Tag: capitalism

2017 Jeep Grand Cherokee in Makarska, Croatia. Elishur19.

Law of Diminishing Marginal Utility

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Imagine you are fond of pizza and very hungry. If I offer you a pizza, you will be very grateful. If, after you have finished, I present you a second, you will not decline, but you will be a bit less grateful. If I offer you a third, you might still eat it, perhaps not to offend me. The fourth pizza you would decline. You might give a lame excuse like nausea to explain your peculiar behaviour. Before the fifth pizza is offered, you may already have sneaked out of my home.

Welcome to the law of diminishing marginal utility. It is a law in economics. It states that the more you have of something, the less use an extra unit has.

It is possible to express the law in terms of money. Suppose you are at a pizza restaurant, hungry, and willing to pay € 12 for a pizza. After eating it, you are not hungry and unwilling to pay € 12 for a second pizza. But if the restaurant owner offers you a discount of € 6, you might accept the offer. A third pizza you may only eat if it is on the house. A fourth pizza you will not eat unless the restaurant owner offers you € 6 to eat it. Eating a fifth pizza might cost the restaurant owner € 12.

number of pizzas eatenvalue of the next pizza in €
0€ 12
1€ 6
2€ 0
3– € 6
4– € 12

What might strike you is that the fourth and fifth pizzas have negative value to you. You are not willing to eat them unless the restaurant owner pays you for it.

Most people have other desires than pizza alone. If you also desire soda, there is a limit to that, too, and at some point, drinking more soda also has a negative value to you. Perhaps you desire a hundred other things, for instance, a refrigerator, and you may even have room for a second, but more refrigerators have no use to you, nor do they fit in your house. And so, the more you have, the less something extra is worth to you, and you might start to think about the future.

Perhaps you have plenty of pizza and soda now, but what about tomorrow and next year, so you might start saving. As we get wealthier, getting more stuff becomes less important to most of us, while certainty about the future becomes more important. At some point, we do not want more stuff, and the law of diminishing marginal utility becomes an obstacle to economic growth.

If you are happy with what you have and care about the future, you may save too much for the economy to grow and capitalists won’t make enough money because they must at least make the interest rate. The law of diminishing marginal utility is, therefore, a grave threat to capitalism. And so is interest. This is where the advertising industry comes in. The trick of advertising is to make us unhappy with what we have and to make us desire more. Buying this or that will make us happier, advertisements promise us.

Fashionable items with a limited lifespan are part of the solution too. It is not always possible to make us desire more stuff, but it is still possible to make us desire new stuff. The dress you bought last year is out of fashion now. In order not to look stupid you have to buy a new one. And then there is technological development. Next year there will be a newer model, and by the way, the software on the old model won’t be supported any more. And of course, luxury items do their bit. Why go for a Volkswagen Polo if you can afford a car with a low marginal sports utility value like the Jeep Grand Cherokee?

Yes, the Jeep Grand Cherokee is an ugly monster, but it is bigger than the Volkswagen Polo and if you can afford to drive it, why not? There is a reason why not.

We, humans, use far more resources than our planet can offer. That’s why capitalism is a grave threat to humanity. Capitalism nowadays is like making us eat the fifth pizza and pay extra for it even though that creates a health hazard while many people are hungry. And there may be no food tomorrow because we have eaten too much today. The Jeep Grand Cherokee is like the fifth pizza. We work hard to buy stuff we do not need. This is how humanity is committing suicide. This can’t go on. There is one obstacle. Businesses must make at least the interest rate, and interest rates below zero are still unthinkable.

In other words, we must learn to care about the future and interest rates may need to go below zero. We must learn to be happy with what we have and settle for less when possible. This may be a grave threat to capitalism for what will happen if we stop spending on excesses? Economists fear that the economy will collapse and that we will be without jobs when business profits decline and interest on debts can’t be paid. That doesn’t have to happen when interest rates are negative. In that case, debts don’t have to be repaid and businesses with little or no profits can survive.

That may seem strange but it is already happening. The law of diminishing marginal utility is kicking in, and it is kicking in big time.

This law affects capital too. If there is only one pizza factory that can supply every pizza addict with one pizza per day, it would almost certainly make a profit. A second factory might make a profit but it might not. And what is more, if the second factory comes into operation, the supply of pizza increases, and according to the law of supply and demand, the price of pizza would drop. That would also cut into the profits of the first factory.

A third factory is even more likely to be loss-making and it could make the other factories loss-making too. At some point, there is little use for capital. That causes the demand for capital to drop and interest rates to go negative. Traditional economics would consider this unhealthy or temporary.

That doesn’t need to be and it can be desirable. Three pizza factories fiercely competing and without profits might be better for consumers than one that is profitable if we assume that pizza is a necessity. Everyone must eat something. There could be an ample supply of investment capital at negative interest rates so profits may not be needed for pizza factories to stay in business.

A problem is that excess investment capital can go to businesses that suicide humanity by using scarce resources to produce the stuff we do not need. Negative interest rates can help to make the economy sustainable but only if the excesses do not happen. This would require governments to ban or tax excesses or to regulate their production so that these products don’t have a harmful impact. That would make them a lot more expensive.

But the fun of driving a Jeep Grand Cherokee, apart from giving environmentalists the middle finger, comes from the fact that you can afford to drive it, so the fun may be even greater when it is three times as expensive.

When people start saving more and businesses hardly make profits then where does the money go? It can be used to make the economy sustainable. It can go to people in need who still have use for money. The money can help to reduce poverty and it can be used to address pressing needs in society. And we could have far more leisure time. What’s the point of working so hard for things we do not need? We may only have to work for twenty hours per week and still have a good life. It seems possible that humanity will survive capitalism and that capitalism will be transformed into an economic model that can endure for the foreseeable future.

Featured image: 2017 Jeep Grand Cherokee in Makarska, Croatia. Elishur19. CC BY 4.0. Wikimedia Commons.

Beautiful countryside in southern California

Capital for the future

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Making the economy sustainable may require an unprecedented amount of capital in the form of knowledge and outfits like solar panels, sustainable farms and energy-efficient transportation systems. It is hard to imagine that it can be done. And imagining it is still a lot easier than really doing it. It is going to require some economic magic to divert investment capital from destructive activities to the future of humanity. We may need more useful capital and less consumption.

Perhaps the invisible hand can be of some help. It is easier to finance a great endeavour from investments than from taxation because nobody wants to pay taxes but everybody is happy to invest. It is the secret of the success of the European empires that conquered the world after the Middle Ages. England, France, Spain and the Netherlands were much poorer and smaller than China, India or the Ottoman Empire, but they didn’t finance their conquests with taxation, but with the use of investment capital.1

Europe won out because European conquerors took loans from banks and investors to buy ships, cannons, and to pay soldiers. Profits from the new trade routes and colonies enabled them to repay the loans and build trust so they could receive more credit next time.1 The same logic may need to be applied to making the economy sustainable. The challenge is so enormous that it may never be possible to finance it by taxes. Nowadays interest rates are so low because there is plenty of investment capital.

It’s the economy stupid!

It is often argued that the economy is unsustainable because of short-term thinking. The economy must grow in order to have positive returns on investments. And it is believed that returns on investments need to be positive otherwise the economy would collapse. The economic time horizons of individuals are reflected in their time preferences. The time horizon of the economy as a whole is reflected in the interest rate.

The lower the interest rate, the longer the time horizon of the economy could be. The following example from the Strohalm Foundation can illustrate this:

Suppose that a cheap house will last 33 years and costs € 200,000 to build. The yearly cost of the house will be € 6,060 (€ 200,000 divided by 33). A more expensive house costs € 400,000 but will last a hundred years. It will cost only € 4,000 per year. For € 2,060 per year less, you can build a house that lasts three times as long.

After applying for a mortgage the math changes. If the interest rate is 10%, the expensive house will not only cost € 4,000 per year in write-offs, but during the first year there will be an additional interest charge of € 40,000 (10% of € 400,000).

The long-lasting house now costs € 44,000 in the first year. The cheaper house now appears less expensive again. There is a yearly write off of € 6,060 but during the first year there is only € 20,000 in interest charges. Total costs for the first year are only € 26,060. Interest charges make the less durable house cheaper.2

Without interest there is a tendency to select long-term solutions. Interest charges make long-term solutions less economical. Interest promotes a short-term bias in the economy. It may explain why natural resources like rainforests are squandered for short term profits. If interest rates are high, it may be more profitable to cut down a rainforest and to put the proceeds at interest rather than to manage the forest in a sustainable way.

Only, things are not as simple as the example suggests. For example, the building materials of the cheap house might be recycled to build a new house. And technology changes. For example, if cars had been built to last 100 years, most old cars would still be around. This could be a problem as old cars are more polluting and use more fuel. Nevertheless, the example shows that long-term investments can be more attractive when interest rates are lower.

This also applies to investments in renewable energy. For instance, a solar panel that costs € 100, lasts 15 years, and generates € 150 worth in electricity in the course of these 15 years, is feasible at an interest rate of 5% but not at an interest rate of 10%. Many investments in making the economy sustainable may have low returns and are only feasible when interest rates are low. Low and negative interest rates can also deal with low economic growth. That may be needed for living within the limits of the planet.

Living within the limits of the planet

When interest rates are negative, the time horizon of the economy could go to eternity so that it makes sense to invest in making the economy sustainable. A few examples from history can illustrate this. In the Middle Ages some areas in Europe had currencies with a holding fee like Natural Money. As there hardly was economic growth, interest rates were negative. It was the era of Europe’s great cathedrals. These cathedrals were built for eternity. As better investment opportunities were absent, wealthy towns people spent their excess money on cathedrals.3 For similar reasons, the people of Wörgl planted trees as the proceeds of the wood were expected to occur in the distant future.3

A bit of calculus shows why. At an interest rate of 5%, putting € 1 in a bank account turns into € 1,05 after a year, so you would rather have € 1 now than in one year’s time, even when you need the money in one year’s time. That’s because you can put the money on a bank account at interest. At an interest rate of 5%, € 100 in one year’s time is worth € 95.25 now. The distant future has even less value. The same € 100 in one hundred year’s time is worth only € 0.59. And € 100 after 1000 years has no value at all in the present.

At an interest rate of -5%, you would prefer to have the money when you need it, otherwise you would end up with less. At an interest rate of -5%, € 100 in one year’s time would be worth € 105. The same € 100 in one hundred year’s time would be worth € 13,501 now. And € 100 after 1000 years would be worth more than everything there is in the present. Income in the distant future is also very uncertain, so it is unlikely that investors will shift their time horizon to 1,000 years, but this logic may help us to come into terms with the limits our planet poses on human activities.

Living within the limits of the planet may require unprecedented investments in the future. These investments may require low or even negative interest rates as their returns may be low. Only low and negative interest rates can make these investments economical. Everyone who has money to save can help by shifting money from consumption to saving and investing. The more people act like capitalists, the lower interest rates may go, and the more sustainable the economy may become.

Capitalists think that money spent on a frivolous item is money wasted, because when you invest your money, you will have more money that you can invest again. Capitalists hardly care about interest rates. They will save and invest anyway because of their capitalist spirit. Rich people may be encouraged to save even more if luxuries that use a lot of natural resources and energy aren’t available any more. One can think of luxury yachts, private jets, but also of travel by airplane for holidays. When energy becomes a constraint, local products may replace long-distance trade.

Featured image: Beautiful countryside in southern California. James McCauley (2005). Wikimedia Commons. Public Domain.

1. A Brief History Of Humankind. Yuval Noah Harari (2014). Harvil Secker.
2. Poor Because of Money. Henk van Arkel and Camilo Ramada (2001). Strohalm.

Heaths near Nijverdal

Our invisible friend

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Market economy

Market economies have an invisible friend called the invisible hand. In market economies, goods are distributed without the need for a planning agency. According to Adam Smith, it is as if an invisible hand makes this miracle happen. His critics, for instance, Karl Marx, did not believe in invisible friends. Not surprisingly, Marx also did not believe in God. Smith claimed that if everyone pursues his own interest, the interest of society is often best served. The followers of Marx felt that the state should plan the production and distribution of goods and services.

I’m the invisible man
Incredible how you can
See right through me

– Queen, The Invisible Man

The following story demonstrates how the invisible hand does its magic. Whether or not it is true does not matter. The story goes that the mayor of Moscow once visited London in the 1980s. Back then, Russia did not have a market economy. The mayor received a tour around the city and noticed that no one queued up for bread as everyone did in Moscow. There was an ample supply of bread at affordable prices. Somehow bread was produced in the right quantities for the preferred tastes and supplied at the right places.

The mayor was amazed about this feat, so he said to his hosts, “Back in Moscow our finest minds work day and night on the bread supply and yet there are long queues everywhere. Who is in charge of the supply of bread in London? I want to meet him!” Of course, no one was in charge. That’s the secret of the market economy. Every baker decided how much he was planning to make and sell and at what price. A few years later, Russia switched to a market economy.

The individual decisions of bakers and the businesses in the supply chain, for instance, farmers and flour mills, make this miracle happen. They all decide for themselves. If a baker could sell more than he produced, he would miss out on profits. The same is true when he has to throw away bread. And some people are willing to pay more if the bread tastes better. Hence, each baker tries to make the right amount of bread to the tastes people desire. It is in their best interest.

In Russia, the state planned how much of each item a corporation should produce. Corporations could not decide on prices. They received compensation for their costs but could not make a profit. Employees received a fixed salary. Corporations that produced more or better products and their employees did not benefit. Corporations also could not go bankrupt when they did a terrible job. That resulted in poor-quality products, a shortage of nearly everything and even outright famine from time to time.

It doesn’t always work out well

This miracle has enchanted quite a few people. They believe that everything will turn out fine if only markets can do their job. But there are many instances where a market economy doesn’t produce the best outcome for society. Economists call them market failures. One can think of the following situations:

  • We have more desires than our planet can support. A market economy may fulfil those desires at the expense of our future.
  • Many people cannot make a living in the market economy, for instance, because they lack the skills or have little bargaining power.
  • Corporations use lobbyists and bribe politicians to pass legislation that favours them.
  • A government may be a more efficient producer of products that do not benefit from competition, for instance, roads and the power grid.
  • Corporations may abuse their power and charge higher prices, most notably if they have no competitors.
  • Products can cause harm to people or the environment, but producers may not pay these costs themselves. For example, cigarettes cause health costs.

In most countries, governments interfere with the economy to deal with these market failures. These are situations where pursuing personal interests does not bring the best outcome for society. In many democratic countries, public expenses are about 50% of national income. People in these countries probably believe that a market economy does not always work best. In some areas, markets produce extremely poor outcomes, for instance health care.

An example can demonstrate why. People in the United States live as long as people in Cuba.1 Cuba is poor and does not have a market economy. The United States spends more on health care than any other country in the world. Every possible treatment is available in the United States. Still, in more than 40 countries, people live longer than in the United States.1 Cuba does not spend a lot on health care, only 10% of what the United States spends per person. Healthcare in Cuba appears efficient compared to healthcare in the United States. How can this be?

The available treatments in Cuba are free for everyone. In the United States, you may not receive treatment when you cannot afford it because the United States has a market economy. There may be other causes, for example, differences in diets in Cuba and the United States. There is no fast food in Cuba because Cuba has no market economy. Life in Cuba may be miserable, but healthcare is one of the few things Cuba has organised well.

Successful societies have market economies and governments that organise things that the market fails to do. And a market economy still needs a government to set the rules and enforce them. Governments of successful societies aim at making the market economy work better where it is beneficial for society and constraining it where it does more harm than good.

Capital

Market economy and capitalism are so closely related that many people believe them to be the same. Capitalism is about capital. Capital consists of the buildings and the machines corporations own, but also the knowledge of how to make products and how to bring them to the market. Knowledge of how to make a film entertaining might be capital for a film company. Networks of customers and suppliers can be capital too if they contribute to the success of a business. The same applies to contracts and brands. For instance, the brand Coca-Cola has a lot of value because people are willing to pay more for cola when the logo of Coca-Cola is printed on the bottle.

Building capital can be costly but in a market economy the value of capital doesn’t depend on the cost to build it but on the future income it is expected to produce. This can lead to peculiar situations. When investors have no faith in the future of a corporation because it is expected to make losses, the buildings and the machines on their own may be worth more than the corporation as a whole as those buildings and machines could be used by other corporations for more profitable purposes.

In most cases, more capital means more wealth because capital produces the things people need or desire. Corporations tend to be more profitable if they fulfil those needs and desires better. Therefore, the value of capital in a market economy often depends on how well it can fulfil the desires of consumers. Investors are willing to invest in corporations that fulfil those needs and desires because they expect to make money by doing so.

It is sometimes argued that when investors are free to invest in the corporations of their choosing, the invisible hand channels investment capital to the most useful corporations because they are the most profitable. That’s why the value of corporations is important in a market economy. Businesses ‘create value’ for investors by making consumers happy. Still, the value of a corporation might not reflect the benefits for society as a whole. For instance, if the profitability of a corporation comes from exploiting people or harming life on the planet, a high value could be a bad sign.

And capital can be useful without being profitable, for instance in the public sector. A hospital in the public sector may have no market value because it doesn’t make a profit but it can be useful nonetheless. Capital in the public sector might even be more valuable than in a market economy. For instance, making hospitals private enterprises for profit might not benefit society as a whole. Hospital care may not improve from the competition as it is often best to have one hospital serving a particular area. And patients might receive unnecessary treatments when hospitals can make a profit. Healthcare in the United States may create a lot of value for investors but it doesn’t always benefit the patients.

As there are basically two types of people, capitalists who save and invest and ordinary people who borrow and spend, it is hardly surprising that capitalists tend to be wealthier than ordinary people. Capitalism can create wealth because it is the capitalists who finance the investments in the corporations that make the items ordinary people enjoy, but this wealth is often unevenly distributed. From a moral perspective, it is a problem that poverty still exists when there could be enough for everyone. So the question that still remains is how to make the economy work better for the benefit of all?

Featured image: Our invisible friend photographed in the moorlands near Nijverdal. Jürgen Eissink (2018). Wikimedia Commons. Public Domain.

1. Life expectancy per country 2017. World Population Review. [link]