Understanding "Multiplier"

-So many topics to choose, so much time to write. The moral of the story is: I am lazy.-

In our very first article of this blog, we mentioned about the misconception of economics, the fact that 99.5% of the entire population thinks of an economy solely in term of money. Where did I get the data? I made it up. That is what economists do daily. Make things up. Actually, that is another one of the widespread misguided belief. It is true that 99.5% is just a made-up number, but you should be able to grasp what I meant. The vast majority (a vague but somehow a justifiable and easy-to-use cliché, "vast majority") of people still think of economics as a not-so-scientific-bedtime story about money. WRONG, I said (and a bunch other economists said)!

So before we begin, let us clear our mind of all the preconceived notions we once held about economics. Economics is not about money, but it is more about converting scarce resources, which have alternative uses, to outputs. Actually, I would prefer it if you associate economics with outputs. Though it is not the perfect proxy, it is still much more suitable, especially in the context of today's discussion about Multiplier.

I have already mentioned about the virtue and vice of spending, but now, let us focus on the good side. If this is the first time you hear "Multiplier", you are probably thinking about multiplication, and you are right. Multiplier multiplies. It does not get any simpler than this. Multiplier multiplies spending.

Wait, what? Multiplies spending?
Yes, you read it right. You do not need your glasses yet. In economics, a $100 spent by Mr.A is not a $100 received by the economy. This is not business 101. Forget about business and accounting, this is Economics 101.

In an economy, spending $100 will get you either more or less, but almost always, especially in a robust economy, you get more. This very idea justifies and advocates government spending (the use of stimulus packages, etc), and most of the time, encourages the government to run deficits (i.e. spend even if it exceeds their earning, meaning borrow to spend) in accordance with Keynesian economics in which multiplier is most used and accredited.

The idea is that spending money or injecting money into circulation within an economy will generate even more money, or to be more specific (and correct), value of outputs. As long as the first recipient of the $100 (from whoever spent it) continues the tradition by spending a portion, no matter how small, of that $100, the economy will receive more than the initial amount ($100) spent. I guess a few, or let be optimistic, some of you, by this point, have already understood the underlying concept that I am trying to explain. To illustrate it further, here is an example:

"Iron man paid $5 to Batman's butler to wash and iron his iron suit (I do not know how that can be done either). Batman's butler, in turn, saved $1 and spent the rest ($4) to buy Batman's favourite pizza from the fast-delivery spidy pizza owned by Spiderman. Spiderman kept $1 (of the $4 he received) in his bank account, and spent the rest ($3) on getting a new and cooler mask. Let us assume that the mask maker (whoever that is, probably the Hulk) saved all the $3 proceeds and stopped the spending chain here."

Now let us re-think of what we get so far from the perspective of the whole economy. What do we have up till now in term of the goods and services produced?

• Batman's butler received the $5 which is the value of his washing and ironing service for Ironman. So we have 1 washing and ironing service produced at $5.
• Spiderman received $4 to make a mouthwatering finger linkin' pizza for batman. So here a pizza was produced in this particular economy at the price of $4.
• The mysterious mask maker (whom I thought might be the Hulk) got paid $3, and he produced a cool-looking mask for spiderman. He just decided to keep it for whatever the reason. So we have a mask produced at the price of $3.

To sum up, the economy has gained:

= a $5 washing and ironing service + a $4 mouthwatering pizza + a $3 mask 

= 3 goods and services in total with the value of $12

From this simple example, we have thus proved the point that money spent will generate more than the initial amount for the economy. This is not about money creating money, but this is about money creating outputs which are valued in term of money. 

I can safely say (based on the example I made up) that multiplier does exist. If you ever wonder what the value of the multiplier is in our example, just do the maths.

Multiplier = $12 (total outputs)/$5 (initial capital injection or money spent) = 2.4

Now what if the initial spending is $1 million instead of $5?

Using the multiplier, then the total increase in the overall production of goods and services in the economy would be $1million x 2.4 = $2.4 million!

Multiplier is extremely important as it determines the effectiveness of spending in an economy. In a consumerism society, where people save less and spend more, we would expect the multiplier effect to be much stronger than that of the one favouring saving. That is why the same amount of government spending does not yield the same result when applied in different countries across the globe. This is why economic research is crucial in understanding both the short-term and long-term consequences of a policy, for instance, expansionary fiscal policy which is pretty much about government increasing spending. 

And that wraps it up for today. Just one last reminder though.

Remember folks, MULTIPLIER is NOT magic. 

GDP, the economic illusion

A country with high rate of GDP growth is mostly regarded as economically healthy. But is it on the right track of development? Is the growth sustainable? Is GDP a good indicator of prosperity? Is this really the best we can do?

We always think of economic growth in term of GDP - short for Gross Domestic Product. It is basically the total amount of outputs produced domestically by a nation, mostly measured in annual term. GDP is measured in USD. Then we have GDP per capita or GDP per person (GDP divided by total population). These are the most prevalent economic indicators used to date to identify the stage of development in which a country situated. The downside of using GDP  to measure development is the fact that it forces people to think of development with reference only to its monetary value. For instance, when a country reaches a certain cut-off, they will move up the rank from, say, low-income nation to lower-middle-income nation, and as a result, most would think that it is now better off. Though this is true in economic sense, this type of classification still misleads our judgement of what development really is.

First of all, development should be clearly defined so to prevent confusion. Development is not about climbing up towards the status of high-income country. Development is not entirely about increasing the GDP. It should not be just about a nation's wealth. Development is the improvement of the general well-being of the people. We do not just want a developed country, but a well-developed country.

So GDP is certainly overrated. GDP is the aggregation of the monetary value of consumption, investment, government spending and net export (export - import). None of its components involves equity, equality, justice, freedom, institutional efficacy, transparency, accountability, health, education, general level of satisfaction, and the list goes on. It does not say anything about income inequality, racial discrimination, corruption, educational inefficacy, etc. GDP might be a good indicator for the aggregate economic growth of a country, but its strength as a development indicator is only moderate, if not weak. 

Imagine this scenario in which a country, Narnia, (with a population of 100) has GDP per capita of $2000. That means that an average Narnian earns about $2000 annually. That is not too bad actually. But what if I tell you that 50 Narnian generates as much as $3900 per year, and the other 50 can manage to earn only $100 per year. Shocking? You should not be. $2000 is the mean income. In fact, you can try doing the math.

$2000 = total income (GDP)/100 = ($3900x50 + $100x50)/100

As mentioned, the calculation does not say anything about the wealthy half of the country and the much poorer half. This much contrast within the society results in what we call "social disparity" (a broad term), or to be more specific, "income inequality".

This is why the United Nation developed another development indicator known as Human Development Index (HDI) comprising income, health and education as its elements. This is far from a perfect determinant of development, but still, it is better than solely measuring growth with total output (GDP).

We are constantly seeking a more holistic approach in measuring a country's overall development, especially the welfare of its people. Believe it or not, aside from the HDI, in Bhutan, they have something called GNH or Gross National Happiness (yes, it has been officially used in Bhutan). It is an attempt to determine living standard or life quality by looking beyond the conventional economic measurement of GDP. I guess happiness is a good enough indicator? Who knows?

So the next time you hear Narnia brags about its GDP growth, remember that GDP does not say much about the country. Try asking Aslan about Narnia's Narnian Development Index (Human Development Index) or its GNH, Gross Narnian Happiness. If the scores are too low, you can just return, close the wardrobe, lock it, and never go back. Because now you know that Narnia is not a happy land for you to conquer!

Food Waste

In our previous articles, we have talked about earning and spending (i.e. consuming). This time, we will focus on waste, food waste in particular. The leftover we stop or do not consume is either donated (to our dogs, cats, pokemons?... hardly to any human), or most of the time, thrown away in the garbage bin. Food waste, in short, is the food that is not consumed or shared.

So what? Well, Economics says it is bad. Actually, there is nothing positive about wasting food. Here is something you ought to know. At the post-harvest or processing stages, food loss is inevitable due to the strict quality standard (so you do not get sick consuming the final products), or other unexplained factors that are difficult to account for. Still, it is always better if the amount of waste can be reduced. 

However, I am not going to discuss about the waste resulting from the supply side. I am more interested in food waste in the demand side of the economy. In other words, I am talking about you and I wasting food. It is estimated that around half of all the food produced is wasted worldwide (2013), and 40% of the waste occurs at the retail and consumer levels. That is a lot. That is almost enough to feed another earth, and yet, millions of people are suffering from chronic hunger (that means you wake up hungry, go to work hungry, and go to sleep hungry). 

How much food have you wasted? People like to put plenty on their plate (and sometimes too much), and end up wasting it. They like to stock up their food supply and store them. Preserved food is okay because they can be kept for a long time, but perishable food (like meat and veggies) will be disposed of much much sooner. Sometimes, it is hard to blame anyone, but that does not mean that a change is not needed. Wasting food, in any form at all, is bad at many levels. 

Now this is what I want to emphasize, the negative economic effects of wasting food. The apparent impact is that the food is wasted. Yes, wasting, per se, is bad. You waste your money buying the unconsumed food. Technically, in economic sense, the money is not wasted (we already talked about this). Someone will get paid. However, this is not a win-win practice. Haven't we discussed about opportunity cost? You could have used the money for something else. You could have saved, invested, or loaned it. Then again, you might think $4 on a wasted McDonald's burger is negligible, but if you waste every day, then the accumulated amount will be huge! You might be able to buy a house with it. That is just an exaggeration, but you know what I mean. 

We do not have infinite food because it is limited by how much we can produce each year, how much resources we have, how much land (arable land) we have, how many farmers we have, etc. Think of it this way. If there are only 2 apples and two people, A and B, in this world, if A consumes an apple and throw the other apple away, then B will get nothing. B will die. Yes, we die if we don't eat. So when we expand this concept to a much larger scale, it still holds true. Though it is not as obvious (since the world is too large, and mass production tricks us into thinking that we have unlimited supply of food), it only requires a little bit of thinking to realize that there really are As and Bs in real world. Of course, when we buy an apple, in reality, there are still so many left for the others to buy. So we do not really see the direct impact. However, buying entails a problem. Buying is pretty much demanding. When there is a demand for something, that something will have value. The more it is demanded, the higher the value it receives. So when people demand (buy) food, food price simply rises. This is fine until they buy too much for themselves (end up wasting the food), and as a result, they are indirectly increasing the food price for everyone else. We might not feel it, but the most vulnerable people (poor people) certainly will. Since 40% of the wasted food is from retailers/consumers, the increase in price should not just be something I imagine. Another problem is at the end of the production chain, which is pretty much about dumping the waste. It is costly, economically and environmentally. Of course, the food itself is not much of a problem because it is mostly compostable. The problem lies in its packages, boxes and so forth. When you think about it, box is made from paper, and where do you get paper? Tree. Yep, so we are simultaneously raising demand for logging, raising prices of other products (since their price also includes the cost of packaging, boxing...).

We are in the 40%, so we should (must) change. Change the habit. Be efficient. Earth may have enough for us to eat and waste, but this is not about the earth. This is not about YOLO either. This is about solving food crisis, something that should not happen providing the resources endowed to us by the nature. The "new normal" should not be food crisis, the "new normal" should be food abundance. 

A tiny contribution towards development is much better than a small contribution to degradation. So roll up your sleeves, and start eating efficiently. No YOLO. 

The Economics of Procrastination

I am procrastinating. So the new article will be written tomorrow.

Now you know what procrastination means. You can thank me later.

"Individual rationality" and "Collective irrationality"

Before we proceed any further, firstly, the definition of rationality must be defined to get rid of all the ambiguity. Rationality, in a nutshell, is all about sensible and justifiable decision. For example, jumping off a burning building is rational if there is a trampoline awaiting you on the ground, but it is not rational to jump off the building because you think you can fly. Of course, rationality is quite susceptible to subjectivity. It is mostly based on personal preference and reason. Being logical is the complete opposite. Buying a Lamborghini because you think it is edible might be irrational to the others, but to you, it is rational. Still, no matter how you look at it, from whichever corner you view it, whoever views it (you or your parent or your dog or complete strangers) it does not change the fact that it is clearly an illogical decision. So logic is a more rigorous and objective  reasoning process.

Individual rationality is basically a sensible decision/judgement/behaviour/action for a person. Collective irrationality is pretty much a collectively unsound or unreasonable decision/judgement/behaviour/action. So what I am trying to achieve here is to explain to you how individual rationality can lead to collective irrationality. In other words, concurrent/similar decisions or actions by the majority can be irrational and lead to adverse results at a macro level.

If you and all your friends suddenly decide to drive to school at the same time, well, to each of you, it is a good decision. It will be safer, and probably, you can find a girlfriend faster than those who ride a bike (like me). However, the problem is that this decision has led to traffic congestion at the school entrance, not to mention the small parking lot that has the capacity of only 5 cars. So it will probably cause lots of inconvenience for you, your friends, teachers, especially the principal (just as planned).

Likewise, what happened in the medieval warfare, some scenarios might be no different. Soldiers' morale weakened, and they deserted their base. Of course, when a soldier decided to run for his life, the others might find it irrational to stay any longer risking their life in the process. In the end, they followed each other's "rational" decision, and ultimately, the war was lost even if there was this possibility that they could have won had they hold on to their base, defending it while waiting for reinforcement. And who knows? If the enemy pursued them, with scattered force like that, their chance of survival would be much lower. This is really what we call "worse comes to worst".

A more relevant example to what happened recently is food price inflation in Cambodia. Since everyone felt insecure due to the political turmoil, the unstable condition of the country, people started stocking up their food supply, buying every single piece of meat they can find on the shelves. The result? Food price spiked. We all made a rational decision by securing food supply for the need of our own family, but at the same time, as the fear pervaded the country, the aggregate demand for food rose high, and food price soared. So we were in fact worsening the situation, creating more fear, increasing the food price, making it more scarce, and killing ourselves and everyone else (especially, the poor who is most vulnerable to the increase in food price) in the long run.

Rationality, just as mentioned in my first article, is one of the core assumption of economics. Of course, people don't always make rational decision, but highly educated people mostly do as education turns people into a more rational being who relies more on thought and reason to reach a certain decision. Since those people are the one with the most impact on the economy, rationality can be scary, especially when we deal with individual rationality which can transform into collective irrationality.

So the moral of the story is that there has to be someone who can oversee the whole process. Someone who recognizes the defect and makes rules and regulations to control and intervene with any form of rationality deemed harmful for the whole society/economy. This is why we have leader, ruler, king, government...etc. And this is why free market can lead to market failure as free market allows free movement with little or no restriction. So just so you know, free market is never the best option. In this world, the ideal free market does not exist. Absolutely, purely free market does not and should not exist. We do not have anything on the extreme, but only things in moderation.

This is still a controversial public discussion among scholars and policy makers as to how much of the free market should be allowed. Regardless, too much is never good. Moderation is almost always better.

In conclusion, rationality should never be considered as evil, but the lack of understanding of its nature and the ignorance of its harmful effect in the absence of regulation are what we all should be afraid of. That is why we should at least be aware of its inherent characteristics, so we can make a better decision for our long-term well-being.

This is an important topic connecting to free market, market failure and policy making, about which I will write later. Enjoy learning.

Implicit Cost

The last two articles are about spending and saving. So today, I would like to go a bit further by involving a pretty simple, yet important and well-known, economic concept, opportunity cost, aka, No Free Lunch thoery.

When we talk about implicit cost, we are talking about the cost that is not explicit (anyone can say that), in other words, hidden cost that might be overlooked. In fact, this is one of the many things that distinguishes Economics from other disciplines such as Accounting. As far as I'm concerned (correct me if I'm wrong), accounting does have implicit cost such as the cost resulting from inventory/equipment/property depreciation. However, the one thing about it is that the value is assigned in a rather subjective way. You would not know how long your laptop is going to last, so you would most likely, based on your own reasoning process, assign the annual depreciation value, say by $100 per year. 

However, the implicit cost in Economics is quite different. We call it "opportunity cost" which is whatever you forsake in order to pursue an alternative option. Simply put, it is what you lose in order to undertake an action or gain a certain benefit. Of course, you can never get away from error when ascribing a certain value to something, but what matters is how much/large your error actually is. For instance, by going to your friend's housewarming party, you will certainly miss your favourite TV show, the first episode of the final season of How I Met Your Mother. It is hard to determine the exact value of the show. One way to do it is to ask yourself how much you are willing to pay just to get to watch it while you are partying, which is still pretty vague as it depends on your personal preference/desire/want/need. Though sometimes subjectivity is inevitable, economics always leaves space for a more objective and accurate estimate. In case like buying a new house, you would know exactly that the cost is the high interest you would have otherwise gained from lending the money to your best friend. So if the interest is 20% on $1 million, then the opportunity cost of buying your new luxurious beach house is $200,000. Ouch!

Remember, it is necessary to know what you are getting yourself into. While a business opportunity might look profitable, the profitability might be mediocre at best in comparison to investing in my imaginary company's stocks. 

It is extremely important to understand opportunity cost because you will need to include it in your major (minor too) life decision. For instance, you want to open a McNoodle restaurant. Well, let's just say the daily profit is great. Deducting all the explicit cost, and you have about $50 profit per day. Looking good here, until you decide to grab a calculator and put in your opportunity cost. In this case, it can be your own personal labour cost! Assuming you can work for McDonald at $10/hour, so if you work 8 hours a day, then you would get 80$ daily. Woah! So it turns out you gain more from working at McDonald than the $50 you earn from managing your own McNoodle. That's right, you are actually losing money when incorporating opportunity cost into the equation, not to mention the opportunity of being sued by McDonald for using the "Mc" part of their trademark (Can they really sue you for that? I'm not sure, but it doesn't hurt to take precaution, does it?). I guess that is the reason why we don't see McNoodle anywhere. (lol)

So opportunity cost should always be considered. Do not leave it out. A once seemingly lucrative business idea might turn into a so-so business or worse if you dare to add opportunity cost in your daily number crunching. So my advice is:

"Don't be silly, think wisely, act carefully because the opportunity cost will be thee's enemy, cookies"

The last one is just random. 

Is spending the best option? (The 1st Fallacy of Economics)

Last time, I told you that spending is crucial for the economy. That is still true, but there is more. Remember, correctness/truth does not translate into completeness.

John Maynard Keynes invented the so-called "Paradox of thrift". The idea directly attached to the concept of "Circular Flow". Pretty much what he said is that being thrifty is good for yourself, but bad for the whole economy. The more you save, the less you spend, the less the economy earns. So he (or the other proponents of his theory) justified it by the following example that:

While broken window does not make you very thrilled, the money does not go to waste (no deadweight) because the repairman will get paid from you. Good for him, and this is how the economy runs.
Spending = Earning.

However! However, assuming that your window is NOT broken, you can instead save the money. Yes, being a little bit thrifty. You can turn the saving into a loan, or invest it to obtain return in the form of interest or capital gain. For instance, you can lend it to your friend at 10% interest rate (a nice return), or you can invest it in various ways such as in stocks and get, hopefully, 50% profit (an even nicer return). Of course, you also have the option to keep the saving in case of emergency, or you can use it to buy yourself a new iPhone!

So by not spending the money on repairing the broken window, you can use the money to generate return (loaning or investing), protect yourself against rainy days (keep saving), or buy stuffs (consuming). All the described options will help you somehow. The first 2 alternatives will most probably increase your future income (increase long-term income), making you richer. The 3rd option will alleviate the burden when, for example, your car broke. The 4th option is nothing but spending. Yes, the same spending, but this time, you spend for something you want/need and still pass the money along to the next person. Not just that, by spending for something you want/need, you will gain satisfaction, improved productivity, and so forth. For instance, buying a new car is not just about classiness, style, and luxury, but it also increases your standard of living and saves more gas! Not to say that the new window glass is not stylish, but wouldn't a brand new car be better?

So I guess spending is not always the best option. Well, it's good, but this is not a win-win strategy because you have to lose something so the others can get something. In contrast, the 4 other options as mentioned above seem to be much more efficient. It is a win-win strategy as the pie is expanded for everyone. You gain, they gain, the whole economy gains. This is much more sustainable in the long run.

In conclusion, spending is a must, but too much is inefficient. Yes, efficiency is important. By allocating your hard-earned $$$ bills (spend it efficiently and effectively) on something that increases your standard of living or resiliency/buoyancy in the future (long run), you are either directly or indirectly contributing to a sustainable economic development, a stable and manageable positive rate of growth that allows for a better welfare improvement.

so this is still rudimentary, just a slight glimpse into economics. It is an easy-to-understand concept, but it must never be underestimated as it is a building block into something bigger, better, much more intriguing, to which we are approaching.

Spending VS Earning

One of the earliest economic concepts I learnt is nothing other than this very idea that spending and earning are pretty much the same thing (i.e. spending = earning) when you look at the broad picture of the whole economy. To an individual, a spending is cash outflow, and an earning is cash inflow. So how can your spending be your earning? Well, that is not possible. But how about your spending = another's earning? Why not eh? Simply put, the $3.3 you spend on your daily Iced Latte at Brown (Brown is the best. True story.) will be credited to Brown's revenue. Let's just say your spending, no matter what you spend it on, is never a waste! Yes, there is always a recipient, and as long as that remains true, the whole economy will be healthy! (let's assume all else constant at this point).

So remember folks, spending may hurt you, but it helps the others because your expense is their income. And that is how GDP is measured. Just to remind you, when we look at the economy as a whole, expenditure is equal to income. So in measuring GDP of a country, to avoid double counting (adding both expenditure and income of the whole country together will severely distort the result by doubling the amount of the actual GDP), what they do is looking at either the income side or the expenditure side, NOT BOTH.

This is also what we call "Circular Flow", the very idea that gave rise to the world renown Keynesian economics. John Maynard Keynes, the father of the dubbed modern economics, was the one who was keen enough to notice that the decline in aggregate expenditure would severely hurt the economy because as expenditure plunges, income also falls (again, expenditure = income). During the great economic depression in the 1930s, Keynes urged the government to pump out spending (run deficit) so to keep the circular flow of wealth (spending -> income -> spending -> income...) going. This is called expansionary fiscal policy, in which the government will spend more or cut tax. As the government spent, the business world was able to rebound back on its feet, employment rose, and people were able to once again earn enough to spend to sustain their livelihood. So the little spending spark created by the government had made it possible to fix the stalled economic engine.

In a nutshell, spending is just as vital to the economy as earning. Even a broken window that forces you to call the glass repairman is not such a bad thing for the economy. I mean if everyone's windows are damage-proof, then we will lose a section of the job market (no window repairman since they have nothing to do!).

Of course, I am simplifying the concept as much as possible so that it is easy for you, the reader, to digest. Things aren't that simple. Theory is not perfect, and this one is no exception. There are loads of criticism deriding what I have just explained to you.

Next time, we will introduce an add-on to this topic. We will look at the forgotten side of the story by including new variables, make it a little bit more complicated for those seeking challenges.

What is Economics?

The first question is "what is economics?"

While some might say that Economics is about demand and supply, or about the study of the most efficient way to allocate scarce resources, they are both right. In fact, economics can be defined in many ways. To the untrained eyes, economics might be just what the former two definitions suggested. However, being correct does not imply completeness. I, personally, think economics is about almost everything we encounter daily. Anything ranging from the most insignificant to the utmost importance. Wondering what to buy for your dog's birthday? You might think about opportunity cost or your dog's maximum utility (think of it as happiness, though happiness is not exactly the right definition), and that is economics. Of course, a flower per se is not economics, but how we use it is certainly about economics. Economics might not be able to explain why or how the universe exists, but it can explain how we can utilize this very existence? What the human race can do to survive in the mega ultra long run (millions of years ahead). For instance, we can find alternative resources here on earth, or how about exploiting resources from other planets? This might sound far-fetched, but it is not impossible.

Simply put, all I would like you to understand is that economics is not merely what it seems to be. It is not just about money, interest rate, inflation, or unemployment. The real economics encompasses a whole lot more. To say otherwise is a pretense of knowledge. We all know that one of the core assumption of the mainstream economics is absolute human rationality which is not true no matter how you look at it. We know that economics only involves saving, loaning, investing, spending and wasting, but none of the generosity of human is mentioned, in other words, sharing. Also, the mainstream economics does not mention how a nation's economy is related to its tradition and culture, how a person's surrounding might have a considerable impact on his/her decision. For instance, a stimulus package might increase consumption in a culture of consumerism, but it might have an opposite effect on the one favouring saving. So I believe that there is no one-fit-all policy, and that, being an economist is more than just about applying the theories you have learnt, but it is more about being able to identify and critically analyse the unique characteristics of each situation before modifying and/or applying the learnt theories. 

In conclusion, I want you to be flexible when thinking economics. Do not jump into the water without realizing its depth. The vast ocean of economics contains more than you have ever imagined. I believe this blog will serve you well intellectually. Economist or not, the understanding of economics will give you the edge in life as a whole. I welcome you to my world, Economind. 

With greatest regards,

Darapheak