Destroy the City to Save the City

Commenting on this blog post, a “Daniel DiMicco” says:

Your commentary couldn’t be more misleading and dead wrong. Rather than the picture you paint, the Steel Industry is the “canary in the coal mine”. It is the case study for the Massive trade Mercantilism and cheating that China is perpetrating on the USA’s entire Manufacturing sector. Your propaganda doesn’t pass the smell test!

Below is my response:

Daniel Dimicco:

You say that the steel industry is the “case study for the Massive [sic] trade Mercantilism [sic] and cheating that China is perpetrating on the USA’s entire Manufacturing sector.”

Presumably, this means China’s low steel prices are harmful to the American manufacturing sector.

However…what would happen to the US manufacturing sectors that are dependent on steel? Like auto-making, construction materials, and the like? They’d face higher price pressures from any resulting tariffs you demand. Assuming they can’t adjust prices, this would mean they’d need to cut adjust costs elsewhere…perhaps lay off workers, perhaps cut hours, all kinds of things. They’d be negatively impacted by your steel tariffs.

Even if they could adjust their prices, now you’re looking at the effects on the consumers of these steel products. They’d start looking for more cheap substitutes or simply cut back on the amount they purchase. This would weigh on the manufacturing sector as well (as well as the consumers).

In short, your effort to save one canary will kill off several others.

On a related note, I found a picture of protectionists celebrating a tariff hike:

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On Bananas, Fish, and Trade

Commenting on this blog post, Warren Platts writes:

If imports were stopped by a stroke of a pen, there would still be a trillion dollars of pent up demand per year from American consumers. If the demand for goods couldn’t be satisfied with imports, domestic manufacturers would take up the slack, creating jobs. Things would be more expensive, sure, but the GDP would grow a lot faster, more people would have good jobs.

Warren’s argument, while common, is incorrect.  Imports, which do satisfy demand, generate more demand for other products by virtue of the fact they are of lower economic cost.  As Warren says, if these imports were stopped, “things would be more expensive.”  This inherently means that there are not “trillions of dollars in pent up demand per year,”that American manufacturers can simply “take up the slack.”  Rather, those trillions of dollars are released by the imports and would become constrained by the forbidding of such.

By way of example, let’s say we have two countries: Bananaland and Fisherland. In autarky (that is, no trade), Bananaland can produce 50 fish or 50 bananas.  Fisherland can produce 100 bananas or 200 fish.  If each country divides their time evenly between each activity, Bananaland can produce and consume 25 bananas and 25 fish.  Fisherland can produce and consume 50 bananas and 100 fish.  In this autarky, the price of bananas in terms of fish is 1 in Bananaland and .5 in Fisherland (in other words, Bananaland needs to give up 1 fish to produce 1 banana.  Fisherland need only give up half a banana to produce 1 fish). The two countries open trade with one other and, given that both countries want to consume the same number of bananas after trade as before (an assumption made for simplicity; doesn’t change the story if we relax this), then the citizens of Bananaland agree to send 25 bananas for 37 fish (a price of .68).  To satisfy this, Bananaland stops producing fish and produces only bananas (they produce 50 bananas).  Fisherland cuts back on banana production to 25 but ramps up fish production to 150.  The day comes and the two trade.  Now, Bananaland consumes 25 bananas and 37 fish.  Fisherland consumes 50 bananas and 113 fish.  Their total economic well-being (crudely called “GDP”) is Bananaland: 62 (25+37) and Fisherland: 163 (50+113).

Bananaland, convinced their getting a bad deal following the lack of fishing in their country (remember, what was once a thriving industry) and the low prices they now pay, elect a protectionist on the grounds that he (and he alone) will “Make Bananaland Great Again!”  He promptly forbids all imports of fish from Fisherland.  They go back to their autarky ways.  Since Bananalanders now pay higher prices for their fish and more resources are devoted there than elsewhere, they can only consume 25 fish and 25 bananas.  Their GDP falls to 50!*  There was “pent up demand,” but the higher costs the various citizens now have to pay to even just consume the same amount they did before eats up that “pent up demand.”  The domestic manufacturing simply cannot supply it.

Adam Smith first explored this concept way back in 1776, and David Ricardo formalized it with the theory of Comparative Advantage.  Trade occurs for the simple reason that it provides people with better outcomes than other alternatives.  Other alternatives simply cannot provide the desired outcomes.

Update: I realized, as reading though this, I made a small math error.  It has been corrected.

*It’s worth nothing a similar decline happens to Fisherland, a nation where they can produce much higher levels than Bananaland.  Their GDP falls to 150.  Even their manufacturing cannot satisfy the “pent up demand.”

Throwing Out the Baby With the Bath Water

At Cafe Hayek, Don Boudreaux highlights a new paper by Jonathan Rothwell challenging the findings of David Autor et al that trade with China is harming American workers.  The abstract of the paper sounds interesting, but I want to focus on one point in particular (Emphasis mine):

At the community level, Autor, Dorn and Hanson (2013) find that local areas have experienced slower job and wage growth and higher unemployment because of import competition with China. Upon analyzing their data, I conclude that their results are biased by the weaker macroeconomic performance of 2000-2007 relative to the 1990s. When I analyze inter-local area economic changes — rather analyzing changes within and across areas — I fail to reject the null hypotheses that import competition has no effect on wage or employment growth, except within the manufacturing sector during the most recent period, or that it has no effect on many other outcomes, including labor force participation, intergenerational mobility, and mortality.

There’s an interesting lesson to be learned here, beyond just what Rothwell finds:

Findings can depend on how one slices the data. To wit, Autor et al find significant negative effects when the data is within or across areas and Rothwell finds significant positive effects when the data is inter-local area. We see the same in minimum wage (time series vs panel data, etc).

Any statistician can tell you that regression models can change depending on how you cut and categorize the data: different “n” can give different outcomes, different controls and dummies can give different signs, etc. We try for robustness, but it is still at the end of the day a model.

Of course, none of this is to disparage the work of Autor et al or Rothwell, or even econometrics in general (an important field, if used correctly). But we need to fully understand its limitations and our own assumptions, and be very careful before tossing out theory.

Gordon Tullock, in his 1967 paper in the Western Economic Journal, demonstrates exactly this.  Tullock begins with a conversation regarding welfare costs from monopolies and tariffs, citing recent research that finds these welfare losses are pretty minimal.  In fact, they’re so small that Tullock finds:

Judging from conversations with graduate students, a number of younger economists are in fact drawing the conclusion that tariffs and monopolies are not of much importance.  This view is now beginning to appear in the literature.

Does this mean our theory about trade and tariffs are wrong?  Does this mean tariffs can be helpful, or at least not substantially harmful?  Does this mean microeconomists spend too much time focusing on tariffs at the expense of other topics?  Or is it a measurement issue and the theory is fine?  Tullock explores this issue and finds it is a measurement issue, not a theoretical issue.  In other words, our tools not theory were incomplete.  Tullock explains in the article the need to factor in lobbying costs which do not show up in the standard welfare analysis but are nonetheless substantial (read the article for yourself to see his argument.  It’s short, 9 pages, and not technical at all).

Had Tullock not looked beyond the initial challenge to trade theory, had he (and other economists) just thrown off the theory based upon the small welfare losses, the world would be a far worse place.  As it is, his (and Jim Buchanan’s) explorations eventually lead to the field of Public Choice and provided us with a cleaner understanding on the theory of trade, tariffs, monopolies, politics, and the costs associated therefrom.

The story of Gordon Tullock in the 1960’s is why anyone should be weary of claims that theory of any kind is “mistaken” or “proven wrong” by this or that study.  We see this all the time with minimum wage.  The good economist (or scientist) will ask the question, as Tullock (and Mundell) did back in the 60’s: Is the theory invalid, or our tools?  It may be the theory is (such as with the case of geo-centrism) or our measurement tools are lacking.  In fact, we see this with regards to minimum wage: measurable job losses may be minimal, but there are many other margins firms adjust along, not all of whom are measured.  It would be mistaken to toss out the theory.

Economics is still a young science.  I suspect, as has already happened, some of our theories will be tossed out as we gain more insight and knowledge.  But we musn’t be too hasty in doing so (especially when there is political pressure to do so), lest we sacrifice knowledge for convenience and insight for what my professor Thomas Startmann calls “naive analysis.”

All Pain, No Gain

In a Facebook response to this cartoon, a Tim Moyers argues for protectionism because:

[H]e [will] get on a new bike. One that doesn’t need supplies from china. Sure there will be short term injury, but there will be long term gain.

Mr. Moyers has the situation exactly backwards.  Tariffs do not cause short-term pain and long-term gain.  They cause long-term pain for (maybe) short-term gain.  The gain are whoever keep their jobs for a little while longer and whatever company remains in business for a little longer (however, by the very virtue they need protecting, we can conclude their time will likely not be long).  In the long run, however, many more resources are poured into keeping these non-preferred firms operating: higher taxes, less resources used in more productive/valuable means, all of which in turn leads to a lower standard-of-living than what would otherwise occur.  To block or slow these innovations would lead to long-term pain in the economy.  Perhaps not enough to crash an economy (although the Smoot-Hawley Tariff didn’t do anyone any favors), but certainly enough to lower the trajectory.

Markets Make Mistakes. That’s A Good Thing

Free markets are not perfect.  In fact, they are anything but (a topic I have spilled lots of digital ink in discussing, for example here).  Markets may end up in inefficient allocation of resources, may give rise to monopolies, or any number of other non-perfect competition outcomes.  However, the fact markets aren’t perfect, that people make mistakes, is a feature, not a bug, of markets.

When a market imperfection (or “market failure”) arises, it indicates that there is some “surplus” (that is, welfare) not being captured.  It’s being lost.  This signals a profit can be made for anyone willing to exploit this failure and correct it.  If, for example, the price of Good X is “too high” because of monopoly power, it encourages people to look for ways to enter the market to capture some of that profit.  This, in turn, brings more of Good X to the market which helps lower the price of Good X.*  The market mechanism helps fix the misallocation.

Of course, enticing others into production is not the only way the market can “heal” itself.  Relatively high prices also cause people to search or create substitutes.  A good example of this is what Mark Perry highlights at Carpe Diem: synthetic diamonds created to combat the cartel power of diamond miners. In fact, the failure or missteps of markets is a major driver of innovation!

However, the profit motive is itself not perfect.  When dealing with public goods or poorly defined property rights, the profit motive may break down.  There is a lot of discussion to be had on that topic, and thus I will avoid it for now.  Rather, I want to focus on the larger message: markets stumble, but they also have mechanisms built in to correct those stumbles.**

The market has failed.  Long live the market.

*This example assumes no government barriers protecting the monopoly.  Other barriers, such as geographical or technological, that help create a monopoly can be broken down eventually.  Government barriers, not so much.

**I’m hesitant to use this language as it may cause the reader to conclude, incorrectly, that markets are machines that can be designed.  I hope readers know markets are organic and not mechanical.

An Economist’s Dream

It’s not often one gets so many economic fallacies contained in one area, but this article in Bloomberg is one of those rare instances where we do.  Rather than quote relevant areas, I’ll just let you read through it; it’s short but contains many mistakes.

There are several econ 101 problems the author makes this article:

1) the first two charts are meaningless. Looking at total unemployment and total wages and not minimum wage unemployment and wages, obscures the truth. For example, if a minimum wage worker was laid off but two new CEOs were hired, then the unemployment rate would fall and real wages would rise. The cost of the minimum wage would be hidden by the hiring of the CEOs.

2) The final graph is the clincher: the minimum wage, at $11 is well below what the workers were already making! According to the graph, they’ve earned well above that for at least a decade! Since the minimum wage was set below the market rate, then it wasn’t “binding”, which means it wouldn’t have had an effect because workers were already earning more!

3) Assuming away my first two points, there is still nothing conclusive. Laying workers off is just one of the margins employers can adjust to a minimum wage hike, and it’s one done more in the long term than the short term (see work by David Neumark). In the short run, which this change represents, employers are more likely to adjust by cutting hours, benefits, or supplementing with capital equipment (to the extent they can). There are many margins they can adjust along. To look only at unemployment (and especially so in such a flawed manner such as this) is mistaken.

4) My final point is one must remember to look for the “unseen” job losses. These are hard to measure but still very real. Let’s say, for example, a business owner was going to expand her store, and to do so needed 4 extra workers. The hike goes into effect. It is now cheaper for her to hire 3 workers and have one machine to augment them (prior to the hike, the relative cost of the machine was too high). The official employment statistics would count this as 3 jobs added, but not count the one job lost. That job was very real, but now it’s gone.

 

On (Im)Perfect Subsitution

Another Econ 101 mistake people make, especially with regard to immigration and international trade, is some form of “foreigners (immigrants) can do all the work we do but for much lower prices!  Without subsidies/tariffs/minimum wage, they’re just going to take all our jobs!”  Other versions of this include “if a bunch of immigrants enter the nation, they’ll drive down wages!  Law of Supply and Demand!”

Both the above arguments make the same mistake, namely they assume foreign labor is a perfect substitute for domestic labor.  They treat all labor (or all low-skilled labor) as a homogeneous blob, one part easily replaceable with another.  But, alas, that is not the case, as price theory can show us.

Looking simply at the wages of laborers, we should ask the question “why do immigrants/foreigners command lower prices than domestic workers?” The fact that there hasn’t been wholesale replacement of domestic labor with foreign means we can rule out any cultural/biological/cost-of-living reasons such as “lower cost of living in 3rd world” or “they have a lower standard of life and thus demand lower pay” etc.  If this were indeed the case, domestic companies could just pack everything up and ship it overseas (that is, stuff that can’t be staffed by immigrants) and make tons of profits (while I have no doubt some people believe that is what is happening, the data say otherwise).

What’s more likely is that foreign workers and immigrants are simply less productive than domestic workers.  Immigrants coming into the country, legal or otherwise, face major barriers, not the least of which is the language barrier.  The manager at McDonalds cannot simply fire an American order-taker making minimum wage and hire a foreign worker for half the cost. The foreigner, simply by virtue of not knowing the language, will be less productive, thus his lower salary.  A similar argument for offshoring can be made: foreign workers, by virtue of less capital augmentation, will be less productive and thus command lower salaries.

In short, foreign workers/immigrants are not perfect substitutions for domestic labor!

It may make sense for some firms to replace/augment domestic labor with foreign labor, but the mere fact it is cheaper is not the reason why.  David Ricardo’s powerful idea shows there are times it is prudent to replace more productive resources with less productive resources, but to do so on a large scale with disregard to opportunity cost is a recipe for disaster, and why firms and individuals do not do it.