Notes on Economy — Part IV

Link to Part III

Idea of Profit

Profit is one of the most debatable ideas in economy. People such as Karl Marx, Bernard Shaw, and Jawaharlal Nehru all opposed the concept of profit making. Prime minister Nehru is reported to have said to Tata, "Never talk to me about the word profit; it is a dirty word.". Hence, we can deduce that, profit making has different meanings in different economic models.

In a price-coordinated economic system (capitalism), profit acts as an 'incentive to creativity'. In an economic system without profit, there is no need of innovation. This means that the standard of living for any individual remains the same — perhaps, it might decrease. 

In socialism 'profit' is considered as an exploitation of the labour. A capitalist can only earn profit if he forces his labour to produce more than the intrinsic value of the product. For example, if the manufacturing cost of a product is 10 rupees, and the capitalist pays only the labour cost for producing this product. The end result would be that the capitalist won't earn any revenue. This is because, the labour value must equal the production cost in a socialist system. The capitalist can only earn a profit, if he forces his labour to produce products within the intrinsic. Hence, while he pays the labour only 8 rupees. The excess 2 rupees in called the capitalist profit or the exploitation of labour.

Nehru tried to develop Indian economy in a socialist framework. There is was profit — hence, no incentives — in such an economy. Sowell gives an apt example of an India car manufacturer 'Hindustani Motors' (HM). HM manufactured a car called 'Ambassador'. This car was a total replica of the 1954 model British car named Morris Oxford. The design remained the same for the next 25 years, with no technological innovations — as innovations don't convert into profits in a socialist economy. Therefore, the quality of Ambassador car remain the same as it was 25 years ago. Furthermore, people had to wait for months to buy a new car. The Indian government had disallowed the import of new cars from outside. As a result, many Indians couldn't own a personal car, and those who had one, the car was out-dated and less efficient. It was expensive to afford an Ambassador as there were no innovations for increasing engine efficiency and mileage per litre petrol.

In should be noted that by excluding profits, socialist economies add in systematic inefficiency. On the ither hand, capitalist economies trade off profit for removing systematic inefficiencies. At the end of the day, capitalist economies allow standard of living to increase.

It is this idea of profit which allowed Western Europe and United States to continuously increase product efficiency. Take the examples of iPhone, iPods and iPad. Apple launched two different versions of iPhone in the same year, while the new iPad 3 was launched in less than an year time. iPods have evolved from simple MP3 players into devices which are equivalent to smartphone and tablet.  All these innovations occurred in a short span of 6 years. Compare this with the development of the Ambassador Car by HM. There was no innovation for 25 years, as the manufactures found no profit in increasing efficiency. 

To conclude, profit plays an integral role in maximizing efficiency in a price-coordinated economy.

Notes on Economy — Part III

Link to Part II


Importance of knowledge in an economy


Knowledge is the most scarce resource of all. In an economic system, millions of consumer buy millions of different product at any specific point in time. As predicting a future demand-supply curve requires absolute knowledge of all these millions of event, it is extremely difficult to conjure.

Any economic system which can handle this flow of market knowledge efficiently, will be the best economic system for the material satisfaction of humans.

There are two ways of managing knowledge, the first is a centralist model (communism) and the second is consumerism (capitalism). In a centralist economic model, knowledge flows from top to bottom, while in a price-coordinated economy, knowledge flows from bottom to top.

The flow of market knowledge in communist and capitalist systems can be understood using the idea of supplying petrol to different petrol pumps across a country. In Pakistan there are about 3,400 CNG pumps. Let us assume that there are 10,000 petrol pumps in the country (I tried to get a figure from APPRA (All Pakistan Petroleum Retailers Association), but no one picked up the phone). All these pumps spread out over a very large surface area, from Karachi to Gilgat. It is near to impossible for a centralist planner to gain all bits of knowledge, and than supply fuel accordingly. The planner won't be able to predict peak-time petrol usage in a specific area; the political conditions in a specific area, which might decrease or increase petrol consumption; how much petrol will be required on daily bases, et cetera. The central planner, to the best of his knowledge, would allocated fix rations of petrol for all areas, and therefore, petrol supply won't vary with consumer demand. There will be excess surplus in some regions, while a shortage will be recorded in others. Maybe, violence in Quetta might halt all traffic, while a motor-race festival in Karachi would inevitably increase petrol demand. A central planner can never have a precise knowledge of such intricacies, forcing the system to follow the personal whims of the central planner.

On the other hand, in a price-coordinated economy, demand-supply transcends central decisions. The dynamics of demand and supply would automatically be managed by petrol pump dealers. If a motor-cross event is going to take place in Karachi, the petrol pump owner would simply purchase more oil from the company, while in case of violence in Quetta, the petrol dealer won't make a oil transaction for tomorrow. Hence, knowledge in a capital system is dynamically controlled. The system automatically synchronizes without any central effort. All petrol pumps receive a dynamic amount of petrol and CNG according to their local knowledge. Intricacies in demand and aberances in supplies are all handled by the petrol pump owners, not by a central planner. This increases efficiency, and surplus petrol finds the best alternative use rather than filling petrol tanks for no use.

Surplus and shortages in an economy


The idea of surplus or shortage of goods has a direct relationship with the importance of market knowledge.

Sowell writes that in a rigid-planned economy, i.e. a centralist system, demands are rationed on static principles — such as the example of petrol described above. The absolute majority of good in a region either results in a surplus or a shortage. It is a frequent event in a rigidly planned economy to find the same product to be in surplus in some regions and to record a shortage in others.

In a free market, demand causes prices to rise when goods are in short supply and vice versa. The price tags around a product would urge a capitalist to sell his products in an area where prices are higher. This movement of products from area of low price tags to an area of high price tags creates a dynamic balance and uniformity in prices across the whole country. This phenomenon is visible in Pakistan. Oil prices only vary around 5% across the whole country signifying the benefits of free-market.

Link to Part IV

Notes on Economy — Part II

Link to Part I

Role of taxes and subsidies

Taxes and subsidies act as distortion in a price-coordinated economic system. Sowell writes, "These extra tags give focus on one subject and discard all other variables."

In India, electricity is free in the agricultural lands of Punjab. This allow farmers to produce cheaper rice allowing India to export more. Although this generates revenue of the country, but there is a big downside to this. The water-table (amount of water below the soil) decreases rapidly making the land no more cultivatable. Secondly, an artificial price of rice creates a surplus, which leads to starvation.

In Pakistan, indirect taxation on petroleum products help oil companies to prosper. On the other hand, they don't invest in exploration as taxation allow them to grow larger. Similarly, the government gives a cross-subsidy on gas, causing a rapid decline in Pakistan's gas reserves.

In United States, water supply in the state of California are heavily subsidized. A Californian farmer pays less than 1% for the same amount of water consumed in New York. As a result, agricultural outputs consume 4/5 of the water resources to produce just 3% agricultural output.

In a true free market, taxes and subsidies should be applied equally, and there should be no support for any product over other. Unforgettably, taxes and subsidies are used by politicians to meet their political objectives. They play with the dynamics of free market causing deterioration in the standard of living.

For example, in President Musharraf's last year in office, 2007, the government gave a 35 billion rupees subsidy on oil petroleum. This was done to attract voter's attention  towards PML-Q (Gen. Musharraf former party). Although this tactic failed, but economically speaking, it was a disaster for Pakistan's economy. A huge circular debt accumulated, the rupee devalued, and  an immediate removal of subsidy caused public anger towards the new democratic setup back in February 2008.

What is incremental substitution?

Incremental substitution is a pure free market concept. Unlike setting up 'categorical  substitution' — like national priorities, explained below — Incremental substitution means to shift allocation of resources on the basis of their consumption or production. Using the idea of incremental substitution, a free market can chose  product A and product B simultaneously. 

For example, if the price of apples soars, the whole market doesn't shift towards mango. Say, 35% shift towards mango, 40% shift towards watermelon while the 25% still buy apples. This is incremental substitution at work. On ther other hand, if a centrally control economy makes eating mango it's 'national priority', mango consumption will record a 100% increase. This will not only increase mangos' price, but would also diminish apples and oranges in the market. 

Another example, Pakistan considers the army as  its 'national priority'. Prioritizing the army over other institutions and services causes a deterioration in the standard of living. 48% of tax payer's money goes for military development. A large chunk of money goes in repaying debts. Hence, a major part of the public sector development program runs either on aid or foreign loan. Eventually, this causes deterioration in the standard of living.

Another example, if a country makes a 'categorical choice' of banning alcohol, the net result would be the scarcity of alcohol product in the country. Citizens would also be deprived from the benefits of drinking alcohol. 

It should be noted that 'categorical substitution' is based on personally whims of the central planner (i.e. a centralist economy), while incremental substitution runs on the dynamics of demand and supply. No external intervention is possible. 

What is scarcity?

Scarcity means that the amount of natural resources are always smaller compared to human desires. Everyone's desires cannot be fulfilled regardless of any economic system.

Scarcity always causes competition in a society. Competition to make the best alternative use of a resources for the betterment of the society. This is an inherent characteristic of a price-coordinated economy. It's always there. A subjective opinion whether this is good or bad is of no use. 

Completion allows creativity to prosper bringing in more efficient products with the passage of time.

For example, there is an ample prove that the world oil supplies — a scare resource — would end at the turn of this century. Today we observe a number of new renewable energy companies competing for this depleting resource. Many world-renowned universities are offering graduate and doctoral programs in the field of renewable energy. The reason we are experiencing these phenomena today is because of the idea of scarcity. Oil supplies were relatively abundant in the 19th and 20th centruy. Now, due to massive industrialization, things are change making oil a relatively more scare resource. 

Scarcity of resources in measured by their price tags. A large price tag means that the resource is more scare. For example, the price of petrol (95 RON) is US$ 0.21 per litre in UAE, while in Pakistan, it's US$1.41 per litre. Regardless of all the taxes included in Pakistani price tag, petrol is cheaper in UAE compared to Pakistan. This more a resource is scarce, the higher its cost.

Link to Part III

Notes on Economy — Part I

All ideas in the following post are taken from 'A citizen's guide to economy by Thomas Sowell'. It's an excellent book which makes economy more comprehensible for non-economists like me. I've tried to extract major themes from the book.

What is economics? 

In the words of Lionel Robbins, "Economics is the study of the use of scare resources which have alternative uses". Economy is all about managing the natural resources for the best use of the majority. We can't have economics in heaven because the amount of resources in there is infinite. Therefore, no planning is required, and hence no economics.

Essentially, economics is about the material well-being of the society. Humans have developed two major economic systems in the last three centuries, i.e. capitalism and communism. Capitalism is a modern form of Mercantilism which from developed between 16th and 18th century, while soviet Communism got it's roots from the writing of Marx and Engels (Das Kapital, Communist Manifesto, and the German Ideology).

Capitalism — as the book explains — is a price-coordinated economic system. A system in which the demand and supply compels production and consumerism. A more efficient and creative company takes a larger part from the profit share.

Communist economy is highly centralist in nature. A centrally planned economy doesn't believe in the idea of making profit, as profit is inherently detrimental to humans. Centrally planned economies believe on the idea of fulfilling all basic human needs, rather than improving product efficiency.

This is a very raw comparison of both systems. A detailed analysis will follow.

What is price?

Thomas Sowell writes, "Price performs the most important function, i.e. to allocate scare resources." It functions as a measure of demand and supply in a society.

For example, nowadays Manto's book 'Manto Nama' costs around 1,200 rupees because Manto's 100th birth anniversary celebrations are on it's peak. The book costed only 600 rupees eight months ago. Why is this 100% increase recorded? In a price-coordinated economy, a increase in the cost of a product means that either the demand has increased or the supply has fallen. In this case, because more people are now reading Manto, therefore the demand increase, causes a price increase.

Another example — this one is from the book — when a hurricane hits a city, the hotel's price of reservation sees a sharp increase. This increase is due to the fact there are no houses are left in the area. Many people are now competing from a small number of hotel rooms, hence the price of reservation automatically increases.

It should be noted that this is not due to individual 'greed', but rather due to simple rule on how a price- coordinated economy works. As the development work starts again, hotel reservation prices begin to fall, gradually coming back to its original position.

This is precisely the reason why houses are expensive near a coastal region compared to suburbs. The coast always has a limited space for development while the construction space in a suburb is many times more compared to the area in a coastal region. More people compete to get a plot in a coastal area, due to its aesthetics or any other reason, which causes a price hike. Prices give a measure on how much a resource is left. As more coastal area is sold, the prices increase proportionally making the land much more expensive.

Making laws to manage a free market

Laws are the basic hindrance in the functioning of a free market. Market laws create an artificial scarcity of resources in a price-coordinated economy, which is essentially an obstacle in the flow of services.

Market laws which try to control free-markets have devastating results on economy. Thomas Sowell gives an example of the rent control law in Sweden, Australia, and United States. He writes, "The rent control laws in these countries increased the number of homeless people, rather than decreasing them. This is a direct co-relation with price control in these areas. There was no scarcity of house construction, but on the other hand, people acquired bigger homes than their need." This caused a decrease in the area of house per person, hence increasing the number of homeless people. Even today, due to rent control laws, many people live homeless in New York and San Francisco.

An example from Pakistan is the government's ban on importing re-conditioned cars. This has increased the prices of the formerly imported re-conditioned cars in the country. Note that — as in the case of rent control laws —  a restriction through market law creates an artificial scarcity of re-conditioned cars. As a result, fewer people can now buy a car in Pakistan.

Link to Part II