A Discussion on Transaction Costs

This post is a riff on a recent op-ed column by Don Boudreaux at the Pitt Tribune “Minimum Wage & Technology.”

As Don writes:

When I explain to my students that minimum wages prompt firms to substitute technology for labor, they often react as if this greater reliance on technology is an upside of the job-destroying nature of minimum wages. But my students are mistaken.

This attitude is often portrayed as justification for all kinds of government interventions: minimum wage, labor restrictions, scarcityism, etc.  Technology is a sign of advancement, so we must advance!

But advancement is not a costless procedure.  Not only, as Don points out in his article, is there costs to developing said technology, but there are also costs to implementing and adopting such technology.  If a self-help kiosk is installed at a fast-food restaurant, its costs are more than just the new machine: it needs to be wired, staff trained (which reduces their productivity in the meantime), company policy created (and all other kinds of backroom stuff), etc.  All these things take time and resources; they all have costs.  If these costs, plus those that Don mentions in his article are higher than the benefits, then the intervention in the market, even if it produces newer technology, is a net loss.

This is an important point that is implied in the above discussion but I want to make explicit: just because there is a hypothetical “better” outcome, it does not mean that the market has failed!  If that outcome does not occur because the transaction and transition costs are too high, then the current outcome, with all its flaws, is the most optimal.

Indeed, there is really only one condition under which we can say with any certainty that a true market failure has occurred: if the outcome is suboptimal, and the transaction costs were misestimated, and this misestimation should have been known to the market participants.  This is an extremely high bar to reach, one that is made all the higher given it requires a huge judgment call on the part of the analyst.  In a sense, the analyst ends up begging the question since he has to assume his judgment and knowledge and subjective evaluations of the costs and benefits are equally shared by the participants (or he knows their inner workings).

Among economists of all stripes, the presumption of liberty, that is the promotion of free markets even when they are imperfect, remains predominant for exactly the reason discussed here: the knowledge of transaction and transition costs are highly personal and their existence gives the economist pause whenever discussing “welfare enhancing” policies specifically designed to control economies.

The Peace of Beggars and Kings

Humans, it seems, have an instinctive need to constantly be dissatisfied with our current position:  “If only I had a little more money, I’d be satisfied,”  or “if only I had a bigger TV.”  Philosophers, including Adam Smith, warn against this mindset, fearing it could lead to perpetual unhappiness and there is nothing to prevent us from achieving that happiness already.

This perpetual unhappiness, or dissatisfaction of the status quo, may be philosophically distasteful (and for good reason) but it appears to serve an economic function: the desire to remove this dissatisfaction fosters economic growth.

Man’s wants are indefinite: as we reach new heights, we become dissatisfied with our current position and desire more, and this holds across time as technology and desires change.  A color TV was good enough in the 1960’s, but now we demand HD and “true color” and all kinds of things.  A small electric fan was good enough half-a-century ago, but now air conditioning is ubiquitous (which, in turn, is giving way to “smart homes” and the like).  To quote Frederic Bastiat: “[A] desire to go thirty miles an hour would have been unreasonable two centuries ago but is not so today [JMM: And now 60 miles an hour is too slow!].”

These desires for advancement come about as we satisfy lower-order desires; there does appear to be a hierarchy of wants.  When all resources were devoted to food production and bare substance levels, desires for speedier travel could not be satisfied.  But as food and shelter needs were met more cheaply (that is, using fewer resources to achieve the same or greater output) thanks to agriculture, more resources could be devoted to other things that were luxuries: fancier clothes, faster means of travel, etc.  Those luxuries then became necessities, and as they were satisfied more cheaply, more could be devoted to satisfying other desires that were luxuries, and so on and so on.

When we were hungry, we desired food.  When that was satisfied, we desired shelter.  When that was satisfied, we desired transportation, etc etc etc.  The constantly evolving desire of man, him chasing that peace beggars have that kings fight for, leads to innovation, the satisfaction of new wants, and general progress.

An implication of this discussion is that it reveals the silliness of many arguments against free trade, namely that trade with other nations make us worse off by reducing our productive capabilities or making us dependent on other nations, but that is a blog post for another time.

Of course, this perpetual unhappiness can have significant negative consequences, as well.  Desire can be a sin as well as a virtue.  Imprudent desire can lead to “arms races” where more and more resources are poured into things that give no gains.  Imprudent desire can lead to all kinds of mental illnesses or acts of crime.  Let us not be accused of denying these basic facts.  But let us not make a bigger deal of it than it is, either, and deny ourselves the benefit of economic progress for fear of arms races or illness.

Desire can be a boon.  Indeed, it has been.  It fosters growth and change.  It must be balanced, sure, just like anything.  But desire is not something to be shunned.  Understanding its role in economic progress is important.

Today’s Quote of the Day…

…is Frederic Bastiat’s 1850 magnum opus Economic Harmonies found on page 493 of the Mises Institute’s The Bastiat Collection:

Upon the subject of human wants, I have to make an important observation – and one that, in Political Economy, may be regarded as fundamental – it is, that wants are not a fixed immutable quantity.  They are not in their nature stationary, but progressive.

Scarcely has a man found shelter than he desires to be lodged, scarcely is he clothed than he wishes to be decorated, scarcely is he satisfied in his bodily cravings than study, science, art, open to his desires an unlimited field.

JMM: Exactly.  Man is always striving to improve his condition.  There is always something new to want, to satisfy some new need that was pushed aside when other things were more pressing.  As one want gets satisfied, two more take its place.

As such, international trade can never fully result in one nation becoming beholden to another.  Those who worry about China destroying US production, who think China can simply dominate us all and subsequently run a monopoly on us, forget this key point.  If China satisfies the need for toys, then the need for computers and airplanes can replace it.  And so on and so on.  As needs/wants get satisfied, more arise, which allows for more specialization and trade.

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.

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

The Role of Money in Trade and Economics

Is money a means or ends?  Confusion over the answer to this question dominates much of the popular conversation regarding economic policy and methods.  Those who see money as an end tend to focus on the production side of economics; wealth is generated by producing and selling things.  The more you sell, the higher your profit, the more wealthy you are (this is the main argument behind mercantilism).  When money is treated as a means, then the focus tends to shift more towards the consumption and trade side of economics: wealth is created when people trade things of lesser value for things of higher value (this is the main argument behind free trade).  Precisely exploring the role of money in trade and economics will go a long way to understanding the means of wealth in society.

Money does not predate economic activity.  Money arose out of economic necessity.  In a simple two-person word, it’s easy to see how a barter economy based on comparative advantage can develop.  One person can make fishing hooks while the other fishes, for example.  They specialize in their comparative areas of expertise and barter physical goods for physical goods.  Both are made better off without the need for money.

But, as the world expands, the barter economy becomes more complex and can start to break down.  That is because barter requires double coincidence of wants.  In other words, to successfully barter, you need something that the other person wants.  I am an academic.  In a barter economy, all I can offer are my economic writings.  If I go to the grocery store and the grocer just happens to want an economic tome for the same amount of groceries I just happen to want, then a trade can be arraigned.  But, if he doesn’t, then no trade can occur.  What can solve this problem?  Well, what if there were some medium of exchange, something that both he and I wanted that could be exchanged in lieu of the physical goods/services but could itself be exchanged for physical goods/services?  A numeraire, if you will?  That numeraire is what we call “money.”

Money solves the double coincidence of wants problem.  I can sell my economic ramblings to some university or bookstore patron in exchange for money and turn around and exchange that money for groceries.  The bookstore patron needn’t necessarily have anything physical I desire other than his money; he needn’t provide me any good or service (he’s already done that for someone else).  He need only give me some pieces of paper.  Likewise, I needn’t perform any services for the grocer (I’ve already done that by providing the book to the patron).  I need only supply her with the desired amount of money.

Money also acts well in reducing transaction costs by being divisible.  Going back to our barter example, neither fish nor fishhooks are particularly dividable.  Selling someone one-and-a-half fishhooks is to really sell them one fishhook and a broken fishhook.  A barter deal may not come about because the amount needed to be exchanged in intact units would be too high.  But money solves this problem.  If, for example, my book sells for $10 and the number of groceries I want to purchase cost $5, then I can essentially sell half-a-book to pay for my grocery bill because money can be divisible.  So, the introduction of money as a numeraire into trade increases the number of transactions, thus the depth of the market and the potential wealth gains, into an economic system.

But, as this discussion shows, money is merely a means of increasing the number of transactions.  The goal is not to acquire money, but rather to acquire money in order to be exchanged for something else (don’t believe me?  How many people are clamoring for forms of money, like the Murphy-Bill, to pay bills?  I got a whole bunch of them for anyone who wants them).  In any given transaction, one may exchange their good/service for money, but that is because the money they acquire is desired to be used in other, more valuable, means (if the value they got from the money was less than the value they got from the labor, they’d not exchange).  Money, in and of itself, provides no other uses (indeed, one of the reasons something is chosen as money is because it has no other use.  For example, would anyone want pictures of dead people and numbers on paper if they couldn’t be exchanged for something else?).  You cannot eat money.  It can only satisfy wants and demands by being exchanged.

Let’s apply this reasoning to international trade.  Money is a means to an ends (consumption).  Thus, people trade with other people on the other side of political borders in order to consume.  Just as I traded my money with the grocer to consume food, I traded a few bills with a French producer to consume gin.  I “exported” my labor to the grocery store so I could “import” food.  I “exported” my labor to the French distiller so I could “import” gin.  Thus, we can see that “exports” are what are given up in a trade (the cost) and “imports” are what are gained (the benefit).  Unfortunately, much popular conversation surrounding trade has this exactly backward.  A “successful” trade is one where a person (or group of people called a “nation”) export more than they import.  In other words, they give up more than they get.  This would be akin to saying the person who is a “successful” grocery shopper is the one who spends the most at the grocery store and gets the least in return.  The “smart” shopper spurns all bargains, sales, discounts, and specials.  Indeed, the “winning” shopper would be the one who demands he pay higher prices.  The “best” shopper “laughs” at all the other shoppers who are buying food in bulk, buying what’s on sale, buying specials.  He laughs at the foolish shopper who, by taking advantage of low prices, buys a month’s worth of food for a week’s salary while he buys a week’s worth of food for a month’s salary.

If we treat money as something that merely represents a divisible number of physical goods and services, we can see that all trade is still ultimately bartering.  Just as the goal of barter exchange is to get as much as possible while giving up as little as possible (that is, to “import” as much as possible while “exporting” as little as possible), the goal of trade is to get as much as possible (import) while giving up as little as possible (export).  the inclusion of money into the equation does not change the underlying logic.

Increased Opportunities Do Not Indicate a Shortfall

Trade deficits are often pointed to as a sign that there is a “savings shortfall” or “savings imbalance” within a nation (see, for example, this article).  This description, as Scott Sumner reminds us, is an implication of the GDP accounting model.  In this lens, there is no objection to classifying as trade deficit as a savings imbalance.  But does it make economic sense to view it in such way?

Let’s go back to a main question of economics: why do people trade?  Specialization of labor allows people to focus on the things they are comparatively better at and trade with others to get the rest of their needs.  In other words, people trade because their time is best spent doing what they are best at.

As David Ricardo showed us, when people specialize, they increase production; that is to say, new consumption opportunities emerge when people specialize and trade.  At no point is this development considered a “production imbalance.”  So, why then is the identical situation considered a savings imbalance when viewed at a macroeconomic level?  Other than the mathematical wrangling of the GDP accounting formula, I have no good explanation.  As people specalize and trade, new opportunities, both for consumption and investment emerge, which indicates a new balance developing.  The economy has gotten larger; there is no imbalance.