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Economic Principles

Economic Principles


Analysis

Economics is all about making (hopefully) smart choices to cope with scarcity.  But how do we know if the choices we make, individually or in aggregate as a nation, lead to good outcomes?

Individuals, small businesses, large corporations, and entire nations all deal with the same fundamental question—how should we allocate our scarce resources in order to realize our maximum economic potential?

The most fundamental measurement used to evaluate our success in allocating our resources is economic growth. Individuals monitor their income and the changing value of their assets. Businesses track their profits and their market share. Nations monitor a variety of statistics to measure economic growth such as national income (the total income from all sources earned in a nation over specified period of time) and gross domestic product or GDP (the total market value of all goods and service produced within a country during a specified period).

Success in maximizing the allocation of our resources is also measured by productivity. For economists, this is a crucial measurement of how efficiently we are utilizing our resources. Productivity measures how much we produce for every unit of labor or capital that we invest—or as economists say, the value of our output for every unit of input. Suppose, for example, that in your one-man furniture shop you produce one chair every hour. With hopes of increasing productivity, you hire three assistants. Now you can produce four chairs per hour. But while your production may have increased, your productivity has not—you are still only producing one chair for every hour of labor invested. So you decide to buy some new machinery and soon discover that you and your three assistants can now produce eight chairs per hour. You have doubled productivity. Yeah technology!

Moving beyond growth and productivity, some economists argue that any assessment of the nation’s economy must also include measurements of distribution and equity—that is, it’s not enough for the economy to grow in aggregate terms, the wealth generated must also be equitably distributed. For these economists, a different set of questions and statistics are important. What is the nation’s per capita income and how close is this figure to the actual personal distribution of income? To determine the per capita income economists simply divide the national income by the population. But to determine the personal distribution of income economists must examine how the nation’s total income is actually distributed. They must determine what share of the nation’s wealth is owned by various sectors of the economy.

One useful tool in measuring income distribution is the Lorenz Curve. It identifies the share of the nation’s income earned by different segments of the population. In 2005, income in the U.S. looked like this:

  • Lowest 20% earned 4.2% of national income
  • Next 20% earned 9.7%
  • Next 20% earned  15.4%
  • Next 20% earned  22.9%
  • Highest 20% earned 47.7%

When plotted on a Lorenz curve, this information looks like this:

Lorenz curve

In order to gain a clearer sense of the distribution of income a line of equality is drawn. If income was equally distributed 20% of the public would earn 20% of the nation’s income, 40% of the public would earn 40% of the income, etc. The corresponding Lorenz Curve would look like this with the difference between the two lines illustrating the gap between perfect and actual distribution of income.

Economists also use Lorenz curves to measure changes in the distribution of income. In 1947, the income was distributed like this:

  • Lowest 20% earned 5.0% of national income
  • Next 20% earned 11.9%
  • Next 20% earned 17.0%
  • Next 20% earned 23.1%
  • Highest 20% earned 43.0%

And the Lorenz curve looked like this:

Lorenz curve with line of equity

A comparison of the 1947 and 2005 Lorenz curves suggests that the personal distribution of income is less equal than it was 50 years ago.  Now, why that is and why it may or may not be significant is another question.  But the Lorenz Curve does a nice job of visualizing the empirical fact:

1947, 2005 Lorenz curve

Economists rely on tools like the Lorenz Curve to trace certain changes in the economy. In their efforts to understand how a particular nation is dealing with the ongoing problem of scarcity, economists compile a wide range of statistic and plot them on a variety of graphs and charts. But these are only the starting point in their analysis. As we will see in the Economic Principles Game, breaking down the numbers is just the first step in assessing economic conditions.

Why It Matters Today

Big macroeconomic stats today produce some seriously big numbers.  The U.S. GDP is now about $15 trillion.  (That's $15,000,000,000,000 for those of you who like to be wowed by lots of zeroes.)

Impressive!

Less impressive: the national debt now stands above $14 trillion, or about 94% of GDP.  That's the highest debt-to-GDP ratio seen in the United States since World War II.  

Work hard so you can help us pay that down!

Sometimes, a Song Says it Better: Boulevard of Broken Dreams, by Green Day

In Green Day’s, “Boulevard of Broken Dreams,” the speaker “walks alone”, not having achieved his dreams.

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