Disequilibrium Analysis of Price Formation – Part 2

Courtesy of Professor Fekete @ NASOE:

PART TWO: THE COORDINATION PROBLEM IN ECONOMICS

We are now ready to discuss the co-ordination problem of economics and to see how entrepreneurs approach it through arbitrage. It will appear that our introduction of arbitrage as the generic form of human action, that underlies all the multifarious activities of entrepreneurs in pursuit of pure entrepreneurial profits, is insightful. It focuses on what is important while deemphasizing what is less important or unimportant in the activities of entrepreneurs when looked at from the point of view of the market process. It also leads to the classification of entrepreneurial strategies as we treat the coordination problem.

The coordination problem and the landscape of spreads

Lack of coordination or the presence of disorder in society represents an opportunity for gain, even though every instance of this remains hidden to most observers until it is exposed by entrepreneurship. Once the opportunity is being exploited, coordination overtakes disorder and the profit potential disappears. There prevails in society a spontaneous tendency for greater co- ordination driven by entrepreneurship. In fact, it is the existence of this process that makes it possible to have theoretical economics as opposed to economic history. But how does the entrepreneur diagnose the presence of disorder? He surveys the landscape of spreads. The latter furnishes an accurate picture of the state of coordination or the lack of it. In more details, narrow spreads indicate a higher and wide spreads indicate a lower state of coordination.

The entrepreneur picks a spread that appears unreasonably wide to him. He then exerts his coordinating influence on the spread through arbitrage using the corresponding straddle. The landscape of spreads is not to be visualized as rigid relief map but rather as a fine cobweb, every node of which is inter- connected with every other. Disturbance at one node will affect the state of every other node. Accordingly, the entrepreneur attacking one spread through arbitrage will transmit information to and will influence the width of every other spread. In order to understand the coordination process more fully we must look at various entrepreneurial strategies. We isolate two of them: the defensive or retrospective (backward-looking) strategies utilizing horizontal arbitrage, and the aggressive or prospective (forward-looking) strategies utilizing vertical arbitrage. As we have seen, producers of nth order goods act as arbitrageurs on three counts: (1) they are doing vertical arbitrage between the nth and (n + l)st order goods; (2) they are doing horizontal arbitrage at the level of output (goods of order n); and (3) at the level of input (goods of order n+1). Different types of arbitrage have different roles to play in the market process. First we look at the role of horizontal arbitrage.

Defensive strategies and horizontal arbitrage

As a direct result of production, vertical spreads will narrow, squeezing profits. This effect is natural, it is to be expected, and all producers ought to be fully prepared to meet the challenge presented thereby. Eroding profitability can be restored, at least to some extent, through horizontal arbitrage at either end of the production line. The alert producer explores alternative inputs, as well 10 as alternative outputs, compatible with his existing plant and equipment. As we may recall, this retrospective (or defensive) strategy aiming at the restoration of profitability can be described as horizontal arbitrage in terms of one-legged straddles. If the producer replaces his input basket x by a cheaper one x’, he has created a one-legged horizontal straddle whose significant leg is the long leg x’.

Alternatively, if he replaces his output y by another y’ which uses the same input but is expected to fetch better prices, he has created a one-legged horizontal straddle whose significant leg is the short leg y’. One sign of eroding profitability is that the production plant is operating far below full capacity. Cutting the price of x outright at a time when profits are squeezed might be a short-sighted strategy and is likely to be counter-productive. (While not a suitable defensive strategy, price-cutting might be effective as an aggressive strategy aiming at increasing the market-share.) But the producer may have recourse to horizontal arbitrage as a more appropriate defensive strategy. Variation in product quality, complementing variation in price, is an important device to improve profitability. The producer puts an alternative product on the market, say, a higher-quality edition x’ of x that could be sold at a higher price with only a minor increase in cost. Suppose that the production capacity of the plant is 100 units of x per day, but only 60 units can be sold at the price of $3, grossing $180 per day.

The producer tries to sell 30 units of x’ at the price of $4 while cutting the price of x to $2 in the hope that he could increase his sale of x to 70 units. This would increase his gross intake to $240 per day achieving, incidentally, full capacity utilization. The producer could afford to spend an additional $1 per unit of x’ to increase quality. If he did, his total profit would still be higher (as long as he could keep the cost of input down to less than $1.25 per unit of x.) Deliberate variation in product quality is an important tool in the hands of the producer to compensate for the erosion of profitability. Equilibrium analysis of price formation is designed to handle the problem of variation in quantity, but it is at a loss to handle the problem of variation in quality by the producer. We may note in passing that increasing sales will increase profitability in two ways: a larger number of units sold usually means (1) larger total profits, as well as (2) higher profits per units sold. Indeed, as the depreciation schedule for capital equipment falls upon a larger number of units, the depreciation quota per unit of production becomes smaller. However, depreciation is a cost and as such it enters the input basket. A smaller depreciation quota implies higher profits per units sold.

Aggressive strategies and vertical arbitrage

Prospective (forward-looking) or aggressive strategies become important when defensive strategies no longer suffice to protect profitability. As pure entrepreneurial profits are ephemeral and elusive, it is incumbent upon the alert producer-entrepreneur to make timely preparations for the day when his vertical spread has been exploited to the fullest, and profitability can no longer be restored through horizontal arbitrage. At that point he abandons his vertical spread and scraps his equipment. He must find a new, wider, and more promising vertical spread waiting to be exploited. To attack this new spread he must initiate the corresponding straddle. He must buy new equipment and must set up a new production line. To be sure, it is possible to continue production without the benefit of pure entrepreneurial profits indefinitely. But this would involve taking capital losses periodically. Let us assume that the proceeds from sales are sufficient to cover the cost of all resources expended in the production effort in full, with the sole exception of the return to capital invested.

This means that capital can no longer be amortized as called for by the original schedule: its value must be revised downwards so that the in- sufficient return can continue to amortize the reduced capital value at the current rate of interest. The resulting capital losses are simply passed on to the shareholders, who are forced to absorb it in the form of a reduced (or cancelled) dividend income. It is clear that marginally profitable enterprises are at the mercy of the rate of interest. A rise in the rate of interest would render the enterprise submarginal (i.e., a loss-maker). The profit margin is seen as the very cushion sheltering the enterprise from an untoward rise in the rate of interest. But of the greatest importance to us are precisely those enterprises that can, thanks to alert entrepreneurship, generate pure entrepreneurial profits consistently. Mark the word “consistently”. It is one thing to make profit sporadically; it is quite another to make it consistently. As we have seen, the skill to make profit consistently is crucial: it is precisely this skill that shelters the shareholders from suffering capital losses.

An important aspect, not sufficiently recognized in the scholarly literature, is the social role of pure entrepreneurial profits. In the modern world most production takes place within the corporate framework, and most retirement pension plans depend on the integrity of the dividend income derived from the ownership of industrial shares. The pension plan will have to declare bankruptcy eventually if the stocks in its portfolio are exposed to periodic capital losses. One can hear a lot of exhortation concerning the need to prod firms to be “good corporate citizens” — to wit: worry about profits less, and worry about civic duties more. The loose talk about corporate citizenship and civic duties misses the point completely. Profits are to be worried about indeed, because they are ephemeral, elusive, opportunities to generate them are hard to find, and because profits play such an important social role in protecting the source of income for the retired segment of the population.

Depreciation quotas

What is the “secret” of those entrepreneur- producers who can consistently generate pure entrepreneurial profits? The secret can be found in their strategy to shift their production line, in a timely fashion, through four-legged vertical straddles. First of all, the provident producer must be aware that profits are ephemeral. He must understand that the more successful he is in producing consumer goods, the faster the vertical spread he is attacking will erode, and the greater his need to find an alternative vertical spread will become. The temptation is ever present for the successful producer to rest on his laurels, and to continue doing what he has been successful in doing. However, in the real world of ephemeral profits such an attitude is bound to back-fire. The initially successful producer will turn out to be a failure after all, unless he is on his toes at all times. Secondly, the provident producer must set his depreciation quotas high enough: they must cover the possibility that his plant and equipment become obsolete prematurely.

The useful life of plant and equipment is not determined solely by physical criteria having to do with wear-and-tear. It could also be shortened by virtue of shifting consumer preferences, which is impossible to predict. To be sure, higher depreciation quotas will increase costs, thus reducing entrepreneurial profit. But this part of lost profits may be recaptured later, after the value of plant and equipment will have been written off completely, when depreciation costs no longer weigh down input. The producer who is in the habit of setting his depreciation quotas by relaxed standards is living in a fool’s paradise. In addition, the provident producer will also set aside a quota dedicated to research and development (R&D). These funds are dedicated to support the inventor and the technologist in developing new products and better production methods. This will help slowing down the erosion of profitability later, and offer a better chance of finding new profitable vertical spreads. To be sure, R&D quotas will increase costs and thus reduce profitability initially. But it would be short- sighted to do without them. They are the very goose to lay the golden eggs of future profits. If there is no room for R&D quotas in view of insufficient profits, then the production effort probably cannot be justified in its present form.

The chimaera of inconvertible capital

Above all, the provident producer is very much alive to the fact that the vertical spread he has set out to attack is shrinking relentlessly, forever squeezing profits. He is making timely preparations for the day when his vertical spread is exploited to the fullest, forcing him to move on to greener pastures. He is constantly on the look-out for wider and more promising vertical spreads waiting to be exploited. When the day comes, he will be ready. He will stop producing x and start producing x’. It is a frequent objection that switching from one production line to another is a costly move. It involves scrapping old plant and equipment and buying new ones. Scrapping may involve huge losses in view of low scrap values relative to the high price of new plant and equipment — hence the chimaera of inconvertible capital.

The objection is not valid. There is no such a thing as inconvertible capital — there are only insufficient depreciation quotas. Had these quotas been set with greater foresight, the full value of the old capital and equipment would have been written off by the time switching fell due, and there would have been no losses on that account. When plant and equipment are fully amortized, the vertical spread gets wider by the amount of depreciation no longer to be charged. But this once-in-a-lifetime shot-in- the-arm is no more than a temporary reprieve. The natural shrinkage of the vertical spread is going on unabated, putting the entrepreneur on red alert that the time to make the switch from one production line to another is fast approaching. The aggressive (prospective) strategy in the pursuit of pure entrepreneurial profits can be described as vertical arbitrage in terms of four-legged straddles as follows. When the producer finally makes his switch from the old production line with input y and output x to the new production line with input y’ and output x’, he has created a four- legged vertical straddle with initial short leg y and initial long leg x; terminal long leg y’ and terminal short leg x’. Note that this four- legged vertical straddle is of the most general kind.

The terminal legs are no longer backward-looking as in previous examples where they simply liquidate the commitments created by the initial legs, but they are forward-looking as they enter new markets. In fact, each of the four legs is in a different market. The calculation of pure entrepreneurial profit follows the same formula “terminal minus initial”: the new vertical spread minus the old. This means that the producer can reap pure entrepreneurial profit consistently, provided that he makes a timely switch from one vertical spread to another as soon as the profitability of the former erodes sufficient- ly, and the profitability of the latter is sufficiently high. Marx and Keynes have made the prophecy notorious that profitability will eventually become extinct and the capitalist mode of production will reach its state of “maximum entropy”. Only people who are utterly unable to understand the true nature of entrepreneurship and the inventiveness of the human mind could believe that. It is true that finding more profitable vertical spreads is getting ever more difficult. But the alert producer will always find them, partly because of the providence of entrepreneurs earmarking funds for R&D, and partly because of the exploration of others in search of cheaper and better sources of raw materials and energy.

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