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Basic Economics
by Thomas Sowell
A Common Sense Guide to the Economy
Published: June 13, 2023
4.4 (700 ratings)
Table of Contents
1
what’s in it for me? a no-nonsense introduction to key economic concepts.2
economics studies the use of scarce resources that have alternative uses3
investing is all about making sacrifices today to create a more abundant tomorrow4
financial institutions harness the well-being of individuals to the fortunes of economies5
insurance companies transfer and reduce risk6
final summaryBook Summary
This is a comprehensive summary of “Basic Economics” by Thomas Sowell. The book explores a common sense guide to the economy.
what’s in it for me? a no-nonsense introduction to key economic concepts.#
Introduction
thomas sowell.
basic economics.
a common sense guide to the economy.
few of us are experts in more than one subject area.
there just isn't enough time.
that means there are many complex fields in which we don't typically operate.
botanists, for obvious reasons, don't throw themselves into the debates of byzantinists, and vice versa.
in other words, we're mostly content to let specialists go at it and report back to us when we need to know something about their field.
it's an efficient division of labor that works pretty well.
in most cases, we don't really need to know all that much about botany or byzantium.
economic policy, though, is different.
it affects just about every facet of our lives while also responding directly to our own behavior as citizens, investors, and voters.
here, then, is an area of life we can't simply leave to the experts.
if we want to make rational decisions, we need to inform ourselves.
the only other choice is to be uninformed, or worse, misinformed.
that's what this chapter to thomas sowell's basic economics is here for, to help readers be informed.
as thomas sowell sees it, fundamental economic principles aren't hard to understand if they're explained clearly.
so, that's just what we'll do.
let's get started.
economics studies the use of scarce resources that have alternative uses#
economics studies the use of scarce resources that have alternative uses.
the basic principles of economics are universal.
they operate in feudal, socialist, and capitalist societies, and they apply to all peoples, cultures, and governments.
these principles are unchanging.
policies that caused the price of grain to rise in ancient rome will have the same impact if you implement them in today's india or european union.
before we get into some of these principles, we need to begin by defining our terms.
first off, what is an economy anyway?
one answer goes something like this.
an economy is a system for producing and distributing the goods and services we require in everyday life.
that's a good start, but there's something missing.
per this definition, the garden of eden, which, among other things, was a system for distributing goods and services, was an economy.
but few economists would classify it that way because those goods and services were abundantly available.
there was as much of everything as anyone desired.
without scarcity, there's no need to economize, and thus, no economics.
put differently, economics studies the choices societies make about the use of scarce resources that have alternative uses.
let's break that down.
scarcity means that there isn't enough of everything to satisfy everyone's needs completely.
what people want adds up to more than there is.
in short, some needs will go unmet.
the impossibility of satisfying all wants and desires is a constant in human history.
at this level, feudal, socialist, and capitalist societies are just different institutional ways of thinking about the trade-offs that must be made due to scarcity.
that brings us to production.
economics doesn't just deal with existing goods and services.
it's also more fundamentally about producing new output from scarce resources, or inputs.
as we've said, scarce resources, inputs, have alternative uses.
water can be used to produce ice or steam, but it can also be used to cool power plants or dye jeans.
if you have petroleum, you can produce gasoline and heating oil.
or you can make plastics or asphalt or vaseline.
you can turn iron ore into paper clips, automobile parts, or the frameworks for skyscrapers.
every economy, then, has to decide how much of each resource to use for which purpose.
these decisions, rather than the existence of natural resources, ultimately determine a country's standard of living.
there are, after all, resource-rich countries with relatively low standards of living and resource-poor countries with high standards of living.
the value of natural resources per capita in uruguay, for example, is several times higher than in japan.
but real income per capita in japan is more than double that of uruguay.
the difference-maker here is efficiency in production, that is, the rate at which inputs are turned into output.
efficient economies maximize output by minimizing waste and getting the most out of scarce resources.
inefficient economies don't.
if you want to visualize this process, it helps to think about real things, the iron ore, wood, and petroleum that go into the production process, rather than the cars, furniture, and gasoline that come out at the other end.
although economics is often conflated with money, currencies and cash are secondary.
money is an artificial device to get real things done.
it's the volume of goods and services, as well as the efficiency of their production, that determine how rich or poor a country is.
investing is all about making sacrifices today to create a more abundant tomorrow#
investing is all about making sacrifices today to create a more abundant tomorrow.
picture the following scene.
a tourist in greenwich village, new york, has his portrait sketched by a sidewalk artist.
the artist charges him $100.
that's a lot, the tourist says, but he agrees to pay the asking price because it's a great sketch.
not bad for five minutes work, he jokes as he hands over the money.
the artist corrects him.
20 years and five minutes work.
in other words, the artist's ability has accumulated over two decades before she was in a position to charge a tourist $100 for a single quick sketch.
her skill, then, is the fruit of an investment.
which brings us to our first principle.
we can define it right away, too.
investment is the sacrifice of real things today so that we can have more real things in the future.
the most obvious sacrifice our artist has made is time.
as she says, she honed her craft over 20 years.
this, though, implies a second sacrifice.
the chance to do something else.
if you decide to become an artist, you can't usually also study medicine or engineering.
this trade-off is an opportunity cost.
the loss of other alternatives when one alternative is chosen.
if we zoom out and look at society as a whole, we can see that investment means sacrificing the production of some goods and services so that capital and labor can be freed up for other purposes.
for example, countries that are industrializing often forego producing consumer goods so that more resources can be available to produce factories and machinery.
the rationale is that producing these kinds of goods will mean that overall production is greater in the future.
the future, however, can't be known, so these kinds of decisions are always risky.
if people are to invest, such risks must be compensated.
the cost of training artists and keeping them alive while their ability develops, for instance, must be repaid to ensure that such investments continue.
this isn't about morality.
it's a purely economic matter.
if the return on such investments isn't large enough to make them worthwhile, fewer people will invest in training, feeding, and housing artists.
crudely put, if a greenwich village sketch artist makes much less than $100 per five-minute sketch, no one's going to bother borrowing money to go to art school.
of course, this principle applies much more widely.
once the price of oil sinks below a certain level, it becomes increasingly difficult to find investors who are willing to cover the cost of looking for new oil fields or drilling new wells.
how many investments ultimately pay off is determined by how many consumers value the benefits of other people's investments.
if people specialize in fields for which there is little demand, their investment has been a waste of scarce resources.
in a free-market economy, they may expect low pay and or limited employment opportunities.
these conditions are a signal that they, and others coming after them, should stop making such investments.
note, though, that the principle of investment also applies to seemingly non-economic activities.
take just one example, tidying up after yourself in your home.
you invest time in putting things away after you've used them, because it reduces the amount of time you'll need to find them the next day.
here, too, today's sacrifice is tomorrow's gain.
financial institutions harness the well-being of individuals to the fortunes of economies#
financial institutions harness the well-being of individuals to the fortunes of economies.
now that we've explored investment in general, we can look at how investments are financed.
some investments are made by individuals.
if you buy corporate stock, you're supplying money to a corporation today in exchange for a share of the value you expect it to generate tomorrow.
in less abstract terms, you give a carmaker cash to expand production, enter new markets, and become more profitable so that you can share in those profits.
most investments, though, are made by financial institutions, such as pension funds and banks.
that's because the people who buy stocks, deposit money in savings banks, and pay into pension funds typically possess fairly modest sums of money.
institutions pool these stocks, deposits, and pensions together, thus creating huge investment vehicles.
in practice, this means that millions of people who can't possibly know each other personally can use one another's money.
now, two things are possible.
firstly, individuals can hitch their investments to those of institutions.
the latter aren't only able to finance large-scale projects such as shipyards, hydroelectric dams, and high-speed railroads.
they're also better at assessing the risks and rewards of doing so.
secondly, it allows individuals to redistribute their personal consumption over time.
let's break that down.
we can start by making some observations about borrowing and saving.
when people borrow money, they're drawing on their future income to cover current purchases.
for this convenience, they pay interest on loans.
when people save money, by contrast, they're postponing purchases.
for this inconvenience, they receive interest.
now, if borrowers are debtors, then savers are creditors.
the money they put into banks is lent out by those banks, which act as intermediaries between savers and borrowers.
most people are debtors and creditors at different points in their lives.
in the united states, for example, people under 30 don't have much in the way of savings.
that's hardly surprising.
they tend to have modest incomes and they're often paying down college debt.
people in their mid-50s, on the other hand, save a lot.
that also stands to reason.
their incomes are higher and they're preparing for retirement and old age.
these observations aren't just relevant to the personal finances of individuals, though.
they also have huge implications for the economy as a whole.
if we zoom out once more, we can see that these transactions between individuals and institutions are how scarce resources that have alternative uses are allocated within societies.
the construction of shipyards, hydroelectric dams, and high-speed railroads requires capital, labor, and natural resources to be diverted away from consumer goods toward undertakings that only generate output years or even decades down the line.
from the standpoint of society, present goods and services must be sacrificed for the sake of future goods and services.
the question is, why do people forego goods and services and postpone purchases?
well, they don't.
unless those future goods and services are more valuable than the goods and services being sacrificed.
if that condition is met, financial institutions receive a rate of return on their investments that is high enough for them to offer individuals a rate of return on their savings that is, in turn, high enough to induce them to postpone their spending.
insurance companies transfer and reduce risk let's wrap things up by looking at a concept we've mentioned in passing without stopping to unpack its meaning.
insurance companies transfer and reduce risk#
risk.
a good way into this topic is to think about how risk is mitigated.
it's time, in other words, to talk about insurance.
let's start with the transfer of risk.
simply put, paying someone to assume your risks.
this is the bread and butter of insurance companies.
in return for the premium paid by policyholders, the insurer assumes the risk of compensating for everyday and extraordinary misfortunes, ranging from car crashes and house fires to earthquakes, floods, and hurricanes.
insurers reduce risk, meanwhile, by segmenting the population into different risk categories and charging them accordingly.
that's why safe drivers pay lower car insurance premiums than their reckless counterparts.
similarly, office workers pay lower occupational injury insurance premiums than professional snowboarders or construction workers.
the most common kind of insurance, life insurance, compensates for a misfortune that can't be averted.
death.
if everyone were guaranteed to die at the age of 80, there'd be no need for life insurance because there wouldn't be any risks.
everyone's financial affairs could be arranged in advance to take into account their predictable death.
in that case, it would only make sense to pay premiums to an insurer if the amount paid in over the years was identical to the compensation paid out to surviving beneficiaries.
that wouldn't really be insurance, though.
it'd be closer to a bond.
in effect, policyholders would issue insurance companies an iou redeemable on a fixed date.
if you bought life insurance at the age of 20, you'd buy a 60-year bond.
if you bought it at 30, you'd buy a 50-year bond, and so on.
of course, in the real world, no one knows in advance at what age they'll die.
this uncertainty means that death is associated with substantial financial risks for the families of breadwinners and the business partners of the deceased, to name just two examples.
so it makes sense to pay life insurance premiums and transfer those risks to an insurance company.
so there's the basic principle behind insurance.
what about the financial side of things?
well, it's important to note that insurers don't let the money their policyholders pay them gather dust in a vault.
as a general rule of thumb, insurance companies can expect to pay out around 60% of premiums in current claims.
whatever's left of the remaining 40% after business costs have been covered gets invested.
these investments are usually pretty conservative — government securities, for instance, rather than property speculation.
even so, returns on such investments can account for around a quarter of an insurer's total income.
that can make the difference between profit and loss.
for example, imagine you pay $9,000 in premiums over a period of 10 years.
in the 10th year, you suffer $10,000 in property damages, which the insurance company quickly pays out.
that could be a loss.
but if the $9,000 you paid in premiums has been invested and has grown to $12,000 by the time you file your claim, the company has come out $2,000 ahead.
final summary#
Conclusion
you've just listened to our chapter to basic economics by thomas sowell.
the key message here is that economics can be an accessible discipline that does not require complex mathematical formulas, but rather common-sense understanding of incentives and consequences.
for everyday economic decisions, remember that prices aren't arbitrary numbers, but instead signals conveying all sorts of information about scarcity and value, which then guide resources toward their most valued uses.
understanding this, you may begin to develop informed opinions on economic policy matters, be it local regulations, insurance policies, or smart investments.
then, with this knowledge at your disposal, you should feel empowered to make better decisions as a consumer and understand your unique role in the economy.
that's it for this chapter.
thanks so much for listening.
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see you in the next chapter!
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