Pulp Economics:
A Brief Story of Money, Part 2
In this article, the so-called "equation of exchange" is introduced and used to explain inflation in an example. As with the first installment, bloggers are pressed into service as the actors in this drama. Their performances are herewith noted: BlondeSense Liz of BlondeSense and Misty of expostulation are thanked for their performances as castaways on a deserted island, and Peter of Lone Tree, also of BlondeSense, is graciously thanked for a cameo appearance.
Among the definitions of inflation are some that don't explain a whole lot. One such nice but somewhat uninformative definition is this: Inflation is a rise in the aggregate price level. Well, yes, but that doesn't really do much to explain why the "aggregate price level" rises.
Perhaps a better, working definition of inflation might go something like this: Inflation is the erosion of purchasing power per unit of the currency. Not much better, huh? Read on and see how this one fits into the story told below, a story about two women trapped on a deserted island where they must engage in trade with one another, exchanging clams for pineapples.
Several years ago, an ugly storm came out of nowhere during a cruise—a three-hour cruise—on which were two hearty women, BlondeSense Liz and Misty. The storm capsized their boat; and of the five passengers who had set sail that day with the crew of two, only Misty and Liz had survived, each of them floating away from the doomed ship on the drowned remains of one of their more corpulent fellow shipmates.
After several days at sea, they beached on a tiny, deserted island paradise in the South Pacific. Shortly after they came ashore, there was something of an ugly scene about whether to eat their corpse/life rafts uncooked or to do so after roasting them on a spit for several hours, and the two stranded castaways finally decided that it would be best if each went her own way and followed her own culinary preferences.
They did stay in touch. Although they didn't speak to each other, they did send smoke signals on special occasions like birthdays and Halloween. They also traded.
Liz lived on the south side of the island, where pineapples and man-eating plants grew. Fortunately for Liz, the man-eating plants didn't eat women, but she stayed clear of them anyway, putting her daily efforts into cultivating the pineapple trees. She could eat or trade them with Misty, whose side of the island had no pineapples at all but did have the occasional really big clam wander onto the beach to get a tan or answer nature's call, at which time Misty would nail the sucker either to eat or to trade for a pineapple from Liz.
After much wrangling on the matter—negotiations made particularly tricky because of the lack of oral communication—Liz and Misty had worked out an exchange rate of one clam for one pineapple, and this equivalence relationship had remained stable for all of the three long years the two of them had been stranded on that beautiful if somewhat harsh little plot of land in the Pacific.
One day, Misty had a brilliant idea. She noticed that there were a whole lot of empty clam shells on the beach, so she decide to take a real clam she had just beaten senseless, open it up, split the meat in two, and put half of the clam meat into one of the empty shells.
She went as usual to make her trade with Liz; but instead of the usual deal, Misty handed her two clams, each of course containing only half the meat of an original, single clam. Liz suspected nothing and wouldn't have been able to verify the clam's worth, anyway, since she had no immediate access to a clam shell prying tool. Liz did look a little surprised at the escalation of the economic activity Misty was proposing but acknowledged that Misty would get two pineapples that day. Obviously, Liz had to work harder thereafter because of what appeared to her as real, extra currency flowing her way. In economics terms, Liz's real output increased, and it did so because the clam-based money supply increased.
Over time, however, once Liz had eaten some of these clams, she realized that it was taking twice as many to fill her up. Without a full stomach, Liz just didn't have the energy she needed to keep up the pace of her work on the pineapple groves.
Exhausted one day, Liz met Misty for their daily trade. As had become usual, Misty produced her two clams, and Liz handed her one pineapple. Liz had worn herself out producing twice as much for what was really the meat of only one real clam. She never did quite come to know that there was only half as much meat in each clam she was getting, but that didn't matter at all: it was purely a matter of capacity to produce under the circumstances of the standing terms of trade.
In terms of economics, this story is about the equation of exchange. Specifically, it is about three different equilibrium states of that equation as it went from its initial configuration to a short-term re-alignment and then to a long-term stability.
The equation of exchange looks like this:
Money Supply × Velocity of Money = Aggregate Price Level × Aggregate Output Level,
or
Now, you're probably saying, "Ah, yes, that's exactly what I was thinking when I read that tragic story about Liz and Misty." Of course, what you're probably thinking is something like, "Dude! That's some g-o-o-o-d stuff you're smokin' if you think that equation has anything to do with anything."
Okay, fine. Let's step through the equation piece by piece. On the left side, M is the supply of money: the amount of it in circulation.
V is the velocity of each unit of the currency: how many times each unit is used in a given period. We usually assume the velocity of money doesn't change during the periods we analyze, which means the number of times a unit of the currency is used doesn't increase or decrease during our scenarios.
So the left side of the equation is M×V: the amount of money in circulation multiplied by the number of times each unit of it gets used per period. M×V is just the total expenditures of an economy in a given period of time. For example, if there are ten one dollar bills in circulation, and on average each of them gets used twice in a year, then the total expenditures in the economy would be $10 × 2 times per year = $20 per year in total expenditures.
The right side of the equation is just the total nominal value of the goods and services of an economy. The word "nominal" means price-denominated, as opposed to "real," which means the actual counting of the units of the goods, themselves, without putting prices on them.
On that right side, P is the aggregate price level, or just the price of the average good (in a simplified way). Q is the aggregate real output of the economy (and notice that the Q by itself is "real" since it's a count of actual, physical things instead of a dollar value of them). As an example for the right side, let's say the economy produces a single good, which has an initial price level of $5 per unit, and the economy creates four of those per year. That means the total nominal (price-denominated) output of the economy is $5 per unit × 4 units per year, or $20 per year.
The equation of exchange simply states that the total expenditures, M×V, must be the same as the total nominal product, P×Q, of the economy in a given period of time.
In the situation on the island, the clams had originally been circulating at the rate of one per period, which would mean that the velocity of clams was exactly one, so we have V=1.
The money supply was one clam in each period of trading, so we have M=1.
On the other side when our story began, the real output of pineapples was one per period, so Q=1.
The agreed-upon equilibrium price for a pineapple was one clam, so P=1.
Hence, the equation of exchange captures this situation by stating that
or
or without the units to obscure the numbers,
Okay, duh.
But look what happened when the clams got watered down. For a while, something very cool was going on. The velocity of each clam stayed the same: each one of the clams was still being traded only once per period, so V stayed at a value of one. However, there were now two of the clams in circulation in each trading period, so the left side of the equation, M×V, which describes expenditures, became
so the M×V side became
Now for the right side of the equation. The price per pineapple was still one clam, but Liz selling the pineapples had to come up with two of them to meet Misty's clam-driven demand. The price stayed firm, but real output rose. In other words, P×Q became
hence P×Q became
Thus, we have a new equilibrium of the equation of exchange:
is now
Notice that the equation of exchange is not in some sense "forcing" the situation; instead, it's merely explaining how the parts of an economy fit together.
What we've just seen was the short-run effect of an increase in the supply of clams that was not matched by any actual change in the fundamental dynamics of production of pineapples. Liz on the pineapple side of the island really didn't have any greater "capacity" to create pineapples, and she didn't have some new technology or anything like that. All she was doing was responding to what she saw as an increase in money she could make for bringing pineapples to market.
Now comes the long run. Liz was harvesting pineapples at a rate higher than she normally could, given the rate at which pineapples grew to harvestable size and given her own ability to gather pineapples in any period of time. Ultimately, the fact that she wasn't getting any more real meat in those two clams than she originally had in the one clam simply forced her to return to a real output of one pineapple. She simply could not produce two, actual pineapples per day, not in the long-run, anyway. But the only way she could then accommodate two clams being handed to her is if she were to revert to what it actually takes in terms of clam meat to deliver a pineapple. Those two clams have the meat of one of the original clams, and that was how much meat it really took for Liz to be able to harvest a single pineapple. Hence, she's going to have to charge Misty two of her watered-down clams for each actual, honest-to-goodness pineapple.
So here's what happened in the long run to the equation of exchange. The left side, M×V had already moved to its new configuration: that happened in the short run when the clam supply went up to two (while the velocity stayed at one). Thus, the left side of the equation hangs at
which means the left side of the equation will be 2×1, or 2.
The right side of the equation for the long-run scenario has changed. The price for each pineapple has risen to two clams, and the real output of pineapples has reverted back to one per period. Hence, the right side of the equation of exchange, P×Q, is in the long run going to be
which means the right side of the equation is now 2×1, or 2.
The long-run equilibrium configuration of the equation of exchange is this:
works out its equilibrium (the equation is in balance) as
Well, look at that. It really is still in equilibrium: the left side equals the right side, just as it did at the very beginning and just as it did in the short run. Not only that, look closely at the three states of equilibrium:
Ah. An increase in the money supply in the short run causes an increase in real output; but in the long run, the only effect is that real output reverts to what it was originally while the price of the output goes up.
In short-hand notation, it might look like this:
Notice something about that island economy. If Liz had actually been able to really produce more pineapples, she couldn't have sold them to the Misty unless Misty had more real (undiluted) clams. As an example, there was an brief incident where the hapless Peter of Lone Tree came ashore on the island, and Liz forced him to serve as her slave labor. With his help, Liz was able to produce two pineapples per period, but she couldn't sell both of them to Misty because she didn't have two real, undiluted clams. In other words, real growth rate of an economy requires a matching growth rate of the money supply. Frustrated by the lack of real money to reflect the real growth in output, Liz was planning to cast Peter back out to sea, where he would eventually be picked up by the floating Republican fund-raising cruise liner Washington HO! and made to serve as bartender under the tutelage of the earstwhile Tom Delay. As fate would have it, though, Peter was eaten by one of those man-eating plants that lived on Liz's side of the island.
Anyway, the point of that last paragraph was that it's not that a central bank should never increase the money supply; in fact, it must, but it should do so only at the rate at which the real output of the economy needs that extra money.
That makes the job of a central bank really hard. Think about it: if the central bank prints money too fast, real output would go up in the short run. That would give the central bank the impression that this real growth required even more money to be printed. But the first round of extra money would eventually be causing inflation and real output would be tending to revert back to its original level. But the central bank would have been printing even more money because it saw the real output of the economy growing from its first excess punch of money, and this would lead to a scenario something like a horse watching its wagon go by in front of it and thinking that it had to run faster to catch up with its cart, not realizing that it was actually pushing the cart to go faster and faster. That could be the beginning of a run-away horse and buggy as well as run-away inflation. The central bank erroneously thinks the economy is really growing well, but it's the central bank that's causing it to happen, and the way it's happening won't last.
And that's why a central bank should never, ever contemplate being in the business of helping (or hurting) an economy: short-run versus long-run effects of accommodative or punitive monetary policy simply cannot be foreseen with the clarity to distinguish between fundamental economic growth and mere reaction to the money supply manipulation.
In conclusion, returning to the story of the women on the island, the lesson should be clear and obvious. In summary, it is stated as such:
TRVTH
Inflation has one cause: too many clams chasing too few pineapples.
The Dark Wraith has thus delivered the tropical goods.
Part 1
of this series.
Published 2/26/2006 06:25:00 PM
<< 46 Comments Total
Who is this Misty biatch? Is she trying to starve me to death? :)
And I could probably come up with further uses for slave boy... unfortunately we couldn't do anything to populate the island but it would be fun anyway...
Dark One, well that was one hell of an interesting course on the equation of exchange. perhaps if more students had an eco teacher like you, they wouldn't be sleeping in class and they would be better able to understand the real life economy rather than the theoretical one that bores us to sleep in the classroom.
Good job!
But you forgot to describe how I fashioned swimwear out of natural materials found on the island (when I wasn't praying over pineapple plants to produce) and started the world's most successful publicly traded resortwear company after I was rescued because I learned so much about economics while I was shipwrecked.
OT, but it fits here nearly as well as anywhere else, and this way it's certain not to be overlooked.
Info. to be shared with senator and president wanna-be Joseph Biden (D-MBNA).
- oddjob
I like pineapples. I also like clams. I'm not sure where that put me on the whole economic food chain - but I can be really creative when it comes to cooking and odd-type ingredients. And what that has to do with the price of tea in China I'll never know.
Congrats on your new Koufax nomination. Perhaps life is indeed that bowl of cherries everyone always refers to! (And how the hell I’ll fit that in with the pineapples and clams is an issue requiring some additional thought).
I think I should have read this before I took the quiz...
Odd Job....
Biden can't be D-MBNA, they are Bank of America now...
Gee, thanks, Dark Wraith! Make me into the evil one! For that I should tie you to a chair and force you to listen to "My Humps" by the Black Eyed Peas for hours on end.
BTW:
Although they didn't speak to each other, they did send smoke signals on special occasions like birthdays and Halloween.
I have yet to see a smoke signal, as today is my birthday. :-)
Misty, I am blowing you smoke signals for your birthday despite your gypping me on the clams because I never hold a grudge. :)
Biden can't be D-MBNA, they are Bank of America now...
Duly noted with appropriate ironic snickering....
- oddjob
Thanks Liz.
And I'm sorry that in DW's fantasy world of us on a deserted isle, no doubt complete with some Baywatch-esque running, that I tried to starve you to death with my evil genius.
;-)
That was fun to read! I'll have to re-read, though, to make sure I understand:)
I think Misty must have been a bartender before being shipwrecked. That's where she learned how to water down the clams.
lol
old white lady,
hahahahhhaahahahahha
good one!
Good evening, Fat Lady Sings.
Thank you for the congratulations on the latest Koufax Awards nomination. (This one is for best commenter.) I'm so excited: now that The Dark Wraith Forums has been nominated in five categories, that means there will be five ways for my work to get roundly beaten into the dust in the competition.
I shouldn't be so pessimistic, but it's better to expect the worst and be pleasantly surprised that to expect good things to happen and get thoroughly disappointed.
And congratulations back at you for your own nominations. You've gotten yourself pretty darned well recognized by quite a few folks in the Blogosphere.
Now, I do like clams and pineapples, but the pineapples just don't agree with me all that well. It's the acidity thing, although I still from time to time make a killer of a pineapple upside-down cake.
As far as clams go, I do like New England clam chowder, but the canned stuff is terribly disappointing. Thin and salty like brine. Clam chowder should be thick enough to require a butter knife. That's how I like to make it, anyway.
The Dark Wraith admits that his tastes run to the slightly not-so-ordinary.
Good evening, BlondeSense Liz.
That whole idea of the all-natural swimwear products sounds mighty risky to me. The last thing I want is a pair of swimming trunks made with some plant that has barbs in it.
Besides, I have no use for some leafy Speedo thong thing that's nothing but bait for aphids. I can just see me trotting along the beach and suddenly having to stop and whirl around like some dog doing bitey-bitey-bitey to my hind flank.
And I'm not even going to think about some beach comber pants made out of bark that will attract forest rodents to make into their home while I'm still in the pants.
Gawd! but that thought makes me want to paw the ground in angst.
The Dark Wraith is getting himself riled up over the outrageous trends in desert island wear these days.
Good evening, Misty.
I can't even imagine a Baywatch thing working out.
I've tried running along a beach in slow motion. It's not as easy as it looks. For one thing, you have to concentrate really hard on keeping your hair perfectly coiffed as you float gracefully at 120 frames per second. For another thing, you have to pretend you don't even notice it when you stub your toe on hard pieces of litter the camera crew left on the beach from the wild party the night before.
And I don't even want to get into the whole thing about what happens if you're doing the slo-mo running scene and suddenly one of the film crew yells, "Tsunami!!!"
I mean, what're you supposed to do? Suddenly go to normal motion and start fussing about how you want to cancel the series because of the director didn't give you a good answer when you asked, "What's my motivation in this scene?"
And then you have to deal with the on-going competition with the other guys in the scene. Every one of them has gut-cuts galore, and it's all a game of who has the most, how deep are they, and can you make you're man-honkers go up and down while not moving your eyebrows.
It's rough in Hollywood. It's even rougher on location in the South Pacific.
The Dark Wraith considers shooting the next Pulp Economics episode in Greenland.
Thanks, sweetie - nice of you to mention me too. Did you see where Oddjob got a nod as well? How cool is that? I gotta tell you - getting even one of these nominations has been absolutely the bee's knees for me - no shit. As everyone here knows, there are no accolades for writing - not really. Oh, someone like you will get feedback from your students after a well-presented lecture - and in my former profession, any abilities I may have had were registered by audience applause. But writing – that’s why blogging is so wonderful – at least to me. One of its most salient aspects is instant feedback; so when someone takes the time to comment on one of my articles – I’m thrilled. Really. Writing is such a solitary art.
So getting those Koufax nominations has been especially sweet for me. And satisfying enough. This is one of those cases where the acknowledgement alone is tantamount to winning. I’ve been having a ball looking over all the sites mentioned in every category. So much diversity, so much talent – what a wonderful idea M.B et al had in instituting these awards in the first place. To foster community, she said. Well – I think it’s done that – at least for me. Did you know M. B.’s thinking this year may have to be the last? Funding problems. More of us means more work for them. I hope that all gets worked out. It would be a shame to see something so wonderful get eaten up by its own success.
So here’s to all of us – and to those of our friends not mentioned this year whose fine work deserves recognition as well. Cheers to us all!
Good evening, once again, Fat Lady Sings.
Seeing that whole process by which the Koufax Awards are being done just makes my teeth hurt. They're doing that whole thing manually, for cryin' out loud.
That nomination process is just screaming for simple forms whose entries are automatically submitted to an SQL database. Three hours of coding, debugging, and implementation: max.
Voting could be done with IP verification just like I do with my little Polling Center cgi routine. Two hours for all of the categories, max.
Once deployed, every year would be maybe thirty minutes of updating.
Cost of the whole thing: just the cost of a Web host providing SQL databases and a generous bandwidth. Maybe twenty dollars a month at tops.
Am I going to suggest this to them? Heck, no. I've seen their responses to commenters making innocent little suggestions. In one instance, the ugliness and inappropriateness was downright appalling. I learned a long time ago that, even when you know of a way that's light-years better than what someone's doing, leave that person alone. And that applies even sometimes when help is requested.
Some time back, an executive I know at a rather largish company was talking to me about finding a more efficient way to deal with the huge number of digital photographs the company has of properties it owns. There were also schematics of the properties, and those I surmised were in some digital format (which I assumed was from a nice CAD program or from a graphics drawing application). I thought immediately of implementing a database (Access was available on their network) that could be used as a starting point for managing the photographs and schematics and allowing them to be integrated down the road into the larger scheme of their disparate compilations of data on their property holdings (appraisals, aquisition information, personnel on locations, etc.) to create a fully user-friendly, one-stop way to get to everything property-related. Just creating a relational database to allow searches, print-outs, and calls of the pictures from Word would be a great starting point for getting a handle on the mess.
After about an hour of chat about other matters, we got back around to those photographs and schematics. It turned out that the company's personnel had been doing the schematics as line drawings in Excel using the Draw toolbar feature! Not only that, the photographs had been "mounted" in Excel spreadsheets as if the digital images couldn't stand on their own as files!
This person just wanted to know if there was a way to make one giant Excel spreadsheet (or something like that, I guess) that included all of the photographs and all of the schematic drawings.
I made the comment, "Excel is primarily a calculations application with some database capabilities. It's not designed to be a graphics management or graphics creation tool."
"Yeah, but that's how we use it. Sometimes, you've gotta be creative," he answered.
Yes, indeed. Unfortunately, I am not creative enough to implement a language that would have been able to communicate to him. It wasn't what he didn't know. It would have been like describing solid objects to a being from a 2-dimensional world. The frame of reference was absent. It just wasn't there, and it couldn't be put there. And it wouldn't be worth even trying.
He was right, though. Sometimes you've gotta be creative. The company has since upgraded its servers massively. Now, the hard drives can hold lots more Excel spreadsheets than they used to.
The Dark Wraith wonders why he didn't think of that.
Good Morning Dark Wraith,
Now, the hard drives can hold lots more Excel spreadsheets than they used to.
*snicker* *snicker* *snicker*
It would have been like describing solid objects to a being from a 2-dimensional world.
Have you ever read Flatland?
- oddjob
S&P Hits 4 1/2 Year High
Good evening, Luther.
The S&P 500 did, indeed, touch a 4½ year high on Monday, but profit takers swooped in today to strip that gain right back out. Here are the numbers at the close today, Tuesday, February 28, 2006:
Dow 10,993.41 ↓ -104.14
NAS 2,281.39 ↓ -25.79
S&P 1,280.66 ↓ -13.46
More importantly (and I'll soon be doing one of my updates on index portfolio performance over the tenure of the Bush Administration), for a relatively broad-based index of the common stock of 500 very large corporations to make it back to the level at which it was almost five years ago is a stunning indictment of the economy's performance under the policies of the Bush Administration.
And those numbers are nominal: there's no inflation adjustment in day-to-day reporting of stock prices, which means that in real (i.e., inflation-adjusted) terms, this Administration has been an unmitigated catastrophe for prudent, long-term, buy-and-hold investment.
This, of course, despite the ever-curious way the government keeps reporting good news upon good news about this economic indicator or that economic indicator.
Stock indices don't lie.
And what they're saying to a financial economist is quite straight-forward: the Bush Administration is an economic wrecking crew on the long-term health of the American economy and the economic agents within it.
Yet somehow, big business just keeps shoveling the money at the very Republican Wrecking Crew who keep this handbasket dead-on toward Hell.
The Dark Wraith wishes he could figure out how to be such a loser and still get hundreds of millions in campaign contributions.
Good evening,all. Congrats on the nominations. Definitely a quality corner of the web.
Mr. Wraith, are you insinuating that the beach comber pants would be a "WOOD" product?
Cute, T. Rogers
Real cute.
The Dark Wraith barks at the suggestion.
[And to think I come from the state that features The Ohio State University, which means I'm from the state of the Great Coach.]
Having not the foggiest notion of what Woody Hayes has to do with beachwear(maybe benchwear?) I shall instead thank you wholeheartedly for these great econ lessons. I look forward to more classes. I have just recently been determined to be 100% disabled by Soc. Sec. This is GREAT news, as I also will collect pension benefits(no small feat in today's business climate). I'm 47 and have the use of all four limbs,(Wrists are shot,though) so I have the time to go back to school at a relatively leisurely pace. My point is that I fervently hope I pick up as much from my other classes as I do here!
My point is that I fervently hope I pick up as much from my other classes as I do here!
That will be a direct function of your instructors. Whenever possible try to schedule with ones known to be excellent for there are some painfully bad professors out there!
I've had both; Dark Wraith is among the best I've experienced.
- oddjob
Just read the story about George and the genie on the upper right of the homepage.....
LOL!
- oddjob
Good morning, OddJob.
I was wondering if anyone was going to like that new story joke of mine.
The Dark Wraith wrote that one in a flash of inspiration.
Completely OT:
Apparently under the correct circumstances a cat can be infected by avian flu.
- oddjob
Great; now I'll have to wear a respirator to cleanup the occasional hairball that the cat leaves for decoration.
BTW, that spreadsheet experience of the Wraith's is a classic - absolutely hilarious.
Well I hate to comment on the wraithy formulae, but being out of the loop here socially it puts me in an awkward position. I suppose I could say Happy Birthday to Misty. And share that I like pineapples but don't do Seafood. And I can thank Fat Lady Sings for participating in our Corruptco Blogfest this week, where we already have dozens of posts from twenty five plus bloggers on the theme of corporate crime. FLS rocks! Love you!
Here's what troubles me about the values, Dark Wraith. You define the difference between nominal and real price as nominal= meaning price dominated and real= being 'an actual counting of the goods themselves'.
Please share why real price is not a price reflective of inputs and the cycle cost? You might ask why I give a shit but from an environmental perspective, it is important to consider real price as a value that considers input and disposal or impact. Cycle cost.If the real price of a widget is $1.00 per unit of ten in nominal terms, might it be $1.30 per unit of ten when you consider input, opportunity cost, and cycle cost? Part of our failure from a policy standpoint is to disengage production cost from disposal as though the production footprint is irrelevant. A company makes a vibrator, it must factor in what it costs to make that vibrator in terms of labor, materials, traditional inputs. But then there is a value to what the vibrator used that could not be used in say, a wiffle ball bat. Relevant when inputs are scarce. Then there is a cost that the producer does not eat but that somebody must eat of the disposal of that same vibrator. That could be very minimal, but in matters of construction or a car it is not minimal to consider disposal in the cycle of cost. I personally think this cost should be added to the point where price meets demand. If impact cost could be factored in, we might be dissuaded from using non biodegradable inputs in the first place in favor of what has a cheaper cost to the planet. Instead of always a focus on cheaper goods by cheaping out on labor, maybe companies should be forced to pay when they use landfill busters, toxins, etc. What value then considers REAL real cost? Adjusted real versus simple real?
OT, but there's no better place to put it:
This Modern World (Hat tip, Kos.)
- oddjob
I also would be interested in what DW has to say regarding pricing models (or accounting models) that could/ought(?) to be adopted so that environmental degradation of the planet might be more accurately reflected in our economic activity.
It's often seemed to me that prices do a great job of reflecting immediate benefits and costs, but that the longer term the costs are the less accurately we account for them, with long-term environmental degradation being the most poorly reflected aspect of price there is.
(Or do I simply not have a clue at all?)
- oddjob
Good evening, Lily.
I should write an actual post about issues you address, but suffer me a summary at this time.
The use of the term "real" applies to goods and services. "Real" to an economist means a physical (or perhaps not-so-physical) "thing," as opposed to a valuation of that thing.
Take an example. Mr. Goat walks into a diner and sees two sandwiches on a plate. He asks the waitresses, "What's that?"
One waitress, Marge, answers, "Why, that's two cheeseburgers, Mr. Goat."
Another waitress, Fanny, chimes in, "That's our two-fer plate for $5.00; each one separately costs $2.50, Mr. Goat."
Now, Mr. Goat has just been given two different economic perspectives. Marge took his question as one about the objects, themselves. Her answer was to an economist an assessment of the "real," which I designated in those equations as Q.
Fanny on the other hand took the real object, and there were two of them, and assessed a "nominal" value to the two-fer plate: she took the real objects and multiplied the number by the price of each: $2.00 per burger × 2 burgers = $5.00. Fanny quoted P×Q, the nominal value of the objects in question.
Notice in this example that Fanny's way of answering Mr. Goat's question contains all kinds of factors associated with both production processes and capacity (the Q factor) in addition to all of the forces that can affect a price.
There is no "real price": any price is entirely dependent upon everything from what currency is being considered to the amount of it being added to the economy in any given period to changes in the velocity of it to prices of complements and substitutes in consumption.
Moving to another aspect of economic analysis, any real output, Q, even of a single "product," is a multi-dimensional thing. Every object that is produced and consumed has many features, although trying to separate them out for analysis treads into dangerous waters about which I've written before. The perils of teasing out the dimensions does not mean, however, that we should ignore them: the real question is one of whether or not the market ignores them. If it does, does this represent an imperfection in the market system and a failure of traditional economic and business finance?
The answer to the first question is, "Yes"; and the answer to the second question follows up on this with a resounding, "No": economists are fully aware of product dimensions that markets ignore. We call them "externalities," and they are a significant reason for government intervention in markets.
An "externality" is a cost or benefit incurred by parties not involved in a transaction. A "negative externality" is a cost incurred by third parties; a "positive externality" is a benefit enjoyed by third parties. The problem with externalities is that the parties to a transaction do not have any incentive to construct their demand for and supply of the full product taking into account these dimensions that only (or primarily) the third parties will experience.
As an example, suppose that OddJob and Lizzy both own houses in a really nice suburb of Boston. Their houses are separated from one another by an empty lot. One day, OddJob and Lizzy come out of their houses, and much to their mutual horror they see that a guy named Dark Wraith has bought that vacant lot and plopped his double-wide house trailer onto it. Not only that, he brought an extra, giant U-Haul loaded with all of the stuff he had in his previous yard on the outskirts of Memphis: there's his junked car collection (five of them, all on cinder blocks), a row fence on which he has mounted his beer can collection, and—good God!—four dogs, only one of which runs on all four legs (and that one has more mange than the rest).
Both of OddJob and Lizzy know right away that the values of their respective houses have just plummeted. Not only that, the value of the Dark Wraith's trailer, being as it is between two really nice houses, has skyrocketed compared to what it was worth in that trailer park outside of Memphis.
There we are: the Dark Wraith and the real estate agent transacted on a "product": the flow of amenities from that vacant lot; but neither the Dark Wraith nor the real estate agent had any incentive to contemplate adverse effects upon homeowners on adjacent properties. Hence, there was no incentive to shape their respective demand and supply conditions—in fact, there was really no way they could—to the effects upon OddJob's and Lizzy's economic conditions.
Okay, where am I going with this? That's the easy part. Economists know all about products that cause adverse (or beneficial) effects on third parties, be those third parties contemporaries right in the line of transactional effects fire or people of generations to come. Libertarian and other extremist economists simply wave their hand at the whole issue of externalities and claim that "free" markets can find solutions in some way. That's utter nonsense, and this whole issue intersects another, seemingly unrelated topic having to do with fiduciary duty.
(And as I'm writing this, I am absolutely convinced that I need to write a long-winded post putting all of this together comprehensively.)
It's not that we are missing the pricing of adverse dimensions of products. The problem is that there is no incentive of rational market participants to recognize those dimensions, so there is no way for a pricing mechanism to form.
The imperfect solution is for the government to intervene and assess taxes, production limits and/or standards and other direct and indirect costs on suppliers and demanders to shift their respective curves to a position that reflects marginal social costs as well as marginal private costs. This solution is, as I just noted, "imperfect" because the very mechanism that would best assess an "accurate" price would be a market with full and complete information; but that's the very thing that doesn't exist in this situation. That leaves the governmental authorities to paw in the dark for what would be a reasonable assessment: place too low a price on the unseen dimensions of a product, and the negative externality just keeps causing problems. On the other hand, place too high a price on those unseen dimensions, and a market that on balance has great benefit to a society can be wrecked.
In the example of the house trailer, OddJob and Lizzy are certainly going to put their foot down for proper zoning ordinances in their neighborhood: that will impose a cost on the Dark Wraith as he has to upgrade his home so that it isn't drawing value from others' houses. However, if those zoning ordinances are ridiculous, they will impose a cost so high that no one from the outskirts of Memphis—or any other poorer place, for that matter—will ever be able to move into and stay in that neighborhood.
As another example, the lead that used to be in gasoline created all kinds of deleterious effects on the health of people, especially children. The cost of those health-related problems was not included in the price of gasoline. Eventually, the government mandated that the lead be removed from gas, which added slightly to the cost per gallon as new technologies had to be brought online to produce the unleaded fuel. Less noticed and noted was the effect on poor people who could not afford late model cars with engines that could use unleaded. For those people, either a lead additive had to be bought every time gas was put in the tank, or the people had to give up their old cars and bear a difficult cost of something newer.
In other words, correcting a negative externality was a matter of placing a price on it for users of gasoline, but the cost of that solution was differentially borne by the very people whose children were probably more at risk from the negative externality to begin with.
The point of all my rambling here, Lily, is that prices can be assessed, with all their volatilities and complications included. The prices aren't the issue when talking about adverse effects; it's the matter of getting markets (both the consumers and the producers) to recognize the existence of the dimensions of concern so that some price can form, whether it be a government-imposed assessment of marginal costs or some quasi-free market assessment of such.
One thing is for certain: the idea that such dimensions are properly ignored because free markets would otherwise find a way to price them is sheer nonsense. It's much harder to dig in and understand those unseen, unrecognized issues than it is to simply pretend that free markets solve every problem posed by the incredible complexity of societies in their productive and consumptive modes.
The Dark Wraith is now officially worn out from writing this comment, so he'll stop, now.
Thank you for the explanation. It's wonderful!
And as to this:
However, if those zoning ordinances are ridiculous, they will impose a cost so high that no one from the outskirts of Memphis—or any other poorer place, for that matter—will ever be able to move into and stay in that neighborhood.
That's a central issue in the matter of the astronomically high price of housing in the Boston metro area. The most appealing suburbs are so in no small part because of their open spaces.
Guess what those suburbs zone to protect?
Massachusetts is weird that way compared to most other states I'm aware of, where rampant development just destroys the land in area after area (near the states' cities), but the municipalities that would like to put the brakes on it all have enormous difficulty doing so because the state's legislators from rural areas are afraid that if they allow municipalities to zone sanely it would make the developers leave the state, and the rural constituents would lose out.
Perhaps the Massachusetts reversal of that other scheme is the outcome of leaving the state capital in the state's largest and most prosperous city?
- oddjob
Good Morning Dark Wraith,
This is why it's so terrible that Bushco has allowed Big Business to stop contributing to the EPA Superfund, which is now bankrupt. The Superfund sites have been plastic-ed over (including LOVE CANAL) and are no longer being cleaned up.
O.O!
So the only way that a minimum wage increase can "cause" inflation is if the central bank takes it upon itself to attempt to control the economy by jiggering the money supply in order to "ease" the horrible, terrible impact of wage increases.
The Dark Wraith has thus delivered the tropical goods.
*the Badger wanders off to munch on the tropical goods and consider stuffs*
Good morning, Stealth Badger.
You get a cookie and an "A+" for the day. That question on the quiz was precisely to this matter: no increase in a price (be it a final product price or a factor price) can create inflation unless the price shock is monetized. Otherwise, a price increase at one point in the economy merely moves purchases away from other goods and services to the extent that the payers can't substitute away from the good or service whose price rose. One way or the other, though, if there is a fixed amount of money in the system, inflation cannot result.
If the minimum wage increases, businesses can substitute away from minimum wage labor. To the extent that they cannot, they must simply have fewer resources for other factors of production (including their own economic profit). If they can "pass along" some of that wage increase in the form of a higher price for their product, then consumers will pay the higher price and have fewer resources for other purchases, or consumers will simply substitute away from the product. Again, one way or the other, the only means by which the price shock could spread to the aggregate price level is if the central bank were to pump more currency into the system, thereby allowing people and business to maintain their levels of expenditures on all other products while not reducing purchases of the product that had been the subject of the price shock.
That's the story of inflation.
Now, go explain this to everyone who doesn't read this blog.
The Dark Wraith will do his part in this regard, as well.
Good morning, SB Gypsy.
Yes. Superfunds were a government-imposed correction for a negative externality. Payments into the Superfund served the purpose of imposing upon polluting corporations an additional cost that reflected a cost they otherwise would not have borne themselves, but instead would have forced the economy and its people as a whole to bear. Whether or not the additional cost imposed on corporations by their Superfund obligations was in some sense "fair" is another matter entirely: the point is that the government had an obligation to cause the companies to face a cost they had been foisting off not merely on the people of today, but also on the people and the economy for generations to come.
I have no tolerance whatsoever for those who wet themselves about the confiscatory nature of government intervention in this regard: those toxic waste producers were confiscating real value—and as such, real property—from people who could not participate in the price formation mechanism for what those companies produced.
In civil law, that confiscation would be called "conversion"; in criminal law, it would be called "theft." And it has been done on a grand, almost incalculable scale for centuries. I shed not a tear for companies that are finally made to pay a small fee for their theft of property from others, both those of the here and now as well as those of the future.
The Dark Wraith loves to throw good, traditional economics into the face of Right-winger economics cry-babies.
Thank you sincerely DW, because you did answer my question very thoroughly and unfortunately generated ten more questions but I will mercifully spare you to remain in your good graces! I am capable of some intellectual self regulation, after all. Its just very hard for me to understand, dammit if I don't try. But it doesn't come easily.
The issue of free market and external cost is really what I struggle with alot lately. The idea of remedy's vehicle. In whose hands do we put our hopes for change?
OK. I will let a week elapse before I bug you again, hows that? :)
I do find that you are able to speak to the heart of what I am asking, what it is that I aim to know, and for that I am appreciative.
Yes. Superfunds were a government-imposed correction for a negative externality.
Actually, I think you give the Superfund process too much credit in this regards. In an ideal situation a site may be cleaned up and returned to its pre-existing beneficial use. This could be called a correction since it removes the externality, however it is incomplete for the most part. Superfund does little to correct for the lost/theft of the resource during the period between when the lost occurred and when it was corrected. Most Superfund sites are many tens of years old, and account for many, many years of lost or impaired resources. In many instances, the people never get compensated for this lost, for example, to the waters of the state.
At least with the NRDA process there is a better attempt at restoration based on the degree of injury.
those toxic waste producers were confiscating real value—and as such, real property—from people who could not participate in the price formation mechanism for what those companies produced.
That real property included people's lives. My grandparents lived not too far away from Love Canal, and we speculate (will never know) that their deaths at 67 & 66 from cancer most likely were a result of the locale in which they had lived.
Confiscatory my ass!
- oddjob
Actually, I think you give the Superfund process too much credit in this regards.
Don't think so... he never said it was retroactive, only that it was a small correction in comparision to the wholescale-getting-away-with-it that had been the norm ever since human activity started producing real toxic changes in the environment (or any way in which land could be made useless through simply not caring about the consequences of your actions).
Yes, there's a usually-unrectified chain of past losses - but if the mess is cleaned up, then at least there aren't more.
*munches on the A+ with a side of cookie*
*toddles off happily to the Land of More Advil*
Well Stealthbadger, if Mr. Wraith had said partial correction I would have walked away, probably without comment. But he did not, and he rarely minces words.
The Superfund process, or more correctly the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA), does little to correct for these situations we discuss. How do I know this? It happens to be directly related to my profession for the last 20 years. I've personally worked on several Superfunds sites, as well as many, many sites that just as contaminated but are under the overview of a state agency or other federal program.
Taxes, or maybe the small fee described by Mr. Wraith, were collected on certain industries to create funds for cleanup of sites on the National Priorities List (NPL); these sites are commonly known as Superfund sites. These funds are held in trust to investigate and remediate sites where no responsible party(ies) could be found. As with most expenses incurred by industry, these taxes are passed on to the consumer in the form of increased prices for goods or services.
If a responsible party (usually there are multiple parties) can be found, then the liability is on them to remediate or contain the site. This liability is joint and several, and can even include a party that had nothing to do with the contamination, but who buys the contaminated property years later. The fairness of joint and several liability relative to correcting for an externality could be its own topic.
Investigating and remediating a site under CERCLA can be a bureaucratic quagmire and cost a few to several tens of million dollars. Sure, companies pay a price for their past sins, but most of the time a large portion of these costs are ultimately covered by past insurance policies. Again, these costs are passed on one way or another to the consumer.
CERCLA will reduce the exposure to contamination at a few of the many polluted sites in the US. Many of these are success stories, many are not. There are many sites that will never, ever be remediated and returned to some beneficial use by the public.
Yes, there's a usually-unrectified chain of past losses - but if the mess is cleaned up, then at least there aren't more.
There is really no relationship between cleaning up a site under Superfund and elimination of future contaminated sites. Many polluters polluted because they could, and many of the instances of contamination were created by accepted practices at the time (including practices where permits were issued by government). Tons of of chemcials are still legally discharged into the land, water, and air every day. Industry bears blame for crapping in our nest, but society bears blame for not caring or not bothering to know better in many cases.
If you want to hope that there are fewer sites in the future you had better hope that industry's pollution prevention efforts and state and federal waste programs (such as RCRA) are effectively managed into the future. Don't look to Supefund though, to keep humans from crapping in their own nest, as it is the entirely wrong program.
Which of the following could cause inflation?
I finally get it. Thank you for taking the time to explain it to us.
By the way, DW, I pride myself on being a good test taker, but if your recent quiz is any indication, you write damn good tests.
Good afternoon, Charlie.
Yes, I do take pride in my tests. Just be glad I spared everyone the short-essay and long-essay sections.
Truth be told, I'm not giving essay tests very often these days, certainly not in the introductory courses. I became so frustrated by the inability of the students to communicate in essay form that I figured I could put a few more years onto my mortal life if I didn't subject myself to the ritualistic rant-fest every time I had to grade those things. Unfortunately, I couldn't bear the thought of not trying to elicit full analyses from students, so I've begun to "creatively" re-introduce written-answer questions, but I'm still feeling around in the dark for a lamp that I rather strongly suspect isn't even in the room.
The bad part is that I run a type of developmental math course program where the emphasis is on students explaining how they arrive at answers. This is a real joy. Just getting the folks to convey their methods in complete, legible, coherent, understandable sentences is a trial in and of itself.
I'll tell you this much: it's a whole lot easier to teach a math course by simply lecturing through the material and then assigning a pile of problems for the students to do. I think to myself, "I'm getting way too old for this aggravation," but then I realize that it has become a matter of academic integrity for me. I can't just walk away from successful methodology merely because it's complicated, difficult, and demanding.
In my mind, I conflate this with the neo-conservative approach to economics. It's so much easier to simply wave your hand at all the complications of markets and declare that free markets will solve everything if left to their own devices. Digging in and actively managing the economy is much, much more difficult and requires great training, extraordinary knowledge, and quite a bit of maturity in knowing how to subordinate passions of personal belief to better and more worldly engagement. The neo-conservatives would have none of that. It's too hard to do it that way. Not only is it too hard, it's just not as much fun.
That's how the neo-conservatives' approach appears to me, anyway.
The Dark Wraith doesn't have much use for amateurs in positions of great responsibility.
Well Stealthbadger, if Mr. Wraith had said partial correction I would have walked away, probably without comment. But he did not, and he rarely minces words.
You're right, he doesn't:
In civil law, that confiscation would be called "conversion"; in criminal law, it would be called "theft." And it has been done on a grand, almost incalculable scale for centuries. I shed not a tear for companies that are finally made to pay a small fee for their theft of property from others, both those of the here and now as well as those of the future.
The relationship described here is not one of direct cause-and-effect, but I respect and personally agree with the sentiment.
*the furry critter is done speaking for the Dark Wraith, since he as absolutely no authority to do so*
There is really no relationship between cleaning up a site under Superfund and elimination of future contaminated sites.
I chose my phrasing poorly. I was not thinking of secondary effects relating to other sites, but putting the second clause in the plural certainly gave that impression.
"Cleaning up a site mathematically reduces the number of contaminated areas" would be a more accurate, if overly obvious, way of expressing the sentiment I was trying to lead that paragraph with.
I think that the best expression of how I feel would be "yes, it's damned little. It is better than absolutely nothing."