A Discussion on Transaction Costs

This post is a riff on a recent op-ed column by Don Boudreaux at the Pitt Tribune “Minimum Wage & Technology.”

As Don writes:

When I explain to my students that minimum wages prompt firms to substitute technology for labor, they often react as if this greater reliance on technology is an upside of the job-destroying nature of minimum wages. But my students are mistaken.

This attitude is often portrayed as justification for all kinds of government interventions: minimum wage, labor restrictions, scarcityism, etc.  Technology is a sign of advancement, so we must advance!

But advancement is not a costless procedure.  Not only, as Don points out in his article, is there costs to developing said technology, but there are also costs to implementing and adopting such technology.  If a self-help kiosk is installed at a fast-food restaurant, its costs are more than just the new machine: it needs to be wired, staff trained (which reduces their productivity in the meantime), company policy created (and all other kinds of backroom stuff), etc.  All these things take time and resources; they all have costs.  If these costs, plus those that Don mentions in his article are higher than the benefits, then the intervention in the market, even if it produces newer technology, is a net loss.

This is an important point that is implied in the above discussion but I want to make explicit: just because there is a hypothetical “better” outcome, it does not mean that the market has failed!  If that outcome does not occur because the transaction and transition costs are too high, then the current outcome, with all its flaws, is the most optimal.

Indeed, there is really only one condition under which we can say with any certainty that a true market failure has occurred: if the outcome is suboptimal, and the transaction costs were misestimated, and this misestimation should have been known to the market participants.  This is an extremely high bar to reach, one that is made all the higher given it requires a huge judgment call on the part of the analyst.  In a sense, the analyst ends up begging the question since he has to assume his judgment and knowledge and subjective evaluations of the costs and benefits are equally shared by the participants (or he knows their inner workings).

Among economists of all stripes, the presumption of liberty, that is the promotion of free markets even when they are imperfect, remains predominant for exactly the reason discussed here: the knowledge of transaction and transition costs are highly personal and their existence gives the economist pause whenever discussing “welfare enhancing” policies specifically designed to control economies.

The Ambiguity of Purpose Leads to Abuse

The case for free trade is not absolute.  There are many reasons, theoretical and practical, where an exception to the general rule of free trade may be desirable.  Reasons of national defense, of terms of trade, of national welfare, can all be justifiably given for tariffs.  As I and others have discussed elsewhere, these exceptions have high hurdles to clear and rely on some rather strong assumptions, but they remain, at least in theory, justifiable.

But it is important to note with these different justifications is they are all mutually exclusive.  The national defense justification is a tariff high enough to prevent competition into the domestic industry.  The terms of trade argument, on the other hand, is a sufficiently low tariff designed to generate welfare gains and force other countries to lower their prices.  In other words, one tariff is designed to decrease imports and the other to increase imports.  These are, obviously, at cross purposes.

Even if these justifications are intellectually impeccable, they remain tactically useless for a simple reason: when scarcityism admits multiple justifications, any number of rent-seeking firms can exploit these various justifications for personal gains.  In other words, multiple conflicting justifications can be given by various firms, and all hope of improving national welfare goes out the window; the more exceptions carved out, the more rent-seeking individuals and firms will seek to exploit them.  As rent-seeking increases, more and more resources are devoted away from satisfying consumer wants and toward rent-seeking.

The presumption of liberty, that is a tendency to allow free trade vs controlled trade, remains strong even if it is, in theory, the option that has lower welfare because of the potential of rent-seekers to exploit ambiguity in a national policy to promote welfare.

The US Probably Won’t Gain Much from Lower Tariffs. That’s a Good Sign

Empirical analysis of potential gains to the US with free trade deals tend to point toward relatively small gains, typically in the neighborhood of a few tenths of a percentage point of GDP.  NAFTA has been a fairly small impact on the US.

Some protectionists scarcityists like to point to this fact as evidence that free trade is oversold, that scarcityism is really the way to go.  They incorrectly interpret these figures as meaning free trade has no/small gains.  But the reality is different:

The US won’t/doesn’t benefit much from lower tariffs because we already have very low tariffs!  Over the past two centuries, with a few exceptions, the US radically liberalized trade.  What this means is the gains from lower trade barriers have already been realized for Americans.  More open trade with other nations (in this case, meaning the foreign tariffs are lowered since the US’ are already virtually at the zero-bound) would lead to a reorganization of US industry; new jobs would be created and existing jobs would be shuffled around, but any net gains are likely, at least in the near term, to be minimal.

What this also means, however, is the US has everything to lose in a trade war.  We’ve realized the gains from trade; going scarcityist would disrupt those gains and a trade war would be a losing proposition.  Conversely, those scarcityist nations, already being at a place where resources are wasted and tariffs are high, are unlikely to be significantly harmed by higher tariffs.  Their tariffs are already high; the damage has been done.  Raising tariffs higher will harm them, yes, but relatively less so than a free trade nation.

By way of metaphor, consider the following: let’s say a doctor says exercise and a good diet are key for healthy living.  He gives this advice to two people: one who exercises an hour a day and eats well, the other who is a couch potato and eats fried and fatty foods.  Who would benefit most from the doctor’s advice?  Obviously the latter; the former is already doing the doctor’s orders.  However, if one were to measure the effectiveness just by looking at the former, it would look like the extra exercise was ineffective!  It would be erroneous to conclude that exercise and a good diet are not very beneficial by looking at the minimal change in the health of someone who is already eating well and exercising.  And yet, that is exactly what some scarcityists do.

Life Lessons from Academia

This past semester, I took Robin Hanson’s Ph.D. Law and Econ class at GMU (Econ 840).  The course grade was a research paper you wrote.  Dr. Hanson gave some excellent advice on writing these papers (I apologize in advance as I am paraphrasing here.  His actual expression of the advice was far more poetic than my rendition here).

He said: Do not try to climb Kilimanjaro.  It takes a long time and a lot of practice to get there.  Rather, find a path and move just a few feet off of it and you’ll be blazing a new trail.

Hearing this was a huge stress release.  We all have egos (especially doctoral students) and we all want that Nobel Idea.  But that is a lifetime achievement which, by definition, takes a lifetime to achieve.  We often get frustrated when our Big Ideas do not come to fruition, when we get tired of trying to climb the mountain, and many quit.  Good ideas are left to die by the wayside.  To hear that the expectation is not Kilimanjaro but rather forging through some new bush makes the task of research much easier and allows one to focus.

This advice applies well outside of academia, too.  Keeping focus and working on the achievable, building up to the mountain, can prevent fatigue and allow one to accomplish goals.

Today’s Quote of the Day…

…is from pages 101-102 of Paul Krugman’s 1997 book Pop Internationalism:

There is no question that in many cases comparative advantgae arises from self-reinforcing external economies rather than as a result of underlying national resources.  In such cases international competition may exclude a country from an industry in which it could have established a comparative advantage, or drive a country from an industry in which comparative advantage could have been maintained.  In these cases, a [sic] intellectually respectible argument can be made for government policies to create or preserve advantage.

The fact that an argument is intellectualy respectible does not mean it is right.  Concerns over competitiveness that are valid in principle can be and have been misused or abused in practice.  Competitiveness is both a subtler and a more problematic issue than is generally understood.

Absolutely.  Some folks like to justify Trump’s economic policies based on obscure or particular economic arguments: optimal tariffs, or increasing terms of trade, or forcing other nations to lower tariffs and subsidies, or national defense.  All of these arguments are intellectually respectable (if not consistent with one another).  The internal logic of them holds.

But just because something is possible does not mean it is probable.  It is possible that a tariff could improve the well-being of a nation (subject to some key caveats).  But how probable is it that government could effectively create and enforce such a tariff and not face public choice concerns?  How probable is it that there would be no additional costs to the process, or that it won’t get hijacked for self-interested uses?

It’s trivially easy to come up with some theoretical reason why something can happen.  Translating that into reality, however, is a totally different beast.

The Peace of Beggars and Kings

Humans, it seems, have an instinctive need to constantly be dissatisfied with our current position:  “If only I had a little more money, I’d be satisfied,”  or “if only I had a bigger TV.”  Philosophers, including Adam Smith, warn against this mindset, fearing it could lead to perpetual unhappiness and there is nothing to prevent us from achieving that happiness already.

This perpetual unhappiness, or dissatisfaction of the status quo, may be philosophically distasteful (and for good reason) but it appears to serve an economic function: the desire to remove this dissatisfaction fosters economic growth.

Man’s wants are indefinite: as we reach new heights, we become dissatisfied with our current position and desire more, and this holds across time as technology and desires change.  A color TV was good enough in the 1960’s, but now we demand HD and “true color” and all kinds of things.  A small electric fan was good enough half-a-century ago, but now air conditioning is ubiquitous (which, in turn, is giving way to “smart homes” and the like).  To quote Frederic Bastiat: “[A] desire to go thirty miles an hour would have been unreasonable two centuries ago but is not so today [JMM: And now 60 miles an hour is too slow!].”

These desires for advancement come about as we satisfy lower-order desires; there does appear to be a hierarchy of wants.  When all resources were devoted to food production and bare substance levels, desires for speedier travel could not be satisfied.  But as food and shelter needs were met more cheaply (that is, using fewer resources to achieve the same or greater output) thanks to agriculture, more resources could be devoted to other things that were luxuries: fancier clothes, faster means of travel, etc.  Those luxuries then became necessities, and as they were satisfied more cheaply, more could be devoted to satisfying other desires that were luxuries, and so on and so on.

When we were hungry, we desired food.  When that was satisfied, we desired shelter.  When that was satisfied, we desired transportation, etc etc etc.  The constantly evolving desire of man, him chasing that peace beggars have that kings fight for, leads to innovation, the satisfaction of new wants, and general progress.

An implication of this discussion is that it reveals the silliness of many arguments against free trade, namely that trade with other nations make us worse off by reducing our productive capabilities or making us dependent on other nations, but that is a blog post for another time.

Of course, this perpetual unhappiness can have significant negative consequences, as well.  Desire can be a sin as well as a virtue.  Imprudent desire can lead to “arms races” where more and more resources are poured into things that give no gains.  Imprudent desire can lead to all kinds of mental illnesses or acts of crime.  Let us not be accused of denying these basic facts.  But let us not make a bigger deal of it than it is, either, and deny ourselves the benefit of economic progress for fear of arms races or illness.

Desire can be a boon.  Indeed, it has been.  It fosters growth and change.  It must be balanced, sure, just like anything.  But desire is not something to be shunned.  Understanding its role in economic progress is important.

Today’s Quotation of the Day…

…is from page 22 of Paul Krugman’s 1996 book Pop Internationalism:

So let’s start telling the truth: competitiveness is a meaningless word when applied to national economies.  And the obsession with competitiveness is both wrong and dangerous.

Although this sentence was written over 20 years ago, not much has changed.  The arguments of Clinton Krugman refutes in this first chapter of his book are identical to ones being put forth now by Trump: concerns about “competitiveness,” bad mathematics, incorrect claims of the trade deficit destroying jobs, etc etc etc.  The scarcityist fancies himself a “practical” man, but he deals in false and long-dead ideas.

The Transition Costs of Tariffs

The conversation around tariffs tends to focus primarily on gains and losses.  Domestic protected producers are said to gain because of higher prices and returns.  Domestic consumers are said to lose because of said higher prices; the consumers now need to expend more effort to acquire the same or a fewer number of goods.

But the standard “welfare analysis” story of tariffs is, while correct, incomplete.  We live in a world of transaction costs and people do not instantly and costlessly move from one state of being to the other; that is, people face “transition costs.”  These costs include: searching for new suppliers and all the transaction costs therefrom (if they’re buying the imported product), tax compliance (if they are the importers), enforcement costs (for customs agents), lobbying costs (if they are lobbying for/against protection), etc etc.  These costs are not directly captured in the textbook model of tariffs but are costs nonetheless.

The implication of including transition costs of tariffs into the analysis is it makes the argument for tariffs even weaker; the true costs of the tariffs are likely considerably higher than typically anticipated.  As resources are devoted to compliance (or avoidance) of the tariff, to finding new suppliers or paying higher bills, that means fewer resources devoted to “building a better mousetrap.”  It means fewer resources dedicated to expanding and hiring and innovating.  It means fewer resources being devoted to satisfying desires.  It means we should be extremely skeptical of anyone who claims tariffs will “make America great again.”

Along the same lines as this post, check out David Henderson’s recent EconLog post on the costs of the TSA.