But Adam Smith didn't say that

In a recent posting on the death of Kenneth Arrow Tim Harford writes,

Two achievements [of Arrow's work] are particularly celebrated: his impossibility theorem about the paradoxes of social choice, and his welfare theorems, which formalised the most famous intuition in economics — Adam Smith’s idea that a market produces social good from individual selfishness.

But Adam Smith didn't say that. As the historian of economic thought Mark Blaug notes,

"[ ... ] Smith's faith in the benefits of 'the invisible hand' has absolutely nothing whatever to do with allocative efficiency in circumstances where competition is perfect a la Walras and Pareto; the effort in modern textbooks to enlist Adam Smith in support of what is now known as the 'fundamental theorems of welfare economics' is a historical travesty of major proportions. For one thing, Smith's conception of competition was, as we have seen, a process conception, not an end-state conception. For another society, a decentralised competitive price system was held to be desirable because of its dynamic effects in widening the scope of the market and extending the advantages of the division of labour - in short, because it was a powerful engine for promoting the accumulation of capital and the growth of income" (emphasis added)

In short, it's not clear to me, at least, that Smith would have been much impressed by the work of McKenzie, Debreu and Arrow et al with regard to the approach and results of general equilibrium theory. In fact, in today's terms, I often think of Smith being more Austrian-like than neoclassical-like.

Ref.

• Blaug, Mark 1996. Economic Theory in Retrospect. 5th edn. (pp. 60-1). Cambridge: Cambridge University Press.

Boudreaux on the minimum wage and free trade

Jacob Hornberger and Richard Ebeling discuss the economics of the minimum wage and free trade with Donald J. Boudreaux on the "Libertarian Angle" (from the Future of Freedom Foundation).

Bottleneckers: gaming the government for power and private profit

From the Cato Institute comes this Cato Daily Podcast in which Caleb O. Brown talks to Dick M. Carpenter II about so-called "bottleneckers" and how they restrict competition and harm the public. Brown and Carpenter of the Institute for Justice discuss Carpenter's new book, Bottleneckers.

Governments and the "war on drugs"

An interesting talk on why governments are loosing the "war on drugs". Affecting demand is more important than changing supply.

When fighting the war on drugs, governments typically devote enormous resources trying to reduce the supply. But is this effective? Journalist and author Tom Wainwright, of the Economist and author of Narconomics, talks with EconTalk host Russ Roberts about the ways that the drug cartels respond to government attempts to reduce the availability of drugs. Like any business trying to maintain profitability, cartels look for ways to cut costs and maintain or grow revenue. Wainwright uses extensive on-the-ground interviews and reporting to understand the behavior of the cartels and argues that reducing demand would be a much more effective strategy for reducing drug use.

A direct link to the audio is available here.

Some thoughts on the role of firms and government interference in the market

This is from the third instalment in (oddly named - seems more pro-state than anything) ProMarket's new interview series on the economic theory of the firm. In this instalment, they ask Chicago Booth’s Steven Kaplan how the existing theory should be modified. Kaplan is the Neubauer Family Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business.

Q: The neoclassical theory of the firm does not consider political engagement by corporations. How big an omission do you think this is?

I am a bit confused. Hasn’t the idea of regulatory capture and, implicitly, political engagement, been a subject of economic study since George Stigler’s “Theory of Economic Regulation” in 1971? In other words, it would be a big omission if, in fact, it were omitted. In reality, economists have paid attention to political engagement for a long time.

Q: To what extent is political engagement by corporations responsible for the current populist discontent?

Very little. The biggest source of populist discontent is the dislocation caused by technological change and globalization. That dislocation has made the global economy much better off overall. The global poverty rate has declined substantially. Billions of people now earn a living rather than starving. It is a huge success. As Nobel Prize winner Angus Deaton wrote, “Life is better now than at almost any time in history. More people are richer and fewer people live in dire poverty. Lives are longer and parents no longer routinely watch a quarter of their children die.” At the same time, this success has challenged the less skilled in developed countries—particularly the U.S. and Western Europe.

The second biggest source of discontent comes from the policies implemented in those countries that make it more expensive to hire less skilled workers. Raising the minimum wage, licensing rules, and other employment mandates increase the costs of hiring less skilled workers. At the same time, technology and globalization reduce the costs of substitutes. The net effect is fewer jobs. France is the best example. Germany is one of the few countries that moved in the opposite direction and has had less of an employment problem. Immigration policies also have fueled discontent.

Political engagement by corporations would be far down the list of important forces.

The basic issue being discussed is that the standard (economic) theory of the firm is silent on the role firms can play in shaping the rules of the game under which they operate. It is argued that in reality, many firms lobby politicians and try to capture regulators in order to modify the rules of the game in their favour.

What I do find strange is 1) Its not clear what exactly they mean by the "standard economic theory of the firm". At times they seem to talk about the neoclassical theory of the firm as if it is in fact a theory of the firm but has Coase pointed out many years ago it's not. If they are not talking about the neoclassical model then what are they talking about? As I have written,

While the post-1970 theory of the firm literature has began the task of developing a genuine understanding of the firm, and closely related issues, it has yet to coalesce around one model or even one group of models. Even within the contemporary mainstream there are a number of competing models, to say nothing of those we could add into the mix if we were to consider the heterodox literature.

2) I’m not sure what they are talking about is a problem with the theory of the firm, they seem to be talking more about a theory of government or regulation or pressure groups or some such thing. Yes firms can influence government policies but so can churches, trade unions, environmental groups etc as well. So I’m not sure their issue is one to do with the theory of the firm as such. 3) As Kaplan points out economists have been thinking about these issues for a long time, even if not as part of the theory of the firm. But as I say in 2) its not clear to me that it is part of the theory of the firm. It's a wider issue than to do with just firms.

A brief prehistory of the theory of the firm

A first draft of a new working paper on the (pre)history of the theory of the firm/theory of production.

The mainstream theory of the firm didn't exist until around 1970. Before then what we had was the `prehistory' of the theory of the firm. For more than two thousand years tools were available that could have given rise to a theory of the firm or, at least, a theory of micro level production, but none appeared. During this time the best that occurred were discussions of macro level or aggregate production. Given the long empirical history of and the importance to the economy of firms one may assume that economists have long been developing a detailed and sophisticated theoretical understanding of the firm but it turns out this is not the case. Up until the 1970s the development of the theory of the firm was a story of neglect and disinterest.

A brief prehistory of the theory of the firm by Paul Walker on Scribd

Seasonality and the invention of agriculture

Why was agriculture invented in one of the big questions in economic history. In a new working paper, The Ant and the Grasshopper: Seasonality and the Invention of Agriculture, Andrea Matranga argues that there is a link between seasonality and agriculture.

During the Neolithic Revolution, seven populations independently invented agriculture. In this paper, I argue that this innovation was a response to a large increase in climatic seasonality. Hunter-gatherers in the most affected regions became sedentary in order to store food and smooth their consumption. I present a model capturing the key incentives for adopting agriculture, and I test the resulting predictions against a global panel dataset of climate conditions and Neolithic adoption dates. I find that invention and adoption were both systematically more likely in places with higher seasonality. The findings of this paper imply that seasonality patterns 10,000 years ago were amongst the major determinants of the present day global distribution of crop productivities, ethnic groups, cultural traditions, and political institutions.

Tyler Cowen on Trumponomics

I still think Trumponomics won’t work. It is too divisive; it will be applied politically, targeting favorites and enemies, rather than in accord with the dictates of efficiency; it may destroy rather than create jobs on net; and most of all it badly damages the U.S.’s global reach by cooperating less on issues of trade and migration. I think of the program as a whole as cashing in on the capital asset of America’s foreign reputation and redistributing some of those rents to Trump-supporting regions. That is a form of shortsightedness, and a sign of the decay of our republic.

That's from Cowen's column, The Left Underestimates Trump's Economic Plan, at Bloomberg. While Trumponomics may very well damage the US economy we also have to keep in mind what damage it will do to the world economy. Trumps moves on trade could spark a trade war which could damage the world trading system. The last thing we need is a repeat of the Smoot-Hawley episode. No one wins a trade war.

"Silent Revolution" by The Benevolent Dictators

"Silent Revolution" by The Benevolent Dictators. The first song from the upcoming album about Adam Smith. Inspired by Book 3, Chapters 2-4 of "An Inquiry into the Natures and Causes of the Wealth of Nations" by Adam Smith.

How old is behavioural economics?

I came across an interesting paper the other day that suggests behavioural economics is older than most people think. The paper "The Relations of Recent Psychological Developments to Economic Theory" by Z. Clark Dickinson in The Quarterly Journal of Economics, Vol. 33, No. 3: 377-421 dates from May 1919!

The summary of the paper reads,

The purely objective factors in economics, 377. - Psychological principles necessarily used in addition, 381. Social assumptions, 385. - Psychical factors are human motives, 387; their analysis needed for most social problems, 389. - Adequacy of psychology assumed in economic theory in dispute, 390. - Analysis of arguments pro and con, 392. - Hedonistic foundation, 394. - Costless production, 401. - Industrial peace, 404. - Sums of utility, 406. - Social demand, 407. - Institutional economics, 409. - Most accurate psychology needed, of producers' motives, 415; of consumers' demands, 419.

Dickinson concludes,

And so our tentative conclusion is that an accurate knowledge of the psychology involved in economic behavior is needed in economic theory, not so much for static as for dynamic purposes. It is needed for static theory if we want to be assured that our static theory is as complete and fundamental an explanation as the existing state of knowledge permits. But it is vital for dynamic theory, which looks beyond the existing conditions of wants, social structures and industrial devices, and prophesies what would be the result of various supposed innovations, if they were made. In this same fashion we have long predicted the probable results of hypothetical taxes and tariffs on production, distribution, etc. If we can set up hypotheses as to ways of changing consumers' demands, or producers' springs to action, which psychological science shows to be plausible, and trace their effect on economic life, we shall be adding to the purely scientific theorems which the legislator or reformer may find helpful. And aside from the possible applications to pure economic theory, such knowledge of motives is bound to be useful in the practice of social art.

So suggesting the use of psychological ideas in economics is older than I guess most economists would think.

The populist parallels of Sanders and Trump

From the Cato Institute comes this Cato Daily Podcast in which Caleb O. Brown talks to John Samples about the parallels between Sanders and Trump.

President Donald Trump and Senator Bernie Sanders have some strong parallels in their populism.

32% off the greatest book ever written

Right now the Book Depository has 32% off The Theory of the Firm: An overview of the economic mainstream with their price being NZ$159. Actually given the publisher price is 95.00 pounds that isn't a bad price.

Those of you with a Kindle, Amazon has it at US$49.68.

Protection and job losses

At the Cafe Hayek blog Don Boudreaux makes the point that protection does not stop job losses.

You are correct that under a regime of free trade some people, through no fault of their own, lose jobs. You are also correct that such experiences are unpleasant. But protectionism does not stop job losses from occurring. Even if Uncle Sam were to completely shut the American economy off from global markets, job losses would still occur. American consumers would still change their spending patterns such that goods and services that were in high demand yesterday would be in lower demand today. Entrepreneurs would still experiment with new products and with new, labor-saving methods of production and distribution. Economic churn would still happen, complete with its unavoidable job losses.

The difference would be that, being denied access to the creative insights and productive efforts of 95 percent of the world’s population as well as to the bulk of the world’s resources, we’d all be much poorer.

What changes in trade policy do is change who has jobs, not the total number of jobs. Change trade policy and you just move jobs around the economy without having much effect on the total number of those jobs. As Paul Krugman has written,

It should be possible to emphasize [...] that the level of employment is a macroeconomic issue, depending in the short run on aggregate demand and depending in the long run on the natural rate of unemployment, with microeconomic policies like tariffs having little net effect. Trade policy should be debated in terms of its impact on efficiency, not in terms of phony numbers about jobs created or lost.

But the other point made by Boudreaux is also important, protection makes us poorer. The more we protect, the more we have to do things we are (relatively) bad at doing and the less time we spend on doing things we are good at doing. In the process we make ourselves worse off. It is better for us to concentrate on what we are good at producing and trading that for the things we are bad at producing with people who are good at producing it. As Krugman notes efficiency is what matter and by doing things we are bad at we become less efficient, not more.

Interesting graph on the relationship between US growth and the trade balance.

This graph is from the Econofact website:

You have to be very careful about causation. Does a trade deficient affect growth or does growth affect the trade balance or do third factors affect both?

It is true that when a country's Gross Domestic Product (GDP) is calculated, a trade deficit counts as a negative. But this is a matter of accounting.

By definition, GDP measures the value of the goods and services produced within a country's borders. To tally GDP we take the sum of what households consume, investment by firms and government spending and account for trade by adding what is produced in the nation but consumed abroad (exports) and deducting the value of imports. The (faulty) idea of a “trade deficit drag” comes from this accounting identity – if the difference between exports and imports is large, then a larger number is subtracted from what households, firms and the government consume and the resulting GDP number must be smaller as well.

But this does not mean that a trade deficit causes GDP to be smaller.

The flaw in this logic is that both the trade deficit and GDP are outcomes of other, underlying factors. For this reason, there is no simple, straightforward link between the size of the trade deficit and the level of overall economic activity as measured by GDP. Consider a case where the United States has a spurt of growth due to, say, an increase in infrastructure spending. This spending will raise incomes and, therefore, consumption – including consumption of imported goods. This would be a situation where faster growth is associated with an increase in the trade deficit. Alternatively, the trade deficit could very well decline when there is a recession that reduces consumption of all goods, including imports.

A two minute video in which Nobel Laureates give advice to President Donald J. Trump

Patents, prizes and innovation

The use of patents versus prizes to stimulate innovation is a long debated subject. Jean Tirole has written,

"Consider the patent system. It has long been recognized that patents are an inefficient method for providing incentives for innovation since they confer monopoly power on their holders. Information being a public good, it would be ex post socially optimal to award a prize to the innovator and to disseminate the innovation at a low fee. Yet the patent system has proved to be an unexpectedly robust institution. That no one has come up with a superior alternative is presumably due to the fact that, first, it is difficult to describe in advance the parameters that determine the social value of an innovation and therefore the prize to be paid to the inventor, and, second, that we do not trust a system in which a judge or arbitrator would determine ex post the social value of the innovation (perhaps because we are worried that the judge might be incompetent or would have low incentives to become informed, or else would collude with the inventor to overstate the value of the innovation or with the government to understate it). A patent system has the definite advantage of not relying on such ex ante or ex post descriptions (although the definition of the breadth of a patent does) " Jean Tirole, "Incomplete Contracts: Where Do We Stand?" Econometrica, Vol. 67, No. 4 (Jul., 1999), pp. 741-781.

Another round in the debate is about to open with a new NBER working paper on the topic of Prestige and Profit: The Royal Society of Arts and Incentives for Innovation, 1750-1850.

"Debates have long centered around the relative merits of prizes and other incentives for technological innovation. Some economists have cited the experience of the prestigious Royal Society of Arts (RSA), which offered honorary and cash awards, as proof of the efficacy of innovation prizes. The Society initially was averse to patents and prohibited the award of prizes for patented inventions. This study examines data on several thousand of these inducement prizes, matched with patent records and biographical information about the applicants. The empirical analysis shows that inventors of items that were valuable in the marketplace typically chose to obtain patents and to bypass the prize system. Owing to such adverse selection, prizes were negatively related to subsequent areas of important technological discovery. The RSA ultimately became disillusioned with the prize system, which they recognized had done little to promote technological progress and industrialization. The Society acknowledged that its efforts had been “futile” because of its hostility to patents, and switched from offering inducement prizes towards lobbying for reforms to strengthen the patent system. The findings suggest some skepticism is warranted about claims regarding the role that elites and nonmarket-oriented institutions played in generating technological innovation and long-term economic development".

So maybe prizes did not stimulate innovation and possibly patents were more effective. But I'm sure this will not be the last thing we hear on this topic.

The Marshalls (Alfred and Mary) on farming

In the past I have discussed the theory of the farm explaining why farming is one of the few areas left in the economy still dominated by family businesses. The standard argument as to why this is so is given by Allen and Lueck (1998, 2002).

The is key to understanding why so is that the incentives generated within agriculture favour family farms. The two basic issues are opportunities for hired workers to shirk due to random production shocks from nature and the limits on the gains from specialisation and the timing problems caused by seasonality. The trade-off between effect work incentives and gains from specialisation help determine the costs and benefits of different farm organisational types.

The abstract from Allen and Lueck reads:

Using a model based on a trade-off between moral hazard incentives and gains from specialization, this paper explains why farming has generally not converted from small, family-based firms into large, factory-style corporate firms. Nature is both seasonal and random, and the interplay of these qualities generates moral hazard, limits the gains from specialization, and causes timing problems between stages of production. By identifying conditions in which these forces vary, we derive test able predictions about the choice of organization and the extent of farm integration. To test these predictions we study the historical development of several agricultural industries and analyze data from a sample of over 1,000 farms in British Columbia and Louisiana. In general, seasonality and randomness so limit the benefits of specialization that family farms are optimal, but when farmers are successful in mitigating the effects of seasonality and random shocks to output, farm organizations gravitate toward factory processes and corporate ownership.

Allen and Luecks's paper is relatively recent, 1998, so this all looks modern using new ideas to so with contracting to explain family farms. But is it so? A week or so ago I was reading Alfred and Mary Marshall's “The Economics of Industry” published 1879 when I came across the following on pages 57-58:

§ 11. The largest industry is that of agriculture; but there is scarcely any other industry which is able to make so little use of the advantages of division of labour and of production on a large scale. For agricultural labourers cannot be grouped together in large masses ; they must be scattered over the country. And each season of the year has its special work: a man cannot spend his life in reaping. So that the work of agriculture cannot be broken up into a vast number of parts each of which is performed by a band of labourers who devote their lives to acquiring a special skill in this class of work.

Agriculture, however, seems to be following in the steps of manufacture. Field steam-engines are becoming common, and new machines to be worked by them or by horse power are appearing in rapid succession. The fields demand every day a smaller number of dull labourers and a greater number of intelligent mechanics.

This change is exercising an important influence in the competition between small and large farms. The small farmer cannot always afford to have a field steam-engine; he cannot afford to have a great number of machines for occasional use. Thus every year puts him at a greater disadvantage relatively to the large farmer. This disadvantage is diminished but not removed by the rapid growth of a subsidiary industry, which undertakes steam ploughing threshing, &c. for farmers, The growth of this industry is the most important step towards obtaining the advantages of division of labour that has ever been made by agriculture.

In comparison with a small farmer a large farmer gains something in economy of buildings, and in economy of materials. He is able to have a better rotation of crops; he can send a great many labourers into a field in which there is anything to be done quickly. He can, as a rule, borrow capital from the banks more easily than a small farmer can. Lastly, the large farmer is likely to have more knowledge and greater skill and enterprise than the small farmer, He probably received· a better education at starting; and he can afford to leave to subordinates much work that the small farmer does himself, so that he has more time and opportunity for increasing his knowledge, And as farms change hands from time to time, the ablest farmers are likely to find their way to the largest farms. Thus the economy of skill is carried further under a system of large, than under one of small, farms. On the other hand the large farmer loses in the matter of superintendence. The small farmer works hard himself: he watches for every trifling gain and every small saving: and those who work under him have little opportunity of being idle or dishonest.

Its often said that in the late 1800s-early 1900s the answer to any student's question about economics was "It's all in Marshall". Well it appears it is!

Refs.:

• Allen, Douglas W. and Dean Lueck (1998). "The Nature of the Farm", Journal of Law and Economics, 41: 343-86.
• Allen, Douglas W. and Dean Lueck (2002). The Nature of the Farm: Contracts, Risk, and Organization in Agriculture, Cambridge Mass.: The MIT Press.

Trump and trade: threatening Toyota via twitter

More on the wacky world that is Donald Trump and trade. From the Cato Institute comes this Cato Daily Podcast in which Caleb O. Brown talks to Simon Lester about Trump threatening companies.

Can the specter of a President-elect threatening companies with punitive taxes really make the U.S. a better place to invest?

Now this is just wacky

In the UK the Labour Party Leader Jeremy Corbyn has suggested setting a maximum earning limit or, effectively, a marginal tax rate of 100%. Here is a two minute video in which Institute of Economic Affairs Director General Mark Littlewood explains why such a 'maximum wage policy' is economically and socially a terrible idea - and why such a policy would even stand to hurt Corbyn's own agenda.

The most obvious point is that high income earners, who are very mobile, just get up and leave the UK or cut back on the work they do. Littlewood makes this point with the example of footballers in the UK. This would reduce the amount of tax that the government gets from high income earners, not increase it. You must also wonder what effect it would have in the long-run on innovation and growth.

Trump and trade: the protectionist triumvirate

From the Cato Institute comes this Cato Daily Podcast in which Caleb O. Brown talks to Daniel J. Ikenson and Daniel J. Mitchell about Trump and trade:

With Wilbur Ross at Commerce, Peter Navarro at the new National Trade Council, and Robert Lighthizer as U.S. Trade Representative, Donald Trump has assembled a team aimed at protecting U.S. industry from competition.

Let the data speak?

From twitter comes these tweets from Modeled Behavior (Adam Ozimek) @ModeledBehavior

People who think that data never "speaks" and the researcher can get basically any result haven't spent enough time doing empirical research

— Modeled Behavior (@ModeledBehavior) January 8, 2017

Point is, it's true that sometimes the data whispers and we must rely on our ability to hear clearly. But sometimes the data screams.

— Modeled Behavior (@ModeledBehavior) January 8, 2017

and my response

@ModeledBehavior "If you torture the data enough, nature will always confess." Coase. You would scream too if you were being tortured.

— GrumpyMcGrumpyface (@psw1937) January 8, 2017

The Coase quote comes from the third G. Warren Nutter Lecture -- "How Should Economists Choose?" -- which Coase delivered at the American Enterprise Institute for Public Policy Research, Washing­ton, D.C., on November 18, 1981.

But its not the full quote,

I remarked earlier on the tendency of economists to get the result their theory tells them to expect. In a talk I gave at the University of Virginia in the early 1960s, at which Warren Nutter was, I think, present, I said that if you torture the data enough, nature will always confess, a saying which, in a somewhat altered form, has taken its place in the statistical literature. Kuhn puts the point more elegantly and makes the process sound more like a seduction: "nature undoubtedly responds to the theoretical predispositions with which she is approached by the measuring scientist."

A little before this quote Coase had said,

Other studies take the form of a test of the theory espoused by the author: there is a model, then regressions, followed by conclusions. In almost all cases it will be found that the statistical results confirm the theory. Sometimes it does happen that some of the expected relationships are not statistically significant, but they will usually be found to be in the right direction. And when results are obtained that do not square with the theory, which occasionally happens, these results are not usually treated as invalidating the theory but are left as something calling for further study. I would not claim that such studies have never led the investigators to modify their theories, but such cases appear to be rather uncommon. Some articles, of course, involve the testing of alternative theories, and this means that some theories are bound to come out worse. But I doubt whether such studies have often led to a change in the views of the authors. My impression is that these quantitative studies are almost invariably guided by a theory and that they may most aptly be described as explorations with the aid of a theory. In almost all cases, the theory exists before the statistical investigation is made and is not derived from the investigation.

Coase goes on to say,

Quantitative studies, or qualitative studies for that matter, may give someone who believes in a theory a better idea of what that theory implies. But such studies, normally quantitative in the natural sciences and increasingly so in economics, also play, as Kuhn indicates, another and very important role. The choice economists face is a choice between competing theories. These studies, both quantitative and qualitative, perform a function similar to that of advertising and other promotional activities in the normal products market. They do not aim simply at enlarging the understanding of those who believe in the theory but also at attracting those who do not believe in it and at preventing the defection of existing believers. These studies demonstrate the power of the theory, and the definiteness of quantitative studies enables them to make their point in a particularly persuasive form. What we are dealing with is a competitive process in which purveyors of the various theories attempt to sell their wares.

Coase then quotes Dan Patinkin:

What generates in me a great deal of skepticism about the state of our discipline is the high positive correlation be­tween the policy views of a researcher (or, what is worse, of his thesis director) and his empirical findings. I will begin to believe in economics as a science when out of Yale there comes an empirical Ph.D. thesis demonstrating the suprem­acy of monetary policy in some historical period and out of Chicago, one demonstrating the supremacy of fiscal policy.

I have always thought there is too much truth in Patinkin's remark.

Coase comments,

Assuming that Patinkin is right and that the empirical findings of economists at Yale and Chi­cago are not the same, this undoubtedly reflects a difference in their view about how the economic system operates, a difference, that is, in the theories espoused at the two universities.

So empirical results are made to fit the theory?

And,

But there are motives for selecting one theory rather than anotherthat are more worrying, and I think it was this concern that lay behind Patinkin's somewhat facetious remark. In public discussion, in the press, and in politics, theories and findings are adopted not to facilitate the search for truth but because they lead to certain policy conclusions. Theories and findings become weapons in a propaganda battle.

To give some perspective on Coase's whole argument, it should be noted that the point of Coase's lecture was to argue against the position Milton Friedman took in his essay "The Methodology of Positive Economics".

Many economists, perhaps most, think of economics as the science of human choice, and it seems only proper that we should examine how economists themselves choose the theories they espouse. The best-known treatment of this question is that of Milton Friedman, who, in the "Methodology of Positive Economics," his most popular paper, in itself a somewhat suspicious circumstance, tells us "how to decide whether a suggested hypothesis or theory should be tentatively accepted as part of " the positive science of economics. As you all know, the answer he gives is that the worth of a theory "is to be judged by the precision, scope, and conformity with experience of the predictions it yields .... The ultimate goal of a positive science is the development of a 'theory' or 'hypothesis' that yields valid and meaningful ... predictions about phenomena not yet observed.

I should say at once that I do not consider Milton Friedman's answer satisfactory.

[ ... ]

The view that the worth of a theory is to be judged solely by the extent and accuracy of its predictions seems to me wrong. Of course, any theory has implications: it tells us that if something happens, something else will follow, and it is true that most of us would not value the theory if we did not think these implications corresponded to happenings in the real economic system. But a theory is not like an airline or bus timetable. We are not interested simply in the accuracy of its predictions. A theory also serves as a base for thinking. It helps us to understand what is going on by enabling us to organize our thoughts. Faced with a choice between a theory which predicts well but gives us little insight into how the system works and one which gives us this insight but predicts badly, I would choose the latter, and I am inclined to think that most economists would do the same. No doubt it would be their belief that ultimately this theory would enable us to make predictions about what would happen in the real world; but since these predictions would emerge at a later date (and probably would also be about different things), to assert that the choice between theories depends on their predictive powers becomes completely ambiguous.

Managing political risk

At the, oddly named, Pro-Market blog Roy Shapira posts about a recent working paper that suggests that firms react to political risk, both passively by cutting investment and employment, and actively by ramping up lobbying efforts.

Shapira writes,

In a recent working paper titled Aggregate and Idiosyncratic Political Risk: Measurement and Effects, Chicago Booth professor Tarek Hassan and co-authors Stephan Hollander, Laurence van Lent, and Ahmed Tahoun employ an innovative methodology to try to narrow the gap in our ability to measure political risks and how firms react to them. Their findings suggest that firms do indeed react to political risk, both passively by cutting investment and employment, and actively by ramping up lobbying efforts. (Emphasis added)

But isn't this exactly what we would expect? Isn't this the outcome that regime uncertainty would tell us we should expect? The whole point of regime uncertainty is that if investors can not be sure as to how future government actions will effect their property rights and their returns to investment they will be hesitant to make long-term commitments. In other words firms cut back on investment and employment. Decisions about such variables are highly sensitive to risk in various forms, including uncertainty over future tax and regulatory policy. One obvious way to deal with such uncertainty is to lobby the government. If you have input into the policy making process you can gain knowledge of any future polices, thereby reducing uncertainty, and also try to influence the policy agenda in ways that are beneficial to your particular industry.

Interview with Jon Elster

An interesting, if too short, interview with Jon Elster (2016 Johan Skytte Prize Winner).


Interview with Jon Elster (2016 Johan Skytte Prize Winner) from The Johan Skytte Prize on Vimeo.

Liquor control and homicide

Howard Bodenhorn, of Clemson University, has a new NBER working paper out on Blind Tigers and Red-Tape Cocktails: Liquor Control and Homicide in Late-Nineteenth-Century South Carolina, NBER Working Paper No. 22980, issued in December 2016..

The abstract reads,

In 1893 South Carolina prohibited the private manufacture, transportation, and sale of alcohol and established a state monopoly in wholesale and retail alcohol distribution. The combination of a market decline in the availability of alcohol, reduced variety, and monopoly pricing at state-operated outlets encouraged black markets in alcohol. Because black market participants tend to resort to extra-legal mechanisms for dispute resolution, including violence, one result of South Carolina’s alcohol restriction was an increase in homicide. A continuous-treatment difference-in-difference approach reveals that homicide rates increased by about 30 to 60 percent in counties that more vigorously enforced the law.

Now while the conclusions of the paper are interesting in and of themselves I can't help but think that such results should give supporters of the current "War on Drugs" pause for thought. I mean what are the chances that the war on drugs has helped enforce a black market for drugs involving a recourse to violence to settle disputes and thus an increase in homicides? This is in addition to the violence inherent in the actions of authorities fighting the war on drugs.

The legacy of Frank Ramsey

A short video from the Royal Economic Society about the legacy of the mathematician Frank Ramsey. A man few have heard of but who has had a huge influence on economics.

Frank Ramsey was an economist who died in 1930 aged just 26. But his remarkable research lives on - in the 125th anniversary edition of The Economic Journal he has not one but two articles. Orazio Attanasio discusses the ongoing influence of his work.

Trump's 100-Day Plan

Donald Trump has a 100 day plan (pdf) which includes "Seven actions to protect American workers" (see below).

With regard to this plan The University of Chicago Booth School of Business Economic Experts Panel was asked the question,

Question A: If all of the “Seven actions to protect American workers” in President-elect Trump’s 100-day plan (see link) are enacted, it will more likely than not improve the economic prospects of middle-class Americans over the next decade.

The responses to the question were,

In addition the panel were asked,

Question B: If all of the “Seven actions to protect American workers” in President-elect Trump’s 100-day plan are enacted, it will more likely than not improve the economic prospects of low-skilled Americans over the next decade.

The responses to this question were,

So in answer to the first question zero percent of respondents "Strongly Agree" or "Agree" while in answer to the second question zero percent "Strongly Agree" and two percent "Agree".

Not exactly overwhelming support for the President-elect's plan. For the sake of middle-class and low-skilled Americans you have to hope the economists are wrong. It just doesn't look that likely to me. I don't see how anything good can come of the First, Second and Third of Trumps actions. As many people have already pointed out trade is good for American, restricting it will only hurt the very people Trump claims he wants to help. As action Four, what exactly is a foreign trading abuse? In the eye of the beholder? As to the Firth, Sixth and Seventh actions I suspect that the devil is in the detail.  The outcome will depend on exactly what policies he puts in place to achieve the end.

Why you don’t have to worry about the trade deficit

From the Marketplace website comes this audio in which Doug Irwin, Jeff Frankel and Margaret McMillan explain why you don't have worry about the trade deficit.

Just before the holidays, President-elect Donald Trump announced he would create something called the National Trade Council to promote U.S. manufacturing. Trump named Peter Navarro, an ardent China critic, to lead the office. Trump and Navarro also share another passion: an aversion to trade deficits. A trade deficit means that the U.S. imports more goods and services than it exports. We've run one every year since 1974. To most economists, that's not a big concern.

Nobel Prize-winning thoughts on incentives and the importance of contracts

On NPR's Morning Edition Steve Inskeep talked to Bengt Holmstrom of MIT, who was one of the winners of the 2016 Nobel Prize in economics.

Perhaps a fitting piece of research to end the year on

A new NBER working paper on Depression for Economists by Jonathan de Quidt and Johannes Haushofer, NBER Working Paper No. 22973, issued in December 2016.

No its not about depressed economists, although recent events are enough to make any economist - especially trade economists - depressed, but rather the economic causes and effects of depression.

Major depressive disorder (MDD) is one of the most prevalent mental illnesses worldwide. Existing evidence suggests that it has both economic causes and consequences, such as unemployment. However, depression has not received significant attention in the economics literature. In this paper, we present a simple model which predicts the core symptoms of depression from economic primitives, i.e. beliefs. Specifically, we show that when exogenous shocks cause an agent to have pessimistic beliefs about the returns to her effort, this agent will exhibit depressive symptoms such undereating or overeating, insomnia or hypersomnia, and a decrease in labor supply. When these effects are strong enough, they can generate a poverty trap. We present descriptive evidence that illustrates the predicted relationships.

But I can't help but think this is, to a degree at least, reinventing the wheel. I'll bet that psychologists have been looking at such things for years.

Why are there still so many jobs?

Here's a paradox you don't hear much about: despite a century of creating machines to do our work for us, the proportion of adults in the US with a job has consistently gone up for the past 125 years. Why hasn't human labor become redundant and our skills obsolete? In this talk about the future of work, economist David Autor addresses the question of why there are still so many jobs and comes up with a surprising, hopeful answer.

Thomas Sowell: so long, and thanks for all the fish

At age 86, Tom Sowell has decided he has better things to do with his time than write magazine columns and so he has retired as a regular columnist. His final column is here. Sowell writes,

Even the best things come to an end. After enjoying a quarter of a century of writing this column for Creators Syndicate, I have decided to stop. Age 86 is well past the usual retirement age, so the question is not why I am quitting, but why I kept at it so long.

It was very fulfilling to be able to share my thoughts on the events unfolding around us, and to receive feedback from readers across the country — even if it was impossible to answer them all.

Being old-fashioned, I liked to know what the facts were before writing. That required not only a lot of research, it also required keeping up with what was being said in the media.

During a stay in Yosemite National Park last May, taking photos with a couple of my buddies, there were four consecutive days without seeing a newspaper or a television news program — and it felt wonderful. With the political news being so awful this year, it felt especially wonderful.

Sowell notes the advances that have been made in terms of material welfare during his lifetime,

In material things, there has been almost unbelievable progress. Most Americans did not have refrigerators back in 1930, when I was born. Television was little more than an experiment, and such things as air-conditioning or air travel were only for the very rich.

My own family did not have electricity or hot running water, in my early childhood, which was not unusual for blacks in the South in those days.

It is hard to convey to today's generation the fear that the paralyzing disease of polio inspired, until vaccines put an abrupt end to its long reign of terror in the 1950s.

Most people living in officially defined poverty in the 21st century have things like cable television, microwave ovens and air-conditioning. Most Americans did not have such things, as late as the 1980s. People whom the intelligentsia continue to call the "have-nots" today have things that the "haves" did not have, just a generation ago.

The effects of economic growth can be dramatic and welcome, and those who are anti-growth, for whatever reason, should keep this in mind.

Realignment: The future of British politics

May be not just UK politics but New Zealand politics, at least to some degree, as well. The idea that in the future politics will not be divided by 'left vs right', but rather by 'nationalism vs liberalism' is one worth considering.

In this audio excerpt from a lunchtime lecture, Dr Steve Davies - Head of Education at the Institute of Economic Affairs - outlines his predictions for the realignment of the UK political parties over the next decade.

The lecture, which took place on September 27th 2016, foreshadowed the Conservative Prime Minister's party conference speech, which showed signs of Steve's prediction that the future of politics will not be divided by 'left vs right', but rather by 'nationalism vs liberalism'.

The fall and fall of Soviet agriculture or why small is sometimes beautiful

In chapter 4 of his recent book “Was Communism Doomed?: Human Nature, Psychology and the Communist Economy" psychologist Simon Kemp outlines the mostly sorry tale of Soviet agriculture. He sums the Soviet experience up by saying,

Overall, Soviet agriculture was not a great success story.

The question raised by this is, Why?

Kemp gives his answer is chapter 8 of his book on “Psychological Ownership”. Kemp notes that agriculture does not require a large organisation. Kemp writes,

Economies of scale are not always important in agriculture. When Stalin initiated the brutal collectivisation of Soviet agriculture, he appears to have done so with the genuine belief that in the long run the larger units would prove more productive. As we have seen, this increase in productivity did not happen [see chapter 4 of Kemp's book]. In part, this is because agriculture does not always benefit from concentrated large-scale production.

Owner-operator (family) farms are still in most countries, including New Zealand, the standard organisation for agricultural production. Why this is so is a question relevant for why collective farms failed. After all collective farms were designed more along large scale industry lines than small scale family lines.

The short economic answer to this question is, I would argue, given by Allen and Lueck (1998). They argue that farms operate in unique circumstances defined by nature, in particular seasonality. This is the main feature that distinguishes farm organisation from industrial organisation. For farmers a season is a distinct period of the year during which a given activity is optimally undertaken.

This is key to understanding the why the incentives generated within agriculture favour family farms. The two basic issues are opportunities for hired workers to shirk due to random production shocks from nature and the limits on the gains from specialisation and the timing problems caused by seasonality. The trade-off between effect work incentives and gains from specialisation help determine the costs and benefits of different farm organisational types.

The family farm model provides the best work incentives since the owner is the sole recipient of the benefits, but this model misses some benefits due to specialisation. This follows from the fact that the farmer must engage in numerous different tasks during each stage of production, and in addition, numerous production stages throughout the year.

On the other hand, large factory-style corporate farms gain from a specialised labour force and lower cost of capital, but suffer from bad worker incentives since hired workers, not being one of the owners, have an increased incentive to shirk.

To some degree all firms are governed by the trade-off between gains from specialisation and work incentives. For the case of farming it is the unique, large impact of nature that biases it towards family operations.

An obvious, but key, feature of agriculture is that it involves a living, growing product. In the case of livestock, for example, you have breeding, husbandry, feeding and slaughter. Such a cycle is largely governed by nature. In principle there is no reason that a different farmer could not own each stage. But timing difficulties between stages result in high costs of engaging in market transactions. Such timing issues are particularly severe in farming because the inventories of the intermediate goods cannot be held given the living nature of the product.

There are a number of factors, such as the number of crop cycles, the length of the production stages and the number of tasks within a stage, which also influence wage labour incentives. When cycles are few, stages are short, random shocks are large and the tasks are few, there is little to gain from specialisation and labour is especially costly to monitor. Thus family farms.

If these issues can be overcome, that is, if farmers can mitigate seasonality and random shocks to output, farm organisation starts to look much like that in the rest of the economy. Under such conditions farm organisation will gravitate towards factory process and develop the large-scale corporate forms of other sectors of the economy. So larger more industrial looking farms may work.

But right now, small it seems really is beautiful.

Ref.:

• Allen, Douglas W. and Dean Lueck (1998). "The Nature of the Farm", Journal of Law and Economics, 41: 343-86.

The enviromental costs of Christmas trees: real vs. artificial

I'm guessing this is the big question in environmental economics. Timothy Taylor takes a look at the issue at his Conversable Economist blog. He writes,

One artificial tree used for one year has greater environmental impact than one natural tree. However, an artificial tree can also be re-used over a number of years. Thus, there is some crossover point, if the artificial tree is used for long enough, that its environmental effect is less than an annual series of trees. For example, the ellipsos study finds that an artificial tree would need to be used for 20 years before its greenhouse gas effects would be less than those of an annual series of natural trees. The PE Americas study offers a wide range of scenarios, and summarizes, but here is the situation "for the base case when individual car transport distance for tree purchase is 2.5 miles each way. Because the natural tree provides an environmental benefit in terms of Global Warming Potential when landfilled, and Eutrophication Potential when composted or incinerated, there is no number of years one can keep an artificial tree in order to match the natural tree impacts in these cases. ... For all other scenarios, the artificial tree has less impact provided it is kept and reused for a minimum between 2 and 9 years, depending upon the environmental indicator chosen."

But a full analysis of the issue needs to look at effects across all the full life-cycle of the tree, whether natural or artificial. And things get complicated right about here.

Under what conditions is the tree manufactured or cultivated, with what use of energy, fertilizer, and logging methods? By what combination of transportation mechanisms is the finished tree moved to the home? A substantial share of artificial trees are manufactured in China and then shipped to North America. What are the different issues in use of the tree, including use of water and emissions of fumes? What is the end-of-life for the tree? For example, the carbon in a natural tree will be stored for some decades if the tree goes into a landfill, but not if if is composted or incinerated.

In short, its difficult being green!

Trump’s trade adviser is a terrible filmmaker

Or so says Scott Meslow at the Politico Magazine. Yes Trump's head of the new White House National Trade Council Peter Navarro has made a film, called "Death by China" (what else?).

No I didn't know either.

The film is apparently based on Navarro's book also with the title "Death by China: Confronting the Dragon - A Global Call to Action".

Perhaps the takeaway from Meslow's review comes early in the article,

As a film critic, I found it an appalling cinematic experience. But it’s a brutally effective, if unsubtle, 79 minutes of propaganda -- which might explain why Trump liked it so much.

Meslow continues,

Within its first five minutes, Death By China lays out the stakes: 57,000 American factories closed, 25 million Americans can’t find "a decent job," and the United States owes $3 trillion to China. The roots of our alleged economic woes, Navarro argues, can be traced back to 2001, when the United States enthusiastically endorsed Beijing’s entry into the World Trade Organization.

Now I have no idea whether this is good film making or not but it sounds like crap economics. As any number of economists have pointed out American's economic woes are not due to trade they have more to do with things like changes in technology.

This bit is interesting,

Navarro attempts to prove this point with an array of cherry-picked talking heads, a series of unenlightening man-on-the-street interviews, and — most strikingly — some computer-animated sequences designed to dramatize Navarro’s argument. In one, a knife bearing the label "Made in China" is plunged into the center of the United States, covering the lower half of the country in a sea of blood. In another, missiles of "currency manipulation" and "illegal export subsidies" are fired from cannons and dropped from planes, leaving American cities in rubble. Navarro structures his film around China’s "Weapons of Job Destruction." Everything is cast in the violent, overheated rhetoric of a war with China — a war Navarro argues we’re losing.

These are all standard tactics in the agitprop documentary playbook: Present one side of a political argument with a dizzying array of semi-credentialed talking heads, leaving dissenting voices on the floor of the editing bay. When your logic is lacking, appeal to emotion instead, depicting derelict factories or unhappy-looking American workers. And, because audiences have been conditioned to expect political documentaries to entertain as well as inform, leaven all the messaging with simplistic cartoons, jaunty music and the occasional joke.

A little later Meslow writes,

Navarro himself appears only briefly, laying out what he views as a practical guide for what the average American can do to combat this threat. "Every time a consumer walks into a Walmart, the first thing they have to do is be aware enough to look for the label. Then, when they pick up that good and it says, 'Made in China,' I want them to think, 'Hmm. It might either break down, or it could kill me, number one. This thing, if I buy it, might cost me, or someone in my family or my friends, their job. Lastly, 'Hey — if I buy this, that money is gonna go over to help finance what is essentially one of the most rapid military build-ups of a totalitarian regime since… when? The '30s. I mean, make no mistake about that."

Again crap economics. So you have been warned. There is more in Meslow's review which you can read for yourself, if you really want to.

Latest Blogwatch column

My Blogwatch column from the latest issue (Issue 57, Decmeber 2016) of the NZAE magazine Asymmetric Information.

A question to end the year with.

A question I have absolutely no idea of the answer to. This comes from Greg Mankiw's blog.

A professor emails me:

My students have the pleasure to use your economics textbook. I have one question: where the symbol "Y" for GDP comes from? All the others, we could detect, such as NX , NCO, etc. My students are curious, and I could not give them a good answer.

My unsatisfying response:

To be honest, I don't know. It is an old convention to use Y to denote real GDP, and I am just following that. But I don't know where or why the convention began.

So anyone who knows the answer let the rest of us in on the secret.

Is the concept of inequality the best way of thinking about our economic problems?

This question is asked by Tyler Cowen in a chapter in a new book The US Labor Market: Questions and Challenges for Public Policy, edited by Michael Strain, which is freely available online from the American Enterprise Institute. The issues raised in the book are relevant to more countries than just the US.

Cowen opens by making an interesting comparison,

I find it useful to compare the productivity slowdown and the increase in income inequality. It seems the productivity slowdown has been of much greater consequence for human welfare, including for lower-income groups. For instance, if American productivity growth had not slowed after 1973, today the median household would earn $30,000 more each year. Alternatively, if income inequality had not accelerated after 1973, today the median household would earn an extra $9,000 more. That is less than one-third of the loss from the productivity slowdown.

One question I would ask is why income inequality and not consumption inequality? Consumption seems more relevant to people's well being.

Cowen goes on to say,

I wish to suggest a simple hypothesis: income inequality (or for that matter wealth inequality) is not the real problem. Rather, the problem is that many Americans are not seeing their lives improve as much as we would like. This is a problem whether or not the top 1 percent is seeing big gains. The problem has to do with the low level of earnings or health or well-being or opportunity for some individuals, not the disparity per se. That is a simple point, but it is difficult to communicate in today’s discourse on these issues, and it turns out to have significant concrete implications for how we should seek remedies.

Later Cowen notes,

Practically speaking, that conceptual mistake misdirects the focus to making people or their outcomes more alike, rather than elevating opportunity for those at the bottom and also in the middle. In fact, opening up enterprise and opportunity for large numbers of people often increases measured income inequality, even when it makes life better for most people, including those at the bottom. Let’s say for instance that global markets were opened up to additional trade, or occupational licensure were relaxed and new commercial opportunities were created. Some people could use these new opportunities to earn much more than others, perhaps millions or even billions more. Probably most people would be better off, but since measured inequality might well rise, analysts who focus on inequality are likely to overlook or undervalue these potential remedies. Keep in mind that the larger a market economy, the larger a country, and the higher the level of aggregate wealth, the higher the level of inequality is likely to be for purely natural reasons; if everything and everyone is clustered at or near zero, inequality just can’t get very high.

Relevant to my question about consumption inequality Cowen points out that,

If we look at the inequality of consumption, rather than income, and count government benefits as a relevant part of income, it turns out actual inequality is considerably lower than many popular or even academic discussions might indicate.

If global inequality is part of the inequality we are worried about, then we should worry less.

Another striking and under-discussed feature of the inequality debates is that global income inequality has been going down for over 20 years. The very poorest people in the world are now much wealthier than before, and significant portions of China, India, Africa, and other developing parts of the world now belong to a growing global middle class. Several billion people have been lifted out of extreme poverty into better circumstances, and over time we can expect the emerging economies to grow at faster rates than the wealthy ones, which will limit inequality all the more. At the same time, scourges such as malaria, polio, and other diseases have for the most part lost ground, most of all in poorer countries. The last 20 to 30 years are probably the most egalitarian time, in terms of income, the world has ever seen. So to the extent income equality is important, we should be celebrating like never before. More specifically, every discussion of income inequality, if it is to be accurate and scientific, should open by framing its worries in the context of a time that has made unparalleled strides toward limiting income inequality overall. Of course for political reasons that is not a popular presentation, but it is an accurate one.

Cowen then looks at key drivers of the increase in inequality. He shows that it makes sense to disaggregate "the inequality problem," as a lot of it isn’t a problem at all, or again it is a problem of some kind other than an inequality problem.

Take as an example one issue you see much discussed which is skills-biased technical change. And there could be a problem here. It is bad that some individuals do not work well with information technology, which is becoming so much more important to most people's work, and this does harm their wages and future opportunities. But the problem part of that equation is not an inequality problem; it is an education problem and a retraining problem. Cowen also discusses issues to do with global markets and rent-seeking.

Cowen sums up this section by saying,

In sum, America [and likely New Zealand] has serious problems of inadequate education, lack of retraining, and some quite bad policies in particular areas. In most cases that disaggregation is a better way of understanding what is going on rather than emphasizing inequality at the macro-economic level. The gap between rich and poor is neither the major driver of the actual problems nor the most important symptom of the most significant problems. Lack of opportunity in absolute terms is the main symptomatic problem.

In the last section of his chapter Cowen looks at the question, How Should Policy Respond? He briefly discusses five areas, Health Care, Occupational Licensing, Education Cheaper Rent and Lower Home Prices, Discontinue or Ameliorate the War on Drugs and End Crony Capitalism.

With regard to house prices and rents, an issue New Zealanders can relate to, Cowen writes,

These days it is harder for Americans to migrate successfully to some of the most economically dynamic American cities, in large part because of high rents and restrictive building codes, stemming from the NIMBY mentality. For a low-skilled worker, the higher wages in New York or San Francisco do not always make up for the much higher rental costs. In the 1950s, a typical apartment in New York City rented for about $60 a month, or adjusting for inflation about $530 a month; today that is closer to the cost of a parking space in Manhattan. If it were cheaper to move into major American cities, more Americans would have an easier path toward a higher salary and a brighter future. Economists Chang-Tai Hsieh and Enrico Moretti have argued that the American economy could become much richer if more workers could move from the low-productivity cities to the high-productivity cities; that would increase income mobility, too. Hsieh and Moretti estimate that lower rents, through building deregulation, could increase American GDP by almost 10 percent. A lot of those gains would go to Americans who cannot currently afford to move to San Francisco and other high-productivity cities.

The size of the effect on GDP of having people move from low-productivity areas to high-productivity areas did come as a surprise to me.

Cowen ends by saying that the United States has some very real and obvious problems, many of which impact the low- and middle-income earners of America in particular, but the concept of inequality is not the best conceptual starting point for finding or evaluating potential solutions.

There are many other interesting points made in Cowen's chapter and it is well worth the read, no matter what your current view of inequality.

The book containing Cowen's chapter also has many other useful chapters on a variety of issues to do with labour markets. Anyone interested in such markets should give it a read.

Should we ban loss leaders?

Loss leaders are one of those retail marketing tricks that are often complained about, for many different reasons. For example, back in 2009 the NBR ran a story Lack of loss-leader sales good news for brand conscious wine industry. In 2011 the Otago Daily Times ran a story claiming,

Supermarkets were also driving binge-drinking by using alcohol as a "loss leader", sold below cost to attract shoppers.

Others see loss leaders as anti-competitive or predatory.

Big chains have the power to buy in bulk, reducing the individual price of products. They use tactics like ‘loss-leaders’ – purposely selling a product below cost to entice customers into their store to buy even more with their ‘savings’. The smaller retailers must match their prices, for fear of losing customers, which reduces their margins. When their rents rise markedly, they are increasingly being forced to move or close.

But are loss leaders really so bad? Are they are anti-competitive or predatory?

A forthcoming paper in the American Economic Review - Unplanned Purchases and Retail Competition by Justin P. Johnson - suggests that loss leaders are non-predatory and possibly even pro-competitive.

Abstract

I propose a framework in which asymmetric multi-product retailers compete for one-stop shoppers who have biased beliefs about their future purchase probabilities (and so make unplanned purchases). One firm carries a full portfolio of products while the other carries an incomplete but endogenous one. Using this framework, I examine the phenomenon of loss leading, the optimal product portfolio of the smaller firm, and the effects of banning loss leading. Among other results, I show that there is a non-predatory (and possibly pro-competitive) justification for the observation that such larger firms may charge below cost on the core product lines of their smaller rivals.

So, sorry, but banning loss leaders may not be such a great idea.

Institute of Economic Affairs: 2016 - a year in review podcast

IEA staff join IEA News Editor Kate Andrews (chair) to discuss all of the surprises and upsets in 2016, what these revelations will mean for the new year.

First, we hear from IEA Director General Mark Littlewood and Digital Officer Madeline Grant join in to discuss the unforeseen triumph of the campaign to leave the European Union.

After that we hear from Communications Director Stephanie Lis and Head of Lifestyle Economics Christopher Snowdon on the aftermath of the Brexit vote, particularly concerning the new government that has risen up because of it.

And finally, Mark will be back to chat with Kate about how America ‘made politics interesting again.’

Also hear from Mark, Maddie, Stephanie and Christopher about their favorite moments, statistics, and 'Person of the Year' in 2016, as well as their best prediction for 2017.

Interesting blog bits

1. The IEA blog covers a new IEA publication on Balancing the economy: The hand of government or the invisible hand?
   

   Despite its considerable strengths, the UK economy is seen as having a number of problems, in particular productivity which lags behind some competitors, low levels of investment and persistent regional disparities. Following the referendum decision to leave the EU, there is wide interest in developing a new industrial strategy. The UK government's proposals are unlikely to help the situation.

2. Jenesa Jeram suggests This Christmas, reject sugar taxes and embrace the joy of food

   We don't need a sugar tax to protect us from Christmas excesses.

3. Andrew Bernard, J. Bradford Jensen, Stephen Redding, Peter Schott on Global firms: Insights for trade and trade policy
   

   Events of the last year have raised questions about the future growth of international trade. This column examines the role played by ‘global firms’ that both import and export, and are likely to be part of multinationals, in the international economy. In a world of interdependent firm decisions, small reductions in tariffs or trade costs can have magnified effects on trade flows, as they induce firms to serve more markets with more products at greater volumes, and also to source greater volumes of intermediate inputs from more countries. At the same time, policies to restrict imports can end up hurting producers for whom both importing and exporting are a central pillar of their overall business strategy.

4. Scott Sumner asks Did monetary offset cause the Great Recession?

   In the past, it has been argued by Summer that tight money caused the Great Recession. But what caused the tight money?

5. Ed Dolan asks What Is the Nairu and Why Does it Matter?

   What happens in terms of US monetary policy will depend, in large part, on what may be the wonkiest number in all of economics—the Nairu. Nairu stands for Non-Accelerating Inflation Rate of Unemployment—such a mouthful that no one ever says it out loud. The basic idea behind the Nairu is simple. It is widely accepted that as the economy moves through the business cycle from recession to expansion to boom, shortages develop in labor and product markets that put upward pressure on prices and wages. The Nairu is supposed to capture the sweet spot—the lowest level to which the unemployment rate can safely fall before inflation starts to accelerate.

6. Scott Burns on Cashing Out of Poverty

   Financial innovations like mobile money have gained fame for transforming commerce in the developing world. But they’re also helping the poor escape poverty.

7. Timothy Taylor offers An Appetizer Buffet of Economic Research Highlights

   The sort of readers who find Taylor's blog interesting might also want to check out the "Research Highlights" blog being run by Tim Hyde for the American Economic Association. Once or twice each week, the blog features a paper chosen from this set of seven journals and offers up a short, readable, nontechnical overview. Here are some examples from the last few weeks.

Import duties

The University of Chicago Booth School of Business Economic Experts Panel was asked the question,

Adding new or higher import duties on products such as air conditioners, cars, and cookies — to encourage producers to make them in the US — would be a good idea.

In response 93% of them "Disagreed" or "Strongly Disagreed". There were three "Did Not Answer" so of those who did answer 100% went with either "Disagreed" or "Strongly Disagreed".

In the comments on their vote Oliver Hart noted,

Duties lead to dead-weight losses and also retaliation.There can be losers from free trade but there are better ways to compensate them.

while Austan Goolsbee just said,

stupid

I guess none of these guys will be getting jobs in Trump's White House National Trade Council.

Fiat money vs. the gold standard

Scott Sumner and Larry White take on monetary policy in this Econ Duel.

Throughout the 19th century and up until the Great Depression, the gold standard was used in the United States. It was largely abandoned in the 20th century.

But what is the gold standard? It’s a system for defining the value of a currency in terms of gold. In other words, you could exchange your $20 paper bill for actual gold at one point in history.

Under a fiat money system, such as the one we have in the U.S. today, that $20 paper bill is inconvertible. You can’t exchange it for a backing store of value because there isn’t one.

In this Econ Duel, economists Scott Sumner and Larry White, who both focus on monetary theory and policy, debate the positives and drawbacks to the gold standard vs. fiat money, and the role of central banks.

On the side of the gold standard, White argues that, when properly implemented without a central bank intervening, it provides a more predictable price level and lower average inflation.

Sumner, taking up the banner for fiat money, argues that the gold standard is simply a rule that worked well in the 19th century and that a good fiat money system is, for this day and age, a better alternative.

What is holding firms back in developing countries?

Chris Woodruff, IGC research programme director, explains why improving management practices is critical for the development of the private sector in developing countries.

Why is rent do damn high?

Many of the arguments here apply to New Zealand.

You’ve no doubt heard it before: the rent is too damn high!

In major cities across the United States, rent prices have been skyrocketing for some time. As a percentage of median income, rent is much higher for those that choose city life over suburbia.

But why are rental prices in these cities so expensive, and what can we do about it?

It’s a classic case of supply and demand: lots of people want to move to big cities because of the opportunities they afford. Naturally, they demand housing. But the supply is often short due to many factors, from geography to regulations. What does economics tell us happens when there’s a lot of demand, but not so much supply? Prices rise. As a consequence, many people are priced out of pursuing the lucrative opportunities available in major cities.

Coastal cities, like San Francisco and New York, have obvious geographical restrictions on building “out.” One way to deal with this problem is to build upwards with more skyscraper housing. This often isn’t feasible due to regulations on building heights, density, parking requirements, etc. But these regulations could be lessened or removed, allowing big cities to become denser and lowering rent prices. Lifelong city-dweller Matt Yglesias discusses this approach in this Duel.

On the other side, Tyler Cowen, who has always lived in the suburbs, argues that allowing cities to become denser may only provide a short-term solution. As more people move in, the cities become more productive with higher incomes for their inhabitants. And the rents rise again.

What to say to those who lose their jobs because of imports

Here at the Cafe Hayek blog Don Boudreaux takes up one of the most difficult issues to do with advocating free trade, what does an advocate of free trade say to to those who lose jobs to imports?

Nothing that you say to someone who loses his or her job to changing market conditions is likely to satisfy that person. The personal almost always trumps the abstract. The seen hides the unseen. The proximate overwhelms the distant. The present is real while the future is still to be created. This reality, however, does not diminish the importance of defending free trade honestly, unconditionally, and without apology.

Such a defense begins with the insistence that jobs are not lost to imports or to foreigners; instead jobs are lost to fellow citizens – in two ways. First, it is the spending decisions of fellow citizens that determine when particular jobs are created and when they are destroyed. Second, the job lost by Smith is replaced with a new (and likely very different) job filled, if not by Smith, then by Smith’s fellow citizen Jones. So when someone complains about losing his or her job “to imports,” it is right to note that protecting that job necessarily requires that fellow citizens’ freedoms be curtailed and fellow citizens’ economic well-being be reduced. Protection necessarily shrinks the spending power of countless fellow citizens. Protectionism also destroys the actual jobs of many other fellow citizens (for example, jobs in domestic machine-tool factories that disappear because steel tariffs take a bite out of domestic machine-tool production) and destroys the job prospects of still other fellow citizens (for example, retail-store-management jobs that never materialize because tariffs on consumer goods reduce consumers’ demand for such goods).

Again, no such arguments will satisfy someone who believes that his job disappeared because of international trade. But that person’s refusal to accept that these arguments are part of a sound case for free trade does not, as emotionally understandable as this refusal is, render these arguments invalid. If we mute or trim our defense of free trade out of understandable sympathy with the unemployed worker who we see, we are complicit in supporting a system – protectionism – that not only destroys the jobs of workers who we don’t see (but who are, and whose sufferings are, every bit as real as the worker who we do see), but also will deny to our children and grandchildren a future that is as prosperous and as peaceful as possible.

It is necessary to keep in mind when defending free trade that it will destroy some jobs (a fact that is often clearly seen), and this has very real negative effects on people, but it is also necessary to realise that it will also create jobs (a fact that is often unseen) which has very real positive effects on other people. As Paul Krugman has written,

It should be possible to emphasize [...] that the level of employment is a macroeconomic issue, depending in the short run on aggregate demand and depending in the long run on the natural rate of unemployment, with microeconomic policies like tariffs having little net effect. Trade policy should be debated in terms of its impact on efficiency, not in terms of phony numbers about jobs created or lost.

The trade economist Douglas Irwin has this to say on the matter of trade and jobs,

The claim that trade should be limited because imports destroy jobs has been around at least since the sixteenth century. And imports do indeed destroy jobs in certain industries: [...]

But just because imports destroy some jobs does not mean that trade reduces overall employment or harms the economy. [...]

So in terms of jobs the free trade/protection debate is about which jobs there are in an economy rather than the total number of jobs. Changes in trade policy moves jobs a round the economy, free trade moves jobs away from sectors of the economy that produce things we are (relatively) bad at doing towards things we are (relatively) good at doing. Each of free trade and protection will be good for some people and bad for others. Perhaps the real question is, how do we best help those who in the short-run are harmed by changes in trade policy?

Bad politics drives out good economics

The idea that politicians will deliberately implement economic policies they know to be bad just to help them politically is highlighted here in a paper about Richard Nixon's wage and price controls.

The Political Economy of Wage and Price Controls: Evidence from the Nixon Tapes by Burton A. Abrams and James Butkiewicz

Abstract

On August 15, 1971, Richard Nixon imposed the first and only peacetime wage and price controls in U.S. history. The Nixon tapes, personal tape recordings made during the presidency of Richard Nixon, are now available to the public and provide a unique body of evidence to investigate the motivations for Nixon’s macroeconomic policies. We have uncovered and report in this paper evidence that Nixon manipulated both monetary and fiscal policies to create a political business cycle that helped secure his reelection victory in 1972. Nixon was very knowledgeable about economic matters and understood the risks to the economy of his macroeconomic policy actions and the imposition of wage and price controls, but chose to tradeoff longer-term economic costs to the economy for his own short-term political gain.

Interestingly the following comes from an 2000 interview with Milton Friedman:

INTERVIEWER: There is a photograph of you and George Shultz with Nixon in the Oval Office. What did you say to him on that occasion? What did you tell him?

MILTON FRIEDMAN: Well, I don't know what occasion that particular one was, but the one that's relevant to your question is the last time I saw Nixon in the Oval Office with George Shultz. What we usually discussed when Nixon wanted to talk was the state of the economy: what monetary policy was doing.

Nixon was a very, very smart person. In fact, he had one of the highest IQs of any public official I've met. The problem with Nixon was not intelligence and not prejudices. The problem with him was that he was willing to sacrifice principles too easily for political advantage. But at any rate, as I was getting up to leave, President Nixon said to me, "Don't blame George for this silly business of wage and price controls," meaning George Shultz. And I believe I said to him, I think I said to him, "Oh, no, Mr. President. I don't blame George; I blame you! " (laughs) And that, I think, was the last thing I said to him. Now, the interesting point of that story is that the Nixon tapes are now available, and I have been trying to get that part of the Nixon tapes, but I haven't been able to get them yet. I want to make sure I didn't make this up.

Legalising all drugs: an interview with Dr. Jeffrey Miron

Steve Patterson interviews Harvard economist Jeffery Miron about legalising drugs and social safety nets.

World trade and world wars

Trade is a mechanism that helps countries exchange goods, raise welfare, and escape poverty. Open markets allow countries to grow their economies through trade. In this video, Faizel Ismail of the University of Cape Town discusses how African countries can work together to build a regional integration project that, in addition to being more balanced and equitable, results in their ability to compete more effectively in the world economy.