Economics 101

money box with coins and notes beside it

Politics and economics have been around since the dawn of time, it’s just that they weren’t given those labels until relatively recently. They’re both social constructs that help us make sense of the world we live in, and navigate our way around without getting into too much trouble. Well, that’s the theory anyway.

What is Economics?

Economics can be described as the study of how wealth works, or how scarce resources are allocated, or what happens when money is introduced to the equation.

Back before money was even invented it would have been what happened when Erg the Neanderthal needed a new axe-head but knew his mate Arg was better and faster at making them. Erg was a faster runner and was the better huntsman, whereas Arg was a bit rubbish at hunting after hurting his leg, so they come to a deal–Arg makes Erg a new axe-head and in return Erg catches an extra deer and gives it to Arg. And so you get bartering.

The flaw with this system is that both parties have to be in need of something, and the other person has to have the exact thing the other wants. What if Arg never hurt his leg and is as good a hunter as Erg? What if Arg actually wants a new cooking pot, because he has an idea for cooking venison? What if neither Arg nor Erg are great potters, but Urg over in the next village is–but Urg is good for axe-heads and venison, thank you very much. Well, that’s when money comes into the equation. Erg sells his extra deer, pays Arg for a new axe-head, and Arg uses his profits to buy a cooking pot. I’ve no idea what Urg does with his money–maybe he goes and buys a jet necklace or something.

That all seems fairly simple and straightforward, but how do they decide what is a fair price? What happens if Erg can’t sell his venison for enough money and he needs to borrow the difference? And now imagine that there are billions of Ergs and Args and Urgs and they’re all buying and selling stuff many times a day–how on earth does the system work?

This is where economics steps in.

Mercantilism

To start with, economics was a bit like philosophy: lots of people sitting around theorising that things ought to work a certain way and then looking for pattern that confirmed that.

Back when a lot more countries had monarchies, the prevailing theory was that there was only a certain amount of wealth in the world, and that all economic interactions were part of a zero-sum game.

In other words, once everyone was done trading and you added up what everyone had made or lost, the result would be a big fat zero, and anyone who won had only done so because someone else had lost. As a result, most countries worked to keep as much wealth within their borders as possible, in a system that is now called Mercantilism. Exports were seen as good, because that brought wealth in, imports were seen as bad because that meant wealth leaving the country, so imported goods had tariffs (an extra tax to make them even more expensive to buy) imposed on them to discourage trade. If this sounds vaguely familiar, it’s probably because it’s a policy Donald Trump has talked about wanting to introduce to the US.

Capitalism 101

Anyway, back in Britain in the the 1700s a man called Adam Smith looked at what was happening around him as the country started to go through the Industrial Revolution, changing from an agricultural society to a commercial one, and he realised that the old ideas about money, trade and the economy were at best incomplete. One of the things that Smith noticed was that increased commercial activity was producing goods that people wanted without wasting too many resources. When there was demand for a new product it would be made, and when demand fell so did production. He speculated that the cumulative effect of every individual acting in their own interests was guiding the market. He called this the ‘invisible hand‘.

If everyone in an economy wanted to maximise profits then they would make goods that were high in demand, and if demand fell for one particular product then they would switch to making something else, and so raw materials and time would not be wasted on making things no one wanted to buy.

To go back to Arg, Erg and Urg for a moment, there’s only so much venison that’s worth hunting at a time. To start with everyone is hungry, and willing to pay for the venison, but after a while Erg can’t even give the stuff away because everyone is stuffed. If you hunt more than people can eat before it all goes off, then that’s a waste–there’s no point–so once he’s saturated the market with deer meat Erg will have to find something else to do to make money. Maybe he finds out that Urg really wants a necklace, so he goes off to mine some jet and teams up with Arg, who shapes the stones, and then they have something that Urg wants to buy.

Adam Smith’s idea was that this ‘invisible hand’ brought order to the market, and that the profit motive would ensure that it would move towards a point of equilibrium, where the demand for a particular product would be perfectly matched by the supply. Smith proposed that governments should leave this process alone to look after itself, and that if they did economic growth and increased prosperity would follow.

The term laissez-faire is used to describe this idea of minimal government involvement in the market system, but even Smith acknowledged that some things were unlikely to be provided by private markets, no matter how much there was a demand for them. These included public goods such as roads, a justice system, and defence.

Smith’s theories covered many aspects of what is now known as Capitalism, and his theories eventually led to the end of the wide-spread system of protectionism, of using tariffs and tax duties to try and keep wealth within borders, and as a result all countries did indeed get wealthier–it was not a zero-sum game as had previously been thought.

Communism 101

While most states have since adopted this approach, with different governments choosing varying levels of state involvement, there have been a significant number of modern states adopting the system of Communism instead.

Capitalism is market led, whereas Communism acts as a Command economy (also known as a Planned economy) with all economic activity dictated by the state. While Capitalism is, at least in theory, efficient, Communism is an inefficient system. It lacks Smith’s invisible hand guiding it.

To go back again to our Neanderthals, if the two villages they live in have been hungry for weeks, because no one has caught any deer for a while, then the first deer Erg catches can be sold for a lot of money, because everyone from the two villages will bid up the price. Then the second deer will go for a little less money because not so many people want to buy it, and so on, until it becomes more profitable to mine jet because everyone has now had enough of deer. That’s Capitalism, although obviously it usually works on a much larger scale with many Ergs, many villages, and so on. The problem with this system is that not everyone may get fed. What if Irg has no money at all, and can’t afford to buy the food at any price?

Capitalism may be efficient, but it is often brutal, and is not a fair system in that not everyone starts with the same resources or with the same access to the market.

So what if Org comes along and decides that a fairer system is that everyone owns everything? Erg still hunts deer, but for Org, and then Org distributes the meat until everyone has enough. In turn, Org makes sure that Erg gets his new axe head, and so on. The problem with this system though is that one Org has to listen to the needs of everyone, each Arg, Erg, Irg and Urg in his state. He might not get around to telling Erg to switch from hunting deer to mining jet until there’s a pile of stinky rotting venison lying around because no one knows what to do with it. Or he might have heard about jet necklaces, thought they sounded really cool, and told Erg to mine jet and forget hunting, despite the fact that everyone is still hungry.

Economics in Reality

Both systems have their flaws, but that’s basically how the pure form of each system works. In practice, most governments have adopted a Mixed economy, which is somewhere between the two extremes. The exact balance of how much is state-owned and controlled and how much is privately owned varies from country to country and from political party to political party.

Whilst in theory economics is simple and systematic, the reality can be a lot messier.

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