Economics in One Lesson

Economics in One Lesson

Introduction to EconomicsMetropolitan University PragueMartin Kolmhofer2011/2012

The Lesson

The Lesson

• Focus on long run and all groups• Economics can be subject to vested interests• Long-run effects are more complex than short

run

The Lesson• Hazlitt reported on Business for the New York Times and the Wall

Street Journal for most of the first half of the last century.• In Economics in One Lesson he wanted to explain all the things he

thought people got wrong in economics. • The insight itself is very easy: All it says is when you consider the

effects of an economic policy you have to consider the effects on all groups and the effects in the long run, rather than just consider some groups in the short run.

The Lesson

• Keynes: “In the long run we are all dead”

• But: Most of us have children…

The Lesson

• Example: Cash for Clunkers

Too good to be true?

• Struggling car companies get new business• Some people get new cars• The environment gets cleaner

Long run effects on all people?

• Low-income people who might want to buy a clunker. Government is now bidding against them.

• People who don’t actually work for car companies?

• Government spends tax money on Cash for Clunkers. Taxpayers can no longer spend that money on anything else. Jobs are lost elsewhere.

The Broken Window

The Broken Window

• It is too easy to focus on immediate outcomes• Unseen hypothetical outcomes are just as

important• We need to look at all possible outcomes

The Broken Window

• Frederic Bastiat • That Which Is Seen and That Which Is Unseen”

Frédéric Bastiat 1801-1850

The Broken Window

• Glazier = Special Interest Groups• Boy = Government

Charlie Chaplin “The Kid” (1921)

The Broken Window

• Common examples of special interest groups practicing the broken window fallacy

• Arguments for public works projects as a way to reduce unemployment. The hidden cost here is of course the tax payer's money, and the special interests are the jobs created by the public works.

• Arguments for protectionist measures such as tariffs, subsidies and/or other regulations in order to protect local industries.

• Inflation as a means to stimulate economic activity by making savings worth less

Public Work Means Taxes


• Paying for public works mean more taxes• Public works sometimes justify the taxes

required• Public works costs and benefits can be

distorted


• Government does not have anything – it can only take from some and give it to others

• While public works seem to benefit people by providing employment, funding them requires the use of taxes.

Public Work Means TaxesSuppose the government builds a bridge that is not entirely justified by traffic

needs. Two fallacies are at work here:

(1) The construction of the bridge creates jobs. (2) With the bridge in place, the nation is richer.

The taxes collected for the bridge are money that would have been spent privately, on consumption or investment, and this expenditure would have created jobs. For each job the bridge creates, one is destroyed in the private sector. We do not see the lost jobs because they are not in one place, as the bridge jobs are. The same for the enhanced national wealth. The bridge is there, but the unbuilt homes, the unmade cars and clothes, the ungrown and unsold foodstuffs, all that would have been paid for by the money that instead went to taxes, are not. Net gain: zero at best.

The Blessings of Destruction


• War cannot stimulate economies• War creates need, not ability to pay (demand)• Destruction can reduce productivity and

ability to pay

Taxes discourage Production

Taxes Discourage Production

• Tax raises revenue and changes taxpayers behavior

• Tax collection discourages productive behavior

• Tax policy should consider behavioral effects

Taxes Discourage Production

Credit Diverts Production


• Government lending always takes funds away from the private sector

• Government lenders face lax incentives compared to private lenders

• Worthwhile government loans don’t need government intervention


• What is credit? • Something a bank “gives” to you or something

you already have?• Credere (lat.) = to believe, to trust


Government-guaranteed home mortgages?

The Curse of Machinery


• Technology displaces some workers in the short term

• It also employs people in developing the technology

• Technology creates more wealth which creates more jobs


18th century – industrial revolution - UK - textile industry - (Luddites)

Spread-The-Work Schemes

Spread-the-Work-Schemes

• These practices spring from the same fundamental fallacy as the fear of machines. This is the belief that a more efficient way of doing a thing destroys jobs, and a less efficient way of doing it creates them.

• Job creation is important but should not be an end in itself

• When more workers produce the same output, average production per worker is lowered - purchasing power is reduced

• This reduces demand, creating less jobs

Spread-the-Work-Schemes

Example: 35 hour week in France since 2000

Spread-the-Work-Schemes• The 35-hour working week is controversial in France.

Generally speaking, left wing parties and trade unions support it, while conservative parties and employers' union oppose it. Critics of the 35-hour working week have argued that it has failed to serve its purpose because an increase in recruitment has not occurred; in their view, the reluctance of firms to take on new workers has instead simply increased per-hour production quotas. According to right-wing parties and economic commentators, the main reason why French firms avoid hiring new workers is that French employment regulations make it difficult to lay off workers during a poor economic period.

Disbanding Troops and Bureaucrats

Disbanding Troops and Bureaucrats

• After war, many soldiers were in Europe and wanted to come home…people were afraid that they would inundate the US. There wouldn’t be jobs for them.

• When millions of men are suddenly released - where is the "purchasing power" going to come from to employ them?

• Demobilization releases to the taxpayers the money to provide private jobs.

“Purchasing Power" argument?

When your money is taken by a thief, you get nothing in return. When your money is taken through taxes to support needless (?) bureaucrats, precisely the same situation exists.

A man walks in a bar and asks the bartender to lend him 100 USD. He promises to spend them all in the bar…

Conclusion: Always consider where the money that creates “purchasing power” comes from

The Fetish of Full Employment


• Most political debates are about JOBS/EMPLOYMENT

• Is work something desirable?• The economic goal of any nation, as of any

individual, is to get the greatest results with the least effort

• Real objective is to maximize production(we can very easily have full employment without full production)


“Job Creation” often really just means “redistribution” – if money comes from taxes, you might as well just give the workers the money...

Demand Side Solutions:• Government-funded employment• Hire people to dig holes and fill them up ?• Let people dig up buried money ?Supply Side Solutions:• making the labor market more flexible• removing the minimum wage and reducing the power of unions

Who’s protected by Tariffs?

Who’s “Protected” by Tariffs?• Example: Suppose Congress is thinking of cutting or abolishing a tariff on sweaters. A sweater

company shows that it would thereby be put out of business and its workers thrown out on the street. Congress relents. The company and its employees continue with their contributions to the American economy. What has been overlooked? Who has been harmed?

(1) The American consumer, who might have bought a sweater at a lower price and had money left over to spend on other things

(2) the companies that would have sold to that consumer(3) their workers(4) the foreign sweater-makers(5) the American exporters from whom the foreign sweater- makers or their compatriots would

have bought goods and services(6) the governments that would lose revenues from the general slowdown of business

VIDEO: WHY DO COUNTRIES RESTRICT TRADE?

Who’s “Protected” by Tariffs?The Candlemakers' petition:

…is a well known satire of protectionism written and published in 1845 by Frederic Bastiat.

All the people involved in the French lighting industry, including "the manufacturers of candles, tapers, lanterns, sticks, street lamps, snuffers and extinguishers, and from producers of tallow, oil, resin, alcohol, and generally of everything connected with lighting“ callupon the French government to take protective action against the “unfair competition” of the sun.

The Drive for Exports


• In the long run imports and exports must equal each other.

• It is exports that pay for imports, and vice versa. The greater exports we have, the greater imports we must have, if we ever expect to get paid. Without imports we can have no exports, for foreigners will have no funds with which to buy our goods.

Hume: Price-Specie Flow Mechanism

• Importing money in exchange for exports – causes inflation – makes exports less competitive

• Exporting money in exchange for imports – causes deflation – makes exports more competitive

Therefore Hume argued that a trade balance is relatively unimportant because it tends to balance itself out in the long term.

China - US

• China exports • U.S. imports• Sustainable?

• China keeps currency artificially low:• By keeping its currency undervalued, China is

discounting its own exports.• China's central bank needs to constantly buy U.S.

Treasury bonds.

Parity Prices

Parity Prices

• What are "parity prices?”

• “Purchasing Power Parity (= Equality)” over time – a plea to keep prices up

• Falling prices are a good thing ( increased productivity)

Parity Prices

• Example: Subsidized prices for farm products• Consequence: Higher prices for food• Consumers spend less on other products

Parity Prices

• We are all producers (sellers) and consumers (buyers) in a sense

• Discussion: Rising Stock Prices positive?Rising Food / Oil prices negative?

Saving the X Industry

Saving the X industry(Why Bailouts don’t work)

• Typical industries: Banking, Auto, Agriculture, Defense

• The idea that an expanding economy implies that all industries must be simultaneously expanding is a profound error. In order that new industries may grow fast enough it is necessary that some old industries should be allowed to shrink or die.

Saving the X industry

• What are the ways that politicians attempt to save Industry X ?

• Direct subsidy = Transfer of wealth, taxpayers lose, less spending, other industries shrink

• Prevent competition = create monopoly (same chain of reasoning)

How the Price System Works


Example: Automatic "governor" on a steam engine: Every departure from the desired speed itself sets in motion the forces that tend to correct that departure.


• It is precisely in this way that the relative supply of thousands of different commodities is regulated under the system of competitive private enterprise.

• Question: Why don’t we produce so much chocolate to cover all unmet “needs”/”wants”?

• Answer: Resources have alternative uses / Competing Bids create structure of production

All Scarce Goods Must Be Rationed Somehow… Alternative Rationing Mechanisms to the Price System:

• Queuing (Waiting in line as a means of distributing goods and services, „first come, first served“ )

• Ration Coupons (Tickets or coupons that entitle individuals to purchase a certain amount of a given product per month )

• Favored Customers (Those who receive special treatment from dealers during situations of excess demand. )

• Rationing according to „needs“• Lottery• Equal shares for all• „Might makes right“• Problem: Excess demand is created but not eliminated

All Scarce Goods Must Be Rationed Somehow

Stabilizing Commodities

Stabilizing Commodities

• Price Floors

Stabilizing CommoditiesPrice Floors

• Side-effects:1.Consumers find they must now pay a higher

price for the same product. As a result, they reduce their purchases or drop out of the market entirely.

2.Suppliers find they are guaranteed a new, higher price than they were charging before. As a result, they increase production.

Stabilizing Commodities Price Floors

• Example: CAP (Common Agricultural Policy) in EU

• “Butter Mountains”• “Milk Seas”

• Because of this problem, the EU stopped these price floors and just pays former farmers regardless of what they do, so as not to cause any undesired indirect effects on the economy.

Government Price Fixing

Government Price FixingPrice Ceilings


• Side effects:• Supply decreases• Quantity demanded increases• SHORTAGE (unless rationing or other

consumption controls are enforced)• Other forms of non-price competition (Black

Markets, Queuing…)


• Would you rather KNOW that you can buy petrol at 2 USD per gallon or HOPE that you can get petrol at 1 USD per gallon?

Minimum Wage Laws

Minimum Wage Laws

• Side effects:• They reduce employment opportunities for

less-skilled workers• When a law exists that no one is to be paid

less than $64 for a 40 hour week, then no one whose services are not worth $64 to an employer will be employed at all.

• Example: Teenage unemployment

Minimum Wage Laws

• Special Interests: Trade Unions

Enough to Buy Back the Product


• Fallacy: “People cannot buy back what is produced” because they are not paid enough

• Lack of demand? “Underconsumption” theories• Saving as lack of demand?

• Laborer’s wage is his purchasing power, but also the business’s profits are the owner’s purchasing power

The Function of Profits


• Is profit something negative/immoral?• Profits serve to guide and channel the factors

of production • Profits result from forecasting the future –

and future consumer needs


• Entrepreneur is continuously scanning the market for undervalued resources with the intention of combining them and then bringing them to market in a much higher valued product.


• Losses signal a waste of resources: It means that resources have a higher value to consumers in other areas than the product that is being produced


• Profit System = system in which people are using resources efficiently and serving others

• Profit guides everybody to get more value out of the limited resources that exist

The Mirage of Inflation


Setting the alarm clock earlier?

The Mirage of InflationWhat is the difference between wealth and money?

What are the various justifications people give for inflationary policy?

What is the basic process by which the money supply is inflated?

What does inflation do to the "structure of production?"

In what sense can inflation counteract problems of above-market wage rates?

Why is inflation so popular among many government officials?

What is the worst-case outcome of inflation?

The Assault on Savings

• People save for good reasons• Money saved does not reduce employment• Saving helps expand the economy



What is the difference between consumer goods and capital goods, and how is savings related?

What is the difference between saving and withholding spending? What causes each?

What harmonizes savings and investment on a free market?

What is the result of keeping interest rates artificially low?


The two brothers:


• "Saving" is only another form of spending. • Interest rate is the relevant price that

translates savings into investment

The Assault on SavingsVirtually low interest rate leads to misallocation of resources. Projects cannot be completed because real savings are missing. (Construction Bubbles…)

Economics in One Lesson

Economy & Finance

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