At the request of Alex and Meghan, re: last week’s post on Social Security, I have decided to lay out some important economic principles in a format you may recognize and understand.
Join me for today’s lecture in lolcatnomics.
SUPPLY AND DEMAND
Nothing in life comes for free. Everything worth having costs money or the sweat of your brow. And even if Stephen Hawking discovered instant psychic cold fusion tomorrow, enabling every human being to turn anything into anything else with a thought, time would still limit our desires.
The theory of supply and demand models the intersection of wants, resources and what we can willingly pay. You learn supply and demand in Econ 101; it’s fairly simple. There are years worth of theories and details that complicate the basics of supply and demand further (demand elasticity, menu costs, etc). But nothing you learn later on invalidates this basic principle.
If we both want the same dish of food, we must come to some accord.
Your two takeaways from this:
(1) Nothing Comes Free. When someone talks about “universal health care,” read that as “subsidized health care.” When a retailer promises “free shipping,” that means they pay for the shipping instead of you – and they’ve probably jacked up the sale price as a result. Everything costs something.
(2) You Pay One Way Or You Pay Another. When President Nixon put caps on the price of oil in the 70s, gas lines formed as a result. When drivers could no longer outbid each other using money, they started to outbid each other using time – time spent waiting in line. You see similar results today with concert tickets or the iPhone.
Unlimited wants, limited resources, like I said. So, when we get something, we use it to fulfill our most important want first. Every additional unit of that good fulfills a less important want. If you only had 1 gallon of water per day, you would probably use it to fulfill thirst (or you’d die). The next gallon of water can be used for hygiene; the next for cooking nutritious food, and so on. This means that each additional unit of a good has diminishing marginal utility.
This idea stumped economists for a while. In Adam Smith’s time, theorists called it the “diamond / water paradox“: why does water, which we need for life, cost so much less than diamonds, which we use for jewelry? For a time, Smith and other economists used the labor theory of value to answer this question: the idea that the value of a good was a function of the labor required to create it. However, this fails once different people start valuing the same thing differently. I don’t care if you made that Subaru Brat by hand or on an assembly line; I don’t want to buy it.
(And the answer isn’t “scarcity,” either – not everything scarce is valuable)
Rather, the marginal utility of a good – its “next best use” – determines what I willingly give up for it. If I am a hungry kitteh who values nothing but Food and Sleep, I will continue eating Food until the next mouthful will no longer satisfy me. Then, I will fall Asleep. Humans have somewhat more complex value systems, but the idea stands.
Your two takeaways from this:
(1) The Labor Theory of Value Is Dumb. I still find people who subscribe to this notion, and not just in colleges. Only a few months ago I passed a car parked on the streets of Cambridge with a bumper sticker reading “LABOR IS THE SOURCE OF ALL VALUE.” Crazies, I know.
(2) Extra Isn’t Always Better. At least 80% of Massachusetts’ high school students graduate within 4 years, per the most recent data I could find. Getting the graduation rate from 70 to 80% must have yielded some impressive benefits. Would getting it from 80 to 90% yield the same? And what would that cost, vs. the cost the Commonwealth paid to get from 70 to 80%?
ALL COSTS ARE OPPORTUNITY COSTS
We tend to think of cost, price and value in terms of dollars – paper currency, bank statements, the financial bottom line. But dollars, as I’ve mentioned before, act as a symbol for other goods. When I spend $20 on something, I’m not giving up that $20 – I’m giving up everything else that I could have spent that $20 on. Economists call this an opportunity cost – I give up the opportunity to use the good I trade for something else.
A hungry mutt can use his freedom for a lot of things – chasing trucks, harassing kittens, exploring the upstairs, going to his food dish. He should only get stuck in a cat door if he thinks something really tasty lies on the other side. He exchanges his freedom – meaning, his ability to chase trucks, harass kittens, explore the upstairs, etc – for something more awesome than all of those things.
To talk about this in human terms, say we’re bartering between my sack of oranges and your stock of handmade shoes. I will only give up an orange if the next best use (see: marginal utility, above) to which I could put a pair of shoes beats the next best use to which I could put an orange. However, I have a lot of oranges – a whole sack of them. I have already eaten oranges and made orange juice and planted orange seeds for the future. I will be giving up relatively few orange opportunities if I trade you a couple, and I’ll be opening up an exciting new future of shoe opportunities if I get a pair of shoes.
Your two takeaways from this one:
(1) It’s Not Just About The Dollars. A real cost is what you give up in order to get something. If you have an opportunity in your life that you can’t measure in dollars – a free concert ticket, a potential new roommate, the birth of a new child – think about what you would be giving up in order to get that thing.
(2) Time Limits All Options. As I said above, even if the human race discovered instant psychic cold fusion tomorrow, we would still lack for the time to do everything we might want to do. Time always conspires to shrink our opportunities, even if money remains plentiful. Even if what we choose to do today costs us nothing – someone offers me Red Sox tickets and a ride to the park and buys me beer – I still pay an opportunity cost of time I might have spent doing other things.
Despite being an early proponent of the labor theory of value that I talked about earlier, David Ricardo produced one work of unquestionable genius as an economist: the theory of comparative advantage. Comparative advantage explains why trade grows wealth more than any other activity.
If I’m better at catching mice and you’re better at guarding against intruders, we’ll have a happier household if I do most of the mouse-catching and you do most of the sleeping in front of the door. That’s common sense. But let’s say you’re better than me at both mouse-catching and guard duty. We’ll still be better off if you focus on guarding while I scamper along the baseboards.
Why? Because every minute you spend hunting is a minute you could spend making the house safer (opportunity costs; see above). You could try to take on both, and do neither of them well, or you could specialize in one and let me take the other.
That’s a big enough deal that I want to restate it: you can be better than me at everything that matters and trading with me will still improve your lot.
Your two takeaways from this one:
(1) Trade Enriches Both Parties. What makes freer markets wealthier than stricter ones is the exchange of goods and services. It’s not the act of producing or stockpiling goods that make a person or a state rich – it’s the act of trading them. Trade makes sure that goods get into the hands of the person who values them most.
(2) Lou Dobbs Is The Stupidest Man On Television. Joe Morgan may be dumber, but it’s close. Every time the U.S. trades with another country – whether it’s labor, in the form of outsourcing; goods, in the form of imports; or capital, in the form of Chinese people buying American companies – Lou Dobbs flips out. Keep this as a steady rule: anything that Lou Dobbs gets mad at will put wealth in American pockets.
CAPITAL MAKES THE DIFFERENCE
Finally, what makes poor countries poor and rich countries rich has little to do with natural resources or the sheer numbers of the labor pool. Bangladesh has plenty of arable land, and China’s population dwarfs that of neighboring Hong Kong. Rather, capital makes the difference – a mental investment in either machinery or technique that allows work to be done more efficiently.
A few examples of world-changing capital off the top of my head: the telegraph, the railroad, crop rotation, the scientific method, the computer, the automobile, assembly line processes, washing your hands with soap, the printing press, sewers, domesticated fire, latitude and longitude … and I could keep going. Think of capital not just as factories and machines, but any discovery that reduces wasted time.
Capital requires savings – either mine or someone else’s. If I want to build a roof over my head, I have to take time out from hunting boar or eating the boar that I’ve hunted. That time represents a cost (see opportunity costs, above), in that I could be spending that time at leisure or in getting the food I need. In civilized society, I don’t need to save up all the money necessary to buy a house – I can borrow someone else’s savings. But somebody has to have saved up resources at some point in order for capital to grow.
Savings requires security. If I think I have a low chance of surviving the week, I’m not putting money toward retirement. Countries wracked with violence, corruption and sickness, like sub-Saharan Africa, never have much in the way of savings. As a result, they never have much in the way of capital, and thus will never grow far past a subsistence level. Sure, a dictator can seize other peoples’ meager savings (as Mugabe did in Zimbabwe, or Chavez did in Venezuela), but that sort of trick only works once. Getting these countries out of the cycle of destruction will probably require the creation of institutions that keep people secure: honest police, reliable banks, clean and well-lit roads, etc.
Leave a kitteh to its own devices and it can only wreck your house. Give a kitteh the Internet and the world trembles.
Your two takeaways from this last one:
(1) Capital Makes The Difference. Economists rarely succeed at picking stock market winners, because economics and business are two different disciplines. You wouldn’t ask a physicist to build a bridge. But if you want a general idea of how a company, a region or a state will grow, take a look at the actions and policies that affect the growth of savings and, therefore, capital. How does borrowing compare against saving? Are plants, factories or processes being designed that will create future output? How long will it take to start turning a profit, and what costs will they have to pay – in other words, what opportunities will they have to forgo – before getting there?
(2) Every Investment May Fail. Consider time the universal currency. Investing it in satisfying your immediate needs pays off. Investing it in leisure time also works, too. But investing it in capital – whether a hut on your desert island, a stake in the East India Trading Company, or the mortgage of your house – always has risks. You’re forgoing present consumption and immediate labor for a future pay-off. The future’s weird and uncertain, though. Even if you calculated everything correctly, something may change very soon – a tsunami, a new Rajah, a change in new housing builds – that you could not have anticipated. You can trace most legislation since the Code of Hammurabi to someone losing returns on capital.
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You could learn all of the above in a good Introduction to Economics class. But not everyone takes Econ 101, not everyone who takes it remembers it, and not everyone who remembers it understands the practical implications. If kittens falling out of ceiling vents or staring bug-eyed at you helps cement these basic principles in your head, then I see nothing wrong with them.