What Naval Warfare Shows About the Market Process

You stare out over the watery landscape through your binoculars.  Endless grey skies that go on for thousands of miles.  Carefully scanning, you look for any sight of the enemy battleship in the area.  You know she’s there…but where?

“Contact!  Starboard!” comes the shout.  You whip around and sure enough, there is, on the horizon, a ship.  You pull out your binoculars and see the distinctive black cross on a red background flag of the Kriegsmarine.  “Target acquired!” you shout, confirming what the officer saw.  “Bring us around.  Gunner, I want a firing solution now!”

“Aye aye!”

Your ship, a massive American battleship, comes around and you gain on your prey.

“Solution plotted!” yells the gunner.  “Elevation, 20 degrees!  Keep this bearing!”  You nod.  You see from the bridge the main batteries change position and elevation, their silence now an omen of the death they carry.

“Guns ready!’ comes the shout.  “Fire,” you command.

The massive ship bucks as all six 15-inch cannons fire.  The blast is loud enough to deafen everyone temporarily.  The ship rocks as though hit by a large wave.  Hot death is quickly headed toward the enemy ship.  You look through your binoculars:

Splash!  Splashsplashsplashsplash!  All six rounds miss.

“Damn!  We overshot!  New solution!”  Again, the gunners recalculate.  “19.8 degrees, sir!”  The guns are realigned and the command is given again.  Splash!  Splashsplashsplashsplash bang!  One round hits, but it is a glancing blow.

“I have you now,” whispers the gunner as he does his calculations again.  “19.9 degrees, sir!”  “Fire everything we’ve got!”

Again, the ship roars with the fury of a god.  You watch through your binoculars.  Even from several miles away, you can hear the boom as the rounds hit their target.  A massive plume of smoke and fire erupts from the enemy ship.  “Direct hit, sir!  They’re sinking.  It looks like we got their magazine!”  A cheer goes up from the crew.  The prey you have been hunting for weeks was now dead in the water.

How was victory achieved?  Tenacity, no doubt.  But also trial-and-error.  The gunner and crew had to operate on their best information at the time.  As new information came in (missed shots), they adjusted their plans.  Eventually, they were able to have a direct hit by making changes.  In other words, their failures allowed them to ultimately succeed.

The same is true for a market process.  Markets fail.  People notice those failures.  They subsequently make adjustments.  Those adjustments help correct for the market failures and bring people closer and closer to their goals.  Market perfection may never be achieved, but it is tended toward.

People fail.  People learn what not to do.  People correct.  That is the market process.  Failure is just as important as success.

Today’s Quote of the Day…

…comes from pages 149-150 of Carl Dahlman’s 1979 Journal of Law & Economics article The Problem of Externality (emphasis added, footnote omitted):

In case I, the laundry owner correctly anticipates the costs of bargaining to be low enough for him to gain from reducing the smoke outpour from the steel mill: the externality becomes internalized by the steel operator. In case II, he correctly anticipates the cost of smoke reduction would be too high: he thus lives with the smoke. The externality is now internalized by the laundry operator, and there is no inoptimality problem. In case III, the laundry owner decides to bargain for reduction in smoke outpour but finds in the process of bargaining and policing the agreement that it cost him too much to do so. In case IV, he decides to live with the smoke in the belief that it would cost too much to reduce it but is incorrect: he would have gained from reducing it in view of the costs of transacting with the steel operator.

We have already noted that in cases I and II there is no Pareto-relevant externality remaining; the question remains whether there is one in cases III and IV. In case number III there is obviously no Pareto-relevant side effect remaining; on the contrary, there is too little smoke. The laundry owner lost by having the smoke reduced, so total income is lower in case III than it would have been if the smoke had been endured. In case IV, however, the laundry owner should have bargained for a reduction in smoke outpour but failed to do so. This is then the only case that can qualify as a potential externality.
From the point of view of the laundry owner, it would not appear that it is a mistake to endure the smoke: given the information that he has at his disposal, he performs his constrained optimization and does nothing. His information is incomplete or wrong, so he makes the wrong decision: given the correct information there is a loss of income from the enduring of the smoke, and the situation looks very much like  that we associate with an  externality. Yet that interpretation is fundamentally incorrect, for, with the information that the laundry owner has at his disposal when he makes the decision, he decides correctly, as constrained optimization procedures would have it. It is only later that he may realize that he has made a mistake, in view of additional information that was not available at the time. This can be regarded as an externality only if you assume that “he should have known better” or that there is someone else who does know better.

Once the logical implications of bargaining under transaction costs are fully accepted, it is seen that all existing side effects are internalized one way or the other. An assertion that externalities represent a deviation from an optimal allocation of resources then implies that the analyst considers himself in possession of superior information than what is available to market transactors: he knows the “true” probabilities, as it were. The issue of whether an alternative and improved allocation of resources exists is then seen to hinge on whether there is available relevant information about better alternatives.

People will act on the best information they have at the time.  That information may be incorrect; they may make mistakes, and mistakes that were obvious in retrospect.  But they are exactly that: retrospect.  Unless we assume the policymaker has superior knowledge of everyone’s costs and benefits (possible but not probable), we cannot say ex ante that some policy prescription is necessary or beneficial for solving externalities or other societal ills.  It’s quite probable, given people’s subjective costs and benefits, that all costs of an externality have already been internalized, that is to say, an optimal level has already been achieved.

Any political policy that alters how a market works, anything ostentatiously designed to correct a “market failure” runs into the same problem Dahlman discusses here: a knowledge problem.  The analyst or policymaker must either prove he has superior knowledge (itself a high hurdle to clear) or merely assume he does.  But it is only by retrospect can we determine if there actually is a market failure; it is damn near impossible to see one in real time.

Thoughts on Scarcity: A Discussion on Keynsian Recessionary Spending (Wonky)

Last week I guest-taught a class for my friend and colleague at GMU Dr. Colin Doran.  The course was Introductory Macroeconomics and the lecture was on fiscal policy.  The textbook is Paul Krugman and Robin Wells’ popular book Macroeconomics (5th ed).  In the chapter on fiscal policy, after explaining its goals and implementation, Krugman & Wells discuss several common objections.  They write (Page 386):

In practice, the use of fiscal policy—in particular, the use of expansionary fiscal
policy in the face of a recessionary gap—is often controversial….But for now, let’s quickly summarize the major points of the debate over expansionary fiscal policy, so we can understand when the critiques are justified and when they are not.
There are three main arguments against the use of expansionary fiscal policy.
• Government spending always crowds out private spending
• Government borrowing always crowds out private investment spending
• Government budget deficits lead to reduced private spending
The first of these claims is wrong in principle, but it has nonetheless played a
prominent role in public debates. The second is valid under some, but not all, circumstances.  The third argument, although it raises some important issues, isn’t
a good reason to believe that expansionary fiscal policy doesn’t work.

This post will address Krugman’s & Wells’ (henceforth shortened to “Krugman”) claim that objections 1 & 2 are incorrect on principle; I will ignore point #3 for now.  What follows will be a wonky discussion.

Continue reading

Who Competes with Who?

President Trump (and other protectionists) like to frame international trade as a context: the domestic nation is competing with foreign nations and that imports must necessarily harm and exports necessarily help.  Aside from the numerous logical and mathematical issues with this interpretation, it is economically incorrect from the perspective of competition.

International trade represents the exchange of goods and services across political borders by individuals.  More simply put, it involves buyers on one side of an arbitrary line and sellers on another.  The fact this is buyers and sellers matter for a simple reason: buyers and sellers do not compete with one another.  They cooperate.

Buyers compete against other buyers.  Sellers compete against other sellers.  Buyers and sellers do not compete with one another.  The seller must offer a price acceptable to the buyer.  The buyer must offer a price acceptable to the seller.  The two will cooperate to make the exchange happen (or else they go their separate ways and other buyers and sellers step in).  What this indicates for international trade is this: when foreign producers are harmed, either through tariffs or quotas, they are not the only ones harmed: their domestic customers are harmed as well.  When Trump mentions “punishing” foreign companies for having the gall to offer Americans the best possible deal, what he is actually talking about is punishing Americans by reducing their options and preventing their cooperation with other people.

If we are to use the (highly misleading) language of nations trading with one another, this means that international trade is not a competition but rather cooperation.  It is impossible for one nation to be losing at trade because there is no competition!  Buyers and sellers cooperate.  When two nations trade, they cooperate.

Trade is Not Zero-Sum

On this post on Cafe Hayek, Per Kurowski writes in the comments:

Trade deficits per se do not worry me as much as a wrongly structured trade deficit. If current trade conditions permit other countries better chances to develop 1st class robots and the smartest artificial intelligence than mine, then I do fret for the future of my grandchildren. Let us not forget the “Arsenal of Democracy”

Mr. Kurowski makes a common mistake regarding trade: trade is not zero-sum.  If other countries are developing 1st class robots and smarter artificial intelligence, it does not necessarily follow that the domestic nation is made worse off by such innovations.  Indeed, the domestic nation stands to gain from such innovations.  A wealthier nation has more to offer the world.  More to trade means more trade.  More trade fosters more growth for both parties.  Even if a nation loses an absolute advantage in robotics or AI or something (as Mr. Kurowski postulates), it still becomes wealthier because of the Law of Comparative Advantage.

Mr. Kurowski also seems to insinuate that such gains by trading partners would pose a threat to national security.  I’ve written on the “protectionism for national defense” argument before, but it bears repeating that trade fosters peace, not violence.  There are two main ways to get what one wants: through cooperation or coercion; through trade or violence.  When trade is encouraged, peaceful cooperation takes hold.  Goods and services can cross borders, making all better off.  Since this trade is mutually beneficial, both nations face higher costs of breaking off those ties.  Even if the two nations get wealthier and can afford more expensive military equipment, the costs of war will rise quicker and the benefits of war fall.  With rising costs and falling benefits, the likelihood of conflict drops (we have seen this pattern take hold over the past few decades as trade liberalized).

If Mr. Kurowski is concerned about the future of his grandchildren, then he should welcome deeper trade ties among nations and not be concerned about trade deficits.  This would mean a wealthier and more peaceful world.  A move to protectionism would mean a poorer and more violent world.

Cooperation, Coordination, and the Law

Markets, by definition, rely on cooperation and coordination.  Buyers must cooperate with sellers in order to exchange; the seller must offer something the buyer wants and the buyer must offer something the seller wants.  Only through this cooperation can a trade occur.

Likewise, buyers and sellers must coordinate.  The buyer must be in the same place as the seller*.  A coordinating agent (ie a middleman) may sometimes be used to bring buyers and sellers together (think, for example, a realtor that brings home buyers to the home seller).  Similar to cooperation, buyers and sellers must coordinate on what to exchange and what their expectations are.

Cooperation and coordination are vital to the market process.

Economic texts tend to focus primarily on the coordinating and cooperation aspects of the market process, as they rightfully should, but a key factor is left out of the equation; that factor is the law.

Law here refers to the “rules of the game.”  Law is both written and unwritten; it is the set of rules, customs, norms, etc that develop through people’s interactions with one another.  Law, while shaped by peoples’ interactions, also shapes those interactions.

Law provides a useful form of coordination: who can sell what, what/how promises should be kept, what remedies exist for lawbreaking, that sort of thing.  Without law, and especially property rights, the coordination necessary for the market process would break down.

Consider, for example, property rights.  Property rights are a form of law; they may be formal (in the case of a deed registered at a local governmental authority) or it may be informal.  Property rights allow the market process to occur by defining who can trade what.  In other words, who owns the right to the use of a piece of property.  Ultimately what is being traded in any situation is a bundle of property rights.  If these are not clearly defined, then folks cannot know how to trade.  There cannot be coordination nor cooperation in this case.

Clearly-defined property rights are important to market transactions, but no property right will always and everywhere be perfectly clear.  We live in a world of “incomplete contracts.”  Not all possible situations can be anticipated and to write and understand property rights that take into account all possible conflicts is both physically impossible and economically wasteful (marginal cost exceeds marginal benefit).  In these ambiguities is where law also helps the market process.  Law, preferably by drawing on established rules of adjudication and precedent, can resolve these conflicts and allow the market process to function better (this was one of the great insights of Ronald Coase).

Law, of course, can have its own problems.  Just like any institution (including the market), it can be abused.  But it is vital to the coordination and cooperation functions of the market process.  Without law, trade cannot exist.  Only war.

*This place need not be physical

The Rules of Free Trade are Simple

What follows is a letter I’ve written to the Wall Street Journal:

Greg Ip’s 31 May 2018 piece, “Lessons in How to do Protectionism Well,” is interesting to say the least.  However, there is a major way in which Mr. Ip errs.  he writes: “He has thus far been relatively easy on China, which even free traders agree is a serial violator of the rules of free trade…”

It is unclear what rules of free trade Mr. Ip seems to think China has violated.  The rules of free trade are simple: people are voluntarily able to exchange their property rights.  China, at least outside of the country, has not compelled anyone to buy from them.  All trade done with China, that is individuals buying from other individuals who just happen to be Chinese, is voluntary.  China has not violated the rules of free trade at all.  If China were forcing American consumers to buy Chinese products, then yes they’d be violating the rules and should subsequently be punished.  But offering Americans goods at low prices is not a violation as the exchange that occurs is still voluntary.

Signed,

Jon Murphy

George Mason University