In Part I, we noted that, as far as the doctor can see, the topic of Economics is too often swept under the rug where Supply Management is concerned. Why? Hard to say, but the recent failure of Macro Economics to predict the biggest downturn since the Great Depression and its continual inability to explain the tortoise-pace of the recovery is certainly a major factor.
But, reasons aside, the reality is that you can’t ignore economics. Not only will you be unable to judge a supply market strategy without a solid understanding of basic economic principles, but when you get down to the basics, as pointed out by Adam Smith in 1776, real wealth is resources and the goods and services produced with them. In other words, all wealth, and economics, revolves around Supply Management.
Remembering that the three basic questions of economics are what to produce, for whom, and how, we need a good understanding of the basics. The first understanding is the production possibility curve/frontier. This is a graph that compares the production rates of two commodities that use the same fixed total of the factors of production. The curve shows the maximum specified level of one commodity that results given the production level of the other. In other words, with fixed resources, there is a trade-off between how many units of each product can be produced. This is the basic theory that underlies your manufacturing planning.
The next understanding we need is that of comparative advantage. This is the ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another. This is the basis of trade. This is because it’s advantageous to produce goods you can produce more efficiently than someone else and trade them for goods that you can produce less efficiently than someone else. In a more complex way, this is not only the basis for trade between nations but the consumer economy we have now.
To see this, we simply add IOUs into the equation. Let’s say you need shoes, but your skills are bookkeeping. Let’s also say that the shoemaker doesn’t need bookkeeping, but needs a hammer from the ironsmith. The ironsmith is poor with numbers and needs bookkeeping skills to keep the taxman off his back. In this case, the shoemaker can accept your IOU in exchange for the shoes and give it to the ironsmith who needs your skills. In this way, neither you nor the shoemaker have to fumble around for days trying to procure a hammer you don’t know where to get or produce one you don’t have the skills for, and the ironsmith doesn’t need to worry about the taxman as he can quickly produce the hammer the shoemaker needs who can quickly produce the shoes you need to walk to the ironsmith’s forge where you quickly do his books to keep the taxman away. When everyone does what they do best, and trade it, all parties profit. The only difference is that, today, instead of negotiating complex multi-party trades or passing around IOUs, we just use paper money issue by banks, which represent the value of the goods and services we trade.
In other words, when we understand the (multivariate equivalent of the) production possibilities curve and the concept of comparative advantage (which tells us that even if we can’t produce anything better than our competition, we can still profit as long as we produce something of value, although we will do better if there is something we are better at than anyone else), we understand how to determine what we should produce and in what quantity. And that’s the first step to successful Supply Management.