Saturday, 20 December 2008

Theories of one versus many

One of the causes of the fallacy referred to in my last post is that people forget there's a difference between one and many.

It may be true that it's better for me to go home at 7.30 than 5.30, because the tube is quieter. It does not follow that it's better for everyone to go home at 7.30.

And similarly, just because I can defer my consumption from this year to next year by saving, does not mean everyone can.

This is because I am embedded in a large system where my actions can be counterbalanced by others, and this enables us both to specialise. Specialisation normally refers to production but can apply to consumption too - you specialise in consuming an egg today, and I specialise in consuming one tomorrow; therefore one chicken can feed us both.

Interestingly, this leads to the insight that some choices are asymmetrical in time. If everyone prefers to consume now instead of tomorrow, today's production will increase, though maybe not enough for everyone. Those who get a share of today's production will be satisfied, and many of those who don't will probably settle for tomorrow instead. Total production across both days may increase or at least will not decrease substantially.

On the other hand, if everyone decides to consume tomorrow instead of today, today's production will collapse and when we all show up at the factory tomorrow, the machines can't run fast enough to satisfy us all. Total production (and satisfaction) across both days will be significantly reduced.

Some goods can be held in stock which partly solves this problem; but others (for example most services) cannot.

Just to be really concrete: let's imagine we want a massage. If we all show up looking for a massage today and there's only one masseur, one of us will just have to come back tomorrow. Perhaps the masseur will work more hours today, which will let the majority of customers have their massage today - and perhaps when there's spare time tomorrow someone will come back for a second one.

If we all decide to save our money today and show up tomorrow instead, the masseur's time has been wasted today and tomorrow it is too late - someone is going to go without a backrub.

Clearly this analysis can be made more sophisticated: the masseur's unexpected leisure time may have some value to him; more generally, net utility is not just given by consumer benefit but by that benefit minus the disutility of the supplier; and in the second scenario, some customers will just come back on a third day, as the real world is open-ended in time.

But the basic lesson remains: if everyone tries to reduce their consumption in the short term, some amount of consumer welfare is lost forever. An economic resource sits idle and the total amount of massages in the world shrinks. Alternatively, if everyone tries instead to increase short-term consumption, the total amount of consumer welfare increases.

This is the fundamental argument for a fiscal stimulus. Total utility over all time is higher if demand is shifted to an earlier date, because utilisation rates of resources increases.

I would expect this argument to be modified slightly if investment substitutes for consumption - if nobody shows up on day one, does the masseur spend the time training in better massage techniques or building a better massage table? I don't, however, believe that is what happens in a realistic situation. Instead, higher consumption demand will stimulate investment - better that an entrepreneurial carpenter builds the new table while the masseur is busy providing massages. I admit, though, that this is speculative and will look for some data to test the hypothesis.

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