BREXIT and Economics

Since BREXIT has been such a hot news item this past week, I decided to take a one-week hiatus from the economics tutorial series to address this important issue briefly. This is an economics blog, so I am going to deal primarily with the economics of BREXIT, especially as it impacts you.

The European Union (EU) is made up of almost all European countries–28 of them. The United Kingdom (UK), including England, Scotland, a small part of northeastern Ireland, and several small islands, joined the European Economic Community (EEC) in 1973. The EEC became the EU in 1993. The BREXIT, or British Exit, movement began several months ago as much of Britain’s populous became disenchanted with the policies of the EU. Although membership in the EU is mostly for economic advantage, the opposition in the UK has been primarily political. Over the years, the EU placed increasing restrictions on member countries, gained more control over business standards, brought open borders to the entire continent, and levied burdensome taxes and fees. This has fostered a nationalist fervor among some nations, and they are beginning to reject these constraining mandates. The UK is the only place where this growing isolationist attitude has resulted in a formal vote of the people to withdraw from the EU. Britain has now severed its ties with the EU and is claiming independence from mainland Europe. Again, most of the rationale is political rather than economic. However, the EU’s main objective is economic cooperation among members, and BREXIT will have an economic impact.

The economic impact will be a reduction in international trade with other European countries. The UK currently sends over 50% of its exports to its European neighbors. Major exports from the UK include automobiles, petroleum, machinery, and pharmaceuticals. Of course, these won’t just dry up, but, without the EU ties, they will certainly suffer loss. Likewise, the UK’s needed imports from neighboring countries will be more expensive and even more scarce without the EU membership trade agreements.

One of my recent posts was about how a nation determined what to produce. You may want to review that post. Comparative advantage is a major factor in what a nation produces and markets. It will be to its advantage to produce what it has most resources for and can do most efficiently. If the UK were best at producing refined petroleum, and Germany were best at producing trucks, then they should trade those items with each other. The UK could produce the petroleum it needs plus a large amount for export to Germany, Germany could buy the petroleum more cheaply than producing it themselves. Similarly, if Germany could produce all the trucks it needed plus a large number for export to the UK, the UK could buy the trucks more cheaply than producing them domestically. That is why global trade is so important for the benefit of all countries. With BREXIT, the UK has chosen to accept less economic advantage in trading with the EU countries. There will be higher tariffs and more trade barriers between the UK and its European trading partners. That will obviously be an economic minus for both the UK and the rest of Europe. But, what will it mean for America, and you?

The UK is the seventh largest source of imports for the US. We import about $59 billion each year from them including automobiles, machinery, petroleum, and pharmaceuticals. Import prices will likely rise, since they will have to make up for lost revenues from the EU. However, that may be offset by the weaker pound (the UK never adopted the Euro). In other words, the dollar will be worth more in the UK. Our exports to the UK such as aircraft, chemicals, and automobiles currently amount to about $56 billion each year. We are their fourth largest supplier of imported goods. The stronger dollar relative to the pound will be to our advantage there also. Plus, they may need more goods and services from America as their trade with Europe becomes more complicated. The bottom line is that America stands to gain from BREXIT in the long run. Then, why did our stock market react so negatively?

A key economic principle that we have to be constantly aware of is volatility. Any time the domestic or global market hiccups, any time there are surprises or unknowns, there will be short term volatility. Particularly since this vote was such a surprise to the world, lots of questions about various ramifications have begun to circulate. Investors tend to run to safety and drop any risky investments when the unexpected happens. Stocks fall as investors seek refuge in bonds, gold, etc. This will probably play out over time, and stability will return. In the meantime, we should look to craft more bilateral agreements with England and solidify our economic partnership with them.

The politics of BREXIT will be all over the map, especially in the election year as the two presidential candidates and each of their parties will try to use the upheaval to their advantage. But, the economics of it will likely settle out after a few months and may ultimately be a positive move for America. You may actually gain personally from the UK’s return to a more nationalistic economy. So, go ahead with your plans for buying that 2017 Jaguar!

My next post will take us back to the basics of supply and demand. Don’t miss it.

 

 

 

Demand and Supply Determines Price and Quantity

Why is chicken $.98 per pound, while rib eye steak is $7.99 per pound? My water from the sink tap is about $1.50 per 1000 gallons, but the 16-ounce  bottle of water I bought at Disney World was $3.00. A $200,000 house in my town of Hot Springs, Arkansas, would cost about $2 million in Beverly Hills, California. What?!

It’s all about economics. The most fundamental principle of economics is demand and supply. Sure, you’ve heard and read that, but what does it mean exactly? How does it work? Well, first we have to understand how the consumers’ demand for a product or service and producers’ supply of that product or service together determine the price paid and quantity purchased. The more buyers want something, the more they will pay for it. Similarly, the more suppliers receive for something, the more of it they will produce. You’re thinking, “duh,” but take a moment to really consider that principle and let it sink in. Understanding the more intricate aspects of economics requires you to have this basic concept down very clearly. Here is the first and most elementary graph an economics student has to be familiar with:

First, a few points about graphs: A graph is simply a depiction of the relationship between one set of data (horizontal, or X, axis–in this case, Quantity) and another set of data (vertical, or Y, axis–in this case, Price). Those relationships are marked by dots connected by lines we call curves (although they are not always curved). In this example the curves are linear and, therefore, straight for simplicity. Note that the graph shows that 400 slices of pizza would be sold (quantity demanded) if the price were $2.00 (see the dot at the intersection of 400 and $2.00). However, if the price were reduced to $1.00, customers would buy 800 slices. The supplier (pizza store owner), on the other hand, is only willing to make and sell 400 pizza slices at $1.00, but would make and sell 800 slices at $2.00 per slice. So, at the $1.00 and $2.00 prices, the supplier loses a lot of sales, and not many consumers get to eat pizza. For instance, at the price of $1.00, the supplier will only make 400 slices for 400 consumers, and the other 400 consumers who would have bought slices at $1.00 have no pizza. The demand curve shows an “inverse” relationship, since the lower the price, the more the quantity. The supply curve shows a “positive” relationship, since the higher the price, the more the quantity. The demand curve always slopes downward, while the supply curve always slopes upward. Make sure you can see and understand this before going further.¬† Understand, the curves are not driving anything; they just provide a picture of all relationships between price and quantity demanded or purchased.

It is obvious from this graph that the only way the supplier and consumers will come together to maximize their desires is to agree on one price and one quantity that they can both live with. Can you see where they came to an agreement at 600 slices produced at a price of $1.50? It is where the two curves intersect. That became the price that the supplier put in his menu, and he is satisfied to sell 600 slices per day at that price.

But, how do we determine the quantity and price relationship? How do we know that 1200 slices wouldn’t be purchased at $1.00 instead of 800 slices? Good question. When a new product or service is introduced into the economy, lots of marketing research or trial marketing is conducted. Usually, before anything hits the market, the supplier has tested the market to determine what most potential buyers will purchase at what price. This testing results in a schedule of buying behaviors that form the demand curve. In the example above, the research and testing had shown that the supplier would sell 1,000 slices of pizza if he only charged $.50 per slice, but a few buyers would pay as much as $2.50 for a slice–200 buyers in this case. The supplier knows he would be willing to make 1,000 slices if he could get that $2.50 per slice, but that would be producing 800 more than he could sell.

The point where the supplier and the consumer agree on a reasonable price for a reasonable number of sales (in this case $1.50 per slice at 600 slices) is called the “equilibrium price.” Everything you spend money on, from pickles to pedicures, from hoses to houses, from dogs to doctors, you pay an equilibrium price that has been negotiated between the suppliers of those things and the consumers of which you are one. The price is the point where willingness to sell meets willingness to buy. This is how the free market economy arrives at prices in most cases.

Next week, we will dig more deeply into demand and supply and address some questions still hanging from the first paragraph in this post. Click “Follow” on this page to ensure that you don’t miss the next post. Become a classmate with those who follow each post.

 

How Do We Decide What to Produce?

“I can’t do everything!”

How many times have you thought or said that when frustrated that you had too many demands on your life and not enough time or resources? We all have to set life priorities according to what we can do best and need to do most. Our economy has the same frustrations and has to set priorities according to “comparative advantage.”

Comparative advantage, as it relates to a nation’s production possibilities, just means that we must produce what we are best at producing and need most. This takes into consideration such things as domestic resources, skills, labor availability, transportation options, and levels of demand. Because our wants will always exceed our abilities to produce, we have to decide what goods and services we want most and can produce most efficiently. Then, we sacrifice those less desired and least efficiently produced goods and services to other sources.

Looking at production decisions from a national perspective, we must determine what we can do more efficiently and economically than other nations. Then we allow other nations to produce what they can more efficiently and economically than we can. I use the following illustration with my students to simplify this concept.

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A country can produce both guns and butter. A gun is valued the same as a pound of butter. According to the graph, the country can produce 1000 pounds of butter if it produces no guns. Or, it can produce 200 guns if it produces no butter. Therefore, it sacrifices the production of five pounds of butter for each gun it produces. So, it is obviously better at producing butter than guns. It takes the same amount of resources to produce one gun as it does to produce five pounds of butter. This is perhaps due to more agricultural capability and resources than manufacturing capability and resources. The country can produce a mix of both guns and butter anywhere along the red curve. It’s always a five to one trade-off. For instance, it can produce 180 guns if it produces only 100 pounds of butter (giving up 900 pounds of butter). But, it can produce only 20 guns if it produces 900 pounds of butter (giving up 100 pounds of butter). I hope you can see that, no matter what mix of production the country chooses, it loses more proportionally when it produces guns than when it produces butter. So, the country’s comparative advantage is in producing butter. The country now has to determine how much it needs guns to be produced domestically and how many guns it could import from another country that has a comparative advantage in producing guns. It might do well to produce most of the world’s butter and let other countries produce its demand for guns. Although oversimplified, that is the concept that drives international trade.

America’s industries rely on this concept when deciding what to produce. Think about what our national comparative advantages include. We are the predominant builder of the world’s aircraft. We build most of the world’s heavy equipment. We produce most of the world’s movies, music, and other entertainment. That is because we have the raw materials, labor, technology, and infrastructure to produce these things more efficiently. In doing so, we have sacrificed the production of other things. Not long ago, we produced the most automobiles, but not any more. Once, we were the breadbasket of the world producing the most food, but China and India now have a slight advantage overall. Over a period of time, industrial leaders decided that we needed to concentrate on building more jetliners and let other countries build most of the home appliances.

America has in recent years transitioned toward a service economy in its comparative advantage. We have become the “go-to” nation for financial, business, and professional services around the world. Our educated and technology-savvy workforce has become better at advisory and solution services than at actually making things.

I know you hear a lot about America losing its commerce to foreign countries. There are lots of reasons for that, but the main reason is that other countries have made gains over us in several areas of comparative advantage. However, just bringing certain production back into our country won’t necessarily change the comparative advantage. Unless we gain back that advantage–more economical labor, resources, technology, etc.–the economy will not sustain reinstated domestic production in the long term. We are partners in a global economy whether we like it or not. The future of America’s economy will largely depend on maintaining vital raw materials, ensuring reasonable labor costs, advancing technology, and upgrading our nation’s infrastructure. Watch with interest as these factors are debated in this election year.

Next week, we will look at the fundamentals of how prices are determined by demand and supply. Click “Follow” on this page to ensure that you don’t miss the next post.

 

 

 

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