Monday, January 16, 2017

Basic Economic Understanding

Last time I wrote about the “cola tax” in Philadelphia, how it went wrong and how the flaws were obvious when it was passed last June.  It took just a little economic understanding, which the lawmakers in the city seemed to lack.

To be able to look at economic decisions and foretell possible problems does not require advanced study of the subject.  Ordinary citizens can develop adequate skill to help them make better everyday decisions and notice the errors of others by understanding a few basic principles.

First, assume that only people have money.  Businesses and governments spend money and move it around, but that money comes from people.  By considering it our money, money that was taken from us through taxes or won from us by offering a tempting product or service, we are able to look at economic decisions and see the link back to our wallets and bank accounts.  There is always a link.

When people (or businesses) invest money, they balance risk and reward.  A bank account pays little interest for low risk.  Corporate bonds pay higher interest for a little more risk.  Return from investments in stocks over a long period is considerably higher, but sometimes you lose.  Running an established business is risky and the return is generally higher.  Starting a new business is even higher risk and may bring a larger reward, but most disappear in the first two to three years.  Higher reward is generally expected (and deserved) when taking higher risk.

The concept of supply and demand is straightforward.  If something is rare or hard to get, the supply is low and the price is high.  If something is common, the supply is high and the price goes down.  If something is popular, the demand goes up and people are willing to pay more, otherwise the price will go down until buyers emerge.  Diamonds are rare and popular, so they are expensive.  Great quarterbacks are in demand by many teams, so they too are expensive.  Ordinary water is common – it falls from the sky – and very inexpensive at the tap; but the fussier you are about the source, purity and packaging, the more you will pay.

Supply and demand in a free market usually work together to set a price where both the buyer and seller are satisfied with the outcome.  Problems arise when someone starts tinkering with this balance.  Last year the price of oil stayed low due to more production in the US and the lifting of sanctions on Iran.  OPEC agreed to restrict their operations hoping the reduced supply would push prices up.  Officials in Philly imposed the tax on sugary drinks hoping the higher price would reduce demand, leading to healthier citizens.

Laws in some states forbid private enterprises from moving food, water or generators to a disaster site and selling them at a profit.  There is already a low supply, and those who could afford it might be willing to pay a little more but they can’t.  So everyone, rich and poor, waits in longer lines for the official relief.  The well-intentioned law hurts everyone.  Where there is no disaster, retail stores do exactly the same thing, ship goods from far away and sell them at a profit – and no one complains.

It is also important to understand business.  Businesses are relatively high-risk operations.  This is clear from the number that are forced to cut back or go out of business each year.  Profit is not a dirty word.  It is the return they get for the risk.  The profit comes from selling goods or services at a price people are willing to pay.  There is no force or coercion.  You buy brand A or Brand B from Store A or Store B, or you don’t buy at all, or you buy a similar product that is almost as good.  It is a free exchange.  In millions of transactions a day, both parties are satisfied.  When you check out, they say thank you (for the purchase) and you say thank you (for the product).  But we hear on the news only of the scams or illegal operations, just like we hear only about the few airline crashes and not the millions of safe landings.

Most businesses are not greedy and evil.  Most business people are no more greedy and evil than anyone else.  Smart businesses know the key to their success is a group of loyal, satisfied customers who return and spread positive comments.  Again, it’s often the tinkering – government favoritism, crony capitalism, regulations that impede competition or favor a small group – that screws up the balance.

Those, very briefly, are the keys to economic understanding:  only people have money, risk/reward, supply and demand, business and profit in a free enterprise system and the dangers of tinkering with the balance.  Thinking about these principles helps anyone do a respectable job of predicting the future.

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