Monday, 11 June 2007

On Physics and Wealth Disparity

Although economics is often hailed as a boring science, I believe it gives us a sense of the reality around us in its own unique way. As a continuation of ‘Random Connections’ (http://www.esnips.com/web/Observations), I started thinking about a rather simple question – Why aren’t all men at the same level of wealth across the world? Maybe an economist would like to say, “Why doesn’t ‘Wealth parity’ exist across the world? This post looks at the question.

The Wealth Equation Let’s look at some obvious reasons for this wealth disparity. If one looks at the economies around the world, one could probably get a consensus on the following reasons behind the wealth disparity. (This isn't an exhaustive list by any means but it more or less captures the 'capturable')
1) Relative disparity in level of technology,
2) Relative disparity in level of education,
3) Relative disparity in level of regulation in an economy and capital markets and,
4) Population
I’m not too sure how much is attributable to innate ‘smarts’…but I’m inclined to think this should figure prominently in the scheme of things.

As I was on a roll, I found myself going off tangentially… Was there a link somewhere? Was there a parallel between the economic question of wealth disparity and one of the most fundamental of concepts in physics – gravitation? I was wondering what would happen if I put the reasons outlined above in mathematical form.

Here is the Wealth equation…in its simplest form.

W = T * E
R * P

In English, the above equation says that the level of wealth of a nation (W) is directly proportional to the level of technology (T) and level of education (E) and inversely related to the level of regulation in an economy and the capital markets (R) and Population (P).

Presented below is the law of gravitation in its mathematical form…

F = G * M * m
r^2

What do we have here? Don’t the two equations look similar?

In the economics world, the amount of wealth in a country is analogous to the force of gravitation in the physics world. The ‘T’ and ‘E’ in the Wealth equation are analogous to the ‘product of the masses’ in the gravitation equation; and finally, the level of regulation and population is analogous to the ‘distance between the two bodies’ in the gravitation equation. (For the physics inclined reader, I have let G = 1!)

The Wealth equation’s beauty lies in its simplicity. It gives us a perspective of economic reality through a simple equation, and a concept – gravity - that is deeply entrenched in our brains.

We are now in a position to try to understand why some nations are inherently wealthier than others. I will use some simplifying assumptions, and rank the components of the Wealth equation on a scale of 1 to 10. After assuming a number for each of the components, I then rank the countries chosen here for comparison, based on their ‘W score’.

Let’s begin with the big daddy of them all, United States. Here are my assumptions for the components.

T = 9, E = 8, R = 3, P = 5 (I am sure you may be thinking up some numbers that differ from my own. I encourage you to put those numbers in the Wealth equation and run the test yourself).

Based on the above assumptions, the W score for United States turns out to be 4.8 {(9*8)/(3*5)}.

United States T = 9, E = 8, R = 3, P = 5; W score = 4.8
United Kingdom T = 9, E = 8, R = 4, P = 4; W score = 4.5
Hong Kong T = 5, E = 7, R = 5, P = 4; W score = 1.75
China T = 7, E = 6, R = 7, P = 8; W score = 0.75
India T = 6, E = 5, R = 6, P = 7; W score = 0.70

Now we can appreciate the reasons why country X is wealthier than country Y. The Wealth equation is by means an exhaustive one. Many other factors could be introduced into the equation. This will lead to increasing complexity but maybe it will result in a better estimate. Further, each of the components can, to an extent, be proxied by a real world measure that is quantifiable.

Can the Wealth equation help policy makers? Investors? Curious souls?

Policy makers could use the equation to figure out how to institute a set of policies that will maximize a country’s W score. Investors could use it to figure out the relative merits/demerits of investing in country X compared to country Y. The last category could use the equation just to admire the beauty of mathematical equations in explaining observable phenomena, or appreciate how closely seemingly unrelated phenomena are linked at a deeper level…and contemplate on the non-economic reasons for wealth disparity.

Why Men are not equal…
It would be interesting to picture a world where everyone was made equal – on everything, so that no disparity existed. Could trade happen? Could investors utilize relative disparity to generate ‘alpha’ – or excess returns? When everyone is equal, there would be no incentive to grow beyond a certain point. There would be no incentive to create something new, because the moment something was created, by nature, everybody else would be elevated to the ‘new’ level. And this would again result in a ‘new steady state’. In my opinion, the ‘steady state’ would ensure that everything came to a standstill.

Manufacturers would have no incentive to seek out low cost locations to grow profit margins, simply because there would be no low cost locations! Everyone would have what everyone wants; it wouldn’t really matter if the ‘steady state’ were a sub-optimal one.

Within the Wealth equation framework, one can explain why such a ‘steady state’ may not exist for extended periods of time. If everybody was equal, there would be no incentive to stretching ones brains, and people would spend more time at home. Animal instinct would probably lead to more procreation than what the optimum level of ‘P’ in the Wealth equation warrants. This leads to an imbalance, where the ‘trigger happy’ nation finds itself dropping on the W score. This is how wealth disparity begins.

Since the fallout of this spurt in population would not be felt instantaneously, the faltering nation would blissfully continue on its task. However, over time, it would find itself forced to invest either in technology or in raising education levels, to keep its W score at par with others. Both these require significant monetary investments…and the poor (no pun intended!) nation would find itself being short on money!

Seeing the development of a relatively poorer nation, some smart countries would move their manufacturing bases into the relatively poorer country, thereby reducing their cost of production. They could keep the prices of their finished goods the same as before, yet make a higher profit, as the cost of production has dropped. Result? The nation gets wealthier.

The Poor country knocks on Rich country’s doors for money to invest in technology and education. Now it’s in the Rich country’s self-interest to ensure that Poor country continues to be poor. So it refuses to extend a part of its wealth. The result of this deadlock is that the wealth divide widens and disparity grows…

Is there a place for a Creator?
The W score can readily and in an intuitively appealing way explain wealth disparity among nations. Nevertheless, it is still silent on the question of ‘why aren’t all men, or nations, made equal?’ Did the Creator have something in mind when he made men unequal? Did the Creator have something in mind when he made some farmland more fertile than others? When He made some areas laden with mineral resources, whereas He filled others with nothing but sand? Indeed, some doubt the very existence of a Creator. Maybe we will never know. Maybe that’s not the right way of questioning things.


It seems that some men and countries are inherently – and somewhat unjustly – blessed, whereas others are doomed to perennially be stuck with the tag of ‘developing’ nations. So maybe the next time we hear politicians painting a rosy picture about a developing country and expounding the merits of becoming a developed country…well…its time to give it a pass…or better still remind them of the mechanics of wealth disparity!