Michael Battalio

Friday, August 28, 2015

Discussions on Wealth (part 10): Chapter 5: summary

This discussion on wealth is an offshoot of  Serious Conversations parts 53 and 54.  We are considering the book  The Origin of Wealth by Eric D. Beinhocker.  (I do not profit from clicks).  (Ed.:  we will be taking the general format of outlining the major points of the chapter and then discussing what we believe to be important or intriguing points.) 

Chapter 5 is devoted to chaos and nonlinear dynamic systems.  A dynamic system inherently depends on initial conditions (i.e. on all the previous states).  In nonlinear systems this is particularly true as even small perturbations in the starting conditions can make large difference in the final solution.  Chapter 5 relates the mathematics of nonlinear systems to economies, including the concepts of stocks and flow, feedbacks and time delays.  Chaotic systems are a type of nonlinear dynamic system that does not repeat and is deterministic; they are difficult to model and predict.
Chapter 5 continues with a description of boom and bust cycles.  They are cyclical and a mix of random and periodic processes, meaning they are not entirely predictable.  A simple example is provided showing how the cycles work.  Imagine a product is experiencing increased demand.  The producer increases prices to stifle demand, but it continues to increase.  The inventory of the product can be a short-term reserve to meet changes in demand.  However, once the inventory of the product is running low, new capacity must be utilized.  Factories rarely run at 100%, so a middle-term solution is to increase the supply.  If demand continues, a decision is made to build a new factory to produce more of the product.  Unfortunately, as soon as the new factory comes online demand decreases as competitors also flood the market.  Prices drop, but because the new factory was build the product continues to be made.  The market is flooded, and prices crash.  The factories as shuttered, and the inventories decrease.  The cycle begins anew.

This cycle is not any different from traditional economic theory.  The difference is the time scale.  Inventory is short-term, tapping into existing but unused production capacity is the middle-term solution, and building new factories is the long-term solution.  There is a lag in the time between increased demand and increased supply.  If there was some way (as it is assumed in the traditional theory) for suppliers to perfectly predict demand with immediacy these cycles would not exist.  Lastly, companies would have to work with competitors to ensure that each was supplying a specific amount (i.e. each company would need to be omniscient).  Unfortunately competitors will not work together in the real world.  This lack of knowledge and competitions prevent the economy from functioning optimally and reaching equilibrium.  

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