The foolish economist takes on inflation

The Foolish Economist: on
Growth and Inflation
A. Arkay (not an economics major)

7/15/2012 The Foolish Economist 2

Foolish Economics
• I confess – I studied economics in my freshman year and my
junior year in college.
• So, a long time ago, I learned all this stuff about how the
economy works.
• But I hardly remember any of it and as I listen to the
–ocrats and –icans battle to the death I wonder if they learned
the same thing that I did.
• So, I decided to reconstruct something from the past.
• But with the passage of time, I must have forgotten something
because, this is what came out.


The canonical eco-world: John vs. Bill
• Two farmers, John and Bill are the sole people in the world. If
you wish, you can think of them as aggregating all the others
behind them.
• For instance, John and Bill could be two nations.


Simplifying assumptions
• Like all economists, I have simplifying assumptions:
1. It’s a closed world with only two people, John and Bill.
2. John and Bill don’t have dependents with varying demands and
future ability to support them.
3. John and Bill don’t age or become weak and so on.
4. John grows grapefruit; Bill grows mangoes.
5. Each of them needs 1 grapefruit and 1 mango for every planting
cycle (“year”, if you will).
6. To grow this minimum amount takes them 1 hour of work each day.
7. They begin with enough for the next “year”


Why these assumptions
• We live in a closed world
• Dependents add complexity. Maybe add this later?
• Aging, Dying, being supported by past dependents, etc., add
complexity.
• Real people need thousands of things – that’s complex.
• They have different skills, and that encourages them to form a
society. Humans live in societies. Societies are complex, but
this one has only 2 people, so looks simple.
• Studies have shown that hunters and foragers spend between 2
and 4 hours daily getting what they need and the rest of the time
doing nothing.


The First Year
John Bill
John works 2 hours/day Bill works 2 hours/day
John produces 2 grapefruit Bill produces 2 mangoes
John to Bill: I can give you a Phew! Thought you’d never ask!
grapefruit, in exchange for a mango Here’s a mango.

And so, they were healthy and happy!


Accounts at end of Y1
Action John Bill
Initial State 1G + 1M 1G + 1M
Grew 2G 2M
Transferred -1G+1M -1M+1G
Held 2G + 2M 2G +2M
Consumed -1G - 1M -1G -1M
Final State 1G +1M 1G+1M
Delta (Final-Initial) 0G +0M 0G +0M

Note: This is a “normal” year and they accumulated nothing (Delta). This
is a subsistence-basis culture that values leisure over accumulation. At the
end of 1 year they have not become richer or poorer, and they have just
enough for the next year.


Year 2
John Bill
I am going to work extra hard this year Why?
I want to be rich! Huh?? “rich” – what’s that?
You’ll never get it

John works 3 hours/day producing 3 grapefruit

Bill works his usual 2 hours/day producing 2 mangoes


Accounts at end of Y2 – Case#1
Action John Bill
Grew 3G 2M
Transferred -1G+1M -1M+1G
Held 3G + 2M 2G +2M
Final State 2G +1M 1G+1M
Delta (Final-Initial) 1G +0M 0G +0M

John has “produced”1G.

What can he do with it?


At the end of Year 2
John Bill
John to Bill: I have one extra “Buy”? What’s that?
grapefruit. Why don’t you buy half a
grapefruit from me?
You give me half a mango for my half Huh? I don’t have ½ a mango!
grapefruit
That’s alright – you’ll just owe me ½ a “Owe”? What’s that?
mango and give it to me next year
It means that next year, you give me ½ Oh. But then, I will only have ½ mango
a mango for nothing. left – so, next year, will you give me 1
grapefruit for the other half of my
mango?
Of course not! If you give me ½ M, Hmm That’s no good. I need 1G!
you will get ½G. You know that!
But that would make 1M equal to It sounds weird the way you put it .
1+1/2G!! But,yes!


At the end of Year 2, cont’d…
John Bill
You simply don’t understand. I’ve worked That is a fantasy. You worked hard, maybe,
hard and increased our wealth. but by producing 3 grapefruit when we only
needed 2, you made 1 mango equal to 1+1/2
grapefruits!
No way! Our combined wealth was 4G. Oh, I see. “price” means how we exchange
Now, with the price of 1M being 1G, we mangoes for grapefruit. OK, I get it.
have 5G.
So do you get it now? Yes I do. And you are wrong! Our combined
wealth used to be 4M. Now your 3G is only
worth 2M, so our combined wealth is still 4M.
You just wasted time during which you could
have enjoyed life, like I did.
How stupid do you think I am? Even if This is “the law of supply and demand”.
you just count the fruits, we have 1 more There’s no demand for the extra half-mango.
than before. Even you don’t need the half-mango you
were reserving for yourself.


At the end of Year 2, cont’d…
John Bill
That’s bizarre! If I use your price of No! The 4G last year has the same value
1+1/2G for 1M, we now have 6G! as the 6G this year – that’s called
That’s an increase from the old 4G, “inflation”. You suffered 50% inflation last
isn’t it. year and your products lost value!
That does it! Inflation-pinflation- But, I know you have it in reserve, so I’ll
pshaw! I’ll hold my extra 1G back and offer 1M to you for 2G.
you wont even see it.
I will refuse to make the trade! I can wait!
The waiting game is dangerous as they both need 1G and 1M for sustenance. In
this case, the person who gives in first sets a precedent. In human society,
precedents are a powerful conservative force.
1. If John wins, he may well established the 1G=1M equivalence for a
considerable period of time.
2. If Bill wins, the law of supply & demand becomes the rule and they have equal
shares in the excess grapefruit!


Accounts at end of Y2 – Case#2
Action John Bill
Grew 3G 2M
Transferred -1.5G+1M -1M+1.5G
(1M=1.5G)
Held 2.5G + 2M 2.5G +2M
Final State 1.5G +1M 1.5G+1M
Delta (Final-Initial) 0.5G +0M 0.5G +0M

Note: Look at the bottom line – Case#2 leaves them equally
wealthy. John worked hard so Bill could have ½ G!!


Case#1 vs. Case #2
In Case#1, John has accumulated 1G. But nobody wants that G! Without
demand, it is valueless.
A crisis that affected the production of G/M/both would give the saved 1G
a value! There are three sources of such crisis:
a) Global effects that apply to both equally
b) Something that affect Gs much more than Ms
c) Something that affect Ms much more than Gs

The two paths differ WHEN a crisis happens
• In Case #1, John has a grapefruit in reserve that will allow him to keep going.
Bill has nothing.
• In Case #2, John and Bill have equal reserves. As a result, they will be equally
affected by the crisis.
• They still need 1 fruit that the other grows, so they are still dependent on
each other.


End of Year 2
Unless there is a crisis of some kind, the saved 1G (or more) will
not have any value.
• After a global crisis John (in Case #1) will find it easier to recover
than Bill will. At the end, John will most likely be significantly
better off and will be more likely to impose a valuation.
• An asymmetrical crisis that hits Bill may force him to accept Case
#1 (since the exchange does not have to happen until
• An asymmetrical crisis that hits John will force him to use the
saved 1G as a supplement. If Case #2 applies, John can expect to
get help from Bill.


What did hard work accomplish?
• John wanted to increase his wealth but he only managed to drop
the price of his grapefruit.
• So now he grew the equivalent of 1+1/3 mangoes
• With Bill’s 2 mangoes, they produced 3+1/3 mangoes
• John’s predicament is called “deflation”
• Meanwhile, Bill’s 2 mangoes are now worth 3 grapefruit
• That is “inflation”
• Notice how inflation for Bill is balanced off by “deflation” for
John.

• So what happened?


Inflation in scarce commodities
We have seen this in practice. If the total quantity of a
product CANNOT be increased, no matter what happens
in the rest of the world, its price increases faster than other
prices!

Some examples:
1. College Education in the US
2. Health-Care costs in the US
3. Public Education crisis in the US.


The rising cost of Higher Education
• The case of college education in the US. It is difficult to create
new colleges, find qualified professors, and so on.
• Assume the rest of the world has X% inflation.
• The college can hire secretaries, janitors, and so on just like the
rest of the world.
• BUT, the price of professors shoots up compared to the price of all these
administrative and service staff!
• Professorial wage inflation for fields in demand go up by multiples of X!
• In non-demand fields, it can even be negative!
• Since many professionals wish to teach as a sideline, ADJUNCT
professors are underpaid – this shows that the phenomenon does not have
to do with the field, or other contextual contingency.
• It all depends on who (Bill the professor or John the student) can hold out
longer.


The rising cost of Health Care
• In the US, the AMA ensures that the number of doctors and surgeons
grows very slowly.
• Med school starts after a 4-year college degree
• Internships and fellowships after obtaining the degree
• Interns have a horrific life-style
• Meanwhile the nurses’ associations/unions have NOT been able to
control the number of new nurses being trained.
• Not that they don’t try (with new credential requirements and all)
• The result:
• The wages for physicians grows much faster than inflation
• The wages of surgeons grows even faster than that!
• The wages for nursing grow only a little faster than the general rate of
inflation
• Since nurses are cheap, demand for nurses in hospitals is extremely
high. They just wont pay them more!
• John, the hospital, can hold out longer than Bill, the R.N.


The Rising cost of Public Education in the
USA
• Shouldn’t this apply to the public school system in the US?
• Well, there is a problem with the theory.
• For both college education and health care, the individual directly deals with the
college or medical facility.
• Public schools in the US are paid for through real-estate taxes (mostly). The parent and
the child pay nothing directly.
• The wage negotiation happens between a government entity and a teacher’s union!
• When the teacher’s union succeeds in getting a raise, TAXES go up. There
is no obvious reason to the taxpayer why taxes should go up faster than
inflation!
• When the teachers get a raise greater than the rate of inflation, the entity
paying it (the town/city/village government and the taxpayers) see that the
teachers are not working harder. Who can hold out longer?
• John the people or Bill the teacher?
• So it looks completely unjustified.
• It isn’t as though there is more real estate being created by God!
• The growth in population is even smaller than the rate of inflation. So the rise in
teacher salaries looks even more lop-sided.
• Incidentally, at the same time, teachers are ASKED to teach more (“our children are
learning less than the South Koreans who get taught from dawn to dusk”)


Solving the Public Education crisis in the US
• Now, we know that everybody can teach! Look at Teach For
America.
• So what’s with seniority, licenses, education degrees, and so on? It is just
pandering to the unions!
• What we really need to do is hire anybody off the street as a public school
teacher and then evaluate them and fire them if they fail.
• Allow anybody or organization to open a charter school and evaluate them
and close them when they fail.
• This is the free market that will solve the problem! (next question, please!)
• What about the poor kids?
• That is another problem. This only solves the problem of how to teach the
teachers and their unions a lesson.
• (if you take the above seriously, I will have failed)


Back to Economics and The Last Word from
the Foolish Economist
Sorry about the digression into solving important national
problems.
What does this simulation tell us?
1. Assumptions affect the result
2. Working hard does not necessarily lead to wealth. It could
lead to poverty.
3. A key transition took place when the law of supply and
demand was proposed for application
a) Ignoring it (Case#1) led to one problem
b) Applying it (Case #2) led to a different problem.
4. One or more crises are needed for hard work to pay off. Even
then, the payoff has to be mediated by “government”, i.e., an
oppressive authority, not a free market!


What does Classical Economics say?
• The classical economist would have classified the initial state as a
case of equilibrium
• Then some mumble about absolute and comparative advantage
explaining the later developments.
• Since neither accepting the law of demand & supply nor rejecting it
leads to a reasonable conclusion, the CE will generally reject this
example as a monster (a case of a simulation gone haywire – see Imre
Lakatos, Proofs and Refutations).
• So – this is the Foolish Economist taking a simulation with a
thousand assumptions seriously.
• He must surely be wrong.

Or, is he?

The foolish economist takes on inflation

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The foolish economist takes on inflation