The Cost of Recalls and Lost Goodwill

Posted by PITHOCRATES - April 7th, 2014

Economics 101

Manufacturers make a Point of not Killing their Customers because it’s just Bad for Business

There have been some costly recalls in the news lately.  From yoga pants that were see-through.  To cars with faulty ignition switches that can turn the engine off while driving.  Disabling the power steering and airbags.  Resulting in the loss of life.  These recalls have cost these companies a lot of trouble.  Including financial losses from the recalls and lawsuits.  Being called to testify before Congress.  And possible criminal charges.

No surprise, really.  As those who distrust corporations would say.  For they believe they constantly put their customers at risk to maximize their profits.  Even if it results in the death of their customers.  Which is why we need a vigilant government to keep these corporations honest.  So they can’t sell shoddy and dangerous goods that can kill their unsuspecting customers.  Which they will do if the government doesn’t have strong regulatory powers to stop them.  Or so says the left.

Of course, there is one problem with this line of thinking.  Dead customers can’t buy things.  And when word spreads that a corporation is killing their customers people don’t want to be their customers.  Because they don’t want to be killed.  Manufacturers know this.  And know the price they will pay if they kill their customers.  So manufacturers make a point of not killing their customers.  Because it’s just bad for business.

The Longer it takes to Recall a Defective Product the Greater the Company’s Losses

Manufacturing defects happen.  Because nothing is perfect.  And when they happen they are both costly and a public relations nightmare.  As no manufacturer wants to lose money.  And, worse, no manufacturer wants to lose the goodwill of their customers.  Because it’s not easy earning that back.  Which is why executive management wants to acknowledge and resolve these defects as soon as possible.  To limit their financial losses.  And limit the loss of their customers’ goodwill.

Let’s illustrate this with some numbers.  Let’s assume a company manufactures 5 product lines ranging from low price to high price.  The lowest priced product has the greatest unit sales.  And the lowest margin. The highest priced product has the fewest unit sales.  And the highest margin.  The other three items fall in between.  Rising in price.  And falling in margin.  Summarized here.

Cost of Recall - Gross Margin per Product Line R1

So each product line produces a sales revenue, a cost of sales and a gross margin (sales revenue less cost of sales).  Adding these departmentalized numbers together we can get total sales, cost of sales and gross margin.  And subtract from that overhead, interest expense and income taxes.  Summarized here.

Cost of Recall - Net Profit

So on approximately $5.8 million in sales this company earns $312,414.  A net profit of 5.4%.  Fictitiously, of course.  Not too bad.  That’s when everything is working well.  And they have nothing but satisfied customers.  But that’s not always the case.  Sometimes manufacturing defects happen.  Which can turn profits into losses quickly.  And the longer it takes to address the defects the greater those losses can be.

Losing the Goodwill of your Customers will end up Costing More than any Product Recall

Let’s say Product 3 suffers a manufacturing defect.  By the time they identify the defect and halt production of the defective product they’ve produced 20% of the total of that product for the year.  Which they must recall.  Limiting their losses to 20% of the total of that product run.  Which they will have to refund the sales revenue for.  But they will have to eat the cost of sales for those defective units.  And despite the company’s quick response to the defective product and providing a full refund to all customers their goodwill suffers from the bad press of the recall.  Summarized here.

Cost of Recall - Recall

Refunding customers for the 20% of the line that was defective reduced net profits from 5.4% to 0.7%.  And when they lose some customers to their defect-free competition they lose some customer goodwill.  Resulting in a 15% drop in sales.  Leaving manufactured product unsold that they have to sell with steep discounting.  Bringing their sales revenue further down while their cost of sales remains the same.  Turning that 0.7% annual profit into a 2.8% loss.  But as time passes they recover the lost goodwill of their customers.  Limiting these losses in this one year.  Now let’s look at what would probably happen if the company had a ‘screw you’ attitude to their customers.  Like many on the left fervently believe.  Summarized here.

Cost of Recall - Loss of Goodwill R1

The company did not recall any of the defective products.  As word spread that this company was selling a defective product sales of that product soon fell to nothing after selling about 50% of the annual production run.  The other half sits unsold.  Even steep discounting won’t sell a defective product.  And seeing how they screwed their customers on the defective products sales fall on their other products (in this example by 30%).  As they don’t want to suffer the same fate as those other customers.  So what would have been only a $159,929 loss with a recall becomes a $1,494,344 loss.  Over nine times worse than what it could have been without a large loss of customer goodwill.  And this is why executive management moves fast to identify and resolve defects.  Because losing the goodwill of their customers will end up costing more than any product recall.  As it can take years to earn a customer’s trust again.

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Communism, Karl Marx, Marxism, Surplus Labor and the Labor theory of Value

Posted by PITHOCRATES - August 20th, 2013

History 101

(Originally published December 13, 2011)

Some would call Putting Profits before People Heaven if they had Lived in the Caring Hell of Communism

No ideology killed more people than communism.  In total numbers.  Such as Joseph Stalin in the Soviet Union.  Or Mao Tse-tung in the People’s Republic of China.  Or as a percentage of population.  Where Pol Pot’s Cambodian genocide holds this honor alone.  These communist leaders killed their people directly for political purposes.  Or starved them to death because of agrarian reforms that produced famines.  All in the name of freeing their people from the horrors of capitalism.

Heaven and hell.  That’s how a defector who escaped communism and made it to capitalism would describe what it’s like to live under each system.  Capitalism would be heaven.  And communism would be hell.  The problem with communism was that it didn’t work.  Economically.  People lived in want of the basic staples of life.  And often went hungry.  When they didn’t starve to death by yet another famine.  And if they complained or spoke out against the system they risked torture.  Or they simply just disappeared.  Banished to a work camp.  A reeducation camp.  Or killed.  So it’s no surprise that people trapped in these countries tried to escape.  Which is why communist states were oppressive police states.  To prevent people from escaping their horrible lives.

And yet to this day some people still hold up communism as the ideal socioeconomic system.  The one that cares about the people.  The one that puts people before profits.  Unlike capitalism.  Which puts profits before people.  Of course some would call putting profits before people heaven.  Especially if they had lived in the caring hell of communism.

Communism as an Economic System is an Utter and Abject Failure

Those who champion communism don’t blame the ideology.  They say it’s the people.  The few who use the ideology for personal gain.  And by few they mean basically everyone.  But if everyone is doing it it’s not the people.  It’s the ideology.  And it goes back to its utter and abject failure as an economic system.

Communism goes back to Karl Marx.  The guy that coauthored the Communist Manifesto in 1848.  And from which we get the terms Marxism.  And Marxist.  To describe varying forms of communism.  And communists.  He’s the guy who said that capitalism exploited the working man.  Those with money (capital) who owned factories, the industrial bourgeoisie, charged more for their goods than they paid their workers to make those goods.  Because Marx believed the value of any good was the labor that made it (the labor theory of value), this excess value (profit) was a labor surplus.  And belonged to the worker.  So he encouraged class conflict.  For the proletariat (the working class) to rise up and take over the means of production from those who owned it.  These middle class capitalists.  The industrial bourgeoisie.  And establish a dictatorship of the proletariat.  So the bourgeois capitalist pig-dogs couldn’t exploit the proletariat any more.  And everyone would then live happily ever after.

But no one ever did.  Like in capitalism.  Where happiness abounds.  Because, in capitalism, the market determines prices.  Not some bureaucrat counting up labor inputs through the manufacturing process.  From the mining of resources.  To the final assembly.  Which can make things very expensive.  And, worse, unwanted by the people.  Because when the market sets the price and assigns value, the market tells people what to make.  Normally when something is a hot seller it tells manufacturers to make more of it.  To cash in on those high prices.  So they do.  And people tend to buy this surge in products.  But when the market isn’t setting the price and assigning value, the market can’t tell people what to make.  So a bureaucrat must.  Which is what happens in communism.  Bureaucrats decide everything.  From what to make.  To the allocation of resources.  To the selling price.  And the things they decide to make are rarely what the people want.  Explaining why stores in communist countries were full of stuff no one wanted to buy.  And why people had to stand hours in line to get the things they did.  Or paid more on the black market.  Which is why communism as an economic system is an utter and abject failure.  And why people wanted to escape it.  Their only obstacle being that brutal and oppressive police state.  Which was necessary because if everyone left that wanted to the communist leaders wouldn’t have anyone to provide for them.

There are no Such Things as Market Failures under Capitalism

Communism was one of the worst man-made tragedies to ever befall man.  Karl Marx was wrong.  And his asinine theories killed tens of millions of people.  People enjoy life and prosper under capitalism.  Under communism they set records for genocide.  Why?  Because the communist economic model is an utter and abject failure.

The struggle between communism and capitalism was an economic one.  And pitted the market against bureaucrats who thought they were smarter than the market.  But it turned out they weren’t.  Not by a long shot.  And despite this history people are constantly talking about market failures and the evils of capitalism.  Much like Joseph Stalin, Mao Tse-tung and Pol Pot.  But for them it was never about the economics.  It was about the power.  Much like it is today.  Because there are no such things as market failures under capitalism.  It’s the bureaucrats who fail.  Not the markets.  At least, based on all recorded history.

Markets fail only when they aren’t free.  They fail when bureaucrats insert themselves into the economic process.  Via regulatory policy.  Or high taxes.  When they try to shape market forces to a political end.  And when they do it is capitalism no more.  It’s crony capitalism.  Or worse.

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Market Forces and Health Care

Posted by PITHOCRATES - March 4th, 2013

Economics 101

Keynesians try to reduce Human Behavior down to Complex and Confusing Math

We hear a lot about introducing market forces into health care.  But what does that mean?  What exactly are market forces?  Are they like magnetic forces?  Electric forces?  Hydraulic forces?  No.  Market forces are not forces that conform to the laws of science.  Rather, they belong in the realm of the social sciences.  That are less science.  And more opinion.  Where there are a lot of theories.  And politicians massage the data to fit their theory.  As Mark Twain said, facts don’t lie but liars figure.  And politicians figure.  A lot.

So there are no hard rules when it comes to the social sciences.  Just a lot of theorizing.  And a lot of drawing conclusions.  Based on the data.  And how some massage the data.  Something to keep in mind whenever anyone discusses economic numbers.  For the accepted school of economics most politicians adhere to is the Keynesian school.  The dirty little whore of economics.  For there is a whole lot of massaging going on with Keynesians.  With the data.  Not each other.  Politicians love Keynesian economics because this school of economic thought calls for governments to tax, borrow, print and spend.  Empowering government.  Making government grow.  And become more intrusive in our personal lives.  All things politicians love.  Which is why they massage the economic data.  They have to.  Because this school of economic thought doesn’t work.

Keynesians make economics very complex.  Open a text book and you will find a lot of graphs and formulas.  Where they try to reduce human behavior down to math.  Very complex and confusing math.  And you can’t do that.  Humans have free will.  They make decisions based on any number of things.  One influencing factor more or less could change the way they decide.  And there’s no way we can quantify all the variables in our lives.  Therefore, there’s no way to reduce human decision-making down to math.  Which is what drives market forces.  Our decision-making process.  That point in time that triggers the free exchange of money for goods and/or services.

When it comes to the All-You-Can-Eat Buffet Customers think more in Terms of Quantity than Quality

Consider an all-you-can-eat buffet.  And how it changes your decision-making process.  But first let’s look at some typical behavior at a normal restaurant.  Where you may spend $15 for a 4-course meal and drink.  Soup, salad, entrée and dessert.  Which you enjoy with a friend.  You have pleasant conversation as you enjoy each of your 4 courses.  Taking your time.  Enjoying each course.  Slowly getting full.  And satisfied.  The portion sizes are just right.  Leaving just enough room for dessert.  You’re full.  But not too full.  Comfortable.  You’re able to go for an after-dinner walk.  Even take in a movie.

Now let’s consider the all-you-can-eat buffet.  Where you may pay $20 for unlimited access to the buffet.  You’re paying more than for a sit-down service.  Why?  Because you plan to eat more.  You will maximize the value you get for your $20.  Which means you’ll probably skip the soup and salad.  And start loading your plate with the expensive entrées.  You’ll probably go back once or twice.  Making sure you get a taste of everything.  And a lot of anything that is expensive.  Again, to maximize your value.  In fact you maximize so much that you become uncomfortably full.  Too full to sit through a movie without nodding off.  And too full for a walk.  All you want to do is go home and nap.

The restaurant sees this from a slightly different perspective.  The all-you-can-eat buffet is simple to serve.  You mass produce food to load up the buffet so it’s ready at the beginning of the buffet hours.  You replace the items people eat most.  While the less popular items sit longer in the buffet.  Becoming less fresh.  Also, the buffet is a good way to get rid of things approaching their ‘serve by’ dates.  Saving the freshest food for the made-to-order sit-down service.  And putting the older food in the buffet.  Because when it comes to the buffet you know customers are thinking more in terms of quantity than quality.  The food is good in the buffet.  But not as good as the food for the sit-down clientele.

If you Pay Cash at the Pharmacy you are more likely to Ask for the Less Expensive Generic Drugs

These are market forces.  People have come together to make voluntary exchanges.  The quantity of food available makes some people opt for the more expensive all-you-can-eat buffet.  Others may opt for the less expensive but higher quality made-to-order sit down service.  For the person who places the greatest value on eating mass quantities of food will choose the buffet.  The person who places the greatest value on the dining experience (quality of food, made-to-order, conversation, after-dinner walk or movie, etc.) will choose the sit-down service.  If more people are choosing the buffet the owner may extend the buffet hours.  If fewer people are choosing the buffet and leave a lot a food to throw away the owner may end the buffet service.  These are market forces.  Buyer and sellers coming together in the marketplace.  Seeing what each has to offer.  If they come to a mutual agreement they make an economic exchange.  The buyer willingly exchanges his or her money for goods and/or services.  The seller willingly accepts an amount of money in exchange for his or her goods and/or services.

The private economy works because it is buyers and sellers meeting and making exchanges they both freely agree to.  This is the key of market forces.  It’s what makes people with money go to the marketplace.  And it’s what makes people bring goods and/or services to the marketplace.  Because they will seek each other out and make these exchanges.  After which both buyer and seller will come away with something they value more.  This is what is missing in health care.  Buyer and sellers aren’t meeting to make exchanges.  In fact, the buyer and seller do not even meet.  Patients never ask for any prices.  Because they aren’t paying for anything.  Their insurer is.  And the medical provider will always provide the most expensive treatment billing guidelines will allow.  For that’s who they must please.  The people paying them.  Not the patient.  And they have to charge as much as they can to cover all the things they won’t get paid for.  People they treat without insurance who can’t pay.  And for the billings the insurers deny.

So this changes the decision making process.  For everyone.  Introducing a third party into the equation removes market forces.  If you pay cash at the pharmacy you are more likely to ask for the less expensive generic drugs.  If you get free prescription coverage you will ask for the most expensive name-brand medicine they have.  For when you’re not paying price is no object.  But when you are paying price is a very important object.  Because when it’s our money getting value for our money is very important.  So we’ll ask if the name-brand has any more value than the generic.  For who would spend more for something that doesn’t give you any more value than something you can get for less?

When it comes to medical tests and procedures patients aren’t going to ask for more than they absolutely need.  And doctors aren’t going to prescribe any more than a patient needs.  Because they aren’t billing a faceless bureaucrat.  They’re billing someone they have a close and personal relationship with.  And they sure aren’t going to try and bill someone they have a close and personal relationship with for someone else’s unpaid bill.  Not if they want to keep them as a patient.  Because a doctor-patient relationship is a long-term relationship.  A doctor could lose a lot of business by mistreating a patient to make an extra buck.  These are market forces.  Which makes the private sector work so well.  And why their absence makes the health care system not work so well.  Transforming our health care from a moderately priced, high quality, custom, sit-down service to a higher priced, mass-produced, lower quality, all-you-can-eat buffet.

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Rolls Royce, Cadillac, Moving Assembly Line, Economies of Scale, VCR, Cell Phones and HD Plasma Television

Posted by PITHOCRATES - January 1st, 2013

History 101

The Moving Assembly Line allows GM to Divide their Costs over more Units than Rolls Royce

Rolls Royce automobiles are very expensive luxury cars.  Of impeccable quality.  It may be the finest automobile ever built.  And I say built not manufactured.  For they build a Rolls Royce by hand to ensure that high quality.  By some of the most experienced and skilled artisans to ever hone metal, wood and leather into an automobile.  Because of this they can’t make a lot of them a year.  They set a record sales total in 2011.  By selling 3,538 hand-crafted automobiles.  The entry price for a Rolls Royce?  Around $250,000.

By contrast GM sold 152,389 Cadillac luxury automobiles in 2011 in North America.  These are not hand-crafted.  The Americans build them on moving assembly lines.  Which is why they can build 43 times as many Cadillacs than they can hand-build Rolls Royces.  The entry price for a Cadillac?  About $33,100.  While a top of the line may cost you around $63,200.  Now Cadillacs are nice.  The name has become synonymous with high quality.  The best quality is the ‘Cadillac’ of something.  The quality may not be Rolls Royce quality but few will complain about that quality when sitting behind the wheel of a Cadillac.  They are glad to settle for a Cadillac over a Rolls Royce.  Especially when it costs 7.5 times as much to get into a Rolls Royce than into a Cadillac.

Why are hand-crafted Rolls Royce automobiles so much more costly than Cadillacs manufactured on a moving assembly line?  Economies of scale.  The higher production levels of the mass-produced cars allows GM to divide all of their costs over many more units.  Bringing the unit cost down.  And the selling price.  With fewer sales the unit cost for Rolls Royce is much higher.  As is the selling price.

As Demand grew Manufacturers were able to Bring Prices Down thanks to Economies of Scale

Rolls Royce pays a price for their commitment to quality.  They can’t sell cars as inexpensively as some of their luxury rivals.  But that’s okay for them.  As the market for hand-crafted luxury cars is large enough to keep them in business doing what they love.  Building the finest quality automobile in the world.  And those who want the best can afford to pay a quarter of a million dollars for an entry-level Rolls Royce.  So they do.  Which is why Rolls Royce doesn’t have to worry about economies of scales to compete against their competition.

Before Henry Ford built the moving assembly line cars were too expensive for the working man.  Henry Ford changed that.  Once they started manufacturing the new driving machine on the moving assembly line Ford was able to reach an economy of scale that greatly increased production rates.  Bringing down the unit cost.  And the selling price.  As new products entered the market place they were typically unaffordable to all but the rich.  But then as demand grew manufacturers were able to bring prices down thanks to economies of scale.  Like Henry Ford did with the automobile.

The first commercially viable video tape recorder was the Ampex model VR-1000 in 1956.  It cost $50,000 (about $421,000 today).  It was the size of a kitchen stove.  And about the only place you found them were in television broadcast studios.  From this early beginning came the technology for the video cassette recorder (VCR).  By the mid to late Seventies schools had one they rolled from room to room.  It cost approximately $5,000 (about $19,400 today).  About a decade later you could buy a smaller unit that could do more for around $2,000 (about $4,000 today).  Just before the DVD player and the digital video recorder made them obsolete you could get a nice one for about $100.  They were so small and so inexpensive that you bought one for every television in the house.

Bringing these Prices Down are State-of-the-Art High-Tech Manufacturers throughout Asia

When the first cell phones came out we called them car phones.  Because they were so big and had no real battery life that they were permanently installed in a car.  Connected to the electrical system of the car.  The first real portable cell phone was something that looked like a brick and weighed in around 2 pounds.  The battery gave you maybe an hour of talk time.  And it cost $3,995 in 1982 (about $9,600 today).  By 1993 the price was down to $900 ($1,400 today) but still weighed in at 2 pounds.  By 1996 the weight dropped to about 3 ounces.  It cost about $1,000 ($1,400 today).  By 2002 you could buy a flip-phone with a built-in high resolution camera for $400 (about $510 today).  And so on until they got smaller and more powerful with longer battery lives.  Today you can often get a pretty nice phone free when you sign a contract for service.

Things people like and demand can accelerate this process of quality improvement and lower prices.  For half a century the television has been a fixture in most American homes.  So technology buffs with money were always ready to spend a lot of money on the next best thing.  And when high-definition plasma televisions hit the market it didn’t take long for economies of scale to bring prices down as demand exploded for these beautiful things.  A Panasonic 42″ high-definition plasma television cost around $2,500 in 2004 (about $3,000 today).  About 4 years later you could get a slightly better set for about $700 (about $750 today).  Today you can buy an even better 42 inch plasma set from Panasonic for as little as $400.

Bringing these prices down are state-of-the-art high-tech manufacturers throughout Asia (Japan, South Korea, etc.).  They can mass produce cell phones and televisions and other high-tech goods at remarkable production rates.  Filling ships with their goods to export around the world.  They bring together high-skilled labor and the best in automated production equipment.  They can retool and begin new production so fast that they can fill the demand for the next big thing without missing a step.  And quickly ramp up to an economy of scale wherever they see growing consumer demand.  Bringing down unit costs.  And prices.  Making a lot of happy consumers around the world.

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Product Pricing

Posted by PITHOCRATES - December 10th, 2012

Economics 101

The First Thing a Business has to do to Determine their Selling Price is Determining their Costs

Did you ever think about how businesses price their products?  Do they just pull numbers out of the air?  Do they just charge as much as they want?  No, they don’t.  Because they can’t.  For if one gas station charges $12 for a gallon of gasoline while the station across the street is only charging $3.50 guess where people are going to buy their gas from.  So free market competition prevents businesses from charging whatever they want.  So how do they determine what to charge?

Well, some look at what their competitors are charging and match it.  Or charge a little less.  To steal customers away from the competition.  Which can work.  But it can also bankrupt a business.  For if a business owner doesn’t know his or her costs selling at the market price could fail to recover all of their costs.  The market price limits what they can charge.  But if their costs are too great to stay in business selling at the prevailing market price they have to do something about reducing their costs.  Which they can’t do if they don’t know their costs.  So the first thing a business has to do to determine their selling price is determining their costs.  Like this.

This is an abbreviated fictional income statement showing last year’s results.  And forecasting next year’s results.  EBT stands for earnings before taxes.  Income taxes for this year are based on the 2011 federal tax tables.  Income taxes for next year are based on the proposed Obama tax rates (increasing the top marginal rate from 33% to 39.6%).  The business is a subchapter-S where the business earnings pass through to the owners’ personal income tax returns.  The owner does not draw a salary but draws $125,000 from retained earnings to support him or herself, his or her stay-at-home spouse and their 3 children. The percentages show each number as a percentage of revenue.

You need to Sell at the Right Price and at the Right Volume to Pay all of the Bills

The difference between this year and next year is the rise in costs.  Obamacare and other business regulations increase the cost of sales (direct labor, benefits, direct supplies, etc.) by 2%.  And they increase fixed overhead (rent, utilities, administrative labor, benefits, etc.) by 2%.  They will have to recover these higher costs in higher prices.  Which will likely reduce unit sales.  But because each unit will sell for more we assume sales revenue remains the same.

The higher costs cause EBT to fall.  A lower EBT means lower federal income taxes.  But it also means less retained earnings to invest back into the business.  The reduction in retained earnings is $36,604.28.  Which limits investments to grow the business.  And leaves a much smaller cash cushion after some of those retained earnings are reinvested into the business.  To pay for the unexpected.  Like a new piece of equipment that fails and halts production.  Things worked well in the current year.  The business owner would like to have things work as well in the following year.  Which means not exposing themselves to such a dangerous cash position.  And how do they do that?  By raising their prices to make next year’s retained earnings as large as this year’s.  By recovering those retained earnings in higher prices.  Like this.

Let’s assume these numbers are for a coffee shop that sells only one type and size of drink (say a large espresso-based drink) to simplify this discussion.  If we subtract this year’s cost of sales from revenue we arrive with the markup on our direct costs.  Dividing this number into cost of sales we get a markup percentage.  For this year it was 72%.  In the current year let’s assume they sold 302,406 cups of coffee.  Which comes to about one cup a minute.  Dividing the costs of sales by the number of cups of coffee sold gives a unit cost of $2.58 for a cup of coffee.  Adding the 72% markup to this cost brings the selling price to $4.45.  Coffee sold at this price and at this volume produced enough revenue to pay all the bills, provided an income for the owner and his or her family while leaving enough left over to invest back into the business.  And provide a cash cushion for the unexpected.  As well as paying state income taxes, city income taxes, etc.

A Business must bring their Cost Structure in Line to be able to Sell at the Prevailing Market Price

To arrive at the new selling price we added the loss of retained earnings to next year’s revenue.  And re-crunched all of these numbers.  Because we are raising the price we can expect a small fall in revenue as customers buy less.  The higher costs and lower unit sales volume raised the unit cost.  The markup percentage is 1 percentage point lower but because the unit cost is higher so is the markup amount in dollars.  Which raises the selling price by $0.32.  Increasing the price of a cup of coffee to $4.77.  But is it enough?  As it turns out, no.  Because the new price raises revenue enough to push the business into a higher tax bracket.  Taking the business owner back to the numbers.

Because of the higher tax bracket, and the higher top marginal tax rate, this higher price still results in a loss of retained earnings.  About another $30,000.  So going through the whole process again brings the selling price up to $4.87.  Adding a total of $0.43 to this year’s price.  As long as the prevailing market price is around $4.87 for a large espresso-based drink this business owner should be able to keep his or her cost structure in place and stay in business.  However, if this exceeds the prevailing market price the business owner will have to make some spending cuts to bring his or her cost structure in line to sell coffee at the prevailing market price.  Make some assumptions.  And some adjustments.  Then crunch these numbers again.  And again.  For getting this price right is very important.  Too high and people will go elsewhere to buy their coffee.  To low and they won’t be able to pay all of their bills.

This may not be how all businesses determine their selling price.  But however they do it they have to bring their cost structure in line to be able to sell at the prevailing market price.   Because if their price is too high no one will buy from them.  If it’s too low everyone will buy from them.  Making them happy.  Until they realize they can’t pay all of their bills because their prices are too low.  The above example was complicated.  And that was with only one product.  Imagine a store full of products to sell.  And trying to calculate new prices on numerous products to cover the costs of new taxes and new regulations.  It’s not easy.  Which is why business owners don’t like big change coming from Washington.  For this change requires important decisions to make.  And if they get these decisions wrong and don’t find out until 6 months or so later they may dig themselves into a hole they won’t be able to get out of.  Putting them out of business.

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Working Capital

Posted by PITHOCRATES - December 3rd, 2012

Economics 101

A Business Owner uses Start-Up Capital to Pay the Bills until the Business starts Making Money to Pay the Bills

Few people understand how business works.  Some think it’s a mystical entity that has an endless supply of money for the taking.  To be taken by the government.  The unions.  And their employees.  While some believe business is some evil entity that acquired its wealth by taking it from poor people.  Poor people that had no wealth to give.  Because they’re poor.  Who we define as being poor because they have no wealth.

But businesses aren’t mystical or evil.  They’re run by ordinary people.  Often doing extraordinary things.  In a constant battle to survive.  They start off by risking everything they’ve ever earned and saved.  Perhaps persuading family to invest in them and their idea.  Or mortgaging their house to the hilt.  Just to get the money to start their business.  Short term financing to pay the bills until the business starts making money to pay the bills.  If the business ever starts making money to pay the bills.

One of the most misunderstood things about business is that their prices are pure profit.  When you buy a $4.50 cup of coffee from Starbucks people think that’s $4.50 of profit.  But it’s not.  That price has to pay for the coffee beans.  The water.  The regular milk.  The low-fat milk.  The flavored syrup.  The cup.  The cup sleeve so you can hold it without burning you hand.  The lid.  The plastic stick that plugs the drinking hole in the lid.  The baristas working there.  The equipment to grind the coffee beans.  To make coffee.  To make espresso.  To make steam to heat the milk.  The point-of-sale cash registers.  The lights.  The heat.  The air conditioning.  The Internet access provided free to their customers.  The soap and toilet paper in the restrooms.  Garbage bags.  Cream.  Sugar.  Sugar substitute.  Coffee stirrers.  The rent.  The telephone bill.  Marketing.  Etc.  They have to recover all of these costs in the sales price of their coffee.  With enough left over to pay for growth.

For a Business to be able to Pay their Bills their Current Assets must be Greater than their Current Liabilities

Bills.  Everyone has them.  And business owners have more than most.  Because it takes money to make money.  A business owner has to spend a lot of money to make something to sell.  Like a cup of coffee.  So they incur a lot of costs.  Costs that their revenues have to pay.  For a business like Starbucks that’s mostly cash and credit card sales.  For other businesses that could be sales on account.  Or accounts receivable.  Sales that don’t result in cash.  But a promise to pay cash later.  Like a lot of those bills Starbucks has to pay.  Things they bought on account.  With the promise to pay cash later.

Businesses have current liabilities.  Which include the bills they owe.  Accrued payroll.  Accrued payroll taxes.  And everything else that they have to pay within one year.  All of which they have to pay with current assets.  Such as cash.  Or short-term assets they can convert into cash within one year.  Like accounts receivable.  Or things that conserve cash.  Like prepaid expenses.  For a business to be able to pay their bills their current assets must be greater than their current liabilities.  If their current liabilities are greater than their current assets, though, they will have some problems paying their bills.

The relationship between current assets and current liabilities is important.  If we divide current assets by current liabilities we get the current ratio.  If this is greater than one then a business will find it easier to pay their bills.  If it’s less than one then a business will struggle to pay their bills.  And may not be able to pay their bills.  If they can’t they are insolvent.  Meaning that they are not selling at high enough prices.  They’re not selling enough.  Or their costs are just too great at the prevailing market prices.  And if any of the above is true they may have no choice but to file for bankruptcy protection.  Because they simply cannot pay their bills.

If a Business can’t Generate Cash (Working Capital) Borrowing Money will only Delay the Inevitable—Bankruptcy

Cash is king.  A business has to have it.  And if they’re business can’t generate it they have to get it someplace else.  Either by borrowing it from the bank.  From family.  Or taking out another mortgage on their home.  All of which are short-term solutions to a much bigger problem.  For if their business can’t generate cash borrowing money will only delay the inevitable.  Bankruptcy.  Which means they either have to raise their sales volume.  Raise their prices.  Or cut their costs.  To get their current ratio above one.  Making them solvent again.

When you subtract current liabilities from current assets you get a business’ working capital.  The greater a business’ working capital is the easier it is for them to pay their bills.  And the easier it is to grow their business.  Or to offer raises, bonuses, more generous benefits, etc.  For to do any of these things a business first has to be able to pay their bills.  If they can keep paying their bills and maintain a current ratio above one for a few consecutive accounting periods they will find themselves with a surplus of cash.  Or working capital.  Useable cash to expand business operations.  Or to better pay their employees.

Of course if a business is too generous with their employees it will dry up that working capital and make it harder to pay their other bills.  For example, when generous union contracts impose heavy costs on a business while the prevailing market prices prevents them from charging enough to be able to afford those generous union contracts a business will soon find itself in financial difficulties.  Leading to a possible bankruptcy.  Where a bankruptcy court allows them to renegotiate their union contracts.  So their sales at prevailing market prices can afford them.  As well as their other bills.  While leaving enough working capital left over to grow their business.  Replace some worn out equipment.  Or repay a loan.

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Iron, Steel, the Steam Engine, Railroads, the Bessemer Process, Andrew Carnegie and the Lucy Furnace

Posted by PITHOCRATES - November 21st, 2012

(Originally published December 14, 2011)

With the Steam Engine we could Build Factories Anywhere and Connect them by Railroads

Iron has been around for a long time.  The Romans used it.  And so did the British centuries later.  They kicked off the Industrial Revolution with iron.  And ended it with steel.  Which was nothing to sneeze at.  For the transition from iron to steel changed the world.  And the United States.  For it was steel that made the United States the dominant economy in the world.

The Romans mined coal in England and Wales.  Used it as a fuel for ovens to dry grain.  And for smelting iron ore.  After the Western Roman Empire collapsed, so did the need for coal.  But it came back.  And the demand was greater than ever.  Finding coal, though, required deeper holes.  Below the water table.  And holes below the water table tended to fill up with water.  To get to the coal, then, you had to pump out the water.  They tried different methods.  But the one that really did the trick was James Watt’s steam engine attached to a pump.

The steam engine was a game changer.  For the first time man could make energy anywhere he wanted.  He didn’t have to find running water to turn a waterwheel.  Depend on the winds.  Or animal power.  With the steam engine he could build a factory anywhere.  And connect these factories together with iron tracks.  On which a steam-powered locomotive could travel.  Ironically, the steam engine burned the very thing James Watt designed it to help mine.  Coal.

Andrew Carnegie made Steel so Inexpensive and Plentiful that he Built America

Iron was strong.  But steel was stronger.  And was the metal of choice.  Unfortunately it was more difficult to make.  So there wasn’t a lot of it around.  Making it expensive.  Unlike iron.  Which was easier to make.  You heated up (smelted) iron ore to burn off the stuff that wasn’t iron from the ore.  Giving you pig iron.  Named for the resulting shape at the end of the smelting process.  When the molten iron was poured into a mold.  There was a line down the center where the molten metal flowed.  And then branched off to fill up ingots.  When it cooled it looked like piglets suckling their mother.  Hence pig iron.

Pig iron had a high carbon content which made it brittle and unusable.  Further processing reduced the carbon content and produced wrought iron.  Which was usable.  And the dominate metal we used until steel.  But to get to steel we needed a better way of removing the residual carbon from the iron ore smelting process.  Something Henry Bessemer discovered.  Which we know as the Bessemer process.  Bessemer mass-produced steel in England by removing the impurities from pig iron by oxidizing them.  And he did this by blowing air through the molten iron.

Andrew Carnegie became a telegraph operator at Pennsylvania Railroad Company.  He excelled, moved up through the company and learned the railroad business.  He used his connections to invest in railroad related industries.  Iron.  Bridges.  And Rails.  He became rich.  He formed a bridge company.  And an ironworks.  Traveling in Europe he saw the Bessemer process.  Impressed, he took that technology and created the Lucy furnace.  Named after his wife.  And changed the world.  His passion to constantly reduce costs led him to vertical integration.  Owning and controlling the supply of raw materials that fed his industries.  He made steel so inexpensive and plentiful that he built America.  Railroads, bridges and skyscrapers exploded across America.  Cities and industries connected by steel tracks.  On which steam locomotives traveled.  Fueled by coal.  And transporting coal.  As well as other raw materials.  Including the finished goods they made.  Making America the new industrial and economic superpower in the world.

Knowing the Market Price of Steel Carnegie reduced his Costs of Production to sell his Steel below that Price

Andrew Carnegie became a rich man because of capitalism.  He lived during great times.  When entrepreneurs could create and produce with minimal government interference.  Which is why the United States became the dominant industrial and economic superpower.

The market set the price of steel.  Not a government bureaucrat.  This is key in capitalism.  Carnegie didn’t count labor inputs to determine the price of his steel.  No.  Instead, knowing the market price of steel he did everything in his powers to reduce his costs of production so he could sell his steel below that price.  Giving steel users less expensive steel.  Which was good for steel users.  As well as everyone else.  But he did this while still making great profits.  Everyone was a winner.  Except those who sold steel at higher prices who could no longer compete.

Carnegie spent part of his life accumulating great wealth.  And he spent the latter part of his life giving that wealth away.  He was one of the great philanthropists of all time.  Thanks to capitalism.  The entrepreneurial spirit.  And the American dream.  Which is individual liberty.  That freedom to create and produce.  Like Carnegie did.  Just as entrepreneurs everywhere have been during since we allowed them to profit from risk taking.

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Opportunity Costs

Posted by PITHOCRATES - June 4th, 2012

Economics 101

Those on the Left are all for Choice as long as you Choose what they want you to Choose

Choice.  It’s what life is.  Every day we make hundreds of choices in our life.  The communists called that a burden.  And that their way removed all that stress from our lives.  The stress of constantly having to choose.  They came up with a new freedom.  Freedom from choice.  To live under oppression.  Like a slave.  Where you no longer had the burden of making a choice every waking hour of your day.  You simply took what the government gave you.  And relaxed.  Truly free.

It turned out the people living under communism preferred having that burden of choice.  And took every opportunity to escape the communist ‘freedom’.  To a freedom where you were free to choose whatever you wanted.  Instead of taking what central planners gave you.  Those on the Left always had a soft spot in their hearts for communism.  And Soviet central planners.  For they never cared that much for free markets.  Laissez faire capitalism.  Freedom of choice.  Because people so often chose poorly in their opinion.  For they weren’t as educated and enlightened as they were on the Left.  And therefore chose the wrong kind of foods to eat.  The wrong kind of beverages to drink.  The wrong kind of cars to drive.  The wrong kind of power to generate.  And the wrong people to vote for.

No.  Those on the Left are no fans of choice.  Except, of course, when it comes to abortion.  When it comes to abortion then they are big fans of choice.  But not so much when it comes to us choosing what to eat, drink and drive.  Or how we generate our energy.  So when it comes to choice those on the Left are like the Soviet central planners.  They are all for choice.  As long as you choose what they want you to choose.

When making any Economic Decisions we make our Choice based on Opportunity Costs 

But we choose.  Because we can.  At least with most things.  But how do we choose?  Does price determine what we choose?  Sometimes.  Quality?  Sometimes.  Loyalty?  Sometimes.  Sometimes it’s one of these things.  Sometimes a combination of all of these things.  Sometimes it’s none of these things.  So what is it that makes up your mind when confronted with a choice?  Do you know?  You do.  For obviously you’re making the choice.  But the ‘why’ we may have to coax out of you.  For you will probably not be able to explain why.  At least not as well an economist can.

The study of economics is all about choice.  And trying to determine what influences people’s choices.  So economists can offer economic policies to maximize economic activity.  By maximizing that thing we ultimately trade for.  Which is what?  Happiness.  We choose to increase our happiness.  Or utility in the parlance of economics.  The things we choose are the things that will give us the greatest happiness.  Or the greatest utility.  But if you’re like me you never saw ‘utility’ or ‘happiness’ expressed as units on a price tag in a store.  Price tags show only price.  Which tells us little how happy something will make us.  So how do we choose the things that will maximize our happiness?  Especially if you’re looking at two different things that have the same price?

Easy.  We don’t make our decision by looking at what we’re buying.  We make our decision based on what we’re not buying.  What we are giving up by buying this thing or that service?  What might have been had it not been for this purchase?  What opportunity we’re passing on to make this purchase?  What cost are we paying in lost opportunity by committing to this purchase?  In other words, when making any economic decisions we make our choice based on opportunity costs.  On an amount of happiness we’re giving up to acquire some other amount of happiness.  And whatever the number of our choices the end result is the same.  What we choose gives us more happiness than all other possible alternatives.  Regardless of price, quality or loyalty.  Though they could influence us when there is a tie.

Liberals make us Buy not what Increases our Happiness but what Increases their Happiness

You can’t put a price on happiness.  That’s what they say.  And they are right.  Whoever they are.  For example, luxury cars are nice.  But they are expensive.  Subcompacts are not as nice as luxury cars.  But they are not as expensive either.  So if you were choosing between these two cars which one would you choose?  I can’t tell because I don’t know your income.  But I can guess at your decision process.  You’re going to compare opportunity costs.  Driving a luxury car gives you enormous amounts of happiness.  For the limited time you spend driving it.  Enormous happiness for a limited amount of time.  Okay.  But what are the opportunity costs?

Let’s say your daily commute to and from work is one hour.  But when you get home you enjoy 4 hours between surfing the Internet and watching cable television.  When you’re not at work or home you like to use social media on your smartphone interacting with your friends.  And using your smart phone apps to maximize your fun in the evenings and on the weekend.  You like to spend your Sunday mornings at the coffee shop with you tablet reading the online Sunday papers.  The hours of driving happiness come to 10 hours a week.  And the hours of online/watching cable happiness comes to 32 hours a week.  Now being that you spend more time online or watching cable than driving then it’s safe to say that driving brings you less happiness than those other activities.  Because luxury cars are expensive they come with a high monthly payment and a high insurance premium.  Which means you will have to cut back on other spending to afford the luxury car.  So to afford the luxury car you have to give up your cable and home Internet access.  And cut back on your minutes on your smartphone.

The opportunity cost of the luxury car is giving up cable TV and cutting back on Internet access and smartphone minutes.  The opportunity cost of keeping those things is getting a subcompact car instead of a luxury car.  This is the ultimate decision we make in all of our economic decisions.  Which will cost us more in sacrificed happiness in the long run?  Which makes those decisions easy.  In the above example you would probably have never given the luxury car any serious thought.  This is why free markets work so well.  Why laissez faire capitalism works so well.  Because the economy is full of individuals making these decisions quickly.  Far quicker than any Soviet state planner.  And with far more insight into our own wants and desires than any Soviet state planner.  And in the aggregate this drives economic activity.  Bringing the things we want to market.  The things that give us the greatest amount of happiness.  The things that have the lowest opportunity costs.  Unlike Soviet central planning.  Or American liberal Democrat central planning. 

No.  These people try to change our purchasing decisions.  Making us buy not what increases our happiness.  But what increases their happiness.  Which is why when liberal Democrats are in power there is a general economic decline.  Because they do alter our purchasing decisions.  By increasing the opportunity costs of the things that increase our happiness.  So that we buy fewer of them.  But we don’t buy more of the things they want us to buy.  Because those things don’t increase our happiness.  When they subsidize hybrid cars (paid for with higher taxes from us) to get us to buy them it doesn’t make the hybrid cars give us any more happiness.  It just leaves us with less money because of the higher taxes.  So we buy less of everything else.  And in the aggregate this lowers economic activity.  Leaving us all less happy.

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Balance Sheet, Financial Ratios, Private Equity, Toys “R” Us, Bain Capital, Leveraged Buyout and Initial Public Offering

Posted by PITHOCRATES - May 29th, 2012

History 101

Private Equity guides a Business foundering in Rough Seas into a Safe Harbor to Refit it for Profitability

The balance sheet is the one of the two most important financial statements of a business.  It’s a snapshot in time of the financial position of a company.  In the classical format all assets are on the left side.  And all liabilities and equity are on the right.  And the total value of all assets equals the total value of all liabilities and equity.  In other words the business bought all of their assets with money raised by borrowing (liabilities), with money raised by selling stock (equity) or with money generated by the business (retained earnings/profits). 

Everything you ever wanted to know about a business you can find on the balance sheet.  Through numerous financial ratios you can determine if the business is using their assets efficiently.  Or have too many assets that cost more to maintain for the revenue they produce.  You can tell if a business has too much debt.  Or has so little debt that new debt can finance growth and expansion.  Which could attract new equity investors for further growth.  You can see if they’re matching the terms of their debt with the life of their assets.  Or if they’re taking on long-term debt obligations to provide short-term working capital.  A review of a firm’s balance sheet can also tell how well the management team is doing.  Or how poorly.

The financial picture the balance sheet provides of a business is an objective picture.  It gives an outsider a different view of the company than an insider.  Who may have a more subjective view.  They may not want to shutter a poorly utilized factory because of pride, sympathy for the employees or unfounded hope that business will improve soon.  So they will risk losing everything by not accepting that they must let some things go.  Like a cargo ship foundering in rough seas.  To save the ship and most of its cargo a captain may have to jettison some cargo.  If he or she doesn’t the captain can lose the ship.  The cargo.  And the lives of everyone on board.  Perhaps having a life or death decision in the balance makes it easier to make those hard decisions.  Perhaps that’s why some CEOs can’t let some things go.  Because they never accept the seriousness of their situation.  Perhaps this is why an outsider can read a balance sheet and see what the CEO can’t.  And act.  Like the captain of a ship foundering in rough seas.  And this is what private equity does.  Guides a foundering business into a safe harbor.  Refits it.  And then re-launches it on a course of profitability.

Toys “R” Us

Toys “R” Us was hitting its stride in the Eighties.  They were dominating the retail toy business.  Even expanding internationally.  And into other lines.  Children’s clothing.  Kids “R” Us.  And baby products.  Babies “R” Us.  There was no stopping them.  The secret to their success?  Sell every hot new toy kids wanted.  And sell it cheap.  At or below cost.  Using these loss leaders to get people into their stores.  Where they could sell them more expensive goods in addition to the most popular ‘must have’ toys. 

Then came the Nineties.  And serious competition.  From the big department stores, discount chains and warehouse clubs.  Target.  Wal-Mart.  Costco.  And then the Internet.  Who could use the Toys “R” Us strategy just as well.  And do them one better.  Toys “R” Us focused on selling the ‘must have’ toys at the lowest price.  Where customers came in knowing what they were looking for.  Finding it.  And heading to the checkout.  With a plan like that you don’t need customer service.  So when the competition matched them on selection and price they also threw in better customer service.  Wal-Mart surpassed Toys “R” Us.  Which was by then losing both profitability and market share. 

In 2004 a consortium of private equity (KKR and Bain Capital) and Vornado Realty Trust bought Toys “R” Us for $6.6 billion in a leveraged buyout.  And they turned the corporation around.  With a new management team.  Made the corporation more efficient.  In the brick and mortar stores as well as online.  The company is better and stronger today.  But it has delayed its Initial Public Offering (IPO) for about 2 years now due to a couple of lackluster Christmas seasons during the Great Recession.  They will use the capital raised from the IPO to pay down the debt from the leveraged buyout now sitting on Toys “R” Us’ balance sheet.  Making the turnaround complete.  Allowing the private equity firms to exit while leaving behind a healthier and more profitable company.

The Goal of the Leveraged Buyout was to make Toys “R” Us a Stronger Company

Private equity was successful at Toys “R” Us because Toys “R” Us was a good company.  From 1948 it consistently did the smart thing and grew into the giant it is.  But then it matured.  And the market changed.  Like a ship foundering in rough seas they just needed a little help to captain them through those rough seas.  And that’s what private equity did. 

Many will criticize the sizable debt they’ve left on their balance sheet.  But the plan was always to take the company public again.  Using the proceeds from the IPO to clean up the balance sheet.  Yes, the equity partners will also make a fortune.  But Toys “R” will emerge from this process a stronger company.  Which was the goal of the leveraged buyout.  They did not chop up the company and liquidate the pieces.  They purchased it in 2005.  And the company is still around today in 2012.  What have they been doing all this time?  Trying to make the company the best it can be.  So they can profit greatly from the IPO. 

No doubt the balance sheet of Toys “R” Us has never looked better.  Other than the debt added for the leveraged buyout.  Which they have been able to service since 2005.  So clearly the company is doing something right.  And just imagine how well they will do after they clean that debt off of their balance sheet.  After the IPO.  Suffice it to say that our grandchildren will be shopping there for their own children one day.

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The Invisible Hand

Posted by PITHOCRATES - April 16th, 2012

Economics 101

A Command Economy Reduces the Overall Economic Output because those Managing the Economy don’t Understand It

Command economy?  Or free market capitalism?  Which works better?  Well, let’s find out with a little experiment.  Let’s go back in time.  Say ancient Mesopotamia.  Just after they developed mass farming.  And produced some of the first food surpluses.  Allowing the rise of a middle class of artisans.  Now let’s look at what could have been the first two of these artisans.  A potter.  And a winemaker.  Who probably weren’t the first two artisans.  But will suffice for our little experiment.

The winemaker needs some pottery vessels to store and sell his wine in.  And the potter enjoys drinking wine.  They each have something the other wants.  And because we’re so far back in time there is no money yet.  We’re still only bartering at this time.  Trading the goods we make with each other.  But in our experiment the high priest of the civilization is also the economic planner.  This priest communicates to the civilization’s gods.  And guides the civilization in pleasing their gods.  Which he is very good at.  For he knows all of the old teachings and rituals.  But he doesn’t know a thing about pottery or winemaking.  But he looks at an empty pottery vessel and a pottery vessel full of wine and sees that the vessel volume equals the volume of wine.  And deems the price of one pottery vessel is the amount of wine one pottery vessel holds.

Well, the potter is quite happy with this price.  Because he is skilled.  And can dig up some clay.  Throw it on the potter’s wheel and knock out vessel after vessel.  Glaze them and fire them in the kiln.  Even working by himself he can achieve some economies of scale.  By repeating this process every day.  Something the winemaker isn’t quite able to.  For he makes wine by the batch.  Because each step in the process takes a lot of time.  Maintaining his grape vines.  Then picking the grapes.  Carrying them back to his winery.  Putting them into his winepress.  Squeezing the juice out of the grapes.  Putting the grape juice in large vats to ferment.  Monitoring the process.  When he determines the process is complete he fills the small pottery vessels with wine.  When it was finally ready for ‘sale’ and consumption.  Considering all the work it took him to make one vessel of wine the winemaker was not at all happy with the price the high priest set.  And instead builds his own potter’s wheel and kiln to make his own vessels.  Greatly increasing his workload.  And reducing his winemaking output.  While the potter loses a potentially large customer.  Thus reducing the amount pottery he makes.  Reducing overall economic output in the command economy.

The Invisible Hand makes sure we use our Limited Resources Efficiently to Make the Things People want Most

In this command economy the civilization suffered a deadweight loss.  Economic resources went unused.  They could have created more economic benefits with the available resources.  They could have made more pottery.  And made more wine.  Perhaps even creating some jobs to help with the economic output of efficiently using the available resources.  But they didn’t.  Because of the fixed prices economic resources went unused.  Thus creating a market equilibrium lower than where it could be.  Hence the deadweight loss.  Now let’s look at the same example with only one difference.  The high priest does NOT set prices.

In a barter economy people agree to trade the goods they make.  And now the potter and the winemaker are free to determine what they think is a fair trade.  That is, they set the price of pottery in wine.  And the price they agree on is one they find mutually acceptable.  Where the potter agrees to trade an amount of his pottery for an amount of wine.  And the winemaker agrees to trade an amount of his wine for an amount of pottery.  Everyone wins.  For the potter gets an amount of wine he values more than the pottery he traded for the wine.  The winemaker gets an amount of pottery he values more than the wine he traded for the pottery.  And the civilization wins because at this mutually agreed upon price both the potter and the winemaker increase their production.  Providing the civilization with more of their goods.  The potter and the winemaker may even hire people to help them produce more goods to meet this higher demand.  Thus increasing the level of happiness in the civilization.  By increasing the amount of economic activity.  Moving the market equilibrium to a higher level of economic output.  And thus reducing the deadweight loss.  By using the available resources in the most efficient manner.  As determined by these mutually agreed upon prices.

This is the Invisible Hand in action.  An economic concept put forth by Scottish economist Adam Smith (1723-1790) in his The Wealth of Nations (1776).  In a competitive market place where traders set the price for their economic trade (not a command economy) two things happen.  First, resources flow to where we demand them most.  That is, to the buyers willing to pay the highest price.  Second, because of the competitive market place only those companies that sell at the low prices the market demands stay in business.  Which means that they have to use those resources as efficiently as possible.  Especially when they’re paying the highest prices for them.  And all of this happens because of the Invisible Hand. 

History has Proven that no Government Bureaucrat can do a Better Job than the Invisible Hand

Those who favor a command economy (or more government intervention into market forces) say the economy is too complex for us to leave it to its own devices.  That without a smart government bureaucrat managing this complex thing we cannot reach a market equilibrium that maximizes economic output.  Whereas Adam Smith says it is because the economy is so complex that no one is smart enough to manage it.  Just as a high priest doesn’t understand pottery or winemaking a smart government bureaucrat cannot hope to understand all the intricacies of a complex economy.  Nor can they ever hope to understand what millions upon millions of consumers want to buy most.  But the beautiful thing is we don’t have to.

The multitudes make individual decisions just like our potter and winemaker.  Where everyone is looking to maximize their own value.  And when they agree on a mutual acceptable price all parties in the trade win.  While making sure our resources flow to where they are demanded most.  And that we use these valuable and limited resources most efficiently.  Thus maximizing overall happiness in our country.  Reducing deadweight losses to a minimum.  And obtaining a market equilibrium that maximizes economic activity.  All of which happens with no one in charge.  As if an Invisible Hand guides us in the market place to make all the right decisions to maximize this economic output.  And our happiness.

So which is better?  Command economy or free market capitalism.  Well, if you’re being honest you have to choose Adam Smith’s Invisible Hand and free market capitalism.  For history has proven that no government bureaucrat can do a better job than the Invisible Hand.  Not the Soviets.  Not the Chinese Communist (under Chairman Mao).  Not the Cubans.  Not the North Koreans.  Even the Americans failed when their government actively intervened in the private economy.  Something that President Jimmy ‘one-term’ Carter knows only too well.  So based on our hypothetical Mesopotamian example, and history in general, free market capitalism is, and always has been, and always will be, better than a command economy.

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