Conservative Lounge

Literature I read in 2011

2011-12-31T10:01:00.001+05:30

Democracy - Hans Hermann Hoppe

Quantitative Economic History - Joshua Rosenbloom

The Economic Causes of War - Lionel Robbins

Why Wages Rise - F.A. Harper

How I Became A Hindu - David Frawley

Religion Without God - Ray Billington

Human Capital - Joop Hartog & Henriette Brink

God - Victor Stenger

Crisis of Abundance - Arnold Kling

The Tragedy of the Euro - Philip Baggus

A Tiger by the Tail - Friedrich Hayek

A Short History of Financial Euphoria - John Galbraith

Epistemological Problems of Economics - Ludwig von Mises

Philosophy - Edward Craig

Ayodhya and After - Koenraad Elst

Collapsing Pakistan - N.S. Rajaram

Demographic Siege - Koenraad Elst

What Does it All Mean? - Thomas Nagel

Indian Muslims - K.S. Lal

The Secret - Rhonda Byrne

Family Matters - Rohinton Mistry

The God Delusion - Richard Dawkins

A Foreign Policy of Freedom - Ron Paul

Creating Your Path to A Policy Career - IHS

The Elements of Style - William Strunk

Striking The Root - Lawrence Reed

Left and Right - Murray Rothbard

The Politically Incorrect Guide to Islam - Robert Spencer

Economics - Robert Hall & Marc Lieberman

The Truth About Muhammad - Robert Spencer

On Hinduism - Ram Swarup

Negationism in India - Koenraad Elst

Monetary Policy Under the International Gold Standard -Arthur Bloomfield

The Making of Global Finance - Marc Flandreau & FredericZumer

Freedom of Expression - Sita Ram Goel

Why was the Industrial Revolution British?

2011-11-11T22:31:00.001+05:30

(Draft of my essay submitted for EH401)

This essay summarizes the argument in R.C. Allen’s, “Why the IndustrialRevolution was British” about how relative factor prices influenced the earlyonset of Industrial Revolution in Britain, and takes a critical look at the thesis.

The “Industrial revolution” refersto the historic increase in the productivity and income levels of a number ofeconomies in the world--starting with Europe and North America initially—in thefields of industry, agriculture, transport services, technology etc., from the earlydecades of the 18^th century and extending well into the latter halfof the 19^th century. The period of onset of the industrialrevolution, however, varied in different countries: with Great Britain beingthe first to witness these revolutionary changes followed by other countries inwestern Europe and the European offshoots (North America), before the benefitsof industrialization spread to the entire globe. Although the countries (thatunderwent the industrial revolution in the 18^thand the 19^thcenturies) possessed strong institutions that fostered increased capitalaccumulation and technology (both of which were important contributors toincrease in productivity and income), all of them did not witness simultaneousgrowth in income levels, or witness any kind of industrialized growth phasethat directly followed as a result of the establishment of stable institutions.For instance, the Dutch economy failed to tread a path of technological andindustrialized growth even under the persistence of stable institutions.

Why did countries that possesseda strong institutional setup, like in Britain, fail to replicate the successfulperformance of Britain? In other words, why was the Industrial revolution, atleast initially, a British phenomenon? The spread of industry and technologywas not a simultaneous process that spanned across Europe. While the Britisheconomy was witnessing growth of new industries and technological innovations(like the steam engine, for instance, that tremendously cut down the cost oftransport), the whole of continental Europe was still predominantly anagricultural society. The underlying cause for the disparity in the structureand income of the British and continental European economies can be explainedby taking into account the peculiar factor prices that existed in Britain, andthat which was absent in continental Europe. Labour wages and energy prices inBritain influenced entrepreneurs to make certain decisions that spurredindustrialization and technological development. The absence of such uniquefactor prices eventually made the difference between the success of Britain andfailure of continental Europe.

Wages in Britain wereconsiderably higher than what prevailed in other European countries, and therest of the world. It was not just the nominal wages that were high in Britain,but also real wages (this can be seen in the welfare ratio figures). Apart fromhigh wages, the other peculiar feature of the British economy was the low priceof energy sources that could be used as capital in production. Also witness tothis are figures on the price of wages relative to energy prices was highest inBritain (Allen, 2011). The presence of high wages and low energy pricesprovided the right mix of incentives for British entrepreneurs to find ways tocut down their outlay on labour and substitute labour with capital resources thatwere very cheap compared to labour. This naturally led entrepreneurs to investin industrial technologies that could make use of cheap energy resources,instead of persisting with old technologies that required the use of expensivelabour. The new demand for labour-saving technologies coupled with the patentsystem spurred the invention of new technologies – a particular feature thatcharacterizes the industrial revolution in general.

Although the Allen’s thesis that outlinesthe factors that led to industrial revolution in Britain-- through thereplacement of expensive labour with cheap capital-intensive technologies--thosefactors that are mentioned to be unique to the British case are not necessarilyso unique in satisfying the requirements of capital-intensive development (thatindustrial revolution calls for) as such. In other words, the existence of aparticular pattern of relative prices in the form of high wages and low energycosts (that is unique to the British case) is not a necessary precondition for productivity-enhancingtechnology to be invented and subsequently adopted. In the 20^thcentury, the experience of improvement in agricultural productivity incountries like the United States and Japan show the role played by relative factorprices in determining the quality of the technological inventions that result.Japan, which had relatively little amount of land (and hence higher landprices) compared to its endowment of labour invested in resource-saving‘biological innovations’ that increased the yield of land; while United States,which had relatively little amount of labour (and hence higher wages) comparedto its land endowments invested in labour-saving ‘mechanical innovations’ that increasedthe productivity of labour.

While relative factor prices caninfluence the incentives of entrepreneurs in adopting either labour-saving orresource-saving technologies, it does not influence the motives ofentrepreneurs to invest in technology itself. The motive to invest intechnology (of either type) is independent of relative factor prices; althoughthe kind of investment (labour-saving or resource-saving) depends on therelative factor prices. If so be the case, there is no reason to believe thatrelative factor prices were decisive in Britain’s technological development.Entrepreneurs who want to cut down on the cost of production of goods, as such,do not care whether their cost-cutting measures economize on labour or resourceoutlays. While there lies a tendency for entrepreneurs to concentrate primarilyon economizing factors of production that contribute most to the cost ofproduction, this does not however mean that disparity in factor pricesnecessarily hastens the process of invention of new technology itself. Thatbeing said, there is definitely an incentive for entrepreneurs to economize on productioncosts of goods that involve high cost of production, irrespective of therespective factor prices. If so be the case, there is no reason not to believethat high energy costs in continental Europe shouldn’t have spurredentrepreneurs to invest in developing resource-saving technology.

The high energy costs incontinental Europe should have spurred the same kind of technologicalinnovation-spree, but of a different quality (resource-saving in the case ofcontinental Europe, rather than labour-saving), that characterizedindustrialization in Britain. The case of 20^th century Japaneseagriculture stands testimony to the fact that an economy could be steered alongthe path of resource-saving technology when factor prices favour such a path.The conditions in 18^th century continental Europe also suggest thatinvesting in resource-saving technologies would have been highly profitable forentrepreneurs. For instance, cost of energy in France was six times high asmuch in Britain (Allen,2009). The fact that continental Europe did not move onthe path towards resource-saving technology probably suggests that there musthave been other qualitative differences in the economic environment of Britainand continental Europe, which needs to be explored further.

Literature I read in 2010

2010-12-31T13:01:00.001+05:30

Economic Sophisms - Frederic Bastiat
The Market That Failed - C.P. Chandrasekhar & Jayati Ghosh
America's Great Depression - Murray Rothbard
The Production Of Security - Gustave de Molinari
The Vampire Economy - Guenter Reimann
The Case Against The Fed - Murray Rothbard
The Politically Incorrect Guide To The Great Depression And The New Deal - Robert Murphy
The Failure Of The New Economics - Henry Hazlitt
Time And Money - Roger Garrison
Common Sense Economics - Albert Hahn
Economic Science And The Austrian Method - Hans Hermann Hoppe
Our Enemy, The State - Albert Jay Nock
What You Should Know About Inflation - Henry Hazlitt
From Bretton Woods To World Inflation - Henry Hazlitt
The Fortune At The Bottom Of The Pyramid - C.K. Prahalad
The Making of Modern Economics - Mark Skousen
Will Dollars Save the World? - Henry Hazlitt
Freakonomics - Steven Levitt & Stephen Dubner
For A New Liberty - Murray Rothbard
Interventionism: An Economic Analysis - Ludwig von Mises
The Inflation Crisis and How To Resolve It - Henry Hazlitt
Denationalization of Money - Friedrich von Hayek
Early Speculative Bubbles and Increases in the Supply of Money - Doug French
Defending the Undefendable - Walter Block
Crash Proof - Peter Schiff
The Austrian School - Jesus Huerta de soto
The Mystery of Banking - Murray Rothbard
Crisis and Leviathan - Robert Higgs
The State - Franz Oppenheimer
Notes on Democracy - H.L. Mencken
Lessons for the Young Economist - Robert Murphy
Two Essays - Ludwig von Mises
Depression, War and Cold War - Robert Higgs
India's Economic Transition - Rahul Mukherji
Greenback Populism as Conservative Economics - Gary North
The Confusion of Language in Political Thought - Friedrich von Hayek
Politically Impossible? - W.H.Hutt
Applied Economics - Thomas Sowell
The Man versus The State - Herbert Spencer
American Capitalism - John Kenneth Galbraith
Walk Away - Douglas French
The Return of Depression Economics - Paul Krugman
Thinking As A Science - Henry Hazlitt

Defending the capitalist

2010-07-26T23:54:00.010+05:30

Not many characters of importance have earned as much scorn as the monopolist, who through his superior business abilities, and through the constant ability to innovate, has managed to stamp his superiority over others. While I do not wish to defend the business owner (or interest groups), who through crony links with agents of the State, manages to amass a fortune for himself, defending the business man who gains a superior stature in the market purely through the satisfaction of the demands of the consumers earns a place high on my agenda.

Natural tendency of the market

A free market when left unto itself, with the aid of the price system (formed through the knowledge decisions of billions), possesses the tendency to allocate the economy's labor resources towards the most important ends. However, it is not 'the market' as an independent entity that performs the task. Rather it is individuals who act in their own self-interest who aid the market in the process. Individual actions make the market.

While all individual choices (for their own self-interest) are guided towards the achievement of the market's objective of efficient allocation of economically scarce resources, the role played by entrepreneurs in achieving allocational efficiency of limited resources is indispensable in any market economy. A planner in a socialist economy would find it immensely difficult to gather all the knowledge that is required to allocate the economically scarce resources in his economy towards uses that are most highly valued by his citizens. In a capitalist economy, however, the total amount of information knowledge that is required to bring about the best allocation of the economy's resources is broken down into smaller pieces, essentially solving the problem of 'economic calculation'.

The capitalist-entrepreneur

While billions offer their labor services to others, in a market economy, in exchange for the products of others' labor, there always remains a huge array of new ends towards which labor (and other resources) could be directed in order to bring about rational allocation of the economy's resources (by maximizing utility). For instance, raw material like iron ore could be directed towards the production of several consumer goods. The essential role of the entrepreneur in a market economy is to sense the demands of the consumer, and thus to direct resources towards ends of the consumers that are most urgent. In this particular case, entrepreneurs would allocate iron ore towards the production of consumer goods that are most demanded by the consumers. In essence, the preferences of the consumers direct the entrepreneur's actions.

Entrepreneurs who best forecast or anticipate the future demands of the consumers make profits (here is a special post on profits), giving them possession of more money and hence the greater power to direct the allocation of resources towards various ends. The better the entrepreneur serves the demands of the consumers, the richer he becomes, and hence, the more his power to direct the allocation of resources.

Is wealth concentration harmful?

Well, a straight answer would be no. As I've explained here, the market certainly directs more of the purchasing power in the economy towards capitalists who serve the demands of their consumers. But does that mean bad news? Are capitalists capitalizing on their ability to initially serve the consumers to exploit them eventually? Well, no again. As I already mentioned, the market economy has the strong tendency to employ or direct the economy's labor into the most important ends of society. For instance, the market prefers to employ Justin Bieber into making music rather than being a doctor or an engineer (in which he'd probably serve less important ends of society). The same applies to the case of capitalists too.

Men who are enterprising than others in serving the demands of the consumers eventually end up with the possession of resources, which they have utilized efficiently to serve the consumers. The position of the capitalist, however, is not permanent. Present or past success offers no guarantee for future endowment with the economy's resources. The capitalist has to keep satisfying his consumers till he wishes to be endowed with the economy's limited resources. Competing capitalists always have the opportunity to take over his position.

But wait, wouldn't too much concentration of purchasing power in the hands of the capitalists lead to the economy's resources being used to serve the ends of the rich capitalists alone? No again. Something very vital to understand at this point is that capitalists need to invest a large part of their resources in capital assets in order to maintain their position at the top, which in turn is essential to fund their big-spending ways. Whenever a big capitalist (or his heirs probably) starts spending his wealth on funding his personal consumption activities, he gives away control over the economy's productive resources (capital assets). He becomes a consumer, making way for other capitalists to serve his own needs as a consumer. Even in the most extreme case of a capitalist who has served his consumers so well that he gains possession of all wealth in the world (except people's labor of course), he (the capitalist) would still have to serve his consumers by investing in productive assets rather than on consumption.

Conclusion

The economic function of the capitalist in a market economy is basically to serve the demands of the consumers. He obviously doesn't carry out his services out of a sense of altruism, but motivated by self-interest. The position of the capitalist depends on his ability to invest his resources in producing goods (that are of use to consumers), and cutting down on consumption. The consumption spending of successful capitalists is probably enough to motivation to spur men towards entrepreneurial adventures, isn't it?

Understanding wealth distribution

2010-07-25T20:08:00.006+05:30

Orthodox public opinion regards wealth distribution to be a zero-sum game, where one man's gain is considered to be others' loss. The booming wealth of Capitalists is supposed to be at the cost of others. If only these Capitalists were controlled, or completely eliminated, by the State, we'd live in a much better 'just society', they say. While the concept of economic scarcity may very well seem to support the zero-sum notion, for what belongs to one person cannot belong to anybody else, it would not hold sway over the public's mind when the actual character of the economics of wealth distribution is understood.

In a planned economy, where every kind of property is 'centralized', the question of wealth distribution assumes a character that is very different from that in a market economy. The State, in a planned Socialist economy, orders it's citizens to produce what it deems fit (according to the planning board's plans) and distributes the produce according to it's plans. In such an 'economy', all wealth is necessarily under the control of the State. In other words, the State owns a monopoly of all wealth. In a market economy on the other hand, which allows peaceful voluntary trade between individuals, the distribution of the economy's wealth is purely based on individuals' ability to produce goods that are 'in demand' in the market. Individuals who produce goods that others are more ready to pay for see their share of the total wealth enhanced, while those whose output is not attractive to consumers are pushed down the economic ladder.

Does this race to the top mean that the rich get richer at the cost of others? If wealth distribution were a zero-sum game, that would indeed be the case. The human race would be in a pathetic situation with the masses fighting it out to plunder most of the limited wealth. But, however, when one understands that wealth is not a given constant, and that it is real human beings who create wealth--which they in turn exchange in return for other goods--he ends up with recognizing the positive side of the natural wealth distribution that results from voluntary trade between individuals. Then comes the realization, the rich get richer not at the cost of others' fortunes at obtaining wealth, but in fact by aiding the masses in enhancing their own standard of living.

How do we measure wealth distribution (or concentration) among different sections of the population? Since the exchange value (in terms of money-price) is the best available 'objective' valuation of any commodity, we shall employ the same to gauge the distribution of wealth. The monetary value or the price of individuals' assets as compared with the total monetary value of all assets in the economy should provide us with an idea of the distribution of wealth in any economy. We shall also, quite safely, assume that in the long-run resources come under the direct ownership control of individuals who are more enterprising than others, or at least under their more active control (in the case of legal owners renting their property to enterprising individuals). In simpler words, it can be concluded that individuals who make money necessarily possess control over the economy's limited resources.

The cooperation of men, under the system of division of labor, to enhance the production of wealth, however, does not relieve mankind of the essential problem of economic scarcity. If economic cooperation in a free market economy cannot relieve mankind of it's scarcity, what is it that necessarily differentiates wealth distribution from a fixed pool of economic wealth, as against wealth distribution from an increasing (but nevertheless scarce) pool of economic wealth? The essential difference lies in the fact that while men try to get the better of others in the former case, they cooperate in the latter case.

A few cases

Lets take the case of a very simple economy where apples (like money) denote wealth. The economy has just three members (X, Y and Z), with each possessing two apples each. So there are totally 6 apples in the economy and each member owns one third of the total wealth of the economy (since apples, as money, can be used to bid for the economy's resources).

First, suppose we are placed with socialist minds, and made to believe X is the Capitalist who is bent upon exploiting his fellow citizens. In such a case, we would have to view X as an exploiter who robs Y and Z. X doesn't produce anything to exchange with either Y or Z, but simply just strips Y and Z of their rightful wealth. Since nothing is produced, and the only thing that happens is exploitation of the weak by the strong, X would end up owning everything (all 6 apples with which he can bid all resources) in the economy, and the rest would be left to starve.

In a second case, lets suppose we are fixed with a good economist's brain. In this case, X is the most enterprising member of the economy. He discovers some new recipes of exotic cakes, uses the labor of Y and Z (for the wage of an apple each) and sells them (say he produced two cakes) to both Y and Z at the price of 2 apples for a piece of cake. Now we see that the total wealth distribution in the economy has altered quite drastically. X now owns two-thirds (four-sixths) of the total wealth while the rest own just one-third. However, in the second case, the total wealth of society has increased from just 6 apples previously to: 6 apples plus two cakes. Both Y and Z are better off (and that's exactly why they gave up 2 apples for a cake, otherwise they wouldn't have) with a cake each, while X too is better off with four apples (as against 2 previously). On the whole, we find that X actually produced goods (cakes) of use to Y and Z, and in the process increasing his share of the total wealth in the economy.

The essential difference between the two cases is the character of the economic relationship between the individuals. The first case explains an exploitative relationship while the latter shows a cooperative (yet competitive) relationship between the individuals.

Now lets move on to a much more extreme case. In the course of time, could an enterprising X end up owning all resources in the economy? Should he own all resources, wouldn't it happen that X completely prohibits others from using his resources? The chances of such a 'catastrophe' are quite minute nevertheless. Lets take the case of an interesting stat I heard recently, about 83% of American stocks lying in the hands of just 1% of the population. Sounds like a disaster? Well, it shouldn't. Ownership of resources by itself does not benefit capitalists. Even when a single or a few capitalists own most or all of an economy's resources, they would still have to cooperate with the overwhelming number of masses in order to produce anything at all. The same basic rules of human association (reading on absolute and comparative advantage should help) still apply. Capitalists would still have to produce, with sufficient cooperation from the masses, for the masses (since they now, by offering their services to the monopoly capitalist, have the purchasing power to guide economic activity according to their needs). Even the capitalist who possesses a monopoly over all resources would have the incentive to make maximum use of the labor of the masses, both to satisfy his own personal ends and that of the masses in a mutually beneficial climate. Proof: Bill Gates still requires the services of General Motors mechanics to make his car which he wouldn't be able to manufacture otherwise (absolute advantage), and the services of his lawn mower to apply his time on managing Microsoft (comparative advantage).

Conclusion

Wealth distribution as such has nothing to do with economic welfare, until trade is peaceful and voluntary. A society with an increasing wealth gap could still be growing richer overall, with businessmen finding it profitable business to serve the masses at cheap prices.

Literature I read in 2009

2009-12-31T14:25:00.002+05:30

An Introduction To Austrian Economics - Thomas C. Taylor
Bureaucracy - Ludwig von Mises
Economic Calculation In The Socialist Commonwealth - Ludwig von Mises
Profit And Loss - Ludwig von Mises
The Anti-Capitalistic Mentality - Ludwig von Mises
Planned Chaos - Ludwig von Mises
The Prince - Nicolo Machiavelli
Government - James Mill
Economics For Real People - Gene Callahan
Economics In One Lesson - Henry Hazlitt
The Conquest Of Poverty - Henry Hazlitt
Media Control - Noam Chomsky

An Introduction To Economic Reasoning - David Gordon
The Politics Of Obedience - Etienne de La Boetie
Deflation And Liberty - Jorg Guido Hulsmann
The Law - Fredric Bastiat
The Government Against The Economy - George Reisman
The Road To Serfdom - Friedrich von Hayek
How An Economy Grows And Why It Doesn't - Irwin Schiff
Chaos Theory - Robert P. Murphy
Not A Zero-Sum Game - Manuel F. Ayau
Inclined To Liberty - Louis E. Carabini
The Concise Guide To Economics - Jim Cox
Principles Of Economics - Carl Menger
Economic Principles - Frank Fetter
The Market For Liberty - Morris & Linda Tannehill
Mises And Austrian Economics - Ron Paul
Gold, Peace And Prosperity - Ron Paul
Capital And Interest - Eugen von Bohm Bawerk
Essentials Of Economics - Faustino Ballve
The Fallacy Of The Mixed Economy - S.C. Littlechild
Economic Calculation In The Socialist Society - Trygve J.B. Hoff
Socialism - Ludwig von Mises
Understanding The Dollar Crisis - Percy L. Greaves
Collectivist Economic Planning - Friedrich von Hayek
Anatomy Of The State - Murray Rothbard
Foundations Of The Market-Price System - Milton M. Shapiro
Economic Depressions: Their Cause And Cure - Murray Rothbard
Capital And Production - Richard von Strigl
What Has Government Done To Our Money? - Murray Rothbard
Planning For Freedom - Ludwig von Mises
Money, Bank Credit, And Economic Cycles - Jesus Huerta de Soto
Human Action - Ludwig von Mises
Protection Or Free Trade - Henry George
The Austrian Theory Of The Trade Cycle And Other Essays - Richard Ebeling
Capitalism - George Reisman
Man, Economy, And State - Murray Rothbard
The Pure Theory Of Capital - Friedrich von Hayek
Market Theory And The Price System - Israel Kirzner
Principles Of Economics - Gregory Mankiw
Principles Of Macroeconomics - Joseph G. Nellis & David Parker
On The Origins Of Money - Carl Menger
Macroeconomics - Gregory Mankiw
Keynes And Hayek - G.R. Steele

What's a false boom?

2009-12-30T23:43:00.004+05:30

(This is a rough write-up I posed on the Mises forum. Documenting certain replies saves me from re-typing answers in future situations, so that's the reason--if you ever wonder why)

It's a boom that is not backed by voluntary savings.

People allocate their money funds towards two things: present consumption (like buying food, clothes, etc.) and future consumption (that is, savings that get invested into building industries that can increase the production of consumption goods).

Suppose the economy's total money supply is $100. People save $50 and spend the remaining $50 on present consumption. If you notice here: 50% of the economy's purchasing power went into savings and the other 50% went into present consumption. Now the Fed increases the money supply to $200 by printing $100 worth of extra money and lends $150 ($100 of new money + $50 of voluntary savings from people) it to investments, while $50 are still spent on present consumption by people. Note here: 75% of the total purchasing power in the economy goes into savings while only 25% goes into present consumption.

People when left to themselves have a consumption-savings proportion of 50-50 with 50 percent purchasing power going into savings (investment) and 50 percent going into present consumption, but when the Fed increases money supply it alters the original consumption-savings ratio of people by increasing money supply and thereby allocating 75% of the economy's purchasing power towards savings while only 25% goes into present consumption. In short, the Fed imposes forced saving on people.

So the industrial sector (fed by lots of phony savings) sees a boom. But it is temporary. Why? Because when the $200 completely percolates into the economy, people would again reassert their consumption-savings proportion, by saving $100 and spending the rest (one hundred dollars) on present consumption. See the difference? People have reasserted that they want only 50% of their purchasing power to go into savings and not 75% as the Fed wants things to be.

This decrease in the savings available for funding investment projects leads to higher interest rates (just like how a decrease in the supply of apples in the market, under constant demand conditions, leads to higher prices), and the marginal borrowers of loans will be unable to fund their projects any longer, or if they have already completed building their project they would be unable to pay the higher interest rates that prevail now after people have reasserted their consumption-savings proportion. For example, James sees that he can get a 4% return on a business project and when he sees that the interest rate (artificially lowered by the Fed) is just one percent, he gets all excited and plunges into the project. But when interest rate eventually hikes, lets say to 5%, he sees that his project is no longer profitable and starts defaulting on his loans.

Lastly, when interest rates hike after savers reassert their consumption-savings ratio, the Fed doesn't usually let the bust happen. Instead it again inflates money supply to impose forced saving on people again, and keeps the interest rates artificially low. But this policy can't continue forever, since the money will eventually get debased because of inflation.

Whoever said Ads were a waste of resources.

2009-12-24T20:28:00.001+05:30

Courtesy: www.youtube.com

Can efficiency wages cause unemployment?

2009-12-23T01:16:00.006+05:30

If one wants to see the market process as a mechanistic repetition with no heed cause-effect approach to analysis, mainstream economics should be the ideal pick. And Mankiw's Principles suggests just the same, for one more time. The issue is with unemployment, and efficiency wages are suggested as one of the causes of unemployment.

Mankiw's case

So writes Mankiw in his best-seller 'Principles Of Economics':

"A fourth reason why economies always experience some unemployment--in addition to job search, minimum-wage laws, and unions--is suggested by the theory of efficiency wages. According to this theory, firms operate more efficiently if wages are above the equilibrium level. Therefore, it may be profitable for firms to keep wages high even in the presence of a surplus of labor."

In essence, Mankiw implicates efficiency wages (which are voluntarily paid by capitalists) to be the cause of the market price staying above the market's 'clearing price'.

Correcting Mankiw

As I've pointed out already, although in a succinct manner, 'efficiency wages' are offered by capitalists in a purely voluntary basis. So it would do good to contrast 'efficiency wages' from minimum wage laws that fix wage levels above the labor market's 'clearing price', a coercive action.

Lets see this difference with the help of an example. Before plunging in, it must be understood that the price at which any market 'clears'(all of the supply is sold) is, essentially, the price at which the the marginal seller and the marginal buyer successfully exchange the marginal product. If sellers flood the market with 500 shirts, and assuming the sellers want to have their whole stock sold-off, they would have to find the exact price at which the buyers are ready to buy the whole stock of 500 shirts. That would be the shirt market's 'clearing price'.

Any price that is above the market's 'clearing price' would lead to an excess stock of unsold shirts. And any price below the 'clearing price' would lead to shortages--buyers ready to pay the price(in this case being the sub-clearing price) of the shirt but finding shirts already out of stock. So it is the 'clearing price' alone that essentially matches the 500 shirts with exactly 500 buyers(who most urgently need, or are ready to pay for it).

If I could rephrase what I've been trying to say through the example as something like this: the market 'clearing price' is that price at which the marginal seller exchanges the shirt for the buyer's money(price).

So now, the next question to be asked would be: does an efficiency wage really mean a price(wage rate, in the case of labor) that is above the 'market clearing' price? Mankiw obviously seems to think so. And the problem could be attributed to his adherence to the mainstream notion of some particular 'clearing price' somewhat automatically generated in the market machine; such that any price above that particular 'clearing price' should lead to the market being left with excesses(unemployed laborers, in the case of the labor market).

But does the real economy suffer from such mechanistic order of things? Is there are any magically processed price at which the labor market clears? No there isn't. The 'market clearing' price, if any, is determined by purposeful human action. All that it requires for the labor market to 'clear' is for the marginal buyer to agree to the marginal wage offer of the capitalist.

Conclusion

So, all that it requires for the market to clear is to let the employers and workers to act voluntarily in the market. And that definitely is the case with 'efficiency wages'. There is no coercive intervention involved when a capitalist wants to provide better wages to his workers. If the capitalist is ready to pay above-average wage rates to the marginal worker, the market will still clear.

The growing size of Government in the US economy.

2009-12-22T11:17:00.005+05:30

Courtesy: www.lewrockwell.com

The Mainstream: Time-less economics

2009-11-27T23:15:00.004+05:30

The basic premise from which various economic theories are derived is 'scarcity'. In fact the study of economics is limited towards 'economic goods', that is, goods that carry use value to people but are scarce compared to peoples' infinite desires. Prices for these scarce 'economic goods' arise out of an implicit process of bidding. In short, the market allocates resources among the several bidders who can outbid their counterparts.

While conventional mainstream economists do not falter till now, they've seldom recognized the scarcity of another important factor in human action--time. It should be obvious to anybody that time is not an abundant source available to human beings. Human beings contemplate the fact that time is scarce, and conform all their actions to harmonize with the limited time available. Thus arises the concept of 'time preference'.

The 'price' of time

The thought of tagging a 'price' for time can sound weird first, but an example can make things clear. Lets take the case of a prosperous farmer wanting to acquire new land to increase production. How much would the farmer be willing to pay for the new land? According to mainstream productivity theory, the farmer will be happy to pay the amount of value that he expects the new land to add to his returns in the future. Suppose the farmer anticipates the land to boost his returns by $1000 per year, he would be ready to pay any price below $1000 for the first year(Let us, for a moment, assume that there is no well-developed financial system established which could offer interest returns on deposits).

So, if $1000 is the return from the new piece of land for a single year, and further since land is productive for centuries together, should the land be priced at infinity? It would have to be, if the world works merely as what the productivity theory claims.

Unlike mainstream economists, the Austrian school recognizes the importance of time as an economic factor. The most important idea to keep in mind, with respect to our farmer example, is the fact that the farmer doesn't live forever; or that he wouldn't value returns from his land when he is bound to his bed in his twilight days(assuming the farmer has no heir). This solves the problem of the valuation of land. Land, like all other economic goods, has a finite price.

The valuation of land being one important lesson this example teaches us, that's not all about it. The example also shows us how the infinite value of land is 'discounted' to a finite value(price) based on the amount of time elapsed. So how does the price of time express itself in the market place? The most basic expression of time discounting being expressed in the valuation of durable economic goods land, the other important market for time is, the loanable funds market.

The loanable funds market

The loanable funds market or the financial market is the most explicit expression of the time market in the economic world. This market witnesses suppliers and borrowers of present capital carrying out the same bidding procedure that is characteristic of any free market. Like the market for other commodities, the borrowers of capital in the loan market bid for present goods, and suppliers of present capital supply their capital to those borrowers who promise the highest amount of future goods. The interest rate thus expresses the premium or discount that is placed on present and future goods respectively.

Ill-effects of the lack of time accounting

While almost all mainstream economists consider land, labor and capital as the factors of production, Austrian economists have for long contended the possibility of the other factor of production--time. Over here looms a wide scope of disastrous implications that could be framed against various mainstream theories, that is, based on their failure to account for time as a factor of human action.

The major effect could be seen in policy recommendations of mainstream economists vying for the government to possess a monetary policy--that is, a set of guidelines to tamper with the time(loanable funds) market. The advent of fiat currency has helped governments to 'fine-tune' the economy with monetary tinkering of the time market.

Any sound theorist of the Austrian should feel aghast at the kind of ignorance that conventional economists lie under when they recommend tampering with key signals(i.e. interest rates) of the time market as one of the ways to 'stabilize' the economy. Inflation, currency debasement, business cycles, the doomsday event that follows any policy based on debasing the currency--hyperinflation, and many other side effects of intervention in the time market, are taken to be normal policy prescriptions in today's economics mainstream--all because of the failure to recognize the role time plays in human action.

How I Became An Austrian.

2009-11-13T22:11:00.003+05:30

I have always been empathetic to the cause of the poor, and had a special liking for charity. A huge influence in this regard comes from within my family and other close quarters. It wasn’t too long before I got enmeshed into the popular trap of associating charity with socialism, and ‘exploitation’ with the free market; goodness with the working class, and evil with the rich. Much of this distorted view of reality could be associated with interpreting economic issues based on what, taking some help from Bastiat, is seen prima facie and missing out on what goes unseen.

It all started sometime in 2006 during my high school days. I had opted for science stream, only to find out that I had made yet another bad choice in my career. My academic graph was plunging quite rapidly, while my affair with political and economic systems, which sprouted when I was in middle school, grew manifold. Meanwhile I persuaded my dad to get me internet at home, and well, I tried out different things online before making it into orkut(the craze then was multifold when everybody had open scrapbooks, zero privacy. Those were great days, duh!). Like few other teenagers, I was a member of the bandwagon of nationalistic fervor and pride, wanting a violent revolution to weed out ‘evil’ capitalists who were, I believed, the reason for all our economic and social problems. Adolf Hitler was so attractive a figure to me, only to be taken over shortly by my romance(which still persists in a somewhat diminished flavor though) for Russia and the “Iron man” Stalin.

During one such endeavors to pick up some fight over orkut, I happened to step into the scrapbook of RFL’s owner. If I’m right, I begun the conversation with him by pasting some old Russian joke(which I don’t remember anymore) deriding Capitalism. Notably he was the first person who took real interest, while others responded to derision with hard words I wanted, in pointing out to the flaws in my thinking process, and my misplaced priorities (Perhaps it’s not really a bad idea, I think now, to take interest in rehabilitating numbskulls on networking sites who are taken over by emotions featuring real world economic problems? After all I was one such…). Our discussions(I like euphemisms) lead us into starting a community on orkut(which now has hundreds of dead members but which still the best place to educate yourself on the subject).

The virtual community was the best thing could have happened to me at that point of time. It served as a graveyard for all my misconceptions about the market. It was a truly nice experience, where I was exposed to the works of Austrian economists, which I nevertheless ignored for more than a year. I knew I had to read them at least to know what the people at the other end were saying. I couldn’t be dishonest.

One of the other important things that happened at the community was the contacts I got with many socialists, who were radicals(except a very few may be). It was spine-thrilling to be a part of a virtual Red army on a battle against the capitalist ‘exploiters’. But things weren’t quite smooth inside the camp. My personal interactions with these socialists gave me an idea of their cause. But I found out that I wasn’t in complete agreement with what they purported. They were more concerned with economic inequality than in the welfare of the poor. ‘Equality’ was their cause, welfare for the poor was to be paid lip service alone. While I had some inclination to gather some logical defense which I could use in support of socialism, I could sense something. Socialism(and most importantly Marxism) doesn’t have any solid logical backing. Marxism is dogma, a pile of completely wrong propositions. Jargon is the best veil Marxist ‘intellectuals’ use to feign their errors. The most outright questions would give me unconvincing answers.

Getting to know the stupidity, and hypocrisy of socialists was never going to change me, for I was sure to stick on to socialism if I could find a logical basis in which I could defend socialism as the system that works for the interests of the majority. But things definitely started to drift. I had to read what my opponents really said. I made repeated attempts to go through previous discussions, many of which I didn’t understand. This was when I was in college. I was least interested in the course I had opted for a course(from which I eventually dropped out), and all that I did in the latter part of the year was to bunk classes and start reading my first economics textbook(which wasn’t actually Austrian). But it got me thinking. My mind gained clarity on how the market works, and why it works to the best interests of the workers.

There was no looking back. I could see that my socialist comrades were wrong many times. I would point them their errors, but they’d be least bothered to think on an unbiased plank. I got branded as a deserter when I decided to count my days in the Left. The recent year has been a very fruitful phase in my intellectual development. My episode must help drive home the point on what actually can change a emotionally handicapped person into a person who can find the right ways to the goal, which is the welfare of the collective(Yeah, and I am indeed aware RFL’s core philosophy). Noble intentions alone do not suffice to provide the desired results. I have no doubt now that the interests of the masses can be served only by the free market. Any other solution proposed is pure hogwash to divert attention.

While socialists would call for the abolition of market anarchy, Austrians would tell me the efficiency of the ‘invisible hand’. While socialism would demonize profits as ‘exploited surplus labor’, Austrian economics would teach me that labor without present goods through capitalist savings would lead us nowhere. While socialism would characterize the stock market as a casino, Austrians would teach me the resource allocative function of the stock markets. While speculation would be derided by socialists as greed, Austrians showed me how speculators shielded the poor from price shocks. While socialists called for a society of abundance, Austrians recognized the importance of calculation under scarcity. While mainstream economists would term interest as usury, Austrian greats would point towards the importance of time as an economic factor. I could just go on!

The only way to diagnose the real economic disease is to learn the science of cure. The cure is here, and it’s definitely Austrian economics—the only easy and fun-filled way to see beyond what’s seen prima facie and explain that what’s unseen.

The Value of Money

2009-10-14T22:00:00.005+05:30

People get enmeshed into a trap when they try thinking about the value of money. That is, why is a paper bill worth so many(tens, hundreds etc.) rupees, dollars or any other monetary unit. How exactly does the mint get about printing these numbers?

Was paper so acceptable?

To start off, lets ask ourselves some questions. Why did the vendor accept a 50 rupees note from me, in exchange for a kilo of sugar? The obvious answer many people give is, money(paper money to be precise) is a commonly accepted medium of exchange in today's economies.

But lets board the time plank, to regress back in time. How did the first issuer of paper money(lets say he was Mr. Spaulding) ascertain any monetary value(like 10 rupees, 100 rupees etc.) to the paper money that he made?

Did he print just arbitrary numbers on the green papers that he printed? If so, what made our predecessors to accept paper pieces with arbitrary numbers(we will later see they weren't really arbitrary numbers printed on the green paper bits) printed on them in exchange for real goods and services?

Lets trust the intellect of our ancestors for a moment(and for lack of real evidence to support that Mr. Spaulding actually got his way through with the trick), to assume that the first men who started using money did not exchange real, valuable goods and services for mere paper pieces printed with numbers.

Evolution of Commodity money

The first money(ies) used by mankind were real commodities, and not paper pieces, which had specific use value attached to them. To get the crux of the idea, lets take a seemingly simple economy of three people.

Lets say Jon has a couple of apples, Jim a couple of oranges and Jame has an ounce of gold. All three guys don't actually make it to the place of transaction at the same time. Lets say Jon and James meet each other, with their goods(apples and an ounce of gold) in hand. But now, it turns out to that James wants apples(from Jon), but Jon isn't actually interested in the ounce of gold James has.

Now this sounds like a trade exchange between Jon and James ain't gonna happen, no?

Surprisingly, the exchange does happen with James exchanging an ounce of gold for apples from Jon. What possibly made Jon to accept the ounce of gold from James in exchange for the apples although he had no real personal use to satisfy with the ounce of gold? The answer is, although Jon does not value the ounce of gold for the personal use-value that it could provide him with, it does help him as a 'marketable' medium of exchange. Jon accepts an ounce of gold from James only because he believes that it can be exchanged with Jim for the oranges.

In short, gold is accepted as a common medium of exchange because it is easily marketable, or in other words, it can be exchanged readily for real goods and services. The principle is quite the same even in complex economies; people trade with a common media of exchange because it is easily marketable(that is everybody accepts it in exchange for real goods and services).

What is money?

We can, by now, actually figure out a few crucial points.

1) Money is just another commodity, but readily marketable than other commodities for certain reasons.

2) Money was a product of the free market, with people engaging in voluntary trading. There is no evidence of people accepting paper money as a valuable common medium of exchange which they could trade for real goods and services.

The bastardized history of paper currency

While this sounds to be a sound case for the evolution of commodity money(like gold, silver, sugar etc.), it does not satisfactorily answer the evolution of paper money. Rightly so, paper money has had a kind of bastardized birth history to it.

What made(or tricked) men of the past to accept paper pieces(of no real worth) as money?

The answer lies partially in the fact that paper money was introduced as a veiled representative of real commodity money. That is, paper money initially only served as a money instrument(representing money) backed by real commodity money(most often gold and silver).

The warehouses in which men deposited commodity money were the first to introduce paper money. Capitalizing on the trust that the depositors thrust on the money instruments of these warehouses, these warehouses started to create fake money instruments which were not backed by real commodity money. But the trust that the customers of the warehouses had on these warehouses prevented them from asking for redeeming their money instruments for the real commodity money that backed them. This made it easy for these warehouses(predecessors of banks) to expand credit, and increase the supply of money.

Imagining today's paper money as the remnants of these warehouse receipts, which were not backed by real commodity money helps us deal with our initial question of the value of money; that is about how Spaulding actually managed to print numbers to green papers he printed. All that he could have done was printing warehouse receipts which bore claims to definite weights of the commodity money which supposedly backed the receipt. This is further confirmed by the fact that today's monetary units like the dollars, francs, pounds etc. were units of weight measurement of commodities like gold and silver of the previous centuries.

Conclusion

Paper money can have a fixed face value only when looked at as a measure of unit weight of commodity money backing the paper money, not if it were to denote it's purchasing power.

The fixed face value of paper money can only represent claims to real commodity money backing it. But, whether, warehouses(or today’s banks) can actually in real redeem commodity money for today’s paper money is another question to explore.

What are profits?

2009-08-08T18:40:00.002+05:30

I have dealt with this question already in one of my previous posts. But judging by the comments I got for that particular article, I found myself guilty of being too complicated. So, I decided to write a detailed article which can explain profits and losses to the layman. A few basic economic concepts to start with.

Scarcity

Human beings essentially live in a world of scarcity. All of us cannot have everything we want indefinitely. Whatever be the sophistication of human civilization, the scarcity of goods refuses to disappear. Hence, goods which are not available in abundance and need to be rationed among different uses of men can be called 'economic goods'.

Goods which are abundant and virtually inexhaustible, like air, are 'free goods', and they do not make a part of economic study.

The Role of prices

As we live in a world of scarcity, and not everybody can have everything they want at any point of time, the available amounts of economic goods must be rationed towards the various uses of men.

A centrally planned socialist economy which does not use the price system employs bureaucrats to carry out the rationing of goods. For various reasons such an allocation process tends to be inefficient. We need not bother about it at this point of time.

The market economy on the other hand uses the ingenuous price system to ration goods. Prices, as most of us know, arise out of competitive bidding by buyers for economic goods. At the end of the auction, a single price is arrived at, which clears all goods from the market(unless the sellers decide to hoard for future).

The Market as a Democracy

The essential character of the market is the price system, with voluntary buyers and sellers engaging in the trading process. Money plays an important role in the market process. It plays the same role in the market, what 'votes' play in democratic elections. Money notes(to keep the example really simple we assume the buyers have ready cash in hand) are 'votes' which various buyers cast in favor of different goods. The highest bidder usually gets the goods on payment of the bid price.

The difference between a market and real democracy is that the market allows the casting of multiple votes by a single buyer. Many skeptics have complaints against this, but, they hardly recognize the fact it gives a chance for the various buyers to express the intensity of their wants through money 'votes'. Under a single vote system it would be an impossible task to figure out whose needs are the most urgent. The market process is the best tool available to mankind.

People make choices!

You might have seen your parents deciding on the month's budget, on what to buy and what to cut, probably so that your family can spend the saved money on something else. You might have also heard of people in the ice-clad polar regions deciding on the amount of wood they might need during the worst times. You might have heard of increasing number of people opting for fuel-efficient cars.

What these decisions have in common is that all involve allocation of various resources(like time, energy etc.) towards various means to attain particular goals which they value at different degrees.

A Robinson Crusoe who lives in an isolated island too would have had to make these decisions, probably on how many logs of wood to cut, how many fishes to catch etc. He would have had to allocate his time, energy and other resources towards these ends he aims to achieve.

What the pricing system does?

What differentiates a complex economy from the simple Crusoe economy is not the decisions we make (after all decisions are always to be made in a world of scarcity). The vital difference is that modern economy conducts this process of allocation of resources towards various ends through the price system, like how Robinson Crusoe allocates his time, tools and energy towards particular ends. But, unlike the simple Crusoe economy where a single individual makes all decisions to himself (since he is both the producer and the consumer of the goods), the complex economy with sophisticated division of labor, involves millions of consumers convey their plans to the producers through the price system.

Hence, basically, what the market does is, it allocates resources in the economy according to the most urgent demands of the consumers.

'Static' vs. 'Dynamic' conditions

The condition of 'Static equilibrium' is an imaginary construct which can help us in economic study. It hypothesizes a world where the goods of the economy have been perfectly allocated in such a way that the most urgent bidders have got what they wanted. This 'static equilibrium' is what mainstream economics texts are usually obsessed with, and as a result mainstream models of the market miss one important element, namely the entrepreneur.

Since Jon expresses his urgency with a higher bid, he gets the apple while Kate does not. This is just one of the many decisions happening in the market, where goods are allocated to the most urgent needs through the price system. If the world were to freeze after this simple allocation in a two-member economy, we would have a 'static equilibrium' condition.

Now, lets assume that the world is in a state of 'static equilibrium' with the best possible allocation of resources (that is resources are allocated to the most urgent uses they are required for). There is the first-ever Christmas season coming up, in just a couple of weeks, and there happens to be great demand for cakes. The flour that was, until then, used to make bread (which was indeed the most urgent use of flour until Christmas came by), has new competition from cakes. Hence, here happens to be a 'disequilibrium' in the allocation of resources, since bread is not the most urgent use of the consumers coming out of the use of flour. Change in consumer taste has caused a 'disequilibrium' in the allocation of the resources.

From this state of 'disequilibrium', the market tends to move towards the static state as cakes start being made and sold to the consumers.

Role of the Entrepreneur

This movement towards the equilibrium state, which envisions the best allocation of available resources for the most urgent uses, does not happen automatically. The driving force behind the market which actually makes it happen is the spirit of entrepreneurship. The entrepreneurs who sense this 'disequilibrium' in the allocation of the available resources can buy these resources at cheaper rates from places where it has not been put to the most urgent use to places in the economy where they can offer more urgent uses.

I am reminded of a famous retail chain in my city which transported laborers from villages where these workers were paid very low wages, and got them to work in the chain's stores in the city where their work was much more valuable. The workers got increased wages since they were serving the most urgent needs of the market unlike when they were working for low wages in the villages. The middle-men who made this transfer of labor possible were able to gain profits, not because they exploited workers, but because they put them to the most valuable use. Anybody who thinks otherwise should understand the role of entrepreneurship in the market economy better!

Marxian Exploitation Theory

2009-07-26T22:27:00.001+05:30

One of the most important theories to make the rounds in 20th century world politics was the 'exploitation theory' proposed by the German Political theorist Karl Marx. Leftists all over the world have found it to their political convenience to blindly accept this theory, and to convince themselves of the morality of the workers' hours of toil.

Karl Marx shouted that the source of the profits gained by the Capitalists is the exploitation of labor's productive effort. He accused scornfully, the capitalists of looting the workers of their rightful share of the returns of their productive labor. So according to Marx, profits are nothing but the 'surplus value' that the capitalist with-holds from the laborer.

Much of this proposition could be dismissed as emotional outburst of an unstable individual, unless there was a 'scientific' discourse from the man himself, in his famous work 'Das Kapital' published in 1867.

Marx's theory of value

Marx, like other Classical economists, recognized the two kinds of values of any commodity: use value and exchange value. Use value being the personal utility that the commodity used as a consumer good yields to the consumer; while exchange value being the value that the commodity commands in a trade exchange in the market.

Marx in his preconceived mindset to arrive at an 'objective' theory of value, tried to find similarities in the properties of commodities that traded at the same exchange value at some particular point of time. He finally concluded that commodities with the same exchange value had the same amount(hours) of labor involved in producing them, and hence exchanged on equal terms. Thus was born Marx's version of the Labor Theory of Value.

The fallacy in Marx's theory of value

Marx believed that if two commodities were exchanged for each other, they had something in common and Marx propounded that to be the amount of labor hours required to produce the commodities. Thus Marx proposed that people exchange commodities which had equal number of labor hours spent in producing them.

The basic fallacy here with Marx's perception of trade relations lies with the conditions of trade, and the source of value of any commodity. The question to be considered with respect to trade is: why would people exchange commodities of equal value?

If Ann and Bob have eggs and apples respectively, and both value the commodity that the other person has the same as the commodity he/she has, why would either of the two want to trade with each other? The only way trade could happen in this case is only when Ann values apples more than eggs; and Bob values eggs more than apples. Marx's theory falls into a pit!

The other even more basic question on which Marx's theory turns out to be nothing short of absurdity is: why would people consider the amount of labor hours involved in producing a commodity while valuing it? The only consideration of a buyer is to consider the commodity's personal use value to him, which is based purely on his subjective preference scale.

What Austrian economics offers?

Austrian economic theory, unlike Marxism, offers two important points for anybody to remember:

1) People exchange commodities with each other because they expect to benefit from the exchange. The only condition is that, the parties involved must value the commodity that they buy from the other person more than the commodity that they give up(or sell).

2) The value of commodity is based on the subjective valuation of the buyer. Commodities have no 'objective' value.

How An Economy Grows And Why It Doesn't

2009-07-08T13:40:00.002+05:30

Learning the basics of good economics never got lighter! Here is the video version of American tax protester Irwin Schiff's comic 'How An Economy Grows And Why It Doesn't. And, special thanks to my new friend for helping me find this amazing video.

Is free trade a zero-sum game?

2009-06-19T18:56:00.001+05:30

Various negative notions about trade deficits (excess of imports over exports), and unemployment in indigenous industries due to foreign competition have got ingrained in the minds of most of the common men, that almost everybody has decided, quite naively, to oppose International trade. International trade is often seen as a new variant of colonialism, advantageous only to rich nations. The utter stupidity of these notions can be dislodged by looking into the basics of free trade between countries.

Free trade is in no ways different from domestic trade, or even a primitive barter exchange that happens between two persons. People have a disposition to trade with each other, only because they perceive it to be mutually advantageous.

A music enthusiast pays $40 to buy his favorite music disc from a local dealer, only because he values the music disc more than $40. Conversely, the music dealer sells the music disc for $40 because he values that sum of money more than the music disc. There is a mutual gain involved in any consensual trade between two parties.

Let me try to posit a very simple case: why does a business owner who supervises his business decide to hire cleaners to clean his office premises while he can do the cleaner's job many times more efficiently? Isn't he actually at a loss? Not really. As you must be able to spot, the owner when deciding whether to hire a cleaner or not will weight his relative costs - between what he gains being the chief decision-maker of his business and what he loses by employing a less efficient cleaner. The business owner will obviously find it to his advantage to concentrate in decision-making (in which he has a greater advantage over the cleaner, than in cleaning itself) if the gains outweigh the losses.

The owner could gain $2,000 every month being the chief decision-maker of his business, while at the same time he loses $20 each month because he has to employ a less efficient cleaner. The owner will decide to be chief decision maker of his business under any circumstances where his losses are lower than his relative gains (which is $2,000 in this case).

Now lets try to fit in what we have discussed until now into International trade. How can trade between rich and poor countries benefit both? While it's self-evident that trade won't happen unless the traders involved feel they are better-off through the deal, lets try to figure the same in more substantive terms.

Lets suppose Germany and Congo are two countries, representing the first and the third worlds respectively, involved in free trade without any government intervention; with Germany being able to produce cars and coffee at lower costs than Congo. A common currency will be assumed to simplify the case.

Assume that Germany produces a car and a kilo of coffee at $2,000 and $20 respectively; and Congo at $6,000 and $40 respectively. As you see, Germany has a cost advantage in the production of both cars and coffee. But the degree of advantage Germany possesses in the production of cars in relatively higher than in the production of coffee. That is, Germany is three times more cost effective in the production of cars; while only two times more cost effective in the production of coffee when compared with Congo. This is similar to the previous example we looked into, in which the business-owner's advantage over the cleaner in supervising the business was greater than in cleaning the office. So it paid the owner to concentrate in the work in which his advantage was relatively higher, although he had an advantage in both.

Lets suppose Germany were to specialize in producing cars, and Congo in making coffee.

The question arises, why shouldn't Germany produce it's own cars and coffee, since it has an advantage over Congo in producing both? That is, why should Germany specialize in producing cars alone, and buy coffee from Congo at $40 per kilo while it can produce the same at $20 (exactly half the price of coffee from Congo)?

As you must be able to answer, Germany will be able to gain from the trade, for the same reason why a business-owner gains by employing a less efficient cleaner to clean his office. That is, Germany will find it to its advantage to buy coffee from Congo until the gains obtained from specializing in producing cars outweigh the losses incurred in buying coffee from Congo at $40 (that is twice the price at which it can produce coffee by itself).

To say it in other words, Germany will gain whenever its gains from selling cars to Congo outweigh the losses incurred in buying (potentially) expensive coffee from Congo.

As you must be able to answer, Germany will be able to gain from the trade, for the same reason why a business-owner gains by employing a less efficient cleaner to clean his office. That is, Germany will find it to its advantage to buy coffee from Congo until the gains obtained from specializing in producing cars outweigh the losses incurred in buying coffee from Congo at $40 (that is twice the price at which it can produce coffee by itself).

To say it in other words, Germany will gain whenever its gains from selling cars to Congo outweigh the losses incurred in buying (potentially) expensive coffee from Congo.

So how do both the countries fair through this trade? Since the cost of production of a car is just $2,000 in Germany when compared with $6,000 in Congo, it is then obvious that Congo will be ready to pay any amount between $2,000 and $6,000 to buy a car. Thus Congo benefits by buying very cheap cars. And at the same time, Germany too benefits from the trade since its gains from selling cars outweigh the losses incurred in buying expensive coffee from Congo.

What we see in the case of trade is essentially a positive-sum game, which maximizes the position of both the parties involved in the trade. Trade between countries does not obliterate the fact that it is trade between individuals, who are intent upon benefiting from the trade. If the trade weren’t advantageous to both, the exchange wouldn't happen at all. Trade, whether domestic or international, is never a zero-sum game.

Profit and Loss - The Importance of Economic Calculation.

2009-06-12T11:45:00.000+05:30

It’s not been tough for me to get to hear of derogatory comments against ‘greedy’ capitalists; about how those selfish pests suck all wealth unto themselves, by selling their products to consumers at prices above production costs to earn ‘undeserved’ profits. Going even further, some distressed souls even expect Capitalists to sell the products they produce at prices below production costs, and suffer outright losses.

I strongly believe most people with an anti-Capitalistic-mentality, are so, only because they don’t understand how the economy actually works. For instance, they don’t really understand why entrepreneurs don’t produce unless they gain profits. Otherwise, I believe, many people are usually sympathetic towards the efforts of the entrepreneurs in growing sustainable business models.

First up, lets analyse how economic calculation originated. We have usually heard of the merits of money, as a media of exchange which solves the trouble of ‘double coincidence of wants’, a store of value, divisibility, etc. But one more very important economic tool money has equipped us with has been the tool of economic calculation. Times of barter witnessed people exchanging goods and services through direct exchange without any common medium exchange called money.

Lets, for instance, take a person named Bob who lived in a barter economy. Bob produces wheat, corn and paper and he exchanges them for wine and squash. So, how would Bob’s book to keep track of his business accounts look like? As you must be able to guess, it would just have an array of goods bought and sold without any monetary values to any of the goods, whether bought or sold. Hence, Bob has no way to economically calculate whether he is economically better-off in an objective manner.

(Notice that Profit and Loss helps in objective measurement of economic value of goods. The subjective satisfaction that people gain when they exchange goods can’t be measured by any means, for obvious reasons)

The evolution of money necessarily revolutionized the way economic transactions happened on earth. There was now a common medium available towards the service of everybody, including Bob, to help them reduce details of their economic exchanges to a common denominator. That is Bob could now ascertain price figures to objects he bought and sold, and thereby enabling him to make economic calculations of profit and loss, and know if he is economically better-off or not. That is if he is richer or poorer at the end of an exchange.

Much has economic calculation helped people to have a hold of their economic situation, thereby directing their efforts towards production of goods that are economically valuable. For instance, Bob could now understand if his net personal wealth has increased or decreased. He now has a objective scale which could guide his production activities towards production of economically valuable goods which he could exchange with others.

Not to be ignored, the advent of the division-of-labor society where people are no longer self-sufficient, but specialize in specific production activities, has further directed our activities towards the production of goods for satisfaction of others.

An important contribution of economic calculation has been the Price system. Money is similar to ‘votes’ that you cast at the ballot every election, only that different people have different number of votes. Consumers vote everyday for products which they want, and refuse to vote for products they don’t like, giving rise to prices. Thus, the market reflects a democracy in action where voting takes place every day.

Prices can also tell us the relative scarcity of different goods in an economy. For instance, if the market is flooded with huge amounts of wheat which out-weighs consumers’ needs, consumers will instantaneously decide to use less of their votes to spend on wheat, giving wheat producers the signal to cut production. The exact opposite happens when a product is not produced in sufficient amounts.

So how, and where, does contempt and disdain against profits figure out in what we’ve been talking about till now?

What we notice until now, in our discussion about economic calculation and the Price system, has been the way the market directed by the spending patterns of the consumers guides producers to produce certain products and stop producing certain other goods. Even in the previous example, in which we talked about the movement of prices according to the preferences of the consumers what we see is it is the consumers who decide how much to pay, or in other words, how many votes to cast in favor of a product.

Another aspect of the problem can also be explained with a critical example. Lets take the case of distilled water. As one must be knowing, distilled water is used for various purposes. For the purpose of convenience, lets assume distilled water of limited stock in a particular town, can be used for two purposes: for filling car radiators, and to treat patients at a local hospital. Lets also assume, the people of the city decide to coerce the supplier of distilled water not to raise his prices, and sell at prices that cover just his cost of production alone. Lets also assume all car owners in the city are getting ready to make their holiday travel, so their demand for distilled water will increase. There is one critical thing that will certainly happen, which is, too many distilled water bottles would get diverted towards usage for cooling car radiators. People who have their dear ones at the hospital will run out off distilled water, unless they were the first in the queue to get distilled water. The problem here is, people who want distilled water for their medical requirements have to lose out, because they were disallowed to bid up prices and compete with car owners for the limited stock of distilled water. This is just a very simple example of how rational allocation is impossible without the price system in place. Now suppose the city managers get to know of the situation and they remove the price controls on the supplier of distilled water, and as expected, people who need the supplies for their medical needs bid higher prices for the distilled water, and the supplier will make huge profits.

Another entrepreneur comes into the city at the same time, and he buys some of the distilled water at those currently prevailing high prices, and mixes some gelatin powder into them and makes nice tasting jellies. He goes to the market place and tries selling those jellies. Nobody in the city wants to buy them at above his cost of production, and his venture goes broke with losses within weeks. The reason obviously is that the entrepreneur had a very bad taste of anticipation.

The entrepreneur failed to understand that distilled water was already selling at very high prices. That is, it was already very scarce. People had no intention to buy jellies from him because their more important needs, like to fill their car radiators, were yet to be realised. The entrepreneur made a very bad mistake which wasted the already scarce supplies. So, he was punished for causing loss to the society.

So, profit or loss of a particular venture is not determined by the entrepreneur who runs the business. It is the market, where consumers vote everyday welcoming and rejecting products, that determines if an entrepreneur makes profits or goes broke. The entrepreneur makes profits, only because he is able to satisfy the most urgent needs of the consumers. He neither plunders nor coerces consumers. It is the consumers who order all actions of the producers.

The Balance of Payments fallacy.

2009-06-12T11:42:00.001+05:30

Not many pseudo-economic propositions have gained as much popularity as the Balance of Payments doctrine. That’s not to say that people are solid when it comes to other economic concepts, but the Balance of Payments fallacy is the best bet when it comes to economic concepts that can be looked exactly upside-down.

To start with the matter in hand, Balance of Payments (BOP) is the difference between the flow of payments into and outside the country. If a country exports stuffs of various kinds more than what it imports, then the BOP situation of that particular country is called ‘favorable’. And if the exact opposite happens, then the BOP situation is said to be ‘unfavorable’.

So if there were two persons Bob and Mike representing two different countries, and if Bob sells a dozen of bottles of wine to Mike and gets in return 5 green papers called money, at that moment, Bob’s BOP situation is said to be ‘favorable’. And Mike who has in possession, now, a dozen bottles of wine is said to have an ‘unfavorable’ BOP situation.

So, all that Bob has to do to make his economic status ‘favorable’ through trade is to produce valuable wine and fill it up in bottles, and sell it to Mike for pieces of green paper called money. Conversely, Mike would make his economic condition ‘unfavorable’ by giving green paper pieces to Bob, in exchange for bottles of wine.

You might just think I have lost my mind, when I don’t direct enough of my attention to the possibility that the green pieces of paper (called money) could be used by Bob to get goods from Mike. But that’s what most people don’t do. They don’t understand that if Bob can sell his wine for, say, 5 pieces of green paper then he can buy other goods worth 5 pieces of green paper from Mike.

That means there is a real ‘balance’ between payments which flow in and out of the economy. If Americans buy €100 worth of goods from France using $200 (assuming an exchange rate of 1 Euro = 2 USD), then it means the French now have the same $200 with which they could buy American goods. The net balance is zero.

What if dollars that go out of the economy to import foreign goods don’t make their way back to buy back American goods? The answer is obviously plain, there’s no better deal on earth than receiving valuable economic goods for pieces of paper money.

Investment flows into a particular country too would set the BOP scale ‘unfavorable’, and withdrawal of foreign investments would set it ‘favorable’. That’s how badly the BOP fallacy recks havoc in people’s minds. It would serve countries better to resolve this semantic confusion sooner than later.

The Underconsumption doctrine.

2009-06-12T11:39:00.000+05:30

One of the theories which tries to explain the cause of capitalist depressions is the under-consumption theory. This forms the thesis of writers like Prabhat Patnaik who often calls Capitalism a ‘demand-constrained system’; and also lingers around in the writings of John Maynard Keynes as the ‘lack of aggregate demand’. The underconsumption doctrine goes as something like this: due to excessive business savings and reinvestment, production of goods and services increases, and leads to fall in prices. But the consumers cannot buy out this increased production because of the lack of purchasing power. That is, in simple words, people can’t buy the goods produced at prices above the cost of production of these goods. Hence, the State has to step in by releasing new money into the economy, either through loose monetary policies or huge fiscal spending, to supply consumers with the ‘missing’ purchasing power.

The fallacious argument of these economists can be busted by looking into a basic fact of production in a capitalist economy. And that is, the cost of production of goods and services can never be more than the purchasing power of the workers (who are also the consumers).

Lets assume a very simple economy of 100 persons all involved in cultivating apples, and consumers (who are also the workers) are content eating apples that they don’t try producing any other good. All that the consumers want is 100 apples, nothing more and nothing less. As a note of caution: do not be concerned about the unrealistic example, this will help us catch the crux of the issue. So, for instance, the land-owner produces 100 apples at labor cost of $100, and hence he wouldn’t be happy with a price below $1 dollar per apple. Note that the farmers have $1 dollar each as wage. So, the farmers now are in a state of affairs in which they are capable of spending at least $1 for an apple, which will certainly cover the production costs of the land-owner. So, there is no question of a lack of purchasing power as such.

The cost of any product is embedded in the wages paid to the laborers, either in a single stage of production or spread through a chain of round-about production stages. So, this automatically implies that wages in the economy will equal (or cover) the production costs in the economy, and hence no question of lack of purchasing power. It’s a self-evident proposition.

One could argue against the example I have provided as non-expressive of various market phenomenon. The most probable opposition to the example I have proposed would be the absence of profits and losses in this hypothetical economy. That’s actually not a problem. The hypothetical economy I have used is an economy in equilibrium with perfectly satisfied consumers. Profits and losses occur whenever this equilibrium is disturbed, that is, when a ‘disequilibrium’ sets in.

Say the consumers (who are also workers in the apple farm) decide to cut down their purchase of apples by half. So every consumer now buys only half an apple at 50 cents. This will lead to losses for the land-owner who is unable to sell his apples. So he lays off exactly half of his work-force anticipating the same pattern of demand next season too. Now an entrepreneur enters into the economy and makes a crude market survey and finds out that people’s obsession with apples is over at least by half, and they are now ready to pay for oranges. So this new entrepreneur immediately absorbs the laid-off workers at cheap wages and employs them in growing oranges in a new piece of land. The harvest season arrives, and true to his expectations oranges have a great demand in the market. He is able to receive profits.

The money that was unspent on any further puchase of apples was rather spent on oranges, and the efficient entrepreneur who was able to anticipate future demands in the best way was able to rake in profits. The change in consumer preference lead to a ‘disequilibrium’ phenomena which leads to losses to those who stick to production of goods which have lost consumer preference; and high profits to those entrepreneurs who forecasted consumer demand in the best possible way. These initial profits of course cease to exist as new producers enter the market sensing high profits and profits are brought down by the bidding up of wages, and increased production which leads to lowering of prices.

The study of a more realistic ‘disequilibrium’ market does not change the basic fact that cost of production of goods and services can never be more than the purchasing power of the workers. The losses that happen in particular sectors, for various reasons, is not because workers (or consumers) lack the monetary purchasing power to buy the products at above production costs, but because they don’t prefer any more of that particular product.

So, although production costs equal the purchasing power of the consumers profits and losses are made possible (and thus not causing a contradiction with real life market happenings) whenever there is a ‘disequilibrium’ in the market caused mostly by change in consumer preference, or even entrepreneurial errors in properly judging consumer demand could lead to relative overproduction of particular goods at the cost of relative underproduction of other goods.

One should be careful here not to assume that profits in an economy will always equal losses. This is possible only in a stationary economy where no improvement in capital occurs. In such an economy the profits of a particular entrepreneur occur causing equal losses to other entrepreneurs. If the capital per head in an economy increases, profits (owing to lowered production costs) will be more than losses. The exact opposite happens in a retrogressing economy with a diminshing capital per head.

It's not about your body!

2009-06-12T11:38:00.001+05:30

Here is Dr. Bernard N. Nathanson explaining why abortion is murder of an innocent life. Makes a comprehensive medical case for the pro-life campaign. I am very glad (and of course depressed with the images in the video) to find and share it here.

The Mulayam Manifesto.

2009-06-12T11:36:00.000+05:30

Recently, the Samajwadi Party (SP) headed by Mulayam Singh Yadav released its manifesto for the coming General elections. The event made national headlines after an interesting slew of policy measures were included in the manifesto. A few of them were the abolition of ‘expensive’ English education to allow fair competition, cutting-down the use of computers, protesting against the use of machines in agriculture, and lastly the ban on forward trading. I will address each of these measures from a purely economic point of view without any materialist morality associated, since I assume its a question of people’s choice to stick to primitive times or move forward with time.

The most defining catcher in the manifesto has been the abolition of English education. This measure supposedly helps in ‘fair’ competition between students, and helps bridge the gap between the haves and the have-nots. First up, it’s undeniable that English is the world’s common language and any productive contacts with the rest of the world requires a level of syncretization with English. Even the Chinese have come to accept this fact, seeing India’s software revolution. That makes a strong case for English as it offers strong prospects of world wide economic opportunities. Of course, stronger cultural sentiments could persuade voters to suffice with smaller opportunities with the lack of English knowledge. It’s up to the voters to decide.

The other issues brought up by the Samajwadi party are regarding the usage of computers and the use of machines in agriculture. This proposal, as usual is the case, roots out from the myth of machines causing unemployment. Let me make it clear, machines do destroy unnecessary jobs. But that’s a necessary development for only when excess labor is released from certain sectors of the economy do other sectors of the economy obtain the necessary labor to expand their operations and raise the living standards of the masses. The process of ‘creative destruction’ (as used by Joseph Alois Schumpeter) is valid today as ever.

The other important issue is the opposition of the SP towards forward trading. To give you a small example of forward trading: a wheat farmer could, for instance, enter into a forward contract in January with a trader promising to deliver 1 tonne of wheat at a pre-determined price of $500 at the end of August. The farmer doesn’t want to take the risk of low prices, and so he agrees to sell a tonne of wheat to the trader at $500. If the price of wheat in August plunges below to $400, the trader has to suffer losses while the wheat farmer has avoided the potential loss. The same example could work in a different way, that is the trader could benefit from prices higher than $500 in August, and the farmer deprived of potential profits. But still, the farmer is able to derive a decent price for his wheat without having to take the risk.

Most often, the scorn against forward trading is because it could deprive the original producer off potential higher profits, while benefiting the trader with so-called ‘unfair’ profits. As with most populist critiques of speculative trading activities, this too is deeply set with a stark bias against traders. Cases of forward trading leading to real losses to the traders, and thereby shielding the original producers off the potential losses are conveniently forgotten. Nobody cares to look into the beneficial effects of forward trading. The SP manifesto manifests just a few of the many unjustified scornful attempts against the market economy.

On Overproduction.

2009-06-12T11:33:00.002+05:30

Karl Marx and Fredrick Engels say in their famous work ‘The Communist Manifesto’:

“It is enough to mention the commercial crises that by their periodical return put the existence of the entire bourgeois society on its trial, each time more threateningly. In these crises, a great part not only of the existing products, but also of the previously created productive forces, are periodically destroyed. In these crises, there breaks out an epidemic that, in all earlier epochs, would have seemed an absurdity — the epidemic of over-production.”

So according to Marx and Engels, capitalist economies are infested with periodic depressions, which they often claim to form an inherent character of Capitalism. And the cause is?

Which they go on to explain further:

“Because there is too much civilisation, too much means of subsistence, too much industry, too much commerce. The productive forces at the disposal of society no longer tend to further the development of the conditions of bourgeois property”

So too much prosperity is the cause of depressions, they say. For better clarity, I would like to cite the Marxist crises theory, which revolves around the concept of the “tendency of the rate of profit to fall” in capitalist economies. Marxist writers often use this in various ways to put forward their theory on Imperialism. I would restrain myself from explaining that here, however.

The basic premise of the overproduction doctrine is that capitalist economies, as they get more and more efficient with labor-saving machines introduced to the production of goods, move towards a state of increased efficiency which leads to overproduction causing losses. All because there is too much capital accumulation and efficiency. It seems, because of overproduction, there are no more profits to be made in the economy, and hence the economy goes into a deep depression. So, it turns out that lack of profits in the cause of depressions.

In order to debunk this Marxist proposition, we need to understand what causes profits to exist in the market. I will explain how profits never cease to exist in a non-stationary economy where consumers’ preferences and production conditions change so often. I will start of by quoting Austrian economist Ludwig Von Mises from his famous work ‘Human Action’:

“Profit is not related to or dependent on the amount of capital employed by the entrepreneur. Capital does not “beget” profit. Profit and loss are entirely determined by the success or failure of the entrepreneur to adjust production to the demand of the consumers. There is nothing “normal” in profits and there can never be an “equilibrium” with regard to them. Profit and loss are, on the contrary, always a phenomenon of a deviation from “normalcy,” of changes unforeseen by the majority, and of a “disequilibrium.”

What Mises says here is that the origin of profits (and losses) is due to the “disequilibrium” phenomenon. So how does this “disequilibrium” phenomenon actually express itself like in a real economy?

Suppose that a market is dumped with millions of tonnes of potatoes which is very much in excess of the desire of the consumers to purchase, so the market gets cleared only when the prices decrease to a large extent. This obviously might lead to immense losses to the farmers. But do these losses, caused by overproduction in a particular sector of the economy cause depressions? Obviously not.

Lets go further and ask, does this overproduction in any way lower the average rate of profit in the economy. Again no, it doesn’t. The partial overproduction in a particular sector of the economy leads to partial underproduction in some other sector of the economy. Like in our example, if potatoes are grown in abundance that it surpasses the consumers’ needs, it simply means the equipments and labor that were used in growing potatoes could have been used better in some other sector of the economy.

So how would this show up in the price level? Simple, the prices of the commodities that are underproduced, because of employment of resources in overproduction of potatoes, will rise proportionately and lead to higher profits. The losses that are made in the sector where overproduction causes havoc is compensated by profits in the sectors where commodities are underproduced.

This is what Mises calls a “disequilibrium” phenomenon, leading to the arousal of profits (and losses). The market always moves in a direction to minimize this disequilibrium, but almost never reaches equilibrium because of various factors like the change in consumers’ preferences, natural causes etc.

Having explained the basic misconception, I would also like to deal with such speculations which contemplate the possibility of an overproduction in every sector of the economy. People argue overproduction everwhere could lead to losses everywhere completely wiping out profits from the economy. But there is no need to worry, the market has answers again. An overall overproduction everywhere in the economy still doesn’t set the “disequlibrium” that exists between the preferred quantities of various goods into equilibrium. Here one needs to understand that people’s needs are humungous and can never be satisfied. The market can only try to provide the proportionate quantities of various commodities according to the consumers’ preferences. Profits (and losses) are nothing but the signals that guide producers to adopt to the consumers’ preferences, and they never would cease to exist.

Chavez & his Socialist Praxis.

2009-06-12T11:30:00.003+05:30

Venezuelan President Hugo Chavez who rose to the chair in 1999, and since then been holding power despite the Washington backed coup attempt of 2002, is certainly in news now than ever before. Chavez has always been vocal about his aim of establishing 21st century Socialism in his country. Whatever that means, lets hope the almighty Marxist Praxis does not trust price controls as the economic tool towards that dream.

Venezuela is currently suffering from severe shortages in the supply of various goods, in particular rice. The nation reminds us of the erstwhile USSR in this aspect, as it does in many other perspectives. Only that direct physical force against the masses has not been let loose yet. Venezuela has been reeling under the impact of shortages in the supply of various goods since 2003, and now the crisis has hit rice supply as well. Keeping up with propaganda records, Chavez has launched a propaganda tirade against private suppliers. He has accused private suppliers of hoarding supply of rice. There could be a certain element of truth in it, suppliers could indeed be hoarding supplies to a certain extent. But that’s definitely not where the fundamental problem lies. The causal problem of this crisis lies in price-controls which have grown in size ever since 2003.

I will first explain the economic basics of prices, and then lead into the cause of shortages, inflation and hoarding.

What are prices, and what do they say? The price of a product simply shows how much money you should give up to obtain it. Then, what else do prices say? And why do prices of commodities change so often in markets? The answer is, people are willing to give up different quantities of money for the same homogeneous product at different points of time. This might sound vague, so lets get on with an example.

You are given 3 bags of rice. You have a particular preference scale based on your individual liking, and it shows those immediate needs that you would like to satisfy with the three bags of rice. The first immediate need that you fulfill with a bag of rice is to feed yourself. So, the first bag of rice goes to feeding yourself. You decide to use the second bag of rice to make some cakes. The third bag goes to feed your pet dog. This explains your preference scale. Your highest valued purpose is to feed yourself, followed by making some cakes, and finally feeding your dog.

Now imagine, you have only two bags of rice, and you are to decide what among the different uses of rice you are going to sacrifice. Since you have feeding your pet dog the least important of all uses, you decide to let your dog starve. Now suppose your neighbor has some extra bags of rice in his kitchen and he is ready to sell it to you for some money. How much would you be ready pay for that extra bag of rice which you would use now to feed your dog? You would see if the utility (or use) you gain from that extra third bag of rice is more than the utility you attach to the money you pay to your neighbor for that extra bag. Lets assume you would probably pay $2 to get a third rice bag from your neighbor, and you use it to feed your starving dog.

Lets further assume now that you have only one bag of rice. So you would have to give up on both feeding your dog as well as making tasty cakes. Now again, your neighbor has an extra bag of rice. How much would you be ready to pay for that second bag of rice? The same kind of reasoning as used earlier applies here as well, you would buy the second bag of rice only when the utility you achieve by buying it is greater than the utility you attach to its price. Perhaps you’d be ready to pay $5 to get the second rice bag from your neighbor, to make some cakes.

Now lets go further and assume that you have no rice bags with you. And again, your neighbor has an extra bag to sell. This time too you’d buy the bag of rice only when the utility you gain from the rice bag you buy is greater than the utility that you attach with the money that you spend to buy it. Now, you would be ready to pay almost anything to buy that bag of rice from your neighbor, and that’s because the utility you attach with the bag of rice is your life itself. You would have to starve without that bag of rice.

We have now seen three instances where the price offered to buy an extra bag of rice varies, quite drastically in fact. Economists explain this as the “law of diminishing marginal utility”. Marginal utility of a commodity is the utility that you gain (or lose at times) from an additional unit of the commodity.

This explains why prices change at different moments in the market. When there is excess supply of a commodity in the market, people would have the liberty to use those commodities for less valuable goals, like how you used the third bag to feed your pet dog. So they are willing to pay only low prices. On the other hand, when there is deficit in the supply of a commodity, people are strained to obtain sufficient goods. They are forced to cut down on their frivolous expenses, like your preference to feed your pet dog. The price of the commodity in this case is high. This explains how prices are set in a market.

What the market does is it rations the goods that are available to the most immediate needs by raising prices when supplies are constrained. So, high prices enables everybody to satisfy their most intense immediate demands, while restricting them from using further units of the commodity towards less intense needs.

So when supplies are inadequate, the price of the commodity increases to make sure that the commodity is diverted towards the most urgent needs rather than being wasted in satisfying less intense needs. This means that suppliers would gain lots of profits.

The suppliers then invest this extra revenue to expand their production in order to gain more profits. Note, monopolies might restrain from producing more to maintain current profits, but they won’t be able to do it for long, until competing firms sensing profits enter the business to produce more of the commodity. This increase in supply would cause prices to go plunge. So high prices leading to high profits are market signals to encourage increased production. And this is how the free market deals with the economic problem.

Governments on the other hand have a very different way of dealing with high prices due to insufficient production of a commodity. They deal with the economic problem with price ceilings. The Government sets arbitrary prices to commodities whose prices are “too high”, and it thinks the problem is solved. But that’s exactly where the problem starts. The lower prices leaves no profits to be gained or even sends firms right into losses, and that discourages firms from increasing production. Witnessing lower prices, consumers demand more of the commodity than they would at the genuine free market price level. That is like, if a sack of rice were available for just 50 cents you’d probably buy hell a lot of rice bags and waste them for weird reasons. We have in hand a very critical situation, production of the commodity plunges due to decreasing profits or outright losses, but at the same time people are demanding more of the commodity. This leads to shortages.

This is what is being experienced in Venezuela because of price controls imposed by Chavez’s government.

The other fact to remember is that price controls which are imposed initially on a a few commodities are spread to other commodities as well. In fact governments are forced to spread the price control regime because of their initial mistake of controlling prices of a few commodities. Why does this happen? When the price of a commodity is arbitrarily set low, people are encouraged to demand more of the commodity but since there is not sufficient supply available, goods are sold to people on a first come first serve basis. This could have a very important side-effect. The supplies do not get diverted to the most intense needs because those customers whose demand for the product is extremely important are prohibited from bidding higher prices for the commodity.

So when such needs are not satisfied, consumers search for alternative goods to buy. People who failed to secure rice because of the shortages would try to buy wheat which is not controlled by the government’s price control regime. As more people who failed to get rice start bidding for wheat, the price of wheat skyrockets. And now the government steps in again to impose price controls on wheat as well. And thus, the price control regime keeps spreading and turns into a universal price control system, with no kind of free market pricing to guide production and consumption.

Now coming to the problem of hoarding. First reason why some people hoard supplies is because they are unsure about the availability of future supplies due to chronic shortages. The second type of hoarding is carried out by speculators who expect a higher price for the product in the future when the price control regime collapses, or they might sell the supplies in the black market at prices higher than the government set arbitrary ones. It must be realized that the problem of hoarding is definitely not the cause of the shortage, it is a minor side effect of the real culprit–price controls.

The Venezuelan economy is in the mud, and the price control regime is spreading all over the economy. The system is bound to collapse and can cause serious problems to the Chavez government. It should also be observed if Chavez does a Stalin here, to use force against his own people. Reports emanating from Caracas already show the seizure of rice processing units, and also the spread of the price control regime towards other goods like meat, sugar and other goods. Just another case of price controls bringing disaster.

The Road to Serfdom.

2009-06-12T11:27:00.000+05:30

“The Road to Serfdom” written by Friedrich Hayek, published in 1944 is clearly the most popular rhetoric of the 20th century, exposing the evil defects of collectivism. The book explains the various stages a country possibly would pass through, starting with voluntary acceptance of the curtailment of basic economic freedom, and gradually towards lame surrender of basic human rights all for the welfare of the collective, before turning into an outright totalitarian state.

Many world countries, like the Soviet Union, North Korea, China, Eastern European countries to name a few, stood witness to this undeniable fact until recently. It stands the moral duty of everyone of us to stand firm against the disguised forms of collectivism which threaten our freedom even today, in the form of authorized coercion by the state.

Here is a very creative short cartoon kind of video on the book’s contents:

The condensed version of the book can be found here

It's recession time!

2009-06-12T11:25:00.001+05:30

It’s recession time, and I don’t hope to find a better moment to dig into the past of some long forgotten logical explanations of recessions. What better than the Austrian explanation of recessions? That’s just what I’ll try explaining in this article.

You are happy today, you’ve probably got your monthly salary, and that means you are next probably going to sit down to plan out how much to spend and how much to save. You’re finally done contemplating the different options, and eventually decide to spend 40 per cent of your salary on food, medicine, dresses, entertainment etc. The remaining 60 per cent of your salary goes into your savings account, opened at your trusted bank, to augur enough money hopefully to fund your daughter’s college expenses when she comes of age. Probably you find it worthy to be thrifty now to make sure your daughter has a bright future.

An Austrian economist seeing your budget would say that you used 40 per cent of your income for present consumption, and set off the remaining 60 per cent for future consumption. He’d further go to say that this ratio expresses your time-preference, that’s nothing but how much you prefer present consumption to future consumption. Further he’d congratulate you for saving quite a heavy proportion of your income for your future by foregoing present consumption, that is, on your low time-preference.

Another thing the Austrian economist would note is that the act of disposing your income is a zero-sum game. When you spend 40 per cent of your income today (for present consumption), you would have only the remaining 60 per cent for the future to help out on your daughter’s education. And by the same reasoning, if you save 60 per cent of your income this month, you can have only the remaining 40 percent to spend today.

This basic principle that is true in your case, holds good when we take the economy as a whole too. When present consumption goes up, savings (or investment) goes down, and vice versa.

Economists often call this the production possibility choices of the economy, that is, the various combination of savings (or investment) versus consumption options available to the economy.

Next, when we look at the economy as a whole, we should be able to note that whatever money you save at a bank, expecting a return at the market rate of interest, is lent out to businessmen who seek loans. To make it more lively, lets imagine that the sum that you deposit at the bank is borrowed by a college graduate who uses the money to train her skills to become a teacher, or may be a budding entrepreneur who is interested in building colleges. These very people might turn up to provide college education to your daughter, or may be some other similar people. These borrowers are lent the money at the market rate of interest.

I mentioned about market rate of interest offered by the bank. Is it any arbitrary rate set by the bank? No. How is the market rate of interest set then? It happens simply, by the same way how the price of a pen or a laptop is set in a consumer market, that is, through supply and demand interaction. The same laws of supply and demand applies to this loanable funds market as well. So now it should be easy to gather that, when people decide to save a lot of their income, that is when they have a low time-preference, interest rates must decline due to availability of funds to be loaned out (similar to how prices plunge down when there is excess supply). When people don’t want to save money and are crazy to spend most of their income in present consumption, interest rates rise because of the scarcity of funds (similar to how prices rise when there is insufficient supply).

So, that’s how the normal market rate of interest works!

Having done so much, the next step is to understand that our economies have a inter-temporal structure of production, ranging different stages from capital equipments to final consumer goods.

We now have to integrate the ideas we have learned till now about the inter-temporal structure of production, production possibility choices, and the normal free market interest rates. Interest rates in an economy play a vital role of acting as signals to businessmen who got to decide if they are to invest in producing consumer goods or capital goods. Investing in capital goods production means that businessmen have to wait for a long span of time before they could come up with the final consumer product which would hopefully yield them profits. Investing in consumer goods production means the exact opposite, businesses start earning profits in quite a short period of time. So it is normal that businessmen invest in capital goods venture only when interest rates are low, and when interest rates are high businessmen invest in producing consumer goods.

Next lets talk about the labor market. It’s simple, if businessmen borrow loans at low interest rates they would be able bid labor resources towards capital equipments production. If loans are available at higher rates of interest, then businessmen would invest in consumer products production and labor would automatically be bid towards consumer good production. Businessmen, guided by interest rates, act as agents who divert labor resources towards production of products which consumers really demand.

That’s how the labor market works!

Finally, we must now be able to understand how the economy works in general in harmony with the natural interest rates. When people want to save, businessmen receive signals through the interest rate and invest in capital development projects and this causes labor in the economy to be employed in capital development projects.The exact opposite happens when people decide to save less.

It must be noted that in a genuine free market, where savings are genuine and hence the investments too are nothing but genuine savings, resources are freed from consumer goods sector to be employed in capital goods projects. There exists a harmonious equilibrium between savings (which are removed from spending on consumer goods) and investments (which are supplied from spend-cuts in consumer goods).

This is how a free economy works! People have to save to send interest rates down in order to encourage businessmen to invest in the production of capital goods which can boost production. This means they release resources employed in consumer goods production into capital goods projects. That is what causes genuine economic growth.

Lets move to understand why economies move into recessions (or even depressions). I have assumed until now that the bank rate of interest is essentially set by the free market (as the interest rate on loanable funds). But in the real world today, interest rates can be set arbitrarily by the Central banks. They have an irresistible appetite to arbitrarily set interest rates low to “boost” the economy. And next the question arises, how can banks provide the necessary loans that businesses seek at low interest rates when people actually don’t save as much at such low rates to provide for the loans demanded by businesses?

Here is where the issue of paper money and demand deposits play a vital role. Central banks can simply print more money and flow it into the banking system, or create new demand deposits to lend loans to satisfy the demand for loans. Thus driving interest rates down. Banks can virtually create new loans from nowhere, as either demand deposits or newly printed paper money. So in essence, inflating money supply in the economy is child’s play for Central banks (backed by Governments of course). Note, banks can now lend more than what is deposited, welcome to the magic of modern day fractional banking!

In short what does this mean? It means Central banks can increase credit offered to businessmen without any regard to the natural market rate of interest. When government flows paper money into the banking system or creates demand deposits at will, it lowers the market rate of interest. This encourages businessmen to increase borrowing funds, but at the same time it removes the incentive for depositors to save money. There arises a gap between genuine savings and investments in the economy.

Businessmen equipped with the new funds will step up investments, and on the other hand consumers without any incentive to save money at such low interest rates spend money in the consumer goods. There is virtually a tug-of-war that happens between the investors and the consumers. Investors on the one hand try to suck in resources of the economy to complete their capital goods projects, and on the other hand consumers with money in hand to spend on present consumption pull resources towards production of consumer goods. There is essentially a shortage of resources in the economy to satisfy either of the sides. This leads investors to bid more for resources, and results in higher project costs. Finally investors find that there is not enough resources available, at previously expected prices to complete their projects. Half-completed projects take a very hard hit, and some investors declare bankruptcy. And we are in a recession, finally!

Thrift or Extravagance?

2009-06-12T11:24:00.001+05:30

“Paradox of thrift” has been one of the major offerings of Keynesian “economics” to economic policy-making. Not many other policies have contributed a solid assault on savings as a genuine way to economic growth. I will now try to explain the gist of Keynes’ (alleged) paradox and follow it up with a short rebuttal. This article will be longer than what I usually write, but bear with me.

Keynesian economics basically considers two major economic aggregates while checking the health of an economy: the income-output scale, and the savings-investment scale of the economy. The total income must necessarily equal total output, but savings need not always equal investments unless the economy is in a equilibrium. When people decide to save too much for any reason, Keynes argues, the economy would dive into a recession because businesses would have unsold inventories (which in turn induces them to cut jobs and halt expansion). The government could actually play an important role in this situation by encouraging people to spend, or even take the initiative itself and start disposing huge public spending–all this to get rid off the lack of demand and make businesses sell their products.

This reasoning forms the policy advise of journalists and economists who advise government spending to remedy recessions. Some even go further and say while savings of an individual could mean that she has an essential safety buffer to sustain herself through a gloomy future, on the larger scale however, as in the case of an entire economy savings have unfavorable effects since the economy is spending based. This was called by Keynes as the “Paradox of thrift” or the “Paradox of Savings”.

Keynes’ proposition could be right if we are to consider ourselves to live in an extremely simple economy, where consumers like us can get our products ready in a very short span of time. Like for example, how we could order water from the stream and the workers would get it for us in no time at all. In such a simple economy where ends are met in a very short span of time with very little complications involved in the process Keynes’ proposition that spending keeps our economies running could work.

(It would pay here to notice that we have not accounted capital goods in this very simple example. This will turn out to be the key point when we enter into a complex economy.)

There is fundamentally everything wrong with Keynes’ proposition when we place ourselves in a complex economy. Keynes’ fallacious argument roots from the basic lack of understanding of the `structure of production’ which is very complex in a division-of-labor society. Any product we use in today’s extremely complex economy is provided after complex levels of processes which happen at different points of time, and at different pace. This is called the economy’s `inter-temporal structure of production’. So there is essentially a time lag involved in the production process. This basic understanding can travel us long forward in understanding the economy and refuting arguments of economists like Keynes.

Now we consider ourselves to be in a complex economy, and so, we have extensive division of labor using capital goods to produce products which serve as inputs to subsequent levels of production before arriving at the consumer market as finished consumer goods. The introduction of capital goods into our economy also brings to our purview the importance of savings. The most important function of savings is that they render capital construction, as the following example will explain.

Lets consider a fisherman who is accustomed to catching fishes with bare hands decides to have a net for himself to boost production. He could fish 10 fishes working 8 hours a day with his bare hands. When he decides to have a net to catch fishes he dedicates 3 hours of his normal work schedule towards building a fish net, thus lowering his time spent on catching fishes and thereby essentially cutting down on his present yield of fishes to say 6. What the fisherman actually does, from an economic point of view, is to annul 4 fishes from his present consumption to save the time equivalent of catching 4 fishes to concentrate on building a net which could boost his future catch of fishes. In simple words, the fisherman forgoes present consumption to fund his future. He simply saves.

Anybody who hears this example should now be able to understand the importance of savings to genuine growth of any economy. But it is this very foundational principle which most economists have done away with.

Now getting back to the issue in hand, excessive savings can actually in no way, as Keynes fears, affect the economy. When people decide to save more of their income, that is when people decide to cut down on their present consumption, they effectively provide a signal (through low interest rates) that they do it to fund their hefty future needs (perhaps a boost in production). This requires investment in capital equipments construction. The entrepreneurs in the economy are those who receive this signal (again the low interest rates). Sensing the availability of loans at low rates entrepreneurs would decide to invest in capital equipments construction projects which essentially require a lot of time lag before the final product reaches the consumer.

The reader must now be able to guess what would happen if people don’t want to save. It essentially means that people don’t wish to cut down their present consumption to fund their hefty future needs. So that would mean higher interest rates, and discourage entrepreneurs to take up loans for capital equipments construction. The economy would essentially, however, keep producing consumer goods with the present amount of capital equipments available at its’ disposal, without any boost in production.

What we see here essentially, and that’s exactly what is pertinent to the issue in hand, is that high savings by people only lengthens the `inter-temporal structure of production’. It would not lead the economy into recession as Keynes fears. It is not that people never spend, only that they decide to save now to spend it at a future date. The bonus consumers get is a boosted future production because of investment in capital goods.

The next question that arises is how then does this model explain recessions that happen so often in modern economies? I will deal with it in the next article I write. Till then people could try to guess it from the alleged mismatch between savings and investments in the economy.

Insourcing disaster?

2009-06-12T11:21:00.000+05:30

US President Barack Obama has announced his intent at withdrawing tax-cuts to American companies that outsource work to foreign countries. This announcement comes in as one of the many ingredients, of a slew of populist measures that Obama has been churning out since assuming office last month. Policy-makers claim that heaping the tax burden on American companies that outsource jobs to foreign countries could save American jobs.

This sort of an economic policy could be disastrous to general efficiency of the economy and slacken creation of new jobs. One must take care of the fact that work is always there to be performed in any economy, since human needs are without boundaries. We essentially live in a world of scarcity, and any level of increase in the productivity of labor will never suffice to satisfy the immeasurable needs of the society. So the basic point is, labor is scarce, and will always remain the same.

But what are those statistical figures we get as unemployment numbers in government reports? Nobody could deny unemployment does exist. But such unemployment in today’s world is usually a result of government policies which adversely affect job prospects, and in turn efficiency of the economy in the long run. In a truly free market, the only two kinds of unemployment that could exist are frictional unemployment (that is, the temporary unemployment during the period when people search for new jobs) and voluntary unemployment (where people make a voluntary choice not to work).

Talking about outsourcing of jobs and it’s impact on domestic unemployment, it should serve us better first to imprint in our mind that labor is scarce, as already mentioned. The next important step is to understand and trace the consequences of discouraging outsourcing of jobs to foreign countries.

The basic reason why companies from developed countries outsource jobs is the availability of cheap labor from developing countries. So this firstly means the products that these companies produce to serve mainly the American consumers become cheaper considerably. This implies that the real purchasing power of an American dollar should increase.

The funds that American companies save by employing cheaper foreign labor while compared with high salaries previously paid towards Americans, could be used as investment in other sectors of the economy, or to increase the size of existing industries which would create new jobs for Americans. In the absence of the outsourcing option, the American companies would be forced to spend comparatively more in the already existing industries (that is when compared with costs incurred when foreign labor could be employed), without having a chance to invest in new industries (or expand existing industries) which could create new jobs.

The availability of cheap labor also means American companies become more competitive and efficient than their counterparts in other countries. It also makes Americans compete and become more efficient. More than anything it makes specialization of jobs, which is the reason for the riches of today’s industrial civilization.

The only thing that policy-makers need to understand is that businesses need to be given complete economic freedom worldwide to create new jobs at home, and increase living standards of Americans. Any short-sighted measure to save current jobs, will definitely halt growth in the long-run.

The end of work?

2009-06-12T11:18:00.000+05:30

A very famous economic fallacy that has won a huge number of supporters has been the belief that machines cause unemployment. Such preposterous beliefs which have neither rational justification, nor any empirical validity have been the roots of growth of primitive ideologies, which have called for mankind’s return to it’s “glorious” past.

For centuries men have believed that machines, or technological changes in general, destroy jobs on a large scale, and that they’d have to stay home jobless the next day on. It is true that technological changes destroy particular jobs, at least partially if not completely, but it should also be understood that these technological changes create new avenues of growth which will create new jobs.

The improvement of production techniques and the resultant mass displacement of jobs from agriculture a century ago, might seem like an unacceptable act of cruelty against the masses. But it’s quite the exact opposite, that is, the technological changes have benefited the masses.

More than half of the labor force of North America and Europe was employed in production of food stuffs during the early twentieth century. But today, less than 3 percent of the labor force is required to feed a population that has grown many times more. In fact, in the last century, the population of North America has increased four times, and Europe’s population has roughly doubled, while the percentage labor force required to feed the increased population has shrunk by about 15 times.

It makes sense to track the fate of those displaced workers. The technological change has in fact helped mankind, by releasing labor from agriculture to be used for production in other sectors of the economy. The advantage of technological changes is that it increases the marginal productivity of labor, that is, the quantity of goods a laborer can produce has been increased by the use of machines. This is the only way the living standards of the masses could be improved.

The dislike for technological change could be seen pronounced in the writings of economists of the modern era as well. Their concern is about the Information Technology revolution that has made economies knowledge intensive, and the disparity in wages among the members of the labor force.

But this could be no reason to stop technological growth, since even though there may be differences in relative wages, which in fact is an unavoidable character of economic competition, the real wages of laborers increases due to increase in the total wealth of the particular society. That is the real purchasing power of a laborer’s wage money increases as wealth of the society increases.

This sort of faulty reasoning of economists is the product of undue emphasis on the immediate effects of technological changes, with no heed to their tremendous beneficial effects in the long run.

As Austrian economist Henry Hazlitt says: “Economics is a science of recognizing secondary consequences. It is the science of tracing the effects of some proposed or existing policy not only on some special interest in the short run, but on the general interest in the long run”.

Mathematics to the rescue.

2009-06-12T11:13:00.001+05:30

The advent of mathematical economics in the modern era (or the neoclassical era) as against the preceding phase when classical economics dominated the scene, has in fact served to strengthen socialists’ claim to central planning and it’s rational possibility, while undermining the approach of Praxeology to the study of economics. Today, mathematical `economics’ has completely flooded the financial world (where econometricians falter the most), and is the dominant player in all other areas.

Present day economics which arbitrarily assumes, that complex human actions should conform to equation constants, and other mathematical jargon can’t get any cruder. Since this article is not supposed to serve as a critique of mathematical economics, I would rather divert a little towards how socialist economics is still propped up mathematical economics of the present era.

Mathematical economists tried to solve the calculation problem of Socialism by a rather innovative, but ambiguous method. The argument of these economists goes like this: the price of a discrete unit of capital good can be determined, by means of calculating the value that particular discrete unit contributes to the total value (or final price) of the finally furnished consumer good. Thus, the value of a particular discrete unit (which forms a part of the complex consumer good) could be determined by calculating the change in total value of the complex consumer good due to the removal of that discrete unit from the completely furnished consumer good.

An example could help us understand the argument in simple terms: Lets suppose a tractor (which is a consumer good) requires, by the simplest estimation possible, five discrete items to be completely furnished into a finished consumer good. The price of one of the five discrete units could be determined by calculating the change in the price of the tractor without that particular discrete unit (in question). That is, if you want to know the price of the wheels, remove the wheels and see how much people are ready to pay for a tractor without wheels.

That’s very innovative, indeed! But lets consider this case: If we are to consider a pair of shoes, how are we to ascertain the price of the discrete units of capital goods that went into making of each of the shoes? If you are still not able to see the trap, lets suppose you go to a boot shop, and a pair of shoes costs 10$ and if our mathematicians are to remove one of the shoes from the pair, and they ask you, “Now, how much would you pay for this single shoe?”. You would certainly say “I value it for nothing!”. This sounds like a logical contradiction.

Or if you want an even better example, lets consider our same old tractor. If I’m to remove the wheels of the tractor, the consumer would be left with nothing but a completely useless unfinished machine whose price he is to valuate, and if the consumer is as rational as you are, he would copy your answer. So the only conclusion is, price determination of capital goods by the suggested method offers no scope.

This makes the case clear, unless and until competitive bidding (from private businesses) for resources is allowed for, there lies no scope for economic calculation and rational allocation of resources. The incessant attempts of mathematical economists to reintroduce the possibility of Socialism does not stop here, it passes also into the ambit of using differential mathematics to achieve economic calculation.

But all those attempts do not hold water because of their over-dependence on hypothetical situations. Analyzing those questions goes beyond the purpose of this article!

Socialism can’t calculate.

2009-06-12T11:05:00.001+05:30

Debates setting the two dominant economic systems of the 20th century viz. socialism and capitalism on opposite poles have always witnessed the acceptance of the superiority of capitalism on account of the better incentives available under it’s basic scheme of things which motivate the individual towards excellence. This induced the depressed to `order’ for the creation of a new `socialist man’ who works for nothing but the goodness of his comrades, and passion he holds for his work. Such moral proponents were the root cause of movements like the Stakhanovite movement in the erstwhile USSR. These things aside, the problems of a Centrally planned socialist economy are immensely larger than mere motivational factors, it lies in the very structure and character of it’s economic institutions.

This was starkly exposed in the `socialist calculation debate’ of the early decades of the 20th century which involved waring minds (of economists) belonging to hostile camps. The capitalist camp was headed by economists from the Austrian School, most notably: Friedrich August von Hayek and Ludwig von Mises; the Socialist camp was represented by Oscar Ryszard Lange and Abba Ptachya Lerner. This article serves the purpose for purporting the essential ideas of Capitalism and the grave shortcomings of Central planning.

The fundamental feature of the Capitalism is the price system, with profit motive and economic competition as it’s inseparable soul. The price system is thus the most ingenious component of the market economy, so invincible that socialist economists of the 19th century trying to apply the labor theory of value to determine the prices of commodities (based on the amount of `socially necessary labor’ required to produce a commodity) accepted their defeat, and adopted the market pricing system, after all the price system is nothing but an expression of the subjective preferences of market players. In simple words, demand and supply forces determine the price of a commodity. Commodities do not have any magical value in themselves. This was the essential outcome of the marginal revolution.

However, a group of economists–namely the “market socialists”–persisting under the auspices of Polish economist Oscar Ryszard Lange refused to bow down (except for their acceptance of the revelations of the marginal revolution), in fact they were immensely excited about prospects of their own system which could allow for central planning of the economy. These economists proposed a hybrid system – adopting the pricing system of the capitalist economy and also the `goodness’ of central planning. They seriously believed they did it.

The “market socialists” proposed the arbitrary fixing of prices of consumer goods and allow supply and demand to match at some given price. They were able to explain their system with temporary success: if the prices were fixed too high, goods would stay unsold on the racks of stores; and if prices are fixed too low, shortages would result. The planning board would fix the prices on a `trial-and-error’ basis to determine the `clearing-price’ of the market, and the economy will be on it’s feet.

So far so good, or is it? It didn’t occur to them that they created the body of their economic system without a soul–the absence of private ownership of the means of production–until Austrian economist Ludwig Von Mises came up with his seminal work, “Economic Calculation in the Socialist Commonwealth” in 1920. Mises pointed out that without private ownership of the means of production, in other words, without competitive bidding from various private players for the ownership of capital and land, there was no way to rationally ascertain the prices of the various higher-order goods (capital and land).

This further means there is no scope for profit-loss calculation, and there ends any dream of rational allocation of resources under centrally planned socialism. The acquisition and usage of capital resources in a centrally planned economy are merely `internal transfers’ within a single body since the State is the only owner of capital goods.

Profits and losses play a very vital role in the market system. Profits in a sector indicate that the commodity (or service) in question is of use to the consumers (and hence demanded by them); losses mean the reverse, that is, the commodity (or service) in question is not of much use to the consumers (and hence not demanded). Because of the absence of economic calculation socialism would lead to massive wastage of resources since the planners would be left groping in the dark to know which sector of the economy is in immediate need of a particular higher-order good.

Some mathematical economists have tried to ascertain arbitrary prices to capital goods by analyzing the price of consumer goods that are produced using the capital good. But such indirect measures have shown no scope of accurate determination of the prices of higher order goods.