Archive for the ‘Economy’ 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

Brief Tutorial on Dynamic Systems

October 16, 2007

From The Origin of Wealth by Eric D. Beinhocker:

A dynamic system is one that changes over time.

When scientists talk about a system being dynamic, what they mean is that the state of the system at the current moment is a function of the state of the system at the previous moment, and some change in between the two moments.

A simple example of a dynamic system is a bank account. The state of the account, or balance, changes over time. Your balance tomorrow is dependent on your balance today, plus any changes during the intervening day, such as deposits, withdrawals, or interest payments.

Changes in dynamic systems can either be discrete, like a bank account, in which the changes occur at specific points in time (e.g. interest is paid on a particular day), or they may be continuous and smooth, like the orbiting of planets.

A convenient way to describe a dynamic system is in terms of stocks and flows. A stock is an accumulation of something, such as the balance in a bank account. The rate at which a stock changes over time is known as a flow, for example, the rate of money flowing into or out of a bank account.

In an economy the various stocks and flows are connected to each other in complex ways. For example, if the stock of employment fell to a low level, a policy maker might decide to cut interest rates in order to encourage borrowing, which would expand the stock of money available for investment, which would then be used by businesses to invest in new productive capacity, creating demand for employees, thus raising the stock of employment, which finally would feed back to affect future interest rate policy. Such chains of relationships between stock and flows in a dynamic system are known as feedback loops.

Feedback occurs when the output of one part of a system is the input for another, so, for example, A affects B, which affects C, which comes back to affect A again.

Positive feedback occurs when the connections are reinforcing – if I push A, it pushes B even harder, which pushes C even harder, which pushes A harder than my original push, and so on.

Despite the word positive in the phrase, downward spirals are also a form of positive feedback. For example, a drop in consumer confidence can lead to decreased spending, which leads to decreased production, which leads to unemployment, which leads to even lower consumer confidence and thus a further drop in spending, spiraling right down into recession.
The key thing to remember is that positive feedback reinforces, accelerates, or amplifies whatever is happening, whether is it a virtuous cycle of a downward spiral.

The opposite is negative feedback. Negative feedback is a dampening cycle – instead of reinforcing, it pushes in the opposite direction. While positive feedback accelerates change, negative feedback dampens change, controls things, and brings things back in line.

Dynamic systems also have a third ingredient – time delays. You have probably had the experience of taking a shower in an unfamiliar place such as a hotel, turning on the hot water, noticing it isn’t hot enough, turning it up some more, and then it turns scalding, so you turn it down, it is still too hot, so you turn it down some more, then it is freezing, and so on. The problem is that there is a small time delay between your actions on the water knob and the feedback from the shower temperature. The delay causes you to overshoot and oscillate around the desired temperature. Eventually you figure it out and the oscillations get smaller and smaller until you hit the desired temperature. The longer the time delay, however, the harder it is to control the shower and the more oscillations you get.

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

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.

Complex Structures Created through Voluntary Exchange

July 9, 2007

The economy is the product of the voluntary exchange of goods and services.

A language is the product of the voluntary exchange of ideas and information.

A scientific discipline is the product of the voluntary exchange of ideas and empirical data.

A musical style is the product of the voluntary exchange of notes and sounds and ideas.

The economy, languages, scientific disciplines, musical styles, social conventions and values, and culture are complex structures that all developed in the same way, through voluntary exchange, spontaneous cooperation, trail and error, acceptance and rejection.

These examples suggest the wide scope and fundamental nature of “voluntary exchange”.

— extracted from Free to Choose by Milton Friedman

We take trust for granted in our economy

July 4, 2007

In our modern economy trust is taken for granted.

For example, I can walk into a store anywhere in the U.S. to buy a CD player and be relatively certain that it will work well.

I trust the store.

And I trust the store even though I may never walk into that store again.

This trust is a remarkable achievement of capitalism.

It wasn’t always this way.

EVOLUTION OF TRUST

Prior to the nineteenth century people would only buy and sell to those people they knew, or to those in the same sect or clan. Trade with a stranger was seen as a one-time opportunity to be exploited to the utmost.

As society became larger and more mobile, personal knowledge and reputations became limited, and a sizable proportion of potentially mutually beneficial transactions involved parties with no prior personal ties.

Breaking with the tradition of defining trust in familial or ethnic terms was essential for the growth of the economy. The type of trust essential to the nation’s economic performance is trust between strangers.

How did our current sense of trust come about?

In the nineteenth century trust started to become institutionalized. These two institutions were created which helped foster a sense of trust:
– Underwriters Laboratory
– Better Business Bureau

Fixed prices and customer service also fostered a sense of trust.

And people started to see that honesty might actually be profitable. People began to focus on return business, word-of-mouth recommendations, and ongoing relationships with suppliers and partners. Individual transactions became seen as links in a larger chain of profitable business ventures.

Of course the trust could not exist without the legal framework that underpins all capitalistic societies.

TRUST ON THE WEB

Can the Web take cues from the evolution of trust in our economy?

Consider the parallelism between the development of trust in our economy to the development of trust on the Web:

– In the early days of the Web exchanges were localized, between people you knew and trusted.
– As the Web became more complex and interconnected, breaking with the tradition of defining trust in familial terms was essential.
– The type of trust essential to the Web’s long-term survival is trust between strangers.

How can trust be institutionalized into the Web?

Reputation systems are the Web equivalent of the Better Business Bureau

How else?
Portions of the above is from The Wisdom of Crowds by James Suroweicki