Agreeing and Disagreeing with Kling on Method

by Levi Russell
I recently ran across a couple of interesting posts on Arnold Kling's blog. One post I agree with wholeheartedly. In the other, I think Kling misses an important bit of information.

Post #1

Consider two rationales for building models:

(a) Build a model in order to clarify the signal by filtering out the noise in a complex causal system. This is a knowledge-seeking endeavor.

(b) Build a model in order to be able to say, “In setting X, I can show how you get outcome Y.” This is just playing a game.

...

Some remarks:
1. I am pretty sure that economists are unique in their attachment to model-building as a game. My sense is that in other disciplines, including those that study human behavior and those that use non-mathematical models, researchers are more likely to be building models in order to try to separate the signal from the noise in a complex causal system.

 As always, I recommend reading the rest of the post.

Post #2

From a commenter:

I’d ask why self-interest needs to be manifested in overtly economic terms.

If you define self-interest broadly enough, then the statement “people pursue their self-interest” becomes irrefutable. And if you cannot refute it, then it is just an empty tautology.
I would much prefer to work with refutable claims than with empty tautologies.
So I continue to treat public choice theory as saying that people pursue economic gain in the political process. With that definition, public choice theory is often wrong, but at least it can be usefully right.

Here's my comment on the post:

The important distinction is between a tautology and an empty tautology.
Much of geometry is tautologous. Does that mean geometry is empty of insight? Certainly not.
It may be tautologous to say that “people prefer their own self interest” where “their own self interest” is whatever they subjectively desire, but it is certainly useful. Focusing on the subjectivity of costs and benefits dramatically increases economists’ ability to understand human behavior. Defining self interest narrowly, such that only objective costs and benefits are considered relevant is actually a step backward, even if it is more consistent with, say, the methods of physicists.

Economics Resource for High School Students

by Levi Russell

I recently ran across a great web-based resource for teaching economics to high school students. FishEconomics.org uses a series of short animated videos, each with an even shorter lecture, to explain basic economic concepts like capital and risk, opportunity cost, comparative advantage, moral hazard, and several others.

The program is free, but you do have to give them your email to get access to the videos. If you want the standards-based evaluation materials, they want a little more info. Overall this seems like a great supplement for high-school students and a great resource for home schoolers!

Potpourri

by Levi Russell

Here's a collection of articles I've read over the last week or so.

David Henderson on Thoma on potential changes to banking regulation.

Economist Allan Meltzer recently passed away. Here and here are two commentaries on his work.

A major contribution of another recently-deceased and well-known economist William Baumol is discussed here.

Don Boudreaux has a fantastic post on the importance of Econ 101. Here's a short excerpt:

To put the point a bit differently, ECON 101 instills the good habit of looking past stage 1, which is the stage at which most non-economists stop their investigations of economic consequences.  ECON 101 prompts those who grasp it to look also to stages 2, 3, and 4.  More-advanced economics courses – all the way to ECON 999 – teach that in theory there is also the possibility of stages 5, 6, 7, …. n.  Awareness of these theoretical possibilities is, of course, useful.  But awareness of stages 5, 6, 7, … n is either meaningless or, worse, practically dangerous without also an awareness of stages 2, 3, and 4.  And nearly all economic ignorance in the real world is simple unawareness of stages 2, 3, and 4.  (It’s also mistaken to conclude – as Kwak concludes – that awareness of stages 5, 6, 7, …. n regularly nullifies policy conclusions drawn from awareness of stages 1 through 4.)

Here's a great piece at Cato on the Net Neutrality issue.

Economics blogger Jim Rose corrects Noah Smith's oft-repeated claim that the economics profession was, until recently, dominated by right-wingers and libertarians.

A Video Primer on Public Choice

by Levi Russell

The video below is a great introduction to Public Choice economics. It's about an hour long and is delivered by Ivan Pongracic, a professor at Hillsdale College who studied under Jim Buchanan.
Here are some of the topics covered:

The Public Interest View
Precursors to Public Choice
Voting and Group Rationality
Rent Seeking
Constitutional Political Economy

At certain points, Pongracic gets a bit too ideological for my taste, but the video is still good if you ignore those bits.

Blue Apron Blues

by Levi Russell

Blue Apron released a very nice-looking ad back in January that I'm certain appeals to their audience. Unfortunately, it perpetuates some wrongheaded ideas about food systems. Yes, I know this is an ad and that it's sort of silly to criticize an ad, but I think there's some value in explaining what is wrong with the sort of thinking put forth in ads like this. Now that I've "poisoned the well," here's the ad:



After mischaracterizing the US food system as a grayed-out assembly line factory, the narrator describes an ideal food system in which "chefs and farmers would plan crops and recipes together to make farm land healthier and grow ingredients that taste better." He then complains about the current system's supermarkets, food transit, and waste. Instead, in the ideal food system, food would be delivered fresh, straight to your door!

All of this sounds great, but what does it cost? Certainly Blue Apron isn't suggesting that literally the entire food system of the US could be replaced by their model. How much does Blue Apron cost? About the same as a meal at a fast-casual restaurant.

Yes, there are problems with food waste, lack of freshness, etc in the current food system. However, specialized production and large supermarkets feed the poorest among us quite well. At its current prices, there's simply no way Blue Apron could do that.

More on Contestability and the Baysanto Merger

by Levi Russell
In a previous post, I discussed monopoly concerns with Bayer's acquisition of Monsanto. The deal was recently approved by Monsanto shareholders but will likely face significant scrutiny from anti-trust regulators.

In the previous post, I went through a paper by several Texas A&M economists that examined the likely consequences of the acquisition for several row crop seed prices. In this post, I'll make some other comments on contestability.

The A&M paper sticks to standard IO theory:

Concentrated markets do not necessarily imply the presence of market power. Key requirements for market contestability are: (a) Potential entrants must not be at a cost disadvantage to existing firms, and (b) entry and exit must be costless.

In contrast to standard IO theory, VRIO analysis suggests costs are always lower for incumbent firms. Managers of incumbent firms have experience with the specific marketing, managerial, and financial aspects of the industry that new entrants simply don't or must obtain at an additional cost.

Does this imply that no industry is "contestable" in an abstract sense? No. As I pointed out previously, prices are falling in many industries, even in those in which entry would entail 1) significant advantages for incumbents and 2) significant sunk costs. It does imply that the conditions for "contestability" are broader than the standard definition. The resource-based view of the firm provides an alternative view of contestability: The advantages for incumbents and potential sunk costs must simply be small enough that they are outweighed by an entrepreneur's expectation of economic profit associated with entering the industry.

So, when we see apparent divergences between price and marginal cost, as I see it there are three possibilities:

1) there are costs we as third-party observers don't see
2) the economic profit is associated with short-term returns to innovation (e.g. monopolistic competition)
3) there is a legal barrier to entry that is extraneous to the market itself.

This dynamic perspective (which I argue is easily teachable to undergrads) is much more powerful in advancing our understanding of real-world market behavior. Yes, the more unrealistic assumptions made in standard theory allow for more elegant mathematical modeling, but if our goal is to understand causal factors associated with firm behavior, the resource-based view of the fiirm, VRIO analysis, and other dynamic theories are more useful.

The Poultry Price Paradox - Why Are Turkeys Cheaper During Thanksgiving?

Guest Post
by David Williamson

Over the holiday, Catherine Rampell wrote a piece for the New York Times that raised an interesting question. Why are turkeys cheaper during Thanksgiving when demand is higher? Rampell offers two possible explanations, but I am not totally convinced by either of them. So, I will spell out my concerns with each of Rampell's explanations below and offer a third explanation of my own. Rampell's comments are in block quotes and mine are not.

Explanation #1 (Rampell) - Turkeys are "Loss Leaders"

The most intuitive and popular explanation for a high-demand price dip is that retailers are selling 'loss leaders.' Stores advertise very low prices — sometimes even lower than they paid their wholesalers — for big-ticket, attention-grabbing products in order to get people in the door, in the hope that they buy lots of other stuff. You might get your turkey for a song, but then you also buy potatoes, cranberries and pies at the same supermarket — all at regular (or higher) markups.

This is certainly the most popular explanation, but I worry that it ignores the consequences of competition. The way your store makes money selling turkeys at a loss is by attracting new customers that would normally buy potatoes, cranberries, and pies from your competitors' stores. But why would your competitors allow you to steal their customers? Wouldn't they lower the price of their turkeys in response? If so, wouldn't this cancel your effort to attract new customers and just leave you losing money on turkeys? Also, as an empirical matter, do stores really charge the same or higher prices for potatoes, cranberries, and pies during Thanksgiving? I can't find any systematic data to answer this question, but Kroger (America's largest traditional grocery store) had sales on all these items before Thanksgiving and not just turkeys.

Explanation #2 (Rampell) - Grocery Stores Are Price Discriminating

[P]lenty of economists...argue that it’s actually demand-side forces — changing consumer preferences — that drive these price drops. Consumers might get more price-sensitive during periods of peak demand and do more comparison-shopping, so stores have to drop their prices if they want to capture sales.

This explanation seems more theoretically consistent to me, but I think it rests on three shaky empirical assumptions. First, a grocery store needs market power to price discriminate. However, even after years of growing concentration, this industry is still pretty competitive (the top four firms account for less than 40% of sales). Second, to preserve its pricing strategy, a price discriminating grocery store needs to prevent others from buying in the cheap market (the Thanksgiving season) and selling in the expensive market (the rest of the year). But how do you stop anyone with a freezer from doing just that? Third, for charging consumers less in November to make sense, it must be that they are more price sensitive during the holidays. But is that true? Rampell gives some good reasons for why it might be true, but I can also see why they might not. Specifically, people tend to be more price sensitive when there are more close substitutes available. I am personally very sensitive to the price of Coke because there are always close substitutes (e.g. Pepsi). But it seems like there are very few substitutes for turkey during Thanksgiving. Would Thanksgiving be the same at your home if you served chicken instead?

Explanation #3 (Me) - The Costs of Stocking Turkey are Lower

My preferred explanation is that because grocery stores are competitive, they must charge prices that reflect the marginal costs of the products they sell. Therefore, if the price of turkeys is higher in July than November, it must be because each turkey is more costly to sell. The tough part is figuring out why. One reason turkeys might be more expensive for grocers to sell in July is that they don't sell very quickly that time of year (i.e. they have low "turnover"). Low turnover means higher costs for grocery stores because every day a product sits unsold on your shelf, you are giving up money you could have earned by stocking something that would sell more quickly. When turkeys start flying off the shelves in November, the cost of stocking each turkeys drops and that is reflected in the price. An advantage of this explanation is that it also implies that we would expect the price of cranberry sauce and pumpkin pie to be lower during Thanksgiving, which I think is the case.

What do you all think? Am I missing something important about Rampell's argument? Am I wrong that higher turnover means lower marginal costs? Are there other reasons why turkeys might cost less to sell and product in November? Your comments are much appreciated. Happy Holidays!

Klingian Philosophy of Economic Science

by Levi Russell

One of my favorite things to do in this blog is to talk about unconventional perspectives on economic theory. A great source for such unconventional views is Arnold Kling's blog. The recent Nobel Prize awarded to Oliver Hart and Bengt Holmstrom prompted Kling to write a series of posts detailing his views on economic theory, specifically about the epistemology of economics. Kling's own brand of unconventionality is especially interesting given that he received his PhD from MIT. Below I reproduce a post from last week:

A commenter writes,

So in your opinion intuition is sufficient. As long as we can tell an intuitive story about something, that is as good as proving it?

I think that “proof” is too high a standard to use in economics. If our knowledge is limited to what we can prove, then we do not know anything. I think that we have frameworks of interpretation which give us insights. This is knowledge, even if it is not as definitive or reliable as knowledge in physics or chemistry.

As an example, take factor-price equalization. The insight is that the easier it is to trade across countries, the more that factor prices will tend to converge. I think that this is an important insight. It is one of what I call the Four Forces driving social and economic trends in recent decades. (The other three are assortative mating, the shift away from manufacturing toward health care and education, and the Internet.)

Paul Samuelson proved a “factor-price equalization theorem” for a special case of two factors, two goods and two countries. However, it is very difficult, if not impossible, to extend that theorem to make it realistic, including the fact that not all industries are subject to diminishing returns. In my view, Samuelson’s theorem per se offers no insight, because it is so narrow in scope. The unprovable broader insight is what is useful.

Incidentally, I also think that factor-price equalization is hard to prove statistically. Too many other things are happening at once to be able to say definitively that factor-price equalization is having an effect, say, on unskilled workers’ wages in the U.S. and China. I believe that it is having an effect, and there are studies that support my view, but it is not provable.

In order to prove something mathematically, you have to make narrow assumptions. In physics or engineering, this often works out well. When you roll a ball down an inclined plane, ignoring friction causes only a small error in the calculation.

In economics, the factors that you leave out in order to build a mathematical model tend to be more important. As a result, the requirement to express ideas in the form of mathematical models is harmful in two ways. We waste time proving false theorems and we miss out on useful insights.

The narrow assumptions lead you to prove something which is false in the real world.. For example, the central insight of the “market for lemons” proof is that a used car market cannot work. However, once we expand the assumptions to allow for warranties, dealer reputations, mechanics’ inspections, and so on, the original theorem does not hold.

Meanwhile, there are insights that are missed because they cannot be represented in an elegant mathematical way. A lot of the insights that I offer in Specialization and Trade fall in that category.

Our goal should be to acquire knowledge. The demand for proof hurts rather than helps with that process.

Bonus: I really enjoyed this piece from the Sloan Management Review published back in 2011.

Teaser: I'll be giving my thoughts on the Baysanto merger later this week or weekend.

A Simple Observation

by Levi Russell

I don't claim to be the first to make this observation and it might very well be something that is discussed often in undergrad micro (though I can't find it mentioned in the 20 or so lecture notes I found online on the subject. Nevertheless, I thought I'd discuss the following briefly:

From the perspective of the consumer, price discrimination and cross subsidization are the same thing.

Here are the simple definitions Google gives when you search "price discrimination" and "cross subsidization"

price dis·crim·i·na·tion
noun
the action of selling the same product at different prices to different buyers, in order to maximize sales and profits

Cross subsidization is the practice of charging higher prices to one group of consumers to subsidize lower prices for another group.

In cases like afternoon matinees at a movie theater or senior citizen discounts at the grocery store, we can certainly see the positive side of firms charging different prices for different people. While it's true that this increases producer surplus, presumably, some of the people who receive the good at the lower price wouldn't be able to get it if the other group weren't paying a higher price.

The problem is that we use two terms to describe the same concept. The first one has a clearly negative connotation (discrimination) but the second sounds more sterile and scientific. There are certainly cases in which we might view price discrimination/cross subsidization as a bad thing. For instance, when an online retailer charges a higher price for someone who shops online a lot. Still, I can't help but think "cross subsidization" is a better term for the phenomenon since it isn't loaded with a negative connotation that might diminish students' focus on its effects, both positive and negative.

Coase and Hog Cycles

by David Williamson

If you read this blog, then you're probably familiar with Ronald Coase's work on the importance of transaction costs. But did you know that Coase devoted a substantial portion of his early career to criticizing the Cobweb Model? He actually wrote 4 separate articles on the subject between 1935 and 1940, but not one makes Dylan Matthew's list of Coase's top-five papers. This work is actually really fascinating in the context of economic intellectual history, so here is a quick summary!  

The 1932 UK Reorganization Commission for Pigs and Pig Products Report

It all started when the UK Reorganization Commission for Pigs and Pig Products claimed in a 1932 report that government intervention was needed to stabilize prices in the hog industry. The Commission found that hog prices followed a 4-year cycle: two years rising and two years falling. The Commission explained this cyclical behavior using the Cobweb Model. In this model, products take time to produce. So, to know how much to produce, firms have to guess what the price will be when their product is ready to bring to the market. If producers are systematically mistaken about what prices will be, this could lead to predictable cycles in product spot prices.

The Cobweb Model

How forecasting errors can lead to cycles in product prices is illustrated in the figure below. Suppose we begin time at period 1 and hog producers bring Q1 to the market to sell. Supply is essentially fixed this period because producers can't produce more hogs on the spot, so the price that prevails on the market will be P1. Since this price exceeds the marginal cost of production (represented by S), the individual producers wish they had produced more. Now, when the producers go back home to produce more hogs, they have to guess that the price will be when their hogs are ready to sell. Suppose it will take 2 years to produce more hogs. The UK Reorganization Commission argued that hog producers will assume the price of hogs next period will be the same as it was this period (in other words that producers had "static" expectations about price). That means, in this context, hog producers think the price of hogs in 2 years will still be P1. So each producer will individually increase production accordingly. However, when the producers return to the market in 2 years, they will find that everyone else increased production too and that quantity supplied is now Q2. As a result, the price plummets to P2 and the producers actually lose money. Not learning their lesson, the hog producers will again go home and assume that the price next period will be P2 and collectively cut back their production to Q3. Hopefully you see where this is going, even if the hog producers don't. The price will go up again in 2 years and then down again in 2 more. Thus, we have a 4-year cycle in hog prices. How long will this cycle continue? That depends on the elasticities of supply and demand. If demand is less elastic than supply, as was believed to be the case in the hog market, then the price swings will continue forever and only get bigger as time goes on.

Source: Wikipedia

Coase Takes the Model to the Data

The Cobweb Model is really clever, but does it actually capture the reality of the hog market? Coase and his co-author Ronald Fowler tried to answer that question by evaluating the model's assumptions. First, are hog producer expectations truly static? Expectations cannot be observed directly, but Coase and Fowler (1935) used market prices to try and infer whether producer expectations were static. It didn't seem like they were. Second, does it really take 2 years for hog producers to respond to higher prices? Coase and Fowler (1935) spend a lot time discussing how hogs are actually produced. They found that the average age of a hog at slaughter is eight months and that the period of gestation is four months. So a producer could respond to unexpectedly higher hog prices in 12 months (possibly even sooner since there were short-run changes producers could also make to increase production). So why does it take 24 months for prices to complete their descent? Even if we assumed producers have static expectations, shouldn't we expect the hog cycle to be 2 years instead of 4?  

This evidence is hard to square with the Cobweb Model employed by Reorganization Commission, but Coase's critics were not convinced. After all, if it wasn't forecasting errors that were driving the Hog Cycle, then what was? "They have, in effect, tried to overthrow the existing explanation without putting anything in its place" wrote Cohen and Barker (1935). Coase and Fowler (1937) attempted to provide an explanation, but this question would continue to be debated for decades.

The Next Chapter

Ultimately, John Muth (1961) proposed a model that assumed producers did not have systematically biased expectations about future prices (in other words that they had "rational" expectations). Muth argued this model yielded implications that were more consistent with the empirical results found by Coase and others. For example, rational expectations models generated cycles that lasted longer than models that assumed static or adaptive expectations. So a 4-year hog cycle no longer seemed as much of  a mystery. I'm not sure what happened to rational expectations after that. I hear they use it in Macro a bit.  Anyways, if you are interested in a more detailed summary of Coase's work on the Hog Cycle, then check out Evans and Guesnerie (2016). I found this article on Google while I was preparing this post and it looks very good.

References

Evans, George W., and Roger Guesnerie. "Revisiting Coase on anticipations and the cobweb model." The Elgar Companion to Ronald H. Coase (2016): 51.

Coase, Ronald H., and Ronald F. Fowler. "Bacon production and the pig-cycle in Great Britain." Economica 2, no. 6 (1935): 142-167.

Coase, Ronald H., and Ronald F. Fowler. "The pig-cycle in Great Britain: an explanation." Economica 4, no. 13 (1937): 55-82.

Cohen, Ruth, and J. D. Barker. "The pig cycle: a reply." Economica 2, no. 8 (1935): 408-422

Muth, John F. "Rational expectations and the theory of price movements."Econometrica: Journal of the Econometric Society (1961): 315-335.

Some Nuance on the $15 Minimum Wage

by Levi Russell

Adam Millsap at the Mercatus Center has a great short piece on the effect the $15 minimum wage would have on labor markets. Though Millsap criticizes the $15 minimum wage, he does it in a very different way than any I've seen.

He takes as a starting point Arindrajit Dube's conjecture that the minimum wage should be set at 50% of the median wage. It's important to note that Dube is actually a proponent of the $15 minimum wage but believes that it could create problems, especially if the ratio is above 80%.

Millsap uses data from Washington D.C. and Minneapolis, MN to calculate the (projected) ratio of the $15 minimum wage to half the median wage in each of these cities. Millsap shows that in Minneapolis, the $15 minimum wage is projected to be 86% of the median wage for people 16 years of age and older. In D.C., the ratio is only 53%.

So, given Dube's preference for a minimum wage set at 50% of the median wage and warning about a minimum wage over 80% of the median, the $15 minimum is potentially very problematic for cities like Minneapolis. I imagine that it would be far worse for smaller rural communities.

Brexit Stock Market Perspective

by Levi Russell

The financial press was abuzz before and after the recent UK referendum to leave the European Union (see here, here, here, here, here, and here). To be sure, the British Pound took a big hit and several stock market indices across the Western world were affected. I'd just chalk this up to political uncertainty, not a referendum on the referendum. After all, we don't actually know if the UK will leave the EU. Perhaps I'm biased.

Here's the perspective I promised in the title. First, a look at the 5-day charts (all taken from Yahoo Finance) of U.S. (Dow and S&P 500), British (FTSE), Spanish (IBEX), German (DAX), and French (CAC 40) stock exchange indices:

To be sure, these are some pretty serious one-day drops. However, the Dow and S&P 500 fell more modestly than the others and the FTSE (British index) has recovered somewhat. The hardest hit so far are the European indices. Interesting, to be sure.

But what does this selloff look like over a 1 year time horizon? How far back in time do we have to go to see these indices at similar levels?

The Dow and S&P 500 are right about where they were last month. If you take out the big troughs in September 2015 and early this year, both indices are pretty much flat. The FTSE looks similar, though it seems to have a bit more of a downward trend than the U.S. The Spanish, German, and French indices are down a bit more relative to the past few months but it seems they're just continuing a downward trend that's been around for the past 12 months.

I'm not saying the referendum had no effect on the markets but after looking at these charts I'm left asking "Where's the fire?" Maybe I'm missing something, or maybe my cavalier attitude to the stock market stems from the fact that I'm 29 years old.

Specialization and Trade - A Reintroduction to Economics

That's the tile of Arnold Kling's newest book. It's published by the Cato Institute and is available in e-book format on Amazon for a mere $3.19. You can also download a PDF copy here free. Arnold Kling is an MIT trained economist who spent the bulk of his professional economic career at the Federal Reserve and Freddie Mac. Kling's blog, one of the best on the web in my opinion, is always thought-provoking. As the title of his blog suggests, he makes every effort to understand and fairly state the positions of those with whom he disagrees.

I read a couple of blurbs about the book last week and have only just finished the first chapter. So, rather than write a review, I'll reproduce a section of the Introduction that gives a short description of each chapter. Kling certainly has a unique perspective and I suspect I'll learn a lot from this relatively short book.

“Filling in Frameworks” wrestles with the misconception that economics is a science. This section looks at the difficulties that economists face in trying to adopt scientific methods. I suggest that economics differs from the natural sciences in that we have to rely much less on verifiable hypotheses and much more on hard-to-verify interpretative frameworks. Economic analysis is a challenge, because judging interpretive frameworks is actually harder than verifying scientific hypotheses. 

“Machine as Metaphor” attacks the misconception held by many economists and embodied in many textbooks that the economy can be analyzed like a machine. This section looks at a widely used but misguided approach to economic analysis, treating it as if it were engineering. The economic engineers are stuck in a mindset that grew out of the Second World War, a conflict that was dominated by airplanes, tanks, and other machines. Their approach fails to take account of the many nonmechanistic aspects of the economy. 

“Instructions and Incentives” deals with the misconception that economic activity is directed by planners. This section explains that although people within a firm are guided to tasks through instruction from managers, the economy as a whole is not coordinated that way. Instead, the price system functions as the coordination mechanism. 

“Choices and Commands” is concerned with the misconceptions held by socialists and others who disparage the market system. This section explains why a decentralized price system can work better than a centralized command system. Central planning faces an information problem, an incentive problem, and an innovation problem. 

“Specialization and Sustainability” exposes the misconception that we must undertake extraordinary efforts in order to conserve specific resources. This section explains how the price system guides the economy toward sustainable use of resources. In contrast, individuals who attempt to override the price system through their individual choices or by imposing government regulations can easily miscalculate the costs of their actions. 

“Trade and Trust” addresses the misconception among some libertarians that the institutional infrastructure needed to support specialization and trade is minimal. Instead, this section suggests that for specialization to thrive, societies must reward and punish people according to whether they play by rules that facilitate specialization and trade. A variety of cultural norms, civic organizations, and government institutions serve this purpose, but each of those institutions has its drawbacks. 

“Finance and Fluctuations” deals with the misconceptions about finance that are common among economists, who often fail to appreciate the process of financial intermediation. This section looks at the special role played by financial intermediaries in enabling specialization. Intermediation is particularly dependent on trust, and as that trust ebbs and flows, the financial sector can amplify fluctuations in the economy’s ability to create patterns of sustainable specialization and trade. 

“Policy in Practice” corrects the misconception that diagnosis and treatment of “market failure” is straightforward. This section looks at challenges facing economists and policymakers trying to use the theory of market failure. The example I use is housing finance policy during the run-up to the financial crisis of 2008. The policy process was overwhelmed by the complexity of the specialization that emerged in housing finance. Moreover, the basic thrust of policy was determined by interest-group influence. The lesson is that a very large gap exists between the economic theory of public goods and the practical execution of policy. 

“Macroeconomics and Misgivings” argues that it is a misconception, albeit one that is well entrenched in the minds of both professional economists and the general public, to think of the economy as an engine with spending as its gas pedal. This section presents an alternative to the mainstream Keynesian and monetarist traditions. I argue that fluctuations in employment arise from changes in the patterns of specialization and trade. Discovering new patterns of sustainable specialization and trade is more complex and subtle and less mechanical than what is assumed by the Keynesian and monetarist traditions.

I Can't Put Enough Scare Quotes Around "Free Market"

by Levi Russell

Earlier this month I read a couple of fantastic posts over at the Coordination Problem blog. The common thread between the two posts is that the "free market" moniker given to many individual economists and schools of thought is really about the conclusions reached through rigorous analysis of real-world institutions, not about any sort of ideological assumption.

The first is a lengthy post by Peter Boettke. Boettke lays out his perspective of the "economic way of thinking" and describes how it's used to analyze the real world:

From my perspective there is a core of the economic way of thinking that can be traced from Adam Smith to Vernon Smith and that deals with basic ideas about human rationality, human sociability, and the coordination of activity through time.  Incentives, Information, and Innovation are part of this core as they derive from the even more primordial ideas of property, prices, and profit/loss accounting.  We live in a world of scarcity, scarcity implies that we face trade-offs, that means we must negotiate those trade-offs and we hope to do so in the most effective way possible, to achieve that we need aids to the human mind, those aids come in the form of high powered incentives and clear signals so we may engaged in the economic calculus.  One of the many implications that follows is that demand curves will slope downward and supply curves will slope upward.  The shape and the magnitude of the effects that follows are empirical matters and is largely determined by the array of substitutes available to economic decision makers.  But the essential logic holds from a style of reasoning that attempts to derive the invisible hand theorem from the rational choice postulate via institutional analysis.  Hume's principles of stability of possession, transference by consent, and the keeping of promises -- in other words, property, contract and consent -- provides that institutional infrastructure within which the human pursuit of individual betterment is channeled in commercial life into publicly desirable outcomes (e.g., wealth creation and generalized prosperity; the least advantaged are made better off).  Again, property, prices and profit/loss gives economic actors high powered incentives and informational signals to allocate resources, time and effort to the most highly valued use, and the constant feedback on whether those decisions are the right ones and the incentives and information to constantly adapt and adjust to improve in the decision calculus. 

This basic economic calculus applies to all human endeavors, and when we find ourselves outside of the realm of the market sphere of monetary calculation, the question for the analyst is what institutions will serve the same function in terms of incentives, information and innovation that property, prices and profit/loss served in the marketplace.  Does electoral politics possess those institutional proxies?  Does the bureaucratic organization of public administration? How about the philanthropic entities in the non-profit sector?  This would be an implication of the economic way of thinking -- how do people weigh the marginal costs/marginal benefits of decisions in the different contexts of human interaction? 

Nothing about what I have said is "libertarian" or "free market", but it is economics.  Consider, for example, a report that was on NPR this morning as part of a series that is being developed on Politics in Real Life as the campaign season moves from primaries to the main event in 2016 -- it was on Paid Family Leave.  Again, the economist in me kicks in while hearing the story -- not the libertarian or free market, but economists.  Thus, I want to think about Means-Ends and the logical consequences of the various proposed means to obtain the desired end, and I want to learn from as much empirically as one can from historically analogous policy experience.  I empathize with the Ends sought and do not question them in the least, my concern is solely with whether the proposed means would achieve the ends sought and at what cost.  This requires recognizing that Paid Family Leave will have its impact on the labor market, and also one must think about the impact on the least advantaged in the labor market -- not the most advantaged, because the tragedy that motivates our initial concern is not the impact on the most privileged in the work force, but the least advantaged -- in economic jargon, the marginal employee.

 Boettke concludes:

But what if, I ask, the very social ills we see before us are due not to malfeasance but due to the logic of individual decision making within the institutional context so reorganized.  The same style of reasoning that explains why individuals pursuing their self-interest can produce publicly desirable outcomes such as productive specialization and peaceful social cooperation within a specific institutional context also explains why that pursuit of self-interest in other institutional contexts results in social tragedies and social tensions. 

That is ECONOMICS, not "libertarian" nor even "free market", but just ECONOMICS pursued persistently and consistently.  And unless we get away from the habit of labeling folks and arguments in order to pigeon hole and disregard our intellectual cultural will continue to fail to understand what is causing the social ills that plague us, let alone encourage creative thinking about how to address these social ills.  That would be tragic on so many dimensions.

The whole post is certainly worth a read.

Another much shorter post by Steve Horwitz also fits into this same theme.

I have been thinking a lot about the misunderstandings of Hayek's "The Use of Knowledge in Society" essay. Below I offer what I think is a quick summary of his argument that stresses both the importance of private property and the price system as jointly necessary for economic coordination.

1. Knowledge IS decentralized in that each of us has our own personal knowledge of time and place (and that is often tacit).

2. Therefore, planning and control over resources SHOULD BE decentralized so that people can take advantage of those forms of knowledge.

3. HOWEVER, decentralization of control over resources (what Hayek calls "several property") is necessary BUT NOT SUFFICIENT for social coordination.

4. Effective decentralized planning also requires that people have access, in some form, to the bits of knowledge that other people have so that they can form better plans and have better feedback as to the success and failure of those plans.

5. Providing that knowledge is the primary function of the price system. Prices serve as knowledge surrogates to enable people's individual knowledge and "fields of vision" to sufficiently overlap so that our plans get COORDINATED. 

6. In other words: decentralized control over resources is NECESSARY BUT NOT SUFFICIENT for a functioning economy. Such decentralization requires some process that actually ensures that separately made decisions are, to a significant degree, based on as much knowledge as possible so that economic coordination can be achieved. That is what the price system enables us to do. [EDIT: and the prices in question are not, and need not be, equilibrium prices.]

Decentralized decision making without a price system will produce very little coordination and prosperity. Centralized decision making will render a price system useless for economic coordination.

The fact of decentralized knowledge requires that an economy capable of producing increased prosperity for all has both decentralized decision-making (private/several property) and a price system to coordinate those decisions.

Nirvana Fallacy Watch: Stiglitz Edition

by Levi Russell

Joseph Stiglitz recently put out a column called "Monopoly's New Era." He starts off with the standard story that unregulated markets lead to monopoly and that anti-trust is an important check on that process. He talks specifically about power relationships and gives the example of asymmetric information.

Stiglitz claims that, since perfect competition theory can't explain many of the monopolized industries we have today, that his brand of economics, which takes the tendency of "unregulated" markets to monopolization as a fundamental assumption, is rising in popularity.

That may be the case, but, I think, not for the right reasons. Stiglitz seems to think that Smith, Schumpeter, and other "free market" economists take a simplistic econ 101 view of competition:

In today’s economy, many sectors – telecoms, cable TV, digital branches from social media to Internet search, health insurance, pharmaceuticals, agro-business, and many more – cannot be understood through the lens of competition. In these sectors, what competition exists is oligopolistic, not the “pure” competition depicted in textbooks. A few sectors can be defined as “price taking”; firms are so small that they have no effect on market price. Agriculture is the clearest example, but government intervention in the sector is massive, and prices are not set primarily by market forces.

Of course, free market economists don't take that simplistic view, as I've discussed previously here, here, and here. It is this comparison, between wise intervention tutored by Stiglitz's theories and the vagaries of the free market, that I think is problematic.

Stiglitz is right to point out that many industries lobby for special government favors, but he doesn't acknowledge the reality that policies designed to correct market failures are often the cause of monopoly. As I noted in a previous post:

Government regulations essentially amount to fixed costs that prevent new firms from entering markets and existing smaller firms from competing with larger firms. Maybe these regulations are still justified, but it's not plainly obvious using the static model Thoma seems to prefer. From their inception, anti-trust suits were and still are brought mostly by competitors, not consumers. A look at the data from the late 19th and early 20th centuries doesn't tell the same "Robber Baron" story we hear in 9th grade history texts. Output was expanding and prices falling in the industries accused of being dominated by monopolies.

Stiglitz's mistake is that he compares the real world with a rose-tinted view of government regulation:

Many of the assumptions about market economies are based on acceptance of the competitive model, with marginal returns commensurate with social contributions. This view has led to hesitancy about official intervention: If markets are fundamentally efficient and fair, there is little that even the best of governments could do to improve matters. But if markets are based on exploitation, the rationale for laissez-faire disappears. Indeed, in that case, the battle against entrenched power is not only a battle for democracy; it is also a battle for efficiency and shared prosperity. 

Arnold Kling's article on Masonomics effectively responds to Stiglitz's claim:

Somewhere along the way, mainstream economics became hung up on the concept of a perfect market and an optimal allocation of resources. The conditions necessary for a perfect market are absurdly demanding. Everything in the economy must be transparent. Managers must have perfect information about worker productivity and consumers must have perfect information about product quality. There can be nothing that gives an advantage to a firm with a large market share. There cannot be any benefits or costs of any market activity that spill over beyond that market. 

The argument between Chicago and MIT seems to be over whether perfect markets are a "good approximation" or a "bad approximation" to reality. Masonomics goes along with the MIT view that perfect markets are a bad approximation to reality. But we do not look to government as a "solution" to imperfect markets. 

Masonomics sees market failure as a motivation for entrepreneurship. As an example of market failure, let us use a classic case described by a Nobel Laureate, which is that the seller of a used car knows more about the condition of the car than the buyer. Masonomics predicts that entrepreneurs will try to address this problem. In fact, there are a number of entrepreneurial solutions. Buyers can obtain vehicle history reports. Sellers can offer warranties. Firms such as Carmax undertake professional inspections and stake their reputation on the quality of the cars that they sell. 

Masonomics worries much more about government failure than market failure. Governments do not face competitive pressure. They are immune from the "creative destruction" of entrepreneurial innovation. In the market, ineffective firms go out of business. In government, ineffective programs develop powerful constituent groups with a stake in their perpetuation.

Stiglitz is right that static models of perfect competition don't explain the economy well, but he makes an unfounded leap of logic based on his idyllic view of policy. Harold Demsetz warned about these leaps of logic when he wrote about the Nirvana Fallacy. Avoiding this fallacy is, I think, an important part of policy analysis.

P.S.
Don Boudreaux points to one tragically bad prediction of Stiglitz's model: Venezuela.

Equal Pay Day

I wasn't going to write about this but a (female) colleague suggested I do so.

Equal Pay Day is supposed to be the day "that symbolizes how far into the year women must work to earn what men earned in the previous year." This is hilariously crude statistical analysis. In fact, men and women in the same occupations with similar experience and education actually make almost exactly the same salaries. In some fields, women earn more. The supposed "wage gap" is mostly a function of the choices men and women make in the labor force and has very little to do with discrimination.

Here's a helpful video:

Hilarity in Economic Education: Externalities

I recently rediscovered this video on the basics of externalities. It's unique in that it's 1) hilarious and 2) includes some important but not often discussed insights about ways in which we can deal with negative externalities.

I've discussed some problems with the standard textbook treatment of negative externalities several times on Farmer Hayek (e.g. here and here), but I haven't yet shared this quote from A.C. Pigou found in the video:

It is not sufficient to contrast the imperfect adjustments of unfettered enterprise with the best adjustment that economists in their studies can imagine, for we cannot expect that any state authority will attain, or even wholeheartedly seek that ideal. Such authorities are liable alike to ignorance, to sectional pressure, and to personal corruption by private interests. A loud-voiced part of their constituents, if organized for votes, may easily outweigh the whole.

Pigou's comment is certainly applicable to many of the debates we are having about modern agriculture's impact on society.

Here's the video!

Video link

Off-Topic - The Stagnation of the American Middle Class

Don Boudreaux (GMU Econ) recently gave a talk at the Economics Club meeting at my alma mater.

Since Boudreaux is such a dynamic speaker and so well informed on this topic, I thought I'd share it with FH readers even though it isn't one of the typical topics we cover.

I'd suggest starting at 3:10 and adjusting the speed (using the gear button at the bottom right) to 1.25 since it's a rather long talk.

Masonomics and Externalities

During a conversation a couple of weeks ago on externalities and market failure, a colleague of mine noted that my perspective on these topics seems to be in line with that of the economists at George Mason University. This is slightly misleading since the origin of GMU Econ's perspective is quite diverse (and thus not uniquely their own), but GMU is certainly a hotbed of research and education in the path-breaking economic work of Alchian, Buchanan, Coase, Demsetz, Hayek, Mises, Ostrom, Williamson, and others.

Given GMU Econ's unique perspective, it's no surprise that a term like "Masonomics" was coined. In an article back in 2007, economist Arnold Kling laid out several characteristics that make Masonomics unique. Below I reproduce the section of Kling's essay on the "cure for market failure."

At the University of Chicago, economists lean to the right of the economics profession. They are known for saying, in effect, "Markets work well. Use the market."

At MIT and other bastions of mainstream economics, most economists are to the left of center but to the right of the academic community as a whole. These economists are known for saying, in effect, "Markets fail. Use government."
Masonomics says, "Markets fail. Use markets." 

Somewhere along the way, mainstream economics became hung up on the concept of a perfect market and an optimal allocation of resources. The conditions necessary for a perfect market are absurdly demanding. Everything in the economy must be transparent. Managers must have perfect information about worker productivity and consumers must have perfect information about product quality. There can be nothing that gives an advantage to a firm with a large market share. There cannot be any benefits or costs of any market activity that spill over beyond that market.

The argument between Chicago and MIT seems to be over whether perfect markets are a "good approximation" or a "bad approximation" to reality. Masonomics goes along with the MIT view that perfect markets are a bad approximation to reality. But we do not look to government as a "solution" to imperfect markets.

Masonomics sees market failure as a motivation for entrepreneurship. As an example of market failure, let us use a classic case described by a Nobel Laureate, which is that the seller of a used car knows more about the condition of the car than the buyer. Masonomics predicts that entrepreneurs will try to address this problem. In fact, there are a number of entrepreneurial solutions. Buyers can obtain vehicle history reports. Sellers can offer warranties. Firms such as Carmax undertake professional inspections and stake their reputation on the quality of the cars that they sell.

Masonomics worries much more about government failure than market failure. Governments do not face competitive pressure. They are immune from the "creative destruction" of entrepreneurial innovation. In the market, ineffective firms go out of business. In government, ineffective programs develop powerful constituent groups with a stake in their perpetuation.

This is a (well-written) summary of my own view on the topic. Thanks to my exposure to this perspective in graduate school I continue to develop interests and to work in the political economy of agriculture. What do you think? What problems can you identify with the Masonomics view of externalities?

Russ Roberts also has a nice blog post giving his take on Masonomics here. Several Farmer Hayek posts have addressed externalities and market failure over the past year and can be read here, here, here, here, here, and here.

Pigou's Persistence

I recently ran across an interesting working paper by James McClure and Tyler Watts on some lesser-known or lesser-applied critiques of the standard Pigouvian perspective on externalities. The authors note that Pigou's perspective is still the standard in today's undergraduate texts, teaching students that externalities cause all manner of market failures which governments can fix with the appropriate political will.

The author's quote Pigou's 1920 book "The Economics of Welfare"

No "invisible hand" can be relied on to produce a good arrangement of the whole from a combination of separate treatments of the parts. It is therefore necessary that an authority of wider reach should intervene to tackle the collective problems of beauty, of air, and light, as those other collective problems of gas and water have been tackled.

Critiques of this perspective can be found all over the economic literature, but much of it is ignored in today's policy discussions. The authors identify 5 critiques and extensions of externality theory missing in current treatments of the subject: 1) the distinction between pecuniary and technological externalities, 2) the "invisible hand" as a generator of positive externalities, 3) the over-emphasis on negative externalities, 4) ignoring Coase's critique of Pigovian taxes as a solution to negative externalities, and 5) ignoring the potential for negative consequences of policy solutions to negative externalities. I'll discuss 2, 4, and 5 here and leave 1 and 3 to the interested reader.

Adam Smith's concept of the "invisible hand" is well known, if perhaps not well understood by most economists. (Pete Boettke recently wrote a great post on this subject.) McClure and Watts provide some helpful discussion on the subject:

The idea that "the market" generates positive external effects has been clearly articulated among a long line of economists, even though the term "externality" is often absent in their discussions. Since Adam Smith, economists have maintained that the use of scarce resources in ways that foster prosperity throughout society generally is the natural, but unintended, byproduct of economic interactions between individuals each pursuing his or her own self-interest.

I agree with the authors that Smith's concept of the invisible hand can be thought of as a positive externality. Boettke's post above also notes that Smith's concept is fundamentally about institutions, not about perfect information and other elements of individual rationality.

McClure and Watts provide some interesting discussion on Coase's critique of Pigou, focusing on Coase's concept of "reciprocal harm:"

To expose the weaknesses in Pigou's approach, Coase considered the reciprocal harm inherent in two conceptual experiments; in each the production of one economic good interferes with the production of other goods. 

Since both production processes in question produce economic goods, there is a trade off associated with taxing or subsidizing either process. In a previous post I discussed a column by Dierdre McCloskey in which she discusses a more important insight from Coase regarding externalities. In her characteristic style, McCloskey puts it this way:

Coase is forever saying that this or that proposal for a public policy entails knowing things that no economist can in fact know. He claims, with considerable empirical evidence, that in many cases laissez faire will be in practice better than what we will get from actual governments - though neither is perfect (we live in a second-best world, that is, a world of transaction costs). The methodological point is that Coase does not claim to have proven laissez faire on a blackboard. He says in effect, "If you look at the FCC or the lighthouses or the law of liability you see that governmental attempts to guide things minute-by-minute - as you say, Tom, 'getting the prices right'- don't work very well. Maybe it's better to just deal the cards and play. But in this veil of tears there are no guarantees. It may not work like some curves you have drawn. Life is hard. Knowledge is scarce. Grow up and admit that you can't extract policy from a couple of lines on a blackboard.

Finally, McClure and Watts discuss inframarginal or "irrelevant" externalities that can be relevant to policy decisions. The idea is that a policy designed to correct some problem with market allocations or prices may, on net, harm people if there is some positive externality "hidden" in a negative one.

For instance, when prices of basic necessities skyrocket during a natural disaster, policymakers might feel the need to outlaw "price gouging." However, such a prohibition on higher prices would reduce the incentive to bring in more of the necessities from areas unaffected by the disaster. Aid might come much slower than it otherwise would have.

The authors state the issue more generally:

Any policy that attempts correction of a negative externality while ignoring positive externalities in the form of inframarginal benefits, risks the possibility that corrective policy may impose welfare losses that could, if of sufficient magnitude, end up making matters worse than had the negative externality been ignored. 

The article is an interesting read so, as usual, I recommend reading the whole thing. There are of course many applications of these theoretical insights in agriculture. As the (vocal subset of the) public continues to emphasize the negative externalities associated with production agriculture, it will become more important to bring the insights of Coase, Demsetz, Buchanan, and others to bear.