Sunday, February 22, 2009

Concepts in Economics made clearer

Some plain English explanations of basic terms and concepts in Economics and other helpful tips for puzzled students and others.

'Marginal' just means 'the last one before you stop'.

You draw the line in the graph for (perfectly) Inelastic as a big I.

You draw the graph for (perfectly) Elastic as a big E without the top line. (This mnemonic did much to get me through first year Microeconomics.)

If it is only quantities/prices that are changing, you move along the supply/demand curve.

If it is how much is demanded (at a given price) or the supply costs (at a given quantity) that is changing, then you move the curve.

The price of something is what you give up to get it.

The cost of something is what you give up to get it.

If you don't ration by price, you ration by queue.* (Hence the hardy political perennial of “reduce hospital waiting lists”.)

Revealed preference is what folk actually do.
Expressed preference is what folk say they will do.
Externalities are effects on third parties. They can be positive or negative. (The victim of a contract killing suffers a negative externality since they were the subject of the contract but not a party to it. Property owners near a new railway station gain a positive externality.)

Gains from trade are why people do. (Trade that is.) They exist because utility is subjective, so the same thing can have different value to different folks. A bookseller already has lots of books, it's money and everything they can do with it that they want; while a book buyer has money, but they don't have that book. If they trade, each ends up with something they value more than what they started with. Which is why people buy and sell.

Comparative advantage is about what you are most productive at, not who is more productive. (A doctor probably can clean her office better than a cleaner: but it's a damn silly use of her time.)

The market system is a profit and loss system. The latter is more important.

Risk matters. (This may seem really obvious, but it's amazing how many otherwise smart people talk as if it doesn't. Everyone who thinks trading futures is a wank, for example. Or all private profit is exploitation—i.e. every Marxist.) So much commercial activity is all about managing risk. For example, the most important labour market intermediary being "friends, relatives, acquaintances, etc": the connection and information that people have about such "friends, relatives, acquaintances, etc" lessens the risks in hiring a new person.

Arbitrage is buying and selling the same thing: the gain is from knowing that some other buyer(s) exist that the first seller doesn't know about or can't reach.

Transaction costs matter. So prices often vary according to how close the nearest competitor is because travel is a cost in transacting.

Networks tend to be natural monopolies because adding an extra person is cheaper (and gives greater benefits) the bigger the network. (I.e. there are economies of scale because the costs of establishment get spread over more and more folk, so fall per person.) Of course, if networks costs are a sufficiently small part of total costs, or there are diseconomies of scale (typically in management), then not so much.

Finally, there are three ways to say anything in economics—words, graphs or mathematics: as long as you can master 2 out of 3, you're fine.

(*Or elite favour, but that's a case we prefer not to think about, it being arbitrary and all.)

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