Sunday, October 30, 2011

Comparative Advantage

The principle behind comparative advantage seems fairly simple: all parties will have a lower opportunity cost for something, giving them the advantage to produce that good or service. It seems like this is the perfect formula for global prosperity. Wouldn't we just have to create a think tank of brilliant people from around the world to determine the comparative advantage for each country and start producing on that model? It would create the ideal scenario for both developing and developed countries. Free trade would be the rule of the day and pigs will grow wings and fly. Even though it sounds pretty amazing, we are still a ways away from free trade. So what are some the factors that are preventing this from happening?

1) Domestic Politics. Politicians protect domestic industries to get re-elected. Even if a small country in Africa that no one can pronounce has a comparative advantage in making shoes, the shoe factories in the U.S. don't want to go out of business. It's a hard sell to convince someone to give up their job for "the better good of the world". So politicians promote protectionism through trade policies and the African country never gets the chance to sell its shoes in the U.S..

2) International Politics. Who would regulate the international economy to make sure that the playing field was even? We would need a referee, but how are we going to agree on what or who that would be?

3) Evil Dictators. Ok, evil dictators might be a strong description, but sanctions are still used as a political tool. So I guess evil dictators would fall under reason 1 and 2, but the point is more about the unpredictability of other nations. Political systems determine national trade policies, so the unstable nature of some countries would be constantly changing the dynamic of international relationships and national priorities. Although the market would adapt to these changes in the long run, the frequency and severity of such changes might make it difficult to ever stabilize.

Comparative advantage is beautiful when it is practiced, so hopefully someday we can work out a system that will allow this on the international level.


Prices-

The term prices, according to the oxford dictionary, means archaic value; worth. I agree with this definition, but only to an extent. To me, prices are the value of everything you must sacrifice to perform a certain action. This can be shown with the amount of time and money one must spend when shopping, as well with the energy and coordination one must use to type a paper, and these scenarios only present two of the many actual expenditures one must do to perform any action. With this in mind, I will go out on a limb and say that any rational person would make decisions based on self-interest, whereas the benefit to themselves outweighs the cost to themselves. Even if someone chooses randomly, it is because they feel picking randomly is better than trying to pick purposefully, thus still motivated by self-interest. Since self-interest is measured in utility and utility is entirely subjective and unquantifiable then understanding the true price of something is difficult. Because of the important nature of understanding prices, determining the actual price of our actions is key in not just economics but also life in general.

In my last blog I talked about how the more informed a person was about the costs of an action, the more likely they were to achieve what was in their best interest. Since rational people regularly decide to act upon their best self-interest, obtaining this information is imperative to achieving maximum marginal utility benefit in any situation. Since wealth is created when someone trades something for something else they would rather have, and people act in their own self-interest, mutual benefit occurs. The only time this doesn’t happen is when the supplier or the demander is misinformed or uninformed on the true costs of their actions. Thus having the same information is essential in a mutually beneficial transaction, and because mutually beneficial transactions are a positive externality of a market it benefits everyone in the long run. The price someone will charge for anything is determined by the information that they know, and that is why there is an extremely high demand for information. With the advent of the information age, where the private and societal costs are so low to obtain information, people are becoming more well informed and the amount of positive externalities associated with transactions is on the rise. This is reflected by increases in life expectancy, living conditions, and overall wellbeing in countries with this low cost of information. The nations in our world that support open access to information have shown impressive growth in their respective economies, like South Korea and the United States. This is because like I said there will be more positive externalities in a well-informed market due to the increase of mutually beneficial exchange. Prices are determined by the information we know, and when everyone has good information they can exchange much more efficiently and set prices at where they truly should be. This will create positive growth in any economy and allow for a much better distribution of resources. When people are afraid of prices they tend to misunderstand them and this can lead to poor allocation of resources like the crusades or the holocaust.

All in all, not every price will be right. But the closer we get to understanding the real price of the actions we choose the sooner we will achieve some sort of utopia where resources are allocated as efficiently and effectively as possible. So it seems prices are our friends, and should not be viewed as the enemy.

Things I wish I'd known before:

A number of summers ago I began work on remodeling a house my wife and I recently moved into. The remodeling involved a number of complex tasks from replacing electrical wiring, insulation, roofing, to simple tasks such as painting and to what I thought might also be simple, improving the yard. I performed this task with my old man, 64 years old at the time. My dad is an attorney and also owns a number or rental units in the town I grew up. He also loves physical labor, and I mean, loves it. He spends the better part of every Saturday and Sunday working with his hands on just about everything that can be touched outside. My love for physical labor is not as pronounced.
So back to, what I thought, was going to be some rather simple yard improvements. It was July in Nevada when we started. For those of you not familiar Nevada that is the equivalent of saying the temperature outside was Hell on earth. Our first task, I was told, was to remove an Elm tree in the yard. One week later, and a few pounds lighter, and still on that same damn tree, I looked my father square in the eye and told him, "ya know, we could rent a machine to do this". He responded, "yeah, for 500 bucks", and went back to chopping at the roots.
My education into economics at that point was very limited. But now I know the value of trade and opportunity cost. My old man only looked at one side of the equation, him having to pay someone for a machine that could do a job that he himself could do with his own labor. What he failed to realize is that the inventor of the machine had created a comparative advantage over the physical labor of his competitors. He also failed to remember that he had a comparative advantage over the owner of the machine with his legal knowledge. So we all lost out economically. My father could have traded his legal expertise for the 4 hours needed from the machine to do the job that took us two weeks!

Saturday, October 29, 2011

                Facebook recently announced that it will be building its first overseas data center, in Lapland Sweden in the artic city of Lulea.  The particular climate that Lulea offers is ideal for regulating the temperature of the huge data center, which if located further south would cost a great deal to cool.  Servers function best in the cold, and the cold is something that Lulea can offer.  It has an inherent comparative advantage when it comes to providing a chilly environment to house cold-loving servers.  Facebook could have taken its business anywhere on the continent in order to provide a data center to support its European business, but the Swedish arctic provided the ideal climate.  Its inherent comparative advantage, superior chilly climate, with a technology savvy workforce, and I’m sure lucrative tax incentives made the choice fairly simple for Facebook.
                What comparative advantages does Alaska hold?  What should the state do to market or seek out new business to Alaska?  Does the state have a role at all?  The Pebble mine is a beautiful example.  The area is contested because two things that Alaska does really well; produce Salmon and extract resources, cannot both happen at the same time.  We either destroy some Salmon territory and extract minerals or leave them in the ground and catch some Salmon.  What if anything does the discussion of comparative advantage have to say on the subject?

Wednesday, October 26, 2011

Price Theory

A few years ago, I had the privilege to listen Deirdre McCloskey give a talk when I was doing a post-doc at George Mason University. She told us that price theory was one of the most difficult theory of economics to understand. I agree. I have been teaching it for many years now and it's really painful to explain what prices come from, their role, and how important they are.

Carl Menger wrote Principles of Economics (1871) [original title is Grunds├Ątze der Volkswirtschaftslehre] and the entire book is dedicated to explain what the value of goods and services come from and to what extent values and prices are different.

Mises in "Economic Calculation in the Socialist Commonwealth" (1920) explains why a system devoid of property rights in the means of production cannot work efficiently as there are no prices and therefore no ability to calculate profits and losses to know where to allocate means of production, what to produce, in how many quantities.

Later, Hayek in "the Use of Knowledge in Society" (1945) explains the crucial role that prices play in saving people information and search costs to make effective decision because prices crystallize the local knowledge that market participants use when they make their decisions that create price movements.

Understanding the market process and the role of prices in allocating scarce resources to their most valued uses is crucial. But as important is the understanding how any meddling with the market process and the price system can lead to dramatic consequences. To be effective in allocating scarce resources to their most valued uses, the price system must work as freely as possible. As soon as the price system is hindered whether with price controls, taxes, subsidies, tariffs, quotas, or inflation, it can no longer perform its primary function of allocating resources to their most valued sources. Often the primary outcome of such interventions is "malinvestment," a term used by Friedrich Hayek to illustrate the process of investing resources in lines of production that are not profitable.

It is true that sometimes when unhampered the prices can lead to overinvestment, underinvestment, overproduction, underproduction, over consumption, or underconsumption particularly the property rights are not well-defined resulting in tragedy of the commons or pollution levels that above the efficient level, or the underconsumption of goods with positive externalities. But one cannot ignore the products of these imperfections of the real world that can be minimized either by market mechanisms or government intervention.

I encourage every student to think of the world in terms of prices. What price am I willing to pay to get what I think I need to get? What am I willing to sacrifice to get what I want or what I think we should have? Why some prices are so high? Why housing prices are so low? Does a high price necessarily mean that a good or service is extremely valuable and very rare? Does the very low price make the good less valuable or abundant?

Mises used to say that Central Planning was actually planned chaos. In a world without prices, the world would look like chaos. It would be one of misery, famine, poverty, and death.


Monday, October 24, 2011

Manipulating a Person to Create an Imbalanced Trade

Hahahahah!!

But really, just like how hacking improves security, I believe that understanding how manipulation works could improve the sophistication of trade. I'm going to describe a 2-step case of manipulation with a story. Environments this can be used in include flea markets, used car lots, with real estate agents, garage sales, craft fairs, black markets, vehicle/computer repair stores, or with your 'friends' you jerk. Basically anywhere where the person you're purchasing from owns the rights to the item being purchased.

Imagine a situation where you and somebody, lets call them Jack, have some items to trade. Alright, before we can begin to describe the process of manipulating Jack to create an imbalanced trade we must first take heed of two things: what Jack wants and what Jack knows. The reason why we must know what Jack wants is so that we may appeal the emotions of Jack. The reason we have to know what Jack knows is so that we can avoid getting detected in our disingenuous schemes!

Go: Jack comes up to you and is like, "Look I just got a lot of [magical item]!" Jealous, and wanting to get more of this [magical item], you start your game.

The first step you can take is to make Jack think less of the [magical item]. THE BEST way to do this is to find REAL faults with the [magical item]. For example, when you go to purchase a used car you may notice that there is a dent in the door or a crack in the windshield. Call those things out -> ????? -> Profit! You can also do this by providing false information about the [magical item] or by devaluing the positive impact of the [magical item]. The reason you may wish to provide false information alongside real information is because perhaps you just can't get the price low enough being honest! And if you can get better than the honest price, why not?

The easiest way to have somebody believe false information is to guise it in an informal fallacy. The reason that informal fallacies are useful in this situation is because Jack isn't stupid, and he knows the basic information about his [magical item]. If we tried telling him that his [magical item] does something extra or doesn't do something that he knows it does, he'll [b]catch us[/b]. Boo. But if we used an informal fallacy such as "Oh, everybody I know that has [magical item] actually say it isn't that great in regard Y" then he will generally be more willing to assimilate your proposition, rather than to just discount it. Also, a key about using informal fallacies is that they are generally difficult to verify! That means two things: Jack would have difficulty verifying it on the spot, and that Jack probably hasn't had the chance to verify such information in the past, especially if the proposition false.


Particularly useful informal fallacies:
-Argumentum Ad Populum: It is of my experience that people tend to trust - at least somewhat - the popular opinion. Nevertheless, be careful because there are some people that - for some reason - are inclined to reject popular opinion.
-Argumentum ad Verecundiam: Similarly you can tell somebody that a very respectable authority claimed something to be true. The awesome thing about this is it doesn't have to be true at all! Precede what you're claiming the authority to have said with the fragment "Dr. X said something like" and all of a sudden your claims are unverifiable.
-Slippery Slope: Oh, this one is slightly harder to employ but so useful. To use this one effectively you could tell Jack "Hey, I heard people that use [magical item] tend to get addicted to [magical item], which leads to [negative habit]."
-Appeal to Emotion: This requires knowing a little about your victims values. Lets say that Jack has a strong aversion to stupid people. You could then claim that the people that generally use [magical item] are stupid, and you don't really want to get caught up with that crowd.

These are all methods of making Jack feel as if his [magical item] isn't quite so valuable. That is, the process we are undergoing is lowering the oppositions wealth inherited from the desired item. Also, the opposition will assume you will not trade quite as much as you would have for the item. It is important that you don't overdo it because the next step is to do the first trade!

Step two is to encounter your first trade with Jack. For some reason you want some of this devalued item. Luckily people don't make sense and you don't have to either. Besides, you're just "trying it out" for the first time! You're not certain of how much the product will benefit you! So you make an offer to give Jack something, probably money, for his [magical item]. Depending on your success at changing Jack's opinion of his [magical item] through information manipulation, you'll get a lower price.

Again, Jack isn't stupid, he wants to get the best price, too, so he's going to try and haggle the price upward! How might he do this and how can you detect it?

1) He may take a long pause or seem undecided, which means he wants more. In these cases your job is to IMMEDIATELY withdraw your offer for trade. A statement like "Oh, well don't worry about it then" does the trick. This does two things: (1) It makes it so that Jack must make his decision to trade or not trade immediately, and (2) If Jack keeps a supply, it makes possible for you to reissue the same offer next time the situation arises.

2) He might lie to you. It's generally hard to tell if somebody is lying, especially if they know how, but a few indicators are: (1) They look towards the right, which indicates creative rather than factual thinking, (2) they touch their face which indicates a rush of blood to the head, (3) they act defensively.

3) He might just outwardly claim he feels like he's being tricked. Just dismiss this with "Well, hmm, I don't know, hmm..."

Beware of:
Competition: Most industries tend to have competition. If Jack is aware of the market conditions for his good then make sure you do not ask for the same quantity of that good that the market provides. That way there is no direct way for Jack to tell if the transaction is inferior or not. Competition can also be used in your advantage if Jack isn't aware of the market conditions. This allows you to claim market conditions. When claiming market conditions you must make sure you're claiming the market sells a different amount than the amount you're buying to avoid any direct indicators of what the price should be in your transaction. I'm sure by this point you're already thinking about making the market look like it offers a better deal than the one you're asking for. ;) Prepare a couple reasons for why you're willing to buy at a worse price than the market offers, ofc. My favourite two are: (1) I just don't want to head over to [place where market is] right now, and (2) I know you have to make a profit.

Useful Phrases:
 "That sounds about right" <-- When accepting offers
"Well, hmm, I'm not so sure, hmmm" <-- To avoid confrontation
"Yeah, but I heard"  <-- To acknowledge information in passing while changing the focus in your favour
"But here's what I'll do for you" <-- When offering to do a trade.

Keep In Mind
Build rapport with your victims!
Stay flexible as the process is highly circumstantial!
Don't be evil!

The Wonders of Markets

Growing up in my high school, I saw the prices of gas change from a little over 2.10$ to now as of today 3.94$. Back then I didn't care so much, I earned enough money in the summer to pay my gas through the school year and have a little extra money to through around. But now during the summer when i'm off campus I have to make a lot more trips into town, and with only a limited income, I have to make every trip count. For example if i'm at work in town I might as well hit up wal-mart while i'm at it.

After taking Econ I finally realized why those prices reacted like that in those years. There are many things external of what I was originally contemplating about how these prices were changing that I never even thought of. Already considering the war and some other natural disasters, the entire world is competing for these resources. Countries are evolving into developed nations which take up huge amounts of the worlds annual consumption and production of energy.

This demand by the world has greatly influenced the way companies are focusing on energy. Because the demand is so high and profitable they continue to research, drill, and mine for more or new energies available. But if this was suddenly not profitable to do any sort of business related to energy; companies would withdraw from the market and consumers would suffer. That woudl probably bother the person at the pump though who has been waiting for 8 hours to fill up because the station is out of gasoline. What the average joe needs to realize is that there is a much bigger picture than just them out there. We are all connected to these markets that drive us and influence us.

However it would be nigh impossible to shuffle every citizen in for an economics discussion. Besides people picketing a street corner would probably make a greater impression than economists trying to show a supply and demand graph in the general public. One couldn't hope but to at least try to all of those around him or her to make it a dinner discussion at the table, or perhaps a simple post on facebook. Although everyone has their own opinions and ideas, no one can deny the market forces and what happens with them.

Free Information . . . Markets!

In today's world, information is found in abundance. This increase in supply has driven the cost of obtaining information quite low in the developed world. Places where the information market is regulated heavily like china or North Korea there is a much larger percentage of their populations living in extreme poverty than other developing nations like Brazil or South Korea. This is because information is a factor in every market transaction, whenever goods are being traded both parties use information to determine what is in their best interest. Since most real markets have imperfect information, they can only use the information they can afford. This problem means that when information is expensive and hard to get, people cannot represent their best interests in a transaction and this will lead to wide scale economic disparity.

That is why I feel that information market should remain untouched by any government body wishing to attain overall prosperity. The only reasons information would be controlled is to give someone, somewhere a better insight to a transaction. That to me is representative of crony capitalism, which the average economist knows is only good for the few and bad for the most. By crony capitalism I mean an institution that fights against asymmetric information for their own personal gain. These sorts of institutions are holding back governments and markets across the globe, and removing them should be a focus of modern economists. Markets should be free, and the information market is no exception.

Sunday, October 23, 2011

Order, predictability, and a good dose of conspiracy theory

Order fascinates me, most likely because organization is something that doesn't come naturally to me. This is why the statement, "There is a certain predictability to prices. An orderliness." stood out to me. It truly does beg the question, "What is the source of that order?", and more importantly, can this order be manipulated by external forces?

Russell Roberts argues that, "many of the policies that a president or legislators might propose to improve something, are often offset by market forces", but if this is true then why does government play such a significant role in regulating our economy? I have no doubt that if I could spend an afternoon with Dr. Roberts he could explain this statement to me, but as of right now I have a hard time understanding how an institution that has the ability to place constraints on both buyers and sellers doesn't have any affect on the determination of prices.

I also have to wonder if Roberts was making a blanket statement regarding governments, or if his position is only referring to republics. Does the ability of a government to influence prices change depending on how it is structured? Comparing Iran, which is a theocracy, with China, a communist state, with Israel, a parliamentary democracy, is like trying to compare apples with polar bears with lamp shades. I might be going slightly conspiracy theory, but if there was a non-market force that could impact prices, could it be used on a domestic as well as international level? If this could be developed, it could mean unmatched economic prosperity for whoever controlled it. According to the modern golden rule (he who has the gold makes the rule), this would concentrate power for whoever controlled the non-market force. In the right hands this could be used to promote positive initiatives, but in the wrong hands it could turn out worse than a zombie apocalypse. Well, maybe not quite that bad, but to sum up that ramble, there is certainly incentive to develop a force that could manipulate prices, but is it possible? If it were possible, how would such a force affect the international political and economic environment? Wow, that was a rabbit trial of paranoia, so maybe it's a good thing that a brilliant economist like Russell Roberts already ruled out that possibility :)

One man's junk is another man's treasure

When I was a kid my favorite candy was a Hershey's chocolate bar, still is actually. It cost 50 cents and it costs just a bit more than that now. I always wondered why that price would change from location to location and over time. I thought it was very odd that it did not stay fixed. About 11 seconds into any econ class and you learn the "why". In a free market, as odd as it might sound, consumers, not the producers, generally set the price for the products they are buying, not the other way around. Trying to get this point across to the average Joe on the street might be a bit difficult, however. We often here complaints about gas being too expensive and that the greedy owners ought not be allowed to charge such high prices. I always thought it might be fun to have a time machine and bring one of the pioneers from early Fairbanks a 100 years into the future and ask him if he thought paying that much for a mechanical machine to move you around and keep you warm during cold winter days was too high. I rather think he would nearly consider spending his last time on such a wonderful contraption. The fact is even at $5 gasoline we would still shell out quite a bit because the alternative to walking to and from where we needed to go at 30 below is unbearable. There is a big difference between what we 'wish' the price would be and where it really is. The free market allows you a variety of choices and the most important of which is to say 'no' I will not buy that good at that price. Sometimes I think people forget they this.

Congressmen Versus Solidier. Who is worth more?

                Directly out of high school, I enlisted in the United States Marine Corps; I will not mention the year, no need to date myself.  Let us suffice to say it was a while ago.  With the invention of Facebook came the opportunity to see what my fellow Marines have been up to, from the amazing to the mundane.  Did I really know need to know that my friend was eating a burrito, probably not.  Circulating around Facebook in this group of Marines has been an image of a soldier grieving his lost brother (where in brother I refer to another soldier) contrasted by an image of a particularly  corpulent section of politicians in Congress, one looking half asleep.  Below these dichotomous images is the statement, “Please, tell us how your job is more deserving of a paycheck than theirs?”  The reaction that this image invokes from viewers is invariably peppered with slanderous statements reflecting deep loathing and anger at this misallocation of worth.  As is the penchant of Facebook users, the image was shared and more outrage was expressed to a wider audience.  Does the higher salary reflect the moral worth of each respective use?  Alternatively, is there something more fundamental at play?
 The first thing that came to my mind upon viewing the image?  Well, I thought about the marginal value of each group; the marginal value of a soldier being considerably less than the marginal value of a Congressmen or Congresswoman.  Let me explain, before my patriotism is questioned and I am slandered as a flaming liberal, (which for the record I am a Classical Liberal, but I refer to liberal using the common parlance of our times). There are plenty of people willing and qualified to sign up to fight and die for our country, especially in this current economic climate.  This can be seen by the relative ease for which service recruiters find their applicants of late.  There are fewer opportunities for this cohort of young, high school educated men and women outside of military service.  Let us now consider the pool of willing and qualified candidates available to run for office for a Congressional seat.  This pool of wiling and qualified individuals shrinks considerably.  There are of course the enumerated legal requirements, but what about the tacit qualifications that the U.S. public expects?  At a minimum we expect an older, college educated, experienced person who has proved himself or herself capable as a leader.  Beyond these tacit requirements, we need to think about their opportunities outside of the “market” for Congressmen and soldiers.  The Congressmen have shown themselves experienced outside the political arena, or perhaps in different facets within the political arena.  The young, high school educated soldier?  That cohort of individuals has far fewer opportunities that pay as well as an enlisted soldier with such generous tertiary benefits; the pride, healthcare, dental care, life insurance, and culture that the life of a service member provides.  The marginal value of a soldier is comparatively low compared to the marginal value of a member of Congress.  This sounds quite harsh and calculating, but it is a mere reflection of the facts in each case, each pool’s skill set, experience, and available opportunities outside the market for their respective jobs.  As any introductory student of economics can tell you, it is at the margin where decisions are made.  It is not a reflection of the moral superiority of one groups’ service compared to others’, but their “value” at the margin.  Wisely, I did not reply with such an unpalatable discussion on Facebook.  Not many enjoy the harsh truths that the study of economics sometimes revels. 

Saturday, October 22, 2011

Markets

First, in response to our discussion this week:

We have talked a little about things like New Zealand's fishing quota management system, which has helped to make the fishing market more sustainable. In this case, it appears as the though the government was able to assist the market by clearly defining and maintaining private property rights. Are there any other ways that government intervention can assist markets? Is this a true government success story?

I really enjoyed the podcast this week. Particularly, I liked the part where Smith discussed the reaction to his first paper, "If you believe in markets, you don't necessarily need evidence." It almost sounds like the editor was defending free market economy on religious grounds. So it was nice to hear Smith showing his skepticism of textbook teaching methods, and emphasizing the need for experimentation in the classroom. Real life models have much more of an impact on me than a price vs. quantity graph written on a sheet of paper, and I also feel that theories should be tested. It is fascinating that price's can be set purely through the exchange of goods, and that this leads to the creation of wealth. Smith's examples made it easier for me to conceptualize the self-regulating nature of a free market. They also lead me to ask the following questions:

How do government education standards affect education?
Should children be placed into specialized education programs that maximize their comparative advantage at an early age? Or should education be more general? If so, what should be taught in schools? Is there a way that the market could determine this?

Tuesday, October 18, 2011

Markets vs. Government VS. Markets & Government

There have been a few good posts here and as a guest on the SWEET blog/club, I am happy to see that there is some diversity among the opinions and arguments. I might have unintentionally steered the discussion toward an apparent dichotomy between Markets vs. Government VS Markets & Government in an earlier post with regard to opportunity costs and a link to Gary Becker's WSJ comment (Becker is in no way an anarchist, by the way but I am). But that discussion is not the purpose of this blog at least not yet.
I think there are two questions that must be considered and those questions are very related.
The first question is: What is the role of the government? This is a question that has been debated since people have thought about economic and political organization of the society. For some the role of the government was to protect and enforce property rights and enforce contracts. Those were the basic King's duties and most political philosophers such as Hobbes (who considered a necessary evil). Adam Smith, considered as one of the founder of modern political economy, thought actually that the government's duties extended beyond this. He thought the government should provide public goods and prevent monopolies.
But to come back to something closer to home, people like to refer to the U.S. Constitution where it says twice it is referred to the "general Welfare." The U.S. Constitution starts:

"We the People of the United States, in Order to form a more perfect Union, establish Justice, insure domestic Tranquility, provide for the common defence, promote the general Welfare, and secure the Blessings of Liberty to ourselves and our Posterity, do ordain and establish this Constitution for the United States of America."

and in Section 8, the Constitution states: "The Congress shall have Power To lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States; but all Duties, Imposts and Excises shall be uniform throughout the United States;"

These two mentions to "general Welfare" have created controversy among people who interpret the Constitution and obviously interpreters often forget that the meaning of words has changed and we have to understand that the democratic process has changed a lot as well as the meaning of federalism.

Overall, I suspect the way one reads the US Constitution (or any Constitution for that matter) is highly related to one's ideology but also one's views on markets operate and what the necessary conditions to have a harmonious society.

Now enter in the picture economists who came up with the model of perfect competition, an abstract construction depicting a perfect ideal world with no market power, completely transparent, equal access to resources, and perfectly identical goods. In addition, the underlying assumptions is that property rights are well defined and enforced. In such world, markets work perfectly and adjust instantly to any changes in market conditions resulting from an external force (such as change in preferences, new information, discovery of new resources, decrease or increase in population, natural disasters, etc.).

In such a world, the role of the government is really minimum: enforce property rights and contracts. However, we live in an imperfect world with imperfect individuals. Which raised the question as to whether the government might have a bigger role than we think. Should the government intervene when markets fail? What happens when property rights are not well-defined (common property problems, externalities)? What happens when information is imperfect or some people are better informed than others (moral hazard, adverse selection, externalities)? What happens when somebody controls a resource or benefits from significant economies of scale (natural monopoly)? What happens when a group of firms or individuals decide to collude (cartels, unions)? The real world is full of these issues. Most textbooks will argue that's where we should have government intervention to tax polluters, issue emission permits, fishing or hunting licenses, mandate information disclosure, prevent firms to collude, ensure that prices are fair, etc. But also textbooks will argue that there are many instances of private solutions to these market "failures." These market failures (that we shouldn't call failures because they only are failures with respect to the perfect competition model, they are more market imperfections or market conditions) leave profit opportunities for entrepreneurs or samaritans to minimize or improve these market conditions. Warranties, privatization, consumer reports, Underwritten Laboratories, Facebook, Match.com, Amazon.com, Apple, Wikipedia, etc. are all examples of market mechanisms that have been created or have emerged to improve these market conditions. The beauty of markets is not that they are perfects or that they solve problems, the beauty markets lies in the constant evolvement of these processes where individuals alert to market conditions and profit opportunities will contribute to improve market conditions even though their goal is very self-interested. We shouldn't discount the effects of reputation mechanisms in keeping short-term oriented self-interested individuals.

There is little doubt that sometimes government intervention has improved market conditions but in effect the real question is not whether government intervention has improved market conditions but rather what type of government intervention has improved market conditions. Taking the example of the environment (which is a big concern in Alaska), when one looks at government intervention, the successful government interventions tend to have been those that simulated markets such as emission permits, cap and trade, or better privatization!. The command and control interventions of government tend to have been very counterproductive and create significant unintended consequences.

Which leads to the second question that is implicitly asked in the title of my post: when trying to improve market conditions, which is better: markets or government? The answer is not easily answered but as Becker replied in his WSJ piece, markets seem to do a better (or less bad) job than the government. This explanation in my opinion lies in two things: (1) Hayek's local knowledge argument and (2) profit-seeking (not rent-seeking, which is seeking to achieve profits by using the government intervention to obtain monopolistic privileges) is healthier than vote-seeking.

This post is already really long. So I am going to let you discuss and ask questions rather than going on an on.



Sunday, October 16, 2011

New requirements for Politicians

To be elected a US Senator you must be:
  • at least 30 years of age
  • a US citizen for at least 9 years
  • a resident of the state one is elected to represent
If only there were one more requirement:
  • A Ph.D in economics
Unfortunately, most politicians have a background in law. Due to this and the fact that it's in their job description most seem to believe that they should make laws. Politicians always have a plan to do something. As humans and Americans we entertain the idea that we control our own destinies. It is part of American ideology that anyone can make it simply through hard work and determination. I will refrain from discussing whether this is true or not (though Malcolm Gladwell has a lot to say to the contrary in his book Outliers). However, it does lead us to believe we can exert control over things like the market.

You can't go half an hour watching the news without hearing about jobs. Every politician and their mother has a plan to "create jobs." I can't help but cringe when I hear this claim. As far as I can tell it's utterly impossible to "create jobs." Even when a politician "creates jobs" it's an illusion. I suppose I could create a job right now. I could hire someone to make my bed. I could hire someone to take my notes. There are many things I could hire someone to do that I have no need for. Someone looking at only the "seen" might say, "Well that's great! The person you hire now has a job and money to spend." However, now I don't have that money. If I happen to be a government I either get that money by a) going in to debt, bad idea b) "creating" the money, worse idea or c) taxing the people for whom I am supposed to be creating jobs for. Option C is obviously flawed because you can't get something for nothing. TINSTAAFL.

Employers hire new employees when the marginal benefits of a new hire outweigh the marginal costs. Government should lower the marginal costs of hiring employees and of doing business. Do not confuse this with covering the costs of hiring employees through stimulus. That's just a complicated version of Option C. Government should simplify the tax code and reduce regulations. Overall, politicians should take their hands off the wheel and realize that they're trying to steer a train.

Growth, like jobs, can't be "created" it must be allowed. There are many government run industries which, if privatized, would allow for competition, growth, and of course, new jobs. How about private roads, private airports, private schools. Private businesses, due to competition and properly aligned incentives, always do it better than cumbersome bureaucracy. (Seeing as how government does such a poor job of managing the economy we might consider even privatizing that.)

The point of all this is that we can't "engineer" economy. Attempts to steer the market always lead to unintended consequences. Perhaps this is why we rarely see economists elected as politicians. I doubt they even try to run. And when they do, what platform do they stand on? "Don't worry folks, everything will work itself out. I know it. We just need to stay calm and wait out the storm. Do nothing." That doesn't quite have the ring of, "If I'm elected, I'm going to create jobs." As if creating jobs is simply a matter of fruition. It's akin to promising everyone a shiny new car and a puppy.

Instead of debates, I'd like to see politicians compete in the "quiet game," and "who can sit on their hands the longest?"

I'm not saying the role of government is to do nothing, I'm just saying it should stick to what it's good at: protecting property rights, ensuring the rules of the game, protecting our borders from war. On second thought, I can't say it's been particularly good at those things either. Can anyone say eminent domain?

The Law of Unintended Consequences

I think the Law of Unintended Consequences does a fantastic job of highlighting the difficulty that is apparent when we try to maximize the utility of our actions and decision making. There is no way to foresee every unintended consequence and it would be senseless and costly to attempt such an endeavor. Through science, via experimentation and reflective contemplation, we venture to make more educated decisions, but I’m not sure that science will always be completely utilized in the decision making process.


Opinions are diverse and people are always operating in a state of rational ignorance, it is just too costly for everyone to have a perfect knowledge of everything. So we have a problem… The general public is rationally ignorant and has been overwhelmed with a multitude of obstacles which need to be addressed and responded to immediately. These obstacles have to do with necessities: food, water, and housing, waste disposal, transportation, etc. What will we do?

The general public elects officials (AKA scapegoats) to take charge and help create legislation and regulations that will help it past these obstacles. We like to believe these officials have a greater comparative advantage when it comes to guiding policy or decision making, but perhaps this isn’t always the case. Politicians, it seems, have more of an incentive to make decisions based on public opinion, than to make decisions based on science. Public opinion gets them elected, but public opinion isn’t necessarily rational and is often stupefied further by appeals for short term conclusions. In light of this, perhaps economists should be less concerned with elected officials implementing poor legislation, and more concerned with influencing the general public to have a greater appreciation for science and education.

Prices and unintended consequences

One of Hayek's greatest contributions to the field of economics was a powerful work on the impossibility of centralizing information and the role prices play in providing information. It is understood that information is essential in any business but simply by shear numbers no one person or firm could possibly obtain all the information they need to make a decision. What I mean by this is a automobile company doesn't need to know that an iron mine in Argentina collapsed and that the supply of iron will decrease. No. All the relative information they need is the price of iron going up and they must substitute if possible. In a sense prices tell us the entire history of a product and all of its inputs. So in the same sense, prices matter, and they cannot be arbitrarily moved up and down because this new price is a lie in regards to the history of the product.
Unintended Consequences--hmmm---this just about sums up every governmental action ever taken. It seems that for every policy instituted 5 bad things happen and thus 5 more policies are instituted resulting in 5 more problem each. Generally speaking bad unintended consequences occur when someone wants to distort a market by interfering in it. For our purposes let me give an example. No one denies that the price of attending higher education has increased over the years. It is then automatically assumed that we need more scholarships, grants, and student loans to counter this. This may, however, not be entirely accurate. As soon as a third party becomes the paying part to A and B then neither A nor B car as much about the price because C is paying it. The student who receives a grant that covers their school expenses has little incentive to 'haggle' over the price because it really isn't their money being spent. So in the end who is hurt? The students who do not receive grants, scholarships, or low interest student loans. So the question now is, are student loans, grants, and scholarships actually pushing the cost of higher education up? If so this is a major unintended consequence of financial aid.

The Real Oppressor

Yesterday I was in a park speaking with some protesters and a man walked up and asked me what I felt about the American Jobs act, and after I told them I thought it was the most short sited bill I have seen recently they accused me of being a right wing oppressor. The plan of this act is to reduce unemployment and stimulate the economy by providing thousands of jobs in public works and extending unemployment benefits for the long term unemployed. By hiring thousands of government workers, they hope to give spending power to the many unemployed. What the propagators of this bill don’t understand is that this would only destroy wealth and lead to even more job shortages. They don’t understand the concept of opportunity cost, that all of that money must come from somewhere.

To address the first fallacy of their argument, there is no way that this bill could effectively reduce unemployment. We have approximately 9.1% of our nation’s workforce unemployed (according to the Bureau of Labor Statistics), and we have a population of a little over 300 million (according to the US census Bureau), doing some simple math this means about 27 million people are in need of jobs. To bring this number down by just one percent we would need to employ at least 3 million people. An undertaking of such magnitude would effectively break the bank of the United States. Just counting wages, if we paid each employed only 30,000$ a year that would incur a cost of 90 billion dollars. This doesn’t account for the rest of the unseen costs of materials and organization to put all of these people to work. But wait, there is more! By placing this cost on the government means we, the tax payer, must pay for this bill in the form of higher taxes. By increasing taxes it greatly reduces the ability of people to participate in entrepreneurship, which has been proven to be the number one creator of jobs. So in the short term we may gain some jobs, but the costs of doing so could easily cost more jobs than it creates. This just doesn’t make any sense.

The second fallacy is that using government capitol to stimulate spending aides the economy and promotes growth. This is entirely wrong; if I take the money out of your pocket and put it in mine I have not created any wealth. In fact by giving people money when they did not produce anything to earn it, it causes a system meltdown. People have no incentive to go to work when they can survive comfortably without it. Also all of this money has to come from somewhere, so there are the additional costs of lost opportunity. Imagine if that money was in the hands of driven individuals that earned that money themselves and had every incentive to make the most of it, the positive effects on the economy are literally countless because people have unlimited potential. Since the money spent has only negative effects on the economy it would be brutal to stack upon the already lagging US market.

Since this act has no practical way of employing even one percent of the population, will reduce the overall number of jobs, and will only drag down the ability of people to participate in entrepreneurship, it would be ridiculous to put into law. After I explained this to the man that called me an oppressor he thanked me for my time and wanted to look at other acts to see if they do had hidden costs he was not aware of. I may not be an oppressor, but this bill definitely is.

The Beauty of Markets

                I am quite fond of the Thomas Sowell maxim, “reality is not optional” that Dr. Roberts uses in his Reality of Markets piece.  The idealist looks at the state of the things and sees how they should be; the economist looks at the state of things and explains why things have turned out the way they have.  An economist is able to explain the here and now because their worldview involves constraints and tradeoffs.  An idealist looks at the world through a prism of the unconstrained; in their eyes society could give everyone a proper wage and no one would ever again feel the pang of hunger.  Alas, it is never so simple, in our world of infinite wants and finite means, the “market” has emerged as the impartial arbiter of allocation.  Society would not want it any other way.  A price, whether it be temporal, monetary, or otherwise conveys precisely all the information a consumer will need to know to make a decision about whether they should buy or participate in a certain market with the endowments that they hold.
 Let us consider one of my absolute favorite foods, cake.  I am an impenitent cake lover.  I love everything about cake, it is fluffy, delicious, generally frosted and I can bake one practically any time of the day or night if I so choose.  Alternatively, I could run to the bakery and purchase one if I had the hankering and was feeling lazy.  The vanilla may be from Madagascar, the flour from California, the sugar from Georgia, the cocoa from Cameroon.   How has this cornucopia of deliciousness arrived from around the world to let me enjoy my delightful snack? How does the grocery store know which ingredients to stock, the bakery which kind of pastry to supply?  Did the coca producers in Cameron need to know that last Tuesday I would be in need of ¾ cup of dark cocoa powder?  No, they did not, because the world market for cocoa and the prices that stores were willing to pay for the product provided all the information they would need to know, beautiful.  The cogency and elegance of the market is irrefutable.  Goods move across the world to come to our doorsteps because we are willing and able to pay for them.
The emotive, specious pleas of the idealists castigate the market and those who advocate them as the means of corruption, a root of evil.  They are no such thing; they are but a conglomeration of individuals dealing with other individuals that will improve the welfare of all involved.  Yes, there is inequality in society, but the mass body of people has had their lots improved exponentially over the generations, not made worse.  This improvement in the quality of life has come through the market, not the conscious design of men, but a byproduct of their interactions.  Let us recognize its beauty and strive to understand it.

Wednesday, October 12, 2011

Opportunity Cost: To Be or Not to Be an Economist ...That's the Question

Frederic Bastiat in his essay entitled "What is Seen and What is Not Seen" wrote that the difference between a good economist and a bad economist is that the bad economist only focus on the direct immediately observation consequences of one action, decision, or policy. On the other hand the good economist takes into account also the long term, not immediately observable effects of that action, decision, or policy. Sometimes, some policies have immediate benefits but can lead in the long run to costs that will outweigh those benefits. At other times, some policies have immediate costs but will lead to long run benefits that will outweigh those costs.

Bastiat's statement is easily applicable to the concept of opportunity cost. The difference between the economist and the non-economist is that the economist will take into account the opportunity cost in the decision-making process. As in one comment I made, there are countless of arguments for policing or regulating markets because they are imperfect, they aren't like the textbook perfectly competitive market. Because, there are opportunity costs in trying to make markets resemble the perfectly competitive markets. A quote I often use is the one by Ronald Coase criticizing the use of the perfectly competitive market as a benchmark for regulating markets (fixing those market failures): "Until we realize that we are choosing between social arrangements, which are all more or less failures, we are not likely to make much headway" (1969). The perfectly competitive market model is a useful model to study why market fails, why you have profits, why you have losses, etc. But it's a very poor tool to be used for normative purposes. This is what Harold Demsetz called the Nirvana Fallacy.

To follow up on a post I read quoting the Naked Economics's author Wheelan, what Wheelan doesn't mention at least in the quotes is that economists and market participants are well-aware of these asymmetric information problems but as Kenneth Arrow mentioned in the postscript of his first article discussion asymmetric information (moral hazard) and healthcare, there are many market institutions that have emerged and been developed to mitigate these problems. Akerlof also points to these mechanisms such as warranties and certifications to mitigate the problems associated with adverse selection. Myself when I buy an used book online, sometimes in another country, I know that the seller might lie about the book condition or might not even mail me the book after I enter my credit card number but there are market mechanisms that I can use to prevent this. I can read the previous customers ratings and reviews.

And even if these mechanisms were absent, one should wonder what the government can do better that markets can't (I encourage you to read that opinion piece by Gary Becker from the WSJ from early september here: http://online.wsj.com/article/SB10001424053111904199404576536930606933332.html).
If market fails because human beings are faillible individuals with asymmetric information problem, why government will not where markets have. Governments also consist of faillible human beings. To quote Milton Friedman, because governments also fail, often the solutions that the government provide to these market problems tend make the problems worse than the problem itself and even if they didn't (which is extremely rare), there are opportunity costs. How significant is the problem and what is the opportunity cost of fixing the problem. I mentioned in a previous comment about the sustainability issue and global warming. There is indeed global warming but how significant is it? What will be the benefits of slowing down global warming? What are the costs? But more importantly what are the opportunity costs of slowing down global warming? The millions of dollars that could be used to rely on geo-engineering to send into the atmosphere SO2 to cool down earth could be used in other alternative uses such as R&D on drugs to cure cancer or a HIV.

I also want to follow up on a comment about opportunity cost and the impact of innovation and globalization. Innovation is largely the results of the specialization process, the division of knowledge and accompanying increase in productivity & economies of scale allowing the lowering costs of production. Similarly, globalization which is nothing more than the increasing interdependence between individuals, firms, regions, nations resulting from the fact that trade allowed people to specialize where they have a comparative advantage. But, if anything, with the increasing specialization, division of labor and knowledge, more markets have emerged (you have markets for dog walkers, wedding planners, house sitters, etc) where people can specialize themselves where they have a comparative advantage thus lowering the costs of goods and services produced because specialization has allowed for that by increasing productivity, having economies of scale, innovation, and thus lowering cost of production. So the results of this increasing interdependence between people, firms, regions, and nations also increased the opportunity cost for one not to rely on his/her neighbors to get the goods or services is not providing. The time that it will take to any of us to assemble an iPhone compare to the time it takes a Chinese worker to do so would be better use developing new models, new technologies, new drugs, etc. Similarly, the time it would take a Chinese worker to develop a new drug (U.S. is among the top developer of pharmaceutical drugs) could be spend assembling hundreds if not thousands of iPhones.
Now because of this increasing opportunity cost associated with specialization and the ensuing globalization, we are indeed more dependent of our neighbors. As a student in my class asked me this morning, is this a bad thing. The answer is while we are engaging in trade with our neighbors, we are not waging war against them. I believe (my opinion) that's why Mises relabeled Ricardo's Law of Comparative Advantages, the Law of Association. Trade allows for division of labor and knowledge, which allows us to specialize where we have a comparative advantage and rely on our neighbors to get the goods and services we are not producing and them to rely on us to get what they can't produce. But ultimately, trade and division of labor and knowledge allow for us to associate ourselves with people we share little with only the desires to get goods and services they produce but this association is peaceful because they want the same from us. Ultimately, everybody is better off (some more than others but that's not what matters. What matters is that everybody wins). Trade and Specialization lead to peace and where there is no trade, often there is poverty and often it leads to plunder.

To conclude, I reiterate what I say at the beginning. The difference between an economist and a non-economist is that the economist (at least good ones) understands that "There ain't no such thing as a free lunch!" Even a free lunch has an opportunity cost!

Alexandre Padilla