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.
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.