So You Want to Know About Economics Read online

  The British traders soon discovered that this new gig was brilliant—they did not have to sell anything to earn money now, they just collected taxes from people they ruled. And they could use that money to buy things from those same people, and never spend their gold at all!

  Needless to say, they wanted more. Over the next 100 years, the East India Company managed to become India’s biggest ‘landlord’. During the same time period, something that we now call the ‘Industrial Revolution’ had begun in England. Machines were being invented that did all kinds of work way quicker, more accurately, and more efficiently than individual people could. The machines were hungry for raw material—cotton, iron, silk, indigo. And India—large, bountiful India, full of people who could be put to work, and rich with fertile fields and minerals—became the hand that fed the mouth of the mechanical beast.

  Suddenly, India, a land of skilled workers which had always exported expensive finished goods (cloth, jewellery, handicraft) to the world and got gold and silver in return, was exporting cheap raw material and getting expensive finished goods in return instead. Her fields were being used to grow things that could not be eaten—cotton, jute, indigo, opium—instead of grain to fill her own people’s bellies. Her farmers were forced to pay huge taxes, often with their own personal store of food grain, even when the monsoons failed, or they faced severe punishment.* Briskly-produced bales of inexpensive machine-made British cloth pushed more expensive home-spun khadi out of the market. This happened in other fields, too, with machine-made products replacing hand-made products, and turning artisans and craftspeople into beggars. Devastating famines broke out, killing tens of thousands of people.

  By the time the British left, in 1947, India’s share of the world’s GDP had slipped from 22.6 per cent (in 1700) to a paltry 3.8 per cent! Since then, in less than seventy years, we have clawed our way back up the ‘share of GDP’ ladder. We are now the world’s seventh-largest economy. Yes, even though we think of India as a poor country, we have plenty to be proud about!

  LEARN THE LINGO

  Zero-sum Game

  Does someone always have to lose for someone else to win, or is it possible for both sides to win? Does trade have to be a win-lose game, like Mercantilism was, or could it become a win-win game, where both sides benefit? In other words, is trade a zero-sum game? Let’s try and understand this with an example.

  It’s your birthday. Your parents have ordered your favourite flavour of cake for your party. You have six friends coming. The easiest way to divide the cake into equal pieces is to cut it first into quarters, and then into eighths, making eight equal pieces. But there are only seven of you, and it is a bit tricky to divide the cake into seven equal pieces. Your friends decide that because it is YOUR birthday, you get two pieces (i.e., 2/8ths of the whole cake), while each of them gets 1/8th of the cake. In the end, each of them gets a little less than what they could have if the division had been equal, and you get a lot more.

  You dig in a little guiltily. What you would have liked is for each of your six friends to get their 1/7ths of the cake (what they fairly deserve), using up 6/7ths of the cake, while you still got your 2/8ths (a little more than everyone else, because it is your special day). But that is a mathematical impossibility since there is only one cake (6/7 + 2/8 > 1). This kind of situation, where, because there is a limited amount of something, someone has to ‘lose’ (or get less of something) for someone else to ‘win’ (or get more of something) is called a zero-sum game. All zero-sum games are therefore ‘win-lose’ games.

  The mercantilists believed that wealth was a zero-sum game—there was a limited amount of wealth in the world, and to ‘win’, you needed to grab someone else’s wealth, which would make that someone else ‘lose’. Adam Smith and other like-minded economists begged to disagree. They believed that the amount of wealth was not limited, more of it could be created all the time (‘wealth’ could mean money, employment, education, healthcare for everyone, a cleaner world, a fairer world, and so on). They also believed firmly that more wealth would be created—for everyone to share—if people worked with each other rather than against each other. In other words, Adam Smith believed that wealth could be a ‘win-win’ game, or a non zero-sum game.

  MERCANTILISM? THAT’S SO LAST CENTURY. FREE TRADE—NOW THAT’S THE TICKET!

  Like Adam Smith, there had been other people who had been making snarky remarks about Mercantilism, but the reason we remember him and not them is that he was the first to actually come up with an alternative new way to do business. He called it ‘Free Trade’.

  Free Trade basically said that countries and people should trade with each other freely and plentifully. Both sides should sell to each other, and both sides should buy from each other, with no restrictions from governments. That was the only way for all countries, and all people, to get more productive, more efficient, and more wealthy.

  ‘This is why Free Trade works, dummies!’* And other wise things Adam Smith said.

  The Wealth of Nations was a fat book, and Smith said many, many things in it. Here are a few of the important ones. They seem like complete no-brainers now, but they were revolutionary when he first said them.

  ▶Everyone—the butcher, the baker, the candlestick maker—works only because of what he can get out of it for himself. A baker, for instance, doesn’t make bread because he wants to be nice to you and/or feed you, he does so because he wants to sell it to you and make money for himself.

  ▶Staying with our baker, no baker supports ideas like ‘Let’s not allow bakers from other countries to sell their bread in our country, we make perfectly good bread here’ out of a great pride in his country. He supports it because he doesn’t want the competition! If a foreign baker can make bread better or sell it cheaper than our baker, and you allow him to come in, our baker is sunk, right?

  ▶Here’s the thing, though—competition is good! For everyone, but especially for the ‘consumer’. A consumer is anyone who buys (consumes) products that different producers produce—products like food, movies, furniture, plane journeys, cows, iPhones, beach vacations, homes, whatever. The basic aim of a producer, we all know, is to attract a consumer.

  When there is competition, producers will:

  ♦Produce good products (because otherwise consumers will buy someone else’s better products)

  ♦Sell their products for as low a price as possible (because otherwise consumers will buy someone else’s cheaper product, especially if both products are more or less the same quality)

  Win-win for consumer! What about the poor producers? They do well too! How? Well, every producer is also a consumer (of his own products as well as other producers’ products). So if all consumers benefit in a ‘competitive market’ (a marketplace for goods where every seller of things is putting the consumer first), these ‘producer-consumers’ do too!

  ▶But if everyone works only for his own selfish reasons and not to make his country rich, how will the country prosper? Isn’t it better that the government, which knows what is best for the country, tells people what to produce, how much of it to produce, when to produce it, and how much to charge for the finished product? No way! In fact, people work hardest, and most efficiently, producing just the right amount of goods, at just the right price, at just the right time, in the least stressful way possible, and so on, when they are working for what they want—more money, more time to watch football, more customers. And when every citizen is working hard and working efficiently, how can the country not prosper?

  You see? You see why Mercantilism sucks and Free Trade rocks? Told ya!

  LEARN THE LINGO

  Laissez-faire*

  In 1681, when Mercantilism (literally) ruled the waves, a group of French merchants led by a Monsieur Le Gendre were in a meeting with the powerful French finance minister Jean Baptiste-Colbert. Eagerly, Colbert asked the merchants how the French government could help them so that they could go out and make even more money from far-flung colonies. Le
Gendre, who, like the other merchants, was getting a little tired of the government interfering in trade, is supposed to have sighed, and famously replied, ‘Laissez-nous faire!’ (Just allow us to do what we want to do! Please!)

  Yup, exactly what Adam Smith recommended to his government a century later, with his ‘Free Trade’ idea. Stop interfering in business, you dunderheads! This whole idea of governments ‘letting go’ of control and allowing people themselves to decide what to produce and what price to sell it at is called ‘Laissez-faire Economics’.

  MOVE OVER, ADAM SMITH, DAVID RICARDO IS IN THE HOUSE!

  So Adam Smith was human, so he didn’t get everything right all the time. One of the things he got wrong was the answer to this question: When we are talking countries, when is it a good idea for one country (let’s call it Desh) to trade with another (let’s call it Videsh)?

  Here’s what Adam Smith said: Desh and Videsh should trade with each other if:

  ▶Desh is ‘better’ at producing a good* than Videsh, i.e., when Desh can make a product in an easier, faster or cheaper way than Videsh.

  ▶Videsh is better than Desh at producing a different good.

  Situation 1

  Let’s say, for example, that Desh is ‘better’ at producing cotton cloth than Videsh, and Videsh is better at producing cheese than Desh (even though Desh also produces its own cheese and Videsh also produces its own cotton). If we drew up a table of comparison, it would look like this.

  DESH’S COTTON FABRIC…

  VIDESH’S CHEESE…

  •

  Is cheaper

  •

  Is cheaper

  •

  Is produced faster

  •

  Has a better flavour

  •

  Is better

  •

  Has more varieties

  …than Videsh’s cotton fabric.

  …than Desh’s cheese.

  Adam Smith’s logic works well in this example (see picture), but it gets a little iffy in this one: what if Desh is better at producing both cloth and cheese? Smith would say that Desh should make both and not trade with Videsh at all. In fact, he would argue that Desh would not trade with Videsh.

  In real life, however, that is not what happens.

  Let’s put countries aside for a minute, and think about our own individual lives. Let’s talk about you and your sister (if you don’t have one, use your imagination. In the study of Economics, as we will see, imagination is very important). Let’s say the two of you want to surprise Mom on her birthday with a fresh-baked cake and a spic-and-span house. BUT. You have to get it all done in the one hour you have between your coming home from school and Mom getting home from work.

  Situation 1

  SISTER

  Better at tidying

  YOU

  Better at baking

  Solution: Sister tidies up, you bake. Mom gets home to a clean house and a fresh-baked cake. Hurray!

  Situation 2

  SISTER

  Better at tidying AND baking

  YOU

  Bad at both

  Most often, countries behave like your sister, too. Even if Desh is better at producing both cloth and cheese, Desh will sometimes decide to buy (more expensive, not so flavourful) cheese from Videsh! Why does this happen?

  The chap who figured out the answer, some forty years after The Wealth of Nations was published, was a British economist called David Ricardo. He said this happens because of choices people and countries make, based on a concept called opportunity cost. The short definition of opportunity cost is: ‘what you give up to get something else’. In a world full of scarcity, said Ricardo, where everyone has limited money, limited time, and limited energy, one has to always give up something to get something.* The good part is that you can usually choose what you want to give up.

  The choice, dear Brutus, is not in our stars but in ourselves

  Let’s go back to Mum’s birthday. If she had more time, or more energy, your sister may have followed Adam Smith’s advice and done both. But there is only one hour before Mum gets home (scarcity of time), and your sister definitely does not want to slog on her own while you watch TV scarcity of energy, especially as the end result will then be either a wonderfully tidy house and a half-baked (haha!) cake, or a lovely cake and an untidy house. Neither of these results is appealing.

  So to make the best use of the resources at hand (an hour of time, her skills, your skills, her energy, and your energy), you decide to split the work.

  Situation 1

  SISTER: You are not as good as I am at tidying up, but you are almost as good at baking, so you bake while I tidy up.

  Result 1: Almost perfect cake, perfectly clean house

  Opportunity Cost (or what you both decide to give up, for the result you both want): Perfect cake

  Situation 2

  SISTER: You are not as good as I am at baking, but you are almost as good at tidying up, so you tidy up while I bake.

  Result 1: Passably tidy house, perfect cake

  Opportunity Cost (or what you both decide to give up, for the result you both want): Perfectly tidy house

  Overall result in either case: Win-win.

  Mum’s thrilled (she doesn’t care whether the cake is perfect or not, or whether the house is perfectly tidy or not, she’s just going ‘awww’ that you made the effort), and you and sis are happy—you both worked hard and gave Mum the best birthday surprise you could have given her, despite the constraints. The best possible outcome for both sides!

  The same logic works with countries, too. Desh may be better at producing both cotton and cheese, but maybe there is more money to be made selling cheese to other countries rather than cloth. Maybe Desh can become way richer by selling lots and lots of cheese across the world than by selling some cheese and some cloth. In such a case, Desh would rather put all its people to work making cheese, and buy cotton from Videsh, even though Videsh’s cotton costs more than its own. In other words, for Desh, the opportunity cost of making cotton (all the lovely moolah it is possible to make by making more cheese) is way higher than the opportunity cost of buying Videsh’s cotton (a slightly bigger spend on cotton). And for Videsh, even though it isn’t the cheapest cotton cloth-producing country in the world, this means a lucrative trade in cotton with Desh. Everyone wins!

  More Opportunity Cost (OC) questions to think about

  Why do people who can drive their own cars perfectly well hire a driver? Obviously because the OC of driving themselves is huge. In their minds, it is bigger than the OC of spending money on a good driver. (Just as an exercise to help you understand the OC concept better, list five ‘opportunities’ that someone gives up when they drive their own car. To start you off, here are two: the opportunity to take a nap while getting from one place to another, the opportunity to pass on the responsibility of finding a parking spot to someone else.)

  In a similar vein:

  ▶Why do mums (or dads) who cook perfectly well choose to order takeout on weekends?

  ▶Why do doctor/engineer/scientist parents, who can surely coach their own children in math and science, choose to send them out for tuitions in these subjects instead?

  ▶Why do you choose to wake up early to do homework when you could have done it just as easily the previous night?

  If you think about it, the answers to these apparently ‘non-Economics’ questions are selfish ones, all of them based on an Economics concept called Opportunity Cost! You can’t escape from Economics!

  AND FINALLY—DRUMROLL PLEASE—THE REAL POINT OF THIS SECTION

  This is the bottomline—everyone wants to ‘win’. Everyone—farmers, schools, factories, cricket teams, countries—wants to use the resources that they have at their disposal—money, time, talent, skills, brains, energy, machines, land—in the best possible way to get the result they want. Because resources are limited and wants are unlimited (economists call this ‘the problem of scarcity’), everyone
is forced to allocate the resources wisely and to make tough choices, i.e., give up certain things to get other things that they want more. Which is what David Ricardo was talking about.

  Who is this ‘everyone’ who is making these choices? Economists divide ‘everyone’ into three main ‘agents’:

  THE CHOICE MAKERS

  All three are essentially making one key choice: a choice between what economists call ‘jam today’ and ‘jam tomorrow’.

  Eh? Economics is about jam?

  Well, yes, in a manner of speaking. Here’s how it works. Let’s talk about individuals, or households, first. As a household, you have to make a choice between blowing up a lot of money on something that you don’t really need but will bring you a lot of happiness right now (jam today) and buying something cheaper and putting the extra money aside for things you might need in the future (jam tomorrow).

  Firms have to make such choices too. For instance, let’s say Biscuit Factory A, which has been the market leader so far, is facing competition from Biscuit Factory B, which is producing more biscuits than A is and filling up supermarket shelves with them. Now Factory A will have to decide whether to start spending its money on extra flour, butter and sugar, and work its existing machines to the maximum (and possibly cause them to break down quicker), so that they can quickly make a ton more biscuits to compete with Factory B (i.e., jam today) or to spend money on buying more and better machines that will, over the next year, help them to produce not only more biscuits than B but many different types of biscuits, which will help them beat the competition in the long run (i.e., jam tomorrow).