Iron Laws & The Foundation of Economics

When one asks who the founder of economics is, one would struggle not to say Adam Smith. Almost every book on the subject has at some point referenced or quoted Smith, he is as Galbraith would remark “the central tradition”.  I have recently taken some issue with seeing Smith as the central foundation of economics, especially as his work has become and has been the central part of conventional wisdom.

David Ricardo & Thomas Robert Malthus may have come after Smith but their significance is often disregarded, whether it is at schools teaching economics or some universities courses. This can firstly be attributed to the bleaker image of life that Ricardo and Malthus portray. Secondly, there seems to be a disparity between economic thinking and the way it is taught, as economic history is experiencing a renaissance of types in regards to its importance.

Ricardo often receives acclaim in his contribution to comparative advantage, trade, and protectionism.  However, he was an integral part in the development of our understanding of wages, developing the “Iron Law of Wages”. Malthus is most well-known for his dictation of the “Malthusian Catastrophe”, which ultimately defines the bounds of scarcity and ultimately poverty in relation to wages. As such one reason Smith may be a more popular source is due to his optimism, but in that he does not pay too much attention to the issues of inequality, distribution of capital, and the existence of poverty. Smith concentrates on the development of wealth and where the individual pursuit of wealth helps society as whole which are far more appealing ideas. Whereas Ricardo and Malthus both reached conclusions that were far from pleasant, to some extent a result of the society they lived in.

The Iron Law of Wages can be considered through the Malthus foundation where population growth occurs as a consequence of wages being above subsistence levels, and population decline occurs as a consequence of wages being below subsistence levels. As below subsistence levels the labourer cannot complete labour. This was concluded in his “catastrophe” where eventually population would surpass agricultural production, ultimately reducing all of society to subsistence levels. Now there are a variety of critiques to Malthus’s conclusion, especially now considering modern conditions as one can consider “surplus population” as a condition that is met where there is surplus wealth. Additionally, one can consider the development of science and technology which can lead to substantial increase in production with little or no change in population, so to some extent one can argue that Malthus’s reasoning is outdated.

Ricardo’s foundation for the Iron Law of Wages draws upon greater flexibility denoting natural prices and market prices. Where the natural price of labour is at subsistence level, but the market price could exceed this level indefinitely if there is a constant increase in capital. As he reasons that an increase in capital facilitates in a greater demand for labour. This is all accumulated in his Law of Rent which considers the return from land in regards to production, which then corresponds with wages. This ascertains that wages are not dependent upon the productivity of labour but in a sense marginal land where production is dependent upon the quality of land. This to some extent argues that the Iron Law of Wages fails to predict wages in the same manner that considering land does; it also disenfranchises the landowner from deciding land rents as it is wholly dependent upon the productivity of the land. Yet again this leaves one with the feeling of outdated concepts as we no longer have such a dependency on land as the central form of capital.

Even though the economics that Ricardo and Malthus respectively developed was applicable at their time it is less so now. But what is important to realise is the influence these concepts of wage, rent, and profit had and have on modern economics. Karl Marx had to some extent based his approach on Ricardian thought, examining the productivity of labour in regards to wages, but viewing labour as a unit of production rather than as a human source.  Thereby, Ricardo and Malthus had influenced one of the most dramatic economic deviations in recent history, on the basis of uniform productivity from a unit of labour exclusive to some degree of market forces. Even more so it allows a comparison of how wages are set now, and to what degree do workers get paid in regards to their marginal productivity or contribution, versus market created prices.

It is possible that we have spent far too much time including Smith in our teaching of economics, that we have not appreciated the contribution of other significant economists. The use of economic history can provide a strong foundation of economic thought and its development, as long as the study involves both orthodox and heterodox views. Let me take this opportunity to lament that Alfred Marshall should be far more involved in IB/A-Level textbooks than just the Marshall-Lerner condition, considering the importance of his Principles of Economics in 1890.

The question is shall I talk about Piero Sraffa next, or back off economic history for a while, and take it back to microeconomics and types of markets?

Barriers to Entry, Profit, & Price

Examine The Impact of an Increase in Barriers to Entry on Prices & Profits:

Barriers to Entry: The inability for a firm to enter the market due to infrastructural, legal, cost, financial, and brand barriers. If there is a high cost to enter the market it discourages smaller firms from entering, therefore limiting competition. This is why high barriers to entry are a signal of the existence of monopoly or oligopoly power.

Normal Profit & Abnormal Profit: Normal profit covers the average total cost of the firm, whereas the existence of abnormal profits means the firm can reinvest the profits into R&D, increase the wages of workers, and pay-out dividends to shareholders. Abnormal profit identifies the existence of monopoly or oligopoly market structure.

If there is an increase in the barriers to entry for a given market it may mean that the market becomes:

  • Less competitive
  • Greater representation of monopoly or oligopoly structure
  • Possible increase in profits for firms
  • Possible increase of prices, since less competition or substitute goods means that the firm could become a price setter rather than taker.

A comprehensive example of increasing barriers to entry having an effect on prices and profit can be identified in the car industry for hatchbacks within Europe. Volkswagen is notable for their immense economies of scale, therefore posing a high barrier to entry for their share of the market. Volkswagen is able to offer affordable hatchbacks and still maintain a high quality product without incurring a loss and maintaining the majority of the market share. However, their main rival PSA Peugeot Citroën is able to create cars of a similar standard but at a marginally higher price.  These are the two biggest firms in the hatchback market, since they already have a foothold in the market, and successful brand recognition it makes it difficult for firms like Kia to enter the market.

Due to the existence of market power through the high barriers to entry Volkswagen and PSA have an oligopoly like relationship within the hatchback market. Therefore, both firms have abnormal profits and tend to have similar prices while pushing out possible foreign competition. Shown below is a graph exhibiting a kinked demand curve and the market of hatchbacks.

Picture1

The above shows limited competition on price. The higher marginal cost of PSA can be justified by the lack of economies of scale similar to Volkswagen, meaning they will not be as efficient or productive with given resources. Shown on the graph is the hypothetical point at which Kia were to operate, they would suffer from high marginal costs at a restricted quantity of units due to export/import fees and the cost involved in the transport of the cars. There is also the issue that Kia does not have the same brand recognition as PSA or Volkswagen.

If the barriers to entry were to increase there would be a greater difficulty for the firms such as Kia to enter the European market. This is what establishes the oligopolistic relationship between Volkswagen and PSA. Barriers to entry are what ultimately cause the formation of monopolies or oligopolies. This then has a consequent impact on the prices of products in a certain market (a possible increase) and a greater opportunity to reach a point of abnormal profit through profit maximisation.

Evaluation:

There are various methods of getting around the high barriers to entry, but it would require a firm to either innovate or be able to obtain investors to help launch it into the market. Kia could offer cars with newer technology, better engines, and greater fuel efficiency in an attempt to win market share within Europe. Kia would probably have to compete on price and offer more in a car than the firm’s rivals. Kia will benefit from cheap East Asian production, but there are still issues surrounding the transport of the vehicles. To circumnavigate the high barriers to entry the firm must be willing to take on debt to attempt to pay high fixed costs, or attract investors which would usually require innovation to persuade investors away from the dominant firms.

The diversification of the market for hatchbacks would benefit the consumer, as the firms are more likely to compete on price as well as offer cars with better base packages (i.e. included option in the car such as xenon headlights). However this may create an unsustainable loss for firms like PSA who suffer from a high fixed cost of wages due to its central production being based in France. PSA has already begun to lose its position as the main competitor of Volkswagen as Ford has vigorously entered the market.

Overtime the high barriers to entry may fall as there is greater symmetry of information in the market, as well as the reduction of the impact of economies of scale through the development of new technologies and tools that can produce cars more efficiently. There will always remain however the high fixed cost of the factory, but over time the issue that will affect firm’s profits and the prices of cars will be the variable costs such as where materials are sourced.

This is why the example of the car industry is good for displaying the effect of barriers to entry, and their entailing effect on the price of the good; as well as the potential for normal or abnormal profit within the market.

Introduction to Theory of The Firm

Fixed Costs → do not vary with output
Variable Costs → vary with output

Revenue of a firm is always dependent on the output.

Materials         → Variable Cost (leather, stitching, etc.)
Capital             → Fixed Cost (sewing machines, leather tanner, etc.)
Labour             → Fixed/Variable Cost (depends on type and payment)
Transport         → Fixed Cost (short term)
Marketing        → Fixed Cost (does not vary with output)
Factory            → Fixed Cost (same size, does not vary with output)

Factory p1

Short Term: The length of time in which one factor of production is fixed (factory determines whether or not the firm operates in the short term or the long term).

Long Term: The length of time over which at least one factor of production becomes variable (i.e. need a new factory to increase output).

The Law of Diminishing Marginal Returns:

Picture2

 

This graph shows how output increases over the initial short term, but in the long term output decreases. This can be explained by several factors, such as there are only so many facilities, employees waiting to use machines, rate of productivity declines as employees may begin chatting to each other or the machinery is now inefficient.

The classic example is “too many cooks in the kitchen”, if the oven is used by one cook the other cook cannot use it, if one cook used all the fish the other cook cannot use it, etc. The limitation of output increases over time due to inherent problems.

If this graph meets the x-axis and goes below it, it identifies the result of less productivity. As at any point below the x-axis adding a greater amount of a factor of production subtracts from the total output.

As a consequence of The Law of Diminishing Marginal Returns:

Picture3

 

Shown above is the example of how adding a unit of labour increases the costs involved in production. The reason marginal cost is at the trough while marginal productivity is at the peak is because the cost of introducing more labour was small in comparison to the increased output. Therefore it can be stated that the cost is counteracted by the increase in output.

This is evident if the following example is given, at one unit of labour 100 baseballs are outputted, as there is an additional unit of labour introduced there is an additional 150 baseballs outputted, this counteracts the cost of hiring the additional unit of labour as the output has increased by 150%.

Picture4

For Marginal Revenue it can be noted that as price decreases, quantity increases. This is because for the producer to sell the next good they will have to reduce the price of their good, in the sense of revenue you have to lower the price to sell more. As there is more supply the price drops as the good is less scarce.

Profit Maximisation: This is where Marginal Revenue is equal to Marginal Cost (MR=MC, Q-P)

At point Q1 there is greater marginal revenue then marginal cost, this is still a point of profit but if you stop at point Q1 you forsake possible profit and this is highlighted by the blue triangle. This is why it is worthwhile for the producer to increase one of the factors of production to increase the marginal cost with the goal of reaching the point of profit maximisation.

At point Q2 there is a greater marginal cost whereas, there is less marginal revenue. This point can be seen as equally inefficient as point Q1, as again there is loss represented by the green triangle. However it can be argued that it is better to be on this side as through this you achieve a greater market share, which is a long term interest.

Notes:

Every firm will attempt to reach the point of profit maximisation, the price of the product does not matter to the firm, and the interest is in profit.

Definitions:

Marginal Revenue: The extra revenue that an additional unit of product will bring.

Marginal Cost: The extra cost that an additional unit of product will bring.

Picture5

The introduction of average revenue allows the producer to see where the price of the good should be in order for the firm to maximize profit. The average revenue can be identified as demand, and while it is in the interest of the firm to maximize profit the accurate pricing of the good is essential.

Average Revenue: Total revenue per unit of output. When all output is sold at the same price, average revenue will be the same as price.

 

The Future of Shale Gas

The Rise of “Unconventional” Gas

Shale gas is a form of natural gas that can be found in shale rock formations which are in abundance around North America, China, Argentina and North Africa. The controversial method of releasing shale gas has started to gain global recognition and may be what is needed to reignite the oil & gas industry.  Currently the largest producers of shale gas are Canada and the United States. Shale gas has begun to gain ground against importation of LNG (Liquefied Natural Gas) and oil, as governments have seen it as an opportunity to become energy self-sufficient and reduce imports. The rise of shale gas as a substitute for LNG has had an effect on the price of gas, and the relationship between supplier and consumer.

Analysis:

Gas prices based on the Henry Hub Natural Gas Front Month Futures reached a peak of $13.50 in 2008 the highest price of gas witnessed since 2005. With the then emerging market of shale gas and the economic crisis, gas prices reached had reached new lows and began to average at a lower price between 2008 and 2010 of $6-7. The developments of new shale fracking technology, government subsidies and guarantees have pushed the price of natural gas in 2012 into the region of $3.00-3.50. This has had a serious impact on the supply &  demand relationship as there has been a major shift in supply.

Picture1

As noted in the graph above there is a radical shift in the position of the supply curve, this is because the determinants of supply have changed making it easier to supply natural gas and the factor that there is another method of obtaining natural gas (shale gas). It is important to note how there would not be a surplus in this example of the United States as it is easy to decrease the amount of natural gas imported. It is also within the interest of the country politically to become self-sufficient, and develop a prospering economic sector. It is speculated that by 2035 the United States will be in a position to begin exporting natural gas, whereas countries such as Japan are still wholly reliant on imports of both gas and oil.

There is no major change in the demand of gas, as there is still the use of oil and coal for energy production and fuel. In time there may be an increase in demand as noted in the article as it will become more affordable to produce cars and public transport driven by natural gas as well as focusing energy production through more abundant natural gas. Another factor identified in the article that is restricting the increase of demand are the negative connotations that the public currently hold towards the shale fracking process, that it harms the environment through the contamination of water supply and causes minor earth tremors.

There is also the factor of the cross elasticity of demand, as shale gas is a substitute for imported LNG. If the price of obtaining LNG through imports increases, then there will be a greater demand of shale natural gas as it easier to obtain and does not rely on importation, therefore an inelastic relationship.

Picture2Evaluation:

The shale gas industry can still be seen as an emerging market, solid foundations have been built in the Northern American market. This now poses a problem to gas exporters as Europe has had to depend upon them for natural gas for the past decade such as Gazprom who are likely to lose market share. The fracking process can also be applied to the extraction of oil from shale formations. This may have an effect on the price of oil around the world, and will bring into question the economic security of countries dependent on oil exports. There is the issue of the environmental impact of the fracking process, and issues surrounding this such as noise pollution and the possible water contamination due to the chemicals used in the fracking process. As the switchover from oil to gas is made, the price of gas will eventually increase due to increased demand. The article states that $90 Billion worth of investment is being injected into the industry as a result of the Shale Gas boom in the USA; this makes it clear that governments are willing to circumnavigate the surrounding issues.