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.

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.

The Doctrine of Scarcity

Two brothers, Charles and Joseph, are sitting at home reading the news.  The following is a conversation between the two:

Charles: Joe, did you see the nation of Zimbabwe is facing a terrible drought?

Joseph: Are they?  What fabulous luck for them!

C: Luck?  How is this luck?

J: My dear brother, have you no capacity to reason?  The drought is a blessing for the farmers of Zimbabwe!  First, since it makes the supply of food more dear, the prices rise.  The farmers get more money!  This, they can spend on employing more workers (since the land is now less fertile) toiling all day to get the wheat out of the ground.  The demand for workers will increase their wages, making the Zimbabwean worker better off.  Surely, only good times can follow!  This is just Economics 101!

C: Perhaps, Joe, but this is only because there is less food.  Perhaps, in nominal terms, workers earn more, but they can buy less with their money.  Are they not worse off?

J: My dear brother, have you learned nothing?  Their increased pay will make them richer!  What they can’t spend on food, they’ll surely spend on other things!  That’ll further increase demand for workers, raising wages even higher!

C: But that doesn’t solve the initial problem, Joe.  There is still less food to go around.  Sure, they may have more money, but that doesn’t calm an angry belly.  Would it not be better for the rains to come and have the fields of Zimbabwe overflow with grains?

J: And have the price of food plummet?  Have the workers no longer needed (since the fields are now more productive) be unemployed?  Why, think of the chaos of having all those people unemployed!  You would undo the Zimbabwean worker with your mana from Heaven!

C: Perhaps there would initially be people who no longer need work in the fields, but they’d have more full bellies.  Since they are freed up from the labor, they could do other things (maybe make clothing?).

J: You are simply a theorist!  No, brother, it is far better for the people of Zimbabwe to have drought, to drive up prices, use more resources for less output.  Indeed, it is in scarcity, not abundance, that true wealth lies!

C: But you live with less-

J: So?  The workers have work!  That is all they need!  They have a sense of purpose, a sense of living!  What more could a person want?

C: Food, shelter, clothing, leisure…

J: Bah!  More of your theorizing!  The true strength of an economy is the number of jobs it has!

C: But what good are those jobs if you can’t buy anything?

J: Better than having lots to buy and not enough farm jobs.

C: But there are other kinds of jobs.  They can do something else.

J: “Something else!”  More theorizing!  Such an unsatisfying answer.

C: But true nonetheless.

(The conversation continued in this manner for some time).

Joe’s comments may seem weird to our ears, and yet it is the common claim of those who practice the doctrine of scarcity commonly known as “protectionism.”  Since scarcity, and not “protection” or “abundance”, is the foundation for “protectionism” I propose calling these people “scarcitists.”

The scarcitists have a weird idea that it is from scarcity that wealth arises, not abundance.   It is as if the best thing to happen to Man was to be cast from the Garden of Eden.  It is as if Hell, and not Heaven, is our goal.  Scarcisim is a strange doctrine.

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:

supply-and-demand-graph

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:

20170406_093528

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:

20170406_094005

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