Thursday, February 03, 2005

Savings and Consumption

In my introductory lecture for my Economics 200 class on Tuesday evening I pointed out that the two largest economies in the world were the United States (largest) and China (second largest). However, when we divide the Gross Domestic Product (GDP) of each by their respective populations to see the output available per person, the U.S. remains the largest while China falls well below the second position it holds with its total production.

China has the largest population in the world and, with all those people, it is able to produce a large output of goods and services. People are needed to produce – Labor is a critical resource in the production process.

But the U.S., with its relatively small population, produces more than China. Why? The answer is CAPITAL. Capital is the tools used by labor to facilitate production. The U.S. has an abundance of capital while China has relatively little. American workers are far more productive than their Chinese counterparts, not because they work harder but because they have more tools (capital) to work with. Chinese workers actually work longer hours and, on average, have more physically demanding jobs than American workers but the Americans are more productive.

Back in the 1970s I spent a day in Istanbul, Turkey at the start of a trip through Eastern Europe. While strolling through the city I stopped to watch four men cutting the grass on a large grassy island in the middle of one of the city's boulevards. The island was not much bigger than the average lot size in an American suburban housing development. However, these fellows were cutting the grass with simple hand tools and it took them a while to complete the job. After my return home to Milwaukee I happened to drive past a suburban factory park. This was a new factory set in the middle of a few acres of grass and trees. One man, sitting on a small tractor with an awning over his seat was in the process of cutting this vast expanse of grass. This American, with his expensive tool (a John Deere type riding mower) was cutting many times the amount of grass that the four Turks with their simple and inexpensive hand tools were able to cut.

With capital, workers are more productive. But capital is expensive because, to create capital individuals in society have to divert labor and other resources to producing capital rather than consumer goods. Only by going without some consumption now can people expect to have more later. This is true of both society as a whole and individuals.

A society that consumes everything that it produces will never grow. Similarly, an individual that spends their entire income on present consumption will never have the funds to purchase things that cost more than they receive in their weekly paycheck.

"Wait!" you say. "I cannot afford to save money but I just brought a car and the dealer financed it for me which means that an individual does not have to save before purchasing big ticket items." You are wrong on two counts. First, other people are spending less than they earn and are SAVING the extra by putting it in a bank. You were able to purchase your car without having previously SAVED the money because the bank paid for your car with its depositor's money. You are now obligated to repay that money, plus interest. Second, because of this debt obligation you are no longer able to spend your entire paycheck on consumption, as part of your check now has to go to the bank to repay your car loan. Instead of saving to acquire the money BEFORE your purchase you have elected to make the purchase and save AFTER it. Either way your ability to consume other goods has been reduced.

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