Multiplication by Division

In economics, one of the less intuitive aspects is why the division of labor leads to a multiplication of wealth.  “Less work is being done!” people cry.  “This means people are poorer!  How can fewer jobs mean more wealth?”  We hear this question in particular with regards to international trade.  The question steams from misunderstanding the very basics of economics: resources are scarce.

Since we do not live in Eden, resources are scarce.  What this means is there simply are not enough resources to satisfy every want and need a person might have.  One of the scarcest resources out there is time.  We’re always running out and we can never get it back.  Division of labor is economizing on time.  A simple example: by dividing necessary labor (in other words, “outsourcing”) to satisfy my wants and needs among other people, I have more free time to spend as I wish.  By not having to worry about growing my own food, making my own clothes, composing my own music, building my own home (but rather outsourcing those jobs to farmers, grocers, tailors, musicians, and carpenters), it frees up my time to work on other things: educating myself, writing a book or blog, etc.  Things that can improve my wealth and/or society.  By dividing labor, we can get more out of the fixed time we have in life.

Division of labor is a good thing, not a bad thing.  Division of labor is what has allowed man to rise above his beginnings as a hunter-gatherer and has nearly eradicated true poverty in the world.  If we want to enrich Americans, to make America great, then we need more division of labor, not less.  We need to maximize our hours on this planet, not minimize them.

 

Are High Prices Necessary for Innovation?

Writing in Bloomberg, Megan McArdle says:

America’s high pharmaceutical prices are what compensates pharmaceutical firms for the risk of developing drugs. If we drive them lower, we’ll get fewer new drugs….After a few years of obscene profits, most of these innovations will be pretty cheap and widely available. Every useful weapon we decide not to try to produce for that arsenal comes at a cost to future people’s health.

Megan’s argument is a common one, and is often used to justify government-granted monopolies through patients. Although it pains me to do so, I must disagree with her here.

Drug research certainly is expensive, but as David Henderson and Charles Hooper point out, regulatory burden is also a major cost for firms:

Economists have shown that the cost to get one drug to market successfully is now more than $2.8 billion. Most of this cost is due to FDA regulation. Some potentially helpful drugs don’t ever make it to market because the cost the company must bear is too high. Drug companies reguarly “kill” drugs that could be effective because the potential profits, multiplied by the probability of collecting them, are less than the anticipated costs.

In other words, firms make a simple probabilistic Net Present Value calculation and the cost of regulation tends to be the deciding factor to cancel a project.  The high prices firms receive are a reflection of both the cost of innovation, but primarily the cost of regulation.  As Henderson and Hooper discuss, drug prices could be lowered (by changing the regulatory regime) and have it not affect innovation.

In a more general sense, high prices/profits are not necessary to spur innovation.  Competition can do the same thing.  In competitive markets, firms must always be on the look out for competitors cutting into their profits.  They look to gain any edge they can, which includes innovation.  Innovation can mean improving the current mousetrap or building a better one.  This is why we continue to see innovation even in highly competitive markets like retail/wholesale even though they do not earn extra-normal profits.

An easy way to test this theory would be, as Henderson and Hooper suggest, reduce regulation.  Standard monopoly theory says that a firm would develop into a monopoly if (among other reasons) there are significant technological barriers preventing entry into the market (in other words, if innovation is so expensive only one firm can efficiently conduct it). If the regulations are lifted and prices remain high and drug companies meld into a monopoly, then we can conclude Megan’s hypothesis is correct.  If, however, drug prices fall (as I suspect they will), we can conclude Henderson & Hooper’s hypothesis correct.

Who Gives A Damn About Jobs?

Good, now that I have your attention I will begin:

Jobs tend to dominate the economic punditry:  President-Elect Trump’s touts about bringing jobs back from overseas (or, inversely Bernie Sander’s admonishes for sending jobs overseas), this company or that company is killing jobs, etc etc etc.  But all this misses the point.

Creating jobs is easy.  Simply ban all labor-saving devices:  washing machines, cars, computers, calculators, shovels, TVs, sound equipment. Basically anything mechanical.  Ban it. If a President were to get such legislation passed, he’d have the greatest job creation record of all time.  You will have tons of jobs, but lots of poverty, too.

Labor is a cost.  It is an input.  The goal of any cost is to minimize it with regards to the ideal level of leisure (leisure time being the opposite of labor time) and maximize one’s returns.  A simple example:  Dr. Doofenschwirtz invents a machine that produces everything anyone could want just by pressing a button.  Out of the kindness of his heart, he gives one to everyone on the planet.  The proliferation of such a machine would necessarily eliminate jobs, but people would be better off because of it.  This would allow people to focus on other things.

Lest I be accused of fantasizing, my above example is a simplified, and extreme, version of how trade works.

In conclusion, it is not the number of jobs that matter.  That is a pointless statistic.  Rather, it is how people can maximize their wealth by minimizing their labor.

There Is No Correct Answer

On this Cafe Hayek post, commentor Chris Killingsworth asks:

What is the correct free market solution, then, for workers in towns around the country who are left jobless en masse when a major local employer packs up and moves overseas?  Go back to school with the money they have hopefully saved up, then move to ‘where the jobs are’?

This question represents a fundamental misunderstanding of what a free market (or market-based economy) is.  Free market is a term used to describe the voluntary interaction of peoples.  As such, each person, using his unique knowledge of time and place, will map out the best way for him/her to respond to different situations.  In short, there is no “correct free market solution,” for any given situation.  For any given situation, there can be millions or billions of “correct” solutions, each one just as valid as the next for differentiating individuals.

In short, Mr Killingsworth’s question is unanswerable because there is no one answer.  His second sentence may work for some, but not all.  Others may make different choices.  It is impossible to know, irresponsible to guess, and unbecoming as an economist to offer “one size fits all solutions.”

Traffic Jam Economics

I-495 (AKA the Beltway) is the interstate that runs around Washington DC from Maryland to Virginia.  Heading toward Northern Virginia, there is a tolled express lane; for a price, you can use this express lane to try to avoid the massive amounts of traffic I-495 gets any given day.  What’s neat about this toll is it is dynamic, that is the pricing reflects the volume of traffic.  Yesterday, I was driving from Fairfax, VA to Silver Spring, MD.  In the middle of the day, the traffic was light.  The toll to drive express from I-66 to the MD border was around $2 (sorry, I don’t remember the exact price).  However, on my way back during rush hour, the toll was around $20 for the same distance!  Why would this be?

Prices are a rationing system.  The higher price of the toll reflects higher demand for the express lane due to increased traffic on I-495.  Drivers on I-495 are faced with a choice: pay $20 and (possibly) get to their destination faster or sit in traffic on the main highway.  The higher the toll, the lower the relative cost of sitting in traffic.  This allows the express lane to be used for those to whom the $20 is the lower cost (those in a rush, for example).

Another interesting note is not everyone in the Express Lane were rich. There were a lot of Benz and BMWs and other luxury cars sitting in traffic, and there were a lot of middle-range cars in the express lane.  This is an example of the economic concept that value, not ability to pay, determines whether an action is taken.  For those sitting in the traffic, the $20 toll was high enough to discourage the use of the express lane, even though they likely could have afforded it.

The moral of the story: there are benefits to sitting in traffic.

Remember Thy Broken Windows

Taking credit for about 1,000 jobs “staying” in Indiana from a Carrier plant’s decision not to move to Mexico, President-elect Trump proclaimed “Companies are not going to leave the US anymore without consequences.  Leaving the country is going to be very very difficult.”  This statement should strike fear into the hearts of liberty-loving, crony-capitalist hating people everywhere. Unfortunately, many of praised it as a step in the right direction, that the $7m in tax breaks is a “good deal.”  However, this is anything but a good deal.  It sets dangerous expectations that will cost Americans jobs, investments, and wealth.

Let’s start with the explicit threat in Trump’s words.  Firms, that operate or expand into the US, will lose their freedom to make business-effective moves.  This will increase the relative cost of doing business in the US (since the cost of relocation outside the country is now higher), making operating outside the country, not expanding operations at all, or automating, more attractive options. Firms will be far more cautious about their operations, thus reducing the total number of potential jobs and investment in the US.  This is the “unseen” effects of Trump’s threats.  The 1,000 jobs “saved” could come at the cost of many more unseen jobs “lost.”

Another side effect (which flies in the face of one of Trump’s campaign promises to “drain the swamp”) is this move will increase lobbying.  As Justin Wolfers tweeted: “Every savvy CEO will now threaten to ship jobs to Mexico, and demand a payment to stay. Great economic policy.”  There is now an increased incentive for firms to lobby government for funds should they want to leave or relocate.  Given lobbying is certainly an arms race, firms will pour more money into lobbying and less into R&D or their employees.  To be sure, this is already a norm in the US, but Trump is merely perpetuating and expanding it, as opposed to ending it.

So, we have reduced investment into the US and increased interest in lobbying, both of which are economically inefficient activities.  Seems like quite a steep price to pay to give a temporary stay of execution for 1,000 jobs.