Debunking the Paradox of Thrift

In which I argue that Keynes did not foresee the role that technological development would have on improving the ability to reduce costs.

Imagine a factory with 3 employees, and a boss who basically lives off of the profits, essentially focused on growing her business rather than taking a salary.

Each employee produces 100 widgets/hour using their existing process & tools. Since there are 3 of them, and they work for 8 hours a day, 5 days a week, they generate 12000 widgets/week between them.

A while ago, the boss found 1200 customers, each of whom consumes 10 widgets a week. Each widget costs $1.

So you can see, the employees each produce $800 in value per day, $12000/week total. They get paid some portion of that, let’s say $0.50 per widget, so they’re taking home $50/hour or $2000/week (nice!), or $6000/week between the three of them. The boss takes the other $6000 and uses it herself, to pay for the rent on the building ($1000/week), raw materials ($1200/week), her own income ($3800/week)

Now, the market tanks, and suddenly those 1200 customers get panicky, and each of them decides to cut their consumption of widgets in half (on average).

So now, the factory is making twice as many widgets as they need for the customers they have.

The boss has some choices. She can fire one of the employees, and put another on half time, and essentially try to maintain everything exactly as it is. Let’s do the math:

6000 widgets = $3000/week in labor costs (1.5 employees), leaving her with $3000. She still needs to pay $1000/month in rent, and $600 in widget cost, so that leaves her with an income of $1400. Plus, one employee is on half salary, and one is unemployed.

Man, those stupid customers, deciding to save their money – they totally paradoxed that poor business. And this would be true, if we assumed that there were no cognitive facilities in any of these people involved.

But, happily, the employees and the boss do have brains, and they are capable of adapting to and solving problems. One employee, for example, discovers a way to improve efficiency by 50% – that is to say, in one hour, they can now produce 150 widgets, instead of 100. Awesome!

The boss also discovers that she can buy a machine that will further improve the efficiency of widget production by another 33%. She uses her life savings to buy the machine (side notethis is why businesses deserve to keep most of their money – they take huge risks with their own money).

Now they can produce 200 widgets per hour. One person, working just 30 hours a week, can produce all the widgets for the customer.

So in theory, the boss could lay off the second employee, cut the last employee’s hours by 25%. Let’s do the math:

30 hours * $50 == $1500 (labor cost)

+ $1000 (rent)
+ $600 (raw materials)

= $3100

So now the boss is making $2900 per week, not terribly far away from her original salary of $3800.

But again, the economy is shafted by the Paradox of Thrift – no net improvements have been made (other than the purchase of the new widget machine).

Of course, luckily, the boss and the remaining worker still have brains. And they realize something – the marginal cost of the widgets has dropped from $0.60/widget (50 cents labor, 10 cents raw materials) to 35 cents. They’re far more productive now than they were before.

What if…. what if they reduced their price on widgets?!?!?!? Maybe they could find more customers! Maybe the existing customers would buy more widgets!!!!!

So the boss takes a second risk. She reduces her price to $0.75. The existing customers each have an extra $1.25 in their pocket every week. Wow. Marginal Benefit. Unpredicted by the Paradox of Thrift! What are they going to do with that windfall? Will they save it? Will they use it to buy more widgets? Will they use it to buy rocks, so they can break windows and engage another fallacy? Who knows? It’s their call.

But even more than that – maybe there are new customers out there – people who would buy widgets at $0.75, who wouldn’t be willing to buy them at $1. The boss can take yet a third risk, and hire someone to go out and try to sell widgets to new customers. Maybe it works. Maybe it doesn’t. This, again, is why the boss deserves most of her money – because she keeps shouldering tremendous amounts of risk. She might go bankrupt, and end up living in ignominy. Or she might make it big. You, of course, will only ever hear about her if she becomes successful, leading to the confirmation bias effect that the only bosses you ever hear about are the successful ones, so it doesn’t seem fair that they got so much money for so little effort.

In summary: The paradox of thrift only exists if you assume that people in the system do not have any ability to innovate – by either costlessly reducing expenses or investing in equipment to reduce expenses. Reducing expenses opens up new opportunities for businesses – the possibilities of new customers and/or increased purchases from existing customers at lowered prices. Both of which can leave everyone better off than they were before. Paradox solved.

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