Posts tagged International Trade
The Paradox of Tariffs for Free Trade

One of the myrid of excuses we’ve heard for Trump’s various trade wars is that the ultimate goal of the tariffs is to reduce/eliminate other countries’ tariffs on US goods (see, for example, here). Indeed, in The Wealth of Nations, Adam Smith mentions as a possible justification for tariffs the “recovery of a great foreign market,” although Smith just hedge on this justification (emphasis added):

The recovery of a great foreign market [from prohibitively high tariffs imposed on domestic goods] will generally more than compensate the transitory inconveniency of paying dearer during a short time for some sorts of goods…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 these classes, but to almost all the other classes of them. (WN Pg.468.39).

Where the paradox alluded to in my title arises is from this “recovery of a great foreign market.” How much benefit is the domestic nation likely to incur from such a recovery? I argue: not much.

When a nation has relatively free trade already, they don’t stand to benefit particularly much from increased free trade; the nation has already capitalized the gains from free trade. To take an example, when the US entered NAFTA, greatly reducing tariffs between the US, Mexico, and Canada, US real incomes rose only 0.1% (see Paul Krugman’s article “The Uncomfortable Truth About NAFTA”). The US was already a largely free-trade nation and there was already moves toward integration before NAFTA came about. Thus, a small increase in real income. Let’s assume a no-NAFTA world and let’s say the US were to launch a trade war with Mexico to reduce tariffs. The above analysis indicates that, for the US, costs of the trade war (ie, the higher prices paid by domestic citizens) would very quickly outpace the benefits of lower tariffs (ie, increased trade with Mexico). For Mexico, however, they would stand to gain from increased trade more than the US. They would be able to launch a longer trade war as their potential benefits are higher. Thus the paradox: the country least likely to benefit from a trade war to reduce tariffs is the country already free-trade oriented and the country most likely to benefit from a trade war to reduce tariffs is the country tariff-oriented. The free-trade country would stand to lose from the trade war.

One might object, reasonably, that in my example Mexico is relatively small, and thus a larger economy like China would be a bigger boon to the US. While that is true, I argue that it doesn’t change the analysis a whole lot. Real incomes in the US would be unlikely to increase a lot from increased trade with China because, as mentioned already, the US has already capitalized on much of the gains from free trade. US tariffs on Chinese goods are fairly low (even with Trump’s tariffs, but let’s discuss pre-trade war for now). Thus, reducing tariffs even more are unlikely to increase imports a whole lot and unlikely to reduce the prices of those imports a whole lot, thus leaving the consumers of those goods relatively unchanged. Exporters would stand to gain from reduced Chinese tariffs on their goods, but even then it is unlikely to cause a major increase in exports. Currently, US trade with China (total, so imports + exports) works out to be about 3.5% of US GDP. Imports would not likely change, but let’s assume for the sake of argument that US exports to China double if China eliminates tariffs. Total trade with China would rise to 4.3% of GDP, a gain of approximately $180 billion. These improvements, and improvements they are, are relatively small (it’s also worth noting that these numbers are a quick and dirty calculation).

For China, however, they stand to gain. By reducing tariffs, the real income of their consumers would increase dramatically as they suddenly have access to all kinds of goods cheaper. The purchasing power of their wages goes up and their standard of living increases. Their exports likely remain the same, but their imports increase, enriching the nation. Thus, though the US would still benefit from lower tariffs with China, the US’ ability to launch a trade war against China for the purposes of reducing tariffs is limited.

The short version of the above: paradoxically, the nation best equipped to win a trade war where the goal is the reduction of tariffs is the nation that is relatively protectionist. But, if the nation’s government is protectionist by design, a trade war is unlikely to get them to change that stance.

The Perpetual Trade War

The thing with a trade war, like any war, is you need not only a will to win, but an end-game as well. One of the things that have led to the quagmire wars of Afghanistan and Iraq is the clear lack of objectives in the wars. Thus, they become perpetual with any small excuse being used to justify ongoing operations. With no clear and obtainable goal, the war will just drag on and on until the soldiers are tired of fighting and just quit. Just like Vietnam.

Trump’s trade war lacks clear objectives; it lacks an end-game. The supposed reasons for the tariffs change on a daily, sometimes hourly, basis. One moment we’re told they’re to get more “fair” trading practices. The next, we’re told they’re for national security. Then, we’re told they’re to bring back manufacturing jobs. Then, we’re told they’re to chase jobs out of China. Then we’re told they’re to address the trade deficit. Then we’re told they’re to address IP theft.

And all that is just from the Administration! Never mind the vast ad-hoc end-games we hear from the Trumpeteers: they’re to screw over China, they’re just optimal tariffs, they’re to force a regime change in China, they’re because Europe didn’t support us in the Iraq invasion, they’re to screw over the libs, they’re just for negotiating, or my absolute favorite “You need to just shut up and trust Trump knows what is best for you as an American.”

With such disparate and often mutually exclusive, not to mention poorly-defined, goals, how can the trade war ever be won? It can only ever be perpetuated.

Today's Quote of the Day...

…is from page 57 the 2002 edition of Milton Friedman’s 1962 classic Capitalism and Freedom:

It is not too much to say that the most serious short-run threat to economic freedom in the United States today - aside, of course, from the outbreak of World War III - is that we shall be lef to adopt far-reaching economic controls in order to “solve” balance of payment problems. Interferences with international trade appear innocuous; they can get support of people who are otherwise apprehensive of interference by government into economic affairs; many a business man even regards them as part of the “American Way of Life”; yet there are few interferences which are capable of spreading so far and ultimately being so destructive of free enterprise.

JMM: Freidman wrote these words in 1962. How little things change

Where's Mine?

Today is Frederic Bastiat’s birthday. He was born in 1801 in Bayonne, France. To celebrate, I am rereading his 1850 tract, written mere months before his death, The Law. I came across this line:

Men naturally rebel against the injustice of which they are victims. Thus, when plunder is organized by law for the profit of those who make the law, all the plundered classes try somehow to enter — by peaceful or revolutionary means — into the making of laws. According to their degree of enlightenment, these plundered classes may propose one of two entirely different purposes when they attempt to attain political power: Either they may wish to stop lawful plunder, or they may wish to share in it.

Last week’s Democratic debate captures Bastiat’s observation quite well. Many of the candidates properly recognized some legal plunder going on in the law by legislators and special interest groups. But not a single one of them proposed stopping that legal plunder. Virtually all of them discussed ways in which they, or the people they supposedly represent, want to share in the legal plunder: whether it be “forgiving” various forms of debt, or taxing more of a certain group of people, or whatever.

A concrete example may help here: student loan debt “forgiveness” or “cancellation.” The idea is simple: people have loan debt, and it is substantial. Therefore, if the government were to, in its misguided philanthropy, forgive that debt, people will be made better off. Many of these people wrongfully took loans without understanding them or without fully being told the consequences of borrowing the money they did. Universities and the debt holders benefit from these loans, and many forms of legislation currently on the books promote this wealth transfer from students to universities and credit holders, not the least of which is the subsidized student loan program of the federal government.

But debt cancellation does not end this legal plunder. In fact, since no one proposed removing that legislation, the schema for legal plunder remains in place (this fact alone should raise questions about the effectiveness of debt cancellation even if the problems we are discussing weren’t here, but no one mentions it). Thus, no one is talking about ending the legal plunder, but ways to participate in it. Debt cancellation is a wealth transfer from one group, taxpayers without college degrees and debt holders and future college students, to another group: current student loan borrowers.

The “where’s mine?” mentality is very powerful. I suspect that in a democracy it will be even more difficult to eliminate legal plunder, with most politicians seeking to curry favor by promising “have yours!” The Democratic debates and the entirety of Trump’s trade policy reflects this point.

Today's Quote of the Day...

…is from page 107 of the 2009 Mises Institute re-issue of FA Hayek’s 1948 book Individualism & Economic Order:

In principle the industrial protectionism and government-supported cartels and the agricultural policies of the conservative groups are not different from the proposals for a more far-reaching direction of economic life sponsored by the socialists. It is an illusion when the more conservative interventionists believe that they will be able to confine these government controls to the particular kinds of which they approve. In a democratic society, at any rate, once the principle is admitted that the government undertakes responsibility for the status and position of particular groups, it is inevitable that this control will be extended to satisfy the aspirations and prejudices of the great masses.

JMM: Hayek first wrote these words in 1947. They remain relevant today. Modern conservatives, in an effort to supposedly constrain socialism, turn to the very policies the socialists advocate. They make the mistake of believing, despite all evidence to the contrary, that their intervention is not the blunt hammer of socialism, but rather a precise scalpel that can just cut out whatever problem they see in society and leave the rest untouched.

But once the cutting begins, especially without an appreciation of how interconnected things are, greater damage is done. And to fix the problems of this one cut, other cuts need to be made, and the problem grows exponentially.

The industrial protectionism of conservatives is just a different flavor of socialism than the left-wing variants.

Trump's Tariff Inconsistency

Trump has long argued that imports harm the importing nation: the represent jobs being sent overseas, they are debts, they represent selling out national sovereignty, they are a hollowing out mechanism, etc. Major aspects of his trade war have been to reduce US imports from China, Europe, and other places while increasing US exports. Trump is a proud mercantilist.

Which makes his behavior towards Iran strange. Trump has imposed a number of sanctions on Iran which prevent Iran from importing. If Trump’s justification for tariffs is true, then the economic sanctions levied on Iran will only serve to strengthen them and weaken US and allied economies by limiting exports. Conversely, if he believes the sanctions will harm Iran, then they must equally harm the US when imposed on us by the government.

If Trump’s trade logic were to be taken literally, he should try to flood Iran with US-made goods, thus “destroying” their country, manufacturing, and economy. Any attempt at preventing this would only serve to “make Iran great again.”

Since I made this observation last night, several Trump supporters have tried to square the circle. No explanation was satisfactory (they all were some variation on “you just don’t understand negotiating. Just read Art of the Deal!”), I am open to any attempt to square this circle.

Trump’s only consistency is his inconsistency.'

See also Mark Perry on this.

Operationalization of Theory is Never Straightforward

Over at EconLog, Pierre Lemieux points us to a recent op-ed by Trump economic advisor Peter Navarro. Pierre writes:

The keystone of his claims in this op-ed is the distinction between “pure free trader” and “fair, reciprocal and balanced trader.” The latter concept is at best underdetermined and at worst absurd. There have been as many definitions of “fair” as there have been political theorists and moral philosophers. Is it “fair trade” that American producers have a big advantage as they master the language of international trade better than their German or Vietnamese competitors? Isn’t that the sort of “trade barrier” that Navarro said should be compensated by a tariff in order for trade to be “reciprocal”? Reciprocity is usually a mere excuse for protectionism.

This is a point I routinely make in my classes when I lecture on supposed exceptions to free trade and operationalizing these exceptions.  In theory, it is easy to design a policy where some “unfair advantage” is corrected.  In reality, identifying these barriers is difficult.

My favorite example is rule of law.  The US, compared to many countries, is very non-corrupt.  We have a good judicial system that is relatively unbiased and even-handed.  Contracts are reasonably enforced.  Bribes aren’t really required to do business.  All this reduces the cost of doing business in the US compared to other countries, which is why many firms do business here.

Since the judicial system is run by the government, one can argue it counts as a “subsidy” to reduce costs for businesses.  Thus, an analyst could use rule of law in the US to justify tariffs against US products.

Is that also what Navarro means when he demands reciprocity?  What about our relatively educated workforce (also subsidized, BTW)?  Or our relatively good infrastructure?  All of these would justify, in theory, subsidies on American products by foreign nations given the loose, vague, and indeterminate language of Navarro.  The theory gives no guidance about what is counted and what is not, which means it is left up to the analyst.  Thus, talking about “fair trade” is not as precise as Navarro, or theory, makes it seem.

Once we begin moving away from theory and into interventionist policy making in the real world, the operationalization of the theory gets very loose very quickly. How things are defined is not straightforward and precise. Calculating “optimal” tariffs will depend crucially on the assumptions and definitions of the analyst. What Peter Navarro considers “reciprocity” may not be considered so by Donald Trump, or by you and I. Indeed, for certain definitions of reciprocity (each as theoretically legitimate as the one Navarro uses), one can argue that any Chinese trade barriers on US goods are “fair and balanced” and the actions of the Trump Administration are unfair trade!

At Cafe Hayek, Don Boudreaux highlights a similar theme put forth by our colleague Bryan Caplan and his co-author Zach Weinersmith:

The right question to ask is never “Will it be perfect?” But “Will it be better than the alternative?”

The problem with perfection is not only that men are not angels and fallible. Were it only that, then it would simply be a matter of creating an algorithm for a machine to optimize and then just internalize any externalities. The problem with perfection includes actually defining perfection. A blackboard model of equilibrium is only “perfect” in the eyes of the analyst. Assumptions we have to make to get there are enormous and context-dependent (for more on this point, see Hayek’s 1937 paper “Economics and Knowledge.” Also valuable is James Buchanan’s discussion in Chapter 1 of LSE Essays on Cost). Thus, even determining what policy should be will depend heavily on the assumptions of the analyst (note this lesson holds over from my blog post “Does Economics Imply Liberalism?”. This is all the more reason why it is important to focus on obtainable alternatives as opposed to idealized outcomes.

None of this implies radical anarchism or that policymakers should be paralyzed with fear (although I am sure people will use the arguments here to justify those stances). Rather, what this is to say is that discussions of ideal economic policy are not straightforward, that there is, as Ronald Coase wrote paraphrasing Frank Knight: “[P]roblems of welfare economics must ultimately dissolve into a study of aesthetics and morals.”

Why It's Important to Know Reality, Not Just Models

In economic theory, one can calculate who bears the burden of a tax by examining the elasticity of demand and supply for the product the tax is placed on. “Elasticity” is a concept that refers to how responsive consumers and producers are to changes in price. Demand/Supply is relatively inelastic when the consumer/producer changes the quantity demanded/supplied relatively little given a change in price. Demand/Supply is relatively elastic when the consumer/producer changes the quantity demanded/supplied greatly in response to a price change. When a good is relatively inelastic, the producer can pass a large portion of a tax onto the consumer since the consumer is relatively insensitive to price changes. When a good is relatively elastic, the producer must pay some of the tax himself since the consumer is relatively sensitive to price changes.

Price elasticity is applied to the concept of international trade as a way of potentially increasing net national welfare from a tariff. If a home government passes a sufficiently small tariff and there is some elasticity to the good, then some of the tax can be passed on to foreign producers in the form of lower prices received. The net national welfare rises as those losses to the foreign manufacturers are not counted, but there is an increase in tax revenue.

That is what the model says. And it is a variation of this model that commentator “Doctor” Joe B* applies at Mark Perry’s blog Carpe Diem:

A tariff is paid by the seller and the buyer, and how much each pays depends on elasticity of demand.

So far the evidence is that China is eating the tariffs, through price cuts and cheaper yuan.

But Mr. B errs in his assumptions. The assumption of the model is there are no middlemen between the producer and the consumer. If there are, the tax burden would be spread out among all of them depending on their various elasticities.

In real life, few people buy directly from Chinese producers. There are all kinds of middlemen involved: shippers, importers, wholesalers, retailers. When we take into all the middlemen, we see that none of the tax is actually being passed onto Chinese producers. It’s being absorbed entirely by Americans.

Knowing the reality of what your studying will enhance the model. Ignoring the reality leads to faulty conclusions.

*I but “Doctor” in quotation marks because I know for a fact this man holds no PhD.

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.

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).

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.

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.