We started by discussing how individuals make decisions and then looked at how people interact with one another. All these decisions and interactions together make up ‘the economy’. The last three principles concern the workings of the economy as a whole. A key concept in this section is economic growth – the percentage increase in the number of goods and services produced in an economy over a period of time usually expressed over a quarter and annually.
Principle 8: An Economy’s Standard of Living Depends on its Ability to Produce Goods and Services
Table 1.1 shows gross domestic product per head of the population in a number of selected countries. It is clear that many of the advanced economies have a rel- atively high income per capita; in the UK it is $35 728 whilst in Germany and France it is $39 442 and $42 092 respectively. In Spain average income is a little lower at $31 142, somewhat higher in Ireland at $51 128, higher still in Switzer- land at $66 127 and an enviable $94 418 in Luxembourg. These figures compare with an income per person of about $39 000 in Canada and $46 500 in the United States. But once we move away from the prosperous economies of Western Eur- ope, North America and parts of Asia, we begin to see differences in income and living standards around the world that are quite staggering. For example, in the same year, 2009, average income in Poland was $11 098 almost a third of the level in Spain, while in Argentina it was just $7 508, in India $1 033 and in Ethio- pia just $418 – less than one half of a per cent of the annual income per person in Luxembourg. Not surprisingly, this large variation in average income is reflected in various other measures of the quality of life and standard of living. Citizens of high-income countries have better nutrition, better health care and longer life expectancy than citizens of low-income countries, as well as more TV sets, more DVD players and more cars.
Changes in the standard of living over time are also large. Over the last 50 years, average incomes in Western Europe and North America have grown at about 2 per cent per year (after adjusting for changes in the cost of living). At this rate, average income doubles every 35 years, and over the last half-century average income in many of these prosperous economies has risen approximately three-fold. On the other hand, average income in Ethiopia rose by only a third over this period – an average annual growth rate of around only 0.5 per cent.
What explains these large differences in living standards among countries and over time? The answer is surprisingly simple. Almost all variation in living stan- dards is attributable to differences in countries’ productivity – that is, the amount of goods and services produced from each hour of a worker’s time. In nations where workers can produce a large quantity of goods and services per unit of time, most people enjoy a high standard of living; in nations where workers are less productive, most people must endure a more meagre existence. Similarly, the growth rate of a nation’s productivity determines the growth rate of its average income.
The fundamental relationship between productivity and living standards is simple, but its implications are far-reaching. If productivity is the primary deter- minant of living standards, other explanations must be of secondary importance.
For example, it might be tempting to credit trades unions or minimum wage laws for the rise in living standards of European workers over the past 50 years.
Yet the real hero of European workers is their rising productivity.
economic growth
the increase in the amount of goods and services in an economy over a period of time
gross domestic product per head the market value of all final goods and services produced within a country in a given period of time divided by the popu- lation of a country to give a per capita figure
standard of living
refers to the amount of goods and services that can be purchased by the population of a country. Usually measured by the inflation-adjusted (real) income per head of the population
productivity
the quantity of goods and services pro- duced from each hour of a worker’s time
The relationship between productivity and living standards also has profound implications for public policy. When thinking about how any policy will affect living standards, the key question is how it will affect our ability to produce goods and services. To boost living standards, policy makers need to raise pro- ductivity by ensuring that workers are well educated, have the tools needed to produce goods and services, and have access to the best available technology.
TABLE 1.1
Gross Domestic Product Per Capita, Current Prices, US dollars 2009
Country GDP per capita
Albania 3 681
Argentina 7 508
Australia 41 982
Azerbaijan 4 864
Bangladesh 559
Belarus 5 122
Brazil 7 737
Canada 39 217
China 3 566
Ethiopia 418
France 42 092
Germany 39 442
Haiti 772
Iceland 36 873
India 1 033
Ireland 51 128
Japan 39 573
Kazakhstan 6 875
Luxembourg 94 418
Mexico 8 040
Norway 76 692
Pakistan 1 017
Paraguay 2 169
Peru 4 377
Poland 11 098
Portugal 20 655
Romania 7 503
Russia 8 874
Saudi Arabia 14 871
South Africa 5 635
Spain 31 142
Sweden 43 147
Switzerland 66 127
Syrian Arab Republic 2 669
Tajikistan 705
Thailand 3 973
United Arab Emirates 46 584
United Kingdom 35 728
United States 46 443
Zimbabwe 303
Source: International Monetary Fund, World Economic Outlook Database, October 2009.
Principle 9: Prices Rise When the Government Prints Too Much Money
In Germany in January 1921, a daily newspaper was priced at 0.30 marks.
Less than two years later, in November 1922, the same newspaper was priced at 70 000 000 marks. All other prices in the economy rose by similar amounts. This episode is one of history’s most spectacular examples of inflation, an increase in the overall level of prices in the economy.
While inflation in Western Europe and North America has been much lower over the last 50 years than that experienced in Germany in the 1920s, inflation has at times been an economic problem. During the 1970s, for instance, the over- all level of prices in the UK more than tripled. By contrast, UK inflation from 2000 to 2008 was about 3 per cent per year; at this rate it would take more than 20 years for prices to double. In more recent times, Zimbabwe has experienced German-like hyperinflation. In March 2007 inflation in the African state was reported to be running at 2 200 per cent. That meant that a good priced at the equivalent of €2.99 in March 2006 would be priced at €65.78 just a year later. In July 2008 the government issued a Z$100 billion note. At that time it was just about enough to buy a loaf of bread. Estimates for inflation in Zimbabwe in July 2008 put the rate of growth of prices at 231 000 000 per cent. In January 2009, the
“…but if daddy increased your allowance he’d be hurting the economy by stimulating inflation. You wouldn’t want him to do that, would you?”
inflation
an increase in the overall level of prices in the economy
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government issued Z$10, 20, 50 and 100 trillion dollar notes – 100 trillion is 100 fol- lowed by 12 zeros. Because high inflation imposes various costs on society, keeping inflation at a low level is a goal of economic policy makers around the world.
What causes inflation? In almost all cases of high or persistent inflation, the culprit turns out to be the same – growth in the quantity of money. When a gov- ernment creates large quantities of the nation’s money, the value of the money falls. In Germany in the early 1920s, when prices were on average tripling every month, the quantity of money was also tripling every month. Although less dra- matic, the economic history of other European and North American countries points to a similar conclusion: the high inflation of the 1970s was associated with rapid growth in the quantity of money and the low inflation of the 2000s was associated with slow growth in the quantity of money.
Principle 10: Society Faces a Short-run Trade-off Between Inflation and Unemployment
When the government increases the amount of money in the economy, one result is inflation. Another result, at least in the short run, is a lower level of unemploy- ment. The curve that illustrates this short-run trade-off between inflation and unemployment is called the Phillips curve, after the economist who first exam- ined this relationship while working at the London School of Economics.
The Phillips curve remains a controversial topic among economists, but most economists today accept the idea that society faces a short-run trade-off between inflation and unemployment. This simply means that, over a period of a year or two, many economic policies push inflation and unemployment in opposite directions. Policy makers face this trade-off regardless of whether inflation and unemployment both start out at high levels (as they were in the early 1980s), at low levels (as they were in the late 1990s) or somewhere in between.
The trade-off between inflation and unemployment is only temporary, but it can last for several years. The Phillips curve is, therefore, crucial for understand- ing many developments in the economy. In particular, it is important for under- standing the business cycle – the irregular and largely unpredictable fluctuations in economic activity, as measured by the number of people employed or the pro- duction of goods and services.
TABLE 1.2
Ten Principles of Economics
How people make decisions 1. People face trade-offs
2. The cost of something is what you give up to get it 3. Rational people think at the margin
4. People respond to incentives How people interact 5. Trade can make everyone better off
6. Markets are usually a good way to organize economic activity
7. Governments can sometimes improve market outcomes
How the economy as a whole works
8. A country’s standard of living depends on its ability to produce goods and services
9. Prices rise when the government prints too much money
10. Society faces a short-run trade-off between inflation and unemployment
Phillips curve
a curve that shows the short-run trade-off between inflation and unemployment
business cycle
fluctuations in economic activity, such as employment and production
Policy makers can exploit the short-run trade-off between inflation and unem- ployment using various policy instruments. By changing the amount that the government spends, the amount it taxes and the amount of money it prints, pol- icy makers can influence the combination of inflation and unemployment that the economy experiences. Because these instruments of monetary and fiscal policy are potentially so powerful, how policy makers should use these instruments to control the economy, if at all, is a subject of continuing debate.
Quick Quiz List and briefly explain the three principles that describe how the economy as a whole works.
I N T H E N E W S
Using Incentives
Policy makers are well aware of the importance of incentives in changing behaviour. The concern over carbon emissions and global warming (despite some questioning the validity of the economics behind some of the predictions that have been made) has meant that govern- ments and the European Union are looking at ways to reduce the reliance on carbon-based energies. In order to change behaviour various policies are adopted to change incentives to achieve the desired outcome. The example in this article highlights a number of the principles referred to in this chapter.
In November 2009, the European Union (EU) issued notice of a new directive in relation to the energy efficiency of newly constructed buildings. The Directive requires member states to plan ahead for the introduction of near zero energy buildings which make use of renewable energy from 2020. The Directive also requires member states to implement targets to the public sector to only use (whether owned or rented) buildings that adhere to near zero energy stan- dards. This means that all members must find ways of converting or refurb- ishing existing buildings to comply with this standard by the end of 2018.
Such a Directive presents major challenges not only to the public sector in member states but also to the private sector. There are trade-offs in putting in place such plans. It has been reported that around 40 per cent of all energy use is attributable to buildings and that they are responsible for over a third of Europe’s CO2emissions. Whilst the Direc-
tive will cost millions to implement, the trade-off is that savings of€300 [per build- ing] each year in energy bills could result (Principle 1). In addition, the EU says that there will be a boost to the construction and building renovation industry through- out the continent (Principle 5).
After 2020, any new building will have to meet energy efficiency standards set by Brussels. If left to the market, the sort of work envisaged by the EU may not happen–the cost of doing this in rela- tion to the benefits accruing to private individuals would likely be insufficient to encourage individuals to act on their own. So in this case the ‘invisible hand’needs some assistance (Principle 7). EU governments are being encour- aged to provide a list of incentives which include technical assistance, subsidies, loan schemes, low interest rate deals and other financial assistance to help change the relative costs and benefits (Principle 4). Part of the reason for this was that following the original
2002 Energy Performance of Buildings Directive, progress towards improving standards had been limited largely due to a lack of inspectors qualified to issue certificates, a qualified workforce and ambition. The market, in the eyes of the EU, had failed to bring about the resource allocation they desired.
As a result the introduction of incen- tives and a restatement of the Directive are designed to bring about that desired resource allocation. Incentives such as subsidies, for example, help reduce the cost to the producer (the building owner in this example) of carrying out the work required to comply with the standards.
In diverting resources to this desired outcome the EU believe that it repre- sents a more efficient allocation of resources and therefore has benefits which are wider than just those to the building owner but to society at large.
Diverting resources by subsidy has a cost, however. Someone has to pay for the subsidy and this is the EU taxpayer.