Unit 1 The supply side of the macroeconomy: Unemployment and real wages

1.9 Studying the economy as a whole: Macroeconomics

microeconomics

Microeconomics is the study of the economic interactions between individual decision makers—consumers, firm owners, employers, employees, borrowers, and lenders—and the particular markets within which they buy and sell goods and services. It is concerned with understanding and explaining what we observe in specific markets, rather than the links between different parts of the economy.

In the companion The Economy 2.0: Microeconomics volume, we focus on the interactions of individual people, such as Doug and Rob Grey and their employers. We study interactions among owners of firms, their employees and customers, and between borrowers and lenders, each trying to do the best they can, given the rules of the game that govern how they interact. To do this, we consider parts of the economy separately—the labour market, the markets for the goods and services that firms sell, and the credit market where borrowing and lending takes place. This approach to studying the economy is called microeconomics.

macroeconomics

Macroeconomics is the study of the economy as a whole, and how the outcomes in one part of the economy affect, and are affected by, what happens in others. So that macroeconomic models are manageable, we typically simplify them by focusing on totals and averages—for example, total employment, or average prices—and ignoring some of the variability among people, firms, and goods.

partial equilibrium

Partial equilibrium analysis is the study of what happens in a single market, or sometimes just a single economic interaction. See also: general equilibrium.

In this volume, we introduce macroeconomics, the study of the economy as a whole. We consider the level of employment and unemployment in the whole economy, rather than a single local labour market like the market for miners and truck drivers in a particular part of Australia that Doug and Rob experienced. We study the total output of goods and services of all producers rather than a single firm, and how that total grows and fluctuates over time. In macroeconomics, we consider inequality among all the members of a population, not simply between a worker and their employer or between a particular borrower and lender.

Other fields have similar ‘micro–macro’ distinctions. In the complex integrated system of the human body, a cell biologist might study some of the basic units of life (cells) making up the human body, while a medical researcher or a researcher on human anatomy would study the body as a whole. The cell biologist is analogous to a microeconomist, the medical researcher to a macroeconomist.

Understanding how the whole economy works requires that we take two steps. The first is aggregation—literally adding up—which is required if we are to make statements about such macroeconomic variables as total unemployment or total output.

general equilibrium

General equilibrium analysis studies what happens in two or more markets, taking into account that what happens in one market affects, and is affected by, what happens in the other(s). See also: partial equilibrium.

The second step required for the study of the aggregate economy is called general equilibrium. General equilibrium analysis studies how the actors in the economy interact either directly or indirectly through effects that carry over from one market to another. We already discussed an example of how the development in the global market for iron ore affected the job prospects and wages of the Grey family. It contrasts with partial equilibrium analysis, where attention is on one set of interactions and everything else in the economy is assumed to be unchanged.

In setting up the model of the supply side of the economy in this unit, we considered two partial equilibrium problems: (1) how workers and firms interact in the labour market holding prices unchanged, and (2) how firms and customers interact in the market for goods and services holding wages unchanged.

The WS–PS model of the macroeconomy combines the two partial equilibrium models to show what happens when we take account of the effect of the wages set in the labour market on firms’ costs and the prices they set, and of the effect of those prices on workers’ living standards and the wage they need to be paid. The WS–PS model helps explain the real wage and unemployment rate in an economy.

Paradoxes of the aggregate economy

Macroeconomics is an important field of study because the whole economy is not just the sum of the parts.

It is often difficult to predict what will happen in the economy as a whole based on what we know about the actors making up the economy and understanding how they interact in particular markets (that is, from partial equilibrium). In many cases, what is true of the aggregate economy seems paradoxical if you rely on the common sense of your personal experience, or even the microeconomics of a single market.

One of the most surprising of these paradoxes dates back to Adam Smith shortly after the birth of economics in the eighteenth century. At a time when self-interest was termed ‘avarice’—one of the seven deadly sins of Christian theology—he explained how people acting entirely selfishly in competitive markets could bring about a desirable outcome for the economy as a whole. He described this as the effect of an ‘invisible hand’ that guided markets. The idea of an invisible hand seems to say that bad morals (self-interest or not caring about others) is good for the economy.

Another surprising result from thinking about the economy as a whole comes from John Maynard Keynes (1883–1946), the founder of macroeconomics, and is called the paradox of thrift. For a single family, saving a substantial fraction of their income—if that is a possibility—is prudent and likely to benefit the family in the long run. By saving, the family will be able to weather a bad event such as unexpected illness, which cuts the household’s income. It will enable a higher standard of living in retirement than would otherwise be the case and accumulating some savings may give the family the chance to take advantage of an investment opportunity at a later date.

But if the economy is in a slump and everyone in the economy saves a lot, then they will necessarily not spend much. And if little is being spent by households and the extra savings are not being spent by the other actors in the economy (firms and the government), then firms will be unable to sell their output and they will cut back on how many people they employ, reducing incomes and further reducing spending, and plunging the economy into a deeper slump. This is the paradox of thrift: what is good for the family is not necessarily good for the economy as a whole.

In this and the next unit, we present a model of the aggregate economy that takes account of the interactions of sellers and consumers in markets for goods and services and of employers and their employees who produce what is being bought and sold. The model includes the effects of government policies that alter the conditions under which buyers and sellers, and employers and workers interact. This model produces a few more surprises based on treating the economy as a whole.