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December 1998
Why Johnny Can't Choose
And what Johnny (and Jane) needs to know to understand the economy
David S. Dahl
Public Affairs Economist
Federal Reserve Bank of Minneapolis
Several years ago a study titled "Why Johnny Can't Read" raised
public awareness of illiteracy. Similarly, to raise public awareness
of economic literacy, the National Council on Economic Education
will kick off a major economic literacy campaign early next year
with the release of an extensive national survey; this follows
the Council's 1992 survey which indicated that only 39 percent
of the general public gave the correct answers to several questions
about economic fundamentals. The Minneapolis Fed's own national
survey, conducted in fall 1998 and reported in these pages, shows
similar results, with 45 percent responding correctly overall.
Because the essence of economics is understanding the choices,
or trade-offs, arising from allocating scarce resources, the question
follows: "Why can't Johnny choose?"
What is Economic Literacy?
Scarcity is a fact of life. People's wants exceed the resources
to fulfill them. Even when there are sufficient resources to meet
basic physiological needs, people must choose which other wants
they will meet—with the resources at their disposal—and
how they will do so. Moreover, each individual in society has
a set of needs and wants that differs from that of other persons.
Thus, deciding which resources are to be used to meet which people's
wants is a complex task. Economics is the study of how individuals
and societies make such decisions.
Implicitly or explicitly, any society has to answer three fundamental
questions: What goods and services are to be produced, how are
they to be produced, and who will get the final output? Answering
these questions forces society to make choices and face trade-offs,
again, either implicitly or explicitly.
Different societies answer these questions in different ways.
Many countries have chosen to allow markets to answer many facets
of resource allocation. Interaction between supply and demand
results in prices that send signals to both producers and consumers.
But in these countries, government also plays a role in defining
property rights, establishing a legal system to settle disputes
and fostering institutions, such as central banks, to help markets
work efficiently. In these market-oriented economies, governments
also transfer income and supply public goods and services ranging
from provision of national defense and police protection to roads,
education and health care. There is variation, though, in the
level of government transfers and the provision of public goods,
with a smaller role in the United States relative to many European
countries.
For much of this century, communist countries made government
the primary mechanism for resource allocation, with the state
exercising a command and control function over all-important production
and consumption decisions. Many noncommunist developing countries
also created a large role for the state in resource allocation.
Such command and control systems have largely collapsed in failure,
and the debate is now about the degree and effectiveness of government
action within a market-oriented economy rather than a stark choice
of state vs. market.
The move to market-oriented economies has not been easy for
many countries, which highlights the importance and difficulty
of developing legal systems and economic institutions that foster
and facilitate private markets. Implementing such systems and
institutions is a formidable task in nations that previously rejected
markets.
To make sound decisions as individuals and as citizens, people, regardless
how developed their economies, need to understand the advantages and disadvantages
of a market-oriented system, and the choices or trade-offs arising from
allocating scarce resources. Thus, to function in societies, people should
be economically literate. To evaluate trade-offs and reason economically,
people must grasp six key concepts.
1. There is No Such Thing as a Free Lunch
People and societies face trade-offs. To obtain something they want, people
have to give up something in return, and what they give up is known as
the opportunity cost. Individuals face numerous trade-offs, from such
mundane choices as whether to attend a ballgame or a movie, to more important
choices, such as how much income to spend vs. how much to save. An important
trade-off a high school senior faces is whether to go on to college. The
opportunity cost of pursuing a college degree is not only the expenses
for books and tuition but also the income the student would forego while
attending college.
Societies or nations also face important choices. Markets on
their own may have undesired outcomes or result in misallocated
resources. For example, governments must decide how to redistribute
income to alleviate poverty, as well as determine the level and
mix of public goods, such as national defense, education, public
safety and other programs.
2. Thinking Incrementally
Recognizing trade-offs does not in itself tell us what choice
to make. Assuming (as economists do) that people behave in their
own best interests, then incremental thinking—that is, marginal
analysis—leads to the right decision. For example, you and
two friends pay $10 to attend a movie on Friday evening that the
critics gave five stars. Forty-five minutes into the movie you
all agree that the film doesn't even rate one star. One friend
wants to leave and go to your house and play pool, but other friends
argue that you should see the rest of the film because you have
paid for it. They turn to you to resolve their dispute, and it's
an easy decision—you favor going to play pool.
On the way to your house, you explain to your friends how marginal
analysis led to your decision. In this situation, it was how to
spend the rest of Friday evening after you had already started
watching the movie. Once you started watching the movie, the cost
of a ticket was what economists call a sunk cost; that is, it's
an outlay that once made cannot be recovered. The trade-off you
faced was spending another hour and one-half watching a boring
movie or playing pool.
In addition to keeping sunk costs from distorting your decision,
you explain that marginal analysis means that decisions are reached
by weighing additional costs against additional benefits. In this
case, the benefit of playing pool is greater than the benefit
of watching the rest of the movie. So, despite the fact that you
had spent money and time watching the movie, your best choice
was to play pool. If you had let sunk costs (that is, the money
and time spent watching the movie) dictate your decision, you
would have spent the hour and one-half in a less gratifying activity.
While marginal analysis can be used to salvage an evening on
the town, it also guides businesses to maximize profits. A business
will continue to expand sales and output to the point that the
incremental cost of providing the particular good or service equals
the price of that good or service.
3. Markets Coordinate Consumption and Production
Market-determined prices—that is, prices determined by producers
and consumers acting in their own best interest—are the signals
that help define the trade-offs we face and that ultimately lead
society as a whole to allocate resources efficiently. Understanding
how changes in supply and demand affect prices is an important
component of economic literacy. When a prospective college student,
for example, contemplates majors, she might speculate about where
demand for workers is increasing fastest, because wages and job
opportunities will probably be greatest in those occupations.
When prices change then trade-offs change, and people's decisions
change. Our college student might discover, for example, that
the demand for software engineers has increased and, subsequently,
that wages for those jobs have also risen. Also, many public policy
decisions, such as changes in the tax code, involve changing incentives
with the hope of changing behavior.
Many times people are unhappy with the prices that markets produce,
but an economically literate person realizes that prices are important
signals that reflect underlying changes in supply and demand.
Consumers and producers respond to these signals in ways that
make society better off. For example, as gasoline prices rose
dramatically in the 1970s due to supply disruptions in the Middle
East, consumers reacted by driving fewer miles, and U.S. oil producers
had an incentive to increase production. Subsequently, oil prices
declined over time. When governments interfere with these market
adjustments, society is usually worse off. Recall that as gasoline
prices first rose in the 1970s, the U.S. government attempted
to control prices. So instead of energy conservation and increased
production, we got shortages, long lines at gas stations and a
more serious disruption in economic activity than otherwise.
4. Relative Price Changes Guide Decision-making
For prices to play this coordinating role, people must be able
to distinguish relative price changes from changes in the overall
price level. To examine how a particular price change alters the
trade-offs, it must be abstracted from an overall change in prices.
Suppose cost of a college education has risen from $5,000 to $10,000
during the last five years. The nominal increase would be 100
percent. But if overall prices had risen 50 percent, the purchasing
power of the dollar would have dropped. Thus, inflation accounts
for half of the $5,000 increase, and the other half would represent
a real increase in the cost of a college education.
Price stability—that is, an economy without inflation or
deflation—gives people the ability to distinguish between
relative and overall price changes, and price stability is generally
determined by the money supply. Given that central banks control
the money supply, part of economic literacy is understanding how,
and to what end, central banks control the money supply.
5. Trade Promotes Growth
Trade is an engine for economic growth because it enables an economy
to take advantage of specialization, and increases and improves
the trade-offs confronting society. Along with the "invisible
hand," Adam Smith saw how the division of labor, that is, specialization,
increases the wealth of nations. He visited a pin factory and
found:
One man draws out the wire, another straights it, a third cuts it,
a fourth points it, a fifth grinds at the top for receiving the head;
to make the head requires two or three distinct operations; to put it
on, is a peculiar business, to whiten the pins is another; it is even
a trade by itself to put them into the paper; and the important business
of making a pin is, in this manner, divided into about eighteen distinct
operations, which, in some manufactories, are all performed by distinct
hands ... I have seen a small manufactory of this kind where ten men
only were employed, and where ... each person ...(averaged) four thousand
eight hundred pins a day. But if they had all wrought separately and
independently, and without any of them having been educated to this
peculiar business, they certainly could not each them make twenty, perhaps
not one pin in a day.
Having established a specialty in the manufacture of pins, a nation would
then have to establish a trading relationship with another country that
specialized in some other product; without trade, the benefits of specialization
cannot be realized. It may be to the advantage of that country to specialize
in pins even if other countries can produce pins at a lower cost, if the
first country can produce pins more efficiently than it can produce other
goods; that is, it has a comparative advantage. Quite simply: "Each producer
has a 'comparative advantage' in doing what it does best—and trading
for the rest," wrote Leonard Silk, former New York Times
business writer.
Specialization allows a person, business or nation to specialize
in those endeavors that they do best, instead of striving for
self-sufficiency. This benefits us in two ways: First, a greater
variety of goods and services are available; and second, they
are available at a lower cost. Between 1960 and 1995 world exports
rose at a 6.1 percent annual rate and world output advanced 3.8
percent. "This growth of trade has led to wider competition, allowing
countries to benefit from their comparative advantage and raising
living standards everywhere," according to the 1997 Economic
Report of the President.
6. Markets Can Fail
Although many decisions in a market economy occur in private markets,
government has a role, and being able to evaluate whether or not
government should intervene in the economy is another element
of economic literacy. For markets to function properly, governments
must define property rights and make contracts enforceable.
But it may also be necessary for government to intervene if
markets are allocating goods and services inefficiently, in other
words, if there is a market failure. In some markets, either the
buyer or the seller may have incomplete information that distorts
the trade-offs confronting them; for example, the government may
require certain labeling disclosures on food products to help
consumers make choices. Antitrust laws are intended to keep producers
from restricting output and charging higher prices than would
be set in perfectly competitive markets.
Left alone, markets may produce too few or too many particular
goods. The justification for many of the goods and services that
government provides is that provisions would be inadequate if
left to the markets alone. That's why the government provides
public goods and services ranging from provision of national defense
and police protection to roads, education and health care. In
other instances, markets may fail to consider the cost imposed
on third parties; for example, market prices may not reflect the
costs imposed by air pollution (when the affected parties cannot
easily negotiate an agreement), and it may be necessary for the
government to intervene.
Besides correcting market failures, governments have a role
in guaranteeing a socially acceptable distribution of income.
Markets compensate people according to their ability to produce
goods and service that others will purchase. They do not secure
for everyone adequate food, clothing, shelter, health care and
so on, thus the justification for a progressive income tax and
government assistance programs.
Moreover, because of government's large relative share of economic
activity, it has a big impact on overall economic performance.
Therefore, another aspect of economic literacy is to understand
government's role in dealing with economic fluctuations and growth.
To acknowledge that government in some instances can improve
market outcomes does not necessarily imply that government always
does improve them. Public policy is often far from perfect—as
noted in the above example regarding 1970s gasoline prices. Sometimes
policy is made with incomplete knowledge or to reward the politically
influential. Thus, an aim of economic literacy is to teach people
how to ascertain when a government policy will improve market
outcomes. That doesn't mean that economically literate people
will necessarily agree on outcomes or policy, but at least they
will understand the choices and trade-offs they are making.
Underlying these six concepts are the 20 Voluntary
National Contents Standards in Economics that were prepared
under the leadership of the National Council on Economic Education.
These concepts, however, cannot be applied in a vacuum. To reason
economically, a person also needs an understanding of history,
current events, politics and statistics.
Students and others make economic decisions without mastering
these six concepts and, for the most part, they make the right
decision because they act in their best interest. So why is economic
literacy necessary? Economic literacy sharpens their analytical
skills. As people advance in life, the trade-offs they face become
more complex, and the more economics they know, the better decisions
they will make—including those in the voting booth. Many
public policy issues involve trade-offs, so responsible citizenship
requires economic literacy.
How Economically Literate are People?
To try to answer the above question, the Federal Reserve Bank of
Minneapolis commissioned a national telephone poll that was conducted
in September and October 1998 by the Minnesota Center for Survey
Research at the University of Minnesota. Four hundred four randomly
selected adults from throughout the United States were asked 13
questions designed to test their understanding of economic literacy.
The average score was 45 percent, which reveals some understanding,
also suggests a need for improvement. (The entire
survey, which has a sampling error of plus or minus 5 percentage
points, follows this article.)
The Minneapolis Fed's 13 questions were based on the six key
concepts of economic literacy described in this article. For example,
as discussed earlier, the basis for much of economic reasoning
is that people and societies face trade-offs. Yet only 28 percent
and 19 percent of those surveyed, respectively, answered correctly
the questions that deal with this concept (questions 2 and 3).
Respondents did only somewhat better when asked about the role
of government in the economy (questions 10, 12 and 13). Only 38
percent got the right answer to the question dealing with incremental
thinking (question 9).
Questions 5 through 8 of the survey ask how markets coordinate
consumption and production, and 46 percent on average answered
correctly. Respondents got a 60 percent score when asked about
trade promoting growth (questions 1 and 4). Ninety percent, however,
got the right answer to the question about relative prices guiding
decision-making (question 11).
What do Economic Surveys Mean?
Going back to the 1960s, tests similar to the Minneapolis Fed's recent
poll have been used to measure economic literacy. The latest was in 1992
when the National Council on Economic Education and The Gallup Organization
surveyed high school seniors, college seniors and the general public.
"When asked questions about fundamental economics, only 35 percent of
high school students, 39 percent of the general public, and 51 percent
of college seniors gave the correct answers," according to the poll. The
National Council is set to release the results of a new national poll
in early 1999.
While these economic literacy tests provide useful information,
they do have their critics. Writing in the Journal of Economic
Perspectives about a 1988 Test of Economic Literacy (TEL),
Julie A. Nelson and Steven M. Sheffrin say: "To put it baldly,
the test promotes a Panglossian microeconomics ..." Moreover,
with a subject as complex as economics, it is difficult to determine
a person's understanding with just a few questions.
Nevertheless, William Walstad, one of the authors of the 1992
survey, later used its results to conclude: "Economic knowledge,
whether measured by an overall score or by knowledge of a specific
question, may be the most critical factor determining public opinion
on economic issues, perhaps more important and more consistently
influential than other personal characteristics such as age, sex,
race, education, income or political party."
Given the importance of economic literacy and the acknowledged lack
of understanding of economic concepts, the balance of this issue of The
Region is devoted to discussing the current state of economic literacy,
what it means for the country and what, if anything, can be done to improve
it.
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