What is Economics About?
Economics is about the wealth of nations. That phrase comes from the title of a book published in 1776 by Adam Smith, the father of economics. The full title of the book is An Inquiry into the Nature and Causes of the Wealth of Nations. In simpler words, that title is asking an important question: Why are some nations rich and others poor?
...the savage nations of hunters and fishers...are so miserably poor that, from mere want, they are frequently reduced, or, at least, think themselves reduced, to the necessity sometimes of directly destroying, and sometimes of abandoning their infants, their old people, and those afflicted with lingering diseases, to perish with hunger, or to be devoured by wild beasts. Among civilised and thriving nations, on the contrary, though a great number of people do not labour at all, many of whom consume the produce of ten times, frequently of a hundred times more labour than the greater part of those who work; yet the produce of the whole labour of the society is so great that all are often abundantly supplied, and a workman, even of the lowest and poorest order, if he is frugal and industrious, may enjoy a greater share of the necessaries and conveniences of life than it is possible for any savage to acquire. (Smith, 1776)
Today, rich nations have grown even richer, while some poor nations are no better off than they were in Smith’s time. Annual per capita income in 2006 ranged from a high of $76040 in Luxembourg to a low of $100 in Burundi.
The wealth of nations like Burundi has hardly changed since Smith’s time, while the wealth of nations like Luxembourg has increased hundreds of times. Why? Smith’s answer was that economic progress is greatest in countries that allow people to peacefully pursue their own best interest.
Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism but peace, easy taxes, and a tolerable administration of justice: all the rest being brought about by the natural course of things. (Smith, 1776)
By “the natural course of things”, Smith meant people’s natural tendency to seek their own best interest: to own the most profitable business, to work at the best job, and to shop for the best products at the best prices. Smith found that a nation’s wealth would be promoted by free trade policies. The government should keep taxes low, avoid burdening businesses with excessive regulations, should not dictate prices or wages, and should not restrict imports or favor exports. This is usually known as a libertarian or laissez faire philosophy. The story goes that in 1680, the French finance minister asked a group of merchants how the government could promote the economic health of France. The leader of the group, M. Le Gendre, answered “Laissez nous faire.” (‘Leave us be.’). By 1750, a popular slogan among free trade advocates was "Laissez faire et laissez passer, le monde va de lui même!" ('Let do and let pass, the world goes on by itself!').
a. The Invisible Hand
One of Smith’s most important ideas was his concept of the invisible hand.
...every individual necessarily labors to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. (Smith, 1776)
In other words, if you want to make a living, you have to produce something that people want to buy. The better you serve your customers’ interests, the richer you will become. Leave people alone, and their own greed will drive them to serve others the best they can.
The invisible hand is a theme that appears again and again in economics, and it is worth noting how the same idea has been expressed by other writers.
Assume that somewhere in the world a new opportunity for the use of some raw material, say, tin, has arisen, or that one of the sources of supply of tin has been eliminated. It does not matter for our purpose—and it is very significant that it does not matter—which of these two causes has made tin more scarce. All that the users of tin need to know is that some of the tin they used to consume is now more profitably employed elsewhere and that, in consequence, they must economize tin. There is no need for the great majority of them even to know where the more urgent need has arisen, or in favor of what other needs they ought to husband the supply. If only some of them know directly of the new demand, and switch resources over to it, and if the people who are aware of the new gap thus created in turn fill it from still other sources, the effect will rapidly spread throughout the whole economic system and influence not only all the uses of tin but also those of its substitutes and the substitutes of these substitutes, the supply of all the things made of tin, and their substitutes, and so on; and all his without the great majority of those instrumental in bringing about these substitutions knowing anything at all about the original cause of these changes. (Hayek, 1945)
And in case you thought that the idea of the invisible hand originated with Smith, here is some sound economic advice from an ancient Chinese philosopher:
If people are hungry, it is because the government is taxing and interfering too much; this is why people rebel. If goods and trade are free and not restrained, black markets won't develop and the people needn't be criminals. When the way of nature is ignored, regulations, codes and hypocrisy emerge. The people are rebellious when rulers meddle in their affairs. The more laws, the more violators. Therefore, that leader is best who governs least. If we keep from meddling with people, they take care of themselves. If we keep from commanding people, they behave themselves. If we keep from preaching at people, they improve themselves. If we keep from imposing on people, they become themselves. The way is like an invisible hand, a spirit guide that leads without interfering. Here is the way: set people free. (Lao Tzu, 450 BC)
b. Central Planning Versus Free Market Capitalism
In the twentieth century, the most serious challenge to the free market philosophy was the central planning philosophy of socialism and communism.
Intellectuals everywhere take for granted that free enterprise capitalism and a free market are devices for exploiting the masses, while central economic planning is the wave of the future that will set their countries on the road to rapid economic progress...The facts are very different...The most obvious example is the contrast between (communist) East and (Capitalist) West Germany. ..People of the same blood, the same civilization, the same level of technical skill and knowledge inhabit the two parts. Which has prospered? Which had to erect a wall to pen in its citizens? ...On one side of that wall the brightly lit streets and stores are filled with cheerful, bustling people...(On the other side) the streets appear empty; the city, gray and pallid; the store windows, dull; the buildings, grimy. (Friedman, 1979)
Milton Friedman, the most prominent advocate of free markets of the twentieth century, wrote those words in 1979, in his best-selling book Free to Choose. That book, more than any other, can take a good deal of credit for the worldwide collapse of central planning in the 1980’s. India, China, Russia and its satellites, all began to move away from central planning in favor of free markets, and as a result saw their rates of economic growth jump from 0-3% per year under central planning into the range of 6-10% per year under free markets.
Most American children have heard the story of the first Thanksgiving: the Pilgrims’ arrival at Plymouth in December, 1620, their suffering in their early years, and their later celebration of a good harvest. Children have not heard as much about the Pilgrims’ experiments with communism and capitalism. The Pilgrims found, then as now, that communal property ownership led to poverty, while a capitalist system of private property led to prosperity. William Bradford, the governor of the colony, described the colonists’ experience in 1623:
...they began to think how they might raise as much corn as they could, and obtain a better crop than they had done, that they might not still thus languish in misery. At length, after much debate of things, the Governor (with the advice of the chiefest amongst them) gave way that they should set corn every man for his own particular, and in that regard trust to themselves; in all other things to go on in the general way as before. And so assigned to every family a parcel of land, according to the proportion of their number, for that end, only for present use (but made no division for inheritance) and ranged all boys and youth under some family. This had very good success, for it made all hands very industrious, so as much more corn was planted than otherwise would have been by any means the Governor or any other could use, and saved him a great deal of trouble, and gave far better content. The women now went willingly into the field, and took their little ones with them to set corn; which before would allege weakness and inability; whom to have compelled would have been thought great tyranny and oppression.
The experience that was had in this common course and condition, tried sundry years and that amongst godly and sober men, may well evince the vanity of that conceit of Plato's and other ancients applauded by some of later times; that the taking away of property and bringing in community into a commonwealth would make them happy and flourishing; as if they were wiser than God. For this community (so far as it was) was found to breed much confusion and discontent and retard much employment that would have been to their benefit and comfort. For the young men, that were most able and fit for labour and service, did repine that they should spend their time and strength to work for other men's wives and children without any recompense. The strong, or man of parts, had no more in division of victuals and clothes than he that was weak and not able to do a quarter the other could; this was thought injustice. The aged and graver men to be ranked and equalized in labours and victuals, clothes, etc., with the meaner and younger sort, thought it some indignity and disrespect unto them. And for men's wives to be commanded to do service for other men, as dressing their meat, washing their clothes, etc., they deemed it a kind of slavery, neither could many husbands well brook it. (William Bradford, 1623)
c. Specialization and Comparative Advantage.
A barber and a bricklayer might earn about the same income, and might have comparable levels of skill and training, each in his own field. But let a bricklayer try to cut your hair, or let a barber try to build a brick wall, and you will soon find that it is best for people to stick to their own field. Adam Smith called this the principle of the division of labor, and it is often called the law of comparative advantage.
The state of Washington has a climate that is good for growing apples, while Georgia is best for growing peaches. Figure 1.1 shows hypothetical production-possibilities curves for Georgia and Washington. These curves show the different combinations of apples and peaches that the two states are capable of producing. The curves show, for example, that Washington has a comparative advantage at growing apples, while Georgia has a comparative advantage at peaches.
If farmers in Georgia specialized in peaches they could grow 60 per day, while if they specialized in apples they could only grow 30 per day. Washington farmers should specialize in apples and grow 40 per day, since if they specialized in peaches they could grow only 20. With specialization, Washington and Georgia could produce a total of 40 apples and 60 peaches. Assuming apples and peaches both sell for $1 each, the total income of Georgia farmers would be $60, while the income of Washington farmers would be $40. If consumers in Georgia want to buy some apples, they should buy them from Washington for $1. Georgia farmers could have grown that apple, but only at a cost of 2 peaches—peaches that could have sold for a total of $2. Similarly, Washington consumers who want peaches should buy them from Georgia for $1.