Busting the Mythbusters

A former professor (and current mentor) of mine passed along this effort by the Department of Labor to bust minimum wage myths.  Unfortunately, they failed at this.  Most of the article is either incorrect, misleading, or formally illogical.  This post will go through bit by bit to address the DOL’s article (some of the questions are legal questions and I won’t be answering those.  I’m an economist, not a lawyer).  Block quotes are from the article.  Regular text are my responses.

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Simplified vs Wrong

Over at EconLog, David Henderson has a great response to Noah Smith’s recent essay “Most of What You Learned in Econ 101 is Wrong.”  I won’t rehash his arguments here, but I do want to address an issue Smith (and some of the commentators on David’s post) raises, but incorrectly attacks: simplification.

To call something simplified is not the same as saying it’s wrong.  Of course in Econ 101 we simplify things.  It’s the intro course for folks who have never studied economics before.  You need to start them with the simple stuff before you work your way up to the more complex.  You wouldn’t start a First Grader reading with the Count of Monte Cristo, would you?

Econ 101 is the foundation of all that follows.  Saying something is wrong means it’s incorrect. Nothing taught in an Econ 101 class is incorrect (assuming a competent teacher, of course). Supply and Demand doesn’t change based upon “real world complexities.” Their slopes might (what with elasticities and all that, another thing learned in Econ 101), but Demand doesn’t suddenly become upward sloping in “the real world.” People don’t suddenly stop responding to incentives or stop thinking on the margins.

With respect, those who argue that Econ 101 (or any 101) is wrong have either misapplied the lessons from the higher-level courses, or misunderstood their foundations (or had bad teachers and should get their money back).

Innovation and the Economy

Continuing with Noah Smith’s Bloomberg article, yesterday I praised him for his insights.  But now, I’d like to point out some of his errors and discuss them, namely how technology and economics interact.

First off, he states:

Economists often treat technology as if it just appears out of nowhere, but in fact it comes from the innovative efforts of companies and researchers.

I do not know of a single economist who treats technology as something that just appears.  I know the Austrians (of which I am a follower) do not.  In fact, we see innovation and entrepreneurial spirit as the key to economic growth.  I know the Keynesians (the dominant school of thought in modern economics) do not.  They recognize the importance of saving to fuel loanable funds and drive innovation.  The Neoclassical, Chicagoians, and yes even the Communists do not.  So I’m not sure what economists he’s referring to here.  Sure, we all may have our own prescriptions on how to drive innovation, but I do not know of a single school of thought that treats technology as something that just happens.

Second, he says:

Why do companies innovate? You might think that companies invent any technology that will make them more productive, but this isn’t actually true, for a number of reasons. First of all, innovators don’t know ahead of time which things they will be able to create — trying to innovate is risky, and companies are usually risk-averse.

Some companies are.  Many companies are not.  That’s how we ended up with the Googles, Ubers, Wal-Marts, JC Pennys, Fords, etc etc.  Those who are risk-adverse tend to disappear (absent of any government support).  Those who innovate become the new cream of the crop.  Should they stop, they’ll die.  Circle of life.

Second, companies may be focused on the short term, and may thus be unwilling to shell out cash for research and development that would only pay off years later.

This is about as popular a myth as can be, but it’s also been busted countless times.

Finally, companies may simply get comfortable with what they have, and fail to engage in innovation unless they feel sufficiently intense pressure to do so.

This statement I actually don’t have any problems with, but it emphasizes the need for competition.  That “intense pressure” is applied by competitors breathing down their necks.  Like Uber and the taxi companies.  When firms are protected, whether by regulation, protectionism, or legal monopoly status, they are shielded from this intense pressure and innovate less.  This is a major reason why I support free markets.

With the above paragraph, I did also notice he tries to have his cake and eat it, too: companies do the research and innovation, but then they don’t do the research and innovation (or too little of it).  I’m not sure what he means by this seeming contradiction.

So what happens if a company suddenly finds that it has to pay higher wages? It might just take the hit to its profit margins and continue operating as before. It might decide to downsize, laying off workers and shrinking its operations.

Or, it might decide to invest in labor-saving technology.

This is a wonderful paragraph.  When individuals or firms face higher costs, they adjust their behavior as necessary.  Absolutely, 100% correct.  In fact, he goes on to cite a few more examples:

McDonald’s is installing a line of automated kiosks where people can create their own burgers.

Economic historian Robert Allen has argued that the Industrial Revolution began in Europe, rather than in China, because European employers were forced to pay more for labor. Since labor was more expensive, companies invested in technology, which then raised productivity so much that it boosted wages even higher, forcing companies to invest more in technology, even as their increased incomes allowed them to make those investments. A 1987 theory by growth economics pioneer Paul Romer operated on a similar principle — expensive labor causes an upward spiral of technological improvement.

Absolutely correct.

But let’s talk about artificial increases in wages vs natural increases.  Remember that prices are signals: they tell us which resources are relatively more scarce, which are more abundant, and we can adjust as necessary.  When the price signal is disrupted, or manipulated, then it gives off incorrect information and causes people to adjust in undesirable ways.  Using the natural price rises of the Industrial Revolution and using it to call for artificial rises in 2015 is misapplying the lessons.  For whatever reason, labor was getting more expensive in Europe and the US, forcing the increase in new machinery (as an aside, this kind of kills the whole “slavery built capitalism” argument).  These innovations were necessary; they represented a shift in the demand curve for labor.  Conversely, a price floor will not have the same effect.  A price floor is movement along a demand curve, not a shift of the curve itself.  This still results in shortages (fewer low skilled workers are demanded and more are supplied).

There is also the question of “how much is too much?”  As with anything in life, there is an optimal amount needed for any given time and place.  Water is good for you, but drinking too much can cause you to get sick or die.  Low interest rates can be good, until a housing bubble builds and bursts.  If minimum wage drives an artificial increase in demand for technology, and more resources are devoted to this, then it could potentially lead to an oversupply of capital goods in the market and eventually lead to a tech crash (for the record, I think this scenario is highly unlikely as minimum wage is such a small sector of the economy.  But I’m doing the cereal box thing: making the size larger to enhance the texture.  However, it is likely such a thing would happen at a small scale).

As with anything, there are pros and cons to Smith’s minimum wage speculative benefit.  But these items must seriously be considered, especially if intended to become national policy, as there will be very real consequences.

Minimum Wage, Productivity, and the Poor

In Bloomberg, Noah Smith has an opinion piece on one of the speculative (his word) benefits of minimum wage: increasing productivity.  This article isn’t perfect.  He has some glaring errors in it, but I don’t want to talk about that (over at Cafe Hayek, Don Boudreaux has done a good job addressing several).

Rather, I want to praise Smith.  He recognizes something that most proponents of minimum wage don’t: minimum wage costs jobs.  After all, that is what increased productivity is: it is using fewer inputs (labor) to achieve the same or a greater result.  Smith points out that minimum wage workers are replaced with machines when wages are hiked.  He puts a positive spin on this, and I’ll let you judge for yourselves whether he is right or wrong, but I am glad he is recognizing this reality.  Bravo!

But what does this mean for minimum wage as a poverty fighting tool?  Well, if Smith is right, it means minimum wage is rather ineffective.  In fact, it would likely work opposite.  Workers are replaced (or lower demand for their services).  This means the low-skilled will have an increasingly difficult time finding jobs with a minimum wage.  Sure, those who are able to keep a job are better off (as Smith suggests), but those who cannot currently get a job, or who are marginal, will be out of luck.  If the goal of minimum wage is to help the least advantaged, then it will fail, according to Smith.  In fact, those most likely to benefit are the owners of capital.  Potentially, if Smith is correct, this would increase income inequality, not lower it!

In general, minimum wage is a poor poverty fighting tool as it only affects a select few.  But, if labor is indeed replaced by capital, then this suggests minimum wage could be a poverty creating tool.

Creating Consensus vs Imposing Consensus

Market-driven decision making and government-driven (or collective) decision making both have this in common: they determine a consensus.  However, the methods each use are radically different.  One is peaceful and the other is not.

Market-driven consensus (that is, the consensus that arises from individual actions within a society) is based off of voluntary interaction.  No interaction takes place unless both parties benefit and agree to the conditions.  If a third party is affected, they can interject themselves into the process in order to protect themselves.  In this method, people are generally made better off and the resulting consensus is highly desirable by all involved (since they all had a hand in creating it).  This is the “spontaneous order” that arises, the outcome guided by an invisible hand.

Conversely, government-driven consensus (that is, the consensus that arises from the political process) is based off of force, either explicit (eg the War on Drugs) or implicit (“pay or taxes or go to jail!”).  In this case, consensus is imposed rather than discovered.  The consensus is pre-determined, either from a single point of view (such as in an autocracy) or from the most broadly-appealing points of view (such as in a democracy). In an imposed consensus environment, there is a limited likelihood that the consensus is best for all involved since it is not determined by individual actions but imposed from the top-down.  FA Hayek’s famous Uses of Knowledge in Society talk shows us that, even under the best set of assumptions, the necessary information to make an informed decision cannot possibly be collected an analyzed to any meaningful extent in this process.  It is most likely the consensus imposed will reflect those who are closest to the politician’s ear, rather than the actual consensus of society.

Even if both methods of consensus reached the same point, the market-driven method is preferable.  It has a distinct advantage over government-driven consensus in that it is able to quickly adjust to new information, new inputs.  government-driven consensus is very difficult to change, and in fact, can be openly hostile to change even when the information all points in a single direction.

Take, for example, climate change.  There is an extraordinarily strong consensus among scientists that climate change is happening and human activity may be a major cause of it.  Market-driven consensus has already occurred and people are changing their behavior: alternative-energy vehicles, fracking, cleaner-burning energy sources, and the like.  In the mean time, government-driven consensus continues to flounder.  There have been summit after summit after summit and no government has been able to get any kind of change to happen, despite the fact they all agree something must happen.

Market-driven consensus allows for each person to react to the stimuli surrounding him and make the appropriate decisions.  This, in turn, leads to a large consensus that is discovered in society.  It is like an organism with millions of sensory organs, each processing information in its little area of the world.  Conversely, government-driven consensus is imposed.  It is a consensus determined via limited sensory organ data.  It is like an organism who has no senses whatsoever but on its feet.

Information is power, and the more information that is put in means the more powerful, the more accurate, the consensus will be.

The Cost of Everything

Everything has a cost.  There is no such thing as “free.”  Any economist worth his salt knows this, but it is a fact generally lost on the population at large.  That is because when most people think “cost,” they think money.  Money is a cost, of course, but it is just part of it.  The other part of total costs are opportunity costs.

Opportunity cost is nothing more than the cost of taking an opportunity; that is, what you have to give up in order to undertake your opportunity.  These costs can be monetary but can also mean lost opportunities in and of themselves.  Let’s look at some simple examples:

  • You and your spouse decide to go to a restaurant for lunch.  You try a new place rather than your favorite place.  The cost of that meal was the monetary price, as well as the lost favorite meal at your other place.
  • You decide to study art at the university.  The cost of such a degree is the tuition and fees, plus the lost income that you could have made pursuing other degrees.
  • You decide to root for a football team other than the New England Patriots.  Your cost is the money you spend on team gear, plus the lost time wondering whether or not your team will make the playoffs this year (Patriots fans don’t have that cost).

The thing about opportunity cost is that it is unseen, and therefore often discounted or ignored in popular discussions.  It is also highly subjective.  Whereas monetary costs are quite stable (a $10 meal is $10 to just about everyone), non-monetary costs can differ from person to person (the arts degree makes a person happier than they would be working in another industry).

Why do I bring this up now?  On the campaign trail, there are often calls for “free” or “low cost” stuff: free housing, free college, free health care, free tax refunds, etc etc etc.  But it is important to remember these things have costs far beyond their monetary ones.  And these costs are rarely discussed and barely acknowledged.

Let’s take medical care: in the US, we spend more on health care than just about every industrialized nation.  That shouldn’t be a surprise to anyone (by the way, I am discussing total spending.  If you strip out cosmetics, like plastic surgery and the like, the figures change, but that’s a discussion for another time).  We could change that easily by adopting universal health care, like so many other nations.  That would reduce the nominal (monetary) cost of health care.  But it would also raise costs in other ways: longer wait times , Fewer doctors, higher taxes, lower quality of care, etc.

Keeping opportunity costs in mind is what separates the good economist from the poor economist, the good thinker from the poor thinker.  It’s easy to reduce monetary prices on things, but reality isn’t optional: there ain’t no such thing as a free lunch.

The ADA and The Biggest Mistake

Over at EconLog, Scott Sumner has an excellent post on the Americans with Disabilities Act of 1990.  An excerpt:

The Americans with Disabilities Act of 1990 (ADA) forcefully articulates this contemporary view of disability: “Physical or mental disabilities in no way diminish a person’s right to fully participate in all aspects of society… The Nation’s proper goals regarding individuals with disabilities are to assure equality of opportunity, full participation, independent living, and economic self-sufficiency for such individuals.”

As documented in Figures 6a and 6b, the employment rate of males in their forties and fifties with a self-reported disability fell from 28 percent in 1988 to 16 percent in 2008 (approximately a 40 percent decline). The employment rate of comparably aged males without a disability held roughly constant at 87 to 88 percent. For females in this same age range with disabilities, the employment rate declined slightly (from 18 to 15 percent) while the employment rate of their counterparts without a disability rose from 66 to 76 percent.

It’s difficult to think of a piece of legislation that failed more abysmally than the ADA.

My thoughts exactly, Scott.  One of the biggest mistakes politicians, pundits, priests, and laymen make is judging a policy based upon its intent rather than its result.  The intent of the ADA was to create more opportunities for the disabled.  In fact, the opposite happened.  And, despite this being an all too predictable outcome, the bill was passed.  Now, after nearly 30 years, we have the data.  I strongly suspect were anyone to suggest repealing this Act, there would be an outcry against them and accusations of harming the disabled, despite the fact the evidence points in the other direction.

We see this with many things, most noticeably in minimum wage.  Many economists oppose minimum wage not because we hate the poor but because we see the costs and see the outcome (plus have a good amount of evidence to back it up).  But very few discussions outside of economic faculty rooms or blogs focus on this, but rather focus on the minimum wage’s intentions.  And, despite evidence pointing in the other way, the discussion remains on its intentions and not results (Don’t believe me?  I’d love to see Bernie Sanders to Hilary Clinton agree with minimum-wage supporter and economist Arindrajit Dube that minimum wage is a poor poverty relief tool, but I got $100 that says that never happens).

The hardest thing in changing the culture of ideas is overcoming this issue.  Overcoming people’s priors is insanely difficult, which is why the job of the economist is full-time.  Getting the repeal of failed legislation is very difficult as you are often combating visions of how things are supposed to be, rather than how they are.