PRODUCTION. 1The Surplus

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1 1The Surplus 2 The US economy produces an amazing number of different products: thousands of different foods, countless movies, dozens of different type cars, hundreds of entertainment products, dozens of different type dog food, and on and on. More than 25 million businesses produce these goods and services while 275 million consumers purchase them. In addition, thousands of government entities at the local, state, and federal level interact in various ways with these millions of businesses and consumers. At the same time, 140 million people work as employees. Thousands of different jobs exist in the economy: nuclear scientist, dog catcher, philosopher, waitress, manual laborers, and so on. Many others, however, experience unemployment. This economy is spread over a vast geographical region containing areas as different as Hawaii, Alaska, Nebraska, Florida, and California. Finally, the U.S. is linked with the other nations of the world through trade and financial connections. Because if this complexity and vastness, it is hard to make sense of the US economy. But we can gain insight into the US economy or any economy by using a few simple tools that come from economic theory. These tools help us identify the key features of the economy. Once these key features are identified, we can focus our attention on these few features instead of being overwhelmed by the millions of separate components of the U.S. economy. The most important of these theoretical tools is the simple and powerful idea of the surplus. This chapter explains the concept of surplus. PRODUCTION People using materials and tools produce all goods and services created within an economy. Production is the term we use to refer to this process: people

2 6 THE SURPLUS transforming raw materials into goods and services by their use of tools and machines. Without people, production does not occur. This is a simple observation, but it becomes very important when we consider any particular economic system. The number of people, their relationship to each other, the nature of the materials used, and the type of tools used in production vary widely, of course, depending on the product made, the geographical area, and the time period in which production occurs. For instance, today shoes are made with materials such as rubber, plastic, various synthetic fabrics, and glue and are assembled by relatively unskilled people using very complex and powerful shoe-making machines. Two hundred years ago, however, shoes were made with leather, wood, various natural fabrics, and nails. The skilled craft workers making these shoes used relatively simple hand tools to assemble the shoes. But in both periods, the production process involved people using materials and tools made shoes. The same is true for every other production process. THE SURPLUS When production occurs the possibility exists that the economy will produce a surplus. The surplus is simply defined. SURPLUS DEFINED The outcome of production is a set of goods or services. Further, a particular production process leads to a certain amount of output: 100 shoes, 14 cars, 200,000 books, and so on. A surplus exists if the amount produced exceeds what is used up in production. The surplus product can be for a single production unit or for production units all making the same product (say, all production units within the shoe industry ). Or, the surplus might be the total surplus produced within a whole economy or country. More precisely, a surplus exists whenever the direct producers in the economy produce more than is needed to maintain them and to replace the materials and tools used up in production. In some sense, the surplus is what is left over after all inputs used in production are replaced. EXAMPLE: SURPLUS PRODUCT IN A CORN ECONOMY Suppose you have an economy that produces only corn. Suppose also that those who live within this economy accept this because (in this hypothetical economy)

3 THE SURPLUS 7 corn can be used both as food and as seed for the following year s planting. I will also assume that the tools needed to plant, take care of, and harvest coin addition, are made of corn (corncob hoes?). This is not realistic, of course, but it makes the story simple. The economy starts with 10 bushels of corn. The direct producers plant the corn and take care of it (weed, get rid of pests, and so on) by using their corncob hoes. The direct producers are those who do the work in the economy. Part of a Modern Corn Economy? At the end of the growing season, the direct producers harvest the corn and discover that they now have 40 bushels of corn. Figure 1-1 illustrates the outcome of this production process: production people using tools and raw materials transformed 10 bushels of corn into 40 bushels of corn. Figure 1-1 production 10 bushels 40 bushels

4 8 THE SURPLUS In this economy, you can determine the surplus in a straightforward way. You begin with the output you have: 40 bushels. You then subtract what was needed to produce this output. The material used (seed) was equal to 10 bushels. Suppose also that the direct producers used as tools in this production process 10 corncob hoes. However, not all of these hoes were used up in production during the year as some can be used the next planting period. Some of the hoes, however, might have been damaged and/or might have suffered ware-and-tear. I ll assume that 2 bushels of corn were needed to repair/replace these hoes. In this case, we can say that 2 bushels worth of corn was used to replace tools used up in production. Finally, let s say that 23 bushels of corn was given to the direct producers. They have to eat after all. Table 1-1 shows that the surplus product of this corn economy is 5 bushels. From the 40 bushels of output you subtract all the deductions mentioned above (initial material, tools used up in production, what goes to the direct producers). Table 1-1 Surplus in the Corn Economy Harvest 40 bushels Minus Initial materials 10 bushels Tools used up 2 bushels Going to Direct 23 bushels Producers Equals Surplus product 5 bushels EXAMPLE: SURPLUS IN A MONETARY ECONOMY The above example used physical quantities (bushels) to measure inputs and outputs. It is possible to restate the above example by using monetary terms: that is, using dollars as our measure of quantities.

5 THE SURPLUS 9 Not every economy uses money. But we will assume that our corn economy above does use it. Suppose a bushel of corn is worth $10. In this case, the production process described above can be represented using purely monetary terms as in Table 1-2. The surplus is now equal to $50. Table 1-2 Surplus in the Monetary Corn Economy Harvest $400 Minus Initial materials $100 Tools used ups $20 Going to Direct $230 Producers Equals Surplus $50 DOES A SURPLUS ALWAYS EXIST? In both examples above, a surplus existed. The output was large enough to cover initial materials, the tools used up in production, and what went to the direct producers. Something was still left over: the surplus. No real-world economy and no real-world production unit, however, are guaranteed to have a (positive) surplus. For instance, an economy might find that their surplus is zero: the output produced merely equals what is needed for production. Or, an individual production unit might find that it has nothing left over after replacing everything used in production. An economy or production unit could also end up with a negative surplus. A negative surplus exists when the output falls below what is used up in production. Something used in production is not able to be replaced. Such an economy or production unit is likely headed for troubles.

6 10 THE SURPLUS Three Ways of Looking at the Surplus Surplus = Output minus what is needed for production Surplus = Output minus (Initial Materials + Tools used up + What Goes to Direct Producers) Surplus = Value of Output minus (Value of Initial Materials + Value of Tools used up + Value of What Goes to Direct Producers) THE SURPLUS, ECONOMIC GROWTH, AND ECONOMIC DISASTER The hypothetical economy discussed above had a surplus. After a year of production it had more than it stated with. The surplus was 5 bushels of corn, which was equal to $50 in our monetary economy. At the beginning of the next year, the economy has 15 bushels of corn available to it. Of this, 10 bushels came from being set aside to replace the starting pile of seed from the first year and 5 bushels of corn came from the surplus. Those who decide what to do with the surplus might decide to add the 5 bushels of surplus to the other 10 bushels which has been set aside for planting. In this case, the economy now has 15 bushels of seed to plant instead of the 10 bushels planted in the previous year. When the surplus is used to increase the amount used for production this is called reinvestment. If the surplus is used in this way, the harvest in the next year should exceed the harvest of the previous year. If in the first year, 10 bushels of seed led to 40 bushels of corn, then in the second year it is likely that 15 bushels of seed will lead to 60 bushels of corn. Such a growth in output is characterized as economic growth.

7 THE SURPLUS 11 Alternatively, perhaps the surplus is used not to increase the amount planted but is used to pay people to find better ways of producing corn or to invent better corncob hoes. If these people are successful, perhaps productivity will rise. Whereas before 10 bushels, 10 hoes, and 10 people lead to 40 bushels of corn, now the same inputs leads to 50 bushels of corn. This is, again, economic growth. Or, finally, the surplus might be used to discover more inputs into production. Perhaps it is used to discover new raw materials within the country or it is used to go to other lands to find (or take!) what exists there. If the surplus is used to reinvest into production, to find better ways of producing the output, or to find more inputs, then economic growth will likely occur. No guarantee exists that more will be produced (perhaps no one finds a better way to grow corn or perhaps bad weather causes productivity to suffer), but such use of the surplus makes it more likely the economy will grow than if the surplus is simply buried in a hole in the ground. Economic growth is more likely if a large portion of the surplus is put back directly or indirectly into the economy. The above discussion for an economy also holds true for individual production units. An individual production unit can also use the surplus it has in ways that lead to increased production for that unit. Not all economies or production units produce a surplus. Some, in fact, might experience a negative surplus, in which the output is less than what was used to produce the output. Such economies are headed for trouble: they might grow smaller and smaller over time as the negative surplus eats way the inputs they use in production. Economic disaster is the likely fate of such an economy. Not all economies with surpluses or even with sizeable surpluses plow back these surpluses into the economy. Even economies with sizable surpluses might fail to grow or, at least, might grow very slowly. History is filled with societies that disappeared because they failed to generate a surplus or, perhaps, because they failed to put enough of the surplus back into the economy. If an economy is to maintain itself over time, it must at minimum earn a surplus equal to zero. Only if the economy has a positive surplus can it have a chance of growing larger or of improving the material standard of living of its citizens in the future. Notably, societies that have prospered in history have generally produced large surpluses. Most often a sizable chunk of the surplus made its way back

8 12 THE SURPLUS into the economy to promote an expanded economy. Often in century s past the surplus was used to expand geographically and to capture, by violence often, the land, raw materials, and even people of lands far away. Economic growth can reduce conflict. When the economy grows well, there can be more for everyone. It is no longer the case that the only way to increase your share is to reduce the share of someone else. Good economic growth might permit more to go to the direct producers and more to be available for the surplus at the same time. Table 1-3 shows a growing economy and simultaneous improvements in the standard of living and in the size of the surplus. Table 1-3 Harvest Replacement To Direct Producers Surplus Of course, if economy growth stops or slow then conflict over how to split the pie might become important once again. MEASURING THE SIZE OF THE SURPLUS THE ABSOLUTE SIZE OF THE SURPLUS One way to measure how much of a surplus exists in a given economy is the absolute amount of the surplus. For instance, the surplus might be equal to 10 bushels of grain or, say, $1,000. In Table 1-2 the surplus appearing at the bottom of the table is the absolute level of the surplus. Everything else equal, larger economies are expected to produce more surpluses. Suppose, say, that every 10 bushels of corn planted leads to a surplus of 5 bushels. If economy A plants 10 bushels while economy B plants 100 bushels, the surplus in A will be 5 bushels while the surplus in B will be 50 bushels. With a larger surplus, economy B might have certain advantages over economy B.

9 THE SURPLUS 13 THE RATE OF SURPLUS Often as important as the absolute size of the surplus is the rate of surplus. The rate of surplus is the ratio of surplus to output: Surplus Rate of Surplus =. Output In the example above, the rate of surplus was 5 Rate of Surplus = = = 12.5% 40 Table 1-4 below presents the rate of surplus for the corn economy and for the monetary economy. The rate of surplus is the same in the two economies: the addition of money to the economy does not change the rate of surplus.

10 14 THE SURPLUS Table 1-4 Surplus Harvest 40 bushels $400 Minus Initial materials 10 bushels $100 Tools used up 2 bushels $20 Going to Direct 23 bushels $230 Producers Equals Surplus (absolute level) 5 bushels $50 Rate of Surplus 5/40 = 12.5% $50/$400 = 12.5% While the absolute amount of the surplus is one measure of the success of an economy to generate a surplus, the rate of surplus indicates the speed with which the surplus is growing. As such, the rate of surplus is a better indication of the potential long-run growth of the economy. WHAT DETERMINES THE RATE OF SURPLUS? For a given sized economy, the rate of surplus will be larger: the greater is the level of productivity; the fewer/cheaper the tools used up in production; and the smaller is the amount going to the direct producers. PRODUCTIVITY Productivity measures how much you get from a given amount of input. Productivity has increased if you now get more from the same amount of input than you did in the past. In the example above, 10 bushels of seed, 10 corncob hoes, and 10 people produced 40 bushels of corn. If productivity improved, then these same quantities of inputs would produce more corn, say 42 bushels of corn as illustrated in Figure 1-2.

11 THE SURPLUS 15 Figure 1-2 production 10 bushels 42 bushels If productivity did happen to be 42 (rather than 40), then surplus would grow. In Table 1-5, the changes following this higher productivity are indicated in a different font. Table 1-5 Surplus Harvest 42 bushels $420 Minus Initial materials 10 bushels $ 100 Tools used up 2 bushels $20 Going to Direct Producers 23 bushels $230 Equals Surplus (absolute level) 7 bushels $ 70 Rate of Surplus 7/42 = 16.7% 70/420 = 16.7% The (absolute) surplus product is now 7 bushels and the surplus is now $70. The rate of surplus in both economies is now 16.7%. What causes productivity to improve? Better tools can lead to improved productivity. The development of a more skilled labor force can contribute to higher productivity. A better knowledge of how to grow corn can also lead to greater productivity. TOOLS USED UP IN PRODUCTION If fewer tools are used up in production, more will be left over for the surplus. For instance, suppose that only 1 bushel of corn was needed to replace/repair the corncob hoes (instead of 2 bushels of corn needed in the examples above). In this case, in the original example surplus product would grow from 5 bushels to 6 bushels. This is illustrated in Table 1-6.

12 16 THE SURPLUS Table 1-6 Surplus Harvest 40 bushels $400 Minus Initial materials 10 bushels $100 Tools used up 1 bushel $10 Going to Direct producers Equals 23 bushels $230 Surplus 6 bushels $60 Rate of Surplus 6/40 = 15% 60/400 = 15% Here the surplus and the rate of surplus grow due to the decline in what is needed to replace tools that were used up in production. What causes a change in what is needed to replace tools used up in production? Perhaps stronger tools are invented that wear out more slowly or break less frequently. Perhaps someone finds a way to make the same tool with less input (say, a corncob hoe is now made with a little bit less corn than before). WHAT GOES TO THE DIRECT PRODUCERS How much of the economy s output goes to direct producers is often the most important determinant of the size and rate of surplus. This is simply because what does to the direct producers is often the largest single deduction from the economy s output. How much the direct producers get is determined by many factors. These factors vary widely over time and over space. For instance, the factors that determined how much when to direct producers in 12 th century England are very different from those that determine how much goes to direct producers in the 21 st century United States. Certainly the amount going to the direct producers in these two economies differs by a great amount. Some generalizations, however, about what goes to the direct producers can be made. First, biology sets the minimum level for the standard of living. To survive, people need basic things such as food and shelter. If the direct producers get less than this biological minimum they die. No economy can survive in this situation who will do the producing if all the direct producers die?

13 THE SURPLUS 17 Second, what goes to the direct producers generally exceeds the biological minimum by a large amount. Social factors customs and traditions play a large part in determining what and how much direct producers get. People not only need clothes, they often desire fashionable clothes. People need food, but they sometimes desire to go to popular restaurants. People might like entertainment, but they might come to really want a DVD player because, well, it seems to be a cool electronic goodie. Third, past improvements in the standard of living often prompt people to expect a continued future improvement in their standard of living. For instance, when dishwashers were first available people saw them as luxury items: they were certainly not part of the customary standard of living. Today, however, many people think that a dishwasher is a necessity; they feel inconvenienced if they don t have a dishwasher. Once people cooked over open fires, then they had stoves, and then microwave ovens appeared. While people in the recent past might have been glad to prepare a dinner within an hour, today many people believe themselves inconvenienced if they have to wait more than 15 minutes to prepare a complete dinner. On the other hand, direct producers might under certain circumstances come to expect that they will receive a lower standard of living. Perhaps they are told they have no choice they must accept a lower standard of living because something bad has happened within the economy or because a greater surplus must be generated for some reason. Or, perhaps the direct producers are convinced that, due to forces beyond anyone s control, they must accept a lower standard of living for the good of all. Fourth, the political and economic power of the direct producers directly affects how much direct producers get for their contribution to production. With sufficient power, the direct producers might succeed in getting a larger amount of the economy s output for their own. The power of the direct producers is often a key determinant of the rate of surplus; I will we will return to it in later chapters. If the direct producers get less than before and everything else remains the same the surplus will grow. For instance, if in the original example above what direct producers get falls from 23 bushels of corn to 20 bushels of corn, the surplus will rise from 5 bushels to 8 bushels. The rate of surplus will, as a result, also grow. This is illustrated in Table 1-7.

14 18 THE SURPLUS Table 1-7 Surplus Harvest 40 bushels $400 Minus Initial materials 10 bushels $100 Tools used up 2 bushels $20 Going to Direct producers 20 bushels $200 Equals Surplus product 8 bushels $80 Rate of Surplus 8/40 = 20% 80/400 = 20% If, however, the direct producers get more than before and everything else remains the same the surplus will fall both in absolute terms and in percentage terms. CONCLUSION The concept of the surplus is central to economic analysis. The success or failure of an economy to generate a surplus is an important determinant of the survival of this economy. A high rate of surplus can permit an economy to grow; a negative surplus will lead an economy to eventually wither away. Much can be learned about an economy by considering the various forces that determine the size, and the use, of its surplus. But no economy can be considered in isolation; all economies are part of a complex social system. As a result, many other (noneconomic) factors lay behind the success or failure of a given economy or society. Not every economy is organized along the same lines. Ancient people had economies that differ greatly from most of those that dominate most nations today.