Tuesday, August 16, 2011

Supply of Admissions

Professor Krugman is slowly converging to my view that supply matters even during recessions. I'll explain more tomorrow in a more lengthy blog post, but the basic idea has been in my seasonal supply paper (see the final para).


Misaki said...

I totally didn't realize you were one of the authors of the NYT Economix blog... was linked to the 2009 entry Compassionate, but Inefficient, from Mike Konczal's blog.

The badness of Narayana Kocherlakota's model of unemployment, which completely excludes prices from business hiring decisions, helped me to realize how serious the misunderstanding is on this issue. Companies will not hire new workers at any wage if lowering prices would lead to a decrease in total revenue, due to inelastic demand. If wages fall they might cut current wages or fire people and replace them with new workers, but the company has no reason to hire more if the only way to sell additional units is to decrease prices to a point where it lowers total revenues, much less profits.

Accordingly, a nice graphic was created to show this. /paste

"...this graphic shows why for many markets, lowering the price of labour will not lead to an increase in production.

It's usually assumed that markets are 'competitive', meaning that production costs are the only thing preventing a good from being made in greater quantities, and increasing production efficiency (or lowering cost) leads to more products being made.

But this is obviously not true if significantly more people do not buy the product when the price is lowered to make up for loss in profit. For most goods with an 'inelastic' price range it's only inelastic for the good as a whole, so a single seller cannot make much profit off the inelastic range (such as salt). But only Apple can make iPods, and people will buy them even at 50% gross profit per unit sold. Making more iPods simply would not lead to higher profits. Even price discrimination might lead to more sales in the short term, but in many cases it would reduce profits in the long term since people don't need to save up to be able to purchase an iPod and long-term revenues decrease.

The demand curve, obviously, depends on the income distribution for the customers, the perceived utility of the product (especially for signalling "cool") as well as alternative products. For many products sold in the US, people have plenty of money so the shape of the demand curve is as described above and lowering prices would not lead to an increase in profits for a marginal decrease, and perhaps even in volume there would not an increase in revenues enough to make up for lost profit (while also sparking a price war in that market that would decrease revenues for all sellers).

So given the income distribution in the US, "lower wages" are not the solution to "low consumer demand" because it wouldn't cause companies to lower prices enough to increase employment. The way to solve this problem, again, is here:

Misaki said...

...or in response to a comment on this issue,

>because there is no such thing as unemployment, just demanding too high a salary.

…and this attitude exists precisely because economists themselves do not understand how unemployment can exist.

Note the recent post that included the modelling of unemployment, by one of the 12 (?) people who administer the Fed or whatever, that included exactly zero information on the price levels people are willing to pay in its model, and the absence of any mention of this in the criticism of that approach.

Here’s a question: if people had the option of getting exactly the same [total] compensation for working 50% less than the[y] do at current, and having the same promotion prospects and protection from being fired, would people do it?

If the answer is that they would not, it shows that under the current framework, people feel they have negative utility from “leisure” time, which a rational person might expect would have radical implications for how economics approaches the concept of unemployment.

Until then, they will have no answers to, or explanations for critiques like this one that the unemployed are just lazy and that’s why they have higher suicide rates, etc.

Misaki said...

Also I think this is funny and appropriate given economists' obsession with "low consumer demand". Because the people of the US seem to be in agreement, given so many of the goods in certain categories (like clothing, furniture, electronics) are made in China, what the US needs most right now is for people to buy less. :)


(I will mention that this is actually a reasonable goal, with the very important condition that people also need to be prepared to spend less time working as well so lower consumption does not prevent people from getting jobs: http://pastebin.com/Wy8B0hK9)

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