1: First Principles

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Economy-Wide Interactions

As mentioned in the Introduction, the economy as a whole has its ups and downs. For example, business in America’s shopping malls was depressed in 2008, because the economy was in a recession. While the economy had begun to recover in 2009, the effects of the downturn were still being felt—not until May 2014 did the number of Americans employed recover to its pre-recession level.

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The Principles of Economy-Wide Interactions

10. One person’s spending is another person’s income.

11. Overall spending sometimes gets out of line with the economy’s productive capacity.

12. Government policies can change spending.

Table :

TABLE 1-3 The Principles of Economy-Wide Interactions

To understand recessions and recoveries, we need to understand economy-wide interactions, and understanding the big picture of the economy requires three more economic principles, which are summarized in Table 1-3.

Principle #10: One Person’s Spending Is Another Person’s Income

Between 2005 and 2011, home construction in America plunged more than 60% 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 wallboard), or in producing goods and services new homeowners need (like new furniture), either lost their jobs or were forced to take pay cuts. And as incomes fell, so did spending by consumers. This example illustrates our tenth principle:

One person’s spending is another person’s income.

In a market economy, people make a living selling things—including their labor—to other people. If some group in the economy decides, for whatever reason, to spend more, the income of other groups will rise. If some group decides to spend less, the income of other groups will fall.

Because one person’s spending is another person’s income, a chain reaction of changes in spending behavior tends to have repercussions that spread through the economy. For example, a cut in business investment spending, like the one that happened in 2008, 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 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 known as the Great Depression.

The lesson economists learned from the troubles of the 1930s is that overall spending—the amount of goods and services that consumers and businesses want to buy—sometimes doesn’t match the amount of goods and services the economy is capable of producing. In the 1930s, spending fell far short of what was needed to keep American workers employed, and the result was a severe economic slump. In fact, shortfalls in spending are responsible for most, though not all, recessions.

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 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 spending.

In fact, government policies can dramatically affect spending.

For one thing, the government itself does a lot of spending on everything from military equipment to education—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 money 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 2008 and 2009 helped prevent the financial crisis of 2008 from turning into a full-blown depression.

!worldview! ECONOMICS in Action: Adventures in Babysitting

Adventures in Babysitting

As participants in a babysitting co-op soon discovered, fewer nights out made everyone worse off.

istockphoto

The website, myarmyonesource.com, which offers advice to army families, suggests that parents join a babysitting cooperative—an arrangement that is common in many walks of life. In a babysitting cooperative, 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 myarmyonesource.com explained, “Instead of money, most co-ops exchange tickets or points. When you need a sitter, you call a friend on the list, and you pay them with tickets. You earn tickets by babysitting other children within the co-op.” 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” described the troubles of a babysitting cooperative that issued too few tickets. Bear in mind that, on average, people in a babysitting co-op want to have a reserve of tickets stashed away in case they need to go out several times before they can replenish their stash 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, nonbabysitting 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.

An economy can also 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 behavior 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.

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Question 1.5

Explain how each of the following examples illustrates one of the three principles of economy-wide interactions.
1. The White House urged Congress to pass a package of temporary spending increases and tax cuts in early 2009, a time when employment was plunging and unemployment soaring.
  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.
2. Oil companies are investing heavily in projects that will extract oil from the “oil sands” of Canada. In Edmonton, Alberta, near the projects, restaurants and other consumer businesses are booming.
  This illustrates the principle that one person’s spending is another person’s income. As oil companies increase their spending on labor 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.
3. 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 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.

Solutions appear at back of book.

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 the airlines lost billions of dollars. When several major airlines spiraled toward bankruptcy, Congress passed a $15 billion aid package that was critical in stabilizing the airline industry.

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 $9 billion dollars. But by 2002 investors had taken a decidedly dimmer view of the company, reducing its valuation by 95% to only $425 million.

To make matters worse, Priceline.com was losing several million dollars a year. Yet the company managed to survive and thrive; in 2014 it was valued by investors at over $63 billion.

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 travelers 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 travelers 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 aggressively moved 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, with many more small hotels compared to the U.S. 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. As of 2013, its revenues had grown well over 20% in each of the previous five years, even growing 34% during the 2008 recession. Clearly, the travel industry will never be the same again.

QUESTION FOR THOUGHT

Question 1.6

Explain how each of the twelve principles of economics is illustrated in this case study.

Explain how each of the twelve principles of economics is illustrated in this case study.

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