The Foolish Economist: onGrowth and InflationA. Arkay (not an economics major)
7/15/2012 The Foolish Economist 2Foolish Economics• I confess – I studied economics in my freshman year and my junior year in college.• So, a long time ago, I learned all this stuff about how the economy works.• But I hardly remember any of it and as I listen to the –ocrats and –icans battle to the death I wonder if they learned the same thing that I did.• So, I decided to reconstruct something from the past.• But with the passage of time, I must have forgotten something because, this is what came out.
7/15/2012 The Foolish Economist 3The canonical eco-world: John vs. Bill• Two farmers, John and Bill are the sole people in the world. If you wish, you can think of them as aggregating all the others behind them.• For instance, John and Bill could be two nations.
7/15/2012 The Foolish Economist 4Simplifying assumptions• Like all economists, I have simplifying assumptions: 1. It’s a closed world with only two people, John and Bill. 2. John and Bill don’t have dependents with varying demands and future ability to support them. 3. John and Bill don’t age or become weak and so on. 4. John grows grapefruit; Bill grows mangoes. 5. Each of them needs 1 grapefruit and 1 mango for every planting cycle (“year”, if you will). 6. To grow this minimum amount takes them 1 hour of work each day. 7. They begin with enough for the next “year”
7/15/2012 The Foolish Economist 5Why these assumptions• We live in a closed world• Dependents add complexity. Maybe add this later?• Aging, Dying, being supported by past dependents, etc., add complexity.• Real people need thousands of things – that’s complex.• They have different skills, and that encourages them to form a society. Humans live in societies. Societies are complex, but this one has only 2 people, so looks simple.• Studies have shown that hunters and foragers spend between 2 and 4 hours daily getting what they need and the rest of the time doing nothing.
7/15/2012 The Foolish Economist 6The First Year John BillJohn works 2 hours/day Bill works 2 hours/dayJohn produces 2 grapefruit Bill produces 2 mangoesJohn to Bill: I can give you a Phew! Thought you’d never ask!grapefruit, in exchange for a mango Here’s a mango. And so, they were healthy and happy!
7/15/2012 The Foolish Economist 7 Accounts at end of Y1 Action John BillInitial State 1G + 1M 1G + 1MGrew 2G 2MTransferred -1G+1M -1M+1GHeld 2G + 2M 2G +2MConsumed -1G - 1M -1G -1MFinal State 1G +1M 1G+1MDelta (Final-Initial) 0G +0M 0G +0MNote: This is a “normal” year and they accumulated nothing (Delta). Thisis a subsistence-basis culture that values leisure over accumulation. At theend of 1 year they have not become richer or poorer, and they have justenough for the next year.
7/15/2012 The Foolish Economist 8Year 2 John BillI am going to work extra hard this year Why?I want to be rich! Huh?? “rich” – what’s that?You’ll never get it John works 3 hours/day producing 3 grapefruit Bill works his usual 2 hours/day producing 2 mangoes
7/15/2012 The Foolish Economist 9 Accounts at end of Y2 – Case#1 Action John BillInitial State 1G + 1M 1G + 1MGrew 3G 2MTransferred -1G+1M -1M+1GHeld 3G + 2M 2G +2MConsumed -1G - 1M -1G -1MFinal State 2G +1M 1G+1MDelta (Final-Initial) 1G +0M 0G +0M John has “produced”1G. What can he do with it?
7/15/2012 The Foolish Economist 10At the end of Year 2 John BillJohn to Bill: I have one extra “Buy”? What’s that?grapefruit. Why don’t you buy half agrapefruit from me?You give me half a mango for my half Huh? I don’t have ½ a mango!grapefruitThat’s alright – you’ll just owe me ½ a “Owe”? What’s that?mango and give it to me next yearIt means that next year, you give me ½ Oh. But then, I will only have ½ mangoa mango for nothing. left – so, next year, will you give me 1 grapefruit for the other half of my mango?Of course not! If you give me ½ M, Hmm That’s no good. I need 1G!you will get ½G. You know that!But that would make 1M equal to It sounds weird the way you put it .1+1/2G!! But,yes!
7/15/2012 The Foolish Economist 11 At the end of Year 2, cont’d… John BillYou simply don’t understand. I’ve worked That is a fantasy. You worked hard, maybe,hard and increased our wealth. but by producing 3 grapefruit when we only needed 2, you made 1 mango equal to 1+1/2 grapefruits!No way! Our combined wealth was 4G. Oh, I see. “price” means how we exchangeNow, with the price of 1M being 1G, we mangoes for grapefruit. OK, I get it.have 5G.So do you get it now? Yes I do. And you are wrong! Our combined wealth used to be 4M. Now your 3G is only worth 2M, so our combined wealth is still 4M. You just wasted time during which you could have enjoyed life, like I did.How stupid do you think I am? Even if This is “the law of supply and demand”.you just count the fruits, we have 1 more There’s no demand for the extra half-mango.than before. Even you don’t need the half-mango you were reserving for yourself.
7/15/2012 The Foolish Economist 12At the end of Year 2, cont’d… John BillThat’s bizarre! If I use your price of No! The 4G last year has the same value1+1/2G for 1M, we now have 6G! as the 6G this year – that’s calledThat’s an increase from the old 4G, “inflation”. You suffered 50% inflation lastisn’t it. year and your products lost value!That does it! Inflation-pinflation- But, I know you have it in reserve, so I’llpshaw! I’ll hold my extra 1G back and offer 1M to you for 2G.you wont even see it.I will refuse to make the trade! I can wait! The waiting game is dangerous as they both need 1G and 1M for sustenance. In this case, the person who gives in first sets a precedent. In human society, precedents are a powerful conservative force. 1. If John wins, he may well established the 1G=1M equivalence for a considerable period of time. 2. If Bill wins, the law of supply & demand becomes the rule and they have equal shares in the excess grapefruit!
7/15/2012 The Foolish Economist 13 Accounts at end of Y2 – Case#2 Action John BillInitial State 1G + 1M 1G + 1MGrew 3G 2MTransferred -1.5G+1M -1M+1.5G(1M=1.5G)Held 2.5G + 2M 2.5G +2MConsumed -1G - 1M -1G -1MFinal State 1.5G +1M 1.5G+1MDelta (Final-Initial) 0.5G +0M 0.5G +0MNote: Look at the bottom line – Case#2 leaves them equallywealthy. John worked hard so Bill could have ½ G!!
7/15/2012 The Foolish Economist 14 Case#1 vs. Case #2In Case#1, John has accumulated 1G. But nobody wants that G! Withoutdemand, it is valueless.A crisis that affected the production of G/M/both would give the saved 1Ga value! There are three sources of such crisis:a) Global effects that apply to both equallyb) Something that affect Gs much more than Msc) Something that affect Ms much more than GsThe two paths differ WHEN a crisis happens • In Case #1, John has a grapefruit in reserve that will allow him to keep going. Bill has nothing. • In Case #2, John and Bill have equal reserves. As a result, they will be equally affected by the crisis.• They still need 1 fruit that the other grows, so they are still dependent on each other.
7/15/2012 The Foolish Economist 15 End of Year 2Unless there is a crisis of some kind, the saved 1G (or more) willnot have any value.• After a global crisis John (in Case #1) will find it easier to recover than Bill will. At the end, John will most likely be significantly better off and will be more likely to impose a valuation.• An asymmetrical crisis that hits Bill may force him to accept Case #1 (since the exchange does not have to happen until• An asymmetrical crisis that hits John will force him to use the saved 1G as a supplement. If Case #2 applies, John can expect to get help from Bill.
7/15/2012 The Foolish Economist 16 What did hard work accomplish?• John wanted to increase his wealth but he only managed to drop the price of his grapefruit. • So now he grew the equivalent of 1+1/3 mangoes • With Bill’s 2 mangoes, they produced 3+1/3 mangoes• John’s predicament is called “deflation”• Meanwhile, Bill’s 2 mangoes are now worth 3 grapefruit • That is “inflation”• Notice how inflation for Bill is balanced off by “deflation” for John.• So what happened?
7/15/2012 The Foolish Economist 17 Inflation in scarce commoditiesWe have seen this in practice. If the total quantity of aproduct CANNOT be increased, no matter what happensin the rest of the world, its price increases faster than otherprices!Some examples:1. College Education in the US2. Health-Care costs in the US3. Public Education crisis in the US.
7/15/2012 The Foolish Economist 18The rising cost of Higher Education• The case of college education in the US. It is difficult to create new colleges, find qualified professors, and so on.• Assume the rest of the world has X% inflation.• The college can hire secretaries, janitors, and so on just like the rest of the world. • BUT, the price of professors shoots up compared to the price of all these administrative and service staff! • Professorial wage inflation for fields in demand go up by multiples of X! • In non-demand fields, it can even be negative! • Since many professionals wish to teach as a sideline, ADJUNCT professors are underpaid – this shows that the phenomenon does not have to do with the field, or other contextual contingency. • It all depends on who (Bill the professor or John the student) can hold out longer.
7/15/2012 The Foolish Economist 19The rising cost of Health Care• In the US, the AMA ensures that the number of doctors and surgeons grows very slowly. • Med school starts after a 4-year college degree • Internships and fellowships after obtaining the degree • Interns have a horrific life-style• Meanwhile the nurses’ associations/unions have NOT been able to control the number of new nurses being trained. • Not that they don’t try (with new credential requirements and all)• The result: • The wages for physicians grows much faster than inflation • The wages of surgeons grows even faster than that! • The wages for nursing grow only a little faster than the general rate of inflation• Since nurses are cheap, demand for nurses in hospitals is extremely high. They just wont pay them more! • John, the hospital, can hold out longer than Bill, the R.N.
7/15/2012 The Foolish Economist 20The Rising cost of Public Education in theUSA• Shouldn’t this apply to the public school system in the US?• Well, there is a problem with the theory. • For both college education and health care, the individual directly deals with the college or medical facility. • Public schools in the US are paid for through real-estate taxes (mostly). The parent and the child pay nothing directly. • The wage negotiation happens between a government entity and a teacher’s union!• When the teacher’s union succeeds in getting a raise, TAXES go up. There is no obvious reason to the taxpayer why taxes should go up faster than inflation!• When the teachers get a raise greater than the rate of inflation, the entity paying it (the town/city/village government and the taxpayers) see that the teachers are not working harder. Who can hold out longer? • John the people or Bill the teacher? • So it looks completely unjustified.• It isn’t as though there is more real estate being created by God! • The growth in population is even smaller than the rate of inflation. So the rise in teacher salaries looks even more lop-sided. • Incidentally, at the same time, teachers are ASKED to teach more (“our children are learning less than the South Koreans who get taught from dawn to dusk”)
7/15/2012 The Foolish Economist 21Solving the Public Education crisis in the US• Now, we know that everybody can teach! Look at Teach For America. • So what’s with seniority, licenses, education degrees, and so on? It is just pandering to the unions! • What we really need to do is hire anybody off the street as a public school teacher and then evaluate them and fire them if they fail. • Allow anybody or organization to open a charter school and evaluate them and close them when they fail. • This is the free market that will solve the problem! (next question, please!)• What about the poor kids? • That is another problem. This only solves the problem of how to teach the teachers and their unions a lesson.• (if you take the above seriously, I will have failed)
7/15/2012 The Foolish Economist 22Back to Economics and The Last Word fromthe Foolish EconomistSorry about the digression into solving important nationalproblems.What does this simulation tell us?1. Assumptions affect the result2. Working hard does not necessarily lead to wealth. It could lead to poverty.3. A key transition took place when the law of supply and demand was proposed for application a) Ignoring it (Case#1) led to one problem b) Applying it (Case #2) led to a different problem.4. One or more crises are needed for hard work to pay off. Even then, the payoff has to be mediated by “government”, i.e., an oppressive authority, not a free market!
7/15/2012 The Foolish Economist 23What does Classical Economics say?• The classical economist would have classified the initial state as a case of equilibrium• Then some mumble about absolute and comparative advantage explaining the later developments.• Since neither accepting the law of demand & supply nor rejecting it leads to a reasonable conclusion, the CE will generally reject this example as a monster (a case of a simulation gone haywire – see Imre Lakatos, Proofs and Refutations).• So – this is the Foolish Economist taking a simulation with a thousand assumptions seriously. • He must surely be wrong.Or, is he?