Like fine wine, good ideas take time to develop. That is certainly the case with Xcheque's third law of economic gravity. It needed a little maturation time before we uncorked the bottle. But here it is! Dr Hauser has found the time to put fingers to keyboard again and reveal all. Xcheque's Third Law deals with the question of supply and demand - fundamentals of economic systems until it all goes wrong and somebody gets poked in the eye.
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The three laws of economic gravity have been something of a journey for me. I set out with all good intentions and absolute certainty - sure in the knowledge that the power of threes would carry me through (remember that - Isaac Newton, Asimov, etc ..). Then I recalled that there was a fourth law of thermodynamics and realised that there were large questions still to answer. My confidence wavered - but not for long! Some serious contemplation gave me the solution - closure of the trinity and just enough complexity for many thousands of hours of discussion in cafes, bars, and dinner tables around the globe.
Just to recap quickly, the first two articles in this series discussed the nature of work and wealth, and the inextricable link between the two ("Xcheque's three laws of economic gravity - Definitions and the First Law" Dr Jon Hauser, Xcheque.com, 13 December 2009 ; "Xcheque's three laws of economic gravity - Exploring the First Law" Dr Jon Hauser, Xcheque.com, 5 May 2010).
The Second Law of economic gravity talks to the drivers of change in economic systems - the principle that continuous improvement marches towards improved efficiency and lower cost ("Xcheque's three laws of economic gravity - The Second Law" Dr Jon Hauser, Xcheque.com, 19 June 2010).
The symbology of the laws is given below and your mousepointer will reveal the First and Second Laws and other important definitions.
The all-important Third Law closes the circle and deals with the issue of the value or price of goods and services and the associated response to supply and demand.
Xcheque's Third Law:
The value of economic wealth is limited to the quantity required to sustain the population. Production and utilisation above this level is waste and of no economic value.
or as my grandfather (and Aristotle) used to say:
Moderation in all things
I'm sure I'll get letters on this one. How can we possibly sustain our wonderful society unless we keep growing the "economy" and consuming all sorts of useless stuff to excess??? Isn't that the secret to building everybody's apparent wealth? Well I'm sorry - I don't buy this idea of endless growth and consumption. There is only so much glucose in the petri dish and when it is gone it is gone.
You all know how I love my charts and here is one that describes this law. There is a fair bit going on here so I will take it step by step.
This chart is plotting the relationship between supply and demand. It may or may not be linear but don't worry about that - there is some sort of positive correlation between the two parameters. The first thing to note is the distinction between necessary demand and actual demand.
Necessary demand takes us back to the concept of what we need to survive and sustain a long and (hopefully) happy life. Food is the obvious an immediate requirement but as we know there is a long list of other goods and services that we need (in principle at least).
Actual demand is what we actually consume. Generally speaking this is more than we need. Even dentists these days are finding new and wonderful ways of attracting people back to their surgeries. (I've got nothing against dentists by the way but I don't exactly enjoy the dental experience).
That's all very straight forward but here is a nasty little corollary to the Third Law that will make modern capitalists and economists shudder:
Xcheque's Third Law - Corollary 1:
Actual Value (as wealth) = ƒ ( Necessary Demand / Actual Supply )
This is saying that the total value of real wealth is related to the ratio of necessary demand and actual supply. That means that real value is capped at the point where supply is matched to necessary demand. Supply in excess of this level will diminish the average value of the product or service. The surplus supply is effectively waste and of no additional economic value.
The reason why this corollary will upset conventional economists is the alternate view that if demand exists wealth can be created - as long as we all want two cars, 3 televisions, houses heated to 27°C, and the latest mobile phone, the value of those products is real. For me the last case here is the best example of the Third Law in action. When you buy a new phone the old one generally goes in the bin. Whether you consider the old one or the new one to be waste it doesn't matter, no additional value has been created but you have transferred some of your wealth to the phone company and a large number of intermediaries.
Xcheque's Third Law - Corollary 2:
When a supply limit is reached demand must contract back towards necessary demand to avoid complete destabilisation of the economy and maintain sustainability of the population.
Extending the supply / demand curve to the limit of available supply creates a point of instability. While actual demand sits above necessary demand the opportunity exists to contract demand and rebalance. This is in fact an argument for some level of surplus demand and supply. In times of shortage there is opportunity to rebalance. When supply falls below necessary demand things can get very ugly and history tells us they probably will.
And how does all this define the price of goods and services? It's pretty simple really. In an unregulated production system price movement is the primary mechanism for rebalancing supply and demand. Supply exceeds demand and the price goes down. Suppliers then back off production or demand increases and a balance is restored. When supply is short prices go up. Suppliers get excited about profit opportunity and produce more. Either that or buyers become price sensitive and buy less.
Enough of the economic theory. Let's get back to what this means to the global dairy industry.
There is good news and bad news. First the good news.
The good news is that the dairy foods are a core part of the Western diet and a growing part of Asian diets. The demand for dairy products is real and can reasonably be associated with the "necessary" products required to sustain the population. Dairy foods are substitutable but that seems unlikely to occur any time soon. So dairy is not a modern fad and is unlikely to go the way of the fax machine or the floppy disk - the demand side is reasonably secure.
The bad news is that milk and dairy commodity pricing is particularly sensitive to small imbalances in supply and demand. Attempts by Governments to control this balance have proved quite ineffective and a high level of price volatility seems inevitable.
This issue of volatility has been discussed in other recent blogs(1,2) and there is much more to be said about the matter. What everyone wants to know is whether there is any predictability in both the short term and the long term trends. This is where the three laws of economic gravity kick in and help us to understand these trends. In the next article of this series I will start to show how we should be reading the tea leaves of international dairy trade and how this flows through to milk price.
1 "Charting global milk price volatility" Dr Jon Hauser 25th July 2010
2 "On the causes of milk price volatility" Dr Jon Hauser 22nd August 2010