Economics is the study of human endeavor — that’s people doing stuff like scoring a goal for Barcelona, writing a song, painting a fence, or pouring coffee in a diner. The goal scorer is in the entertainment industry; the song writer is an artist; the fence painter works in construction; and the waiter in hospitality. We have a name for the grand sum of all human endeavor. We call it the economy. Even if you’re a full-time student right now, you’re participating in the economy as a client in the education industry.
I have simplified this definition of economics just a little, but not much. The bit I left out is that economics looks at human endeavor with a particular purpose, and that is to measure its value. Economic value is different from, say, aesthetic or spiritual value, although one might relate to the other.
What’s the economic value of Vincent van Gogh’s endeavor to paint Starry Night? He barely sold a painting in his lifetime died penniless. But its value today is estimated at hundreds of millions of dollars.
How much economic value do we place on the many types of human endeavor, and who decides or sets the value of each activity? Actually, we all decide through our many choices of how we spend our time and money. We seem to have decided, for example, that the goal-scorer for Barcelona generates more economic value than the waiter in the diner, but less than Jeff Bezos, who founded Amazon.com.
I won’t in this post debate the rights and wrongs of various economic valuations. That is the concern of politics and the philosophy of economics, and those topics can wait for a later time. Of course, economists, like all people, hold diverse beliefs about what is best for society, and their beliefs may play a critical role when politicians and governments ask for their help. But as a matter of intellectual inquiry, the subject of economics is amoral. It tries to explain human endeavor (also known as economic activity) without judgment.
The creation of economic value
Endeavor — exerting ourselves to create value for society — is at the very heart of economics, whether that’s fixing a leak, driving a bus, or assembling an automobile. No less worthy examples include raising a child, caring for an elderly parent, or studying for a high-school exam. You don’t have to be paid for the economic value you generate, although perhaps you should be.
Endeavor and the creation of economic value date back to the earliest gatherings of our cave-dwelling ancestors. Their very survival called for acts of endeavor such as hunting or foraging for food, gathering firewood, making clothes from animal skins, tending to their young, and looking out for predators.
Nowadays, our day-to-day survival is more or less assured, and many of us enjoy a multitude of options in selecting an occupation. Should we feel guilty about such freedom of choice? No said eighteenth century Scottish economist and philosopher Adam Smith, whose hugely influential book The Wealth of Nations (1776) showed how society benefits most when we each specialize —pursuing our particular talents and interests — as long as we then exchange goods and services with one another. Trade is the basis of market economics. More on that later too.
Cooperation, collaboration, and specialization
Powered by centuries of innovation, from the plow to the printing press and beyond, modern economies are considerably more complex than the primitive economy of our prehistoric ancestors. By dividing responsibilities such as hunting, gathering, and watching for predators, cave dwellers learned to cooperate with one another. In contrast, participants in modern economies collaborate.
Collaboration is like a super-charged form of cooperation, linking specialized activities into so-called value chains. Each additional endeavor in the chain adds an x-factor or multiplier effect to the value of the chain. As we’ll demonstrate, value chains can create extraordinary amounts of economic wealth. Meanwhile, innovation upon innovation leads to new value chains and ensures existing ones grow in size and efficiency. Let’s take a look at a modern day value chain.
Pizza anyone?
If like me you live in California, you can order one on your phone for delivery in minutes. But that speed is powered by a highly evolved value chain. The chain begins with farmers growing wheat for the pizza crust, planting tomatoes for the sauce, and raising cows for the cheese. These raw materials are then processed into ingredients: wheat milled into flour; cheese cultured from milk; and tomatoes crushed, seasoned, and canned. The logistics industry may then ship these processed goods great distances to wholesalers and retailers, and onwards to your local pizza shop, where a pizza chef adds yet more value by combining the ingredients into pizza.
That might have been the end of the chain except you placed a mobile delivery order. Internet technologies extend the value chain with the inclusion of an app-based delivery service, a mobile phone operating system, a digital payment platform (itself a whole ecosystem of financial institutions and security technologies), a mobile phone network, and an Internet service provider, all connecting the pizza shop to your incoming order.
If contemplation of just that one value chain leaves you breathless, consider that each endeavor in the chain may itself be part of several other chains. The tomato farmer, for example, is part of a chain that includes research into plant genetics, seed production from globalized agri-business, and mechanized harvesting.
These diverse and specialized providers of goods and services have collaborated to create something wonderful — the opportunity to summon a freshly made pizza whenever the fancy takes us! The economic value of all that endeavor? Combining dine-in and delivery options, the value of the pizza market in the United States alone was estimated at more than $100 billion last year.
Market economies
Human endeavor, not markets, drives economic activity. But markets are an important catalyst. They are so important because they provide answers to a vast range of difficult questions: How much should a grocer charge for a dozen eggs? Who should a company hire to be its new Regional Sales Manager? How might a new college grad negotiate better terms of employment after receiving offers from two competing companies? Among several new ventures offering shares to investors, which represents the best opportunity?
Not only do markets solve these and similar problems, they seemingly solve them effortlessly. All each of us needs to do is follow our own self-interest, which we’d naturally want to do anyway.
Adam Smith of Wealth of Nations fame was first to recognize and articulate markets’ magical power. He eloquently described the effect of a market as “an invisible hand” that orchestrates economic actors (buyers and sellers) to ensure the very best outcome.
Of course, in reality there is no invisible hand orchestrating anyone. Markets work by empowering people to exercise freedom of choice. And when we have that choice, we choose to spend less of our economic resources (money and time) to get the things we want now so we’ll have more resources available for the things we want later.
Given a choice to, say, purchase a dozen eggs at store A for half as much or at store B for twice as much, we shop at store A (all other things being equal). Soon store A is selling a lot of eggs while B is selling hardly any.
A’s shelves are now empty. Tomorrow, when a fresh delivery arrives, A’s manager will increase the price of its eggs in hope of making more money. Store B meanwhile still has unsold eggs on its shelves. B’s manager does exactly the opposite, lowering the price in hope of attracting more customers.
The opportunity to trade offered by markets and the freedom of choice exercised by buyers and sellers continually drive prices. And the market always drives prices towards an optimal price i.e. the price at which the most goods get sold based on supply and demand.
Our example showed the impact of markets on the price of eggs. Markets work exactly the same for all types of products and services. And equally so both for labor (remember the lucky college grad with a choice of job offers) and for investment capital (another catalyst for a special type of economic activity known as entrepreneurship).
Markets invisibly (to borrow Adam Smith’s metaphor) dictate the most efficient allocation of resources. More than likely, the college grad accepts the highest paying job offer, and the investor picks the venture with the best prospects.
Centrally planned economies
If markets offer up such a magical solution to balancing supply and demand, you’d be forgiven for supposing there is any other way to determine the economic value of a dozen eggs or anything else for that matter! But there is an alternative. Command-and-control or centrally planned economies draw on ideas first put forward by another economist and philosopher, Karl Marx (1818-1883).
Whereas economies based on free trade and minimal government regulation (the kind proposed by Adam Smith) dominate today, Karl Marx’s belief in central planning has also found favor. Some form of central planning is practiced today in Cuba, North Korea, Iran, Venezuela, Libya, Russia, Belarus, and, to a lesser extent, China and Vietnam. Its advocates reason that state actors such as governments and their economic boards have the political motivation, authority, and control of their country’s resources to ensure better outcomes for their citizens than would emerge from markets’ invisible hand.
So who’ s right? Adam Smith or Karl Marx? Standards of living are typically higher in market economies. But coherent arguments exist for the virtues of central planning.
Many economists would say that a balanced approach leads to the greatest societal benefits. And most governments agree, pursuing middle-ground policies that may allow markets to allocate resources under some measure of regulatory supervision.
Governments have been particularly active in the regulation of money markets (i.e. the markets for lending and borrowing money). But government policies can also impact the several other types of market — housing markets, labor markets, ccommodity markets, and capital (i.e. investment) markets, to name some. For example, in an effort to increase the number of jobs in the economy, a government might offer employers a break on employment taxes if they hire more workers.
The final word
It’s not economists but politicians who have the final word in deciding how much a government should intervene in the economy. Free marketeers like Adam Smith believe the best thing governments can do is to step aside and let markets work their magic. Adam Smith even coined a term — laissez-faire — for this “hands-off” approach . Roughly translated from the French, it means “let [the market] do what it does.”
Social democrats in countries like France, Canada, Sweden, Norway, the United Kingdom, and the United States favor a much greater role for policy makers in economic life. Even so, they typically stop short of advocating Marxist-style central planning.
Most economists agree that whereas markets are the best mechanisms to allocate resources like labor, investment capital, and goods and services, government intervention is sometimes necessary.
We’ll take a closer look at the particular ways in which governments might intervene in the economy in other posts, exploring topics like central banks, tariffs, employment, and inflation. And if that sounds boring, you’re in the right place!
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