Thursday, August 6, 2009

Wealth of Nations: Book 1: Chapter 9: Of the Profits of Stock

Let's talk about stock!

I'll be honest. I've taken too long to make this post because reading (and re-reading) this chapter was difficult because of the word stock. In contemporary usage it can mean the same thing, like "Do you have Pepsi in stock?" But most of the time we think of stock in terms of stocks and bonds, wall street, buy low sell high etc. So whenever Smith talks about inventory and selling goods as stock I had to loop back round and make another pass at the sentence. Similar issues occurred when I learned in college that what economists call profit, and what business folk call profits are not the same thing. (Basically in the economist world view, if you are making a reasonable rate of return on your business, say 3%, you have zero economic profits, while the MBA would say profits were at 3%.)

So Smith starts off by saying knowing how much the average yearly profit one merchant makes is really hard to figure out, because it large part the profits are tied to so many things like how your inventory is, how many other merchants showed up at the market, how your customers are doing, wages of your workers, etc etc. So knowing how much profit you made is kinda hard to figure out on average. So historically it would be nearly impossible. So instead he comes up with a clever way to figure this out...interest rates.

So let's say it is January first and you have $100,000. What are you gonna do with this? You could hold on to it, and at the end of the year you'd have $100,000. You could buy a whole bunch of stuff, and hire someone to sell that stuff for a profit, or you could lend it out at a rate of interest. These basically help us frame how to think of profits, and in turn judge how an economic region is doing in regards to profits and economic health.

If as a rational person, you could lend the money out at 5%, you'd have $105,000 come Dec 31st. But if you thought you could stock up on products to resell at some price, and by December 31st have $105,001 you would probably do that. So the interest rate serves as a baseline for gauging the economic health of the region in question.

He goes on to say that the lower the interest rate, the more advanced the economy. This is because as more merchants crowd into the market to get a piece of the pie, they end up bidding up wages of employees against each other. This cuts into their profits since instead of the surplus revenue going to their hands, it goes into their workers hands. He compared Scotland to England. Scotland had a 5% interest rate, while England was near 0%. But Scotland was behind England in economic development, wages were lower etc. As progress is made the rates will lower.

He also notes later in the chapter that the ability to enforce contracts equitably is important for the economic society to prosper.
A defect in the law may sometimes raise the rate of interest considerably above what the condition of the country, as to wealth or poverty, would require. When the law does not enforce the performance of contracts, it puts all borrowers nearly upon the same footing with bankrupts or people of doubtful credit in better regulated countries. The uncertainty of recovering his money makes the lender exact the same usurious interest which is usually required from bankrupts. Among the barbarous nations who overran the western provinces of the Roman empire, the performance of contracts was left for many ages to the faith of the contracting parties. The courts of justice of their kings seldom intermeddled in it. The high rate of interest which took place in those ancient times may perhaps be partly accounted for from this cause.

Basically stated without the ability to enforce contracts, people pay for the risk in the money lent. This can also prove as a way for wealth inequity as he notes China does with the Rich enjoying a "pretence of justice" against a poor who have little recourse.

So to restate, profits off of stock(inventory), is influenced largely by the market it is in. In a market where there are few competitors and labor isn't scarce, they can bid down labor prices and have a nice rate of return. But as competition enters and you get closer to a perfectly competitive marketplace your profits will approach zero(in an economic sense).

Up next: "Of Wages and Profit in the different Employments of Labour and Stock"

Friday, July 10, 2009

Wealth of Nations: Book 1: Chapter 8 Of the Wages of Labour

Adam Smith's wacky work of labor economics, family planning, and the fair wage.

I'd like to begin by apologizing for my brief absence. I've been a bit busy in other things, and this project had to be shelved. But I am back.

This chapter is a large one and covers a grand scope of topics. I think he might have served himself well to spin off the topics into subchapters, but the topics covered are so interwoven that breaks aren't natural in the subject so you end up with a rather large chunk of text to digest.

First let's review the nature of wages. Wages in Smith's time are often framed in the master vs journeyman setting. So for examples in this blog I will assume the role of master furniture maker and you the reader are a journeyman (among many) who are in my employ. We have competing goals. I want to maximize my profits and so have reason to want to pay you as little as I can get away with. You having no stock of goods or savings in some form by which to rely upon want to secure the highest wage you can get. Thus the cycle of "can I have a raise boss?" begins. Smith makes some observations on the bargaining tactics of how the wage is determined. Should wages be insufficient, you would strike. The tactics for how each party responds is pretty much the same as it was in the 1700s. I as the master craftsman would whine and bemoan how I can't afford to pay you more, and lock you out of the workshop and live off the supply of goods you produced for me before. This puts me in a strong position because I can wait longer than you given my stock of goods I am still selling. You as the worker don't have the luxury of a stock and probably don't have a savings of great size allowing a strike to continue on for some great amount of time, so public disruption and advocacy of boycotts might be employed to raise alarm and attempt towards a quick resolution by means bordering on outright intimidation. Smith even hints at the formation of worker unions to even the odds by having the workers in mass counter the power of the masters. Smith also notes that master craftsmen are fewer in number and control most relevant capital and workshops have an oligarchical power to control wages by collective understanding.

Smith does go on to say that there is a floor for how low wages can go. Specifically he says the amount needed for a man to provide for his family. At this point he takes a sort of morbid calculus on childhood mortality.
Mr. Cantillon seems, upon this account, to suppose that the lowest species of common labourers must everywhere earn at least double their own maintenance, in order that one with another they may be enabled to bring up two children; the labour of the wife, on account of her necessary attendance on the children, being supposed no more than sufficient to provide for herself. But one half the children born, it is computed, die before the age of manhood. The poorest labourers, therefore, according to this account, must, one with another, attempt to rear at least four children, in order that two may have an equal chance of living to that age.

And in a sense this makes sense. If the lowest wage a person could get is to provide only for his own food and subsistence, then we would die out pretty quick. Smith also later in the chapter notes that the lower classes tend to have more kids than the upper classes, but the rate of childhood death is much higher in the lower classes.
Poverty, though it no doubt discourages, does not always prevent marriage. It seems even to be favourable to generation. A half-starved Highland woman frequently bears more than twenty children, while a pampered fine lady is often incapable of bearing any, and is generally exhausted by two or three. Barrenness, so frequent among women of fashion, is very rare among those of inferior station. Luxury in the fair sex, while it inflames perhaps the passion for enjoyment, seems always to weaken, and frequently to destroy altogether, the powers of generation.

I guess somethings never change.

Geography does play a role in wages, and often works to the journeymen's advantage. Smith did a comparison of a few economies. The American Colonies had much higher wages than England for comparable work, and this was in large part due to the high demand of labor. China was viewed as a stagnate economy, not growing, nor shrinking so much. Compared to England where people with services would set up shops, and customers would come to them, China apparently had skilled laborers traveling with their tools begging for work. He also noted that descriptions of China in Marco Polo's time are almost identical to contemporary (ie 1770s) descriptions of China. Shrinking economies would see starvation as he noted was readily available in places like Bengal. Clearly a sign of economic regression. But in that description of Bengal he also gives us a preview perhaps of what to expect later when talking of corporations and regulations.
This perhaps is nearly the present state of Bengal, and of some other of the English settlements in the East Indies. In a fertile country which had before been much depopulated, where subsistence, consequently, should not be very difficult, and where, notwithstanding, three or four hundred thousand people die of hunger in one year, we may be assured that the funds destined for the maintenance of the labouring poor are fast decaying. The difference between the genius of the British constitution which protects and governs North America, and that of the mercantile company which oppresses and domineers in the East Indies, cannot perhaps be better illustrated than by the different state of those countries.

(emphasis mine)

The geography doesn't even have to be across the globe. Smith also describes the variety of wages in England, and the net result on how the wage differences affects the diet based on wheat and oatmeal prices. Commodities tend to fetch the same price over an area, whereas wages can differ greatly. For example compare the wage difference between New York City and Scranton PA. Probably a pretty big gap for the same kind of work, but if you went to a Denny's in NYC versus Scranton, the prices would be almost identical. One lesson to take away from this, though not spelled out, is that the market for goods does vary. Just because the Denny's Grand Slam is the same price, don't expect the rent for a 900 square foot apartment to be the same. But that lesson isn't the focus of the chapter so we press on.

The business cycle is also covered in this chapter. It is pretty straightforward stuff. As the economy rises, wages rise as more labor is needed to meet growing demand. This rise in demand encourages journeymen to strike out on their own instead of working for a master craftsmen. This in turn decreases the pool of available journeymen forcing each master to bid for workers services breaking the oligarchy mentioned in the top of this blog. Wages rise as a result of this bidding. But as the cycle turns and we enter recession, some of the now independent journeymen come back to the masters looking for work, and compete with other journeymen by underbidding labor costs driving wages down. Fewer jobs, abundance of labor, low wages. He spends a good deal spelling this out by citing various industries as examples.

I want to end on a note about wages and what is probably known today as a fair wage. Smith's time had two kinds of labor in common use, slaves and free men. Each had a different role and in terms had different sense of responsibility of control over his wage. Slaves obviously had no choice, and relied on the slaveholder to care for his well being. Freemen on the other hand were expected, as we see at the beginning of this blog, to look out for their best interest in terms of wage. Smith did see a morally responsible role for a shop master to look after his employees.
The wear and tear of a slave, it has been said, is at the expense of his master; but that of a free servant is at his own expense. The wear and tear of the latter, however, is, in reality, as much at the expense of his master as that of the former. The wages paid to journeymen and servants of every kind must be such as may enable them, one with another, to continue the race of journeymen and servants, according as the increasing, diminishing, or stationary demand of the society may happen to require. But though the wear and tear of a free servant be equally at the expense of his master, it generally costs him much less than that of a slave. The fund destined for replacing or repairing, if I may say so, the wear and tear of the slave, is commonly managed by a negligent master or careless overseer. That destined for performing the same office with regard to the free man, is managed by the free man himself. The disorders which generally prevail in the economy of the rich, naturally introduce themselves into the management of the former: the strict frugality and parsimonious attention of the poor as naturally establish themselves in that of the latter. Under such different management, the same purpose must require very different degrees of expense to execute it. It appears, accordingly, from the experience of all ages and nations, I believe, that the work done by freemen comes cheaper in the end than that performed by slaves.

Well paid people he says are happier and more productive, have families and continue promoting the nation's wealth by pumping up the economy. So while wages aimed to be controlled by government fiat might be a disaster, it is ultimately in the shop master's best interests to pay his workers well for the greater good. This might be one of the lost lessons of capitalism. It isn't about getting all you can for you, but rather working towards a better tomorrow for everyone.

Wednesday, July 1, 2009

Wealth of Nations: Book 1: Chapter 7: Of the natural and market Price of Commodities

Our prices are so low! We will beat anyone!

In the last chapter we took a journey through a supply chain to figure out what the cost of something is, but that isn't necessarily the price the goods will fetch. Smith divides the price into two kinds. There is a natural price which he defines as:

When the price of any commodity is neither more nor less than what is sufficient to pay the rent of the land, the wages of the labour, and the profits of the stock employed in raising, preparing, and bringing it to market, according to their natural rates, the commodity is then sold for what may be called its natural price.

Now that natural price does include a reasonable amount of profit. It is important to think of profits here as just compensation for your time or stock of goods. So a good example of this is your savings account at the bank. It is you setting aside money with a promise to not use it for other stuff for a small rate of return. This is usually a few percentage points. So the interest is profit. But it is just a modest rate of return. If you could put your money into anything else that had a higher rate, but take on no additional risk, you would do so.

And then there is market price, which is much more dependent on the number of buyers and other sellers in a given market. This can be above, at or below the natural price. Let's give an example of each of these situations to show how they may come about.

Market price equals natural price
. Let's say we take our organic tomatoes from the field to the farmer's market. There are other organic farmers sell organic tomatoes as well. The quality of all the tomatoes are comparable, and the costs to produce the tomatoes are all more or less the same. We are all bloggers who employ our readers at small wages to till our rented land for these tomatoes. There are plenty of buyers each looking for the best deal, they will go from farmer to farmer searching for the lowest price, we will keep lowering our price to get our stuff sold, and it will naturally work itself out that the market price equals the natural price. None of the sellers have an incentive to take a loss per tomato, and buyers don't have a reason to pay more than the natural price. This is called a perfectly competitive market.

Market price is lower than the natural rate. Let's say for a moment that we get to the Farmer's Market and everybody is selling tomatoes. And because of an unseasonably hot day there aren't many buyers. I have a dilemma as a seller. I can't sell at the natural price because there is no way I can sell all my stock and cover the cost of each tomato, and I can't afford to just take home what doesn't sell and try again next week because my stock will go bad and be of no value. So I will lower my price below the natural price and take a loss just to move the inventory. But when it comes time to replenish my stock for the next Farmer's Market, I won't farm as many tomatoes. This could mean less hours for you dear reader, or rent less land to till. This contraction will help the next market day to have supply and demand meeting once again.

Market price is above the natural rate. This happens when the sellers, and products available are less than the demand for the product at the natural rate. Simply put if I normally bring 100 tomatoes to the market, and they fetch a dollar each, if I only bring 80, and no other sellers make up that deficit of 20 tomatoes, then we can fetch a few cents more per tomato by having the buyers bid up the price for each tomato. So per unit instead of a dollar, maybe I get a buck and a quarter. This can happen for various reasons. Maybe the total demanded went up. Maybe an accident wiped out a competitors stock. Maybe I made a deal with the person running the Farmer's Market and became the exclusive tomato provide. That last scenario would be a monopoly, and basically let's me set the price as I see fit to extract the most per unit I can get away with. If the market price is above the natural price, this will encourage other people to look at the market and start producing items in that market until the market price equals the natural price again, provided there aren't barriers to entry like no available farmland or monopolies or something of the kind.

If you think of price a struggle between buyers and sellers I think the following quote from Smith sums it up quite nicely:

The price of monopoly is upon every occasion the highest which can be got. The natural price, or the price of free competition, on the contrary, is the lowest which can be taken, not upon every occasion, indeed, but for any considerable time together. The one is upon every occasion the highest which can be squeezed out of the buyers, or which, it is supposed, they will consent to give: the other is the lowest which the sellers can commonly afford to take, and at the same time continue their business.

Smith finishes up the chapter with an outline for what the next few chapters will be about. There will be labor wages, profits, stock and rent prices coming up.

Tuesday, June 30, 2009

Wealth of Nations: Book 1: Chapter 6: Of the component Parts of the Price of Commodities

What is profit? The core of this chapter is laying the framework for what become the terms for evaluating economic situations. All revenue basically falls into three categories. Rents are what's paid to a landlord for use of land or factory space, and later I'm sure that which is paid to lease equipment. Profits are what's made in regards to maintaining and supplementing a stock of finished goods. And wages are what's paid for a persons labor.

All revenue Smith says is either one of these three or derived from one of these. And they all can play a role in a products final cost. Imagine for a moment I lease land to grow organic tomatoes. I am however lazy so I'm going to employ you dear reader as my farmer. So I will pay rent to the owner of the land. I will pay you wages to till the land. And there are various costs in figuring out farming materials. But the final price of the tomatoes at the market factor all these things in. So if it takes us $1000 total to produce 1000 tomatoes, we would charge $1 per. That does include an expected rate of return. Namely by devoting my energies into managing this operation I'd expect let's say 10% of the total revenue (so $100).

This is really just common sense really. If you think about all the things that go into making almost anything you have, and trace back to its basic most materials, there exists a long train of people doing things to get materials for someone else to manufacture into parts for yet someone else to assemble into your thing. And all those wages divided up, rents people paid, managers looking for some small measure of profit. Welcome to the supply chain baby!

Thursday, June 25, 2009

Wealth of Nations: Book 1: Chapter 5: Of the real and nominal Price of Commodities, or of their Price in Labour, and their Price in Money

Chapter 5 in Book 1 is a rather dense chapter in the concepts presented. Initially the theory put forth is that the true measure of value of any thing is labor. How much time would you do whatever you do to produce enough products, services or money to get what you want. Imagine for a moment you mow lawns for a living. In a barter society you might agree to mow lawn for a butcher in exchange for one steak he cuts up every week. His time of steak prep is maybe 20 minutes (I don't know much about being a butcher and am just throwing out numbers) and you know it would take one hour to mow his lawn every week. We could conclude that in real value his labor is three times more valuable than yours.

Money comes in as a necessary and convenient way to approximate value. You may not always want steak, and the value of the steak may change over time so you both would be better off if you had some impartial neutral item to trade with. Thus money is really this abstract scoring system. You can't eat money, it provides poor housing, won't keep you warm etc. Intrinsically it bears little value. But in the context of the trades it serves a useful tool towards trade. Think of monopoly money for a second. Absent a game of monopoly it is worthless, but in the course of the game you might value having a $500 monopoly bill more than one or two dollars of real money. So I guess context matters.

He then went on to talk about the real and nominal values of commodities. He spent a long time explaining how corn has been valued over time and while year to year may fluctuate wildly, over time it has retained its value quite well. Comparing college rents in Elizabethan times with the 1770s, what previously was 33% now was over 66% even though the amount of corn requested was the same. So commodities can retain value over time more than money.

He finishes showing how different commodities, namely gold, silver and copper, interplay in the formation and use as currency compared to their bullion state. While the value of the metals might not match the comparative value of the coins. So to use an American example if a nickel is 5 times a penny always, it is irrelevant to the comparative value of nickel bars to copper bars. It is important however to keep the value of the coin higher than the metal to prevent people from smelting their nickels and pennies for raw materials to sell.

Overall I think the most important things in a modern context given we use paper money and in some cases digital money, is the role that commodities have and to think of our labor as being a real measure of value. Think of your daily expenses, and think of how much you make an hour at your job, and ask yourself when you buy something, if you would be willing to work X minutes for that same thing. It is an interesting way to look at value.

Tuesday, June 23, 2009

Wealth of Nations: Book 1: Chapter 4: Of the Origin and Use of Money

Book One, Chapter 4 traces the probable emergence of currency. Division of labor produces a variety of men, each with stocks of goods of their own labor which he may wish to trade for other men's goods. But how can that trade occur when any given person may not want what you wish to trade or in the innate quantities your good presents itself in? If I herd cattle does all trade have to be in relation to 1 cow? This poses any number of problems.

Societies established a center object of trade. Shells, salt, oxen or even nails in one remote Scottish village served as the currency of choice. Over time metals proved to have many characteristics which prove valuable in the establishment of currency. Metals like gold, copper or silver are durable, divisible, and lack much in the way of practical use like oxen would. But metals by themselves could prove hard to manage given dividing them from one pound bars could be trying, or subject to fraud. Maintaining accurate scales was also a barrier to trade of metal. The formulation of mints as a standard way of assuring the value of the metal became commonplace.

Then Smith describes how the Pound was originally a pound, but shrunk over time as a way to allow greedy princes and sovereigns a way to cover their debts, but the long term effect was to benefit debtors across the board at the expense of creditors. I don't know whether Smith realized it, but he basically outlined the basic concept of inflation and an expansionary money supply.

He concludes by making a few points which I assume he will expand on through future chapters. First value has two types. Value of use (like tools) which are poor instruments of exchange, and value of exchange(like coins) which have little practical use. Second he outlines a framework for what I can only assume is the foundation of price theory.

Monday, June 22, 2009

Wealth of Nations: Book 1: Chapter 3: That the Division of Labour is limited by the Extent of the Market

The core of this chapter is basically a two pronged descriptive analysis of how division of labor occurs.

First if you have a small village and a large town, you can expect that in the small village any given worker would be forced to cover many different trades. This is simply illustrated by the simple porter (think moving company). In a tiny village he maybe a porter maybe once a week or once a month if he was lucky. So on many of his days, he'd be doing other tasks which the small population of the village would be lacking in. "So you don't need stuff moved today, how about I mow your lawn or fix your leaky faucet?" While in a large town, he'd be a porter every day, and there would be a gardener every day, a plumber everyday. The demand for these services is large enough to support the trade in that market.

The second point is that the first can be partially negated if a healthy trade route was available. He compares how land transport at the time (some horses and a wagon) compared in cost to a ship transport. The net result was the cost of transport from one place to another is pretty cheap if you can get there by water. As examples of the benefit he compares the economies and productive nature and division of labor in great empires who either had constructed or utilized waterways to prosper, to the less civilized people who as a by product of geography had no such available option.

The points are pretty salient. You can have divided labor provided you can export the excess cheaply in exchange for stuff you can't make. The basic take away is the trade can produce greater affluence than isolation. I think it is important to review the second point in a modern context. Think for a second how much you pay for a package to be delivered by air quickly versus by ship and cargo crate. I think that as fuel prices get more expensive over time, a resurgence of rail versus highway shipping of goods could be a very likely outcome. Some wine shippers in Ireland are already toying with wind sail powered ships versus their diesel counterparts.

The notion that urbanization leads to greater societal wealth seems to have borne itself out with the grand urbanization in the last century. Think of the wealthiest countries and look at their population concentrations, you'll see large city after large city. Even looking at China's modernization over the last 20 years is a case study in the largest human migration in human history.