Prerequisite To Economics

Why Should We Need Prerequisites for Economics?

Economics is a funny subject. While it can get complicated pretty quickly (not to mention boring), the subject is really based on common sense. To master the intricacies of the marginal propensity to consume but to miss the obvious seems to be a characteristic of many a modern day economist. So before we talk about supply and demand and monetary policy we need to get some basic truths under our belt.

Things of Value Are Worth Something / Things of No Value Are Worth Nothing

This may seem obvious, but the majority of Americans do not understand this basic premise of economics. They glibly speak of “creating jobs” and increasing their “portfolio” as though every job “created” and every “investment” were of value. They are not.

What Determines “worth” or “value”?

In economics, something has value if someone is freely willing to pay for it. This is called demand. The term “freely willing” is critically important here. If someone is not willing to pony up to the bar with cash and actually make a purchase, then the item is of no value – it is not “in demand”. Since people demand things, other people will supply them to make a profit. Hence the economic terms supply and demand.

Producing Worthless Things

Why would producing worthless things be an issue? It seems a bit silly to talk about the value of something that is worthless. If something is not demanded, it will not be supplied, right? Well, not necessarily. Here is one entity that will always produce things of no value, and that is the government. This is not to say that everything the government supplies is worthless. They supply many worthwhile things such as protection (national defense, fire, police), transportation (roads, bridges), etc. But there are many things produced by government that are in fact completely worthless. Note that we are not talking about producing demanded things wastefully (inefficiencies) here, which is another topic. We are talking about actually producing things that are simply not demanded. This is important because even these items are a part of the economy.

Real Demand is Not Artificial

Oftentimes we hear talk of stimulus packages provided by the government. Sometimes in the short run these can be helpful, but for the most part they are not real demand rather they are an artificial demand. This distinction is important because there is a difference in building a bridge over a river to a popular destination vs. building a bridge to nowhere. The bottom line is that we should resist as much as possible the notion of providing things that are not actually demanded by anyone; artificial or manufactured demand.

Is Perception Reality?

People’s perception can affect the outcome of economic events. For example people are always trying to predict the future. If they perceive an opportunity in the near future (perception), they may increase spending (short run reality). Or if all their co-workers get laid off, they might stop spending. But are these fluctuations artificial or true demand? They are neither. Instead they are temporary aberrations that may have an affect in the short run but should be ignored in the long run.

You Shouldn’t Demand Things You Can’t Afford

One basic tenet of economics is that everything costs something. Therefore we should carefully examine a market before we produce anything lest we lose the money we invest in creating something. Again, pretty straightforward stuff but it is amazing how few economic participants play be these rules.

Resources Are Scarce

In economics, resources are the things we use to produce goods & services. It is assumed that there is a limited supply of every resource, and so to some degree all resources are scarce. Scarcity drives up price; plentiful resources drive prices down, all else equal.

The Invisible Hand of Economics

Suppose we break the laws of economics. Say we spend more than we earn by borrowing or we produce things of no value. What are the consequences? One thing to be sure of – there will be consequences. The market will automatically make adjustments to compensate for any economic criminals. If we borrow to spend, our future income will be diminished by the amount of interest we pay on the loan. If we make laws against things that people demand, they will be supplied anyway (albeit illegally). If the government or the banks print money by fiat or by fractional reserve banking, the value of the currency will fall (its future buying power will become diminished). If we “create jobs” where there is no demand out of thin air and do not have the taxes to pay for them, the cost of paying employees will have to be borrowed, further eroding future income streams. There is simply no way to avoid the invisible hand of economics. There is no free lunch.

The Greater Fool Theory

Many people think their stock is worth something – that if they just hang onto it for a while it will always increase in value. The truth is it is only worth what someone else is willing to pay for it at a moment in time. What about trends that show stock prices increasing over time? Well did you ever map that against the money supply increase over time (inflation)? What is the net return? Probably zero or perhaps even a negative return. Or perhaps you invested in a Ponzi scheme and don’t actually own anything! While it is possible to buy low and sell high, this is not true value. Rather it is an example of what Robert Ringer coined as the “Greater Fool Theory” which states that one can make a profit only if they can find a greater fool than themselves to buy something. It is a zero sum game where there are winners and losers, but the net result is not anything of worth. No wealth is created. Instead money just changed hands. There is no sound reason behind an increase in value other than pure speculation – basically legalized gambling. So what does create wealth?

Net Present Value of Future Income

Financial assets
such as stocks or bonds have value based upon their future income stream. If stocks pay dividends, then the net present value of that future income stream is the true value of the asset. The notion that the stock itself has any value at all is pure speculation. Since the principal amount of a bond is typically guaranteed, its value is also the value of the principal. What about stocks? Since there is no guarantee of a return of the original cost of the stock issue at all, stocks are not really worth much at all. In fact their value is typically diluted over time as more investors join in, so this is a really bad deal. Unless you buy into in the greater fool theory, of course!

Regressive Utilitarian Value

Regressive utilitarian value is the notion that the utility of an asset decreases with time, yet some things decrease at a much faster rate than others either to either decay or to risk. The closely related concept of
utilitarianism measures the value of things based on intrinsic value. This is the idea that some things are more useful than others. A house has intrinsic value in that if all else fails, at least people can live in it – it has utility. This utility decreases over time as it wears out, but very slowly. The same can be said of many other physical assets. What is the utilitarian value of a stock? Stocks have a high degree of both utility decay and risk. Stock splits reduce their value, as does the fact that the company backing the stock may simply disappear at any time by going out of business. With global competition, this risk increases.

The Multiplier Effect

Whenever someone spends money, it benefits the economy as a whole by a multiple of the net amount gained. So if I buy a car, the salesman makes a commission, the dealer makes a profit, the manufacturer makes a profit, the suppliers to the manufacturer make a profit, etc. Each of these either spends more money or saves / invests money. This “multiplier effect” ripples through the economy and benefits everyone in the short run. If it continues to occur over a long period of time it will create long run wealth as people save, invest or produce new goods.