The Economic Time Machine

Note: As always, the topic is huge. I cannot cover everything all at once. For instance, I did not distinguish between Central Bank and Commercial Bank. For simplicity, many other variables are unaccounted for so that the core concept can be put forth and accentuated. 

What is Economic Time Machine?

Economic Time Machine is real!

Everyone wants a time machine, but most think only science can make it happen. Not to mention, there are those who are skeptical of the capability of our current technology to create one. Even far into the future, we cannot say for sure. I don't know. I don't have an answer. I am not one of those scientists living at the frontiers of such knowledge. But, my friend, what I do know is that of my own realm of study, Economics.

What if I tell you that we have been using the so-called time machine for centuries already? You don't believe me? But trust me, I'm an Economist (or am I?). This time machine is imperfect though. It only allows you limited access into the future and only to yourself. But hey, that is still quite something!

It was born out of innovation in resource redistribution! It is an Economic Time Machine! ETM for short (I completely made that term up)!

The first ETM , according to Wiki and historyworld.net, dates back to around 2000 BC in the ancient city of Babylon! No, I am not kidding. ETM has been employed ever since throughout human history. It has evolved through time and is now, in our modern world, known as the "Bank". Shocked? Don't be. You will see why in a minute... more or less depending on your reading speed.

No, there is no Time Machine inside.

No, Banks do not allow you to physically travel to the future, but banks do perform 2 primary functions that make it the first time machine of our world. They pay interest for savers' deposits, and they charge interest for borrowers' loans. This ingenious system creates a constant and vibrant circulation of resources without ever letting them take a rest, and as a result, it allows you to access the future and make a better present.

What do I mean by that? You see, you might think that when you borrow money from a Bank, you actually borrow money from the Bank. Not really. That is a false logic at 2 different levels.

First, let me tell you that, the money you borrow almost always belong to someone else. Second, you are actually borrowing from yourself. Does this sound crazy to you? But I am not insane. Let me take you off track a little bit so you get a better view of the concept.

What do Banks offer? Operational Efficiency, Allocative Efficiency, and Money Multiplier

Essentially, banks just make borrowing and lending way more convenient by acting as a medium/intermediary. Just like a market where buyers are connected to producers without them ever having to face each other, banks are places where borrowers are linked to savers (who have loanable fund) without them having to meet, without them having to interact with and hate one another. This significantly reduces the cost of loan transactions because it eliminates risks due to inside lag, outside lag, moral hazard, and asymmetric information. Inside lag can be a result of prolonged unsettled negotiation or conflict between borrowers and lenders if they are to face each other directly. Outside lag can be due to document processing and formality required/done by third parties in public service before the loan can happen. Moral hazard can be the inclination of borrowers or lenders to violate the term of loan should there exist opportunities as a result of loopholes within the contract (or the grey area that is not clearly defined). Asymmetric information can increase risk (and thus, risk premium/interest rate charged on loan) as a result of uncertainty, for example, that lenders have on the ability of borrowers to repay the debt. These are all inconvenience that substantially drives the cost of borrowing (or in fancy term: "interest rate") up.

Plus, if bank did not exist in the first place, should there be default on any loan made, all the risk would fall directly upon the lenders, rendering them bankrupt in the worst-case scenario (it actually can get worse than the worst-case scenario if the lenders somehow ended up in jail or committed suicide... who knows...). However, Bank, as a large institution operating at large scale over a variety of financial transactions, can significantly diversify the risk (and thus, cost). Simply put, by making many loans continuously over the course of time, banks are able to generate considerable gain that offsets the loss incurred. Individuals who lend small amount of money with limited number of loans are not able to do this because the loss and gain of each loan matters way more. For instance, with only 2 loans made, if one is a bad loan, you are pretty much screwed. Well, hope you get the idea.

To sum up, what mentioned so far are all related to "Operational Efficiency". Banks enjoy lower cost as it operates at a large scale allowing the risks it bears to be diversified by a great degree. This is also known as "Economies of scale", something we discussed before.

If you want to learn more about Economies of Scale, visit the link below:
http://economind101.blogspot.com/2014/12/cheaper-more-economies-of-scale.html

Another perk of having banks running the financial component of our economy is "Allocative Efficiency". Simply put, banks are driven by incentive to cut cost and allocate resources to where they are most needed; and where resources are most demanded are usually within areas/economic activities that yield highest return per unit of investment or capital input. Basically, this is what guarantees repayment of loans. To tie things up, individual or institutional borrowers who plan to use resources in such high-return economic activities are deemed credit-worthy, and this type of borrowers are whom banks most likely channel their resources to. This process is what makes banks so efficient and effective. Their thirst for optimal return to each loan made causes them and the aggregate economy in which they operate to become much more efficient and flourishing if compared to those with dysfunctional banking system.

Of course, for the above mentioned to happen, it requires firmly established rules and regulations so that the incentive to seek profit does not run wild. The lack of such rules and regulations, the misuse of policy, the oversight of the inherent risks of capitalism and free market, can lead to financial instability and eventually to severe economic consequences just like the global financial crisis in 2008.

That's not all. On top of operational and allocative efficiency, banks also create more money out of money! This entire process is called Money Multiplier! If you are thinking about money printing, then, no, this is not the same. I'll give you an example of how a bank uses money to create more money:

Consider a scenario in which you deposit $100 into a bank. Bank normally puts a portion of your deposit into their vault, which is known as reserve. If the reserve ratio is 10%, then $10 of your initial $100 will be kept. What does bank do with the $90? They loan it out or invest it in stuffs. Say, if they lend the 90$ to your friend, do you think the total amount of money is still $100? True, the monetary base is still $100. The actual amount does not change. However, when banks are taken into account, the amount of aggregate money supply is expanded beyond the initial monetary base. In your case, the $90 (that has been loaned out) has actually become a new addition to the total money supply. You actually still have $100 in your bank, but your friend now also has the $90 lent to him. So, the aggregate amount of money in the economy is now $190. If your friend deposits the $90 into his own account, bank can then keep 10% of that (or $9) as reserve. They can then loan out the remaining $81. And someone else in the economy will receive the $81 created out of thin air. Then, the economy will have $100 + $90 + $81, a total of $271! This keeps repeating itself. And I guess you get the idea. More money created out of a fixed amount of monetary base. That's just so cool.

Check out another article of Economind to learn more about Multiplier:
http://economind101.blogspot.com/2013/12/understanding-multiplier.html

So, these are some of the merits of the so-called Bank. Yes, the role of bank is not a direct lender, but an agent that match the supply of money to the demand for money. Simply magical. What I am trying to tell you is that banks exist because of the advantages they offer that attract depositors and borrowers, and make them a critical component in economic development, not because they (banks), themselves, were born with truckloads of cash for people to borrow. They simply take money from one person and loan it to another. They make profit from the "net interest rate spread": the difference between the interest banks pay depositors and the interest banks charge their borrowers. That is how banks sustain themselves and drive them to operate and allocate efficiently.

How is Bank a Time Machine? Is that even possible?

Before the long explanation, I did mention that those who think they are borrowing money from banks misconceive at 2 differently levels. First, just like what have been discussed so far, you actually borrow money from another person or group of persons.

Second, when we dive deeper into the idea, when you take out a loan from a bank, you are neither borrowing from the bank nor other people; in fact, you are actually borrowing from your future self!! (My god... this twisted, confusing plot makes it feel a little bit like "Inception"). Banks allow you to easily access future resources the future you hold, which are otherwise unavailable and inaccessible to your present self. That is exactly why I call it "the Economic Time Machine"!

The thing is when you borrow in the present to spend more, you will have to save more and spend less to repay the debt in the future. In other words, your future self will have to work his/her butt off to pay for the loan your present/past self took. If you borrow to invest in your start-up or existing business expansion, that is like asking for your future self to make you advance payment from your future self's earning to elevate your own investment or business outcomes. Of course, no matter what the outcomes may be, you (your future self) will still have to pay for the loan.

For this reason, consumer loans (borrow to buy new TV, Game console, New clothes, etc that do not enhance your future earning potential) are more risky because you are just borrowing from yourself to spend more now (and less in the future). If your earning does not increase over the course of the loan period, your future self will have to suffer the consequence. He/she will have less to spend and maintain the living standard you once enjoyed. Investment loans, on the other hand, elevate your income generation capability, and thus, you are actually increasing the overall well-being for your future self.

For the same reason, at macro level, banks that are not properly regulated and that give out too much consumer loans without properly assessing the ability of the borrowers to pay it back will face higher risk of default on loans by the borrowers.

The global financial crisis, the Dire Consequence resulted from the Misuse of the Economic Time Machine

In essence, lending recklessly was what ignited the onset of the global financial crisis back in 2008. Let's talk a little bit about it, shall we?

Well, back then, American banks ignored 2 important factors that make a borrower credit worthy: their income generation capability and their assets (that can be used as collateral). Banks gave out easy residential loans (for people to buy their own home and live the American dream), and they did not care much about the borrowers' credit worthiness. No down payment, no collateral, no string attached. If borrowers can no longer pay back their debts, they can simply forfeit their new home and never return. The banks will seize the houses. Simple like that. Is that profitable? Oh yes, it was a lucrative business. Very rewarding. Despite some warning from a bunch of Economists, the home mortgages were put into packages known as Collateralized Securities, rated super safe by the rating agencies, and sold to investors who were at that time very optimistic. Why?

Most of those involved, including the Banks, expected house price to keep rising because they thought there was a high demand in the market. So, even if the borrowers were unable to pay back the loans, banks thought everything was still cool because house price would just keep rising (due to the apparent strong demand) and they would still make good money out of the loan (when they seized and sold the houses). Many people at individual and institutional levels eventually got involved, but they did not realize that the demand was artificial (i.e. not much real demand for home). Many people bought houses in hope of capital gain (sell the houses to make good profit). However, as more purchases were made with the same expectation in mind, it gave rise to housing bubble (artificial inflation in house price). People did not actually buy to live. They bought to sell. Following individual rationality, more and more jump on the bandwagon. This is what mal-investment means.

As time passed, they realized that in reality, there was not that much demand for houses, or to be specific, home. They could not sell the houses at the high price anticipated, so they lowered the price. The harder they tried to sell their houses, the harder it became to find real buyers. Price started to plummet. Even worst, those who actually moved into their newly bought home were unable to afford to live in one. They were not even credit worthy to begin with. Their current "future self" (if that made any sense at all) could not earn enough to pay the mortgage. Defaults swept the housing market. The financial sector could not handle the immense stress and it snapped. The bubble burst. The economy crumbled. Stock price plunged. Gold price fell sharply at first as investors sought to refinance their losses and as the US currency was, at the beginning (if I am correct), considered safe haven for investment. The change in many investors' portfolios was indeed scary. It was a dark time for the global economy. Even countries like Cambodia can feel the impact, especially on one of its main export sector, garment. As reported by the PhnomPenh Post in October 9th 2008, and I quoted: "62,100 garment workers have experienced job loss as of april 2008, bre wing a general feeling of uncertainty and fear in workers."

The East definitely felt the impact from the Crisis of the West!
Image source: http://data.worldbank.org/news/mdg-challenges-from-2008-financial-crisis

Bad Experience, Good Lesson

This is one bad experience that yields a good lesson learnt. Individuals and institutions in public and private sectors alike need to be prudent and borrow/lend wisely by following clear criteria for loan evaluation. Expansionary policies should be implemented with utmost caution to avoid unnecessary losses. Standard must be established, trade-offs evaluated, options presented and priorities set. These will allow money to be allocated to those whose future selves are able to make effective uses out of the scarce resources and make due repayment for the loan they took.

Long term solutions demand social, political, and economic structural changes. Decentralization and Diversification of economy are something to be carefully considered, something I would love to talk about in a later article after I have done my homework (research about the topics) a bit more.

This is all for now, and I hope you've learnt a great deal from this article. Constructive feedback is welcome.

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References used:

http://en.wikipedia.org/wiki/History_of_banking
http://www.historyworld.net/wrldhis/PlainTextHistories.asp?historyid=ac19
https://www.cambodiadaily.com/archives/garment-industry-continues-to-shed-jobs-63998/
http://www.phnompenhpost.com/special-reports/job-losses-garment-sector

Getting closer to Globalization: The Obsolescence of GDP

In this article, we will first talk about GDP on a national scale and how a widespread belief in GDP as a sole indicator of growth can be detrimental to the development process. Then, we will turn our attention toward a bigger picture concerning the implications of using GDP within the context of globalization.


Possible causes explaining why GDP has become a prevalent economic indicator, and some of the impacts its prevalence has on development as a whole:

In an article posted not too long ago about GDP as an economic illusion, we argued that GDP is not a good enough indicator to measure the welfare of a nation, particularly, its people. We explained the idea from the development perspective; we talked about how GDP does not account for inequality, corruption, discrimination, human rights abuses, social or political instability, environmental damage, and so forth. As far as I am concerned, none of these are included in GDP and GDP per Capita (at least, not at the moment).

However, the misconception about GDP and its effectiveness as an indicator comes mostly, not from economists (who, we can safely assume, have clear understanding of the issues), but from people untrained in the discipline (who make up the majority of the world population). This is problematic because the economy is driven by the 99%. So what? Well...  

...You see, GDP is used as an indicator of economic performance of a country, not because they consider it the best and most inclusive indicator, but because GDP serves as a practical means of measuring aggregate production of goods and services of an entire nation during a period of time, which is great.

GDP = C + I + G + NX 

GDP for gross domestic product, C for consumption, I for investment, G for government spending, NX for net export. Simple. Clear. Intuitive.

Furthermore, the fact that it has become a common measurement method adopted by almost every nation is the result of what we call "Network Effect". The more countries use GDP as its economic indicator, the more GDP is valued and used by other late adopters. This is no different from how things like phone, email, and QWERTY keyboard layout were brought into popularity. Their value rose significantly as their user base got larger and larger. Imagine a world with only you using phone. Who are you going to call anyway? Not to forget, the more people adopt and accept something, the harder and more costly it is to change/switch to another option even though the long-term prospect for such changes to happen is actually a lot better than sticking to the status quo. I mean, this might sound a bit counter-intuitive and stupid, but it really happens in real-world. For the same reason, I believe, GDP has become so popular, and people have become so accustomed to thinking in terms of GDP (using it as their frame of reference) that they unconsciously resist the transition from GDP to a new indicator (which cause the transition like this to be quite costly). Time is, of course, required for the change to occur. Regardless, I have to admit that we need to start somewhere (Maybe there are people who have already been working hard on the transition process).

Another cause of the proliferation of GDP as an indicator is the "bandwagon effect" which basically states that the more people do/believe in something, the more likely everyone else do/believe in that same thing despite their own belief or the initial skepticism they had. Another term to describe this psychological phenomenon is "herd mentality". Individuals are predisposed to follow the crowd by ignoring their own reasoning. Globalization and localization of foreign knowledge (esp, through the media) might play a role in spreading this economic fallacy concerning GDP, from the misguided few to the entire global population.

One must never ignore the fact that decisions are always made at individual level, and thus, they are further constrained and rendered less effective if the individual's rationality is bounded by his/her limited information and cognitive capacity (we call this "bounded rationality"). In our case, the lack of knowledge about GDP acts as a constraint that renders individual decisions and the following collective outcomes less effective and favorable.

Therefore, the universal employment of GDP as an economic indicator is, on the one hand, good because GDP has become a common language/term used by everyone despite their different native languages. It reduces the cost during encoding and decoding processes, which would have been incurred had we use different languages/terms when referring to a single idea. Thus, GDP as a universal indicator of productivity allows for comparison, mutual understanding, and convenience when attempting to establish a common ground where all nations can begin their engagement in cross-border development, in the globalization process.

However, the herd mentality and the limited information available (bounded rationality) can have a profound impact on the knowledge and understanding of the population, their rationale and the outcomes of their decisions.

I have, hundreds of times, heard people talking about GDP and GDP per capita as if these are divine tools for measuring growth. This is a serious misconception, and if the majority of the global population continues to hold on to such fallacy, they will be more prone to manipulation and misguided behaviors towards states and development itself.

GDP can be a double-edged sword in development as it has the ability to mislead a nation and its population into either underestimating or overestimating (because, for instance, GDP does not factor in informal sector which is huge in many developing nations) their own growth rate, their physical and soft development rate, and the level of welfare they achieved. Overuse of GDP can harm a society by masking reality and clouding the judgment for both state and non-state actors. Why should it be a concern? Because not being able to analyse the situation one is in will incapacitate one's ability to determine the remedies necessary to enable proper recovery and improvement.

That is exactly why countries who are proud of its 7% or 10% GDP growth rate are too complacent. First of all, you have to think in terms of the base used to measure the growth rate. A country with $1 million in GDP can easily grow 10% more by increasing their output to $1.1 million ($0.1 million increase). However, a country with an annual GDP of $100 million will have to increase its output by $10 million to maintain the same 10% growth rate. Thus, growth rate, while it is useful, does not tell you everything about growth.

In addition, by overlooking their shortcomings in other dimensions of development, they will not be able to achieve a sustainable and equitable inclusive growth. Our previous article on Poverty has provided substantial reasons to justify the claim made in this article. A $30 increase in income (which contributes to growth shown in the calculation of GDP) does not necessarily imply better well-being of an individual. A sick person might not be able to eat the food or absorb all the nutrients in the food bought with the $30 increase in income. An uneducated person might not wisely put the $30 increase in his/her earning into good use (ex: the person might end up spending all on gambling). GDP has the power to hide such facts from the public eyes, and governments who want to increase their popularity and credibility might resort to using GDP as an expedient to manipulate and sway the public opinion in their favor.

Globalization: What does it tell us about GDP?

"Globalization: We all play a part in it"
Image source: http://imgarcade.com/1/globalization-and-cultural-diversity/

In the context of globalization, GDP is losing its effectiveness as a universal indicator of growth, especially in the long run. Basing one's understanding about the world economy on GDP is exactly the reason why some people start to talk about the so-called post-american world with China hegemony on the rise. It is the idea that the United States will soon decline from its position as the global powerhouse, the leader of nations and that China will soon surpass the United States simply because its GDP is growing larger than that of the US. This sounds promising, but is it really happening? No, or at least, not anytime soon.

By making such a statement, many variables are unaccounted for. China's aggregate GDP, first of all, is only growing larger than the US due to the 1.3 billion+ population (cheap labour) it has, the influx of FDI, and the mass export to developed regions it enjoys since the implementation of the open door policy initiated by Deng Xiaoping (one of the most prominent leaders in the entire history of China, best known for the economic revolution he brought forth for the country) in 1978, which set into motion the economic transformation into the current modern China. Of course, it simply means that China is heavily reliant on the west for its growth, socially and economically (while incurring substantial environmental cost... just a side note). Inter-dependence is probably a better term to describe the real world situation, in which all countries are increasingly depending on each other economically due to the world economic integration, or in a broad term, globalization.

Notwithstanding this tremendous achievement, GDP per capita wise, China is still behind the US by a long shot. According to the online data published by the World Bank, as of recently, the Chinese, on average, earns about US$6,800 a year, while the American is earning US$53,143/year. Of course, you might argue that goods and services offered by the Chinese market are cheaper, but even if this allows the Chinese to buy more goods and services compared to the American given both having the same amount of money, you cannot deny the fact that the American is still several times better off. Moreover, you have to take into consideration the quality of goods and services offered that ultimately constitutes the quality of life itself... which is how it is in contract-intensive economies (please google the term "contract-intensive economy"). And don't forget the different social and political environments encompassing the two populations (democracy vs communism, etc).

Furthermore, since globalization gives rise to stronger inter-connectedness/interdependence between states, it also leads to high capital and labour mobility across countries. This means that capital is actively seeking places with higher potential return, the selling point of developing nations. Consequently, more capital, especially in the form of FDI (long-term investment), from the first-world countries are flowing into the thirds. This can be witnessed in the activities of multinational corporations are expanding their operations and outsourcing strategies in many countries across the globe.

What does this tell you about GDP? I think what it, once again, implies is that a new indicator should be adopted, or GDP (the traditional indicator) should be adjusted/improved to the changing real-world conditions. Why? Because GDP only measures the total output (value of all goods and services) produced within a country (literally, within a country) at a specific period of time. If capital and labour mobility increases as a result of globalization (ex: in the form of economic integration), this implies that factors of productions (inputs) and outputs happen elsewhere outside of the nation where they come from (in our case, outside of the US). In that sense, GDP is losing its accuracy and potency as an economic indicator.

For less-developed and least-developed nations, GDP might overstate the nation's well-being as its labour and capital might be exploited by the multinational giants, taking advantage of the nation's inclination towards corruption and weak rule of law.

When talking about globalization, we have to also consider the previously discussed mini-concept related to self-fulfilling prophecy. When people misinterpret GDP as an accurate predictor of growth, they tend to also believe that falling GDP foretells impending crises, and as a consequence, they react accordingly in response to the warning siren. The strangest thing is that most of the time, by conforming to the popular belief about GDP, people end up saving themselves in the very short-run but aggravating the situation for themselves and everyone else later on. How? For example, upon hearing the news about the imminent global economic crisis, they couldn't help but withdrawing money from banks and start saving to prepare for the heavy rain ahead. Just in the bank sector alone, two things end up happening.

First, the fear of bank run compels more people to withdraw their deposits, which make it more likely for the bank to really become insolvent, a prophecy self-realized by the mass panic. Since banks are the financial intermediaries, the link between producers & consumers and between lenders & borrowers, their bankruptcy is a real apocalypse for our modern society.

Second, paradox of thrift comes into play. The fear of economic downturn and the subsequent effects force people to start saving more and more, to buy more precious metals (considered as safe haven for investment), and to hoard money and goods; all of which drain away capital supply from the economy. The aftermath? Less money spent, less money received (earned). Less money earned, less tax. Less tax, less potent fiscal policy. Government resorts to printing money, but that increases the risk of inflation if overdone.

The thing is... as bad as it might sound on a national scale, globalization can make things a lot worse. To reiterate, globalization implies strong links or interdependence between countries, and thus, when the majority blindly relies on a single indicator as a predictor of economic health, a national or regional crisis has the potential to escalate even further into a global crisis. In other words, countries are gravitating towards the core of the global network, which most of the time, lessens the day-to-day economic volatility, but worsens the impact of a shock occurring in the central network. Remember that misconception can lead to a level of panic disproportionate to the actual problems at hand, and this can lead to self-fulfilling prophecy, giving rise to the most unlikely event (that would most probably not have happened had people been better informed).

Still, GDP as an indicator, per se, is not detrimental to the development of any nation (not that bad of an indicator either), but the fact that most people are confused about what GDP really is, the fact that people (esp, the media) hold a strong belief in GDP as an indicator of their countries' economic performance without considering the flaws of this indicator, are what really make this traditional indicator, GDP, a less desirable economic measurement tool. We need to find a new and better indicator, either a brand new one or a combination/improvement of the old ones. At the very least, what we should do is get people to understand more about GDP, particularly its strengths and weaknesses.

Don't get me wrong though. I am not saying that GDP is a failure. No. Whoever came up with the idea is a genius. GDP has served us well, but we are living in a dynamic world, meaning that things change all the time. We are able to survive because we win in the natural selection competition (survival of the fittest). How did we win? How did we overcome constant changes? Because we evolve, we adapt, we improve. We, humans, have come a long way, and globalization is a new milestone for us. As we get closer and closer to globalization, there is a demand for changes in the way we do things so that we can realize the true potential of the "one earth, one country" concept (I completely made it up).

Adapt and evolve. This is the bottom line of this article.

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Sources used:
http://data.worldbank.org/indicator/NY.GDP.PCAP.CD

Economies of Scale: Cheaper More

*08.12.2014 @5pm: This is my first draft. Published as soon as I finished writing it. Please forgive me for mistakes. I will re-read the whole thing and make corrections accordingly should there be any errors.

*08.12.2014 @11pm: I have re-read and corrected mistakes here and there. There were quite a lot of unintended errors. Hope it is much easier to understand now.
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08.12.2014:

We have been playing around with the same old concepts such as the paradox of thrift, demand and supply, spending and income, multiplier, income inequality, etc. It bores the heck out of me, and I guess it is getting boring to you, my dear readers, too. Don't you wish you can just win some millions bucks by now and stop learning everything all at the same time? If you do, then don't. We always learn something new even if we don't want to. Stop learning is pretty much being dead. So, don't.

Anyway, enough with the joke. I guess the time has come to introduce a new concept to make this blog a bit more alive.

In our previous article about Equality and its viability as a global practice, we discussed about how equality will reduce the incentive to produce and expand to reach the optimal point of efficiency, the result of economies of scale. Economies of scale... music to my ears! Let's pick this one up and get to know it better.

Well, what are Economies of Scale? Economies of scale is a really cool economic concept. All it really tells you though is very simple: "The more you produce, the less it costs you". The idea can be easily witnessed in reality (or even from pure logical thinking), which is based the fact that most of the time, firms face higher cost when producing lower than a certain threshold.

Long-Run Average Cost curve
As Output increases (to the right of the curve), the average cost or per unit cost is also getting lower)
http://www.bized.co.uk/reference/diagrams/Economies-of-Scale

Hold on there. Shouldn't produce less result in lower cost? Think about it. You want to make a pie, and to do that, you have to spend money (buy ingredients), spend time and energy (to bake the pie), and incur an implicit cost (which is probably the time you could have spent on studying to get an A+). So, shouldn't baking 2 pies cost you more than 1 pie? 

How does the concept of economies of scale work? What is the big idea? It doesn't seem to add up.

My friend, you are not wrong if that is how you think. In general, yes, it applies to business as well. The more they produce, the greater the total cost.

See what I did there? It is "total cost" that increases, but "per unit cost" is a different story. Per unit cost is basically total cost divided by total quantity produced, and when I said "produce more, cost less", I was referring to cost per unit, not total cost. How can that be? 

You see, when you start a business, two types of cost arises. The first one is fixed cost, and the second one is variable cost. Fixed cost is simply fixed (does not change) regardless of the increase/decrease in business activities (i.e. the increase or decrease in the total quantity of goods/services produced). A $10,000 per month lease on a building by a business, say bike manufacturing firm, can be considered fixed cost because no matter how many bikes the firm produces, the lease on the building will remain at $10,000/month (unchanged). This is important for further explanation of our concept, so mark it down in your head.

In contrast, variable cost, just like its name suggests, varies/changes in relations to the amount of goods produced. For instance, to produce a bike, you need two wheels, and they cost money. The more bikes you produce, the more wheels you need (#wheel = #bike x 2), the more cost incurred. Thus, wheels are associated with variable cost. 

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*How do we determine which is variable cost and which is fixed cost?*

Just to make it clear here, specific activities are tied to either one of the two types of cost, but it is also dependent on the time span. In other words, whether a cost is fixed or variable is also a matter of time. In the short-run, say 1-2 years, the cost of leasing the building by the bike manufacturer, is regarded as fixed cost. After all, it is very unlikely for them to start leasing or buying more buildings any time soon because the demand for bike and their business is not going to grow fast enough to warrant the need of more buildings. On the contrary, when we talked about 50 years into the future (the long run), buildings might then be grouped as a variable cost as well. Because by the 50th year, there is a chance that the business will be successful, and as a result, it will compel them to lease/buy more and more buildings during that period of 50 years. 

Nonetheless, we like to live in the present, and 50 years of time might involve too much uncertainty and unpredictability, rendering the fate of the firm and many other variables undetermined. I guess that might be a reason why we normally consider the cost incurred from leasing property as fixed cost. I mean it just makes more sense. You are not going to lease 10 more  building anytime soon even if you business is expected to perform well. So, for simplicity, in this article, property (buildings, land...) is labelled as "fixed cost".
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So, what have we learnt up until now?

Let TC denotes Total Cost, VC denotes Variable Cost, and FC denotes Fixed Cost (not Football Club). Then we have:

TC = VC + FC

Based on the equation, we have learnt that Total Cost is made up of Variable Cost and Fixed Cost.
Make sense?

Basic math here. How to find Cost per unit?

Let Q be Quantity of goods or services produced. Then, Cost Per Unit is simply TC divided by Q.
Now we have the following equation:

TC/Q = VC/Q + FC/Q

TC/Q = Cost per unit
VC/Q = Variable cost per unit
FC/Q = Fixed cost per unit

This means that:

TC/Q (decrease) = VC/Q (decrease) and/or FC/Q (decrease)

To put simply, cost per unit will fall only if either one or both of its components, which are VC/Q and FC/Q, fall. And in case of an increase in a component's value (say, VC/Q increases), then TC/Q can only decrease if the other component falls by a greater degree (i.e. FC/Q decreases more than the increase in VC/Q).

So, the magic of economies of scale is not cast on Total Cost, but rather, the Cost Per Unit: FC/Q and/or VC/Q.

In other words, economies of scale, while it may or may not reduce the total cost incurred when you produce more bike, it causes the cost per bike to get lower and lower.

You: "What the heck? Are you telling me that more bikes = cheaper bikes?"

Economind: "Certainly. Now shut up and listen."

Image source: http://blogs.mprnews.org/statewide/2013/08/pride-profit-drive-bike-builders-minnesota-made-dreams/

For example, in the manufacturing of bike, the variable cost consists of the cost of wheel, pedal, handlebar, and body. When the firm manufactures 100 bike, and the variable cost is $10 per bike (2 wheels = $4, pedal = $1, handlebar = $2, and body = $3... well, getting this detailed is completely unnecessary...), are you going to sell your bike at $11 and expect $1 of profit? Wrong!

You forgot to consider the fixed cost incurred. If the fixed cost of leasing a building as the manufacturing house is $2000, that means you have to add $2000 to the total cost of the bikes, which translates into additional $20/bike (Fixed cost per unit of bike= FC/Q = $2000/100 bikes = $20/bike).

So, to be at the breakeven point (i.e. to survive and make no loss), you have to price your bike at the very least $30/unit.

$30/bike (TC/Q) = $10/bike (VC/Q) + $20/bike (FC/Q)

For the sake of our topic, let's just assume that out of nowhere, suddenly, the economy is doing so well and people are becoming more concerned of their health ==> they want to ride bike instead of driving. This is a great opportunity for the bike manufacturer (you) to start produce more bikes to match with the demand and earn more money.

This is when we witness the beauty of the economies of scale, which is the fact that as you produce more bikes in response to the greater demand, assuming all else constant (no shock from shortage in raw material or bike components), even without the decrease in variable cost, you will be able to lower the cost of production by simply producing more. How??

Fixed cost per unit is the answer. Remember, fixed cost does not change when you produce more bike. Now, let's say, due to the economic boom mentioned earlier, your firm has then decided to produce 100 more bikes. So the total quantity of bikes your firm manufactured is now 200. Same variable cost, same fixed cost. This implies the following:

Variable cost per unit = VC/Q =  cost of (2 wheels at $4 + 1 pedal at $1 + 1 handlebar at $2 + 1 body at $3) = $10/bike

Variable cost seems to stay the same. Now, pay attention to the next one.

Fixed cost per unit = FC/Q = $2000/200 bikes = $10 per bike!!!

Did you see that?

Before, when we produced 100 bikes, FC/Q = $2000/100 bikes = $20 per bike
Now, when we produce 200 bikes, FC/Q = $2000/200 bikes = $10 per bike!!

Fixed cost just falls by half! What kind of sorcery is that? No magic spell here. This is pure economics. Being able to remark such a simple cost-cutting mechanism is the true beauty of Economics.

So how much does a bike cost you now? (after having produced 200 bikes)

$10/bike (VC/Q) + $10/bike (FC/Q) (decreased by $10) = $20/bike (TC/Q) (decreased by $10)

As illustrated, economies of scale allow you to sell more bike at less cost per unit. Thus, you now have gained more price advantage in both domestic and international market.

The whole manufacturing process has just become much more efficient! As a result, the reduction in cost due to economies of scale has allowed you to do one or a combination of the followings:

1. Sell your bike at lower price, and thus, gain more competitive advantage via price and attracting more demand;
2. Sell your bike at the same price (at $30), but gain more profit from doing so (this also depends on "the price elasticity of demand", which I will probably discuss it in another article).

The lower production cost as a result of economies of scale can now be passed on to consumers (ex: to bike enthusiasts) in the form of lower price. You company can now sell more bike and make more profit as well. Everyone wins.

It does not end here. When economies of scale happens, variable cost can also fall as a result. This can simply be explained by the sheer size of a firm. When a firm gets larger, a bunch of other things happens:

• The firm becomes more efficient in its operation (Experience gained through time);
• The effectiveness of labour increases;
• Capital is employed at its maximum capacity (Machine is used to produce more given similar amount of energy inputs like electricity, gasoline...);
• Less inventory in idle state, meaning inventory is used up faster than its depreciation rate;
• The firm is gaining from its ability to make greater bulk purchase of raw materials, and thus, allows for the cost to be reduced as the suppliers of raw materials is now producing more to meet the bike manufacturer's demand, and thus, they themselves are able to also experience economies of scale in their respective firms;
• The firm is gaining from getting closer and closer to becoming a Monopsony (The sole/only purchaser of certain products/raw materials), and thus, grants the firm an immense power to put pressure on suppliers to lower price (Ex: Wal-mart)
• And you can probably find more from google

Again, it does not end here. When a firm becomes larger, they can also get capital at a much cheaper rate as compared to smaller firms. First, they have more earning. Second, they have more collateral. Third, they have better credibility derived from their goodwill (implicit value of the firm based on its current performance and its growth based on future projection). So, economies of scale can also lead to financial advantages.

What we have discussed until now is related to "internal economies of scale", something that happens inside the firm, and that the firm has control of.

It does not end here! (I can say this forever) We have yet to talk about the "external economies of scale", which are the external factors or positive externalities arisen else where (that the firm has no control of), but benefits the firm, even the entire industry and even the whole economy or region. For instance, the discovery or invention of a cheaper and stronger type of metal might not just lower the cost of the bike components (handlebar, pedal, body, wheel), but it will also lower the cost of the components/raw materials used in the production of car, ship, plane, building, and thousands of other products and services. This kind of discovery/invention will positively impact many industries across the globe, not just limited to a single industry or economy.

This has been a fun discussion so far. Nevertheless, economies of scale is not to be taken too far, or else, we will end up with... DIS-ECONOMIES OF SCALE!

Growing up is good, don't you think? But nobody wants to be too big or too fat or too tall because all of these conditions of "too much of something" entail problems. Likewise, a firm's growth is a positive sign for both the firm itself and the economy, but that applies only to a certain extent. As the firm gets larger, the reverse (of what discussed so far) can happen, resulting in the so-called "diseconomies of scale". We will talk more about it in the future. For now, I encourage you to do some research about it by yourself first. Google is the key!

Hope you enjoy this article and have learnt something new about economics from it.

Is Equality viable as a universal practice?

This article builds on the ground of free-market, market failure, and causes and consequences of income inequality (i.e. equality from economic perspective). I will discuss the downsides and upsides of the principal of equality, and at the end, I hope it will leave you with something to think about, at least, for another 4-5 minutes after having read the article.

Is Equality justice?

You see, people often talk about how they want to promote equality within a society, that it is the ultimate goal we aspire, the goal that marks the attainment of the ideal society where there are no rich, no poor, and thus, no single person with the power to oppress the others, no one to impose their own judgement as the righteous ways of doing thing. This very foundation of thinking gave birth to socialism and even its more extreme forms such as communism. 

Instead of focusing on dictatorship, a popular example derived from the regime mentioned, I want to focus more on the economic side of the coin.

The flaw in such thinking, which is the fact that "equality demotes incentive", is not taken into account. Equality, whether it is about equality in the ownership of means of production or the actual outputs, does not allow personal interest and effort to yield suitable level of return to stimulate further production, expansion and innovation. For instance, even in capitalism, when a rich person is taxed by a large proportion of his income so the government can redistribute the taxed money to failing businesses or the unemployed portion of the population (to promote equality), such method of income redistribution does not allow full ownership of a person's earning from his strenuous exertion of his time, mental and physical energy, and capital. In a way, too much suction of personal wealth, if overdone, will result in moral hazard for both ends, the takens and the takers. How? 

On the recipient end, we might face with "free rider" problem. Income transferred to the unemployed might just be enough for them to survive without having to work at all, and when that happens, people might lose the incentive to seek jobs just to earn a little bit more than what they are receiving for free.

The takens or the rich might have less motivation to work harder, to produce as much as he can. Additionally, such restriction on ownership of resources will give birth to a new incentive, which is for people to try to avoid taxes.

But the problem does not end there. On many different levels, equality can produce adverse effects. One of such effects is "spillovers".

Spillovers can be in different forms. The most obvious is wage paid to employees. Allowing businesses/personal interests to expand will allow higher wages and greater well-being for the mass. The less obvious is probably technological spillover, and by "technological" spillovers, I don't just mean iPhone and iPad. I mean machinery, agricultural methods, systematic management, philosophy, culture, ethics, etc.

Furthermore, maybe ones that have not been received much attention are some of the economic impacts resulting from the lack of understanding of basic economic concepts such as the paradox of thrift (spending = earning), efficiency, economies of scale, multiplier effect, and so forth. Let me illustrate via a few examples.

Paradox of thrift simply states that the less you spend, the less you earn, and vice versa because when there is expense, there is income; when you spend a dollar, there is another person who earns a dollar. Moreover, from our understanding of multiplier, the 1 dollar can turn to 100 dollars using the magic of economics. To gain an understanding of how that can happen, I encourage you to read my other article "Understanding Multiplier" via the link below: 

http://economind101.blogspot.com/2013/12/understanding-multiplier.html

Efficiency is can be either a direct and indirect result of incentive. An incentive can be in the form of more profit and less cost (thus, more profit, competitive power...). This incentive only arises in privately operated organizations, and the presence of such incentive in non-profit or governmental organizations is, if none at all, faint. The continuous effort to drive down cost, to raise profit, to have the edge in competition (which also encourage higher quality), and to survive in the fierce competition imposed by free market put great pressure on private organizations, forcing them to find ways to do things efficiently both in their operation and allocation of scarce resources. For this simple reason, most government's traditional tasks, including various public services and development projects once done by the government, are now contracted out to private companies, giving birth to the term we so love: "Privatization". For example, municipal trash collection, which used to be done by the governments, is now, in many countries, the job of private firms. So, not allowing incentive by imposing the principle of equality will divest the firms of the incentive they enjoy, and thus, reducing the motivation for them to operate efficiently and to compete.

When equality is practiced and pervasive, another implication is that firms are less likely and less willingly to expand and innovate. When people do not perceive additional gain from their additional effort, they simply don't try any harder. Now you might say: "But what about social return? the prosperity of one's society? Wouldn't all the good citizens want that?" Let me tell you that, yes, that they desire. However, at the same time, people also question fairness when it comes to equality. Will you be able to work hard if what you achieve is to be shared among people who do not work as hard as you do? The thing is resentment at free-riders will cause the system driven by equality to fail. As a result, in such a system, businesses (if there is any at all) do not have the incentive to expand (increase their inputs), and when they do not expand, they cannot produce more to reach the pinnacle of production, mass production large enough that per unit cost can be reduced significantly resulting in cost reduction for the entire population when consuming such a product. I will explain more about economies of scale (internal and external ones) in later articles. In the meantime, you can google the term out and get some understanding of it.

So far, it seems equality loses, don't you think? Can we lead an economy by not considering equality at all?

Like what I mentioned in my very first article, the study of Economics will eventually teach you about the flaws of Economics, and the need to explore a broader world of knowledge to compensate for what Economics fails to explain.

In Economics, I was taught mostly about how free market and capitalism is about equal chance of success, not equal level of success regardless of what you do, not central planning. This makes so much sense that I really wanted to believe in this system of governing resources. It makes so much sense that it initially narrows my view into thinking that equality is not the "thing". After all, we should get what we work hard for given the equal chance we have to reach our goal (which is conforming to the principle of equity, but I am not going to use the term here for various reasons). I wouldn't want the result from my hardwork to be shared among those who do nothing or not perform as good as I do. I work hard for it, I deserve it. People, who do nothing or slack off, should get less, if not nothing. That way of thinking, my friend, is false.

Sorry, let me rephrase it. What I want to say is "Using that mindset to justify the need to deride the principle of equality is misleading."

Equality is not always a bad thing. Think of it this way; ketchup is not good with cookies, but it is great with burgers.

Equality might not work well if we apply it as equal redistribution of returns, but what if the principle of equality is moderately applied at the start of businesses?

Let me illustrate this concept with a simple example. You have two persons, A and B, who are identical twins. Both have the same intelligence level, same education, same personality traits, and same level of physical endowment. The only difference is that A is adopted and raised by a rich family, and at the age of 20, A is entitled to a tremendous amount at A's disposal to start any business as A pleases. B, on the other hand, is adopted and raised by a poor family. B has to start from scratch at his 20 when he wants to start his own business. Both, by laws, are given equal chance. All else constant, again, the only difference is the amount of wealth A and B have to kick start business. What do you think will be the outcome?

If all else constant as stated, A will end up with larger amount of wealth faster and is able to expand his business and accumulate much more wealth, giving him the edge in competition. Why? Because business is also about who gets there first. A, eventually, will also inherit more wealth from his rich family allowing him to do much better if compared to B (who will undergo much more financial stresses and challenges due to both internal and external factors).

Simple as it may sound, when you expand the scale of such an example, you will see a bigger picture. You will notice that as time goes by, inequality tends to manifest itself in the form of wealth concentration in the lineage of the richer few. This gives them the power to acquire political favors and manipulating the once exogenous variables (such as taxes, economic policies, and international trade, etc) to further increase their advantages in the business and political playing field. Whether this is happening or not in reality, the fact that the mass most likely think this way is dangerous.

As a result, this increasing income inequality can create a situation in which the majority of the population, who does not possess such amount of wealth, start to rely on the strength of number. This can lead to public discontent, political turmoil, social instability, insurrection, and the worst possible scenario, civil war and social collapse.

Note: The impact of inequality is probably even more severe in developing countries. For developed nations, the unfavorable impact might be mediated by strong and effective governance with solid rules and regulations.

This sounds too gloomy, and most people might simply dismiss this idea as simply fantasy of the naive mind. However, one cannot reject the possibility of such events.

Economic principles, thus, should be practiced with prudence, and they should be accompanied with equality of all citizens in terms of human rights, universal education, protection, legal obligation, etc. This is like going back to the topic about "Poverty", about human capabilities. Capitalism and free-market will give everyone a shot at success, but a sick person, by pure logical reasoning, will still be less likely to achieve as much as the healthy ones can. Therefore, equality is to ensure a level playing field for everyone.

So this means that, a broad application of just a single principle in an economy will not yield the optimal outcome or total failure as some might expect. Since an economy, a society, a country comprises so many dimensions of many different types (social, economic, political, environmental, ethical, etc), we need to adopt the right practice adapted to a specific dimension. One-size-fits-all principle is to be avoided at all cost.

The simple truth is embedded within the idea of Equifinality, which basically accepts and states that there are different ways towards a goal. This implies that a different combination of different principles can be used to achieve a greater positive outcome. We can also conclude that by including a moderate degree of equality, one can reach an equilibrium state where social welfare is actually improved, not just some economic indicators such as GDP and unemployment rate.

Just something extra here. Truth be told, there are certain policies that hurt in the short-run, but yield tremendous returns in the longer run. So, I strongly encourage you, especially economists and econ students of all ages, shapes and sizes, to explore the vast universe of economics and start questioning the economic models and theories you have learnt (and find the optimal option) before applying them in work, in the real world.