The Difference Between Econ 101 and Econ 801

An advantage of teaching undergraduate students as I simultaneously work on my graduate work is I get to go through both undergrad textbooks and graduate books at the same time.  Currently, I’ve been working my way through Cowen and Tabarrok’s Principles of Economics for my undergraduate class and George Stigler’s Theory of Price and Donald Watson’s Price Theory and Its Uses for my research.

We often hear, primarily by people who dislike the implications of Econ 101 models, that Econ 101 is too simplistic, too unrealistic for the real world.  They’ll point to other economic models that better conform to their desired views (eg, the monopsony model for minimum wage).  “We can’t rely on Econ 101!  It’s just too simple!”

But what’s interesting to me is that going through these upper-level texts (Stigler is a high-Masters, low-PhD text), one sees they are not fundamentally different from the undergrad texts.  This holds in other texts, too, such as David Kreps’ Microeconomic Foundations.  There may be more math to formalize the models, but the intuition remains the same; the implications remain the same.

Basic supply and demand analysis gets us a very long way.  It is not complete, of course.  No theory ever is.  But supply and demand is fundamental.  Seeking to overthrow the foundations will not necessarily lead to a more coherent theory.

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.

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.

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.

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.