The Real Issues: Economics

Economic Basics

No discussion of economics could begin without a discussion of the laws of supply and demand. In fact, once the principles of supply and demand are understood, understanding other areas of economics becomes possible once their effects on supply and demand are also understood.

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Supply and Demand

Fairness, Selfishness, and Greed

Counterproductive vs. Productive Measures to Promote Fairness and Security

Capitalism and Morality: Unlikely Bedfellows?

Supply and Demand
Supply and demand determine the prices of goods and services, and the price also has an effect on the quantities supplied and demanded. So how does it all work? I always have felt the best way to explain things is with examples. Let's have a look.

Supply:
Let's say your company produces a good. Your factory can produce 100 units per day at a price of $20 per unit (supply and demand also set (and can therefore change) your costs, but let's not get too complicated). You can produce up to 125 units per day, but the cost per unit then begins to increase to $25 per unit (80% capacity is most efficient, which is often the case, approximately). You would therefore like to sell 100 units a day to have the largest profit margin (money from sales (turnover) minus production costs).

Demand and pricing:
How much should your product cost? It is clear that it must be more than $20 per unit, otherwise you'd be losing money. Well, the supply, from you at least, is set to a maximum of 125 units/day. The DEMAND, then, will determine your price. Let's say your product is totally new and only you have the rights to produce it (no competition). At first, you may need to offer it at a low price to get it sold and well-known. So you start of at $27 per unit. You'd then be making $700/day in profit. Not bad. Keep in mind that you will want and need to reinvest a good amount of this profit back into the business.

Your product now becomes a total scream. More and more orders start flooding in (300 units per day are demanded). What do you do? You don't yet have the money to expand production, and that would increase costs and might not be worth it. You decide to raise the price to $50/unit. The quantity demanded decreases to 100 units per day. You can reduce production down to it's most efficient level again and you're now making $3,000 per day! It may now be time to expand your business. You invest in quadrupling your capacity. With the new, bigger factory, you can produce 400 units per day at a cost of just $15/unit. Demand has continued to pick up. You drop your price from $50/unit back to $27. You manage to sell 400 units/day at that price instead of the 100-125 you were selling at the higher price. In addition, although your profit margin is smaller ($12/unit instead of $30), your turnover is much higher. Your profit is now $4800/day. The result: more people get to own your product for less, and you get to make more money.

Competition
That's nice in an environment without competition, but those environments are rare. Eventually, someone would come along and build an enormous factory producing 1000 units a day and selling them for $15 per unit (cheaper than you can sell them). You would have to react accordingly, as no one would want to buy your product at a higher price, unless you can rightfully claim the quality is considerably better. Marketing and quality could allow you to keep the price higher (more marketing would also cost more). The other option would be to lower prices and cut costs, by expanding, automating, etc. Then you could reduce your costs further to compete with your competitor. This is how competition generally functions to keep prices lower. This is also why laws exist to prevent companies agreeing together on prices and companies creating monopolies. This is seen as unfair market manipulation and artificially holds prices higher. This is against the principles of a free market, and is bad for consumer and the economy at large.

Fairness, Selfishness, and Greed

Now it's time for the obligatory ethical discussion. This is one of the most difficult areas when discussing free markets. Many would argue it is wrong to set the price for a product according to how many people want it. The idea does seem rather shady when taken at face value, but let's look at the (often undiscussed) benefits of that system. Unsurprisingly, they are related to supply and demand.

Supply

First, let's look at the supply of the product. Taking our example from above, there are a great deal of people who would like to have the product you're making. The problem is, you can't produce enough to meet the quantity demanded at the price at which you are selling. How do you decide who gets the product? There are two possibilities: you keep the price the same and give them to people on a first-come, first-serve basis. This would mean long waiting times for your product. All right, one possibility. The good thing about this scenario is that a great deal more people can afford your product from the get-go, which is nice (as long as they are willing to wait for it). The bad thing about it is that it will prevent you from expanding, dropping unit production costs, and increasing production. The result: in the end, fewer people will get to own the product. You will also employ fewer people because you won't expand your factory. Result: fewer jobs and fewer people earning money.

Let's have a look at the scenario with option two: raise the price so that the quantity demanded (which decreases as the price increases) matches the quantity supplied (which reflects your production capacity). You raise your price and continue selling 100 units per day at a much-improved profit margin. That's good for you, but it means consumers are either unable to afford your product, or must pay considerably more for it. This, of course, seems unfortunate or undesirable at first, but let's continue with the scenario. As stated above, you can now decide to expand the factory. You expand, so your factory can produce 400 units per day, more than the quantity originally demanded at $27/unit. That's all right though, because you expect lower unit costs due to economies of scale (generally, the more produced at a time, the cheaper production becomes per unit, more in a later section), allowing you to reduce your sale price, and you expect demand to increase more anyway. Another reason it doesn't matter so much: even with a margin less than that originally seen when 100 products were produced per day and sold at $27 apiece, you will still increase overall profit by virtue of your much expanded turnover. 

So let's look at the profit for the consumer with option two, since we've already seen that you, as a producer, are profiting from the expansion, even with smaller margins. The result for the consumer is: more consumers can have the product, they can have the product for less, and they don't have to wait in line for it. There's also a third benefit to the economy as a whole: workers! You require more workers for your larger factory. That reduces unemployment and poverty, and increases the amount of money changing hands in the economy.

“But wait!” you say. “The consumer did have to wait in line. They had to wait until the product became cheap enough!” Well, you're absolutely right, of course. The wealthier consumers were able to get the product even when demand was high and production low, while others had to wait. That may seem like a case of the rich winning (again), but it's not for a couple of reasons. The first: the rich paid more, so they lost more. Their money was also used to expand the factory, which created jobs and lowered the price for everyone else! In essence, then, the money flowed from the wealthier consumers to the less wealthy consumers via your factory and product. The wealthy helped you expand and produce cheaply enough and en masse so that poorer consumers could also reap the benefits.

It sounds, suspicious, doesn't it? “Everybody wins?” you ask? We are hesitant to believe such a phenomenon. By why is that, actually? That's because we are used to a world of zero-sums.

Zero-sum and non-zero-sum interactions

So what's a zero-sum interaction? Many things in life could be categorized in this way (sometimes falsely). Concluding something is zero-sum is often the easiest explanation, as it's often the first thing we see. Let's look at a couple of zero-sum interactions.

"Might makes right"

Many interactions in a might-makes-right system of anarchy truly are zero-sum. Let's think of a playground bully. He goes to another child and demands lunch money, or else! He gets it. In this case, there is a clear winner (+1 for the bully), and a clear loser (-1 for the kid with the lunch money). The sum of 1 and -1 one is, of course, 0. This is what is meant by zero-sum. Wars, and fights are generally viewed as being zero sum. One wins, one loses.

It is for this reason, I would argue, that we tend to see the world on zero-sum terms and are therefore skeptical when economists and neo-liberals come to us and assure us that everyone can win. Let's look at some other situations that appear zero-sum, but upon closer inspection are perhaps not so simple.

You work for a company. Your boss tells you and another person s/he would like you both to apply for a position in management. You both do so. Your boss takes the other person. You see that as his/her win and your loss. Zero sum. But maybe it's not that simple. I would argue it's positive sum, especially since you haven't actually lost anything. In addition, assuming your boss made a good decision (this may be a dangerous assumption, but let's just say it's true for this example), s/he now has the best person for the job. That would mean that the whole company now benefits, including you. You are less likely to benefit if the company does worse.

Looking at the flip side: suppose you'd been selected and were not the right person for the job. It could even end up with you being fired. That is also not a zero-sum situation, because it would damage both you and the company. Everyone loses. These things happen all the time because people make mistakes. Maybe you were the right person, and your boss chose the wrong person. Even if the person doesn't get fired, the company will perhaps not do as well as it would have under your leadership. This is maybe not a loss, but it is a lack of a gain. THAT would be a zero-sum situation. Your colleague, who got promoted, benefits, everyone else suffers (maybe he will too if the company goes under, but let's say it doesn't).

So, do we have zero-sum situations in real life? Certainly! However, we often tend to look at things that are not really zero-sum as if they were. This is a mistake because it could lead us to make counterproductive decisions.

Counterproductive vs. Productive Measures to Promote Fairness and Security

Viewing capital flows as a zero-sum game is essentially the mistake (in my view) that has lead to socialism. This is however further complicated because the market does not always do what is best for everyone, at least not right away. We'll come back to that later when we discuss what happens when your product is food people need to survive, for example.

We've seen how competition can force companies to reduce margins and sell and produce products and services more cheaply. We've also seen how this benefits the consumers. More of them have access to the product and more of them can afford to purchase it. But what about the consumers who are also producers, the ones working in the factory? What happens when your competitor produces something much better and cheaper than you can? What happens when a factory closes?

This is a negative aspect of life, and one that tends to make people blame capitalism. But let us not forget that those jobs would never have been created in the first place if it hadn't been for capitalism. Let us also not forget all the workers in the competitor's factories and the ripple effects of lower prices. If other companies use the product, it may allow them to produce more cheaply and expand. This also generates more jobs, lowers prices in other industries, increases consumer access to cheaper products, and the cycle starts over again. These are all good things, but often times people take low prices for granted and underestimate their effect on their standard of living. Afterall there are two ways to increase your prosperity: earn more, or spend less. If prices drop, consumers can afford more, and their standard of living rises.

Alas, we still have some very unhappy workers. Their situation is real, they are not currently profiting from the free market. How can they be helped and this problem addressed? Though some extremely neo-liberal economists might disagree with me on this issue, this is where, in my view, some sort of safety net is indeed in order. This is where real discussion and real analysis are needed, however, because safety nets carry very real costs for the entire system and therefore for every individual in that system. These costs are often spread out and harder to measure, meaning they are often not seen. Below are some of the options I'm aware of, my view of what the best options are, and what costs they carry with them.

Layoff protections

Particularly common in Europe, layoff protections are laws that make it more difficult for companies to lay off workers in hard times. At first glance, this seems like a good idea. After all, who would want to encourage companies to lay off workers? We must remember that such measures always carry costs and that these costs are often not apparent at first glance. But what are these costs and how do they compare to the benefits?

What effect does having to hold on to employees for, for example, three months before laying them off have on the company? It reduces the company's flexibility. If a crisis hits, it essentially slows it's reaction time by three months, causing the company to incur additional costs due to a slower reaction. What benefit does it have for the employee? The employee has more time to look for another job and may have a package to aid the employee financially until another job can be found. Are these good things for the employee? Certainly. There are, however, additional hidden costs. One of the most striking and rather unanticipated costs of layoff protections is that they actually increase unemployment rates and delay companies' hiring new workers when times are good (further reducing their capacity, flexibility, profitability, and ability to employ more people). Why? Companies are much more reluctant to hire new workers if they are afraid they won't be able to shed them when things go south.

So what's the bottom line? The overall effect of layoff protections is negative. They benefit the worker already employed and about to be laid off (who may, as a result, not be quite as motivated to search quickly and vigorously for a new job, keeping him unemployed longer), but they harm the company and any potential future employees. They also hurt the just-laid off employee when s/he looks for another job with another company reluctant to hire her/him.

Layoff protections, though they sound like something one could hardly morally oppose, are counterproductive and should therefore not be implemented at all.

So we should just let companies lay people off and too bad for the employees? Not so fast, that's not what I'm saying. I'm a worker too, after all. Letting companies lay workers off, though counterintuitive, is a good idea. Doing nothing for the laid off workers, however, is not a good idea.

Unemployment Insurance or Federal Benefits

Unemployment insurance/benefit schemes are very commonly implemented programs for helping the unemployed. They too, sound good, but they also carry costs. There are also many different ways of running such a scheme, some of which are better than others. In any case, I believe such schemes are necessary in a competitive free market to encourage the type of risk-taking necessary to get people out there and encourage people to start business, apply for better jobs, etc. To my mind, however, any such scheme must not remove the incentive to work, must be a temporary help, should be coupled with an adult education program, and should include extensive monitoring by an employment counselor to ensure effectiveness and prevent abuse.

So what would such a scheme look like? It would have to be set for a limited amount of time (a couple years), should provide the recipient with enough money to live, but not much more (possibly eventually requiring them to move into less expensive housing if the disbursement period extends beyond, say, six months), require the recipient to go on job interviews and accept, at first, any job within the field that offers at least 75% of what he or she was previously earning. Later on, the recipient may be required to accept other jobs in other fields that pay less. In my view, the system should keep people from ending up on the streets, but it shouldn't give them a great life. It's for emergencies.

My experience with the unemployment system in Austria is that some people took jobs, worked for a day or two there, and quit, telling the unemployment office they just “didn't like it.” In my opinion, this is an abuse of the unemployment system. I've also met students who worked over the summer and then got on unemployment so they didn't have to work during the school year. This is particularly perverse (from an American perspective at least) when one considers how inexpensive colleges in Austria are (around $300-500 per semester) and how long students study (sometimes up to ten years to graduate with their first college degree!). The system is there for emergency aid, not to help people find their dream jobs by supporting them with taxpayer money indefinitely until they find it or finish their studies. I do not doubt that many people in Austria would agree with me, many of them unemployed and trying in earnest to find a job (I've met several of those as well). These should be the limits of the system in my view.

The unemployment counselor should follow up on interviews to try to get an idea of what went wrong. What did the candidate do or say (or have on his/her resume/CV) that made the employer decide against him/her? How can this information be used to improve the candidate's chances the next time around? An additional concern would, at some times, be: Did the candidate sabotage the interview to avoid having to work? In this case, the unemployment aid would be threatened. I think such cases should be treated as what they are: fraud.

For the system to work, it should be coupled with another aspect that also exists in Austria (and which is a good thing about the Austrian system): free furthering education. Suppose the counselor finds out from multiple employers that the candidate's computer skills just aren't up to snuff. This could and should be remedied via a computer class targeting the skills needed in the candidate's field. I think this should also be paid for by the unemployment office if this knowledge is deemed essential. Yes, it would cost more money in the short term, but getting the person back to work would reduce the long-term costs to the unemployment system. Also, an increase in the number of skilled workers would reduce costs for industry and spur on expansion and job creation, once again benefiting nearly everyone.

So much for the benefits. What about the costs? The costs, unfortunately, are substantial. Such a comprehensive system requires a good deal of taxpayer money, especially if implemented at a time of high unemployment. However, as it should reduce the number of unemployed and brings benefits for the economy as a whole, I firmly believe that this system would actually be cheaper over time in terms of budgetary and opportunity costs than a less comprehensive system (or indeed, no system at all), in particular for an advanced economy requiring more skilled workers that is able to finance such a system (for less developed economies, such a system may not be feasible due to its high initial costs).

There is one further benefit not often mentioned. If people have a functioning safety net that can effectively get them back to work at a reasonable (or possibly better wage), they will be more satisfied. Having satisfied citizens is not just nice, and not just good for political reasons. It is also good for economic reasons, and not just because they are likely to work better and be more productive. Unhappy workers and unemployed are more likely to jump on board with less well thought-through measures (such as layoff protections) that are counterproductive and actually hurt workers in the long run.

In addition to adult education programs for the unemployed, education in general is of extreme importance, and for more than just economic reasons. At this stage, though, I'll focus mainly on the economic reasons.

Education is essential for getting a job in a modern economy and for providing a modern economy with skilled workers. It is also essential in fighting income inequality. Really? Why? Because income inequality is not caused only by non-progressive tax structures, it is caused by a gap in supply and demand (of course). This time it's the supply of skilled workers and the demand for skilled workers. The latter is considerably higher than the former. This means skilled workers' wages are climbing dramatically. At the same time, demand for unskilled workers is declining, while their supply has actually increased. This has led to stagnant or even falling wages for many people, from people working simple jobs in factories, to retailers, to salesmen (this is exacerbated party by (illegal) immigration of unskilled workers). Trying to solve this problem by setting limits on pay would be counterproductive (as higher pay results in more people getting educations in a certain field and eventually will serve to increase the supply (and reduce the price of the labor), just as it would with a factory product. This is only possible, of course, if the education system allows students to acquire the skills they need!). A solution via progressive tax structures (though desirable anyway), would serve only to treat the symptom somewhat, but would NOT get at the cause. In addition, if a tax structure progredssive enough to effectively treat the symptoms would also slow the economy enough to hurt everyone in it, making it also counterproductive.

No, the long-term solution is education (the short-term one would be immigration laws that let in more skilled workers, slowing wage growth for skilled workers and slowing the speed with which the income gap grows. In addition, slowing the inflow of unskilled workers could also be considered). So should our colleges become free? Another idea that sounds good, but after experiencing free colleges in Europe I can say one thing for certain: you get what you pay for, especially when you pay for it directly. According to the Institute of Higher Education at Shanghai Jiao Tong University, the United States is home to 17 of the top 20 Universities in the world. The U.S.'s ability to attract bright people from around the world in unprecedented.

So our educational system is all right? NO! Our public schools rank very poorly compared with other industrialized countries. They are unable to prepare today's students for tomorrow's jobs. So, since the private universities function so well, and the public schools don't, we should privatize the schools, right? No, this is an area where the principle of equality of opportunity would not allow us to privatize schools. Besides, education is a risky business. It takes some 12-20 years or more, and the outcome is fairly uncertain (you can't be sure if the things you teach will still be needed later). Plus, if we began educating our children according to specific economic needs of today, we would be training a workforce that would be outdated by the time it came into existence. Also, we would stamp out the innovative and creative possibilities essential to progress by teaching only things that seem “useful” at the current moment.

No, in my opinion, public education must remain the task of the government. It must also be improved, however. High school students must graduate with the knowledge they need in this changing world. In addition, the government should also offer better financial aid and affordable student loan packages to college students. This is an investment not only in the future of our society's children, but in the future of our society itself. Not to mention the fact that it would be a permanent solution to the cause of income inequality in the United States and elsewhere in the industrialized world. In addition, more funding needs to be put into research. This is an area where the U.S. already spends a fair amount (especially the private sector, but the government could still spend more) and where many countries in Europe have some catching up to do.

Capitalism and Morality: Unlikely Bedfellows?

As mentioned earlier, capitalism is not a zero-sum game and can benefit all. It is, therefore, not at all inherently immoral, as so often proposed. That does not mean, however, that it is completely free of moral dilemmas. Economists are also generally aware of these dilemmas. I'll take a moment to look at one of them as an example.

As mentioned earlier, we have a problem with the standard model of increasing supply by first increasing price and then expanding capacity if the good in question is necessary for survival. Let's take food. Let's say there isn't enough food being produced to meet the quantity demanded (i.e. needed). Our usual model of raising the price and using the additional revenue to expand production could very well be considered immoral, as it would require that some (the poor) go hungry. On the other hand, if there isn't enough food, there isn't enough food, so some will go hungry no matter what. Luckily, this is rare in the real world (a true lack of food, not that people go hungry, which is unfortunately all too common). If enough food cannot be produced in a country, it can usually be imported – generally at a higher price. OK, so paying more can get you the food you need, that doesn't solve the problem of hungry poor people. So what can?

In this situation, I'm afraid, the government must have a role. The government must invest in expanding the food supply (supply siding) and, in the meantime (and temporarily, why later) subsidize the food being imported and produced to keep the price low enough that the poor can afford to buy it. Over time, as supply increases, the subsidies should slowly be cut back and eliminated, as there will be enough supply and the price will be low enough for people to pay without subsidies.

Why is it so important to eventually eliminate the subsidies? I would argue it is the case on moral grounds. Many people support farm subsidies because they believe they support farmers. If you want to support farmers, buy local produce. The heavy farm subsidies in the U.S. have not led to more little, family-owned farms (although they cannot be directly blamed for their disappearance), but they have had a second, highly undesirable and regrettable effect on the poor in the developing world. Because the subsidies have held food prices so low and have encouraged over-production in the developed world, the food ends up exported. At first glance, sending cheap food to third-world countries seems like a good idea. It is not.

Third world countries, able now to receive cheap food supplies from the U.S. and Europe, begin to move away from subsistence farming (seen as no longer necessary) and small commercial farms (no longer profitable). They begin producing cash crops. This is all very well until events around the world simultaneously reduce food supply. Suddenly, people in developing countries, reliant on cheap, subsidized food, are unable to pay for the food, and, since they have given up farming, unable to produce food for themselves. The problem is exacerbated by export stops in other countries, which serve to keep prices lower there, but raise prices on the global market.

What's the solution? In this case: self-sufficiency (known as the mercantilist approach, something I would advocate for core necessities in developing countries only). Money is not the only measure of wealth: it starts with being able to feed yourself. One way we can help countries become self-sufficient is by reducing slowly and eventually eliminating agricultural subsidies. These subsidies serve only to cause global imbalances, instability, hunger, death, and of course: anger at the west and at capitalism. The west may be to blame, but as you can see, capitalism is not the real culprit, but rather well-meaning but poorly implemented government policies.

These lessons apply to many other areas as well. This (along with education and other topics) is part of the equation for helping capitalism work for everyone, including the poor, helping to ensure that economics really remains positive-sum, bringing benefits for all.

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