1.3 Economy-Wide Interactions
As we mentioned in the Introduction, the economy as a whole has its ups and downs. For example, business for Canada’s auto dealers and shopping malls was depressed in 2009, because the economy was in a recession. By 2013, the economy had somewhat recovered. To understand recessions and recoveries, we need to understand economy-
Principle #10: One Person’s Spending Is Another Person’s Income
In late 2008, home construction in Canada began a rapid decline because builders found it increasingly hard to make sales. At first the damage was mainly limited to the construction industry. But over time the slump spread into just about every part of the economy, with consumer spending falling across the board.
But why should a fall in home construction mean empty stores in the shopping malls? After all, malls are places where families, not builders, do their shopping. The answer is that lower spending on construction led to lower incomes throughout the economy; people who had been employed either directly in construction, producing goods and services builders need (like drywall), or in producing goods and services new homeowners need (like new furniture), either lost their jobs or were forced to take pay cuts—
One person’s spending is another person’s income.
In a market economy, people make a living selling things—
Because one person’s spending is another person’s income, a chain reaction of changes in spending behaviour tends to have repercussions that spread through the economy. For example, a cut in business investment spending, like the one that happened in 2009, leads to reduced family incomes; families respond by reducing consumer spending; this leads to another round of income cuts; and so on. These repercussions play an important role in our understanding of recessions and recoveries.
Principle #11: Overall Spending Sometimes Gets Out of Line with the Economy’s Productive Capacity
Macroeconomics emerged as a separate branch of economics in the 1930s, when a collapse of consumer and business spending, a crisis in the U.S. banking industry, and other factors led to a plunge in overall spending. This plunge in spending, in turn, led to a period of very high unemployment worldwide known as the Great Depression.
The lesson economists learned from the troubles of the 1930s is that overall spending—
It’s also possible for overall spending to be too high. In that case, the economy experiences inflation, a rise in prices throughout the economy. This rise in prices occurs because when the amount that people want to buy outstrips the supply, producers can raise their prices and still find willing customers. Taking account of both shortfalls in spending and excesses in spending brings us to our eleventh principle:
Overall spending sometimes gets out of line with the economy’s productive capacity.
Principle #12: Government Policies Can Change Overall Spending
Overall spending sometimes gets out of line with the economy’s productive capacity. But can anything be done about that? Yes—which leads to our twelfth and last principle:
Government policies can change overall spending.
In fact, government policies can dramatically affect overall spending (sometimes referred to as aggregate expenditure).
For one thing, the government itself does a lot of spending on everything from military equipment to employment insurance benefits—and it can choose to do more or less. The government can also vary how much it collects from the public in taxes, which in turn affects how much income consumers and businesses have left to spend. And the government’s control of the quantity of money in circulation, it turns out, gives it another powerful tool with which to affect total spending. Government spending, taxes, and control of the money supply are the tools of macroeconomic policy.
Modern governments deploy these macroeconomic policy tools in an effort to manage overall spending in the economy, trying to steer it between the perils of recession and inflation. These efforts aren’t always successful—recessions still happen, and so do periods of inflation. But it’s widely believed that aggressive efforts to sustain spending in 2009 and 2010, such as Canada’s Economic Action Plan, helped prevent the financial crisis of 2008 from turning into a full-blown depression.
ADVENTURES IN BABYSITTING
The website sittingaround.com, which offers advice to families on locating babysitting services, suggests that parents consider joining a babysitting co-operative—an arrangement that is common in many walks of life. In a babysitting co-operative, a number of parents exchange babysitting services rather than hire someone to babysit. But how do these organizations make sure that all members do their fair share of the work? As sittingaround.com explains, “Instead of exchanging cash, members simply exchange sitting for sitting. Coops make sure everything nets out equitably by tracking points. You get points when you sit for someone else, and you spend points when others are sitting for you. The Johnsons can sit for the Browns, the Browns can sit for the Smiths, and the Smiths can sit for the Johnsons. Because you are part of a group, you never have to worry about reciprocating directly with those sitting for you—eventually, it all gets around.”
In other words, a babysitting co-op is a miniature economy in which people buy and sell babysitting services. And it happens to be a type of economy that can have macroeconomic problems. A famous article titled “Monetary Theory and the Great Capitol Hill Babysitting Co-Op Crisis,” published in 1977, described the troubles of a babysitting co-operative that issued too few tickets (its medium for tracking points). Bear in mind that, on average, people in a babysitting co-op want to have a reserve of tickets or points in case they need to go out several times before they can replenish their reserve by doing some more babysitting.
In this case, because there weren’t that many tickets out there to begin with, most parents were anxious to add to their reserves by babysitting but reluctant to run them down by going out. But one parent’s decision to go out was another’s chance to babysit, so it became difficult to earn tickets. Knowing this, parents became even more reluctant to use their reserves except on special occasions.
In short, the co-op had fallen into a recession. Recessions in the larger, non-babysitting economy are a bit more complicated than this, but the troubles of the Capitol Hill babysitting co-op demonstrate two of our three principles of economy-wide interactions. One person’s spending is another person’s income: opportunities to babysit arose only to the extent that other people went out. And an economy can suffer from too little spending: when not enough people were willing to go out, everyone was frustrated at the lack of babysitting opportunities.
And what about government policies to change spending? Actually, the Capitol Hill co-op did that, too. Eventually, it solved its problem by handing out more tickets, and with increased reserves, people were willing to go out more.
Quick Review
In a market economy, one person’s spending is another person’s income. As a result, changes in spending behaviour have repercussions that spread through the economy.
Overall spending sometimes gets out of line with the economy’s capacity to produce goods and services. When spending is too low, the result is a recession. When spending is too high, it causes inflation.
Modern governments use macroeconomic policy tools to affect the overall level of spending in an effort to steer the economy between recession and inflation.
Check Your Understanding 1-3
CHECK YOUR UNDERSTANDING 1-3
Question 1.5
Explain how each of the following examples illustrates one of the three principles of economy-wide interactions.
The prime minister urged Parliament to pass a package of temporary spending increases and tax cuts in early 2009, a time when employment was plunging and unemployment soaring.
Oil companies are investing heavily in projects that will extract oil from the “oil sands” in Alberta. In Edmonton, near the projects, restaurants and other consumer businesses are booming.
In the mid-2000s, Spain, which was experiencing a big housing boom, also had the highest inflation rate in Europe.
This illustrates the principle that government policies can change spending. The tax cut would increase people’s after-tax incomes, leading to higher consumer spending.
This illustrates the principle that one person’s spending is another person’s income. As oil companies increase their spending on labour by hiring more workers, or pay existing workers higher wages, those workers’ incomes rise. In turn, these workers increase their consumer spending, which becomes income to restaurants and other consumer businesses.
This illustrates the principle that overall spending sometimes gets out of line with the economy’s productive capacity. In this case, spending on housing was too high relative to the economy’s capacity to create new housing. This first led to a rise in house prices, and then—as a result—to a rise in overall prices, or inflation.
How Priceline.com Revolutionized the Travel Industry
In 2001 and 2002, the travel industry was in deep trouble. After the terrorist attacks of September 11, 2001, many people simply stopped flying. As the economy went into a deep slump, airplanes sat empty on the tarmac and airlines around the world lost billions of dollars. When several major U.S. airlines spiralled toward bankruptcy and laid off more than 100 000 workers, the U.S. Congress passed a US$15 billion aid package that was critical in stabilizing the American airline industry. At the same time, Air Canada, sought a government bailout of $2 to $4 billion. In the end, the Canadian government compensated all Canadian air carriers with a bailout package worth $160 million.
This was also a particularly difficult time for Priceline.com, the online travel service. Just four years after its founding, Priceline.com was in danger of going under. The change in the company’s fortunes had been dramatic. In 1999, one year after Priceline.com was formed, investors were so impressed by its potential for revolutionizing the travel industry that they valued the company at US$9 billion dollars. But by 2002 investors had taken a decidedly dimmer view of the company, reducing its valuation by 95% to only US$425 million.
To make matters worse, Priceline.com was losing several million dollars a year. Yet the company managed to survive; as of the time of writing in 2013, it was valued by investors at US$40.3 billion. Not only has it survived, it has thrived.
So exactly how did Priceline.com bring such dramatic change to the travel industry? And what has allowed it to survive and prosper as a company in the face of dire economic conditions?
Priceline.com’s success lies in its ability to spot exploitable opportunities for itself and its customers. The company understood that when a plane departs with empty seats or a hotel has empty beds, it bears a cost—the revenue that would have been earned if that seat or bed had been filled. And although some travellers like the security of booking their flights and hotels well in advance and are willing to pay for that, others are quite happy to wait until the last minute, risking not getting the flight or hotel they want but enjoying a lower price.
Customers specify the price they are willing to pay for a given trip or hotel location, and then Priceline.com presents them with a list of options from airlines or hotels that are willing to accept that price, with the price typically declining as the date of the trip nears. By bringing airlines and hotels with unsold capacity together with travellers who are willing to sacrifice some of their preferences for a lower price, Priceline.com made everyone better off—including itself, since it charged a small commission for each trade it facilitated.
Priceline.com was also quick on its feet when it saw its market challenged by newcomers Expedia and Orbitz. In response, it began aggressively moving more of its business toward hotel bookings and into Europe, where the online travel industry was still quite small. Its network was particularly valuable in the European hotel market, which is comprised of many more small hotels in comparison to the North American market, which is dominated by nationwide chains. The efforts paid off, and by 2003 Priceline.com had turned its first profit.
Priceline.com now operates within a network of more than 295 000 hotels in over 190 countries and territories globally. As of 2013, its revenues had grown at least 21% over each of the previous three years, even growing during the recession by 24% in 2009 and 32% in 2010.
QUESTION FOR THOUGHT
Question 1.6
Explain how each of the twelve principles of economics is illustrated in this story.
