Key Economic Concepts for Policymakers and Business Leaders

Key Economic Concepts for Policymakers and Business Leaders
July 1, 2004

This is the first in a series of occasional columns on economics for policymakers and business leaders.

Opportunity Cost and Tradeoffs: The true cost of any spending or investment decision is the cost of the foregone opportunity, or what could have been bought or the return on the investment that would have occurred if a different decision were made. For example, the opportunity cost of building a parking lot on a vacant lot in downtown Chicago is the revenue foregone from building another skyscraper. Every government regulation, tax, and spending program imposes opportunity costs on businesses and consumers. It's been estimated the opportunity costs associated with cost-ineffective federal regulations and programs--the costs of failing to spend the moneys more wisely and effectively--amount to 60,000 lost lives per year.

Marginality:

It is the marginal, not the average, behaviors of buyers and sellers that determine the prices at which goods are bought and sold. For example, marginal tax rates, not average tax rates, determine the effects of changes in the tax code. And it is the response of the marginal buyers and sellers that determines the impact of an increase in the price of an automobile or a gallon of gasoline.

Rationality:

The best way to understand, explain, and predict economic behavior is to assume consumers and sellers are rational. Everyone does not have to be rational: The concept of marginality says we need only assume the marginal buyers and sellers are rational. Economists have found this assumption holds even in mental asylums. The debate over whether or not to raise Corporate Average Fuel Economy standards, for example, always seems to come down to whether policymakers view consumers as rational: In the absence of net negative externalities (see below), rational consumers in competitive markets do not need to be told what to do.

Externalities:

These are opportunity costs not fully accounted for by the market system. Negative externalities are costs (e.g., pollution from cars and trucks) borne by others, while positive externalities are benefits (e.g., the economic and social benefits created by greater personal mobility) the owner or producer of a good does not get paid for. Government regulations also impose externalities, both negative and positive. For example, the government's economic analysis of the recent increase in the fuel efficiency standard for light trucks showed the negative externality--safety and congestion costs--imposed by the increase exceeded the externality benefits by a factor of 4 to 1.

The First Law of Demand: All else equal (holding all other economic variables such as personal incomes, the prices of other goods, demographics, and personal tastes unchanged), an increase in the price of a good will result in a reduction in the quantity of that good demanded.

Elasticity of Demand and Supply: The responsiveness of consumers and producers to small changes in prices or regulatory costs is very important in the assessment of the impact of regulatory, tax, trade, and other government policies, as well as to business and personal planning. For example, all else equal, a 10 percent increase in gasoline prices translates into a one-year reduction in the demand for gasoline of 1 percent, growing to a 5 percent reduction if the price increase is sustained over a period of five years.

Equilibrium:

The point at which the supply of a good equals the demand for it. Prices and profits make markets trend toward equilibrium, since shortages lead to higher prices, greater profits, and more supply, while surpluses lead to lower prices, lower profits, and less supply. Equilibrium is a concept useful for analysis because it directs attention to government policies that interfere with market processes. Shortages are invariably the result of government interference. For example, the gasoline queues following the OPEC oil embargo in 1973 were caused by fuel price controls. The U.S. was the only nation with such queues because it was the only nation with price controls.

The Equal Marginal Principle: Welfare or utility is maximized for individuals and for society if the value of each dollar spent is the same for all items on which the dollar is spent. This principle, together with the assumption of competitive markets and markets free of externalities, implies the following theorem.

The First Theorem of Welfare Economics, also called "The Invisible Hand Theorem" of Adam Smith: The allocation in a competitive equilibrium in which all externalities are internalized is economically efficient--that is, societal total net benefits (total costs less total benefits) are maximized. This theorem has numerous implications for public policy analysis, including:

  • In order to justify a regulation, tax, or other interference with a market or economy, there must first be a showing that the market is not "competitive" or there are externalities that individual buyers and sellers fail to take into account.
  • The level of stringency for any government regulation or tax that maximizes societal net benefits is the point at which the marginal social benefit of such a tax or regulation equals its marginal social cost. These first two principles are embedded in the President's Executive Order 12866 for regulatory analysis (established under President Clinton).
  • Price controls (e.g., minimum wages, agricultural price supports, gasoline price controls) necessarily harm a competitive economy.

The Power of Compound Interest: Earnings have greater long-term productivity the earlier they are reinvested. For example, a thousand dollars invested today at the historical (last 75 years) and current real or inflation-adjusted compound annual rate of return on U.S. government notes, or 2 percent, would grow to $2,692 dollars after 50 years. If it were invested at the historical 7 percent per year compound real return on stock market investments, it would grow to $49,457. This disproves Karl Marx's labor (only) theory of value. Some believe Einstein once remarked this is the most powerful insight in all of mathematics.

The Theorem of Comparative Advantage: "Whether or not one of two regions is absolutely more efficient in production of every good than is the other, if each specializes in the products in which it has a comparative advantage (greatest relative efficiency), trade will be mutually profitable for both regions and real wages of [workers and other] productive factors will rise in both places." [From Paul Samuelson, Economics, Sixth Edition.]

The Accounting Identity that Determines a Nation's Balance of Payments: The external trade deficit (imports less exports) is identically equal to the sum of the government budget deficit (or the excess of government expenditures over receipts) and the excess of private domestic investment over private domestic savings. Together with the theorem of comparative advantage, this identity is useful to rebut the common wisdom that exports are better for the economy than imports and that the trade deficit is the result of a deficit in any particular sector such as autos or oil. Rather, the current U.S. trade deficit is caused primarily by government budget deficits, high rates of return on foreign (direct) investments in U.S. businesses such as auto transplant facilities, and Asian bank purchases of U.S. government securities, especially by China and Japan.


Tom Walton is an economist with General Motors in Detroit and a member of the Board of Directors of The Heartland Institute. He can be reached by email at think@heartland.org.