Destruction of Production from Unbalanced Trade

Walmart promises lower prices.  But at what cost to society?  Locally, the consumer seems to benefit.  But what about the domestic producer, who may be put out of business when a foreign supplier is chosen over him?  He is also a consumer.

We further discuss the situation of unbalanced trade, where one country runs a trade deficit with another country.  For previous discussions, see:   http://anamecon.blogspot.com/2011/03/free-trade-welfare-and-debt.html  and the pointer there.

We start with a retail outlet, which sells the product of a domestic producer.  The domestic producer (or it may be many producers)  produces quantity  Q of his product at price P, at the equilibrium point e, intersection of the supply S and demand D curves (blue and red dashed curves.)  The quantity Q goods sell at price P for total revenue to the producer, or producers, of P x Q.  This is also the price paid by the total of all consumers.

 A foreign producer produces at price P’ less than P. If the domestic producer cannot produce at P’, the retailer chooses the foreign producer.  The supply curve shifts down by the difference between the prices, P – P’, in the diagram to the solid S curve, and the new equilibrium point is at e’.  This would be an improvement for the consumer. He would get more goods, at a lower price. However, this is not the whole story, because the domestic producer is also a consumer.  The consumer is also a producer.  The revenue which formerly went to the domestic producer, P x Q, is lost to the domestic market. The new amount of revenue, P’ x Q’, the size of the market at e’, goes overseas, to the foreign producer.  Or would if e’ was the new equilibrium point.

 

But it is not, because the domestic producer, no longer in the market, shuts down, and the demand is shifted down by P' because of the loss of revenue to the domestic producer. (The reduction in demand is going to be the area between the two demand curves. This is equal to the money lost to the overseas producer.)  This revenue the domestic producer no longer has to consume with. 

Thus the new equilibrium point is really at e”, the new intersection of the shifted demand and supply curves.
So whether or not the the new equilibrium point e” is to the left or right of the original equilibrium point is going to depend on the relative elasticities of the supply and demand curves, and the relative difference in the size of the shift of those curves.If the demand is inelastic and the price for imports is sufficiently lower, ( a decrease to something less than 50% of the domestic price of production,) the increase in consumer welfare in the domestic market could be comparable to and even greater than the loss in domestic revenue. So the domestic economy might even show a benefit. 

In general, if we just compute the gain in consumer welfare to the loss or producer welfare, there will generally be some gain. However, this neglects the loss in producer welfare to producers of factors higher up the production chain. The costs to a producer are always revenues to the producers of factors to that producer, and these other producers will also suffer  Whether this chain of suffering amplifies or diminishes as it propagates would seem to require a closer analysis of the different cases..

With balanced trade, there is an increase in welfare for everybody. Producers get to produce more.  Consumers get to consume more. However, that increase also includes an increase in marginal production and marginal consumption. The possibility remains that the increase in benefits is at a cost in resources which would be more efficiently used elsewhere in the trading countries, the cases generally being those with inelastic supply and elastic demand.

EDIT: Diagram and discussion corrected 05-20-2019 .

Price goes down, but income goes down further, since money goes overseas, following foreign suppliers, and does not come back to consumers, except perhaps as a loan.  But money continuously goes overseas, and does not come back.    

The true equilibrium point is at quantity Q* = 0.  That is, without balanced reciprocal trade, the equilibrium is at zero imports. It may take a long time to get there, but the net final result is merely the destruction of domestic production. The economy is no longer able to import except by selling off capital. But in this it is limited, also. There is only so much capital.  There does exist, however, the argument from debt:  The economy can be maintained by borrowing.  But this is in the long term untenable, and any net import must eventually be paid for by destruction of future production.  Further, because of the costs of borrowing, the amount of future productive capacity destroyed is greater than would be destroyed without borrowing.  Borrowing makes a bad situation worse.   

Let’s take a different look at the change in situation.  Consider first the domestic economy as a closed system. The flows of  money (Black) and goods (Red) stay within the domestic boundaries, and the system is in equilibrium, by which we mean that roughly the flows compensate for each other.  (The rest of the economy consists of other producers and consumers.)  There may be changes, but these are accompanied by corresponding changes in other flows.

If, however we introduce unbalanced trade, money is exported to the foreign economy and goods are imported from the foreign economy.  Since there is no flow of money into the domestic producer, the domestic producer closes down. As a result, all flows of goods and services to and from the domestic producer close down. 

We observe, like water through the drain in a sink, money continuously flows out of the domestic economy.  Goods flow in, but unless the goods are capital goods, (and they would likely not be, because the return on investment is lower in the country running the deficit,) they are consumed and need to be continually replenished.  The continual loss of money represents ever increasing demand (money is demand) by the foreign economy on the domestic economy, while the domestic producer has been eliminated.  The domestic economy is thus ever less able to pay an increasing debt. It is certainly less able to repay with production. But it is also increasingly unable to repay this debt even with capital, because the value of capital has decreased, since its return is lower due to the foreign competition.

For comparison, we draw the same diagram with balanced trade, where the domestic producer has found a foreign buyer for his production.  Note that, while the domestic economy is here balanced, the upper foreign economy in the diagram runs a deficit wrt the domestic economy, and the lower foreign economy in the diagram runs a surplus wrt the domestic economy.  In the long run, these tendencies would have to be compensated for, by trade between the two foreign countries, just as they would have to be compensated for in the domestic economy. 

So, what would be the effects of a trade deficit on the domestic economy.  We already know that the domestic producer shuts down, resulting in a shift downward in the demand curve greater than the downward shift in the supply curve.  Since the new equilibrium point e” is to the left of the original equilibrium point e, the quantity supplied at Q” is less than the original quantity supplied at Q. However, the same phenomenon happens for all imported goods. All imported goods are supplied at lower quantities than were originally produced by domestic producers.  Otherwise the domestically produced good would be preferred by domestic consumers.

On the level of the individual, the mean income decreases, and is greater than the decrease in price.  That is, in real terms, the average consumer is poorer, because of the trade deficit, than he was before there was a deficit. The decrease in price does him no good, because the decrease in his income is greater. From a social point of view, poverty increases, and income and (long term) spending of the average individual decreases.  From an economic point of view, capital investment decreases, and indeed, on average, the economy is decapitalized, that is, its capacity for production decreases.  This has the implication that the costs of capitalization increase.  Another way of putting this is that the return on investment decreases.  The economy is less able to maintain itself and its infrastructure can be expected to be under maintained, and to decline.

The results of running a trade deficit demonstrate the need for government regulation of trade. Clearly, a private entity may increase his profit while destroying a part of the domestic economy, if it is not compensated for. The free market credo would be that this is just too bad for the domestic producer.  This should be discouraged, because the damage is not restricted to the domestic producer.

It also shows some of the consequences of incompetent, or if it be, treasonous, government, allowing or even encouraging the destruction of the livelihood of many of its citizens.

Finally, it shows that it is sometimes necessary to think two steps, instead of only one, in reaching conclusions.  

Tax the Rich More

The idea of cutting taxes on the rich, so they will have more money, so they will ‘create jobs’ and hire more people, is nonsense.  Why would they hire more people, to make money, when they already get the money with the tax cuts? And why would they hire anybody, if the people have no money, and are already in debt?  If the people have no money, they can’t buy anything. (O, sure, they could go deeper in debt.)  So the rich can’t sell the people anything, so there is no reason to hire anyone to sell them anything, nor is there any reason to hire anyone to make anything to sell.

What can you rely on the rich to do?  You can rely on the rich to try and take money from other people. 

So the way to get the rich to hire someone is to get the money to the people.  Then the rich will hire that someone to take that money from the people.  The rich will hire someone to make things, and others sell those things to the people, to get their money.

But getting money to the people is inflationary, you say.  Well, take the money from the rich in the first place.  Tax the rich. Tax the rich more.  

Letting the rich have all the wealth is not in anyone's interest, not even the interests of the rich themselves. With the rich having all the wealth, the interests of the people and the rich diverge.  No longer is the promise of advancement plausible to the people.  No longer do the people see the benefits to contributing to a society which has taken everything they had, and left them effective slaves. Only compulsion will continue to secure their grudging labor, and this will not be enough to sustain the commonwealth, which is itself the foundation of all private wealth.  And without its foundation, private wealth will dissolve. 

The rich have more power when they are less wealthy, for then their society is richer, and more powerful, and they can protect, and project, their interests into the world more fully.

Does Holiday Shopping Boost the Economy?

Does the holiday shopping season boost the economy? Or does it matter? Or is the economy actually harmed by it?

Or does it depend on the state of the economy? 

By tradition, Black Friday is when retailers, when their sales are summed out over the year, first start netting a profit. ( If so, we can figure that retailers net on average over 10% profit, figuring total sales over the month of December to be even slightly more than the average month.)

But we follow the money.  First, consumers only have so much to spend over the course of a year. No matter how their spending is distributed, it doesn’t affect how much they have to begin with, and that is what limits how much they have to spend. If they spent less during the holiday season, they would have more to spend during the rest of the year. From that point of view, the holiday shopping season doesn’t affect the economy at all, except to make its activities uneven.  

However, suppose the season motivates people to take on a larger debt burden than they otherwise would.  This in the long run might lead to a decrease in growth in the real economy.  This is the consequence of the fact that, when we subtract the cost of borrowing, that is the interest paid by the consumer, the consumer has less to spend in the long run.  Of course, that interest is someone else’s income.  Since borrowing is by the poor from the rich, and the rich spend a lower percentage of their income, the implication is that total demand is reduced, and will grow more slowly. And so the economy with it. Also the distribution of wealth is changed, further concentrated on the rich, and this is not a good thing.

Supposing instead, on average, the existence of the holiday shopping season induces people to save more. Then in the long run, they would have more to spend, because of the interest, and this would lead to greater demand, and increased growth.  In the long run. But evidence doesn’t suggest increased savings to be the case. 

There is the additional cost of increased competition, the cost of stores open on holidays, and longer hours, the increased burden on infrastructure.  This additional destruction of resources makes us all a bit poorer.

There is the time and opportunity cost to consumers, waiting for their place in line, when they could be doing something more productive, and that makes them, and all of us, poorer.

If the economy was at full capacity before the holiday season, the increase in demand might lead to production bottlenecks, and inflation. This might be harmful. In a slack economy, it is hard to see this would be a problem, and might temporarily help the employment situation.  However, it shouldn’t affect the employment averaged over the course of a year.   

Anyway, at best, in net, we conclude the holiday shopping season has a slightly negative effect on the total economy.  Further, the compromising of the holiday of Thanksgiving, (and some might argue of Christmas also,) in the unseemly pursuit of profit, and the induced and equally unseemly pursuit of bargains, must be counted a social negative, and evidence that we cannot evaluate the well being and progress of a society merely by the measurement of economic factors.

Government and the Fallacy of Composition

A successful society perpetuates itself.  It first of all must balance its internal functions. Since a society is made up of people, this means it must balance the interests of its members. Second it must be able to unify and make coherent its collective action.  It must act effectively in its environment, both to secure resources for itself, and to act against threats to itself. 

Every successful society has a government.  This implies that governments are necessary for successful societies.  What functions do governments fulfill, and which are necessary? The Constitution of the United States, the founding document of its government, lists several functions in its preamble:” …to form a more prefect union, establish justice, insure domestic tranquility, provide for the common defense, promote the general welfare, and secure the blessings of liberty to ourselves and our posterity.”  (And we already come up against a defect in the Constitution in the preamble: the only coherent purpose it authorizes for society in its environment is for the common defense. There is no explicit purpose expressed for taking coherent action to secure resources, or assure an economic future, although this might be inferred from ‘promote the general welfare.’)

As may be, for a society to perpetuate itself, its government must act against the forces, both internal and external to that society, which will debilitate and cripple that society. 

One of the most important sources of internal socially disruptive forces is a result of the fallacy of composition:  When one person may do a thing it may be good for himself, but when many, or all, do it, the result is bad for society, that is, bad for all individuals.  Therefore one of the most important functions of government is the prevention, or if prevention is impossible, the countering, of situations where the failure of composition pertains. 

These are many.  And of these many fall under the general category of externalization of costs.  Pollution, for instance, is externalizing the cost of producing a good or service.  Costs are also externalized when a company pays less than subsistence, forcing its employees to go elsewhere, often to charity of governmental assistance, to supplement their earnings.  These can be phrased in terms of a tragedy of a commons:  Pollution consuming the commons of the air we breath and the water we drink.  Low pay to workers is abusing the market.  Clearly, each company can make more profit by paying its workers less.  But if all companies pay their workers less, all companies will make less money,   Just as clearly, if all companies pay their workers more, the workers will have more to spend, and all companies will make more money. 

Another is the ‘Paradox of Thrift,’ brought to the attention of economists by John Maynard Keynes.  If one person saves, he may be better off, but if all people save, there is a shortage of spending, the economy contracts, people become unemployed, and in general, everyone is worse off.   The government can counteract this by lowering interest rates, increasing inflation, or increasing its own spending, either by deficit spending or increasing tax and spend. 

Consider the fact that Americans work harder than people in any other developed country, yet our society is the most unequal among them.  Cynics have the people believing that by working harder, they can each of them get ahead.  But it is like a race:  Even if everybody runs faster, still only a few will get the prizes.  Even if everybody works harder, still only a few will advance.  The efforts of workers are increasingly devalued.  This is becoming increasingly obvious as growth stagnates, and increases in income and wealth are becoming more and more concentrated among the few percentages at the top.  See my last post. But the top percentages promote this myth, because all the benefits of all that harder work, all that greater productivity, by the workers, accrue to the wealthy.

So this is a failure of government. The government is already failing in its purpose to promote the general welfare, promoting instead the welfare of a few at the expense of the many, and by allowing increasing segments of population to become indentured by debt to a few, failing to secure the blessings of liberty for them.  Indeed, as the government increasingly becomes a creature of the wealthy, its failures may be expected to increase, as it becomes less and less capable of defending against fallacies of composition.  Already economic crimes among the wealthy, taking from society, from the commonwealth, without return, go unpunished. As regulations are weakened, as more and more costs or production are externalized, as the unfettered free market succumbs to the tragedy of the commons, not just the worker, but the wealthy, will be the poorer. 

The commonwealth is also the wealth of the wealthy.  They already control it, but in the obsession of each to ‘own’ an ever greater share of  it, they will destroy the world, and the wealth of us all.

Income Growth During the Latest Expansion

Check this out:

Got this graph from mashable.com: http://mashable.com/2014/09/25/this-really-depressing-graph-about-the-u-s-economy-is-turning-heads/

The article is titled “This Really Depressing Graph about the Economy is Turning Heads.”  Which it should.  I share it here with you.  The source is Pavlina Tcherneva, who is an economist at Bard College, in Annandale-on-Hudson, New York, and the Levy Economics Institute, a think tank associated with the college, using data from Piketty and Saez.  Basically it shows the wealthy’s control of the economy increasing until now the growth of their wealth and income is obtained by plundering the rest of the economy, which is to say us, the rest of the people.  The graph charts increase in income, but you better believe the rich are getting richer, at our expense, we are getting poorer.  Not much of a recovery, this latest, when it is gotten for a few by preying on the many.

Thanks, Yahoo, for the pointer, on Sept. 25, 2014. 

Something from Adam Smith

Having wiled away the month, and having come up with nothing of my own, I present this little gem from Adam Smith, from his CONCLUSION to CHAPTER XI, OF THE RENT OF LAND, the concluding chapter of BOOK I of his AN INQUIRY INTO THE NATURE AND CAUSES OF THE WEALTH OF NATIONS.

...

The whole annual produce of the land and labour of every country, or, what comes to the same thing, the whole price of that annual produce, naturally divides itself, it has already been observed, into three parts; the rent of land, the wages of labour, and the profits of stock; and constitutes a revenue to three different orders of people; to those who live by rent, to those who live by wages, and to those who live by profit. These are the three great, original, and constituent, orders of every civilized society, from whose revenue that of every other order is ultimately derived.

The interest of the first of those three great orders, it appears from what has been just now said, is strictly and inseparably connected with the general interest of the society. Whatever either promotes or obstructs the one, necessarily promotes or obstructs the other. When the public deliberates concerning any regulation of commerce or police, the proprietors of land never can mislead it, with a view to promote the interest of their own particular order; at least, if they have any tolerable knowledge of that interest. They are, indeed, too often defective in this tolerable knowledge. They are the only one of the three orders whose revenue costs them neither labour nor care, but comes to them, as it were, of its own accord, and independent of any plan or project of their own. That indolence which is the natural effect of the ease and security of their situation, renders them too often, not only ignorant, but incapable of that application of mind, which is necessary in order to foresee and understand the consequence of any public regulation.

The interest of the second order, that of those who live by wages, is as strictly connected with the interest of the society as that of the first. The wages of the labourer, it has already been shewn, are never so high as when the demand for labour is continually rising, or when the quantity employed is every year increasing considerably. When this real wealth of the society becomes stationary, his wages are soon reduced to what is barely enough to enable him to bring up a family, or to continue the race of labourers. When the society declines, they fall even below this. The order of proprietors may perhaps gain more by the prosperity of the society than that of labourers; but there is no order that suffers so cruelly from its decline. But though the interest of the labourer is strictly connected with that of the society, he is incapable either of comprehending that interest, or of understanding its connexion with his own. His condition leaves him no time to receive the necessary information, and his education and habits are commonly such as to render him unfit to judge, even though he was fully informed. In the public deliberations, therefore, his voice is little heard, and less regarded; except upon particular occasions, when his clamour is animated, set on, and supported by his employers, not for his, but their own particular purposes.  

His employers constitute the third order, that of those who live by profit. It is the stock that is employed for the sake of profit, which puts into motion the greater part of the useful labour of every society. The plans and projects of the employers of stock regulate and direct all the most important operation of labour, and profit is the end proposed by all those plans and projects. But the rate of profit does not, like rent and wages, rise with the prosperity, and fall with the declension of the society. On the contrary, it is naturally low in rich, and high in poor countries, and it is always highest in the countries which are going fastest to ruin. The interest of this third order, therefore, has not the same connexion with the general interest of the society, as that of the other two. Merchants and master manufacturers are, in this order, the two classes of people who commonly employ the largest capitals, and who by their wealth draw to themselves the greatest share of the public consideration. As during their whole lives they are engaged in plans and projects, they have frequently more acuteness of understanding than the greater part of country gentlemen. As their thoughts, however, are commonly exercised rather about the interest of their own particular branch of business. than about that of the society, their judgment, even when given with the greatest candour (which it has not been upon every occasion), is much more to be depended upon with regard to the former of those two objects, than with regard to the latter. Their superiority over the country gentleman is, not so much in their knowledge of the public interest, as in their having a better knowledge of their own interest than he has of his. It is by this superior knowledge of their own interest that they have frequently imposed upon his generosity, and persuaded him to give up both his own interest and that of the public, from a very simple but honest conviction, that their interest, and not his, was the interest of the public. The interest of the dealers, however, in any particular branch of trade or manufactures, is always in some respects different from, and even opposite to, that of the public. To widen the market, and to narrow the competition, is always the interest of the dealers. To widen the market may frequently be agreeable enough to the interest of the public; but to narrow the competition must always be against it, and can only serve to enable the dealers, by raising their profits above what they naturally would be, to levy, for their own benefit, an absurd tax upon the rest of their fellow-citizens. The proposal of any new law or regulation of commerce which comes from this order, ought always to be listened to with great precaution, and ought never to be adopted till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention. It comes from an order of men, whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it. 

________________

Smith, Adam (2011-01-12). AN INQUIRY INTO THE NATURE AND CAUSES OF THE WEALTH OF NATIONS (non illustrated) (Kindle Locations 4147-4191).  . Kindle Edition.

A Problem with Capitalism

Capitalism, as a system, is inherently unstable.

Consider a closed economy.  By closed we mean no money, and no resources, flow in or out of it.    This is more general  than it seems, since we are really talking net flow:  We are thus talking about any economy where the flow of money in and the flow of money out are equal in magnitude. And any economy where the flow of resources in and the flow of resources out are equal in magnitude.

   

The economy consists of capital and labor. Profit is required by capital, in order to invest in greater production, that is, more capital.  Thus capital must exploit labor.  But, since the economy is closed,  labor is capital's only market, except for itself.  (Capital does not give its money, its demand, away to third parties.) But, capital cannot take a profit from itself. (Well, it can. But this is called taking a loss, when the expense borne by capital is greater than the return.)  Indeed, capital  cannot even break even, selling to itself, because of the  costs of business, and  because of the depreciation of capital. 

Thus, capital must get in return more than it produces. (This is on two levels, real and financial.) So it takes a profit from labor.  But what does this mean?    The capitalist exploits labor twice.  First, less is paid for labor than that labor produces. This produces a surplus of goods. This surplus is the profit of the capitalist.  Some of this surplus is retained by the capitalist. Yachts, for instance.  But yachts are an expense to the capitalist.  And not all of this surplus can be retained. If it is, that is the break even point  for the capitalist. 

So the surplus must be sold, and it can only be sold to labor.  This requires that the capitalist takes less from labor than it gives labor. But second, the capitalist takes more from labor than it gives labor in the first place as wages.  But this results in an ever diminishing market, whereas the capitalist requires an ever expanding market. 

Capital, in maximizing its profits, minimizes the return labor gets, even to the point where labor's return is negative.  That is, each year labor is paid less, in real terms, than the year before.   But this collapses the market for capital.  This is the problem.  

Indeed, for its market to grow, the capitalist must give labor (or some third party) some of the surplus of production.  That is, capital must share its profits with labor.  That is, labor must receive more than its costs.  This will result in an expanding market, which is required for capital to grow.  

Now with a closed real economy, the money supply can be changed. Thus an economy can be closed in real terms, (this is called Autarky,) yet 'open' in terms of money supply.   That is, the money supply can be adjusted to favor either the financial or the real sector of the economy. 

 

Keeping a fixed money supply is good for finance, but death to producers of real goods and services.  Finance takes money out of the real economy.  This is finance's cost, to the real economy, of doing business.  This is its profit, as it redistributes demand in the real economy.   Thus the money supply in the real economy decreases, and the real economy experiences deflation.   But this means that, on average, the producers of real goods experience negative profit.  Roughly, this means that, each year, over half of all non-financial businesses suffer losses.  

Loaning money to the real economy does not reduce this over time, but rather increases it, because of the interest.  Thus a period of deflation may be compensated for by finance loaning sufficient money to the real economy.  However, it will subsequently be followed be an even greater period of deflation, as the loans come due.  But this is superposed on the decline in production brought about by non-financial companies making negative profits. They will make money, and perhaps grow, while the money is being lent, but their markets will subsequently suffer an even greater contraction when loans come due, and can no longer be rolled over.  Thus while there are fewer dollars, they are also pursuing fewer goods, which may even be inflationary, if production declines at a rate greater than the money supply in the real economy. Meanwhile, the supply of money in the financial sector increases, but has no outlet, except in bidding up asset prices. Of course, real assets, that is the producers of real goods, are increasingly overvalued, as their markets are increasingly undermined. Depending on the degree of indebtedness, the transition is more or less dramatic.  

Therefore, the money supply must expand so that this profit, the money finance takes out, is zero.  This requires that the money supply be expanded in the real economy, and not in the financial economy, which will merely aggravate the situation. Effectively, this means it must be done fiscally, and not monetarily.   Finance must be taxed, and the money spent in the real economy.