Category Archives: Specialization and Trade Economics Intro

Market Failure and Analytical Failure

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Tyler Cowen writes,

The upshot is that economists hold a lot of views whose justifications they cannot articulate very well. I think you would find the same when it comes to the Ex-Im Bank (are you sure it fits the model of strategic trade theory?), the mortgage agencies (what was that externalities argument for home ownership again?) or all sorts of random regulations. The relatively interventionist economists will pull some justification out of a hat, and the relatively pro-market economists will be pretty skeptical.

In The Book of Arnold, I have a chapter called “Policy and Practice” in which I go to great lengths to emphasize the analytical gap between the theory of market failure and actual policy. My prime example is housing policy. I write,

The policy pattern that consists of subsidizing demand and restricting supply is not limited to the housing market. It pervades government regulation of industry. For example, in education, the government subsidizes demand by helping to pay for education, and it restricts supply by limiting accreditation. In health care, government subsidizes demand through Medicare, Medicaid, and various tax breaks and subsidies for obtaining health insurance. Yet it restricts supply by regulating the practice of medicine, requiring a “certificate of need” before a new hospital may be built, and requiring inventors to undertake extensive studies to demonstrate efficacy of their treatments to the satisfaction of the Food and Drug Administration.

From the standpoint of the theory of market failure, the subsidize-demand, restrict-supply pattern almost never makes sense. If there is a market failure that results in under-production of a good, then it makes sense to subsidize both demand and supply. If the market failure results in over-production, then it makes sense to restrain both demand and supply. Subsidies for demand and restrictions on supply inherently work at cross purposes.

However, from the standpoint of another theory, called Public Choice, in which government policy tends to serve concentrated interests rather than address market failures, it is understandable for government to subsidize demand and restrict supply. In a specialized economy, we know that the market for what you produce affects your well-being much more than the market in any one of the myriad of goods and services you consume. Thus, concentrated interests develop on the supply side, not on the demand side. The pattern of subsidized demand and restricted supply is what you would expect to result from successful political action in a specialized economy.

My Latest Project

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It is a short book on specialization and trade. I have a first draft, that I plan to edit at least once more before sending it around for comments. Here are the first paragraphs of the forward:

Early in 2015, I came across a volume of essays edited by E. Roy Weintraub called MIT and the Transformation of American Economics. After digesting the essays, I thought to myself, “So that’s how it all went wrong.”

Let me hasten to mention that my own Ph.D in economics comes from MIT, in 1980. Also, the writers of Weintraub’s book are generally laudatory toward MIT and its influence.

Yet I have come to believe that the MIT approach to economics has stifled critical thinking. The critical thinker is always asking the philosopher’s epistemological question, “How do you know that?” The MIT approach suppresses that question and instead presumes that economic researchers and policy makers are capable of obtaining knowledge that many believe is beyond their grasp.2 This is particularly the case in the field known as macroeconomics, whose practitioners claim to know how to manage the overall levels of output and employment in the economy.

What I have set out to write is an introduction to economics as I believe it would have been written had the MIT revolution not taken over the academy. It sets out what I see as important principles of economics, and important issues in social theory in general. Some of the ideas were understood by classical economists but forgotten by the MIT revolution. Other ideas reflect more recent thinking about the factors that enable trust in society.

A few additional notes:

1. There is a Boudreaux-like emphasis on the gains from trade throughout the book.
2. There is a Boettke-like emphasis on the co-ordination problem and on economics as comparative institutional analysis.
3. There are some themes that are not heavily emphasized in Austrian economics, and may even run counter to it. One such theme is that trust is very important for a society’s economic well-being. Trust depends on individual beliefs, cultural norms, and formal institutions. Trust means that people have confidence that rules are being enforced. All enforcement mechanisms come with advantages and disadvantages. People count on government to serve as one important mechanism.
4. Another theme is the that financial intermediation is inherently fragile. Here, I also emphasize trust. I offer a version of the Minsky cycle, but with trust in opaque financial intermediaries, rather than sheer business confidence, as the variable that changes over the cycle.
5. My take on finance and the real economy is very antithetical to monetarism. It also differs, probably in substance and certainly in presentation, from the standard Austrian story of “the” interest rate, “the” structure of production, and malinvestment.

Should I refer to it as The Book of Arnold?

Kirzner vs. Samuelson

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David Glasner writes,

In Kirzner’s view, the divergence between Mises and Hayek on the one hand and the neoclassical mainstream on the other was that Mises and Hayek went further in developing the subjectivist paradigm underlying the marginal-utility theory of value introduced by Jevons, Menger, and Walras in opposition to the physicalist, real-cost, theory of value inherited from Smith, Ricardo, Mill, and other economists of the classical school.

…as the neoclassical research program evolved, the subjective character of the underlying theory was increasingly de-emphasized, a de-emphasis that was probably driven by two factors: 1) the profoundly paradoxical nature of the idea that value determines cost, not the reverse, and b) the mathematicization of economics …The false impression was created that economics was an objective science like physics, and that economics should aim to create objective and deterministic scientific representations (models) of complex economic systems that could then yield quantitatively precise predictions, in the same way that physics produced models of planetary motion yielding quantitatively precise predictions.

neoclassical economists who developed this deterministic version of economic theory, a version wonderfully expounded in Samuelson Foundations of Economic Analysis…

Pointer from Mark Thoma (!).Read the whole post, which refers to this lecture by Israel Kirzner. (Kirzner starts about 17 minutes in)

The Samuelson tradition keeps wanting to treat production technology as known and costs as objective. It is long on math and short on philosophy. For an exploration of subjective cost, see James Buchanan’s Cost and Choice. For an analysis of the ideological implications of subjective cost, see my essay.

Non-marketable Outputs and Executive Compensation

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I have suggested that one can think of firms as taking marketable inputs and producing non-marketable outputs. These non-marketable outputs ultimately contribute to marketable outputs. It is the non-marketable outputs that bind the firm together. If instead all outputs were marketable, then you could unbundle the firm and arrive at marketable output using market transactions among many firms.

I have also suggested that non-marketable outputs have an indeterminate value. This in turn makes the compensation paid to workers indeterminate.

Apply this to CEOs or other top executives. A CEO produces non-marketable output. The CEO’s “output” consists of key decisions with regard to strategy and personnel. It also includes intangible effects on employees, customers, and other firms.

Non-marketable output is, by definition, mostly valuable within the firm. The value of firm X’s CEO to firm X is likely to be quite a bit higher than the value of firm X’s CEO to firm Y. Thus, the CEO’s opportunity cost easily could be low relative to the value that the CEO provides. Whereas for low-level positions, it is plausible that competition serves to narrow the range of potential compensation, the same is not true at the level of CEO. It would seem that the range of indeterminacy in CEO pay ought to be especially high.

Observers on the left have argued that the rise in CEO pay in recent decades reflects changes in social norms rather than an increase in CEO productivity. Although there may be other explanations, I would think that the range of indeterminacy is sufficiently high that one should not dismiss the social-norms story out of hand.

Non-marketable Outputs

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A non-marketable output is something that has relatively little value outside of one firm. One company’s tax return won’t help any other firm file its return. A half-finished Chevy is not of much use to Toyota.

1. I claim that a typical firm buys marketable outputs, produces non-marketable outputs, and turns at least some of these non-marketable outputs into marketable outputs.

2. I can imagine a firm that produces only non-marketable outputs because it works only for a single buyer. However, there is a sense in which the firm and its buyer can be treated as a single entity.

3. Non-marketable outputs are what determine the configuration of firms. Suppose that there are ten stages of production. If at each stage the output is marketable, then there might exist firms at each stage of production. On the other hand, if only the final stage is marketable, then there will be just one firm.

4. The value of a non-marketable output is indeterminate. It has to be worth at least as much as the cost of the inputs required to produce it, and it cannot be worth more than the entire marketable output of the firm. But that leaves a wide range. Consequently, workers engaged in the production of non-marketable output do not have a well-defined marginal revenue product.

5. I conjecture that the larger the firm, the higher the proportion of non-marketable output relative to total output. If all you are doing is buying marketable outputs and selling marketable outputs, then you can be a tiny firm, like somebody who sells on e-Bay. On the other hand, if you manufacture airplanes, then most of your effort goes into producing unfinished airplanes, so you need a large firm.

Compare the old-fashioned general store to Wal-Mart. Wal-Mart has important non-marketable output in its supply chain, consisting of logistical systems and contracts with sellers. That supply chain might be worth something to an old-fashioned general store, and you can imagine a different Wal-Mart acting solely as a wholesaler/distributor. However, the supply chain is worth even more when it is integrated with large, strategically-located retail outlets, namely Wal-Mart stores.

6. I conjecture that non-marketable output tends to become increasingly important as the economy becomes more complex. That in turn would suggest that the trend would be for firms to get larger.

7. Some important creative destruction takes place in the arena of non-marketable outputs. Uber and taxi companies both offer on-demand rides. But Uber replaces the taxi company’s non-marketable output, its dispatching system, with something different. Amazon and traditional sellers both offer books. But Amazon replaces the non-marketable outputs of the traditional sellers (inventory management, product display, and customer fulfillment) with something else.

Note that Amazon found that a lot of its infrastructure proved to be marketable. Other companies rent server space from Amazon or sell products using Amazon.

The Computer as Economic Metaphor

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Cesar Hidalgo says,

So countries with a lot of trust and good institutions can create very complex computers that are able to process large volumes of information and create complex products that are rare and have a big premium on the market. So by thinking of economies in terms of information and computation, you can also connect institutions with the mix of products that countries make and with wealth. A social network is nothing other than a distributed computer.

Pointer from Mark Thoma. Read the whole interview. Perhaps he is one of those fellows who sounds deep and profound but is not really saying anything.

But I think that there is some significance in the availability of the computer and the Internet as a metaphor. In 1960, machines were the most salient sources of metaphors, and so economists thought in mechanistic terms. As we start to expand our use of computers and networks as metaphors, I think this affects how we view the economy. In some sense, the emphasis on institutions and other components of what Nick Schulz and I call the “software” of the economy are insights that are more likely to occur to economists living in the computer age.

More Essential Hayek

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Again, the book will be released next week.

Another point Boudreaux makes is that in a specialized economy, our production activities are much narrower than our consumption activities. This makes rent-seeking more prevalent on the production side.

This point is easily missed. For example, Stephen G. Cecchetti and Kermit L. Schoenholtz write about the mortgage interest deduction as if its political strength comes entirely from home owners. (Pointer from Mark Thoma.) In fact, I would argue that it is the NAR, NAHB, and the MBA that make it inviolable.

We know that food stamps are popular with the farm lobby. And perhaps Medicaid does not benefit recipients as much as it does providers of medical services.

When Marginal Product is Undefined

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In an Alchian-Demsetz firm, marginal product is not defined.

Think of a business that has exactly one full-time tax accountant (TA). In a sense, the marginal product of the TA is zero, since the TA contributes zero output. On the other hand, the tasks performed by the TA have tremendous value, allowing the firm to remain in business and keeping the owner out of prison.

What determines the compensation paid to the TA? It cannot be less than the TA’s best alternative, or opportunity cost. It cannot be more than the firm’s best alternative, which could be to hire a different TA, outsource to an accounting firm, or try to automate the process using software. If there is lots of competition on both sides of the market, then compensation will be driven to some unique level. Otherwise, there may be a range of plausible outcomes.

Remember that most of us are Garett Jones workers. We do not produce output. We produce organizational capital. So most of us have undefined marginal product.

Don Boudreaux on The Essential Hayek

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It is a project for Canada’s Fraser Institute. It will launch next week.

Boudreaux starts with a “nobody knows how to” introduction. He uses paper and ink as examples of mundane goods that require many different people and specialized tasks to be produced.

As I start my book on specialization and trade, I find myself doing the same thing. This is in a great tradition. Adam Smith used the woolen coat. Leonard Read used the pencil. My thought was to use a bowl of cereal.

Alchian and Demsetz on Specialization and Firms

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A reader pointed me to their classic paper, which is exactly on point.

there is a source of gain from cooperative activity involving working as a team, wherein individual cooperating inputs do not yield identifiable, separate products which can be summed to measure the total output. For this cooperative productive activity, here called “team” production, measuring marginal productivity and making payments in accord therewith is more expensive by an order of magnitude than for separable production functions.

In their summary,

While ordinary contracts facilitate efficient specialization according to comparative advantage, a special class of contracts among a group of joint inputs to a team production process is commonly used for team production. Instead of multilateral contracts among all the joint inputs’ owners, a central common party to a set of bilateral contracts facilitates efficient organization of the joint inputs in team production. The terms of the contracts form the basis of the entity called the firm-especially appropriate for organizing team production processes.