Thursday, January 31, 2008

Macroeconomics for the "Compassionate"

Before you cast your vote for someone who promises to 'help' the downtrodden by fixing the prices of things, you ought to understand some basic economics.


Methodology note: Although it's said that a picture is worth a thousand words, I make every effort to avoid using pictures unless they are absolutely necessary. This is one of those necessary cases. I'll be using the kind of pictures you can see in most macroeconomic texts, only with the P and Q axes reversed, because it makes more sense to my math/science background: Quantity is a function of price, so the P axis is horizontal.

Fundamentally, a sale takes place when both parties to the transaction believe it benefits them. The buyer values the good/service more than the money he's spending, and the seller values the money he gets more than the good/service. Economists like to split this up and look at the motivations of both parties:

The Law of Supply

People sometimes have trouble grasping this simple concept:

When the price of something goes up, more of it will be produced.

It may seem backwards, especially to those familiar with 'volume pricing' arrangements, where suppliers will offer incentives to purchase large quantities, or 'sale' pricing designed to help liquidate inventory, or to keep contstruction workers productive during the slow season, etc. Those are actually responses to the interaction of the LoS and the Law of Demand as we'll see later. One factor that's important here is there are short- and long-term effects of the LoS: Potential producers make long-term decisions based on that they expect the price they can charge for their goods/services will be, that affect their capacity to produce the actual goods/services. Then they make short-term decisions based on fluctuating market conditions.
  • If farmers think the price they can get for wheat will be higher next year, they may plant more wheat and less soybeans, or spend more money on fertilizer and pest control to increase yield per acre.
  • If the price of oil is expected to go up, it justifies drilling deeper, or other more expensive techniques for getting to it.
  • If the net income that can be earned by doctors (after paying for such things as malpractice insurance) looks like it's going down, fewer people will practice medicine. Perhaps some of them will work for insurance companies, medical schools, or malpractice law firms.
The exact amount that the quantity of the good/service produced goes up or down with the expected price thereof varies. Economists call this 'elasticity of supply'. The more elastic the supply curve is, the more the quantity will respond to increasing or decreasing prices. Economists also talk about short-term elasticity vs. long-term (it takes a long time from planting to harvest), but the general idea remains - in a few cases increasing prices will not increase the quantity produced, at least in the short to medium term (there are only so many seats in a stadium for a sporting event, but other/larger stadiums can eventually be built), but will never decrease

The Law of Demand

This one's a lot easier to understand:

When the price of something goes up, less of it will be consumed.

There are a handful of situations where a low price affects the perception of the quality of the good/service, but that's contrary to the 'all other things being equal' clause that's implicit, if not explicit, in all economic discussions. How much quantity responds to price, once again, is 'elasticity'. The more elastic demand is, the more the quantity demanded will fluctuate with the price. Once again, long-term expectations drive long-term decisions. The more the price of gasoline is expected to rise over the life of your next vehicle, the more likely you are to buy one with good fuel economy, and thus you will use less gasoline. Even short-term changes in price will produce effects such as carpooling, riding public transportation, and cutting back pleasure travel in response to a sudden gas price hike.

Equilibrium

Since the supply curve slopes upward and the demand curve slopes downward, there must be a certain point at which they cross:

At the equilibrium price, exactly the same amount is produced as consumed.

It isn't hard to understand why.
  • When prices go above equilibrium, the producers want to sell more than consumers want (and can afford) to buy. After producers have already made the investment to produce a good, or build the capacity to provide a service, they naturally want to maximize the return on that investment. Parking lots full of cars that aren't selling don't make an auto manufacturer any money, so the price will have to come down to move the merchandise.
  • When prices go below equilibrium, the producers know that even if they raise prices, they'll still sell the same quantity, and make more money in the process, so they do.
Whichever direction prices drift from equilibrium, they are pulled back to it....

Interference with Equilibrium

Well, they are when market forces are allowed to work.

Here's where the Compassionate come in. The market can seem cruel and harsh, so they want to help protect people from it. All sorts of government policies have been enacted to manipulate markets by force.
Artificial Maximum Price
Sometimes, a government decides that the price of something is getting out of hand, and the best solution is to set a legal maximum that can be charged for it.

If that maximum is higher than equilibrium, then it doesn't do much other than make people feel good about having Done Something™ to fix it. It may actually have the perverse effect of reducing the expectation of future price increases, and therefore discouraging people from investing in the capacity to provide that good/service. The long-term effect of that may be best described as a flattening of the supply curve; the reduction in capacity shifts the point of equilibrium beyond the maximum price...

When equilibrium is above the maximum price allowed by law, we have locked in place the situation that would ordinarily only obtain temporarily without the price control: People are willing, and have sufficient funds to be able, to purchase more of the good/service than others are willing and able to sell to them.

If a maximum price law has any effect on price, it creates shortages

Artificial Minimum Price
Sometimes, a government decides that it's unfair that the people who produce some good or service get so little for it, and try to set a minimum price. There are two ways to do this:
  1. Have the government guarantee a minimum price that it will pay to producers, so they can always get that minimum price.
  2. Make it illegal for anyone to pay them less than the minimum.
Either way (if the minimum is actually above equilibrium) the result is that people are willing and able to produce more of the good/service than people are willing to buy at that price, the price cannot drop to correct the imbalance. If a minimum price law has any effect on price, it creates surpluses

Here's where the two ways to set a minimum price diverge. In the first case, such as for farmers, the government has committed to actually purchase the surplus commodities that no one wants to buy, at least in the short term. Typically, those commodities eventually are distributed ("government cheese") at a later date, absorbing some of the demand that would otherwise exist at that time, or they're simply destroyed. But in the second case, such as minimum- or prevailing-wage laws, it has made it illegal for the labor to be sold for less than the specified price.

A minimum wage law that has any effect on wages creates surplus workers, also known as unemployment.

It's really obvious when you think about it. The law doesn't guarantee that anyone who wants a job at $x/hr will get one, it only says that it's illegal to make anything less. If you believe that someone is better off unemployed than making anything less than some magic amount per hour, then this may make sense to you.

Minimum-wage laws disproportionately affect lower-income, inner-city people with little education and no work experience in a particular skill (important voting blocs for the politicians who insist on increasing the minimum wage from time to time). They don't get many chances to work those low-skill/pay jobs and gain experience that makes them more attractive to employers who are willing to invest in training them to be even more productive (and therefore pay more to retain those productive workers).

These wage laws are the economic equivalent to the secure fire escape on the side of a building, where the ladder from the 2nd floor to ground level is retracted to prevent burglars from climbing it. People who lack formal education or training can't get on the ladder and begin to pull themselves up to higher rungs. The true beneficiaries of minimum- and prevailing-wage laws are the leaders of organized labor, who can win higher wages from which to extract union dues, and the leaders of minority ethnic advocacy groups, who benefit from having a societal ill to organize against.

Because the workers they represent are better skilled, and therefore more productive, the labor leaders can demand a multiple of the minimum wage for those workers. Suppose there is a job that can be done in an hour by a union worker with years of experience, or in three hours by an unskilled worker. If the minimum wage is set to $7/hr, so long as the union scale is under $21, it's actually cheaper to hire union labor at nominally higher rates. So the employer agrees to a contract at $19-20/hr. it's a good deal for both sides. The union is using the law to forbid competition. It would be an anti-trust violation if it weren't being done by the government itself, or on behalf of a union. (Anti-trust laws specifically exempt labor unions.)

The very people that the law pretends to help are the ones hurt the most. (This is a long one, so click on the title to read the whole essay, which won't appear on the front page.)

3 comments:

  1. Great job!
    Is "Macroeconomics For The Stupid(tm)" up next?

    ReplyDelete
  2. As a 'B' student in economics, this is great!

    ReplyDelete

We reserve the right to delete comments, but the failure to delete any particular comment should not be interpreted as an endorsement thereof.

In general, we expect comments to be relevant to the story, or to a prior comment that is relevant; and we expect some minimal level of civility. Defining that line is inherently subjective, so try to stay clear of insulting remarks. If you respond to a comment that is later deleted, we may take your response with it. Deleting your comment isn't a personal knock on you, so don't take it as such.

We allow a variety of ways for commenters to identify themselves; those who choose not to do so should take extra care. Absent any prior context in which they may be understood, ironic comments may be misinterpreted. Once you've earned a reputation for contributing to a conversation, we are likely to be more tolerant in those gray areas, as we'll understand where you're coming from.