Archive for June, 2009

From Samuelson’s Economics

June 27, 2009

From: Economics (10th ed) by Paul A. Samuelson (1976)


The preceding theories help explain a famous question that troubled Adam Smith in The Wealth of Nations.  He asked, How is it that water, which is so very useful that life is impossible without it, has such a low price-while diamonds, which are quite unnecessary, have such a high price?

Today even a beginning student can give a correct answer to this problem.  “That’s simply explained,” he can write on an examination.  “The supply and demand curves for water are such that they intersect at a very low price, while supply and demand curves for diamonds are such that they intersect at a high price.” (Today he could add that water is no longer all that cheap.)

This is not an incorrect answer.  Adam Smith could not have given it because supply and demand curves ae descriptive tools had not yet been invented, and were not to be for 75 years or more.  But after he had mastered the new lingo, old Adam Smith would naturally ask the question, “But why do supply and demand for water intersect at such a low price?”

 The answer is by now easy to phrase.  It consists of two parts:

Diamonds are very scarce, the cost of getting extra ones is high; and water is relatively abundant, with its cost low in many areas of the world.  This first part would have seemed reasonable to even the classical economists of more than a century ago, who would probably have let it go at that, and would not have known how to reconcile these facts about cost with the equally valid fact that the world’s water is more useful than the world’s supply of diamonds.  In fact, Adam Smith never did quite resolve the paradox.  He was content simply to point out that the “value in use” of a good -its total contribution to economic welfare-is not the same thing as its “value in exchange”-the total money value or revenue for which it will sell.  Smith had not arrived at the point where he knew how to distinguish marginal utility from total utility!

Today, we should add to the above cost considerations a second truth:

The total utility of water does not determine its price or demand.  Only the relative marginal utility and cost of the last little bit of water determine its price.  Why?  Because people are free to buy or not buy that last little bit.  If water is priced higher than its marginal utility, then that last unit cannot be sold.  Therefore the price must fall until it reaches exactly the level of usefulness of the last little bit, no more and no less.  Moreover, because every unit of water is exactly like any other unit and because there is only one price in a competitive market, every unit must sell for what the last least useful unit sells for.  (As one student put the matter: The theory of economic value is easy to understand if you just remember that the tail wags the dog: concentrate on marginal and not on total utility.)

Paradox resolved:  The more there is of a commodity the less the relative desirabilty of its last little unit becomes, even though its total usefulness grows as we get more of the commodity.  So, it is obvious why a large amount of water has a low price.  Or why air is actually a free good despite its vast usefulness.  The many later units pull down the market value of all units.

Pigou on the wage unit in Keynes

June 27, 2009

From Keynes’s ‘General Theory’: A retrospective view by A.C.Pigou (1950)

[…] Keynes uses for a measure a labour unit, in the sense of a unit of ordinary labour;  labour that is paid, for example, twice as high as ordinary labour being counted as two labour units (p. 41).  In so far as the relative rates of pay of different varieties and grades of labour remain constant, labour can be ‘made homogeneous’ by this device without any awkwardness.  But, in so far as that condition is not satisfied, the same index number problem that hampers the measurement of changes in real income has to be faced-or ignored.

The Lecce framework

June 13, 2009

By email from the US Treasury:

Statement of G8 Finance Ministers‏ 

The Lecce Framework: Common Principles and Standards for Propriety, Integrity and Transparency

We are in the middle of the worst crisis since the Great Depression. The breadth and intensity of the prolonged downturn have revealed the importance of strengthening our commitment to standards of propriety, integrity and transparency. Excessive risk taking and the violation of these basic principles contributed to undermine international economic and financial stability. This occurred both in areas that relied on self regulation and market discipline and in fields with formal rules and oversight, revealing flaws in the functioning of markets.

For the market economy to generate sustained prosperity, fundamental norms of propriety, integrity and transparency in economic interactions must be respected. The magnitude and reach of the crisis has demonstrated the need for urgent action in this regard. Reform efforts must address these flaws in international economic and financial systems with resolve. This will require promoting appropriate levels of transparency, strengthening regulatory and supervisory systems, better protecting investors, and strengthening business ethics.

Today, we, the G8 Finance Ministers, discussed the need for a set of common principles and standards for propriety, integrity and transparency regarding the conduct of international business and finance. We have agreed on the objectives of a strategy, “the Lecce Framework”, to create a comprehensive framework, building on existing initiatives, to identify and fill regulatory gaps and foster the broad international consensus needed for rapid implementation.

The Lecce Framework recognizes that there is a wide range of instruments, both existing and under development, which have a common thread related to propriety, integrity and transparency and classifies them into five categories: corporate governance, market integrity, financial regulation and supervision, tax cooperation, and transparency of macroeconomic policy and data. Specific issues covered include, inter alia, executive compensation, regulation of systemically important institutions, credit rating agencies, accounting standards, the cross-border exchange of information, bribery, tax havens, non-cooperative jurisdictions, money laundering and the financing of terrorism, and the quality and dissemination of economic and financial data. International institutions and fora have already developed a significant body of work addressing a number of important issues in these areas, but, in many cases, the initiatives suffer from insufficient country participation and/or commitment.

Today, we agreed to create a coherent framework which builds on work done by the IMF, World Bank, OECD, FSB, FATF, and other international organizations, to strengthen the global market system. To ensure effectiveness, we will make every effort to pursue maximum country participation and swift and resolute implementation. We are committed to working with our international partners to make progress with the Lecce Framework, with a view to reaching out to broader fora, including the G20 and beyond.

On utility

June 13, 2009

There is something about utility (hence demand) theory that I’ve never quite understood, and I would be glad if someone could shed light on this matter.

To confirm my impression of the profession’s current level of understanding, I went to that splendid textbook, which has never failed to illuminate in the past, “Economic Theory and Operations Analysis” by William J. Baumol.  There I turned to section on utility theory, and was greeted by a diagram giving the utilities of various combinations of servings of zabaglione and number of cummerbunds.

Now my point is that we don’t choose between combinations of servings of zabaglione and number of cummerbunds, but between combinations of servings of zabaglione per unit time and number of cummerbunds per unit time.  Consumption, and demand are flows, not stock variables.  Yet the theory blithely treats them as stock variables.  I have found the same prestidigitation in Samuelson’s texbook.

Time is an essential input into production, and the economic problem vanishes if inputs are converted to outputs instantaneously.

Neoclassical mainstream economics ignores the problem of time, and thus seems stuck in a pre-newtonian vision of the world.

The diamond water paradox

June 11, 2009

Why does water, which is of such vital importance to us, cost so little, and why does a diamond, which has no earthly use, cost so much?

Economists have provided various answers to this question.  Not all of them I find satisfactory.  Marx made the distinction between value-in-use and value-in-exchange.  Water has much value-in-use, but little value-in-exchange.  The converse for diamonds.  Some economists posited the low marginal utility of water, and the high marginal utility of diamonds.  These marginal utilities evidently underly the demand curves.  Where the demand and supply curves intersect, gives us the equilibrium price.

But Marshall was not so facile.  He saw that time played an essential role in supply and demand.  In the market period, that period in which the factors of production (land, labour, capital, enterprise) are committed and thus relatively fixed (in amount and proportion to one another), supply curves are near vertical, with huge increases in prices offered, bringing forth only a small increase in supply.  He then goes through the short period, and the long period, to the secular period, in which all factors of production are flexible (as to amount as well as proportion).  In the secular period, supply curves are near horizontal, with a small increase in bid prices, bringing about a large response in supply.  In the secular period, equilibrium price approximates to cost of production.  And since labour is the only real cost of production, Marshall can be said to have had a long period labour theory of value. 

What then would Marshall make of the diamond water paradox?  What in fact did he make of it?  Will have to burrow into Principles.

India’s export trade

June 10, 2009

India exports its best quality manali, its best quality mangoes, its best quality Darjeeling tea, its best quality tiger prawns.  I don’t care about froglegs because I don’t eat froglegs.

Q:  Why doesn’t the market supply best qualities to domestic consumers, I’m sure they can pay the world price.

Task: Look at detailed trade stats to bolster this anecdotal summary.

A complaint

June 10, 2009

Was contemplating the choice in the Levis store. They didn’t stock the liberal (broad leg) cuts, and didn’t stock the true blue denim (just an awful blue black). I’ve been exposed to jeans in the USA, and have been spoiled forever.

Q: Why doesn’t the market provide the best quality choices?

Will have to seek out a Lee store to see if they can fill the gap.

Further, years ago Flying Machine jeans were doing a fine job of providing well fitting jeans. Where are they now?

Lex prudence

June 9, 2009

It’s not that one doesn’t want to write, but something holds one back from making confessions that could potentially harm ones’ source of income.  There is ambivalence here, and contradiction.  There is certainly liberation in confessing to an unheeding world.  But there is also fear that it may turn around and bite.  Will have to resolve this.

Ramana Maharshi did most of his teaching in silence.  But I don’t see the blog quite doing that.  What would it look like, a blank slate with the potential to be populated with whatever thoughts the interested reader projects upon it?  Too much to hope for.  But with a giant thought reading machine it could work.  What were Wiener, and Bateson, and Lilly and the rest of them working on in the sixties?  Not a Giant Thought Reading Machine, surely?

Some prices

June 8, 2009

Price of a 650 ml bottle of Kingfisher premium beer in Gurgaon was Rs 60/-.  The price of the same bottle in Bangalore is Rs 75/-.

White sugar (1 kg, parrys) was Rs 28/- at Savitha Stores.  This was Rs 24/- just a while ago (how long?) and I remember when it was Rs 14/- then Rs 16/- then Rs 18/-.  The price rise in sugar has been terrible.

Back in Bangalore

June 6, 2009

Back in Bangalore after a blissfully uneventful flight.  It was 25 C in Bangalore, a perfect rainish day.  Have not smoked a cigarette in the past three days and am not losing any sleep over this fact.  To be seen how long I can take this abstinence.