The Importance of Considering Transaction Costs

Over at Carpe Diem, Mark Perry points us to an article detailing a potential move by Wal-Mart:

Target and Walmart will now face a tough choice: They can absorb the higher costs from tariffs by taking a hit to their profit margins, or they can pass some of the price increases on to their customers.

“Either consumers will pay more, suppliers will receive less, retail margins will be lower, or consumers will buy fewer products or forego purchases altogether,” Walmart warned in its letter.

The Trump administration is using tariffs to push companies to manufacture more goods in the United States. But the National Retail Federation says the administration’s thinking is flawed and carefully planned supply chain plans can’t be redrawn overnight. Retailers order their products six months to a year in advance, and they are left scrambling to find new options for 2019. “The [administration] continues to overestimate the ability of US companies to shift supply chains out of China,” the trade group said in its own letter to Lighthizer. “Global supply chains are extremely complex. It can take years to find the right partners who can meet the proper criteria and produce products at the scale and cost that is needed.”

Implicit in this conversation is the costs to retailers (and manufacturers and anyone else who uses imported goods) to search and find new suppliers.  These costs are very real and necessarily contribute to fewer economic gains in the country.

Trump’s tariff schemes, to use tariffs to force companies to relocate supply chains or operations to the US relies on something of a Nirvana fallacy: that these relocations/readjustments can be done costlessly.  As a former business executive, he should know better.  Firms cannot just adjust their operations costlessly.  Contracts are in place.  New ones would need to be written.  New relationships need to be formed.  Adjustments need to be made to product specifications.  Etc etc.  These are not costless processes.

Even if we were to assume, contrary to ex-ante evidence, that Wal-Mart suppliers relocating back to the US is 1) possible and 2) would be beneficial for the economy as a whole, when you figure in all the costs associated with such a move (that is, all the transaction costs), it is highly improbable that, on net, the move would be positive.


Ruminations on Equal Pay Day

Today is Equal Pay Day, which means two things are certain: 1) some groups will be arguing that the pay gap is very real and must be addressed and 2) some groups will be arguing the pay gap is a myth and should be dismissed.  Both groups are simultaneously right and wrong.  It is true that, adjusting for various economic factors, much of the pay gap goes away (Group 2 is correct).  However, it is also true that there is some gap that remains which could be due to discrimination (Group 1 is correct).

But economics is limited in this story.  We can provide economic explanations, but there are other factors that other fields could provide insight into as well.  For example, why is it that there is an unadjusted 80-cent gap to begin with?  Are women encouraged to avoid the higher-paying fields?  Sociology could help answer that.  Are women just worse negotiators then men?  Psychology could help answer that.  Are the biological differences that could account?  Biology could help answer that.  Is there legislation that encourages discriminatory hiring practices?  Legal studies can help answer that.  These various disciplines could provide valuable insights.

A mistake I think many economists make (myself included) is sometimes thinking the economic way of thinking is the only way of thinking.  It is powerful, to be sure, but it is not alone.  We can help provide some answers (like on the pay gap) but not all the answers (nor should we.  Division of labor).

My two cents on the pay gap: Is discrimination an explanation for the difference between men’s and women’s pay?  It’s probable; the size of the effect is difficult to know.  Unlikely responsible for a large portion.  Is government the solution?  Possibly.  If the issue is poor incentives from legislation, then government would have to repeal such legislation.  If there are other causes, governmental interference would likely cause more harm than good.

I think the pay gap deserves more thought than many economists are willing to give it, and it especially deserves thought from the sociologists and legal scholars (my gut feeling is that is where we will find much of the gap explained).

The Case Against Renewable Energy, as Presented By Bernie Sanders

On his Facebook, Sen. Bernie Sanders uploaded the following graphic*:


The Senator is trying to spin this as an argument for renewable energy, but in doing so he confuses costs and benefits.  Ironically, he makes an extremely strong case against renewables:

Looking at this chart, we see approximately the same number of jobs in coal and nuclear.  Renewables have a considerably higher number of jobs.  But their output are quite different.  According to the EIA, coal produces approximately 16% of our energy consumption (or about 15.6 quadrillion BTU).  Nuclear power is ~9% (or ~8.8 quadrillion BTU).  Renewables are ~10% (or 9.8 quadrillion BTU).

What does this mean for resource efficiency?  Quite a lot.  The average worker in coal produces 2.1e^11 BTU.  The average nuclear worker produces 1.1e^11 BTU.  The average renewable worker produces 1.8e^10 BTU.  That means the average coal worker is 1033.92% more efficient than the average renewable worker!   We’d need to put in approximately 10x the number of labor resources into renewables as coal to get the exact same results!  That’s highly inefficient and quite against the idea of resource conservation.  On environmentalist grounds, I oppose renewables at this date and time.

But, the point the Senator is making, is that the jobs themselves are desirable.  But he confuses costs and benefits.  Jobs are a means not an ends.  Our lives are improved by finding ways to reduce the amount of labor in them, not increase it.  In short, the Senator has things exactly bass ackwards.

*Note: I have not independently verified these figures.

On Foreign Ownership

At this Cafe Hayek blog post, commentators Ed Rector and Tony Hart echo similar concerns.  First, Ed:

In other words, foreigners owned 17.46% of US assets in 2000 and foreigners owned 26.41% of US assets in 2009.

What is overlooked in the series of posts on the trade deficit vs returning capital flows is that those foreign-owned US assets earn a return that is presumably paid to those foreign owners.

and now Tony:

So, Griswold tells us about US assets owned by foreigners. What about foreign assets owned by US citizens and businesses? And then compare the incomes going out and coming in.

Both echo concerns that a greater share of US assets (that is, assets that are located in the US), are now owned by foreigners.  For some reason, this is a bad thing (although neither elaborate why).  But there is little reason to be concerned in these numbers.

First, the capital stock of the US (and indeed the world) is not fixed.  The fact that a greater share of US assets are owned by foreigners does not necessarily mean that fewer assets are now owned by Americans.  Indeed, as Griswold’s data (in the linked blog post) show, American-owned assets have been rising, too!  Americans are getting more productive and foreigners want a piece of that pie, too.

Second, the fact that assets are foreign-owned is not, as is often insinuated (to be fair, not by these two comments) a national security threat.  If anything, it reduces security issues.  As economic ties build between areas, then the risk of conflict falls.  Foreigners earn returns on their investments, which makes the cost of going to war higher.  Sure, there may be some assets you don’t want owned by a potentially hostile foreign nation (power plants, weapon factories, etc), but that’s not what’s being bought.  Trust me, the Swedes aren’t going to weaponize their Ikea stores.

Third, in a direct response to Tony’s comment above, the fact that foreigners are investing more into the US than we are investing elsewhere is a good thing.  It’s not a sign of US weakness; it’s a sign of US strength.  It indicates the US holds better opportunities for investments than other options in the rest of the world.  Just logically, it doesn’t make sense that foreign-owned assets make the US weak: no one boards a sinking ship just to plunder its treasure.

Fourth, in direct response to Ed above, the fact that foreigners earn returns on their investments is, again, a good thing.  It means those assets are productive: their producing goods/services valued by Americans, they’re employing Americans (generating payroll and the like); in short, they’re being useful.  Again, this is a testament to the strength of the US economy, not a weakness.  The fact that the returns go to someone on the other side of an imaginary line is meaningless.

The tl;dr version of this post: I fear assets owned by a Chinese person no more than I do assets owned by a North Carolinian.

Ruminations on Monopoly and Antitrust

Monopolies are often derided by economists and non-economists alike, and often for good reason: monopolist firms are less efficient than their perfectly-competitive counterparts (to use more technical language, they charge a price higher than their marginal costs), which means consumers pay more for fewer goods.  Partly based off this theory (but also because of political pressures from reformers) the US in 1890 passed the Sherman Antitrust Act, which has become the main tool for the government to break up monopolies into more firms.  This act is hailed even by some free-market advocates for its efforts to create competitiveness.  Are monopolies undesirable and do they run counter to free market principles?  I argue “no” to both questions below the fold.

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What Human Action Can Tell Us

As Ludwig von Mises taught way back in 1949, economics is, above all, the study of human action. The two main assumptions of economics back this up: 1) economic actors are rational (that is, with the knowledge they possess, they are working toward some goal), and 2) economic actors seek to improve their conditions (that is, their goal is improvement of wealth, utility, happiness, etc rather than the reduction of such).  Essentially, these assumptions boil down to: people, generally speaking, know what they’re doing (as the incomparable Walter Williams likes to say: “never assume someone is stupid until they prove themselves otherwise”).  One should deeply consider these two assumptions as what follows is derived from them.

The study of human action in the present can provide us with important insights. In this author’s opinion, I fear this study of present conditions is not done enough by economists.  Many economists focus too much on the future (what will the effect of this policy be, etc) rather than an analysis of the current situation.  Current-situation analysis can provide us insights into the future, too.  For example, an oft-heard defense of minimum wage is the “efficiency-wage theory,” that is, employers, when faced with a mandatory higher wage, will increase the productivity of their workers through training or other programs in order to meet the new wage.  Any lost profits from the higher wages would be offset by the higher profits from the increased productivity.  However, given the two assumptions mentioned in the first paragraph, we can look at the current situation and question the validity of the prediction: if employers could already increase productivity (and thus their profits) of workers, why aren’t they already doing it?  From this point, this current-situation analysis, should the conversation begin, rather than the future-situation analysis of a post-minimum wage world.  We should be further skeptical of any answer to the current situation question that involves tossing away one or both of the two main assumptions discussed in the first paragraph.

The current-situation analysis is also helpful in understanding why institutions and law pop up where they do.  Why was a private-property rights regime adopted in one area but not in another?  Why do people in New England act a certain way compared to people in North Carolina?  And so on.

The current-situation analysis prevents us from falling into the pretense of knowledge problem.  For future-situation analysis, there can always be models or logical steps that can come to all sorts of conclusions (eg, the efficiency-wage theory and minimum wage example earlier). Current-situation analysis helps us avoid this mistake.

An Important Caveat

The above discussion holds most true when the acting parties feel the majority of costs of their actions.  In situations where this is not true, where the costs of an individual’s actions are diffused over a large group that may not even involve the actor himself, it becomes harder to derive a clear picture from his current-situation actions.  For example, voting.  With voting, and politics in general, the cost of the action (or, more importantly, being wrong) is diffused among a large group of people that may not include the actor himself.  For example, if a voter votes to increase minimum wage, he is not paying the cost for such an action.  Rather, he is (potentially) compelling others to do his preferred action with no or minimal cost to himself.  His action is consistent with our two assumptions, but it is not a clear picture of what his preferred action is.  In other words, we cannot draw a conclusion from his action here as we could with the businessman in the above example.  For this reason, we should be careful drawing conclusions from political actions. Rather, his actions where he bares the brunt of the costs gives us more information.

Are High Prices Necessary for Innovation?

Writing in Bloomberg, Megan McArdle says:

America’s high pharmaceutical prices are what compensates pharmaceutical firms for the risk of developing drugs. If we drive them lower, we’ll get fewer new drugs….After a few years of obscene profits, most of these innovations will be pretty cheap and widely available. Every useful weapon we decide not to try to produce for that arsenal comes at a cost to future people’s health.

Megan’s argument is a common one, and is often used to justify government-granted monopolies through patients. Although it pains me to do so, I must disagree with her here.

Drug research certainly is expensive, but as David Henderson and Charles Hooper point out, regulatory burden is also a major cost for firms:

Economists have shown that the cost to get one drug to market successfully is now more than $2.8 billion. Most of this cost is due to FDA regulation. Some potentially helpful drugs don’t ever make it to market because the cost the company must bear is too high. Drug companies reguarly “kill” drugs that could be effective because the potential profits, multiplied by the probability of collecting them, are less than the anticipated costs.

In other words, firms make a simple probabilistic Net Present Value calculation and the cost of regulation tends to be the deciding factor to cancel a project.  The high prices firms receive are a reflection of both the cost of innovation, but primarily the cost of regulation.  As Henderson and Hooper discuss, drug prices could be lowered (by changing the regulatory regime) and have it not affect innovation.

In a more general sense, high prices/profits are not necessary to spur innovation.  Competition can do the same thing.  In competitive markets, firms must always be on the look out for competitors cutting into their profits.  They look to gain any edge they can, which includes innovation.  Innovation can mean improving the current mousetrap or building a better one.  This is why we continue to see innovation even in highly competitive markets like retail/wholesale even though they do not earn extra-normal profits.

An easy way to test this theory would be, as Henderson and Hooper suggest, reduce regulation.  Standard monopoly theory says that a firm would develop into a monopoly if (among other reasons) there are significant technological barriers preventing entry into the market (in other words, if innovation is so expensive only one firm can efficiently conduct it). If the regulations are lifted and prices remain high and drug companies meld into a monopoly, then we can conclude Megan’s hypothesis is correct.  If, however, drug prices fall (as I suspect they will), we can conclude Henderson & Hooper’s hypothesis correct.

Predatory Pricing and International Trade

A classic piece of industrial organization literature is John McGee’s 1958 article in the Journal of Law and Economics Predatory Price Cutting: The Standard Oil (NJ) Case.

In the article, McGee looks at price-cutting allegations leveled against Standard Oil in the early 1900’s. He examines the evidence of the case but also lays out a rather brilliant critique of price cutting as an effort to secure/gain monopoly power in a market. In short, he logically shows that price cutting is, by far, the least effective means of accomplishing this. It tends to be far more devastating to the price-cutting firm and, if the market is competitive, such price cutting could go on for years and years. It is far cheaper to simply buy up competition.

Dr McGee’s analysis should give us pause when considering “dumping” allegations in regard to international trade.  Dumping is a form of predatory pricing: manufacturers exporting goods to foreign markets and selling well below cost in order to grab market share.  As Dr McGee logically lays out in his article, predatory pricing tends to be extremely costly to the predator.  This could be why governments need to subsidize the firms in order to perpetuate the scheme.  However, as GMU economist Don Boudreaux points out in this blog post, subsidies harm the economy as a whole, while enriching the few who receive them.  Assuming China is subsidizing exports for the purpose of monopolizing highly-competitive markets, China is opting for short-term gains for firms by socializing the losses from the predatory pricing behavior on the off-chance they can monopolize a market.  Dr McGee’s analysis in the article indicates this is an extra-risky strategy (mergers and partnerships with US firms would be a far more effective way of accomplishing this goal).

Right to Work vs Right to Contract

One of the local ballot issues in Tuesday’s election here in Virginia was a constitutional amendment to the state barring “closed-shop”, that is barring agreements between firms and unions to require union membership or dues as a condition of employment.  Such legislation, referred to as “right to work” (RTW) are common in the US. However, the ballot measure was defeated here in Virginia, an outcome which I support and voted for.

On the surface, this could be seen as a violation of my free market (free from coercion) principles.  Aren’t such agreements coercive?  Why should a worker be compelled to join a union?  These questions are legitimate, but ultimately inaccurate to describe closed shops.  In fact, the RTW legislation is coercive.

I will make a simple case.  Firms should be allowed to enter into voluntary agreements as they wish.  They have property rights, just like people.  If a firm wishes to enter into an agreement of its own free will with a union for a closed shop, then it should be able to.  Legislation to prevent such agreements violates the firm’s right to contract.  If a worker voluntarily agrees to take a position in a closed shop knowing full well of the requirements, he has no right to complain or challenge the agreement between the firm and union.  This would be akin to a person buying a home in a HOA knowing the rules require it to be painted green and then complaining he can’t paint it orange.

Firms, unions, and individuals all have the right to enter freely into contracts.  None of them have the right to use government coercion to change the terms of the contract after the fact.

PS: please forgive any typos.  I am typing this on my phone while trapped underground on the Metro

Update: Fixed typos and grammatical errors.