The Subtle Cruelty of Efficiency Wages

One of the more sophisticated arguments for minimum wage stems from the Efficiency Wages Hypothesis (EWH).  The EWH asserts that firms will sometimes pay higher-than-market wages for their workers.  These wages reduce turnover and increase productivity, making the wages more viable for the firms.  However, it is important to note that with EWH, there is still unemployment in the industry: higher-than-equilibrium wages reduce quantity demanded and increase quantity supplied from the equilibrium point, creating a surplus of labor (unemployment).

Minimum wage activists will cite the EWH for reasons for the minimum wage, claiming the reduced turnover and increased productivity is a positive for the firms.  That much is true.  But how does the EWH increase productivity and reduce turnover?  Workers may be feeling better with a higher wage, so they’ll naturally work harder.  That’s possible.  But the real reason is the cost of losing the job is now higher.  With persistent unemployment in the industry, the threat of firing forces workers to work harder in order to keep their jobs (thus increasing productivity).  Turnover is reduced not out of some sense of loyalty to the firm now paying higher wages but because there are fewer jobs available and they are being competed for by more workers!  

In short, an Efficiency Wage (especially if legally mandated like the minimum wage) gives employers more power over workers; it reduces worker bargaining power and reduces worker ability to leave if conditions are unfavorable to them.

The minimum wage is a very cruel policy.  The minimum wage as an efficiency wage is even more so.

Water, Water Everywhere

This morning at Cafe Hayek, Don Boudreaux writes on water, responding to a radio program describing water as “our most precious resource.”  Don says (emphasis added):

While it’s true that water is a scarce resource, it is simply untrue that water is a precious resource.  Potable water is sufficiently abundant today in most places where human beings live that it can be acquired at a low price.  Indeed, given modern techniques for delivering and safely storing potable water, water is widely available today even in some desert areas, such as Las Vegas and Tucson.  And while I don’t defend (quite the contrary!) government subsidies that make water more available where and to whom it would be less available, it remains silly-talk to say that water is “our most precious resource.”  The market price of water testifies powerfully to the contrary.

Don’s comment is true for most of the US.  But what about places it’s not?  Third-World countries and the like?  Why is it we can produce water in Las Vegas, Phoenix, and Tucson, but not Venezuela, Zaire, and Somalia?  It’s clearly not the environment; the US has harsh deserts and tundras and yet no water issues (in fact, water to spare!).  I suspect it has more to do with the free market institutions of the United States that allows us to bring water everywhere.  There’s a lot of private water here (think bottled water).  It is sold (mainly) at market prices, so places that have abundant water (like Maine) can bottle it and sell it to Arizona, where it is more scarce.  The areas where there are no functioning price systems and lots of trade controls (like Venezuela, Zaire, and Somalia) are facing water crises.

In short: water is precious in places where it is not treated as a commodity (and, in some cases like Venezuela, called a “right”).  It is abundant in places it is treated as a commodity.

Transferring Wealth is Not the Same as Creating Wealth

The Commerce Department has proposed tariffs of up to 20% on Canadian sofwood lumber imports.    These tariffs are phrased by the Administration and supporters as “leveling the playing field” and wealth creating measures.  Ramiyer, commenting on this blog post by Mark Perry, has a typical protectionist scarcityist argument:

Plus [the tariff] saves thousands of jobs who can afford to purchase and go out and eat. These people are real workers. Not some people who just throw their opinions or Wall Street Looters or big cheaters as in case of some CEOs.

It is true that some jobs are ‘saved’.  But that is only half the story: many jobs are lost, too.  Tariffs do not create wealth.  They transfer it.  Tariffs transfer wealth from consumers to producers and the government (for a graphical representation, see my blog post here).  Unlike free trade, no new wealth is created (in fact, tariffs cause wealth to disappear!). The wealth is merely transferred from the consumers and their spending habits to the producers and their spending habits. Therefore, a nation cannot, though tariffs and artificial scarcity, create wealth; it cannot tax itself into prosperity.  It can merely redistribute wealth.

What’s interesting about this is, until very recently, the same people arguing for tariffs now understood this.  They decry welfare and high corporate taxes for the exact same reason I outlined above for opposing tariffs.  I find the hypocrisy nauseating.

Toward a Better World

According to the organizers of Earth Day: “Education is the key to advocacy and advocacy is the key to change.”  I agree.  Toward that end, allow me to explain why free markets, and in particular secure private property rights, help make the world a better, cleaner, and more environmentally friendly place.

Property rights are important because they encourage the owners of that property right to maximize the property’s uses.  Property rights do this by having the owners incur the costs of their property (its upkeep, its development, etc), but also confers the benefits onto its owner; in other words, the greater concentration of costs and benefits means each person’s success is dependent on his/her activities.  As such, the property owner is incentivized to minimize costs and maximize benefits over the life of the property.

While there are many kinds of property rights, the type of right matters for environmentalism.  Contrary to many popular claims, public ownership of natural resources (national parks, nature preserves, and the like) may be counter to the goals of environmentalism; in other words, state-produced environmental efforts may make the situation worse, not better!  The reason for this is the incentive may not be as strong to maximize effort on the part of the property owner.

Allow me to explain by way of paraphrasing an example Armen Alchian gives in his 1965 Il Politico article Some Economics of Property Rights:

Suppose there is a community with 100 people in it, and 10 enterprises.  Further suppose that each person, by devoting 1/10th of his time to some enterprise as an owner, he can generate a gain of $1,000 for the enterprise.  If ownership of each enterprise is divided equally among the populace (that is, all the enterprises are “publicly owned,”), then he will produce a gain of $100 for himself each day (1/100th part owner and 10 firms) and the rest of his product ($9,900) going to the other members of the community.  If the other 99 people in the community act the same way, he will get $9,900 from them, bringing his total wealth gain to $10,000.

Now suppose that each person owns 1/10th of a single enterprise.  The individual now works to produce $10,000, of which he keeps $1,000 and the other $9,000 goes to the other owners.  If the other owners do the same, all end up with $10,000.

If we go to the extreme end and each enterprise is owned by a single person, then he gets to keep all $10,000 of his own hard work.

As we can see, in each case above, the reward to the property owner depends partly on his own effort and partly on the effort of others (except the last option).  In the first of the cases, the incentive for him to maximize his efforts is minimal: no matter how hard he works, he’ll only get $100 direct benefit from it.  The other $9,900 must come from someone else who may or may not have the same work ethic as him.

So, if a person is most incentivized to act when s/he absorbs the costs and the benefits, how will that help the environment?  Well, it’ll help by incentivizing the person to keep their property in working order.  A person who owns a home will do her best to keep the house neat, to keep the fixed costs (heating, cooling, water, etc) low.  They may, if they have time and money, plant a garden or maintain a yard in order to keep the house pretty.  Larger groups with common goals could pool money to maintain a park.  Firms, seeking to minimize their costs, are constantly looking for ways to reduce waste and increase output.  Owners of farms, of mines, and the like are always looking for ways to extend the life of their sources of wealth.

In short, people will look to take care of their own little plot of the world.  Environmentalists often urge us to “think globally, act locally.”  I can’t think of anything better than property rights to accomplish this task.

There are objections some might raise to the above discussion, and those I will address in another post as this one, at nearly 700 words, is already too long.

High Costs and Low Costs

All production requires costs; all output requires input.  To that end, costs (which we will refer to here as the economic resources, namely land, labor, capital) are essential.  We free-marketers, in promoting our cause, will sometimes be glib on costs and argue that free trade will reduce costs (that is, reduce the amount of resources necessary) to produce.  But yet, here in the United States (and elsewhere), as we expanded trade we’ve used more resources.  More labor is used in the US than in past decades and centuries.  More land, more capital.  And, indeed, the rates those resources command have risen.  Wages are high.  Rents are high.  Are we wrong?  Are the protectionist worries of joblessness and ruin overblown?

Here, we return to our supply and demand diagram.  Such a simple picture, but it tells us much:


A rise in price (that is, an increase in costs) can occur for two reasons: 1) An increase in demand (the demand curve shifting to the right) or 2) a decline in supply (the supply curve shifting to the left).  Both these shift result in higher costs, but the reasons are staunchly different.  One is desirable, the other is detestable.  An increase in demand is a sign of increasing welfare: people have more to spend on various goods and services.  This increased competition for goods raises prices, which generates more production.  Firms, reacting to these higher prices, increase their inputs: they hire more workers, invest in more machines, build more factories.  The wage rate and rental rate increase; the prosperity causes the firms costs to rise.  Prices are higher, yes, but so is the standard of living.

But what happens in the opposite manner?  If the supply of a good is cut, then price rises but production is reduced.  Although prices are high, firms are not looking to expand production; resources are scarce.*

The price rises are caused by two separate things.  Whereas the first (demand-shift) is caused by abundance, by wealth, the second (supply-shift) is caused by scarcity!

It is also true in the opposite manner: prices can fall because of abundance in supply (supply curve shifts to the right) or scarcity in demand (demand curve shifts to the left).

Protectionists often tout the higher prices their policies will bring as a good thing: they will grant the firm more profit and thus higher demand for workers and higher wages, they promise.  But they confuse the effects of their policies.  They implicitly argue their policies create higher prices because of an abundance of demand, but it is really because of a scarcity of supply!  This stands in stark contrast to the higher prices that develop from free trade, from the abundance of demand.  This is also why wealthy nations tend to have higher prices (in nominal terms) than poorer nations.

Once again, we see the protectionists arguing the most absurd notion that it is in scarcity we grow strong and abundance we grow weak!

*I am quick to add that, for the sake of our conversation, I am assuming the shortage-driven price is not causing others to look for alternative methods to supply the demand.  This assumption is not true, but it simplifies the discussion.  Relaxing this assumption does not change the outcome discussed.

Free Trade as Insurance

Nature has blessed humans around the world with different endowments.  Some live near water, and thus have lots of fish.  Some are good with numbers and figures.  Some live near forests and timbers.  Et cetera et cetera. Trade helps evenly distribute those gifts that Providence has bestowed upon us.  The person with lots of fish can trade it for timber.  The person with lots of clothes can trade it for jewelry.  The goods are distributed across the people, not according to the “luck of the draw” of their endowments, but by their desire to better themselves.

The same is true of nations (after all, nations don’t trade.  People do).

But trade also acts as an insurance policy.  If the US (the world’s largest supplier of many foodstuffs) were suddenly hit by a drought, and half the crop died, there wouldn’t be mass starvation in the country.  The US could import what was needed from elsewhere.  The price would be higher, to be sure, since there is no a smaller supply (globally) that needs to be distributed, but there would still be the supply.  If, however, the US were “independent,” as the protectionists wish, then such a agricultural disaster would be magnitudes worse.

Having supply lines across the world doesn’t, as the protectionists like to claim, make the US more vulnerable.  It makes us less vulnerable!

Sacrificing the Ends for the Means

Throughout his writing career, Frederic Bastiat repeatedly emphasized that consumption is the end goal of economic activity, that the consumer should be the focus of economic analysis.  While each man is both producer and consumer, man produces so he can consume.  In other words, production is the means and consumption is the ends.  This makes sense if we look at our own lives: we go to work so we can afford our homes, food, cars, clothes, etc.  We don’t consume our clothes, cars, food, homes, so that we can work more!

Although not considered much of a theorist, Bastiat was a bit ahead of his time with this emphasis.*  It would be another 50 years before the commonly-recognized supply and demand curve we use today was developed by Alfred Marshall.  Using the Marshallian Curve, we can explore Bastiat’s** insights with regard to international trade.

Let’s ask the question: what happens when we impose a tariff on international trade?

First, let’s start with our standard supply and demand curve:


The green-shaded areas are “consumer surplus,” or what the consumer gains from the international trade.  The orange is domestic producer surplus (what domestic producers gain).  Domestic producers supply some of the quantity demanded (Qs) and the rest is made up in imports (Qd-Qs).  The total societal surplus is the green and the orange areas added together.

What happens when we impose a tariff?  This:


Green is, as above, consumer surplus.  Orange is producer surplus.  Added in here is the blue area (tax revenue) and red (deadweight loss).  What’s going on here?  Much of what we have is a transfer of wealth: producers gain (from the consumer), government gains (from the consumer).  But where does the deadweight loss come from?  The consumer!  Not only is there a total reduction in welfare in the society (not merely a redistribution), but it all comes from one segment, the segment that is the ends of all production.  The entire welfare loss is borne by the consumer!  

The implications of this analysis are stunning, at least from an economic perspective: you reduce the ends to get more means; Protectionism results in more effort for less welfare!  The supposed blessings of scarcity that protectionism promises never materialize.

*Nor should Bastiat be considered a theorist.  He wasn’t.  He was a great distributor of economic ideas, but didn’t form any himself.

**And Say’s, Smith’s, and Ricardo’s