On Predatory Pricing

China is in the news for (among other things) devaluaing their currency, the Renminbi (RMB, or Yuan).  This has lead to a return of mercantalist fears about China, including that they are devaluing their currency and subsidizing exports in order to harm America and undercut our industry by selling their goods well below market price.  This is called predatory pricing.

The idea behind predatory pricing is this: An economic actor enters a market and sells at such a low price that they take losses.  With their lower prices, they drive out all competition and effectively create a monopoly.  Then, using their monopoly power, they raise prices above the market level in order to gain extra-normal profits.

The problem with this argument is that it assumes a dynamic market up to the entry of the predatory pricer, and then a static market thereafter.  Absent artificial barriers to entry in this market, when the predatory pricer raises their prices to extra-normal levels, it would create opportunities for new firms to enter the market at a lower price point, and thus erode the predatory pricer’s extra-normal profits.  In order to regain their advantage, they would need to cut prices down again.  In other words, in order to maintain their advantage, a predatory pricer would need to constantly take losses, which negates the whole point of entry.

To be fair, this strategy can work in the short term.  It is currently being employed by both the Saudi Arabians and US oil miners to maintain/grab market share in the oil market (much to the benefit of oil consumers everywhere).  But one can only absorb losses for so long.  Eventually, he’d have to adjust and create efficiencies to operate profitably at the new level.

As with most fears regarding China, the predatory pricing one is largely unfounded.  Ultimately, the one being hurt the most is not the US but rather China and its citizens.

On Perfect Information

An argument I recently heard in favor of protectionism is that consumer’s don’t have perfect information, therefore it is the job of the government to pass tariffs against companies and trade partners who do things objectionable.

There are two main issues with this argument.  First, “objectionable” is a moral judgement.  What a rich, white person in the United States considers objectionable a poor, Asian in China might not.  Additionally, what Jon Murphy finds objectionable, John Smith might not.  To base national policy on one person’s morals is a gateway to tyranny.

The second issue with the argument is the note about perfect information.  “Perfect” doesn’t exist in this world.  Nothing is perfect.  No market is perfectly competitive.  Economic actors are not perfectly rational.  There are no good people or bad people.  We are merely people who do good and bad things.  And there is no such thing as perfect information.  What is necessary is not perfect information, but accurate information.  Prices, we know, convey such information.  When prices are distorted (whether through price controls, tariffs, what-have-you), the information provided is no longer accurate.  Decisions made off such information is now more likely to be harmful.  More harmful, indeed, then having imperfect information.  Chances are, any given economic actor will never have perfect information.  But what he will have is the knowledge and information of his particular time and space.

Besides, if any given economic actor doesn’t have perfect information, why assume some government entity would be in any better position?

Free Trade and Welfare

One argument protectionists make for tariffs is the cost to the economy of free trade (in terms of higher welfare payments because people are now laid off) are higher than the cost of the tariff.  However, that does not appear to be the case.

Let’s look at a few examples:

1. According to the Peterson Institute for International Economics, the cost of US tariffs on Chinese tires in 2009 was very high.  The tariff “saved” some 1,200 jobs, but cost US consumers approximately $1.1 billion/yr due to the higher prices.  That works out to be about $900,000 per job per year.
2. A 2002 paper from Mackinac Center for Public Policy found that a tariff on steel imports will cost about $439,485-$451,509 per job.
3. A 1994 research paper from the National Center of Policy Analysis estimates US tariffs costs $170,000 per job saved.

As we can see, the cost varies greatly depending on the industry and the tariff, but they all have costs involved (and these costs fall disproportionately among lower-income Americans).

But what does welfare cost?  A 2012 US Senate report estimates welfare costs per household on welfare is approximately $168 per day, or $61,320 a year (please note, this is toward the higher end of estimates, but there is a very very wide range.  As you can imagine, this is a highly political issue, and, depending on how you measure it, it could give you different answers.  I choose the higher bound to be as fair as possible to the trade protectionists).

According to this, the cost of welfare is actually considerably lower than the cost of tariffs.  This would suggest that, despite many (typically left-wing, but some right-wing) objections, free trade is preferable even in a welfare state!

I suspect we may see something similar when looking at the costs of immigration, but that’s a post for another time.

Update: In the comments section, Bill points us to additional evidence on the cost-per-job of tariffs.

Sweet Home Alabama

Writing for al.com, Prof. Art Caden of Samford University writes carefully about to an issue out of Birmingham, specifically the City Council voting to increase the city’s minimum wage to $10.10 over the next two years.

I think this will be an interesting municipality to watch.  As you may know, I theorized a little while ago minimum wage hikes tend not to show large increases in unemployment because the new wages is set below the market wage.  This may be a good place to test this theory.  According to the BLS, the median wage for many low-skilled jobs in Alabama is approximately $8.74/hr.  The new minimum wage puts the wage floor above the effective equilibrium wage.  If my hypothesis is correct, this would mean Birmingham would likely see greater negative effects from the minimum wage hike than other municipalities.  I will be watching this event with close interest.

HT: Don Boudreaux

The Economics of Barbecue Sauce

First off, let me apologize for my extended, and unexpected, hiatus.  Life got busy.  But enough of that, back to the post.

I love to cook.  Specifically, I make my own barbecue sauces.  There’s usually a molasses base, with ketchup, sugar, and other spices.  Combine the ingredients, simmer and mix them until they are well-blended, and boom: a sauce fit for a pig.  Interestingly enough, this is also a good metaphor for how wealth is created.

One of the toughest things for me as I studied economics in high school and college was overcoming the zero sum fallacy (that is, the idea that one person’s gain must come at another’s expense).  How could wealth be created?  It wasn’t until I began cooking that I really understood it.

Consider the aforementioned barbecue sauce.  It has many components to it.  Some would taste fine by themselves (like the ketchup), but others wouldn’t be so good alone (like the spices).  But by combining them, they create something new; new wealth was created by combining old inputs.  And, in many ways, this is how markets work: they take inputs (people’s labor, raw materials, knowledge), combine them together to create new outputs, which are then traded for other outputs!  The lives of all those involved get better (and, just as a good sauce enhances a pig roast, good outputs enhance all those around it).

Put Your Money Where Your Mouth Is

Seattle CEO Dan Price caused waves a few months ago when he raised the minimum wage of everyone in his company to $70,000.  Why’d he do this?  He found a study which convinced him that people who earn $70,000 are happiest.  This would mean that many people in his company would get a substantial pay raise.

Unfortunately (but predictably), the move backfired.  Some of his top people have left.  The guy is having trouble making ends meet.  His labor costs have skyrocketed far beyond what he had anticipated.  Morale has been hurt.

Despite this, CEO Dan Price has my respect.  He risked his own money, his own neck, to test his theory.  Unlike so many armchair economists and politicians who advocate minimum wage but risk nothing, Mr. Price had the guts to attempt to change the world.  Yes, his plan failed, but that’s what happens in real life, that’s what happens in markets.  Most businesses do fail, and there are lessons on how not to do things.  This is how we get progress, by trial and error.

Another thing to keep in mind is the cost of the failure is born by Mr. Price.  Unlike nationally enacted policies, which spread the pain to everyone whether they took risk or not, the cost of Mr. Price’s $70,000 experiment is his and his alone.  Likewise, the reward would have been his.

I respect Mr. Price immensely more than any politician or armchair philosopher who preaches but risks nothing.  I wish him the best in future endeavors.

Open Borders and Institutions

I am 100% in favor of open borders and damn proud of it. Aside from the humanitarian aspects (of which people far smarter than I have talked about and I may touch on again), and the libertarian “freedom of movement prevents tyranny” argument, there is an economic argument I’d like to discuss.

Proponents such as I will often argue that an increase in population will increase the economic pie because the labor resource of a country is increased. A typical opponent quip is “if these people are so productive, why aren’t they helping their own countries?”  This quip ignores the importance of institutions.

Allow me to explain with a parable. Where is a baseball bat more effective: in my hands or Bryce Harper’s?  Bryce Harper is one of the best hitters in all of baseball.  I am an overweight nerd who can barely hit a baseball out of the infield. In my hands, even the greatest baseball bat ever invented would look like a dud.  Only in Harper’s hands would it achieve its full potential.  That is because only with Harper are the conditions right.

This is the same with countries. Despite all its problems, the US is still a market-based economy. Mexico, on the other hand, is considerably less so.  It is far easier for a resource  (and labor is a resource) to be utilized in a productive fashion in the US than Mexico because the institutions are present.  And this, in turn, leads to increased wealth for all.

On Malinvestment, Austrian Economics, and Prices

In an interesting piece for Bloomberg, Noah Smith tries to apply Austrian economic theory to the current economic slowdown in China.  The article comes off as a bit confused, partly because Mr. Smith doesn’t fully understand what exactly Austrian economic theory is. (His description of it is rather unflattering, and mostly incorrect).  I’d like to address one question he raises:

One of these [items that are appearing in China] is “malinvestment.” Austrian thinkers such as Mises contend that recessions happen because too many resources are funneled into assets that won’t actually be productive in the future. By the time businesses realize that they have made a mistake, they are locked into bad lines of business, or bad business locations.

It has never been very clear exactly why malinvestment causes an economic hangover. Why don’t businesses just cut their losses and immediately start investing in something more useful, as soon as they realize that they’re doing the wrong thing? Austrian theory has never been particularly clear on that (and its notorious refusal to use precise mathematical models certainly doesn’t help).

Let’s ignore the childish quip about “refusal to use precise mathematical models,” (if Mr. Smith has come up with a way to predict randomness, free will, and black-swan events, I’d love to see it).  Malinvestment, he correctly notes, is the idea that resources are funneled into unproductive causes.  It’s a head-scratcher to me that his next question is “why do unproductive resources cause recessions?”  The reason seems pretty obvious to me: unproductive resources cause recessions because they are unproductive.  Given that the ultimate goal of all production is to promote more and better consumption, when production produces something that cannot or will not be consumed, it will ultimately lead to recession.

The next question is a good one: “Why don’t businesses just cut their losses and immediately start investing in something more useful, as soon as they realize that they’re doing the wrong thing?”  Some do.  They reallocate their resources as necessary, sometimes resulting in layoffs or, in extreme cases, bankruptcy.

But sometimes, the incentive system is messed up and it continues to reward malinvestment.  This is usually when the price system is tampered with.  For example, the very evidence Mr. Smith cites: China.  The Chinese government, through diktat and subsidies, had firms create massive Potemkin villages; ghost cities with no one living in them.  These are classic examples of malinvestment caused by government.  These buildings were funded by artificially induced debt, and now that the time has come to pay the piper, the Chinese government finds itself short of resources.  Another example is the 2008 Housing Crisis: the Federal Reserve kept interest rates (and thus borrowing costs) too low, the government prompted banks to give out sub-prime mortgages (both through diktat and the promise it would back/buy said mortgages via Fannie Mae and Freddie Mac), and subsidized new borrowers who had little to no credit.  These activities lead directly to a housing bubble and the subsequent and inevitable bust.  A third example is price controls in Venezuela: by keeping prices artificially low, firms invest too little toward consumer goods, and this creates shortages.

The answer to Mr. Smith’s question is that yes, we have been clear on what causes malinvestment.  We fight so much to keep government from creating price distortions simply because those distortions create the malinvestment!  And, because it takes time for resources (including labor) to move from malinvested uses to more productive uses, time inevitable will be marked by recessions.

Update: My good friend and colleague Jim reminded me of something so important I am ashamed I skipped over it.

Regarding why malinvestment causes a hangover, it is also important to remember that real capital goods are not homogeneous; they are not lumps of k that can be quickly reassigned.  A dump truck is a dump truck and cannot easily be turned into a computer.  A dump truck factory cannot be effortlessly retooled overnight to make computer parts.  These things take time, and that time period is called a “recession.”

Quoted, with his kind permission:

“Capital heterogeneity is really core to Austrian Capital Theory and the Austrian Business Cycle Theory.” -Jim Chappelow, The Barbarian Economist.

Can’t Have Profit Without Productivity

Over at EconLog, David Henderson has a great post on markets and worker safety where he tries to answer the question “Does the market under-provide safety for the poor?”  The blog post is a good one and I’d like to add my two cents:

From a purely productivity viewpoint, disregard for safety is disregard for profits. If workers are constantly getting hurt on the job, it hinders their productivity. Given that profit is tied to productivity, lower productivity means lower profit. Workers can’t increase their productivity if they are being hurt or killed. Any firm would tell you constant turnover is bad.  You lose intelligence and skill. 

Accidents happen in the workplace, not due to some careless disregard for safety (although I am willing to bet that may be the case in some minority of instances), but because they are indeed accidents.  Any firm looks to protect its investment, whether that be a worker, piece of machinery, or building.  An employer does not subject his investments to unnecessary risk.  or, if he does, he doesn’t stay in business long.  

Making Eden out of the Wasteland

I was driving on the highway this evening and was greeted by an amazing sight: a tiger sky lit my way; the orange of the setting sun was overlayed by black clouds from a nearby thunderstorm.  Against this backdrop, the green of the trees was even more vibrant.  It hadn’t started raining yet, but the air held that electric anticipation that comes before a storm.  I thought to myself “God hath made wondrous things.”

But then it occurred to me: it’s wondrous because of the wealth we have in this nation.  I am well protected from these storms thanks to 4 sturdy walls and a roof.  I can enjoy the pageantry of the storm (lightening and hail) from the comfort of my air-conditioned living room.  In fact, the biggest inconvenience was when I lost satellite reception for my TV.  The interconnections of humans, as coordinated by markets, made this possible.  200 years ago, such a storm would have been terrifying.  Markets have helped us tame Nature and create our very own Eden.