Mainstream Economists Rediscover the Marginal Pair

I have published my first blog post over at Mises Canada. The post relates Böhm-Bawerk’s price theory to modern job-matching models. Here are the key paragraphs:

[M]odern labour economists’ use of discrete reasoning in job-matching models should be lauded as a step towards greater realism. In these models, there are a discrete number of unemployed workers seeking to fill a discrete number of job openings. These models are summarized by Alvaredo, Atkinson, Piketty, and Saez:

“[I]n the now-standard models of job-matching, a job emerges as the result of the costly creation of a vacancy by the employer and of job search by the employee. A match creates a positive surplus, and there is Nash bargaining over the division of the surplus, leading to a proportion β going to the worker and (1 – β) to the employer.”[4]

In these models, as in the real world, workers and employers must find each other before they can engage in exchange. Often, the model is set up such that only one worker and one employer find each other at a given time, making their exchange a case of isolated exchange. If multiple workers or employers discover each other at the same time, then Böhm-Bawerk’s analysis of one- or two-sided competition applies. Both workers and employers form their valuations based on their expectations of the other opportunities they might find if they engage in further search.

However, while Böhm-Bawerk and his heirs in the Austrian school are satisfied to leave the determination of price unspecified within the range bounded by the marginal pairs, modern economists feel the need to uniquely determine prices within their models, thus the addition of Nash bargaining and the nebulous “β” term, the “bargaining power” of the worker. β must be precisely specified and known so that the homines economici in search models can form their valuations based on perfect knowledge of the random processes determining the future outcomes of search and of their exact payoffs under all possible matchings. If economists were to admit that the division of surplus is inherently idiosyncratic and unpredictable, their models would break.

Furthermore, simply by referring to “bargaining power,” economists imply more than their models can support. Suppose that the marginal pairs determined that the price of a given item should fall between $396 and $412. If the actual price attained is $400, should we conclude that buyers’ “bargaining power” is four times that of sellers, or that they settled on $400 simply because it is a round number acceptable to both buyers and sellers? One cannot know.

Read the whole thing.

Gold and the Great Depression with James Caton

In this episode, James Caton discusses the classical and inter-war gold standards. James is an economics PhD student at George Mason University.

Gold has many qualities that make it an ideal money: It is valuable, scarce, divisible, and easy to transport. It is also easy to verify the value of a given amount of gold: The Old Testament references weights and scales being used to measure gold. Ancient people could verify the purity of the gold by observing its water displacement.

Before 1870, only Great Britain was on a gold standard, while gold, silver, and other metals would circulate freely alongside one another throughout the rest of Europe. The classical gold standard began in the wake of the Franco-Prussian War, when the victorious Germany demonetized silver in favour of gold and the rest of Western Europe followed suit (see Caton on the deflation that resulted from the demonetization of silver). America converted to the gold standard in 1879 upon redeeming the Civil War greenbacks for gold.

The classical gold standard operated as a fixed exchange rate regime. As England was the center of global finance, the Bank of England held a privileged position whereby other central banks would follow the Bank of England to keep their currencies constant against the Pound Sterling (see Eichengreen and Bordo). This was the case until the First World War.

Europe’s governments suspended the convertibility of their currencies into gold during the First World War. These governments created a great deal of inflation to finance the war, but they were reluctant to devalue their exchange rates after the war had ended. They wanted to return to their pre-war exchange rates.

At this point, the Fed did something crazy: It slashed the US money stock by over 40%, increasing demand for gold, and causing a general deflation. Before 1925, as gold flowed into the United States, the Fed did not increase the monetary base in tandem with the increasing gold stock, thus sterilizing the gold inflows’ influence on prices. After 1925, when Europe returned to the gold standard, the Federal Reserve did increase the monetary base alongside the gold stock. The typical Austrian narrative about the Great Depression (see Robbins and Rothbard) blames the Fed for the 1920s inflation that created an unsustainable boom resulting in the eventual crash that became the Great Depression. However, James disagrees with the blame put on the Fed in this story, as the ratio between the base money stock and the gold stock was fairly constant from 1925 to 1929.

From 1925, the Bank of England was acting as Europe’s central bank, holding most of Europe’s gold. This was politically unpalatable for the French, who began hoarding gold in 1927, devaluing the Franc and causing gold to flow into France (see Irwin). Between 1927 and 1932, France went from holding 7% to 27% of the world’s monetary gold. The resulting deflation exacerbated the Great Depression.

The Bank of England went off gold in 1931, sounding the death knell for the international gold standard. FDR devalued the dollar and outlawed private ownership of gold in 1933, ending what was left of the gold standard. Although this mitigated the ongoing institutional collapse in the American banking sector, the Great Depression continued on until after the Second World War.

See also: Irwin and Rustici on the Smoot-Hawley Tariff.

James can be found online at his blog, Money, Markets, and Misperceptions, and at the George Mason University website.

Download this episode.

Simple Keynesianism

XKCD Comic about simple English Wikipedia
Source: http://xkcd.com/547/

Simple English Wikipedia is an edition of the open-source encyclopedia designed to be intelligible to small children, adults with learning disabilities, and people who are learning English.  It is also an entertaining read, because the simple language often makes things silly. I found the article on Keynesian economics to be particularly silly and entertaining:

Keynesian economics (also called Keynesianism) describes the economics theories of John Maynard Keynes. Keynes wrote about his theories in his book The General Theory of Employment, Interest and Money. The book was published in 1936.

Keynes said capitalism was a good economic system. In a capitalism system, people earn money from their work. Businesses employ and pay people to work. Then people can spend their money on things they want. Other people work and make things to buy. Sometimes the capitalism system has problems. People lose their work. Businesses close. People cannot work and cannot spend money. Keynes said the government should step in and help people who do not have work.

This idea is called “demand-side policy”. If people are working, the economy is good. If people are not working, the economy is bad.

Keynes said when the economy is bad, people want to save their money. That is, they do not spend their money on things they want. As a result there is less economic activity.

Keynes said the government should spend more money when people do not have work. The government can borrow money and give people jobs (work). Then people can spend money again and buy things. This helps other people find work.

Some people, such as conservatives, libertarians, and people who believe in Austrian economics, do not like Keynes’ ideas. They say government work does not help capitalism. They say when the government borrows money, it takes money away from businesses. They do not like Keynesian economics because they say the economy can get better without government help.

During the late 1970s Keynesian economics became less popular because inflation was high.

When a big recession happened in 2007, Keynesian economics became more popular. Leaders around the world (including Barack Obama) created stimulus packages which would allow their government to spend a lot of money to create jobs.

Hilarious!

How Private Certification Regulates the Market for Piano Teachers

The economic argument for state certification of certain professions rests on asymmetric information. The idea is that consumers might not know enough about medicine, for instance, to tell the difference between a good doctor and a quack. If we let consumers choose their doctors without constraint, so the reasoning goes, we would be overrun with quacks.

This is a decent argument for certification, but it’s not a good argument for mandatory state certification. If mandatory state certification were necessary to combat asymmetric information problems, the world would be overrun with bad piano teachers. Most parents are not pianists; how are they expected to know the difference between good and bad piano teachers? The answer is that they don’t have to know. If they want to know that their kid’s piano teacher is qualified, they just need to hire a teacher that a respected institution like the Royal Conservatory of Music has certified. Parents may not know what makes a good piano teacher, but this only means there is a market opportunity in delivering that information.

Private certification has many advantages over mandatory state certification. The first is that consumers who care less about quality, such as the parent who only wants a piano lesson as a substitute for babysitting and doesn’t intend his child to become a virtuoso pianist, can still choose to hire the cheaper, uncertified service.

The second is that competition regulates private certifying boards’ behaviour. Piano teachers are willing to pay to take Royal Conservatory examinations because of the premium paid to certified piano teachers over uncertified ones. The Royal Conservatory could attempt to sell certification to unqualified people, but it doesn’t do so because once people become aware of the dubious nature of the certification process, the price premium on certified piano teachers will shrink. The Royal Conservatory could also use its position as the premier certification body to excessively restrict the issue of certificates, but two factors mitigate its ability to do so: First, piano teachers and consumers could turn to other certification bodies or other means of signalling teachers’ skill. Second, more parents could risk hiring potentially less-skilled piano teachers.

The force of law eliminates these mitigating factors. Thus, state certification boards can get away with excessively restricting entry into the professions they certify, with police cracking down on anyone who attempts to offer a competing service. They can restrict consumer choice to only high-cost, high-quality services, while many consumers might prefer a low-cost alternative.

I can speculate with confidence that, if the state both certified piano teachers and strictly enforced the prohibition on uncertified piano teaching, piano teaching would be too expensive for many poorer families. This would probably be used as justification for the government to offer socialized piano teaching to all children (beyond that already offered in public school band programs). The irony is obvious from our perspective; we know that piano instruction is affordable when people are free to hire the piano teacher of their choice. We live in that world. But who, besides free market economists, would recognize the connection between mandatory state certification of piano teachers and the high costs of piano instruction? If public attitudes toward the mandatory certification of accountants, lawyers, doctors, and nurses are any indication, few would question a similar law applying to piano instructors.

Radicalism and the Political Landscape

Last night I had a nice conversation with some other Queen’s economics alumni. When the conversation turned to politics, I said that I didn’t want to follow the next election and that I had promised myself I wouldn’t support the lesser evil. I may have come off as apathetic about politics, but that was not my intention.

The way I see it, there is a tradeoff between having a small (i.e. negligible) influence on present politics, by volunteering for political parties, talking (or blogging) about current political issues, and of course voting, and having a potentially larger influence on future politics. Here is the opening paragraph of Hayek’s essay, The Intellectuals and Socialism:

In all democratic countries, in the United States even more than elsewhere, a strong belief prevails that the influence of the intellectuals on politics is negligible. This is no doubt true of the power of intellectuals to make their peculiar opinions of the
moment influence decisions, of the extent to which they can sway the popular vote on questions on which they differ from the current views of the masses. Yet over somewhat longer periods they have probably never exercised so great an influence as they do today in those countries. This power they wield by shaping public opinion.

Hayek’s view, which I share, is that there is a fundamentally different mechanism at play in short-run politics and in long-run politics: The short run turns on popular opinion, while the long run turns on the forces that shape popular opinion.

Short-run politics is mostly characterized by a competition between very similar alternatives. The differences between politicians and parties often come down to the particular personal characteristics of the individuals and to differences in emphasis on basically similar platforms.  The fact that under a Democratic administration Rush Limbaugh is criticizing the state and Bill Maher is apologizing for it, and under a Republican administration Limbaugh and Maher reverse roles, has more to do with the perceived differences between Republican and Democrat than the actual differences in policy. Limbaugh and Maher focus on different things to complain about and apologize for, so we hear about different things depending on who is doing the complaining and who is doing the apologizing.

Politicians and political parties play to people’s beliefs, but people’s beliefs are shaped, in the long run, by the ideas and information they absorb largely from the intellectual class. This is where the tradeoff I mentioned before, between having a small influence on present politics and having a potentially larger influence on future politics, comes into play. Participating in present politics means communicating to people within the context of their preexisting beliefs.  This means sacrificing the opportunity to plant the seeds of a fundamental change in those underlying beliefs.

For example, I favour open borders. I could hold my nose and speak out for the present politician who I think might loosen migration restrictions ever so slightly. Alternatively, I and my fellow open borders radicals could give that politician the criticism he deserves. If we could force the “slightly less closed border” crowd to address our concerns, they would have to speak out in defense of migration restrictions. That would mean relinquishing the appearance of being pro-immigrant and the moral high ground that goes with it. In a few decades, the entire context of the debate could shift in the direction of open borders.

The entire libertarian movement has pursued a very successful strategy of political irrelevance in recent years. Libertarians don’t form a large enough voting block to enact any of their preferred policies, but they have forced mainstream pundits to address them. It seems like a new article about how crazy and wrong libertarians are comes out every day. As the saying goes, “First they ignore you, then they laugh at you, then they fight you, then you win.” Ordinary people now know what a libertarian is and can ask themselves, “Am I a libertarian?” Even if the answer is no, that’s a huge improvement over total ignorance of libertarian concerns.

I favour the long run strategy in politics. It allows for a single individual to have significant influence. If I talk three people into radicalism, and they each talk three people into radicalism, and each radical shifts the views of five moderates, it doesn’t take very many iterations to dramatically change the political landscape. Those iterations take time, so the further in the future you look, the greater the influence of a successful radical.

Hermione Granger, Capitalist

J. K. Rowling has revealed in interviews what some of her characters went on to do after the close of the Harry Potter series. Unfortunately, they all became bureaucrats! Here is what she revealed about Hermione Granger’s future:

Hermione Granger

Hermione began her post-Hogwarts career at the Department for the Regulation and Control of Magical Creatures where she was instrumental in greatly improving life for house-elves and their ilk. She then moved (despite her jibe to Scrimgeour) to the Department of Magical Law Enforcement where she was a progressive voice who ensured the eradication of oppressive, pro-pureblood laws.

I think a lot of people see politics as the noblest and most altruistic career path. The world would be a better place if the misplaced respect for politicians was instead directed at entrepreneurs. A better epilogue for Hermione would go something like this:

Hermione began her post-Hogwarts career working in potion development. Her greatest creation was an elixir for the enhancement of non-pureblood wizards’ magical abilities. She used the wealth from this popular elixir to start a financial firm that specialized in extending loans to house elves and their ilk, allowing them to buy their freedom from servitude. Despite an extended legal battle with the Department for the Regulation and Control of Magical Creatures, Hermione’s firm became large and successful. She retired wealthy and comfortable, and when the history of house-elf servitude was written, the wizarding world remembered that over 60 per cent of freed house elves had bought their freedom with a Granger Capital loan.

There, now isn’t that better?

Archie Dies for Leftism

Well, that was unexpected:

Archie Andrews, a staple of American comics since 1941, will die in Wednesday’s issue of Life with Archie. And he’ll say goodbye to the series with one last act of heroism: Archie will take a bullet meant for best friend Kevin Keller, the first openly gay character in his comic universe. In doing so, he’ll foil an assassination attempt against Keller and, according to the story’s creators, give rise to greater understanding and tolerance in his fictional town of Riverdale. The final issue arrives as many Americans continue to work tirelessly on behalf of gay rights and to extend marriage equality across the US.

“He dies selflessly,” said Jon Goldwater, Archie Comics publisher and co-CEO, speaking to the Associated Press. “He dies in the manner that epitomizes not only the best of Riverdale but the best of all of us.”

That’s a little dark for a comic book about teen romance and hamburgers, but OK. I hope the creators would agree that dying selflessly for a friend would still qualify as a noble act regardless of the friend’s sexual orientation, race, religion, or gender.

Wednesday’s finale finds Keller as a newly elected senator fighting for tighter gun-control laws. The gun epidemic comes to Keller’s attention after his husband is shot trying to thwart an in-progress robbery.

Yikes. When did Archie Comics become a branch of the Democratic Party? This is an example of someone totally failing to understand the nature of a problem. Note that it is a “gun epidemic” that comes to his attention, not a “violence epidemic” or an “armed robbery epidemic.” In any case, the presumed solution is to have tighter gun-control laws. Such laws, obviously, would increase the costs of getting guns.

Increasing the cost of guns leads marginal gun consumers to go without. Who is the marginal gun consumer? Is it someone who is planning on robbing a liquor store? Not unless his kung fu is really good. It’s someone who doesn’t expect to use his gun. It’s the person who lives in a safe neighbourhood and feels that the security of owning a gun only slightly outweighs the cost of getting one. How exactly was that person’s gun the cause of Keller’s husband’s shooting?

Oh well, Archie Comics are just delivering what their consumers want:

Kevin Keller was introduced to Riverdale in Veronica issue 202 almost four years ago. That issue proved so popular that Archie Comics needed to order a reprint — the first in its 70-year history.

If lionizing the political class while demonizing guns is what sells magazines, capitalists will provide.

American Apparel Demonstrates a Fundamental Principle of Capitalism

The American Apparel board of directors has ousted the company’s founder. The company stock jumped up nearly 20% on the announcement. Contrary to what we see in the movies, being a successful founder of a big company does not entitle one to kick back, smoke cigars, and let the profits roll in. Dov Charney had some innovative ideas about clothing and about turning a small enterprise into a global chain, but his personal failings became damaging, so he had to go.

An interesting question to ask is “who works for whom?” A week ago we might have thought that American Apparel worked for Charney, and not the other way around, but we would have been wrong. The board that fired him is itself beholden to the shareholders; the old share price (before the 20% jump) was the result of investors restricting their investments in the company because its bad CEO made it less appealing than some alternative investments. And who are the shareholders beholden to?

They are beholden to the consumers. Ultimately, any return on an investment in American Apparel can only come from satisfying consumer wants. If consumers decided tomorrow that they would never buy another pair of neon green skinny jeans, American Apparel’s stockholders would take a massive loss as they tried to sell off their now-worthless shares.

Ludwig von Mises said it best:

The market economy — capitalism — is based on private ownership of the material means of production and private entrepreneurship. The consumers, by their buying or abstention from buying, ultimately determine what should be produced and in what quantity and quality. They render profitable the affairs of those businessmen who best comply with their wishes and unprofitable the affairs of those who do not produce what they are asking for most urgently. Profits convey control of the factors of production into the hands of those who are employing them for the best possible satisfaction of the most urgent needs of the consumers, and losses withdraw them from the control of the inefficient businessmen. In a market economy not sabotaged by the government the owners of property are mandataries of the consumers as it were. On the market a daily repeated plebiscite determines who should own what and how much. It is the consumers who make some people rich and other people penniless.” Mises, Inequality of Wealth and Incomes, 1955

My Get-Rich-Slow Scheme

Today I will be dispensing life advice. There’s a certain type of person who will tell you that you should follow your passion regardless of money concerns; to do otherwise would be “selling out.” This is pretty terrible advice. If eating, sleeping, and going to the bathroom are not my passions, should I never do these things?  What is it about money (or rather, all the things that exchange for money) that makes it unacceptable to include among one’s goals?

The big problem with this advice is that it is often given to young people. Young people have passions, but they can only be passionate about the things they have experienced at their young age. When I was young, I was passionate about painting. Now I am passionate about economics. If I had taken the oft-repeated advice to “follow my passion,” I would be struggling to make a living as an oil painter. Only by not following my passion was I able to discover a different (and much more remunerative) passion.

Not bad, huh?
Not bad, huh?

Compensating differentials are key. The standard, textbook definition of a compensating differential is a difference in compensation that emerges because of the pleasantness or unpleasantness of a job. People who drain septic tanks earn more than people of similar skill levels because draining septic tanks is unpleasant. People who play in symphony orchestras earn less than people of similar skill levels because playing in an orchestra is neat.

However, the compensating differential as described above presumes that people know how pleasant or unpleasant the jobs are. What would be the compensating differential for a job that everyone thought was unpleasant but that was really quite pleasant? The answer is that the perceived unpleasantness would prevent most people from entering that job, so the people who did enter the job could get both a positive compensating differential and a pleasant work experience. There’s a significant benefit to seeking out such a career!

Here is my advice: Learn what you can about the careers that both pay well and sound unpleasant to most teenagers (hint: many of these careers involve doing math). Discover the one that you find most pleasant. Make that your career.

How Do We Know (That The Minimum Wage Hurts Workers)?

Airplane Takeoff
One thousand internet points to the commenter who can correctly identify this image!

Here’s a conversation between a reporter and one of the alleged beneficiaries of Seattle airport’s $15/hour minimum wage:

“Are you happy with the $15 wage?” I asked the full-time cleaning lady.

“It sounds good, but it’s not good,” the woman said.

“Why?” I asked.

“I lost my 401k, health insurance, paid holiday, and vacation,” she responded. “No more free food,” she added.

The hotel used to feed her. Now, she has to bring her own food. Also, no overtime, she said. She used to work extra hours and received overtime pay.

What else? I asked.

“I have to pay for parking,” she said.

This may have come as a surprise to some, but not to those of us who are familiar with economic theory. The minimum wage hike here was large and sudden, so the impact was dramatic and visible.

It should be noted, however, that sound economics does not draw causal connections between events (such as a minimum wage hike and a cut in workers’ benefits) because of examples like this one. If A and B happen to coincide, we cannot say whether this was a coincidence, or whether some third event, C, caused both A and B, or whether A and B will continue to coincide outside of the particular context in which they were observed. The thesis that a minimum wage hike will lead to cuts in workers’ benefits where possible rests on a solid, timeless theory derived from known premises about human action and the nature of economic competition.

The unhampered market is a selective process that selects for those entrepreneurial strategies that can generate the highest possible returns. If an entrepreneur directs capital such that his costs exceed his revenues, he must change his approach or face continual losses and eventual bankruptcy. If an entrepreneur directs capital such that his revenues exceed his costs, he can plow his profits back into his business and he can get greater sums from creditors, so he will come to control more capital in the future. The outcome of this process is to move the task of allocating resources from less able hands to more able hands.

Entrepreneurs hire factors of production (including labour) when their expected marginal revenue products exceed their costs. If they didn’t behave in this way, the selective process described above would “retire” them from entrepreneurship. If an entrepreneur expects a return of $12 for an additional hour of cleaning services, and he can hire a cleaner at a wage of $10, he will do so. He will continue to hire cleaning services until his expected return for the next hour of cleaning services falls below $10.

Employee benefits simply fold an additional transaction into this process. Rather than paying for cleaning services and then contracting separately for the cleaner’s parking space (which will often come with additional costs), the entrepreneur can purchase a different service, cleaning services with parking space, the expected marginal revenue product of which will be lower than the expected marginal revenue product of only cleaning services by the cost of providing the parking space. However, since cleaners value parking, they will also accept lower wages when the employer provides parking. If the cleaners are willing to accept a wage cut for parking that is greater than the cost to the employer of providing that parking, both parties can exploit additional gains from trade by contracting with the parking benefit.

Now, consider what happens when the government imposes a price control such as the minimum wage.  The minimum wage applies to contracts with and without benefits. Employers provide benefits because, although these benefits cost more to provide, employees are willing to accept wage cuts that are at least equal to the cost of the benefit. At the imposed higher wage, the employee cannot legally accept a wage cut in return for a benefit, so those gains from trade must be foregone.

This is precisely what happened to the worker quoted above. However, since we derived the result from sound economic theory, we can generalize the result beyond this particular worker, beyond this particular wage hike, and far beyond the Seattle airport. We can generalize it to any time and place where people buy and sell factors of production under competitive market pressures.