum benefit from compound interest.
7. Most economies rely heavily on markets to allocate resources and products because they are usually more efficient than systems that rely heavily on tradition and command.
8. Markets are not perfect. Market failures occur when the marketplace fails to provide socially desirable outcomes.
9. Governments can improve some market outcomes.
10. The primary distinction between traditional conservatives and traditional liberals is the difference in their attitudes toward government.
11. Traditional conservatives believe government, and thus taxes, should be relatively small.
12. Traditional liberals believe government, and thus taxes, should be relatively large.
13. The three primary macroeconomic policy goals are economic growth, low unemployment and low inflation.
14. Increased trade with the rest of the world and investments in physical capital, education, and technology are the keys to increased productivity and economic growth.
15. Relatively high rates of unemployment and inflation reduce economic growth and result in a lower standard of living than would occur in their absence.
16. Unemployment occurs when there is not enough spending in the economy.
17. Inflation occurs when there is too much spending in the economy.
18. The government plays an active role in managing the economy by using monetary and fiscal policies to influence the amount of spending in the economy.
19. Monetary policy is the Federal Reserve System's use of the banking system to alter the money supply and interest rates to influence overall spending in the economy.
20. One of the most powerful people in the world in the chairman of the Board of Governors of the Federal Reserve System.
21. Fiscal policy is taxation and government spending.
22. Fiscal policy has a large political bias because politicians are reluctant to increase taxes or cut spending on constituents.
23. The U.S. political system is biased toward fiscal irresponsibility.
24. The public debt is the accumulation of federal budget deficits over time.
25. Entitlement programs, such as Social Security, Medicare, and Medicaid, will become an increasing portion of federal government spending unless modifications are made.

Economic Perspectives - Topics for Further Study