Learning Economics…

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I started blogging about Economics recently because I was saddened by the lack of understanding people have about a Social Science that is critical to our survival as a race. Yes Critical.

My last few posts on Demand & Supply were to try and clarify exactly what a Free Market it is, and the criticisms and and ‘failure’ of the Free Market are false. On publishing that post, I came across this old post circa 2007 in the ‘related posts’ section. Maybe the author has received a better education since then, but if not, I will answer his questions here. The questions asked display a shocking lack of understanding of Economics and again saddens me. The author of that post wasn’t a layman, he was studying economics, and yet, did not seem to get a good grounding of fundamentals. Again, I will assume that since that post was 2 years old, the author may have been enlightened since then. But there are probably tons & tons of people like who have the same questions, and it is to the general multitude that I address this post:

Scarcity

I was taught that the central problems in economics were that of scarcity, of unlimited wants and how one chooses the best option. And here optimization (a mathematical apparatus) comes to the aid of economics- in finding the optimum. But are resources really scarce? If resources were really scarce, how could an economy grow? Land, of course is scarce; but the availability of land can be increased through reclamation, deforestation etc. Economics ought to be concerned about wants that are backed by purchasing power; otherwise the theory will be trying to reconcile dreams and scarce resources.

The first question – are resources really scarce?  It is amazing that this question needs to be answered. But I will answer it. Off course they are! Is there an unlimited supply of steel in the world? Of gold? Of Accountants? Of course not! There are finite limits to all of these things. We may (or may not) be able to increase the amount available of these things in the long-term, but in the short term (i.e. in the next year, or the next month) – the amount of total possible steel available, accountants, oil, cellphones is finite. So yes! Resources are scarce!

The second question – ‘How could an economy grow?’ is far more complex, but let us answer it simply. An Economy grows through the creation of wealth. Wealth is created when you move a factor of production from a low-value usage to higher-value usage. So… what that means is that if you have  scarce resources, you need to put them to their most efficient uses to get richer, and therefore grow!

The final statement – Economics ought to be concerned about wants that are backed by purchasing power – is PRECISELY what Economists ARE concerned about. If you refer to my previous post about demand, I defined as those people who are WILLING & ABLE to buy a good or service at a given price. The ABLE part of sentence refers to purchasing power. If you’re not ABLE to purchase something, then in an ECONOMIC sense, you do not constitute the DEMAND for a product.

Equilibrium

Equilibrium is reached when the demand and supply curves intersect in the graph having quantity demanded and supplied on the x axis and price on the y axis. Joan Robinson (1973) wonders why one uses a metaphor based on space to explain a process which takes place in time.

 

This approach has for quite some time disturbed me. Why is it that we take ‘equilibrium’ to be favorable? Equilibrium is a thing very commonly found in Physics. One of the meanings is that ‘it is a state of rest’ and this is precisely the meaning economists provide. For, in equilibrium, the quantity demanded will be equal to quantity supplied and all is well. Coming to think of it more, why would a stagnant economy be favorable? What is more frightening is that, we are taught that it is what economic policies should aim at!

 Firstly, the Demand & Supply curves that we draw are a) Theoretical Constructs and b) Are snapshots of Demand & Supply at a given point in time, to keep things simple. Trying to teach students Demand & Supply with a 3 dimensional graph of demand & supply over time is only going to increase the global suicide rate, and the global internal combustion rate. Furthermore, Joan Robinson (1973) was all praise for China’s Cultural Revolution, which seriously puts her credibility in doubt!

Second – Equilibrium, in the case of Economics, is again, A THEORETICAL CONSTRUCT. When left completely to themselves, Demand & Supply will organise themselves around the equilibrium price BUT they may never ever reach the actual equilibrium price. That is to say that the world is TRYING to get to a ‘state of rest’ but will never actually do it. Buyers want to buy as much as they can, at the lowest price available to them, sellers will only sell more if they can get more money for selling more. So it should be blatantly obvious, that these 2 sets of people are working at opposite ends, and the result will turn out to be ‘somewhere in the middle’. It is not ‘a state of rest’ meaning people stop producing more, or buying more. The reason equilibirum is considered ‘Optimal’ is because it is at this point that there is MATCH in terms how much people want to buy, and how much they want to produce.

So…it is an efficient & fair allocation of scarce resources (at the equilibrium point).

What does ‘fair’ mean in this context? – it doesn’t mean an end to the Middle East Crisis or the end of World Hunger. It specifically means that all those who are willing & able to buy something at a given price will be able to – AND – all those who are willing & able to produce at a given price will be able to. At the equilibrium price, you are not producing any more of a good than you have to – and everything that is produced is consumed – so the resources that were used in the best possible way, without any wastage, or shortage. This WHY you want to target your economic policies towards the ‘Equilibrium point’. But in reality – this point may never actually be reached, for a variety of reasons. In an ideal world, where supply and demand react instantaneously, on the split fraction of a second, and there were no taxes, no subsidies, then yes, you may actually accurately hit the equilibirum price. But in all other cases, the prices you see are an approximation of the Equilibrium OR Market Price based on the current circumstances.

Prices

Prices, according to the mainstream neoclassical theory are determined based on the intersection of demand and supply; that too in a static set up. Prices, in today’s world is certainly not fixed in the before said manner. The producers decide the price based on the cost of raw materials and other items needed for production, wages and salaries of employees, advertising costs, existing taxes, etc. So this means, prices in an economy has more correspondence to the supply side than the demand side.

 

What is the significance of the demand side? One of the reasons could be to point out the importance consumers have in deciding the prices in a ‘perfectly competitive’ economy. It would signify consumer sovereignty in such an economy. Again, this belief of ‘consumer sovereignty’ is something one would like to have, but is absent totally.

This particular part really shocks me, and it just goes to show how much damage bad teachers can do. the author of the post seems to be entirely clueless about the determinants of Supply. The supply curve is derived from the Marginal Cost curve of all the suppliers in the universe. ‘Marginal Cost’ = the change in cost of producing one more unit  of the good. So the supply curve IS A REPRESENTATION OF THE SUPPLIERS’ COSTS!!!!!!!!!

Second, consumers ‘decide the price’ by actually buying something. Yes, a supplier sets his or her OWN price – but that MAY or MAY NOT be the market clearing price. The consumer ‘soverignty’ referred to here is that if the price the supplier sets is too high, consumers will not buy a good from that specific supplier, but will go to another one, or buy less of it than the supplier would like. Therefore, in order to make more money (by selling more, but only the more money the supplier makes is greater than the cost of making more), the supplier has to improve his product to justify the higher price, or lower the price, i.e. tend towards the equilibirum price. That means, the reaction of consumers to the price affects how the supplier will behave. Again, this immediate change in prices only occurs in the IDEAL situation. In reality, we don’t have an infinite number of buyers and sellers in the market. In some cases, there are only a few suppliers, and in others, only a few buyers (more on this later).

Perfect Competition

No student of economics graduates without studying ‘perfect competition’. It is very much entrenched in economic theory as taught today. Why? The answer given is that it is the ideal state for an economy. Or rather, as the name suggests, it is ‘perfect’. Then we are taught about imperfect competitions keeping in mind what is good or ideal-perfect competition.

 

One of thoughts one could have is ‘why is it considered perfect’. The price is assumed to be given or it is said that the firm is the price taker. Another query would be- is perfect competition possible? The main driving force behind corporations and businesses is money or precisely speaking, profits. Would firms like an atmosphere where they are unable to fix prices and hence unable to earn more profits? It reeks of Orwell’s Animal Farm. Why would there be any competition at all? Aren’t differences that lead to competition? Would there be any incentive to produce or to diversify?

The first mistake the author makes in this case, is taking the definition of ‘Perfect’ to mean ‘Ideal’. That is incorrect. The use of the word ‘Perfect’ in this context, is the same as when you refer to a ‘Perfect Storm’. Is a ‘Perfect Storm’ an ideal storm? A storm you desire to have? Of course NOT! The dictionary definition of the word ‘Perfect’ can be found here. When we talk of perfect competition, we mean the dictionary definitions 6 & 7 – i.e. ‘through, complete, utter, pure unmixed’ competition.

It is again, a theoretical construct used to describe a specifc situation. It allows you to ‘predict’ what would be the case in the real world, if there was some situation similar to this. Are there situations similar to this? Yes there are – the Stock market is one such example.

If this student of Economics did not understand these basic fundamentals, what hope is there for the trillions of people who have never had a lesson in economics. Is it then any wonder why the garbage spewed by Marx is so common, worldwide?

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