10 Principles of Economics You Should Know [Infographic]

Economics is a critical part of our life. Almost everything we do is in one way or the other connected to it. Whether we go to work in the morning, buy something to eat for lunch, or simply sit at home and watch TV in the evening, there is always a multitude of economic principles at play.

Thus being familiar with the most fundamental of those principles can be extremely helpful, Not only will it help you to understand what is going on in the world around but it will also enable you to take well-informed and better decisions which is vitally important in all part of life. 

With this in mind we have created an infographic that illustrates and explains the 10 most relevant principles of economics you should know. Take a look:

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<a href="http://principles-of-economics-and-business.blogspot.com/2015/02/infographic-10-principles-of-economics.html"><img src="http://i.imgur.com/9Zi8Ay8.png" alt="Infographic - 10 Principles of Economics You Should Know"></a><br />Source: <a href="http://principles-of-economics-and-business.blogspot.com">Principles of Economics and Business</a>

Leave well enough alone

You may have noticed that there is a rather ugly (in my view) effort underway to bring the US Federal Reserve under closer political control. The latest attempt to pass a so-called Federal Transparency Act was introduced by Kentucky Congressman Thomas Massie, who said, "Behind closed doors, the Fed crafts monetary policy that will continue to devalue our currency, slow economic growth, and make life harder for the poor and middle class", a statement which (against stiff opposition) must combine more idiocies in a single sentence than anything else recently spouted by US politicians.

It's easy to smirk at the partisan piffle from Washington, but before we get too sanctimonious it's worth recalling that pretty much every one of our recent general elections has had one political party or another wanting to change our existing - and perfectly satisfactory - monetary policy arrangements. I've covered this before, but in the past few days I've come across a variety of further material which also points in the same direction: when you've got an independent, transparent, and inflation-targetting central bank, don't mess with it.

First, the Money and Banking site had an excellent article, "The Congressional Reserve Board: A Really Bad Idea", which hoed into the proposed bring-the-Fed-to-heel legislation. And along the way it included this graph (which is an improved, easier-to-read version of a graph in the original academic article), and which handily included New Zealand.

It shows how the world used to be: New Zealand used to have the least independent central bank of any developed economy, and consequently had one of the developed world's inflation rates. And countries with the most independent central banks had the lowest inflation rates.

The Money & Banking article also included a link to a poll of expert economists on the issue of potential tighter political supervision of the Fed. The results? As shown below, not a single expert economist was prepared to support the idea: a large majority thought it was a bad idea.

And then I came across this, which I think is the latest state of play as far as academic research goes: a 2014 paper on "The Effects of Central Bank Independence and Inflation Targeting On Macroeconomic Performance: Evidence from Natural Experiments", which is available as a pdf either from the Review of Economic Analysis here or as a working paper here.

Here are the key findings:

The main conclusions are: (1) When a central bank becomes more independent, it lowers the inflation rate and lowers the variability of inflation but has no effect on real GDP or unemployment. (2) When a central bank becomes an inflation targeter, it lowers the inflation rate, lowers the variability of inflation, lowers the variability of real GDP growth and the output gap, and has no adverse effect on the unemployment rate. The real GDP growth rate also increases but the source of this increase is unlikely to be inflation targeting. (3) An inflation targeter that becomes more independent delivers a similar outcome to that of a more independent bank that does not target inflation.

As the article notes, we were at the very front of the pack in adopting an independent, transparent, inflation-targetted monetary policy - "New Zealand made the first move toward greater central bank independence with the sweeping Reserve Bank of New Zealand Act 1989, which created an independent central bank with the single mandate to achieve price stability" - and we were right to do it, and to stay with it. As the article found, and other articles had found before it, there have been big ongoing payoffs, and no ongoing cost. It would be nice to think that come the next general election, the tinkerers-for-the-worse left our monetary policy arrangements alone.

Don't block the entrance - or the exit

I wrote a while back about the excellent data the Bureau of Labor Statistics in the US produces on the labour market - what they call the JOLTS data (Job Openings and Labor Turnover Survey). You can access it yourself here. The graph below shows the key results from the latest (December '14) reading.

The mechanics of the thing are simple - when hires (the blue line) are greater than separations (essentially layoffs and quits, in red) total employment grows (in green). What's really striking about the US labour market - and indeed most labour markets - is the huge gross flows compared with the much smaller net outcome. In December alone, for example, hires were 5.1 million and separations 4.9 million: for 2014 as a whole, there were 58.3 million hires and 55.4 million separations, for a net gain in employment of 2.9 million.

We don't have the equivalent set of data in New Zealand, though it is on Stats' radar, but we do have some data that shows the same patterns operating here. Here, for example, are the numbers of jobs created at new firms, and the numbers of jobs lost through firms closing - the jobs associated with company 'births' and 'deaths'. The numbers come from Stats' Linked Employer-Employee Database, and again you can find them for yourself at Stats' (free) access site NZ.Stat under the 'Business demography statistics' heading.

This is only a slice of the labour market - the bigger part is the hiring and firing at ongoing firms - but it's interesting nonetheless. Again the gross flows are considerably larger than the net flows.

What's the relevance? It's because most folk (I believe) don't realise this is how the labour market works. I'd guess that most people reckon hiring dries up during a recession, and layoffs dry off in good times. They don't: there are very large numbers of new hires even in bad times, and very large numbers of layoffs even in good times. Rather, the ratio between them changes: hires drop faster than layoffs in bad times, and grow faster than layoffs in better times. But both power along in large volumes all the time, with a high degree of churn or turnover going on. There's a vast amount of matching and rematching going on all the time as both employers and employees look for the best fit. The efficiencies from a process where people are continually looking for the best option for both parties must be very large indeed..

The wrong idea, that layoffs happen only or overwhelmingly in bad times, tends to lead to a well-intentioned but wrong policy prescription: that if we stop the layoffs, we can keep employment up. Unfortunately in some over-regulated markets, 'job protection' measures, that aim to make it harder to lay off people, gummage up both sides of the labour market. Employers can't lay off people when they'd like (or need), and knowing that, they're less inclined to to hire in the first place, or only in unregulated ways (eg with short term contracts that don't accrue the same protection rights). Much of continental Europe is lumbered with high unemployment as a result. Well-meaning but inefficient job protections aren't the only reason for Europe's high unemployment, of course, but they're a part of it, and likely to be a substantial part of it when it comes to youth unemployment or the unemployment of more marginal groups in general.

There's also a school of thought that employees need to be protected, because the employers have the whip hand: there's some kind of market power on the employers' side. That's not true, either. Have a look at this, also from the latest JOLTS data.

In fact, things don't just 'happen' to employees at employers' discretion.  Most of the time, voluntary 'quits' are substantially larger than involuntary layoffs. In a bad recession, more people than usual prefer to sit tight, for obvious reasons. But usually there are substantially more people leaving jobs of their own volition than are leaving them because they've got the pink slip. Again the efficiencies - and personal career and life satisfaction - from a system where people can freely leave and freely find new jobs must be enormous. Anything that throws sand into this process - and it's not just job protection regulation, but could be barriers of other kinds, such as the US system of employer-provided medical insurance, or in New Zealand arguably differences in regional housing costs - risks jeopardising one of the main productivity engines of a modern economy.

Diminishing Marginal Utility

The concept of marginal utility is one of the most fundamental principles of economics. It describes the additional satisfaction an individual gets from consuming one more unit of a good or service. This information is critical for predicting and explaining consumption decisions.

Although actual utility cannot be measured in hard numbers, it is possible to reveal consumer preferences, tendencies, and other relevant aspects that are critical for decision making. However to be able to do this, we must first look at the principle in some more detail. 

Thinking at the margin

First of all, to describe decision making processes accurately it is necessary to think at the margin. Particularly we need to focus on the "next step" and analyze its consequences (e.g. what happens if we buy one more bottle of water, etc.). In other words, to understand decision making processes we have to look at the effects of small (marginal) changes from various states.

The idea behind this is actually quite simple. Rational individuals should always consider costs and benefits associated with every action they take. As long as the additional benefits (i.e. marginal benefits) are greater than the additional costs (i.e. marginal costs), the individual will be better off afterwards and thus take the action. For example, if you have to decide whether or not to buy ice cream you probably trade off your desire for ice cream against its price and only buy it if you feel like you are better off if you do so.

Hence, mathematically speaking marginal utility is the first derivative of total satisfaction (i.e. total utility) at a specific point. This aspect will be relevant once we introduce the law of diminishing marginal utility.

Diminishing marginal utility

The law of diminishing marginal utility states that the additional utility of a good (or service) decreases as its supply increases. This suggests that every additional unit that is consumed has a lower marginal utility than the unit before. At a certain point the additional utility can even become negative for some products. In those cases consuming another unit will actually decrease overall satisfaction. This principle is illustrated in the graph below.

Illustration 1: Diminishing Marginal Utility

The most important thing to note from this graph is that the utility curve (UC) is not linear, but becomes flatter as quantity (Q) increases. As a result the changes in total utility (U) resulting from an increase in Q become smaller as total quantity grows. For example, if quantity increases from q1 to q2, the change in total utility (u2 - u1) is quite significant. However if quantity increases from q3 to q4, there is only a very small increase in total utility (u4 - u3) even though the change in quantity is the same. 

To make this more comprehensible we can look a simple example: the utility of a glass of water. On a hot summer day the satisfaction you get from drinking this glass will most likely be high (especially if you have not had anything to drink for a long time). However if you have just consumed two other glasses of water a minute ago you are probably not that thirsty anymore so the additional satisfaction you get from drinking the additional water will not be that high anymore. At some point if you drink too much you might even get sick and have to vomit, thus marginal utility becomes negative.

Limitations and Exceptions

Although the law of diminishing marginal utility is an important and widely applicable concept there are certain exceptions that need to be considered. Thus for the sake of completeness the most relevant of those limitations are listed below.

• As mentioned before, the law of diminishing marginal utility only applies to rational individuals. If individuals do not act rationally their actions become somewhat erratic which makes it impossible to accurately describe and predict their behavior.
• The law does not account for fashion trends or other changes in taste. If a product comes into fashion its utility increases (irrespective of the quantity consumed), whereas its utility decreases once it goes out of fashion.
• There is no (or limited) diminishing marginal utility for goods that are added to a collection (e.g. stamps, coins, etc.). This is due to the fact that collections generally become more valuable the more extensive they are.
• The law is not applicable for situations that require a specific amount of a good or service to achieve a desired outcome. A common example here is the use of antibiotics. While the right dose might cure an illness, not taking enough pills will leave bacteria with an increased resistance and thus aggravate the illness.

In a nutshell

The concept of marginal utility is one of the most fundamental principles of economics. It describes the additional satisfaction an individual gets from consuming one more unit of a good or service. Most products experience diminishing marginal utility, which means the amount of additional utility decreases as their supply increases. For those goods and services every additional unit that is consumed has a lower marginal utility than the unit before. Even though this concept is widely applicable it is important to note that there are several limitations (i.e. assumption of rational individuals, disregard of fashion trends) and exceptions (i.e. collections, required specific amounts) to it.

More house lending controls to come?

As we all know, the Reserve Bank is in a difficult spot.

It can't easily raise rates. It probably doesn't want to anyway, since (as I've argued before), overall monetary policy conditions are already too tight. But even if it did, the Kiwi dollar would appreciate, or at the very least not fall to the levels the RBNZ would like: "The upward pressure on the TWI reflects several influences but primarily investors have been attracted by the broad strength of the economy and our higher interest rates", as the Governor's speech last week said (it's here as a web page and here as a pdf), and wider interest differentials in NZ's favour would clearly make the fight on the NZ$ front more difficult (as is already the case with the A$/NZ$ cross rate after the Aussies' cut in interest rates).

It can't easily lower rates. There's an argument that the low oil price has lowered any inflation risks, and another (which I'm partial to) that, in hindsight, it overtightened with its latest OCR increases, but cutting rates in the middle of a boom would still be rather odd. "New Zealand is the only country among the advanced economies that has had a positive output gap in the past two years, our unemployment rate is low and falling, net inward migration and labour force participation is at record levels, and business and consumer confidence surveys remain strong", as the Governor said, plus it would make the housing market even more exuberant - "we have already seen some effective easing of credit conditions with declines in fixed-rate mortgages, at a time when we have financial stability concerns about accelerating house prices in Auckland".

So by default it's stuck with leaving interest rates where they are, which means that its financial stability headache over Auckland house prices doesn't go away, or even gets progressively worse - floating mortgage rates stay where they are (or even drop a bit if the banks' marketing wars heat up a bit more), while fixed rates fall as long maturity bond yields remain very low overseas (essentially we're lumbered with importing world bond yields, plus a credit/risk premium).

All of which leads you to think that there may be another round of "macro-prudential" regulation around the corner. We've got the existing regulation - only 10% of new bank lending on houses can have a loan to value ratio (LVR) higher than 80%, or put another way, 90% of new lending must have at least a 20% deposit - but while it's had some impact, it doesn't look as if it's been enough to rein in the Auckland market in particular. Prices in an already expensive market are up another 13% in the year to last December (on the latest REINZ data),

Yes, there's more going on than just easy credit. As the Governor said, Auckland prices reflect a melange of "rising household incomes, falling interest rates on fixed-rate mortgages, strong migration inflows and continued market tightness". But there's still a financial stability issue. When these factors ease, or reverse (eg when housing supply finally come on strong), banks risk being left with big loans on lower priced assets. So you'd reckon the RBNZ must be looking in the cupboard for another macro-prudential stick.

As it happens, there's a brand new model for them to have a look at, and that's the Irish Central Bank's. The Irish had one of the biggest housing market busts of all time - the national house price halved, almost exactly, between the peak in September '07 and the trough in March '13 - and, to put it very mildly, are not keen to see a repeat. With Irish house prices up 16.2% over the year to last December, they've just stepped in with a package that combines LVR ratio limits and loan to income ratios. You can read the whole thing in the Bank's FAQ here: the gist is a 3.5 times income limit for all new loans except loans to buy rental properties, a 20% LVR ratio limit for most mortgages, a 10% first time buyers' LVR limit up to €220,000 (about NZ$340,000), and a 30% LVR limit for rental property loans. There's room for the banks to do some business outside these limits (20% can be outside the income limit, 15% outside the LVR limits).

Interestingly, one of the questions in the FAQ reads, "Has the Central Bank considered that these measures may be discriminatory against people looking to buy in Dublin and the surrounding areas?" The Irish Central Bank preferred to downplay that aspect - it says, yes, but only a bit - but that's exactly the sort of selective impact we'd like to see happening in Auckland.

"We will be talking more about the housing market over the next few months", the Governor said last week. I wonder if they'll be talking with an Irish accent?

Who got what?

The Productivity Commission has just come out this morning with an interesting new Working Paper, "Who benefits from productivity growth? –The labour income share in New Zealand", and if life's too short, there's an accompanying "cut to the chase" summary. The labour income share, by the way, is as it sounds  - "The labour income share (LIS) is the proportion of income generated from production that is spent on labour in the form of wages and associated on-costs" such as employers' super contributions. The rest of the income in the economy is attributed to capital, so the paper is about the split of national income between wages and salaries on the one side, and returns to the owners of capital on the other.

At first sight, the headline finding risks feeding the post-Piketty fears of those who think the working stiff is losing out to the plutocrat: here's a graph (it's Fig 1 in the summary) of GDP and labour's share of it. The labour share's gone down from around 64-65% of GDP to around 56%.

But whether this is a good thing or a bad thing isn't at all obvious: as the paper says (p6), it "depends on the situation and is partly a matter of preference. For example, would New Zealanders prefer to participate in an economy where real wages are increasing strongly but the LIS is falling because productivity growth is even faster, or an economy with weak growth in real wages and productivity so that the LIS is more constant?", and the paper steers clear of making any judgement calls.

One factor in the background is that capital's share will depend on how much capital there is. If there's a lot more capital going into the business of producing GNP then there used to be, and most of us would reckon that's a good thing (lots more equipment at work in the Aussie economy is one of the reasons Australia has been growing faster than us in recent years), then its share will tend to go up and labour's to go down. It's not a given - could be, for example, that wages go up fast enough for labour's share of the total cake to hold up - but it's likely. And as it happens, we have in fact seen the amount of capital in use growing faster than the amount of labour employed. Here are the numbers. 'MS-11' in the title is the 11-industry 'measured sector' that the paper has looked at, and  'MFP' is 'multifactor productivity', or that bit of GDP that isn't explained by increased inputs of labour and capital.

The fall in labour's share is also not a uniquely Kiwi phenomenon, by the way, if you've been thinking deep dark thoughts about the distributional consequences of Rogernomics and its successors*. In a range of OECD countries the labour income share typically rose to a peak in the late '70s or early '80s and declined since as a result of a bunch of things. As the paper notes summarising the research on the whys and wherefores (p10), "Perhaps most importantly, technological advances that have increased the return on capital have led to capital deepening as businesses have substituted capital for more-expensive labour...Other contributing factors include shifts in industry composition towards more capital-intensive industries, increased globalisation that increased the global supply of cheap labour, and institutional developments that have reduced labour’s bargaining power". 

And if you're still nurturing "they're watering the workers' beer" thoughts, the paper shows that there are actually good links between the value that employees bring to their business (the growth in labour productivity) and what they get out of it as a result by way of higher real wages, as these two charts from the summary show. Over time (left hand graph)  and across industries (right hand one), if firms are doing well because the employees are more productive, it turns up in the payroll run.

The paper doesn't have a lot to say about policy, and that's fine, it set out to be more of an analytical piece, but what it does say is sensible: if there are all these trends buffeting labour's share of the goodies, then (from p7)

benefiting from new technology requires investment in the necessary complementary skills. In particular, the education system must be of high quality and sufficiently responsive to provide new and dislocated workers with the skills they need to enter productive and lucrative occupations where they can make the most of new technology. Policy should also work to minimise entry barriers and other frictions, such as excessive occupational licensing, that prevent workers from moving to where they can work most productively. There is also a geographic aspect to this in that cities are one of humankind’s most productive inventions. So restrictions on housing supply that mean low-skilled workers cannot afford to live in economically dynamic places can limit productivity growth and economic resilience to change.

Even if policy is set just right to ensure that the benefits of technology-based growth and globalisation are widely spread, a social safety net may still have to catch people who fall through the cracks. Accordingly, policy must ensure that social services function effectively to deal with the side effects of rapid technological change

It may not be original - much the same policy combo is what has traditionally been prescribed to cope with the impact of freeing up international trade - but it's none the worse for that.

Another thing I liked about this paper is that it's given us a handy summary way of thinking about our recent economic growth, and here it is. You've got the different growth cycles, and their sources, all in one nicely packaged schematic.

As the graph indicates, we had a 'high productivity' phase in the 1990s, when that tricky multi-factor productivity kicked in much more forcefully than it had been doing before, or has since. Australia did, too, as the data below shows (snipped from Table 6.2 of the paper).

And that brings us to the biggest policy questions of all. Where did that surge in productivity come from? Why did it go away? And, most crucially, can we get it back?

*I'd also note that one of the bigger dips in the labour share occurred pre-reforms, in 1982-84, when Muldoon in his Late Anarchy period imposed a wage and price freeze. As the report notes (p39), "In practice, this proved to be more a wage freeze than a price freeze".