Today’s Quote of the Day…

…is from Page 145 of Adam Smith’s classic 1776 work The Wealth of Nations (Liberty Fund Edition):

People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. It is impossible indeed to prevent such meetings, by any law which either could be executed, or would be consistent with liberty and justice. But though the law cannot hinder people of the same trade from sometimes assembling together, it ought to do nothing to facilitate such assemblies; much less to render them necessary.

The first line of this quote is one of the most famous of all of Smith.  But the conversation usually ends there (typically with an erroneous claim that Smith would support antitrust legislation).  The immediately-following sentences provide deep insight into Smith’s classical liberalness as well as the dilemma we all face in the trade-off between liberty and security.

Smith also here has a discussion on incentives.  The law should not render associations between producers (ie trade groups, cartels, etc) necessary.  While Smith is discussing in the context of labor regulations and business regulations here, that discussion can be easily extended into the realm of what we now call Public Choice.  When government can hand out favors, firms will try to capture those favors.  They may even form associations to pool resources to increase the likelihood of capture (eg a Chamber of Commerce).

The foresight of Adam Smith, and his continued applicability to modern economics is astounding.

Today’s Quote of the Day…

…comes from page 198 of the Liberty Fund edition of James Buchanan’s 1975 book The Limits of Liberty: Between Anarchy and Leviathan:

It is unrealistic to assume that elected officials who occupy executive and legislative positions of responsibility have no personal preferences about the overall size of the public sector, its sources of revenue, and, most important, the particular components of public outlays.  A person who is genuinely indifferent in all these respects would not be attracted to politics, either as a profession or an advocation.  Politicians are likely to be those persons who do have personal preferences about such matters and who are attracted to politics precisely because they think that, though politics, they can exercise some influence over collective outcomes.  Once this basic, if simple, point is recognized, it is easy to see that budgetary results will not fully reflect voters’ preferences, even of those who are members of the effective coalition that achieves victory for its own candidate or party.

This simple, if basic, point is one often forgotten in discussions of the political.  Politicians are assumed to either be guided by the Will of the People and The People just need to be educated on an issue, or politicians are guided by experts, and it’s just a matter of getting the right experts to the right ears, or politicians are influenced by dollars and donations, and it’s just a matter of limiting money in politics.  But none of these assumptions ascribe any agency to politicians.  In short, they forget politicians are people too, fashioned from the same clay as the rest of us.

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.

 

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.

Optimal Tariffs and Blackboard Economics

Don Boudreaux favorably quotes Doug Irwin over at Cafe Hayek.  Below is a slightly edited comment I left:

What Iriwn, like Hayek and Coase before him, points out I think is just brilliant: the scarcityists’ arguments are one long exercise in begging the question. They’re assuming they have the very knowledge they’re trying to show they can acquire. Yes, if one just happened to know the complete set of preferences and demand curves for all people in the nation, then one could create an optimal tariff or policy for that given moment in time. But it’s in getting that knowledge where the trick lies.

Note that the key word here is “knowledge,” not “information.” You don’t need data points to feed into a machine, but precise observations about the nature and time and place of each individual, observations the individual himself does not necessarily know. Collecting these necessary observations are impossible.

But there is another thing to keep in mind: Bastiat. Let’s grant the scarcityist’s assumptions and say we can set an optimal tariff policy. Such a policy is optimal in name only; it’s optimal only through incomplete accounting. It’s optimal only from the point of view of the country levying the tariff. But economics is not about only looking at one person in one time period (the seen). We must look at all people over all time periods (the unseen). An optimal tariff in the US may temporarily raise US net welfare, but at the same time, the world as a whole is made worse off. A poorer world means fewer buyers of US products and fewer sellers of goods to the US (exacerbated by the tariff). A poorer world also means increased instability, and likely more war. Both these effects will rebound on the US, leading to a poorer US as well over time. In short, even if we grant the assumptions of the scarcityists, the outcome from tariffs, when explored across all people in all time periods, is still negative.