More Advanced Economic Concepts

by Pat Heyman | Feb 20, 2010 | Essays, Nursing, Pat

Money is the root of all good.

Now all the pieces are in place to introduce money. As we saw earlier, trade made the world go round because it allowed specialization and the division of labor, which in turn increased production, which made society richer. The simplest form of trade is barter–I’ll give you this if you give me that. The problem is that trade requires what is called the coincidence of desires. What are the chances that a candlestick maker is going to want the fletcher’s arrow? Or the blacksmith’s horseshoe? The fletcher must first trade the arrow for something the candlestick maker wants and then go trade that item for the candle. The other problem is the problem of divisibility. What happens if a cow is worth three goats, but the goatherd is only willing to trade one goat?

The answer is an intermediate commodity. The farmer can trade a whole cow for bits of silver and then use some of those bits of silver to trade for a goat. The goatherd can take some of that silver and trade it for a candle. The candlestick maker can in turn take some of that silver and buy a steak, and so on. The major requirements for the intermediate commodity are that it be readily divisible, universally accepted (valued), have relatively high value for its weight, and preferably be durable. Eventually this commodity will become more desired for its ability as an intermediary use than for its other uses. The commodity is then known as money. A society may have several commodities that serve as money–for example gold and silver. Local communities may use commodities that other neighboring communities do not. For example, in prisons, cigarettes are often used as money. In late eighteenth century Pennsylvania, whiskey was used as money.

Money is the root of all (economic) good because it facilitates trade which allows for the division of labor, which increases production, which makes society richer (better off). Gold and silver were already established as money by the time the Israelites escaped from Egypt.

Savings make increased production possible.

In our topsy turvy world influenced by a quack economist known as John Maynard Keynes (Keynesian economics), we constantly hear that debt drives the economy. President Obama himself has even said as much. But this is completely wrong. It is savings that drives the economy. Take for example, a wheat farmer who is able to pick two bushels of wheat with his hands. He eats one and sells the other and uses all of the money on other consumer goods (meats, clothes, house, etc.) One day, he has an idea. Instead of using all of the money from the second bushel on consumer goods, he’ll go without (he’ll save) so that he can buy a sickle (a capital good). Once he has enough money saved to buy a sickle, he can harvest four bushels of wheat.

Is the farmer better off? He can eat one bushel and now has three bushels to sell instead of just one. Is society better off? It now has two additional bushels of wheat available. Everyone is better off. What made it possible? Savings. The farmer didn’t have to be the one to do the savings, however. Someone else could have saved and then lent their money to the farmer to buy the sickle. The farmer would then pay the money back with the additional money from the increased wheat production. In either case, whoever does the savings takes on the risk that the capital good may not work as expected and the savings will go to waste. If the farmer does the saving himself, he takes on the risk, but also reaps the full reward. The someone else does the saving, the farmer has less risk, but has to pay back a portion of the larger harvest.

So we see the Theory of Capital Production: Someone does not consume as much (saves) and then uses those savings to buy capital goods (investment) which are used to increase production which makes both the producer, saver, and society richer. A corollary is that if someone saves and lends to someone who consumes the savings, no one is better off because the savings were not used for capital goods (opportunity cost). Thus, we have an important lesson for getting rich.

Don’t borrow money unless it helps you increase your production.

For example, if you need a car to joy ride in, save your money and purchase it. If you need a car to go to work, consider borrowing the money, but only enough to get a car that will reliably get you to work. The next time you are considering whether to purchase an item with a credit card, ask yourself whether it will help you make money or not. If not, borrowing is simply making you poorer faster…and reducing the overall

Now I’m Free. Free fallin’

There’s one last effect that we need to mention from our example above about the wheat farmer. Do you remember the Theory of marginal value? (The more of something you have, the less you value any one of the units.) Well when the farmer now has three bushels of wheat to sell instead of just one, the value of wheat will go down, and so will it’s price in relationship to other items. Is the farmer richer? Yes. Is the society richer? Yes. Did the price of wheat go down? Yes. Strange. This leads us to an important idea. Money is simply a means to trade for stuff. The more stuff that is produced, the less money it takes to buy it…and this is a good thing.

Think for a moment about almost any modern gadget that you enjoy. At one point in time, it was rare and expensive, but over time, savings allowed capital to improve their production, and as they became more plentiful, the producers and society were better off. Even though the price fell. Consider flat screen televisions: when the first plasma screens came out, a 42 inch model cost $15,000, and the companies only sold a few thousand units to big companies and to rich people. As the technology improved, eventually, the price fell so below $1000, and now, even people on welfare have flat screen televisions. Is society better off? Yes. Are the companies better off selling hundreds of thousands of units at $1000 than before? Yes. Did the price come down? Yes.

One cause of falling prices is that an item is being produced more cheaply than it used to be as we saw in the example of the flat screen televisions. Another cause of falling prices is that people don’t value an commodity as much as they used to. It might be caused by a shift in values–people who value fitness are not as likely to value or purchase donuts and pastries. People might not value a commodity as much as they used to because better items are now being produced. For example, people stopped buying as many Walkmans once MP3 players became less expensive. As it became harder to sell Walkmans because people were buying MP3 players instead, stores lowered the prices on Walkmans. The lower prices sent a signal to the companies that the public no longer needed/wanted as many Walkmans and the companies had better start producing something else. Businesses that ignore these signals and continue to produce unwanted goods will eventually go bankrupt and their capital will be sold to other businesses that will produce goods the public wants—to the benefit of society. This ensures that capital goods are not wasted on products no one wants or needs.

Either way, falling prices are good, because either they convey information. If the cause of falling prices is a reduction in consumer demand, it tells companies that they should shift capital to other products. If the falling prices are due to lowered costs of production, it signals that ordinary people can now purchase items that they could not afford previously. No matter how you cut it, falling prices are good for society.

Why am I repeating myself so much about falling prices? If you turn on the news, you will hear story after story about how falling prices are bad, how falling prices are ruining the economy. Wrong. Wrong. Wrong. Falling prices are good because they mean more people can afford those things. Falling prices are even better if they are the result of increased production due to capital improvements. And falling prices are also good because they tell businesses what people don’t want.

As Thomas DiLorenzo points out, even poor Americans live better than than kings and queens two hundred years ago with instant access to the entire world’s produce at their local supermarket, and the ability to keep it fresh in their refrigerators; able to hop on a commercial flight and travel thousands of miles in a few hours for about an average day’s pay; able to summon instant entertainment from all over the world with the press of a thumb. (And I will add that a ten-year-old Nintendo Gameboy has more computing power than the Space Shuttle Columbia had on its maiden voyage.) And we have falling prices to thank for it.

I can see clearly now that the rain is gone.

Now that we have established that falling prices are good, we can talk about another economic principle: Not all the results of actions are immediately seen, but people tend to act only on the obvious ones. Henry Hazlitt has an entire (short and very readable) book called Economics in One Lesson dedicated to this idea. He one lesson can boiled down to a single sentence, “The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.” (emphasis in original) After stating the lesson, he applies it to eighteen economic situations and fallacies: The first is the broken window fallacy (first described by Bastiat). Imagine that someone passes by a shop window that was broken by a vandal. At first they begin to commiserate with the shop keeper who will now have to repair the window. But then someone points out that this will give the glass maker more business, who will then have more money to spend and so on, until the vandal becomes a hero because he has stimulated the economy by forcing the shopkeeper to spend money repairing the window.

The fallacy is that the crowd does not see the things the shopkeeper could have used the money for (opportunity cost) had the window not been broken. The shopkeeper might have been planning on expanding his line of products or taking a vacation or buying a new suit, or any number of things that would also have stimulated the economy, but now never will.

The same problem is seen with government spending. When government acts, its efforts are seen, but all of the things that could have been had the government not acted are not seen. And so we come to one of the most pervasive and insidious problem to infest society…rent seeking. Rents, economically speaking, are money or rewards above and beyond what one could get on the free market.

Let us go back to our example of the wheat farmer who has increased his production of wheat from two bushels to four and inadvertently pushed the price of wheat down. The decreased price of wheat means that the farmer will most likely make slightly less money than he anticipated, but still more than he had before. If he is a wise farmer, he will be happy with this arrangement. The lower price will cause other things to happen. Perhaps a farmer who is not as good will stop farming and do something else more productive. Perhaps families will be able to have more children and grow bigger increasing the demand (and price) of wheat. Or perhaps the farmer decides that he would prefer to work less and only produce three bushels of wheat. All of these things are perfectly legitimate, and society will work out the details quite smoothly and automatically.

But, what if the farmer has connections in the government and persuades the government not to let the price of wheat fall? In that case, the farmer will be richer than before, but society will not. In fact, society will be poorer because the artificially high price will induce the farmer and other farmers to produce excess wheat. Fields that might have been used for other crops will be plowed under for wheat. Marginal land like marshes will be used for wheat. People who are not good at farmers will begin to farm wheat. Society will have more wheat than it needs, but not enough of other goods, the environment will be damaged, and needless energy will have been expended on wheat production. Society will be unwilling or unable to purchase all of the farmers’ wheat. Then the wheat will go bad, and the farmer will make less money because not all of the wheat has sold. A disaster all round.

But our enterprising farmer is not done yet. He convinces his connections in government that the government itself should buy up the excess wheat. Now the government takes money from the people who didn’t want to buy the wheat and buys the wheat, which still goes bad. And because of government waste, corruption, and administrative costs, the wheat has now cost society even more than it did before. No matter how politically connected the farmers are, eventually such a scheme will anger the rest of society. Instead of simply scrapping the law that caused the problem in the first place, the government will do such things as putting crop limits on the farmers or even paying the farmers not to farm.

Such schemes to escape falling prices are simply insanity, yet, in the United States they have been going on for more than a hundred years. Every time you eat, you are paying a higher price for your meal because of government interference with farmers. Every time you get paid, a piece of your money is sent to those same farmers who just stole your money last meal. Unanticipated or unseen consequences are more important than the seen ones. The farmers simply wanted to keep their prices from going down, and in the end damaged themselves and society, yet are too blind to see that they are worse off for it.
Falling prices are good.

Mercury rising.

Hazlitt’s book is called Economics in One Lesson for a reason: it takes the single lesson of unseen consequences and applies it to several different scenarios. Since we took so long on falling prices, let us consider the same lesson when applied to rising prices. If falling prices are good, then rising prices must be bad also good. Just as falling prices allow consumers to purchase more of a good, rising prices tell them to purchase less, or to value it more.

Just as there are two basic causes of falling prices (increased production and consumers valuing the product less), there are two causes of rising prices: decreased production and consumers valuing the product more. The third principle of economics is that resources are scarce. Production of a product may fall because of the scarcity of the raw materials that go into its production when compared to its demand. Or production may fall because of natural disasters. For example, following hurricane Katrina, the production of gasoline fell because of damage to Texas refineries. This in turn caused higher prices, which in turn signaled consumers to value it more (i.e., not waste it).

When the price of gasoline is low, people buy bigger cars and trucks, think nothing of taking extra trips to the store, long road trips, or even joyriding. But when the price of gasoline rises because of decreased production, people begin to buy smaller cars, think more carefully about their trips, car pool, and take other gasoline-conserving measures. At the same time, the higher prices send a signal to businesses that they should increase production to take advantage of the opportunity for higher revenues.

Another effect of high prices is that they signal consumers and businesses to look for lower priced alternatives. A classic example is that sugar is more expensive because of the misguided government policies (some of which were) described above. As result, businesses that sold products containing sugar began to look for lower priced substitutes and found high fructose corn syrup. Interestingly, recently, the government has further meddled in the market for corn, causing high fructose corn syrup’s prices to rise, causing some businesses to switch back to sugar.
Another cause of higher prices is a shift in consumers’ values. The day president Obama was elected, the price of ammunition jumped. Prices almost doubled from the day before the election. Some people in the gun community have suggested a government conspiracy, but what actually happened is that people simply valued the ammunition more and were willing to pay a higher price.

The increased prices serve a useful market function. They prevent some people from buying up and hoarding all the ammo. They also discourage frivolous uses such as plinking by telling gun owners to save it for important things like self defense or serious training.

The higher prices also provide businesses with a profit opportunity, signaling them to increase production. The profit opportunity will eventually lower prices by encouraging more businesses to enter the market and for existing ones to scale up their operations.

To recap, higher prices are good because they signal companies to increase production and consumers to reduce consumption and conserve valuable resources. Just as businesses do not like falling prices and sometimes persuade the government to intervene, consumers do not like rising prices and sometimes get government to intervene. Just as there are unintended consequences with preventing falling prices, there are unintended consequences when government prevents rising prices.

When government sets a maximum price (price ceiling) on a good, it reduces the signal to businesses to produce that good resulting in decreased production. Conversely, the artificially low price signals consumers to purchase more of the good. The result is shortages. The lower the price ceiling, the more severe the shortage. A classic example of this was seen in the 1970s when the price of gasoline began rising. Congress implemented a price ceiling on gasoline, and although you probably were not around to have witnessed it, your parents probably had to wait in long lines to get gasoline. Eventually, economists convinced Congress to remove the price ceiling and within a week, the lines were gone and there were no shortages.

A similar example is seen with “anti-gouging” laws which prevent companies from raising rates “too quickly” especially in response to a localized reduction of production. For example, before a hurricane, people anticipate interruptions in gas and food supplies, so they begin to value those items more. But businesses are prevented from raising prices. The result is that everyone goes to the gas station and buys as much gasoline as they can, whether they need it or not, causing long lines and sucking the gas stations dry. They also strip the grocery stores of all their goods. People who heard the news late or had to work later are out of luck. If businesses were allowed to raise prices, people would be more selective in their purchases, leaving gas and groceries available for latecomers.

In a classic example, after Hurricanes Hugo ice went to $10 per bag because power outages made refrigerators useless. This was seen as price gouging, and laws were quickly enacted to prevent it, so naturally ice sold out immediately. Because the price was artificially low (for the situation) ice was not used efficiently. The first few customers bought enough ice to preserve not only their perishable groceries but also non-perishables like beer. Meanwhile, everyone else got nothing. When it had cost $10 a bag, people bought just enough to preserve their perishable groceries leaving enough for later customers. Moreover, because the profit incentive was also artificially low, companies had no reason to ramp up the production of ice nor was ice diverted from areas not affected by the hurricane. In the end, a few early purchasers benefited greatly, and everyone else suffered.

So, one last time: rising prices are good, and falling prices are good. The reason they are good is that they reflect relative production, scarcity, and consumer values. If not interfered with, high prices encourage businesses to enter markets, correctly allocate capital, and increase production to the benefit of society. Low prices signal businesses to shift capital to other goods. From the consumer’s side, low prices enable more consumption, and high prices signal consumers to conserve.

Fight the Machine

At this point, we need to talk about one of the most pervasive economic fallacies–that technology and machines cause unemployment. As seen before, technology and machines allow increased production which enriches society. The case was quite clear in our example of the farmer who bought a sickle. But what happens if instead of a self-employed farmer, we apply a dose of technology to a business with employees?
Imagine for a moment that the owner of an oil field has four employees who can produce eight barrels of oil per day using outdated pumps. The owner saves up (or borrows) and buys newer, faster pumps and can now produce twice as much oil but only needs two employees to run it. Oil production has doubled, so society and the owner are both better off and so are the two employees whose production has increased and will most likely be compensated accordingly. But what about the two employees who are no longer needed? There are three possibilities.

As increased production drives the price of oil down, new customers who could not afford oil before will begin to buy it driving the price up again giving the owner of the oil field incentive to drill a new well reemploying the workers who had previously been unemployed. A second possibility is that the unemployed workers are now free to pursue more pleasant work. A third possibility is that as society as a whole becomes richer and more productive, the oil field owner will have to reduce the work week to keep good employees and will have to hire additional workers to maintain production. In fact, because of this very reason, in the United States the average work week fell from more than sixty hours in the late 1900s to close to forty hours even before unions were able to convince the government to enact legislation requiring employers to pay a premium for work performed after forty hours.

Sometimes the industry that loses jobs is not the same as the one that has increased production due to technology. For example, once it was discovered that kerosene could be refined from oil, the whaling business saw a dramatic decrease in employment. Before kerosene, whale oil was the major source of lighting at night, and only relatively wealthy people could afford it–everyone else went to bed soon after sundown. Kerosene allowed more people to use lighting oil and enjor evenings reading or playing with family. Meanwhile, the whales were saved, and the whalers no longer had to risk all of the horrors you didn’t read about in Moby Dick. And yet, somewhere, there was most likely a whaler’s guild lobbying to outlaw kerosene.

To be sure, some people will lose jobs due to advances in technology, but the losses are temporary, and because of the increased production, the unemployed workers’ money will go farther while they are seeking new employment. This fallacy is a favorite of the “concerned for the downtrodden” crowd. I was first introduced to this fallacy in elementary school when I was told that a single tractor could put 100 farm workers out of work in India. Even then, something seemed wrong with this argument; it seemed to me that picking cotton was not fun work (it is partly why slave labor was used in the United States), and a chance to do something else would be welcome. Yet my social studies teacher would have deprived them of the chance to do less backbreaking labor and deprived the Indian people of the benefits of increased production for the sake of “saving jobs.” Henry Hazlitt dedicates an entire chapter to this fallacy in Economics in One Lesson.

Capital Markets

As discussed earlier, capital makes increased production possible, thereby improving society as a whole. In order to get the capital in the first place, someone or someones must first save. A business can rely on the savings of the owners (who would then be known as capitalists) or they can rely on the savings of someone else by borrowing. Capital markets are where capital is bought and sold. Capital markets make it easier for businesses to find someone willing to take the risk of losing their savings by lending or investing (owning a piece of) someone else’s business. The cost of borrowing capital is interest.

When society consumes more, it saves less, and the relative scarcity of savings is reflected by a higher interest rate. The higher interest rate signals consumers that they should devote more of their productivity to savings, and also sends a signal to businesses that consumers want to consume right now, discouraging borrowing. The converse situation is equally intuitive. When society consumes less, it saves more, and there will be more resources available to loan. As the theory of marginal utility reminds, the more of something there is, the less valuable any given unit will be. This is reflected in a lower interest rate. The lower interest rate sends a signal to businesses that consumers do not want more goods to consume right now, but are planning on consuming them in the future. The lower interest rate also allows businesses to borrow more capital to develop their businesses so as to increase future productivity.

As with prices, interest rates are simply a reflection of the supply and demand of resources available in society for use as captial in improving production. High and low interest rates are neither good nor bad; they simply convey information to consumers and businesses.

Basic Principles of Economics

by Pat Heyman | Feb 20, 2010 | Essays, Nursing, Pat

These principles are generally agreed upon by most contemporary schools of economic thought, but they are presented here as elaborated by the Austrian School of Economics.

People are rational.

The first principle is that people are rational. By rational, we don’t necessarily mean logical, but purposeful–there is a reason for the things they do, no matter how smart or stupid seeming. For example, a drowning person will often desperately grab onto a would-be rescuer, thereby drowning both of them. The drowning person’s actions are completely rational; the rescuer floats, so holding onto them must help the drowner float as well. Unfortunately, their actions lead to their doom instead of salvation. Continuing with our example, being rational, professional lifeguards and rescue swimmers are taught this and how to escape from drowning victims. (See Kevin Costner’s The Guardian for a visual.)
People are imperfect and have desires. These desires are infinite.

Every person has desires and wants…even if it is simply to take another breath or scratch an itch. As long as we live, we will require food, water, and shelter. But even having these, we will want better and more. When you combine the first principle with the second, you get: People are rational (purposeful) in their actions to satisfy their desires. (Note that just because they are rational does not mean they will be successful in any particular degree, and even if they do meet with success, their will always be more desires.)

Resources are scarce.

Even though demands are infinite, the resources to satisfy those demands are not. This concept of scarcity does not mean that there are only a few resources available, simply that they are finite. If you eat an apple, that means you cannot also use it to decorate your table. If you throw an egg at your neighbor’s cat, you cannot also eat it (the egg that is). This is called opportunity cost. Your time and effort are also finite and subject to opportunity cost. If you spend your time in school studying, you will have less for partying. The time and effort it took to write this booklet is time that I was not working on a tan or learning how to kite surf. Economics is about learning the consequences (opportunity costs) of our actions.

Production is king.

Wealth in a society is based on its production. There are only two kinds of goods that can be produced: consumer goods and capital goods. Consumer goods are consumed (used up). Despite the name, a consumer good can be quite durable. For example, a tennis raquet is a consumer good, but a person can get several years of enjoyment out of it. Capital goods are any goods that are used to produce consumer goods (or other capital goods). For example, fire wood is a consumer good. An axe or saw would be a capital good that is used to produce the fire wood. The key aspect to economics is that capital goods allow more consumer goods to be produced, making society richer, because Production is King. Hail to the King, Baby!

What’s Labor Got To Do With It?

In order to produce goods, resources are mixed with labor and sometimes capital goods. For example, fallen wood can be gathered (labor) without the use of any capital goods, but its collection (production) can be increased with a wheelbarrow (capital good), and its quality may be enhanced by splitting it with an axe (capital good). Capital goods are usually technological but can also be information or knowledge.

Specialization is the key.

In primitive societies…so primitive that we don’t really know of any…everyone had to do everything for themselves (produce food, clothing, shelter, protection, and entertainment). Very quickly, people figured out that people with big pudgy hands weren’t as good at sewing; people with big muscles were better at protection; etc. Thus specialization was born. People who specialized in one or two things were more productive than someone who had to do everything for themselves. Economists call this division of labor. The division of labor can happen on any scale, from families, to cities, to entire countries.

Trade makes the world go round.

Once people began to specialize, they had to begin to trade. The sewer had to trade the weaver for cloth. Both had to trade with farmers or hunters for food. The hunter had to trade with the fletcher for arrows. And so on. When two people trade, they both become richer because they both have something they want more. We call this a win-win trade or a positive-sum gain. The weaver has more cloth than she could ever wear. When she trades it for food, the hunter now has clothes and food, and the weaver now has food and clothes. They are both better off…as long as they enter into the trade willingly and knowingly.

This introduces us to one of our first crimes: fraud. Fraud is simply misrepresenting oneself or one’s goods. The misrepresentation can be about the quantity of the good, the quality of the good, the ability to deliver the good, or one’s ownership of the good.

Value is marginally subjective.

Everyone has different desires, and different ideas about how to satisfy them. This is called the subjective theory of value. Think about what you would like for dessert tonight. Some of you thought about fruit, while others cake or ice cream, and others cheese. Think about how much you would be willing to pay for that dessert. Some of you would be willing to pay more than others.

This brings us to our next concept: The marginal theory of value. This simply means that more of something that someone has, the less he values any one of them. For example, someone who has 2 Chocolate Sin Cakes is more likely to share than someone who has one. Someone who has a bag of marbles is more likely not to care if one marble is lost than someone who only has one. Someone who has a wallet full of cash is less likely to notice when their son steals a bill than someone with only a few dollars. This concept is extremely important.

1. Other things being equal, it’s better to have more of something than less of something.
2. The more of whatever you have, the less valuable any one of them is.
3. The lower the value, the lower the price.

Which bring us to THE LAW OF DEMAND: The greater the quantity, the lower the price someone is willing to pay, and conversely, the higher the price, the lower the quantity demanded (all other things being equal).

And what if things aren’t equal? Then you can increase (or decrease) price and quantity simultaneously. For example, during the New York power outage a few years ago, all the dollar stores sold out of candles, and people were reselling them for $5 on the sidewalk. People suddenly valued the candles more highly because of the blackout, leading to an increase in both price and the quantity demanded. Under ordinary circumstances, a rise in the price of candles would result in fewer candles being sold.