Institutional Diversity and Trade

A popular argument against free trade is that the logic of trade requires identical (or at least similar) rules/institutions between the trading parties.  Dani Rodrick recently made this argument, and you can see Don Boudreaux’s response here.  There is absolutely nothing in the logic or argument for free trade that necessitates similar institutions between the partners.  Only one thing is required: both parties benefit.

However, for both parties to benefit from trade, they must inherently be different from each other.  If the two were identical, then no trade would ever occur.  Diversity in tastes, in endowments, in incomes, even in rules, are desirable and, to differing degrees, necessary.  The idea that trading partners must be similar to one another, including in their belief structures, undermines the logic of trade.

Moving from the individual level to the national level, institutional diversity helps show actual costs and benefits of various institutions.  For example, if the whole world were as protectionist as Red China in the 1950’s, no one would know what a horrible scheme that is as the whole world would have looked like massive starvation.  Fortunately, the Chinese realized their mistake and have become rapidly more open-trade, thus leading to their huge economic gains lately, but it was the fact that institutional diversity existed that such folly was understood.  If a given national government decides not to allow peaceful trading between their citizens and another group of citizens, then their citizens are harmed and the true costs of their institutions, as well as their true benefits, are not known.

Diversity is a necessary ingredient of trade.

Today’s Quote of the Day…

…is found in a letter from Frederic Bastiat to Richard Cobden (leader of the Anti-Corn Law League) dated 8 April 1845.  The letter can be found on page 58 of the Liberty Fund’s collection of Bastiat’s correspondence, The Man and the Statesman (emphasis added):

Sir,

Since you have permitted me to write to you, I will reply to your kind letter dates 12th December last.  I have been discussing the printing of the translation [of Cobden’s speeches and pamphlets] I told you about with M. Guillaumin, a bookseller in Paris.

The book is entitled “Cobden and the League, or the Campiagn in England in Favor of Free Trade.”  I have taken the liberty of using your name for the following reasons: I could not entitle this work “The Anti-Corn Law League.”  Apart from the fact that this would have a barborous sound for French ears, it would have brought to mind a limited conception of the project. It would have presented the question as purely English, whereas it is a humanitarian one, the most notably so of all those which have brought campaigning to our century.

By presenting the issue of free trade as a humanitarian issue rather than a sectarian or nationalist issue, he demonstrates the universality of the principles of free trade.  Many opponents of free trade like to argue that free trade is conditional.  They may argue that free trade requires “transnational rule-making institutions.”  Or that trade only is good if one nation (ie the nation of the speaker) benefits.  Or that free trade needs to be “fair” (whatever that means).  But Bastiat makes no such prerequisites.  Bastiat and Cobden both argue that free trade is not an English concern, not a French concern, not an American concern, but a human concern.

The Anti-Corn Law League that Cobden was part of was founded in opposition to the Corn Laws, a series of mercantilist legislation that raised the price of food within Great Britain by restricting imports.  Given this legislation occurred at the same time as the Irish Potato Famine, the Corn Law, by artificially increasing scarcity of food, likely caused many deaths in Ireland from the famine.  The Corn Laws contributed to a humanitarian crisis.  We are seeing similar situations going on in Puerto Rico, where scarcity is increased because of the Jones Act, and Houston and Florida where scarcity is increased because of anti-price-gouging legislation.  Free trade is a humanitarian concern, not a sectarian concern.

In Stark Contrast

In booming economic times, the detrimental effects of policies like minimum wage, immigration restrictions, protectionism scarcityism, or socialism, can be hard to see.  The good growth outweighs the bad from the policies, obscuring their effects.  However, once times get tough, then the negative aspects of these policies stand in stark contrast.  By way of metaphor, imagine going downhill in a car.  Lightly applying the brakes won’t do much (depending on how steep the hill is, you may actually gain speed!).  However, if you are going uphill, even a light tap will have a large effect on the car.

Unfortunately, the obscurity generated by the good times can cause less careful thinkers to determine that there are no negative effects of the policies they want.  We see this quite often with protectionism.

We are now seeing the negative effects of protectionism and immigration restrictions here in the US following three major hurricanes that have hit in the past month: Harvey in Houston, Irma in Florida, and Maria in Puerto Rico.  In normal times, the detrimental effects of artificially high prices and artificially scarce resources tend not to be noticed.  Like the farmer who grows 100 acres of corn, and 1 acre is destroyed by parasites, it’s not too noticeable.  But if a disaster hits, and how only 10 acres can grow with 1 acre being destroyed, it’s very problematic.  When times are tough, and resources scarce, the market needs to work.  These artificial restrictions only make the scarcity worse.

Looking at disasters like Irma, Harvey, Maria, etc give us an excellent chance to test the claims of the scarcityists, that protectionism, minimum wage, and immigration restrictions grow the economy, not shrink it.  Given the tough time Texas, Florida, and Puerto Rico have is recovering basic supplies, it’s hard to believe the claims of the scarcityists.  Abundance is wealth, not scarcity.

On Monopolies

Earlier today, my friend Vanessa texted me the following question (small edits made for grammatical purposes):

So almost dr of economics- Am I correct in thinking monopolies are bad for consumers, thus must be bad for the economy?

Vanessa’s intuition on this question is good.  As Bastiat said, we must evaluate economics through the lens of the consumer.  Below is my response to her (sorry for the weird spacing.  I don’t know how to fix it):

“Are monopolies bad for consumers?”  This depends on what the meaning of the word “bad” means.  Monopolies are output restrictiors (that is, they get a higher price by reducing the output they make), and they produce not where price equals the marginal cost of output (ie the “zero profit” level), but the highest price they can get.  So, compared to “perfect competition,” the monopoly produces less at a higher price; they are inefficient compared to the perfect competition model.  Since “bad” is a judgment call. I’ll leave that up to you.

However, there are some situations where monopolies, as inefficient as they are compared to perfect competition, are the preferable option:
1) In economics, the only way a monopoly can naturally arise is if there are natural barriers preventing entry into the market (eg. high start-up costs, geographical barriers, that sort of thing).  We call these, shockingly enough, natural monopolies.  The implication of these conditions is that multiple forms of similar firms could not exist at the same time (ie, competition).  So, breaking up of this monopoly would not lead to lower prices and more output, but no output at all!
2) Imagine we have a firm who is a major polluter of the water.  For every item they produce, they dump a gallon of waste into the local river.  Further, assume (unlike the example in item 1 above), that this firm is not a natural monopoly.  If an effort to break up this company were undertaken, and output was to increase, then one would see an increase in the pollution dumped into the river!  From an environmental POV, this the monopoly is more efficient since it pollutes less!
Just like all economic questions, the answer is ‘as compared to what?”  It’s possible, as I explain here, that monopolies may be the preferable option.  A blanket statement like “monopolies are bad” or “monopolies are good,” depends on the context in which we’re speaking (and also what “good” and “bad” mean).

Coase, Transaction Costs, and Environmental Entreprenureship

Today’s Quote of the Day comes from pages 7-8 of Ronald Coase’s 1988 book The Firm, the Market, and the Law [emphasis added]:

Markets are institutions that exist to facilitate exchange, that is, they exist in order to reduce the cost of carrying out exchange transactions.  In an economic theory that assumes transaction costs are nonexistant, markets have no function to perform and it seems perfectly reasonable to develop the theory of exchange by an elaborate analysis of individuals exchanging nuts for apples on the edge of a forest or some similar fanciful example.

Many readers of Coase (including economists!) misunderstand him.  This is evident in the improperly named Coase Theorem (it’s improper in that it’s not a theorem).  In fact, Coase is so often misunderstood, he felt compelled to write the book this quote is from to clarify his point!  Coase is often understood to say that, absent transaction costs (or sufficiently low transaction costs), externality issues (eg pollution, noise, etc) can be solved by an allocation of property rights and, regardless of their initial allocation, will result in a Pareto-efficient outcome.  This is correct, but only a partial understanding of Coase.

Much of Coase’s work (and work that spun off from him, such as with Armin Alchian, Harold Demsetz, Gordon Tullock, and many others including my own) focus on the role of the market in addressing externality issues.  Detractors from Coase argue that his insights, that markets for externalities can exist only if there are no/low transaction costs, are not applicable to the “real world,” since transaction costs abound and, therefore, government intervention is necessary.  But this argument represents a misreading of Coase.  In a purely ideal world, there would be no transaction costs, but then no market would be necessary.  As Coase says in the above quote, it is in the world of transaction costs that the market is most useful!  The existence of transaction costs gives rise to firms and other means of human collaboration, which in turn reduce transaction costs, and increase the market exchange of individuals (see The Nature of the Firm (1937) for a more in-depth conversation on this point).

Expanding the idea of markets, firms, and transaction costs to environmental issues, we see the rise of “enviropreneurs” (to use the phrasing of PERC), that is people who seek out and find ways to mitigate these transaction costs in order to achieve desired environmental ends; in short, a market process of environmental concerns (for a detailed look at many different kinds of enviropreneurs, see Free Market Environmentalism for the Next Generation, especially Chapter 9).  The fact transaction costs exist is not a detriment to free market environmentalism, like the detractors of Coase argue, but rather what allows it to come about!

Like Coase (and Buchanan and many others) before me, I realize the market is not a panacea.  There may be conditions for government to get involved (namely where involvement by the firm or an individual are too costly).  But the work of Coase (and Alchian and Demsetz and Buchanan and Tullock and Anderson and many others) show us that the mere existence of an externality and transaction costs is not enough to justify intervention.

Economics as a Positive Science

Following a natural disaster, one can count on two things in the opinion pages and blogosphere: economists of all stripes decrying price-gouging legislation in a disaster and proponents calling economists immoral for questioning such legislation.

The conversation/disagreement between these two is a microcosm of a much larger discussion: the difference between the normative (subjective) and the positive (objective).

Economics is a positive science.  It deals with what is, not what ought to be.  When economists argue that price ceilings (like price-gouging legislation) cause shortages, that is a positive claim: it is a claim of what is.  This claim can be empirically tested, but it does not reflect the moral positions or suppositions of the economist.  In fact, the claim carries with it no moral implications whatsoever.  The claim price-gouging legislation causes shortages carries with it no more or less moral weight than the claim the sky is blue.

Conversely, morality is a normative science.  It deals with what ought to be, not what is.  When moralists argue that raising prices during a disaster is immoral, that is a normative claim: it is a claim of what ought (not) to be.  This claim cannot be empirically tested (although it can be tested to see if it falls into various moral criteria).  It reflects the belief structure of the person making the claim.  The claim raising prices during a disaster is bad carries with it no more or less empirical weight than the claim the sky is blue is good.

Allow me to elaborate, lest I give the mistaken impression that normative and positive sciences are opposed.  Normative and positive are not opposed; in fact, they compliment each other quite well.  Normative can prevent positive from becoming abusive (think, for example, our modern sensibilities against eugenic human breeding [normative] despite knowing certain traits are genetic [positive]).  But positive can also keep normative from being “pie in the sky,” by explaining how the world is.  For example, normative claims like “one should not kill his neighbor,” are all well and good, but the positive claim that “murder happens,” is important to know, too.  Knowing the two together brings us to the conclusion that police are needed for the few who do break the law.

To apply this reasoning to disasters, knowing price-gouging legislation makes the logistical system worse is important to know, as it can help inform better forms of aid and legislation.

In short, answering a positive claim with a normative claim will get us nowhere, but the two must be given, and understood, concurrently.

Price Gouging Legislation Means Fewer Resources for Search & Rescue

Police, like any resource, is scarce: there simply is not enough to satisfy every want and need.

Because of this simple fact, anti-price-gouging legislation has two perverse effects on a disaster.  The first, and the one economists tend to focus on, is what I discussed the other day, namely that price controls create shortages.  The other, as the title of this post would suggest, is even more of an immediate threat to life and limb.

If police resources are diverted toward price-gouging enforcement, then that means there are fewer police resources for search and rescue operations!  A cop who has to spend his time making sure merchants don’t charge too much is not spending his time looking for people, or preventing looting, or distributing goods.

Just your daily reminder: scarcity is a thing