A Bit of Economics — Part 5

{Read part 4 here.}

In the previous bit, we briefly discussed prices. Prices are important because without prices we will be incapable of economic calculations. Prices guide us to choose the best among alternative courses of action. Imagine going to a store in which there are no prices — just stuff that we pick up and at the checkout they charge some random amount for it. We have to know prices before we buy.

Firms face the same problem.

We will use the word “firms” to mean small (mom and pop stores, little hole in the wall joints), medium (a car dealership, a garbage collection service) and large businesses (corporations like Toyota, Apple and Google.)

What do firms do? They buy or hire inputs — materials, labor, technology, capital — and produce various goods and services. That involves costs and they have to use prices to guide what to produce and how. Should they make it in-house or would it be cheaper to buy from some other supplier?

The revenues of firms comes from the sale of their production. Which means that they have to produce stuff that people willingly part with their money for. If the revenues don’t cover the costs over the relevant time period, they go out of business.

Strictly speaking, Tim Cook bosses over every Apple employee but he is not his own boss; Tim Cook has millions of bosses who are called customers of Apple products. If Tim Cook doesn’t please sufficient number of his bosses, Cook and his employees would be out of their jobs.

In a market economy, the customers are the real bosses. The customers decide whether the price they pay is worth the stuff they buy. They have choices — whether to buy from this or that firm. This choice serves an essential function in the economy. It disciplines producers.

Toyota produces good cars because Honda produces good cars. If Honda produced good cars and Toyota produced lemons, Toyota would be toast, and vice versa. If Honda produced trash, Toyota would get away with producing trash. This is why monopolies are bad for the consumer. That is why firms like to get protection from competition by lobbying the government. And those governments that get into bed with businesses, end up ruling over failed economies.

What motivates firms to produce good stuff? One word: profits. When a firm makes a profit in a free market (which we must remember  is a market that has no barriers to entry or exit), it first of all means that their cost of production is lower than the revenue they get.

Let’s unpack that last statement very carefully. It means that the firm has combined factors x, y and z (which together cost them C) to produce some product which consumers paid R for. If C is less than R, then the firm makes a profit; else it suffers a loss.

Equation time:    Profit (of loss) = Revenue – Cost or F = R – C.

The profit the firm makes is a proxy measure of only a fraction of the welfare gains for the economy. The claim here is that the total gains to the society from the production and sale of the firms output is G.

What are the components of the total gains G? First, there’s the firm’s profit F. Then there’s the aggregate consumer surplus, S. What’s this S, you may ask.

When you buy a gizmo for $100, you get more than what you paid for. We don’t know exactly how much more value you get out of the $100 gizmo but it has to be more than $100. Why? Because if you gained exactly $100 of value, why would you bother doing the exchange. You would just keep your $100 and forget getting the gizmo.

Logically, therefore, we have to conclude that you got, say, $150 of value. Your consumer surplus s is therefore $50 in that case. So now, we can say that when one million people buy smartphones and each of them on average gains $50 of consumer surplus s, then the aggregate consumer surplus S from it all is $50 million.

Now back to our firm that made those 1 million smartphones. Suppose that firm’s profits from making the smart phones worked this way. Their cost of a smartphone was $90 and they sold the phones at $100 a pop. So per phone they made $10, and therefore they had a profit of $10 million from the million phones they sold.

Therefore, the total welfare gains from this whole business of making and selling one million phones was $10 million (profit to the firm) plus $50 million (the aggregate consumer surplus), which is $60 million.

Note that the firm was able to capture only a fraction (10 out of 60) of the total welfare gains that it created for society. When we note that some firm has made $100 billion in profits (and horror of horrors, has not paid taxes on those profits), we have to remember that they have likely created hundreds of billions of value for society.

Conversely, when a firms makes a loss, that loss is only a small fraction of the larger loss that the society suffers. When Air India loses $10 billion, Indians suffer many multiple that amount.

Question: Jeff Bezos has a net worth of around $200 billion. How much value has he created for the world?

The bottom line here is that profits are wonderful. And losses are bad. A firm making losses tells you that they are destroying resources which could have been used by others to create welfare gains for society.

The basic responsibility of a firm is therefore to make a profit. That is their corporate social responsibility — to make a profit doing honest business. We in India traditionally call it shubh labh.

It’s not the business of firms to do social work, or to do charity or to make their customers morally upright or anything else that strikes the fancy of politicians and moral busybodies. It’s not the firms’ business to save the earth or make the world a better place.

We’ll discuss this and other matters in the online session. In the meanwhile, please feel free to add your questions in the comments section to this post.

Talk to you on Friday at 9 PM IST.


Author: Atanu Dey


5 thoughts on “A Bit of Economics — Part 5”

  1. Atanu,

    I have the following questions.

    1. What is your opinion on Anti-Discrimination Laws on hiring and firing in a free market?
    2. Do you think the free market mechanism with no restrictions on firing also enables the cancel culture (https://en.wikipedia.org/wiki/Cancel_culture)? For Example, A firm can be arm-twisted by its customers (or rather a loud small group of customers) to remove someone from a platform or disconnect someone from a service based on public opinion. Should we make a distinction between basic utilities (Telephones, ElectricityInternet) and Services (Websites, Club memberships)?


  2. Hi Atanu,

    1.Why is MSP(Minimum support price) all the rage in India for farm products?
    2.Is there no trust in the Market Mechanism leading to an organic price discovery?
    3. Is our Market manipulated by Corporates leading to a distrust in this mechanism , since this seems to be the common discourse in the public domain.

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