Posts tagged Price Theory
What Milton Freidman Gets Wrong About Monopolies

In his excellent book Capitalism and Freedom, Freidman writes (Pg. 28):

Exchange is truly voluntary only when nearly equivalent alternatives exist. Monopoly implies the absence of alternatives and thereby inhibits effective freedom of exchange.

I disagree with the first sentence. The second sentence is flat-out wrong.

Monopolies do not imply the absence of alternatives. There is no economic problem without alternatives. If monopoly implies the absence of alternatives, then that means there are no costs interacting to the monopoly, something we know is incorrect. It also implies there are no substitutes for the monopoly’s good, something we also know isn’t correct. After all, demand curves (even for a monopolist) slope downward.

Perhaps an example will help. Say there are two competitors, one who offers green shirts for sale and one who offers blue shirts for sale. The one who offers blue shirts closes down, so all that is left is the one who offers green shirts. In Freidman's description, the alternatives have fallen from green shirt-blue shirt to just green shirt. But this is incorrect. There is another alternative. The relevant choice is not between green shirt, blue shirt. It is between green shirt, blue shirt and going naked (ie, no consumption). Thus, the next scenario comes down between green shirt and being naked as the day you were born. There is always an alternative. Just because the alternative is undesirable does not mean the alternative does not exist.*

Furthermore, there is always the alternative, that Friedman himself notes earlier in the book (Pg. 13), of producing for one’s self (emphasis added):

The incentive for adopting this indirect route [of producing some goods and exchanging them for other goods voluntarily] is, of course, the increased product made possible by the division of labor and specialization of function. Since the household always has the alternative of producing directly for itself, it need not enter into any exchange unless it benefits from it.

Returning to our example above, we have another always-present alternative: green shirt, nothing, self-production. Like with the “nothing” alternative, the cost of self-production may be extremely high and undesirable, but that does not mean the alternative does not exist.

In regard to substitutes, substitutes always exist. The Law of Demand teaches us that, as prices for one good rise, the demand for substitute goods increases. People seek out alternatives. As prices get higher, the intensity of their search increases. People may develop new alternatives, or they may use things in different manners. For example, if the price of firewood gets high enough, people may start burning phone books. The mere presence of these alternatives help define the shape of the demand curve the monopoly faces.

Along this same point, firms are petrified of competition, either real or shadow competition. A monopoly, by definition, does not face any other direct competitors in their industry (however defined), but that does not mean competition does not exist. As just mentioned, as prices rise, people seek alternatives (substitutes). The longer prices stay relatively high, the greater that search becomes and the more elastic the demand curve becomes. As such, monopolies tend not to capitalize on their positions and capture all the rents they could (for more on this, see this 1999 article by Don Boudreaux and Burt Folsom).

Monopolies can be problematic from an economic perspective, but their existence does not imply the absence of alternatives.

*We could go even farther here and point out that other alternatives are represented by the opportunity cost. I could buy the green shirt, or a pair of pants.

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.”

Does Economics Imply Liberalism?

Economics as a field of thought as we understand it today began with the Enlightenment period.* As such, the initial study of economics was done through a liberal lens. The economic policy recommendations that came out of this study, popularly known as laissez-faire certainly has a liberal feel to it. Indeed, Smith christened his system developed in The Theory of Moral Sentiments and The Wealth of Nations as “the liberal system.”

But does this foundation imply that economics is inherently liberal? I posit it is not necessarily the case. One can understand economics very well and be illiberal.

Let’s take, for example, a simple supply and demand model. This model serves as the foundation of much of economics (indeed, we can derive pretty much all of economics from one simple fact; resources are scarce. This fact leads us to opportunity cost, which leads us to demand curves, with leads us to supply curves, which gives us the foundation of modern economics). Liberals will often point to the supply and demand model, rightfully so, to show the unintended consequences of illiberal policies; according to the model, minimum wage will lead to unemployment (especially among the marginally employable) or price controls will lead to shortages. These outcomes of the model are cited by liberals.

But those outcomes were also initially cited by illiberals in support of those same policies. The fact that minimum wage kept marginally employable people out of work was a benefit to many initial proponents of the minimum wage (see the Congressional debates on the Davis-Bacon Act). It has been used recently for justification for minimum wage to keep immigrants out of jobs.

But there are other implications of the model. As A.C. Pigou showed, if there are costs that fall on other people, the model suggests that a tax can be imposed to correct for these costs. Ronald Coase showed this logic holds if there are transaction costs to negotiating. Paul Samuelson showed that one of the implications of the model is, given certain assumptions, international trade without barriers can actually harm a domestic nation’s overall economic welfare. More recently, some behavioral economics like Richard Thaler have shown now, again as implied by the model, that certain “nudges” can be applied to correct market failures. All of these are implied by the model and are illiberal in nature.

Liberals can, and do, object to some of the items discussed in the previous paragraph. They cite public choice concerns, or calculation and knowledge problem issues. They cite the self-interest of politicians or the problems of bureaucracy. All of these are important (and also implied by the model as well).

As we can see, the model itself (which we are using here as a segment of economic knowledge) does not imply in and of itself any liberal or illiberal bias. It is, in that sense, apolitical. How the model is applied, what exceptions or policies are proscribed, do not depend, thus, on the economic science but rather on the subjective and estimated probabilities of the individual using the model. For example, let’s say we have two people using the supply and demand model to recommend policy dealing with pollution. An analyst who puts relatively low probability on government’s ability to correctly set a Pigouvian tax would recommend no explicit policy (or, perhaps, something akin to cap-and-trade). Meanwhile, an analyst who has a relatively high probability of the government’s ability to correctly set a Pigouvian tax may recommend such a tax. Both these analysts are guided by the same model, but their recommendations and predictions based of the model are different. They’re not different because one is more ignorant than the other. The objective data being used is the same. What is different is the subjective data each analyst uses.

Economic knowledge does not imply a liberal outlook. Just like any science, it can be interpreted and applied in different ways.

*I am hesitant to give it an exact starting point, such as highlighting Adam Smith as many people do. Smith may have been the first systematic treatment of economics in English, but there were many other authors who were considering the problems of economics before him: David Hume, Francis Hutcheson, Gershom Carmichael, the French Physiocrats (who influenced Smith), and the Salamanca School, just to name a few.

Today's Quote of the Day...

is from page 66 of the Liberty Fund’s 1999 edition of James Buchanan’s Cost and Choice:

In order to estimate the size of the corrective tax [to correct an externality], however, some objective measurement must be placed on these external costs. But the analyst has no benchmark from which plausible estimates can be made. Since the persons who bear these “costs” - whose who are externally affected - do not participate in the choice that generates the “costs,” there is simply no means of determining, even indirectly, the value that they place on the utility loss that might be avoided. In the classic example, how much would the housewife whose laundry is fouled give to have the smoke removed from the air? Until and unless she is actually confronted with this choice, any estimate must remain almost wholly arbitrary.

JMM: The fact that the cost to the external party is almost wholly arbitrary unless they are actually confronted with the choice does not imply that the estimation of the cost is irrelevant. What it does imply, however, is that welfare economics is not as precise and accurate as the blackboard models would have you believe. We should be wary of any scheme that relies on some “optimal” tax, tariff, or price in order to operate. The result of that model is wholly dependent on the analyst’s assumptions about what people would do if actually faced with a given choice.

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.

Today's Quote of the Day...

…is from G. F. Thirlby’s 1946 paper in Economica, quoted on page 30 in the 1999 Liberty Fund edition of Jame’s Buchanan’s Cost and Choice (original emphasis:

The cost is not the things-e.g. money-which will flow along certain channels as a result of the decision; it is the loss, prospective or realized, to the person making the decision, of the opportunity of using those things in the alternative courses of action. A fortiori, this cost cannot be discovered by another person who eventually watches and records the flow of those things along those channels. Cost is not something which is objectively discoverable in this manner; it is something which existed in the mind of the decision-maker before the flow began, and something which may quite likely have been but vaguely apprehended…

Cost is ephemeral. The cost involved in a particular decision loses its significance with the making of a decision because the decision displaces the alternative course of action.

JMM: A concept oft-misunderstood in the study of economics is cost and its relation to choice. Costs, probably understood, are subjective. They are what alternatives face an individual when making a choice. They are not the monetary outlay, but rather the foregone opportunities at that point in time.

Have Coase - Will Travel

In 1960, Ronald Coase published what would become one of the most cited articles in economics and contribute to his receipt of a Nobel Prize. Coase’s point was both simple and revolutionary.

These are the opening lines to my latest article at the Online Library of Economics and Liberty, Have Coase - Will Travel, coauthored with John Schuler (also a GMU economics PhD candidate).

Another slice:

Coase’s paper “The Problem of Social Cost” appeared in the October 1960 volume of the Journal of Law and Economics. This brings us, for reasons that we will explain, to the television show Have Gun – Will Travel, which aired from 1957 to 1963. A particular 1958 episode, called “Bitter Wine,” is likely the most Coasean episode of television ever made. Every element of the “Problem of Social Cost” makes an appearance in the episode: the reciprocal nature of externalities, how the initial allocation of property rights matters in a world with transaction costs, and how the legal system can overcome transaction costs to allow for an efficient allocation of rights.

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.

On the Presumption of Liberty

“[Harvey] Weinstein’s behavior is certainly dreadful, but even dreadful people have the right to a criminal defense. Indeed, probably most people who are charged with serious crimes, whether guilty or not, are not nice people, and many are moral reprobates. Yet forcing the government to prove guilt before tossing our fellow citizens in jail—even the reprobates among us—is the mark of a free people.”

This quote is taken from John McGinnis’ fine blog post The Campus Mob Comes for the Presumption of Innocence. A presumption of innocence permeates our justice system: the government has the burden of proof to convict. What’s more, this burden of proof is extremely high. The prosecution does not just need to produce some theory that the defendant might have committed the crime. Even a preponderance of evidence is not enough to take away a man’s liberty. What is necessary is the government needs to prove guilt beyond a reasonable doubt. Until that threshold is met in the eyes of a jury, the defendant is presumed innocent.

A presumption of innocence has a parallel in the presumption of liberty. The presumption of liberty holds that in assessing government policy we must meet a high burden of proof in order to endorse a reform that reduces liberty. There may be occasions where such intervention is desirable, sometimes even for overall liberty, but the mere possibility of such exceptions does not in and of itself justify the exception. A burden of proof must be met.

No liberal society can suffer the lack of a presumption of liberty. As McGinnis says above, the presumption of innocence, even to moral reprobates, is the mark of a free people. Likewise, the presumption of liberty, even if dealing with moral reprobates, is the mark of a free people. Exceptions can be made, such as the moral reprobate being thrown in prison after being shown beyond a reasonable doubt he committed a crime, but they must be exceptions rather than general rules.

Trade cannot be kept as free as it is without a presumption of liberty. The “free trade = fair trade” and “only reciprocal trade is free trade” claims are damaging to liberal society, because they weaken the presumption of liberty. Managed trade, where freedom to exchange is treated as an exception rather than a rule, spells illiberalism. The presumption of liberty must stand.

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.

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.

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.

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
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.