Friday, November 25, 2011

How the Economy Works

imageGuest post by M. Northrup Buechner, Associate Professor of Economics, St. John’s University, New York

Here is the fundamental problem of economics: Every consumer good that you buy reaches you through the cooperation of literally millions of people. The six-pack of beer that a man purchases at the corner deli was delivered to the deli by a wholesaler, who gets the beers he delivers from several different beer producers. To produce the beer, the manufacturers need hops and barley which they buy from grain elevators or farmers. To grow the hops, the farmers need pesticide and fertilizer which are produced by other businesses. To manufacture beer, the producer needs cans which he buys from, let us say, American Can. To manufacture cans, American Can needs aluminium which it buys from Reynolds or Kaiser or Alcoa. To produce aluminium, the aluminium companies need bauxite and electricity, the two raw materials of aluminium. Bauxite has to be mined for which heavy equipment is required, like steam shovels, bulldozers, and trucks, which are purchased from still other companies.

If we were able to trace back through the economy all the businesses and all the workers who directly and indirectly participated in the provision of that beer (or Coke or milk or hamburger or golf clubs), we would find that it involved at least half of the economy and probably much more: that is, half the labor force, half the businesses, half the capital value of the economy.

imageWhat makes this almost miraculous is that of all the millions of men and women whose work jointly puts beer in the deli, the only one of them who gives a thought to putting beer in the deli is the wholesale. All of them (including the wholesaler) are concerned with nothing but their own personal financial interest. In their work, they are focused exclusively on earning the money necessary to support themselves and those they love, and to achieve other goals of their own to which money is a means. Yet somehow, the actions of all these millions of human beings are integrated into what is normally a smoothly functioning unit that puts beer where the man wants it, when he wants it, and as much as he wants. If one steps back for a minute and thinks about it, that is an amazing, unbelievable phenomenon—a phenomenon which we live with and take for granted every day and on which our lives depend. How is it possible?

The answer is prices. It is prices that integrate the economy into a unit. It is prices that reconcile the apparently opposing interests of the members of an economy. It is prices that make everyone’s desires consistent with one another so, for example, a furrier wants to give a woman the exact fur coat she wants to possess.

I. The Origin of Prices

Every price is set by someone. That is our starting point. Some human being must name the price. This is actually not a self-evident truth, but it is close. Because what would be the alternative? The wind blows the sand to form the price or the clouds write the price in the sky? If prices were determined that way, there would be nothing to talk about.

Every price originates in the mind of an individual human being. In a modern industrial economy, that basic fact is reflected in five different methods for creating prices. In this paper, I will deal only with the one that is most familiar (almost all consumer goods and services are created by this method) and probably the most widespread. That one is: someone sets the price.

The prices in the economy that are directly involved in the production and sale of goods and services can be divided into three classes:
        (a) the prices businessmen charge other businessmen for producer good and services. These are the
              goods and services that are used in production (of other goods and/or services).
        (b) the prices businessmen charge consumers for consumer goods and services. 
        (c) the wages businessmen pay their employees for their work. (Wages are prices; the price of human work.)

imageLet us begin with the prices of producer goods and services.

When a businessman sets the price, how does he decide what price to charge? If he wants his business to survive, we can be sure that he looks at and weighs the relevant facts, and sets a price that reflects those facts so he can sell his product and continue in business.

This principle, that prices are based on facts, is a crucial point. It removes economics from the realm of hopes and daydreams. It immediately nullifies the popular saying, “Businessmen can set any price they want.” Prices reflect facts. Prices originate in facts. In a free economy, businessmen set prices to reflect the facts of their markets.

2. The Facts Prices Reflect

Many different facts may be relevant, depending on the specific product, industry, or market, but the price-setter will almost always consider these three:

  1. the demand for his product;
  2. his competition; and
  3. his cost of production.

(1) Businesses face the alternative of life and death just as living entities do. If a business fails to secure its means of survival, it dies, it goes bankrupt, and in the end, nothing at all may be left. The fundamental requirement for business survival is profit, and the means to profit is sales. The expectation of sales is a prerequisite for production in a market economy. Some businesses, like realtors, can survive on occasional, irregular sales. But most businesses require regular, continuing, repeated sales over time, often numbering in the millions. (Just think of Ford cars, Cheerios, and Dell computers.) The price-setter choses a price that he expects to yield those sales. This is his estimate of the demand for his product—the quantity he expects to sell at the price he selects.

image(2) Competition affects this result. His sales will be higher if competitors charge higher prices or sell inferior products. His sales will be lower if competitors charge lower prices or sell superior products. The price-setter chooses a price that is consistent with the price others are charging and with the quality of their products. The better the quality of his product relative to his competitors’ products, the higher the price he can charge, while usually it is economic suicide to try to charge a higher price for an inferior product.

The price based on (1) and (2) together constitutes the price-setter’s estimate of his customers’ “willingness to pay.” How urgently do buyers want his product?—therein lies the meaning of economic value, as opposed to political value or aesthetic value. This is what prices measure: the price-setter’s estimate of the price his customers will pay and in what numbers.

(3) The third element the price-setter considers is the cost of production. Over the long run, total revenue must exceed total cost. This is the business world’s absolute from which there is no escape. Income receipts must exceed total outlays. The businessman must make a profit--and not just any profit, but a profit sufficient to allow him to replace his plant and equipment as they wear out. But this is a long run, average requirement; that is, his accounts must show a profit on average over time. In the short run, a businessman may chose to set a price at which he knows he will take a loss (to meet the competition, to establish a new product, or to enter a new market). Usually this is not a disaster or even a hiccup, because he can easily make it up in the future.

3. What the Buyer Knows: Producer Good Prices

Now let us look at the price of the producer good or service from the buyers’ side. What does the price tell the buyer? It tells him the seller’s estimate of other customers’ willingness to pay, that is, the value placed on the good by the seller. It also tells him that the seller thinks enough people are willing to pay this price that he will be able to continue to produce it at a profit. But at first glance, there does not seem to be any reason the buyer should care about these things. Let us see.

imageCertainly, the potential customer cares primarily about what the product will do for his business. Maybe he expects the product to reduce his costs of production or improve the quality of his product or improve the efficiency of his secretarial staff or increase the reliability of communication within his business. In deciding whether or not to buy in the light of what the product will do for his business, he decides whether the product is worth the value placed on it by the seller as given by the price. Given the origin of the price, this means that in effect he is thinking, “Am I willing to pay what this seller thinks others are willing to pay?” If he is, he buys the product. But there is more to the role of price than this.

Imagine all the producer goods of the economy divided into three broad categories according to their cost:

  1. Very expensive, that is, selling for a million dollars or more. This category includes things like turbine engines to produce electricity, machine tools, and heavy construction equipment such as steam shovels, bulldozers, and cranes.
  2. Moderately expensive (thousands of dollars): things such as copy machines, office furniture, and central air conditioning.
  3. Inexpensive: things such as copy paper, pens, and paper clips.

Remember that the price reflects the seller’s estimate of his customers’ willingness to pay. A high price reflects a high estimated willingness to pay; the seller thinks buyers are willing to pay a high price in sufficient numbers to cover his cost and yield a profit. A low price, on other hand, reflects a low estimated willingness to pay: customers are willing to pay only a low price, but still in sufficient numbers to cover cost and yield a profit.

The thought and consideration given by businessmen to the purchase of a producer good varies directly with the price. Inexpensive products such as copy paper and paper clips are purchased routinely. In effect, they are sufficiently inexpensive that little or no thought is given to them. Moderately expensive products do get some serious thought and the businessman may decide that something in this category, such as a copy machine, is too expensive to justify its purchase.

imageProducer-customers give by far the greatest thought and consideration to the most expensive producer goods. These are the goods with the greatest value in production to other businessmen as proved by the high price that buyers are willing to pay; the goods most highly valued by other producers for their own productive ends. Thus, in thinking carefully about expensive purchases, it is as if producers were thinking, “The high price of this machine means that it is important to other producers, so I am not going to pay that price, and remove it from another man’s use, unless I am going to get a greater benefit than he would get.” If he buys the factor, he does get a greater benefit because the man thereby excluded from the factor excludes himself by refusing to pay the price.

The value in production that businessmen receive from the factors they buy exceeds the value that would have been received by the businessmen who do not buy, both in the judgment of the individuals involved. This is the principle by which capitalism distributes the nonhuman factors of production among all the businesses of an economy. The highest valued factors go to the highest valued uses, both in the judgment of the businessmen involved. As a result, economic output and growth are maximized.

4. What the Buyer Knows: Consumer Good Prices

The same principle applies to consumer goods and services. Expensive consumer goods are given more thought than inexpensive consumer goods. Again, it is as if the buyer were thinking, “The high price means that this good has high value to other buyers, so I am not going to buy it and remove it from their use unless it has more value to me than to them.” If he buys, it does have more value to him, because the other party excludes himself by refusing to pay the price. Thus the consumer goods and services of the economy are distributed to the consumers who value them most.

imageSocialists object to this argument on the grounds that the rich have more money. If everyone’s income were equal, they say, then distribution of the economy’s goods according to who was willing to pay the most would be fair. But in reality, those willing to pay the most are those with the most money. The economy distributes its economic output according to the dollar votes of the consumers, but the rich have more votes. The result is that the rich man buys steak to feed his dog while the poor man eats rice and beans. The system, they say, is unjust.

The answer to this objection is found in the origin of wages in a free market. What causes differences in wages? Why do some people make much more money than others?

5. The Creation of Wages

imageTo grasp the cause of differences in wages, let us think of the labor market as consisting of hundreds of worker pools. Each worker pool consists of all the workers of a particular kind or type who are looking for work in their field. These are the workers who have been fired or who quit or who are entering the work force for the first time or who are re-entering the work force. There is a different pool for each type of worker: mechanics, teachers, secretaries, accountants, nurses, chemical engineers, civil engineers, mechanical engineers, and so forth. Each type of engineer has his own pool because they cannot do each other’s job. The same is true of other specializations, of which there are hundreds.

When the economy is functioning normally, that is, neither booming nor crashing, new people enter a worker pool looking for work at approximately the same rate that businesses hire people out of the worker pool. The pool neither shrinks nor grows, and wages for each type of worker stay about the same.

6. How Wages Rise

In order to understand how wages rise, we need to understand the thinking of the businessman who raises his wage offer first. That is the difficult subject. Once one competitor raises his wage offer, it is easy to see why others choose to follow.

Let us take the pool of unemployed accountants. The economy is growing, and there is an increasing demand for accountants. Consequently, the rate at which accountants are hired out of the pool exceeds the rate at which unemployed accountants enter the pool. As time goes by, the pool of unemployed accountants shrinks and it becomes harder and harder to hire an accountant. Eventually some businessman, one who perhaps has been looking unsuccessfully a long time for an accountant, decides that if he is going to hire an accountant, he has to offer a higher wage. This news will soon be known throughout the accountants’ labor market, and other firms looking for accountants find that they also must offer a higher wage in order to compete.

imageIf the higher wage for accountants lasts, it will redound throughout the accounting profession. First the wages of new hires will rise, then the wages of junior accountants will rise to keep ahead of the new hires, and then the wages of senior accountants will rise to keep ahead of the junior accountants.

Businessmen raise wages because they must in order to hire and keep the workers they need. Thus, wages rise with increasing scarcity, as the demand for a particular type of labor increases relative to the supply. This is true not only of accountants, but of every kind and type of worker.

7. How Wages Fall

The wages of workers fall when there is decreasing scarcity (or rising abundance) of workers of a particular type. This occurs when the supply of workers increases while the demand does not change, or the demand for workers decreases while the supply does not change, or the demand decreases and the supply increases at the same time. This last case is one of the chief signposts of a recession.

In a recession, demand decreases for practically every type and kind of worker. At the same time, the supply of unemployed workers in the worker pools increases dramatically as workers are fired or laid off and businesses stop hiring out of the worker pools.

The result is that there are abundant workers for businessmen to hire at the current wage. In response to an advertisement, potential employees besiege a business or word of mouth about a job vacancy brings a surfeit of applicants. Under these circumstances, employers may offer to pay lower wages and workers may offer to work for less. In 1982 and 1983, the average union wage rate fell as unions negotiated lower wages to avoid layoffs. From 2007 to 2009, both skilled and unskilled workers negotiated lower wages.

8. Relative Wages and Relative Scarcity

An increase in demand for workers of a particular type relative to the supply represents an increase in relative scarcity, and wages rise. This is the typical result of an economy coming out of a recession.

imageA decrease in the supply of workers relative to the demand also represents an increase in relative scarcity. Historians estimate that the Black Plague killed between one third and two thirds of the European peasants. This created an enormous increase in the relative scarcity of labor, and wages rose, creating [ironically] what may be called the golden age of the European peasantry.

A decrease in demand relative to the supply represents a decrease in relative scarcity, and wages fall. This typically happens at the beginning of a recession.

An increase in supply relative to demand also represents a decrease in relative scarcity. The wage increases following the Black Death reduced mortality so more people lived to adulthood and had more children. Within a hundred years, the population increased to the point that wages fell back to the level preceding the Black Death.

Now let us consider the wages of different occupations in terms of the relative scarcity of their members. The most widely known minimum wage employees are fast-food workers. Why are they paid a minimum wage? Because, although the work is hard, almost anyone can do it, so if the wage rises above the minimum wage level, more workers enter the field. Sometimes this happens.

imageA good divorce attorney in New York may earn $400 an hour. Why does he get so much more than fast-food workers? Because few people can do what he does and many people in New York need divorce attorneys. Divorce attorneys are much more scarce than fast-food workers. On the other hand, an attorney with political connections in Washington may get $1000 an hour, because such attorneys are even more scarce than divorce attorneys.

The scarcest employees in the business world are CEOs. Out of the world’s population of approximately 7 billion, there may be 50,000 who might be able to run a major corporation. I estimate that a CEO making $10 million a year earns about $3000 an hour.

But CEOs are not the scarcest workers in the economy. Much more scarce are NFL quarterbacks, of which there are probably less than ten who excel at their work. I estimate that their pay comes to about $10,000 an hour.

Great opera singers are certainly as skilled and dedicated and rare as NFL quarterbacks, but they make much less. Why is that? Because the demand for football is huge while the demand for opera by comparison is small.
Finally, there are the scarcest of all the workers in the economy, the true superstars, the highest paid members of the free market: movie stars. Casual observation suggests they may make as much as $100,000 to $1,000,000 an hour.

9. Justice

Now we can answer the socialist argument at the end of ‘Part 4’ above. To call the capitalist economy “unjust” is a gross act of injustice. Capitalism is the epitome of justice.

imageObserve the principle of justice governing the operation of the worker markets of a free economy. The wage rate of every worker reflects his relative scarcity as measured by the worker pools described above. Workers whose skills and abilities are more scarce receive higher wages than workers whose abilities are less scarce. This is just because an employer chooses to pay the wage required by the worker’s relative scarcity only if the employer thinks the worker is worth it. In other words, every employee receives a wage that measures the value of his work to the business as judged by the businessman who pays the wage. From this perspective, the hierarchy of wages in a free economy is a hierarchy of productive contribution.

Taken altogether, the array of annual wages and salaries of all the employees in the economy is a hierarchy reflecting the relative scarcity of every kind and type of employee. Workers with higher salaries are relatively more scarce than workers with lower salaries. The same hierarchy ranks all the different kinds and types of workers according to their value to their employers. Employees with higher wages and salaries have higher value. The businessman chooses to pay the wage required by a worker’s relative scarcity only when he thinks the worker is worth it.

Consider, for example, a scientist working in the research and development department of a large corporation. The scientist contributes nothing to current output; he has no role in reducing current cost, or in selling the corporation’s products, or in improving communications, or in facilitating management control, or in any of the other crucial day-to-day operations of the business. His contribution is entirely prospective and uncertain. Yet management chooses to pay him a very high salary, perhaps on the level of a vice president. Why? First, because his scarcity value is such that they must pay him that salary to retain his services. But second, and equally important, his work is judged to be essential to the survival of the company—because while his contribution is prospective and uncertain, it is a certainty that the corporation will fail without him (that is, without research and development).

10. Conclusion

This then is how the economy works. Every price reflects exactly the judgment of the price-setter as to what his customers are willing to pay. That in turn reflects the value placed on the product by those customers, which depends to a large extent on the prices and products of competing businesses. In addition, over the long run, every price often measures (roughly) the cost of production, which in turn depends on the prices and quantities of all the resources (including human beings) required to produce the product. [Contrary to the claims of socialists monopoly theorists, therefore, prices are not set arbitrarily by business owners; nothing could be further from the truth.]

Whenever anyone, producer or consumer, chooses to buy a product or engage an employee, he does so in consideration of the price. If the price is so low that he needs to pay no attention to it, that is still a kind of consideration, because there is always some price that would demand his attention.

imageWhen he considers the price, he considers all the other potential buyers of the product and the value of all the goods and services required to produce the product. If he buys, it is because the product is more valuable to him, as a producer or as a consumer, than to everyone who chooses not to buy. Thus all the economy’s productive resources end up in the hands of those producers who value them most highly in production, and all the economy’s consumer goods and services end up in the hands of those consumers who value them most highly in consumption. This is the integration a free economy performs. This is why each individual’s choice is consistent with every other individual’s choice—because everyone is making their choices on the basis of the same prices—each of which conveys the relevant information about the buyers’ willingness to pay and the resources required for production.

Thus, in pursuing his rational self-interest, each producer and each consumer, each buyer and each seller—each of them focuses on the prices he must pay or wants to receive and chooses actions that are consistent with those prices in conjunction with all the other values of his life. He focuses on prices in the same way and for the same reason that he focuses on all the other facts he must take into account in order to act successfully.

imageThe difference between prices and the other facts he considers is that every price reflects, directly or indirectly, all the economic facts, so that in adjusting his actions to the prices he faces, he integrates himself into the economy.

This essay is based on M. Northrup Buechner’s book Objective Economics: How Ayn Rand’s Philosophy Changes Everything About Economics. For excerpts from the book, videos and additional essays visit www.ObjectiveEconomics.net. For a full exposition of Dr. Buechner’s ideas on economics please read the book which is available at Amazon.com.

This essay is copyrighted 2011 by M. Northrup Buechner. Permission is granted to republish it on websites as long as it is reproduced in its entirety including links in the paragraph above and this notice.

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2 Comments:

Anonymous Falafulu Fisi said...

What he's describing is the concept of network theory and econophysicists are at the forefront of researching how network theory can describe macroeconomic behaviors. Mainstream economics hasn't caught up to economic network theory yet, but it is slowly catching their attention.

Network theory is an attempt to quantitatively describe how an economic system behaves, from producer/consumer/capital-lender networks to international trading networks. The interesting dynamics are revealed when feedbacks is being taken into account, such as the domino/cascading effect if a (some) node/s in the network (a product, service, company, capital, consumer, etc,...) is affected.

The following would be of interest to economists.

From Graph Theory to Models of Economic Networks. A Tutorial

11/25/2011 08:02:00 am  
Anonymous Falafulu Fisi said...

Another useful one for economists:

Abstract:
Analyzing real data on international trade covering the time interval 1950-2000, we show that in each year over the analyzed period the network is a typical representative of the ensemble of maximally random weighted networks, whose directed connections (bilateral trade volumes) are only characterized by the product of the trading countries' GDPs. It means that time evolution of this network may be considered as a continuous sequence of equilibrium states, i.e. quasi-static process. This, in turn, allows one to apply the linear response theory to make (and also verify) simple predictions about the network. In particular, we show that bilateral trade fulfills fluctuation-response theorem, which states that the average relative change in import (export) between two countries is a sum of relative changes in their GDPs. Yearly changes in trade volumes prove that the theorem is valid. Supported by the well-known qualitative findings about economic crises, we argue that the theorem provides valuable quantitative insights into the mechanisms underlying the emergence of worldwide crises.

PDF Download : Statistical mechanics of the international trade network

The macro behavior that Hayek called spontaneous order is being observed when the economy is treated as a complex system of many agents (producer, banking institutions, consumer, companies, etc,...) interacting via network as opposed to the mainstream neoclassical economic theory of a single representative agent (who only interacts with him/herself), which in reality it is a wrong picture of an economic (dynamic inter-linked complex) system. From time to time, new links are formed/connected (such as a new company started trading with Microsoft) and old links died/disconnected from time to time such as Enron.

Enron was a major hub to some of its sub-network links, which affected them when it collapsed. The Enron sub-network links that survived and not went down with Enron as a result of its collapsed, must have tried to re-establish themselves to avoid collapse by re-connecting to other nodes (new hubs it never dealt with before). The links between nodes are represented by how strong they interact (weight). The stronger node A interacts with node B, the higher the link weights between them.

Network theory is synonymous with an evolving system (such as economy) that re-wires itself on a continuous basis and that's a dynamic process. Old alliance amongst a group of nodes (higher weights) become competitors at some stage over time (zero or lower weights - no direct interactions) from some reasons. Old monopolies die and new monopolies arised and the process of rewiring the network never stops.

11/25/2011 08:31:00 am  

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