The Difference Between Econ 101 and Econ 801

An advantage of teaching undergraduate students as I simultaneously work on my graduate work is I get to go through both undergrad textbooks and graduate books at the same time.  Currently, I’ve been working my way through Cowen and Tabarrok’s Principles of Economics for my undergraduate class and George Stigler’s Theory of Price and Donald Watson’s Price Theory and Its Uses for my research.

We often hear, primarily by people who dislike the implications of Econ 101 models, that Econ 101 is too simplistic, too unrealistic for the real world.  They’ll point to other economic models that better conform to their desired views (eg, the monopsony model for minimum wage).  “We can’t rely on Econ 101!  It’s just too simple!”

But what’s interesting to me is that going through these upper-level texts (Stigler is a high-Masters, low-PhD text), one sees they are not fundamentally different from the undergrad texts.  This holds in other texts, too, such as David Kreps’ Microeconomic Foundations.  There may be more math to formalize the models, but the intuition remains the same; the implications remain the same.

Basic supply and demand analysis gets us a very long way.  It is not complete, of course.  No theory ever is.  But supply and demand is fundamental.  Seeking to overthrow the foundations will not necessarily lead to a more coherent theory.

What is Unique About International Trade?

What is unique about international trade?  This is the question that I pose to my two trade classes (Econ 390: International Economics and Econ 385: International Economic Policy) every day this Fall.  This question is crucial toward understanding the content in the courses.

In Econ 390, the more technical of the two courses, we’re using Paul Krugman, Maurice Obstfeld, and Marc Melitz’s textbook International Economics (among others).  The opening chapters deal with the main models of trade theory: Ricardian, Specific-Factors, Hecksher-Ohlin, and the combined Standard Trade Model.

As with any good model, we start with the simple case of two people.  How does the model develop here?  What are the driving forces of change and outcomes?  What are the impacts of the assumptions?  We then expand the model into the world of international trade.

When we expand the model outward, we notice something interesting: nothing unique happens when the model is expanded to include international trade.  The factors adjusting income distribution stay the same.  The influences governing specialization stay the same.  The key for any of these models is that a change in relative prices changes the distribution of income and economic activity.  This result is no different than microeconomic outcomes.  Any change in relative prices, regardless of whether this occurs because of domestic or international conditions, will cause changes in the economy.  This is a point Krugman et al repeatedly stress in their textbook and a point I repeatedly stress as well.

Let’s take, for example, the Specific-Factors model, which argues that in any form of production, there are some factors of production specific to that production and some factors that are mobile and thus can switch from one form of production to the other.  If there is some relative price change, the model predicts the domestic owners of the specific factor of the now relatively-expensive good will benefit (increased income), the domestic owners of the specific factor of the now relatively-inexpensive good will not benefit (less income) and the domestic owners of the mobile factor will have an ambiguous impact.  Note that it doesn’t matter if this change in relative prices is caused by domestic issues (say, a tax on one good that changes its relative price) or by international trade (a change in world price).  The effect is the same.

So, what then is unique about international trade?  Is it that differing legal regimes between countries have a major impact and thus people should be upset about that?  This doesn’t hold, especially in the United States, as each of the 50 states has different legal rules and regulations.  California, for example, has very stringent rules about labeling and selling; New Hampshire, not so much.  New Hampshire thus has an advantage over California, but people in California aren’t protesting New Hampshire products.  So, the uniqueness of international trade cannot rest on differing legal regimes.

Dani Rodrik suggests its a perception of unfairness due to different “domestic norms” and “social understandings” that is unique.  While the perception may be unique, the actual reality of any unfairness due to these differences is not unique.  Again, domestic norms and social understandings are legion among the various regions of the United States.  Some states have stronger social safety nets than others.  Firms will move to take advantage of less costly regulations.  So, this difference in social understandings is not unique to international trade, either.

There are many other excuses people can give for the uniqueness of international trade and why tariffs are justified internationally but not nationally; I’ve just listed two.  But the same analysis should be performed for each of these excuses.  You’ll find they do not hold up.

In short, there is nothing economically or socially unique about international trade that renders it subject to special rules and regulations.

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.

 

What Naval Warfare Shows About the Market Process

You stare out over the watery landscape through your binoculars.  Endless grey skies that go on for thousands of miles.  Carefully scanning, you look for any sight of the enemy battleship in the area.  You know she’s there…but where?

“Contact!  Starboard!” comes the shout.  You whip around and sure enough, there is, on the horizon, a ship.  You pull out your binoculars and see the distinctive black cross on a red background flag of the Kriegsmarine.  “Target acquired!” you shout, confirming what the officer saw.  “Bring us around.  Gunner, I want a firing solution now!”

“Aye aye!”

Your ship, a massive American battleship, comes around and you gain on your prey.

“Solution plotted!” yells the gunner.  “Elevation, 20 degrees!  Keep this bearing!”  You nod.  You see from the bridge the main batteries change position and elevation, their silence now an omen of the death they carry.

“Guns ready!’ comes the shout.  “Fire,” you command.

The massive ship bucks as all six 15-inch cannons fire.  The blast is loud enough to deafen everyone temporarily.  The ship rocks as though hit by a large wave.  Hot death is quickly headed toward the enemy ship.  You look through your binoculars:

Splash!  Splashsplashsplashsplash!  All six rounds miss.

“Damn!  We overshot!  New solution!”  Again, the gunners recalculate.  “19.8 degrees, sir!”  The guns are realigned and the command is given again.  Splash!  Splashsplashsplashsplash bang!  One round hits, but it is a glancing blow.

“I have you now,” whispers the gunner as he does his calculations again.  “19.9 degrees, sir!”  “Fire everything we’ve got!”

Again, the ship roars with the fury of a god.  You watch through your binoculars.  Even from several miles away, you can hear the boom as the rounds hit their target.  A massive plume of smoke and fire erupts from the enemy ship.  “Direct hit, sir!  They’re sinking.  It looks like we got their magazine!”  A cheer goes up from the crew.  The prey you have been hunting for weeks was now dead in the water.

How was victory achieved?  Tenacity, no doubt.  But also trial-and-error.  The gunner and crew had to operate on their best information at the time.  As new information came in (missed shots), they adjusted their plans.  Eventually, they were able to have a direct hit by making changes.  In other words, their failures allowed them to ultimately succeed.

The same is true for a market process.  Markets fail.  People notice those failures.  They subsequently make adjustments.  Those adjustments help correct for the market failures and bring people closer and closer to their goals.  Market perfection may never be achieved, but it is tended toward.

People fail.  People learn what not to do.  People correct.  That is the market process.  Failure is just as important as success.

Who Are the Economic Experts?

Economists are considered the economic experts.  After all, we’re the ones with the PhDs, the fancy mathematics, the complex theories that purport to explain everything.

But the reality is quite different.  We are not the economic experts.  Indeed, a good education in economics inoculates one from thinking himself an expert and forces him to think himself more of an observer.

The real economic experts are everyone.

People understand how to act in their own best interests. Nothing about the market needs experts to guide it. People are not fools who require technocrats to tell them what they can and cannot buy.  The outcome of the market, the observed phenomena that are the market process, is nothing more than the results of people interacting with one another; human action but not human demand.  People are acting on information that they have and the signals they see.  They are the experts, not the economist or technocrat.

Protectionists disagree, however. They believe they know better than everyone else. They believe they know better than the Joes of the world. They believe they know better than people what is in their own best interest. So they seek to impose their will upon everyone else, the opinions, hopes, and dreams of the others be damned. “They are not educated,” the protectionist thinks. “They are not versed in the theorems and mathematical proofs that show that Joe is harming himself. If only he had a benevolent hand to guide him; to push him in the right direction (or tug on the leash, if necessary).”

Free marketers believe non-economists do indeed know more economics than the economists. That’s precisely why they argue for free markets; so people can exploit their knowledge and expertise to the best of their ability. The protectionists and socialists (but I repeat myself) disagree. They believe themselves to be far smarter than the Joes of the world and that the Joes are simply too stupid to act in their own behalf.

Markets are observed empirical phenomena, not a technocratic outcome.  The market process is not a theory per se but an actual outcome.  The theory is used to explain why that outcome occurs, but it is an outcome nonetheless.

The Big Rock Candy Mountain

On Monday, I opened my inaugural lecture in my Econ 100 (Economics for the Citizen) class by showing this video:

The Big Rock Candy Mountain is a hobo’s Paradise.  Everything he wants is at his fingertips.  Lakes of whiskey and stew, lots of places to sleep, where they “hung the jerk that invented work.”  Truly a Heaven on Earth.

But the economic problem is that we don’t live on the Big Rock Candy Mountain.  We live in a world of scarce resources, that is a world where choices need to be made.  How does one decide?  How can one maximize his resources?  How do we interact with one another on this issue?  How do we develop rules and institutions that govern these interactions?  These are the questions that economists study.*

Economists spend most of our time repeatedly reminding people that resources are scarce.  Politicians like to pretend otherwise.  Scarcityists like to pretend otherwise.  But they are merely chasing a hobo’s dream.

*Note the subtle difference between these questions, which are positive in nature, and the normative questions of “how should resources be allocated” and “who should decide” that many pseudoeconomists like to think economics is.

Cause, Effect, and Misallocation

In preparation for a price theory book I am writing, I am re-reading George Stigler’s classic 1966 text The Theory of Price.  The following is found on page 19 (3rd edition):

[I]t has become a major task demanded of all economies: they are required (as soverigns use this word) to provide technological advances, capital accumulations, improved labor forces, and larger incomes.  So strong is this demand, that sometimes a method by wich western nations become richer–industrialization–is confused with the growth itself, and inappropiate industries that reduce a nations’s income are adopted to increase it.

Confusing cause with effect is a major problem facing all analysts.  This becomes doubly true when discussing economic growth when policy is involved.

Industrialized nations are wealthy, but it doesn’t necessarily mean such industrialization is the cause of wealth.  Rather, industrialization is itself a symptom of a deeper cause, that is the division of labor.  “Industrialization” is a term without definition, as it can refer to many kinds of industries.  Comparative advantage is what tells us what kind of industrialization is needed to foster growth.

The United States has a comparative advantage in high tech industries; we are an extremely intelligent people with lots of capital (both human and machine) at our disposal.  China, however, has a comparative advantage in low tech industries; they have lots of unskilled labor at their disposal.  It makes sense for the US to industrialize in high tech industries and China to industrialize in low tech industries.

But even within countries, industrialization is varied.  In the US, the vast middle of the country has some of the most fertile farmland in the world.  It makes sense for those states to be agriculturally-based and other places, like Texas, to be resource-based, and others, like Massachusetts, to be tech-based.

A scheme based on the mistaken notion that “industrialization = progress” will lead to misallocation of resources.  Resources, such as labor, capital, time, will be diverted into less productive and more costly areas.  This, in turn, leads to a net decline in wealth compared to where it otherwise would have been.  An example of this is China during the “Great Leap Forward.”  Industrialization, specifically of steel, was all the rage of the Communist Party.  All production was geared toward steel production.  This inherently meant a rapid decline in production of other items–like food.  China’s poverty deepened.

The Great Leap Forward is an extreme example, but other historical cases of misallocation of resources due to the mistaken belief of “industrialization = wealth” include the USSR, modern Venezuela, and North Korea.

When examining the causes of economic growth, one must be very careful in determining cause and effect.  This is where price theory really shines.

The Law of Demand in Action (or Why Monopoly Power is Fleeting)

Writing at Human Progress, Martin Tupy has an excellent article on the real effects of predatory pricing and monopoly.  Here is the upshot (although one should read the whole article.  It is excellent):

In a 2014 Council on Foreign Relations report, Eugene Gholz, an associate professor of public affairs at the University of Texas at Austin, revisited the crisis and found that the Chinese embargo [of rare earths to Japan] proved to be a bit of a dud.  Some Chinese exporters got around the embargo by using legal loopholes, such as selling rare earths after combining them with other alloys. Others smuggled the elements out of China outright. Some companies found ways to make their products using smaller amounts of the elements while others “remembered that they did not need the high performance of specialized rare earth[s] … they were merely using them because, at least until the 2010 episode, they were relatively inexpensive and convenient.” Third, companies around the world started raising money for new mining projects, ramped up the existing plant capacities and accelerated plans to recycle rare earths.

In other words, when faced with a sudden shortage, people compensated through other means.  It’s almost as if demand curves slope downward.

Monopolies are still subject to the whims of consumers.  They cannot raise their prices with impunity.  As prices remain high, people will innovate around them.  This indicates that the fear of predatory pricing, that a firm (or country) will seize market power and use it to jack up prices or manipulate people, are greatly overblown.

 

Has the Human Cost of War Gotten Too Low?

File this under “counterintuitive things economists say.”

Has the cost of war gotten too low?  The United States has been at war for almost my whole life.  I was born in 1989.  In 1991, on my birthday, the Operation Desert Storm began.  Throughout the 90’s, the US was launching strikes on Iraq, Bosnia, and Africa.  In 2001, we invaded and occupied Afghanistan.  In 2003, we invaded and occupied Iraq.  In the 2010’s, we attacked Lybia, Yemen, multiple places in Africa, and now Syria.  I’m nearly 30 and the US has been at war in some capacity almost every year.

Last night (EDT), the US and allies launched a missile strike on Syria.  The French put out a video of the strikes presumably from a French warship (it’s the second video in the link.  I can’t link directly to the video because technology is hard).  What I notice in the video is computer screens.  Lots and lots of computer screens.  The launches are being made many miles from their targets.  To the extent the people attacking see their targets, it’s from drones.  They face no immediate danger nor immediate feedback of the carnage they wrought.  Just like when we watch an action movie and we don’t smell the horrors of the battlefield, neither do they.

US and Confederate General Robert E. Lee once said: “It is good war is so terrible, lest we grow fond of it.”  The burden of war was once shared by both sides.  On the battlefields of the Civil War, the World Wars, the Far East, the soldiers had to combat each other face to face.  Wave after wave of men crashed into each other in Fredericksburg.  The mud and creeks of Antietam flowed red with blood.  The soldiers of Normandy had to scale walls and engage in hand-to-hand combat.  There was a major human cost to war and the military leaders (with exceptions) were cautious about going to war.

But war has become less terrible.  We can strike at an enemy from the comfort of our beds.  Much of modern war is played like a video game.  This, in turn, reduces the cost of war; the aggressor no longer feels the pain if he can attack from thousands of miles away.  The comfort of the politician to wage war from the safety of his capital is now enjoyed by the soldier, too.  Yes, this means (initially) fewer deaths of servicemen, but will it also lead to more war?  If the US had to actually invade Syria, not be able to rely on missiles, would have the strike happened?  Will the use of drones, of long-range bombers, of other technological killers, create a perpetual war by reducing the human costs?  I suspect so.

So, let me ask the unpopular question: are wars too safe?

The Parable of the Two Shipmasters

A prudent ship captain his crew set sail for a multi-month journey.  In port, he makes sure he has enough supplies for his crew for the entire journey and then some (just to be safe).  While underway at sea, he checks the galley and finds that about half of his food stores are spoiled because there was some unforeseen blight in the crops he bought.  The captain gathers his crew together and says: “Mates, we have a problem.  Half of our food is gone.  Unfortunately, this means I must put you all on half rations for the remainder of our voyage.”  The crew, understandably, begins to grumble.  They enjoyed their rations and now there will be half?

“But sir!” cries one young sailor, “We were used to our old rations!  The life on the ship was fun.  We had beer and bread and meat.  It gave us strength and kept morale high.  Why must we be tortured so?”

“Because,” replied the captain, “otherwise we may not have enough food to survive our journey.  We are weeks from the closest port and these stores must last.  I promise it is better to have a dearth now than a famine later.”

The crew grumbles, but they comply.  Two months later, the ship arrives at its destination with the full complement of crew who are tired but alive.

At the same time as the above story, a second imprudent ship captain also buys the same amount of food for his journey of the same length.  While out at sea, he also suffers the blight and loses half his stores.  He gathers the crew around and says: “Mates, half our food stores are gone.  It looks like I may have to cut rations.”

“But sir!” another young sailor objects.  “Half rations are no good!  We won’t be merry!  Our lives will be tougher.  This is no good!”

“Agreed,” said the captain.  “The happiness of my crew must come first.  We should not have to suffer inconveniences.  Rations will not be cut!”  The crew cheers.

Two months later, a ghost ship drifts into the port full of emancipated men who have not eaten in over a month.  The few that survived resorted to eating whatever they could find, including each other when necessary.

The above parable is adapted from Adam Smith’s Wealth of Nations, in particular, Book IV Chapter V.  In times of scarcity, prices must rise in order to encourage conservation of resources (in this case, the price acts as the ship captain rationing food).  Prices rise through the acts of speculators buying goods in periods of relative plenty and selling in times of relative scarcity (thus the maxim “buy low sell high”).  It is obvious that the higher prices cause discomfort.  People eat less or less desirable things.  But the alternative to this discomfort is famine.  If prices are not allowed to adjust for whatever reason (the ship captain who keeps rations the same), then the resource is consumed too quickly and famine can quickly set in.  The discomfort is delayed to the future, but it is repaid with heavy interest.