Thursday, November 26, 2009

What is the Short Run!

The short-run is a much used concept in Economics. However when one investigates what it is actually supposed to mean it appears so nebulous as to be virtually meaningless.

One context where is it widely used is in relation to costs of production. Here the distinction is made as between the short run and long run based on fixed and variable costs.

Fixed costs relate to financial commitments that occur at certain discrete time intervals and are therefore not related directly to changes in the output level.

For example a retail firm could enter into a leasing agreement on a premises for a period of 3 years. Therefore the rent on the premises would have to be paid for this period of time irrespective of trading conditions.

The implication therefore is that in the case of - say - a sharp downturn in sales that cost adjustments would have to be confined to variable costs e.g. raw material inputs and labour.

However though there is a certain truth to this, in practice it is not so clear cut. Fixed costs may not be entirely fixed. Thus in the present climate of recession many tenants are seeking to renegotiate lower rental terms on lease agreements (with varying degrees of success).

Also there are a whole series of fixed costs which come for renewal at varying periods of time. So there is therefore not just one short run period (which varies from sector to sector) but in fact a number of vaguely defined overlapping short runs occurring as certain payments fall due for payment.

There is also another source of confusion as the short run is sometimes referred to the period in which the overall scale (or size of the business cannot be changed.

For example a retail business might be operating out of a certain sized premises on a lease agreement.

Now if business is good and the owners wish to move to a larger premises they may feel obliged to wait till the present lease agreement expires. However in the meantime other fixed cost payments may come up for renewal e.g. insurance, interest payments to banks, depreciation etc.

So, the long run in this sense i.e. where the scale of a business can be changed does not equate in any exact way with the previous definition (where certain fixed cost commitments occur not directly related to the level of trading).

The short run is also used in another vague sense to refer to somewhat different circumstances.

For example it is accepted that it may make sense for a firm to trade at a loss in the short run (provided that variable costs are covered). So, many hotels in Ireland are in this position at present due to the severity of the current recession. The rationale for doing this is based on the hope that trading conditions will eventually pick up with acceptable profit margins once again attainable.

However the short run here has no clear time scale. Some hotels with deeper financial pockets would be able to ride out the recession for a considerable period of time. For others more deeply in debt, inevitable closure would occur at an earlier stage. Indeed these calculations can be complicated further by the fact that in certain cases the banks may not want hotels to close because of the slump in property prices thereby enabling them to keep operating (without even variable costs being fully covered).

The short run is used yet again in another economics context (which bears no direct relationship to previous meanings).

For example in speaking of perfect competition, economists distinguish as between the short run and long run.

The idea here is that certain firms could steal a march on rival firms e.g. through greater efficiency thereby making supernormal profits. However in a highly competitive sector one would expect other firms to keep catching up thus eliminating excess profit margins. So in the long run only "normal" profits would be made. However clearly this meaning of the "short-term" while again extremely vague in practical terms bears no direct relationship to previous definitions based on the distinction between fixed and variable costs.

Monday, November 16, 2009

The Paradox of Competition

One of the key assumptions of the free market approach to Economics is the benefit of competition in ensuring greater efficiency in the provision of goods and services. And indeed from one valid perspective this has considerable merit. For example look at how the airline industry was revolutionised (for the better) through greater deregulation allowing private operators to compete against the - formerly - state owned airlines!

However there are subtle problems inherent in this approach. Some companies will always for various reasons be "more equal" than others with a strong incentive to use inherent advantages to achieve a more permanent dominance in their sector.

For example we might view Microsoft in this light. Now, one can theoretically argue that any firm is free to enter the software sector and compete with Microsoft. However Microsoft has already built up such a strong position that it would not be able to do so on equal terms. So it is only the possibility of new technological revolution - led by another pioneer firm - such as Google that can really hope to threaten its position.

So if we are to ensure that firms such as Microsoft do not abuse market power we need more rather than less regulation (which goes against free market instincts).

However there is an even bigger potential problem which has received very little attention. Once again the benefit of free markets is based on the preservation of competition. However for the the free market system - as both an economic and political ideology - since the ending of Communism in the early 90's, there has been no such competition.

Indeed one can justifiably argue that the near collapse of the international financial crisis recently has been due to the unhealthy dominance of just one ideological system (devoted to unfettered market competition).

There are inherent weaknesses in the capitalist system that remain continually ignored. Unfortunately despite this latest near miss I expect in the short-term that there will be an attempt to return to business as normal.

If it is justifiably considered unwise to have markets without competition, it is even more unwise in ideological terms to then attempt to maintain a monopoly for the market system!

Monday, November 9, 2009

Who Bears Risk?

Anyone who has been exposed to an introductory course on Economics will be familiar with the four factors of production, land, labour, capital and enterprise.

These - we are told - serve as the basic inputs for all economic output. Thus to produce any economic good or service, some unique combination of the factors of production is required. Likewise associated with each of these factors is a characteristic payment. Indeed all income that is generated relates to payments to these respective factors.

Associated with land we have rent, with labour, wages (salaries and other earnings), with capital, interest and with enterprise, profits.

However the 4th of these i.e. enterprise, is quite problematic especially in light of the recent financial crisis. I am not the first to raise queries regarding the nature of profits!

For Karl Marx "value" attributed to enterprise in capitalist societies properly belonged to the workers who produced the commodities.
And major communist societies such as the Soviet Union and China for many years attempted to organise production without proper recognition of the special contribution of enterprise.

However, while acknowledging the important role of enterprise, it is still valid to raise important issues regarding its interpretation.

The entrepreneur in capitalist society is viewed as the person who, in attempting to initially set up a business, takes a special risk.

In economics the characteristic payment for this risk is referred to as "normal profits". However due to the many uncertainties typically involved actual returns may exceed the normal return (leading to supernormal profits) or fall below (resulting in supernormal losses).

In large publicly quoted businesses e.g. banks, these risks are spread out among a wide number of shareholders. Typically a shareholder might expect a characteristic dividend payment (as measurement of normal profit). However in good times extra rewards might arise through substantial capital gain in share values and/or extra generous dividend pay-outs. However - sticking with banks for the moment - there is a big problem with this view of risk, as taxpayers in countries, such as Ireland, are now financing the massive losses of banks resulting from reckless mismanagement.

The point I am making is that we need to distinguish as between risk (as narrowly defined), applicable to shareholders and a more general risk that is shared by all society. The narrow risk in this context relates to the possible losses that accrue directly to bank shareholders. The more general risk relates to possible misperformance - and perhaps ultimate collapse - of the banking system generally that would cause huge losses for taxpayers.

For example this is very obvious in my own country, where taxpayers are rightly indignant at being asked to provide for the attempted "clean-up" of the major banks while business also suffers other losses due the the continuing lack of liquidity in the system.

Given that this is patently the case i.e. that the losses of the banks are being generally borne by society as a whole, it makes little sense therefore in good times to associate profits exclusively with bank shareholders. It is precisely this lack of symmetry in the way that we view the matter that is leading to such a strong sense of injustice worldwide. It indeed represents a fundamental problem with the capitalist system.

Thus there is a holistic collective irreducible nature to rightful reward in any society that is blatantly ignored in present market economics.

The collective nature of risk also extends to the setting up of new businesses. Now, in the normal course of events many such businesses are doomed to fail (often within a relatively short time frame). The risk here does not merely extend to the prospective owners of such failed businesses but also to unpaid creditors and loss of resources generally to society. Given that this clearly is the case then it makes little sense to identify the profits of successful surviving businesses merely with their owners!

Another strong example of this problem arises from the fact that millions of workers are now losing their jobs in the private sector. Once again there is a narrow and general risk involved in running a business. If a large business fails, the shareholders clearly will suffer (representing narrow risk).

However the workers employed by that business will also suffer. And because in a recession the possibility of obtaining alternative employment is greatly reduced the loss that is thereby suffered by the workers may be much greater that that pertaining to the shareholders.

Once again the logic of this is that in a very real sense as workers are exposed to - perhaps - the greatest risk (in terms of possible job loss) that have a right to participate in the profits of a business when it prospers.

The failure to recognise this fact therefore exposes the lack of any true collective dimension in our treatment of economic society.

I will give just one more example. If we look at a highly successful company e.g. Microsoft we can see that enormous profits have accrued to its owners especially to founding member Bill Gates. However we cannot properly view a successful innovation such as a seminal new software product solely with its producers!

In fact, the success of any product entails a complex relationship involving both producers and consumers. Therefore there is a much more general aspect to risk with respect to any new product or service that involves the wider group of consumers as essential partners. Therefore the attempt to associate all risks narrowly with the producer is strictly invalid.

What we need therefore is a radical change in perspective.

The success or failure of any product pertains ultimately to society as a whole (and not just narrowly to initial producers who are never independent of consumers).

When we recognise this essential collective dimension, profits from economic production accrue ultimately to society as a whole and thereby should be distributed much more equally than in present circumstances.