ECONOMIC SERIES 7:7

Macroeconomics

Macroeconomics, often used by governments and central banks, explores large-scale economic trends affected by variables like inflation, national income and GDP.

Absolute Advantage

REVIEWED BY JIM CHAPPELOW   Updated May 1, 2019

What is Absolute Advantage?

Absolute advantage is the ability of an individual, company, region, or country to produce a greater quantity of a good or service with the same quantity of inputs per unit of time, or to produce the same quantity of a good or service per unit of time using a lesser quantity of inputs, than another entity that produces the same good or service. An entity with an absolute advantage can produce a product or service at a lower absolute cost per unit using a smaller number of inputs or a more efficient process than another entity producing the same good or service.

KEY TAKEAWAYS

• Absolute advantage is when a producer can produce a good or service in greater quantity for the same cost, or the same quantity at lower cost, than other producers.
• Absolute advantage can be the basis for large gains from trade between producers of different goods with different absolute advantages.
• By specialization, division of labor, and trade, producers with different absolute advantages can always gain over producing in isolation.
• Absolute advantage is related to comparative advantage, which can open up even more widespread opportunities for the division of labor and gains from trade.

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Basic Concept Of Absolute Advantage

Understanding Absolute Advantage

The concept of absolute advantage was developed by Adam Smith in his book Wealth of Nations to show how countries can gain from trade by specializing in producing and exporting the goods that they can produce more efficiently than other countries. Countries with an absolute advantage can decide to specialize in producing and selling a specific good or service and use the funds that good or service generates to purchase goods and services from other countries.

By Smith’s argument, specializing in the products that they each have an absolute advantage in and then trading products, can make all countries better off, as long as they each have at least one product for which they hold an absolute advantage over other nations.

General Example of Absolute Advantage

Consider the two hypothetical countries, Atlantica and Krasnovia, with equivalent populations and resource endowments, which each produce two products, Guns and Bacon. Each year Atlantica can produce either 12 Guns or 6 slabs of Bacon, while Krasnovia can produce either 6 Guns or 12 slabs of Bacon. Each country needs a minimum of 4 Guns and 4 slabs of Bacon to survive. In a state of autarky,producing solely on their own for their own needs, Atlantica can spend ⅓ of the year making Guns and ⅔ making Bacon for a total of 4 Guns and 4 slabs of Bacon. Krasnovia can spend ⅓ of the year making Bacon and ⅔ making Guns to produce the same, 4 Guns and 4 slabs of Bacon. This leaves each country at the brink of survival, with barely enough Guns and Bacon to go around. However, not that Atlantica has an absolute advantage in producing Guns, and Krasnovia has an absolute advantage in producing Bacon.

Absolute advantage also explains why it makes sense for individuals, businesses and countries to trade. Since each has advantages in producing certain goods and services, both entities can benefit from trade.

If each country were to specialize in their absolute advantage, Atlantica could make 12 Guns and no Bacon, while Krasnovia makes no Guns and 12 slabs of Bacon. By specializing, the two countries divide the tasks of their labor between them. If they then trade 6 Guns for 6 slabs of Bacon, each country would then have 6 of each. Both countries would now be better off than before, because each would have 6 Guns and 6 Bacon, as opposed to 4 of each good which they could produce on their own.

This mutual gain from trade forms the basis of Adam Smith’s argument that specialization, the division of labor, and subsequent trade leads to an overall increase of wealth from which all can benefit. This, Smith believed, was the root cause of the eponymous Wealth of Nations. 

Absolute Advantage and Comparative Advantage

Absolute advantage can be contrasted to comparative advantage, which is when a producer has a lower opportunity cost to produce a good or service than another producer. Absolute advantage leads to unambiguous gains from specialization and trade only in cases where each producer has an absolute advantage in producing some good. If a producer lacks any absolute advantage then Adam Smith’s argument would not necessarily apply. However, the producer and its trading partners might still be able to realized gains from trade if they can specialize based on their respective comparative advantages instead.

Adam Smith and “The Wealth of Nations”

BY JOY BLENMAN  Updated Jun 1, 2019

What was the most important document published in 1776? Most Americans would probably say The Declaration of Independence. But many would argue that Adam Smith’s “The Wealth of Nations” had a bigger and more global impact. 

On March 9, 1776, “An Inquiry into the Nature and Causes of the Wealth of Nations”—commonly referred to as simply “The Wealth of Nations”—was first published. Smith, a Scottish philosopher by trade, wrote the book to upend the mercantilist system. Mercantilism held that wealth was fixed and finite, and that the only way to prosper was to hoard gold and tariff products from abroad. According to this theory, nations should sell their goods to other countries while buying nothing in return. Predictably, countries fell into rounds of retaliatory tariffs that choked off international trade.

Adam Smith is generally regarded as the father of modern economics.

The Invisible Hand

The core of Smith’s thesis was that humans’ natural tendency toward self-interest(or in modern terms, looking out for yourself) results in prosperity. Smith argued that by giving everyone freedom to produce and exchange goods as they pleased (free trade) and opening the markets up to domestic and foreign competition, people’s natural self-interest would promote greater prosperity than with stringent government regulations.

Smith believed humans ultimately promote public interest through their everyday economic choices. “He (or she) generally, indeed, neither intends to promote the public interest nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention,” he said in “An Inquiry into the Nature and Causes of the Wealth of Nations”

This free-market force became known as the invisible hand, but it needed support to bring about its magic.

The Invisible Hand

The automatic pricing and distribution mechanisms in the economy—which Adam Smith called an “invisible hand”—interacts directly and indirectly with centralized, top-down planning authorities. However, there are some meaningful conceptual fallacies in an argument that is framed as the invisible hand versus the government.

The invisible hand is not actually a distinguishable entity. Instead, it is the sum of many phenomena that occur when consumers and producers engage in commerce. Smith’s insight into the idea of the invisible hand was one of the most important in the history of economics. It remains one of the chief justifications for free market ideologies.

The invisible hand theorem (at least in its modern interpretations) suggests that the means of production and distribution should be privately owned and that if trade occurs unfettered by regulation, in turn, society will flourish organically. These arguments are naturally competitive with the concept and function of government.

The government is not serendipitous—it is prescriptive and intentional. Politicians, regulators, and those who exercise legal force (such as the courts, police, and military) pursue defined goals through coercion. However, in contrast, macroeconomic forces—supply and demand, buying and selling, profit and loss occur voluntarily until government policy inhibits or overrides them. In this sense, it is more accurate to suggest that government affects the invisible hand, not the other way around.

Government Response to the Invisible Hand

However, it is the absence of market mechanisms that frustrates government planning. Some economists refer to this as the economic calculation problem. When people and businesses individually make decisions based on their willingness to pay money for a good or service, that information is captured dynamically in the price mechanism. This, in turn, allocates resources automatically toward the most valued ends.

When governments interfere with this process, unwanted shortages and surpluses tend to occur. Consider the massive gas shortages in the United States during the 1970s. The then newly formed Organization of Petroleum Exporting Countries(OPEC) cut production to raise oil prices. The Nixon and Ford administrations responded by introducing price controls to limit the cost of gasoline to American consumers. The goal was to make cheap gas available to the public.

Instead, gas stations had no incentive to stay open for more than a few hours. Oil companies had no incentive to increase production domestically. Consumers had every incentive to buy more gasoline than they needed. Large-scale shortages and gas lines resulted. Those gas lines disappeared almost immediately after controls were eliminated and prices were allowed to rise.

While it is tempting to say the invisible hand limits government, that wouldn’t necessarily be correct. Rather, the forces that guide voluntary economic activity toward large societal benefit are the same forces that limit the effectiveness of government intervention.

KEY TAKEAWAYS

• The central thesis of Smith’s “The Wealth of Nations” was that our need to fulfill self-interest results in prosperity.
• Smith believed that people promote public interest through economic choices—a free-market force that became known as the “invisible hand.”
• The invisible hand is what comes from the collaboration of consumers and producers in commerce.
• Government interference in this process results in shortages and surpluses.

The Elements of Prosperity

Boiling the principles Smith expressed regarding the invisible hand and other concepts down to essentials, Smith believed a nation needed the following three elements to bring about universal prosperity.

1.Enlightened Self-Interest

Smith wanted people to practice thrift, hard work, and enlightened self-interest. He thought the practice of enlightened self-interest was natural for the majority of people.

In his famous example, a butcher does not supply meat based on good-hearted intentions, but because he profits by selling meat. If the meat he sells is poor, he will not have repeat customers and, thus, no profit. Therefore, it’s in the butcher’s interest to sell good meat at a price that customers are willing to pay, so that both parties benefit in every transaction. Smith believed the ability to think long-term would curb most businesses from abusing customers. When that wasn’t enough, he looked to the government to enforce laws.

Extending upon self-interest in trade, Smith saw thrift and savings as important virtues, especially when savings were used to invest. Through investment, the industry would have the capital to buy more labor-saving machinery and encourage innovation. This technological leap forward would increase returns on invested capital and raise the overall standard of living.

2. Limited Government

Smith saw the responsibilities of the government being limited to the defense of the nation, universal education, public works (infrastructure such as roads and bridges), the enforcement of legal rights (property rights and contracts), and the punishment of crime.

The government would step in when people acted on their short-term interests and would make and enforce laws against robbery, fraud, and other similar crimes. He cautioned against larger, bureaucratic governments, writing, “there is no art which one government sooner learns of another, than that of draining money from the pockets of the people.”

His focus on universal education was to counteract the negative and dulling effects of the division of labor that was a necessary part of industrialization. 

3.Solid Currency and Free-Market Economy

The third element Smith proposed was a solid currency twinned with free-market principles. By backing currency with hard metals, Smith hoped to curtail the government’s ability to depreciate currency by circulating more of it to pay for wars or other wasteful expenditures.

With hard currency acting as a check to spending, Smith wanted the government to follow free-market principles by keeping taxes low and allowing free tradeacross borders by eliminating tariffs. He pointed out that tariffs and other taxes only succeeded in making life more expensive for the people while also stifling industry and trade abroad.

Smith’s Theories Overthrow Mercantilism

To drive home the damaging nature of tariffs, Smith used the example of making wine in Scotland. He pointed out that good grapes could be grown in Scotland in hothouses, but the extra costs of heating would make Scottish wine 30 times more expensive than French wines. Far better, he reasoned, would be to trade something Scotland had an abundance of such as wool, in return for French wine.

In other words, because France has a competitive advantage in producing wine, tariffs aimed to create and protect a domestic wine industry would just waste resources and cost the public money.

What Wasn’t in “The Wealth of Nations”?

“The Wealth of Nations” is a seminal book that represents the birth of free-market economics, but it’s not without faults. It lacks proper explanations for pricing or a theory of value and Smith failed to see the importance of the entrepreneur in breaking up inefficiencies and creating new markets.

Both the opponents of and believers in Adam Smith’s free market capitalism have added to the framework setup in “The Wealth of Nations”. Like any good theory, free-market capitalism gets stronger with each reformulation, whether prompted by an addition from a friend or an attack from a foe.

Marginal utility, comparative advantage, entrepreneurship, the time-preference theory of interest, monetary theory, and many other pieces have been added to the whole since 1776. There is still work to be done as the size and interconnectedness of the world’s economies bring up new and unexpected challenges to free-market capitalism.

The Bottom Line

The publishing of “The Wealth of Nations” marked the birth of modern capitalism as well as economics. Oddly enough, Adam Smith, the champion of the free market, spent the last years of his life as the Commissioner of Customs, meaning he was responsible for enforcing all the tariffs. He took the work to heart and burned many of his clothes when he discovered they had been smuggled into shops from abroad.

Historical irony aside, his invisible hand continues to be a powerful force today. Smith overturned the miserly view of mercantilism and gave us a vision of plenty and freedom for all. The free market he envisioned, though not yet fully realized, may have done more to raise the global standard of living than any single idea in history.SPONSORED

Capitalist vs. Socialist Economies: What’s The Difference?

BY POONKULALI THANGAVELU  Updated Apr 20, 2019

Capitalist vs. Socialist Economies: An Overview

Capitalism and socialism are economic systems that countries use to manage their economic resources and regulate their means of production.

In the United States, capitalism has always been the prevailing system. It is defined as an economic system where private individuals or businesses, rather than the government, own and control the factors of production: entrepreneurship, capital goods, natural resources and labor. Capitalism’s success is dependent on a free market economy, driven by supply and demand.

With socialism, all legal production and distribution decisions are made by the government, with individuals dependent on the state for food, employment, healthcare and everything else. The government, rather than the free market, determines the amount of output, or supply and the pricing levels of these goods and services.

Communist countries, like China, North Korea, and Cuba, tend toward socialism, while Western European countries favor capitalist economies and try to chart a middle course. But, even at their extremes, both systems have their pros and cons.

Capitalism

In capitalist economies, governments play a minimal role in deciding what to produce, how much to produce, and when to produce it, leaving the cost of goods and services to market forces. When entrepreneurs spot openings in the marketplace, they rush in to fill the vacuum.

Capitalism is based around a free market economy, meaning an economy that distributes goods and services according to the laws of supply and demand. The law of demand says that increased demand for a product means an increase in prices for that product. Signs of higher demand typically lead to increased production. The greater supply helps level prices out to the point that only the strongest competitors remain. Competitors try to earn the most profit by selling their goods for as much as they can while keeping costs low.

Also part of capitalism is the free operation of the capital markets. Supply and demand determine the fair prices for stocks, bonds, derivatives, currencies and commodities.

In his seminal work, “An Inquiry into the Nature and Causes of the Wealth of Nations,” economist Adam Smith described the ways in which people are motivated to act in their own self-interest. This tendency serves as the basis for capitalism, with the invisible hand of the market serving as the balance between competing tendencies. Because markets distribute the factors of production in accord with supply and demand, the government can limit itself to enacting and enforcing rules of fair play.

Socialism and Centralized Planning

In socialist economies, important economic decisions are not left to the markets or decided by self-interested individuals. Instead, the government—which owns or controls much of the economy’s resources—decides the whats, whens, and hows of production. This approach is also called “centralized planning.”

Advocates of socialism argue that the shared ownership of resources and the impact of social planning allow for a more equal distribution of goods and services and a more fair society.

Both communism and socialism refer to left-wing schools of economic thought that oppose capitalism. However, socialism was around several decades before the release of the “Communist Manifesto,” an influential 1848 pamphlet by Karl Marx and Friedrich Engels. Socialism is more permissive than pure Communism, which makes no allowances for private property.

Key Differences

In capitalist economies, people have strong incentives to work hard, increase efficiency, and produce superior products. By rewarding ingenuity and innovation, the market maximizes economic growth and individual prosperity while providing a variety of goods for consumers. By encouraging the production of desirable goods and discouraging the production of unwanted or unnecessary ones, the marketplace self-regulates, leaving less room for government interference and mismanagement.

But under capitalism, because market mechanisms are mechanical, rather than normative, and agnostic in regard to social effects, there are no guarantees that each person’s basic needs will be met. Markets also create cycles of boom and bust and, in an imperfect world, allow for “crony capitalism,” monopolies and other means of cheating or manipulating the system. 

In socialist societies, basic needs are met; a socialist system’s primary benefit is that the people living under it are given a social safety net.

In theory, economic inequity is reduced, along with economic insecurity. Basic necessities are provided for. The government itself can produce the goods people require to meet their needs, even if the production of those goods does not result in a profit. Under socialism, there’s more room for value judgments, with less attention paid to calculations involving profit and nothing but profit. 

Socialist economies can also be also more efficient, in the sense that there’s less of a need to sell goods to consumers who might not need them, resulting in less money spent on product promotion and marketing efforts.

Special Considerations

Socialism sounds more compassionate, but it does have its shortcomings. One disadvantage is that people have less to strive for and feel less connected to the fruits of their efforts. With their basic needs already provided for, they have fewer incentives to innovate and increase efficiency. As a result, the engines of economic growth are weaker.

Another strike against socialism? Government planners and planning mechanisms are not infallible, or incorruptible. In some socialist economies, there are shortfallsof even the most essential goods. Because there’s no free market to ease adjustments, the system may not regulate itself as quickly, or as well.

Equality is another concern. In theory, everyone is equal under socialism. In practice, hierarchies do emerge and party officials and well-connected individuals find themselves in better positions to receive favored goods.

KEY TAKEAWAYS

• Capitalism and socialism are so different that they’re often seen as diametrically opposed.
• Capitalism is based on individual initiative and favors market mechanisms over government intervention, while socialism is based on government planning and limitations on private control of resources.
• Left to themselves, economies tend to combine elements of both systems: capitalism has developed its safety nets, while countries like China and Vietnam may be edging toward full-fledged market economies.

What Is the International Monetary Fund?

The International Monetary Fund (IMF) is an international organization that aims to promote global economic growth and financial stability, encourage international trade, and reduce poverty.Volume 0% 

International Monetary Fund (IMF)

Understanding the International Monetary Fund

The International Monetary Fund (IMF) is based in Washington, D.C., and currently consists of 189 member countries, each of which has representation on the IMF’s executive board in proportion to its financial importance, so that the most powerful countries in the global economy have the most voting power.

The IMF’s website describes its mission as “to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world.”

IMF Activities

The IMF’s primary methods for achieving these goals are monitoring, capacity building, and lending.

The IMF makes loans to countries that are experiencing economic distress in order to prevent or mitigate financial crises.

Surveillance

The IMF collects massive amounts of data on national economies, international trade, and the global economy in aggregate, as well as providing regularly updated economic forecasts at the national and international level. These forecasts, published in the World Economic Outlook, are accompanied by lengthy discussions of the effect of fiscal, monetary, and trade policies on growth prospects and financial stability.

Capacity Building

The IMF provides technical assistance, training, and policy advice to member countries through its capacity building programs. These programs include training in data collection and analysis, which feed into the IMF’s project of monitoring national and global economies.

Lending

The IMF makes loans to countries that are experiencing economic distress in order to prevent or mitigate financial crises. Members contribute the funds for this lending to a pool based on a quota system. These funds total around SDR 475 billion (US $645 billion) as of September 2017. (IMF assets are denominated in special drawing rights or SDR, a kind of quasi-currency that is comprised of set proportions of the world’s reserve currencies.)

KEY TAKEAWAYS

• The mission of the IMF is to promote global economic growth and financial stability, encourage international trade, and reduce poverty around the world.
• The IMF was originally created in 1945 as part of the Bretton Woods agreement, which attempted to encourage international financial cooperation by introducing a system of convertible currencies at fixed exchange rates.

IMF funds are often conditional on recipients making reforms to increase their growth potential and financial stability. Structural adjustment programs, as these conditional loans are known, have attracted criticism for exacerbating poverty and reproducing the structures of colonialism.

History of the IMF

The IMF was originally created in 1945 as part of the Bretton Woods Agreement, which attempted to encourage international financial cooperation by introducing a system of convertible currencies at fixed exchange rates, with the dollar redeemable for gold at $35 per ounce. The IMF oversaw this system: for example, a country was free to readjust its exchange rate by up to 10% in either direction, but larger changes required the IMF’s permission.

The IMF also acted as a gatekeeper: Countries were not eligible for membership in the International Bank for Reconstruction and Development (IBRD)—a World Bankforerunner that the Bretton Woods agreement created in order to fund the reconstruction of Europe after World War II—unless they were members of the IMF.

Since the Bretton Woods system collapsed in the 1970s, the IMF has promoted the system of floating exchange rates, meaning that market forces determine the value of currencies relative to one another. This system continues to be in place today.

BUSINESS CORPORATE FINANCE & ACCOUNTING

International Finance

REVIEWED BY JULIA KAGAN  Updated Apr 20, 2019

What Is International Finance?

International finance—sometimes known as international macroeconomics—is a section of financial economics that deals with the monetary interactions that occur between two or more countries. This section is concerned with topics that include foreign direct investment and currency exchange rates.

[Important: International finance also involves issues pertaining to financial management, such as the political and foreign exchange risk that comes with managing multinational corporations.]

Understanding International Finance

International finance research deals with macroeconomics; that is, it is concerned with economies as a whole instead of individual markets. Financial institutions and companies that conduct international finance research include the World Bank, the International Finance Corp. (IFC), the International Monetary Fund (IMF) and the National Bureau of Economic Research (NBER). There is an international finance division at the U.S. Federal Reserve that analyzes policies relevant to U.S. capital flow, external trade and development of markets in countries around the world.

Concepts and theories that are key parts of international finance and its research include the Mundell-Fleming model, the International Fisher Effect, the optimum currency area theory, purchasing power parity, and interest rate parity.

Example of International Institutions of International Finance

The Bretton Woods System

The Bretton Woods system, which was introduced in the late 1940s, after World War II, established a fixed exchange rate system, having been agreed upon at the Bretton Woods conference by the more than 40 countries that participated. The system was developed to give structure to international monetary exchanges and policies and to maintain stability in all international financial transactions and interactions.

The Bretton Woods conference acted as a catalyst for the formation of essential international institutions that play a foundational role in the global economy. These institutions—the IMF and the International Bank for Reconstruction and Development (which became known as the World Bank)—continue to play pivotal roles in the area of international finance.

Special Considerations

International or foreign trading is arguably the most important factor in the prosperity and growth of economies that participate in the exchange. The growing popularity and rate of globalization have magnified the importance of international finance.

Another aspect to consider, in terms of international finance, is that the United States has shifted from being the largest international creditor (lending money to foreign nations) and has since become the world’s largest international debtor; the United States is taking money and funding from organizations and countries around the world. These aspects are key elements of international finance.

Key Takeaways

• International finance is a section of financial economics that deals with the monetary interactions that occur between two or more countries.
• The growing popularity and rate of globalization have magnified the importance of international finance.
• International Finance is concerned with topics that include foreign direct investment and currency exchange rates.

ECONOMIC SERIES 7:7