Tuesday, December 27, 2011

Real microeconomics (demand shocks)

Part 1: What is "real"? (commentary)
Part 2a: Real microeconomics (demand shocks)

One definition of microeconomics is the economics of individual firms (or consumers) by themselves, as opposed to macroeconomics, which is the study of the economy in the aggregate. Another definition, which seems especially useful for studying real economics, is that microeconomics takes the total level of output of an isolated* national economy for granted, and is concerned with optimizing the mix of goods and services within that economy.

*International trade notwithstanding, it's easier to consider the national economy as an isolated whole, and international trade doesn't substantially change the underlying theory.

Even the most casual reader should be aware of the standard supply and demand curves, with the equilibrium price at the point where the marginal cost of supply (the amount of something required to produce one more unit of the product) equals the marginal utility of demand (the amount of something for which a consumer will forego to obtain one more unit of the product). In financial microeconomics, the y-axis is the price level. In real microeconomics, the x-axis is still quantity produced, but real economics ignores money. So how should we label the Y-axis?

The supply curve increases not primarily because of diseconomies of scale, but primarily because of rising opportunity costs. Every coat we make means that we cannot make a hat*. To make the first, most demanded coat, we sacrifice the last, least demanded hat. To make the second, slightly less demanded coat, we sacrifice the second to last, slightly more demanded hat. And so forth, until we get to the point where we are making the coat that is just about as demanded as the hat we are not making. Therefore, in real economics, the y-axis represents opportunity cost, the quantity of all other goods and services that we're not making in order to make the quantity of the specific good or service under consideration.

*We can assume wolg that the trade-off is one-to-one and linear so long as the demand curves are monotonically decreasing.

For obvious reasons, it is not the case that the amount of each and every service is at exactly the correct level. Tastes, preferences, and costs are all constantly changing. Therefore, the quantity of most goods and services we're producing constantly changes. But in an industrial economy, we cannot simply turn on a dime and change production instantaneously. Suppose, for example, that we are producing too many coats. If we were to not produce some of those coats, we could produce more hats, which we want more than the coats. However, we cannot instantaneously just produce fewer coats and more hats.

We must undertake a two-step process to modify production. First, we have to invest. We have to make more hat-making factories, and we have to train more workers to make hats. Since we are making too many coats, we make (and maintain; factories wear out too) fewer coat-making factories than is necessary to sustain current production. Once we have the new hat-making factories, we have to actually make more hats, deliver them to stores, and distribute them to consumers. All of this activity takes time.

Usually, it all evens out. We're usually making just a little too many of some goods and services, a little too few of others, and everything evens out. We produce about the same amount for consumption and investment overall, month to month, year to year. Everybody is always a little bit dissatisfied: coats are a little bit too cheap, hats are a little bit too expensive, so people end up with coats they didn't want as much as the hats they couldn't afford. But again, this dissatisfaction is more-or-less constant, and drives long-term economic growth.

But sometimes there are more radical microeconomic shifts, radical enough that they deserve to be called "crises". For example, when the computer was invented, a whole lot of people suddenly really wanted one. It took more than one annual accounting period — about twenty or thirty years, all told — to invest enough to make enough computers (and computer programs) for everyone who wanted one (badly enough) to actually get one. That meant that for a couple of decades, we were consuming measurably less than we wanted and expected to, so we could invest in building computers. It eventually sorted itself out, but it took a long time.

At the real level, microeconomics is concerned with precisely what we should produce. Because the real microeconomy cannot "move on a dime", we have to predict, as best we can, not only what we're short of now, but what we'll be short of — and how short we'll be — in the future.


  1. Larry, saw not many have commented lately.

    Wanted to let you know we're still out here reading.

    Keep up the good work and hope you and yours are having a nice holiday season.

  2. ". . . we have to predict, as best we can, not only what we're short of now, but what we'll be short of — and how short we'll be — in the future."

    In the end it all comes down to oil; the short answer to how short we'll be is "very."

  3. Bah. The old oil bugaboo. Pure bullshit. There's a ton of free energy falling on the Earth (well, half of it) every day. All we need is manpower to harness it, and lo! we have 14 million people un- or under-employed. Think real, Phil, not nominal.

  4. What you seem not to have considered, Larry, is that our entire economy is based on the consumption of fossil fuels; indeed, the transportation industry (upon which all other industries depend) cannot at present function without them. To capture enough solar energy to equal the amount of energy currently derived from fossil fuels will require completely different infrastructure and a new electrical grid; making those changes will demand huge inputs of fossil fuels, primarily oil. There's also a time factor involved; legislating, planning, engineering and design, innovating, fabricating, assembly and construction--all of these take time--and will probably take several decades to fully implement. In the meantime, we rely on fossil fuels to deliver the bulk of our energy needs. So, yeah, in the end it still comes down to oil.

  5. It will indeed take several decades to implement alternative energy sources. In the meantime, yes, we will have to rely on oil. But in the end, after decades of rebuilding our infrastructure, we will no longer need oil.

    Oil is going to become progressively more expensive, both in real terms (it will require more abstract labor time to extract and refine each barrel of oil) as well as nominal terms (those "owning" oil will attempt to extract more surplus labor from the rest of the economy), but it is precisely these price pressures that will provide an incentive to develop alternatives.

    It is certainly the case that dependence on oil and avoidance of alternatives could become a political priority. We could choose to allocate more and more surplus labor to the owners of oil, and we could hardly expect the owners of oil to invest aggressively in alternatives. But that is a political problem, not an economic problem, and certainly not a real economic problem.

  6. (And, of course, I mean "real" in this context in contrast to "nominal", not in contrast to "imaginary".)


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