Be Skeptical of Regulations Because Knowing the Market is Difficult (Even for Experts)

Given how much money business consultants make, one would think they have pretty good insight into a given industry or market.  And sure, they may have lots of information unavailable to most people, but does that necessarily imply they are better?

All data received, we must remember, is context-dependent.  Data never, ever, speak for themselves.  Interpreting and developing models for given market structures is extremely difficult in this regard because it requires certain assumptions.

Consider the following real-world example: when the guys from Xerox (the copy machine company) wanted to start selling their machines to businesses, they met stiff resistance from consultants and financial backers.  “Why would anyone spend thousands of dollars on a copy machine when we have a perfectly good, cheap substitute: carbon paper?  Copy machines will never sell.”  Prima facie, this criticism seemed legitimate.  Firms and experts observed secretaries and typists using carbon paper to make copies for distribution.  There didn’t seem to be any demand for copy machines.

Undeterred, the Xerox guys pressed on.  They decided to give companies the hardware, toner, and paper for free up until the first 2500 copies per month.  Firms jumped at the idea.  After all, how were they ever going to use 2500 copies a month?

Well, the rest is history.  Xerox is still around.  Carbon paper is not.

Why?  What did the experts get wrong?

They got wrong the scope of the market.  Copy machines weren’t for people writing letters.  They were for people receiving and distributing letters!  The market for copy machines was for the owner who got a letter from his lawyer who wanted to distribute it to the rest of the team.  It was for the product manager who needed to itemize his costs for different departments.  Etc etc.

There is an implicit conceit in economics that we know the market, the shapes of demand and supply curves.  But the reality is, we never do.  We have only data points in a certain context which may or may not provide useful information about other contexts.  This implicit conceit becomes vitally important when we start talking about regulation or “optimal taxes,” which require knowledge of the scope and shape of the market.  Knowledge we simply do not have.

What is Unique About International Trade?

What is unique about international trade?  This is the question that I pose to my two trade classes (Econ 390: International Economics and Econ 385: International Economic Policy) every day this Fall.  This question is crucial toward understanding the content in the courses.

In Econ 390, the more technical of the two courses, we’re using Paul Krugman, Maurice Obstfeld, and Marc Melitz’s textbook International Economics (among others).  The opening chapters deal with the main models of trade theory: Ricardian, Specific-Factors, Hecksher-Ohlin, and the combined Standard Trade Model.

As with any good model, we start with the simple case of two people.  How does the model develop here?  What are the driving forces of change and outcomes?  What are the impacts of the assumptions?  We then expand the model into the world of international trade.

When we expand the model outward, we notice something interesting: nothing unique happens when the model is expanded to include international trade.  The factors adjusting income distribution stay the same.  The influences governing specialization stay the same.  The key for any of these models is that a change in relative prices changes the distribution of income and economic activity.  This result is no different than microeconomic outcomes.  Any change in relative prices, regardless of whether this occurs because of domestic or international conditions, will cause changes in the economy.  This is a point Krugman et al repeatedly stress in their textbook and a point I repeatedly stress as well.

Let’s take, for example, the Specific-Factors model, which argues that in any form of production, there are some factors of production specific to that production and some factors that are mobile and thus can switch from one form of production to the other.  If there is some relative price change, the model predicts the domestic owners of the specific factor of the now relatively-expensive good will benefit (increased income), the domestic owners of the specific factor of the now relatively-inexpensive good will not benefit (less income) and the domestic owners of the mobile factor will have an ambiguous impact.  Note that it doesn’t matter if this change in relative prices is caused by domestic issues (say, a tax on one good that changes its relative price) or by international trade (a change in world price).  The effect is the same.

So, what then is unique about international trade?  Is it that differing legal regimes between countries have a major impact and thus people should be upset about that?  This doesn’t hold, especially in the United States, as each of the 50 states has different legal rules and regulations.  California, for example, has very stringent rules about labeling and selling; New Hampshire, not so much.  New Hampshire thus has an advantage over California, but people in California aren’t protesting New Hampshire products.  So, the uniqueness of international trade cannot rest on differing legal regimes.

Dani Rodrik suggests its a perception of unfairness due to different “domestic norms” and “social understandings” that is unique.  While the perception may be unique, the actual reality of any unfairness due to these differences is not unique.  Again, domestic norms and social understandings are legion among the various regions of the United States.  Some states have stronger social safety nets than others.  Firms will move to take advantage of less costly regulations.  So, this difference in social understandings is not unique to international trade, either.

There are many other excuses people can give for the uniqueness of international trade and why tariffs are justified internationally but not nationally; I’ve just listed two.  But the same analysis should be performed for each of these excuses.  You’ll find they do not hold up.

In short, there is nothing economically or socially unique about international trade that renders it subject to special rules and regulations.

The Importance of Considering Transaction Costs

Over at Carpe Diem, Mark Perry points us to an article detailing a potential move by Wal-Mart:

Target and Walmart will now face a tough choice: They can absorb the higher costs from tariffs by taking a hit to their profit margins, or they can pass some of the price increases on to their customers.

“Either consumers will pay more, suppliers will receive less, retail margins will be lower, or consumers will buy fewer products or forego purchases altogether,” Walmart warned in its letter.

The Trump administration is using tariffs to push companies to manufacture more goods in the United States. But the National Retail Federation says the administration’s thinking is flawed and carefully planned supply chain plans can’t be redrawn overnight. Retailers order their products six months to a year in advance, and they are left scrambling to find new options for 2019. “The [administration] continues to overestimate the ability of US companies to shift supply chains out of China,” the trade group said in its own letter to Lighthizer. “Global supply chains are extremely complex. It can take years to find the right partners who can meet the proper criteria and produce products at the scale and cost that is needed.”

Implicit in this conversation is the costs to retailers (and manufacturers and anyone else who uses imported goods) to search and find new suppliers.  These costs are very real and necessarily contribute to fewer economic gains in the country.

Trump’s tariff schemes, to use tariffs to force companies to relocate supply chains or operations to the US relies on something of a Nirvana fallacy: that these relocations/readjustments can be done costlessly.  As a former business executive, he should know better.  Firms cannot just adjust their operations costlessly.  Contracts are in place.  New ones would need to be written.  New relationships need to be formed.  Adjustments need to be made to product specifications.  Etc etc.  These are not costless processes.

Even if we were to assume, contrary to ex-ante evidence, that Wal-Mart suppliers relocating back to the US is 1) possible and 2) would be beneficial for the economy as a whole, when you figure in all the costs associated with such a move (that is, all the transaction costs), it is highly improbable that, on net, the move would be positive.

 

A Hidden Danger of Aggregation

I have been verbally outspoken against macroeconomics (not so much writing).  Macroeconomics, that is the examination of aggregate economic data for the purpose of discovering observable phenomena, is quite distinct from microeconomics.

Despite my verbal abuses, macroeconomics does have uses.  Observing these phenomena, such as the impact of interest rates or foreign exchange rates or GDP, can provide useful information.

But they are only useful insofar as the assumptions behind these aggregate measures hold; only insofar as they are used as a signal.  GDP, for example, is used as a measurement for economic well-being.  In a relatively free market, with a working price system and protected property rights, it acts as a pretty good indicator.  Given these assumptions, if GDP rose, say, 4% over the course of a year, it’s reasonable to conclude the people who make up the economy are likely approximately 4% better off than they were the previous year.

However, once those measurements become an object of choice, then they lose all value.  GDP growing at 4% due to market forces tells us important and helpful information.  GDP growing at 4% due to deliberate actions taken by governments to increase that number (say, arbitrarily increasing government spending) does not tell us anything useful.  If anything, it can be misleading.  The signal is distorted.

This argument is the same as discussions on the distortion of price signals.  A price, when determined by supply, demand, and all their components, provides valuable information on the relative scarcities of goods.  A price, when it becomes an object of choice and is thus manipulated to meet some desired level (eg, minimum wage, price controls, tariffs, etc) provides no useful information.  The price no longer functions as a price.

The great sin of macroeconomics is confusing this point; how often do we hear an argument along the lines of “Higher GDP is good.  This action would increase GDP.  Therefore, we should do it”?  But a higher GDP is only useful insofar as it conveys market transactions.  Anything else, and it becomes useless.

Should Economic Growth be Traded for National Defense?

One of the stronger arguments against free trade is the national defense argument: some industry may be so vital to national security to warrant its protection from foreign competition.  This justification may be easily abused, but let’s ignore that possibility for the moment.  Is it still worth restricting trade and reducing opulence for the sake of national security?

The trade-off between security and opulence doesn’t appear too clear cut to me.  Protected industries tend to become listless, stagnant, and non-dynamic.  Protected from the forces of competition, they can become complacent.  As AEI economist Mark Perry likes to say: competition breeds competence.  These protected industries may become so undynamic, so technologically backward or stagnant, that in the event of a national emergency, they are unable to handle the military needs.

Furthermore, protected industries (especially if they are subsequently subsidized) may discourage development of newer technologies that may be better suited for national defense.  Let’s say, for example, that the steel industry is vital for national defense.  Since steel is protected from competition, it can make it a more attractive investment for people given its security.  This would divert resources away from other developments that could rival the industry, say some sort of lighter metal or steel substitute.

If an industry is protected from competition and it becomes listless and non-dynamic, not only is it coming at a sacrifice for national wealth but may also be a hindrance to national defense as well if it cannot adapt to changing war needs.  This becomes deadly true if a climate of rent-seeking rather than innovation takes hold in the national economy.

In short, while theoretically, tariffs could be helpful for national defense, they could very well end up being detrimental.

People Trade, Not Countries

In a short post on EconLog, Pierre Lemieux points us to the flawed thinking of many scarcityists.  In the article, he quotes Trump:

“Their consumer habits,” [Trump] explained about Europeans, “are to buy their cars, not to buy our cars.”

What the scarcityists don’t understand, even with their fancy models, is that trade is ultimately and everywhere a microeconomic phenomenon.  It is people’s preferences that shape the pattern of trade, and merely imposing some tariff here to removing some tariff there may not be enough to create “balanced” trade.  In a world of free trade, people will be free to make their own choices.  In this case, the people have spoken: Europeans prefer European cars to American.  And to a tyrant like Trump, that is unacceptable.

 

Thinking about Collective Nouns

This semester at GMU, I am teaching two sections of international trade (Econ 385: International Economic Policy and Econ 390: International Economics).  In both classes, I began with a lecture (reiterated in subsequent lectures) that the focus of analysis is the individual: the government does nothing.  The decision-makers in government do something.  Ford Motor Company does nothing.  The CEO (or COO, or purchasing manager, etc) do something.

As such, these collective nouns (the government, the firm, the society, etc) can be useful shorthand so long as it is understood that the individual remains the focus of analysis.  But they can also be highly misleading.  In international trade, for example, nations do not trade.  It doesn’t make sense to talk about China trading with the US or the US specializes in X and Croatia specializes in Y (even as a shorthand).  Bobby in Boston buys a toothbrush from Li in Lanzhou.  End of story.  These transactions may be aggregated upward based on all the transactions that occur within some political boundary, but ultimately it is still individuals who trade.

When does it make sense to use a collective noun such as government or firm?  When the action taken calls for collective action.  In other words, when there is a margin being adjusted upon that the individual cannot adjust upon.

Perhaps an example will help.  Consider two men trying to load a heavy box into a truck.  The effort is not merely the summation of their two efforts.  If Joe lifts and then Richie lifts, the box ain’t going anywhere.  It is only through their combined efforts at the same time that the box is moved.  The two men working as a team adjusts along a margin (moving the box into the truck) that individually they could not do alone.

So, it makes sense to refer to a collective noun as a collective noun when there is some effort going on that only the collectivity can achieve.  Only Ford by its nature as a firm man design, manufacture, market, distribute and retail cars. It is the collective action taken by many individuals whose individual contributions are hard to separate from the collective goal; where anyone individually working alone would face costs too high to make the action occur.  The team of Joe and Richie does and Joe and Richie cannot alone do.  It makes sense to refer to them as a team.

The way international trade is discussed and taught is largely misleading if one is not careful about this subtlety.  International trade remains, ultimately, a microeconomic event.