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.

Does Public Choice Describe Political Reality?

by Levi Russell

Ben Southwood, Head of Research at the Adam Smith Institute, recently wrote a piece for Jacobite Magazine in which he argues against the applicability of public choice theory to politics in Western democracies. Below I quote Southwood at length and explain in detail where I think his analysis goes wrong. The overarching theme is this: Southwood seems to think (erroneously) that public choice is about ill intent or corruption on the part of politcians. In fact, it is merely about the application of rational, individual choice frameworks of economics to the study of politics. Politicians may have the best of intentions, but the limitations of collective action and opportunities to maximize their own benefit (as we all try to do, even if that sometimes entails benefiting others we care about or with whose interests ours align) in the political sphere lead them to act in ways that are inconsistent with an idealized view of politics.

In his description of public choice, Southwood starts off well, but understates the predictive power of public choice theory.

Public choice is true on the margin—that is: people’s actions in politics and government tend to be affected by self-interest—but if you predicted what people did using only or mainly public choice you’d get it wrong nearly every time, at least in the modern West.

In fact, public choice theory can predict the actions taken by politicians, bureaucrats, and voters well, if not perfectly. Politicians may have altruistic motives, but they cannot effectuate their agendas without acting in ways described by public choice theory. Southwood's first example is voting:

Start with voting. Voting is an extremely widespread behavior in Western societies. A third or two fifths of adults will turn out even for the most trivial local elections. Eighty per cent might turn out for a major contest. But public choice cannot explain this.

Your vote has a tiny influence on the outcome of most elections. The chance of an individual voter deciding an American presidential election is about one in sixty million (ranging from one in ten million in some swing states to about one in a billion in Texas or California). If you only care about the election’s impact on your own personal prospects, then the election would need to be worth about a billion dollars to you personally. Elections often make trillions of dollars worth of difference overall, but rarely more than thousands or hundreds to individuals or their families.

This is a complete misunderstanding of public choice theory on voting. The cost-benefit analysis of voting for an individual is straightforward if we account for the social dimesion. People turn out to vote because they and their peer group believe it is part of their civic duty. The cost of voting is small relative to the benefit of signaling to one's peer group that we care about our civic duty. The fact that an individual vote is highly unlikely to affect an election simply doesn't matter.

Southwood goes on:

In public choice theory politicians stand for elected office not in order to enact a program, based on their views and convictions, but in order to maximize their personal power. To do so, they maximize votes at elections. This claim is also a familiar conventional wisdom to the point of cliche: politicians are unprincipled schemers who will do anything for votes.

There's a lot to unpack here. The first sentence gives the impression that politicians' desire to enact a program "based on their views and convictions" precludes their intent to maximize personal power. On the contrary, the former is dependent on the latter! Immediately after their elections, presidents and prime ministers are often said to have a "strong mandate" if they win more votes than expected. This "mandate" is said to give them political leverage to implement their agendas. All of this is orthogonal to their status as "unprincipled schemers who will do anything for votes." They may be unprincipled schemers, or they may be very well-meaning people. The fact is, if they want to implement the policies they think best, they have to work the system. The idea that politicians are evil might be a popular shorthand for public choice theory, but it doesn't represent the theory itself.

Southwood continues:

Public choice also predicts that officials are easily lobbied: they can be bought by rent-seeking special interests. But the literature is almost unequivocal: the source of campaign funds makes little difference to campaigns or policies. The fact that the decisions politicians make affect how trillions of dollars are spent, and yet firms spend figures in the low billions on elections caused a famous economics paper to ask “Why is there so little money in US politics“?

Again, Southwood starts off fine. Campaign donations, lobbying, and the revolving door more generally are all ways certain interest groups can influence politicians. The literature, specifically the paper he cites, does find that campaign donations only influence legislators' votes in some cases. However, this doesn't include lobbying and other rent seeking behavior. There is a revealed preference component here; even if interest groups are not "buying votes" with campaign funds or lobbying firm fees, they apparently see some value in spending several billion dollars per year (at the federal level) on it. We can't observe a counterfactual world in which there is no "money in politics," so it's difficult to know precisely how much impact campaign funds and lobbying have on legislator's behavior. Finally, there is a point to be made here about marginalism. It's true the US federal budget is in the trillions. However, the votes held in any single legislature will only affect this budget at the margins, not halving or doubling the budget year to year.

Public choice is fundamentally not about corruption or other criminal behavior; it's simply economics applied to political problems. Oftentimes, it's about incentive and information problems specific to the political world that result from the constraints we face in human interaction. Regulation can indirectly benefit special interests incentivizing rent seeking behavior, some laws can give politicians the power to benefit themselves personally, and arbitrary enforcement can create confusion and uncertainty. Even popular and well-meaning politicians understand the poor incentives they sometimes face.

Boetkke on Buchanan

by Levi Russell

I've enjoyed reading every bit of George Mason University economist Peter Boettke's work that I've had the time to read in the past several years. His work is very interesting in part because he addresses issues most of us don't spend a lot of time on. In this post, I reproduce some of my favorite quotes from a recent speech Boettke gave. The speech focuses on Jim Buchanan's perspective on economics generally and political economy specifically. As usual, I suggest you read the whole speech, as it is very good and very short.

The problem as Buchanan sees it is that economics as a discipline has a public purpose, but modern economists have shirked on that purpose and yet are still being rewarded as if they were earnestly working to meet their educational obligation. As he put it:“I have often argued that there is only one ‘principle’ in economics that is worth stressing, and that the economist’s didactic function is one of conveying some understanding of this principle to the public at large. Apart from this principle, there would be no general basis for general public support for economics as a legitimate academic discipline, no place for ‘economics’ as an appropriate part of a ‘liberal’ educational curriculum. I refer, of course, to the principle of the spontaneous order of the market, which was the great intellectual discovery of the eighteenth century” (1977 [2000]: 96).

Prices serve this guiding role, profits lure them, losses discipline them, and all of that is made possible due to an institutional environment of property, contract and consent. These are the basic principles from which we work in economics. Important to note, economic analysis relies neither on any notion of hyper rational actors myopically concerned with maximizing monetary rewards, nor on postulating perfectly competitive markets. It relies simply on the notion that fallible yet capable human beings are striving to better their situation, and in so doing enter into exchange relations with others. Atomistic individualism and mechanistic notions of the market is, as Buchanan has stressed, nonsensical social science.

From a Buchanan perspective, basic economics can be conveyed in 8 points.
1.Economics is a "science" but not like the physical sciences. Economics is a "philosophical" science and the strictures against scientism offered by Frank Knight and F. A. Hayek should be heeded.
2. Economics is about choice and processes of adjustment, not states of rest.Equilibrium models are only useful when we recognize their limits.
3. Economics is about exchange, not about maximizing. Exchange activity and arbitrage should be the central focus of economic analysis.
4. Economics is about individual actors, not collective entities. Only individuals choose.
5. Economics is about a game played within rules.
6. Economics cannot be studied properly outside of politics. The choices among different rules of the game cannot be ignored.
7. The most important function of economics as a discipline is its didactic role in explaining the principle of spontaneous order.
8. Economic [sic] is elementary.

A Lawyer and a Physicist Walk Into a Bar

by Levi Russell

A lawyer and a physicist walk into a bar... 

I don't have a good joke for that intro, but I do have a punchline: physicist Mark Buchanan's recent Bloomberg View column entitled "The Misunderstanding at the Core of Economics." What is this misunderstanding, you ask? Well, it's the (mistaken) belief that markets are perfect. This belief, Buchanan alleges, is widely held among professional economists. Buchanan argues that this widespread belief has had tragic consequences:

Economists routinely use the framework to form their views on everything from taxation to global trade -- portraying it as a value-free, scientific approach, when in fact it carries a hidden ideology that casts completely free markets as the ideal. Thus, when markets break down, the solution inevitably entails removing barriers to their proper functioning: privatize healthcare, education or social security, keep working to free up trade, or make labor markets more “flexible.”

Those prescriptions have all too often failed, as the 2008 financial crisis eloquently demonstrated. ...

The trouble with all of this is that none of it is true. If political party affiliation is any indication, the fact that academic economists are overwhelmingly Democrat indicates that pro-market utopianism isn't widespread. Another survey indicates that a mere 8% of academic economists can be considered supporters of free-market principles and only 3% are strong supporters. In terms of economists, Buchanan's only reference is to the late Kenneth Arrow. He provides no evidence that a massive swath of the profession are all free-market ideologues incapable of nuance. Buchanan cites one newly-popular economic commentator, an historian and lawyer, James Kwak. Kwak has been roundly criticized by economists for his simplistic analysis of economic phenomena many times, notably here, here, here, and here and many other times over the years.

So-called "free market" economists are far more nuanced in their views of market and government solutions to the problems in our imperfect world inhabited by imperfect human beings. A short but accurate summary would be something like: "In the real world, markets are, for the most part, better at dealing with externalities and other economic problems than actually-existing governments staffed by actually-existing politicians and bureaucrats." That is, no institutional arrangement is perfect, but the problems associated with voluntarily and spontaneously generated institutions are usually relatively minor when compared with those associated with institutions designed by a central authority. Examples of this nuanced position can be found in previous Farmer Hayek posts here, here, here, here, here, and here, as well as in the writings of Jim Buchanan, Gordon Tullock, Deirdre McCloskey, Pete Boettke, etc. A closer reading of these and other "free market" economists might change Buchanan's mind about the types and level of analysis that leads to "free market" conclusions.

Monopoly Concerns with Baysanto

by Levi Russell

The recent merger of DuPont/Pioneer with Dow and the acquisition of Monsanto by Bayer have sparked a lot of discussion of market concentration, monopoly, and prices. A recent working paper published by the Agriculture and Food Policy Center (AFPC) at Texas A&M University written by Henry Bryant, Aleksandre Maisashvili, Joe Outlaw, and James Richardson estimates that, due to the merger, corn, soybean, and cotton seed prices will rise by 2.3%, 1.9%, and 18.2%, respectively. They also find that "changes in market concentration that would result from the proposed mergers meet criteria such that the Department of Justice and Federal Trade Commission would consider them “likely to enhance market power” in the seed markets for corn and cotton." (pg 1) The paper is certainly an interesting read and I have no quibble the analysis as written. However, some might draw conclusions from the analysis that, in light of other important work in industrial organization, are not well-founded.

The first thing I want to point out is that mergers an acquisitions can, at least potentially, result in innovations that would justify increases in the prices of the merged firm's products. To the extent that VRIO analysis is descriptive of firm's behavior with respect to innovation, we would expect that better entrepreneurs would be able to price above marginal cost. Harold Demsetz made this point in his 1973 paper Industry Structure, Market Rivalry and Public Policy. The authors of the AFPC study point this out as well, but the problem is that, even though we have estimates of potential price increases due to the mergers, it is very difficult to determine whether any change in price in the future is actually attributable to market power or simply due to innovation in the seed technology.

Secondly, the standard models of monopoly assert that pricing above marginal cost is at least potentially a sign of a firm exercising market power. Here, articles by Ronald Coase and Armen Alchian are relevant. I provided a discussion of the relevant portions in a previous post so I'll just briefly summarize here: pricing above marginal cost is an important signal that the current market demand is potentially not being met by the firms in the industry. It's a signal to other potential investors that entering the industry might be worth it. Further, there is an issue of measurement. Outside observers may calculate fixed cost, variable cost, and price and determine that a firm is pricing above marginal cost. However, there may be costs of which said observers are unaware. For example, there may be significant uncertainty (which is not the same as risk) about the future prospects of the industry. This is certainly possible in the biotechnology industry since the government heavily regulates firms in this sector. This is not to say that such regulation is bad or should be removed, simply that it presents costs that are difficult for outsiders to calculate.

Finally, I want to examine one part of the analysis in the AFPC paper. On pages 10 and 11, the authors write (citations deleted):

A market is contestable if there is freedom of entry and exit into the market, and there are little to no sunk costs. Because of the threat of new entrants, existing companies in a contestable market must behave in a reasonably competitive manner, even if they are few in number.

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. For entry and exit to be costless or near costless, there must be no sunk costs. If there were low sunk costs, then new firms would use a hit and run strategy. In other words, they would enter industry [sic], undercut the price and exit before the existing firms have time to retaliate. However, if there are  high sunk costs, firms would not be able to exit without losing significant [sic] portion of their investment. Therefore, if there are high sunk costs, hit-and-run strategies are less profitable, firms keep prices above average costs, and markets are not contestable. 

I submit that under this definition, scarcely any industry on the planet is contestable, yet we see prices fall in many industries over time, even in those we would expect to have significant sunk costs and in which we would expect incumbents to have significant cost advantages over new entrants.

 Image source.

It's true that we sometimes must make simplifying assumptions that are at odds with reality to forecast future market conditions. However, some might infer from the AFPC paper (though I stress that the authors do not) that something must be done by anti-trust authorities to unwind the mergers and acquisitions under discussion. To infer this would be to commit the Nirvana Fallacy. To expect anything in the real world (whether in markets or in the policymaking arena) to be "costless" is an impossible standard.

It will be interesting to see what becomes of these mergers and whether seed prices move sharply upward in coming years. What is certain is that there is tremendous causal density in any complex system, such as the market for bio-engineered seed. Thus, policymakers should be humble and cautious about applying the results of theoretical and statistical analysis in their attempts to better our world.

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.

Some Alternative Views on the Recent Nobel

by Levi Russell

I enjoy talking about and linking to alternative, minority points of view in economics on this blog. Sometimes the views I talk about are genuinely only held by a minority, others are held by many but are under-emphasized or, in my mind slightly misunderstood.

In this case, I just want to link to some short (and one very long) posts I read about Hart and Holmstrom's Nobel. Certainly I'm happy to see the prize go to work on theory of the firm and contracts and I believe they are deserving of it. That said, here are some alternative perspectives you might not read in other outlets.

Pete Boettke has a rather long, but certainly interesting, post here.

Arnold Kling gives his thoughts in two posts here and here.

Finally, here's Peter Klein on the prize.

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.

The Legacies of Jim Buchanan and Elinor Ostrom

by Levi Russell

About a month ago I ran across a blog post entitled "How to start thinking like a public choice economist." Given my interest in this field of study, I read and enjoyed the post and watched the (short) video interviews. Another post entitled "Putting the action back in collective action" recently came out on the same site, so I thought I'd share them both.


If you're interested in the work of Jim Buchanan and Elinor Ostrom (Nobel Prizes in Economics in 1986 and 2009, respectively), I'd encourage you to check out the posts and videos.

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.

Intentions, Faith, and the Nirvana Fallacy

I've addressed the Nirvana Fallacy several times on this blog, and keep finding new examples of it, especially in the popular press. Many economists seem to be unaware of this fallacy and Mark Thoma is no exception. I've critiqued him previously on this issue, but his most recent commission of the fallacy is especially interesting. Below I share key parts of his recent CBS News column (in block quotes) with some of my commentary.

The Nirvana Fallacy, as put forth by UCLA economist Harold Demsetz, is the comparison of real-world phenomena to unrealistic ideals. The mere fact that economic models can specify a perfect policy solution to a problem doesn't imply that real-world political and legal institutions can successfully implement that policy. More importantly, though, imperfections in markets which are the result of informational inefficiencies can't be solved readily by governments because the governments themselves lack the necessary information.

In addition to being quite confident about the ability of economic models to generate policies that "break up monopoly" and "force firms to pay the full cost of pollution they cause," Thoma seems to put a lot of stock in the intentions of regulators and politicians.

When government steps in to try to correct these market failures -- breaking up a monopoly, regulating financial markets, forcing firms to pay the full cost of the pollution they cause, ensuring that product information is accurate and so on -- it's not an attempt to interfere with markets or to serve political interests. It's an attempt to make these markets conform as closely as possible to the conditions required for competitive markets to flourish. 

The goal is to make these markets work better, to support the market system rather than undermine it.

It may very well be that all legislators and regulators have the purest of intentions. Even so, that doesn't imply that their policies will actually achieve the results they desire. Good intentions are a necessary but not sufficient condition for efficient and effective government solutions. Decades of work in public choice economics and more recent work in behavioral public choice show that the implementation of government policies is fraught with its own government failures. Why doesn't Thoma mention these?

Perhaps the clearest example of the Nirvana Fallacy in Thoma's column comes a few paragraphs down:

In other cases, it's less well understood that failure is the reason for the government to regulate a market, or even provide the goods and services itself. Social security and health care come to mind. But once again, the private sector's failure to deliver these goods at the lowest possible price, or to deliver them at all, is at the heart of the government's involvement in these markets. (emphases mine)

Here we have Thoma's standard for real world markets. They must deliver certain goods and services at the lowest possible price. What does he mean by "possible?" Possible in the abstract world of economic theory? Why is this a relevant comparison? Does Thoma also propose we hold the actual activities of politicians and regulators to such an ideal?

Further, I'm not sure what he means by "deliver them at all." We have accidental death and dismemberment insurance, life insurance, and health insurance in private markets and have had them for a long time. We've had health care for much longer than the government has been as heavily involved as it is now. In fact, the evidence suggests that political favoritism killed a very useful alternative health care system for the poor and blue-collar folks back in the 1930s. On the insurance side of things, it's at least plausible that increases in payroll taxes decades ago helped bring about employer-provided insurance and exacerbate the problem of preexisting conditions.

Finally, let's unpack the last two paragraphs in Thoma's column. He writes:

Conservatives tend to have more faith in the ability of markets to self-correct when problems exist, and less faith in government's ability to step in and fix market failures without creating even more problems. Honest differences on this point are likely, but there are certainly cases where most people would agree that some sort of action is needed to overcome significant market failures.

Where to start? From his use of the word "conservative" as the only descriptor of his intellectual opponents, it's clear that Thoma is thinking about this as a purely political issue, not as a technical economic issue. He also seems to think that mere faith is the only reason someone might disagree with his view. Conservatives, he says, have more faith in markets and less faith in governments. Again, the public choice literature documents quite well the problems actual politicians and regulators have with implementing the idealized policies derived from economic models. He goes on to say that honest differences are "likely," not "possibly justified" or "important to consider." It seems Thoma can't conceive of a reason for his opponents to doubt the ability of the government to fix the problems he sees with the world outside of pure ideology.

Thoma's final paragraph really demonstrates the problems with the static model through which he views the world:

However, when ideological or political goals (such as lower taxes for the wealthy or reduced regulation so that businesses can exploit market imperfections) lead to attacks on those who call for government to make markets work better -- often in the guise of getting government out of the way of the market system -- it undermines government's ability to promote the competitive market system the opponents claim to support.

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.

Richard Langlois' recent testimony to the British Parliament on dynamic competition provides some important critiques of static models. Here are some excerpts:

On monopoly and barriers to entry:

There are only two ways that a platform can maintain prices above marginal costs. One is to be more efficient that one’s competitors – to have lower costs, for example. Such a situation would not be “policy relevant,” in the sense that taking regulatory or antitrust action against the more-efficient competitor would make society worse off. The other way to maintain price durably above marginal cost is to have a barrier to entry.  

The static and dynamic views are in agreement that competition requires free entry. Taking a static view often leads to intellectual confusions about the nature of barriers to entry (that they can arise from the shape of cost curves, for example); but in the dynamic view it is clear that barriers to entry are always property rights – legal rights to exclude others.(1) For example, one can have a monopoly on newly-mined diamonds if one owns all the known underground reserves of diamonds. More typically, especially in the case of platforms, the property rights involved are government-created rights of exclusion, either in the form of intellectual property or regulatory barriers.

On the abuse of market power:

What if it is customers who complain about the “abuse” of market power? To an economist, the problem with market power is the (static) inefficiency it creates. There is no such thing as the “abuse” of market power. Economists have understood for some time that a firm possessing market power cannot by its own actions increase that market power. The only way a firm can get market power (apart from being more efficient) is to possess a barrier to entry. What many see as “abuses” are usually what modern-day economists have come to call non-standard contracts: contractual practices beyond the simple calling out of prices in a market, practices that seem “restrictive.” These practices are often solutions to a much more complicated problem of production and sales than is contemplated in the simplified models of market power. They are very frequently an effort to overcome problems created by high transaction costs.(2)

The quality of discussions of the benefits of government intervention would be greatly improved if some notion of the costs of such intervention were mentioned. This would include discussions of dynamic models of competition and the explicit admission that politicians and regulators are subject to the same cognitive biases and information problems that cause real-world markets to deviate from the perfection of static economic models.

Environmental Common Law vs Administrative Regulation

I recently listened to an old EconTalk podcast featuring Clemson economist Bruce Yandle. Yandle is famous for the "Bootleggers and Baptists" theory of regulation. In this episode, he discusses an alternative to the current form of federal environmental regulation. Specifically, he talks about the pre-1970s era when state-level common law settled disputes between parties in regard to environmental quality.

Yandle begins by discussing the tragedy of the commons or the commons problem. For those who don't know, the tragedy of the commons refers to the problem we face with public access to scarce resources. He talks about the stages of evolution of property rights and introduces his juxtaposition of common law approaches to environmental policy to administrative regulation with some historical examples. I'll leave those for the interested listener (the podcast is about 1 hour in length, the extra run time at the end is devoted to a comment by the host).

Here are several of Yandle's points that make his case for the common law approach vis-a-vis the current regulatory approach:

- The state- and city-level common law standard prevalent before the 1970s applied to the parties to the dispute, no one else, though a particular case might be cited in the decision of another. The basic principle was that you didn't have a right to pollute your neighbor's property without their permission.

- Many businesses seeking to discharge waste went to downstream landowners and offered to pay to offset the water quality deterioration rather than purchase the land outright (though this was common as well). This makes a Coasian point: there must be someone who is harmed by the discharge for an externality to exist. Getting rid of all pollution is not likely to be cost-effective. The downstream property holder had a right to water quality based on his or her ownership of the land.

- Common law generally works on a  case-by-case cost-benefit standard whereas regulations don't. The license to discharge or the technological standard required to mitigate pollution applies to all, Yandle says that this implies that the damage done by the pollution isn't legally relevant, only the rules laid out by the regulator.

- Though differential access to legal services is potentially an issue, district attorneys (or tort law, in my amateur, non-lawyer opinion) could be used to solve this problem.

- Did the common law standard work well? Previous research indicates that progress in water and air quality before 1970 was roughly indistinguishable from progress after.

- Yandle is positive about the prospect of using the EPA as an environmental research organization and expert witness in environmental common law cases.

- I can't resist one example. Anglers' associations in England and the English part of Canada have successfully brought suit against polluters and improved water quality under the existing common law standard. This is possible because a landowner also owns the wildlife on his or her property. Yandle says that this is not so in the US; that wildlife are considered public property here. Anglers' associations in the UK have been so successful in common law courts and are now so powerful that all they have to do is make a phone call to a business inadvertently killing fish in a stream or river and the problem is fixed quickly and quietly. Overall, Yandle makes a persuasive case in favor of environmental common law.

Potpourri

House Ag Committee chair Conaway comments on the state of the ag economy.

Don Boudreaux corrects Paul Krugman on the definition of a public good.

Bryan Caplan blogs about an interesting article by Niclas Berggen on the pro-govt bias of behavioral economists. Berggen's results:

Our main findings are that 20.7% of all articles in behavioral economics in the ten journals contain a policy recommendation and that 95.5% of these do not contain any analysis at all of the rationality or cognitive ability of policymakers. In fact, only two of the 67 articles in behavioral economics with a policy recommendation contain an assumption or analysis of policymakers of the same kind as that applied to economic decision-makers. In the remaining 65 articles, policy recommendations are proffered anyway.

Richard Vedder on the Transformation of Economics

Richard Vedder, who is well-known for his work on the minimum wage, wrote a short op-ed in the Wall Street Journal about a month ago that I thought was pretty interesting. Vedder makes 5 observations about changes to economics over his career. Below I'll share three of them but the whole piece is worth reading.

Vedder starts off discussing ideological creep in the profession:

Economics as ideology in camouflage. Economists who achieve fame for genuine intellectual insights, like Paul Krugman, sometimes then morph into ideologues—predominantly although not exclusively on the left. The leftish domination of American academia is partly explained by economics. Federal student-loan programs, state appropriations, special tax preferences and federal research-overhead funds have underwritten academic prosperity, even at so-called private schools. The leftish agenda today is one of big government; academics are rent-seekers who generally don’t bite the hand that feeds them. The problem is even worse in other “social sciences.”

On a related note, he describes the rise of policy think tanks:

The rise of the nonuniversity research centers. A reaction to the liberal ideological orientation and inefficiencies of colleges has spawned this phenomenon. When I was attending college around 1960, the Brookings Institution, National Bureau of Economic Research and the Hoover Institution were among relatively few major independent think tanks. Today there are many, especially ones funded on the right to provide intellectual diversity, including nationally or regionally oriented centers such as the American Enterprise Institute, Cato Institute, Heritage Foundation, Heartland Institute and the Independent Institute, as well as dozens of state-policy think tanks. Universities have lost market share in social-science research.

Vedder then turns to his own work on labor economics:

A major cause of America’s economic malaise: the government’s war on work. My own research with Lowell Gallaway has stressed the importance of labor costs in explaining output and employment fluctuations. If the price of something rises, people buy less of it—including labor. Thus governmental interferences such as minimum-wage laws lower the quantity of labor demanded, while high taxes on labor reduces labor supply, as do public payments to people for not working. 

Tumbler Competition - The Rise and Fall (?) of the Yeti

Some time last year I became aware of the phenomenon that is the Yeti brand. The company makes what appear to me to be wildly over-priced coolers and tumblers. They have successfully built a lifestyle around their brand seemingly through social media marketing and word of mouth. Living along the Texas coast, I regularly see their branding on bumper stickers, hats, and of course the coolers themselves.

The prices for their tumblers seem particularly egregious: $40 for a 30 oz. and $30 for a 20 oz. The good thing about them is that they work. Several colleagues told me that they were able to keep drinks cold all day long. I received one as a Christmas gift last year and was quite impressed.

Sometime late last year I began seeing ads for a competing product by a company called RTIC. They claimed that their product was as good as the Yeti, but at half the price. The 30 oz. model could be had for $20 and the 20 oz. for $15. A YouTube video seems to confirm that the RTIC product performs as well as the Yeti.

Today a friend shared a post on Facebook that alerted me to yet another entrant into this market. Nearly-identical Ozark Trail-branded tumblers can be had from Wal-Mart for the low prices of $9.97 (30 oz.) and $7.97 (20 oz.). Currently the prices online are higher ($14.74 and $9.74, respectively) and are sold out.

This is a fascinating case study on the effects of competition and innovation on prices. I have little doubt that Yeti will be able to maintain its high-priced tumblers, at least for awhile, because it has built brand recognition. Certain segments of the population will pay more either because they don't shop around or because they want to have that YETI logo on the bottom edge of the cup.

Those of us who are willing to shop around and aren't concerned about brands are, thanks to competition, able to get the same drink-cooling performance at a much lower price (from a big-box store often vilified for the negative effects it supposedly has on the working class).

It's important to remember that price theory is ultimately about what goes on in our heads, not necessarily the "objective" components of a physical good. Having the YETI logo stamped on the outside of the tumbler might not make it any better in terms of its objective performance, but those who buy YETI for the sake of YETI are certainly, from their own point of view, better off than if they had purchased the other brands' offerings.

It's Still a Unicorn

The latest polemic from biologist David Sloan Wilson is an attempt to “update” the work of Friedrich Hayek on the nature of the state and spontaneous order. In it, Wilson interviews economist Daron Acemoglu on his work on the role of institutions in economics. The title, “Stop Crying About the Size of Government. Start Caring About Who Controls It.” is indicative of the level of discourse provided in the article. I'd wager that nearly all those who are skeptical of government power are pretty much equally concerned about its size, scope, and the identity of those in power.

So with that red herring as the start, let's see what Wilson and Acemoglu have to say. The first interesting claim is about the beginnings of the post office. Acemoglu's research indicates that there is a positive correlation between the establishment of early post offices in the U.S. and the number of patents filed from that region. This is then taken as evidence that where there are more post offices, there is more innovation. The problem here is that patents aren't a very good indicator ofinnovation, especially in the more distant past. Equating the two is akin to the proverbial drunk searching for his car keys under the light of the nearest lamppost.

The crux of Wilson and Acemoglu's argument comes a bit later in the piece:

Some think that human cooperation can develop in a spontaneous way (Hayek comes close to this at times), or because cooperation creates an edge, the forces towards the evolution of a psychology of group cooperation are going to ensure that tribes, villages or even bigger polities can develop a sophisticated order without the state. The famous book by Robert Ellickson, Order without Law, claims that the complex relations between farmers and ranchers in Shasta County, California happens not thanks to the law, but without any reference to the law, instead relying on informal norms that have evolved over time. This may well be true, but is not the general pattern of what happens without law and the state playing the role of conflict resolution and law enforcement in much of the world. In Why Nations Fail, we explain why Somalia is so dysfunctional, linking this to the almost complete absence of conflict resolution from the state. Even small disputes in Somalia can spiral into feuds or even clan warfare because there is no central authority to resolve these conflicts. The one big difference between Somalia and Shasta County is, of course, that in the former there really isn’t the state, whereas everything that happens in Shasta County happens under the shadow of the state. For example, if a group of ranchers decide that these informal social norms aren’t working for them and take up guns and shoot some of the farmers, they know that it will be the US marshals coming after them.

As a general rule, and this is consistent with the Hayek quote you started with, no civilization has flourished economically, and I would also say socially, without a state powerful enough to provide security, property rights protection, dispute resolution and some amount of public goods to its citizens. It is also the case, and this is something we emphasize a lot throughout Why Nations Fail, that most states throughout history and even today serve the interests of the political elite and are part of their economic problems, not their solution. But this is not because the state is unnecessary or evil, but because of who controls it and what capacities it has invested in and developed.

There are several problems here. First, there are plenty of examples of spontaneous development of human cooperation. The mutual aid societies that operated across the U.S. until the mid-20^thcentury, which went extinct thanks to legislation supported by politically powerful medical organizations, are one example. Among otherexamples, the (actual, historical) story of the “wild west” is a clear demonstration that rules of conduct can and do emerge spontaneously to benefit everyone involved. David Friedman lays out theoretical and empirical cases in thisarticle. Peter Leeson has done significant research on theoretical and empirical examples of spontaneously-generated governance structures.

Acemoglu cites Somalia as a counterexample, but the reality is that Somalia isbetter off now economically than it was in 1991 when it became anarchic. The chaos that continues there is largely a result of outside attempts to establish a new government. The bottom line is that there are many differences between Somalia and Shasta County, CA, not just the presence or absence of a state.

The rest of the article is essentially an exercise in the unicorn fallacy, attempting to define the state as something other than a “monopoly of the legitimate use of physical violence”, as sociologist Max Weber defined it nearly 100 years ago. Acemoglu is right that we should be concerned about who is in power. The trouble is, we have been for a very long time and it hasn't fixed the problems Acemoglu and Wilson seem to think it will. 

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.