Trump's Trade War Rests Heavily on the Sunk Cost Fallacy

The trade war of the past year, and the rumblings of it on the campaign trail in 2016, are in support of a singular message from the President: “Make America Great Again!” By imposing tariffs on friend and foe alike, the idea is to force manufacturing jobs from other countries back to the United States. This scheme will supposedly bring back the halcyon days.

However, this argument rests on a logical fallacy: the sunk cost fallacy. The sunk cost fallacy is when one considers unrecoverable costs in their decision making. For example, someone goes to the movies and pays $10 for a ticket. The movie is terrible and they are trying to decide whether to stay or leave. Some will say “well, I paid the $10 so I might as well stay.” But that is fallacious reasoning. The choice being faced is whether to stay or go, not whether to pay $10 and stay or go. The $10 is already gone. The person will not get that money back; it’s property of someone else now.

The situation is similar with trade. Even if we take the short-run findings of Autor, Dorn, and Hanson at face value, even if we take the assumptions of Trump et al, that trade has made America weak, it does not logically follow that tariffs are a preferable option or that bringing back those jobs is desirable. The situation has changed. The effects of international trade are sunk costs; they do not factor into future decision making. The question is not whether or not tariffs can bring jobs back or return us to some virtuous past. The question is whether or not, given current conditions and margins along which people adjust, are tariffs the best trade-off?

Economic activity is dynamic. It evolves, just like any ecosystem. It is shaped by the people within it as much as it shapes their behavior. Just as returning Earth to a super-hot primordial period (or an ice age) in order to achieve some goal may benefit certain elements but destroy most others, so would tariffs mess with the economic ecosystem.

Merely closing off trade is not the answer, even if we are to (erroneously) assume trade is harmful. People have adjusted around it, and the cure may very well be worse than the disease.

Today's Quote of the Day...

…is from page 227 of the 6th edition of Robert Cooter and Thomas Ulen’s textbook Law and Economics:

In communist countries like the former Soviet Union, planners could not get the information that they needed to manage an increasingly complex economy, which caused the economy to deteriorate. An increasingly complex economy must rely increasingly upon markets, which decentralize information. In this respect, making law resembles making commodities. As the economy grows in complexity, central officials cannot get the information that they need to make precise regulations. Instead of centralized lawmaking, the modern economy needs decentralized lawmaking analogous to markets.

JMM: Oftentimes, complexity is given as a reason to justify increased regulation. But, just like with markets, more complexity means more knowledge, wisdom, and information are needed to formulate such regulations. What’s more, as complexity increases, the costs and likelihood of systematic errors increases. Law develops, emerges, and evolves not through some central planning process, but rather in the same manner as the market process: through challenges, trial and error, and good old-fashioned human ingenuity. Law is, like the economy, a matter of human action but not human design.

For more on this point, I highly recommend Bruno Leoni’s Freedom and the Law and Bruce Benson’s The Enterprise of Law

Jon MurphyLaw & Economics
The Presumption of Liberty in Adam Smith

As I discussed the other day, Adam Smith had a presumption of liberty that permeates his “liberal system.” There were exceptions that could be made, naturally, but these exceptions mere existence did not in and of themselves justify the sovereign to act. Consider one such example discussed in the Wealth of Nations (emphasis added):

Were all nations to follow the liberal system of free exportation and free importation, the different states into which a great continent was divided would so far resemble the different provinces of a great empire. As among the different provinces of a great empire the freedom of the inland trade appears, both from reason and experience, not only the best palliative of a dearth, but the most effectual preventative of a famine; so would the freedom of the exportation and importation trade be among the different states into which a great continent was divided. The larger the continent, the easier the communication through all the different parts of it, both by land and by water, the less would any one particular part of it ever be exposed to either of these calamities, the scarcity of any one country being more likely to be relieved by the plenty of some other. But very few countries have entirely adopted this liberal system. The freedom of the corn trade is almost every-where more or less restrained, and, in many countries, is confined by such absurd regulations as frequently aggravate the unavoidable misfortune of a dearth into the dreadful calamity of a famine. The demand of such countries for corn may frequently become so great and so urgent that a small state in their neighbourhood, which happened at the same time to be labouring under some degree of dearth, could not venture to supply them without exposing itself to the like dreadful calamity. The very bad policy of one country may thus render it in some measure dangerous and imprudent to establish what would otherwise be the best policy in another. The unlimited freedom of exportation, however, would be much less dangerous in great states, in which the growth being much greater, the supply could seldom be much affected by any quantity of corn that was likely to be exported. In a Swiss canton, or in some of the little states of Italy, it may perhaps sometimes be necessary to restrain the exportation of corn. In such great countries as France or England it scarce ever can.

Page 539.39

In short, there may be good reason to limit exports of food to a neighboring country if they are so famished that they would draw away local food production due to higher prices. However, this potential exception does not in and of itself justify the prohibitions. Smith goes on to say (emphasis added):

To hinder, besides, the farmer from sending his goods at all times to the best market is evidently to sacrifice the ordinary laws of justice to an idea of public utility, to a sort of reasons of state; an act of legislative authority which ought to be exercised only, which can be pardoned only in cases of the most urgent necessity. 

Page 539.39

The act of interfering in trade is a sacrifice of the ordinary laws of justice, the laws the sovereign is sworn to uphold in the liberal system of Adam Smith (for the list of sovereign duties, see Pg. 687.51). Thus, Smith reasons, the sovereign should only undertake these exceptions, not when it is merely justified, but when it is “urgent[ly] necessary.”

Another example of this high burden of proof exists in his discussion of the national defense exception to free trade. Smith writes:

There seem, however, to be two cases in which it will generally be advantageous to lay some burden upon foreign for the encouragement of domestic industry.

The first is, when some particular sort of industry is necessary for the defence of the country. The defence of Great Britain, for example, depends very much upon the number of its sailors and shipping. The act of navigation, therefore, very properly endeavours to give the sailors and shipping of Great Britain the monopoly of the trade of their own country in some cases by absolute prohibitions and in others by heavy burdens upon the shipping of foreign countries.

Pg. 463.23-24

However, Smith goes on to say this mere justification is not enough (emphasis added):

When the act of navigation was made, though England and Holland were not actually at war, the most violent animosity subsisted between the two nations. It had begun during the government of the Long Parliament, which first framed this act, and it broke out soon after in the Dutch wars during that of the Protector and of Charles the Second. It is not impossible, therefore, that some of the regulations of this famous act may have proceeded from national animosity. They are as wise, however, as if they had all been dictated by the most deliberate wisdom. National animosity at that particular time aimed at the very same object which the most deliberate wisdom would have recommended, the diminution of the naval power of Holland, the only naval power which could endanger the security of England.

Page 464.30

The acts of navigation, which were indeed a violation of the ordinary laws of justice, were justified and proper (note this word “properly” appears in his initial justification in paragraph 24) in this particular case because war with Holland was inevitable and imminent. National defense, then, is not a broad exception to the liberal system of free importation and free exportation, but rather a very specific exception in the face of imminent national danger.

The duties of the sovereign in Smith are threefold: defend the nation from outside invasion, enforce the rules of justice domestically, and provide public works that are necessary and proper for the nation. These actions imply a presumption of liberty within the liberal system. The sovereign certainly has the right as a sovereign to perform certain actions that may violate liberty, but this power is one that must be executed with propriety as it violates the role of the sovereign as administrator of justice. Violations of the most ordinary laws of justice should not be undertaken lightly, and as these above quotes show (and many others throughout the Wealth of Nations, Theory of Moral Sentiments, and Lectures on Jurisprudence, not to mention his own correspondences), mere justification for a sovereign act is not enough to authorize such an act.

Economic Growth and the Division of Labor

Tyler Broker, the Free Expression and Privacy Fellow at U. Arizona Law School (also my friend), has a very good article at Above the Law. There is much to like in Tyler’s article, but I do want to pick one important nit. Tyler writes:

Indeed, in near-Earth space one can easily visualize how the best aspects of capitalism will be utilized to lift humanity into a new age. Capitalism operates best when markets are allowed to continually grow and expand. This is in part why a capitalist system has been so successful (for some), here in the United States. This country began with 13 colonies and followed with continual territorial and population expansion for the next 200 and counting years. Of course, this expansion came at the great conquest and exploitation of human labor, including enslaving whole civilizations and generations of human beings. An unfathomable wrong yet to be fully acknowledged, appreciated in the scope of barbarity, or morally corrected.

Tyler is correct that markets are best when they can grow and expand. However, Tyler’s comment suggests this growth is in physical territory and labor. While those resources are important, they are not the only thing. Markets also expand by taking advantage of the division of labor and specialization. Early on in his famous book, Adam Smith shows how specializing allows a pin factory to become more productive. When people divide their labor, they can become more productive. This means they produce more with fewer (or the same number of) inputs.

However, the division of labor is limited by the extent of the market. On a deserted island, Robinson Crusoe cannot specialize. When Friday comes, he can. If more people can come to the island, Robinson can specialize more and more.

Expanding the market can mean, as Tyler discusses above, expanding land and labor. But it can also occur by trade. If the world were to discover an alien race beyond the stars and (assuming transaction costs overcome) began trading with them, that would expand our markets.

More land and labor can help markets flourish, but imperialism need not be an end-point for capitalism (I do not think Tyler is suggesting it is, but there are some out there who do argue imperialism is the only way to sustain capitalism). Rather, simply opening up trade, markets can expand, and prosperity can grow.

Adam Smith and the Nirvana Fallacy

Adam Smith was no anarchist. Indeed, at the time he was writing, he was a fairly conservative liberal (interesting that those of us who follow Adam Smith’s teachings are considered radical). Adam Smith did have a strong presumption of liberty, but this presumption was not absolute. Under certain conditions, a jural superior (such as a sovereign or magistrate) could violate this presumption of liberty.

But Smith’s analysis did not stop there. He also explored the nature of the jural superior. While Smith does have a science of the legislator, he also repeatedly emphasized that jural superiors are also human beings like us.

To give one such example, in the Theory of Moral Sentiments, Smith writes on how it is a natural human reaction to feel resentment and revenge when once does something against us. Indeed, not rendering gratitude where gratitude is due can cause this passion to arise (see Part 2, and especially Section 2). This jealousy can cause us to act in a harmful and unjust manner; beneficence cannot be extracted by force. But, while Smith is examining jural equal relations here, he also applies this same sentiment to national governments and legislators. In The Wealth of Nations, when Smith is discussing a potential use of tariffs to reduce/eliminate tariffs by other governments, he begins by stating that, when one nation raises tariffs on another “[r]evenge…naturally dictates retaliation, and that we should impose the like duties and prohibitions upon the importation of some or all of their manufactures into ours. Nations, accordingly, seldom fail to retaliate in this manner“ (Page 467.38). Revenge, that natural emotion according to Smith, is applied to national governments here and not just individuals. Smith goes on to tell of a trade war between the Dutch and French which became a shooting war.

After this story, Smith lays out his potential exception to the aforementioned presumption of liberty (Emphasis added):

There may be good policy in retaliations of this kind, when there is a probability that they will procure the repeal of the high duties or prohibitions complained of. The recovery of a great foreign market will generally more than compensate the transitory inconveniency of paying dearer during a short time for some sorts of goods. 

Page 467.39

However, he immediately follows it up with a reminder that we are dealing with people here. The science of a legislator may recommend this policy, but we must remember we are dealing with people with passions, not necessarily a dispassionate legislator:

To judge whether such retaliations are likely to produce such an effect does not, perhaps, belong so much to the science of a legislator, whose deliberations ought to be governed by general principles which are always the same, as to the skill of that insidious and crafty animal, vulgarly called a statesman or politician, whose councils are directed by the momentary fluctuations of affairs.

Page 467.39

He then brings us back to the presumption of liberty:

When there is no probability that any such repeal can be procured, it seems a bad method of compensating the injury done to certain classes of our people to do another injury ourselves, not only to those classes, but to almost all the other classes of them. his may no doubt give encouragement to some particular class of workmen among ourselves, and by excluding some of their rivals, may enable them to raise their price in the home-market. Those workmen, however, who suffered by our neighbours prohibition will not be benefited by ours. On the contrary, they and almost all the other classes of our citizens will thereby be obliged to pay dearer than before for certain goods. Every such law, therefore, imposes a real tax upon the whole country, not in favour of that particular class of workmen who were injured by our neighbours prohibition, but of some other class.

Page 467.39

By starting with a reminder that revenge is a natural passion within our breast and a story about a war of jealousy between two nations, Smith argues that the probability that higher domestic tariffs will lead to the reduction of foreign tariffs is not particularly high.

Smith avoids the trap that many economists after him would fall into: the Nirvana Fallacy. A term first coined by the late Harold Demsetz, the Nirvana Fallacy is when one compares an imperfect current situation to an idealized alternative. Mid-Century economists often made this mistake by pointing to market failures and justifying some policy to correct these failures. Public Choice economics expanded on the Nirvana Fallacy by assuming government actors are just like market actors. Smith did not fall into this trap, and thus his presumption of liberty was extremely strong in his eyes.

The fun thing about reading Adam Smith is seeing insights in his work that would, for one reason or another, be lost to economists only to be discovered centuries later. The example above of the Nirvana Fallacy is one, but Smith also had many insights into Law & Economics.

Adam Smith had a presumption of liberty, and while that presumption was not absolute, he was under no impression that the mere existence of a justification for policy X or Y was in any way sufficient to create policy X or Y. After all: “They whom we call politicians are not the most remarkable men in the world for probity and punctuality” (Lectures on Jurisprudence, Pg. 539).

Today's Quote of the Day

Comes from Ball State University economist Steve Horwitz, who writes on Facebook:

The question remains: why do we want to leave "essential services" in the hands of people operating under institutional incentives that put their self-interest at cross-purposes with providing the essential services in question? When your whole manner of raising and allocating funds is completely separate from actually providing those services, you are at the mercy of third parties with their own interests at stake.

Food is pretty essential, but Kroger doesn't "shut down."
Clothing is pretty essential, but Lands End/Eddie Bauer etc don't "shut down."
Amazon doesn't "shut down."

If you really think services are "essential," why would you leave them in the hands of people whose incentives are primarily, if not exclusively, political, rather than oriented toward service provision?

The great virtue of the market process is it turns self-interest toward the greater good. The great vice of politics is it turns self-interest against the common good.

Jon Murphypublic choice
Market Failure, Epiphany, and $20 Bills on Sidewalks

There’s a joke economists like to tell:

Two economists are walking down the street. One spots a $20 bill on the sidewalk in front of them. He bends down to pick it up. “What are you doing?” says the other. “I am picking up this $20 bill,” says the first. “Nonsense! If that were a real $20 bill, it would have already been picked up!”

Economists like to tell this joke as an effort to demonstrate that profit opportunities tend to be quickly accounted for in a market: if there was indeed a $20 bill on the sidewalk, then the “market” is “out of equilibrium” and someone would have recognized this, picked up the bill, and the “equilibrium” would have been restored.

But there is a subtle assumption in this joke, namely that the two economists would have been aware of an opportunity to pick up the $20 bill. There is some behavior they are doing (such as paying attention to the sidewalk) that allows them to be susceptible to notice this profit opportunity. Perhaps everyone else walking down the street had their eyes upward doing window shopping.

Perhaps a literary tale will better tell this story: “The Verger” by W. Somerset Maugham. In the Verger, the verger of St. Peter’s was sacked for being illiterate. In his sadness, we wandered the neighborhood and fancied a cigarette. He noticed no tobacco store existed and alighted upon the idea to open his own store in the neighborhood. It was a roaring success (this story is recounted in Dan Klein’s book Knowledge and Coordination, and much of this blog post is inspired by that book).

Many people walked the streets the verger did. Why was the verger able to notice the metaphorical $20 bill on the sidewalk and not the many others who were walking? It appears it was because he was in a position to notice this particular $20 bill. He was in a certain frame of mind that allowed him to notice this particular “market failure,” this profit opportunity.

Dan Klein, in the aforementioned book, calls this form of discovery “epiphany.” This has an interesting implication for regulatory economics in that market failure needs to be “discovered.” The “market failure” in the verger (that the quantity supplied of tobacco products was less than the quantity demanded) was discovered only when the verger was in the right frame of mind to notice it and in a position to reduce transaction costs (he made have had passing thoughts in the past on the lack of a tobacconist, but given his job as a verger, did not possess the resources, such as time, to act on this market failure). Thus, market failures are something that arises from the market process. But likewise, the solution to this market failure had itself to be discovered. It was discovered in an alert mind: this street needs a tobacconist!

That both the failure and solution need to be discovered gives us great pause when considering law & economics. Mere welfare analysis does not capture this discovery process. Indeed, your standard economic analysis assumes all knowledge is known by all actors. Once we realize that such knowledge is dispersed and cannot easily be obtained, the whole concept of activist government to “fix” market failures becomes extremely shaky to say the least.

On the Optimal Tariff and the Law of Demand

In his 1987 Economic Review article detailing the history of optimal tariffs, Thomas Humphrey writes:

“[The optimal tariff model] assumes unrealistically (1) that foreign countries will not retaliate with tariffs of their own, (2) that elasticities of supply and demand in foreign trade are not so large in the long run as to render the tariff ineffective, (3) that the optimum tariff rate can be precisely identified and skillfully administered, and (4) that politicians can resist pressures to raise tariff rates above the optimum level” 

All four of these objections of the optimal tariff model are difficult to overcome when addressing the model as a policy procedure. I have written on some of these other points before (as have many people far smarter than I). However, I want to focus on point #2 and I’ll try to keep this not wonky.

That the optimal tariff model depends on elasticities of supply and demand is not controversial. Indeed, that is how the calculation of the tariff works. However, given condition (2) above, we can see the optimal tariff is, at best, a short-run policy. This follows from the Law of Demand.

Most people tend to think of the Law of Demand in its common form: all else held equal, an increase in the price of a good will reduce the quantity demanded of that good. But there is a second Law of Demand: the longer a price remains relatively high, the more elastic the demand for a good becomes.

Given that the goal of a tariff is to increase the relative price of a good, then as long as the tariff remains in place, the more elastic demand for that good becomes. Indeed, if the tariff remains in place and, again, everything else held equal, over enough time, the tariff could cause the demand curve for a good to become perfectly elastic. A perfectly elastic demand curve would indicate no consumer welfare gains from the trade. The elimination of consumer welfare would then mean that the tariff is a net welfare loss for the country in question. So, an optimal tariff cannot persist in the long run, only in the short run given the Second Law of Demand.

Some might object by saying: “But wait, Jon, you sly and handsome devil! That would just mean the optimal tariff would need to be reduced. There’s no reason to think the tariff would eventually become a net welfare loss.”

Indeed, it may very well be that some benevolent government can milk the tariff for everything its worth by constantly adjusting the optimal tariff as the elasticities change. However, this is where public choice comes into play. As Gordon Tullock discussed in 1975, government support of firms is very difficult to remove. Domestic producers have capitalized on the gains the tariff has provided them. To remove the tariff is not to eat up “extra normal” profit for monopolizing firms, but rather to eat into normal profit for them. These firms are legitimately harmed, profit-wise, by the removal or alternations of these protections like an optimal tariff. Any adjustment to an optimal tariff, even if demanded by the economic scenario is likely to be fought tooth-and-nail by affected firms. The resulting stagnation will likely result in an optimal tariff that is too high! Any short-run gains from the optimal tariff (assuming all the above conditions are met) would likely be eaten up by this un-optimal tariff that results from the changing elasticity and lack of change in the statuary tariff.

In a general-equilibrium theoretical framework, an optimal tariff makes perfect sense. But, once public choice enters the fray, the reasonableness of an optimal tariff goes out the window. And, as my professor Garett Jones likes to say: in a knockdown fight between general equilibrium and public choice, public choice wins every time.

HT to Dallas Weaver, whose comment on this Cafe Hayek blog post inspired this post.

Who Are the Job Creators?

We sometimes hear about job creation in the economy and typically this is referenced toward business owners. Jeff Bezos created X number of jobs with Amazon, or some new company will move to an area and create Y number of jobs. There is a sense where these entrepreneurs created jobs since their actions are bringing the jobs into being.

But there is another way to consider who creates jobs: to whom does the job benefit? A job exists in a market because it looks to fill a hole, to satisfy some end. My mechanic has a job because I need him to work on my car. My grocer has a job because I want her to feed me. My doctor has a job because I want her to give me medical advice. In this sense, the consumers are the job creators.

A productive job exists to serve some end that someone is willing to pay for. A job that does not serve some end ceases to exist. To the extent entrepreneurs are creating jobs, it is because they are seeking to satisfy some desire; the “demand” for the service has created the jobs.

Jon MurphyEconomic Thought
Institutions Matter, Even for Monopolies

Noah Smith has a rather interesting new article at Bloomberg detailing new research and proposals on regulating monopolies. I have written on the dangers of knee-jerk regulation as a solution to various market failures and others have written on the dangers of the perfectly competitive model to measure market failure. However, there is a different flaw I want to discuss with Smith’s article:

The big question Smith needs to ask is this: what are the institutional arrangements that allow for the monopoly (granting that the effects discussed, lower wages and higher prices, are due to the monopoly) to arise and persist? Monopolies are not necessarily a permanent fixture in industries; they always face competition (think of once “dominant” firms that are now on the garbage bin of history: Sears, Blockbuster, Myspace, etc). Monopolies theoretically arise under only a handful of situations and are constantly feeling the pressure of competition. Why is it some of these firms can now effectively ignore competition and suppress wages?

Smith blames lax anti-trust regulation and implicitly blames low minimum wages and unions. (The irony, of course, of using these last two options to “solve” monopoly issues is that both minimum wage and unions are themselves means of building monopoly power). However, the issue may (and, I’d wager, likely is) not one of lax regulation but rather excessive regulation. Regulation, by its nature, restricts competition. Granted, some restrictions may be desirable (eg, a prohibition on using violence to conduct business), but that does not change the fact that regulations are designed to restrict competition and this provides some level of monopoly power to firms. So, what are these institutional arrangements? What legislation is in place? Occupational licensing? Tariffs? Environmental Regulations? All these things raise the fixed costs of suppliers, and when fixed costs rise, and subsequently barriers of entry imposes, one should not be surprised when monopolies arise.

By not considering the institutional framework in which economic activity takes place, Smith is mistaking symptoms for causes. Regulation, even if we ignore the public choice, law & econ, and behavioral economics concerns laid out in my linked article, would at best be treating these symptoms rather than the causes of monopolies. Indeed, ignoring institutional arrangements may lead to a regulatory action that worsens, rather than helps, the problem.

Whenever some “market failure” is supposed, the first question in any analysts mind should be “why did this outcome happen?” That is the line of inquiry for the economist, for the lawyer, for the scientist. We assume too much by ignoring that all important question.

Turning Wizards into Teachers

Competition turns wizards into teachers.

-Roger Koppl and E. James Cowan, quoted in “Expert Failure” pg 91

Neither do men light a lamp, and put it under a bushel, but on a lamp stand; and it gives light unto all that are in the house.

The Gospel of Matthew, 5:15

In my spare time, I have been reading The Dresden Files by Jim Butcher. They’re dime-store paperback fantasy novels about a crime-fighting wizard in modern-day Chicago (highly recommend). In the second book of the series, Fool Moon, the titular character, Harry Dresden, is having a conversation with his subconscious while passed out from blood loss. He is reflecting on the death of his apprentice and attack of his partner/friend Lt. Murphy (no relation) at the hands of a werewolf. His subconscious reflects: “perhaps you should spend less time playing ‘shepherd’ and more time playing ‘coach.’ Ready [Lt. Murphy] for what she faces.”

This is a profound insight into the role of the teacher and mentor. Teachers can take on two main roles: that of the wizard, guiding people toward certain ideas or conclusions while hiding the details behind the veil of magic; or that of the “coach”, where people are prepared to think on what they are learning and all the magic is stripped away.

This seems doubly true in the economics profession, where we can hide behind complex mathematical models as a method to display brilliance. Sort of a “look how smart I am! I must be right because my math is correct!” attitude. That attitude can be conveyed by professors onto the students who memorize endless models on maximizing welfare, finding tangent points on curves, or endless proofs that cost-minimization is the same as profit-maximization. These students may learn these phrases and formulae, and indeed chant them like the nonsense phrases of a wizard casing a spell, but do not understand a lick of what is behind them, what the magic really is.

I think this outcome is a failure of teaching economics. I see my role of the teacher is to strip away the mathematics and look at what is really going on. What really is “marginal analysis”? What really are “indifference curves”? Why do we think with the tools we do? Why do we use homo economicus? etc. In other words, I want to teach “The Economic Way of Thinking” rather than calculus or algebra (let the math teachers do that, I say!). I want the students to understand the world they live in.

Our jobs as economists, as experts, is not to hide our light under a bushel but rather to share that light with the world. I want to start with my students. And I hope, by stripping away the magic, I can help them see who really are the wizards and who are just people who glued stars onto the dunce caps.

Jon Murphy
Do Not Fear Monopolies: Competition is a Process

CNBC reports that a large deposit of rare earth metals, enough to supply current world demand for nearly 1,000 years, was discovered off the coast of Japan.

Presently, almost all of the world’s rare earth metal consumption is supplied by China. This effective monopoly on rare-earths have caused some to wring their hands in fear of Chinese dominance and calls for protectionists tariffs soon followed. While this seems like a classic national-defense argument for tariffs, and a textbook case for monopoly regulation, the result of Japan indicates why fears of monopolies are overblown.

From the article:

Japan started seeking its own rare-earth metals after China held back shipments in 2010 during a dispute over islands both countries claim, Reuters reported in 2014. As a major electronics manufacturer, Japan needs rare earths for components.

Separately, China held back exports of certain types of rare earths starting 2010, which caused prices to jump by as much as 10 times — further pushing Japan to seek other sources, according to the Journal.

The Chinese government attempted to flex their “market power” on Japanese consumers in order to get some policy change (again, a classic example of protectionist fears). However, simple price theory predicted why the strategy would fail: Demand curves slope downward and (subsequently) supply curves slope upward. When China raised the relative price of rare earth metals for Japan, Japan looked for other sources and indeed discovered this massive deposit.

Currently, the deposit is too expensive to mine profitably given current prices. But, if China were to try and flex their “market power” again, they would quickly find another competitor in Japan (indeed, when China attempted to raise prices on rare earth metals through their role of a monopoly in 2008, it failed miserably as mothballed mines in other countries came back online).

Monopolies are not perpetual things. Relatively high prices induce people to enter the market (note this is true even when there are high barriers to entry). Relatively high prices induce technological innovation (like fracking in oil). If a monopolist seeks to exploit “market power,” then we will find people who respond. The Law of Demand remains in effect.

In short, I do not fear monopolies, even one that dominates like China and rare earths, because competition is a process, not a static state of affairs.

Jon MurphyPrice Theory
Harold Demsetz: 1930-2019

The great Harold Demsetz passed away on January 4th. He was 88. Demsetz was a professor of economics at UCLA and University of Chicago who, along with his frequent co-author Armen Alchian, dramatically shaped how economists think about property rights, transaction costs, and the theory of the firm. His work laid the foundations of law & economics, environmental economics, industrial organization, and institutional economics. He was an excellent thinker and writer those of us who were his students, either directly or indirectly (like me, who benefits greatly from studying with those who studied closely with him like Walter Williams, David Henderson, and Larry White) will miss him.

For an excellent remembrance of him, here is Pete Boettke.

Jon Murphy
Revealed Preferences Matter

Below is an open letter to Spectator USA:

Editor:

The Spectator USA report “Identity is Just as Important as Wealth. Why Don’t Economists Get That?” contains a number of errors and strawmen versions of economic theory. However, the largest error is the premise of the article stated here:

But apart from the needless fear [nationalism] generates, it is also slightly dubious to suggest that it is the gilets jaunes or the Five Star Movement or the supporters of Brexit or even Donald Trump who are acting intemperately. It is perfectly possible to argue that these movements are a sensible, overdue reaction against governments that have imposed economic globalization on the world at a pace that is entirely inconsistent with the human lifespan and the speed at which we can adapt to change. The free movement of people, the euro, large-scale immigration, the dissolution of the nation state — for that matter the admission of China to the WTO… all were imposed on the world by ideologically motivated elites with little public consultation. Regardless of whether you think they are good or bad, there is a perfectly sensible secondary question to be asked about whether they were too much too soon. Remember, such decisions are usually made by economists, who do not really understand either time or scale.

Globalization, by definition, cannot be imposed. What freedom of trade and freedom of movement means is people, not elites, not economists, not governments, choose how people choose to deploy their resources. Liberalization of trade no more imposes on people than freedom of religion imposes on people. You, your readers, and all other people are free to choose to buy local or choose not to. When China joined the WTO, it did not impose on anyone to conduct business with them, nor did the WTO impose anyone to deal with China.

The fact of the matter is, however, people were free to deal or not deal with foreigners and they chose to deal with foreigners. Given this was an action freely taken, we can conclude that no, nationalism isn’t preferred to globalization. People choosing freely chose more than identity, and for whatever reason. The revealed preferences of Americans and Britons was to trade with foreigners. Indeed, trade liberalization indicates that national identity is not as strong a force as nationalists believe, which is why nationalism, not globalization, needs to be imposed.

Despite your claims otherwise, economists are not “obsessed with the gains arising from scale.” Rather, we study the interactions of people and the gains from trade freely made. Scale is just one side benefit of that; the real benefit is people improving on their current position. Any intro textbook will explain that (indeed, I highly recommend William Allen and Armen Alchian’s newly-released “Universal Economics”).

Signed,

Jon Murphy

George Mason University

Fairfax, VA

Ruminations on the Law of Demand

Two events today caused me to start thinking on the Law of Demand and its power as an explanatory tool.

The Law of Demand in Medical Care

When I lecture on the Law of Demand, which simply states that all else held equal as price rises quantity demanded falls, I inevitably get the objection: “What about necessities like food, water, health care?”

Even for these supposed necessities, the Law of Demand applies. Relatively high prices cause people to search for alternatives. One such example of this is in the Bob’s Burgers episode “Sexy Dance Healing” (Season 6, Episode 8). The titular character, Bob Belcher, goes out on a walk to try and gain inspiration for his Burgers of the Day (a running gag in the show. Each of the Burgers of the Day are usually pun-named, such as the “Never Been Feta Burger” (comes with feta cheese)). While walking past a message parlor storefront, Bob slips on oil poured on the sidewalk and tears his labrum. Bob goes to the doctor who informs him he’ll need surgery and his deductible is super-high: “like, $6,000 high.”

As per the Law of Demand, Bob begins to consider different options to pay for the surgery he wants but cannot afford outright. He considers suing the store that poured the oil on the sidewalk. He even goes so far as to have his lawyer serve notice, but the masseuse offers Bob a deal: the masseuse insists he can heal Bob without surgery. If Bob is not healed after 10 sessions, he will pay for Bob’s surgery.

So, the lesson from this story: the relative price of Bob’s surgery was high. Even though Bob needed medical care, the high price caused him to search for alternatives (spoiler alert: the alternative Bob chose worked out well). The doctor’s price of surgery was too high. If he lowered the price, Bob would participate; in technical terms, if the price fell, Bob’s quantity demanded for labrum surgery would increase.

A high price of medical care causes people to seek alternatives. A diabetic may try to change their diet. A person suffering arthritis may seek holistic approaches. A person suffering from psoriasis may move to a more humid climate. Et cetera. That these people seek alternatives, thus implying that if the price was lower they’d consume more of the good in question, indicates that the Law of Demand holds even in the case of medical care.

The Law of Demand and Power over Consumers

The second example of the power of the Law of Demand comes from the realm of trade. Commenting on this Cafe Hayek post, Jorod Smith writes:

Voluntary exchanges are nice. Now what happens when one country becomes so dependent on imports from and exports to one other country? The other country actually controls the country that relies on it for imports and exports. This is exactly the problem we have with China. 

Mr. Smith’s fears are unwarranted. Imports and exports do not equate to “dependence” on another individual, regardless of how much they might make up your trade. Currently, 100% of my food comes from sources external to me, namely Wies Supermarket. I grow none of my own food. However, despite this, Wies holds exactly no sway over me. They cannot dictate to me in any way, shape, or form my behavior. If Wies were to try to jack up prices or exert some other kind of pressure on me, I could easily go to another competitor. But what if there is no other competitor? Then I would seek other alternatives: I could grow my own food or seek some other substitute (consume less food, switch to things that get me more calories per dollar, etc). In other words, they’d have no influence on my behavior as I could seek alternatives.

To bring this back to China, if the Chinese government were to try to impose some preferred policy on the US by threatening trade disruptions, it’d be as ineffective as the US blockade was in forcing the Castros out of power in Cuba or the Kims out of power in North Korea. Economic sanctions tend to be very ineffective. Why? Because of the Law of Demand. As relative prices rise, people start to seek alternatives. In the case of the Castros, it caused them to look toward the Soviet Union. In the case of the Koreans, it caused them to look toward the Chinese. If the Chinese were to try to threaten something, US consumers could seek other competitors. If none are available, they could turn inward. Indeed, this is why the attempt by the Chinese to jack up rare earth metals prices failed.

Conclusion

In his classic book, The Theory of Price, George Stigler writes of the Law of Demand:

How can we convince a skeptic that this “law of demand” is really true of all consumers, all times, all commodities?… Perhaps as persuasive a proof as is readily summarized is this: if an economist were to demonstrate its failure in a particular market at a particular time, he would be assured of immortality, professionally speaking, and rapid promotion while still alive. Since most economists would not dislike either reward, we may assume that the total absence of exceptions is not from lack of trying to find them. And this of course hints at the real proof: innumerable examples, ranging from the wife who cuts down on strawberries because they are out of season ( =more expensive) to elaborate statistical investigations, display this result.

Pgs. 22-23

The Law of Demand remains an extremely powerful tool. Indeed, one can build all of price theory off of it. My above two examples show its utility. A thorough understanding of the Law of Demand can get one very far.

On the Nature of Freedom

Occasionally, one will here in the argument against open borders: “How many immigrants will you let into your house?” or “Why don’t you have any immigrants living in your house?” or some variation thereof. These retorts miss the point of freedom.

Freedom means the right to do something. The flip side of that is the right to not do it. Freedom of movement, for example, means I have the right to move from Virginia to North Carolina. It likewise means I have the right to not do so. Freedom to purchase tobacco necessarily means the freedom to not purchase tobacco. To call for the freedom of migration between countries does not imply any form of contract to house or employ immigrants. What it does do is call for the freedom to contract with those individuals for all people. I may not want to hire person X for a job, but that does not mean no one should hire person X.

In a free market, everyone is allowed to buy what they with with whomever is willing to sell it to them (barring violations of the rules of justice, of course). Likewise, a person is free to not buy anything.

Advocates who use the above argument (other variations include “people who support gun rights should be shot first” or “people who want abortions should be forced to listen to the heartbeat”) fail to understand the dual nature of freedom.

Jon Murphyimmigration
On Justice

My friend and colleague at GMU, Nathan Goodman, writes the following on Facebook (link added):

"To remain neutral in situations of injustice is to be complicit in that injustice."-Desmond Tutu

Nine years ago today I thought this was correct. Today, I am not so sure. After all, people have limited knowledge and may in many cases be unable to choose an action that is effective at combatting injustice. The unintended consequences of their actions may generate new injustices. Neutrality may therefore often be the best available option in a complex world. See also Michael Huemer's paper "In Praise of Passivity."

That said, I don't reject Tutu's statement here entirely. It is a useful rhetorical device to induce participation in social movements. This is important, given that the end of an injustice is non-excludable and therefore there is an incentive to free ride on the activism of others. Moreover, in some cases, Tutu's comments may be not just useful but true. There may be no option for neutral action. For instance, if the perpetrator of an injustice is a state you live under, then you are financing the injustice by paying your taxes. Absent other choices taken to combat the injustice, your impact on the injustice is not neutral.

I wish to expand on Nathan’s first point regarding the knowledge problem and justice.

Archbishop Tutu’s quote is Ciceroian in its origins. In De Officiis, Marcus Tullius Cicero writes:

But there are also two kinds of injustice: first, the injustice of those who inflict injury; second, those who, although able, do not repel injury from those upon whom it is being inflicted. For he who unjustly attacks another, whether he is incited either by anger or by some other perturbation, that person, as it were, seems to raise his hand against an ally. And he who, although able, neither defends against nor opposes the injury done to another, that person is as vicious as if he had abandoned his parents, friends, or country.

De Officiis 1.23, pg 31 (Newton Translation)

However, to Nathan’s point above, Cicero goes on to say:

[B]ecause we perceive and feel those things that turn out either well or adverse for ourselves more than those for others, we see the latter as if from a far distance, and judge them differently from our own. Consequently, such people advise well who forbid any action in which you may doubt whether it is equitable or inequitable. For equity is conspicuous in itself; doubt signifies the contemplation of injury.

1.30, pg 33

The intervention upon an injustice may, given our self-knowledge, be misguided. The prescription to intervene in the name of justice laid out by Cicero (and perhaps, consequently, by Tutu) is more nuanced and guided by our limited knowledge. Indeed, Cicero seems to urge caution in matters of justice.

Cicero distinguishes between two kinds of justice. While Cicero doesn’t name these two kinds of justice, preferring to simply call them “one kind” or “the other,” they are very similar to the kinds of justice Adam Smith lays out in The Theory of Moral Sentiments: communitive justice (simply put, not messing with other people’s stuff) and distributive justice (simply put, making a becoming use of your resources) (see TMS, in particular pages 269-270.10). We cause injustice, according to the Cicero quote above, when we cause harm to another person (violation of communitive justice) or we fail to prevent an injustice from occurring if it is within our power. Cicero seems to treat the rules of this first kind of justice as “precise and accurate” like Smith does and the rules of this second kind as “loose, vague, and indeterminate”, again like Smith. To commit a violation of the first kind of justice is pretty straightforward: inflict injury (or cause “real harm” to use Smith’s phrasing). Violations of the second kind of justice are more vague and depend on one’s knowledge, one’s abilities, one’s personal circumstances, and the good of the community as a whole (see 1.27-33, pgs. 32-35). The Tutu quote that Nathan provides gives the impression that the second form of justice has precision in its rules, which is not necessarily the case (it’s possible, indeed even probable, that Tutu realized this subtlety and, in a greater context, acknowledges and discusses it).

Knowledge, temperance, and propriety do need to play a role in our actions. As with any virtue, it is possible to take it too far and become a vice. Justice burns hotly within the soul of every person; injustice inflames passions and makes us feel that extreme passion known as resentment. Resentment can be strong (how many people call for the head of a murderer?). And it’s all the more reason to intervene in the name of justice carefully. Our own perceptions and world views color our view and what may seem like an injustice may actually be not. Intervention in these grey cases may actually be the injustice.

Jon MurphyMoral Philosophy
Necessary But Not Sufficient

In my latest article for Libertarianism.org, I argue that the existence of a “market failure” is a necessary but not sufficient condition for government intervention in the economy.  A slice:

As with all economic questions, the answer is “compared to what?” Externalities, compared on an idealized hypothetical world where all information is known and transactions are costless, appear easy to solve via government regulation. However, when we compare a world of externalities to the real world, where costs and benefits are subjective and ultimately judgement calls must be made by analysts, we see that externalities are necessary but not sufficient justification for government intervention.

Jon MurphyLaw & Economics
Stay Tuned...

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Jon Murphy