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by Ian
Wilkinson BS, MS, Ph.D., DClinChem, CSCC(Cert), FACB, MBA Chair,
IFCC EMD Committee on Laboratory Management
�Common sense is what tells you that a ten pound weight falls ten
times as fast as a one pound weight�, Anon
�Common sense is the collection of prejudices acquired by age
eighteen.� , Albert Einstein
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Abstract
The need for leaders and managers to have a basic understanding
of elementary economics is demonstrated. The limited retrospective
view of the accountant must be supplemented by the broader,
prospective view of the economist. The limits and scope of
economics are defined. The First and Second Fundamental Theorems of
Welfare Economics are introduced. The mythology behind the
mechanism of action of Adam Smith�s Invisible Hand is dissected;
and the mechanism of the free market is explained in terms of the
effect of marginal cost on net market efficiency. The apparently
simple case of the effect of legislating a minimum wage upon a free
market is discussed. This provides an example of the real-world
complexity of economies and of applying economic concepts to the
business world.
The Dismal
Science
A sound knowledge of basic accounting principles is the sine qua
non of running any business. Without these essential tools it is
impossible to effectively and efficiently manage money, the liquid
resource required to oil the machinery of enterprise. Most managers
have acquired basic accounting skills or at least understand the
language of accounting, and can ask intelligent questions of their
accountants. However, as anyone involved in management soon
realises, managers need to think beyond the narrow world of
accounts and accounting. An accounting focus is by and large
retrospective, i.e., it looks backward at expenditures already
incurred. It does not focus on the future or on the vast range of
costs, concepts and potential pitfalls that lay beyond its narrow
compass.
Ceteris Paribus
The best kind of economist has only one arm. This prevents him
from qualifying every prediction he makes with the caveat �But
then, of course, on the other hand..�. Even one-armed economists
tend to mumble under their breath the Latin incantation ... ceteris
paribus; which roughly translated means �Other Things Being Equal�,
which of course, they never are! This is in effect an economist�s
�Get Out of Jail Free card� allowing him or her to pontificate,
make predictions and advise politicians with no risk to themselves
or to the remains of their reputations. Cynicism aside, Economics
has been called �the dismal science� which is probably unfair and
certainly bad for its image and that of economists. In fact, a
basic understanding of economics can elevate the average manager to
the status of a star achiever. Economics is the science (or
would-be science!) of rationing scarce resources. For example, a
person�s income is finite and he or she must make choices on how to
spend or save the money earned. Usually, the goods and services
which they desire, exceed their ability to pay for them. Similarly
businesses must constantly make decisions about which product to
develop, which project to invest R & D money into, which people
to hire or promote. This series of articles will look at some of
the myths and legends of economics, that all too often confuse and
mislead leaders and managers into incorrect solutions, misguided
policies and counter-productive actions.
Adam Smith�s
Invisible Hand
Most people have a vague notion of Adam Smith�s Invisible Hand:
a spectre that haunts the capitalist world and somehow magically
drives capitalist societies to ever greater heights of success,
wealth and productivity. Many people even try to explain it in
terms analogous to Darwin�s theory of evolution, i.e., that those
enterprises best fitted to survive will prosper and those less
efficient will not. This is an unfortunate and misleading analogy,
for there is no biological equivalent of the Invisible Hand. There
is no evolutionary equivalent of the exquisite efficiency of the
invisible hand of the competitive market place. For example,
peacocks have immensely long and spectacular tails which they use
for display in order to show females how healthy and therefore, how
suitable they are as mates. These tails are useless for flight and
may actually be a hindrance to escape and/or to evading predators.
In addition, maintaining such exuberant iridescent appendages
consumes a substantial amount of resources. If evolution were
really analogous to the invisible hand of market forces then there
would be no exorbitant tails. In economics, the tails are said to
be �inefficient�, i.e., they represent a lost opportunity to make a
more efficient system. To extend the argument, if evolution were
really akin to market forces, then market forces would in effect
enforce the consensus that all peacocks would benefit by having
their tails cut off. This would put all male birds on an equal
footing without having to expend scarce resources on growing
beautiful but unnecessary tails. Adam Smith described each
participant in an economy as an actor who intends only his own gain
but who, nevertheless, is guided as it were by an invisible hand to
promote an end which was no part of his intention, i.e., the
welfare of society, which economists call �efficiency�.
In modern economics, Adam Smith�s invisible hand theory is known
as the First Fundamental Theorem of Welfare Economics and may be
stated thus :
- Competitive markets allocate resources efficiently.
There is also a Second Fundamental Theorem which follows from
the First,
- No matter which of the many efficient allocations you want to
achieve, you can always achieve it by first distributing income in
an appropriate way, and then letting competitive markets function
freely.
The key feature of the free market is the existence of market
prices, without which there would be no efficiency.
Consider the following example: You have been appointed head of
a new US Department of Laboratory Services by the new
administration. You have been given extraordinary powers to dictate
how lab services will be provided in the US. Your job is to ensure
that 1 billion lab tests are carried out in the US this year at the
lowest possible total cost. In order to achieve this goal you need
to utilize the concept of marginal cost. Marginal cost is a
critical concept for managers to grasp. It is the cost of
performing one more test or producing one more widget. Economists,
leaders and managers should be obsessed about their marginal costs.
Marginal cost is not the same as the average cost per test, because
marginal cost tends to vary from one test or widget to the next one
produced. For example, the marginal cost of a given test performed
on an autoanalyzer may fall at first but eventually begins to rise.
This is due to the law of diminishing returns which is based on two
clich�s: (a) All good things must come to an end and; (b) Too many
cooks spoil the broth. You cannot perform an infinite number of
tests in a finite amount of time or space. There is an optimal
number of tests beyond which it becomes increasingly inefficient to
go. The secret of controlling costs is to operate at the point
where the marginal cost curve is at a minimum. For example, let us
say that it costs Acme Labs $1 to produce a test result for sodium
rhubarb at the minimum point on their marginal cost curve. In order
to produce the next test result of sodium rhubarb costs $3; and
producing yet another test result will cost $7. Thus Acme lab�s
marginal cost increases from $2 ($3-$1) to $4 ($7-$3). Another lab,
Dumbo Labs Inc, is not quite as well managed as is Acme Labs and
its marginal cost for sodium rhubarb is $9 compared with Acme Labs
marginal cost of only $4. As Head of the new US Department of
Laboratory Services, you have the power to order Dumbo Labs to
produce one less sodium rhubarb test (reducing their costs by about
$9) and order Acme Labs to produce one more test (increasing their
costs by about $4). The net effect is that the same number of
sodium rhubarb tests are produced but at the significantly reduced
(and more efficient) cost of about $5.
Dumbo Labs Inc are now producing less tests and so their
marginal cost will no longer be $9 and will have fallen, perhaps to
$7 or less. On the other hand (as a two-armed economist would say!)
Acme Labs are now producing more tests, so their marginal cost has
increased, perhaps to $5. However, using your absolute authority as
Head of the US Department of Laboratory Services you could order
Dumbo Labs to cut back production even further and for Acme Labs to
increase their production by a corresponding amount. Clearly, you
can continue to do this until Dumbo Labs Inc has the same marginal
cost as does Acme Labs Inc. You can then expand this �game� to
include more and more labs, each time decreasing or increasing
production until all labs have the same marginal cost. This is the
lowest, most efficient marginal cost for the US consumer as a
whole. To achieve this efficiency, all labs must face the same
marginal cost. The remarkable consequence is that each lab acts
only in its own self interest, i.e. it seeks to maximize its own
profits by producing only sufficient tests such that their marginal
cost is equal to the market price; and yet the net effect to
society is the production of the required number of lab tests at
the lowest possible price. This is the essence of Adam Smith�s
�invisible hand�. Let us now apply this concept to a real life
problem: the question of whether or not there should be a
legislated minimum wage.
Should there be a
minimum wage?
Should governments legislate a minimum wage? Liberal minded
people might say �Yes�. That it is reasonable to expect that every
person who is willing to work should be paid at the very least a
minimum amount, which has been determined to be sufficient to live
on and to make working for a living worthwhile. They may also offer
social conscience arguments to the effect that a minimum wage is a
�good thing� from an ethical/moral point of view.
However, others (which may perhaps be labelled as
�conservatives�, �capitalists� or �selfish�) may say �No� to the
proposal that there should be a minimum wage, legislated by law.
They argue that the market place - the balance between the supply
of labour and the demand for labour ought to set the minimum price
of labour, and not some centrally planned legislature or executive
(or perhaps judicial!) entity. Who is right? The �liberals� or the
�conservatives�?
The answer to this perplexing socio-economic question was until
recently considered to be to be fairly straightforward. Despite the
apparent obvious social justice of guaranteeing every person
willing to work a minimum wage for their labour, economists argued
that in reality, the imposition of a minimum wage actually causes
more harm than good. Their argument has nothing to do with moral or
ethical questions of social justice but is based entirely on the
objective, uncaring behaviour of the market place and Adam Smith�s
invisible hand. Why is this so? In a perfect free market the curve
for demand for labour will intersect the curve for the supply of
labour, i.e., the market will set the price for labour. If
government interferes in this market efficiency (paralyzing Adam
Smith�s invisibly hand) by legislating a minimum wage much above
the unregulated price of labour, then we would assume that young
and/or unskilled workers will no longer be able to find employment.
In effect the government has amputated the lower part of the demand
curve. The higher the minimum wage is set, the greater the degree
of job loss .
Unfortunately, economics, just as in real life, is seldom this
simple, or straightforward. According to a study performed by David
Card and Alan Kreuger into the effect of a major increase in the
minimum wage within the New Jersey fast food industry, employment
actually increased! This led to a counter-claim by David Neumark
and William Wascher who used different data to come to the exact
opposite conclusion! You can see why politicians hate economists.
However, Thomas Michl suggests that perhaps both studies were
correct. How can this be? Michl proposes that the minimum wage
increase did not effect the net number of workers employed but did
reduce their average number of hours worked. This is quite possible
given the preponderance of part-time workers in the fast food
industry. Thus the apparent paradox is solved: the demand for total
hours of labour did decline (as predicted by the classical model of
supply and demand) but that the incomes of those workers employed
actually increased as a result of fewer hours at their part time
job and an increase in the hourly rate of pay.
Peter Tulip has taken this discussion even further. He contends
that a high minimum wage may have wider indirect effects on the
so-called economy-wide equilibrium wage. A high minimum wage
results in a decrease in pay differentials, which in turn leads to
a demand for their restoration thereby increasing wage demands and
fuelling inflation. This will lead to higher unemployment but not
necessarily among the workers to whom the minimum wage increase was
originally applied.
It is apparent from this example, that the effects of Adam
Smith�s invisible hand to the real world of complex economies, is
not always straightforward or obvious. Nevertheless, through an
understanding of the basic mechanism of the free market we have
prepared the way for discussing some more introductory concepts in
the next article in this series: the causes and effects of business
cycles, recessions, depressions, booms and busts.
REFERENCES
- . Landsburg, S E, The Armchair Economist: Economics and
Everyday Life, Chapter 8: �Why Prices Are Good.� Simon &
Schuster, New York, 1995 .
- . Economic Focus: Debating the Minimum Wage, The Economist, Feb
3rd, 2001 p80.
- . Neumark, D and Wascher W, �Minimum Wages and Employment: A
Case Study of the Fast-Food Industry in New Jersey and
Pennsylvania: Comment�, American Economic Review, December
2000.
- . Michl, T, �Can Rescheduling Explain the New Jersey Minimum
Wage Studies?�, Eastern Economic Journal, Summer, 2000.
- . Tulip, P, �Do Minimum Wages Raise the NAIRU?�, Federal
Reserve Finance and Economics Discussion Series, 2000-38. Note:
this can be obtained at www.federalreserve.gov
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