What is the Economy?

Most people have some idea, to a greater or lesser extent, of what the economy is.  However, a lot of confusion exists.  A friend once encouraged me to watch a video on YouTube because it “had to do with economics”.  In reality, it was just a video about “sustainability” and anti-corporatism.  It was an honest mistake, but upon reflecting later, I realized that it might be good to do a post telling what the economy is and is not.

            A long time ago, when civilization was mostly tribal, there was not much of an “economy” as we know it.  People would grow food, hunt food, gather food, and perhaps go to war if they were bored.  At some point, people realized that different people were good at different things.  Some were good at farming, others at making tools, and still others at yet other skills.  This gave rise to what we call the “division of labor”. In a society that operates with a division of labor, people do what they are good at doing and trade with others for what do not do.  A smith would make tools and trade with the farmer for food.  They would both be better off in the end because they were able to procure something that they didn’t have to make themselves and only had to do the one thing that they were good at.  The division of labor gives rise to a social system characterized by specialization and trade.  The extra benefit of specialization is that when a person focuses on one vocation, he is able to acquire more and more skill, as well as innovate in his field.  This is the time in history when we see the first big jumps in technology. 

            Fast forward to a later point in humanity’s history and we see the invention of money.  What is money and why was it made?  There was a need for some medium that could store value permanently.  This need is perhaps most clearly seen in farmers who, in the absence of a method of storing value, could only trade during the times that they had a fresh harvest.  In those times, they had plenty, but the stocks did not last long enough that they could trade for other necessities during the rest of the year.  Another problem with a society based solely on trading is: what if the person you want to buy from does not want the good that you have to offer.  The trade gets even more complicated when attempting to trade something of little value, say corn, for something of great value, a guitar.  What if the guitar is worth a couple thousand ears of corn and the guitar maker won’t trade for it because he does not want to have to deal with carrying around those thousand ears?  Yet there is a rub because guitars by nature cannot be divided into some smaller segment that can be traded for fewer ears.  Money was invented to solve all of these problems.  Whatever form it has taken throughout history, money has shared these characteristics: it holds value permanently, is easily divisible into smaller parts, and is universally (or at least widely) accepted by everyone in a region.  With the creation of money, people were able to specialize even more because they did not have to worry about their product being immediately marketable to an end user.

Ludwig von Mises, author of "Human Action"

            Adam Smith wrote about the growth of a society from specialization and trade in 1776 in his book The Wealth of Nations.  This sparked the Industrial Revolution which saw specialization increase to such an extent that a person’s sole occupation might be the creation of a firing pin of a gun.  Trade expanded too so that each country could take advantage of its own natural resources and the skills of its labor force and trade with other countries for their products.  This is where we get the idea of an “economy”.  An economy is the sum of the resources that are used and the products that are made and the processes by which they are exchanged in a society as well as the actions of the people who participate in them.  Civilization has progressed a long way since the days of hunters and gatherers and has become nuanced enough that no one person or group of individuals can hope to understand it fully, but it does not keep us from trying. Economics at its very core is the study of human action, how people use resources for the betterment of themselves and of humanity. 

Read More...

Mind Games: The Role of Advertising in the Competition of the Coca-Cola and Pepsi Companies

This is the term paper that I wrote for a game theory class called "Competition and Strategy". I believe it to be a prime example of my writing and thus thought that it would be good to share here.

Mind Games

Read More...

Today's Incentives at Work

            My dad rented a car recently for a business trip and these were the keys.  Now I’ve seen a lot of rental car keys before, but never one with a label right on it that said the replacement cost.  This unusual tag got me to wondering about the role of incentives in everyday life, as I’m sure it would do to any of you.  To start off, think about this, how much does it actually cost to replace a car key?  I highly doubt that it is really 225 dollars.  After a minute of some search research, I discovered that replacement keys for Kias actually cost around 150 dollars, more or less, depending on the locksmith you use.  How much do the materials themselves cost?  There’s no easy way of finding that out, but again, I would suggest it be much less than even 150.  Now, to be fair, a markup is to be expected for the cost of the smith services, but why does the rental car company charge so much?  225 dollars for a key, after all, is a lot of money for a key even if you take into account the trouble the company has to go through to order a new one.

            I submit this explanation for the overpriced key.  No one wants to pay hundreds of dollars for a key and the car company certainly does not want to have to go through the trouble of ordering a new one.  I’m going to cut to the main point here and say that since no one wants to pay or have to deal with getting a new one, the best way to ensure that the keys don’t get lost in the first place is to charge an exorbitant price for its replacement.  The result is that I suspect these car keys don’t get lost very often.  My dad certainly did not lose it.  The effectiveness of this policy is best seen in its absence.  People would probably be much more careless with their keys if it was less.  Case in point: consider that my family has, in the past, lost our house keys fairly often.  These cost less than five dollars to replace.

            Look at the incentives at work here.  If you want to discourage some actions, make it more costly for people to participate in it.  The ramifications of that statement extend far beyond car keys.  Think of carbon taxes for pollution.  Think of prison sentences for various crimes.  The list goes on.  Now I submit that society could not exist in an orderly fashion without these incentive penalty structures.  Imagine what the country would be like with everything from murders that never got punished all the way down to library books that have no reason to ever be returned.   

Read More...

Letter from the One Percent

The purpose of this letter is to put a face to the ones who are often so hated by much of the populace (the now-defunct Occupy Wall Street movement epitomized this attitude) for being wealthy, “The One Percent” as they are called.  In particular, they are the ones that have an approximate income of over 500,000 dollars per year.  The resentment, wherever it stems from is beyond the scope of this piece.  To that end, I have written a story conflated from the anecdotes of four individuals with whom I am acquainted in real life to various degrees. All the stories are true. 

Dear Occupy Wall Street,

Let me begin by posing a question: if someone were to make an unkind generalization about a certain group of people, what would you call it?  What is the word for hating individuals based on some aspect of them?  It would be called prejudice, ageism, sexism, racism, etc.  These things are all highly frowned upon in the modern world and yet one group remains that is fashionably hated by you and in popular culture.  “Income-bracket-ism” doesn’t quite have the same ring to it as the others, but the same mean spirit pervades them all.  So why do you hate the most wealthy of America, the “One Percent” as you call us?  Is it from jealousy?  Does it seem to be unfair?  Is it because if your minds, we are the ones that “steal” money from the hard working people like you?  Let me ask you a question: have you ever thought that we may deserve the paychecks we receive?  After all, shouldn’t a person be compensated for the value they create in the economy?  A factory worker and an investment banker both do work that makes the world better off.  It is different work, but they both add value and so deserve their compensation. 

But you reply: why the huge gap between what I earn and what the average American earns?  What did I do to deserve so much more?  Well it turns out that I do a lot more work than the average American.  Have you heard of the hundred-hour work week?  That’s my life as an investment banker.  Do you think I go home at 5 to my wife, kids, and dog?  No!  Work takes the vast majority of my time.  Perhaps you ask, “What kind of life is that with so much work?”  I sense a tone of judgment but respond that you have no right to judge my lifestyle any more than I do yours.  Though, to be fair, I will only be doing this for a few years because I have other plans for the future.  Further, you should know that I don’t do it for the money.  As one wise man said, “my paycheck is seeing my ideas implemented!”  Everyone knows that money doesn’t buy happiness but they live like it does.  The truth is: I work for the thrill of the hunt and a love of the game.  The job itself, “seeing my ideas implemented” gives far more satisfaction than a fat paycheck.

I also want to let you Occupiers know that you don’t get your way just by complaining and whining about it.  I learned this lesson at a very young age when my parents didn’t just hand me everything I wanted.  Here’s the secret to actually getting something: you have to work for it.  Another lesson I learned: if you don’t grind, you don’t shine.  Ask anyone who makes six figures how they got there.  They won’t say it was handed to them and it certainly wasn’t handed to me.  In college, when my peers would get drunk and high, I studied.  When they wasted their time on whatever it is that college kids waste their time on, I studied.  During the summers, I worked.  I worked in a recycling warehouse forty hours a week and was subjected to terrible verbal abuse.  With the money I made, I saved and invested when my co-workers blew their paychecks on second Xboxes…despite sometimes being on welfare.  When the burden of that life seemed too much to bear, I remembered that it was only temporary and that it was simply part of the grind before the inevitable shine.  In another job, I was promoted before people who had more experience and knowledge than me for one reason: I worked harder than the rest.  Experience is just a matter of time and knowledge can be gained, but a strong work ethic comes from within and can only be taught to oneself.  I do not tell you this to boast, but because I want you to know that diligence is rewarded.

A common complaint, a stereotype, is that the “One Percent” are corrupt crooks that prey on everyone else’s money.  Well it isn’t unfounded because that has certainly happened.  But I wish to remind you that any other person might do the same thing if given the opportunities that my peers were.  After all, don’t you know poor people that are also inclined to unkindness?  Do you know people who are wealthy but kind and generous?  Do you know poor people that are kind and generous?  Income is a terrible judge of a person.  All that income tells you about someone is how much money they make.  Furthermore, people have identities outside of their work!  Who I am is not tied to what I do.  I get far more satisfaction from and find meaning in giving of myself for the betterment of others.  I use my business experience to go to the Third World and teach people how to start and manage their own businesses.  I provide them with loans to buy equipment, amounts too great to be filled by microloans but that banks will not provide because the recipients do not qualify for them.  Again, I don’t tell you this to brag because I’m sure that many people do what I do, as would many more if they had the opportunity.  But as it stands, everyone does their piece for humanity according to their means and their contributions are all valuable.  In light of this, I ask that you give up your hatred for me and my peers and direct your energies to more constructive ends. 

            Sincerely, a person just like you

You know he made Microsoft, but he does other things too. 

Read More...

The Four Goods

            In economics there are four categories by which we describe goods.  It is helpful to think in these terms because being able to label characteristics on things allows us to be more informed when making decisions about how it should be treated with regards to property rights, legislation, etc.  The four goods are private, public, natural monopolies, and common resources.  The one that a particular good falls into depends on two qualifications: two questions that we ask of it.  The first is, “is it excludable?”  This essentially asks if the good can be kept from people.  Apples are excludible because a farmer or grocery store can choose to sell or not sell. Roads, with the exception of private and toll roads, are non-excludible because unless there is some interruption in normal operation, anyone can go on roads at any time.  The second question is, “is it ‘rival in consumption’?”  “Rival in consumption” is a phrase that means when one person uses it, there is less for everyone else to use.  Tea bags are rival in consumption.  When one is stepped, then the number of usable tea bags in the world has shrunk by one.  Fire alarms, on the other hand, are not rival in consumption.  When one person hears it, everyone else can hear it just as well and there is just as much fire alarm to be heard regardless of how many people are within earshot.

            The first good, private goods, is pretty straightforward.  It is anything that is both excludable and rival in consumption.  Apples are private goods.  “Apples to Apples”, the game, is a private good.  Apple sauce is a private good.  Apple iPads are private goods.  I won’t belabor the point: private goods are easy to understand. 

            The second good, public goods, is also fairly easy to comprehend.  Though, to be fair, it is a little more difficult to think of examples for.  Public goods are non-excludable and non-rival in consumption.  In other words, people cannot be kept from using them and their use by some people does not diminish the usefulness of them to others.  Lighthouses are a public good.  A lighthouse just sits out there shining its light to the sea.  When one boat sees the light, it can still be fully seen by other boats.  In normal operation, it is not excludable either because it isn’t feasible to try to hide the light from some people and not others. The military is also a public good.  Whether there are 250 million or 300 million people in America, there will still be the same public defense system that keeps law-abiding citizens safe.  It’s non-rival and non-excludable.  General knowledge is also a public good, like math and science.

            Things get a little dicier when it comes to the intermediate natural monopolies and common resources.  Natural monopolies are goods that are excludible but non-rival in consumption.  (They are also known as “club goods”.)  Cable television, satellite radio, the internet, and movie theater shows are all kinds of natural monopolies.  Intellectual property is a kind of knowledge that is a natural monopoly.  The owners of a patent will share it with their constituents and it can be shared as much or as little as the owners desire, with no loss to the original creator.  It is important to note that intellectual property can only legally to be used for those intended to have it.  I put “legally” in because patents and other intellectual property can be stolen with various effects, but all laws being abided, intellectual property is a natural monopoly.  Also, spoiler alert, intellectual property deserves a post of its own in the near future.  Public education is another natural monopoly.  Its non-excludability is literally legislated.  Yet the quality suffers as quantity of children in each class increases.  As such, there is certainly some level of rivalry in consumption regarding a teacher’s lesson.

            Common resources, another category that deserves its own post, are defined as goods that are non-excludable but rival in consumption.  This gets into all sorts of sticky situations like the “tragedy of the commons” and “collective action problems” that could be written about in detail until the world runs out of resources entirely.  What are some non-excludible yet rival in consumption goods?  Fish in international water, the atmosphere, fresh water wells, oil reserves, unprotected forests, and the like are all good examples.  One characteristic of common resources is fungibility.  That is, the ability to substitute from any source.  Oil from Venezuela burns just as well as oil from Saudi Arabia or Canada.  A house can as easily be made from Oregonian wood as Indonesian wood.  Ownership is the issue at stake here, which goes back to tragedy of the commons and collective action problems.  This is what should be discussed in more depth later.

            The different categories of goods require different treatment.  Private goods do not necessarily need legislation to direct their use, though the government would probably disagree with me and this is not a universal statement.  Public goods usually have to be provided by the government because of a collective action problem.  Natural monopolies are the subject of some disagreement in the world because of intellectual property rights and the like.  Common resources, however, are the cause of the most legislation and are the most contentious of the four goods.  Who owns the electromagnetic spectrum?  Is it first-come-first-served?  Who owns the atmosphere or oil reserves?  Knowing where a good fits into the quadrant of goods allows us to be better informed citizens when considering how it should be treated with relation to use and the law.  

Read More...

Crisis! (Part 2 of 2)

            The roots of the United States’ financial crisis began during the Clinton administration when banks Fannie Mae and Freddie Mac started encouraging subprime loans to people who could not afford houses.  Additionally, the government bailed out a company called Long-Term Capital Management, which pioneered the development of securities and credit derivatives.  This business plan failed eventually.  When it was bailed out, however, something insidious was signaled to the rest of the industry.  Namely, banks lost their incentive to be fiscally responsible since they knew that they could be rescued by the Federal Reserve in the event of a monetary emergency.  The Reserve followed that action by bailing out Bear Stearns, which only served to reinforce the policy.  This assurance of safety allowed a trend to form that ended up becoming the housing bubble.  Bubbles are not new, however.  “Financial bubbles, characterized by substantial rises in asset prices departing from previous trends that are suddenly interrupted by a sharp fall, have been common in economic history.”⁵ Real estate was targeted in America’s recent crisis.  As prices of housing began to rise, people started to buy houses that they could not afford since they believed that they could continue to make money on it.  Unfortunately, many of these “sup-prime” loans were destined for failure and borrowers declared bankruptcy en masse.  A result of these bankruptcies that came in such a high volume over a short duration was that the financial system in America started to collapse as well.  These collapses manifested themselves as issues with insolvency and liquidity.  When these “liquidity crises” start, they are usually accompanied by damage to the economy as consumers lose confidence in the financial system and begin to panic⁶.

            Fannie Mae and Freddie Mac were originally created and sponsored by the government to facilitate construction and loans during the Housing and Urban Development program. Both contributed in a unique way to the housing bubble that precipitated the crisis.  Fannie Mae was started to securitize debt and resell it as an investment.  Initially this process was only applied to safe (or “prime”) mortgages where the lender was confident, based on some qualification matrix, that he would be repaid.  Eventually, however, securitization was given to riskier ones (which are, “sup-prime”, or loans where banks believed they had less of a chance of being repaid by the borrowers due to low incomes or other factors) as well.  This was the result of the federal government’s increased requirements, via the HUD program, for creating affordable housing.  Suddenly Fannie and Freddie had a higher quantity of loans to securitize.  They continued the securitization of sup-prime mortgages even during the crunch, when loans began to default on a massive scale in 2007 and 2008.  These government-supported enterprises had internal issues as well.  They were fraught with corruption, mismanagement, and fraud.  For these and other reasons, much of the sub-prime lending that contributed to the housing bubble can be credited to the irresponsibility and corruption within Fannie Mae and Freddie Mac⁷.

            As banks began to fail at an alarming rate, the government stepped in and gave them emergency funding under a program called TARP, which stands for Troubled Asset Relief Program.  The justification for these massive influxes of cash was that the banks were “too big to fail”.  This phrase became quite popular during the latter 2000s.  Essentially this expression meant that if a bank were to go bankrupt, there would be serious implications, unquestionably catastrophic ones, for the economy.  Fisher’s 2010 article in the CATO Journal speaks to the issue of whether or not an entity should be allowed to unravel if such a thing would influence the downfall of other entities (financial institutions in the case of the former and the American populace in the case of the latter).  Serious debate has been sparked over the TARP, with staunch supporters of the bailout on one side and those who oppose it with equal vigor on the other.  Fisher suggests that there are two schools of thought when dealing with institutions that are deemed “too big to fail”.  The first states that large firms (especially banks) are the lifeblood of the global economy and without them, there could not be as much growth since they permit borrowers access to incredibly large sums of money.  Without the ability to borrow this money, businesses would have to save their own money to be able to invest in new projects.  This would be especially difficult if they were starting for the first time.  So banks are necessary.  The second school states that while banks are a big part of society, society could still continue in their absence.  Further, when a bank has reaches the status of “too big to fail” and is guaranteed the bailout if they get in hot water, they lose the incentive to be careful with their money, as mentioned above.  This loss of responsibility is called a “moral hazard”.  A side effect that accompanies this is the realization that when times are good, banks reap the benefits of their actions.  But when times are bad, society is forced to pay the consequences twice, in the actual bailout money that is used and in the loss to the value (purchasing power) of their money because of inflation that results from the creation of new money.  Thus the bailout policy encourages risky behavior in a two-fold manner.  The debate cannot be satisfactorily resolved, however, because there is only one chain of events that actually happened (namely, the bailouts were affected) and so there is no way of knowing if the economy would have been better or worse without the stimulus spending⁹. 

            While the Federal Reserve was busy bailing out 928 institutions with 652 billion dollars (as of April 18^th, 2012)¹⁰, the Bank of England was doing the same with Northern Rock and similar British firms.  In fact, the actions of both central banks mirrored each other quite closely in both the bank bailouts and the quantitative easing that followed.  “Quantitative Easing” is a technical term for injecting liquidity (money) into the economy.  Both the Federal Reserve and Bank of England introduced huge amounts of money into their respective economies.  Quantitative Easing is best described by the Bank of England’s Website: “the Bank buys assets from private sector institutions…So the seller has more money in their bank account, while their bank holds a corresponding claim against the Bank of England…The end result is more money out in the wider economy.”¹¹  By purchasing mortgages (as the “asset” in this case) from lending firms, both central banks were able to stimulate the economy and rescue banks from their defaulted loans simultaneously.

            While the central banks’ responses in fighting the crisis caused by unwise loans were similar, the responses of each country’s populace differed.  In England, there was a run on Northern Rock when they announced their need for emergency funding.  In fact, a full five percent of its entire holdings, over one billion pounds, were withdrawn over the course of a day¹².  In America, no runs were initiated, but the Occupy Wall Street movement was formed to generally protest the actions of big banks and wealthy individuals.  There were no other similar reactions to the crisis since the goals of the Occupy Movement were broad enough to encompass the objections of all disgruntled citizens.

            As abuses of both borrowing and lending power have been perpetuated on both sides of the Pond, the central banks of England and the United States have been quick and responsive in dealing with the new First World problems that societies face today.  While there has been no shortage of debate on the merits of “bailing out” banks and quantitative easing, there cannot be any doubt that each country has learned many lessons for the future.  Such wisdom will be valuable as other countries develop, especially in Asia, and experience hard times of their own.  With the benefit of hindsight, upcoming crises may be truncated or remedied faster.  The benefit for the whole globe cannot be understated as humanity lives in an age where the fate of each nation continues to be ever more inextricably tied to the fates of the rest.

Sources

Lal, Deepak. "The Great Crash Of 2008: Causes And Consequences." CATO Journal 30.2 (2010): 265-277. Academic Search Premier. Web. 14 Apr. 2012.

Sánchez, Manuel. "Financial Crises: Prevention, Correction, And Monetary Policy." CATO Journal 31.3 (2011): 521-534. Academic Search Premier. Web. 12 Apr. 2012.

Thompson, Helen. "The Political Origins Of The Financial Crisis: The Domestic And International Politics Of Fannie Mae And Freddie Mac." Political Quarterly 80.1 (2009): 17-24. Academic Search Premier. Web. 12 Apr. 2012.

Reinhart, C, and K Rogoff. This Time Is Different: Eight Centuries of Financial Folly. Princeton, N.J.: Princeton University Press, 2009 pgs. (158-162)

Fisher, Richard W. "Paradise Lost: Addressing Too Big To Fail." CATO Journal 30.2 (2010): 323-331. Academic Search Premier. Web. 12 Apr. 2012.

ProPublica. “Bailout Recepients.” New York: 18 April 2012. Web. <http://projects.propublica.org/bailout/list>

Bank of England. Quantitative Easing Explained: Putting more money into our economy. London: 1996. Web. <http://www.bankofengland.co.uk/monetarypolicy/Documents/pdf/qe-pamphlet.pdf>

Anonymous. “Rush on Northern Rock Continues.” BBC News [London] 15 September 2007. Web. <http://news.bbc.co.uk/2/hi/business/6996136.stm> 

Read More...