Tag: Economics

Gresham’s Law: Why Bad Drives Out Good As Time Passes

Whenever coins containing precious metals have been used along with base metal coins of the same denomination, both legally accepted as tender, the bad coins have driven the good coins out of circulation.

Gresham’s Law is named after Sir Thomas Gresham (1519-1579), an English financier in the time of the Tudors.

However, the original principle had been stated at least forty years before by Nicolaus Copernicus and has been credited to Christian and Islamic scholars even before that. In some parts of the world (mostly Central and Eastern Europe), the law is still known as the Copernicus Law.

The idea may practically date back as far as the Athenian playwright Aristophanes. In his play The Frogs, Aristophanes compares the degradation of great politicians to the introduction of bad coinage.

I’ll tell you what I think about the way

This city treats her soundest men today:

By coincidence more sad than funny,

It’s very like the way we treat our money.

The noble silver drachma, which of old

We were so proud of, and the one of gold

Coins that rang so true

Throughout the world have ceased to circulate.

Instead the purses of Athenian shoppers

Are full of phoney silver-plated coppers.

Just so, when men are needed by the nation,

The best have withdrawn from circulation.

The coinage problem is mostly obsolete in the modern age, but the practical problems are as large as ever.

The outcome described by Aristophanes is common in competing human groups or organizations: When bad behavior has taken root, and that bad behavior has a “survival advantage” against good behavior, it becomes difficult, and occasionally impossible, to drive out the bad behavior; a process akin to natural selection.

In fact, one might call Gresham’s Law something of a special case of natural selection itself.

Forms of human behavior survive because they have a competitive edge against other behaviors. Self-interested groups naturally tend towards what works, so bad drives out good (in a moral sense) if it causes superior practical effects. This is one large reason why forms of regulation and policing are needed in human systems, to prevent the Law from working its magic.

In an illustration of this tendency, Charlie Munger applied Gresham’s Law to 1980s savings and loan banking practices in his 1984 Letter to Wesco Shareholders:

Although interest rates have subsided from the 1981-82 peak, the low and slowly changing interest rates of former years are plainly gone with the wind, as are the former government-decreed limits on interest rate competition for savings accounts and the favouritism for savings and loan associations over banks. But an agency of the U.S. Government (…) continues to insure savings accounts in the savings and loan industry, just as it did before. The result may well be bolder and bolder conduct by many savings and loan associations. A sort of Gresham’s Law (“bad loan practice drives out good”) may take effect for fully competitive but deposit-insured institutions, through increased copying by cautious institutions of whatever apparent-high-yield loan and investment strategies seem to allow competitors to bid away their savings accounts and yet report substantial earnings. If so, if “bold conduct drives out conservative conduct,” there eventually could be widespread insolvencies caused by bold credit extensions come to grief.

This can be common in some business fields. Take two drug salespeople – one willing to bribe doctors to make sales, and one not willing to do so. If the industry functions such that fraudulent business practices are not punished, and the bribery goes uncovered by the buyer’s organization, then bribery obviously gains a sustainable competitive advantage over non-bribery. Clearly, the deceptive practice will take hold, as salespeople unburdened by morals are promoted and compensated better than the high-roaders. It’s a clear form of Gresham’s Law.

Take also sub-prime mortgage lending practices in the lead up to the 2008 financial crisis. If two banks are competing for borrowers and one lets their standards slide to zero (or less), which is likely to prevail? Even if the practice is a “long-term loser,” it can still take hold in systems where short-term incentives provide encouragement to the actual decision-makers.

Canadian Prime Minister Mackenzie King once described the origins of Gresham’s Law and its effects in a similar fashion, dubbing it the Law of Competing Standards.

In the reign of Queen Elizabeth, an official named Gresham observed that where different metals were in circulation as coinage and some were better than others of the same nominal value, the coins made of the inferior metal tended to drive the better out of circulation. The better coins were either hoarded or melted down and sold as bullion, were used in the fine arts, or were absorbed in the foreign exchanges. In other words, what Gresham discovered was that cheaper money tends to drive out dearer; that when people begin to discriminate between two coinages, they will invariably pay out the inferior and hoard the better, thus removing the better from circulation. This phenomenon once generally observed came to be described as a “Law,” and was identified with Gresham’ s name, since it was Gresham who was first successful in drawing public attention to it. Amongst money-changers, Gresham’ s Law of the precious metals is better known than the Ten Commandments.

Something analogous to Gresham’s Law will be found to obtain in the case of competing standards in Industry. Assuming there is indifference in the matter of choice between competing commodities or services, but that in the case of such commodities or services the labor standards involved vary, the inferior standard, if brought in this manner into competition with a higher standard, will drive it out, or drag the higher down to its level. This is effected by the opportunity of under-selling which comes, where in such cases human well-being is sacrificed to material ends. The superior standard, not being recognized or demanded, is unable to hold its own, and in time disappears. This Law is just as real and relentless in its operation in Industry as Gresham’s Law of the precious metals is with respect to money and the mechanism of exchange. Indeed, a more accurate exposition would describe both as manifestations of one and the same law, which I propose to call the Law of Competing Standards. I see no reason why economists should not recognize the existence of such a law, and incorporate it immediately in economic science as being quite as significant as the Law of Supply and Demand, the Law of Diminishing Returns, or any other Law accorded a place in its nomenclature.

The Law of Competing Standards is doubtless a part of the general Law of Competition, under which the cheaper of two commodities gains in competition a preference over the dearer. What Gresham discovered was an important sequence of the Law of Competition as applied to coinage; namely, the disappearance, in the course of time, of the superior metals. Observance of a like sequence in the case of standards in Industry is highly desirable. As respects labor standards, I believe that recognition of the operation of the Law of Competing Standards over ever-widening areas would do more than aught else to clear up the most baffling problems with which Industry is confronted, and to point the way to a solution of many situations which hitherto have seemed incapable of solution.

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Perhaps the most important application of Gresham’s Law is to avoid becoming part of systems where good behavior cannot win. Certain industries and activities lack the “policing” necessary to keep systems free from bad behavior. While it’s admirable to be the “cleanest shirt” in a pile of dirty laundry, certain areas of human life do not allow the clean shirts to win.

On the flip side, you’ll occasionally find situations where the good money drives out bad, and the cleanest shirts end up being worn the most. Those are the areas to aim your focus.

Gresham’s Law is one of Farnam Street’s Latticework of Mental Models.

The Principles of Comparative Advantage: Why Tiger Woods Shouldn’t Mow Your Lawn

In economics, comparative advantage refers to the ability of a person or nation to produce a good or service at a lower opportunity cost than another person (or nation). This is why trade can create value for both parties—because each person can concentrate on the activity for which they have the lower opportunity cost. It also explains why Tiger Woods shouldn’t mow your lawn.

The term “comparative advantage” is usually attributed to David Ricardo. In his 1817 book On The Principles Of Political Economy And Taxation, Ricardo used the example of trade between England and Portugal.

Portugal could produce both wine and cloth with less labor than it would have taken to produce the same output in England. However, the relative costs are different (currencies have different values). From Ricardo’s point of view, England had difficulty producing wine and very little difficulty producing cloth. Portugal, however, could easily produce both wine and cloth. Ricardo concluded that while it was cheaper to produce cloth in Portugal than England, it is cheaper still for Portugal to produce excess wine and trade this for English cloth. England would benefit from this trade because its cost of producing cloth has not changed but it can now get wine at a lower price. Thus, each country can gain by specializing in the good that has a comparative advantage.

One of the drawbacks of trade in this way is that it creates increasing interdependence among people or nations. In Ricardo’s example, England and Portugal relied on each other for certain goods. This is possible as long as it is in the self-interest of each nation and there are no disruptions.

In the leading economics textbook, Principles of Microeconomics, Greg Mankiw offers the following:

Differences in opportunity cost and comparative advantage create the gains from trade. When each person specializes in producing the good for which he or she has a comparative advantage, total production in the economy rises, and this increase in the size of the economic pie can be used to make everyone better off. In other words, as long as two people have different opportunity costs, each can benefit from trade by obtaining a good at a lower price than his or her opportunity cost of that good.

 

Real Life Examples

Should Tiger Woods Mow His Own Lawn?

Tiger is a great athlete. One of the best golfers to have every lived. Most likely he is better at other activities too. Tiger is probably in better shape than most: He can run faster, lift more, and work quicker. For example, Tiger can probably mow his lawn faster than anyone else. But just because he can mow his lawn fast, does this mean he should?

To answer this question we can use the concepts of opportunity cost and comparative advantage. Let’s say that Tiger can mow his lawn in 2 hours. In the same two hours he could film a television commercial for golf clubs and earn $100,000. By contrast, Joe, the kid next door can mow Tiger’s lawn in 4 hours. In that same 4 hours he could work at McDonald’s and earn $24.

In this example, Tiger’s opportunity cost is $100,000 and Joe’s is $24. Tiger has an absolute advantage in mowing lawns because he can do the work in less time. Yet Joe has a comparative advantage because he has the lower opportunity cost. The gains in trade from this example are tremendous. Rather than mowing his own lawn, Tiger should make the commercial and hire Joe to mow his lawn. As long as Tiger pays Joe more than $24 and less than $100,000, both of them are better off.

(Another example, this one from wikipedia)

Two men live alone on an isolated island. To survive they must undertake a few basic economic activities like water carrying, fishing, cooking and shelter construction and maintenance. The first man is young, strong, and educated. He is also, faster, better, more productive at everything. He has an absolute advantage in all activities. The second man is old, weak, and uneducated. He has an absolute disadvantage in all economic activities. In some activities the difference between the two is great; in others it is small.

Despite the fact that the younger man has absolute advantage in all activities, it is not in the interest of either of them to work in isolation since they both can benefit from specialization and exchange. If the two men divide the work according to comparative advantage then the young man will specialize in tasks at which he is most productive, while the older man will concentrate on tasks where his productivity is only a little less than that of a young man. Such an arrangement will increase total production for a given amount of labor supplied by both men and it will make both of them richer.

Mental Model: Supply and Demand

Supply and demand is a foundational economic mental model. Understanding it is instrumental in building a better picture of how the world works.

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The law of demand states that there is an inverse relationship between the price of a good and the quantity of the good demanded. Demand can be influenced by: the income level of the buyer, the price of the good, the availability of substitutes.

The law of supply states there there is a positive relationship between the price of a good and the quantity supplied. The price levels of the good, the costs of inputs to produce the good, and the technological costs to produce a good are all factors that influence the level of goods supplied. We can also consider wider factors which influence demand, such as:

In Principles of Microeconomics, Greg Mankiw offers the following introduction to Supply and Demand:

When a cold snap hits Florida, the price of orange juice rises in supermarkets throughout the country. When the weather turns warn in New England every summer the price of hotel rooms in the Caribbean plummets. When a war breaks out in the Middle East, the price of gasoline in the United States rises, and the price of a used Cadillac falls. What doe these events have in common? They all show the workings of supply and demand.

Supply and demand are the two words that economists use most often–and for good reason. Supply and demand are the forces that make market economics work. They determine the quantity of each good produced and the price at which it is sold. If you want to know how any event will affect the economy, you must think first about how it will affect the supply and demand.

The terms supply and demand refer to the behavior of people as they interact with one another in markets. A market is a group of buyers and sellers of a particular good or service. The buyers as a group determine the demand for the product and the sellers as a group determine the supply of the product.

We assume (in this chapter) that markets are perfectly competitive. Perfectly competitive markets are defined by two primary characteristics: (1) the goods being offered for sale are all the same, and (2) the buyers and sellers are so numerous that no single buyer or seller can influence the market price. Because buyers and sellers in perfectly competitive markets must accept the price the market determines, they are said to be price takers.

The determinants of individual demand.

Consider your own demand for ice cream. How do you decide how much ice cream to buy each month, and what factors affect your decision. Here are some of the answers you might give.

Price: If the price of ice cream rose to $20 per scoop, you would buy less ice cream. You might buy frozen yogurt instead. If the price of ice cream fell to .20 per scoop, you would buy more. Because the quantity demanded falls the the price rises and as the price falls, we say that the quantity demanded is negatively related to the price. This is what the economists call the law of demand: Other things being equal, when the price of a good rises, the quantity demanded of the good falls.

Income: What would happen to your demand for ice cream if you lost your job one summer? Most likely it would fall. If the demand falls when income falls, the good is called a normal good. Not all goods are normal goods. If the demand for a good rises when income falls the cood is called an inferior good. An example of an inferior good might be bus rides. As your income falls, you are less likely to buy a car or take a cab and more likely to ride the bus.

Price of related goods: Suppose that the price of frozen yogurt falls. The law of demand says that you will buy more frozen yogurt. At the same time you will probably buy less ice cream. When a fall in the price of one good reduces the demand for another good, the two goods are called substitutes.

Tastes: The most obvious determinant of your demand is your tastes. If you like ice cream you buy more of it.

Expectations: Your expectations about the future may affect your demand for a good or service today. For example, if you expect to earn a higher income next month, you may be more willing to spend some of your current savings to buy ice cream.

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In his speech, entitled ‘Academic Economics Strengths and Faults after Considering Interdisciplinary needs,’ Charlie Munger said:

I have posed at two different business schools the following problem. I say, “You have studied supply and demand curves. You have learned that when you raise the price, ordinarily the volume you can sell goes down, and when you reduce the price, the volume you can sell goes up. Is that right? That’s what you’ve learned?” They all nod yes. And I say, “Now tell me several instances when, if you want the physical volume to go up, the correct answer is to increase the price?” And there’s this long and ghastly pause. And finally, in each of the two business schools in which I’ve tried this, maybe one person in fifty could name one instance. They come up with the idea that occasionally a higher price acts as a rough indicator of quality and thereby increases sales volumes.

This happened in the case of my friend Bill Ballhaus. When he was head of Beckman Instruments it produced some complicated product where if it failed it caused enormous damage to the purchaser. It wasn’t a pump at the bottom of an oil well, but that’s a good mental example. And he realized that the reason this thing was selling so poorly, even though it was better than anybody else’s product, was because it was priced lower. It made people think it was a low quality gizmo. So he raised the price by 20% or so and the volume went way up.

But only one in fifty can come up with this sole instance in a modern business school – one of the business schools being Stanford, which is hard to get into. And nobody has yet come up with the main answer that I like. Suppose you raise that price, and use the extra money to bribe the other guy’s purchasing agent? (Laughter). Is that going to work? And are there functional equivalents in economics – microeconomics – of raising the price and using the extra sales proceeds to drive sales higher? And of course there are zillion, once you’ve made that mental jump. It’s so simple.

One of the most extreme examples is in the investment management field. Suppose you’re the manager of a mutual fund, and you want to sell more. People commonly come to the following answer: You raise the commissions, which of course reduces the number of units of real investments delivered to the ultimate buyer, so you’re increasing the price per unit of real investment that you’re selling the ultimate customer. And you’re using that extra commission to bribe the customer’s purchasing agent. You’re bribing the broker to betray his client and put the client’s money into the high-commission product. This has worked to produce at least a trillion dollars of mutual fund sales.

This tactic is not an attractive part of human nature, and I want to tell you that I pretty completely avoided it in my life. I don’t think it’s necessary to spend your life selling what you would never buy. Even though it’s legal, I don’t think it’s a good idea. But you shouldn’t accept all my notions because you’ll risk becoming unemployable. You shouldn’t take my notions unless you’re willing to risk being unemployable by all but a few.

I think my experience with my simple question is an example of how little synthesis people get, even in advanced academic settings, considering economic questions. Obvious questions, with such obvious answers. Yet people take four courses in economics, go to business school, have all these IQ points and write all these essays, but they can’t synthesize worth a damn. This failure is not because the professors know all this stuff and they’re deliberately withholding it from the students. This failure happens because the professors aren’t all that good at this kind of synthesis. They were trained in a different way. I can’t remember if it was Keynes or Galbraith who said that economics professors are most economical with ideas. They make a few they learned in graduate school last a lifetime.

Warren Buffett on Supply and Demand

Our second non-traditional commitment is in silver. Last year, we purchased 111.2 million ounces. Marked to market, that position produced a pre-tax gain of $97.4 million for us in 1997. In a way, this is a return to the past for me: Thirty years ago, I bought silver because I anticipated its demonetization by the U.S. Government. Ever since, I have followed the metal’s fundamentals but not owned it. In recent years, bullion inventories have fallen materially, and last summer Charlie and I concluded that a higher price would be needed to establish equilibrium between supply and demand. Inflation expectations, it should be noted, play no part in our calculation of silver’s value.

In the 1978 shareholder letter, Buffett offered the following comment on supply and demande as it relates to commodity businesses earning a profit:

The textile industry illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage. As long as excess productive capacity exists, prices tend to reflect direct operating costs rather than capital employed. Such a supply-excess condition appears likely to prevail most of the time in the textile industry, and our expectations are for profits of relatively modest amounts in relation to capital.

In the 1982 annual letter to shareholders, Buffett wrote:

If, however, costs and prices are determined by full-bore competition, there is more than ample capacity, and the buyer cares little about whose product or distribution services he uses, industry economics are almost certain to be unexciting. They may well be disastrous.

Hence the constant struggle of every vendor to establish and emphasize special qualities of product or service. This works with candy bars (customers buy by brand name, not by asking for a “two-ounce candy bar”) but doesn’t work with sugar (how often do you hear, “I’ll have a cup of coffee with cream and C & H sugar, please”).

In many industries, differentiation simply can’t be made meaningful. A few producers in such industries may consistently do well if they have a cost advantage that is both wide and sustainable. By definition such exceptions are few, and, in many industries, are non-existent. For the great majority of companies selling “commodity”products, a depressing equation of business economics prevails: persistent over-capacity without administered prices (or costs) equals poor profitability.

Of course, over-capacity may eventually self-correct, either as capacity shrinks or demand expands. Unfortunately for the participants, such corrections often are long delayed. When they finally occur, the rebound to prosperity frequently produces a pervasive enthusiasm for expansion that, within a few years, again creates over-capacity and a new profitless environment. In other words, nothing fails like success.

What finally determines levels of long-term profitability in such industries is the ratio of supply-tight to supply-ample years. Frequently that ratio is dismal. (It seems as if the most recent supply-tight period in our textile business – it occurred some years back – lasted the better part of a morning.)

In some industries, however, capacity-tight conditions can last a long time. Sometimes actual growth in demand will outrun forecasted growth for an extended period. In other cases, adding capacity requires very long lead times because complicated manufacturing facilities must be planned and built.

And In the 1991 letter, Buffett wrote:

In contrast, “a business” earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management.