Thursday, February 18, 2016

Understanding Inflation - Part 2

Think of running a business like it's a video game, like a level in Super Mario World. It's an adventure with many trials and obstacles, and you want to find Princess Profit at the end. I mentioned costs previously.

Variable Costs

Let's start with variable costs. Variable means that these costs go up as you produce more items:


Fixed Costs
Now we get to fixed costs which aren't proportional to output. They may rise or fall from year to year, but hopefully not by much, and these costs are usually predictable, so you can plan for them.

Unpredictable Costs
As with any project, life is full of surprises. These next costs are sure to come to you eventually, you just don't know when...
More Factors That Affect Price:
So, in every business, you have all these factors, working and changing at a micro scale and a macro scale, and you think the minimum wage, of all things, is going to affect inflation? I hope you can see now that it's all more complicated, and trying to control inflation is a bit like controlling the weather. Good luck.

Understanding Inflation 1

I remember back in the 90's, when I was a student, hearing on the school news program about Bill Clinton wanting to raise the minimum wage. There was a short discussion about it, and when I supported it, the kid next to me said this:

I noticed two things:

1. This boy was repeating what he'd heard from someone else. He knew nothing about inflation.

2. He was basing his argument on the assumption that all inflation is bad, and raising wages accelerates it recklessly.

This was a popular narrative at the time, based on a flawed understanding of recent statistics. Let us first review the history of America's minimum wages over time. You will note, in recent history, the minimum wage tends to rise under a Democratic president, while stagnating during a Republican administration:

As you can see, Democratic administrations do, for one reason or another, tend to raise the minimum wage more frequently, at least over the past 30 years. If this really did encourage inflation, you would expect a similar graph to correlate. And yet...

the lines don't match, do they? Inflation remained steady all through the 90's, despite raising the minimum wage, and the booming economy. It's also remained steady throughout Bush Jr. and Obama's administration. The only time inflation correlated with a rising minimum wage was during Carter's presidency, which also coincided with two oil crises, caused by Middle East oil embargos. A group of countries decided to stop selling oil, forcing the price up from $3 a barrel to $12. This triggered a global oil crisis and inflation everywhere.

So, what was wrong with my classmate's logic? Well, a lot. Where to begin?

First of all...    Wage Inflation ≠ Price Inflation

Price inflation is when prices go up, and many factors affect it. But, whatever the cause, when prices go up, people grow relatively poorer, unless their wages rise to match it. And that's why wage inflation is so great! When wages rise faster than price inflation, people become richer!

But, wait a minute? Isn't one worker's wage another person's cost? Isn't that a price too? Well, yes, but when talking about wages, this is the price of putting money into consumers' pockets, whereas most prices involve taking money out of them.

But, doesn't wage inflation lead to price inflation? Yes, over time. When people are richer, they can afford more, and so companies raise prices. Inflation is the natural result of a growing economy, and the richer the country, like China, the higher their inflation rate. But, it takes time, and, meanwhile, people increase their purchasing power, gaining wealth, and helping the economy grow.

A second question: how influential is the minimum wage to wage inflation? Well, currently, in America, the labor force consists of 135 million workers. Of these, only 75.3 million earn an hourly wage. The rest receive a fixed salary, with possible bonuses, depending on job performance. Of that 75.3 million, only 1.6 million earn the minimum wage. Oh, and another 2 million earn less. How is that, you might ask? Well, some workers, like waiters and waitresses, earn so much from tipping, they are exempt from minimum wage laws. They live mostly off of their tips, and they're taxed on them too!

So, when 1.6 out of 135 million earn this minimum wage, does raising it a dollar really change things? No, not really. First, you must understand:

Price = Cost + Profit

So, if a cost, like that of labor, goes up, companies have a choice. They could raise prices, or they could simply accept less profit. Depending on competition, it might not be wise to raise prices, so many companies lower their profit instead. And, you'd be surprised how little profit a company needs to stay in business. The best industries in America only earn about 19% profit:

Historically, companies gave workers so little money they could barely survive. Three factors changed this:
1.the rise of unions
2. skilled labor
3. government regulations, including a minimum wage.

And many salaries today are so much higher than the minimum, that nobody would switch to a minimum wage job, despite raising it. There's also a question of status, as many people would be embarrassed to work a minimum wage job, and then there's the question of benefits such as health plans and holidays, of which minimum-wage jobs offer little.

So, there's little evidence of the minimum wage increasing other wages, which is too bad, as it would help the economy.

There's a third misconception - that inflation is bad, it must be stopped at all costs, and it can be. The reality is, in a healthy economy, you can't stop inflation, and you wouldn't want to. A little inflation is actually a good thing for a number of reasons.

1. Inflation means your money is worth less and less over time. So, any smart person would spend it. Buy something, anything, and save your wealth! Buy something collectable, buy a house, buy a flat, buy a garden. Buy baseball cards! When everyone has this attitude, it helps the economy grow. Compare that with deflation, where no one wants to spend money. Everyone thinks, if I wait longer, I can save money on a purchase, and if I buy something expensive, it'll just lose money over time. So, while everyone waits and saves, companies go out of business and lower prices further to attract customers - causing even more deflation.

2. Inflation means you can buy something and sit on it, and get wealthy. The things you buy now (a house, stocks, bonds) can be worth a fortune when you retire, and therefore help you retire.

3. Inflation also makes it easier to pay off loans. As you earn more and more, the debts you made in the past will feel smaller and easier to pay off (so long as the interest rates are low!!!)

So, inflation, at about 2%, is actually a good thing! It's healthy, and it's also pretty much inevitable. Inflation is going to happen no matter what. Raising the minimum wage just helps the poorest workers from feeling the most pain from it. And what other factors cause inflation? See part 2 in this lesson.