Category Archives: Economic education and methods

Co-ordinated Specialization

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I have been thinking about the problem of teaching emergent economics. A commenter suggested The Economic Way of Thinking, so I got the eleventh edition. Paul Heyne started the franchise, and this edition, from 2006, adds as co-authors Peter Boettke and David Prychitko. It is quite good. It is certainly an improvement over the Samuelson tradition in which the market is a machine, technocrats are its repairmen, and economists write the repair manual.

The authors write (p. 16-17)

The economic way of thinking was developed by social theorists largely to explain how order and cooperation emerge from the apparently uncoordinated interactions of individuals pursuing their own interests in substantial ignorance of the interests of those with whom they are cooperating. Economics is a theory of choice and its unintended consequences.

The fundamental assumption of the economic way of thinking is that all social phenomena emerge from the actions and interactions of individuals who are choosing in response to expected benefits and costs to themselves.

I prefer something more Smithian and less Misesian. I would be inclined to start with something like this:

The most striking economic feature of modern society is that we can consume the products and services requiring millions of tasks while performing only a few tasks ourselves. Obviously, this requires some form of coordinated specialization. How can this coordination take place? Consider three possible extremes.

1. Decentralized decisions, but with no prices and profits. People just spontaneously decide on their own what would be most useful to society.

2. Centralized decisions, made by an expert planning bureau.

3. Decentralized decisions, guided by prices and profits, and regulated by competition.

The problem with (1) is that you will get imbalances. Suppose that getting milk to urban consumers requires both dairy farmers and truck drivers. If too many people would rather be truck drivers than dairy farmers, then there won’t be enough milk to transport. If too many people would rather be dairy farmers, then the milk will spoil on the farms. More generally, the jobs that no one wants to do will tend to go undone. Computer programmers will all work on video game hacks, not on inventory control systems. Basically, (1) only works when there are very few tasks to be divided among a small number of people who all get along.

Top-down planning is widely used in the economy. I think of corporations and non-profit organizations as operating this way. But as planning organizations increase in their scope of activities, prolems arise. When central planners draw up their plans, they do not know true costs. Part of the reason for their lack of knowledge is that all costs are opportunity costs, and opportunity cost has a subjective component. Moreover, central planners are not well positioned to gauge alternatives to the status quo. How can a remote planner know whether a factory will be managed more efficiently by Jane than by John?

In a complex economy, these knowledge problems are better solved by competition under a price system with profit incentives.

Returning to Heyne-Boettke-Pryhitko, I would prefer not to put as much emphasis on the methodological dogma that people choose in response to expected benefits and costs. Instead, I prefer to emphasize the question of how a society can operate with each individual performing a few tasks while consuming the products of vast multitude of tasks.

I am not saying that one can do away with the dogma. Offhand, I do not see how to get to “all costs are opportunity costs” without invoking it at some point. But I want to be up-front that the dogma has philosophical consequences.

What I’m Reading

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The Aggregate Production Function and the Measurement of Technical Change: ‘Not Even Wrong’ by Jesus Felipe and John S.L. McCombie. It is a long technical book. Here is my attempt to summarize one of the main arguments.

Suppose I give you two observations, which might come from otherwise-similar economies or from the same economy at two different points in time:

1. Output per worker = 400, capital per worker = 100.

2. Output per worker = 410, capital per worker = 110.

Can you calculate the elasticity of output with respect to capital?

The answer is “yes” if we are measuring physical units. Bushels per worker. Tractors per worker.

But suppose that we are using national income accounting data. Then our measure of output is GDP. And our measure of capital is income not going to labor. Now, in addition to having well-known aggregation problems in computing output and a capital index, we have to assume implicitly that the marginal product of the 10 additional units of capital is the same as the average product of the first 100 units of capital. But that amounts to assuming that you knew the answer before you even had the second observation. You are only pretending to learn from the data.

This calls into question a whole lot of empirical research purporting to describe economic growth or cross-country productivity differentials.

What is a Job?

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In a recession, we speak of jobs being “hard to find” and “the need to create jobs.” As intuitively reasonable as these phrases seem, they run counter to conventional economics.

The goal of an economy is not to create work. What we want is higher productivity, which means that more goods and services can be obtained with less work.

The traditional view of the economic problem is that we have unlimited wants and limited resources. The folk Keynesian view is the opposite: we have resources that are superfluous because of limited wants (low aggregate demand).

When we focus on trade as the central principle of economics, we can resolve this tension. That is, we can explain a shortage of “jobs” even though the economic problem is to try to produce more with less.

The most striking thing about a modern economy is specialization. Most of us produce goods or services that cannot be directly consumed. And all of us consume goods and services that we could not possibly produce.

As an individual, I earn a living by doing a few tasks that do not produce a single item that I consume. Instead, my few tasks allow me to exchange for goods and services that require many tasks. Think for a moment about all of the tasks required to produce a pencil or a toaster.

How many tasks go into the production of the goods and services that I consume in a single day? My guess is that the number is in the millions. And yet I only have to perform a few tasks myself in order to earn the means to obtain these goods and services. That is the miracle performed by complex patterns of specialization and trade.

So I arrive at this definition of a job:

A job is a context for performing a particular small set of tasks that can be exchanged for the means to obtain goods and services produced by a far larger set of tasks.

This definition of a job is consistent with the ordinary intuition that jobs must be “created.” You cannot just do any random set of small tasks to earn the means to obtain the goods and services of the market. That is why I do not define a job as the set of tasks. Instead, I define it as the context in which those tasks are undertaken. Without a context in which the set of tasks adds value, there is no basis for exchange. In order to have a job, you or an employer must discover a context in which sufficient value is created by a particular set of tasks that you are capable of performing.

This definition avoids the suggestion that jobs are lacking because of a scarcity of wants. It also avoids the suggestion that the labor market should be described as a “matching problem,” with employers and potential employees in search of one another. It is a definition of a job that reflects the importance of patterns of sustainable specialization and trade.

The Middle Man as Information Processor

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Suppose that I am one of three boys at a summer camp. Each of us receives an identical care package, consisting of two bags of pretzels and two boxes of apple juice. I like pretzels and apple juice, but boy A only likes apple juice and boy B likes only pretzels. I trade one bag of pretzels to A for two boxes of apple juice. I trade one box of apple juice to B for two bags of pretzels. [OOPS. This was backwards. I trade the apple juice to A and the pretzels go B] Everyone is happier after the trading, but I wind up with three bags of pretzels and three boxes of apple juice.

How did I end up with so much, without producing any apple juice or pretzels myself? What I did was process information. I used the information about the preferences of the other boys to make them better off while earning a profit for myself. Some further remarks:

1. Because the middle man is an information processor and not a producer, his role is often resented. People talk about eliminating the middle man. But you cannot eliminate the middle man without coming up with an alternative way to process the information.

2. There is a classic article by R.A. Radford, called The Economic Organization of a P.O.W. Camp. See also Michael Munger’s essay.

3. There is often competition, involving multiple middle men. They may use similar methods, or they may use very different methods.

4. Because they are information processors and because there is competition, middle men need to be mentally sharp.

5. Finance is to a large extent a middle-man industry.

The Central Principle of Economics

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Trade is almost always good.

I want to propose that as the central principle of economics. More on that in other posts. In this post, I want to talk about how trade might be bad or might be perceived to be bad.

1. If you hold a gun to my head and demand something, that is bad. In fact, I would say that does not even count as trade.

2. If I buy on the basis of fraud or deception, then the trade is bad. Florida swampland. Snake oil.

3. What if I was not deceived, but afterward I regret the trade? In 1964, the Chicago Cubs traded Lou Brock to the St. Louis Cardinals for Ernie Broglio. The Cubs came to regret that trade. I have made some investments that I regret. But in my view there is nothing unfair or morally wrong about trades that someone later regrets making.

4. What if you are in the desert in danger of dying of thirst, and I offer to sell you a bottle of water for $1000. Is that a bad trade? I would argue that what is bad is the circumstance in which you find yourself, but the trade itself is legitimate. I would argue that even more strongly in the case of buying clothing made in a sweatshop. Assuming that the worker chose to work in a sweatshop over other alternatives that were worse, it is not a bad trade. For more on this issue, I recommend this podcast with Russ Roberts and Michael Munger.

5. Is it bad to trade with people whose cultural or political views you dislike? A lot of people feel that way, but the opposite might well be true. Suppose that you choose to trade solely on the basis of profit. Clearly, that makes you better off. Also, by not discriminating against others on the basis of ethnicity or culture or politics, you are probably helping to make the world a better place.

6. In fact, trade is probably best when it is impersonal. The closer you are to a person, the more doubtful trade becomes. I would not recommend to parents that they pay children to help around the house. Instead, I would recommend telling children that you consider it their responsibility to help around the house (and being specific about what that means).

7. Trade involving a person’s body makes people squeamish. We do not want people selling themselves into slavery. Many people, although not all, oppose prostitution. Many people, although not all, oppose the sale of drugs like heroin or cocaine. Many people, although not all, oppose allowing people to pay for organs to be used in transplants. Among economists, there is more support for legalized prostitution, drugs, and a market for organs than there is in the general population.

8. It could be that one of the reasons that we rely heavily on third-party payments in health care is that we are squeamish about trade that pertains to the body. We prefer to think of the doctor as offering the gift of healing rather than as someone making a trade.

Interpreting Roland Fryer

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He is the latest winner of the John Bates Clark Medal. The announcement reads, in part

Roland Fryer in a series of highly-influential studies has examined the age profile and sources of the U.S. racial achievement gap as measured by standardized test scores for children from 8 months to seventeen years old. Fryer (with Steven Levitt) has shown the black-white test score gap is quite small in the first year of life, but black children fall behind quickly thereafter (“Testing for Racial Differences in Mental Ability among Young Children,” American Economic Review 2013). The racial test score gap is largely explained by racial differences in socioeconomic status at the start of schooling (“Understanding the Black-White Test Gap in the First Two Years of School,” Review of Economics and Statistics 2004), but observable family background and school variables cannot explain most of the growth of the racial test score gap after kindergarten. Fryer’s comprehensive chapter in the Handbook of Labor Economics (2011, “Racial Inequality in the 21st Century: The Declining Significance of Discrimination”) documents that racial differences in social and economic outcomes today are greatly reduced when one accounts for educational achievement gaps. He concludes that understanding the obstacles facing minority children in K12 schools is essential to addressing racial inequality. Fryer has taken up this challenge to study the efficacy of education policies to improve the academic achievement and economic outcomes of low-income and minority children.

His research has a lot of bearing on the Null Hypothesis. Some of his papers contradict the Null Hypothesis, and some do not.

It certainly is intriguing that the racial test score gap is low in the first year of life and rapidly rises early in the school years but that “observable family background and school variables cannot explain most of the growth of the racial test score gap after kindergarten.” Some possibilities:

1. The Null Hypothesis is incorrect, but the school variables that make a difference are subtler than what we now find to be “observable.” Some of Fryer’s other studies might lend some support to this, but other of his studies would not.

2. The Null Hypothesis is correct because test scores performance is dominated by non-school environmental factors.

3. The Null Hypothesis is correct because test score performance is dominated by genetic factors. Then the problem is to explain why the gap appears at age seven (say) but not at age one. The lack of any gap at age one might be due to tests not being able to discriminate ability as well at that age as at later ages. This would give rise to a measurement error problem, one which biases differences toward zero.

Incidentally, someone pointed me to the blogger Isegoria’s link to a journal article entitled Individual Differences in Executive Functions Are Almost Entirely Genetic in Origin. The article comes from 2008, and the finding of 99 percent heritability strikes me as ridiculous. My guess is that if the same person is measured for executive function by two different investigators, the correlation will not be anywhere close to 99 percent. I hereby invoke Merle Kling’s third iron law.

Throw Peer Review Under the Bus?

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From The Independent

Richard Smith, who edited the British Medical Journal for more than a decade, said there was no evidence that peer review was a good method of detecting errors and claimed that “most of what is published in journals is just plain wrong or nonsense”.

…Speaking at a Royal Society event earlier this week, he said an experiment conducted during his time at the BMJ, in which eight deliberate errors were included in a short paper sent to 300 reviewers, had exposed how easily the peer review process could fail.

Pointer from Jason Collins.

What might be better? Off the top of my head, I propose that:

1. No individual study should receive more than a page or two in a journal. Just explain the findings, interpret them, and put all of the methodological details and literature review on the author’s web page. Results from all such papers should be treated as “preliminary and unconfirmed.” Accept any study for publication, including studies with findings of “no significant effect.”

2. Longer articles should be survey articles that focus on studies that have been replicated and confirmed. The survey articles should also report on studies where attempted replication failed or the method was otherwise shown to be invalid.

3. Do not assign high status to researchers just because they get studies published. Instead, assign high status to researchers who attempt to replicate or otherwise confirm other studies and also to researchers whose work is cited favorably in survey articles.

The Wartime Economy

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The first and second world wars were characterized by entire societies being mobilized for war. In order to out-fight one another, countries had to out-produce one another. During both wars, England attempted to blockade Germany using surface ships, and Germany attempted a counter-blockade using submarines. During World War II, the location of oil, rubber, and tin helped determine strategy. In the decades following World War II, the Defense Department budgets remained high in order to deal with the Korean War and the Cold War, leading President Eisenhower to issue his famous warning about a military-industrial complex.

Wartime economies involved central planning, as governments sought to control production and allocation to serve military needs. I argue that trade is the central economic activity. But in a wartime economy trade takes a back seat to planning, production and allocation.

I believe that the wartime economy had influence long after wars ended.

1. In the 1930s, intellectuals looked back fondly to the economic mobilization of the first World War. Many of the first New Deal planning bureaus, most notably the NRA, were modeled on wartime agencies. Roosevelt’s team used the metaphor or war, and the phrase “moral equivalent of war” came into use. (Decades later, President Carter famously declared that higher oil prices required a response that was the moral equivalent of war.) In contrast to the free market’s aimless satisfaction of base consumer desires, the wartime economy was considered more rational and purposeful.

2. The story told in MIT and the Transformation of American Economics shows the influence of the wartime economy. The MIT economics department was funded lavishly by the Defense Department, as MIT’s research agenda was useful in planning, production, and allocation.

One of the mathematical tools that became popular in postwar economics, linear programming, is designed to help the central planner solve a resource allocation problem. The classic textbook on linear programming, written in the late 1950s by Dorfman, Samuelson, and Solow, was only just beginning to fade from use in the late 1970s when I was in graduate school.

I believe that the research methods and textbooks that came out of this MIT-centered transformation were too heavily influenced by the wartime economy. Economists worked very hard to develop tools for “seeing like a state.” They lost track of the way that an economy does not have to resemble a wartime economy.

1. The patterns of specialization and trade can emerge, without being centrally planned.

2. The economy does not maximize an objective function. If anything, it maximizes subjective functions. Value depends on what is in the consumer’s head, and this information is not accessible to the central planner.

3. Costs cannot be measured objectively by adding up the prices of inputs. All costs are opportunity costs, and opportunity costs are subjective.

4. Trade is a technology If you think in terms of a production function, new patterns of trade shift the production function.

Look at it and Think About it

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That is John Cochrane’s advice on the unit root issue.

A unit root means a random walk component. A random walk will eventually pass any upper and lower limit. Look at it [the unemployment rate]. That’s as stationary a series as you’re going to find in economics. (“Look at it” and “think about it” are the Cochrane unit root tests.)

Yes, unemployment like other stationary ratios in macro (consumption/GDP, hours/day, etc.) have important and frequently overlooked low-frequency movements. But they are far from random walks, and they like unemployment have a very large transitory component at business cycle frequencies. When unemployment is above 8%, it is a good bet that it will decline over the next 5 years.