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Sunday, March 01, 2015

Economics: Projects for Future Benefit

This is part of a series of posts on economics.  Unlike my typical posts, these posts are dynamic—I'm going to come back and edit them as my thoughts develop.  I am basically "thinking out loud."  I am trying to fit things together in a modular way, so that each piece stands on its own analytically.  But no promises.

We are not going to develop a very detailed model of the market for goods and services.  As we have noted, people get utility from consuming goods and services, which is reason enough to buy them.  But people can also buy goods and services for reasons that are less directly related to utility.  We've already briefly discussed this topic, but let's look at it in a little more depth.  There are various projects that can be undertaken with the following feature:  resources are spent at time t = 0 and then there is some benefit that accrues at time t = n (the benefit may also be spread out over several periods).  Examples include things like adding more machines to a factory to expand its production capacity, or buying a microwave so that you can easily heat food in your kitchen.  These examples are different in that one is an investment in capital, while the other is investment in a consumer item, but we are not going to make very much of this distinction.  In both cases you must spend money at time t = 0 in anticipation of benefiting in the future.  The main differences between the factory and the microwave that will interest us are when and for how long those future benefits will accrue, and what risks attach to the project (for instance, maybe the microwave has a 5% chance of breaking down each year, and its warranty lasts only a year).  There is not a sharp distinction between immediate consumption and a consumption project that lasts several time periods — there is a continuum from 100% of the utility being gained at t = 0 to 100% of the utility being derived far in the future.

We are not going to look very closely at these projects, except to note a few features that we will assume.  First, the anticipated value of a project is dependent on circumstances.  If you are going to build an ice cream factory, your expected profits depend on your view of the market for ice cream in the future, when the factory starts producing ice cream.  If there is a health craze, or if refrigeration becomes much more expensive, then the demand for ice cream may be depressed and your investment may prove unprofitable.  Or it may be that milk and sugar will be more expensive in the future, reducing profits even if demand remains steady.  Another important aspect (which we will examine more closely in a separate post) is the interest rate and the risk premium available in the market.  If the ice cream factory yields a return of 15% and the market interest rate is 20%, then the ice cream factory may be a bad investment even if it is profitable as an accounting matter.  In other words, the ice cream factory may earn enough profits to more than pay back the original investment, but the investor might still have done better by loaning the money to someone else.

Second, we are going to assume (somewhat unrealistically) that when someone spends money on consumption or on a project for future benefit (such as the ones we have been discussing), the expenditure involves using scarce resources.  So for instance, if I invest in machines for my factory, those machines will be unavailable for anyone else.  If they are custom-made, then the materials and labor that go into making them are unavailable for anyone else to use.  This is realistic for many goods and services, but it's not universally true.  When an individual buys software, or pays to stream a movie over the internet, there is no reduction in resources available for other people to use (or the reduction is minor, such as the use of bandwidth on the internet, which represents a small part of the price of the movie).  We are going to ignore these non-rival goods and services.

We are also going to ignore non-market use of resources.  Technically, if someone operates an orchard, she may be using carbon dioxide, without which she couldn't produce any fruit.  But there is no market for carbon dioxide, and realistically her use of carbon dioxide is trivial.  The same would be true of a facility that concentrates argon from the atmosphere and then sells it.  Technically, in addition to the market goods and services that are used (machines, electricity), the facility also removes argon from the atmosphere.  This is not what we mean when we talk about using up resources.  And we are going to ignore other cases in which people use up society's resources in a more material way without paying for them (as when a farmer removes water from an aquifer that extends beyond his land).  This may be economically significant, but it is not a project for future benefit for our purposes because the farmer doesn't spend anything for the water at time t = 0.  If she has to buy a pump to get the water, on the other hand, then that would count as a project for our purposes.

So in conclusion, projects for future benefit require spending at time t = 0, they use up scarce resources, and their profitability depends on external circumstances such as market demand for the particular good in question, as well as the market rate of interest and the risk premium that attaches to financial products.


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