The Armchair Economist

Happy Thanksgiving!

2009-11-25T09:02:00.000-08:00

"As we express our gratitude, we must never forget that the highest appreciation is not to utter words, but to live by them." - John Fitzgerald Kennedy

I haven't posted anything here in a while as my life has taken a turn for the busy, which is something I truly give thanks for this year! I have had a lot on my mind about what to post, and I will come back in December with some thoughts on the current political landscape and how it relates to the economies of the United States and to the world. But for now, here is a list of things I am thankful for:

My family and friends who encouraged me to keep my head held high during this rough time
All of the people I have met over the past year who encouraged me to write this blog
The fact that I live in the country that I live in, and the fact that I have freedoms that many do not have
All of my teachers who helped me to shape my critical thinking skills, and who showed me the way to become a free market economist
Every person who stands up for what they believe in regardless of whether I support their opinion or not
The connectivity that the internet brings
The spirit of entrepreneurship
And lastly, but most importantly, I am thankful for the opportunities and challenges that God has put before me

I hope that my readers have a wonderful Thanksgiving, and that your families are happy, healthy and safe!

Consumer Confidence Index - Reflections of Consumers' Viewpoints on the Economy

2009-11-02T08:08:00.000-08:00

"For decades, we have piled deficit upon deficit, mortgaging our future and our children's future for the temporary convenience of the present. To continue this long trend is to guarantee tremendous social, cultural, political, and economic upheavals. You and I, as individuals, can, by borrowing, live beyond our means, but for only a limited period of time. Why, then, should we think that collectively, as a nation, we are not bound by that same limitation?" - Ronald Reagan - Inaugural address, Jan. 20, 1981

In our current economic environment, we are seeing a lot of things happening that brings us uncertainty in our decision making. This uncertainty leads to tighter cash management, which leads to less cash flow in the economy, leading to limited or even negative economic growth. In measuring the direction the economy will take in the future, economists point to the Consumer Confidence Index as an indicator of this direction.

There are many things that influence our decision making as consumers. Price today vs. price in the future, utility of good and/or service, and necessity of item play a role in our purchasing decisions. For example, I may need a bag of flour today because I am out of flour, but you might have enough flour to last several weeks. Therefor, our flour buying decision is affected by necessity of item, utility if item, and price of item (I may buy store brand vs. a national brand).

As a nation, though, we have to look at many other factors in our purchasing decisions. During recessionary periods, we tend to spend less on 'luxury' items, and focus our spending on bills and 'survival' items. And as you might expect Consumer Confidence tends to follow other economic indicators. I created a chart to show trends and movements of Consumer Confidence, National GDP, and the Dow Jones Industrial Average yearly close for years 1978 - 2008 to illustrate these trends. Please note, this chart is not to full scale, rather, it is made to scale to show movement of the indicated trends.

As you can see in the chart, during the current and last 3 recessions, you can see all three indicators trending downward. One question, though, is do any of these indicators predict another? Or both?

From 1978 - 1980, the stock market was on the rise, yet consumer confidence was falling. And even in the midst of a recession during 1981 - 1982, Consumer confidence was up and down, but almost opposite of how the GDP and DJIA numbers moved. From 1986 - 1991, all three indicators seemed to move in the same direction together. But in 1992, while both the GDP growth was positive and the DJIA finished higher than the previous year, Consumer Confidence shrank. During the 1993 - 2000 period, Consumer Confidence and the DJIA took stellar climbs while the GDP percentage change was typically flat or steady. From 2000 - 2008, the Consumer Confidence Index shows similar movement between the CCI and the DJIA, while the GDP % change tends to follow along as well. Most notably, 2008 when all three indexes took nosedives from their 2007 closing numbers.

As we can see from the chart and analysis, their isn't a really good predictor of future performance of the economy by looking at the Consumer Confidence, and we can't necessarily say that a bad economy flattens consumer confidence. What another influencing factor might is is also the current political climate as well. During the 1981 - 1982 recession, the political climate was one of fear of a "Cold War" with the Soviet Union going "Hot", combined with confidence in a new Presidential administration. During President Reagan's term, Consumer Confidence never dipped near or below it's first three years numbers, which included the lowest CCI measured until 2008. Additionally, the DJIA began a steady climb, and GDP growth spiked, but remained fairly steady until 1986.

In 1990 - 1991, the "Cold War" with the Soviet Union was over, but a new threat to national security was on the horizon in the form of an Iraqi invasion of Kuwait. The political climate was one of almost comfort aligned with feeling of real positive worldwide change, a change in which many countries were beginning to embrace free-market over planned economies.

From 1992 - 2000, the DJIA saw tremendous growth as did Consumer Confidence, yet the GDP growth remained steady. In that political climate, the Clinton Presidential Administration opened up the borders to free trade by signing NAFTA. Meanwhile, internet and information technology companies were taking off and growing fast. All while the stock market and consumer confidence was growing, we possibly missed out on the fact that the GDP was growing steady and not booming. Everyone was making and spending money, and many economic indicators grew to their highest levels to date.

From 2001 - 2008, the United States took an interesting turn politically. About half of the country wanted the status quo, but with the Vice-President from the previous administration. The other half want the Status quo, but with the former Governor of Texas. We won't debate the merits of election return results here, but the point is that the country was divided politically, and really had been since 1992 (Bill Clinton won both elections by close margins as well). As a nation, we did come together for a brief period after the September 11, 2001 terrorist attacks on New York and Washington, D.C. However, the nation went back to being divided politically especially once the United States went to wars in Afghanistan and Iraq.

During this period, the United States suffered a recession, which as it turns out ended two months after September 11th. Consumer Confidence dropped from 2000 - 2003, rose in 2004 - 2006, and fell sharply in 2008. Also during 2000 - 2005, the DJIA had sharp drops and rises, ending practically at the same level. 2006 - 2007 saw the DJIA take a sharp rise, falling significantly in 2008.

And the GDP % growth continued it's 1999 trend by growing less in 2000 and 2001. From 2001 - 2005, the GDP % also grew, before declining in growth in 2006, 2007, and then the sharp decline downward in 2008. These factors probably influenced the political climate more so than the political climate affecting the indexes. As 2008 rolled around, the economy was in the forefront of most of our minds, and hopefully still is today!

In 2009, these indexes continue to bounce around as would be expected, and we are starting to see again the political climate influence these indexes as well. Consumer Confidence remains low, probably due to the high unemployment rate. The DJIA continues to be volatile, taking large moves on almost a weekly basis. And GDP growth percentage has still been bad, just not as bad.

As we think about these indexes, think too how they effect our government and business decision makers. In one instance, you have those who believe that the government should step in and fix this, in another, you have those who believe that the market should fix this, and their are those too who think that the responsibility lies on both. In my opinion, it is the third choice that is correct. The free market has a responsibility to correct its mistakes and government has the responsibility to allow it to do so under prescribed regulatory mandates. In other words, if we could just get the government out of the free market, and the free market out of the government, and let each work independently within their frameworks, we would see these indexes rise once again, and remain steady through natural business cycles.

Consumer Price Index - What it means and how it effects you

2009-10-14T12:54:00.000-07:00

"Currently a level of unemployment of 7 percent or more seems to be required to keep inflation from accelerating, a level quite unacceptable as a permanent situation." - William Vickrey

As you watch the news reports, especially these days, you may hear a lot of talk about unemployment, inflation, and the Consumer Price Index. These three items tend to be mentioned together as indicators of the current economic condition, and rightly so. Low unemployment obviously means a good economic condition, and high inflation can also indicate a good economic condition. More on that later in this writing, but first, a brief explanation of the Consumer Price Index, and how that relates to inflation.

The Consumer Price Index, abbreviated CPI, is a measure of the average cost of a "basket of goods" within an economy. That economy can be as small as a state or region, and as large as a country. Typically, the CPI is reported as a national number, but you may also see where states' or regions' CPIs compare the the national CPI. So what comprises that "basket of goods" in the CPI, and why do they matter?

The answer depends on which index is being referenced. The broad CPI category consists of a national average price of goods and services in the following categories: Food and Beverage (sub-categories in-home, away from home, and alcoholic beverages); Housing (sub-categories rent/mortgage, outside of home lodging, housing insurance, utilities, furnishings, and operations); Apparel (sub-categories men's, women's, and children's); Transportation (sub-categories private transportation, fuel, maintenance, and public transportation); Medical care; Recreation; Education and communication; other Goods and Services (sub-categories tobacco, personal care products). As you can see, there is a broad range of price groups, and some groups that many people don't buy (alcohol and tobacco). As you can also see, these groups consist of typical items that people buy regularly.

To understand why the prices of these goods and services rise, yielding to inflation, goes back to our old friend supply and demand. We know that when supplies become scarce in the face of demand, prices rise. As prices for goods rise due to supplies shortening, wages also have to rise in order to keep up with the rising prices, or, demand must fall in order to get prices back to a range of affordability. Many items listed above will always have a strong demand, simply because we could not live without food, shelter, clothing, transportation, and medical care. We can typically go without recreation and education, and some of us would like to go without communication some days too! And when it comes to personal care and grooming products, we could live without those, but choose not to for many great reasons.

The list of goods and services above typify items of consistent demand, meaning that as supplies of these items become scarce or limited, prices will rise and continue to rise because demand does not fall. And as the population grows, so too does demand for these goods and services. In mapping graphically the United States population vs. the CPI, we can see how the CPI rises with the population growth (years 2001 - 2009 population estimated).

(click on graph for larger size)

After running a correlation between the United States Population and the CPI, I found a correlative effect of 0.92 between the U.S. Population and the CPI. This states that there is an almost 1:1 ratio of effect between these two numbers, indicating that the CPI grows with the population growth. This information lends itself to the theory that population creates inflation.

Now, we can also have a situation of hyper-inflation in economies where governments intervene in monetary policy by introducing more currency into the economy. Currently, the United States is facing this situation since the Federal Reserve has put more currency into the economy by printing money to buy United States debt. The goal of the Federal Reserve is for this money to never reach the economy, rather for it to sit in banks until they can sell the debt off to other investors. Once that happens, the Federal Reserve should pull the money back into their system and hold it as reserve funds. We are getting a little deep here, but understand that the laws of supply and demand are in play with our currency as well. As the supply increases while demand holds steady, the price (value) of the currency falls. This is troubling to economists and debt-holders of United States Treasury Bonds. The devaluing of the dollar outside of normal economic forces devalues the Treasury Bonds, strengthens currencies that trade against the dollar, and forces prices of goods and services higher as the dollar becomes worth less.

This hyper-inflation scenario could also lead to a point in which imported goods costs go up due to a weakening dollar, and exported items sell for less in economies where currencies are worth more against the dollar. Once again, we are getting a little deep in economics here, but the understanding is that the laws of economics can not be broken without consequence. Back to the CPI and inflation to finish up the post.

In the opening paragraph, I theorized that inflation (not hyper-inflation) is an indicator of a good economy. As we saw in the CPI vs. Population growth chart, a rising CPI indicates that a population is also growing. Additionally, rising prices indicate steady or rising demand for a supply of scarce goods. Therefore, inflation indicates population increase, consumers buying, and wages rising. The problem with inflation, though, is at what point inflation too high or too low? Additionally, the stated goal of the Federal Reserve Banking system is to manage inflation so that it does not rise too high. However, recent actions by the Federal Reserve (keeping interest rates low and injecting money into the banking system) indicate that they are failing to meet this goal.

So, in conclusion, keep your eyes on the indicators discussed in this posting as they play a big role in your everyday life. High unemployment leads to less cash flow in the economic system; rising population causes prices to rise; and the combination of the two can lead to a period of stagflation, a period of prolonged economic recession.

Nucor Steel - A study in how management decisions are influenced by economic conditions

2009-09-29T12:25:00.000-07:00

“Men are like steel. When they lose their temper, they lose their worth.” - Chuck Norris

In the last post, "A brief look at Delta Airlines, and how prior economic theories apply to their business", I touched briefly on how decisions made during Leo Mullin's stewardship of the company brought the company to bankruptcy. We then explored their business model and how economic theories from prior posts applied to the airline. In this post, I am going to speak more about management decisions of Nucor Steel, and how they maintained a strong presence in the steel industry through various economic conditions.

Nucor Steel is one of my most favorite companies to discuss simply because management has run the company very effectively and efficiently. Their business model is one in which day-to-day decisions can be made by virtually anyone in the company, giving each employee a stake in the decision-making process. To further elaborate, let's look at what Jack Buffington, corporate manager, MillerCoors Brewing Co. said in his article - Consider This -- Rethinking Management for the 21st Century:

"Nucor Steel, the largest steel producer in the United States ($23 billion in revenue), thrives in an industry that has been long written off as one that is no longer winnable against foreign competition. Nucor's leaders practice classical management by achieving productivity through having a ridiculously small corporate staff (95 managers), effectively pushing decisions down to the shop floor. Managers are paid below-market wages, but all employees are eligible for bonuses based upon the sales and the profitability of the company. Nucor's business strategy has been developed to deploy innovations in steel production anchored through an empowered and well-compensated workforce."

So how do the economic theories in previous posts play a role in Nucor's success? We can certainly speak to the supply and demand of steel and pricing strategies. We can also look at the businesses economic utility in purchasing and re-fabricating used steel vs. making steel from raw materials. But I want to look a little deeper in economic theory, and how the sociology and the psychology of management and employees play into economic decision as related to the prior theories. In doing so, this will open some doors for us to explore some deeper theories in upcoming posts.

In the article cited above, we see that Nucor doesn't make all company based decisions in the managers office or boardroom alone. The management sets strategy, and allows all employees to have a say so in how that strategy is implemented. By doing so, Nucor Steel can run a large company like a small business, changing tactics on the fly to match current economic conditions. Compare that to the previous company we looked at, Delta Airlines, which makes its decisions on a top down basis and not from the bottom up. Delta's board allowed a CEO to come in, and treat the employees and customers in a way that was not compliant with the foundations of the company. Look at a comparative stock chart comparing over the past 5 years Nucor, Delta, and the S&P 500. As you can see on this chart, percentage-wise of stock price growth, Nucor has outpaced the S&P 500, while Delta's stock is almost an inverse of what Nucor is doing. Delta being run from the top down limits flexibility in decision making, and their stock percentage movement indicates this.

Looking at these charts on steel prices over the past 5 years, we see too that Nucor's stock percentage gain tracks similarly:

But if we look at this chart showing the materials industry average stock percentage movement over the past 5 years, Nucor outpaces the industry by a large margin despite fluctuations in the price of steel. Once again, this shows Nucor's strength as a company comparatively speaking, and that strength comes from how the business is run from the bottom up.

So what does this tell us, and how can we apply this to our everyday lives? Well, the first thing that this tells us is that when employees are truly empowered to make decisions, the company is a stronger company. Giving workers a true stake in the business through incentives related to decision making gives Nucor an advantage that many companies do not have. Additionally, being able to run efficiently and effectively, Nucor can keep its steel costs down and manage their profit margin better. And lastly, this tells us that manufacturing models that depend on slow to move decision making are not wise investments for companies' stock and bond holders.

In studying this model, it may be tough for us to apply this to our everyday lives especially when most of us aren't manufacturing anything! But in reality, many families follow this model. Let's take for example a family of 4; a mom and dad with children aged 13 and 17. The parents may empower the children to make decisions based on activities such as sports, friends, school, work, etc... If this family empowers their children to decide to excel in sports and rewards them with a bonus (say letting the child go to baseball camp if they maintain good grades), isn't that family following a similar model? Or, if a children make straight A's, the children get a cash reward for doing so follows this model similarly. If the children stay out of trouble by choosing to hang out with friends who don't get into trouble too, maybe the parents allow the children to do more outside of the home activities. And too, if the parents stay engaged with the lives of the children, by getting their input when things aren't right (bad grades, trouble at school, not making the team), the parents can then guide the family strategy better. As the parents do stay engaged with the children, and the children perform better in school, athletics, etc... the parents may find themselves too rewarded by the children being considered for scholarships to universities and trade schools, saving the parents the expense of the children's education. By taking a bottom up approach to child raising, and staying engaged with the lives of the children, all are rewarded more so than if the parents force a top-down decision making process.

Now, let's also take into account the culture of the family as also related to what is referred to as "corporate culture". Nucor certainly doesn't allow decisions made outside of the realm of their core business to be made, unless that decision is one that pays off to all involved. Same with a family, the parents establish a culture within the organization based on foundations laid out by prior experiences. Families should establish rules similar to how businesses establish rules, and those rules should be enforced by all stakeholders. Otherwise, the organization loses vision of its goals, and wanders aimlessly reacting to outside forces instead of utilizing internal forces to be proactive in decision making. Delta Airlines being a great example of this phenomenon, although their current leadership is now moving more so to empowering their employees with on the spot decision making abilities.

Moving forward in the next posts, we will explore some terms related to economics that we hear about but may not completely understand. The next post will talk about the Consumer Price Index, followed by the Consumer Sentiment Index in the following post. And of course, I always welcome suggestions about topics from my readers, so if you have a question about economics, feel free to post the question in the comment section. And as always, I appreciate my readers taking time to read my blog!

A brief look at Delta Airlines, and how prior economic theories apply to their business

2009-09-18T01:28:00.000-07:00

Elaine Dickinson: “Ted! What are you doing here? You can't fly this plane!”

Ted Striker: “That's what I'm trying to tell these people!” – From the movie “Airplane”

If you know much about Delta Airlines, this line should have been uttered to Leo Mullin when he took over as CEO of the airline in 1997. Mr. Mullin came to Delta from the banking industry, and not having experience in running an airline, his mismanagement of the company coupled with the fallout from September 11, 2001 brought the company to its knees. After going through a bankruptcy in 2005 – 2006, Delta has found its way back to being a strong company, and a world-wide leader in the airline industry. We certainly can’t fault Mr. Mullin for all of the bankruptcy woes, but he played a major role in his decision making to lead the company to financial distress.

Now, this blog is not going to go deep into the financial and leadership problems with Delta Airlines, yet, we will explore how economic theories from prior posts apply to this company. Additionally, I am not projecting any future results from the current Delta leadership’s decision making. If you are interested in reading more about Delta, certainly you can read up about them on their website - www.delta.com. and I found the book “Airline Without a Pilot” by Harry L. Nolan, Jr. to be a great read about the airline. Mr. Nolan’s leadership assessment is very valuable to those who are seeking a self-help book on leadership.

Let’s start from the beginning of Delta, and how the basics of supply-and-demand played into their growth as a worldwide leader in the airline industry. Delta’s roots as an air service go back to the 1920’s when C. E. Woolman led the effort to by Huff Daland Duster’s air fleet. Huff Daland Duster’s started in Macon, GA as the first commercial agricultural flying company, and then moved to Louisiana, providing crop-dusting services to farmers in the Mississippi Delta region, hence the basis of the name, Delta Airlines. Eventually, Delta moved its headquarters from Mississippi to Atlanta, where the corporate headquarters currently resides. So let’s take a look over Delta’s history in regards to the laws of supply and demand.

When Huff Daland was started as a company, they provided a service not yet created. They could fly modified planes over farmers’ crops, spraying the crops with various chemicals faster, cheaper, and more often than the farmer who had large fields. In essence, they created demand for this product by offering a supply of a service that was beneficial to his clients. Eventually, as the company grew, so did the need for their services. Since the Southeastern United States was still largely an agriculturally based economy, Huff Daland had a larger market where they could sell these services. By creating the demand through his unique supply, a cottage industry was created that grew with the addition of other crop dusting services.

After this company was sold to C. E. Woolman, the company went through a transformation of being a company servicing other businesses (farms), to a business servicing both businesses and consumers. Mr. Woolworth saw a future need of air transportation, and eventually took the fleet of planes bought from Huff Daland Duster’s and transformed them into cargo carrying planes. This was accomplished either through modification or through the purchase and leasing of larger planes. Now, with the ability of passengers to travel and ship items faster for a competitive price, Delta was able to provide a supply of services to meet this demand.

Additionally, the users of this service found economic utility in converting paying cash into saving travel and shipping time. As Delta grew from being a regional airline flying between Louisiana, Mississippi, and Texas to an airline servicing transportation between the Southeast and Southwest regions of the United States, once again Delta satisfied economic utility of saving travel and shipping time over greater distances. And even as the company expanded into other markets while facing competition from other airlines, the company found itself providing economic utility, but it had competitors satisfying the same need or demand.

So what would differentiate Delta from its competitors? Delta’s leadership knew that their level of service and the treatment of its customers would build and retain market share in the airline industry. So in order to differentiate itself, Delta provided the economic utility of a higher level of service. By adding in-flight service crews, then called stewards and stewardesses, Delta gave its passengers another reason to fly Delta. Their planes certainly weren’t any faster than any other airlines’ planes, but giving the passengers the opportunity for food and beverages on the flights put them ahead of the other airlines. Soon, that caught on industry wide too, so how again would Delta differentiate itself?

As the airline industry matured, competition in the industry came down to service routes. A brief explanation is needed about service routes to understand how this competition fostered itself in the industry. Major cities in a region generally have direct flights between those cities, with servicing flights to other cities in the region. For example, if you were to fly from Los Angeles to Jacksonville, FL, you would not take a direct flight. You would most likely fly from Los Angeles to Atlanta, then Atlanta to Jacksonville. However, a flight from Los Angeles to New York would be a direct flight from LAX to La Guardia. This cross country route is very valuable to airlines. More valuable than the flight from LA to Jacksonville, FL since the passenger traffic between those two cities is much lower than between LA and New York. But to an airline, especially one servicing the Southeast United States, the Atlanta to Jacksonville route is vital.

This type of routing is called “hub and spoke”, with the larger airports servicing regional and cross-regional routes being the “hubs”, and the regional airports as the “spokes”. A counter to this example is Southwest Airline’s direct flight routes, typically between regional airports, even if those regional airports are cross-regional. For example, if you were to fly on Delta from Nashville, TN to Orlando, FL, you would go through Atlanta. But on Southwest, that might be a direct flight (obviously depending on route rights). So for the major airlines, keeping the mid-sized airlines out of “hub” airports is vital to their operations, as well as maintaining a fleet that can service regional airports from the “hubs”. The same thing applies to international flights among major carriers. American Airlines dominates international service from the United States to South America, and United Airlines dominates service from the United States to Asia and Australia. Delta, not being really a dominant player in international flights (yet), they must protect their service routes from smaller airlines, or partner with those airlines to service the regional airports.

As we can see, Delta finds economic utility in maintaining route rights between the “hub” cities, and either partnering with airlines servicing the “spoke” cities or providing service to those cities itself. But what about the consumers who either live in or near a “spoke” city? Well, if a passenger, for example, is flying out of Wichita, KS to Dallas, TX and then to New Orleans, LA, there might not be as much economic utility if that passenger can take a direct flight from Wichita to New Orleans. However, a passenger flying from Wichita to Atlanta, GA might not have a direct flight opportunity, and therefore appreciates the opportunity of the “hub and spoke” travel option.

Let’s go back to the international travel concept as well, and see why international routes are important to the major air carriers. Say, for example, a traveler wants to take a flight from Atlanta to Beijing, China. Until recently, when Delta acquired route rights to Beijing, one option was a flight from Atlanta to Chicago to Beijing on United Airlines. Since Delta had not yet acquired those rights, and had no partnership with United, loyal Delta passengers had to utilize another airline’s services to make the flight to Beijing. Now that Delta has acquired that route right, and now with direct flights from Atlanta to Beijing, loyal Delta passengers can bypass having to use another airline’s services to Beijing by flying the Atlanta to Beijing route. Now, for the traveler in a non-international airport serviced area wanting to fly Delta to Beijing, that traveler must take a flight to an airport that Delta services in order to complete the flight to China. The passenger in Jacksonville wanting to travel to Beijing is utilizing the “hub and spoke” route from Jacksonville to Atlanta, and the international route from Atlanta to Beijing.

So let’s look at another situation involving air-travel, and that situation is one where the “spoke” airport is bypassed by the air traveler. A great example would be the air-traveler living in Montgomery, AL. Let’s say that this traveler wants to fly to Los Angeles, and can either catch a flight from Montgomery to Atlanta to LA, or can make the 3 hour drive from Montgomery to Atlanta to catch the flight. The passenger may decide that there is no real savings in time or money by taking the flight from Montgomery vs. driving to Atlanta. So why would Delta continue to service the Atlanta to Montgomery route if there is no difference in benefit for passengers to utilize that route? One way is to make the flight from Montgomery to Atlanta a more positive experience than making the drive. Is that enough to generate enough passenger traffic on the route? Since Delta continues to service the route, apparently Delta believes that it is an important route to maintain.

So we’ve gone through some basics of supply and demand as related to Delta Airlines and its services. We also took a look further at economic utility of both the airline and its passengers. In the next two posts, we will explore the theories of supply and demand and economic utility a little further. We may even go a little deeper in the theories and bring in some math. I promise it won’t be any wicked statistics, but numbers that will be easy to follow. In the next post, we will explore another one of my favorite companies, Nucor Steel, and how their economic evaluations have helped them become a major steel manufacturer.

Economic Utility and the Modern Consumer - Part 3

2009-09-09T13:03:00.000-07:00

"Price is what you pay. Value is what you get" - Warren Buffett

In prior posts in this series, we explored economic utility as related to consumers and consumerism. To fully explore economic utility, we also need to look how this concept effects business decisions made by businesses of all sizes. As we saw in the last post, Economic Utility and the Modern Consumer - Part 2, consumers base buying decisions made by the current situation of their lives. We saw also how consumers derive value from those choices they make, be it a decision to buy a Big Kahuna burger instead of a McDonald's burger, or even a pressing decision of when to have a water heater fixed. As we know, businesses make similar decisions daily, and we will see too how these decisions are similar to how consumers behave.

First, let's look at what I will define as a small business, which I will say is a business that earns less than a million dollars in annual revenues and employs less than 20 people. Let's think of some small businesses we know and see everyday: your dry cleaner, your dentist, your cleaning service, and a small retail boutique are some good examples where we can start. Now, I know that the dry cleaner and small retail boutique can be parts of chain businesses, and your dentist can work for a large dental group, and your cleaning service may be Merry Maids, but those businesses will be classified as mid-sized businesses. The small business owner typically has around two to five means of selling goods or services (store-fronts, internet, catalogs, retail partnerships, trade show sales), typically store fronts and/or the internet being where you would find them doing business most. And this is a good place to start looking at economic utility, the place where a small business conducts business.

Does your dentist really need a website? That's a question of economic utility that is very interesting to look at, as we don't typically think of finding a dentist via the internet. But the dentist could certainly advertise his services via the internet to draw in new business. How about your dry cleaner, how could a dry cleaner benefit from having a website? Maybe in order to draw in new clients, the dry cleaner advertises locally on search engine sites to drive business to the store, possibly even offering a promotion on the website available only to clients who visit the site. So how do these businesses who operate both a store front and a website know the economic utility of each of these sales opportunities? Typically, small business owners simply look at how much revenue is coming in versus cost of the good or service that they buy, and in this case, storefront rent, advertising, and cost of operating a website. But could the owner find a better way to reduce costs of these items? Certainly, there are negotiating processes involved in paying rent to a building owner, and as the business owner is building his business plan, he understands what his monthly costs and revenues should be in order to continue operations. But what if it made sense to shut down the store front and operate solely as a web-based business? Could the owner say that he would not drop off customer sales by doing so? The dry cleaner would have a very hard time doing that, unless he offered pick-up and delivery services while advertising heavily on the internet. And the cleaning service doesn't necessarily need office space, rather they need some kind of storage space for their cleaning items. But we could almost safely say that the dentist needs to have some kind of office in which he works, since we haven't developed technology to allow the dentist to work outside of his office! So to answer the question of a web site's economic utility vs. a physical location's economic utility, we must know the costs and benefits of the locations, and also all of the business' inputs and outputs.

The next point to explore is inputs into the business that allow for outputs. Inputs are cash, raw or finished materials, skill sets, equipment, etc... Outputs are the goods and/or services sold to another business or to consumers. Cash can come from business loans made by banks, or by a capital investment made by the owner. The cost of this cash can be measured in interest paid on a loan plus interest lost by not investing the money, or if this is a capital investment by the owner, the interest lost by not investing the money in another business (stocks, bonds, capitalizing another business). You may hear these costs defined as 'economic costs'. Skill sets are not as easily quantifiable as cash inputs, but suffice to say, if a business owner hired an accountant, that accountant should have experience in working with small business owners. And the equipment and materials as inputs are a little more easily defined in the sense that your dry cleaner probably isn't going to by a dental chair for his office, and hopefully your dentist isn't buying dry cleaning chemicals for use in his office. So we can say that to a dry cleaner, chemicals used to perform dry cleaning would have positive economic utility, but a dentist buying dry cleaning chemicals would have a negative economic utility (unless, of course, the dentist can use those chemicals safely in his operations at a cost that is less than the income derived from the use of those chemicals). The goal of the small business owner is to ensure that the inputs have a net positive economic utility so that their outputs also have positive economic utility for their customers. But sometimes, an owner has to maintain items that provide negative economic utility in order to obtain positive economic utility. A great example would be if paying rent on a building costs more than the income derived from in-store sales, but the web-based business would not exist without a brick-and-mortar location. We see that the website provides enough positive economic utility to counter the negative economic utility of the storefront.

I could go on for days on end about the small businesses, but we need to explore the mid-sized businesses, and how economic utility relates to their operations. Let's also define mid-sized businesses as organizations who have one to ten million in annual revenues, and employs from 20 to 1,000 people. And in looking at these businesses, we need to look at a concept of economics called "economies of scale". Some people struggle understanding this term, but simply put, as a company grows, its outputs become more cost efficient until it hits the point of negative return, or negative marginal costs exceed positive marginal income. Let's look at this point further, and use an example from above. Say that your dry cleaner stores his chemicals in a 100 sq. ft. storage space, but one store's worth of chemicals only utilizes 50% of this storage space monthly. If the dry cleaner opens a second store, he can then use the remaining space for chemical storage for the second store. Let's assume, too, that the rental on the storage space for one store provides positive economic utility for the one store. Now that he has two stores sharing the cost of storage, this facility's economic utility increases as long as both stores provide income enough to cover the cost. But there is a point where the cost of increased storage outweighs the income produced by operations that cover this cost. Let's say that the owner determines that this point is eight dry cleaning stores in a local area (arbitrarily, of course). So should the dry cleaner open a ninth store? Well, we have to look at costs across the operation. If the owner can find a comparable storage facility that meets the needs of inventory storage, is located in an area where transportation costs to deliver the chemicals to the storage facility and from the storage facility to the stores do not increase significantly, then the business owner should explore further adding another store to his business. We just got a little deeper into economics, and even looked at some accounting. I could throw some finance and marketing in there as well, but then we are going real deep into business school teachings where I don't want to take you! From this passage, though, we can see how economic utility can get complicated and deep, especially when organizations get bigger. So hold on, we are about to get into large organizations, but I promise to keep you real close to the surface.

Let's define large organizations as those who have annual revenues of more than ten million, and directly employ anywhere from 20 to 10,000 or more people. When we look at these businesses and how they look at economic utility, we need to look at some very specific items. For example, Caterpillar, Inc. is a great company to use as an example, and let's compare them to Microsoft, and how they would look at economic utility. Both companies are greatly different in their operations and industries, but there is also some commonality there as well. Both companies find economic utility in software developers, and even though Microsoft is more interested in selling you an operating system and professional software, they also employ software that helps them mange costs and make business decisions. Same as Caterpillar in the sense that they want to bring in software developers that help them manage costs, inventories, scheduling, business decisions, etc... However, Caterpillar being a heavy equipment manufacturer would find more economic utility in buying steel, tires, and Diesel engines more so than software development. Microsoft probably wouldn't know what to do with steel, tires, and Diesel engines even if they got them for free! So looking at these larger companies, it almost seems a little easier to point out economic utility in inputs, but in reality, it goes much deeper than this. So deep, in fact, that we have to bring in some higher math and even wicked statistics that I certainly dare not expose you to in this blog! But do understand, too, that the reason that these larger companies get this big is through the same concepts the small business owners utilize. In fact, if you look at the history of many current larger organizations, especially technology oriented firms, you will find that many, if not all, started out as a small business concept that grew seemingly rapidly, but that growth was managed well. In the management of that growth, the owners and managers understood economic utility and how it applied to their businesses.

In this series of posts, we looked on the surface at some concepts related to business and economics that should apply to your everyday lives. Understanding cost vs. value helps business owners with their daily decision making, and it should yours as well. Going back to the last post, we looked at time as being valuable just like money, yet time costs us nothing. It's how we utilize time and money to add value to our lives. Businesses too understand that concept, and the one's who can pull together these and many other concepts tend to continue rather than halt operations. In the next posting, we will take a look at one specific business and it's decisions, and how we might apply those to our everyday lives. That company is Delta Airlines, and I will explore how it's managers made a series of decisions that we should look at and how we can avoid making similar decisions in how we live our everyday lives. Now if you will, please pardon me, as I have a juicy Big Kahuna Burger waiting for me!

Economic Utility and the Modern Consumer - Part 2

2009-08-31T21:19:00.000-07:00

"Big Kahuna Burger. That's that Hawaiian burger joint. I hear they got some tasty burgers. I ain't never had one myself. How are they?" - Jules Winnfield - from the movie "Pulp Fiction"

In the prior post, Economic Utility and the Modern Consumer - Part 1, we explored briefly Economic Utility and some key definitions and concepts about this important facet of economics. In this post, I am going to go into a little more detail about Economic Utility as it relates to individuals. There are some concepts of economics we need to explore a little further before going into economic utility which play a big role in how we find value in goods and services. First concept to discuss is a term called "elasticity of demand". Basically, this term refers to the price range which consumers are willing to pay for goods and services. An example would be - could a company sell a good or service at a higher price than what is currently advertised? If, the Coca Cola company could sell a can of coke at $1.00 per can vs. $0.50 per can, and not lose sales volume in units sold, they certainly would. Another example for the Coca Cola company to explore is if they could increase sales volume without losing profit by reducing the cost of a can of Coke, at what price do they then sell the Coke? Coke spends lots of money on studying pricing so that they can determine the optimal price per market in order to gain maximum profits on sales of their goods. This concept is vital to the continuing operations of their business, and they study these concepts on an on-going basis.

The next concept to discuss is the consumers marginal propensity to consume vs, save. Consumers have choices to make in the market place each day, and one of the biggest decisions that they make is whether to buy a good or to save money for later purchases. A consumer with a high marginal propensity to save money vs. spending money is a marketers bane. Those consumers tend to be very frugal and rarely spend money on non-essential items. Additionally, those consumers shop for the best deal that they can get on products, forcing marketers to be flexible in their pricing in order to make a sale. Conversely, consumers with a much higher marginal propensity to consume vs. save are a marketers dream! These spendthrifts will buy items at a price close to or at the advertised price, typically will not negotiate pricing down, and also will buy non-essential items on a whim. And of course, there are consumers who fall in between these two types of people.

So let's explore a little more about where these types of consumers find value in goods and services. First of all, the consumer with the lower propensity to consume and a higher propensity to save will have a higher need for value in the product or service they buy vs. the cost of that product or service. Let's take the Big Kahuna Burger from the quote as an example. A person with the lower propensity to consume might pass up the Big Kahuna Burger if it costs more than say, a McDonald's burger of equal size. This person might nor find economic utility in taste, only in the fact that the burger fulfills the desire to eat. A person who seeks to experience the Big Kahuna Burger might learn the recipe on how to make the burger, buy those items at a grocery store, and make the burgers themselves, thus finding greater economic utility in the taste and value of the home made burger. This person, too, has a low elasticity of demand, meaning that that are seeking the same components of supply at a lower cost.

On the flip side, the person with the higher marginal propensity to consume might drive past several McDonald's in order to get to the Big Kahuna Burger. Additionally, this person might even buy a large order of fries and a large drink! By spending the money on gas to get to the burger place, and then buying the burger, fries, and drinks, this person finds a greater economic utility at a higher cost in the Big Kahuna Burger. This person's economic utility is found more so in their desire for the burger than in their desire to save money by buying a less costly burger. This person has a high elasticity of demand, meaning that they are willing to pay a higher price for similar goods than what the person described in the prior paragraph is willing to pay.

Somewhere in between, most people tend to weigh out their consumption options. Say for example, there is a Bug Kahuna Burger that is the same distance from all other burger options, and the price of the Big Kahuna Burger is equitable to those options. Where, then, can we find economic utility, especially for the person who falls somewhere in between the high propensity to consume and the high propensity to save? This is where marketers spend a lot of time and effort to identify these types of people. Studying buying habits of the people who would consume a Bug Kahuna Burger, and then giving those who would buy their burger a greater economic utility is key for the business to add customers to their stores. This discussion is for another post, though. Additionally, the people in this range vary in their elasticity of demand, some willing to pay more for like goods, some willing to pay less.

So how does one know where their economic utility falls in the range of consumption vs. saving? We all have different views on what we like to consume, and different needs for that consumption. And definitely, if time is of the essence in a purchase, our marginal propensity to consume may rise above our normal levels. Ever call a plumber in the middle of the night to fix a hot water heater? If you have, you may have paid a higher fee for the emergency call, especially if you need the hot water for the next day. If you might be able to wait until normal business hours, and maybe even a day or so in order to get onto a regular schedule of the plumber, the cost to fix the water heater should fall.

Now, how can economists measure these margins on an individual basis? If I had the answer to that question, I would be a multi-billionaire! Consumers, each day, make a decision to purchase or save largely depending on the day at hand, and what they believe is in the future. A young family expecting a child would certainly have different margins of consumption and saving vs. a middle aged couple with no kids and higher salaried jobs. The young couple might decide to put money into savings to prepare for the birth of the child. Additionally, their consumption habits would revolve around the purchases needed for the baby, such as clothes, toys, cribs, etc... The young couple, depending on their financial situation, might decide to buy these items second-hand rather than new in order to save costs. New baby clothes accomplish the same task as second-hand clothes, so why wouldn't the couple opt for the second hand clothes? Same for the crib and many of the toys, especially for a new-born.

But what about the higher dollar items, such as housing, cars, and even electronic equipment? In the prior post, we looked briefly at the difference between a family buying a larger 4 bedroom house vs. buying a smaller 3 bedroom house. If the 4 bedroom house costs are similar to the 3 bedroom house, and is in a similar location, would it make sense for the couple to buy the larger house? Once again, depending on the day at hand, and what the couple believes the future holds, it might make more sense to buy the 3 bedroom house than the 4 bedroom house. The smaller house may take less time and effort to keep cleaned and maintained, but should the family need a bedroom for a home office, a bedroom for the kids, and maybe even another bedroom for an older parent in addition to the bedroom for the couple, the 3 bedroom house might not make as much sense as the 4 bedroom house.

In the prior paragraphs, I briefly touched on the concept of time. Any business school graduate will certainly get more teaching about the Time Value of Money than they could possibly want! But this concept can remain foreign to people outside the world of business, whether academic or professional world. In a nutshell, the theory states that money today is worth more than money tomorrow. But what about the human value of time, is time today more valuable than time tomorrow? I would argue yes, as each second that passes in our lives is one second closer to the end of our lives. Ever think, "I sure wish I had that hour of my life back"? Unlike money, we can not create or earn more time in our lives. We might be able to do things that would shorten or lengthen our lives' time span, but when we reach the end of our lives, we can't go to the bank and withdraw time saved and extend our lives. Sorry if this sounds somewhat gruesome, but the next paragraph will be a lot happier, I promise!

The way that we all enjoy our time varies from person to person. We all have to spend our time doing certain things, like working, sleeping, and other daily basic functions. We all enjoy the time when we don't have to work, and spend that time doing fun things. In our lives, where we find the most pleasure is where we want to spend the most time. So, we also tend to do things that might save time, especially if we can save time on doing things we don't enjoy as much. The economic utility we find in our time spent is measured individually, and we could certainly study where we spend our individual time, which might give us insights as to how we better utilize the time we have.

For myself, I find studying and explaining economics as a good use of my time. I find great joy in learning new things, and also teaching others. I do hope that my readers find this blog a good use of their time, and are learning new things too. As a student of life, I always appreciate the time, effort, and money spent on learning, and my readers are a big part of my learning process. I do hope that as you take the time to read this blog, you too will educate me with your thoughts and ideas. To me, reading your input is a very valuable use of my time, and has a very high economic utility for me!

Writer's note - this is part two of a three part series that I will complete over the following weeks. The next post will be more about businesses utilization of time and money.

Economic Utility and the Modern Consumer - Part 1

2009-08-24T12:53:00.000-07:00

"A feast is made for laughter, and wine makes life merry, but money is the answer for everything." - Ecclesiastes (ch. X, v. 19)

For many posts now, I have concentrated on very broad theories of economics on the macro level, but have yet to go back to theories on the micro level. In one of my first posts, "The Deadliest Catch" - Lessons in micro-economics, I did go into some depth concerning supply and demand theories. But in reality that post was a prelude to delving into macro theories. This posting will touch more so on the micro level, especially in dealing with consumerism.

Let's take a step back before going into this post, and define a few terms to make this post a little more clear to those who aren't quite familiar with economic terms. Macro-economics is the study of economics across a broad scale, typically economies of nations. Most economists speak in macro terms as macro economic decisions affect a broader population than do micro-economics. Micro-economics looks more so at the small scale, usually businesses and industries. All economists look at the micro-level in some way shape or form, especially when forming macro theories. We have all heard specific talk about the automobile, banking, and health care industries, especially of late. But many economists who speak on terms of these industries are doing so with the scale of looking out over the broader spectrum of the larger economy. Typically, micro-economists focus more so on the economics of one particular business (i.e. Ford vs. the Automobile industry) and make recommendations to that business (when asked to do so). Consumerism, at least as defined in this post, relates to behavior of consumers, and how those consumers find utility in their purchases. And utility as defined in this post refers specifically to usage of a product and/or service that the consumer desires and is willing to purchase.

So, now that we have cleared a little mud out of the water, let's start by taking a look back at the Biblical quote, and the wisdom of Ecclesiastes. In economic theory, as discussed in earlier posts, money is the common means by which business is conducted between entities. Whether those entities be businesses buying from other businesses, or consumers buying from businesses and other producers of goods and services. We can state that the other producers can be government entities, and also people who hire their services out to consumers. Let's take for an example, a person who works on cars as the service that he provides to consumers. The mechanic has a certain set of skills that most do not possess, and therefore provides utility in fulfilling the need of having an automobile repair made. Some of us can make some basic repairs to our vehicle, but the mechanic is adept at making those repairs that we can not make ourselves. Of course, there is competition in the automobile repair market, and we have to derive our utility from the price paid for the service rendered. Additionally, mechanics may specialize in the repair of specific makes of automobiles, so we also have to take that into account when deciding to optimize our utility of the mechanic's services. Kind of sounds a bit like we are going back to our old friend supply-and-demand! And really, we are, since the mechanic can certainly set a price for their services based upon the demand for those services, and the supply of the mechanic's services available.

So how do we know what the utility is for those services? Well, we need to go a little deeper into the concept of money, and how it relates to our lives. So let's take for example a family of four. Dad works full time as a manager in a business, and he has $4,000 disposable income each month. Mom is a stay-at-home mom, but works a part-time job on nights and weekends to bring in an additional $1,000 a month in disposable income. The children are young and in school, so not old enough to work a job but still need money for supplies, clothes, food, etc... After paying a mortgage of $1,800, water/power/gas utility bills of $400, and a car payment of $500, the family is left with $2,300 per month in disposable income for other needed items. Let's say that groceries are $1000 per month, and gas and maintenance for the vehicles runs another $500 per month, which leaves the family $800 per month for the family to either invest, save, or spend. What should the family do?

Well, we need to look at the utility of the monthly bills. $1,800 + $400 goes to the basic need for housing. These numbers represent payments for a house large enough for a family of four to live comfortably. The family might consider downsizing their home to get a payment of $1,500 per month, but would the $300 in savings each month living in a smaller home give the family the room needed to live? In some cultures outside of the United States, we see families much larger living in homes much smaller. Why is it that this particular family needs a 4 bedroom 3 1/2 bath house, when in other cultures a family of 6 might live in a 2 bedroom 1 bathroom house? And could the family reduce their monthly grocery bill by clipping coupons or shopping on days when there are sales, or maybe even buying items in bulk? What about possibly growing vegetables in a garden to cut back on food costs?

The beautiful part about this study in consumerism is that the family is free to make those choices whereas some cultures don't have the freedom of choice that we have in the United States. It is the importance of these choice we make that fulfill our needs as consumers. Possibly, this family could live in a smaller home, but the decision to buy in this particular location is related to the school system that covers the location of the house. Maybe there aren't smaller homes available for sale, or maybe the family also needs the larger house because they know that they will also house a parent in the future. Could be too that the family bought the house for it's increasing value, and they know that the house could become an investment in the future. Additionally, taking time to clip coupons or grow a garden, or shop on days of grand sales does not fit into their busy schedule. Sure, clipping coupons might take an hour out of their day, but what is the value of their time compared to the value of their money? That's a question that I will explore in the next post. For now, I want to discuss the utility of the remaining disposable income.

We have a family with $800 per month in disposable income after normal bills are paid. Let's now answer the question of where the money should go, and the ramifications of each decision. Should the family use the money to invest in stocks, bonds, or mutual funds, the money is put back into the economy in the form of business investment. Those businesses receive the investment and use the money to expand operations, thus employing more people (in the long term). Actually, the money would go through an investment clearinghouse or brokerage which buys the instruments of investments and then resells them on the open market, so the clearinghouse or brokerage now has more money to use to invest in expanding businesses. Should the family put the money into a bank savings or money market account, the bank then takes that money and puts it back into the market in the form of lending. This lending can help someone buy a house, a car, a boat, or even start or expand a business. The purchase of these items pays for the cost of the goods sold, which include payrolls of businesses, increasing the amount of free cash flow in the economy. Should the family decide to go to dinner or a movie, or maybe spend it on sports, once again the money enters back into the economy and covers the costs of the goods or services, including payrolls. What about a charitable donation, how would that money re-enter the economy? Well, charities pay for goods and services for those whom the charity supports, which in turn, covers the costs of those goods or services provided, which you guessed it covers payrolls!

So the bottom line is that the family has to decide on where they get the best utility for the money spent. Let's go just a little deeper into this idea of consumerism, and the free market approach. In the prior paragraph, the disposable income is best utilized by returning it in some form or fashion back to the economy. By returning the money back into the economy, the supply of cash stays normalized along with the demand. If the family takes that cash and puts it into a tin can and buries it in the yard, they are reducing the supply of cash, increasing the value of cash if demand stays normal. Now certainly, in an economy of trillions of dollars, a few hundred a month won't put a dent in the money supply, but multiply the number of money hoarders by a factor of millions, and you can see see how the reduction of supply would actually increase the value of money were demand to stay normal. And with the limited supply of money, demand would actually increase, causing the value of the money to rise even higher! So should we as consumers hoard cash and keep it out of the economy if we want our cash value to grow? Well, it turns out that unexpected things happen in our lives that cause us to return that money back into the economy, such as a vehicle break down.

Now we are back to the mechanic and his services provided to the family when a vehicle breaks down. The family wisely put part of their disposable into stable investments in the stock and bond markets, while also putting some of that money into their bank savings account for such emergencies. When needed, the bank relinquishes the money from the savings account from the bank's reserves (a topic to be covered later), and the family used it to fix the broken hoses and belts. The mechanic got paid for his services, and was able to pay his lease and order common parts for his shop. Meanwhile, the family (mom and dad) also found that spending $150 on a "date night" brought some form of joy to the parents. The stock brokerage took the money from the family and pooled it with other investors' money, and bought a corporate bond allowing another business to expand. And the restaurant and movie theater got a little bit of the "date night" money each, along with money from other consumers, giving them the ability to continue operations. The family returned the money back into the economy, essentially spreading the wealth through investments, saving, and spending.

Hopefully this sheds a little more light on the importance of consumerism in our economy, and that you have a little more understanding about the importance of cash flow in the economy. Additionally, hopefully this post sheds a little more light on where your dollar goes when you invest, save, spend, and even hoard. It is a very important concept on both the micro and macro levels, and you can see why macro economists also have to put in effort to study micro economic concepts. So the next time you buy a hamburger or a soda or go to the movies or put your money into a savings account, think about the fact that you are helping the economy by returning those dollars back into the system. You are a vitally important mechanism in the economy, and you should choose the utility of your dollars wisely.

Writer's note - this is part one of a three part series that I will complete over the following week. This post is written to lay down some concepts necessary to complete the next two posts. The next post will be more about individual utilization of time and money, and the third post will cover businesses utilization of time and money.

What if I studied one of Friedman's economics theories every day, and wrote a blog about it?

2009-08-18T10:48:00.000-07:00

"Once you have mastered a technique, you barely have to look at a recipe again" - Julia Child from Julia's Kitchen Wisdom: Essential Techniques and Recipes from a Lifetime of Cooking

I don't know if writing a daily blog on Friedman's economic theories would garner a book and movie deal, plus, it would probably be very boring to the readers! Well, maybe if I could explain his theories in everyday speak, it might make a lot of sense, but Friedman, like many other noted economists, think on a level much deeper than I could achieve when it comes to economics. However, keeping it on the surface, I believe I can shed a little light on some concepts.

Other then being an Armchair Economist, I am also fond of cooking. I love to learn new recipes, techniques, and ingredients covering a wide range of cuisines. Additionally, I am learning a lot more about baking too (baking is more chemistry than cooking...), which has provided me with many new challenges! I also love to watch cooking shows, especially competitive cooking shows where chefs have to show off their skills and creativity. One of the shows I like to watch is "Chopped" on the Food Network. Recently, I watched an episode where during the dessert phase of the competition, a chef mistook salt for sugar. As he blended together his batter, he poured in about a cup of salt instead of a cup of sugar. The results, were of course, disastrous. Funny thing about salt and sugar is that at first glance they both look just alike. Had the chef tasted or even felt the ingredient, he might not of made the mistake. And even if he had tasted the final batter, he would have known too that he messed up and needed to start over. So how is this related to economics, you may ask? Well, let's take a look at a cake recipe, and see if we can make some analogies with the ingredients and economies:

Dark Chocolate Cake I

INGREDIENTS
2 cups boiling water
1 cup unsweetened cocoa powder
2 3/4 cups all-purpose flour
2 teaspoons baking soda
1/2 teaspoon baking powder
1/2 teaspoon salt
1 cup butter, softened
2 1/4 cups white sugar
4 eggs
1 1/2 teaspoons vanilla extract

DIRECTIONS
1) Preheat oven to 350 degrees F (175 degrees C). Grease 3 - 9 inch round cake pans. In medium bowl, pour boiling water over cocoa, and whisk until smooth. Let mixture cool. Sift together flour, baking soda, baking powder and salt; set aside.

2) In a large bowl, cream butter and sugar together until light and fluffy. Beat in eggs one at time, then stir in vanilla. Add the flour mixture alternately with the cocoa mixture. Spread batter evenly between the 3 prepared pans.

3) Bake in preheated oven for 25 to 30 minutes. Allow to cool.

Let's take a look at these ingredients, and see if we can make some connections. Water, eggs, and butter act as binders, holding everything together. Cocoa powder, vanilla, sugar, and salt provide the flavor. Baking soda and baking powder add leavening power, causing the cake to rise. So how do we equate these ingredients to an economy? Looking at the ingredients thusly: The water, eggs, and butter are the laws that govern commerce, holding everything together by allowing for the enforcement of contracts, the protection of consumers, and regulating trade. The Cocoa powder and vanilla is money from foreign lands. They are not needed in the cake, but help to add flavor to the overall end product. The sugar is the money put into the economy by consumers, the sweetest ingredient of them all! The salt is money put into the economy by the government. Bitter and harsh, but a needed ingredient to balance the sweetness. The baking soda and baking powder are the business to business transactions, needed for a growing economy. And finally, the most important and most vital ingredient is the flour, or in our case, consumers and workers.

In this recipe, as with any economy, the ratios of ingredients are crucial. In baking, even a slightest adjustment in any of these ratios could lead to a bitter taste of the cake, or a cake that doesn't rise properly, or even a cake that is too sweet. Once the batter is mixed together and complete, it's merely batter until you place it in the oven to cook. Let's call the oven cash flow. As we have learned in earlier posts, economies love and need cash flow. In our case, cash flow brings the economy together, activates the ingredients, and causes the cake to rise perfectly with the taste we all love. At least us chocolate cake lovers! And what, then would be the icing on the cake? Icing could simply be butter, cream, sugar, and flavoring (chocolate, vanilla, lemon, orange, etc...). The icing is simply another mixture of money available from consumers, and the laws that govern. But let's say that the icing is money used by consumers in investing (savings in banks or investing in stocks and bonds). The icing isn't necessarily needed, but it makes the cake taste better.

So now we have a perfectly mixed, baked, and iced cake. The end product suits the desires of its creators and utilizers, and everyone is happy. The process is repeatable and always turns out perfect. But let's say we adjust those ratios a bit. What if we mistook salt (government spending) for sugar (consumer spending)? Instead of a 1/2 teaspoon of salt, we added 1/2 teaspoon of sugar, and we also added 2 1/4 cups of salt instead of the 2 1/4 cups of sugar. How would that cake turn out? No one would want to eat it, and it would be a waste. What if we left out one egg? would the cake rise and hold its volume? What if we took out a protective law, what effect would that have on the economy? What too, if we left out the baking powder and baking soda? The cake would turn out to be very dense, but edible. What if business to business transactions stopped in the economy? There would still be consumer cash flow, but the economy would be tough and hard like the cake.

So we see that the proper ratio of ingredients in baking added to the right cooking environment is crucial for a perfect cake. The same can be said about economies, which is why professional economist, like the bakers of old, are working hard to find those ratios. We know that we need consumer cash flows. We know that we need business to business transactions. We know that we need laws and we know that we need government spending. But what is the right ratio, and what happens when those ratios are not right?

We need to explore a couple of these ideas in today's economic environment. Several years ago, the banking industry was allowed to create what are termed toxic assets for sale in the open market. Let's say we left out some of the egg product in the cake. The laws and banking regulations were adjusted down as the other ingredients were adjusted up. In September of 2008, the cake began to come apart as there were fewer binders holding the cake together. As a result, business to business transactions (baking powder and baking soda) waned, trying to get us back to the right ratio. Consumer spending (sugar) too fell off as we tried to get the ratio back to normal. Additionally, the foreign money that was coming into the United States economy (cocoa powder and vanilla) declined in the following year. The only ingredients that have since been increased in this cake is government spending (salt), and laws (eggs) regarding the banking industry. So now, we have a cake that is bound together, not rising correctly, and tasting very salty! In other words, we have seen an increase in regulations that are now hampering the financial services industry (even though the intent was to free up lending), we have seen an increase in government spending (which too was to stimulate the economy by putting cash back into the system), and we have seen an increase in unemployment, a result of less consumer spending and fewer business to business transactions.

So what is the solution? How do we get the cake back to its right ratios? How do we get more sugar and flour into the mix? Or do we simply pull back the other ratios and try to re-bake this cake? The first solution that I have seen concerns the stimulus package that was passed in February, geared towards putting money into the economy to stave off unemployment. The problem was that the majority of the stimulus spending only took effect after 2 years time had passed. Basically, there was a threat to put the salt into the cake gradually, and at a time when no more salt was needed. It is my opinion that the stimulus money should be pulled back and not used to allow the other ingredients an opportunity to catch up to the proper ratios. The second solution that I have seen too says that even though we aren't putting all of this salt into the cake yet, there is a threat of more salt being dumped into the cake in the form of a public option health care solution, and more eggs being put into the cake in the form of the cap-and-trade legislation. As a free market economist, I believe that the salt being poured into the cake is in a much higher ratio than what is available in terms of the other ingredients. We need to re-adjust the ratios, put the cake into the oven, and see what turns out. The more flour and sugar we can add to get these ratios back to normal the better off the cake, and the economy will be after going into the oven.

One final note. As a free market economist, I do believe that there should be government spending to a degree. There are services provided by the government that Constitutionally speaking, are guaranteed and should be paid for by taxes. Defense spending, payment to government service employees, and payment to Treasury debt holders being the primary forms of spending of our government. During the drafting of the Constitution, it seemed that the Founders had figured out a good first ratio to make and bake the cake that is the United States economy. As time passed, the ratios kept getting out of proportion and the economy eventually righted itself through market activities. Eventually this economy will right itself, but it would certainly right itself better without the unnecessary addition of ingredients, and not confusing the salt for the sugar.

In defense of Communism - What is this free market economist thinking?

2009-07-28T07:57:00.000-07:00

Society does not consist of individuals but expresses the sum of interrelations, the relations within which these individuals stand. - Karl Marx

One definition of communism (from dictionary.com - http://dictionary.reference.com/browse/communism) states that communism is: A theoretical economic system characterized by the collective ownership of property and by the organization of labor for the common advantage of all members. We have seen in history that nations who subscribe to the communist theory of economics have not faired as well as nations who subscribe to the free market theory of economics. But does communism work? Or better put, can it work? In this writing, I will pose a theory that communism can and does work, but only on a voluntary basis. It is forced communism where failures are found, at least in human nature.

Let's take a look outside of human nature for a second, and look to the insect world for ways in which communism not only flourishes, but is necessary for the survival of a species. The first stop in this journey is in the world of honey bees. It could be said that the honey bee hive is collectively owned by all that inhabit the hive. Each member of the hive has a place to live within the hive, although there is typically no assigned living space, save that space for where the queen bee lives. Each worker bee has assigned jobs to do, mainly to collect pollen for the generation of honey for food for all in the hive, to build and maintain the hive, to procreate, and to defend the hive in order to protect the queen. The worker bees are acting collectively for the betterment of the hive and for its survival. Should one of the bees fail at his assignments, the collective within the hive could certainly make up for short-fallings caused by that worker not doing his job. However, should many of the workers decide to not do their assignments, and live off of the labor of the other bees, the society in the hive will collapse, and all of the bees perish. In the case of the honey bee society, the primitive thought patterns pre-programmed into the minds of the bees cause the collective to act as one providing for the needs of the many. This is found true of many other insects, especially ants and termites.

The next stop in the world of nature where communism is present is in the world of killer whales, also known as orcas. Orcas spend their lives within a social structure known as a pod, which is typically a small community of 5 - 30 individuals. Within these pods, the killer whales have shown a sense of community by taking care of and raising new born orcas, as well as hunting in packs to more effectively provide food for the group. Additionally, these pods may connect with other pods during certain times of the year to hunt in larger packs, thus making the search for and acquisition of food more readily available to all members of the larger group. This formation of the larger community of orcas is also needed for breeding newer generations of orcas. Now, this isn't a very strong presence of communism, yet, we see that the individual orcas generally do work for the needs of the whole through their hunting, breeding, and child rearing needs.*

The next stop in the world of nature where communism can be observed is in the world of primitive man. In an earlier post, In Defense of Capitalism, I posed that capitalism is inherent in human nature, so how can I then say that primitive man also held communist beliefs? Let's go back and take a look at the hunter/gatherers and farmers from pre-historic times, and dive a little deeper into the origins of their functions. When man first began forming the clans and communities, the basis for the formation was survival of the current generation and the addition of the new generations. These clans had a sense of community in which, similar to the orcas, these clans worked for the needs of all within the community by hunting/gathering or farming for food. Additionally, child rearing was a communal activity in which children in the clans were raised by all adult members, ensuring survival knowledge was passed from one generation to the next. Certainly, as these communities grew, and clans separated to form other communities, these similar activities took place until at some point, the communities found survival of the larger communities depended on capitalistic activities. So did capitalism evolve from communism? In human nature, it seems so, in that capitalistic activities found more efficient ways of providing for needs. But let's take one more stop on this journey.

The last stop is modern man. Modern man has shown that the capitalistic or free-market economy is the best way of distributing goods and services. Centralized government controlled allocation of resources has shown to cause shortages in goods as well as flourishing black market activities. The countries of Russia, China, and Cuba are perfect demonstrations of how socialized distribution of goods and services cause rampant poverty, which is why the governments of Russia and China are moving to a hybrid form of socialist/capitalist economies. But there are those who still believe in living in a collective community where all workers do so for the benefit of the whole community. Localized communes attract men and women who believe in the communist philosophy of a collective ownership of property where the organization of labor is for the common good of all members. But in order to make the modern commune work, there has to be a strict commitment to the commune by each member.

According to the economic theory of clubs, if there are public goods (those that the consumption of which cannot be excluded to members of a community), these public goods can be efficiently produced and consumed by self forming groups of individuals. A potential problem for clubs is free riding, that is, the joining or continued participation of members who do not contribute their fair share and yet who consume the public goods produced by the clubs. The egalitarian distribution of wealth and income, which characterizes communes, poses a severe problem of free riding. Lawrence R. Iannaccone argues that requiring commitment through constraints on dress, grooming, sexual conduct, and so on, retards the free-riding problem by screening nonbelievers and helps to bond members together. These seemingly arbitrary impositions on personal conduct may, therefore, serve a useful purpose.**

Even in our own lives we see individual communal efforts. Whether those efforts relate to our family, friends, organizations, jobs, towns, states, and even our country, we all exhibit at least one part of the definition of communism. Our labor is organized, through free markets however, for the common advantage of all members. What I mean by this statement is that as individuals, we all see an area in which we can contribute our skills best to the betterment of ourselves and ultimately to society as a whole. When individuals optimally utilize their skills, they provide the labor necessary to accomplish goals. These accomplishments are rewarded monetarily, which we then use to to consume items created and services provided by other workers, yielding advantage for all members within the local, regional, national and international communities.

Over time, man has experimented with both forced communism and voluntary communism, and studies show that communism only works when there is a full commitment to the ideal. When our passions for freedom interfere with those commitments, communism falls on its face. Additionally, free markets run without oversight of consumer protection tend to fall hard too when they fail. In order to minimalize these failures, in my opinion, humans must find that happy medium where individual and communal needs are met with capitalistic activities.

So are we communists, capitalists, or a hybrid combination of the two? One could argue that we, as humans, exhibit qualities tending toward a hybrid combination. We tend to take care of our friends, families, and communities because of the passion that we have for each of those entities. Believers in free markets see that the best way to ensure we can provide the best options for these entities do so through the participation in capitalistic ideals. Why defend communism, as the title of the blog states? Because the root of communistic ideals is community, and the betterment thereof. If we humans set the high goal of benefiting our communities, we in turn make ourselves better individuals. In turn, societies become greater and quality of life improves. Let us not lose sight of those goals, and the best ways to achieve those goals.

*Information about the orcas' behavior was found at http://www.seaworld.org/infobooks/KillerWhale/behaviorkw.html
**Clifford F Thies. (2000). The success of American communes. Southern Economic Journal, 67(1), 186-199. Retrieved July 28, 2009, from ABI/INFORM Complete. (Document ID: 56582143).

The Baseball of Economics

2009-07-20T11:52:00.000-07:00

“You can observe a lot by just watching.” – Yogi Berra

Many of us are familiar with baseball, whether it is a deep knowledge of the game, or just the knowledge that the game exists. The same can be said about our knowledge of economics. There are brilliant economists with deep knowledge of the inner workings of economies, and there are those who are aware that economics exists. Economists gain their knowledge through consistent study and mathematical experiments while most of the world gains their knowledge through televised news reports, newspaper and magazine articles, and internet blog postings. This posting is intended to explain economic workings a little better though analogous workings of a sport many of us know and love.

"A good friend of mine used to say, 'This is a very simple game. You throw the ball, you catch the ball, you hit the ball. Sometimes you win, sometimes you lose, sometimes it rains.'” – From the movie “Bull Durham”

Both baseball and economics have many statistics that are always discussed. In baseball, you see statistics for pitchers’ ERA (Earned Run Average), win/loss percentages, balls pitched vs. strikes pitched, and games saved for relief pitchers. Hitters are measured by batting average, slugging percentage, and on base average to name a few. Fielders have fielding percentages and errors committed. We could sit down with the game and identify many other statistics that may have deeper meaning, like how a pitcher fairs in a certain ball park in July when the team is leading their division. Or how batters who switch-hit perform against an individual pitcher or a team’s pitching staff from which side of the plate he is hitting. We could look at team performance in day games vs. night games. Truly we could get lost in numbers to the point of where any decision made has some kind of relevance, statistically speaking.

The same thing happens in economics. We can bury ourselves in statistics concerning GDP (Gross Domestic Product), and how industries go through cyclical trends affecting the overall GDP. We can speak of consumer spending and consumer confidence while looking at savings and investing rates. We can look at unemployment numbers to see if we are in a period of dire unemployment, significant underemployment, or if employment rates are what would be considered normal. We can analyze trade imbalances, industry shifts, political persuasions, taxation, and the effects of all of these items and many more until we can identify any decision made by business and political leaders have some kind of relevance, statistically speaking. In both cases, knowing how to shape your statistical analysis is key in order to point to that statistical relevance. However, statistics aside, baseball, like economics, loves activity at its base – the movement of the ball in baseball and the movement of cash in economies.

So let’s dig a little deeper into the quote and see how we can relate baseball to economics:

You throw the ball – In baseball, of course the pitcher initiates action on the field by throwing a pitch to the batter. If the ball is hit and is playable (not a pop-fly resulting in an out), the fielder is then going to throw the ball to either try and get the runner out, or to hold the runner at a particular base. In economics, the throwing of the ball is activity, or in economic terms, cash flow. Banks and/or investors initiate activity by putting investment capital into the economy in order for economic activity to start.

You catch the ball – The ball leaves the pitchers hand and moves towards the catcher. If there is good communication between the two, and the pitcher throws the ball specific enough to what the catcher is expecting, the catcher will catch the pitch, and then throw back to the pitcher. That is unless the batter hits the ball, in which case a fielder is required to catch the ball in order to get a runner out, or hold that runner at a base. In economics, catching the ball is equated to making good business and economical decisions through good communication and observation. When a bad decision in either is made, you hear the term “drop the ball”.

You hit the ball – The opposing team, of course, is trying to hit the ball and score runs. Does the batter hit the ball hard for a potential home run? Should they line it into shallow right field for a base hit? How about a driving hit down the third base line to score runners? Or even the bunt to move runners around the bases? Maybe simply your goal is to make the pitcher work by throwing you lots of balls, so you fight off bad pitches in foul territory, getting the pitcher’s pitch count up, wearing him down for future batters. Surely, there are many opportunities for a batter, if they are good enough to do any one or more of these activities. But you are an opposing business or other economic entity (government, charity, individual, etc…), and you need cash. How do you analyze the situation to know whether to lay down a bunt or swing for the fences? Should you swing at that outside curveball, knowing you will foul it out of play, but making the pitcher tired by causing him to throw more pitches? As with baseball, the situation at hand dictates the decision to be made. A business might swing for the fences by launching a big product, but end up striking out when that product fails. A business might lay down a sacrifice bunt (getting rid of a product) in order to move the runner to better scoring position (re-aligning another product’s marketing, manufacturing, distribution, etc…). Should a firm not be aware of the situation, and make a costly error (sacrificing a line-drive hitter by having him bunt instead of swinging for the outfield with runners on base), the firm will find itself in a situation where it will lose more than it will win.

Sometimes you win, sometimes you lose – In baseball, the team with the most runs at the end of the game is the winner of the game. At the end of the season, you have playoffs between the teams from each division that has the most wins, eventually leading to league championships, and series championships. In economics, the team (business, country, individual, etc…) that has the most wins through consistently good decision making ends up on top in their division in some way shape or form. A restaurateur wins when his business consistently attracts people to come eat at his restaurant(s). A consulting firm wins when a large majority of their consultants are out on projects. Conversely, an apartment complex loses when their have a high vacancy rate. Car manufacturers lose when consumers discontinue buying their car lines. Through careful analysis and decision making, a team can end up in the World Series, and a company can rise to the top of the Fortune 500 list.

Sometimes it rains – There are days when the weather is bad to the point where a game is not played on a particular day. That game is either made up on a later date, or not played at all if it becomes insignificant to the overall placement of teams in playoffs. In economics, there are days when businesses and individuals don’t play. Could be that businesses don’t invest to grow or hire additional employees because of current factors in the overall economy. Could be that the overall economy doesn’t play because of lack of cash flow from businesses and individuals. Mainly, there are sunny days where the economy gets the chance to play, but every once in a while there is rain as well, stopping or slowing the play of economies.

So let’s piece this together and relate the game of baseball to economics, hopefully giving a better understanding of the world of economics. As in baseball, economies love activity. The movement of the ball (cash) in order to stimulate activities (catching, running, throwing) and force decision making by all involved in the game itself. By carefully analyzing relevant data, the pitcher can make the decision to throw a certain type of pitch. Similarly, banks and investors can make decisions to put cash into play. The pitcher is looking to either strike out the batter, or force the batter to hit a ball in play where there is an out at the end of the activity. The banks and investors want their investments to have a positive return on cash by making the competition miss the cash opportunity, or misuse the cash opportunity. The hitter (the competitive opposition) is looking to take advantage of the cash for their benefit, by either achieving a short term goal of getting on base (successful business decision), by making the pitcher work harder to see a positive return (forcing banks and investors to make more cash infusions or change the way the cash is infused in the economy), or by achieving the long term goal of a win and championships. If the opposition makes the right decision and puts the ball (cash) into play, the fielders (business supporters) try to recapture that cash and use it in a way to stop the opposition from seeing a positive return. The runners (business supporters) also try to make the opposition work harder to keep the ball (cash) moving in favor of their team.

In its simplest terms, both baseball and economies boil down to simple activities that are analyzed to make better decisions. Don’t throw an inside fastball to an inside fastball hitter – don’t invest cash in a business opportunity that you know is certain to lose. Don’t lay down a bunt if you are the slowest player on the team and no one is on base – don’t waste a business opportunity by spending cash on a project that you know is doomed to fail. If you are a hitter with speed, try to hit a line drive into the right field wall so that you can advance to second base on your at-bat – If you are an individual who has had success investing in stocks and bonds, don’t try your hand at commodities (at least not without a lot of training!). If your left fielder is your best outfielder and hitter, make sure his order of appearance in the batting line-up gives him opportunities to put the ball into play – if you have an employee who excels in mastering various tasks, give her the opportunity to make decisions in your company. And if you know that pulling the double-switch in the 8^th inning will give you a better opportunity to win the game, make sure that your best pinch hitter is available and does not replace another crucial fielder/hitter – If you have the opportunity in economics to make a significant change, ensure that the change you make will be in the benefit of your team and not the opponent.

As seen in this writing, we can find many analogies between the game of baseball and economics on many levels. Hopefully in the text, there are eye-opening statements that help you, the reader, better understand economics. Just remember when you are reading a news story on the internet, watching a report on the news, or debating with a friend, economics at its core is a very simple game:

“You throw the ball, you catch the ball, you hit the ball. Sometimes you win, sometimes you lose, sometimes it rains.”

“You move cash in favor of your economic entity, you prevent your competitive economic entities from taking advantage of cash, you make your opponents cash opportunities work in your favor. Sometimes you make good decisions and achieve goals, sometimes you make bad decisions and have to regroup, sometimes you see no economic activity.”

The last part of this quote from the movie is: “Think about that for a while." I hope that you will.

In defense of Capitalism - why free markets flourish even in the shadow of government controls

2009-07-09T10:34:00.000-07:00

"When we hang the capitalists they will sell us the rope we use." - Joseph Stalin

A statement on its face when it was made certainly looked like it would be a truth at many points in world history since it was first made. The Soviet Union being a world super-power from the end of World War II until recent history threatened free-market societies by imposition of force, and the threat of war. Many leaders stood their ground against the Soviets, and certainly others embraced the Soviet philosophies of economics, government, and society. In today's world we have seen once strong communist/socialist countries shift their ideals to be more free-market capitalist societies, or a hybrid thereof. Glasnost and Perestroika led the Soviet empire down a path of deconstruction of centralized state government, and China is now too opening up more to capitalistic ideals while they are experiencing rapid growth into a role that many are calling super-power status. But did internal capitalism in these two countries play a role in their shift?

Throughout the history of man, capitalism in its basic form led to the organization of clans, tribes, villages, religions, and nations. Anthropologists discovered that early man was generally placed in one of two groups: Hunters/Gatherers, and Farmers. The Hunter/Gather group set out looking for food to support their families and fellow tribesmen, whereas the farmers generally found land where they could cultivate food and stayed put in that area as long as the crop yield supported the tribe. Of course, skirmishes and battles between clans and tribes took place either over food sources or access to other basic necessities such as shelter, water, and favorable climates.

As man moved through history, capitalism played the role of forcing tribes to analyze their risk/reward for their actions. A Hunter/Gatherer group may see that the risk of traveling outside of their known favorable climate might lead to better hunting grounds where they could flourish, or maybe they stumbled into an area barren of food and and water. Same with the farmers, their risk of planting seeds may reward them with a bountiful crop, or their food source could be completely wiped out due to animals eating crops, weather destroying fields, or travelers passing through ravaging crops for food.

Additionally, these people knew that their efforts of investment should yield a reward. If, for example, a tribe planted a field whose crops were destroyed by weather, insects, or natural disaster, these people might either move to a more favorable area or build up a defense against the attackers on their crops. Same with the Hunter/Gatherers, should their efforts of stalking game on a hunt provide little to no food yield, these groups would either move, take up farming (if it is more favorable), or attract game to the area for an easier kill. Efforts expended must yield some sort of reward, else those efforts will be shifted or stopped all together, sometimes stopping due to death from famine.

As societies grew, and leadership positions in these groups were formed, humans began to place rules and laws among themselves to benefit each other. Basic rules against theft, murder, and other rules such as when to plant and where to hunt were formed. A hunting ground may become forbidden territory because of dangers posed, and tribesmen avoided those areas. Maybe too, an area that once flourished with planted crops, and then went barren, may be labeled as forbidden territory in order to prevent other farmers in a tribe from wasting time planting crops in that area. Furthermore, as societies grew and people began to interact, Hunters/Gatherers began to trade with the Farmers, creating markets for items not local to these separate tribes.

As time moves forward, and now we have trading taking place, more rules and laws are put into place, even if localized, to facilitate better relations between societies. What is 200 pounds of freshly killed meat worth to a farmer, 200 pounds of freshly harvested grains? Somewhere along the time line, exchange rates were formed between the two groups of people, and eventually societies began to meld where Hunter/Gatherers lived side-by-side with farmers in lands where both crops flourished and game animals were plentiful. The Farmers certainly saw a benefit of interacting sociably with the Hunter/Gatherers, as the Hunters kept wild game from destroying crop yields, and Gatherers brought back new food that could possibly be cultivated locally, giving the Farmers opportunities to provide more food through their efforts.

Now we have localized societies living together and flourishing together, other services became necessary if people were to stay in a local area and not move around searching for better hunting grounds and fertile territories. Education became a big need, as lessons learned about prior hunting and farming techniques needed to be passed along generations. Additionally, clothes needed to be made and repaired if the people were going to protect themselves against weather and climate changes. Houses needed to be constructed in order to give shelter against weather, wild animals, and of course to store needed items. Wood needed to be gathered for fires used to stay warm and cook food. Vessels that people used to cook food were needed to be made. And of course, leaders were needed in order to keep societies at peace with one another.

Eventually, these other services took place of the Hunter/Gatherer and Farmer functions. So how could a Potter be rewarded for the work performed? Is a set of pots worth 20 pounds of fresh meat or 20 pounds of freshly harvested grains? Even so, should a Potter exchange all of his wares for an extraordinary amount of food, how would he keep it fresh for his family? What about the Farmer who needs pottery, but whose crop will not yield until many months later, should he have to wait until his crop yields in order to obtain pottery? It was at this point where currency and trade really became an important factor in the history of man.

So how do you do an IOU between Potters, Clothiers, Builders, Farmers, Hunters, and others? Some form of desirable items that are common were used in order to facilitate delivery of goods at a future date. Many societies used colorful beads and rocks as their form of currency, but soon found that without an identifying mark and controls over the currency, these items could be counterfeited. Either a new form of currency was needed, or a system of controlling the transfer of beads was needed. Additionally, where could one keep his beads safe from theft? New services were of course born out of this need, and became the basis for a future banking and currency systems.

Now we have villages formed with basic needs of food, clothing, shelter being, and trade being met through laws, rules, societal norms, all through interactions locally and with other villages. Eventually, these villages had to adopt rules and laws that all could agree upon as government, and religions began to play an important role in the creation of these rules and laws. As nations form, leaders desire more power of rule, or need to attain more lands for their people to thrive and flourish. Some of these leaders begin imposing laws restricting trade, and centrally manage currencies. Additionally, for the privilege of the people having government entities providing services of law, defense, and even contributions to deities, taxes were levied to pay for these needs.

But what about Capitalism at its root? Did these laws prevent trade? Did people skirt the issue of taxes? As people began thwarting efforts of governments, so-called black markets were formed where people could exchange goods and services without the over-watching eye of government officials. Certainly, once these markets were discovered, people participating in these activities were punished. However, the black-marketeers profited heavily since demand for the items they sold was high; there was a huge risk/reward factor involved. Additionally, with the creation of craft guilds, black-marketeers found a huge opportunity to create inferior products based on what trade craftsmen made, and sold low quality products at a lower cost than what guild members created, still making huge profits for the black-marketeers since the price/cost margin was great. And with black-market transactions not being reported, or in business terms accounted for, governments had no recourse to impose taxes on these illegal trades. Being a black-marketeer was hugely attractive to people willing to risk the imposition of penalties of law for the reward to making extraordinary amounts of trade currency.

So let's move through time to recent history and modern day. Black-market trading exists in areas where capitalism is stifled. Go back to the 1980's, and recall stories of people in the Communist Soviet Union buying Levi's blue jeans at a risk of being jailed, and paying high currency amounts for the privilege of owning a pair of these jeans. In China, knock-off products of luxury items found their way into the marketplace. Even today, these marketplaces are out in the open in cities like Beijing and Shanghai, where formalized markets like the Silk Market and the Pearl Market exist, while street vendors will try to sell you just about anything you want for a price. Cuban cigars are illegal in the United States due to trade sanctions, but people will bring them in from outside the country regularly. Cocaine, being an illegal and dangerous drug, still yields high profits for dealers who risk severe jail time and even death.

So how did internal capitalism in the Soviet Union and China change these countries from Communist/Socialist societies to ones that embrace free-market ideals? As we have seen through the history of man, capitalism is a base ideal formed through meeting basic needs. In order for people to perform certain tasks, there must be a reward for performing those tasks. Whether it be avoiding jail, avoiding harm or death, earning money, or simply providing food by hunting/gathering, farming, and shelter by building a home, the reward must meet the risk and effort. It is as natural as breathing that we, as people, yearn to meet needs. No amount of governmental rules, laws, regulations, and other attempts to stifle our internal capitalistic needs can survive permanently. Eventually, the economics of stifling capitalistic functions indicate that the cost/risk of preventing capitalism is not worth (in monetary terms) the effect/reward of stopping these functions.

As the Soviet Union found, the United States and her allies were much more powerful adversaries than what they once believed, and it was because of our societal beliefs in freedom and free market enterprises. Additionally, China discovered that although they tend to be more focused internally, there was a powerful trade partner across the Pacific Ocean that would help them to build up their economy, providing better living for their people. These two countries learned powerful lessons about capitalism and its effects, the most prolific being that when free-markets flourish, so do the participants in those markets. Both countries found that instead of trying to outspend a country whose gross domestic product (GDP) accounts for nearly a quarter of the world's GDP. it was better to trade with and invest in that country. Today, China owns a significant portion of our Treasury debt, while we currently openly trade with the Soviet Union. Levi's blue jeans in Russia today cost significantly less than those illegally obtained blue jeans of the 1980s, and the Russian government can now tax those imported jeans, finally making money off of the transactions rather than spending money trying to stop them.

Yes, Mr. Stalin, capitalists will sell you that rope, but only if the sale of that rope meets the needs of the marketer, and perpetuating your ideas and ideals never met the needs of free-market capitalists. Rather, your need of rope to hang free-market capitalists was so high that you were willing to pay any price for that item. Free-market capitalists saw this, and charged you heavily for the rope, knowing that you could not afford the rope, the gallows, and the hangman. This rope you bought was was later used by your fellow countrymen to throw out as a lifeline to the free-market capitalists. The free-market capitalists then pulled hard on that rope made of good quality material, and brought your country back to a safer place, far away from the depths of misguided thoughts where you believed that you could change basic human needs.

"The Deadliest Catch" - Lessons in micro-economics

2009-07-03T09:31:00.000-07:00

"If you are going to be stupid, you better be tough. Mother Nature does not play favorites."

Statistically speaking, it has been determined by people far smarter than me that crab fishing in the Bering Sea is is the deadliest and most dangerous job in the United States. The Discovery Channel several years ago produced a documentary on this occupation, which of course led to one of their most successful series, "The Deadliest Catch". So what is it about this occupation and lifestyle that keeps our eyes glued to the television sets each week? Is it the romance of the sea? Is it watching in anticipation of danger, like we watch NASCAR for the wrecks? Is it the fact that a mere deckhand can make a lot of money in a short amount of time working? Is it the personalities that the producers focus on that bring us in to watch the show? A combination of things associated with all of this drama?

For my entertainment enjoyment, I watch with anticipation of how human interaction on the fishing vessels play out, because each person plays a vital role and the interaction between the crew is vital for the success of all on board each boat. The captains have to navigate through dangerous waters to find the crab, while the deckhands have to bait, set, and retrieve crab pots at the captians insistence. If one of these functions breaks down, someone has to jump in and take over, and your supply of labor to perform each function is scarse and limited. Most of the boats shown on the show have crews of less than 8 people, making cross-functional skills vitally important for each crew member.

Ultimately, the captain has the final say-so about the activities on board the vessel, but the captain can not force activity from his crew without providing an incentive for the crew to perform their duties. It is this interaction between all on board the vessels, as well as the interaction between the captains and the processors, the captains with the boat owners, and captians/owners with government officials at each level that I will explore on a micro-economic level.

The deckhands, deck engineers, and greenhorns are the backbone of the workforce in any fishing fleet. What incentive does someone have to risk life and limb to work 36 straight hours in miserable weather conditions? Obviously, the first answer is the opportunity to make a lot of cash in a very little amount of time. Crew members routinely walk off the boat after an offload of product with several thousand dollars in their hands after only 4 - 6 weeks worth of work. If these crews could make that kind of money consistently, most would earn 6 figures within the first 4 - 6 months of their work year. When the crews come back to work year after year on the boats, they move up in the payout scale, thus earning more money per trip than the prior year, given that the crab boats catch and sell crab consistently. But catching crab is not a given. The captain of the boat has to figure out where the crab lie so that the boat can make the catch. There is a demand of the captain by the crew to find the supply of crab so that the crews' incentive to work stays high. Inevitably, the crews pull empty pots and moral demoralizes quickly and their work pace slows. When the crews pull fuller pots, their moral shoots up and their work pace quickens, even after long arduous days. It is incumbent of the captain to get as much crab on the boat as quickly as possible in order to satisfy the psychological needs of the crew, keeping them working and focused.

Once the boat is loaded with its catch, it must return to port to offload the catch to a processor. The processor sets its prices per pound of crab caught based on their economic research of supply and demand. Obviously, the consumer is willing to pay a price for the enjoyment of the crab. It is up to the processor to determine the price it is willing to pay to the boat captains and owners for live crab based on what the consumer is willing to pay. If the boat captain or owner is not satisfied with the price the processor is willing to pay, they are not in a position to effectively negotiate pricing up or down. Their only recourse is to provide a high percentage of live crab to the processor, and ensure that the processor gives them a fair count of their live haul. Pricing of the crab is known prior to the season starting, so the captains and boat owners know what level of live catch is needed to ensure operation of the vessels. Working in this set price environment, demand is set and it is up to the captain to meet the supply.

After the offload and the boat owner has been paid, the money earned must be distributed to the labor. As a boat owner, costs of operations must be met in order to continue operations. Boat maintenance, labor, equipment, insurance, and fuel must be considered before any profits are taken. Of course, there are other considerations, such as taxes, fees, and licenses as well, which will be discussed in a following paragraph. Of the overhead costs of operations, labor is the most important consideration. You could own the biggest and most modern vessel in the fleet, but without a captain and crew, the boat becomes a floating paper-weight. The boat owners know this and seek out the best crew for the price. Before setting sail with a crew, labor prices are negotiated. The price of labor is based upon production levels, and typically the negotiating strength weakens the lower you go in the crew hierarchy. A captain will command a much higher share than a greenhorn, and the captain has some leverage in his labor price negotiation if he has proven to be a consistent performing fisherman. A greenhorn, and the other hand, is basically a cog in the wheel of the machine, and must perform to his highest level in order to prove himself worthy of the share earned, and possibly an opportunity to return the following season and make a higher share.

In the sense of a boat owner, the demand is for a great crew to operate the vessel is high, and the supply for quality captains and crews is low. However, pricing of labor is set by the income from the catch, so percentage pricing comes into play. As an example, a 20 year captain who has brought in several million dollars of income to a boat owner should command a higher share percentage than a 2 year captain who has just started his career. Greenhorns really have no say in their labor price, and deckhands who have many years experience tend to get an industry standard share. So in order to balance the costs of operations, owners must ensure that the percentage of the labor share covers the cost of a skilled captain and crew, yet yields profits after other costs. The supply of a percentage of the haul must cover the demand of labor, specifically the experienced captain and crew with some left over for the cheaper and less experienced labor of the greenhorns.

The State of Alaska issues permits to these vessels allowing them to fish in waters bordering the state. Additionally, these boats go into international waters, which are of course covered by treaties between nations. And too, the United States Coast Guard, a military branch of the United States Government, must be on the ready to warn vessels of impending danger, conduct safety inspections, and attempt rescue should a boat and/or crew need assistance. Surely we see governments supplying needed services and resources demanded by the fishing fleet. The costs of these services are set prices as well, either through flat fees or percentage of income in taxes. Pricing is non-negotiable, so the basic economic functions are primarily demand driven.

As we have explored in this writing, supply and demand functions of micro-economics come into play a role across all levels of operations of a crab fishing vessel in the Bering Sea. Of course, these same functions apply across every business operation, but not every business operation has given permission to be filmed in a documentary series either. So, the last exploration of these economic functions should be The Discovery Channel, and its decision to air The Deadliest Catch.

How many would tune in week after week to watch a series on corporate accounting? Doesn't sound too exciting to watch, but there certainly is some excitement for those people who perform those functions. Through its marketing research, producers and executives at the Discovery Channel found a demand for the series. After finding this market, they have put film crews on several fishing vessels to capture the stories told for television entertainment consumption. As ratings for the series climb, the channel can charge higher rates for advertising during the program. Supplying airtime to businesses demanding to advertise their products to the viewers of The Deadliest Catch.

The observation and exploration of economic functions helps many people make better personal and business decisions. As you go through your day, pay a little more attention to the economic activities that surround you that you may not have noticed before. Explore in your mind how the laws of supply and demand create activity and drive psychological and sociological decisions. Critically think, too, how small scale activities and large scale activities effect each other, and ultimately yourself.

Disclaimer: The Deadliest Catch is a copyrighted and trademarked product of The Discovery Channel, its parent company and subsidiaries. The names used in this post were to illustrate examples, and are in no way affiliated with the writer of this blog. NASCAR is a copyrighted and trademarked brand. No attempt to benefit from the usage of any copyrighted or trademarked name was made in the writing of this blog posting.