Economics 101: What you missed while sleeping through class

“People are reasonably predictable” Adam Smith

How does a bakery decide how many loaves of bread to bake each day?

A bakery estimates how many loaves of bread it can sell every day. If they do not make enough loaves, they lose out on sales. If they make too much, they waste the loaves and the finite ingredients required to make the bread.

In both scenarios, the bakery loses money. An economist can predict what the correct amount of loaves are needed on an average day.

Economics is not about money. It is about people and how they make their way through the world.

Most people’s motivations are simple. Economists can identify a few primary motivations.

Economists are limited to the ordinary business of life. What do people repeatedly do?

Predictable

Each person is predictable enough in their behavior to make mathematical models. Economic theories are usually presented in a mathematical model.

Economists use mathematics to show their rigorous thinking and logical conclusions. The complex mathematical equations are stories turned into the language of mathematics.

Using stories or theories economists can predict a wide variety of human behaviors. People become a mechanism in a machine.

Adam Smith called this the “Invisible Hand” of the market. Smith thought each person’s behavior was predictable enough to make the whole system operate efficiently.

The “Invisible Hand” concept was that each individual’s economic self-interest under certain market conditions could contribute to the greater economic good.

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Complex

The world has changed since Adam Smith wrote his seminal work “The Wealth of Nations.”

In the modern world, most products have complex supply chains. It is rare for a product to be made all in the same place.

For example, a sweater is sewn together in Thailand, but the wool came from New Zealand sheep. The sweater is shipped from Thailand to an American store where it is purchased.

“Economics is the dismal science” Thomas Malthus

Economics studies the good and bad times.

Why?

Because economics is about constraints on people, nothing is an infinite resource.

Thus, economics is not a happy subject. Who would not want one of everything?

However, economics creates better thinkers who make better decisions.

2 Fundamental Principles of Economics

There are two fundamental principles of economics.

Principle one is that people respond to incentives.

When someone is given a choice to improve their life from doing a transaction, it should be utilized.

Principle two is that every transaction has two sides.

In every transaction, each person gives up something and acquires something.

For example, a person goes to the bakery to buy a loaf of bread for a dollar. They exchange the dollar for the bread. They get the bread, and the baker gets the dollar — transaction complete.

We buy and sell something in every transaction.

Countries import but at the same time must export.

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David Ricardo

David Ricardo is a famous economist.

He came up with several of the main economic theories including the Law of Diminishing Returns, the Law of Comparative Advantage, and the Law of Diminishing Marginal Returns.

As a stockbroker and loan broker, David amassed a fortune. David was worth $100 million in today’s dollars.

David was a self-made man. His family disinherited him for not marrying a Jewish woman.

At 27, he read Adam Smith’s “Wealth of Nations” and became enthralled with economics.

It took a decade before David started writing his own articles.

Ricardo managed to create very complex economic theories without using any mathematics which underpins modern economics.

In 1815, he wrote “Essay on the Influence on a Low Price of Corn on Profits of Stock” which became the Law of Diminishing Marginal Returns. One of the most influential economic laws.

For example, a farmer combines more of his labor and machinery on a farm. But, the farmer will have diminishing returns as the land constrains his output. There is a cap on how much the land can produce.

David argued against the protectionist Corn Laws. He was an avid supporter of free trade.

His Law of Comparative Advantage explains how trade is beneficial to all parties involved.

A country is better off if it trades its products with other countries who make a product for less money than the country could itself.

For example, Country A can make a loaf of bread in two hours and a t-shirt in one hour. Country B can make a loaf of bread in one hour and a t-shirt in two hours. Both countries are better off if Country A specializes in making t-shirts and Country B specializes in making bread.

Finally, David articulated the Law of Diminishing Returns which today underlies economists’ understanding of supply and demand, and how prices and wages are determined.

Final Thoughts

Good economics can be beautiful and beneficial to our lives.

It is time to go and create your own economic story.

“Economic theory is mostly just a collection of stories” Paul Krugman

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