Econ 101

A brief economics primer (forgive my indulgence for those of you that already understand these basics).

An economy functions best when supply = demand. If these are out of whack, you get high inflation (increased prices, demand is greater than supply) or high unemployment (decreased output, supply is greater than demand). Supply is the amount of goods available to purchase in the marketplace. Demand is the number of these goods that can and will be purchased.

Supply can be stated another way: the productivity of workers. If X number of workers can produce Y number of goods and the productivity of the workers increases, then X number of employees produce Y + increased productivity. This represents the number of goods available for purchase in the marketplace.

Demand can also be restated in 'real world' terms. Demand is the real wages of the workers. If X number of workers has Y number of dollars available to purchase goods, than one can expect these dollars to enter the marketplace in the form of demand. If the same number of workers' productivity increases (supply), but their wages stay stagnant or (heaven forbid) even decrease in terms of real wages, then demand will not keep up with supply and we'll have an inequilibrium in the marketplace.

Now obviously, this has been greatly simplified and there are other factors at play, but for basic purposes of understanding what has and is happening economically, this model will work.

As I stated, if supply (productivity) increases and demand (wages) doesn't, then we'll have an oversupply of goods. In a perfect marketplace, the net result will be higher unemployment (or decreased prices, which is so rare it warrants ignoring), as companies are forced to layoff employees to reduce output. In reality what happened was the lax credit policies, resulting in increased debt, both public and private. This increase in debt made up the difference between demand and supply, so our new equation looks like this:

Supply (productivity) = Demand (wages) + Debt

The increase in debt allowed workers to continue to purchase the goods and services they needed or wanted, so there was no impact to the supply and demand equation and all was good (at least on the surface). Of course, the service of that increased debt would prove to be an issue to the equilibrium at some point, which is what we saw when the credit market dried up.

Now, I won't go into what happened with the banking fiasco nor who's to blame, since that isn't really the root of our problems. I'll save that for another blog, perhaps. The real source of our problems was the artificial propping up of the supply-side of the equation via debt.

What happens when the debt is taken out of the equation and productivity continues to outpace wages?

Supply > Demand

Companies layoff employees and unemployment increases, which is of course what we are seeing now. Does laying off workers make sense in this economic model? While obviously laying off employess will reduce the supply-side of the equation, does that suffice to bring our equation back to equilibrium. Let's plug in some numbers and see.

Suppose 1 worker produces 10 thingamajigs every hour and works for 10 hours a day. At the end of a day, that worker has produced 100 thingamajigs (things for short). Now suppose that same worker makes $20 an hour. At the end of the day, he has earned $200 (10 hours x @20). In a perfect economy then:

100 things = $200

In order to understand this, we need to establish price. There are a lot of factors that influence price, but for simplicity's sake, we'll set the price of a thing at $2 per.

100 things X $2 each = $200

Thus, our supply and demand equation is happy and all is good in the land. Now, in order to evaluate the impact of layoffs, lets add 19 more workers, to bring the total to 20. Simple math then says:

20 workers X 10 hours each X 10 things per hour = 2000 things at the end of one day. This is our supply.

20 workers X 10 hours each X $20 an hour = $4000 in wages for a day.

Our supply and demand equation is:

2000 things = $4000

Now, if I bring in new equipment, new processing procedures, new computers, or my workers just get darned good at making things, I'll see their productivity increase. Let's say it doubles. Now, I don't see the need to pay these workers any more. Afterall, it was my incredible management skills that brought all this good fortune on. It was I who brought in the equipment, trained the employees, kept the good workers happy so I didn't lose that skillbase to attrition, etc. If anything, they're not working as hard to make those extra things.

Now, each worker produces 20 things an hour. Our equations look like this:

Supply = 20 workers X 10 hours X 20 things and hour = 4000 things a day.
Demand = 20 workers X 10 hours X $20 an hour = $4000 a day.

What happened to the price? In theory, it should have dropped to $1 per thing, in order to keep the equation in equilibrium:

4000 things X $1 = $4000

But, being the good businessman I am (and understanding the economics behind price), there wasn't any reason to lower the price. The marketplace still supports my good at $2 per. I'll just pocket the excess as profits. So, instead of equilibrium, the equation is:

4000 things X $2 per > $4000

Uh oh. At the end of the day, I only sold 2000 things. Now, I have excess inventory. This is costing me money to store. If this keeps up, I'll have WAY too much in stock and eventually, I'll have to start dumping things. What will I do? I know, I'll lay off some employees. That'll reduce my output and give demand a chance to catch up to supply. I'll layoff half of the workforce. Forgetting my excess supply in storage, here's the new equation, after my incredible management techniques:

10 employees X 10 hours X 20 things per hour = 2000 things per day
10 employees X 10 hours x $20 per hour = $2000

2000 things X $2 per > $2000

Wow. I'm still out of whack. Should I reduce the hours they work each day?!

Econ 101 lesson over. So sorry this was so long, but amazingly there are people who don't understand this basic stuff. Again, my apologies to those that waded through and already understood all of that. I also apologize this was so simplistic, but I really just wanted to lay the groundwork for more indept thoughts later.