Economics Questions and Answers:
General Economics

Copyright 2001-2008 by Scott Palmer.

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Why study economics?

Question: What is so interesting about economics? Why study it?

Answer: Economics deals with the most basic issues of life: Will you have a good job? Will you have something to eat? Will you be able to take care of your family and children? Will your society have sufficient resources to care for people who are down on their luck?

All those and similar questions are answered by economics. Angels don't need economics -- just those of us who live on earth.

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How good are economic forecasts?

Question: I am trying to find economic forcast levels. To be specific I'm trying to find data that is at least 15 years in the future forcasting this topics: GDP trends, interest rates, money supply, inflation rates, unemployment levels, disposable and discretionary income. Can you help?

Answer: No one can make economic forecasts 15 years into the future with even a slight assurance that the forecasts are true. The events of the previous day (the World Trade Center and Pentagon attacks) are just one example of the millions of unknown and uncontrollable factors that affect the economy.

To take a more mundane (and short-term) example: Why do you think that Alan Greenspan and the US Federal Reserve are taking such small steps to stimulate the economy -- cutting the federal funds rate and the discount rate just a quarter or a half percent at a time? It's because even the Fed's best economists can't predict how much effect a large cut would have; therefore, they are taking things slow and easy.

It's important for you to understand that this is not a matter of insufficient computing power. We simply don't know all the facts (present and future) we need to know in order to make such predictions.

Even if you have the best econometric computer model in the world, if you put in incomplete information, you will get uncertain and incomplete answers. The required knowledge is distributed among millions or billions of different people, each of whom has plans and goals that we don't know about: see "Economics and Knowledge" by F.A. Hayek in his book Individualism and Economic Order for a good discussion of this problem.

Generally, you can expect GDP levels to go up over 15 years, but even that isn't carved in stone. Increasing GDP depends on a number of factors, including technological progress and capital accumulation. Technological progress is going fine, but the US has a very low savings rate, which slows capital accumulation. When the baby boomers hit retirement age, payroll taxes on current workers might go through the roof to finance the boomers' Social Security benefits (because the so-called "Social Security trust fund" doesn't really exist), and that tax hike would further reduce people's ability to save and the economy's ability to accumulate capital.

The money supply usually increases over time because of government's ability to engage in "coin clipping," i.e., inflating the money supply to fund its pet projects. As for the other variables you cited -- interest rates, unemployment, etc. -- there's no reliable way to predict which way they'll go.

Economics can make certain hypothetical predictions: IF you do X, and other factors remain equal, then Y will probably happen. IF the central bank raises interest rates and cuts the money supply, then if other factors remain equal, you will probably have an economic slowdown or recession; IF the government passes a law setting the minimum price for good or service Z above the market price, then if other factors remain equal, there will be unsold surpluses of Z; and so forth. But economics can't predict if any of these causal events (the IF clauses) will happen, or if the "other factors" will remain equal..

The bottom line is that, like psychoanalysis, economics is best at explaining what has already happened -- and not so good at predicting what is going to happen, especially in the far future.

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What are induction and deduction, and which does economics use?

Question: Can you tell me what the difference is between inductive and deductive theories are? When an economist talks about the rise in interest rates is that inductive or deductive? Would a scientist who studies specific creatures on the ocean floor to have an understanding of ocean life be using inductive or deductive reasoning?

Answer: Induction and deduction are different types of logical reasoning. Induction looks at specific facts and tries to derive general rules. Thus, it works from the specific to the general. Here is an example of induction:

1. This apple is red.
2. Another apple is red.
3. Still another apple is red.
Therefore, all apples are red.

Deduction takes one or more general rules, sometimes puts them together with specific facts, and tries to derive more specific facts. Thus, it works from the general to the specific. Here is an example of deduction:

1. All economists are popular.
2. Milton Friedman is an economist.
Therefore, Milton Friedman is popular.

Economics uses a variety of tools, including both inductive and deductive reasoning. Most economists would not use the word "inductive" to describe what they do; they would more likely characterize economics as "empirical," meaning that it relies on observable evidence to verify its theories.

In some ways, economics is like any other science. It observes facts, and tries to devise explanations of those facts: that's induction. It then uses the explanation (i.e., the theory) to make predictions about what will happen in similar cases: that's deduction. Finally, it collects data about similar cases to find out if the theory is making accurate predictions that verify or disprove the theory: that's the scientific method.

Economics does differ in significant ways from physical sciences. Notably, it deals with human actions and goals that are not completely controlled by antecedent physical conditions. Therefore, it can't make predictions with the same degree of certainty as, say, biology or chemistry. Also, it deals with systems that are significantly more complex than those covered by physical science. However, just like biology or chemistry, economics is an empirical science, based on observable evidence, that uses induction, deduction, and the scientific method to create and test its theories.

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I need a topic for my "Economics and Public Policy" paper.

Question: I have to write a 5 page paper in my economics & public policy class. I am a pre-med student and would like to relate my paper to medicine. For example, something on health insurance, cost of medicines, etc. Do you have any suggestions as to what topic I could choose?

Answer: One good topic might be the issue of intellectual property as it applies to prescription drugs. It's current, hotly debated, and there's plenty of material about it on the Web.

Drug companies spend billions of dollars to develop new medicines, anticipating that patent law will protect their discoveries and let them recoup their investments. But this also means that the most advanced medicines are too expensive for sick people in poor countries, such as AIDS sufferers in Africa.

Drug companies have a good argument: They have invested huge amounts of time, money, and talent in developing new medicines, and they deserve to be paid adequately for them. They also have a pragmatic argument: If they can't be sure of patent protection for their discoveries, they will be less inclined to devote such enormous resources to research, and fewer life-saving drugs will be developed in the future.

Advocates on the other side also have a good argument: People are dying of diseases for which there are treatments available -- if you've got the money to pay for them. Is it right, as they'd put it, to let money stand in the way of saving lives?

Here are two links to get you started:

There are also many good articles in The Economist magazine, but you need to be a subscriber to access them on the Web. If you can find The Economist in your college library, I'd suggest that you look at the following:

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Is interest just a monetary phenomenon?

Question: I"m a student from India....I'm working on a project given......"Interest is a purely monetary phenomenon." Well I just wanted to ask what exactly does it mean?

Answer: I might have misunderstood what your teacher meant, but the statement that "interest is a purely monetary phenomenon" does not strike me as being correct.

Interest is most obvious when it's expressed in money, and it is most often expressed in money, but it comes from facts that have nothing to do with money. Interest has two main components: time preference and risk.

The first component, time preference, is the fact that people prefer to have goods now rather than in the future. As an example, consider this answer to your question about interest: would you prefer to have it now, or would you prefer to have it a year from now?

If you're like most people, you'd prefer to have it now. The same applies to housing, clothes, cars -- and to money. If you have goods now, you can use them now; but if you won't get them until the future, then you must wait to use them.

As a result, having goods now is worth more, in economic terms, than having them in the future. If I give you money now that I won't get back until the future, you must pay me the difference in value between the money now and the money in the future. That's part of what interest is, and as you can see, it has no necessary connection with money: time preference applies to almost all goods. (Money is a good like any other: a commodity's price is simply the exchange rate between one unit of the good and units of money.)

The second component, risk, is the fact that future events are always uncertain. You might be a very good credit risk, and you might intend to pay back the money I loan you: but what happens if you get run over by a car, or if you lose your job? Then I might not get my money back. As a result, in addition to time preference, you must also pay me for the risk I take, that I might not get my money back.

Sometimes, if price levels are rising, lenders also add an "inflation premium," though this is not an essential part of interest. If prices are rising, then when you pay back a loan I've given you, the monetary unit won't be as valuable as it was when I gave you the loan. Therefore, the amount you pay back might also be adjusted for inflation, so that I don't lose purchasing power because prices have risen.

So you can see that, although interest usually arises in connection with money, it is based on fundamental, non-monetary facts of human life: time preference and risk.

If you want to read more about the nature of interest, I suggest the following:

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What did Adam Smith consider the proper role of government?

Question: According to Adam Smith, what would be the proper role of government in society?

Answer: I'm not an Adam Smith scholar, but I'll tell you what I know.

Adam Smith did not publish a fully-developed theory of government, though at the time he died, he was writing a book about it. Unfortunately, he left instructions that all of his papers be burned after his death, so we don't know what he was going to say.

However, Smith said a few things about government in the two major works that he did publish: The Theory of Moral Sentiments and The Wealth of Nations. His remarks are not systematic, so we have to use them to deduce his theory of government.

In The Theory of Moral Sentiments, Smith comes out fairly clearly for what classical liberals called "limited government:" the idea that government should stick to a small list of clearly-defined tasks, such as protecting people from criminals, and should otherwise leave everyone alone. Limited government was the fundamental idea of the US Constitution, though it is of course no longer observed.

In The Theory of Moral Sentiments Part IV, Chapter 2 (pp.308-309 of the Liberty Press edition), Smith writes that:

"The fatal effects of bad government arise from nothing but that it does not sufficiently guard against the mischiefs which human wickedness gives occasion to."

Here, Smith seems to warn against the harm that can be done by corrupt and evil government officials, and points to the desirability of limiting that harm by limiting the power of government officials.

Later, in Part VI, Chapter 2 (pp.380ff), Smith goes on to say:

"The man whose public spirit is prompted altogether by humanity and benevolence will respect the established powers and privileges even of individuals ... Though he [might] consider some of them as in some measure abusive, he will content himself with moderating what he often cannot annihilate without great violence. When he cannot conquer the rooted prejudices of the people by reason and persuasion, he will not attempt to subdue them by force ..."

Then (pp.380-381) he expands on an observation Plato made in The Republic, that absolute power is nowhere so dangerous as in the hands of someone who imagines himself fit to exercise it:

[The tyrant] "seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chess-board; he does not consider that the pieces upon the chess-board have no other principle of motion besides that which the hand impresses upon them; but that, in the great chess-board of human society, every single piece has a principle of motion of its own, altogether different from that which the legislature might choose to impress on it."

From these passages, we can reasonably infer that Smith was wary of letting government have too much power, because evil men (and in Smith's time, it would have been men, not men and women) would abuse that power to oppress the people. I leave it to you to read the newspapers and decide if that's our current situation.

In The Wealth of Nations, Smith was reacting against extreme over-regulation, such as French government policies that tried to control almost every aspect of commerce and indeed of life, right down to the number of threads that were required to be in blankets.

Smith's bottom line in The Wealth of Nations was that when governments leave people free to run their own affairs, they produce the greatest amount of wealth for society. Likewise, when governments interfere in people's lives and in the marketplace, it almost always leaves people and the society worse off than if governments had left things alone.

Smith did believe that government had some specific roles to play, such as providing national defense and building infrastructure such as roads, though he thought that some government tasks such as law courts could be wholly or partly privatized. He was probably aware of the private, for-profit courts that had existed in the Middle Ages, when a traveling judge would come to a town, and both parties to a dispute would pay him to decide their case.

Here are some additional sources of information for you:

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