Monday, December 31, 2007

Economics 101

I'm going to broaden the focus here with a lesson in elementary economics. This is a fairly standard example used by economists everywhere, to illustrate how competitors position themselves to divide up a market.

Suppose there is a nice beach somewhere. (It may be either swimsuit optional, or else the gov't requires all users to wear suits, because the gov't knows what's best for everyone. However, that's not germane to what follows.)

Suppose further that two hot dog vendors want to locate their carts on the beach in order to maximize their revenue. You might think that the best way to do this is to imagine the beach divided in half, with each vendor in the middle of one half. That places one 1/4 of the way from one end, and the other 1/4 of the way from the other end. Assuming people are uniformly distributed on the beach, this minimizes the maximum distance a customer needs to walk in order to get a hot dog – at most 1/4 the length of the beach.

But counterintuitively, either vendor can apparently do better by moving to the middle of the beach. That way the vendor who moves to the middle first can still have all of his previous customers, plus half the customers between the center of the beach and the other vendor. Unfortunately, if the other vendor moves to the center also, to avoid losing business, the total quantity of hot dogs sold will be less for both than previously. This is because about half of the customers would have to walk farther to get a sausage, and many of these won't want to get so much exercise.

Actually, however, this only illustrates how hypothetical a lot of reasoning by economists is. What "should" happen if markets were efficient (which they aren't) is that after both existing vendors have moved to the center, then somebody with a little capital would buy new carts, hire two undocumented immigrants (at less than minimum wages), and set them up in the old .25/.75 points.

This could go on indefinitely, until the "point of diminishing returns" when the market for hot dogs on the beach is "saturated".

But at that point, someone with even more capital would step in with an advertising campaign to promote eating hot dogs to beach-goers, and then set up additional carts, selling hot dogs made from recycled turkey parts at prices below cost, to drive all the other vendors out of business. Then the last entrant can buy up the remaining assets in bankruptcy, cut back on the number of locations, but not raise the product quality, and make more money than everyone in total previously.

Maybe, just maybe, the beach-goers would demand gov't regulation of hot dog vendors at that point. But the remaining vendor can use his substantial profits to buy off any relevant gov't officials and fix any elections that might be held (using his electronic voting machine subsidiary), to prevent any gov't action.

And then, using this new gov't-relations infrastructure, the vendor would lobby for gov't subsidies to help produce lower-cost hot dogs. The gov't would oblige (since many officials are former vendor executives) and hold secret meetings to plan the subsidies and make all necessary arrangements. Mainstream media (large portions of which are owned by friends and suppliers of the vendor) would laud the gov't for its foresight. Some sharp lawyers might challenge such practices in court, but since a majority of judges have been appointed by the gov't on the advice of its lobbyists, the lawsuits would go nowhere. Further lawsuits would be forestalled by "tort reform".

And "consumers" would go on obliviously, happily eating hot dogs until they (the "consumers") keel over from cardiovascular disease, due to bad diet and lack of exercise. The only mistake made by the vendor and his allies in all this is failing to secure gov't health care to keep the "consumers" alive a little longer. Because "economists" had forecast that such a move would not actually improve profits in the long run, since older "consumers" would be too sick to eat many hot dogs.

Wealthy preachers of religion would then step in to assure the populace that all of this was God's plan, and remind all the survivors that there was still time to contribute to the church's building fund, before the Rapture.

Happy New Year!

Update (1/12/08): At a link to this post, the writer comments that governments and other powerful actors have long intervened in economic affairs. The example cited involves medieval cartels and monopolies, but of course this goes back much farther in history – as long as any sort of gov't has existed, I would suppose.

And in case anyone thinks this note is a little over the top in parodying economics, here's something I came across just a few days after writing the above. It's by economist and hedge fund manager Jean Paul Schmetz:
In my field (theoretical economics), I believe that most ideas taught in economics 101 will be proved false eventually. Most of them would already have been officially defined as false in any other more hard-science, but, because of lack of better hypotheses they are still widely accepted and used in economics and general commentary. Eventually, someone will come up with another type of hypotheses explaining (and predicting) the economic reality in a way that will render most existing economics beliefs false.

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