the foolish economist takes on inflation

The Foolish Economist: on

Growth and Inflation

A. Arkay (not an economics major)

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.

7/15/2012 The Foolish Economist 2

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

grapefruit, in exchange for a mango

Phew! Thought you’d never ask!

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

grapefruit. Why don’t you buy half a

grapefruit from me?

“Buy”? What’s that?

You give me half a mango for my half

grapefruit

Huh? I don’t have ½ a mango!

That’s alright – you’ll just owe me ½ a

mango and give it to me next year

“Owe”? What’s that?

It means that next year, you give me ½

a mango for nothing.

Oh. But then, I will only have ½ mango

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,

you will get ½G.

Hmm<That’s no good. I need 1G!

You know that!

But that would make 1M equal to

1+1/2G!!

It sounds weird the way you put it<.

But,yes!

At the end of Year 2, cont’d…


John Bill

You simply don’t understand. I’ve worked

hard and increased our wealth.

That is a fantasy. You worked hard, maybe,

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.

Now, with the price of 1M being 1G, we

have 5G.

Oh, I see. “price” means how we exchange

mangoes for grapefruit. OK, I get it.

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

you just count the fruits, we have 1 more

than before.

This is “the law of supply and demand”.

There’s no demand for the extra half-mango.

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

1+1/2G for 1M, we now have 6G!

That’s an increase from the old 4G,

isn’t it.

No! The 4G last year has the same value

as the 6G this year – that’s called

“inflation”. You suffered 50% inflation last

year and your products lost value!

That does it! Inflation-pinflation-

pshaw! I’ll hold my extra 1G back and

you wont even see it.

But, I know you have it in reserve, so I’ll

offer 1M to you for 2G.

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

(1M=1.5G)

-1.5G+1M -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 EconomistSorry 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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