What is Economics and Why Do MBAs have to Study it?

Economics is the study of how societies cope with scarcity of resources (like human resource time, natural resources, investment capital, know how, etc.). When economic actors (workers, investors, owners of land, etc.) are free to choose for themselves, we have what we call a “market economy”. This is more or less what we have in most parts of the world. In such a situation (where individual economic actors like workers, businesses, farmers, and investors are working to make choices that make themselves and their families better off) things change a lot. Some prices are rising, other falling, capital is flowing into some industries and away from others, firms that had no competitors sometimes find themselves with new ones. The playing field for businesses in particular is ever changing.

In this environment it is critical for success that businesses correctly assess what is going on in their environment, how it will impact their situation, and what might be the best response. Economics is helpful here. it helps us anticipate what the consequences might be when situations change (like changes in the competitive structure of a market, like changes in food prices when the weather in California is particularly harsh, like changes in tax laws, or changes in duties on imported goods, and many others). Situations affecting most businesses change almost continuously— their customers get concerned about losing their jobs, competitors are changing strategy, their supply chain is being affected by economic policy of foreign governments, and many others. How do businesses keep up with these threats and opportunities?

Well, an economics course will help understand how markets work, and how these markets are often linked together— helping string together the impact of some event or changed circumstance to the consequence on a particular business.  But how do we get data to say whether relevant circumstances are changing, or relevant events are occurring? Where’s the data coming from? It comes from the news, talking with customers, reading trade magazines, watching TV, the dinner table, and lots of other places. Economics data is everywhere— though people not trained in economics don’t often see it. We need to be sensitized to it being there—  Once we see it, we realize we are swimming in data–some of which may have consequences for our business, our career, the way we allocate our 401k money, the strength of our big competitor, and the way our customers are going to behave.

It is like an awakening to what’s always been surrounding us. As we develop and learn we come to realize that data is everywhere, but only when we learn to connect the dots do we bother to pay attention to all the data. We just don’t see all the data until we are sensitized to it being there.  Like children, we are all born pretty oblivious to “connecting the dots” about what the future will bring to us. The child’s world is simple, not complex. As they age they begin to learn about things. One example of a new level of understanding , an awakening so to speak,  is “learning about relationships”. Kid begin to learn that people don’t always get along. And, some get along in “very special ways”. Some people hurt each other, some marriages fail, some people make lots of new friends, others stay pretty much alone. There are lots and lots of complexities in how adults, and children “get along with each other”.  Once this “world” strikes people, they begin to pay attention–they begin to be analytic about it—what are the predictive signs? When they begin to notice and try to “predict” what sort of relationship tendencies are present, they see that their world is full of data about “relationships”. They develop this appreciation for data slowly. But, if you are interested, the world is full of data. Biologists see the world differently because it is full of “biologic data” that others not trained to see the value of it just don’t see. Artists too see a different world than the rest of us– a world of shapes and colors and textures.

So it is with economic signals and clues— situations are changing and events occurring all the time. If we begin to care about how the world is changing in ways that are going to impact my business or my career or my investments, i will begin to see the data for the first time. It is everywhere. Economics helps to open our eyes to the clues that effect the economy, our business success, our family’s economic future.

Economic Forces and Assumptions

All microeconomic forces in market economies stem from 3 basic assumptions about economic actors like buyers, sellers, investors, employers , and employees:

• everything is scarce— there just not enough time, resources, and money and the the stuff you can make with these things to satiate everyone’s needs. Collectively, we say that society has insatiable wants.
• free choice — because of scarcity every economic actor has to make choices, because they can’t have everything they might like.
• pursuit of individual self interest— the driver behind the choices they all have to make is self interest (or maximization of their own or family welfare).

Why choose these assumptions? It seems rather random–but its fairly simple. Think about the most basic kind of economy. A bunch of hunters, gatherers, and primitive artisans meet up for the first time at a common watering hole in Ethiopia or Kenya. They quickly become aware of the variety of foodstuffs, tools and clothing available. Some want to acquire things they don’t have. Some want to trade excess stuff they have for other things they dont have. Some individuals want both. They start trading. What are the assumptions that characterize this basic economy.  Not enough stuff for everyone to have everything they might want. Free choice. All scrambling to make the best deals they can for their own (and family) welfare.

Based on these three assumptions, economic forces are formed from the economic  scramble to wherein everyone is striving to get the most they can out of their scarce resource endowments. The “scramble” looks like chaos for those that dont know economics. But, to those who have studied economics, the “scramble” is subject to a few simple patterns of market forces. These market force “winds” blow predictably across the economy, helping those people who understand them to “predict” what the consequence will be of economic events that are happening (eg. a new study suggests that prunes are bad for health, political leaders in the middle east restrict oil production, trade barriers are taken down, or a new kind of better battery technology is perfected, etc.).

The market forces discussed here are very basic ones. They are;

1. substitution in choice behaviors
2. productive efficiency and specialization
3. competition for customers
4. avoiding competition and market power
5. the drive to equilibrium
6. profits and investment flows

Economists have studied real situations for hundreds of years, and have developed an array of “theories” about these and derivative “forces” that may exist under more specific kinds of assumptions. But, we will stick to the basic, and more ubiquitous market forces here. But, before explaining these 6 forces, it would be good to briefly discuss two related issues:

First, these market forces only occur when the 3 assumptions we made actually exist. This situation of the three assumptions is often characterized by the term “the free market economy”, or “capitalism”. People (investors, employers) are all on their own to deal with scarcity, and their own needs and wants. That chaos or “scramble” is the way “capitalism” works. Everybody trying to make the best of their initial endowments of time, money, skill, and knowledge. Free choice is running amuk.

Of course, there are other ways to organize an economy. Think about what goes on inside a business firm, a big one, like GM or GE or Exxon. These “internal corporate economies” are themselves bigger than the economies of some small countries. Millions of exchanges of things occur every day between business units and between individual workers, and yet the “economy” within these companies is hardly a “free market”. Owners don’t want that, they want these economic activities all organized and coordinated to serve their own (owner’s)needs, not the needs of all the individual workers. They want everything planned out, and they hire managers to make sure that all the workers and business units know exactly what is expected of them, and how they should behave. This is a planned economy. Workers don’t have “free choice” about what to do, what to do with their finished products, and the like. Departmental managers are not free to use their “budgets” in any way they choose. No, the business firm is a carefully planned economy, where participants don’t have free choice. And, nobody (except the owners and very top managers), is able to pursue their own self interest. The main choices they have is whether to work there, or not, and what to do with their take home pay.

Such planned economies have also been established within country borders — China, USSR, and Cuba are the most well known. Here, a central government authority makes a plan for the economy– what’s going to be produced, how much of everything will be produced, where it will be produced, how it will be produced, who will be working in which place to produce all of it, and most importantly, who will receive the finished products and services, etc. etc. Yes, its a complex plan. But, doing such plans and organizing their implementation is feasible. We could call it “a socialist economy”. Here, the needs, wants, and priorities of the “society” are placed above those of the “individual people” (eg. the individual economic agents have very limited choice to pursue their own self interest). Different assumptions! The “market forces” described here just dont exist the same way in such a place —though uncontrolled aspects of those economies, where people are free to choose according to their own selfish preferences, do seem to function in a scrambled fashion, according to market forces.

Are the 3 basic assumptions “better” than other sets of assumptions? That is not possible to say. That is a political question, not an economic one. Political issues are always a matter of winners and losers. Better for who? Worse for who? Some people argue that “free market assumptions”(the three individual rights listed above) may have “winners” and “losers” according to initial “endowments” of talent or wealth. And, therefore, not be “fair” to all, and could be modified in order to provide a better result for all groups. Others believe (including most economists) that the “economic forces of capitalism”– described below– generate a more efficient use of scarce resources, and produce a bigger pie for society to share — allowing society to be better off. Is this a winning argument? That’s a political question, not an economic one, because there is involves assessment of the comparative welfare of the “winners and losers”. These political questions involve fairness, or normative issues. Similarly, questions of sustainability of resources, global warming, and issues of social fairness are often raised about “free markets” or “alternative ways of deciding how the economy works”.

In the words of a famous political economist, socialism is an economic system designed so as to achieve “from each according to ability, to each according to need”. Capitalism might be characterized as “from each according to ability, to each according to ability”. These are terribly important political issues, and while they may influence how we vote, they are way beyond the study of “how market forces” work.

1.substitution as a universal response to change — the most basic economic force is called “substitution”. It stems from scarcity of resources. It is the behavior of economic actors to make “adjustments” in their choice behaviors in order to maximize self interest when circumstances change. When circumstances change, they “adjust” what they buy, how much they buy, how much they produce and how they produce it, and all other choices. Adaptation always occurs as economic actors fine tune their use of time and money to changed circumstances. They always have some options available about how they might adjust. They can change what brand they buy or whether to spend money on any brand at all. They can change the skill requirements of the employees they hire, or even whether to be in the business any longer. They can change the timing of their buying and selling behaviors.

That is, they always can respond to the market circumstances by making a change if it is in their best interest to do so. This possibility of substitution works for consumers, suppliers, investors, for every economic actor. Even when there is only one airline flying to the place your going, you have options. You can substitute. You could drive, take the train, hitchhike or even do GoToMeeting or Facetime in a pinch. Substitution possibilities for what we do, or how much of it we choose to do, are always possible as adjustments to changes in market situations. It is a powerful force in the economy– and it stems from scarcity and fine tuning to maximize self interest.

For consumers, when the price of a Public Transit-pass goes up by $0.25, they have to decide how to respond to the circumstance– they can substitute other ways of transport. Or, it is also  possible to change by moving other items in the budget around in order to accommodate the price change. Maybe some consumer will change by no longer doing public transit– and others will not stop riding, or stop riding as much. Everyone will “adapt” by some form of substitution.

The extent of substitution by consumers is related to preferences and the availability of close “substitutes”. Maybe, for one commuter, the wife drives near to the ‘destination’ an hour earlier, and this “alternative” presents a close substitute for taking the “T” when the price goes up. Not everyone has a “close substitute” like this. But some do.

So, individuals will vary in their substitution behaviors according to their wants and situation. So when the ticket price goes up by $0.25 if they have a “close substitute”, they will be more likely to make a change and “substitute” another form of transport for this one. And their tendency to substitute against the higher priced good relates to how long we wait to observe (and measure) the substitution behavior. if we give the person only a day to make a change, few will be able to do it— but if we give them a month to consider a change, many more will be able to substitute. Individuals will always find ways to substitute to some degree against things that have become more expensive. On the other hand, as certain products become more attractive in some way (price, functionality, fashion, etc.) consumers will substitute in favor of them.

Substitution is the reason for the “law of demand”. This hypothesis in economics says that when prices go up, people (all people in the market taken together) buy less.  Some people who have urgent (or addictive) needs for the product may not buy less. But, in the aggregate, the market demand will be lower at a higher price. Why is this? It is substitution at work. Because of scarcity, and fixed budgets, people will adjust the amount they buy when prices rise. Some will make no changes, some will make small reductions, others larger changes— as they try to rebalance their mix of consumption according to the new relative price situation. Consumers will spend their scarce resources differently:  buying more of the things whose relative price has fallen, and less of those things for whom the relative price has risen.

Firms/Employers substitute too.  When the price of labor goes up they “fine tune” their operations in order to use less of the now more expensive labor by substituting cheaper and less skilled labor. Or, if given enough time, by substituting more or more versatile equipment or by outsourcing certain processes entirely. When circumstances change, adjustments will follow to substitute away from resources that have risen in price or against selling in markets that have become less attractive.

2.Production Behaviors and Specialization

Why do we have firms anyway, specializing in making only one thing?  Why do our jobs often so narrow or specific — selling want ads for one newspaper, or riveting the left side of honda bumpers on an assembly line? Why do we have economic exchanges anyway, why dont we all just move to Idaho and become self sufficient? How does this specialization happen? Why does it happen? The answer is quite simple. Given endowments of scarce resource each person (or family) tries to get as much from them as possible. And, it turns out that teamwork (economic cooperation) makes it possible to take advantage of diversity in endowed capabilities to make the economic pie bigger if we do things in teams.  The only way this “team” or cooperative approach does not yield a bigger pie (for all to share) is if there is not any initial disparity in endowed capabilities!

Lets start to look at the from the earliest kind of economy. Fred, Barney and other “hunter-gatherers” living alone in the great rift valley in Ethiopia or Kenya. They have a chat about their hard life. Barney admits that in a day he can hunt down (chase) 1000 calories worth of meat. Or, alternatively, he can gather up 800 calories worth of fruits/veggies in a day. Fred, in turn, says his usual output in a day is about 1000 calories of meat and 900 calories of fruit/veg. After discussing and using Excel to model the various cooperation scenarios available to them they conclude:

1. they can produce more together if they each “specialize” in one kind of activity
2. given endowments of speed, smarts, eyesight, and smell (or whatever contributes to differential productivity in hunting and gathering) it is “cheaper” for Barney to hunt, than Fred (because Barney has to give up only 0.8 calorie of fruit/veggie to get a calorie of meat, and Fred has to give up 0.9 calorie of fruit/veggie to get a meat calorie).

3. so, Barney has a “comparative advantage” in producing meat, while Fred has a comparative advantage in producing fruit/veggies

4. and, if they each “specialized” in what they could do relatively more efficiently than the  other, they could produce more as a team, than as the sum of their individual work.

In this case if they each spent two days doing “hunting” for one day, and  “gathering” for one day, they would produce a total of 3700 calories of food

Barney            Fred                 B+F Sum

meat calories           1000               1000                 2000

fruit/vegg calories   800                 900                   1700

TOTAL                        1800               1900                 3700

 

On the other hand, by specialization, they would produce 3800 calories

Meat Calories     Fruit/Vegg     B+F Sum

Day 1                       1000                900                   1900

Day 2                       1000                900                   1900

TOTAL                     2000                1800                  3800

This isn’t a huge differential (3700 vs. 3800), because the relative capabilitiy of the two fellows is quite close. Larger differentials in in initial capabilities yield larger gains from cooperation through specialization.  The ‘absence of diversity’ is the only situation when further specialization doesn’t produce more output.

The only glitch in this solution is that “if” they decide to cooperate by specializing, they must decide how they will “share” the pie in the end. Yes, the pie is larger, and there is more for both if they do specialize. But, they theory of specialization doesn’t say how the gains are to be split.

In summary:

• Cooperation via specialization always yields more total output for the group because it takes advantage of relative productivity (efficiency) advantages across members.
• They can produce the most by letting everyone do what they can do most cheaply (giving up the least to do it)–eg letting everyone do what they have a comparative advantage in doing within the group.
• How the gains from specialization are shared is another matter altogether

This “drive” to be more efficient in groups, drives larger and larger groups, and more and more specialization —  to further increase the size of the pie. This drive for “efficiency” in production with fixed (scarce) initial endowments in capabilities is a very powerful response to scarcity (the human condition). Yes, progress in production technology (machines like a bow and arrow for Barney, or assembly line production, or computers, or wireless) —  all are capabilities that expand production levels that are possible with our fixed resources. But, at core, specialization drives a lot of what we see;

• Groups (tribes) residing together (more economic well being + safety)
• Growth of cities and guilds/trades (more and more specialization is possible)
• Formation & Growth of firms (that internalize the benefits of more and more specialization)
• Globalization of Markets (broader reach of specialization’s potential benefits— free trade is based entirely on maximizing the benefits of specialization and trade across countries )

This drive to become more productive by cooperating based on specialization and trade is a fundamental force, created by scarcity and growth goals. By making the cooperating team bigger, and the degree of specialization more and more detailed, the pie will always grow. Always!.

The caveat. Yes, more and more free trade (eg no barriers to free trade) will improve the size of the global pie. This takes more and more advantage of the comparative advantage of the cheap labor in some places, and the super capable scientific base in other places, and the cheap access to oil in other places, etc, etc. Capitalizing on this global diversity in resource endowments makes the pie bigger, but it doesn’t mean there are not winners and losers in each country of taking advantage of diversity and specializing. Yes, some people will lose jobs, others will gain from increased opportunities. So, again, there are “political” or “fairness” issues in ‘growing the pie’.

3.Competition for customers — this is a supply phenomenon. Because households (consumers) are striving to “fine tune” their purchases (and choice of job) at every possibility to maximize self interest, sellers are always wary of wanting consumers to “choose them”. Sellers will make adjustments to their products and services (price, quality, service, convenience) in order to make it more likely that consumers will choose them. And, the more competing sellers there are in a market, the more pressure each of the individual sellers will be under to improve the attractiveness of their product in the eyes of consumers. Competition is when multiple sellers are vying for buyers. The more options the buys have, the more intense will be competition.

Competition and competitive seller behaviors are, for sellers, a way of “adjusting: to changing market circumstances” for existing products. Of course, sellers also make adjustments to refine product features, expand scale, expand scope of product offerings, or stop producing altogether.

How does competition occur. The basic list of competitive behaviors is:

• lower price
• cut the costs of producing products/services (which enables lowering price and still earning a profit)
• improve product/service quality
• better customer service
• more convenience
• new functionality/features
• developing new related products

These kinds of seller behaviors are good for customers. They improve range of choice for the consumer. and the value the customer gets when they buy. The more sellers of the exact or similar products, the harder the seller will have to work to get the “customer to choose them”. This force is good for customers, and not good for owners of supply organizations.

Society and well as consumers do benefit from competitive behaviors. Firms that cant compete often fail. This includes the high cost (inefficient) firms, and the ones that produce the lowest quality products. This winnowing process caused by competition helps society “get the most bang for the buck” out of the scarce resource endowments; eg the most “value for money” for the consumers.

Suppliers, of course, find competition to be a game they don’t want to play. They try to avoid it at all costs. This is discussed below.

4.The drive for market power by sellers

 Competition stemming from more sellers is a powerful force, enhancing the value for customers. Firms don’t like it:

• they have to lower prices and trim profit margins
• they have to continuously search for ways to improve products and services
• they have to run serious risks of insolvency if they fail to be successful in the “competition game’ with other sellers.

So what do sellers do about this unpleasantness? They try to avoid direct competition with other sellers. They do this by try to reduce “competition” for their products by:

• branding (differentiating) their products and services—so that customers will not see as much likeness with products/services sold by other sellers, reducing the need to “compete” as described earlier
• They try to increase their market share (market power) and reducing the importance of competitors in the markets in which they operate (and reduce the range of choices the customers have)
• through scale and other means they try to increase control of their supply chain and their distribution networks (in order to increase the business problems and costs of the “competitors””
• getting government to help restrict competition (patents, business licenses, exclusive contracts, exclusive tax subsidies)

This agenda is what business firms do to avoid “competition”. It is central to their survival strategy.

As firms successfully create market power (through branding, increased market share, government action) what do they do to capitalize on their “reduced exposure to competition? Essentially, firms with market power have control over their own price (rather than have price set by pure supply-demand scrambling as for corn, oil, phosphate, etc.). And, they choose a price that will maximize their profitability. Of course, unless suppliers use a gun, they can’t force consumers to pay $10 for a can of diet coke.  Consumers have the ultimate choice to make about how much the prefer to buy at all possible prices. But, the firm with market power will restrict production levels somewhat in order to elevate price above the price that would be set by demand-supply forces alone. This will increase profit margins (profit/revenue) .

Firms with market power will, if they can, also set separate prices for different “segments” of their customers. Profit is higher in this situation by charging “tailored” prices to each segment, rather than some “average” price across all segments.  Some segments of the customer base may value “convenience” more than others, who value “low price”. Grocery stores, for example face this kind of bifurcated market, and the use coupons to differentiate the two groups. Almost every retail seller today uses a segmentation strategy in their pricing.

5.Getting to Equilibrium — as situations change, and as adjustments are made by consumers and sellers in markets the prices fluctuate, and situations of Shortage and Surplus develop. These situations create powerful forces to establish an equilibrium market price– a situation of balance– where the price tends to settle at a level such that the amount being demanded at that price is exactly equal to the quantity that sellers want to sell at that price. This is equilibrium, a point of rest, where the forces created by shortage and surplus are quiet.

• shortage forces–  a situation where the price is too high relative to the equilibrium price. The quantity demanded at the current price is greater than the amount being supplied at that price. — this situation will cause potential buyers to become frustrated with an inability to buy as much as they want. And, they will begin to offer a higher price to “meet their needs”.  And as the price goes up, more supply will be forthcoming, and less will be demanded. These forces will continue until the quantity supplied = quantity demanded at a higher price than was occurring at the initial “shortage situation”. This will be the new, higher, equilibrium price.

• surplus forces —  a situation where the price is too low relative to the equilibrium price. The quantity demanded at the current price is lower than the amount being supplied at that price. — this situation will cause potential sellers to become frustrated with an inability to sell as much as they want. And, they will begin to offer discounts to “meet their sales quotas”.  And as the price goes down, more demand will be forthcoming. These forces will continue until the quantity supplied = quantity demanded at a lower price than was occurring at the initial “surplus situation”. This will be the new, lower, equilibrium price.

The equilibrium price will be a reflection of consumer and seller preferences; which are driven by, respectively, the willingness of consumers to pay, and the costs of resources to make the product. These things can change. and throw a stable price situation into “disequilibrium, and the powerful forces created by surpluses and shortages will be engaged until a new equilibrium price is reached.

This is often depicted by the use of demand and supply curves (interacting behaviors of buyers and sellers) , intersecting at the equilibrium price.

6.Prices, Profits and Resource Flows — We know resources in our economy are not unlimited. They are scarce. As the individual households scramble to make the best of their opportunities, and as the individual businesses in the economy scramble for their own competitive survival the system —all of this apparent chaos ends up directing which businesses actually get which resources, and which households get which jobs and what pay level, and which products actually get produced and what price they get sold for. Somehow out of all the chaos, these things get determined in what we call “markets”—-  where the buyers and the sellers for every thing (types of products, types of labor, types of other resources, rental markets for property, etc etc. These markets end up deciding everything in a capitalistic economic system (what the price is, how much gets traded (bought and sold), and which buyers actually go home with the goods, and which ones dont). 

The strength of the seller interests relative to the buyer interests in every market end up deciding these things— more buyer interests cause price to go up as supply shortages occur — more selling interests in a market cause surpluses to occur and prices tend to fall. And, in all cases the household buyers who end up going home with the goods and services are ultimately the ones who are willing to pay the most for the product. Likewise, the businesses who end up being able to go home with the most resources (labor, materials, investment financing, space) are the ones who are willing to pay the most for the resources they need.

When demand for some new product is hot, prices can rise, which cause profit margins for those businesses to rise, and demand for the key resources they need to produce their product to rise as well. The “hot” products that customers want to buy, generate higher demand for the “hot” resources that are needed to produce more and more of that product. Competitors that find ways to be successful in finding those “hot” resources cheaply can be more successful than their competitors that aren’t so successful (eg supply chain management is often a key to success of businesses). So, what the system of scrambling for survival by buyers and sellers tends to do for us is: allow the consumers who are willing to pay the most to successfully get the final products and services, and to cause the successful suppliers to supply those who are able to to be successful in getting the resources they need at lower prices than competitor suppliers—allowing the successful suppliers to be able to achieve a lower price point than competitors, and still make profit.

So, capitalism allocates both products and resources used to make the products on the basis of markets, where prices are set so as to allocate those scarce things according to who is willing to pay the most. Households compete for product. Businesses compete for resources to make those products. This is good for the economy— and for consumers —- would you want the households who dont really need or want to get the goods and services of the economy? Would you want the suppliers to get the scarce resources who are the firms who can figure out ways to keep the costs and prices down to lowest possible levels?

Socialist economies (where the government decides who gets the products and services, and decides which firms will get which resources to use to operate) are not nearly as good at allocating resources as are markets. But, of course, capitalism is not always a fair system if some people are poor, or otherwise cannot participate in labor markets to get money.  That is discussed elsewhere— market failure is a big policy problem, particularly in health care.

6a.   Investment capital Resources the Flow of capital 

The flow of resources (including investment money) in our economy is a critical driver of economic growth and opportunity. (eg Capital is key to capitalism!).  How the marketplace for “investment capital” works is very important in making sure that the capital flows to the best opportunities (eg Apple and Google) and isn’t wasted on lousy opportunities (like Kurt Shilling’s Video Game business).

Businesses, old and new need capital to fund operations, expansion, innovation and research, acquisitions, relocations, etc. They get such capital from earning and saving profits, from outside investors, by borrowing money (bonds and banks), and buy selling more shares of their stock. Given levels of retained earnings (profit) and borrowing, their access to capital, particularly to large amounts, is largely a matter of how high their stock price is and how much they can get via a “new public offerings” of their own stock.

Investors are willing to provide funds as long as they get a return on their investment. Its all about profit! The pursuit of profit is not evil— it is the name we give to the return on a scarce resource– the provision of capital for investment purposes! Profit and other forms of capital funding is very scarce in any economy, and it is very valuable to new businesses, to successful businesses that want to expand, even to promising students wanting to become doctors and lawyers, who need to “borrow” in order to enter the profession. Indeed, many people earn their incomes by having capital on which they earn a return. A owner of a 3 family apartment house, for example, financed from savings from his job as a tradesman —now earns his family’s income by the “return” he gets on his investment. He gets rental income month by month which he hopes exceeds his expenses, and he hopes to eventually sell for way more than he paid for the house, providing a retirement nest egg. Profit on the “house” is essential for the owner-of-capital (capitalist) to survive.

 Investors (people with wealth) pursue opportunities by investing their savings in exchange for a return. Owners of capital (people with savings, or net assets tied up in a house or a business or the stock market) try to pursue their self interest as best they can, just like the rest of us. Except, rather than me, who chases the next-best-career-move, they chase better profit opportunities (or returns on the investment, ROE).  We will call capital owners “investors” here (even though many people are both wage earners who sell their time, and investors, who also have savings or net assets of one form or another). Investors allocate their capital (savings) across investment opportunities based on the expected gains from, those opportunities in the context of what they see as the expected riskiness of the investment.  Treasury debt offers a very low return, but exceedingly low risk of not being repaid. Alternatively, some stock offerings (eg equity) may offer considerable upside potential returns (20-50% a year) but are accompanied by many kinds of uncertainty, including the possibility of a loss. Investments in 3 apartment rental units may have pretty good returns, but wild fluctuations in the price of real estate and rents may make it pretty risky.

There is a “market” or scramble for finding the best “profit-making” opportunities among investors. Investors in the economy (the 55 year old accountant living next door, Warren Buffet, the owners of Apple stock, the teamsters pension fund, the Magellan fund, the Local Community Bank. the Government of China, and millions of others) are all chasing a high return on their invested monies, after adjusting for the variations in riskiness. If opportunities to make profit in Boston real estate are improving, more and more investors will pull their money from lower-profit-opportunities and put their money into those Boston opportunities. Capital will flow into the “high profit” opportunities. If Pharmaceutical and Biotech industry profits are going up, likewise capital will flow into those industries (investors will buy stock, bidding the price of shares higher and higher — and making the value of all stock in that industry higher–this aggregate stock value is called the market cap).

Profit levels are a crucial signal in the economy. Capital (for expansion of successful businesses, for start ups, for student loans, for buying real estate, for government to borrow to fight a war, etc.) will flow in the direction of the highest return or profit. This is good. It means that the most valued uses of capital (as determined by consumer’s willingness to pay) will be attracting the most investment resources. And, the least attractive objects of consumer attention (where profits have become low), will suffer losses of capital (investors will sell stock, prices of stock will fall, and market cap will fall).

The last point about investor behavior and the flow of capital concerns the importance of “expected profits and expected risk” in investor decision making.  Investors may get their “return” in several ways: dividends from earned profit (a profit payout), from interest payments (on lent money), and from appreciation in the investment instrument when it is eventually sold (eg the difference between purchase price and selling price). Since the “future value” of the investment asset (stock, bond, partnership share, etc.) is not known with certainty, investors are always trying to read the tea leaves about what is happening to ‘future value’. Generally, future “stock price” or “business value” would depend on expected future profitability. This is hard to predict, adding an element of risk to any decision to hold an equity investment. For this reason, investment capital (as a resource) has to receive a somewhat higher return than returns on labor (human capital).

Thomas Picketi, a French economist,  has recently used this notion of a “somewhat higher return on accumulated wealth’ as an explanation for the very divergent flows of income (skewed income distribution) in capitalist economies. He claims the divergence in the income distribution in capitalism (where the rich get richer, and the working class poor do not) is the result of chronically higher returns to capital than the returns to labor.

So, in general, the “scramble” in markets tends to cause the  scarce resources to flow where they are most valued. This ebb and flow of the scarce resources doesn’t occur because of a change in “plan” and a memo from the central planning committee. Rather, the ebb and flow is driven by the changes in the urgency of buyers, or changes in the the scarcity of  resources. And, though not a memo, Adam Smith called it “the invisible hand’ directing the flows of scarce resources across industries in the economy according to profit signals. This profit signal provides a huge set of  “market forces” in the economy, directing capital flows.

Scarce Labor resources —  will flow toward industries/jobs where pay is rising, and           away  from industries where pay is stagnant (as people pursue their  self interest and pursue the best return they can get on the investments they have made in skills and careers (called human  capital)

Scarce Natural resources — Like land, oil, bauxite, iron ore, etc—  resources will flow         to uses  that are willing to pay the most for the resource. Land, for example, is flowing to high rise buildings in Boston’s Fenway area, because developers are willing to pay more for land to make profit on these kinds of real estate plays in a booming tech economy—- but this is driving out resources available for single family dwellings, low profit industries (pizza shops, other local retailing).

Scarce Capital resources  — Equity Investors earn profits from the business. Where           profit  opportunities are high, investment monies will flow in (bidding up stock prices)- giving opportunities for managers to generate money for expansion, research, acquisitions by selling more  shares of stock. This flow of capital will come from investors  shedding less profitable investments (by selling stock) which will drive down stock prices and make it less and less likely that the  unprofitable businesses can grow,  or survive.