The Principle of the Inevitability of Production Purchase
There are three principles that I need to first establish in order for me to be able to explain why it is that the present economic system that predominates in the world’s national economies is incapable of solving the problems that are increasingly making things worse. In spite of all the economic growth being experienced in the healthy economies, poverty has persisted and affluence has continued to wane for all but a tiny percentage of the population. Decade after decade since the boom years of the 50’s and 60’s the people have found it harder and harder to own homes, have a leisurely life, and make ends meet.
The first principle I need to establish is that “all of production must be purchased”. The discussions that follow explains my “First Principle” of production-based economics.
What Happens When 100% is Not Sold
If a community is producing $1,000M worth every year, and 10% of production is not purchased (i.e. only $900M is sold), then that 10% of unsold inventory will need to be sold next year on top of the normal $1,000M production. In other words sales next year will need to reach $1,100M, or sales will need to increase by 10% in order to make up for the 10% lack of sales this year.
If sales were to stay at $900M next year (same level as was sold this year), and production stayed at the normal level of $1,000M, then there will be another 10% inventory that will add to unsold stock, making it a total of 20% unsold stock.
The repercussion of unsold stock is not simply that the warehouses will be overflowing at the end of the year. The more critical repercussion is that if only 900M were sold, then the manufacturer will be 100M short in its expected revenues. The most likely consequence is that the company will elect to reduce production by 10% so that it will not have too much stock in its inventory. A reduction in production levels almost certainly means jobs will be lost, and some people will lose income.
At a national level, that is, taking into account all of the factories in the economy, reducing production by 10% is like having the GDP (Gross Domestic Production) reduced by 10%. This is something that national governments try very hard to avoid. National governments will do anything for their GDP to increase by a few percentage points every year. Most healthy national economies will have their GDP increase by between 2% to 6% per annum. High fliers like China and India will increase, and have been increasing, their GDP by 8 to 12% p.a.
To keep production at the same or slightly higher level, consumption must stay at least the same or go slightly higher. For production to continue at the same pace, then, it is necessary that all of what is produced is purchased.
Contraction of the Economy
A decrease in the level of production is called a contraction of the economy or a recession. Recessions can sometimes go on for a few years in a row. If the decrease in production is large then it becomes a depression. What percentage does it have to be before it is referred to as a depression? An economy is officially regarded as being in a recession when there is negative GDP growth for two quarters in a row. For it to be regarded as a depression, there is no fixed percentage but it will probably be in the region of 10% to 15% reduction. A decrease in production at this level will have dire consequences for an economy in terms of the number of people that would have to be laid off. And if the depression goes any deeper than this then, other than the economic aspect, you can imagine the disastrous social consequences as well. The Great Depression of the 30’s was exactly this – a society with almost a third of the population out of work. A lot of people with no money to pay for their daily needs, even to buy food. A lot of people ended up in food lines in order to eat and survive. There was a lot of hardship and people had to survive on the very little that they could pay for.
What is 100% Consumption?
Consumption must be maintained for production levels to stay healthy. When an economy is growing, “100% consumption” will most likely translate to between 105% and 110% production in the next cycle because companies will almost always produce more in anticipation of sales growth.
Even if we assumed that there will be no speculative increases in production, there must be 100% consumption for production to be maintained at the same level at the next cycle. If we looked at individual companies and specific industries we know, of course, that there is not always 100% consumption. The agriculture sector quite regularly chooses to discard produce rather than sell at a loss. There would always be companies that would be stuck with unsold cameras, unsold sound systems, unsold appliances. There would always be restaurants with unsold food at the end of the day. A reduction in the purchase of one type of product will most likely be balanced by an increase in the purchases of another product. The purchasing dollar is there and it will be spent. If not on a camera, it will be on a sound system, or a new extension to the house, or on a holiday. Some items will lose out and some will gain.
The thing to note is that most companies, in the calculation of their costs already made room for this “waste”. This waste becomes a cost. It is a cost in the sense that even if these “extra” items went to waste, the workers were still paid wages for their manufacture. Whether the items planned for “waste” are purchased or not…the cost to the company would be the same – because the wages would have been paid regardless.
When a company spends say $1,000 for the cost of production, it expects to get $1,100 in sales. If they had programmed for 10% waste, this means that they will price their items so that they receive $1,100 even if only 90% of their products were sold. Making the $1,100 in sales would be regarded as 100% consumption. This means they were able to sell what they had targeted to sell. Some companies will sell more than what they expect because their targeted “waste” were still sold anyway.
In saying “100% consumption” here, I am referring to the economy as a whole, and not to individual companies or to any specific sector. At 100% consumption – some entities will sell less than 100% of their cost + profit, and some others will sell more than 100% of their cost + profit, and still the overall result will be an average of 100% consumption. This brings us to the definition of 100% Consumption as: if the total cost of production were 1,000M, then 100% consumption would be sales of 1,100M in an economy expecting 10% average profits.
There will always be a small percentage of stock in inventory because there will always be that gap between production and purchase – i.e. the items in the show room, the items “in stock” and ready to deliver as soon as the order is placed. This inventory is irrelevant to the discussion here. 100% consumption is actually about how much money was spent (cost of production) compared with how much money was made (sales) and how much profit resulted.
How to Measure GDP
Cliff Notes in the internet:
http://www.cliffsnotes.com/WileyCDA/Section/id-305001.html
has a graphic illustration of GDP as shown below. GDP can be measured using the Expenditure or the Income Approach.
The difference between the expenditure and income approaches to GDP measurement is illustrated in Figure 1 .
The bottom line for all the discussion above is that GDP (Gross Domestic Production), as cost of production plus profits (i.e. using the Income approach, cost of production = wages + rent + depreciation, and profits include rent and interest), needs to be “consumed”, or purchased. It does not matter how it is purchased, whether it be purchased in cash or in credit, or indeed by barter exchange, as long as it is purchased.
Governments Do Not Like Recessions
Knowing that every national government will do its utmost to make sure that GDP growth will stay positive, then they will do anything to make sure that all of production is consumed. Witness the example of 2009 when almost all of the leading economies on the planet went into “stimulus” spending! This happened because sales were “tanking” and the government “needed” to step-in in order to avoid a disastrous depression akin to the Great Depression of the 30’s. All of the first world economies prodded not just each other but also the BRIC countries to be bold and participate in stimulus spending.
Since the Great Depression, governments and economists have learned how to avoid a massive downturn in the economy. They do this with fiscal adjustments (by changing the prime rates of interest in order to encourage or discourage new investments), or by monetary adjustments (by pumping money into the economy), or by other financial instruments that reserve banks have in order to affect liquidity and extension of credit. Stimulus spending in 2009 mostly took the form of pushing funds towards the banks or placing appropriate government guarantees so that the banks will lend money and allow credit to flow to the consumers. Not all of the stimulus initiatives had the desired outcome but the net effect was that the various stimulus packages were credited with having avoided a massive recession and that economies were again on the rise (i.e. with GDP growth) by 2010.
With massive government intervention in 2009, consumption has been steered back to 100%. Production costs + 10% average profit was again possible. If there is slightly less than 100% consumption, then average profit would come down from 10%. If there is more than 100% consumption, then profits would go above 10% on average, and the economy would be considered healthy and humming.
Conclusion
This is the way the economy works today. All of production costs, overall, must be covered. If we do not achieve 100% consumption, then there will be a downturn in profits, and therefore a downturn in economic activity will follow. 100% consumption must be achieved and governments will bend over backwards to make sure this is maintained at all times – thus the principle that “all of production must be purchased” applies under an economic system that is predicated on profits and growth.
This is what I refer to as The Inevitability of Production Purchase. The arguments above establish this inevitability, and I state this as the first principle of production-based economics.
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