Happy 29th

With Monday (29 January) being declared Milton Friedman day, I have a rare excuse to show off some economics geekery to promote the study of economics. Contrary to the common assumption, economics isn't just the study of bits of money moving around being only of interest to bankers and stockbrokers. A major goal of economics is to determine the best of a number of choices, and who doesn't have decisions with ambiguous outcomes?

But first, Mr. Friedman. The graph below shows the inflation in the United States (statistics from the BLS) over just short of a century. I've added a few red lines at significant events: in 1920 the First World War ended and the wartime inflation gave way to massive deflation, 1929 was the beginning of the Great Depression. In the late 1930's Inflation is starting to run back up as World War Two breaks out.

You'll notice that before 1980, the inflation rate was chaotic. Years of terribly high inflation mixed with years of deflation (both are very bad situations). After 1980, inflation came down, and remained around 2-3% (a low, but positive, inflation is considered healthy). What happened in that year? Paul Volcker, the Federal Reserve Chairman, (and I suppose some credit needs to be given to President Reagan) implemented a monetary policy following the work of Mr. Friedman. The impact of his work showed that manipulation of the money supply could be used to prevent inflation and unemployment from going out of control (he also predicted that inflation and unemployment could go out of control by correcting a relation called the Phillips Curve). And for the past 25 years we havent had any major economic disasters.

He's also known for his defense of the free market and individualism (you could go on and on with the papers he published showing the benefits of these). Free To Choose is his work. The phrase, "There ain't no such thing as a free lunch," is often associated with him, as well as a number of witty comments. "Many people want the government to protect the consumer. A much more urgent problem is to protect the consumer from the government." is one of my favorites.

For those who weren't scared off by the graph, economics is a very practical subject. Many politicians (in both parties) take advantage of voters by proposing a plans that are economically damaging, but reap votes because most voters aren't educated in the basics of economic theory (keep in mind, the public schools are part of the government and that the basics of economics needs only linear algebra to understand. Getting suspicious?). There are also ways to obscure politically damaging plans, proposing the raise income taxes would kill a politician, but most people won't complain if they propose to raise corporate income taxes. Both plans however have the same effect.

The following is one of my favorite puzzles in Economics, a 1+1=3.

Lets suppose we have two neighbors: Alice and Bob. Alice being a very stereotypical imaginary person happens to be good at baking, she can make a pie in 1 hour, but takes 6 hours to shovel her driveway of snow. Bob is just as stereotypical, he takes only 4 hours to shovel the driveway, but needs 2 hours to bake a pie. In an 8-hour day, Alice shovels her driveway and makes 2 pies, Bob shovels the driveway and makes 2 pies. But, if they work together, something very strange happens. Bob shovels both driveways, and Alice bakes 8 pies. Shared equally, each now has 4 pies (and a shoveled driveway) whereas before they only had 2 pies. Both of them are better off. They traded, and both gained.

But that's not surprising you say. Alice is clearly better at baking, and Bob is better at shoveling. If one does what they're best at, of course they'll produce more. Ah, but what if I said it still works, if one of the neighbors is utterly inferior to the others?

Take two more neighbors: Chris is superhuman, he can shovel the drive in 2 hours and bake a pie in 1, Dave is pretty pathetic it takes him a full 8 hours to finish the driveway, and 2 to make a pie. Without any exchanges, Chris would shovel his drive and have 6 pies, Dave would only get his driveway finished. But if they exchange services, Both drives are shoveled (by Chris) and 8 pies are produced (4 made by each). Compare that to the 6 pies that were produced before.

Something to remember the next time someone claims there's no benefit when the United States trades with a South African nation. Ponder it out, how does Chris get an extra pie when he helps is utterly inept neighbor? Or you can cheat and read my explanation.