Generalizations in Interpreting Supply and Demand Diagrams

In a recent post Hidden Benefits of Taxes we argued that while a tax wedge reduced allocative efficiency, it increased productive efficiency.  With a tax wedge,  a portion of the remaining Social Surplus was allocated to the government, the Harberger Triangle in the diagram being discarded since it was no longer being (inefficiently) produced.  Inefficient production is a waste of resources, often irreplaceable ones.  For a very nice post on this issue, see this book review of:  "Capitalism 3.0 A Guide To Reclaiming The Commons" https://www.amazon.com/s/ref=nb_sb_noss_2?url=search-alias%3Dstripbooks&field-keywords=Capitalism+3.0 (2006) book by Peter Barnes,over at Portrait of the Dumbass

So.  Consider the situation where the source of a product, the factory or the mine, is far from the consumer, and the cost of transport is significant.
The shipper must cover the cost of transport, so the price the consumer is going to have to pay will be much higher than the shipper pays the producer.  We also observe that the quantity bought from the producer will ordinarily be the same as the quantity sold to the consumer.  And we see that if we draw a diagram of the entire process, including the cost of transport, we have an identical diagram as if we had a tax wedge:  The wedge now going to cover the costs of transport, instead of going to government coffers.

Now the wedge covers all transport costs T so we can consider it as the resources consumed to include those that are necessary to support the capital involved in the transport.  This would as well include any retained surplus. What was actually surplus and what was cost to the shipper is not yet defined by the diagram.  Where the infrastructure costs are zero,  the wedge is merely the costs incurred by the shipper.

We note that high transport costs imply that the productive costs must be low, since only the most eager and wealthy of consumers are willing to pay the high prices for the product. Productive efficiency, per se, must be high.  There is thus a large Allocative loss, but also correspondingly large deferred costs.

Now, where transport costs are low, we see that there is still a market for those goods which are produced at a higher cost, with less efficient processes, among those with a lower inclination to pay.  With a lowering of transport costs, there is an increase in allocative efficiency, a reduction in allocative loss, and a reduction of productive efficiency

However, there is another way of looking at low transport costs.  We can say that lower amount of resources given over to transportation support a smaller infrastructure.

So we can consider a rectangular wedge in any situation where there is a cost between supplier and consumer, and the quantity supplied does not change.

Now we will define a community to consist of consumers and the local businesses to support them. The supplier will input into this community.
The supplier will sell to the local businesses, who sell the input to the consumers.  The difference between the price the businesses pay and the price the consumers pay the businesses, times the quantity supplied by the businesses, is seen to support the businesses.

The interesting thing is that the size of this wedge, that is, the size of the business sector in the community, depends on the inefficiencies involved in the conveyance of the input from the suppliers to the consumers.   A totally efficient conveyance between supplier and consumer would eliminate any business sector in the community.

The point is, while from one point of view this wedge is wasted resources, from another point of view it supports the business sector of the community. And from that point of view it is not wasted at all.  Indeed, let us look at the worst possible alternative to the community:  Suppose a more efficient supplier is able to provide inputs directly to the consumer, at just below the price community business would have been able to supply them.  We see that the consumer is marginally better off, but the business sector of the community has essentially been destroyed.  Virtually the entire surplus has been absorbed by the supplier, and the surplus which would have gone into the community to support the business sector is denied the community..



Where the transport costs become low, it may become in the interests of the society to increase the tax wedge, in order to maintain productive efficiency.  And see the previous discussion at http://anamecon.blogspot.com/2017/05/hidden-benefits-of-taxes.html

On the Social Benefits of Taxation

On the Social Benefits of Taxation

Here we present a proof, or at least a demonstration, without words. Or labels.  For the cognoscenti, or even just those having some familiarity with Econ 101, the diagrams as they are should be enough to work out the point. And if not, labels to the diagram and explanation will be provided next week.

The result is quite robust.
Please enjoy.

When, and Why, did the Economy Start to go Downhill

When, and Why, did the Economy Start to go Downhill

This post is in response to a question to a comment I made over at:

http://econospeak.blogspot.com/2015/11/gas-all-boomers-or-at-least-tax-and-cut.html

It is also posted as a series of comments at that site.

rosserjb@jmu.edu  asked the question:

“So, greg, please, exactly when out of all that mess was "the turning point"?” referring to the point at which I said “when the increasing energy cost of energy and other resource production started to be a significant problem.”  The word “mess” refers to the entire price history of oil production.

So:  The short answer might be that point when it became (nominally) more profitable to exploit society, to plunder it, rather than provision it and invest in it.  When it became more profitable to be a pirate, than a builder.  (Understanding this clarifies the motives and actions of the Right, and the modern capitalist. “Greed is good” is the motto of a pirate, not a builder.)   But this transition itself is a consequence of the increased difficulty in extracting resources from the environment.  In particular, non-renewable energy resources. 

So if you want a date, sometime around the Reagan presidency, in perverse reaction to the oil crises of the1970’s.

Roughly:

In the beginning, (Well, once the ball got rolling, about 1880.) http://cdn3.chartsbin.com/chartimages/l_oau_dff4ad5a049ca559d9105471f82bf873

the real cost of energy extraction was low, lower than the cost of  developing the infrastructure needed to distribute and consume the oil.  So the cost of extraction was the benchmark for the price. Only as the infrastructure for demand was emplaced did demand on occasion drive the price.  In the first half of the 20^th Century, because of the- inconsistent nature of the supply and its irregular rate of increase, sometimes demand, sometimes supply drove the price. 

With the opening of the Middle Eastern fields, supply smoothed out.  Supply and demand both expanded apace, the price relatively stable and low.     Until the Arab oil embargo of 1973, and the later panic in 1979 due to the Iranian crisis. The result was an effective and dramatic increase in the *real* cost of oil to the US, since it now had to hand over an increased quantity of goods and services to pay to import foreign production.  Domestic fields were becoming exhausted.  New ones (Prudhoe Bay, etc.)  more expensive to develop.

In an energy based society such as ours, (almost) all inputs can be traced back to the energy needed to support them. Thus the size of the economy can be measured in terms of energy consumption, and this is measured in terms of energy input. This instead of dollars.  With this understanding, the inverse of the EROI, the energy return on (energy) investment, is the portion of the real economy which must be devoted to the extraction of energy.  Only the remainder of the economy is available not only to providing services to society, but also to investment and maintenance.

For EROI, see: "Energy, EROI and quality of life"

http://www.sciencedirect.com/science/article/pii/S0301421513006447

Check out: Fig. 1  The Net Energy Cliff

Now:  From about 2004, supply has been constant, but until the 2008 crisis, demand increased, driving up the price.  Demand and price then crashed with the recession, increased with the recovery, and recently spiked again, and is now again depressed. 

http://www.themacrotrader.com/wp-content/uploads/2012/03/Global-Oil-Supply-1.jpg

The question is why is the price, and demand, now (relatively) depressed. 

We return to the short answer, considering the gradually decreasing EROI, that is, a gradually increasing average real cost of extraction.   

So:  We have two different measures of accounting in an economy:  Energy accounting, and money.  Is the price in money necessarily a faithful measure of the real cost, in energy, of energy production?

Why should it be?  Instances where monetary price does not reflect cost, real or even merely monetary, are common occurrences.  Is the current energy market one of them?  In particular, we ask: “How can we subsidize energy production? 

Well, we can’t.  When we subsidize something, we divert real resources from elsewhere in the economy to promote the production of the subsidized good.  We decrease the nominal cost, and therefore the nominal price at which the good may be offered for profit.  However, the real cost must be greater than if the good were produced without the subsidy. So when we subsidize the real cost of energy, we are merely increasing the real cost of production. (Note:  Subsidizing production is not to be confused with subsidizing the capitalization of production.)   That is, because of the cost of our churning resources through the mechanism of subsidy, we are worse off than if we let the price reflect the real cost of production. 

However, we can still manage to increase quantity produced, and depress price. Especially if we also depress demand.  Remember, those resources transferred to subsidize production can only come from one place:  The remainder of the economy, where a portion of those resources would have gone to maintain and capitalize the infrastructure which supports the economy, the infrastructure which also enables the consumption of oil.  

How much is the subsidy?  Well, according to: http://thinkprogress.org/climate/2015/11/12/3721677/g20-fossil-fuel-subsidies/

the world formally spends about $400 billion per year, one way or another subsidizing fossil fuel production.  (The US, formally, a mere $25 billion.)  Given an inelastic demand curve, this can result in a dramatic reduction in price. 

But there are other mechanisms of subsidy.  For instance, consider the US trade deficit in goods.  All those goods, if made in the USA, would require energy inputs, and concomitant infrastructure, for their production.  Just as agricultural imports can be regarded as water imports, the importation of goods can be regarded as energy imports. So energy supply is increased, while demand is contracted. 

Further, the production cost of fracking, while recently improved, is still above the current market price of oil. (Externalization of costs also represents a form of subsidy.)  This production has been financed in large part by massive quantities of debt. This debt represents an enormous effective subsidy, much, much larger than the formal subsidies provided the fossil fuel industry, especially those debts, (and they represent a substantial fraction,) which will never be repaid.  Considerations of the relative discount rates of oil and money, also suggest the actual effective subsidy is much greater.  (The discount rate of a non-renewable resource should probably be considered at most zero, and more likely negative, since all current consumption necessarily implies less ultimately available in the future, likely coupled with an increase in demand.)  And as above, these debts represent demand transferred from the larger real economy to support the production of energy.

Infrastructure neglect is also an effective subsidy. 

My guesstimate of a price that reflects the real cost, everything I can think of considered, of oil is somewhere well over $100 per barrel.  The difference between that and what we actually pay we are passing to the future, our own and that of our descendants.  It is a price we will begin to pay when the delusion live under (and which requires an input of real resources to maindain,) can no longer be sustained.

So, sometime around or, actually before1980, the leaders of society decided to pursue their own narrow and what may ultimately prove to be ephemeral gains, rather than look after the enduring interests of their society. The actual process of their choosing the consolidation of power has been noted elsewhere.  (Consider also eg the Exxon climate data suppression scandal.)  They propounded an ethos to justify their actions, and geared up their media to convince society of the rightness of those actions.  And the people, for their part, got to live beyond their means, splurging on underpriced energy,  their political acquiescence purchased with their own futures, and that of their descendants.  Most of them.  So now society is in a hole, 30 years and many trillions of dollars of squandered resources and mal-investment, with an economy ill-adapted for a future of costly energy.  

Now some might argue that the economy has not been going down hill for the past 30 or so years.  That we have instead made remarkable progress during that time.  We will address that issue in the next post. 

The Standard Definition of Money is in Error

The standard definition of money is in error. 

The standard definition of money is given in terms of its three functions:

                  1:  Money is a medium of exchange.

                  2:  Money is a measure of value.

                  3:  Money is a store of value.

Number 1 is at best misleading.  Numbers 2 and 3 are simply wrong, and these things are easy to show.  It is also easy to show that this is important.

First, the actual definition of money:

                  1:  Money is a token, or instrument, of demand, which is exchanged for goods or services.  Or simply: Money is demand. 

                  2:  Money is a measure of demand.

                  3:  Money is a store of demand.

In the standard definition, Number 3 cannot possibly be true.  Were Number 3 true, money would have value of itself.  The value of money would be independent of what ever else an economy produced. But consider, the best monies are those instruments which have no intrinsic value whatever.  How can any amount of something which has no value, be a store of value?  Even where commodities have been used for money, (and this may be the origin of the error,) they have tended to be those commodities, precious metals, for instance, which, because of their properties, were of only limited economic use. The reason for this is known and simple:  These commodities had to be more valuable as money than they were valuable as commodities.  If they were more valuable as commodities, they would be consumed, and so their use as money would disappear.  But this implies that the value of these commodities, as money, over their value as a commodity, is not intrinsic, but as with plain fiat money, purely a matter of other factors.  That is, the value of the commodity as money is not based on any intrinsic value of the commodity to the economy. 

So fiat money has no intrinsic value, and therefore cannot be a store of value. If the economy produced only money, that money would have no value.  It does not have value as, say, a refrigerator full of food has value, or a tank filled with gasoline.  But, what the third function of money actually is is as a store of demand.  If you have $100 in the bank, or in your pocket, you have a store of demand, which you can keep as long as you want, and when you choose to, you can spend it.   You can demand something which is offered for sale, to the amount of $100.

Then you can take your $100 of tokens of demand and you can go to the grocery store and with it buy $100 worth of food.  This shows that money is also a measure of demand:  You have as much demand for food, or anything else, as $100 will purchase.  If you have more money, you have more demand.  If you have less money, you have less demand.  If you have no money, you have no demand.

Money is not a store of value.  Can it reliably be a measure of value?  Economically worthless things may be in much demand, and therefore command a price beyond their value.  Yachts, for instance.  Economically valuable things may be in little demand, or supplied at prices below their value.  Water, for instance.  With money, you have demand for these things, at the prices they are offered.  But their prices do not reflect their economic value, only the amount of demand, the amount of money, which must be exchanged for them.

This counters the claim that the only value a thing has is that set and measured by the market:  The toys of the wealthy are much in demand, but of little value.  The goods needed by the poor are to them of great value, but it may be that those poor are only able to demand a meager portion of them.  Markets only measure demand.  They need not measure value.  This is the primary inadequacy of markets. 

So because money is demand, or more exactly a token or instrument of demand, it serves as a 'medium' of exchange:  Because money is not demand for any particular good or service, but is demand for any offered good or service, it may be exchanged for any offered good or service. Money is a medium not in the sense of being an environment for exchange, but in the sense of being a generalized instrument.  It is an abstract good, which is offered in exchange for other goods and services. The individual who exchanges his good or service for money then himself has equal demand on others for different goods or services.  Money thus flows opposite to the flow of goods and services, not to the degree of the value of these goods and services, but according to the demand for these goods and services that are offered.

Goods or services are thus exchanged for an equal demand on other goods or services.  Money, then, is an instrument for comparing the demand for dissimilar objects.  However, we have shown it is not reliable for comparing the value of dissimilar objects. 

By mistaking demand for value, the standard definition of money thus implicitly fails to distinguish between the value of an object, and the demand for that object.  In an informal sense, this results in the failure to distinguish between the needs of an economy, and its wants.To provide another example, the economy 'needs' streetlights in Highland Park, Mi.  It 'wants' yachts in Newport, RI.

If we regard the economy as like a tree, money cannot distinguish between the fruits of a tree, and its roots.

There is a larger issue. The standard definition of money goes back, essentially unchanged, to 1875. See eg. Wikipedia.  It is, implicitly, a key part of the foundations of the entire field of economics.  That it is in error calls into question the soundness of the entire economics project.

A Keynesian Look at the Great Recession

               Recently there has been a prolonged period of productivity increase without a corresponding increase in labor income.   The result is that the supply of goods and services throughout the economy has increased, while the purchasing power of labor has not. We analyze  the consequences of this from a Keynesian point of view.

In Diagram  0 we show the classical Aggregate Supply curve AS. It is just a vertical line at the size of the economy, the size of the Gross National Product of the economy.  The thinking behind the classical AS curve is that production is independent of price level.  If money is added to the economy, or the velocity of money increases, prices merely rise, or inflate, but production does not increase.  Similarly, if money leaves the economy, or the velocity of money decreases, prices merely decrease, or deflate.  Production does not decrease.  The actual price level at e is set by the intersection with the Aggregate Demand Curve AD, which is the relationship between the total demand for goods and services and the price level.  If the price level goes up, things are more expensive, and people can buy, or choose to buy,  a smaller quantity of goods.  If the price level goes down, things are cheaper, and people can buy, or choose to buy, a larger quantity of goods.  So for a given quantity and velocity of money, at a given supply of goods and services, there is feedback: An increase in quantity demanded, above Q drives the price level back up toward e, and a decrease in quantity demanded  below Q drives the price level back down toward e.  

This is the same sort of feedback that sets the equilibrium for the intersection of ordinary supply and demand curves:  If the price of a good goes up, manufacturers want to make more, but people want less of it.  If the price goes down, manufacturers want to make less, but people want to buy more.  These two tendencies settle where the supply and demand curves intersect.

Diagram  1  shows the Keynesian Aggregate Supply   AS curve, as opposed to the classical Aggregate Supply curve.  The rationale for the Keynesian AS curve bending  back is the idea that, if the price level goes below this level, production decreases dramatically because wages (and actually some other prices, too, under oligopoly,) do not decrease rapidly.  They are considered 'sticky,' for various reasons, and so instead of wages going down, employment decreases.  That is unemployment increases. Fewer workers implies, in the short run, production of goods and services decreases.  That is, Aggregate Supply decreases.  Meanwhile, the Aggregate Demand curve shifts to the left, because fewer workers have  money to purchase things. This is the situation during a depression or recession.   (Shown in red. The AD curve is about in the position it was during the Great Depression, when first demand, and then production, decreased by about a third.)  The capacity to produce is still there.  It is still at Q, but it isn't being utilized. Actual production is reduced to Q'.  The GNP is smaller than it could, and should be.

The curved region of the AS curve represents the idea that, as the economy approaches full capacity, resource bottlenecks appear, as some sectors reach full capacity before others, driving up the price level. The closer to full capacity, the greater the number of bottlenecks, and the more the price is driven up.  We show the equilibrium point, where the economy is actually performing, part way up the curve, at less than full employment, and at less than full utilization of capital and resources. We would expect this situation in a growing economy. An economy only rarely operates at 'full' capacity.

In Diagram 2 we see what happens when wages increase along with labor productivity.  More is being produced, so the AS curves shifts to the right, and more is being demanded, since wages have also increased.  Both curves shift a comparable amount , so employment remains  high, as does the utilization of capital.  Other things being equal, the price level stays the same, while the economy, the GDP, grows from Q to Q'.  (We are implicitly adjusting for any inflation.)  

   

 Next, in Diagram 3,   we consider when wages do not increase at a rate equal to the increase in labor productivity,  Since productivity increases, more is being produced, so the AS curve shifts to the right.     The Aggregate Demand curve also shifts to the right, but not as much.  This is because income which would have gone  to labor instead goes to the owners of capital, who save a greater proportion of their income.  Saving more, they spend proportionately less.

  Since it moves less, it is now further back along the backward bend of the Aggregate Supply curve, into the recession region.  Because labor borrows, in order to maintain its living standards, this does not happen gradually.  This borrowing temporarily shifts the AD curve along with the AS curve, as in Diagram  2.  But this can only be temporary, because eventually labor's credit runs out, and this happens suddenly.  When it happens, the AD curve shifts back to the left (the red AD" curve), and we have a recession. (Diagram  4.) 

       

            Here the economy produces at quantity Q", less than the potential Q', which the real economy has grown capable of producing.   With labor productivity increased, but demand down, the economy becomes locked into a high unemployment mode, with reduced demand.  It also becomes locked into a mode of low capacity utilization of capital and resources.  This discourages investment.  

            There still remain questions. One is why haven't prices declined significantly?  Well, one of the things that has been happening is that the economy has been running a trade deficit for a number of years.  So for a long time now, many sectors have already been running at below capacity.

           Another, more ominous possibility is that the consequences of Quantitative Easing are slowly being felt in the real economy.  People have wondered why, with an apparent increase in the money supply, there hasn't been inflation.  But if the money is trapped outside of the real economy,  then the quantity (M x V) hasn't changed much.  This is  because although M has increased, V, in reality, counting all the QE money outside of the real economy which has zero velocity, has become very low, and is only slowly increasing as more money slowly enters the real economy.  One of the reasons this money is slow to enter the real economy is the dearth of investment opportunities, a consequence of the fact that, although nominally the economy is growing, from the point of view of employment, and labor income, and thus consumer demand, it is still in recession.