Sunday, 25 August 2013

The law of rotten apples

Yichuan Wang has a lovely post in which he uses apples to explain how goods markets work in a money economy. It is of course a deliberate over-simplification of a general equilibrium, and I am perhaps being a trifle unfair to Yichuan in picking it to bits. But I couldn't resist.

Yichuan defines a recession as a "general glut of goods that aren't consumed", and goes on to suggest that this is because some people have apples but choose not to eat them. Indeed they do. Apples don't fall from the sky as Yichuan suggests, they grow on trees. Trees produce lots of fruit all at once, creating a glut, then none for the rest of the year, creating a shortage. So the market for apples is seasonal (for the purposes of this post I'm going to pretend that there is no international shipment of fruit to smooth out seasonal variation). Furthermore, in some years apple trees produce more fruit than usual, and in other years they produce less, largely due to weather conditions. So the production of apples is highly variable. The glut of apples in September is not because people are saving up to buy apples for Christmas, it is because there are more apples then than at any other time of year. It has nothing to do with people's intertemporal preferences, and everything to do with the desire of apple trees to reproduce.

Let's imagine an apple farm. The farmer's capital stock is his trees, which are a long-term investment since an apple tree doesn't produce fruit in its first few years. They require fertilizer in the Spring, they may need watering in the summer if the weather is dry and in the winter they need pruning. And in the autumn, of course, the apples produced by the mature trees in the orchard need harvesting. All of this creates year-round employment for the farmer and his staff. But the farmer's only income comes from the fruit produced by the trees, and as I've already noted, that is both seasonal and variable. He has something of a cash flow problem. I shall return to this shortly.

So let's imagine we have an amazingly good harvest of apples because of unusually favourable weather conditions. The apple farmer employs extra staff to pick apples, pack them (carefully) and take them to market. And to start with, it works well. Apples are popular: they come in different varieties, so there is something to suit everyone; they don't need to be put in the fridge; and they are handy for children's lunch boxes. So everyone buys apples. There is a boom in apple sales, our farmer makes lots of money, he pays all his staff and has money left over to buy a new Mercedes.

But the fruit just keeps on coming. By the end of September, everyone has had their fill of apples. No-one wants to eat an apple ever again. The price in the local market has crashed, but there are still piles of unsold apples. Traders start to refuse further supplies. But the apple trees are still laden.

So our farmer employs more people to take the apples to markets further away. He incurs transport costs, reducing his profits. But he manages to sell his apples - for a while. Then people further away become sick of apples too. Markets stop accepting his apples. So he sends his staff even further afield..... I'm sure you can see where this is going. Eventually the cost of transporting the apples to distant markets exceeds the returns from apple sales. There is a limit to how far you can afford to transport goods in saturated markets.

Now our farmer has a real problem. He can't sell his apples. In fact he can't even give them away. But he isn't beaten yet. He employs several local housewives to bake apple pies and apple cakes. Suddenly people start buying again: even people who now hate the very smell of fresh apples will eat apple pie. By creating new products that use apples as a raw material, he has found a solution to his over-production of apples. But he soon discovers that he has to keep on creating new products to keep people interested, or sales tail off. Fortunately the tendency of apple trees to over-produce is a well-known phenomenon, so the housewives' cookery books are full of recipes using apples.

But our farmer still has a problem. He still can't sell his entire apple production without causing the price to fall through the floor. To keep the price up, he needs to create an artificial shortage of apple products. So he starts to limit the number of apples he picks. The rest fall from the trees. The law of rotten apples is that when you can't sell apples in any form at a price that justifies the cost of picking them, you leave them to rot.

Yichuan says that people who don't want apples today will save their money so they can buy apples at some point in the future. But apples don't keep. Well, they do for a while - but they eventually shrivel. So when our consumers want apples, they may find that none are available. But you can preserve apples in the form of cider. So suppose our farmer buys a cider press and makes cider with his apples. Suddenly he has a year-round market for an apple product. He has not only solved the problem of seasonal over-production, he has solved the cash flow problem I mentioned earlier. He has enabled people to delay consumption of apples well into the future. Though even in this market, you can over-produce....there is only so much cider that people can drink before the local police start taking an interest.

So did our glut of apples cause a recession, with associated unemployment? Well, no. Actually it created additional employment, and it forced our farmer to innovate. The price of apples did fall, of course - we had deflation - but our farmer supported the price by creating new products, and as a last resort by restricting production. And if over-production became a yearly problem even with a cider press, he would diversify. Recessions happen when people cut consumption despite price falls and innovation. If people refused to buy apples in any form at any price, our farmer would go out of business and his staff would lose their jobs.

You will note that nowhere in this discourse has money been involved. This is not a pure barter economy - the farmer is paid in money - but people's decision not to eat apples has nothing to do with money. They simply cannot consume any more apples. Deflation is not necessarily a monetary phenomenon.

Now let's look at the other side of this - crop failure. Suppose our trees are attacked by a pest that causes most of the fruit to drop from the apple trees long before it is ripe. Now we have a problem. Instead of a glut of apples, we have a serious shortage. Let's assume for the purposes of this post that there is no substitute, so apples are an essential good. The farmer can charge whatever he likes for the few apples he manages to bring to market. And he does. Apples become more valuable than gold. Though of course people don't usually pay for apples in gold, they pay in money. So we have inflation - in fact we have hyperinflation. And note that creating more money does not solve the problem: all it does is enable prices to rise even more. No doubt money creation will be blamed for this, but the real cause is the failure of production. Inflation is not necessarily a monetary phenomenon.

Nor does our apple scarcity create employment. There are fewer apples to pick, fewer to transport, the farmer has no need to send apples to more distant markets since he can sell his entire production locally, he has no need to create apple products and his cider press remains idle. Because he can charge very high prices for apples he makes lots of money, so he still solves his cash flow problem even without making cider. Inflation benefits producers of essential goods at the expense of consumers - and also at the expense of producers of NON-essential goods as people are forced to devote more of their income to essentials. High inflation in essential goods can cause serious deflation and rising unemployment in the rest of the economy.

If you substitute "potato" or "corn" for apple, this situation should look more realistic. Failure of a staple crop is disastrous. In monetary terms, it causes very high inflation. But the real cost is people's lives. Hyperinflation in the price of essential goods causes starvation.

So which is worse, inflation or deflation? From the point of view of the consumers of apples, inflation is terrible and deflation is desirable. But from the farmer's point of view, deflation is a nightmare and inflation is beneficial. Remember that Yichuan defined both apples and money as "wealth"? If the price of apples falls to the point where it is not worth the farmer's while to pick them, his "wealth" is worthless. But if apples become so scarce that the farmer can charge whatever he likes for them, consumers' "wealth" - which we assume is in the form of money - becomes worthless. In the end neither gains, because worthless money is of no use to anyone, and apples that no-one wants to eat will be left to rot. Mild inflation can encourage producers to produce more and consumers to buy more in the expectation of higher prices: mild deflation can encourage innovation and diversification. But at their extremes, both inflation and deflation destroy wealth. And at their very worst, they destroy lives.

UPDATE: Euronomist points out that consumers may suffer when there is deflation as their wages may be cut or they may lose their jobs. And producers of essential goods (as in this example) can also suffer when production is falling and inflation rising, because they have to choose between consuming and selling. Nothing is ever simple in economics.

Related links:

A primer on general equilibrium, or Why Money Matters - Synthenomics
There is no such thing as fiscal policy - Market Monetarist

If anyone really wants me to translate this into econo-speak, I will. But I hope that the real economists out there will appreciate my brand of everyday economics. 


  1. Helpful explanation Frances, however, the "crop failure" scenario begs the question: Will giving more spending power, via whatever route to the general populace, actually achieve any kind of recovery?

    That, of course, depends on one's perception of prevailing shortages.

    1. If there are no substitutes for the crops that have failed, giving people more spending power merely pushes up prices - as I said in the post. Supply-side failures need supply-side fixes. The problem is that they can look like demand failures: it is easy to interpret people starving because they can't afford food as a problem of tight money and unequal distribution, when it may actually be a supply failure.

    2. Question is, do western governments believe the current problems lie with demand or supply? Their actions seem rather schizophrenic.

      Perhaps they simply don't have a clue and are trying to sit on the fence?

    3. Their actions suggest they think the problems are demand-side - extensive use of monetary easing is a demand fix. This is consistent with the view that the economic problems stem from the financial crash and are mainly caused by a badly damaged financial system. But I think there are are supply-side problems that are not being addressed, notably high energy prices which have clobbered industrial production for the last three years. I've written about this before.

  2. Nice post.

    By the way, you can make the main text box wider in blogger, so it fills up more of the screen. (Just saying, in case you didn't already know)

    1. I have no idea how to do that!

    2. in the top right hand corner it should say 'design' next to 'sign out'. Click on 'design'. This takes you to the template page. There should be a small image of your blog under the heading 'live on blog'. Click on 'customise' under that image. This takes you to the blogger template designer. In the top left hand corner under 'templates' it says 'adjust widths'. Click on that and you can change the text box width.

  3. Now introduce apple Prepay. ie tokens returnable in payment for (say) a kilo of apples.

    Farmers now have the option of funding themselves by selling apple tokens at a discount to the market prices and using the proceeds to pay costs of production instead of getting into debt with banks.

    Investors may sell the tokens to other investors, or simply use them to pay for apples from the producer or even - possibly - apples from other producers who are members of the Apple Clearing Union.

  4. Frances,

    This is an interesting post, but I don't think your stylized model (I now have a craving for apple pie!) maps into the GE framework. Because the market for apples is supposed to represent a composite market of all goods, to have "too many apples to consume" literally means there are too many goods produced that nobody could ever want anything! But given levels of childhood hunger and other obvious examples of scarcity, this seems very unlikely.

    I would also want to add to your pest example. Clearly, if a pestilence wipes out the apple stock, then this is a reduction in aggregate wealth. So no matter what the central bank does, on aggregate society would be worse off. In this case, inflation is bad because it's the result of a negative AS shock.

    But by thinking about money and apples, it's clear why central bank monetary policy should have no effect on aggregate wealth. While it's true that apples have a higher "price", it's only because people are holding more money! They can still afford to buy the apples, and therefore they won't rot on the trees! Of course, if price fluctuations are severe enough that production loses value too quickly, it could be that the supply side is hurt.

    As a more general point in the two examples, the focus should be on shifts in aggregate supply, and not just inflation. You do it, but perhaps a more explicit treatment would have been good.

    1. There is a possibility that in the Western world, at any rate, we are reaching the point where too many goods are produced. We still have poverty, but that is caused by distributional problems rather than supply shortages. We have abundance of goods, but too many people don't have enough money to buy them. I think this is the cause of the disinflationary trend in most Western economies.

      My inflation example is indeed caused by a negative AS shock. I did say I would put this in econospeak if anyone wanted me to!

      On the upside, yes I would agree that monetary policy should have no effect on aggregate wealth, generally. I'm simply questioning the view that people necessarily "choose" to save money instead of spending. If goods really are abundant (positive AS shock!), people simply are not able to consume enough in the present to absorb all production in the present. Clearly, if abundance is cyclical (as in my example), the supply side needs to transform excess production into forms that can be consumed in the future when there is scarcity - hence cider - and people will hold money in order to enable them to consume those transformed goods in the future (mulled cider at Christmas, yumm). But persistent over-production of goods that have a short shelf life can severely damage the supply side unless some means is found of supporting prices. Our farmer really can go out of business if the price of apples falls to the point where it is not worth his while picking them. Governments tend to support farm gate prices when there is over-production for exactly that reason.

      I did intend this as a post about AS effects on inflation and deflation, actually - I've been meaning to write about that for a while.

    2. You're right... an abundance of goods is, by itself, not a sufficient antidote of poverty. The problem, however, is not distribution of wealth. The problem is that the 'poor' don't get to participate in the production process. Like I've argued in a post under this topic, we pay for other people's production with production of our own. Money being merely a medium of exchange.
      I pose that this situation is a result of the zero interest rate policy (ZIRP). Today, financing is too cheap and this leads to a scenario where entrepreneurs are replacing human labor with capital equipment at a rate so fast that labor doesn't have time to re-adjust. In short, the low interest rate regime is hurting the ability of people to participate in production.

    3. I completely disagree that ZIRP is causing replacement of labour with capital. If anything it is the other way round. Businesses are seeing so few long-term profitable opportunities that they are not investing in capital equipment and are using cheap labour to operate on a day-to-day basis. I've written about this extensively.

  5. Useful analysis... I always like using Robinson Crusoe. Makes a lot of things easier to explain. I can always introduce Man Friday to the economy and so on and so forth.
    You have developed a couple of issues such as inflation and deflation... as well as production, trade, innovation, recession and destruction of produce.
    I, however feel, you've mixed issues. Inflation is a general increase in pricing levels while deflation is a general reduction of pricing levels. The cause matters. Deflation doesn't cause demand destruction... but inflation does.
    Overproduction and underproduction may or may not imply overinvestment and underinvestment. Overproduction as a result of apple tree giving birth is not within the control of the producer. Overproduction as a result of over-investment, however, is. Overinvestment, according to Austrian economists, is exposed by overproduction and the structural realignment process is what causes a. deflation and b. recession.
    I also see a glossing over the importance of production to an economy. Jean Baptiste Say taught a long time ago, what many people misunderstand as Say's law, where he says we pay for other people's production with production of our own... i.e. production creates demand. The definition of money 'as a medium of exchange' fits snuggly in this world view. Many economists think that money is wealth and Bastiat points this out... however, the correct proposition is that money is a store of wealth as a result of production of other citizens. This may raise the issue of money being non-neutral non-neutral but that is a derivative of three problems in finance- principal-agent problem (problem between the citizen and the central bank), the problem of information asymmetry (inflation leads to purchasing power collapse which lags the process of money creation and therefore cause-effect is hard to determine) and the problem of adverse selection (expressed as Gresham's law).

    1. I did allude to over-production caused by over-investment, actually. It was subtle, but when I suggested that the farmer would diversify I meant he would cut down some of his apple trees and grow other crops instead - or leave the land fallow, or sell part of it for development.

      You've defined inflation and deflation as changes in the general price level. So did I, actually. But price changes don't happen for no reason. I looked beyond that to the CAUSES of changes in the general price level. The change in the price level reflects the balance of supply and demand.

      I completely disagree that deflation does not cause demand destruction. Persistent deflation IS demand destruction, by definition - prices fall because supply chronically exceeds demand. The deflationary spiral described by Irving Fisher and illustrated by Steinbeck in "The Grapes of Wrath" is a demand collapse, not a supply failure. And inflation does not destroy demand, it accelerates it, as people consume more in the present in the expectation of higher prices in the future: increasing consumption drives further price rises. If money remains neutral, deflation begets deflation and inflation begets inflation. To control inflation, therefore, we create artificial scarcity of money relative to goods to subdue demand. But when the problem is deflation, we need to create an excess of money relative to goods to encourage demand.

      However, the point I am making in this post is that there are occasions when tinkering with the money supply isn't enough to solve the demand problem, because the underlying problem is actually some kind of supply failure. Collapse of production causes hyperinflation when governments respond by printing money to stimulate demand instead of fixing the supply problem. Persistent over-production of goods saturates the market and causes the price to fall to zero regardless of the amount of money in circulation. When there are more apples than anyone can eat in any form, they are worthless.

  6. Great post - the analysis of apples. I never knew all that :)

    If we are going to be valuable economists shouldn't we try to analyse every good and service, or as many as we can manage - say 100 or so. And get all its contexts such as, location - which country, psychology of buying, fashion, advertising, peer pressure to buy, health aspects.

    What is the analysis for 1) Antibiotics?
    a) No value at all unless we need them to treat a disease then huge value, we'd pay a fortune to heal ourselves b) Cannot overdose on them bc it would be poisonous, so supply/demand curve truncated c) Only some people need some types of antibiotics, the others are not worth a penny to them. d) Huge production lead times and costs.

    2) Dry food that does not go rotten - that opens a whole new can of economic worms.

    Are generalised models good enough? Every professor will say they are worthwhile in one respect but on the other hand they are not.

  7. What I am trying to say in my comment above is that we should try to make more complex models. After-all we have computers to do the heavy lifting and a couple of thousand goods and services and locations could be analysed and fit into general economic macro AND micro models.
    Same for econ. theories that often, also are time and place dependant as we are learning at present. (inflation is always a monetary phenomenon everywhere and... blah blah)