What Is An Economy?
While it seems like a simple and almost condescending question, it’s important to remind ourselves of the fundamentals.
An economy forms when groups of people leverage their skills, interests and desires to trade with each other. People trade to make themselves better off by getting what they need and want.
Individuals are financially rewarded based on the value others place on their productive outputs. The more I value what you bring to trade, the more I will give you for it with what I have to trade.
Over time, money is introduced to make trade easier. It is crucial to constantly remind yourself that money is only worth the value of the goods it substitutes for.
If I trade you apples for bananas, you don’t have to figure out how many apples a banana is worth. Or for the next person in line, how many carrots a banana is worth.
If we use money, I still must produce apples (or something else of value to someone else) to get the money to buy your bananas. You must trade with someone else willing to take that paper to get my apples (or something else of value to them from me). The pieces of paper are simply a promissory note to get apples from me.
Otherwise, the paper, metal, rocks or sticks we use as money are worthless. Foreign trade is no different than domestic trade. (For more, see our primer on trade.)
People tend to specialize in those things in which they are most valuable. The total sum of these productive efforts is referred to as an economy.
What Makes Economies Grow?
A worker is more productive (and worth more) when he or she can more efficiently turn resources into valuable goods and services. This could be everything from a farmer improving crop yields to a hockey player selling more tickets and jerseys. When a whole group of economic actors can produce goods and services more efficiently, it's known as economic growth.
Growing economies turn less into more, faster. This surplus of goods and services raises the standard of living. This is why economists are so concerned about productivity and efficiency. It's also why markets reward those who produce the most value in the eyes of consumers.
There are only a handful of ways to increase productivity. The most obvious is to have better tools and equipment — which economists call capital goods. The farmer with a tractor is more productive than the farmer with just a small shovel.
This is also why employment in a particular industry is a bad measure of economic growth since it takes more people to farm a field with shovels than a tractor.
Innovation that initially reduces jobs creates more profit. Whether the farmer (or company) reinvests that profit in its business or puts it in a bank for others to invest, ultimately more jobs are created.
It takes time to develop and build capital goods, which requires savings and investment. Savings and investment increase when present consumption is delayed for future consumption. The financial sector (banking and interest) provides this function in modern economies.
The other way to improve productivity is specialization. Workers improve the productivity of their skills and capital goods through education, training, practice and new techniques. When the human mind better understands how to use human tools, more goods and services are produced and the economy grows. This raises the standard of living.
The economic growth of a country is the increase in the market value of the goods and services produced by an economy over time.
Why is Economic Growth Vital?
Growth is one of the most important indicators of a healthy economy. One of the biggest impacts of long-term growth of a country is that it has a positive impact on national income and the level of employment, which increases the standard of living. As the country’s GDP is increasing, it is more productive which leads to more people being employed. This increases the wealth of the country and its population. All things being equal, the faster the economy grows, the richer the country gets.
Higher economic growth also leads to extra tax income for government spending, which the government can use to develop the economy. This expansion can also be used to reduce previous spending made to grow the economy. Additionally, as the population of a country grows, it requires the growth to keep up its standard of living and wealth.
Economic growth also helps improve the standards of living and reduce poverty, but these improvements cannot occur without economic development. Economic growth alone cannot eliminate poverty on its own.
The fundamental nature of economic activity only differs from place to place based on the restrictions placed on economic actors. The economy of North Korea is very different from South Korea, despite a similar heritage, people and set of resources. It's public policy that makes their economies so distinct.
What Can Governments Do?
Free Markets: Let individuals make economic decisions, so the laws of supply and demand provide the basis of the economy. Understand that not every individual decision is wise, but in aggregate, all the individual decisions lead to the right outcome. Don’t protect people (or especially companies) from the consequences of their decisions.
Rule of law: Property rights must be enforced. Individuals will not take the time, effort and energy to build something if someone else can take it. Contracts must be enforceable.
Regulation: Trust is vital in a market. Cheaters and scammers must be deterred and punished.
Training: A skilled labor force has a significant effect on growth since skilled workers are more productive.
Infrastructure: Businesses need electricity, water, ports, and roads.
Wise redistribution: Marx is a terrible prescription for the ills of markets, but a wonderful diagnosis of the main problem. Without wise redistribution, capital will end up in the hands of very few. Healthy economies need genuine competition, and that doesn’t occur if a handful of conglomerates dominate most markets. They also need a middle class with purchasing power.
However, the government cannot give to anybody anything that the government does not first take from somebody else. What one person receives without working for, another person must work for without receiving. Redistribute too much, and the productive stop working.
Small Government: Government is a giant pot of other people’s money. Like flies to honey, it attracts freeloaders. Whether dictatorship or democracy, governments are prone to distribute that money in ways that are politically expedient (reward friends and punish enemies) rather than making the best investments to grow the economy. Vast bureaucracies invest in themselves rather than fixing the problems they were created to deal with. The more money the government has, the greater that danger.
Six Factors that Limit Economic Growth
1. Poor health and low levels of education
People who don’t have access to healthcare or education have lower levels of productivity. This means the labor force is not as productive as it could be, so the economy does not reach its potential.
2. Lack of necessary infrastructure
Developing nations often suffer from inadequate infrastructures such as roads, schools, and hospitals. This lack of infrastructure makes transportation more expensive and slows the overall efficiency of the country.
3. Weak Law
Property rights must be enforced. Contracts must be enforceable. Individuals must be rewarded with the fruits of the their labour.
4. Flight of Capital
If a country is not delivering the returns expected from local investors, they will take their money out of the country to find higher rates of returns (or less risk.)
5. Political Instability
Political instability in the government scares investors and hinders investment. Zimbabwe had been plagued with political uncertainty and laws favoring indigenous ownership. This instability has scared off many investors who prefer smaller but surer returns elsewhere.
6. Bad Trade Deals
Genuine free trade is a boon to all. That’s not what any of the world’s existing trade deals are.
A full discussion goes beyond the scope of this. But, a true free trade deal is simple, since if we agree to open our markets to each other, there’s little to supervise.
So, if a trade deal is more than about 10 pages, or requires huge bureaucracies to manage, it’s not free trade; it’s managed trade that advantages some and disadvantages others. And note that not all of the disadvantaged are “the other side.“ Again, governments tend to reward friends and punish enemies. Affects the developed and developing world equally.