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«50 IDEAS YOU REALLY NEED TO KNOW: ECONOMICS Edmund Conway is Economics Editor of Sky News. He was educated at Pembroke College, Oxford, and the ...»

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50 economic ideas text:Layout 1 16/5/12 14:24 Page i

50 IDEAS YOU REALLY NEED TO KNOW: ECONOMICS

Edmund Conway is Economics Editor of Sky News. He was educated at Pembroke College, Oxford, and the Kennedy School of

Government, Harvard, where he was a Fulbright and Shorenstein Scholar. He lives in London.

50 economic ideas text:Layout 1 16/5/12 14:24 Page ii

50 economic ideas text:Layout 1 16/5/12 14:24 Page iii

title artwork to follow?

50 economic ideas text:Layout 1 16/5/12 14:24 Page iv This paperback edition published in 2012 by Quercus 55 Baker Street Seventh Floor, South Block London W1U 8EW Copyright © 2009, 2012 Edmund Conway The moral right of Edmund Conway to be identified as the author of this work has been asserted in accordance with the Copyright, Designs and Patents Act, 1988.

Hardback edition originally published by Quercus 2009 as 50 Economics Ideas You Really Need to Know All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopy, recording, or any information storage and retrieval system, without permission in writing from the publisher.

A CIP catalogue record for this book is available from the British Library ISBN 978 1 78087 585 9 Designed and typeset by Ellipsis Digital Ltd Printed and bound in Great Britain by Clays Ltd. St Ives plc 50 economic ideas text:Layout 1 16/5/12 14:24 Page v Contents Introduction 1 1 The invisible hand 5 2 Supply and demand 9 3 The Malthusian trap 13 4 Opportunity cost 18 5 Incentives 22 6 Division of labour 26 7 Comparative advantage 30 8 Capitalism 34 9 Keynesianism 39 10 Monetarism 43

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‘A dreary, desolate and, indeed, quite abject and distressing [subject]; what we might call, by way of eminence, the dismal science.’ Thomas Carlyle’s description of economics dates from 1849 but has stuck, for better or for worse. One should hardly be surprised. Economics is something people usually take notice of only when things go wrong. Only when an economy is facing a crisis, when thousands lose their jobs, when prices rise too high or fall too fast, do we tend to take much note of the subject. At such points there is little doubt it seems pretty dismal, especially when it underlines the challenges and the restraints we face, spells out the reality that we can’t have everything we want and illustrates the fact that human beings are inherently imperfect.

The truth, I should add, in typical economist fashion, is far less simple. If it were merely a study of numbers, of statistics and of theories then the dismal science analogy would perhaps hold more ground. However, economics is, to its very heart, the study of people. It is an inquiry into how people succeed, into what makes us happy or content, into how humanity has managed over generations to become more healthy and prosperous than ever before.

Economics examines what drives human beings to do what they do, and looks at how they react when faced with difficulties 50 economic ideas text:Layout 1 16/5/12 14:24 Page 2

50 ECONOMICS

or success. It investigates choices people make when given a limited set of options and how they trade them off against each other.

It is a science that encompasses history, politics, psychology and, yes, the odd equation or two. If it is history’s job to tell us what mistakes we’ve made over the past, it is up to economics to work out how to do things differently next time around.

Whether it succeeds in doing so is another question. As this book was going to press, the world was coming to terms with one of the biggest financial crises in history, as decades’ worth of debt overwhelmed international markets. Some of the world’s biggest and oldest banks, retailers and manufacturers collapsed.

The crisis had many novel aspects – new and complex financial instruments, for example, and new economic relationships as, for the first time since the end of the Cold War, the position of the United States as global superpower came under question. But it was in reality very similar to many crises in the past. If we can make the same mistakes over and over again, went the cry, what is the purpose of economics?

The answer is very simple. The wisdom we have gleaned over centuries on how best to run our economies has made us richer, healthier and longer-lived than our forefathers could ever have contemplated. This is by no means a given. One has only to look at countries in sub-Saharan Africa and parts of Asia – where people are, in effect, stuck in the same conditions as Europe in the Middle Ages – to realize our prosperity is by no means assured. It is, in fact, extremely fragile, but as is always the case with economics, we take this success for granted and tend instead to focus on the dismal side of things.

Such is human nature. Many economics books attempt to dispel such illusions. This is rather desperate and, frankly, not 50 economic ideas text:Layout 1 16/5/12 14:24 Page 3

INTRODUCTION

my style. The aim of this book is simply to explain how the economy works. The dirty little secret of economics is that it’s not really complicated at all – why should it be? It is the study of humanity, and as such its ideas are often little more than common sense.





This book is not intended to be read as a continuous narrative:

each of these 50 ideas should make sense on its own, though I have highlighted where you might benefit from looking at

another chapter.

My hope is that by the time you’ve read most of the ideas you will be able to think that little bit more like an economist: to ask probing questions about why we act the way we do; to reject the conventional wisdom; to understand that even the simplest things in life are more complicated than they seem – and all the more beautiful because of it.

A case in point is this Introduction. The done thing for an author is to include thanks to all who helped put the book together. But where to begin? Should I start by thanking the owners of the forest where the wood used to make the pages was felled? Or the factory workers who manufactured the ink that lines the pages? Or the operators of the machines in the bookbinding factory in China where the book was put together? Like so much else in this interconnected world, millions of people played a part in the creation of this book – from the publishers and manufacturers of the book you’re holding, to the shipping firms that sailed it from China to your bookstore, alongside many others. (To find out why the book was printed in China, read the chapter on globalization.) In particular, this book is a product of the thousands of conversations I have had with economists, professors, financiers, 50 economic ideas text:Layout 1 16/5/12 14:24 Page 4

50 ECONOMICS

businessmen and politicians in recent years; and of the excellent economics literature available on store bookshelves and, more excitingly, the Internet. Many of the ideas echo those by prominent and less prominent economists too numerous to mention.

However, I should like also to thank Judith Shipman at Quercus for allowing me to be part of this excellent series; my copy editors, Nick Fawcett and Ian Crofton; Vicki and Mark Garthwaite for giving me a place to write it; David Litterick, Harry Briggs and Olivia Hunt for their input; and my mother and the rest of my family for their support.

–  –  –

‘Greed is good,’ declared Gordon Gekko, villain of the classic 1980s movie Wall Street, in one fell swoop confirming polite society’s worst fears about financiers. In this cut-throat Manhattan world, flagrant avarice was no longer anything to be ashamed of – it should be worn with pride, like a striped shirt and red suspenders.

Shocking as the film was in the late 20th century, try to imagine how a declaration like that would have sounded some two centuries earlier, when intellectual life was still dominated by the Church, and defining humans as economic animals was close to blasphemous. Now you might have some idea of the impact Adam Smith’s radical idea of the ‘invisible hand’ had when he first proposed it in the 18th century. Nevertheless, like its Hollywood descendant, his book was a massive commercial success, selling out on its first publishing run and remaining a part of the canon ever since.

The role of self-interest The ‘invisible hand’ is shorthand for the law of supply and demand (see chapter 2) and explains how the pull and push of these two factors serve to benefit society as a whole. The simple conceit is as follows: there is nothing wrong with people acting in their self-interest. In a free market, the combined force of everyone pursuing his or her own 50 economic ideas text:Layout 1 16/5/12 14:24 Page 6

–  –  –

individual interests is to the benefit of society as a whole, enriching everyone.

Smith used the phrase only three times in his 1776 masterpiece The Wealth of Nations, but one key passage underlines its

importance:

–  –  –

The idea helps explain why free markets have been so important to the development of complex modern societies.

Taught by the hand Let’s take an inventor, Thomas, who has come up with an idea for a new type of light bulb – one that is more efficient, longer-lasting and brighter than the rest. He has done so to serve his own self-interest, in the hope of making himself rich, and perhaps famous. The by-product will be to benefit society as a whole, by creating jobs for those who will make the bulbs and enhancing the lives (and living rooms) of those who buy them. If there had been no demand for the light bulb, no one would have paid Thomas for it, and the invisible hand would have, in effect, slapped him down for making such a mistake.

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THE INVISIBLE HAND

Similarly, once Thomas is in business, others may see him making money and attempt to outdo him by devising similar light bulbs that are brighter and better. They too start getting rich. However, the invisible hand never sleeps. Thomas starts undercutting his competitors so as to ensure he keeps selling the most. Delighted customers benefit from even cheaper light bulbs.

At each stage of the process Thomas would be acting in his own interests rather than for those of society, but, counter-intuitively, everyone would benefit as a result. In a sense, the theory of the invisible hand is analogous to the idea in mathematics that two negatives make a positive. If only one person is acting in his or her own self-interest, but everyone else is being altruistic, the benefits of society will not be served.

One example concerns Coca-Cola, which changed the recipe of its fizzy drink in the 1980s in an effort to attract younger, more fashionable drinkers. However, New Coke was a complete disaster: the public did not appreciate the change, and sales plunged.

The message of the invisible hand was clear and Coca-Cola, its profits slumping, withdrew New Coke after a few months. The old variety was reinstated, and customers were happy – as were Coca-Cola’s directors, since its profits quickly bounced back.

Smith recognized that there were circumstances under which the invisible hand theory would not work. Among them is a dilemma often known as the ‘tragedy of the commons’. The problem is that when there is only a limited supply of a particular resource, such as grazing land on a common, those who exploit the land will do so to the detriment of their neighbours.

It is an argument that has been used with great force by those who campaign against climate change (see chapter 45).

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50 ECONOMICS

Limits to free markets Although the idea of the invisible hand has occasionally been hijacked by right-wing politicians in recent decades, it is not a theory that necessarily represents a particular political view. It is a positive economic theory (see chapter 16), though it seriously undermines those who think economies can be run better from the top down, with governments deciding what ought to be produced.



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