Cause, Effect, and Misallocation

In preparation for a price theory book I am writing, I am re-reading George Stigler’s classic 1966 text The Theory of Price.  The following is found on page 19 (3rd edition):

[I]t has become a major task demanded of all economies: they are required (as soverigns use this word) to provide technological advances, capital accumulations, improved labor forces, and larger incomes.  So strong is this demand, that sometimes a method by wich western nations become richer–industrialization–is confused with the growth itself, and inappropiate industries that reduce a nations’s income are adopted to increase it.

Confusing cause with effect is a major problem facing all analysts.  This becomes doubly true when discussing economic growth when policy is involved.

Industrialized nations are wealthy, but it doesn’t necessarily mean such industrialization is the cause of wealth.  Rather, industrialization is itself a symptom of a deeper cause, that is the division of labor.  “Industrialization” is a term without definition, as it can refer to many kinds of industries.  Comparative advantage is what tells us what kind of industrialization is needed to foster growth.

The United States has a comparative advantage in high tech industries; we are an extremely intelligent people with lots of capital (both human and machine) at our disposal.  China, however, has a comparative advantage in low tech industries; they have lots of unskilled labor at their disposal.  It makes sense for the US to industrialize in high tech industries and China to industrialize in low tech industries.

But even within countries, industrialization is varied.  In the US, the vast middle of the country has some of the most fertile farmland in the world.  It makes sense for those states to be agriculturally-based and other places, like Texas, to be resource-based, and others, like Massachusetts, to be tech-based.

A scheme based on the mistaken notion that “industrialization = progress” will lead to misallocation of resources.  Resources, such as labor, capital, time, will be diverted into less productive and more costly areas.  This, in turn, leads to a net decline in wealth compared to where it otherwise would have been.  An example of this is China during the “Great Leap Forward.”  Industrialization, specifically of steel, was all the rage of the Communist Party.  All production was geared toward steel production.  This inherently meant a rapid decline in production of other items–like food.  China’s poverty deepened.

The Great Leap Forward is an extreme example, but other historical cases of misallocation of resources due to the mistaken belief of “industrialization = wealth” include the USSR, modern Venezuela, and North Korea.

When examining the causes of economic growth, one must be very careful in determining cause and effect.  This is where price theory really shines.

Grad School Advice from a Grad Student

What follows below are some of the lessons I’ve learned while in school.  I write them here to share them with you:

Econ 101 is called “fundamental” because it is just that. Everything you’ll learn in your higher level classes are built off of Econ 101. All the theories, all the techniques, all the tricks you’ll learn are spawned from Econ 101. Just as calculus is built off of mathematical operations like addition, subtraction, division, and multiplication.

When I am doing research, I often find it is best to go back to my introductory Econ textbook (either Alchian & Allen or Tabarrok & Cowen) and review the material. Several times, I’ve found either a mistake in my reasoning or a better way of exploring my problem.

It’s easy to drink one’s Kool-Aid and become enraptured with the mathematics and statistics of economic analysis. It’s trivally easy to prove just about anything you want. But do not fall into that trap. Use the mathematics and statistics as a tool to tease out your assumptions. Translate your formulae into English. If you can’t do that, burn the mathematics. (Paraphrased from Alfred Marshall)

One thing about grad school is that it is extremely tough on the ol’ ego. There are constant rejections, frustrations, failures, and nonsense. There are insane levels of stress and pressures and it takes a lot to get even one praiseworthy bit of work done.

What makes it bearable are the people you surround yourself with. Mentors are invaluable. But so are friends, colleagues, and collaborators (who are often one and the same). Without my friends here at GMU, I’d probably go insane. 

 Grad school isn’t an individual effort. It’s a team sport. We pick each other up when we’re down, we boost each other to get over obstacles, and we share in each other’s victories and defeats. I’m part of a fraternity that they couldn’t pay me enough to leave.

Find your friends. Stick by them. Remember that we’re all strapped to this roller coaster named Life together.

A Note on China

On an earlier post, frequent commenter Greg G writes in two separate comments (condensed here for readability):

I think the best argument for tariffs is the astonishing economic success of China in lifting so many people out of poverty in such a short time. It’s not easy to explain how they did that if tariffs are really so inimical to the interests of their own people. Those of us in favor of free trade (and I count myself among that group) need to admit we can’t explain that. As always, we could argue that they would have done even better in some counterfactual where everyone listened to us but that is a very weak argument for a couple reasons. One is that it is always available to everyone. The other is that none of us would have predicted in advance that such an economic miracle was possible even if we had been guaranteed we could dictate policy.

Free market theory predicts that all these state interventions should be bad for Chinese consumers yet no other country’s consumers in history have enjoyed a comparable jump in their standard of living in such numbers in such a short time. Yes, I know they started from a place of extreme poverty and even more Draconian state interventions where it was easy to make big percentage gains. Even so, there are countless other countries that started in extreme poverty and stayed there both with and without a lot of state intervention in the economy. I am not pushing any economic theory that I prefer to free trade but I do still think that the Chinese example stands as a challenge to some of the economic theories that we prefer. It’s at least a little bit awkward that the regime that engineered the biggest economic leap forward in history still calls itself Communist.

Let me begin with a quick point.  Free market theory does not predict that all state interventions are bad.  There are many theoretical cases where interventions such as tariffs can be beneficial.  However, such theories require strong assumptions and a level of knowledge we deem impossible to possess, so we are skeptical of the applicability of such arguments.

More specifically on China:

Greg is right to wonder about China’s massive increase in wealth over the past 30 years.  It is astonishing.  Does it represent trouble for the free market thesis?  I don’t think so.  It adds a lot of credence, indeed.  China has been rapidly reducing tariffs over the past 30 years.  Non-Tariff barriers are falling, too.  In short, China opened their markets to the international market.  I think this has contributed to their economic growth.  It could be better, sure, but they’re steps in the right direction.

However, I fear if China does not institute market reforms, they could find themselves stagnating.  Japan had a similar growth strategy as China in the 70’s and 80’s.  They saw rapid growth but subsequently stagnated from 1990 to present as their protected firms became moribund and unable to handle competition or anticipate market changes.  Unless they allow true market reforms beyond what they already have, China will likely also face such stagnation, albeit at a higher level than Japan.

Murphy in the Library of Economics and Liberty

Here is a link to my latest column at the Library of Economics and Liberty.  A slice:

One last point on the national defense argument. If China, a national security threat and military threat for influence in the region according to President Trump’s economic advisor Peter Navarro were dumping steel in the U.S. market to gain some military advantage, the logical thing for the U.S. government to do would be not to encourage U.S. exports but, rather, to encourage Chinese imports. Since steel is a scarce resource, sending it abroad (i.e., encouraging exports) necessarily reduces the stock of steel in the United States, whereas imports increase it. If China is dumping, then it means that the product is being sent to the United States rather than being used in Chinese markets; for every unit of steel sent to the United States, that is one less unit that could be used for a Chinese war machine and one more for a U.S. war machine. The logical action for the U.S. government would be to purchase a lot of low-cost steel from China and simply stockpile it, thus depriving China of war materials while maximizing U.S. steel stockpiles. In the event of war, the United States would have a large stockpile from which to draw, while China’s would be reduced.

The Law of Demand in Action (or Why Monopoly Power is Fleeting)

Writing at Human Progress, Martin Tupy has an excellent article on the real effects of predatory pricing and monopoly.  Here is the upshot (although one should read the whole article.  It is excellent):

In a 2014 Council on Foreign Relations report, Eugene Gholz, an associate professor of public affairs at the University of Texas at Austin, revisited the crisis and found that the Chinese embargo [of rare earths to Japan] proved to be a bit of a dud.  Some Chinese exporters got around the embargo by using legal loopholes, such as selling rare earths after combining them with other alloys. Others smuggled the elements out of China outright. Some companies found ways to make their products using smaller amounts of the elements while others “remembered that they did not need the high performance of specialized rare earth[s] … they were merely using them because, at least until the 2010 episode, they were relatively inexpensive and convenient.” Third, companies around the world started raising money for new mining projects, ramped up the existing plant capacities and accelerated plans to recycle rare earths.

In other words, when faced with a sudden shortage, people compensated through other means.  It’s almost as if demand curves slope downward.

Monopolies are still subject to the whims of consumers.  They cannot raise their prices with impunity.  As prices remain high, people will innovate around them.  This indicates that the fear of predatory pricing, that a firm (or country) will seize market power and use it to jack up prices or manipulate people, are greatly overblown.