Author Archives: Bala

Government is bad for human well-being – Part 1 – Causing Economic Depressions

Most of us are educated (I would say indoctrinated) to believe that government is either a good institution or, at worst, a necessary evil. We learn that without a government, the world would be overrun by chaos and lawlessness. Examples typically brought up are those of Somalia, Sudan and other African nations where, apparently, government failures have led to chaos and lawlessness.

We are told that the market is an inherently fragile set up prone to frequent and severe economic crises that may be called depressions, recessions, slowdowns, downturns, etc. We are also told that without government and its intervention, people would become hapless victims of these market failures that would randomly impoverish millions of people for no fault of theirs.

Another justification given for government is that there are economic goods which are not best left to the free market to provide. The reasons are many and varied. Even the most die-hard free market advocate would face difficulty explaining why education and healthcare should be left to the free market. It is said that on a free market, the poorer a person is, the lesser the chance that he gets access to even basic education and healthcare. A free market, it is further added, would leave vast numbers of the population uneducated and sick/dying/dead simply because they are poor.

In the case of goods like “infrastructure” (that includes, roads, railways, ports, water supply, drainage, electricity generation and supply, etc.), the kind of investments required are said to be so huge that it would be impossible to build infrastructure and get on to a path of accelerated growth without government intervention. For goods such as law and order, justice and defence, it is said that it is impossible for the free market to provide these services without the society turning in a bed of chaos and lawlessness.

What we do not ever learn unless we take the initiative to do so and do that outside of the mainstream education system is the extent of harm that government is capable of and has been inflicting on human beings in general for many millennia. It is only in the last 3 centuries since the development of economic thought has it been possible for us to understand the depth and the breadth of the damage that governments do to the economy and thus to people’s lives and to the very fabric of civilisation.

In this series, I plan to cover many of the ways in which government has brought and still brings misery upon ordinary, honest, hard-working people. My arguments would be largely economic, though it is very difficult indeed to avoid the political arguments completely. As a start, I shall show in this piece how government is the cause of the massive human suffering caused by the much dreaded phenomenon called the economic depression.

Introduction to Economic Depressions

Nobody likes an Economic Depression. We don’t like recessions, slowdowns and downturns in the economy either (It’s a different matter that these are all just fancy names coined to denote what were originally called depressions, but I’ll leave that for another day). Economic Depressions are periods characterized by widespread business failure accompanied by liquidation of past investments that are suddenly not worthwhile anymore, scary levels of job losses and massive levels of unsold inventory all through the production system. On top of all this, a number of projects started in a period when unlimited prosperity seemed possible now inexplicably become not worth completing and are abandoned. The net result is general misery all around. A number of people even commit suicide unable to repay the debt burden caused by business failure.

Anyone who wants to relate to how an economic depression hurts people would do well to watch the movie “The pursuit of happyness” (See? Even MS Word knows that it is happiness and not happyness. I had to overrule it twice 🙂 ). Large number of people, even the educated and highly qualified, being out of jobs and standing in queues of soup kitchens and overnight shelters run by charities and products involving (apparently) cutting edge technology (bone density scanners in this case) suddenly appearing “not worth it” are normal during a recession. Will Smith is without a job and struggling to get rid of his inventory, not because he has suddenly become incompetent but because he is being tossed around in the storm waters of the 1980-82 recession in the US.

What are Economic Depressions?

Mainstream economic thought holds that Economic Depressions are unpredictable events caused by factors external to the economy. According to this notion, a market economy typically tends to oscillate between periods of extreme (irrational) optimism and extreme (once again irrational) pessimism. During periods of extreme optimism, the economy witnesses rapid growth in consumption of consumers’ goods accompanied by significant investments in building production capacity. Prices of various assets such as land, stocks, precious metals, commodities, etc., rise rapidly and significantly and everyone experiences a general feeling of prosperity.

Then, suddenly, just when the prosperity seems never ending and the world is about to turn into a land of milk and honey, the mood of optimism vanishes and is replaced by a general mood of pessimism. People suddenly consume far less than they were consuming during the period of optimism. Their irrational and deep pessimism also drives them to cut back severely on their investment spending. This further drives incomes down even further forcing people to cut back further in their consumption and investment spending. Businesses, seeing the sharp drop in volume of business, further cut back spending of various forms including through firing their employees. The result is a further deepening of the downward spiral in income and investment which also causes many debt defaults and sends demand for goods spiralling down as well. This condition of the economy is what we call the Economic Depression. It is also called by other names such as recession, downturn, slowdown, etc.

After sufficient time has elapsed (and sufficient measures have been undertaken, says mainstream theory), the mood of pessimism wanes and optimism returns, leading to a recovery in incomes and investments. The process described above repeats and the economy goes through a fresh cycle of rapid economic growth fuelled by (irrational) optimism and an economic depression caused by (irrational) pessimism. This cyclical process by which an economy goes through repeated phases of rapid growth and economic depressions while growing in the long term is called the Business Cycle.

Causes of Economic Depressions – The Mainstream View

According to the Keynesian school of Economics (the dominant school of economic thought, especially in the area of Macro-Economics) and its modern variants, the causes of economic depressions lie outside the market economy. Irrational bouts of pessimism and optimism are, according to this school, inherent weaknesses in a market economy. Greed fuelled by ‘animal spirits’, it says, drives the boom and a sudden waning of the ‘animal spirits’ causes the bust.

Recommendations for depressions – The Mainstream View

The mainstream view holds that since economic depressions are unavoidable, all that needs to be done is to mitigate the effects of the depression and pull the economy back on a path of rapid growth. It visualises government as a stabilising factor in the market economy. During the boom, the government is supposed to build surpluses through wise taxation policies and during the depression, it is supposed to step in in place of the now scared private sector and spend the surplus it has built to keep the economy at ‘full employment’ or bring it back to that state. Some representatives of the mainstream also recommend government engaging in deficit spending (i.e., spending beyond its revenues) to prop up the failing economy.

How sound is the mainstream explanation of depressions?

The main problem with the mainstream explanation is that it is not an explanation at all. A ‘theory’ that says that investments are driven by a surge of ‘animal spirits’ and that these ‘animal spirits’ vanish suddenly and inexplicably causing depressions is not economics at all. It is not a causal explanation. In fact, it is tantamount to saying that there is no explanation.

On a more substantive note, an important weakness with the mainstream explanation is that it does not address the rash of entrepreneurial failures that always happen at the start of and through a depression. This point is made all the more stark if we realise that the entrepreneur’s role in the market economy is to correctly anticipate future demand and organise the different factors of production, reaping entrepreneurial profit in the process. The market has an inherent mechanism to weed out less effective entrepreneurs and to ensure that only the more effective ones survive and continue as entrepreneurs – the profit and loss mechanism. Ineffective entrepreneurs soon chalk up enough losses that they cease to be entrepreneurs and become salaried employees. There is only so much loss of capital they can stand. Therefore, a good theory of the business cycle has to explain why all or most entrepreneurs make erroneous forecasts that get revealed during the depression.

A further important weakness with the mainstream explanation is that it does not address a very important characteristic of economic depressions – that the rash of business failures is more pronounced in the capital goods or producers’ goods sectors than in the consumers’ goods sectors of the economy. If, as the Keynesians say, under-consumption (driven by a vanishing of ‘animal spirits’) is the reason for the depression, the depression should be as pronounced or more pronounced in the consumers’ goods sectors as in the producers’ goods sector. That it is the converse says that something is seriously wrong with the mainstream explanation of depressions.

Thus, we are forced to conclude that the mainstream explanation of the causes of depressions is not worth considering very seriously. What is worth considering is the Austrian Theory of the Business Cycle, originating as it does in the theory proposed by Ricardo which was developed into a comprehensive explanation of every aspect of the business cycle by the great economists Ludwig von Mises and Friedrich von Hayek. In fact, it is interesting to note that Friedrich von Hayek won the Nobel Prize in Economics for his theory of the business cycle.

The Austrian Theory of the Business Cycle

The boom-bust cycle is caused by an artificial suppression of the interest rate below its free market level. By suppressing the interest rate thus, the banking system expands credit way beyond the available pool of savings. The credit thus expanded enters the production system directly at the higher stages of the production system, i.e., in the capital goods industries rather than in the consumers’ goods industries. This happens because of the false signal given to entrepreneurs by the artificially depressed interest rate. A low interest rate on the free market indicates that consumers prefer future consumption to present consumption and hence that entrepreneurs shall be better off producing capital goods that will ultimately be ‘transformed’ into consumer goods for future consumption than producing consumers’ goods for present consumption. The artificially depressed interest rate, however, indicates no such real preference. Consumers have not set aside a portion of their income, i.e., they have not saved in order to consume more in the future.

To make matters worse, the massive credit expansion is necessarily accompanied by an equally massive monetary inflation or an increase in money supply. This increase in money supply during the boom phase drives up prices of all goods including producers’ goods as well as of factors of production such as nature and labour giving an illusion of greater profitability. This is why there is a general feeling of prosperity during the boom phase. Everyone seems to be making more money: entrepreneurs, labour and owners of factors of production such as land and capital goods. This illusion of greater profitability further drives up investments in the capital goods sectors.

Banks engage in this massive credit expansion and monetary inflation simply because it is profitable for them to create money out of thin air and lend it out at an interest. The more money they create out of nothing and lend it out, the more profits they make in the short-term.

This fairy tale does not last forever. There soon comes a time when the increased supply of consumers’ goods made possible by all the boom-time investments in capital goods hits the store shelves. The increased supply is not accompanied by a fall in prices because of the general price inflation induced by the monetary inflation. Consumers haven’t saved any money to buy the increased production either (that’s why credit had to be expanded by suppressing interest rate in the first place). As a result, demand falls below the ambitious boom-time projections. In the meantime, input prices still rise as monetary inflation drives prices up further. The price inflation soon forces interest rates up in an effort to curb the supply of money sloshing around in the economy. This has the adverse effect of raising the cost of credit for businesses.

The triple whammy of below-projected demand, rising input prices and rising interest rates suddenly reveals many a boom-time investment as a bad decision, a malinvestment. Many businesses shut down, some of them even before they could be completed, unable to bear the rising interest and other costs. Since a large number of these boom-time malinvestments necessarily happen in the capital goods sector, the rash of failures too happens in the capital goods sector. Large number of people get laid off and business investments are liquidated leading to a further fall in consumption expenditure leading to further rounds of business failures, a process that repeats till all the errors of the boom period have been cleansed from the economy. A recovery starts around this time, once again fuelled by a credit expansion backed by interest rate suppression and monetary inflation. The next round of the boom-bust cycle begins.

The Austrian Theory of the Business Cycle thus explains every important observed characteristic of the Business Cycle and can be considered the most comprehensive explanation available till date. What I have not explained so far is the role of government in all this. After all, I said right up front that I would show why government is harmful to all people. I’ll do just that now.

Exposing the nasty hand of government in creating the business cycle

Very simply put, the combination of massive credit expansion and equally massive monetary inflation is not possible on the free market. This is simply because such a move would render the entire banking system highly unstable and prone to collapse. Banks that expand too much credit would face the threat of the bank run where customers, having lost confidence in the bank’s stability, land up at the bank’s door-steps en masse to withdraw their cash. The bank, having engaged in monetary inflation, clearly would not have the cash to meet all customers’ demands and would have to declare bankruptcy.

What saves the banks today and makes it possible for them to engage in unbridled credit expansion? Very simply, it is the intervention by government to protect the banking system, in the process creating a ‘never-ending’ source of spending money for government itself. Over the last couple of centuries, governments have engaged in massive interventions in the monetary system to the point where they have completely taken it over.

Today, governments, through the Central Banks, have a complete monopoly over the production of money in the economy. Legal tender laws force everyone to accept government printed pieces of paper as money. Such paper money is a blatant attempt to escape the free market limits on monetary inflation. Unlike gold and silver which are scarce commodities that have to be mined, processed and minted, paper money is almost costless to produce, making it ‘easy money’ for its monopoly producer, government.

Over two centuries, governments have used their monopoly over the use of force to thrust their pieces of paper onto a public that was until then willing to accept only gold and silver coins as money. At various points in time when money was essentially gold or silver coins and paper money was just a substitute that had to be redeemed for the promised gold or silver on demand from a note holder, banks that had issued paper money way beyond their available reserves of gold or silver and were facing bankruptcy were saved by government by engaging in gross misuse of its monopoly over the criminal justice system. Very simply put, government passed unilateral moratoria freeing banks from the legal, contractual obligation to redeem their own notes and deposits in gold or silver.

Central Banking is another massive intervention by governments in the monetary system. On a free market, a bank that faces a bank run would collapse. Under Central Banking, the failing bank can access a ready supply of cash needed to tide over temporary surges in demand for cash. The Central Bank stands ready to save banks from their own excesses. What makes it possible for Central Banks to do so is the monopoly privilege of money creation granted to them by the government. The Central Bank also greatly enhances the extent of credit expansion that the banking system can engage in by providing the funds necessary for banks to do so.

Conclusion

The business cycle is not a product of the free market but a result of sustained and massive government intervention in the economy. Austrian Business Cycle Theory explains how the business cycle is essentially a creation not of a free market but of a banking system run amok. What makes it possible for the banking system to run amok is the active connivance of government in an act that enriches the banks and government itself at the expense of the billions of common people who are impoverished by the boom-bust cycle. If this doesn’t convince you that government is bad for human well-being, I wonder what will. However, I shall not give up and shall continue to try doing that in subsequent articles in this series.

Why Anna Hazare’s victory is likely to be pyrrhic

Definitions first: For those who are unfamiliar, a pyrrhic victory is a victory with a devastating cost to the victor. It carries the implication that another such victory will ultimately cause defeat.

As I watch the celebrations happening over the decision by the Government of India to accept the demands of the ‘civil society’ representatives led by Anna Hazare, I just can’t help thinking of how this could be the biggest red herring in our history. I am afraid this is going to be a perfect case study of how government perpetuates itself by lulling people into inaction by getting them to feel that they are finally free. In the process, it will also highlight the fundamental flaw in the just concluding ‘mass movement’ against corruption, primarily Anna Hazare’s ‘crusade’ against corruption.

What is wrong with Anna Hazare’s ‘crusade’?

The fundamental problem with Anna’s crusade is that it is based on the premise that rampant corruption is an outcome of the failure of government. It is based on the additional assumption that by bringing in a mechanism to check corruption, it is possible to eliminate corruption. It further assumes that this corruption is the biggest problem faced by Indian society and that by eliminating it, the Indian people are taking a decisive step in the direction of progress. If these assumptions are flawed, there is every chance that this ‘victory’ ends up as a massive and debilitating defeat. That’s what I set out to show in this article.

Making understanding simple using a parallel

If you suffer from severe abdominal pain, is a steady dose of pain-killers necessarily the best treatment? What if the reason for the severe abdominal pain is an ulcer or, worse, a cancer? By treating a symptom rather than understanding the real problem, we run the risk of letting the real ulcer or cancer develop to a stage where it becomes life-threatening. This danger is all the more real if the subsidence of the pain lulls us into thinking that all is well. On similar lines, while corruption may exist and be rampant, if it is not the problem, we may end up feeling very good that we are tackling it while all the while the real problem grows bigger and bigger till it threatens the very existence of civilisation. That is precisely the problem with this ‘victory’.

Is corruption the real problem?

Corruption in India is pervasive. But is it the real problem to be tackled? The answer to this question cannot be found without understanding what corruption is and what causes it.

Corruption, as we understand it, is something to do with government. When government functionaries, be it ministers, legislators or bureaucrats, do not perform their duty until they are personally compensated for the same or misuse their power to extract money from the victims against whom they misuse their power, we call it corruption. A very common form is the bribe we need to pay in order to get various documents signed by government functionaries. Money paid to an RTO officer to get a licence or to an employee of the civil supplies corporation to get a ration card or to a sub-registrar to get your property tax assessment done are all common bribes. An equally common but less noticed form is the bribe that business owners and managers pay to various government functionaries to ‘allow’ them to circumvent rules and laws or to do them special favours. Simple examples of this are bribes paid to ministers and bureaucrats to get mining or telecom licences.

Why does corruption happen?

There are two parts to this question.

  1. Why does the government functionary demand money from the citizen?
  2. Why does the citizen pay money to the government official?

The answer to both these questions lies in the imbalance of power between the citizen and the government functionary. In simple terms, the government functionary is in a position to coerce the citizen to act contrary to the citizen’s own volition. He is in a position to initiate force or violent action against the citizen and get away with it. He is able to get away with it because his actions have the prior sanction of the Law. In other words, the government functionary’s legally defined job is to initiate force, as defined and ‘permitted’ by the Law, against fellow citizens. Do you find this to be an extreme interpretation? Let me take an example to help you understand the real nature of government and realise why my statement, while extreme, is not an unreasonable one.

Understanding the nature of government

Let’s say you earn Rs. 10 lakh in a year. You think it is all yours? The Income Tax official thinks otherwise. He is in fact legally empowered to coerce you to part with a maximum of Rs. 1.3 lakh. What happens if you do not pay and keep the money in your house? He is empowered to bring a search party, force his way into your house, break open all the storage lockers in your house that you refuse to open, take the Rs. 1.3 lakh and a little more as a punitive penalty for daring not to pay. Your name would appear in the newspapers as a ‘tax evader’ and what happened to you would be used as promotional material to scare other people from doing as you did.

Now imagine how you would view these actions if I (not an Income Tax officer) did the same to you. In the first place, when I threaten you to give me Rs. 1.3 lakh failing which I would initiate violent action against you, my act would be labelled ‘extortion’. If I tried to force myself into your house to take the Rs. 1.3 lakh by force, my act would be labelled ‘burglary’. If having forced myself into your house, I am unable to locate the money and whip out a gun and threaten to pull the trigger unless you give me the money, my act would be called ‘robbery’. If I take you away and incarcerate you until you pay me Rs. 1.3 lakh plus a ‘fine’ for not paying promptly, you would call my act ‘kidnapping for ransom’. If the justification I give for using all this violence against you is that I will protect you from other violent people, I would be deemed to be running a ‘protection racket’.

Are we then saying that acts of extortion, burglary, robbery and kidnapping for ransom become legitimate because a piece of paper says that it is ‘legal’? Are we saying that if an individual runs a protection racket, it is criminal but if a group of people who we decide to call ‘government’ do the same, it is non-criminal? Whether we like to admit it or not, this is what we do when we say that government is legitimate and that coercion used by government functionaries against other citizens is non-criminal.

The primary reason government functionaries get away with the kind of criminal acts I have described above is that citizens have only one way to seek redress and protection from such crime – to approach the police. The response of the police to the kind of criminal action by government functionaries is simple – to not initiate action or even record the action as something criminal. Their reasons are simple – if the government functionary is acting within the Law, there is no criminal action (as per the police). The same is the response one will get from the justice system that we call the courts. No court will initiate action against a government functionary as long as his actions are within the Law as passed by government.

To make it even tougher for the aggrieved citizen, no one other than government is allowed to run the equivalent of a police force. If anyone attempts to, the police are empowered to initiate violence against them including arresting them and seizing their property. If they are too well equipped for the police to tackle, the government may unleash a far better equipped and trained force called the military on them. Thus, we see that government is able to protect criminal acts by its functionaries by virtue of the monopoly on the legal use of force, i.e., the police and the courts.

This brings us to the point where we are in a position to define government and understand its nature. Government is a set of people who have given themselves a monopoly over the use of force in a certain geographical region. Operationally, government is a particular relationship among citizens where certain citizens may freely engage in acts that, if engaged in by other citizens, would be deemed criminal. It is the act of according a non-criminal status to criminal acts of particular people, simply because they carry the label “government functionary”.

Why and how corruption happens

Corruption happens when a government functionary and a citizen realise that paying one government functionary a certain amount will make the same or a different government functionary use the force that he is legally mandated to use in favour of the citizen who pays or not use it at all.

The different forms of corruption

Based on this understanding, it is also possible to understand the different forms that corruption can take.

  1. A payment to a government official to prevent him from initiating force against the citizen – Typical examples of this are bribes to various tax officers (income tax, service tax, central excise, customs, etc.), town planning officials, labour inspectors, PF officers, licence-quota inspectors (from the pre-1990 Inspector Raj era), police officers (for example, to induce them not to use force to shut down an ‘illicit’ liquor distillation unit or to seize narcotic drugs/weapons or to arrest prostitutes and pimps ), etc.
  2. A payment to a government official to prevent another government official from using force against the citizen – Typical examples of this are bribes to passport officers and licensing officials, bribes to obtain various documents such as birth certificates, death certificates, etc.
  3. A payment to a government official to use force against other citizens in favour of the bribe paying citizen – Typical examples of this are bribes to industrial licensing authorities (for example, a licence to manufacture liquor) and bribes for issue of documentation related to property ownership and inheritance. The 3-G spectrum scam is a specific and recent example of this type.
  4. A payment to a government official to receive a portion of the goods or money that have been taken from other citizens by the use of force (in simple terms, for a share of the loot) – Typical examples of this are bribes to ration officers, MNREGA officers, bribes to PSU and Government department officials to obtain contracts, etc.

Why Anna Hazare’s ‘victory’ is going to be pyrrhic

The reason is very simple. It has no valid answer to the age-old question ‘Quis custodiet ipsos custodes?’. For those who are not familiar with Latin, this translates to ‘Who will guard the guards?’. The Lok Pal Bill (regular or Jan) seeks to create a parallel set of custodians who will be empowered to use force against government functionaries who use their power to use force against citizens to coerce the citizens to pay them bribes. If a parallel set of custodians is all you seek to create, the question ‘Quis custodiet ipsos custodes?’ becomes very important indeed. Nothing stops the Lok Pal from being corrupted by the irresistible incentives for corruption that power over others offers. There is no reason to say for sure that we won’t be screaming on the streets 10 or 20 years from now asking for a reform of a by-then-totally-corrupted Lok Pal. In fact, there is every reason to say we will.

What would be a real solution to corruption?

As explained earlier, the source of corruption is the very nature of government. As long as there is government, there is scope for some individuals to use force against other individuals and get away with it. As long as this situation persists, there is scope for corruption. If you want to eliminate corruption, you need to eliminate government and with it, the State.

This is not to say that you eliminate government overnight. The route to complete elimination is very long. What we need to do to achieve it is to wind down government to the point where eliminating it will not lead to social disruptions. The free market is capable of providing alternatives to government. All that is needed for them to flower is ever smaller government. As government shrinks, the free market will throw up solutions based on voluntarism. Are we ready for this challenge? Sadly, I think not. Too many people believe (wrongly) that government is either a necessary evil or a noble institution. That’s what really scares me.

The Right to Education (RtE) Act – A few policy prescriptions

In my previous pieces about RtE, it might have seemed that all I was doing was finding fault with what was done. My arguments ranged from

  • Education is not a right. Therefore, the RtE Act is fundamentally and fatally flawed

to

  • Education is not schooling. By focusing on “compulsory schooling”, the RtE Act becomes even more flawed.

and

  • Government control over education destroys education. The RtE Act strengthens government’s stranglehold on education. Hence, the RtE Act is inimical to education.

Having said these, I’ll now move on to the other important part – What should have been done. The policy prescriptions I shall lay out in this article are relevant even today when the RtE Act has been passed.

Step 1 – Repeal RtE Act

It is important to reverse damage already done before launching on corrective action. As I have already explained, the RtE Act is a definite step towards destroying the very foundation of education. Repealing it is therefore the first step in the right direction.

Step 2 – Open all Boards of Education to Private Candidates

At present, it is impossible for a student who does not study in a school affiliated to the CBSE or the ICSE to appear for the examinations conducted by these boards. You might respond with the question “Why don’t these students appear for the exams of the Boards that allow private candidates to write the exams?”

Two points on this issue. The first is the question of what sort of education will be delivered. If you have to score well in the Tamil Nadu State Board examination, you don’t need education. You need drilling. What a criminal waste of 2 years!! I am sure that many people from different states may each think their State Board is worse, but that just underscores my point.

The second is that this is only one step in the process. The next step I suggest will explain the relevance of this step further.

Step 3 – Eliminate all recognition and affiliation requirements for schools

In effect, what I am saying is that free education. Let anyone run a school anyway. I should not need government recognition or affiliation with any Board. This will do a number of wondrous things for education.

  1. A school will no more need to be run only by a ‘not-for-profit’ body such as a Trust, Society or a Section-25 Company. This move automatically makes education an “industry” on par with others. Investing in education becomes much simpler and creates room for anyone with entrepreneurial capabilities to start a school.
  2. A school will no more need to invest huge amounts in land and building before it starts off. I could start a school in a rented house and rent out more houses as I grow in size. A large part of the capital investment currently required to start a school completely vanishes from the scene. Thus, the entry barriers that prevent competent people from starting school will vanish completely.
  3. Combined with Step 2, children will no more be tied to a particular school. They could walk out of one school and walk into another just as smoothly as you could give up your membership in one gym and become a member at another.
  4. Schools will be free to teach as they please. This means that they could even teach only particular subjects they are good at. A good Maths teacher could start a Maths training institute where children receive excellent education in that subject. Another teacher who is good at some other subject, say Physics, would establish a Physics Academy that would provide excellent education in Physics. Some of these people may even tie-up to offer means by which a student could attend classes on various subjects on the same day and maybe even the same place.
  5. Parents and children will be free to study as they please. Parents could admit their child in a traditional school if they think that is the best thing for their child. Some else who feels that given his/her child’s aptitude, attitude and interest, a focused education in particular areas and in a sequence of their own choice is better may choose a clutch of non-traditional set-ups that provide specialized education in particular subjects of study. Some others may even engage private tutors, if they could afford it, thus providing for home education.

These are just a sample of the beneficial effects of a move to abolish compulsory recognition and affiliation.

Why will these steps save education, at least at the school level?

They will save education because they release education from the stranglehold of government. They will unleash the power of entrepreneurship and drive choice and quality in education. Providers of education will be exposed to the forces of competition, thus driving them to provide quality education as sought by the customer. Children and parents will no more be “at the mercy” of schools.

What about the poor?

I have a one word answer – charity. I also believe that there are enough charitable souls in this world who will donate for the cause of educating a poor child, all the more so if the child is desirous of and ready to work hard for an education. I am also quite certain that it is in the interests of schools themselves, especially schools delivering quality education and in with a long-term view of education, to set up charities and actively seek contributions from those willing to fund the education of children from poor families. Who knows which spark is hidden in which child? For the sake of churning out that one unbelievably brilliant child who, unfortunately, was born poor but who, if given a good education, would be a great brand ambassador for his/her school, I would definitely start such a charity the day I set up my school. Schools don’t need an RtE to force them to admit poor children. They just need to be exposed to the forces of the free market.

Conclusion

Contrary to what has been done in the form of passing the RtE, the right step to take to re-invigorate education and ensure its widest possible availability at the best quality and at a price that each person is ready to pay is to liberate it from the clutches of government. This will include repealing the RtE, modifying the charters of the Boards of education to allow students to write Board Exams without studying in an affiliated school and ultimately eliminating the requirement that schools require recognition from the State Government concerned and affiliation to a Board of education.

The Right to Education (RtE) Act – How it will enhance government’s control over education and strangulate education

In my previous article, I had explained why government control over education is detrimental to education and how it has the potential to destroy education. This time, I shall try to demonstrate how exactly the RtE Act increases government control over education and is therefore harmful.

Understanding the RTE

The link below leads to an official GoI document that lays out the entire Bare Act of the RtE Act for anyone who wishes to read it.

http://education.nic.in/Elementary/free%20and%20compulsory.pdf

For the purposes of this article, I will be taking select extracts from this link for a discussion.

First, let us know what RtE is all about. This is best understood by taking select sections of the Act that explain it. Firstly, as the title of the Act says, the correct name of this act is “The Right of children to free and compulsory education”.

In Chapter II, Clause 3 (1) reads

Every child of the age of six to fourteen years shall have a right to free and compulsory education in a neighbourhood school till completion of elementary education

While it is clear that the word “free” means that the child will not have to pay for the education, it is not clear what the word “compulsory” means. The word “compulsory” always carries the additional question “For whom is it compulsory?”.

The Act provides the answer. In Chapter III, after Clause 8 (a), it says the following.

Explanation – The term “compulsory education” means obligation of the appropriate government to

(i) Provide free elementary education to every child of the age of six to fourteen years

(ii)    Ensure compulsory admission, attendance and completion of elementary education by every child of the age of six to fourteen years

Thus we see that the RtE Act places an obligation on government to ensure that every child gets an education. The obligation is being placed on government by government itself. However, it is meaningless to place an obligation on oneself without talking of the means of fulfilling that obligation. The RtE Act does that too.

It goes on to add under Clause 8

(b) Ensure availability of a neighbourhood school as specified in Section 6

(c) Ensure that the child belonging to weaker section and the child belonging to disadvantaged group are not discriminated against and prevented from pursuing and completing elementary education on any [emphasis mine] grounds

(d) Provide infrastructure including school building, teaching staff and learning equipment

(e) Provide special training facility specified in section 4

(f) Ensure and monitor admission, attendance and completion of elementary education by every child

(g) Ensure good quality [emphasis mine] elementary education conforming to the standards and norms [emphasis mine] specified in the Schedule

(h) Ensure timely prescribing of curriculum and courses of study for elementary education; and

(i)      Provide training facility for teachers

Section 9 repeats these clauses for the “local authority”. The next bit is interesting.

10.          It shall be the duty [emphasis mine] of every parent or guardian to admit or cause to be admitted his or her child or ward, as the case may be, to an elementary education in the neighbourhood school

So, it is no more the responsibility of the parent to the well-being of his or her child. It is now their legally declared “duty” to ensure that their child is admitted to “the” neighbourhood school. What if I as a parent consider the neighbourhood school to be rotten and am willing to admit my child to a school reasonably far from where I live? Will I be prevented from doing so and my child forcibly admitted to the neighbourhood school? I wonder why I am reminded of Sparta and Plato’s Republic. The very thought is scary.

The Act does not restrict the role of government to setting up schools and admitting children. It does the following. First, it identifies 4 categories of schools in Section 2, Clause (n)

(n) “school” means any recognized school imparting elementary education and includes

(i) A school established, owned or controlled by the appropriate Government or a local authority

(ii) An aided school receiving aid or grants to meet whole or part of its expenses from the appropriate government or the local authority

(iii) A school belonging to specified category

(iv) An unaided school not receiving any kind of aid or grants to meet its expenses from the appropriate government or local authority

It also mentions that specified category refers to schools like Kendriya Vidyalayas, Navodaya Vidyalayas, Sainik Schools  and other schools with a similar character.

The next part is where it gets interesting. Chapter IV titled “Responsibilities of Schools and Teachers” starts thus.

  1. 12. (1) For the purposes of this act, a school

(a) Specified in sub-clause (i) of clause (n) of section 2 shall provide free and compulsory education to all children admitted therein

(b) Specified in sub-clause (ii) of clause (n) of section 2 shall provide free and compulsory education to such proportion of children admitted therein as its annual recurring aid or grants so received bears to its annual recurring expenses, subject to a maximum of twenty-five percent

(c) Specified in sub-clauses (iii) and (iv) of clause (n) of section 2 shall admit in Class I, to the extent of at least 25% of the strength of that class, children belonging to the weaker section and disadvantaged group in the neighbourhood and provide free and compulsory elementary education till its completion

Provided further that where a school specified in clause (n) of section 2 imparts pre-school education, the provisions of clauses (a) to (c) shall apply for admission to such pre-school education

(2) The school specified in sub-clause (iv) of clause (n) of section 2 providing free and compulsory education as specified in clause (c) of sub-section (1) shall be reimbursed expenditure so incurred by it to the extent of per-child-expenditure incurred by the State, or the actual amount charged from the child, whichever is less, in such manner as may be prescribed

Provided that such reimbursement shall not exceed pre-child-expenditure incurred by a school specified in sub-clause (i) of clause (n) of section 2.

In case you found the above legalese too long-winded to follow, let me summarise it for you. Government and aided schools will in any case provide free education. The same holds for Kendriya Vidyalayas and other similar schools. The critical element is the private unaided schools. Under the RtE, these schools are compelled (Yes. That’s the proper word to use unless of course you prefer the even better and more truthful word “coerced”.) to ensure that 25% of the students in any class from pre-school to class VIII/IX shall be admitted “free of charge”. The State, however, is “generous” and “considerate” enough to reimburse the costs, though such reimbursement shall be limited to how much the State spends on each child in its own schools.

Inefficiency in government schools apart, we see a very interesting point here. The State is essentially saying “I command you to provide education to 25% of every class free of charge. That I am giving you as much in reimbursement as I spend on each child I educate is good enough for you”. I challenge anyone to explain how this is not coercion and how such coercion is justified. If a private individual were to do this, we would call it goondaism. If the State does it by passing prior legislation, it is the Law. Funny definition of “the Law” out there!!

Another interesting aspect of this point is what happens in schools that have invested many crores to build infrastructure on the assumption that they will be able to charge a certain fee and provide a certain quality of service to their students. Assume that there is a school whose management has decided that they intend to cater to a segment of parents who are comfortable paying Rs. 50,000 per annum as school fee and have promised to have a class strength of 24 in order to give every child good attention. Let’s also say that this school has 2 teachers per class to further ensure that every child gets a high level of attention. Let’s now assume that the cost of education in a government school is around Rs. 20,000 as estimated by government itself.

The immediate implication of the RtE to such a school is that if they decide to retain their class strength at 24, they lose Rs. 30,000*6 or Rs. 1.8 lakh per class from which they would have earlier obtained a revenue of Rs. 50,000*24 or Rs. 12 lakh. So, the school loses a straight 15% of its planned revenue. How is the school to make up for this revenue shortfall? The RtE does not care to answer. That’s the school’s headache. And after all, they are just fulfilling their social responsibilities, aren’t they? They shouldn’t be cribbing. They should in fact be glad for the opportunity to be sacrificed thus. But what do we do when some existing schools decide that it is not worth their time and energy to operate thus and shut down? Or what do we do when potential entrepreneurs who are ready to overcome all the other obstacles in their path including the high investments and the not-for-profit clause now decide that the returns on setting up a school do not justify their investment and do not start new schools? Is that also part of the collective sacrifice we have to make to ensure that the “noble” intentions that lie behind the RtE are realized?

What else can the school do? It can try to make up for the shortfall by increasing its class strength by 4, of which 3 will be fully paying students, thus netting the school additional revenue of Rs. 1.7 lakh per class, bringing the shortfall to Rs. 10,000 per batch. That looks OK, but what happens to the quality of the attention that the school planned to offer to the fully paying students who paid a freaking Rs. 50,000 for it? I guess it’s time for them to make sacrifices for the sake of the poor and the down-trodden. Since all schools are going to face the same problem, this option then means that every school-going child will now have to settle for poorer quality education than they would have got sans the RtE. What better way to teach children to make sacrifices for the greater good of humanity. Collectivism! Here we come!!

The horror story does not end here. Let us now try to understand how the RtE Act tightens the grip of government and its bureaucracy on the neck of the education industry (if I may call it that). In the very next clause, it says

(3) Every school may provide such information as may be required by the appropriate government or the local authority as the case may be

So, the State is essentially empowered to collect whatever information it deems necessary to ensure implementation of the RtE. Why do I get the feeling that the RtE gets us ever closer to an Orwellian nightmare?

OK! Let’s have more of the horror story. Section 18 starts thus.

(1) No school, other than a school established, owned or controlled by the appropriate government or the local authority, shall, after the commencement of this act, be established or function, without obtaining a certificate of recognition from such authority, by making an application in such form and manner, as may be prescribed.

Let’s understand the enormous implication of this statement. It simply means that you may not run a school that does not have the recognition of an “appropriate” authority of government. Clearly, it also means that government has the right to shut down any school that runs without its permission. Even if the land is yours, you may not run a school on it. What a way to make the government the de facto owner of the land! They couldn’t have found a better way to say “Eminent Domain” which is nothing more than legalese for “Government is the ultimate owner of what you think is your land. You live by the permission of the government which is your lord and master. When you displease your master, he shall withdraw the pleasure of allowing you to use his property”. If this is not a handing over of control, I wonder what is.

Further, we see that RtE has also made it mandatory for schools to provide whatever information is asked for by a government authority. Thus, the government has been empowered to keep a close watch on the functioning of all schools, government owned or aided and unaided. Apart from the fact that this sounds positively Orwellian creating a “Big Brother is watching” environment, what can government do with this information, especially if the information pertains to what fraction of the school’s students are getting the “free and compulsory” education? Let’s check out some more aspects of the RtE Act to understand this. Clause 18 continues like this.

(2) The authority prescribed under sub-section  (1) shall issue the certificate of recognition in such form, within such period, in such manner, and subject to such conditions, as may be prescribed.

And what are those conditions? The RtE Act does not mention this but going by the fact that this is part of the RtE Act, I would be perfectly justified in assuming that the 25% “free and compulsory” education would be one of the many conditions to be included. What happens then if a school does not meet that condition? The answer comes in the very next clause.

(3) On contravention of the conditions of recognition, the prescribed authority shall, by an order in writing, withdraw recognition.

What happens then? The school loses its affiliation and hence its students can’t appear for the “all important” qualifying exam. Further, in consonance with clause 18, sub-clause (1), the government cannot permit the school to continue operating. It has to shut it down. How do they do that? That too is made clear by the RtE.

(4) With effect from the date of withdrawal of recognition under sub-section (3), no such school shall continue to function

(5) Any person who establishes or runs a school without obtaining a certificate of recognition, or continues to run a school after withdrawal of recognition, shall be liable to fine which may extend to one lakh rupees and in case of continuing contraventions, to a fine of ten thousand rupees for each day during which this contravention continues.

So, the act first states explicitly that the school may not run and that government may act to shut it down. On top of that, it says that government is empowered to impose fines on derecognised schools that continue to operate. Note also that it is applicable to schools that start without a certificate of recognition.

The fine is the punitive action that is supposed to force the school to shut down unable to bear the financial burden of the fines. In simple words, the government will unleash its muscle to rob the owners of the school at gun point and, under threat of such robbery or by actually robbing them, cause the school to shut down. I am shell shocked! This is the law that most of this country is celebrating as a great step in the right direction!!! If ever there was a decisive step towards moving this country towards fascism, this is it.

Note also that the other outcome of the regime of fines is the obvious avenue for sundry bureaucrats and politicians to make money by threatening schools or by just standing in the way of their getting recognition. This is a step that greatly tightens government’s already tight grip on education. If it takes Rs. 20-25 lakh today to get recognition, I wonder what it will take to get it after RtE is actually implemented. I also wonder what kind of people will then invest in setting up schools and for what reasons.

The take-over does not end here either. It goes all the way to curriculum. Here’s Section 29 under Chapter V.

(1) The curriculum and the evaluation procedure for elementary education shall be laid down by an academic authority to be specified by the appropriate government, by notification.

So, government and its “authority” and not the school shall specify the curriculum that schools should follow. In case I have ideas that I think are better than what they specify, I better not be running a school.

(2) The academic authority, while laying down the curriculum and the evaluation procedure under sub-section (1), shall take into consideration the following, namely:–

(a) Conformity with the values enshrined in the Constitution

There are other conditions that follow, but those are less critical, though problematic in their own ways. However consider sub-clause (a). What if I run a school and do not agree with some of the “values” enshrined in the Constitution? I already object to many, many clauses in the constitution and find it to be a document that is irretrievably flawed. What am I supposed to do? Dump my reasoning and parrot out the lines the authority hands me? I wonder why this sounds like a clause straight out of the Nazi handbook.

Conclusion

Far from being a momentous legislation, the RtE Act is a most dangerous piece of legislation that gives government total control over the entire education system. It creates conditions where operating a school and providing quality education can become very difficult indeed. It also enables any and every government functionary to line his pocket while pretending to enforce the act. Above all, it makes government the de facto guardian of every child and gives it a free-hand in deciding what children may learn. Such steps have been seen in the past, not in free societies, but under the Nazi regime in Germany and many fascist and sundry totalitarian regimes in the world. Is this what we wish to celebrate as a great step? Heaven help this country.

The Right to Education (RtE) Act – Perpetuating the error of Government control over education

One of the biggest downsides of the Right to Education (RtE) Act is that it perpetuates the mistakes of the past and hands the entire education sector on a platter to the agency that has messed it up big time – government. In this article, I shall try to outline why government control over school education is bad for the education sector itself and as a consequence for every citizen of this country as well.

How has government controlled school education?

A number of people think that our education sector is driven largely by private enterprise and that it is pretty much a free market in education. However, like so many notions of the concept free-market, this too is a misunderstanding. The truth is that government has a complete stranglehold over education and the entire formal education set up is ultimately forced to act as an arm of government.

Government control over education primarily happens through the Department of Education of the respective State Government and the Board of Education that a school is supposed to affiliate with. For a school to get students, parents need to be clear that the child will be able to appear for a “recognised” school leaving exam. This raises the question “recognised by what or whom?”. The answer is the agencies offering further education or seeking to employ people. The results of the school leaving examination should be capable of being used to pursue various options of further education or employment. Without this, no parent would risk putting their child through a school, no matter what they think of the school and the quality of education it may offer.

Pick up the admission-related rules and regulations handbook of any university or higher education set up operating in India and go through the segment on “qualifying examinations”. You will find them all to be exams conducted by government or quasi-government bodies such as the CBSE, the ICSE, various State Boards, etc.

A further perusal of the rules and regulations of these different Boards of education will reveal something interesting. Boards of Education like the CBSE and the ICSE require a candidate to be a registered student of a school affiliated to the Board in order for them to appear for the Board Examination. The concept of a “private candidate”, i.e., a candidate who appears for the Board Exam without having studied in an affiliated school, is non-existent under the CBSE and the ICSE. There are State Boards that allow it, but that’s a matter I shall explore in greater detail on another day.

Suffice it for now to state that parents feel an irresistible compulsion to admit their children in a “recognised” school affiliated to a government/quasi-government Board. It does not stop here. To even get the affiliation, schools need to first get “recognition” from the Department of Education of the state government concerned. To get that recognition, schools need to get a number of approvals from sundry government departments. And we all know what this means – tremendous scope for what is called “rent-seeking behaviour” or, in common man’s language, bribes.

This is the control mechanism over schools – Board exams as qualifying exams + Affiliation for appearing for Board Exams + Recognition for getting affiliation + Approvals for getting recognition.

The consequence of government control over school education

The primary consequence of government control is the bureaucratisation and politicisation of education. This in turn leads to (and has led to) a steady deterioration in the standards of education. Lakhs of students complete their schooling every year without understanding what they were supposed to learn at school. Let me now lay out the process by which this happens.

The first culprit is the entire concept of affiliation based on adherence to certain bureaucratically determined norms. Firstly, the Boards dictate that only someone with “sufficient” land may start a school. How much land is “sufficient”? As per the CBSE, in a metropolitan city, a school planning to offer education till XII standard should have a minimum of 0.75 acres of land. In a city like Chennai, that could translate into around Rs. 7.5 to 75 crores depending on how close to the centre of the city you wish to locate your school. Outside a metropolitan city, you would require a minimum of 2 acres of land. Taking Chennai as a benchmark again, at a distance of around 15-20 km from some suburban areas, you could get land at between Rs. 3 to 6 crores. That’s entry barrier 1.

Throw in a few more crores for a building where every classroom is necessarily over 400 sq ft and you have entry barrier 2. While these barriers need not deter everyone from entering the business of education, the next one will truly get your goose. A school may get affiliation only if it is run by a Trust, Society or a Section-25 (Not-For-Profit) company. In other words, you may invest in a school, but you shall not take any profits out of it openly and legitimately. In case you are wondering why entrepreneurs do not start schools but politicians, their lackeys and real estate developers do, these 3 entry barriers explain it for you.

It does not end here. There are norms related to teacher qualifications. They require every teacher to be sufficiently qualified for the job. The important point is what “sufficiently qualified” means. It means having the minimum educational qualifications and having completed government approved teacher training courses like a B. Ed..

To me, that was the most laughable. I’ve been delivering education for the last 11 years. I guess all those thousands of students who have trusted me and my counterparts in various cities across the country must be insane because we have been recruiting people for faculty positions with little or no regard for their qualifications. Of the 30-odd English faculty I have employed over 11 years, around 3-4 must have an MA English qualification. What’s even funnier is that I just don’t know their qualifications. The fact is that it doesn’t matter a whit to me. What matters is how well they know the language and how well they can teach. The picture is worse in Mathematics. Of the over 150 people I must have employed across the years, I don’t think more than 4 or 5 would have been Masters’ degree holders in Mathematics. Once again, the very fact that I do not know my people’s qualifications but have been able to deliver quality education by employing them stands testimony to the utter ridiculousness of using qualifications of teachers as the criterion to specify for affiliation purposes.

I had my most interesting experiences with typical school teachers when I ran coaching classes for IIT-JEE, AIEEE and AIPMT. I did that for about 7 years. During that period, I did some teaching of Physics and a little bit of Maths as well. As in every other line of business in education, faculty were the most critical resource. What shocked me, however, was how few people with years or even decades of experience in teaching Maths, Physics and Chemistry to school students knew their respective subjects and were fit to teach. I realised then that being a PGT with a B.Ed. degree does not mean that the person either knows the subject or is capable of teaching. It could mean neither.

It was then that I realised the reason the entire educational machinery is incapable of delivering quality save for a few exceptions here and there. The people out there are just not good enough. Try as they might with all the sincerity that they can muster, they still would not be able to deliver. Mere tinkering and experimenting with methodology (like the CBSE is doing with its CCE) can only yield marginal improvement. The real problem lies elsewhere.

Why education is in the sorry state it is in

The reasons are not difficult to understand. Firstly, there is the combination of the 3 entry barriers I identified above – the high cost of land, the high cost of infrastructure and the requirement that schools be run as a not-for-profit establishment. In very simple terms, what these 3 factors do is that they dramatically distort the profile of people who get into the field of education and set up schools. Their reasons could be far removed from providing education. To a politician or his minion, a school is a good means to turn black money into white or to generate black money. To a religious entity, a school is a good means to propagate its religious agenda. To the philanthropist, it is just a means to do good to others, especially the poor who cannot afford an education.

Delivering quality education requires the person setting up and running the institution to know what quality education is and what the drivers of quality are. He needs to know what constitutes good educational methodology and content. He needs to know what makes a good teacher. He needs to know how to identify good people in critical roles such as teaching. He needs to know what training to provide to people he recruits as teachers. He needs to commit himself to conducting such training and faculty improvement on an ongoing basis. He needs to be on a never ending drive for quality.

Therefore, only a person who enters the field of education with a passion for it and who is on an unceasing quest for improvement will be able to deliver quality education. With the kind of motives I have identified above, I don’t see where quality fits.

One may argue that some good people still can and do manage to run good schools. I agree it is possible and that there are a few good schools. That brings into the discussion the second important reason for the sorry state of education – the politicisation of education that is in turn an inevitable consequence of government control of education. Very simply put, politicisation of education destroys education. I take the case study of Tamil Nadu as an example.

Tamil Nadu as a case study of how politicisation destroys education

Once upon a time (when I was in my IX standard), Tamil Nadu had a fairly decent standard of education. In the early 1990’s in a process of keeping up with the IT boom, there was a boom in the Engineering College sector. Almost everyone wanted to become an engineer because that was seen to be a passport to a good job in the IT industry and a bright future.

Admission into Engineering colleges in Tamil Nadu was based on a combination of marks obtained in the Board examination and an entrance exam called the TNPCEE (Tamil Nadu Professional Courses Entrance Examination). Initially, Board Exam marks in Maths, Physics and Chemistry were taken (in a ratio of 2:1:1) for a total of 200 while the TNPCEE constituted 50 marks. Later, the TNPCEE marks were raised to 100. Even in those days, however, there was a significant advantage to students from the State Board stream. Getting high scores (198 to 200) was much easier in the TN State Board while getting comparable scores in the CBSE or ICSE streams was much tougher. For every 1 mark lost out of the total in any subject, a CBSE student would lose twice as much as a State Board student would. This was simply because maximum marks in the CBSE stream were 100 while in the State Board Stream, they were 200. Further, the TNPCEE was completely based on the TN State Board syllabus, making it that much more advantageous to TN State Board students.

In spite of these disadvantages, a good number of CBSE students were making the grade for even the top-most colleges in Tamil Nadu. A number of coaching institutes also came up offering training for the TNPCEE and students who prepared well clearly had an edge when it came to the 100 marks that the TNPCEE mattered for. That’s when the rumblings started. It was alleged that the entire system was “rigged” in favour of students from urban areas while students from rural areas, with their lack of access to good schools and coaching institutes, were being excluded from the entire process.

Faced with the (politically motivated) challenge to improve the number of rural students making it to Engineering colleges, the Tamil Nadu government and the department of higher education took some incredible steps (incredible for the damage they have wrought). If the challenge is to improve the proportion of rural students making it to the top engineering colleges, there are clearly two routes to achieving it. The first is to take steps to improve the quality of education that these students receive so that they too could perform well in the entire selection process. The second is to dilute the entire examination system so that rural students can perform well in spite of the poor quality of education that they receive.

The Tamil Nadu government and its departments chose the latter option. As a first step, the Tamil Nadu State Board Exam was diluted. Henceforth, questions had to be completely from the text book. No questions may be asked from beyond the text book as they would then be deemed to be “out of syllabus”. How far was this joke carried? An example would explain it best. In the Mathematics paper, every question was (and still is) supposed to be straight from the TN State Board text books. If even a number is different, the question is considered to be out of syllabus and not taken into account for scoring. How’s that for a Mathematics exam? What Mathematics do you expect these students to learn?

If this is going to be the nature of the exam students are going to write, what do you expect schools and students to do? As is to be expected, the focus of education shifted from understanding the concepts being learnt to mindlessly memorising the contents of the text books and learning how to answer the questions that may be asked in the Board Examination. Schools soon transformed from centres of learning to drilling camps where students would be put through innumerable practice tests and exams to ensure that they made it a habit of scoring good marks. As the TN State Board Exam covered only the XII Standard, syllabus, few schools bothered to cover the XI Standard syllabus (which people serious about education would consider the foundation of what is learnt in XII Standard).

To make matters worse, the Tamil Nadu government took the unprecedented step of abolishing the TNPCEE and made admission to all engineering courses under Anna University based completely on XII Board Exam marks. The immediate consequence was obviously that the drills became more rigorous than ever and students needed to understand concepts even less than before. The TNPCEE at least had some questions from outside the text book. With its abolition, students were freed from the “tyranny” of entrance exams. The obvious casualty of these choices, driven as they were by the initial act of politicisation, was the quality of education.

The damage did not end with the TN State Board. It was soon to spread all over the country. Here is how it happened. Shortly after the TN State Board started diluting its examinations, panic spread among CBSE schools in Chennai and the rest of Tamil Nadu. Their XI standard classrooms were suddenly empty as students migrated en masse to State Board schools in order to ensure that they got the maximum possible marks in their XII Board exams. Many CBSE schools were on the verge of shutting down at least the XI and XII standards if not the entire school. Many of these “endangered” CBSE schools responded to the challenge aggressively by starting State Board wings in the XI and XII Standards. They even built separate blocks to accommodate these sections. While this saved the schools, the drift away from the CBSE seemed unstoppable.

Thus was the CBSE forced to compete with the TN State Board. Challenged thus, it soon started engaging in competitive populism. Unlike in my time when getting a 97 in Chemistry would make you All India No. 2 in the subject (with very few students getting that score), it is common these days to see CBSE students getting centums in one or more subjects among Maths, Physics and Chemistry. The CBSE being a board with affiliated schools and students across the country, the dilution in standards of education thus spread from Tamil Nadu to the rest of the country as well.

The damage did not end here. It was transmitted down the levels in every school. If memorising by rote and repeating verbatim was the means to demonstrate performance in XII Standard, then why not do it in earlier classes as well? Clearly, with this transformation, schools no more needed good teachers. They needed good drill masters who could put students through the grind and make them pass examinations by memorising.

To the majority of people who had set up and were running schools, this did not matter. After all, what was quality for them? Standards for teacher recruitment fell. With it fell (or rather stagnated with respect to the rest of the labour market) salaries for teachers. Teaching soon started to become an extremely unattractive career proposition even for women ready to consider the advantages that come with working in a school. When IT industry is ready to pay you Rs. 20,000 at the entry level with scope for reasonable increases as time progresses, would you be crazy enough to take a job as a teacher for Rs. 5000-8000 given that increments would be fairly low? It turns out that not too many competent people were that crazy. They took up lucrative offers in various other sectors of industry including the parallel education sector. Many competent and passionate people with a high level of knowledge and skill in Maths, Physics and Chemistry drifted into the coaching industry to train students for exams like the IIT JEE and the AIEEE. The shortage of talent, in terms of quality and quantity, became acute. In simple terms, @#$% hit the roof.

Where is education headed after all this politicisation?

Since I am not an expert at crystal ball gazing, I shall not make a prediction. What I would say is that if you are a believer, for the sake of your own children, start praying to your favourite God. To know what else you can do, go over to the conclusion.

Conclusion

Government control is the most destructive thing that can happen to education. The RtE hands education over to government on a platter. Hence, the RtE Act is bad for education. Anyone who is concerned about the well-being of future generations should fight the RtE Act tooth and nail. If you think I made sense in this article, show it to more people you know. Thanks in advance.

The Right to Education (RtE) Act – A flawed legislation based on flawed premises

In my previous piece, I had focused on how education is not a right. This time, I shall take another fundamental problem with the Right to Education Act. Many people might not know it, but what we commonly recognise as RtE is actually called ‘The Right of Children to Free and Compulsory Education Act, 2009’.

As per The Right of Children to Free and Compulsory Education Act, 2009,

Every child of the age of six to fourteen years shall have a right to free and compulsory education in a neighbourhood school till completion of elementary education

The simplest thing that we can infer from this is that as per the RtE Act, education is synonymous with schooling. In simpler terms, education is schooling and vice versa. Frankly, this error alone shows the RtE Act to be a document that demonstrates the complete intellectual vacuity of the people who drafted it.

What is education and why do we need it?

Education is a process of gathering knowledge, skills, values and attitudes. Education involves the grasping of concepts and principles and learning to apply these to tackle the wide variety of challenges we face in our life. Learning to bake bread is as much education as learning to solve partial differential equations is.

We need education because an education can help us achieve more in life than we would without an education. Armed with the knowledge, skills, values and attitudes that a good education can confer on us, we can lead a more fulfilling life. The effects of a good education can be felt on the professional as well as personal front.

An education with a sharp focus on particular areas can make us an expert in those areas. Such expertise, if valued by others, can even help us develop a career in that area. For instance, an education focusing on what the human body is and how it works can help a person become a medical professional. An education focusing on creative expression in the written form can help a person become a novelist by profession.

What is schooling?

Schooling is just a particular way of delivering education. A school is an establishment that puts together the people, materials and educational methodology required to offer an experience leading to education.

Is Schooling essential for education?

Frankly, it is not. Education can just as well happen at home. The growing home-schooling movement in the US and its off-shoot in India is proof of that. At one level, one can even say that schooling is a very inefficient method of education because it lumps together students of varying capabilities, levels of development and different learning methods into “classes” in which the same instruction is given to every student. The inevitable outcome of a classroom environment is deteriorating standards as the education is progressively dumbed down to the level of the slowest students.

The advantage of schooling

The main advantage of schooling is the cost, especially in comparison with better options. While the best form of education might be personal tutoring, it is so expensive that most people cannot afford it. Schooling allows for far higher economies of scale by dividing the process of education into many stages and grouping together many children at each such stage into a class. Further, a set of tutors may cater to multiple classes in a single day by framing and adhering to a time-table. Thus, the cost of tutoring is defrayed over many children, thus making it possible to offer education at prices much lower than for personal tutoring. This advantage in fact makes a school a viable business proposition where entrepreneurs could earn a profit by delivering education.

The disadvantage of schooling

Schooling (as it exists today) is a capital intensive business. Huge investments need to be made to set up a good school. As per today’s estimates, that could be anywhere from Rs. 15 to 25 Cr to cater to around 1200-1300 children. Even these figures assume that land is available at a cost of Rs. 4-5 Cr. To make it even tougher, merely pouring a lot of money does not make a good school. The quality of a school depends on the quality of the people running the school and the people structuring, organising and delivering the education. Every bit of this costs a lot of money. All this makes a school a very long gestation project. A well-run school can take around 7-8 years to pay back the investments made in it. A poorly managed school can be a drain for a long time to come. It takes a person with a lot of commitment to education and a very strong stomach to start and run one.

The Fallacy of the RtE

The Right to Education Act should actually be called the Compulsory Schooling Act. All it does is to declare that every child should compulsorily attend a school. In doing so, it assumes that such a step automatically guarantees that every child gets an education so that it may legitimately be called the Right to Education Act. Talk of the mother of all fallacies.

What else could have been done?

To answer this question, let us address a very basic point – Why does a huge proportion of our population not receive education? As an additional point, why does a huge proportion of those who do receive education receive substandard education?

The answer lies simply in the fact that we have chosen schooling as the primary, or rather the sole vehicle of delivering education. To be a little more explicit about it, schooling has been thrust upon the people of India as a ‘one size fits all’ solution to get an education. Not just schooling but an entire educational establishment consisting of schools, colleges and universities has been thrust upon us. Even worse, this entire establishment is a part of and is controlled by – guess who – no prizes for guessing – Government.

Doubt what I say? The CBSE, the ICSE, various State Boards of Education, the Departments of Education of various state governments, a chain of government schools, a vast network of private aided and unaided schools (compulsorily) affiliated to one or the other of these boards – this is our system of “education” at the school level. The UGC, the AICTE, Universities, affiliated colleges – this is our system of higher “education”. I wonder which part of this is not controlled by government.

Now here’s what could have been done – You could have freed education from the clutches of government. You could have disbanded all the bodies mentioned above (and many more not mentioned above). You could have completely eliminated government’s stranglehold on education. You think I am nuts? I’ll explain my position in my next article. For the moment, I’ll stick to the consequences of such an action.

The consequences of implementing my idea

Very simply, no one who needs an education will have to go to a school. People can get an education through whatever means they please. To some, it would mean home education. To others, it would be learning through apprenticeship. To yet others, it would indeed be studying at an organised set-up like a school or a college.

In the absence of government control, the free market would throw up a variety of solutions to meet the educational needs of people belonging to various strata of society. The super-rich would engage private tutors to educate their children. The rich would send their children to high-end private schools. The middle class would send their children to more modest establishments charging them as much as they can pay. The poor would send their children to schools run by charitable institutions founded by philanthropists (I am quite sure there would be many in a free society who would donate to such causes). Those who can’t do any of this would still be free to study on their own or focus on developing skills that would make them employable.

A good number of people would not even go to schools to get an education. They would go to establishments that offer education but do not fit into the category of schools. These would be establishments running out of apartments and other rented premises. Before you deride these as “sweat shops”, please bear in mind that what they are sweating out is their assets. The better they sweat their assets out, the more likely it is that their service continues to be offered.

Many others would educate themselves on their own based on educational materials available on the market. This would include books, educational CDs, distance learning programmes, etc. The poor who cannot afford to buy these could educate themselves through books obtained on a hand-me-down basis. Some may choose to harness the power of the internet to educate themselves or their children.

Certifying agencies would crop up on a for-profit basis because there would be a crying need for each person to demonstrate what he/she knows and how well. No more CBSE or ICSE Board Exams to be written when you complete X or XII standard after going through 12-16 years of schooling. You would be able to write these certifying exams at various points in time in the year, meaning at a time and place of your choosing. That in turn means no more exam pressure than you put on yourself because you want to perform well in the certifying exam. Not just that. Fast learners could write their exams earlier while slow learners could write it later. No bright student would need to be held back because other slow learners in his class aren’t able to cope. No slow learner needs to suffer the anguish of being labelled incompetent or dull just because he takes a little longer to learn. You wouldn’t be required to attend a single day of school either. That also means that parents and children are no more at the mercy of the school. Attend a school only if you think it is worth it. Don’t like a school? Walk out today. Enough people will welcome you/your child with open arms.

Rating agencies would crop up to rate schools, non-school established education providers, certifying agencies, etc. The ratings would indicate the quality and reliability of the service being offered (because these are the critical aspects). Competition between educational establishments would now also be on the ratings they get from such agencies. There would also be multiple rating agencies competing on their respective credibility.

A common allegation thrown at a free market in education is that schools would fleece students and offer them substandard education. This allegation is laughable because as outlined above, on a free market, parents would be free to move their child in and out of any school whenever they pleased. They or the schools to which they move would be answerable to no one but themselves. One school delivering poor quality or high cost education is an open invitation to a more competent person to set up a good quality and/or lower cost school and attract dissatisfied customers of the poorly run/expensive school. Further, on a free market, the entry barriers that today prevent people from starting schools would be completely absent. There would no more be a need to have land and building of your own or on 30 year lease to start a school. All it would take is a rented apartment and you could be in the business of education. You could even rent out class-rooms from established schools and colleges outside of their working hours and offer your education (I’ve been doing precisely this for 11 years now. So don’t tell me it’s not possible).

All this, however, would mean elimination of the power of the establishment over our lives. That does not suit the establishment, does it? No wonder then that they passed the Right of Children to Free and Compulsory Education Act, 2009.

The Right to Education (RtE) Act – Flawed at the root

As I watch the circus happening over the RtE act, I just can’t help thinking what a sad moment it was when the bill was actually passed. It represents the moral degradation of many decades and shows that if you repeat a lie enough times, you can get a good number of people to believe it.

At the core of the RtE Act is a fundamental flaw – the notion that Education is or can ever be a “right”. If we ever pause to think of the very concept “right” and understand the nature of education, it will be obvious that it is utterly ridiculous bordering on (intellectually) criminal to treat education as a “right”. That’s exactly what I shall do out here.

What’s wrong with the RtE Act

The error at the core of the RtE Act is to treat rights as an entitlement (let’s not pretend that it is not so). The very notion that everyone is entitled to education and that the State has an obligation to ensure, by whatever means, that everyone gets an education is totally ridiculous. No one is entitled to anything. Not food. Not water. And surely not education. We all have to EARN what we want to consume.

The problem with treating rights as an entitlement is this – someone, somewhere has to PRODUCE the thing that you are “entitled” to. Government (or the State) does not produce anything, least of all education. To give something to A, it has to first take that something or the means to obtain that something from B. It has to do that forcibly because B will not give that up voluntarily.

It does not matter whether it is running government schools or coercing private schools into accepting 25% of their students from economically weaker sections (at a lower fee, of course). In every case, government is forcibly taking away what belongs to B in order to provide education for A. To run government schools, the government robs everyone in the unholy name of tax and steals from everyone under the garb of inflation. To coerce private schools to admit students at lower fees, it just flexes its muscle and threatens to shut down schools (they call it withdrawing recognition/affiliation).

Let’s face it – whichever route government chooses to implement RtE, it has to behave like a common thug on the streets. Right to Education, therefore, translates very simply into Right to unleash violence on others. I am amazed to see that a lot of people really think that this is indeed a legitimate right.

What rights are

Rights are a moral concept defining and sanctioning man’s freedom of action in a social context. Saying “you have a right to X” means that you are FREE to act to get/maintain X. In a social context, that in turn means that no one may prevent you from acting thus. It does not mean that you are entitled to X or that anyone else is obligated to provide you X.

For instance, if I say “You have a Right to Life”, it only means that you are free to act to sustain your life as you deem fit. If that means eating fatty foods or consuming narcotic drugs or smoking cigarettes or drinking yourself into oblivion, then so be it. No one should be free to force you to act otherwise. It does not mean that anyone at all has an obligation to keep you alive.

The concept “Right to property” does not mean that you are entitled to some property and that others should provide you some property. It means that you are free to act to acquire property and hold property that you have acquired. To claim that others should provide you some property is tantamount to claiming that others are your slaves.

The same holds true for education. You are free to get the education you seek and can get. That does not mean that anyone else is obligated to provide you with that education. Unless you are claiming that some people have the right to treat others as slaves who ought to provide them with an education, RtE makes no sense.

Conclusion

From an ethical perspective, RtE is shockingly immoral. The only right thing to do is to call for its repeal.

Key Concepts in Economics – 12 – Money Prices – Their meaning and their determination on a free market

In this article, I shall attempt to lay out the basic concept of money price of a good and explain the process by which money price of a good is determined on the free market, i.e., a system based on voluntary exchange. Before that, however, it is important to clarify a few important points.

  1. Man’s real revenues, costs and profits are all psychic and not monetary. This is simply because what man seeks to get through his action is the satisfaction of his ends. His revenue is the satisfaction of the ends he chooses to satisfy. His costs are the non-satisfaction of the ends he had to forego in order to do so. His profits are the net satisfaction assessed as revenue “less” costs, both of which are psychic, thus leaving profits to be a psychic figure as well.
  2. On a free market, every seller seeks the maximum price he can get while every buyer seeks the minimum price he can get. This is simply because the sole purpose of means to man is that they may be used to satisfy his ends. Every unit of means that could be obtained or saved but is not means the foregoing of the satisfaction of an end. The greater the price a seller manages to get for his wares, the greater the psychic revenue he may obtain. The lower the price a buyer manages to get for the goods he procures, the fewer the ends whose satisfaction he has to forego.

Money Prices – Their Meaning

In an earlier article, I had mentioned that price is an exchange ratio. Using the example of wheat exchanging for rice, I had explained that the wheat price of rice is nothing more than the ratio of the quantity of wheat offered per unit of rice being offered in exchange while the rice price of wheat is the ratio of the quantity of rice offered per unit of wheat. In the particular example used, where 2 bags of wheat were exchanged for 1 bag of rice, the prices were as below

  • Wheat price of rice – 2
  • Rice price of wheat – ½

Since money is just another commodity that has evolved into a medium of exchange primarily because of its extremely high marketability, it too has to be exchanged in some ratio. This ratio is called the money price of the good being exchanged. For instance, if silver were the money commodity, then if one offers a 1 ounce coin for a bag of rice, the money price of rice is 1 ounce per bag. If the same 1 ounce of silver could get 2 bags of wheat, the money price of wheat would be ½ ounce per bag. In either case, the money price is the ratio of the quantity of the money unit being received to the quantity of the good being offered.

  • Money price of rice = 1 ounce silver coin / 1 bag of rice = 1 ounce silver coin per bag
  • Money price of wheat = 1 ounce silver coin / 2 bags of wheat = ½ ounce silver coin per bag

Money Prices – Their Determination on a Free Market

As in the case of the direct exchange economy, money prices too are determined by the interplay of demand and supply schedules of each good at different exchange ratios while the demand and supply schedules in turn are determined by the value scales of all the individuals who constitute the market for the good concerned.

Consider a hypothetical market consisting of 3 buyers, A, B and C, of a product, say butter. Let their value scales be as given below.

Table 1 – Value Scales of 3 buyers A, B and C

A B C
7 milligrams of gold 6 milligrams of gold 5 milligrams of gold
(1st kg of butter) (1st kg of butter) 4 milligrams of gold
6 milligrams of gold 5 milligrams of gold (1st kg of butter)
5 milligrams of gold (2nd kg of butter) 3 milligrams of gold
(2nd kg of butter) 4 milligrams of gold (2nd kg of butter)
4 milligrams of gold 3 milligrams of gold (3rd kg of butter)
3 milligrams of gold 2 milligrams of gold 2 milligrams of gold
(3rd kg of butter) (3rd kg of butter) (4th kg of butter)
2 milligrams of gold (4th kg of butter) (5th kg of butter)
1 milligram of gold 1 milligram of gold 1 milligram of gold

Before we proceed to working out the demand schedules of A, B and C, let us pause for a moment to understand the meaning of the table above. In the case of A, for instance, he values the utility of 7 milligrams of gold as higher than that of the 1st kg of butter. The reasons for this could be

  1. Higher use value for the 7 milligrams of gold than for the 1st kg of butter
  2. Higher utility for the other good that 7 milligrams could get than for the 1st kg of butter
  3. Higher utility for the presence of 7 milligrams of gold in his cash balance, i.e., higher utility for the goods he can get in the future than for the 1st kg of butter he can get now

This means that A will not to give up 7 milligrams of gold to get the 1st kg of butter. However, the utility of 6 grams of gold is less than the utility of the 1st kg of butter (for the converse of one or more of the 3 reasons given above). Therefore, A will be prepared to give 6 milligrams of gold for the 1st kg of butter, though he may actually give up less than that.

Having obtained the first pound of butter, the marginal utility of the 2nd unit of butter would clearly be less than that of the 1st. As per the table, A values 5 milligrams of gold higher than the 2nd kg of butter. So, he will not pay a price higher than 4 milligrams for the 2nd kg of butter. Following the same analysis for A, B and C, we may now be able to work out all their demand schedules as given below

Table 2 – Demand Schedules for the Value Scales depicted in Table 1

Price A’s Demand B’s Demand C’s Demand Cumulative Demand
1 3 4 5 12
2 3 2 3 8
3 2 2 1 5
4 2 2 0 4
5 1 1 0 2
6 1 0 0 1
7 0 0 0 0

Let the market also consist of 2 sellers X and Y with value scales as given below.

Table 3 – Value Scales of 2 sellers X and Y

X Y
(7 milligrams of gold) (7 milligrams of gold)
(6 milligrams of gold) (6 milligrams of gold)
6th kg of butter (5 milligrams of gold)
(5 milligrams of gold) (4 milligrams of gold)
5th kg of butter (3 milligrams of gold)
4th kg of butter (2 milligrams of gold)
(4 milligrams of gold) 6th kg of butter
3rd kg of butter 5th kg of butter
(3 milligrams of gold) 4th kg of butter
2nd kg of butter 3rd kg of butter
1st kg of butter 2nd kg of butter
(2 milligrams of gold) 1st kg of butter
(1 milligram of gold) (1 milligram of gold)

Once again, before drawing out the individual and cumulative supply schedules, let us make sense of the table above. From the Law of Diminishing Marginal Utility, it is clear that foregoing of the first unit of a good results in non-satisfaction of the least valued end that could have been satisfied with that additional unit of the good. Hence, the marginal utility of the 1st kg of butter foregone is the lowest while every subsequent unit of butter foregone has greater marginal utility.

Further, as per X’s demand schedule, at a price of 2 milligrams of gold, he would not be prepared to offer even 1 kg of butter for sale while at a price of 6 milligrams or more of gold, he will be ready to offer 6 kgs of butter for sale. Y, on the other hand, will not offer even 1 kg of butter at a price of 1 milligram of gold while he will offer 6 kgs of butter for sale at any price equal to or greater than 2 milligrams of gold.

Based on this, the individual supply schedules of X and Y and the cumulative supply schedule for the entire market may be worked out as below.

Table 4 – Supply Schedules for the Value Scales depicted in Table 3

Price X’s Supply Y’s Supply Cumulative Supply
1 0 0 0
2 0 6 6
3 2 6 8
4 3 6 9
5 5 6 11
6 6 6 12
7 6 6 12

For clarity’s sake, let us also draw the demand-supply curves with money prices as per tables 2 and 4.

Fig 1 – Demand-Supply Curves with money prices

We see from Tables 2 and 4 as well as the Demand-Supply Curve in Fig 1 that the equilibrium price will be between 2 and 3 milligrams of gold per kg of butter. If the unit of money is not divisible any further, the price would be either 2 or 3 milligrams. If it were further divisible, say into ½ milligram, a price of 2 ½ milligrams may be set. The quantity exchanged at equilibrium would be 8 or 6 kg if the money unit is not further divisible and around 7 kg if the money unit were further divisible.

What we learn from this analysis

Money prices of all goods on a free market are determined in the same manner as the exchange ratios of any pair of goods in a direct exchange economy – starting from the individual value scales of all the buyers and sellers in the market. At the equilibrium price, the market is cleared, i.e., quantity supplied would be equal to quantity demanded. Thus, we see that money prices too evolve from the Law of Diminishing Marginal Utility, which in turn evolves as a logical corollary of the Action Axiom.

Ref: Man, Economy and State with Power and Markets, Murray N Rothbard, Chap 4

Key Concepts in Economics – 11 – Indirect Exchange and the Money Economy

In all my posts till date, I have explained concepts based on the assumption of a direct exchange economy. In such an economy, recipients in an exchange accept only goods that they intend to use. However, there are some serious and fundamental limitations that such an economy will face. One of them is the double coincidence of wants.

In simple terms, the term double coincidence of wants refers to a basic requirement that needs to be fulfilled for an exchange to happen. For A and B to engage in a direct exchange, A should want what B offers while B should simultaneously want what A offers. The wants of A and B need to coincide, failing which no exchange can happen between them. As a simple example, let’s say that A offers wheat in exchange for B’s eggs. However, if B desires butter in exchange and not wheat, there is no scope for an exchange between A and B.

How can A and B overcome the double coincidence of wants on a free market?

Let us say there is a third person C who wishes to consume wheat and offers butter in exchange. Now, A may exchange his wheat with C, offer the butter received in exchange to B and obtain the eggs that he desires. In this process, A, B and C are all better off as they have obtained the good they each sought in order to satisfy their own respective ends.

What we can note is that A accepted the butter from C not because he intended to use it but because he wanted to further exchange it for B’s eggs. Thus, to A, the butter was not a consumers’ good that he wished to consume to directly satisfy an end but a medium of exchange that enabled him to get the actual consumers’ good that he desired, i.e., eggs.

However, we also see that the butter could serve as a medium of exchange only because it was already in demand by B. This is a basic requirement that any good should fulfil for it to serve as a medium of exchange – it should be a good that is already desired for consumption by people in that society. The more widely desired a good is in a society, the more capable it is of serving as a medium of exchange in that society. What serves as a medium of exchange in any society also depends on the conditions in that society.

For instance, during World War II, cigarettes served as the medium of exchange in prisoner of war (POW) camps. In ancient Abyssinia, salt served the role of medium of exchange. In fact, the term salary that we use to refer to regular income comes from the use of salt as a medium of exchange and payment. In certain fishing communities, fishing hooks have served as a medium of exchange. A variety of goods such as tobacco, sugar, cattle, nails, copper, beads, tea, cowrie shells, etc., have been used as a medium of exchange.

From medium of exchange to money

The more marketable a commodity is, the more widely it is likely to be used as a medium of exchange. A commodity that is in general use as a medium of exchange is called money. The term money is not as precise a definition as medium of exchange is. However, we see that there is a strong impetus on a free market for a highly marketable commodity to come into wider and wider use and eventually become a generally used medium of exchange, i.e., money.

The advantages that money confers on an economy

The emergence of a commodity as money greatly increases the scope of specialisation and division of labour possible in an economy. To understand why this would be so, let us take a hypothetical case where a man, A, wishes to build a house for himself and seeks to employ the services of a carpenter, a mason and many other tradesmen and labourers for the purpose. Every one of these people he employs is offering their labour in exchange for which A will have to offer them a certain quantity of a good they wish to consume to satisfy their own ends.

Each of these people could have different ends and might hence seek different means for their satisfaction. For instance, the mason may want rice, the carpenter linen, the labourers wheat, fish, eggs, leather, etc. In order to do so, A has to either produce the particular combination of goods that these people want or procure these goods from other people who produce them by offering them goods that they in turn want, in which case he will have to produce these goods first. Production takes time. Given that at the time of commencing the production, A has no way of knowing

  • which individuals will be in possession of the goods he wants so that he may produce the goods they want
  • which individuals he will actually employ so that he may then produce those very goods that these individuals want

Seen from the eyes of the mason, the carpenter and all the other labourers, how are they to know which particular employer of their services is likely to be in possession of the very goods they seek to consume? How then are they to decide to develop skills such as masonry or carpentry given whatever their ends are?

These problems, insurmountable as they seem in a direct exchange economy, are solved easily in an indirect exchange or a money economy. Since there are commodities that function as media of exchange, A can pay every person he employs in the form of a medium of exchange. Each person in turn can use this medium of exchange to buy the particular goods that he wishes to consume. That too is made possible because the sellers of these goods can in turn use the medium of exchange to buy the producers’ and consumers’ goods that they wish to procure.

With the confidence that he can earn a certain quantity of the medium of exchange which he could then use to satisfy his own ends, a person can now decide to specialise in the trade of masonry or carpentry or plumbing or any other trade where he feels he is likely to do well. Thus, the existence of a medium of exchange makes specialisation possible. This specialisation makes division of labour among all these specialists possible.

It is the emergence of money that, therefore, permits the mind-boggling level of specialisation and division of labour that makes the modern, industrial and technologically advanced economy possible. It makes it possible to have a complex structure of production with multiple stages of production, each producing producers’ goods that are used in further stages of production till, many stages and lots of time later, consumers’ goods are produced and exchanged for money. Every producer in every stage of production may use money to buy the factors of production and in turn sell the goods they produce for money. Without money, it would be very difficult indeed for any economy to proceed beyond the primitive level.

Another important benefit that stems from the emergence of money is the very possibility of economic calculation. Without money, it would be impossible to estimate if one is making a profit or a loss by venturing into a business. It would be impossible to know how to allocate resources and move them from less profitable lines of production to more profitable ones. With money, everything is now priced in terms of money. By keeping an account of how much money is earned and how much spent, it is possible for a business to know if it is earning profits or incurring losses. Calculation using money can also help entrepreneurs evaluate a business opportunity even before investing in it. Money makes comparison of investment opportunities possible and is thus indispensable in making wise investment choices.

Thus we see that the emergence of money is an event of monumental significance in human evolution. Contrary to opinion widely held, money is not the root of all evil. It is the thing that makes possible all the well-being that we experience today. In subsequent articles, I shall explore the economics of an indirect exchange or a money economy.

Key Concepts in Economics – 10 – Capital Formation, Capital Maintenance and Capital Consumption

In an earlier post, I had mentioned that goods fall into two broad categories – consumers’ goods and producers’ goods. Consumers’ goods are scarce means whose consumption directly leads to the satisfaction of human ends. Producers’ goods are scarce means that are used to produce consumers’ goods or other producers’ goods that are closer to the stage of consumption.

Capital goods are one of the 3 classes of producers’ goods. Unlike the other two – land and labour – that occur in nature, Capital goods do not occur in nature and must first be produced. Capital goods are produced by applying human labour to means found in nature to convert them into means that may be further used in combination with labour and nature to produce consumers’ goods and other producers’ goods.

Production takes time. Production is always aimed at producing consumers’ goods (directly or indirectly) at some point in time in the future. At any point in time, man has the option of engaging in consumption or production, which in turn means that he has to make a choice between consumption in the present and consumption in the future. The more the stages of production before the means in hand may be transformed into consumers’ goods, the later in time consumption will happen.

Thus, we see that the most fundamental requirement for man to be able to produce capital goods is the giving up of consumption in the present in order to consume at some time in the future. Let us now take a simple example to understand this concept.

Robinson Crusoe and Capital Formation

Robinson Crusoe is shipwrecked and marooned on an unknown and uncharted island. He does a reconnaissance trip of the island and finds that there is little to eat other than berries that he may pluck off the trees on the island. The trees are quite tall and the berries grow at various heights on the tree, at heights where he could just pluck off the berries as well as on the upper branches of the tree which he cannot reach since he does not know how to climb a tree. However, he finds that he could comfortably pluck 20 low-hanging berries an hour for about 10 hours a day to eat well and have enough time to rest and enjoy his leisure.

Robinson Crusoe also sees that the upper branches have far greater density of berries and that he could therefore pluck many more berries every hour if he could only reach the upper branches. Even though he does not know how to climb the trees, he knows that if he could fashion a few sticks he could pick off the ground and some vines he could pluck off trees into a tool (a capital good), he may be in a position to pluck berries off the upper branches and increase his catch to 50 berries an hour. However, to produce the tool, he would have to devote 10 hours of effort.

He could devote the 10 hours at one stretch or over a period of many days. He could choose to work 10 hours less at plucking berries or he could use 10 hours less of leisure or a mix of the two. Whichever way he does it, he has to forsake consumption in order to produce the capital good (leisure is also a consumers’ good). For the sake of convenience, let us assume that he leaves his leisure alone and decides to work for 10 hours less at plucking berries so that he may use the 10 hours to fashion his tool. Let us also assume that he decides to work 2 hours a day for 5 days to make the tool.

In that case, he foregoes the consumption of 200 berries (20 berries per hour *10 hours) over a period of 5 days. At the end of the 5 days, he will have in hand a capital good that can increase his output to 50 berries an hour or 500 berries a day working 10 hours a day. Thus, we see that it is the foregoing of consumption in the present that is absolutely essential to produce capital goods that yield consumers’ goods for consumption in the future.

Obviously, this need not be the end of the story. The tool will undergo wear and tear as Crusoe goes about his work of plucking berries. He will have to work in order to keep the tool in working condition and thus maintain his output at 50 berries an hour. This may take around 1 hour a day. In that case, he will be able to get a total output of only 450 berries a day. However, we note that even in this case, he is far better off than he was without the capital good.

Crusoe now has more options. He could consume 450 berries a day keeping his capital good (the tool made of sticks and vines) in good shape. He could consume fewer berries, say 300 a day (still more than the 200 he was consuming prior to the production of the capital good) and devote the 3 hours a day saved thus to produce an axe with which he could chop trees to clear a portion of the woods and to make a log-house for himself. Let us assume that making the axe takes 30 hours of effort and clearing the land and that making a house takes 300 hours including the time taken for maintaining the axe and the fruit-plucking tool in good shape till the end of the construction. By reducing his consumption from a potential 450 to 300 for 110 days, Crusoe can provide himself a house to live in and a potential consumption of 450 berries a day at the end of the 100 day period.

He could even cut his consumption down to 200 berries a day and devote the additional 2 hours he gets everyday for 50 days to fashion a boat and a fishing net so that he could provide himself with berries as well as fish to eat. Once the house is constructed and he no longer needs to spend time constructing it, he is once again faced with options

  • devoting (say) 3 hours a day to maintaining his capital goods (the fruit-plucking tool, the boat, the net and the house), 5 hours to plucking berries and 2 hours to fishing thus consuming 250 berries and 20 fish (assuming he can get 10 fish an hour)
  • devoting (say) 3 hours a day to maintaining his capital goods (the fruit-plucking tool, the boat, the net and the house), 4 hours to plucking berries and 1 hour to fishing thus consuming 200 berries and 10 fish and using the 2 hours thus made available to scout the island more thoroughly for resources he could utilise to improve his own condition

Key terms and lessons from the example used above

When Robinson Crusoe decided to live with lower (than potential) consumption to produce his capital goods, he was engaging in capital formation. When he decided to live with lower consumption to maintain his stock of capital goods in working condition, he was engaging in capital maintenance or capital replacement. If, on the other hand, he had chosen not to devote time for capital maintenance/replacement, he would soon have reached a point where the capital good became incapable of delivering increased output (say the stick breaks and becomes unusable for fruit-plucking) and he would have been engaging in capital consumption.

We also note that thanks to all the effort he devotes to capital formation and maintenance, Robinson Crusoe is much better off than he was before. He is in a position to provide himself a higher quantum of consumers’ goods by working for the same time and has also been able to provide himself shelter from the elements. We can say that by forming capital and maintaining it, Robinson Crusoe has become more prosperous, i.e., capable of providing for himself much better than without it.

This process of capital formation and maintenance, explained here for Crusoe, is as essential for a society made up of a large number of individuals to lift itself from poverty into prosperity as it is for the isolated individual Robinson Crusoe. When people in a society favour consumption in the future over consumption in the present, they give themselves the potential to produce enough capital goods to enjoy a prosperous future. If, on the other hand,  the people in the society prefer consumption in the present to consumption in the future, they either fail to produce capital goods or, worse, consume their existing stock of capital goods, thus making themselves only as good as or worse off than they were before. In short, capital formation and maintenance makes an individual and society more prosperous while capital consumption makes the individual and society poorer.

Ref: Man, Economy and State with Power and Markets, Murray Rothbard, pp 47-70

Applying Economics to daily life – The folly of Government trying to control school fee

In my last post, I introduced the idea of demand-supply curves as a useful tool for economic analysis. This time, I shall demonstrate the power of the tool to help us make sense of the world around us.

Understanding the effect of price control

Every now and then, the price of one or the other good becomes too high for the comfort of our “wise” politicos. The prompt response of those in government is to impose price controls by trying the stipulate how much producers may charge for that good. A very recent attempt at this is the ongoing effort by the state government of Tamil Nadu to prescribe the fee that schools may charge.

The toughest part of understanding price control (as it is in the case of any government intervention in the economy) is to understand the unintended effects of apparently well-intentioned actions. A sound understanding of the laws of economics enables us to do so.

Let us consider a product whose Demand-Supply curve is as given below.

Fig 1 – Demand-Supply Curve

Under equilibrium, the market throws up an equilibrium price of between 91 and 92 and the quantity exchanged is around 9 units. Along comes a politician or a government functionary who feels that a lot of people who wish to and need to consume the good are unable to do so. He comes to the conclusion that if he can force sellers to charge a lower price, many more people would be able to afford the good. So, he decides to pass an edict that no seller may sell the product at a price above 85. He is convinced that he is acting to benefit a number of people. But, is he? What actually happens?

This is best understood by super-imposing the price-ceiling of 85 on to the original demand supply curve. The result would be as below.

Fig 2 – Demand-Supply Curve with a Price Ceiling

As seen in the graphical representation above, at a price of 85, demand for the good is B (approximately 14 units) while the supply of the good is A (approximately 3 units). The result is therefore a huge mismatch between quantity demanded and quantity supplied. This situation is what we commonly call a shortage.

The good that is in short supply soon starts getting rationed. Whatever may be the method of rationing, a number of people who wish to consume the good have no way of doing so as suppliers are not willing to supply as much as they wish to consume. Thus, we see that the apparently well intentioned action of the politician results in an outcome exactly the opposite of what he hoped to achieve. The net result is that people are worse off than they were before the price ceiling was imposed.

Why will this be different in the case of education?

Frankly, it will not be. If the government tries to impose a price ceiling on education, the inevitable outcome will be that education will become unavailable to vast segments of the population that is willing to pay as per the price ceiling or even more in order to get the education. No attempt to evade this fundamental law of the market will work. In the case of education, the sufferers will be an entire generation or two of children who will be unable to get the education that is extremely critical for them to progress and prosper in their lives. What should we do as citizens? Would you be surprised if I said “Oppose this intervention tooth and nail”? What saddens me is that vast majority does not understand Economics and in fact supports this ill-thought out proposal. Talk of chopping off the very branch you are sitting on!

Key Concepts in Economics – 9 – Demand-Supply Curves and Economic Analysis

In one of my previous posts, I had explained verbally and numerically, the working out of demand and supply schedules for goods being exchanged. I had also explained there how price discovery and clearing of the market happens on the free market. In a subsequent post, I had further explained the concept of Total Demand to Hold and how its relation with Stock leads to the same price discovery and the matching of Stock and Total Demand to Hold.

I am devoting this post to giving a graphical form to those very ideas. These graphical forms are very useful tools that enable us to grasp important concepts in economics visually and hence quickly. As they say, a picture is equal to a thousand words.

Drawing Demand-Supply Curves

In an earlier post, I had developed a demand-supply schedule for horses and barrels of fish with 8 sellers and 9 buyers. Just for clarity, I repeat here the demand-supply schedule.

Price Demand Supply Price Demand Supply
80 9 0 91 4 6
81 9 1 92 3 7
82 9 1 93 3 7
83 9 2 94 3 7
84 8 2 95 3 7
85 8 3 96 2 8
86 7 3 97 2 8
87 6 3 98 2 8
88 6 4 99 1 8
89 5 5 100 1 8
90 4 6 101 0 8

Representing this on a graph with Price on the y-axis and quantity (of demand and of supply) on the x-axis, we get the following representation.

Fig 1 – Demand-Supply Curve

In this graphical representation, we see that the curve representing the demand schedule, henceforth called the demand curve, is downward sloping while the the curve representing the supply schedule, henceforth called the supply curve, is upward sloping. We also see that these 2 curves intersect at a point and the coordinates of point of intersection gives us the equilibrium pricing and the quantity exchanged under equilibrium.

For the sake of convenience, without any loss of generality, it is normal to smoothen out the two curves and represent the demand-supply curves as given below.

Fig 2 – Demand-Supply Curve Smoothened Out

In a similar manner, the Total Demand to Hold vs Stock schedule may be represented as below.

Fig 3 – Total Demand to Hold vs Stock Curve

The same curve may be redrawn after smoothening out the curves as below

Fig 4 – Total Demand to Hold vs Stock Smoothened Out

Why these graphical representations are considered very useful

Firstly, as I said earlier, they are useful in enabling us to imagine the processes that enable price discovery and clearing of the market. Secondly, they help us extend our understanding from a static to a dynamic pricing situation. For instance, they help us quickly answer the question “What will happen to equilibrium price and quantity exchanged if exchange demand increases at all price levels?”. This is represented in the graph below.

Fig 5 – Demand-Supply Curve with Increased Demand at all Price Levels

In this graph, the curve marked Demand + represents the curve of the increased demand schedule at all price levels. We note that the supply curve remains the same and that the point of intersection between the Demand + and Supply curves has moved to the right and upwards. In other words, we see that as a result of an increase in demand at all price levels, there would be an increase in the equilibrium price discovered (from P to P’) on the market as well as the final quantity exchanged at equilibrium (from Q to Q’).

While the same result could be obtained by drawing out tables consisting of the demand and supply schedules, the graphical method enables us to do the same visually and quickly. This is the primary reason these curves are used in economic analysis.

The analysis could be repeated with a number of scenarios – demand decreasing, supply increasing, supply decreasing, demand increasing with supply increasing, demand increasing with supply decreasing, demand decreasing with supply increasing and demand decreasing with supply decreasing. If you have been able to grasp the graphical method by now, you should be able to draw the relevant conclusions on equilibrium price and quantity exchanged at equilibrium in each of these situations without even drawing the graphs. The following table lists out the conclusions that we may draw.

Effect of changes in Demand and Supply schedules on Equilibrium Price and Quantity Exchanged at Equilibrium

Demand Supply Price Quantity Exchanged
+ Same + +
Same
Same + +
Same +
+ + ? +
?
+ + ?
+ ?

+ denotes an increase; – denotes a decrease; ? denotes “cannot be determined”

Thus, the graphical method of representing demand and supply schedules enables us to draw quick conclusions about important economic phenomena and could be used to simplify many an analysis. In subsequent articles, we will freely use this construct to simplify our analysis and the drawing of conclusions.

An important point of caution regarding demand-supply curves

While I have taken the demand-supply curves to be smooth curves (straight lines) for the purpose of representation, it would be erroneous to be taken in by the beauty of these curves and the insights they give us and get overly mathematical about economic analysis. We should never forget that the source of these curves and the graphical method of analysis is the demand-supply schedules that we draw up in each case and that the demand-supply schedule in itself evolves from the value scales of all the individuals that constitute the market.

Key Concepts in Economics – 8 – Analysis of Total Demand to Hold vs Stock

In an earlier post, I used an example of exchanging horses for barrels of fish to explain how demand and supply schedules for goods being exchanged are drawn out. I had also demonstrated how these demand and supply schedules explain the discovery of price on the free market. Finally, I had also mentioned that this process of drawing up demand and supply schedules based the principle of marginal utility is the basis of the commonly seen demand-supply curves used as an explanatory illustration in most Economics courses.

This time, I am going to take that process a step forward to develop another method of using the process of drawing up demand schedules to understand how price discovery happens on a free market, particularly with a given total stock of goods. This tool is a useful counterpart of the exchange demand vs supply curve we drew earlier and will help us understand that supply schedule too evolves from the concepts of utility and marginal utility.

Revisiting the demand and supply schedules

In the case we had studied earlier, we had used the following scenario. There were 9 people with barrels of fish to offer in exchange for horses and 8 people with 1 horse each to offer in exchange for the fish. Based on a set of assumptions about the value scales of each individual, we drew up the following demand-supply schedule.

Price Demand Supply Price Demand Supply
80 9 0 91 4 6
81 9 1 92 3 7
82 9 1 93 3 7
83 9 2 94 3 7
84 8 2 95 3 7
85 8 3 96 2 8
86 7 3 97 2 8
87 6 3 98 2 8
88 6 4 99 1 8
89 5 5 100 1 8
90 4 6 101 0 8

In this case, at equilibrium, 5 horses are exchanged. Specifically, sellers S1 to S5 sell their horses to buyers B1 to B5 and obtain barrels of fish in exchange. Buyers B6 to B9 were the less capable buyers who valued 89 barrels of fish above a horse while sellers S6 to S8 were the less capable sellers who valued a horse above 89 barrels of fish.

Let us now look at this scenario from a slightly different perspective. The total stock of horses on the market is 8. All stock has to necessarily be in the possession of and be the property of someone. This stock of horses was originally in the possession of sellers S1 to S8. Finally, they are in the possession of buyers B1 to B5 and sellers S6 to S8. However, the total stock remains 8 under all circumstances.

At every price in the table above, there are two aspects of demand. The first is what we may call the exchange demand, i.e., the demand from buyers eager to buy horses. The second is what we may call reservation demand, i.e., the demand from sellers of horses who prefer to hold the horses rather than sell them at any price. Why would sellers prefer to hold their horses? There could be 3 reasons.

  1. The use value of the horses is more than the use value of the number of barrels of fish offered in exchange
  2. The exchange value of the horses with respect to another commodity is higher than the use value of the number barrels of fish offered in exchange
  3. The seller is speculating that the future price of his horse would be better and sees greater value in selling it later at the higher price

In either case, the utility of the horse is greater than the utility of the barrels of fish being offered. Whether it is exchange demand or reservation demand, it constitutes what we may call demand to hold horses. In simple terms,

Total Demand to hold = Exchange Demand + Reservation Demand

Price Total Demand to hold Stock Price Total Demand to hold Stock
80 17 8 91 6 8
81 16 8 92 4 8
82 16 8 93 4 8
83 15 8 94 4 8
84 14 8 95 4 8
85 13 8 96 2 8
86 12 8 97 2 8
87 11 8 98 2 8
88 10 8 99 1 8
89 8 8 100 1 8
90 6 8 101 0 8

This is the total demand to hold horses from buyers and sellers put together. For instance, at a price of 85 barrels of fish for a horse,

  • Exchange Demand = 8
  • Reservation Demand = 5 (8 original sellers – 3 sellers willing to sell)
  • Total Demand to hold = 8 + 5 = 13

However, the stock of horses available is only 8. There is thus a greater demand to hold horses than are available. This perceived shortage leads to overbidding by those eager to possess horses, sending prices up.

At another sample price of 92 barrels of fish for a horse,

  • Exchange Demand = 3
  • Reservation Demand = 1 (8 original sellers – 7 sellers willing to sell)
  • Total Demand to hold = 3 +1 = 4

However, the available stock of horses is still 8. There is thus a greater stock of horses than there is demand to hold them. This perceived glut leads to underbidding by holders eager to get rid of their stock of horses, sending prices lower.

At a price of 89 barrels of fish for a horse,

  • Exchange Demand = 5
  • Reservation Demand = 3 (8 original sellers – 5 sellers willing to sell)
  • Total Demand to hold = 5 +3 =8

We see that at this price, the available stock of horses is equal to the total demand to hold them. There is thus no perceived shortage or glut and hence the price tends to remain at this same level. We also see that supply is just the difference between the total stock (a physical quantity) and the reservation demand on the part of the sellers, which in turn is a reflection the utility of the horses to the current possessors (the sellers with reservation demand).

Thus we see that supply is also a function of the utility just as demand is. We also see how the market is cleared when the underbidding and overbidding above and below the equilibrium price drive prices towards equilibrium and remove the mismatch between total stock and total demand to hold.

This perspective of demand and supply and the process of price discovery is a counterpart of the exchange demand vs supply analysis we did earlier. Its main disadvantage is that it does not tell us the quantity that would be exchanged at the equilibrium price. However, it has its advantages in particular situations as we will see in later articles.

Key Concepts in Economics – 7 – The Nature of Revenues, Costs and Profits

If you ask any common person basic questions like “What is revenue?”, “What is cost?” and “What is profit?”, you are likely to get an answer revolving around money. Revenue, you will be told, is the total money you get through sale, cost is the total money expenditure you incur and profit is the net of money revenue over money costs. When money revenue is less than money costs, we say that the person has made a loss. This explanation is perfect from an accounting perspective. Since money is the unit of account, it makes perfect sense to define these terms in this manner.

In economics, however, these terms are defined differently. All these terms are defined around the concept utility. Consider a simple example where A sells 2 horses to B in exchange for a cow. Let us analyse the position of A and B just prior to the sale. This analysis, in economic terms, is called ex ante analysis and against ex post analysis which is done after the exchange happens.

Ex ante, A’s revenue can be of 2 forms

  1. The use value of the cow – This is the utility he gets by using the cow in the service of his own ends
  2. The further exchange value of the cow – This is the utility he gets by consuming some other good that he could exchange the cow for in the future

Similarly, ex ante, A’s cost can be of 3 forms

  1. The foregone use value of the 2 horses – This is the utility he foregoes by losing the opportunity to use the 2 horses in the service of his own ends
  2. The foregone exchange value of the 2 horses for some other good – This is the utility foregone in terms of the other goods that he could exchange the 2 horses for
  3. The foregone opportunity to exchange the 2 horses for something more than 1 cow – While this sounds silly with cows (considering you can’t get ½ a cow), let’s try imagining it with a divisible good. Even in this case, it is the utility of the goods he gets in the future that is relevant.

A’s revenue would be the higher of the 2 utilities he may get and his cost is the highest of the 3 utilities he may forego. The case would be the reverse for B with the words horses and cows swapped for each other.

Thus, A engages in the exchange if his utility received exceeds the utility foregone in the exchange. The same is the case for B, except that his valuations would have to be the reverse of that of A.

In the process, if A feels that the utility received exceeds the utility foregone, he is better off or has attained a profit. However, given that utility is a subjective assessment of the usefulness of a means in satisfying an end and that it is ordinal in nature, how is one to “calculate” A’s (or B’s) profit? Frankly, it just cannot be. Not even the parties to the transaction can. All they can say is that by their subjective assessment, they are better off. This feeling of being better off is essentially a psychic phenomenon. Therefore, in economics, it is said that real profits are psychic profits. Psychic losses are not possible ex ante because man acts to exchange because he assesses himself to be better off as a result.

Thus, we see that in any exchange, both parties to the exchange profit ex ante. The situation could be different ex post. Having exchanged the 2 horses for the cow, let us say that A realizes that he is worse off as a result of the exchange. That knowledge has no bearing for the exchange itself. What it can do is to serve as knowledge that will guide his choices in future exchanges.

What do we learn from this?

The next time you walk into an outlet of Barista or Café Coffee Day and order a cup of coffee and wonder why you should pay Rs. 50 or more for just a cup of coffee, just remember that you are doing so because the cup of coffee in that environment is of greater utility to you than the Rs. 50 or more that you forego. In fact, it has greater utility for you than anything else you can do with that Rs. 50 at that time. So, rather than add to your acidity moping over the “high” price of the coffee, just sit back, enjoy the coffee and thank the owners of the coffee shop for agreeing to trade with you.

Key Concepts in Economics – 6 – Indifference and the Action Axiom

I am devoting this post to exposing a key fallacious notion taught in many B-Schools and Economics courses at colleges and universities across the world. The reason for doing this is that in my opinion, this fallacious notion is primarily responsible for making economics unintelligible for anyone without a hard-core mathematics background. It is the starting point of many a fallacious notion that makes economics the “dismal science” that it is called today. As a person who thinks Economics is the most wonderful subject you could learn, this pains me no end. This article is an attempt at relieving that pain. I hope you like it too.

The key fallacy in Economics as it is taught today

These days, anyone who attends a serious course in Economics at the graduate, post-graduate or MBA level is taught a concept called “indifference”. As ordinary people, we are accustomed to using the words “indifferent” and “indifference” rather commonly. Type out the word “indifferent” on http://dictionary.com and these are the results you will get.

http://dictionary.reference.com/browse/indifferent

Of the many meanings out there, the ones most relevant to economics, especially the notion of indifference as taught in economics courses, are meanings 6 and 9, more so the latter as it implies a person making no difference or distinction. Therefore, I take meaning 9 – “making no difference or distinction, as between persons or things”.

What does the term “indifference” mean in Economics?

In Economics too, indifference means the same thing. When you say “I did pick up a plain white shirt but I would just as well have picked up a blue shirt”, it is said that you have expressed “indifference” in an economic sense. While the white shirt and the blue shirt are apparently “different” things, you did not see the differences as material and hence that you are economically “indifferent”.

Why is it important to understand that indifference is a fallacious concept?

The concept “indifference” is used to counter the concept of preference. In an earlier post, I had mentioned that action implies preference. If indifference were possible, it is possible that action can happen without preference, then it would be fallacious to state that action implies preference and hence that the action axiom leads to the conclusion of a hierarchy of values ranked on a single value scale.

From this point, proponents of the notion of indifference move many steps further and develop an entire body of economic theory based on utility functions, differential calculus including differential equations, indifference curves, etc. This entire body of economic theory is so mathematical and complex that it is not possible for a person without a strong foundation in Mathematics to understand it. As a sample, read this page.

http://en.wikipedia.org/wiki/Indifference_curve

While Wikipedia is probably not the most authentic source of information or understanding about anything at all, leave alone indifference curves, just note the mathematical complexity of that page and imagine how mathematically complex a serious academic explanation of indifference and indifference curves and the body of economic thought based on it would be!

At that rate, it would take an entire life-time to learn economics! That very thought sends a shiver up my spine. Economics is the body of knowledge that tells us how the world of human beings works. If a life-time is what it takes to get a grip on economics, it surely is not worth it for most people to bother themselves with learning it. After all, so many people get along fine without learning economics.

However, if the concept of indifference is fallacious, there are two implications. Firstly, the entire body of mathematical economics falls apart. Secondly, it makes the “subjective preference” based approach to economics that I have been trying to outline in my previous posts a very plausible and in fact a very sound one. Further, the “subjective preference” based method makes economics very easy to learn. Take me for instance. I learnt the entire body of economics that I write about all on my own by just reading a series of books and applying my mind to the logical arguments contained in those books. I did not learn it in my MBA programme at IIM Ahmedabad. What I learnt then was in fact the very mathematical economics I am trying to dismantle in this post. And it took me just about 3 years of reading books without taking a break from running my own business.

This means that you too could learn it. That  in turn means that understanding why the world works the way it does will not take a life-time but just a few months of diligent study. Now how’s that for an attractive prospect! So, here I go demonstrating why the concept of indifference is either fallacious or insignificant for a study of economics. Note that I am not saying that when you say you are indifferent between two options, you don’t know what you are talking of. Rather, I am going to show how the concept indifference has no place in a study of economics.

How the Action Axiom demolishes the concept “indifference”

Action is the purposeful striving towards ends. Without ends, the concept action is superfluous. However, the concept action is undeniable. Hence, it is equally undeniable that human action has ends it seeks to achieve or satisfy.

Ends are ranked on an ordinal scale of value. This is simply so because man, as the originator of his own ends, has unlimited ends. However, in any action that seeks to satisfy an end, there are many ends that are not sought to be satisfied. If you choose to satisfy end A rather than end B, it can only mean that you now prefer satisfaction of end A to satisfaction of end B. To say otherwise would be to deny purpose and hence to deny action. The concept action, however, is axiomatic and undeniable.

Further, any preference for one end over another is essentially a subjective preference and all you can say is “I’d rather satisfy end A than satisfy end B”. What you cannot say is “I prefer satisfaction of end A x% more than I prefer satisfaction of end B”. To understand the silliness of a statement of that kind, I suggest you make a list of your five best friends and list out by what percentage you prefer each more preferred friend to any other less preferred friend.

All this leads us to only one conclusion – that ends are ranked on an ordinal scale of value. The very fact that we have to choose satisfaction of one end over that of another also means that equality of ranks on this ranking scale is impossible. Thus, we see that the action axiom renders indifference over ends impossible.

That leaves us with the job of addressing the claim of relevance of the concept indifference in the area of means. Before we do that, however, we need to understand how the concept of indifference enters the analysis of ends-and-means.

Indifference and the analysis of means and ends

The main claim of proponents of indifference is that if A prefers good X to good Y at an exchange ratio p/q but prefers good Y to good X at an exchange ratio p1/q1, there exists some ratio between p/q and p1/q1 where A is indifferent between good X and good Y. This sounds perfectly plausible if utility of each good were a smooth function, i.e., without any abrupt jumps in utility. We use this notion in mathematics when we say that if a continuous function were to take a positive value at x1 and a negative value at x2, there must exist at least one point between x1 and x2 where the function takes a value zero.

While this concept makes perfect sense for continuous functions, to apply it to utility and claim that there is a point where the utilities of the two goods are equal, one needs to first assume that utility itself can be represented as a continuous function. To do that, one needs to be in a position to measure utility. This is where the attempt to apply a perfectly sensible mathematical principle to an economic concept fails.

Utility is a subjective assessment of the usefulness of a means towards satisfaction of an end. As a subjective assessment, it is not quantifiable by anyone at all, leave alone someone other than the acting individual. You can never know my utility and hence have no means to comment on “how much” my utility is with respect to a particular means towards satisfaction of a particular end. To even talk of utility functions is therefore fallacious. To talk of utilities being equal and hence that there exists a point of indifference is even more fallacious.

Secondly, the preference of the individual is known only at the points x1 and x2. How can one even talk of what the preference would be between the two points? The preferences at x1 and x2 are all that are revealed through the individual’s action of engaging in exchange of one good for another.  Does it even make sense to talk of points in between?

Thirdly, imagine that A accepts an exchange of 3 horses for a cow but rejects an offer of 2 horses for a cow, does it mean that there is some ratio, say 2.6935 horses for a cow at which A would be indifferent between horses and cows? The silliness of this notion is apparent with horses and cows. “But what about perfectly divisible goods?”, the proponent of indifference would respond.

This is where these proponents reveal their complete lack of understanding of economics per se. As I have explained in a previous post, an “economic good” is a means applied towards the satisfaction of an end. The utility of a good is a subjective assessment of its ability to satisfy ends. There are two scenarios possible.

Firstly, the 2.6935 horses (let us assume that “horses” here denotes a perfectly divisible good) could be applied to an end different from that to which the 1 cow could be put. In that case, it is impossible for the individual to not prefer the 2.6935 horses or the 1 cow because one of them must satisfy an end ranked higher on his value scale. To claim indifference will have to mean that the person is deliberately ready to forego satisfaction of a higher valued end to satisfy a lower valued end.

Secondly, the 2.6935 horses and the 1 cow may be applied to the satisfaction of the same ends and provide the same level of satisfaction of that end. In that case, the 2.6935 horses and the 1 cow are the same economic good. This means that while they may have a number of different physical characteristics, the only characteristic that matters to the individual is their ability to satisfy the same end. They are in effect the same for economic purposes and not different goods. Indifference is the act of not recognizing differences that exist because they do not matter. In this case, there are no differences. They are the same economic good. What is the meaning of talking of not recognizing non-existent differences?

If one were to insist that one good is 2.6935 horses and the other is one cow and that they are different “things”, one makes the classic error of mistaking a thing for a good. Different “things” can be the same economic good if they are perfect substitutes in the satisfaction of the same end. This concept was best demonstrated in the case of US railway companies which thought that people had a demand for “train travel” and hence failed to see the competition from roads and airlines. What people were looking for was satisfaction of the need for “transportation” and when roads and airlines served that need better and at lower cost, they switched. To those people, trains, cars and aeroplanes were the same economic good “means of transportation”. Economics does not deal with “things” but with goods. Only scarce things can be goods. But the “good” in the good is the satisfaction of ends it provides and not its physical composition.

Even if one were to be charitable to the notion of indifference among different units of the same economic good, one can only say that it is superfluous as it has no bearing on the action axiom and the concept of preference. If I am indifferent between 2 goods that satisfy the same end to the same extent, it says nothing about preferences for different ends and preferences for economically different goods. In particular, it shows that the attempt to use the concept indifference for a pair of economically different goods, which is what indifference curves are all about, is fundamentally flawed. Thus, a proper application of the action axiom helps us see the fundamental flaw in the concept of indifference and the popular approach to Economics.

Applying this learning to the white shirt-blue shirt indifference

Very simply put, there are no economic goods “red shirts” and “blue shirts”. There are “red or blue shirts”. Whether he picks up a red shirt or a blue shirt, he is picking up the same good. Hence, to talk of indifference is either erroneous or superfluous.

Key Concepts in Economics – 5 – Insights from the Analysis of Exchange – Use Value, Exchange Value, Specialisation, Division of Labour and the Law of Comparative Advantage

One of the most basic inferences we can draw from the fact that people engage in exchange is that they must be exchanging different things. If Smith and Jones both produced wheat, there is no rationale for them to engage in exchange. This simple point leads us to some truly amazing bits of understanding of production and exchange.

Let us say that Smith produces wheat while Jones produces rice. Each consumes a part of his produce while offering the balance in exchange for the produce of the other person. To Smith, his crop of wheat has two dimensions of value. The first is the direct use value he gets by consuming the wheat himself. The second is the exchange value he gets in the form of the rice it enables him to get in exchange and consume.

At any point in time, a good may have use value and exchange value. Which of these two is higher is what determines the course of action followed by the individual concerned. Take for instance custom-made spectacles. It is highly unlikely that anyone else has the same eye defect as you do and hence that they would have any use at all for it. Therefore, your spectacles have little exchange value for you and you tend to use them rather than exchange them.

These values may also change with time and circumstances. Something that has a high use value today may have little tomorrow. A familiar example is the tricycle you loved when you were a child but have little use for once you grew older. You would rather exchange it (if you could) for something you value more today, say a couple of rare stamps. Some things may have high exchange value, but circumstances may cause a drop in the exchange value leading to its being used rather than exchanged. Let’s say you are an expert glass-blower who has produced a piece that is wonderful except for a small bubble. This defect greatly reduces the exchange value of your piece and you may therefore decide to keep it in your own house as a display piece rather than sell it.

So what’s interesting about this understanding of use value and exchange value? What’s interesting in the example of Smith producing wheat is his decision making prior to the act of producing the wheat. Even before he produces wheat, Smith knows that his crop of wheat can give him more things to consume than the wheat itself. As long as he is reasonably certain that there would be other people producing the other things that he would like to consume and that they would in turn be interested in acquiring some of his wheat crop, he may produce wheat not just for his own consumption but also for the purpose of exchanging it for other goods he would like to consume.

Thus, Smith produces wheat not just for himself but for the market as well. In doing so, he is also making an important choice – to specialise in the production of one commodity, wheat. Jones too is making a similar decision to specialise in the production of one commodity, rice. Likewise, a number of other people decide to specialise in their respective trades and professions, offering their produce to others in exchange for the produce of these others. While every person may require many more goods than they themselves produce, they divide the task of producing all the goods among themselves so that each may specialise in that which is in his best interest to produce. This process, which is a logical corollary of specialisation, is what we call division of labour.

Factors that drive specialisation and division of labour

Specialisation is primarily an outcome of the special conditions of the 3 primary factors of production – land, labour and capital goods. Smith may live in a part of the world where the soil and climatic conditions are more suitable for the cultivation of wheat than it is for the cultivation of any other crop. His knowledge and skills and those of the people he may employ to work for him may be knowledge handed down by their forefathers who have in turn cultivated little other than wheat. The kind of capital goods he has at his disposal too may be more suited to wheat cultivation than for rice, vegetables or any other crop. If he were to switch crops, he may simultaneously be wasting the capital goods he has in his possession and investing in a whole new set of capital goods for rice or vegetable cultivation.

Other factors that influence the choice of specialisation are the use value and exchange value of the goods that a person could produce.

Outcomes of specialisation and division of labour

Specialisation and division of labour lead to the particular pattern of exchange based relationships that we call the market. It is the existence of and in fact people’s knowledge of the existence of the market that makes it possible for people to make any plans at all for their production. It is the existence of a market for wheat that tells Smith that he could produce more wheat than he could ever consume because the market makes it possible for him to exchange his surplus for other goods that he wishes to consume as well.

Specialisation and division of labour also lead to greater productivity in the market as a whole. If Smith can produce more wheat per unit of effort than Jones can and Jones can in return produce more rice per unit of effort than Smith can, it is in the interest of both of them that Smith specialises in producing wheat and Jones in producing rice. The total output of wheat and rice is likely to be higher in the event of specialisation than if both of them were to produce both crops.

A common point of opposition to this concept is “What if Smith is better than Jones at growing wheat and rice? Won’t he then produce more of both leaving Jones with nothing to produce and offer in exchange? Does Smith then not corner the entire market and leave the others dependent on him?” This objection is handled effectively by a simple principle called the law of Comparative Advantage.

The Law of Comparative Advantage

This law, also known as the Law of Association, essentially states that exchange may beneficially take place even when one party is superior in both of two available lines of production. A highly skilled heart surgeon may be a far better nurse than the best nurse he can employ, but he would find it more beneficial to leave the job of nursing to professional nurses, thus freeing himself to conduct more heart surgeries.

Just to put some numbers behind this*, let us consider the following example. Let A be better than B in the manufacture of products p and q. Let us assume that to produce 1 unit of p, A takes 3 hours against B’s 5 hours while to produce 1 unit of B, A takes 2 hours against B’s 4 hours. Even in this case, while A has an absolute advantage over B in the manufacture of p and q, it makes sense for A to focus on the manufacture of q leaving the manufacture of p to B. This is because while A has a comparative advantage over B of 5/3 in the manufacture of p, he has an advantage of 4/2 or 2 in the manufacture of q. It is the difference in the comparative advantage in p and q rather than the absolute advantage in both p and q that makes it better for A to specialise in manufacturing q rather than to manufacture both products.

This can be understood even better using a little simple arithmetic. Let us say that A and B both devote 120 hours to manufacture p or q. If we assume that both A and be divide their time equally between manufacture of p and q, their quantities manufactured would be as below

  • A – 20 units of p + 30 units of q
  • B – 12 units of p + 15 units of q

Thus, the total produce of A and B is 32p+45q. Now let us assume that A specialises in manufacturing q leaving the manufacture of p to B. Their quantities manufactured would be as below.

  • A – 60 units of q
  • B – 24 units of p

Thus, the total produce of A and B is 24p+60q. To make this comparable with the previous figure 32p+45q, we could see what each means to A and B in terms of either p or q. This is possible because in the time taken to manufacture 1 p, A could manufacture 3/2*q while B could manufacture 5/4*q. Thus, the two combinations work out into q equivalents for A and B as below

Total Output For A For B
32p+45q (32*3/2)q+45q = 93q (32*5/4)q+45q = 85q
24p+60q (24*3/2)q+60q = 96q (24*5/4)q+60q = 90q

Thus we see that A and B are both better off by specialising. This mathematical demonstration only illustrates what we saw intuitively in the case of the specialist heart surgeon and the nurse.

Summary

A careful and systematic analysis of exchange gives us an understanding of some important ideas such as use value and exchange value. Taking this train of reasoning further helps us understand fundamental principles of economic organisation such as specialisation and division of labour. The Law of Comparative Advantage takes these ideas much further and tells us how specialisation and the division of labour are actually inevitable and are beneficial to all participants in the system of exchange that we call the market.

*Based on the example given in pp 159-160 of Human Action by Ludwig von Mises

Key Concepts in Economics – 4 – Means, The Role of Time, Consumers’ and Producers’ Goods, Factors of Production, Structure of Production

Human action involves the application of objects found in acting man’s environment to satisfy his ends. These objects can be classified into two types

  1. those that are for all practical purposes unlimited, e.g., air, sunlight – These are called the general conditions of action. There is no need for man to economise on these. He may use these as much as he wishes to and can do so in order to achieve his ends.
  2. those that are scarce, e.g., land, water, minerals, food, etc – These are called means. As they are scarce, man has an inherent need to economise on them. Action involves application of specific quantities of means towards achieving ends.

Time as a means

As explained earlier, all action takes place in time and is directed at rendering conditions at some time in the future more satisfactory than it would be without the action. Time for man is essentially a scarce resource because applying the available time to satisfy one end means that many other ends remain unsatisfied. Therefore, time is a means to acting man and he therefore acts to economise his time. The amount of time involved in an action is certainly a factor in man’s choice of action including which ends to satisfy.

Economic Goods

Means used to satisfy wants are called goods. Such goods fall into two categories.

  1. Those that are used to directly satisfy ends – These are called consumers’ goods
  2. Those that are used to produce other goods that directly or indirectly satisfy ends – These are called producers’ goods or higher order goods

To illustrate this concept, let us use a simple example. Let’s say you are watching a cricket match at home and wish to munch on a bowl of popcorn as you do so. When your mother walks up to you to give you a bowl filled with popcorn, the popcorn is a good that directly satisfies your end – consuming popcorn. It is a consumers’ good.

However, you know perfectly well that the bowl of popcorn is not going to materialise if you were to sit in front of your television and wish that it would. Getting the bowl would require the cooperation of a number of scarce means applied for the purpose of getting you your bowl of popcorn. Your mother will need to pick up the corn, oil, salt and spices (scarce means), mix them in a suitable vessel (a scarce means) using a suitable ladle (a scarce means), switch on the stove (a scarce means) that runs on gas (a scarce means), heat the vessel with the mixture of ingredients over the flame till all the corn pops, pour it in a bowl (a scarce means) and walk from the kitchen to where you are seated so that you may enjoy the popcorn without interrupting your viewing of the cricket match. In all this, there are other scarce means such as your mother’s labour, her time, the space in the kitchen and the table on which she does her work.

All the scarce means that went into converting the ingredients into the popcorn in the bowl in your hand did not directly serve the end of consuming the popcorn but made the popcorn ready for consumption. These are called producers’ goods or higher order goods. One may walk another step back in time to the stage before all the scarce means listed above had to be made available for the purpose of being transformed into popcorn. In particular, all the factors other than your mother’s labour and her time need to be produced by the application of producers’ goods of a higher order, labour and time before they could be applied to produce the consumers’ good, the popcorn in the bowl in your hand.

If one takes sufficient steps back in time, one reaches a stage where there was nothing except the elements of nature and human labour. From this point on, the application of human labour enabled the transformation of the scarce means available in their natural state into producers’ goods of various stages till the final consumers’ good was ready for consumption. Clearly, such a process of production involves many stages each of which takes the output of previous stages as its input and produces its own output that may either be used in further stages of production or be directly consumed. This systematic organisation of the process of production is what we may call the structure of production.

The role of time in the analysis of the structure of production

It is also clear that each stage of the structure of production takes a certain amount of time. The total time taken for the production of the consumers’ good is the sum of the time taken in all the different stages of the structure of production put together. Except for the final stage, all the stages of the structure of production produce goods not for immediate consumption but for consumption in the distant future. In fact, in any advanced economy, only a small fraction of the total structure of production would be devoted to the production of consumers’ goods while the rest would be devoted to the production of producers’ goods.

Further, once we recognise the indispensability of the factor, time, in the process of production, we are also in a position to recognise that it is possible to categorise different stages of the production structure into stages closer to or remoter from the stage of consumption. The final stage is the one that leads to the output of consumers’ goods. The producers’ goods that go into this stage are called first order producers’ goods. The capital goods that go into the previous stage to produce first order producers’ goods are called second order producers’ goods and so on.

In fact, it is the recognition of the role of time and the identification of producers’ goods of different orders that gives us a systematic and coherent definition of production. Production is the process of transforming higher order producers’ goods into consumers’ goods or into lower order producers’ goods.

Further classification of producers’ goods

In the example used above, apart from time, there are two broad classes of producers’ goods that go into any stage of the production process. These are

  1. Goods that occur in nature – These may be divided into two further categories
    1. Land (which includes goods derived from land)
    2. Labour or the application of human energy
  2. Goods that need to be produced – These are called capital goods

Of these, land and labour are called the original factors of production while capital goods are called the produced factors of production. Every process of production thus involves the application three factors of production – land, labour and capital goods – to produce consumers’ goods or lower order producers’ goods.

One more factor of production

Mere possession of land, labour and capital goods does not make a production process. One needs to have a “technological idea” of how to transform the 3 primary factors of production into the desired producers’ or consumers’ good. This technological idea, which may be viewed as a “recipe”, once produced, need not be learnt again. However, its production is indispensable to the production process. In the example used above, the knowledge that corn, oil and salt need to be mixed together and then be heated over a flame to produce popcorn is the technological idea in the absence of which no amount of use of materials, labour and time may result in the desired consumers’ good. However, once one knows the recipe, it is infinitely reproducible and may be used over and over again without needing to be “produced” each time.

Summary

A systematic analysis of means from a perspective of analysing human action leads us to an understanding of the classification of means in terms of their direct and indirect use in the achievement of human ends, i.e., as consumers’ goods and producers’ goods. A further analysis of the process of production leads us to realise that a process of production involves many stages each of which transforms producers’ goods into consumers’ goods or other producers’ goods closer to the stage of consumption. The sum total of all the stages of production is called the structure of production. The role of time in the process of human action also enables us to classify different stages as stages closer to or remoter from the stage of consumption. This enables us to categorise producers’ goods into different orders based on how close to or remote from the stage of production of consumers’ goods they are employed. This further enables us to give a clear and coherent definition of the term production. A further careful analysis of the category producers’ goods leads us to the identification of 3 factors of production that go into any process of production – land, labour and capital goods. The first two are together called the original factors of production and the third, the produced factors of production. All these factors are integrated by the technological idea or the recipe that enables the transformation of the three primary factors of production into the desired producers’ or consumers’ goods.

Key Concepts in Economics – 3 – Subjective Value to Exchange and Price discovery

In my previous post, I had touched upon the basic concepts value, utility, marginal utility and total utility. In particular, I had emphasized the nature of these important economic concepts – their subjective and ordinal nature. This time, I shall take the process of reasoning a few steps further and demonstrate the mechanisms that drive exchange and price discovery on the free market.

Ends, Means, Value Scales and Human Action

Consider a man who has a variety of ends that he seeks to attain through the employment of cows and horses. Let’s further say that the first cow satisfies the most valued end, the first three horses satisfy the next three most valued ends, the next cow satisfies the next lower valued end and so on as per the table below.

Ranking of End Satisfied by
1 Cow 1
2 Horse 1
3 Horse 2
4 Horse 3
5 Cow 2
6 Cow 3
7 Horse 4
8 Cow 4
9 Horse 5
10 Cow 5
11 Horse 6
12 Horse 7
13 Cow 6
14 Cow 7

Let us try to understand how the man would act if he had a certain number of cows and horses and faced choices. Let us start with the scenario that he has 3 cows and 4 horses. Let us also suppose that he has to give up 1 animal – a horse or a cow. Which would he forego? Clearly, the 3rd cow satisfies an end ranked higher than then end satisfied by the 4th horse. Hence, he would give up a horse and be left with 3 cows and 3 horses. If instead of 3 cows and 4 horses, he started off with 2 cows and 3 horses and faced the same choice of giving up 1 animal, we see that the 2nd cow satisfies an end ranked lower than the end that the 3rd horse satisfies. Hence, he would give up a cow rather than a horse.

If on the other hand, the man starts off with 4 cows and 4 horses and has the option of adding one animal to his stock, which one would he add? Clearly, the 5th horse satisfies an end ranked higher than the end satisfied by the 5th cow. Hence, he would have to add a horse to his stock. To take another example, let us assume that he starts off with 3 cows and 3 horses and faced the same option of adding an animal to his stock. From the table above, we see that the 4th horse satisfies a higher ranked end than that satisfied by the 4th cow. Hence, he would choose a horse rather than a cow.

Many men and the phenomenon of trade and price

Let’s say there are 2 men – Smith and Johnson. Smith has barrels of fish and wishes to trade some barrels for a horse while Johnson has a horse and seeks to trade it for some barrels of fish. Let’s say their value scales are as below. Items in brackets are what a person does not have but has ranked on his value scale.

Smith Johnson
103 barrels of fish (103) barrels of fish
102 (102)
101 A horse
(A horse) (101) barrels of fish
100 barrels of fish (100)
99 (99)
98 (98)

In this case, 100 barrels of fish is Smith’s maximum buying price for a horse while 102 barrels of fish is Johnson’s minimum selling price for a horse. Clearly, Johnson would not trade his horse in for anything less than 102 barrels of fish because doing otherwise would require him to act to lower his own utility. Smith, on the other hand, would not trade anything more than 100 barrels of fish to acquire a horse because offering more than that would require him to act to lower his own utility. Thus, we see that no trade is possible between Smith and Johnson.

If on the other hand, Johnson’s value scale were as below,

Johnson
(84) barrels of fish
(83)
(82)
(81)
A horse
(80) barrels of fish
(79)

Smith’s maximum buying price of a horse would be 100 barrels of fish while Johnson’s minimum selling price of a horse would be 81 barrels of fish. Thus, we see that there is scope for Smith and Johnson to exchange a horse for anything from 81 to 100 barrels of fish and with both attaining positions higher on their value scales as a result of the exchange. We thus note an important point about trade – for trade to happen, the maximum buying price of the buyer has to be higher than or equal to the minimum selling price of the seller. Thus, we see in this case that the price of a horse can be any number from 81 to 100 barrels of fish. The exact figure would depend on the circumstances and the negotiating skills of Smith and Johnson.

This mechanism of price discovery becomes more complicated with the addition of more buyers and sellers in the market. Let’s for instance include another buyer of horses, Brown and let’s assume that their value scales are arranged as below.

Smith Brown Johnson
103 barrels of fish 93 barrels of fish (84) barrels of fish
102 92 (83)
101 91 (82)
(A horse) (A horse) (81)
100 barrels of fish 90 A horse
99 89 (80) barrels of fish
98 88 (79)

In this case, Smith’s maximum buying price is 100 barrels of fish while Brown’s maximum buying price is 90. Johnson, on the other hand has a minimum selling price of 81 barrels. Clearly, Johnson could trade with either Smith or Brown and be better off. For any price Brown offers, Smith is in a position to “outbid” him by offering a higher price that is still lower than his maximum buying price. If and when Smith offers 91 barrels of fish for the horse, Brown drops out of the race as any higher price would leave him giving up a higher ranked end to satisfy a lower ranked end. In such a circumstance, we call Smith the more capable buyer and Brown the less capable buyer. The actual price in such a circumstance would be high enough to exclude the less capable buyer though the exact price would be somewhere above the maximum buying price of the less capable buyer and up to the maximum buying price of the more capable buyer. Specifically, the price in this case could be anything from 91 to 100 barrels of fish and the exact price would depend on the circumstances and on Smith’s and Johnson’s negotiating skills.

On similar lines, when there are two sellers, the more capable seller would be the one with the lower minimum selling price while the less capable seller would be the one with a higher minimum selling price.

Let us now extend this case to a situation where there are multiple buyers and sellers. Let their maximum buying prices and minimum selling prices be as below.

Buyer Maximum Buying Price Seller Minimum Selling Price
B1 100 S1 81
B2 98 S2 83
B3 95 S3 85
B4 91 S4 88
B5 89 S5 89
B6 88 S6 90
B7 86 S7 92
B8 85 S8 96
B9 83

Let us assume that each seller has exactly 1 horse to sell. Let us draw out a table of the number of horses that would be offered by sellers (supply) and asked for by buyers (demand) at various prices from 81 to 100 barrels.

Price Demand Supply Price Demand Supply
80 9 0 91 4 6
81 9 1 92 3 7
82 9 1 93 3 7
83 9 2 94 3 7
84 8 2 95 3 7
85 8 3 96 2 8
86 7 3 97 2 8
87 6 3 98 2 8
88 6 4 99 1 8
89 5 5 100 1 8
90 4 6 101 0 8

We see from the above table that at a price of 89 barrels of fish, the supply of horses is equal to the demand for horses and the market is said to be cleared at this price. There is no surplus or shortage of horses. At any price higher than this, it is possible for more capable sellers to outbid less capable sellers by bringing the price down. At any price lower than this, it is possible for more capable buyers to outbid less capable buyers by pushing the price up. Thus, we see that the market clearing price is also an equilibrium price towards which the market price of horses tends.

The table of the quantity supplied at each price level may be called the supply schedule for horses and the table of the quantity demanded at each price level may be called the demand schedule for horses. A graphical representation of the 2 tables (using the example described above) plotting the price at each quantity demanded and supplied will give us a very clear illustration of the principle of price discovery and equilibrium price and will show how the commonly used demand curves and supply curves of any good actually evolve from the process of reasoning explained above.

From the data in the table above, we can see that the Demand “curve” would be downward sloping and that the Supply “curve” would be upward sloping. This principle, demonstrated with horses priced in terms of barrels of fish, is applicable to any good priced in terms of any other good.

We also note that the demand and supply schedules, the identification of the equilibrium price and our understanding of the equilibriating process stems from our ability to draw up a hierarchy of values for each actor for each set of goods involved. This in turn is made possible by our understanding of the concepts value, utility, marginal utility and total utility as applied to ends and means, which in turn is a straightforward logical corollary of the action axiom.

Conclusion

The action axiom and its logical corollaries – value, utility, marginal utility and total utility – and their subjective and ordinal nature are powerful concepts that help us understand the processes of exchange and price discovery in a free market. Proper application of these concepts enables us to draw up the demand and supply schedules of any good in terms of any other good and thus understand the processes of price discovery and equilibriation of price on the free market.

p.s. : My entire analysis above is based on the far more elaborate analysis done by Murray N. Rothbard in his book Man, Economy and State with Power and Markets.

Key Concepts in Economics – 2 – The Action Axiom

One of the most fundamental concepts in the study of Economics is the concept “human action”. It forms the bedrock on which all economic theory is developed. It is a premise so self-evident that it is considered an axiomatic concept.

What is an axiomatic concept?

Any line of reasoning has to start with some premises. For instance, when you advise a friend to work hard in order to achieve success, you are starting with the premises that

  1. your friend desires success
  2. you have understood the kind of success your friend desires
  3. that working hard is possible at all given the kind of success your friend desires
  4. that working hard is necessary for the kind of success your friend desires

An axiomatic concept is a premise in a line of reasoning. It is a given for the line of reasoning. It is a premise that is self-evident. It can only be recognized and not validated or invalidated. In fact, even an attempt to invalidate it has to necessarily and implicitly accept its validity.

Consider the concept “existence”. It represents everything that exists. If you ask the question “What is existence?”, the answer can only be a sweep of the hand accompanied by the statement “All this”. An attempt to define “existence” can only lead to the statement “that which exists”. Any attempt to demonstrate that the concept is invalid will have to be performed by a person who himself has to exist in the first place and is hence part of existence. To say existence does not exist, one has to implicitly smuggle the concept “existence” or “that which exists” into the statement and make the self-contradictory statement “That which exists does not exist”. Thus, a denier of the validity of existence has to implicitly acknowledge the validity of the concept “existence”.

The Action Axiom

In the science that studies human action, the concept “action” is axiomatic. “Action” means the purposeful striving towards ends. An attempt to deny the axiomatic nature of the concept “action” has to itself be a purposeful action. It becomes the purposeful striving to prove that the concept purposeful striving is invalid. Thus, it has to implicitly acknowledge the validity of the action axiom even to attempt to invalidate the action axiom. It is also independent of experience. One cannot “perceive” that an action is taking place. The understanding of an observation as “action” presupposes an understanding of the concept “action”. Thus, we see that “action” is an axiomatic concept.

Action and Time

Purpose means a preference for a particular state. It could be the very state the acting human is in. It could be a state different from the present one. Whatever the case, it is clear that the desired state is sought to be attained at a time later than the present moment. In other words, all action is aimed at attaining a particular state in the future. One also sees that doing nothing is also as much action as doing something.

Whenever we talk of action, there are 3 aspects of time involved.

  1. The start time of the action
  2. The duration of the action
  3. The end of the action or the time when the purpose is to be achieved

For instance, if a person decides to grow food for consumption, he has to start a process which begins with identifying a place to grow food in and engage in a sequence of activities over a considerable period of time before the food is ready for consumption. Even decide to decide to consume an apple growing on a tree, you will have to walk up to the tree, pluck the apple, wash it if necessary and then eat it. There is thus a start time, a duration and an end-time which coincides with the attainment (or even non-attainment) of the end, i.e., consuming the apple.

Ends and Means in the context of Action – Concept of “Preference”

Achieving ends requires the application of means towards the same. For instance, a person who sees an apple on a tree and wishes to consume it has to apply his scarce resources, labour and time, to reach up to the other scarce resource, the apple, and pluck it before he may consume it. The end sought to be achieved is “consuming an apple” and the means applied towards it are the scarce resources “labour”, “time” and “the apple on the tree”. A person who has the following scarce means – a few slices of bread, vegetables, cheese – and wishes to consume a sandwich will have to apply further scarce means – his labour, his time, a table, kitchen implements, his kitchen – to transform the scarce means into something that in itself serves the end desired – consumption of a sandwich.

Acting man, in the process of applying scarce means to achieve his ends, expresses his “preference” for one means over another. Faced with the choice of 2 apples, a person who plucks one expresses a “preference” for it over the other. This “preference” is a subjective one and is an expression of his subjective assessment of the usefulness of each of the means available towards achieving his ends. In economics, this subjective preference expressed for different means is called “value”. Please note that this subjective “value” is different from the equally common usage of the word “value” to denote the price or the estimated price of a good.

The understanding that value is a subjective preference was a major advance in the field of economics. It was a big step away from other theories of value that existed till that date. Until Carl Menger proposed the concept of subjective value, economists used to subscribe to either the objective or intrinsic theory of value (which was the idea that the value of a means is embedded in the means itself) or the labour theory of value (which was the idea that the value of a means is dependent on the labour that went into it).

The main advance in economic thought that came about as a result of the subjective value hypothesis, the understanding that value is a preference, is the understanding that value is an ordinal and not a cardinal number. This means that it is only possible to rank a person’s preferences on a scale of values. One can only value one thing over another. One cannot talk of how much one prefers one thing over another. You can say “I prefer A to B” but not “I prefer A 30% more than I prefer B”. The point that value is subjective means that it is not possible to compare the value scales of different individuals. You cannot say “This is of higher value to A than it is to B”.

The analysis above is as true of ends as it is of means. That man acts means that he chooses to pursue some ends and hence that he chooses them over others. Thus, we see that ends are also ranked on an ordinal scale of value. There are more valued ends and less valued ends. What we cannot do is talk of how much more valuable one end is over another or how much more valuable an end is for one individual than it is to another individual.

The Action Axiom and the concepts of Utility and Marginal Utility

The point that means are applied to serve ends tells us that the means provide for the satisfaction of the ends for otherwise the means would not be applied towards achieving the ends. This satisfaction that a means provides is called the “utility” of the means to the acting human. It is a subjective concept and an ordinal number just like value. Just as one can talk of being more or less satisfied but not of how much more or less satisfied, one can talk of higher or lower utility but not of how much greater or lesser utility. This is the ordinal nature of utility. One can only place different means on an ordinal scale of utility. Further, no one can ever know or claim to know how much utility a means provides a particular acting individual. Hence, it is a subjective concept and one cannot compare the utility of a means across different individuals. An example of this is the folly of saying that Rs. 1000 has far greater utility for the poor man than it has for the millionaire.

The other important point that derives from the action axiom is that action is never on classes of means but on particular units of the means. Man does not compare all the water in the universe with all the gold in the universe to express a preference for one over the other. Rather, he expresses a preference for a certain number of units of each means. It is fallacious to ask the question “Is gold more valuable than water?”. The correct question to ask would be “Do you value 1000L of water over 1 gram of gold?”. Here, the unit of the means “water” is 1000L and that of the means “gold” is 1 gram.

This important concept explains why exchange happens. If the utility of Rs. 56 is lower to you than that of a cappuccino, you are ready to forego Rs.56 to consume the cappuccino. At the same time, it is because for the owner of the coffee shop, the cappuccino has lower utility than the Rs. 56 has that he is ready to sell you his cappuccino at the price of Rs. 56.

A further implication of the understanding that utility is for units of a means is the concept “marginal utility”. To understand this concept, let us remind ourselves of some basic concepts. Means are applied to achieve ends. Means are scarce. Ends are themselves ranked on a value scale. In the context of the above 3, one is forced to infer that acting humans have a need to economise on scarce means, i.e., they need to apply every additional unit of a means to the highest ranked and hitherto unsatisfied end that it can satisfy. This means that every additional unit of a means goes to satisfy ends ranked lower than the ends satisfied by the already available supply of means. Thus, we see that the additional unit of the means has a lower utility to the acting human than any existing unit of the means.

Another dimension of the concept marginal utility is the concept “total utility”. This concept refers to the total satisfaction provided by the entire supply of means available. Clearly, if a supply of means is used to satisfy the most valued ends, the total satisfaction provided by a greater supply of a means has to be greater than the total satisfaction provided by a smaller supply of the means as the former always makes it possible to achieve additional ends in comparison to the latter. This is the principle of total utility.

Conclusion

The action axiom is the most important and fundamental concept in economics. It is the most fundamental premise of the entire line of deductive reasoning that we call economic thought. It leads us unerringly to such important concepts as value, utility, the subjective and ordinal nature of the above two concepts, marginal utility and total utility that form the pillars of our understanding of economics. It is the first principle that any serious student of economics must strive to grasp.

Key Concepts in Economics – 1 – The Free Market

No study of Economics can begin without an understanding of the fundamental concept of a free market. In fact, economics itself is the study of exchange. Any study of exchange that does not take into account the particular conditions under which the study of exchange is being conducted cannot be called economics. The concept “free market” is an important construct that makes such analysis of exchange possible. Before we understand the concept free market, however, it helps to understand the concept exchange first.

What is exchange?

To most of us, exchange is the process of giving something that we have to get something else that is in the possession of the other party to the exchange. In economics, such exchange is only one of two forms of exchange and is called interpersonal exchange. In any interpersonal exchange, each party to the exchange offers the other a certain quantity of a good (or service) and receives from the other party a certain quantity of another good (or service). The quantity exchanged of each of the goods is something that is usually decided by the two parties through a process of negotiation.

Types of exchange possible

For the purpose of understanding the concept “free markets”, I am identifying two broad categories of exchange.

  1. Voluntary exchange – In this type of exchange, both parties to an exchange enter into the exchange on their own volition. No force of any sort is used to make the exchange happen. A typical example is when you walk into a grocery store and buy 2 kilos of rice. Both parties, you and the owner of the grocery store, enter into the transaction voluntarily. The price is agreed upon by negotiation.
  2. Forced exchange – In this type of exchange, one party uses force to make the other party agree to give up the good when in the absence of the force, the second party would not have agreed to do so. An example of this is robbery at gun-point. The robber uses the gun to force the victim to give up possession of the money and other valuables on his person in exchange for the robber not pulling the trigger and killing or hurting him grievously. In the absence of the threat, the victim might not have given up his money and other valuables. Another example of forced exchange is slavery. The slave is forced to offer his labour to his master, in exchange for which he gets food, clothing, shelter and a basic level of security.

    What is a Free Market?

    The term free market refers to a hypothetical construct. It is an abstraction. In simple language, the term free market is used to refer to an environment where all exchange is voluntary and dependent only on the choices of the individual(s) engaging in the exchange. In a negative sense, a free market is one in which no individual uses force to bring about an exchange and where no one else other than the individuals engaged in the exchange may set the terms for it. A “free” market may thus be understood as a hypothetical social system free from the use of force by one individual against another.

    Why is the concept “free market” important to a study of economics?

    Economics is the study of exchange. Starting from the premise that all exchange is voluntary, economics applies deductive reasoning to axiomatic concepts in order to identify the laws that govern the functioning of the free market. In its methodology, Economics is like Mathematics. The laws of Economics have the same validity as the theorems of Mathematics. Like the theorems of Mathematics, the laws of Economics are not and cannot be validated through experimentation. They can be shown to be false only by showing their premises to be faulty or by pointing out errors in the reasoning used to arrive at them.

    Having identified the laws that govern the functioning of a free-market, Economics then goes further to study the effect of the introduction of forced exchange into the free market. The tool it uses is, once again, deductive reasoning. The concept “free market” enables us to conceptualise an environment devoid of the use of force by one human against another, thus making economic analysis through deductive reasoning possible. It is only the concept “free market” that enables the identification of Economic laws.

    Is a free market desirable?

    Going by the definition I have given above, a free market is just an environment where every individual is free to act as per the guidance of his own mind. Banishing force from exchange essentially means that every individual has to and can only participate in the market by producing goods and services that others would want and by offering those goods and services in exchange for the goods and services that others in turn produce. The free market is therefore a system where every individual is engaged in the production of goods and services that are useful to others and enhance their quality of life. Thus, the free market makes possible a wide array of goods and services that make human life longer, healthier and happier. It therefore appears most desirable to anyone who genuinely wishes an improvement in the conditions of his own life and chooses to attain the improvement in a peaceful manner through voluntary cooperation with his fellow human beings.

    What are the common charges leveled against free markets?

    The free market is frequently blamed for a number of our problems, be it economic recessions or severe shortages in the provision of healthcare and education to the poor or environmental degradation. The main charge against the free market is that it is based on untrammeled greed and is hence a dog-eat-dog world where only the fittest survive while the weaker ones fall by the wayside. It is blamed for rising inequality of income and the growing gap between the rich and the poor. It is also accused of being prone to frequent and catastrophic failure bringing hardship to millions of people.

    Economic analysis, however, demonstrates that all these charges against the free market are false. In fact, it demonstrates that all the problems identified above and many others are not a result of free markets but of sustained and systematic interventions in the free markets by an agency capable of intervening in this manner. What that agency is, how it intervenes in the free market, how a free market works and what needs to be done to usher in a genuine free market is something I will cover over the course of many articles to follow.

    Is a free market possible at all?

    It is probably not possible at all, but it is possible to move ever closer to the ideal of a free market. Once may never be able to say that there will never be individuals who will not use force against other individuals. In all likelihood, there will always be murderers, robbers, fraudsters, kidnappers, pickpockets, rapists, etc. What a free market may do is to provide services to try to reduce the incidence of and to handle situations created by such events. The important point, which economic analysis demonstrates, is that only a free market is capable of providing a sustainable economic environment in which human beings can be engaged in a never ending effort to improve the quality and quantity of their lives.

    The sad state of thought in Economics in India

    A small point before you read this article: The Nobel Prize in Economics is a prize instituted by the Sveriges Riksbank in memory of Alfred Nobel.

    http://nobelprize.org/nobel_prizes/economics/laureates/2009/

    The Sveriges Riksbank is the Central Bank of Sweden. That’s equivalent to the Federal Reserve Bank of the USA, the Peoples Bank of China or the Reserve Bank of India.

    http://en.wikipedia.org/wiki/Sveriges_Riksbank

    Given that Central Banks are responsible for half the economic troubles we face, what credibility should we attach to the prizes they offer or to the quality of thinking that these prizes represent? Can we expect them to do anything other than reward those who support the thesis that Governments and Central Banks are here to save the world?

    Here’s an example of what I mean. I am a regular reader of The Hindu, not because I like what they publish but because I find more pieces of economic irrationality coming up in that publication than in any other. Usually, they are hilarious. This time, it was saddening, all the more so because it came from an Indian who has won a Nobel Prize in Economics. In his article “Growth and other concerns“, Dr. Amartya Sen had a lot to say, but this line made my eyes pop out of their sockets in absolute shock.

    “One of the great things about economic growth is that it generates resources for the government to spend according to its priorities.”

    While I was prepared for “government worshipping” and “statolatry” among the intellectual elite, this one was taking it just too far.

    Economic growth does generate resources. What I fail to understand is how the resources that economic growth generates get to belong to government. Such statements hide the thinking that taxation is to be considered a legitimate transfer of private property into the hands of government. It is this thinking that is shocking.

    Let’s face it. Taxation is an act of forcible taking away of the property of an individual by government. Morally, it is no different from an act of dacoity. Anyone who considers Phoolan Devi a criminal because she robbed a number of people should also consider taxation as an equally criminal enterprise. That it has legal sanctity in the form of an Act of Parliament that gives it a place in The Constitution does not make it any less of a criminal enterprise.

    This line by Amartya Sen, sadly, reveals in its entirety the mentality of Welfare Statists. They are people who have no qualms about committing criminal acts as long as it is done in the name of government and they have the fig leaf cover of using the funds (thus taken away from their rightful owners) for public “welfare”. The schools, hospitals, public health centres, noon-meal centres, etc., justify the prior act of dacoity…. oops…. taxation. It is a different matter that such an approach does not make economic sense either, but I thought it better to stick to the ethical angle today.

    Gandhi once mobilised an entire nation of (then) over 30 crore people to fight British Raj. One of the pillars of his fight against the British was their taxation policies. It was to protest the Salt Tax that he set off on the now famous Dandi March. It was a symbolic defiance of the British Raj and its attempts to tax the life out of India’s people. What beats me is how a nation that rose as one to revolt against British taxation policies (among other forms of atrocities) succumbed so quickly and meekly to the same tyrannical taxation policies of the Government of a (supposedly) independent India. Dr. Sen’s statement only shows how Indian academia too seems to have surrendered just as meekly and become a  propaganda machine for the State.

    Food Security Bill – An ethical blunder

    In my previous article, I had highlighted why the Food Security Bill is an economic blunder. This time, I thought it good to focus on the ethical blunder that we will be committing by passing the Food Security Bill and how that very ethical blunder shall be our undoing and the cause of untold human misery.

    My ethical framework

    The ethical framework I use here is simple. Ethics is the science of right and wrong. An action is deemed wrong if it involves aggression against the person or property of another. Aggression against person involves the use of force to coerce an individual to act against his will or to cause bodily harm. Aggression against property involves the use of a man’s property without his permission. This includes actions in violation of the code of behavior that the owner lays out for his property. That’s as simple as saying “If you behave in a way I deem inappropriate in my house, I would be doing no wrong in throwing you out of it”.

    What conclusions does this lead us to?

    There are very few actions that one may deem wrong. These are actions that involve bodily harm (including murder) and taking away an individual’s property without his consent. Anything that an individual does beyond this does not come under the realm of ethics.

    For instance, acts like prostitution, smuggling (of whatever including humans who consent to be smuggled), selling narcotic drugs, selling weapons, breaking the Law, etc. are not violations of the ethical code. There is nothing unethical or immoral about them. They are absolutely ethically sound actions. If you are shocked by my inclusion of breaking the Law, remember that Gandhi’s act of picking up a handful of salt at Dandi was an act of breaking the Law. Charging a rent for use of property or charging an interest on money being lent out are perfectly ethical. Laying out and enforcing rules of behavior for others on one’s own property is absolutely ethical.

    On the other hand, forcibly taking away an individual’s property is wrong. This means that all forms of taxation are wrong, i.e., ethically unsound. Similarly, taking away a person’s property without his knowledge is wrong because it is a use of his property without his express permission. This means that stealing is wrong. If an act may be demonstrated to be stealing, it will have to be treated as ethically unsound. Fraud is wrong because it violates the terms on which transfer of property was agreed upon. That which is gained by fraud is not considered a man’s legitimate property.

    How the Food Security Bill is to be funded

    There are only two ways that government may fund the Food Security Bill. The first is taxation. It will either have to raise more taxes now or issue government bonds which are backed by future tax collections. In either case, taxation is the basis. Taxation is a forcible taking away of an individual’s property. Hence, it is wrong.

    The second is by printing money. This act would constitute stealing because it transfers to the new paper printed up by government, a portion of the exchange value that similar paper in the hands of other people has. In effect, government steals from people who have money in the form of paper and bank deposits and spends it. Therefore, this method of financing the Food Security Bill is also wrong.

    Why the Food Security Bill is ethically unsound

    It is ethically unsound because it can only be funded by robbing or stealing. It is no more than a systematically organized scheme to rob Peter to pay Paul. Paul is very happy and probably better off in the short run. So are all the bleeding hearts who have no qualms about robbing others rather than giving their own money to feed the starving millions. But that does not negate the point that the act of robbing or stealing from Peter is ethically unjustifiable.

    Down the slippery slope

    Accepting the principle that it is alright to rob Peter to pay Paul creates an apparent ethical justification for many more such boondoggles. Today it is food. Tomorrow it will be housing. The day after that it will be healthcare. A further day later it will be clothing. Take it a little further and you will find education, televisions and, who knows, even Apple iPods being included in this act of systematic plunder. Incidentally, education has already been included in this scheme through that laughable piece of legislation called the “Right to Education Act”. So have televisions in Tamil Nadu. It won’t be long before the same scheme is repeated in other states as well.

    Where does that leave us and why should we oppose this horrible legislation

    The Food Security Bill strikes at the very root of the concept freedom. If government has the power to take away what you earn and give it to those it chooses, you are essentially going to slave away to keep others better off. The notion that government may dispose of what you earn is nothing short of abolishing the very concept private property and ushering in Socialism. Socialism is an unsustainable system and a sure-shot route to economic disintegration. That means that our own future well being and that of many generations to come is at stake. That is why we should oppose it tooth and nail.

    Food Security Bill – An economic blunder

    A new disaster is in the making. It is called the “Food Security Bill”. The article below gives the basic details we need to understand why this bill is an economic blunder.

    http://economictimes.indiatimes.com/news/economy/policy/govt-committed-to-tabling-food-security-bill-in-par-soon-pm/articleshow/7469879.cms

    Just quoting the specific portions of the article for the convenience of my readers,

    UPA chairperson Sonia Gandhi-headed National Advisory Council (NAC) is working on a draft Bill. The NAC has proposed a legal entitlement to subsidised foodgrains for 75 per cent of the country’s total population.

    According to NAC’s proposal, the government should provide 35 kg of foodgrains a month to “priority households” at a subsidised rate of Rs 1 per kg for millet, Rs 2 for wheat and Rs 3 for rice

    Why it is an economic blunder

    Let’s do the numbers. 75% of India’s population constitutes around 80 crore people. Assuming 5 people per family on the average, we have 16 crore families to feed. 35 kgs of foodgrains per month constitutes 420 kgs per annum. Assuming that rice, wheat and millets will be distributed in the ratio of 1:1:1, we have an average realization of 16 crore * 420 * 2 = Rs. 13,440 crore.

    Let’s now calculate the payout. For this, let’s assume a reasonable quality of each cereal. Let’s say that government purchases the cereals on the wholesale market. In order to be realistic, I obtained the prices of cereals from

    http://agmarknet.nic.in/agnew/NationalBEnglish/commoditywisedailyreport3.aspx

    I omitted outliers (extraordinarily high and low prices) and took a simple average (I know that’s not precise, but it is indicative enough). Under these assumptions,  Rice costs around Rs. 19.52 per kg on the open market, wheat around Rs. 13.38 per kg and millets around Rs. 10.66 per kg. At a ratio of 1:1:1, this makes the average price Rs. 14.52 per kg. The total payout is therefore Rs. 16 crore * 420 * 14.52 = Rs. 97,574 crore.

    Therefore, assuming that the government is going to purchase these cereals on the wholesale market at market prices, the government will have to make an outlay of Rs. 84,134 crore. My head reels at the sheer magnitude I see. This is even bigger than the equally disastrous MNREGS (which I shall write about another day). Tinker around with the number for all you want. The numbers wouldn’t change by much.

    With a government that is already running a fiscal deficit of Rs. 4,12,307 crore (http://www.business-standard.com/india/news/2009-10-fiscal-deficit-stands-at-66gdp/396788/), this means a massive addition to the fiscal deficit.

    How is the government going to fund this massive bill? Will you be surprised if I say that it will get the RBI print up the money? I had explained here how government fiscal deficit adds to the money supply. What does this magnitude of addition to the money supply mean for prices of all goods and services that are not covered under this idiotic bill? I’m scared. I wish I could move over to another planet. Since I cannot, I thought I’ll just write about it and help more people see what monumental idiocy this misconceived move of bleeding hearts who have no qualms about robbing Peter to pay Paul is. My only question to these bleeding hearts is, “If you are so concerned about the starving poor, why don’t you use your own money to buy food for them? Why steal my hard-earned money using government to do your dirty job?”. That, however, constitutes the ethical blunder we commit by passing the Food Security Bill. I’ll leave that for another day.

    GDP growth estimated at 8.6% – Why it is macroeconomic nonsense

    The Central Statistical Organisation recently released its estimates for India’s GDP (Gross Domestic Product) during the current financial year, i.e., the period from April 2010 to March 2011. As per the CSO’s estimates, GDP for the current period is expected to grow at a rate of 8.6% as against the previous year’s figure of 8%. The Finance Minister Mr. Pranab Mukherjee announced promptly after the CSO release that GDP growth is satisfactory and encouraging despite difficulties such as rising inflation and trade imbalance.

    What do they mean and what do they want us to infer?

    The figures and the accompanying announcements are meant to communicate to ordinary Indians that the economy is doing fine and that the government and the monetary authority have done quite an admirable job of steering the ship (the national economy) in fairly troubled waters. We are supposed to infer that they have done their job and that if we face problems, it must be because we as individuals have not performed well enough.

    Are their conclusions correct?

    Frankly, no. The reason is simply that the very basis of their conclusion is faulty. GDP is not a sound macroeconomic indicator and hence any macroeconomic conclusions drawn from it are also bound to be equally unsound. The rest of this article seeks to explain the concept of GDP in simple terms and argue that it is a fundamentally unsound indicator of macroeconomic health.

    What is GDP?

    The concept GDP forms the cornerstone of an area of study called National Income Accounting. The aim of this study is to establish the total income of all the people living in a chosen geographical area in a given period of time. The idea behind it is that if income is more, people are economically better off. Hence, measuring the total income in this manner is a good indicator of macroeconomic health of the geographical region.

    The idea also finds its most ardent proponents in the Keynesian School of Economics which uses the concept of the Keynesian Circular Flow Framework to equate Income and Expenditure. In the Keynesian Circular Flow Framework, there are two sets of entities – people and businesses. People offer their labour to businesses for which they receive wages. It is this very wages that they spend to buy the output of their own labour from the businesses. It views the economy as two overlapping circles. One consists of a flow of labour from people to businesses which continues as a flow of goods and services from businesses to people. The other consists of a flow of wages from businesses to people which then continues as expenditure from people to businesses.

    The basic idea is that one man’s expenditure is another man’s income. Hence, the sum total of all expenditures must be equal to the sum total of all incomes. As per this framework, expenditures fall in 5 categories.

    1. Consumption expenditure (C) – Expenditure on goods and services that people “consume”. Note that a good or service once consumed is not capable of rendering its services once again. Such goods are called consumers’ goods.
    2. Investment expenditure (I) – Expenditure on buying plant, machinery and other equipment required for the production of consumers’ goods or for other goods that are ultimately used to produce consumers’ goods. Such goods are called capital goods or higher order producers’ goods.
    3. Government expenditure (G) – Government spends money on a variety of activities. The money thus spent becomes income of a number of people in the same economy.
    4. Exports (X) – These are expenditures by people in geographical regions other than the one under consideration which become income to the sellers who are part of the region being studied.
    5. Imports (M) – People and businesses buy goods and services from sellers outside the geographical area under consideration. The money paid to such sellers, however, does not remain in the hands of people who form part of the said economy. Hence, it subtracts from the total income figure.

    Since income must equal expenditure, the Keynesian framework claims that the total income (Y) of the people in an economy defined as a geographical region is

    Y = C + I + G + X – M

    Please note that the left hand side of this equation represents income and the right hand side represents expenditure.

    Why is GDP an unsound macroeconomic indicator?

    The fundamental flaw in the concept of GDP is that it tells us nothing about the health of an economy and is hence to be treated as random noise. The real health of an economy is indicated by the capital structure of the economy. By this I mean the sum total of all the capital goods that have been produced and are used for the production of consumers’ goods or of other producers’ goods that may be used in stages of production closer to the stage of consumption. Also note that by sum total, I just mean the disaggregated total and not the total money value of these capital goods.

    The conceptual basis of this view is that the only ultimate purpose of production in an economy is consumption (in contrast to the Keynesian view of production for its own sake). Producers’ goods serve to produce the consumers’ goods that people consume to obtain various forms of satisfaction. Under this view, an economy is the complete structure of production that makes possible the consumers’ goods that we seek to consume. A primitive economy has precious little capital goods. An advanced economy is one that has, over a considerable period of time produced a large volume of capital goods and an entire capital structure that drives production of a wide variety of consumers’ goods.

    Just to understand this visually, imagine yourself walking into a primitive tribal hamlet. You look around and find nothing but thatched huts. People wear few or no clothes. What little they wear is little pieces taken straight from plants and animals and strung together into clothing or jewellery using other materials taken straight from the same plants and animals. The tools they use are objects taken from nature and modified using the power of their hands into usable implements. Take for example a spear consisting of a sharpened stone tied to the end of a stick using vines. The reason this economy is incapable of producing a vast array of consumers’ goods whose consumption improves people’s standard of living and that on a sustained basis is that there are few or no capital goods to speak of. They cannot think of producing the goods and services they need beyond the immediate future. Surviving the day is likely to be their top priority and providing for the uncertain future is a pipe-dream.

    Now move over to a modern, advanced, industrial economy. People live in houses made of steel and concrete, some in an apartment on the 51st floor of a 60 storey building. They use a variety of implements like gas stoves, microwave ovens, televisions, refrigerators, washing machines, mobile phones, etc. These devices are all consumer durables produced to provide their services over a period of time stretching far beyond the present moment. They consume soaps, toothpaste, detergent, processed and refined food products, etc. You wonder where they came from and walk out of the house into the work-place where all these marvels were produced. Firstly, that there is something called a work-place should itself catch your attention. Secondly, the sheer range of productive machinery and equipment you find there is absolutely mind-boggling. From small staplers that help people hold pieces of paper together in a set to huge thermal power plants that churn out electricity that makes people’s lives better, they are all capital goods that enable us to produce consumers’ goods for future consumption. It is the very presence and functioning of these capital goods that makes it possible for this advanced economy to plan for provision of consumers’ goods not just for the present moment but also for a considerable time in the future.

    This capital structure is what makes the advanced industrial economy prosperous and it is the lack of it that makes the primitive tribal society poor. It is the size and quality of this capital structure that determines the income that a population may earn and hence the standard of life they may enjoy. No society is endowed by nature with capital or a capital structure. It produces them. It is equally important to understand that society as a whole does not form capital. That task is accomplished by individuals who defer consumption. By choosing consumption at some date in the distant future over consumption in the present, individuals create the savings that make capital formation and a capital structure possible. This capital structure requires not just formation but maintenance and replacement as well. Capital goods get worn out and used up in the process of churning out consumers’ goods. Failing to maintain or replace them will be tantamount to consuming the capital. Such capital consumption will impair the ability of the capital goods structure to churn out more consumers’ goods in the future.

    Real macroeconomics must study the drivers of the process of capital formation, maintenance and replacement that enables and leads to the production of the consumers’ goods that we seek to consume. Real macroeconomics has to be capital based. A single-minded focus on income exclusive of the capital base required to make this income possible cannot constitute good macroeconomics.

    GDP is flawed as a macroeconomic indicator because it says nothing about the capital structure in the economy, much less about whether it was enhanced or depleted in the period under study. Even the figure I (for “Investment Spending”) included in GDP calculation does not tell us how much of the “investment” spending was spent on maintenance or replacement of pre-existing capital goods and how much of it was spent to add to the capital structure. It does not tell us whether there was net capital formation or net capital consumption in a given period. Thus, it does not tell us whether people have become better off or worse off in the current period. It is therefore meaningless data for a person interested in a serious study of macroeconomics.

    Why then do our “economists” and “leaders” focus so much on GDP? There can be two reasons. The first is that they are completely ignorant that GDP is a meaningless macroeconomic indicator. While this explanation may be acceptable for our politicians, it is perplexing to see leading economists mouthing and supporting this macroeconomic nonsense. The second is more sinister – that they know that it is macroeconomic nonsense but have other reasons to propagate the myth that it is indeed an indicator of macroeconomic health. The first requires them to be ignorant, bumbling, well-meaning but dangerous fools while the second requires them to be diabolical manipulators of people’s minds. I leave the choice to every reader.

    Reducing crime rate is simple – We should just want to achieve it

    Today’s news:

    In the northern part of the country, a girl is maimed because she resisted rape by 3 youth. Down south, a young woman of 23 dies after being pushed out of a train and then raped.

    These incidents are not just random occurrences but part of a pattern we are seeing in various parts of the country. Our national capital is fast becoming infamous as the rape capital of the country. Our streets are becoming increasingly unsafe for women. These problems are all the more acute these days as women are beginning to step out of the (relatively) safe confines of their homes to earn a living and make careers for themselves.

    The point I seek to address is, what needs to be done to reduce the rate of such crimes and make our streets safe for women.

    Policing cannot prevent rape

    Heaven knows how and where a rapist picks his victim. It is just impossible to know who is going to be the target of a rape attempt. A rapist needs just a few seconds to subdue his victim and bundle her into his car or a dark spot. This is all the more easy if it is a group of 3-4 men or if there are few other people around, leave alone a policeman. How does one ensure that a policeman is present at the very moment a woman is being picked up thus and is therefore in a position to save her? Clearly, this is plain impossible. Increased policing is not a solution for rape.

    Deterrence does not prevent rape

    A number of people suggest that imposing the death penalty will act as a deterrent. If that were true, the number of murders should have been far less than it is today. In fact, one can argue that imposing the death penalty will reduce the rate of conviction in rape cases as judges will tend to apply stricter standards before pronouncing a person guilty. Given the already pathetically low rates of conviction in rape cases, one shudders to think of what would happen if judges think twice as much as they do before pronouncing guilt in a rape case.

    Let’s face it – Women are physically weaker

    I’m not a sexist. However, I am quite sure that every woman would acknowledge the point that in general, women are physically weaker than men. The very reason men are able to rape women is that men are able to subdue their female victims. Even women who have learnt martial arts know that sometimes brute force has its way and defending yourself is not easy when your attacker is quite determined to have his way.

    What makes a potential rapist bold?

    It’s simple. The more certain the potential rapist is that his target is defenceless, the more likely he is to attack. If a potential rapist had no way of being sure how capable the target is of defending herself, he will think ten times before he launches upon his assault. Replace the term “rapist” with the term “criminal” and the above statements will still ring true. Certainty of vulnerability increases chances of a crime while uncertainty over vulnerability reduces chances of a crime. One has to therefore infer that increased rate of crime is a result of increasing certainty that the target of the intended crime is defenceless.

    What do potential victims need to defend themselves from crimes like rape?

    This is simple too. They need weapons that would scare potential criminals. They need weapons that they can use to ward off attackers. If a potential rapist has no idea whether or not his target has a gun, the chance that she is defenceless appears very low to him. If, on the other hand, he can be reasonably certain that his target does not have a weapon such as a gun to defend herself, he becomes emboldened enough to attack her.

    What causes criminals to infer that their targets are defenceless?

    This one is truly a no-brainer. In this country, it is difficult for a law abiding citizen to possess a gun even if it is for self-defence. Gun ownership requires a licence. I will need to explain to the licensing authority why I need a gun. Every criminal knows that. Licensing creates a huge black market in guns and ammunition. It takes one to have the spirit of a law-breaker to get a gun for oneself on the black market. That spirit comes easily to the person with a criminal bent of mind and rarely to the law abiding citizen. So, every potential criminal knows that the majority of the citizenry, law abiding citizens that they are, rarely possess guns and are hence very likely to be defenceless.

    How does one reduce crime rate and the rate of rapes in particular?

    Remove all restrictions on gun ownership. Eliminate the need for a licence to possess a gun. Let there be a free market in guns and ammunition. Let every hand-bag potentially conceal a loaded gun. Let every well-worn sari or salwar-kameez potentially conceal a fully loaded Smith and Wesson. Let learning to use a gun and being quick on the draw be a part of the upbringing of every girl. Let every potential rapist see his target not as his potential victim but as his potential slayer. That fear of death or serious injury is the only thing that can deter a potential criminal, especially one as inhuman and barbaric as a rapist.