Economic analysis can be useful for investors, business, and government policy makers. Yet, economic concepts can seem complex because of all the bars, charts and technical jargon involved. Naked Economics explains powerful economic concepts in layman terms, helping us to understand the fundamentals of the economy at work. In this Naked Economics summary, we’ll give a brief synopsis of some of the key economic concepts and fundamentals in the book including:
• How Markets Work
• The Use of Incentives and Disincentives
• The Roles (and Inefficiencies) of Government
• The Economics of Information
• Human Capital
• Financial Markets (including financial instruments and investment principles)
• Politics, Economic Indicators and Globalization
There are 2 key assumptions which explain pretty much how the world works, and why market mechanisms are so powerful.
Assumption 1: Individuals Act to Maximize Utility
People act to make themselves as well off as possible, i.e. they maximize their utility. The meaning of “utility” however varies from person to person. A key message here is: it does not make economic sense to impose our preferences on others. For example, someone in a developed country will see the issue of deforestation very differently from the villager who is cutting down a tree to pay for food and medication for his sick and starving son.
Wheelan also explains how we make decisions with imperfect information, weigh trade-offs, and define “cost” (which is more than just cash). Generally, when costs decrease, we consume more of something and vice versa.
2. Firms Act to Maximize Profits
“Firms” can refer to a person (e.g. a doctor, artist) or a multinational company. The second economic assumption is that firms aim to maximize profits (i.e. revenue less costs). Individuals will go where they are paid the most for their talents, and firms will do businesses that make them the most money in the long run. Wheelan explains how entry barriers and prices influence behaviours.
How the market works
The 2 assumptions above explain more or less how the world works:
• The market economy can make our lives better, because the only way firms make profits is by delivering what we want to buy.
• Prices are used to allocate scarce resources, based on who is willing the pay the most (in terms of money, time etc.).
• Every market transaction makes all parties better off. However, since we define utility differently, we may not always understand the choices made in other parts of the market.
People react to incentives and disincentives. The right incentives align the interests of various parties so they act towards a common desired outcome.
Good government is essential to a strong, productive market while poor government can lead to the demise of an entire economy.
The Government Can be Your Friend
• Legal Frameworks. Governments set the rules, without which countries and markets cannot function. This includes defining and protecting property rights, and lowering the cost of doing business.
• Correcting Externalities. An “externality” is the gap between the private cost and the social cost of a specific behaviour (e.g. littering, drunk-driving, smoking etc.). When the gap is large, individuals tend to do things that make them better off at the expense of others.
• Public Goods. Governments raise our collective utility by providing public goods (e.g. parks, law enforcement, lighthouses) that we can’t purchase for ourselves, and wouldn’t otherwise be provided by the private sector.
Government involvement can generate negative outcomes
While good government is essential for markets to function, some government activities are less effective and may even generate negative outcomes. These include the limitations and potentially-adverse impact on wealth distribution, resource allocation, restrictions from regulations and setting the “right” level of taxes. Do get more details on each of these elements from the book or our full book summary.
In economics, the bars and charts are often drawn with the assumption that all parties have perfect information. In the real world, no one has perfect information, and we make decisions with and without them. Part of economics is understanding how people acquire information, how they use it and how they make decisions. In the book / full summary, we elaborate on how people make decisions when they lack information, why knowledge offers a real economic advantage and why brands have an economic value.
PRODUCTIVITY AND HUMAN CAPITAL
Human capital is the combination of the skills in a person, including education, work experiences, charisma, vigor, talents etc. Resources invested in human capital today will yield a return in the future, and historically, the pie has been growing, with more jobs being created than lost. Find out more from the book / full summary about how investments in human capital can lead to better quality of life and a larger pie in the long run.
Financial markets function like all other markets – capital flows to where it can earn the best return, given available information.
Financial Instruments & Investment Principles
All financial instruments are built on 4 basic needs – to raise capital, protect/ grow wealth, insure against risk, and speculate.
In the book and complete summary, we touch on these 4 factors, including Wheelan’s 4-point investment principles to help you get predictable returns on your investment. His advice to the average investor is this – you can’t beat the market and you shouldn’t try, and he explains why in the book.
THE POWER OF ORGANIZED INTERESTS
Despite our growing knowledge about public policy, good policies often don’t get implemented due to politics and interest groups. Generally, interest groups lobby for what they want (e.g. subsidies, tax breaks) or what they don’t want (e.g. protection from new technologies and international trade).
When it comes to interest group politics, it’s better to be small – the favours given by the system is spread over a small number of people (making it more lucrative for each one), while the costs are spread over a large number of people (making it smaller, less painful and less prone to resistance).
ECONOMICS AND ECONOMIC INDICATORS
• Key Economic Indicators. To measure economic progress, we need to first define “progress”. The book covers many economic indicators, and we zoom in on a few key indicators in our full summary, including Gross Domestic Product or GDP (which measures a country’s production), unemployment (the percentage of workers who want to work but can’t find jobs), cost of living (the time we must work, in order to live), budget deficit/ surplus (how much the government is spending relative to what it collects), and current account surplus/ deficit (how much we earn from the rest of the world relative to how much they earn from us).
• Recessions. All major economies, be it rich or poor, tend to move through cycles of recession and recovery. Recessions usually (i) stem from a shock to the economy (e.g. collapse of stock market or property bubble), and (ii) involves more than 1 cause. The sustained drop in income makes people spend less, which spreads the economic damage to other markets. In the book / full summary, we take a look at how recessions work, using the 2007 recession as an example.
• The Federal Reserve. The US Federal Reserve (“the Fed”) controls the money supply and the credit tap for the US economy. It affects not only the US economy but the global economy. In the book and complete 12-pg summary, you’ll get a great overview how economic tools like interest rates and monetary policy work, and how the government can use fiscal policy and monetary policy to stimulate the economy.
• Currencies and Exchange Rates. Changes in exchange rates make foreign goods cheaper or more expensive. There’s nothing inherently good or bad about a strong or weak currency, since an undervalued currency promotes exports and a stronger currency increases purchasing power. The book explains different ways to value currencies against one another, including the Gold Standard, floating exchange rates, fixed exchange rates, and pegging your currency to another currency.
TRADE AND GLOBALIZATION
Finally, in the book and our full summary, we look at the various economic bases upon which international trade is built. Wheelans shares why global trade benefits all countries in the long-run (as opposed to protectionism, which creates the opposite effects).
OTHER DETAILS TO LOOK OUT FOR IN THE BOOK
The book is US-centric, focusing mainly on examples in America. Wheelan uses cases studies and examples to show economic concepts and principles at work, e.g. in free trade agreements, smoking campaigns, online job creations, healthcare and insurance, conservation efforts, and even daily behaviours like whether we clean up after our dogs in public places. Do get a copy of “Naked Economics” for the full details, or get a detailed overview with our Naked Economics summary bundle!
Deepen your understanding of economics and how the world works with these resources!