Tuesday, January 19, 2010

Taxonomy of Incentives and Production; Optimization

Each good or service provided by an economy has its own means of production, marketing, and consumption. These differences are not rooted in government policy or market structures, but rather in the physical realities of the natural resources, available technologies, and cultural paradigms involved. If one were to compose a list of all the different types seen in these three categories, one could then describe each good or service according to which of the types are present. The means by which a good or service is consumed is an important aspect of consumer demand and helps to make consumption patterns predictable, e.g. the correlation between cigarette and alcohol consumption. Furthermore, the characteristic given by the combination of means within each category partially determines the incentive structure that predicts the behavior of the business leaders controlling the production and marketing of the goods or services, e.g. the prevalence of beer commercials and absence of gasoline commercials. Therefore, the particular quirks of each product constitute an extra-market force that can be corrected by government policy, irrespective of concerns relating to market structure and externalities. It is worth noting that in this capacity, it is not the individual preference but the individual benefit with which the economic analysis is maximally concerned, and that even when benefits accrue to the individual, there is nothing to suggest that costs are passed exclusively to individuals in practice.

Production is described by a capitalization rate, which is the portion of the cost of production of each unit of finished good that depreciation of the capital assets consumes. The remainder of the cost of production is labor cost. Capitalization will come from natural resources, factor goods, and machinery.

Marketing is described by three cost categories: advertising, distribution, and pricing. Advertising is a direct cost calculated to stimulate demand at a given price level; distribution is mostly correlated with the inclusion or exclusion of various geographic markets; pricing costs are costs incurred through coupons, promotions, sales, and other temporary price variations designed to stimulate demand or reduce inventory levels.

Consumption is described by probable aggregate goods consumption bundles given household budget levels. This is further divided by demographic. For each good at a particular price with a particular marketing and production strategy, there is a predicted consumption level (a mean with a standard deviation) and covariance with each other good available or changes to budget levels. In practice, the predicted consumption levels for each good are empirically determined. Accepted business practices and rules of thumb dominate over any "assumption of rationality" and so none is needed.

Businesses attempt to maximize profits by coordinating both production and marketing strategies. Businesses are constrained from an absolute realization of efficiency by limits to their own strategic abilities. Many choices made by a business are probabilistic in nature, meaning that as a business approaches its maximum profit level, the probability of moving closer to maximum profits decreases. Thus, the uncertainties of the production and marketing of any given good create an efficiency ceiling for the business. Furthermore, businesses typically have steeper cost discounting curves than either the "firm as a sovereign entity" would have or the society at large would agree on (in fact, it is arguable that society does not discount future costs at all).

In order to realize the true scale of the possible improvements to quality of life, the behavior of consumers must be described in such a way that it becomes possible to criticize it. A model such as a revealed preference model is not sufficiently rich in its psychological descriptors to be of service in this capacity. For this purpose, I would rather develop a marginal benefit impact for each consumed good. Underlying such a measure would be the assumption that rather than measuring individual welfare relative to no consumption, the more common concern is the effect of changes when measured relative to existing consumption levels. There would be no assumption of self-rationality; we merely observe that individuals tend to pick goods that benefit them, but that these are not always optimal choices nor are individuals aware of every possible budget composition available to them. The actual values used would be based on health and lifestyle data and sociological studies.

Optimization across these categories takes the following form:

1. marginal benefit - marginal cost = net gain

2. predicted consumption level * effective price - distribution costs - advertising costs - capitalization costs - labor costs = business profits

3. business profits are maximized when the marginal business profit is zero; but since the function is multidimensional we must also calculate the Jacobian to assure ourselves that we are in fact viewing a global maximum (rather than, for instance, a saddle point). In general, this situation shows the failure of automatic market correction because the under(or maybe even over)supply of financing to businesses can lead to inefficient capitalization ratios. High(or low) advertising and distribution costs can also affect the general level of sales of the entire business.

4. Even when the situation exists that all externalities and market structure inefficiencies are properly counterbalanced by regulation, two situations will tend to exist in the market provision of any good: 1. The marginal benefit will be less than the individual's perceived marginal benefit. This follows from the effects of advertising and the incompleteness of individual strategies. 2. The marginal costs will be greater than strictly necessary because businesses cannot realize maximum efficiency levels and have steeper future discounting curves.

5. If marginal benefits are well known, government policy can be organized around changing the various cost and incentive structures affecting businesses and individuals to push them toward decisions that maximize marginal benefits. Generally, this means 1. Ensuring adequate capital flow to emerging or expanding businesses. 2. Ensuring media diversity and access so that all types of business that seek to advertise have the opportunity to. 3. Planning local, regional, national, and international infrastructure to ensure that markets are accessible to distributors at a low cost. 4. Relatively high educational subsidies to promote competence within organizations and to ensure that individuals have adequate self knowledge to build good consumption bundles in the first place.

It is worth noting that this only looks at the individual business and consumer. It does not consider externalities or market structure issues (e.g. monopolies). Public goods and various types of Government activity are also justified by the existence of these situations. In particular, wealth redistribution and monetary policy are crucial functions of Government.

It is also worth noting that existing Government policies do not always reflect solutions to problems, but can often be problems in themselves. The best way to put the policy recommendations that follow from a principled economic analysis is not "regulation" or "deregulation" but "reregulation" as many problems exist on both sides of the issue.

1 comment:

Lyle said...
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