## Saturday, 29 December 2012

### "Impossible" to end drug trade

Or so says Felipe Calderón, Mexico’s outgoing president. The Economist reports that,
ENDING the consumption and the trafficking of illegal drugs is “impossible”, according to Felipe Calderón, Mexico’s outgoing president. In an interview with The Economist Mr Calderón, whose battle with organised crime has come to define his six years in office, said that countries whose citizens consume drugs should find "market mechanisms" to prevent their money from getting into the hands of criminals in Latin America.

In an interview recorded last month for this week’s special report on Mexico, Mr Calderón said: "Are there still drugs in Juárez [a violent northern border city]? Well of course, but it has never been the objective…of the public-security strategy to end something that it is impossible to end, namely the consumption of drugs or their trafficking…
and
Mr Calderón’s comments sum up what seems to be a growing consensus: stopping or even seriously reducing drug consumption has so far proved impossible, so it is time to focus on ways of making that consumption less harmful. That sort of thinking has been fashionable for a long time on the demand side, with innovations such as needle exchanges and methadone replacement now common in many rich countries. The next step is to explore legal ways of managing the supply side, as Colorado and Washington have recently voted to do.

Sitting presidents such as Juan Manuel Santos of Colombia and Otto Pérez Molina of Guatemala are pushing for a rethink. As a result of this agitation the Organisation of American States, a regional body, is compiling a report on drug policy which is expected to explore alternatives to the current regime.
Here's an idea, make drugs legal.

## Friday, 28 December 2012

### EconTalk this week

Lisa Turner of Laughing Stock Farm talks with EconTalk host Russ Roberts about life as a small organic farmer. She describes her working day, the challenges of farming, the role of the U.S. Department of Agriculture in her life and what some job applicants who want to work on her farm need to understand about business.

## Saturday, 22 December 2012

### Quote of the day

From Ronald Coase and Ning Wang's "How China Became Capitalist":
The tragedy of the Great Leap Forward illustrates that the differences between a command and a market economy reflect a deep difference in mentality and attitude. A market economy can only be tolerated when no one is confident enough to claim omniscience. A point stressed by Hayek, the far-reaching implications of which have yet to be fully recognized, is that the most critical advantage of a market lies less in its allocative efficiency, and more in its free flow of information. But the flow of information would not make much sense, indeed it would be wasteful, if the problem that it helps to solve is not recognized. A market economy assumes two deep epistemic commitments: acknowledgement of ignorance and tolerance of uncertainty. It was hard for a defiant Mao and a triumphant Chinese Communist Party to accept either, even in the aftermath of the disastrous Great Leap Forward. (p. 18)
I have to say I wish someone has pointed out the bit about claiming omniscience to Muldoon, the New Zealand economy would have been better for it. When Muldoon published his book "The New Zealand Economy: A Personal View" a copy was sent to the economics journal, New Zealand Economic Papers, for review. In the 'Books Received' section of the journal the following note appeared below the entry for the book,
'Not a book which is likely to appeal to economists for, in Sir Robert's view, they are all disqualified from offering advice because they are either academic (and therefore theoretical), foreigners (irrelevant), Treasury officials (inexperienced) or Reserve Bank employees (inclined to panic). Sir Robert doesn't need economic advice because he alone possesses the experience, common sense, social concern, understanding of the New Zealand way of life and knowledge of the people which enable him to make "the judicious use of the widest range of weapons that are available"!' (Emphasis added).

## Wednesday, 19 December 2012

### What is an MP worth?

Homepaddock writes,
The Remuneration Authority has recommended a small increase in pay for MPs and that has resulted in the usual carping:
While Christmas is still grim financially for many New Zealanders, politicians – who earn nearly three times the average wage – are about to pocket even more. . .
Good MPs are worth far more than they get.
No, an MP is worth whatever it takes to get them to do the job. If the current pay is enough to get MP's to do the job, and it is as they are doing the job, then that is what they are worth. No more; and may be even less. A nice experiment would be to lower MP's pay and see how many leave.

## Tuesday, 18 December 2012

### Incentives matter: tax file (updated)

From the New Zealand Herald.
France's leading actor Gerard Depardieu says he will give up his French passport after the prime minister called him "pathetic" for trying to avoid taxes by moving to Belgium.
and
Depardieu has joined some of France's wealthiest business figures in Belgium following moves by President Francois Hollande's Socialist government to tax annual incomes above one million euros ($NZ1.6 million) at 75 per cent. and "I am leaving because you consider that success, creation, talent, anything different, must be punished," he [Depardieu] said. Update: Mark Hubbard notes that Tax Them, And They Will Leave. ### Cash transfers and domestic violence Tyler Cowen notes this paper on Cash transfers and domestic violence. The abstract reads: Violence against women is a major health and human rights problem yet there is little rigorous evidence as to how to reduce it. We take advantage of the randomized roll-out of Ecuador's cash transfer program to mothers to investigate how an exogenous increase in a woman's income affects domestic violence. We find that the effect of a cash transfer depends on a woman's education and on her education relative to her partner's. Our results show that for women with greater than primary school education a cash transfer significantly decreases psychological violence from her partner. For women with primary school education or less, however, the effect of a cash transfer depends on her education relative to her partner's. Specifically, the cash transfer significantly increases emotional violence in households where the woman's education is equal to or more than her partner's. ### EconTalk this week Don Boudreaux of George Mason University talks with EconTalk host Russ Roberts about the work of F. A. Hayek, particularly his writings on philosophy and political economy. Boudreaux provides an audio annotated bibliography of Hayek's most important books and essays and gives suggestions on where to start and how to proceed through Hayek's works if you are a beginner. ## Monday, 17 December 2012 ### Just how stupid are Australians? Eric Crampton points us to this wee gem from the West Island: The Director of the Centre for Research & Action in Public Health at the University of Canberra, Rachel Davey, lauds Britain's wartime and post-war food rationing as an example for reducing obesity. Wartime food shortages and government directives forced people to adopt different eating patterns. They ate considerably less meat, eggs, and sugar than they do today. Rationing was enforced in Britain for 14 years, and continued after the war had ended. Meat was finally derationed in June 1954. Petrol was also rationed, so people stopped buying and using cars, and public transport was limited. There was no “obesity epidemic” as food supply and travel was limited, meaning people ate less and did more physical exercise (walking). Interestingly, during the years when rationing was enforced, the prevalence of obesity was negligible in the United Kingdom. And waste was minimised as both individuals and government agencies were busy finding new ways of reducing the waste of food resources to a minimum (sustainable consumption). Is it conceivable that some form of food rationing and portion control may help address the dramatic rise in obesity and the sustainability of our foods supply? If we continue to over-consume foods in unsustainable ways for both our health and our planet, we may be left with no other choice. War time rationing as the answer to obesity? You have got to be taking the piss! I'm sure we could stop people consuming all sorts of things if we introduced rationing but I foresee all sorts of problems, not the lest of which would be the huge enforcement costs of such an idea. You can see criminal gangs just loving this notion. The black market that would develop, and did develop in the wartime U.K., would be a money spinner for criminals. Also you have to wonder about the misallocation of resources that would result from the government direction of industries like farming, transport and food retailing. Rationing may be tolerated in extreme situations like war but I can't see it going down at all well as a permanent policy. No matter what Ms Davey seems to think to the contrary, people do have the right to decide how they will spend their income and they do not have to put up with being dictated to by the likes of Ms Davey. ### Glad to see Fonterra has proved me right Earlier I argued with regard to Fonterra's "Milk In Schools" program that, Or if you get the kids drinking milk now and they keep on doing it you have, with a bit of luck, created a market for milk in the future. What firm wouldn't want this? Well Fonterra wants it. From the TVNZ website comes this, Fonterra announced it will roll out the "Milk in Schools" to every primary school in the hope of a future pay day. "Long term we want to have these kids on milk and not on carbonated drinks when they are 20 years old," says Spierings. "And when they earn a salary, they go to the supermarket and buy our milk." Now all the owners of Fonterra have to ask is, Is this the best way to build a future market for milk? It does look an expensive way to achieve the end. ## Friday, 14 December 2012 ### Yes, demand curves do slope downwards even for milk. In a PR piece on the free milk in schools trial in Northland Fonterra writes Research conducted by the University of Auckland has shown that children’s milk consumption in the Northland community, both at school and at home, has significantly increased since the pilot began. So if you make the price of something zero people consume more of it! Who would have guessed? "We are totally committed to Fonterra Milk for Schools because we believe it will make a lasting difference to the health of New Zealand’s children. We want Kiwis to grow up drinking milk because it’s good for them and we are proud that this programme will give every primary school kid the chance to enjoy this nutritious product,” he said. Or if you get the kids drinking milk now and they keep on doing it you have, with a bit of luck, created a market for milk in the future. What firm wouldn't want this? ## Thursday, 13 December 2012 ### The Crampton "What if?" lecture This is the video of Eric Crampton's "What if?" lecture on "What if alcohol were not as socially costly as everyone says?", from a couple of weeks ago. ## Wednesday, 12 December 2012 ### Blatant self promotion A new version of my "The Past and Present of the Theory of the Firm" paper is up at Scribd. The abstract reads: In this survey we give a short overview of the way in which the theory of the ﬁrm has been formulated within the ‘mainstream’ of economics, both past and present. As to a break point between the periods, 1970 is a convenient, if not entirely accurate, dividing line. The major difference between the theories of the past and the present, as they are conceived of here, is that the focus,in terms of the questions asked in the theory, of the post-1970 literature is markedly different from that of the earlier (neoclassical) mainstream theory.The questions the theory seeks to answer have changed from being about how the ﬁrm acts in the market, how it prices its outputs or how it combines its inputs, to questions about the ﬁrm’s existence, boundaries and internal organisation. That is, there has been a movement away from the theory of the ﬁrm being seen as developing a component of price theory, namely issues to do with ﬁrm behaviour, to the theory being concerned with the ﬁrm as a subject in its own right. Past and Present of the Theory of the Firm ### Economists are still abandoning principle On December 3rd 2008 Oliver Hart and Luigi Zingales published an article in the Wall Street Journal under the title "Economists Have Abandoned Principle" with the subtitle "Twelve months ago nobody could have imagined government interventions we now take for granted". I reread the article yesterday and was left wondering just how different the article would be if written now. I suspect - unfortunately - that there would be few if any changes. Hart and Zingales wrote, This year will be remembered not just for one of the worst financial crises in American history, but also as the moment when economists abandoned their principles. There used to be a consensus that selective intervention in the economy was bad. In the last 12 months this belief has been shattered. Practically every day the government launches a massively expensive new initiative to solve the problems that the last day's initiative did not. It is hard to discern any principles behind these actions. The lack of a coherent strategy has increased uncertainty and undermined the public's perception of the government's competence and trustworthiness. The Obama administration, with its highly able team of economists, has a golden opportunity to put the country on a better path. We believe that the way forward is for the government to adopt two key principles. The first is that it should intervene only when there is a clearly identified market failure. The second is that government intervention should be carried out at minimum cost to taxpayers. How do these principles apply to the present crisis? First, the market economy provides mechanisms for dealing with difficult times. Take bankruptcy. It is often viewed as a kind of death, but this is misleading. Bankruptcy is an opportunity for a company (or individual) to make a fresh start. A company in financial distress faces the danger that creditors will try to seize its assets. Bankruptcy gives it some respite. It also provides an opportunity for claimants to figure out whether the company's financial trouble was the result of bad luck or bad management, and to decide what should be done. Short-cutting this process through a government bailout is dangerous. Does the government really know whether a company should be saved? As an example of an effective bankruptcy mechanism, one need look no further than the FDIC procedure for banks. When a bank gets into trouble the FDIC puts it into receivership and tries to find a buyer. Every time this procedure has been invoked the depositors were paid in full and had access to their money at all times. The system works well. From this perspective, one must ask what would have been so bad about letting Bear Stearns, AIG and Citigroup (and in the future, General Motors) go into receivership or Chapter 11 bankruptcy? One argument often made is that these institutions had huge numbers of complicated claims, and that the bankruptcy of any one of them would have led to contagion and systemic failure, causing scores of further bankruptcies. AIG had to be saved, the argument goes, because it had trillions of dollars of credit default swaps with J.P. Morgan. These credit default swaps acted as hedges for trillions of dollars of credit default swaps that J.P. Morgan had with other parties. If AIG had gone bankrupt, J.P. Morgan would have found itself unhedged, putting its stability and that of others at risk. This argument has some validity, but it suggests that the best way to proceed is to help third parties rather than the distressed company itself. In other words, instead of bailing out AIG and its creditors, it would have been better for the government to guarantee AIG's obligations to J.P. Morgan and those who bought insurance from AIG. Such an action would have nipped the contagion in the bud, probably at much smaller cost to taxpayers than the cost of bailing out the whole of AIG. It would also have saved the government from having to take a position on AIG's viability as a business, which could have been left to a bankruptcy court. Finally, it would have minimized concerns about moral hazard. AIG may be responsible for its financial problems, but the culpability of those who do business with AIG is less clear, and so helping them out does not reward bad behavior. Similar principles apply to the housing market. It appears that many people thought that house prices would never fall nationally, and made financial decisions based on this premise. The adjustment to the new reality is painful. But past mistakes do not constitute a market failure. Thus it makes no sense for the government to support house prices, as some economists have suggested. Where there is arguably a market failure is in mortgage renegotiations. Many mortgages are securitized, and the lenders are dispersed and cannot easily alter the terms of the mortgage. It is unlikely that the present situation was anticipated when the loan contracts were written. Government initiatives at facilitating renegotiation therefore make a lot of sense. Our desire for a principled approach to this crisis does not arise from an academic need for intellectual coherence. Without principles, policy makers inevitably make mistakes and succumb to lobbying pressure. This is what happened with the Bush administration. The Obama administration can do better. Four years on and I'm not sure just how much has really changed. Hart and Zingales were right to think that the Obama administration could have has done better, it just didn't. Policy makers, and not just in the U.S., are still acting without principles, they are still making the same mistakes and are still succumbing to lobbying pressure. But even more worrying is that some economists have yet to regain principles. Government interventions in the economy which five years ago would not have been imagined are still being taken for granted; and in some quarters even welcomed. As we know in New Zealand "economists" at BERL have argued for changing the aims of the Reserve Bank Act. But up until now the Reserve Bank's sole goal of controlling inflation has had wide support among economists. The two principles Hart and Zingales suggest deserve our attention. The first is that it should intervene only when there is a clearly identified market failure. The second is that government intervention should be carried out at minimum cost to taxpayers. Just how many of the interventions made by governments could pass the first principle is an interesting question. Genuine, as opposed to claimed, market failures are rare. And even if one is found, how many government "solutions" are ever cost minimising? Or more effective than market solutions? Government policy making would look very different in a world of Hart-Zingales principles. ## Tuesday, 11 December 2012 ### EconTalk this week Chris Anderson, author of Makers: The New Industrial Revolution, talks with EconTalk host Russ Roberts about his new book--the story of how technology is transforming the manufacturing business. Anderson argues that the plummeting prices of 3D printers and other tabletop design and manufacturing tools allows for individuals to enter manufacturing and for manufacturing to become customized in a way that was unimaginable until recently. Anderson explores how social networking interacts with this technology to create a new world of crowd-sourced design and production. ## Monday, 10 December 2012 ### Interesting blog bits 1. Stelios Michalopoulos, Alireza Naghavi and Giovanni Prarolo on Trade, geography, and the unifying force of Islam Islam spread remarkably quickly before the era of European colonialism. This column argues that an important economic factor in determining the geographic range was spatial inequality that necessitated a politically unifying force like Islam. Regions that harboured such economic inequality were especially ripe for a system like Islam that offered progressive redistributive tenets with centralised authority to enforce them. 2. Marco Annunziata on The next productivity revolution: The ‘industrial internet’ Today’s technological innovation is regarded by many as all about social media and entertainment, with no impact on economic growth. This column argues that such scepticism is premature. A closer look at selected industries suggests that the ‘industrial internet‘ – a network that binds together intelligent machines, software analytics and people – through accelerated adoption of sensors and software analytics, will have a powerful impact on productivity and growth. 3. Mario Rizzo on Interests are More Powerful than Ideas? What has changed since 1960 with regard to economic liberty? From an intellectual perspective, so many more people are aware of Ludwig von Mises, Friedrich Hayek and non-Keynesian economic thought. Milton Friedman spread his ideas about market-oriented economic policy. Thanks originally to James Buchanan and Gordon Tullock, we know again about public choice and rent seeking. (Somehow intellectuals had forgotten the lessons taught by James Madison and others.) Most economists are, at long last, convinced that Mises and Hayek were broadly correct about socialist calculation. And yet government is more involved in more aspects of the economy, by far, than in 1960. 4. Winton Bates asks Can happiness surveys predict the desire to migrate? The Gallup organization has found in its surveys that about 15 per cent of the world’s adults would like to move to another country permanently if they had the chance. The rate varies substantially between different parts of the world, with about 38 per cent of adults in Sub-Saharan African countries saying that they would like to move permanently if they were able. About 80 per cent of those who wish to leave low-income countries would like to go to high-income countries, with the United States the most popular destination in terms of absolute numbers. The desire to move tends to be higher in countries with medium to low human development, according to the UN’s Human Development Index. 5. John Taylor on Recent Books to Read on Rules-Based Money For a respite from the saga of the fiscal cliff why not read some of the latest books on monetary economics and policy? Below is a list of books on money published in 2012 which I found to be interesting and provocative. You can find a common theme in these books: that poor economic performance provides convincing evidence of the need for a sound rules-based monetary policy. But you can also find disagreement about how to achieve such a policy with proposals for interest rate rules, money growth rules, fixed exchange rate systems, nominal GDP targeting, and gold and commodity standards. Though my favorite is a simple interest rate rule (also discussed in this book on the Taylor rule), one can learn a lot by studying the case for other rules 6. Anton Howes on Out-innovate the state Even in the face of high taxes, borrowing and debt, the history of modernity gives us every reason to be optimistic. Economic growth and the rise in living standards since around 1780 has been immense. In Britain, not even accounting for improvements in the quality and choice of consumer products, the average person is 1500% wealthier than their ancestor in 1780. Crucially, this progress has been the result of sustained innovation, increasing the productivity of existing processes and products, and displacing the markets for old goods with newer and better substitutes in a process of creative destruction. Perhaps more importantly however, innovation is also able to displace government provision and restriction of certain goods. ### The Economist’s Greg Ip on economics reporting As Canterbury is starting up its journalism program again this interview with The Economists's Greg Ip could be of use to would be economics journalists. Ip is the U.S. economics editor for The Economist and a keen observer of the intersection of business and policy. An award-winning journalist, he was a longtime writer for The Wall Street Journal, where he served as chief economics correspondent in Washington, D.C.. He is author of the The Little Book of Economics: How the Economy Works in the Real World, a useful primer for young journalists — and anyone wanting to improve his or her economic literacy. And to be fair most journalist need to improve their economic literacy! Part of the interview reads: JR: What are some pitfalls that young economics reporters should watch out for? Greg Ip: Let’s cover a few things that are especially important for journalists. Number one is the failure to consult the original source. It is amazing how many times you can read something, for example, in a news report or blog post and think you know what they’re saying, and then you just quote it – maybe changing a word or two. And then you realize you’ve completely misinterpreted it. As often as possible, you need to go to the original material. For example, if someone is talking about the unemployment numbers, don’t just quote from somebody’s news article. Go to the Bureau of Labor Statistics itself. You’d be surprised at how often, looking at the raw data itself, the numbers are saying something different than you thought. And you often find something that you didn’t realize before in the numbers. Also, be careful when you’re quoting a policymaker – for example, when the President addresses the country or gives an interview or makes off-the-cuff remarks at an event. Sometimes only one sentence or two will make it into the news. But when you consult the entire context of what was said it’s often a lot more interesting, and the context makes what was said very valuable. By the way, that’s true in all journalism, not just economic journalism JR: What about specific errors to be mindful of? Greg Ip: People often confuse levels and rates of change. For example, people will often say, “Inflation rose last month by 1.7 percent.” What they meant was prices rose 1.7 percent. Inflation is itself a measure of a rise or fall. So inflation is 1.7 percent. That issue to a lot of people isn’t intuitive. You see similar misunderstandings when people talk about the debt and the deficit, or the difference between a stock and a flow. So you can have a debt one year and a surplus at the same time. How is that possible? It’s because you started with a debt of$100, then had an annual surplus of $2, so you end the year with a debt of$98. If you started with a debt of $100 and you ran a deficit of$2, you’d end up with a debt of $102. You need to understand these differences. You need to think like an economist. Any time anyone says something is bad, the immediate question you should ask is: Relative to what? It’s very important, for example, in assessing the President’s economic program. So someone says, “The economy is bad.” Well, relative to what? Relative to what it would have been? Relative to another country? These are important questions to ask because they help you think through the implications of what you’re saying. Just to give another example: The President says, “Oil and gas production are at record highs.” Well, relative to what? Relative to what they would have been if you weren’t President? Then you realize it is mostly driven by private exploration and development on private land. If you look at production on federal land, it’s down. But then President Obama could himself say, “Relative to what?” Because as it turns out, some of the deposits on federal land are very old and are being tapped out. Also, because of the Macondo oil spill in 2010, there was a drilling moratorium. So, whenever someone asserts something – especially a partisan – the question is “Relative to what?” That is why when people say, “The debt is at a record level!”, you should ask that question. Economists know that you do not just look at the debt and say, “Well, it was$100 last year and it’s at \$102 this year. It’s at a record level –that’s terrible!” That’s up 2 percent. If GDP grew 3 percent over the same period, then debt relative to GDP went down. And that is the metric we should be looking at.

Another question journalists should ask is: “What is happening at the margin?” People will say that the housing market is in really bad shape – look at all those foreclosures, look at all those vacancies. But if at the margin each new month of data tells us the number of foreclosures has gone down and the number of homes for sale has decreased, you say, “Yes, things are bad, but at the margin things are getting better.” This is very important if you cover the financial markets, because they care intensely about what is happening at the margin. It is always the case that the stock market turns around while the economy is still in recession. Why is that? Because investors are interested in what is happening at the margin. Does the latest information we have indicate that things will be better a year from now or worse?
This question I think is interesting. I wonder how many journalists in New Zealand have a list of contracts they can approach on a particular issue and how many have ever read an actually academic paper to see whats it's about?
JR: You speak with a lot of academic economists. How do you approach experts and interact with them in an effective way? Do you read their papers? How do you prepare?

Greg Ip: There are probably two ways I approach academic experts. Number one: There’s a stable of people I’ve known for years who I always say, “This is a person I want to turn to when I have a question about such and such.” In international trade, for example, I might turn to Doug Irwin at Dartmouth, because no one knows international trade better than Doug. I trust the guy, and he’s not biased. And he’s the first person a lot of other reporters would call about the same thing. If I have a question about economic history, I’ll call Peter Rousseau at Vanderbilt or Michael Bordo at Rutgers. If I have a question about taxes, one of the first people I’ll often call is Alan Auerbach at Berkeley. He’s a highly credible academic, and I’m pretty sure I’ll get a good answer from him.

Number two: when I get into more specialized areas, I’ll often come across a piece of research which is new and I’ll not know the authors. So the first thing I’ll do is read the paper. Then I’ll go to that academic’s website. Almost all academics now have home pages, where they will not only have copies of their research, they’ll also have commentaries and popular writings which are easier for non-specialists to read and get the basic understanding.

## Saturday, 8 December 2012

### Deck The Halls With Macro Follies

Another fun econ video from Econ Stories:

## Friday, 7 December 2012

### Keen still keen on attacking standard micro (updated)

Steve Keen has a another paper out on Debunking the theory of the firm—a chronology. Its by Keen and Russell Standish and appeared in issue 53 of Real-world Economics Review (never heard of it).

Matt Nolan and myself have commented on Keen's analysis before, see here. Remember that Keen's claim is that the standard (textbook) analysis of the competitive model is mathematically wrong, and if one does the math correctly, one finds that the competitive equilibrium and the collusive outcome are the same. He argues that his results follow from standard textbook assumptions, and that all other economists have simply gotten the maths wrong (I'm not sure how likely this last bit is. Many of the economists who have gotten it wrong, starting from Cournot and Marshall, have been trained as mathematicians.).

Chris Auld has a new post up at ChrisAuld.com which notes that Steve Keen still butchering basic microeconomics. Chris writes,
A “competitive” firm in economic theory is one which takes prices as given, ignoring the effect of its own output on price. This is an assumption, not a result. Keen notes, correctly, that this assumption is false when there are a finite number of firms. Suppose demand is given by P(Q), where P is price and Q is the total output of all firms. Consider any one firm, which without loss of generality I will call firm 1 (same as firm $i$ in Keen’s paper), let $q_1$ denote that firm’s output, and let $R(q_1)$ denote the total output of the rest of the the firms, which in general depends on $q_1$. Then we have $P(Q)=P(R+q_1)$, and, as Keen says, price must fall as $q_1$ increases if we hold R constant, since P() is by assumption decreasing in its argument.

Along with Keen, suppose firm 1 does not take price as given. Rather, firm 1 acts to maximize its own profits taking into account that it will fetch a lower price for each incremental unit it produces, holding constant the output of all other firms. If firm 1 produces $q_1$ units, its revenues will be $P(R(q_1)+q_1)q_1$, and its profits will then be

$P(R(q_1) + q_1) q_1 - c(q_1), \>\>\> (1)$

where $c(q_1)$ is the cost of producing $q_1$ units. What value of $q_1$ maximizes firm 1′s profits? To find that, we find how much profits change as output changes, and find the maximum by setting that derivative to zero:

$P'(R + q_1)[ R'(q_1) + 1]q_1 + P(R+q_1) - c'(q_1) = 0. \>\>\> (2)$

If we hold other firms outputs constant, as Keen claims to do, $R'(q_1)=0$ and the expression simplifies to

$P'(Q)q_1 + P(Q) = c'(q_1), \>\>\> (3)$

which is the textbook solution. “Marginal revenue” here means “how much does revenue change when $q_1$ increases by one unit?” Note that the left-hand side is firm 1′s marginal revenue and the right is firm 1′s marginal cost, so the firm equates the two to maximize profits.
Steve Keen claims that that bit of math is wrong. He claims (page 62):

However, the individual firm’s profit is a function, not only of its own output, but of that of all other firms in the industry. This is true regardless of whether the firm reacts strategically to what other firms do, and regardless of whether it can control what other firms do. The objectively true profit maximum is therefore given by the zero of the total differential: the differential of the firm’s profit with respect to total industry output.

Let’s consider that claim. Yes, firm 1′s profits in equation (1) depend on firm 1′s own output and on the output of all other firms, R. No, that does not imply that we solve firm 1′s profit maximization problem by taking the derivative of equation (1) with respect to total output. And, no, the term “total derivative” does not mean “derivative with respect to a total.” This conceptual confusion then leads Keen to incoherent math: he takes the derivative of firm 1′s profits with respect to, in the notation here, $Q = ( R + q_1 )$ (equation 0.4). That derivative isn’t defined because firm 1′s profits don’t depend solely on the sum of its own output and the output of all other firms.

The math Keen proceeds to do treats total output, $Q$, as if it’s a parameter that affects all firms’ outputs. Instead of $Q$ we could use some other symbol to denote this variable to highlight that it’s not really total output, but I will stick with $Q$. Keen treats each firm’s output as depending on this parameter Q and on the output of all other firms, so we could write

$q_1 = q_1( q_1(Q),..., q_n(Q), Q)$,

and likewise for all other firms’ outputs, to clarify what’s being assumed. Keen then asks what value of this parameter Q maximizes firm 1′s profits. Notice this problem has nothing to do with the problem we’re supposed to be considering: how does firm 1 set its own output to maximize its own profits?

The way Keen has set this up, as the parameter Q changes, a firm’s output changes for two reasons: there is a direct effect of Q on each firm’s output, and there is an indirect effect operating through the effect of Q on other firm’s outputs. Keen takes the derivative of firm 1′s profits with respect to this parameter Q. He claims to treat firms as atomistic, that is, they ignore the effect of their own outputs on other firm’s outputs, by setting the derivatives of all firms’ outputs with respect to all the other firms’ outputs to zero. But he sets the derivatives of all firms’ outputs with respect to the parameter Q to one. Since firm 1 is for some reason choosing this parameter Q, to increase its own output by one unit, it increases Q by one unit. When firm 1 increases Q by one unit, all other firms also increase their output by one unit. Keen claims repeatedly and explicitly that he assumes other firms do not respond to changes in firm 1′s output, but the math he actually does assumes otherwise.

Getting back to the problem Keen for some reason considers: How should firm 1 set Q to maximize its own profits? Take the derivative of firm 1′s profits (1) with respect to the parameter Q and set it to zero to find

$P'( R + q_1 )[ dR/dQ + dq_1/dQ]q_1 + P(\cdot) - c'(q_1)dq_1/dQ=0.$

Keen assumes that all firms including firm 1 increase their output by one unit when Q increases by one unit. Then trivially $dq_1/dQ=1$, and since there are (n-1) firms other than firm 1 and they all increase their output by one unit too, $dR/dQ = (n-1)$. The term in square brackets is then equal to (n-1) + 1 = n, and the equation above simplifies to

$P'(Q)nq_1 + P(\cdot) = c'(q_1) \>\>\> (4)$.

That is Keen’s major result, equation (0.9). It differs from the textbook result, equation (2), in that the number of firms, $n$, appears in the first term. That is, again, because as Q increases $q_1$ and all other firms’ outputs increase at the same rate in the problem Keen solves. Firm 1 then must take into account that as it increases output, price will fall much more rapidly when all other firms respond by increasing their output than when all other firms’ outputs are fixed. Keen does not solve firm 1′s problem taking all other firm’s outputs as given.

Keen insists that, if we do the math correctly, profit-maximizing firms do not equate marginal revenue and marginal cost. But equation (4), which is, again, Keen’s solution, says that the firm sets Q to equate marginal revenue (the left-hand side) with marginal cost (the right). Keen appears to think that marginal revenue is defined as the expression “P’(Q)q_i + P,” so whenever marginal revenue cannot be expressed in exactly that way, it’s not marginal revenue. All of the claims about marginal revenue not equalling marginal cost follow from that basic conceptual error. Generally, any optimization problem that can be expressed as maximizing (f(x) – g(x)) with respect to x has the property that f’(x)=g’(x) at an internal solution (assuming differentiability, etc, which Keen does), so marginal revenue equalling marginal cost is a very general condition. Keen thinks he’s arguing against the “neoclassical dogma” that equates marginal revenues and costs, but he’s actually arguing the sum rule of differentiation doesn’t hold.

We can also see that Keen implicitly assumes all firms react to changes in firm 1′s output by increasing their own output by the same amount by noting that that assumption is the same as an old-school approach to strategic interaction among firms called “conjectural variations” (Keen implies later in the paper, starting on page 74, that he invented this approach. It’s actually not just textbook, it’s outdated textbook, as it’s an approach which has been eclipsed). A “conjectural variation” of 1.0 means here that firm 1 assumes that all other firm will react to a change in $q_1$ by changing their own outputs exactly as $q_1$ changes: if firm 1 increases its output by one unit, it expects all other firms to also increase their output by one unit in response. So if $q_1$ goes up by one unit, the output of the other (n-1) firms, R, changes by (n-1) units. Consider equation (2) again, but set R’(q_1) = (n-1) instead of zero to find

$P'(Q)nq_1 + P(\cdot) - c'(q_1) = 0$,

which is exactly the same as equation (4), which, again, is the same as Keen’s equation 0.9.

Assuming conjectural variations of one is almost but not quite the same as simply assuming that firms collude. If firms collude, firm 1 would set its own output to maximize industry profits rather than its own profits, which entails setting industry marginal revenue rather than firm 1′s own marginal revenue equal to firm 1′s marginal cost. One sufficient condition for Keen’s problem to be exactly the same as assuming collusion is that we restrict attention to outcomes in which all firms produce the same amount. Call that amount q. Then firm 1′s profits can be expressed

$P(nq)q - c(q),$

and differentiating with respect to q gives

$P'(nq)nq + P = P'(Q)Q + P = c'(q),$

because total output Q is equal to nq. P’(Q)Q+P is industry marginal revenue, so this is exactly the same as simply finding the collusive outcome. Another way to see this is to note that if all firms produce the same output and have the same costs, then total profit is just n times the profit of any given firm, so maximizing any given firm’s profits is just maximizing (1/n) times total profits, so the solutions must be identical. This is just a clumsy way of solving the Econ 101 monopolist’s problem.

Steve Keen’s arguments are simply wrong.
For a more advanced version of the argument see Chris's Debunking Debunking Economics.

Update: Tim Worstall comments on Keen's piece here and Nick Rowe comments here.

### John Cochrane's Condliffe lecture

For those who could not make it.

## Thursday, 6 December 2012

### You just have to love journalists!

These headlines come via the Freakonomics blog. Thank you Stephen Dubner! Some of these are brilliant.