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Why Johnny Can't Choose

And what Johnny (and Jane) needs to know to understand the economy.

December 1, 1998


David S. Dahl Regional Economist
Why Johnny Can't Choose

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.