Different Rules for Different Worlds

It’s Christmas Time.  That magical time of year where friends get together, families visit, and, for a little while, all seems well.

But, as sure as Christmas time comes around, we also get economic defenses of Scrooge and calls for cash to be given rather than gifts.  From a mainstream economic point of view, there’s nothing inherently wrong with these articles.  However, they miss a larger point, a point once known to economists, but have since been forgotten (or trivialized): moral rules matter.

Humans, as social creatures, live in two worlds at once (to paraphrase Hayek).  We live in our personal worlds, which have their rules, and we live in the commercial/interpersonal world, which has its own set of rules.  We must move in between these worlds constantly and manage the two rule regimes.  What is appropriate in one world may not be appropriate in the other.

By way of example, imagine if a friend asked you for a ride somewhere.  It’d be frowned upon if you asked him for money (outside gas money or maybe tolls). However, for a taxi to do the same thing, you’d expect to pay and there’d be no impropriety. No one would accuse the taxi driver of inappropriate behavior and no disapprobation levied on him. However, for a friend to make a profit, it’d be inappropriate and he would be saddled with disapprobation (considered a bad friend, etc).  Asking for money would violate the rules in the personal world but not the interpersonal world.  To try to apply the rules of one to the other would be problematic.

We expect people to behave in certain ways.  The cold indifference Scrooge shows toward Cratchit elicits feelings of disapprobation, especially during Christmas.  We expect this time of year to bring about beneficence and we expect employers to treat their employees a certain way.  When the interpersonal rules are applied in this situation, they appear wholly inappropriate, at least within a certain level of propriety.   Further, Scrooge’s transformation at the end of A Christmas Carol is itself praiseworthy.  He becomes benevolent, which is virturous.

I hasten to point out that nothing Scrooge does, either before or after his transformation, is unjust.  Scrooge, at no time, violates any rules of justice: he does no harm to anyone.  But simply because an act is just does not mean it is praiseworthy.  As Adam Smith says, the rules of justice can be obeyed by sitting still and doing nothing; but that behavior is hardly grounds for any approbation.  Justice is a negative virtue; it only affects other people when ignored.  Benevolence and the other virtues are positive, and they can do real good through acting.  While Scrooge was surely just, he was hardly praiseworthy.

Another example of the difference between these two worlds is from cash as a Christmas gift.  Again, from a purely economic point of view, there is hardly anything to object to.  But we are not in the interpersonal world of economics, but rather the personal world, where different rules exist.  One of those rules is: you give gifts to those you love.  Money is unacceptable according to these rules.  Loved ones are expected to exchange thoughtful gifts, not cash.  Violations of those expectations lead to hurt feelings and disapprobation.

One of the things these economic models of gift-giving do not take into account is the moral currency from obeying the rules.  This is likely why an institution that is so inefficient on its face (gift-giving) has remained a tradition for centuries.

Humans are social creatures and we live in multiple worlds at once.  Using a set of behavior from one world as a role-model for the other is a poor choice.  We must consider what makes a person good and just.  And that is the role of moral philosophy.

What, Exactly, is Free Trade?

Calls for government intervention into the economy usually focus on some supposed deviation in the free market system: currency manipulation, tariffs by trading partners, taxation, etc.  As the argument goes, because these things deviate from the ideal assumptions of the model, some government intervention (usually in the form of retaliatory or punitive actions against their citizens) becomes necessary.

However, this form of argumentation represents a fundamental misunderstanding on what free trade is and is not, and more importantly the uses of economic models.  This post is an effort to clear up these misconceptions.

Free Trade is Not a Policy

The language surrounding is misleading, both by its advocates and its opponents.  Both coach free trade in terms of policy: “Government needs to do laissez-faire!” or “Government needs to reign in free trade!” or something like that.  Free trade, however, is not a policy.  One does not implement free trade.  A government can take action to promote free trade (reducing tariffs, cutting regulations, etc), but it cannot adopt a free trade policy per se.

Free trade is nothing more than allowing peaceful interactions between consenting individuals.  It requires no active government policy.  In a free trade society, any governmental role would be naturally be limited to a passive role of enforcing contracts and protecting rights (what Jim Buchanan calls the “Protective State“).

Furthermore, since free trade is no policy, it is not dependent upon the assumptions of the economic models to function (I will return to this point in the next section).  None of the arguments for free trade require perfect information, identical principles between buyers and sellers, known utility functions and universal preferences, etc.  Free trade is robust to deviations from the ideal; the system still works because it is a process, not a policy.  Deviations from the ideal, movements away from equilibrium, present opportunities for entrepreneurs to correct issues; the many plan for the many and do not require the guiding hand of government to correct for deviations.

Models as Analysis and as Policy Tools

Models serve two roles: first as a means of analysis and second as a means of directing policy.  In these two roles, the characteristics of the model matter.

An analytical model, which is the proper use of economic models, involve simplifying assumptions in order to explore (or “analyze”) a particular question.  By way of example, let’s look at minimum wage.  The question is: “What effects will minimum wage have?”  Through a set of assumptions contained in the supply and demand price theory model, we can make a pattern prediction: a binding minimum wage will cause a surplus of labor in the market.  We can make this pattern prediction because our model reasonably reflects reality, even though it has many simplifying assumptions which are, to be frank, unrealistic (for example, the model contains the assumption of “all else held equal,” a condition which never happens).  Our analytical models give us the tools to analyze.

Where the problem comes in is using an analytical model to guide policy (both free-market supporters and opponents make this mistake).  To guide policy, you need a descriptive model, not an analytical model.  In other words, you need a model that is descrptive of reality, not one that reflects reality.  When attempting to guide policy, this is where the assumptions of the model become important.  To impose an “optimal tariff,” you need to know the demand and supply curves (something which is unknowable), you need to know indifference curves and von Neumann-Morgenstern utility functions (which are unknowable), true relative prices and equilibrium, etc etc.  To paraphrase Hayek, to use these models to guide policy, you need to assume knowledge that the price system alone can actually give you!  When using models to guide policy, deviations from the model’s assumptions become critical!

Conclusion

Any good scientist needs to know the limitations of the tools he uses.  Price theory models are extremely helpful in providing a lens through which to analyze the world.  They allow us to make pattern predictions and conduct analysis.  What they do not allow us to do is to make point predictions and guide policy with any level of accuracy needed.  Anyone who pretends otherwise is operating under the pretense of knowledge; he is not acting as a scientist, but rather as a charlatan or a fool: a charlatan if he deliberately knows the limits of his models but pretends they are more accurate than they are and a fool is he believes his own models give him the ability to shape policy.

Today’s Quote of the Day…

…is from Page 31 of the Liberty Fund edition of James Buchanan’s 1975 book The Limits of Liberty: Between Anarchy and Leviathan:

In a world without interpersonal conflict, potential or actual, there would, of course, be no need to delineate, to define, to enforce, any set of individual (family) rights, either in the ownership and use of physical things or in terms of behavior with respect to other persons.  I use “conflict” rather than “scarcity” here, because even if all “goods” that might be “economic” should be avaliable in superabundence, conflicts among persons might still arise.  Social strife might still arise in paradise.  Total absense of conflict would seem to be possible only in a setting where individuals are wholly isolated from one another, or in a social setting where no goods are scarce and where all persons agree on the precise set of behavior norms to be adopted and followed by everyone.  In any world that we can imagine, potential interpersonal conflict will be present, and, hence, the need to define and enforce individual rights will exist.

 

The Law of Demand in Action

On Monday, Virgina began imposing flexible tolls on the I-66 stretch between the Beltway and Washington, DC.  I-66 is one of the most congested roads in the nation during rush hour and the goal of these tolls was to have drivers look for alternative routes so that the interstate remained relatively free-flowing for those who needed to get into the city quicker.

 

Lo and behold, it worked:

Traffic moved smoothly throughout the morning, and WTOP’s traffic center reported that the number of drivers on I-66 declined compared to typical Monday morning volume.

“There were no delays inside the Beltway; that’s the point of congestion pricing — to keep the carpools and paying solo drivers moving. As demand goes up, the price does too,” said WTOP’s traffic reporter Dave Dildine.

VDOT reported that the average speed on I-66 during the morning rush hour was 57 mph, up from 37 mph at the same time a year ago.

The George Washington Parkway absorbed the brunt of the traffic, with Virginia Route 123 and U.S. 50 picking up extra drivers as well.

As price rises, quantity demanded falls as people seek substitutes.  Those who are willing to pay the higher price are those who value the resource most highly.

There has been a backlash, of course.  No one wants to pay a $40 toll one-way.  There have already been calls to cap the tolls.  How does the state respond?

“If we don’t get the tolling right, all we’re going to do is clog up those lanes again, and so that’s why the algorithm is multifaceted. It may change, we’ll study it. But in terms of moving traffic, it looks like it’s doing its job,” [Virginia Transportation Secretary] Aubrey Layne said.

“I know all the publicity is ‘Oh, $40,’ but the whole idea is for the person to make a rational decision. ‘Is it worth [it for] me to pay this to use it or is another method better?’ If you start limiting that, you impact the entire network,” Layne said of requests to cap tolls or make other dramatic changes.

Price goes up, quantity demanded falls.  You put a price ceiling on the market, you “impact the entire network.”

Good to see some Econ 101 knowledge on the part of the Transportation Secretary.

Taking Models Too Literally

At Cafe Hayek, Don Boudreaux points us to a wise quote from Milton Friedman.  Below is a comment I left on that post, expanded:

 

In the highly stylized world of models, where information is perfect, markets are costless, where all preferences are known, where government is costless, and things never change, it is trivially easy to come up with exceptions to free trade and free enterprise. Shift a curve here, refuse to count costs there, and boom! a theoretical reason why tariffs or export subsidies can be beneficial.

However, when those stylized assumptions are relaxed, in other words in a more realistic world where information is imperfect, markets have transaction costs, where preferences are revealed, where governments have administration and operation costs, and where things change, these theoretical reasons disappear like a shadow in the sun. Conversely, the case for unilateral free trade becomes stronger, since it is not dependent upon those assumptions the way the other theoretical cases are; free trade is formulated under those assumptions, yes, but it is robust to movements away. Things like optimal tariffs are formulated under those assumptions but are not robust to movements away from those assumptions.

The true test of any theory is not how well it holds up in perfect conditions, or how well does it perform in the circumstances in which it was conceived, but how robust it is to movements away from those idealized conditions.  Economists from Adam Smith to Harold Demsetz and beyond have warned us against these nirvana fallacies.  True knowledge is gained when we stress-test our models and see how robust they are.  Testing this robustness gave us such fields as Public Choice, Law & Economics, Political Economy, Money and Banking, and the like.

Economic models serve a purpose: they are ways of thinking, methods of analyzing phenomena. However, they are not descriptive of reality. They were never meant to be. When basing policy off of those models, the policy-proponents are making a grave mistake: they are moving their models away from the abstract and into the descriptive. In other words, they are taking their models too literally. This literal interpretation of models can be extremely dangerous.

Hard Coase, Soft Coase

Over the course of this semester, I have been working on two research projects which parallel each other very closely.  Both look at water market exchanges (ie, people who buy and sell water), one from a Coasian perspective (ie, how changes in legislation affect markets), and the other from an Ostrom/Ellickson perspective (ie, how social norms and mores affect markets).  Both these papers are being finished up and I will post links to them here, but there is an interesting connection between the two: both forms of bargaining are “bargaining under the shadow of the law.”

“Bargaining under the shadow of the law” typically refers to working within a framework established by a court (eg, how a court determines property rights).  This is the “hard Coase” theorem.  However, “law” need not apply to just courts; indeed, it does not.  There are general rules, or laws, that develop “[From] our continual observations upon the conduct of others,” to help us “form to ourselves certain general rules concerning what is fit and proper either to be done or to be avoided,” (Adam Smith, The Theory of Moral Sentiments, Section III, Chapter IV, Paragraph 9).  These rules are the social norms and customs, what the Romans called mos, or “a guiding rule of life” (see On Duty by Cicero, translated by Benjamin Newton, specifically Newton’s glossary at the end of the book).  These rules, customs, laws govern our behavior and our interactions just as much as legislation does (perhaps even more so) since we face not jail or prison if we violate these rules, but censure, disapprobation, and demerit from our fellow man; extreme cases could result in isolation from the community, a terrible punishment, indeed, given that man is a social creature.  It is these rules, this law, that I refer to as “soft Coase.”

In both the hard Coase and the soft Coase situations, Coase’s arguments about bargaining hold generally true: changes in the law affect how we behave and interact with one another.  This, in turn, affects how we address externalities and other economic behavior.

The Coase/Ostrom/Ellickson look at collective behavior, sprinkled liberally with Alchian/Demsetz insight and Tulluck/Buchanan public choice theory, is an important way of exploring the market process.

The Problem with Optimal

In economics, the concept of “optimal” is often used: optimal taxation, optimal pollution, optimal consumption, etc.  Optimal, in an economic sense, just means marginal benefit equals marginal cost.  For individual actors, such a definition and usage makes sense.  However, problems arise when trying to generalize optimality over collective units.

With optimality, it is important to remember a key characteristic about benefits and costs: they are subjective.  All value, whether a benefit or a cost, is subjective.  Therefore, an individual can optimize his behavior by aligning his subjective marginal benefits and subjective marginal costs.  But this is not true with collective action.  When analyzing collective action, the point of view of the analyzing person comes into play.  Collective agencies cannot have subjective feelings about things, they cannot optimize; the one who does the analysis optimizes based on his/her subjective values.

Therefore, it doesn’t make sense to talk about the optimization of collective units in the same way it does to talk about the optimization of individual units.  Concepts like “optimal tariffs,” “optimal taxation,” etc., lose their meaning when we start considering subjective costs.  It comes down very heavily to the subjectivity of the person who is doing the calculating, what he/she believes the costs/benefits are.  When that individual is responsible (ie, they pay the cost if they are incorrect) for the results of their actions (eg, the owner of a firm), then such subjectivity is not an issue; they are properly incentivized to make sure their subjective understanding aligns with their collective goal.  When the person is not responsible (eg, government agents), then such optimization becomes…problematic.