Posts tagged Economic Thought
Today's Quote of the Day...

…is from this EconLog post by David Henderson (emphasis added):

If you think that the government should provide truly public goods, that is, goods that are non-excludable and non-rival in consumption, then you should think that government should provide the public good of preventing an asteroid from hinting earth. Here’s the problem: The U.S. government, which has access to more resources than any other government on earth, is almost certainly underinvesting in the technology to deflect or destroy asteroids. Just as private actors don’t have much of an incentive to produce truly public goods, neither do government actors.

JMM: In standard economic treatment of market failures, governments are treated as something of a deus ex machina. They can just come in costlessly and effortlessly to solve any problem by applying just the right remedy. On paper, it’s a simple enough story. But what incentives do governments face to provide such solutions (assuming away knowledge problems)? It’s unlikely they face incentives from voters. Market failures tend to be characterized by free-rider problems, and free-riders do not suddenly want to start paying, even if they benefit. Furthermore, the problems are often dispersed, making them hard to observe. Perhaps they are motivated by “doing the right thing,” and that’s all fine and dandy, but are we ready to assume all judges, bureaucrats, and politicians are purely motivated by the Greater Good?

On top of the difficulties of identifying a true market failure, we need to keep in mind the incentives people face.

Are Public Goods Necessarily Undersupplied?

In economics, public goods are goods which are non-rival (a person’s use of the good does not reduce the ability of another person to use the same good, eg listening to the radio) and non-excludable (people who do not pay cannot easily be prevented from using the good, eg when a burglar is arrested, everyone in a neighborhood benefits, not just those who paid for the security service). Because of this definition of public goods, we tend to teach undergrads that public goods will therefore necessarily be undersupplied, that in a free market the amount of the good produced is less than the socially optimal level of production. As such, government may be able to step in and, though use of taxation, correct this underproduction (see, for example, Page 369 of Modern Principles of Economics by Tyler Cowen and Alex Tabarrok).

But is it necessarily the case that public goods are necessarily undersupplied in a free market? It does not seem clear to me that it is.

The first question we need to ask is “as compared to what?” What is the free market outcome undersupplied compared to? It is compared to what would be the socially optimal level where everyone who benefits pays the cost (the intuition here is this: if an individual can earn more producing something, they will produce more of it, all else held equal. Supply curves slope upward).

Now we need to ask: is this an attainable alternative? In a free market setting, it does not appear to be so. After all, as we argued above, given the characteristics of a public good, they will tend to be undersupplied. Getting people to pay for their use is difficult. A more technical way of saying this is the transaction costs are high. The marginal benefit of receiving the payments exceeds the marginal cost of obtaining those payments. In a zero-transaction cost world, the socially optimal level would be easily obtained. There is some bargain that could be reached where those who enjoy the benefit without paying the cost (free rider problem) could be incentivized to pay the cost and production would increase. This is just an application of the Coase Theorem.

If, however, as posited by the public goods problem, the transaction costs of solving the free rider problem are too high, then the socially optimal level is not necessarily an attainable alternative. It’s a fantasy alternative. Thus, it is an irrelevant comparison. It’d like saying “I’d be better off with a fairy godmother who grants wishes than needing to work for my well-being.” Sure, but given faeries don’t exist, that’s a meaningless choice. The choice is between working and living well or not working and living poorly.

If the socially optimal outcome of the model is not a real alternative, then the situation is already at an optimal outcome. There is no undersupply. Thus, public goods are not necessarily undersupplied.

A note of caution: none of what I just wrote should be taken to mean that the free market outcome is necessarily the best outcome. There may be better alternatives. Government (or some other non-market force) may be able to achieve an alternative arrangement that is superior to the free market outcome. For example, better defining property rights can lead to less undersupply of public goods. But in movement from one alternative to the other, we need to consider the transaction costs. Do the benefits of moving from the market alternative to the non-market alternative outweigh the costs?

With this article, I reiterate a point made by Ronald Coase, Carl Dahlman, Harold Demsetz, and many others before me: transaction costs matter. We need to compare attainable alternatives and consider how institutions actually work as opposed to an idealized version of them. Comparing a market outcome to an idealized, but unobtainable, alternative does not provide any guidance to our thought.

Today's Quote of the Day...

…is from this 1997 Reason Magazine interview with Ronald Coase:

Reason: Can you give us an example of what you consider to be a good regulation and then an example of what you consider to be a not-so-good regulation?

Coase: This is a very interesting question because one can't give an answer to it. When I was editor of The Journal of Law and Economics, we published a whole series of studies of regulation and its effects. Almost all the studies--perhaps all the studies--suggested that the results of regulation had been bad, that the prices were higher, that the product was worse adapted to the needs of consumers, than it otherwise would have been. I was not willing to accept the view that all regulation was bound to produce these results. Therefore, what was my explanation for the results we had? I argued that the most probable explanation was that the government now operates on such a massive scale that it had reached the stage of what economists call negative marginal returns. Anything additional it does, it messes up. But that doesn't mean that if we reduce the size of government considerably, we wouldn't find then that there were some activities it did well. Until we reduce the size of government, we won't know what they are.

JMM: Ronald Coase’s careful study of the data through the lens of theory is important for us to observe. Coase was unwilling to move to the conclusion that, just because the majority (if not all) the government regulation led to undesirable outcomes, it must therefore be true that all government regulation is necessarily harmful. He points out another answer that is contained within the very models used in the analyses: negative marginal returns.

Data cannot “speak for themselves.” Data without theory have no context and thus mislead. The man who looks only at data and ignores theory is not practicing science, but rather scientism.

From Spontaneous Order to Codification

A while ago, I did a blog post on the “Hayek Memorial Pathway,” one of a series of pathways that have developed on campus though people’s actions. Well, they’re doing a bunch of construction on campus and part of it includes paving the Hayek Memorial Pathway.

Some years from now, people will forget that the pathway was one unpaved and unplanned, that it was only by the constant movement of thousands of students that the path at all formed in the first place. All the “government” (i.e., George Mason University) did was codify what people already did.

Socialists and central planners often point out various institutions and state proudly “look at the good government is doing!” What they fail to see, however, is the spontaneous orders that predated those codifications. For example, they fail to see the development of the law that legislation merely codified. Or the development of money that legislation merely codified. These institutions were not part of government planning, but rather of government codification of already-in-action plans.

Likewise, this is why I disagree with “one-drop” libertarians (ie, those who oppose anything and everything government does, insisting it must inherently be inefficient). Not every institution the government codifies is inherently inefficient. When they merely codify what people are already doing, then that may not change the efficiency at all (indeed, given certain conditions, it may improve efficiency). GMU paving the Hayek Memorial Pathway does not in and of itself imply the pathway is in any way less a spontaneous order or less efficient.

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.

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
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.