Archive for the ‘Economics’ Category

Humanity’s Most Complex Creation

January 31, 2008

Take a look around your house. Take a look at what you are wearing. Take a look out your window.  No matter where you are, from the biggest industrialized city to the smallest rural village, you are surrounded by economic activity and its results.  Twenty-four hours a day, seven days a week, the planet is abuzz with humans designing, organizing, manufacturing, servicing, transporting, communicating, buying, and selling.

The complexity of all this activity is mind-boggling.  Imagine a small rural town, the kind of quiet, simple place you might go to escape the hurly-burly of modern life.  Now imagine that the townspeople have made you their benevolent dictator, but in exchange for your awesome powers, you are responsible for making sure the town is fed, clothed, and sheltered each day.  No one will do anything without your say-so, and therefore each morning you have to create a to-do list for organizing all the town’s economic activities.  You have to write down all the jobs that must get done, all the things that need to get coordinated, and the timing and sequence of everything.  No detail is too small, whether it is making sure that Mrs. Wetherspoon’s flower shop gets her delivery of roses or that Mr. Nultey’s insurance claim for his lumbago is processed.  Even for a small town, it would be an impossibly long  and complex list.

Now think of what a similar to-do list might look like for managing the global economy as a whole.  Think of the trillions of intricately coordinated decisions that must be made every minute of every day around the world to keep the global economy humming.  Yet, there is no one in charge of this to-do list.  There is no benevolent dictator making sure that fish gets from a fisherman in Mozambique to a restaurant in Korea to provide the lunch for a computer worker who makes parts for a PC that a fashion designer in Milan uses to design a suit for an interest-rate futures trader in Chicago.  Yet, extraordinarily, these sorts of things happen every day in a bottom-up, self-organized way.

It is clear that the global economy is orders of magnitude more complex than any other physical or social structure ever built by humankind.

The Origin of Wealth by Eric D. Beinhocker

Fallacy of Tariffs as an Economic Advantage

December 3, 2007

Suppose that in our country we import woolen sweaters from country A, and the sweaters sell for $25.

The local sweater industry petitions the government to impose, say, a $5 tariff (duty) on the imported sweaters. They argue that they cannot produce woolen sweaters for $25 and need this tariff in order to compete with country A. So, the government imposes a tariff.

As a result, the local sweater industry is able to employ many people. However, the consumers now pay $30 for the same quality sweater. The consumers no longer have that $5 to spend on other things. Thus the local sweater industry thrives, but a hundred other industries shrink.

You can see the sweater employees going to and from the factory each day, and you think, “The tariff was a good idea, it has given employment to people in our country.” But you don’t see the hundred other industries that have shrunk and all the lost jobs from that.

— Extracted from Economics in One Lesson by Henry Hazlitt

We see this cognitive error recurring over and over: humans focusing on what they can immediately see, and failing to consider those things that are not immediately or easily visible. See Cognitive error: acting on only what is immediately visible

The number of economic choices the average New Yorker has is staggering

August 31, 2007

“The number of economic choices the average New Yorker has is staggering. The Wal-Mart near JFK Airport has over 100,000 different items in stock, there are over 200 television channels offered on cable TV, Barnes & Noble lists over 8 million titles, the local supermarket has 275 varieties of breakfast cereal, the typical department store offers 150 types of lipstick, and there are over 50,000 restaurants in New York City alone.”

“Retailers have a measure, known as stock keeping units, or SKUs, that is used to count the number of types of products sold by their stores. For example, five types of blue jeans would be five SKUs.”

“The number of SKUs in the New Yorker’s economy is not precisely known, but using a variety of data sources, I very roughly estimate that it is on the order of tens of billions. To put this enormous number in perspective, estimates of the total number of species on earth range from several million to several hundred million.”

The Origin of Wealth by Eric D. Beinhocker

What economic incentive is there to form decentralized organizations?

August 20, 2007

Adam Smith wrote a seminal book in 1776 called The Wealth of Nations. It is a classic, laying the foundations for most of today’s economic ideas. Smith’s ideas are deeply ingrained into western societies.

Division of labor is central to Smith’s thesis. Division of labor leads to high productivity. By focusing one’s efforts on a single task, one develops a talent for that task and become very productive. The greater the productivity, the greater one’s wealth.

Division of labor is consistent with one’s self-interest.

Conversely, when a person attempts to perform many tasks he masters none, is inefficient, has low productivity, and is unable to attain wealth. This is not consistent with one’s self-interest.

Division of labor results in a society that does lots of trading (if a person produces only one thing, he must trade for the other things he desires or needs). This creates a highly interconnected, interdependent society.

Today there is much excitement about decentralization. In a decentralized organization there is no one in charge, everyone is independent.

“Units of a decentralized organization are by definition completely autonomous … In decentralized organizations, anyone can do anything … Any and every activity is within anyone’s job description.” [1]

In a decentralized organization each person is not focused on a single task; rather, each person is a jack-of-all-trades. Smith would argue that this leads to low productivity, which leads to low wealth, which is not consistent with one’s self-interest.

So I wonder: what economic incentive is there to form decentralized organizations?

[1] The Starfish and the Spider by Ori Brafman and Rod A. Beckstrom

Similarity is not Sameness … Dangers of Misused Metaphors

August 15, 2007

“Human beings are skilled pattern recognizers and use metaphors to help them understand and reason about the world. Saying that something resembles or has qualities of something else enables us to quickly, and in just a few words, grasp the essence of a complex phenomena. Shakespeare could have given us a long passage about how Juliet was central to Romeo’s life, brought him happiness, and so on. Instead, with the simple phrase “Juliet is the sun!” Shakespeare conveyed those meanings in a far richer and more powerful way.

Science uses metaphor as well, both to inspire creativity and to help communicate complex ideas. For example, the metaphor of tiny, vibrating loops of string has helped inspire the physicists who are developing string theory (an attempt to unify the fundamental forces of the universe and explain the origins of subatomic particles) to think in radically different ways from their predecessors. Likewise, the phrase loops of string helps metaphorically communicate the key ideas of string theory to a lay audience more easily than does “eleven-dimensional Calabi-Yau space.”

But while the metaphor is useful in inspiring and communicating science, science itself is based on more than metaphor. Scientific theories do not merely make claims that one thing resembles another. Scientists make claims that something literally is a member of a universal class of phenomena.

Similarity is not sameness. When a cosmologist says our sun is a star, the scientist doesn’t just mean it is similar in some way to a star. Rather, our sun is a member of a universal class of phenomena, which are called stars, which share certain empirically observable characteristics.

When you see a similarity of one idea to another you may be inspired to use the tools and techniques from one field in another. Danger! Is the similarity a metaphor or science? That is, does the one idea genuinely share the same properties as the other, or is there merely a superficial similarity? If there is merely a superficial similarity but you treat it as the same then you are headed for erroneous results.

Example: in the nineteenth century was an economist by the name of Walras. He was eager to put economics on a mathematical basis. He observed the physicists and noted that they had created mathematical equations to describe equilibrium in nature. He thought, “Hmm, we have a similar situation in economics: prices seem to converge to equilibrium, supply and demand seem to converge to equilibrium.” So Walras hijacked the mathematical equations from the physicists and applied them to economics. The problem is with the word “similar”, i.e. “we have a similar situation …” He mistook a metaphor for science. Prices converge to something that approximates equilibrium, but doesn’t really attain equilibrium. Supply and demand converge to something that approximates equilibrium, but doesn’t really attain equilibrium. The consequence of Walras mistaking metaphor for science is that he placed the whole field of economics on a wrong footing.

— Extracted from The Origin of Wealth by Eric D. Beinhocker

The Most Persistent of all Economic Delusions is the Belief that Machines Create Unemployment

August 14, 2007

“Among the most persistent of all economic delusions is the belief that machines on net balance create unemployment.

The belief that machines cause unemployment leads to preposterous conclusions. Every technological improvement must cause unemployment. The logical conclusion would be that the way to maximize jobs is to make all labor as inefficient and unproductive as possible.

Let us see exactly what happens when technological and labor-saving machinery is introduced.

Example: a clothing manufacturer learns of a machine that will make men’s and women’s overcoats for half as much labor as previously. He installs the machines and drops half his labor force.

This looks at first glance like a clear loss of employment. But the machine itself required labor to make it; so here, as one offset, are jobs that would not otherwise have existed.

It is likely the labor employed to build the machines is less than the labor cut by the manufacturer. So there is still a net loss of employment to be accounted for.

The machine was a large investment, so it takes several years for the machine to pay for itself. After the machine has produced economies sufficient to offset its cost, the clothing manufacturer has more profits than before.

The manufacturer must use these extra profits in at least one of three ways:

  1. He will use the extra profits to expand his operations by buying more machines to make more overcoats; or
  2. He will invest the extra profits in some other industry; or
  3. He will spend the extra profits on buying things for himself, e.g. buy a new house or a new car.

Whichever of these three courses he takes, he will increase employment.

The manufacturer, as a result of improved production has profits that he did not have before. Every dollar of the amount he has saved in direct wages to former overcoat-makers, he now is able to pay out in indirect wages to the makers of the new machines, or workers in another industry, or to the makers of a new house or car. In any case, he gives indirectly as many jobs as he ceased to give directly.

But the matter does not rest at this stage. The manufacturer competes with others. Due to competition the price of overcoats drops. The savings are passed along to the consumers. The consumers now have more money to spend on other things, which results in more employment.

In brief, on net balance machines, technological improvements, automation, economies and efficiency do not throw men out of work.

The central lesson is that we should try to see all the consequences of any economic policy – the immediate effects on special groups, and the long-run effects on all groups.”

Economics in One Lesson by Henry Hazlitt

P.S. It is fascinating to see how interconnected things are, how a change has an effect that ripples outward to things that you cannot anticipate, i.e. unanticipated consequences.

The law of supply and demand isn’t a law!

August 13, 2007

“One of the oldest principles of Traditional Economics is the law of supply and demand.  A basic prediction of this ‘law’ is that the counterbalancing forces of supply and demand will drive a market to an equilibrium price and quantity level.”

“For example, if a car company introduces a new model that suddenly becomes popular, the company will typically raise the price while demand exceeds supply, expand production, and then lower the price once demand has cooled off and supply has caught up.”  (Lesson learned: don’t buy something when it first comes out; wait a few months and you can get it at a lower price)

“If, however, we zoom into a more fine-grained level, we see that real-world markets are almost never at equilibrium, supply rarely equals demand, and markets rarely come into balance.  In fact, virtually all markets are built around the assumption of disequilibrium rather than equilibrium.  Most markets have stocks of inventory and order backlogs.”

“Your local car dealer has a parking lot full of vehicles that are slower selling and an order backlog of ‘hot’ vehicles that customers are waiting for.”

“The law of supply and demand isn’t a law after all (at least not in any scientific sense); rather, it is more appropriately the rough approximation of supply and demand.”

— The Origin of Wealth by Eric D. Beinhocker

Congestion Pricing

August 8, 2007

Definition: Congestion pricing is increasing the price on something during peak usage.

Examples:

  • long-distance calls are more expensive during the day
  • airplane tickets are more expensive during the summer
  • in NYC the tolls on certain bridges and tunnels are increased during rush hour
  • in London people who drive their car into town between 7am and 6:30pm are charged a toll of £5

All of these are examples of price responding to demand: when demand for a resource is high, the price goes up, and when it’s low, the price goes down.

The telephone line, the seat on a plane, the bridge, the tunnel, and the road space are “resources”. They are not unlimited. When demand for a limited resource is high, the persons who are willing to pay the most get the resource.

Individuals weigh the cost of using the resource against its benefit. If the cost is too high, they find alternatives (such as calling during a non-peak time, or taking public transportation).

The goal of congestion pricing is to make the costs obvious to people. The hope is that when people are clearly aware of the costs they will make individual decisions that produce a collectively smart result, i.e. congestion is decreased.

— extracted from The Wisdom of Crowds by James Suroweicki

“Resources” – a Fundamental Idea in Economics and the Web

August 5, 2007

Economists talk about resources.  For example, they talk about the demand for a resource, the abundance or scarcity of a resource, allocating resources, the price or value of a resource.

Examples of resources: mahogany wood,  oil, land.

The founding fathers of the web (e.g. Tim Berners-Lee) chose to also use the word “resource”.  On the web anything that can be identified by a URL is a resource.  For example, Google is a resource, identified by http://www.google.com.  A resource that no longer exists is indicated by the error message, 404: Resource Not Found.

Why did Tim Berners-Lee choose to use the word resource?  Did he see a parallel with resources in an economy?  I think the answer is yes.  Consider this: there is demand for web resources, e.g. there is a high demand for the Google resource, and there is a low demand for many other resources.  Web resources have a price or value, as evidenced by the recent purchases of certain web sites.  I am not sure that the web has a parallel concept of abundance or scarcity of a resource, or allocating resources.  (Can you think of a parallel?)

“Resource” seems to be a fundamental idea.

Economics in Three Words

August 3, 2007

No Free Lunch

— Henry Hazlitt