Friday, January 13, 2017

What can a pencil teach us about economic theory?

How is a pencil created? This question was posited by Leonard Read in his popular story, “I, Pencil”. A pencil is a relatively simple product – relatively meaning, in comparison to other products. Still, it would be impossible for any one person to oversee the entire process of producing a pencil. Where does the wood for the pencil come from? How is it processed? How do the lumberjacks acquire sustenance? Where does the graphite lead come from? How is it processed? Who makes the lacquer? Where does the rubber for the eraser come from? Who brings all of these elements together? "I, Pencil" is a foray into the world of economic complexity.


Richard Wagner describes the economy as including an ecology of plans (2010). Bryan Arthur describes the complexity paradigm as an accounting of continual emergence in an economy as plans of agents are constantly upset and readjusted (2013). Not every plan that exists can be executed. Some plan to use scarce resources must be chosen over other plans. Economic theory identifies certain regularities that arise as plans of actors compete for resources.

Economics is the study of human action. Action entails the execution of a plan or plans. Categorically, a human agent acts to improve one’s state of well-being, however the agent defines this. We may say, more generally, that action is aimed at improving the state of the world that the acting agent will inherit in the future. While all action occurs at the level of the individual, interaction between agents requires coordination. This requires that agents come to share and interact with knowledge that impinges upon their decisions. As F. A. Hayek noted, “the empirical element in economic theory . . . consists of propositions about the acquisition of knowledge (33, 1937).”  

Under a system of private property, much of the work of knowledge transmission is performed by market prices. Prices help coordinate economic activity. Having a finite budget, each agent must choose what he will and will not consume. He must choose which inputs to use. He must plan accordingly so that his flow of income at least offsets expenditures. Agents all follow some form of this rule, and must change their approach if the rule is violated. Otherwise, they will go bankrupt. 

For a price to exist, there must be an exchange executed between two parties. We know that this price will lie somewhere above the willingness to accept of the seller and below the willingness to pay of the bidder. As long as the price lies somewhere between these two points, markets will approximate the efficient outcome predicted by neoclassical economic theory (Gode and Sunder 1993; Axtell 2005) and we will observe coordination at the system level (Caton 2016). The price I pay in an exchange is simply that which is given up in order to gain the good I desire. If I am willing to pay a price that is greater than the price willing to be paid by any competing bidder, I can assure control of the desired good. Consider a house that is for sale. If I and another person both desire the house, we will both have to guess at the bid price that will secure the house. One of us will earn claim to this physical capital with a higher bid, the other will not.

The party who owns a resource is the one who is able to choose how the resource will be used and toward what end. Thus, in constructing a theoretical system of exchange, we must include a theory of property rights. The parameters of such rights depend upon the community in which a person operates and are set by beliefs of actors in the community and the incentives that reinforce certain patterns action. Ownership starts with the body. If you do not own yourself, how can you own anything at all? A person can choose the manner in which he invests his labor. Likewise, a person’s use of resources represents an extension of the will. You can only make plans using resources that you own or that the other owners are willing to share through contract or an implied reciprocal relationship. We will mostly concentrate on the use of resources that depend upon contract, though reciprocal relationships are of special importance to a theory of entrepreneurship and can be analyzed through the lens of economic theory.

Who gets to plan is simply a result of one’s budget constraint, whose growth or lack thereof is a function of one’s ability to perceive the needs of other actors and act in a manner that coheres with the future. Not every plan that is executed will succeed in achieving the end that the plan is believed to promote. I may buy a home with expectation that its price will rise and allow me to resell it for a monetary profit 5%. However, if upon resale, I only received 95% of the value that I paid for the home, I have in fact suffered a loss (negative profit). Prices represent the value of a good and allow an economic agent to perceive whether or not her action is profitable. Prices allow for accounting and, thus, for agents to make more efficient use of their resources.

In the world that we observe, the economy is comprised of relationships that are profitable for each party involved. Employees of each firm in this process offer their service at a price amenable to both themselves and their employer. These inputs are combined within a firm to offer wood to companies that process that wood for a profit. Those companies will offer the refined wood to the pencil manufacturers in Leonard Reed’s story of the pencil. If the relationship between firms ceases to be profitable, the firms will either have to reorient their internal structure, their relationship with one another, or, failing a profitable orientation, cease to have a relationship.

We can imagine firms as forming a network that is the structure of production. Each node in the network is a firm employs a particular bundle of resources that is positively valued. In order to be maintained, the structure of production must contain firms whose revenues exceed their expenditures.In the long run, the structure of production will tend to lose any nodes/firms that are not at least earning the average (market) rate of return. In that case, the capital dedicated to this process can be more profitably invested elsewhere. This reinvestment is facilitated by financial markets where the interest rate tends to match the market rate of return.

A simple rule organizes production without a single overseer. Total revenue must equal or exceed total costs (TR => TC). Firms do not have the privilege of attempting to guarantee that marginal revenues equal or exceed marginal costs (MR => MC) for each process of production except over a discrete period where they reevaluate their actions at the end of that period. A firm must choose a strategy for production and reevaluate at some later date. At the end of each period, a firm can continue employing its previous strategy, revise its plans, or exit the pool of competing firms. Likewise, a laborer will compare the costs incurred for work with the revenue currently earned from her labor. If she can earn a greater wage elsewhere, she has incentive to alter the employment of her labor.

This structure of economic action, both at the individual and system levels, contain knowledge that promotes the ends of consumers - this class includes, ultimately, those actors who act and produce profitably. This structure, based upon a system of property rights, simplifies reality sufficiently enough for agents to form expectations among one another. They provide a medium through which production and exchange can occur. With common expectations regarding interactions sufficiently realized, profit and loss guide agents in the system. Those who have foresight will quickly adjust to changing agent preferences, technologies, and flows of revenue and capital in order to increase the likelihood of earning a profit. Those who don't will likely incur economic losses.

The production of the pencil follows this general process. The firm that processes the timber, like the firm that creates rubber erasers or that produces yellow paint, will continue to produce as long as revenues remain sufficiently high. As long as entrepreneurs find a way to profit from each step of production, they will, in piecemeal fashion, successfully coordinate the resources and labor necessary to produce the final good. In a single, brief exposition, Leonard Reed’s story of the pencil has shown the mysteries that can be uncovered by economic theory.

Key Terms:

Profit – The difference between the value of the object or state acquired and the value of the object or state given up in an exchange. At its foundation, this is a feeling of gain or of loss. Monetary prices allow us to calculate an objective measure of profit.                                          

Efficiency – A criterion of action representing the lowest cost means of achieving a particular outcome

Exchange – The trading of resources between agents where the value of the object gained by each agent is valued more highly than the object that is given up.

Labor – Action offered by an economic agent either for a contracted income. The value of labor tends toward the value added to goods produced by that labor.

Capital – Goods owned by agents that can be used toward production. Markets tend to value capital according to the sum of discounted expected income that it will earn in the course of its life.

Technology - The structure of organization of elements, both physical and social. Technology is contained in capital For example, a physical hammer is capital that embodies technology that we may think of, in abstract, as a hammer. Likewise, a the structure of production itself includes social and physical capital, both of which embody technology.

Structure of Production - The network of activity comprised by firms and their capital. These existence of firms and relationships between one another depend upon exchange that promotes the profit of each party involved.

Adapted from "'I, Pencil', Complexity, and Economic Coordination"

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