Here’s a reprint of an article that summarizes all you need to know about economics in 10 easy steps. They come courtesy of the best-selling introductory economics textbook by Gregory Mankiw of Harvard University.

Economics is the study of how society manages its scarce resources, where ”scarce” means there are fewer resources than we’d like to be able to use.

The first four of Mankiw’s 10 principles concern the way people make decisions, and the first is: people face trade-offs. That is, to get one thing we like we usually have to give up another thing we like. Economics is about the trade-offs people – and societies – have to make, and about helping people improve the trade-offs they’re making. One common trade-off society faces is between efficiency and equity. Efficiency in the allocation of resources means society getting the most it can from its scarce resources. Equity means the benefits from those resources are distributed fairly among the members of society. Often, the things we could do to make the cake bigger (efficiency) make the slices of the cake more unequal (equity) and vice versa.

The second principle is: the cost of something is what you give up to get it. That is, its ”opportunity cost”. Economics is about comparing the costs and benefits of alternative courses of action. The benefits of doing something or buying something are usually pretty obvious, but they need to be weighed against the costs involved to see whether option A is superior to other options. The cost of going to university full time is not the cost of accommodation and food (because you’d face those even if you didn’t go to uni), nor even just the cost of the uni fees and textbooks. The biggest cost is the income you lose by not being able to work full-time – a classic opportunity cost.

Third, rational people think at the margin. Marginal changes are incremental adjustments to a plan of action. Say you’re running a short course for 10 students at a total cost of $10,000 – that is, an average cost of $1000 per student. Now say an extra student wants to join the course. How much should you charge him – $1000? No. The first question is: what’s the marginal cost of adding an extra student? It’s probably quite small – say, $50 for the extra set of course notes. This means that any price you charge above the marginal cost of $50 will leave you ahead on the deal. But if you name a price that’s too high and the student decides not to pay it, you’re worse off to the extent that the amount he would have been willing to pay (marginal revenue) exceeded $50.

Fourth, people respond to incentives. Because people are assumed to make decisions by comparing costs and benefits, their choices may change when the costs and benefits change. If so, they’re responding to incentives. When Cyclone Larry caused the price of bananas to skyrocket in 2006, most people ate fewer bananas and more apples and pears. They were responding to changed incentives.

The next three principles concern the way people interact. The fifth is: trade can make everyone better off. Trade between Australia and China is not like a sporting contest where one side wins and the other loses. Rather, trade makes both sides better off (though not necessarily equally better off), which is why it happens. Trade between countries is merely an extension of all the trade that goes on within countries between businesses and households.

Sixth, markets are usually a good way to organize economic activity. A market economy is ”an economy that allocated resources through the decentralized decisions of many firms and households as they interact in markets for goods and services”. The other main way to organize economic activity is to have central planners make all the decisions about what goods and services are produced, how many are produced, who does the producing and who gets to buy what’s produced. It doesn’t work.

Seventh, governments can sometimes improve market outcomes. Government intervention in markets may be justified in cases of ”market failure” – ”a situation in which a market, left on its own, fails to allocate resources efficiently”. One common cause of market failure is the existence of an ”externality”, where a transaction between a buyer and a seller affects – whether favorably or unfavorably – the well-being of third parties. Another cause is ”market power,” where one or a small group of firms is able to substantially influence market prices (and thus make profits well in excess of the opportunity cost of the capital they have put up and the risks they are taking).

The last three principles concern how the economy as a whole works. The eighth is: a country’s standard of living depends on its ability to produce goods and services. The value of a country’s production of goods and services during a period is measured by gross domestic product. A simple measure of its material standard of living is its GDP divided by the size of its population. Income per person is very much higher in the developed countries than the developing countries. Why? Mainly because the rich countries have higher productivity – each hour of a worker’s time produces more goods and services. Why? Because the rich countries’ workers are better educated and trained (”human capital”) and have better equipment to work with (”physical capital”).

Ninth, prices rise when the government prints too much money. This proposition is usually true, but it doesn’t apply when – as now in the United States and Britain – the demand for goods and services is falling far short of the available supply of goods and services.

Tenth, society faces a short-run trade-off between inflation and unemployment. Usually, the things governments do to reduce inflation have the effect of increasing unemployment and the things they do to reduce unemployment have the effect of increasing inflation. This relationship is known as the ”Phillips curve” after the Kiwi who invented it, but in the long run the trade-off breaks down and if you push it too hard you can end up with high inflation and high unemployment. If you can get people’s inflation expectations down, however, you can enjoy the best of both worlds.

If you’ve followed me this far you’ve passed the course. Your reward: look up the economics professor and stand-up comedian Yoram Bauman on YouTube and watch his send-up of these 10 principle

s.

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Thank you for following Making Cents during 2009. Perhaps it was not the best year the Green Industry has ever seen, but it sure wasn’t dull. Looking forward to sharing 2010 with you!

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Interesting commentary from Grant McCracken from his article entitled “Why American Consumers Will Spend Lavishly Again”
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The “new normal” — the idea that when income, credit and confidence return, Americans will not return to our free-spending ways — is an idea on the march, recruiting everyone from PIMCO CEO Mohamed El-Erian to Wal-Mart CEO Mike Duke. It’s spreading so fast it threatens to become the new orthodoxy.

I believe the argument is flawed. When Mike Duke says, “[P]eople are saving more, consuming less, and being more frugal and thoughtful in their purchases,” he is right in the short term, but wrong in the long term. When income, credit, and confidence return, consumers will party like its 1999.

We’ve never had a good explanation for why consumers consume. So when they stop consuming, it’s easy to think they will never start again. If pressed, we say consumption is about vanity, status, greed, cheap money and the consumers’ own brand of irrational exuberance. Even in good times, we keep expecting consumers to come to their senses. In tough times, we think, but of course they will. A new normal is inevitable.

But it’s wrong. As a classically trained anthropologist, I have spent many years doing ethnographic research in American homes. This represents hundreds and hundreds of hours of careful listening, two hours at a time. I know the American consumer as few do.

Let me introduce you to Susan Householder.* Here she is, standing in the entrance of her garage in a middle class suburb of Ridgefield, New York. She is surveying a mountain of stuff: bicycles, toboggans, a work bench, exercise equipment, canned goods, Christmas decorations, a picnic hamper, board games, lots of wrapping paper, several boxes of stem ware, and lots and lots of containers, contents unknown. There’s so much stuff here, this ceased to be a garage a long time ago. It’s now a storage locker, Susan’s very own U-Store-It. (Cars are consigned to the drive way.) If we wanted a monument to all the spending Susan did in the 00s, this is it.

What created this mountain of stuff? Was it irrational exuberance and cheap money? It was not. This crowded garage springs from cultural motives. These things were not purchased to express vanity or pursue status. They were purchased to help Susan build a life.

Susan’s been listening to Martha Stewart, so she now celebrates Christmas, Thanksgiving and birthdays with more formality, and yes, more stuff. Like everyone, she is cultivating new ideas of childhood for her kids and this requires another great wave of stuff. In the 18th century, the average American child had a wooden toy and an iron hoop. Susan’s kids need many more things, including soccer boots, Karate outfits, paint kits, building blocks, skateboards, Xboxes, iPods, cell phones, and a ton of games and books.

Susan’s biggest recent expenditure is the “great room” she and her husband installed a couple of years ago. Like millions of other Americans, Susan created one large, sumptuous room by combining her living room, dining room, and kitchen. It cost $45,000, a princely sum for this household, but it caused Susan not a flicker of remorse. After all, she has a new idea of entertainment. Susan had tired of being a “servant in my own home.” When entertaining friends, she was forced to ferry food to and from the dining room, missing half the conversation, working as her own household staff. Now her guests sit at around the island in the great room, glass of wine in hand, looking on while Susan cooks brilliantly beneath halogen lighting. From 2005 to 2007, expenditures on interior renovation in American homes rose about 40 percent to $13 billion. Much of this was driven by Martha and the great room.

We could say this is irrational consumption, but actually it has a deeper, culture motive. Susan is fashioning her social life. To be sure, there is status seeking here. But there is also something richer and more cultural, as Susan works out new ideas of the “host,” “guest” and “entertainment.”

Susan has her eye on a purse by the designer Kate Spade. It’s called the Cornelia Street Noel Blair and it costs $425. Susan has many purses, around 20 of them. So she doesn’t need this bag…at all. This must be all about vanity, status and greed.

Not really. Susan loves this bag because it captures a concept of the person she thinks she might be becoming. Kate Spade has a positive genius for plucking new signals out of the noise of culture and turning them into something a woman can own, wear, and become. This is a luxury purchase in so far as it costs vastly more than a container needs to. But what makes it valuable for Susan is that it contains the idea of who she wants to be.

Right now Susan is hunkered down. She and her husband have scaled back expenditure. But this much is clear: The cultural motives of Susan’s consumption have not changed. When circumstances allow, she will return to spending enthusiastically to fashion her children, her family, and herself. The “new normalists” missed one thing. Susan has real and substantial motives for spending. When income, credit, and confidence return, she’s going to start spending again.

*Susan is a compilation of several consumers I have interviewed.

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Grant McCracken holds a PhD from the University of Chicago in cultural anthropology. He is the author of Culture and Consumption, Culture and Consumption II, Plenitude, The Long Interview, Flock and Flow, and Transformation. He has been the director of the Institute of Contemporary Culture at the Royal Ontario Museum, a senior lecturer at the Harvard Business School, and a visiting scholar at the University of Cambridge, and he is now a research affiliate at C3 at MIT. He has consulted widely in the corporate world, including the Coca-Cola Company, Diageo, IBM, IKEA, Chrysler, Kraft, and Kimberly Clark. He has served on marketing advisory boards for IBM and the Boston Beer Company. Basic Books will publish his new book, Chief Culture Officer, on December 1 this year.

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