Is economics (mostly) the study of public policy?

Obviously economics is about more than public policy.  But to me it seems to be mostly about public policy, and I’d be interested in your thoughts about whether I am right.  Let’s approach this in a roundabout fashion.  I just finished Tyler Cowen’s new book (which is excellent–highly recommended) and noticed this claim (p. 222):

We [economists] still haven’t dispensed with models, because there are a few models we believe in pretty strongly, such as that when price goes up, people usually buy less of that good or service . . .

I don’t think that’s true.  Never reason from a price change.  Perhaps Tyler saw me looking over his shoulder, and hence the complete sentence is:

We [economists] still haven’t dispensed with models, because there are a few models we believe in pretty strongly, such as that when price goes up, people usually buy less of that good or service, all other things being held equal.

OK, am I happy now?  No, I still think it’s wrong.  Recall that every transaction is two-sided.  When someone buys something, someone else sells something.  So when you describe the quantity of something purchased changing, you are also describing the quantity of something sold changing.  Let’s re-word Tyler’s claim into something exactly equivalent:

We [economists] still haven’t dispensed with models, because there are a few models we believe in pretty strongly, such as that when price goes up, people usually sell less of that good or service, all other things being held equal.

If Tyler had said this, I believe some eyebrows would have been raised.  But Tyler did say this!  It’s not easy to avoid reasoning from a price change.  So how should he explain this concept to the public?  How about this:

We [economists] still haven’t dispensed with models, because there are a few models we believe in pretty strongly, such as that when price goes up, people usually have a lower quantity demanded of that good or service, all other things being held equal.

That’s true, but since it’s impossible to directly observe “quantity demanded,” it’s sort of a weak claim. Don’t we want to show non-economists some sort of claim that can be directly observed?  OK, how about this:

We [economists] still haven’t dispensed with models, because there are a few models we believe in pretty strongly, such as that when a frost destroys 90% of the orange crop, people will buy fewer oranges, all other things being held equal.

Yes, that’s true, but it’s also obvious.  Supply changes.  If there are 90% fewer oranges, it stands to reason that people will consume fewer oranges.  It’s so obvious that it won’t even strike non-economists as a “model.”

So let’s do a supply shift that doesn’t obviously reduce the quantity of oranges available:

We [economists] still haven’t dispensed with models, because there are a few models we believe in pretty strongly, such as that when a tax is placed on a good, people will buy fewer of that good, all other things being held equal.

Finally we have something that is both true and observable and also non-trivial.  And it’s a public policy issue. Here are some more public policy claims:

1.  Increasing the money supply will raise all wages and prices by the same proportion, in the long run.

2.  Increasing the money supply growth rate will raise nominal interest rates in the long run.

3.  Rent controls will lead to housing shortages.

4.  People should be allowed to sell a kidney.

5.  Higher tax rates might lead to less government tax revenue.

6.  A higher legal minimum wage might hurt low income workers.

7.  Mandating certain employment benefits might hurt workers.

8.  Mandating higher product quality, or lower service fees, might hurt consumers.

9.  Taxes are a more effective deterrent to pollution that regulations.

10.  Income from capital should not be taxed at all.

11.  Congestion fees are often better than building new roads.

12.  Trade barriers hurt the country that imposes them.

13.  If an orgy of debt-fueled borrowing leads to a bubble that bursts, the government should borrow dramatically larger amounts during the subsequent recession.

Put aside the question of whether you agree with these claims.  I agree with most but not all.  The fact remains that these are the sorts of claims that economists make.  And they are all about public policy. There are also interesting claims about issues unrelated to public policy, but in my view they are much fewer.  What do you think?

Tyler tried to make a claim unrelated to public policy, and fell short.  I wonder if it is because economics is so focused on public policy issues that we are not used to making those sorts of non-policy claims.


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39 Responses to “Is economics (mostly) the study of public policy?”

  1. Gravatar of Kevin Dick Kevin Dick
    9. November 2013 at 17:01

    I think you are overly macro focused. I think this is a model most economists believe, is true and nontrivial. But it’s micro.

    We [economists] still haven’t dispensed with models, because there are a few models we believe in pretty strongly. If a business’ rent goes up, the owner may naively assume that he can look at the number of units he sold in the previous period and increase prices by just enough to offset the increased rent. But our models tell us that customers will demand less of his products at this higher price, so his revenues will be less than he expects. In fact, our models say that it might be impossible for him to raise prices at all and increase his profit.

  2. Gravatar of ilya ilya
    9. November 2013 at 17:51

    I would say that to make a claim you need to have some external variables, one example being tax rate. Then you can say, “according to my model, changing some external variables in that way will change observables in that way”.

    Now if you think about it, external variables that can be changed are by definition part of public policy. There are other types of external variables — as in your example, sudden and extreme weather conditions. So you *can* say (and I’n surprised you didn’t!)

    > We [economists] still haven’t dispensed with models, because there are a few models we believe in pretty strongly, such as that when a frost destroys 90% of the orange crop in one country, the price of oranges will rise, and more oranges will be imported from other area, all other external variables being held equal.

    This is a non-trivial conclusion from the model! It’s interesting, but, by design, it will be harder to test those models (you have to sit and wait for a frost…). While in the model with tax rates, every legislature tweaks some rates once in a while.

    So, my point is, models that depend on human-controlled external variables have some good reasons to be more widespread and testable. But, on the other hand, they are tied into politics, which lowers quality of discourse about them.

  3. Gravatar of Tom Tom
    9. November 2013 at 18:03

    Insofar as economics is a study of Human Action, it is not just gov’t policy — and when you say “public policy” don’t you really mean gov’t, not all people?

    Newspeak relabeling of gov’t as equal to “public” has been terrible, and you’re contributing to this confusions (as did J. Buchanan with “Public Choice theory”, which is really Gov’t choice theory).

    There’s tons of study of what the public does, and even an industry, called advertising (or marketing) all about changing the policy of the public to buy the product of the advertiser (see, you’re not talking about this — you’re not really so interested in the public, mostly the gov’t).

    Similarly, inside companies, cost & benefit analyses are done using economics. When economics is used in non-gov’t ways, it’s usually relabeled. Family buying decisions are seldom seriously studied in the economics … blogosphere, where I spend my reading time. I doubt there’s much in the econ journals. But all monetary purchasing decisions are economic
    decisions.

    What PhD & Professors of Economics seem to find most interesting are the gov’t choices about economics. So academic economics does seem to be mostly macro / gov’t policy.

    “when price goes up, people usually buy less of that good or service, all other things being held equal.”

    And you think this is wrong???? Because you have your own rule: “Never reason from a price change.”
    That’s a stupid rule.
    People really do change their behavior because of price changes.
    Further, while you might prefer other wording, absolutely nowhere do you show that it’s wrong.
    On the contrary, you agree with a subset:
    “when a tax is placed on a good, people will buy fewer of that good, all other things being held equal.”

    Adding a tax is one way the price changes. A reduction in supply is another reason the price changes, and the increased price–less bought model holds.

    In fact, most economics is the study and concern about of price changes, including changes in the price of money. Most economic reasoning is reasoning about the causes and consequences of price changes.

  4. Gravatar of Lorenzo from Oz Lorenzo from Oz
    9. November 2013 at 19:47

    Macro economics can’t really help being about public policy. Not in a world of central banks, government control of base money supply, taxes at 30-50% of GDP, etc.

    Micro less so, but in terms of public discourse, the public policy stuff is what gets the attention.

    On Tyler C’s claim, would using “sold” or “bought” get around the problem, since that is explicitly about both sides of the transaction (as in: “less of the good or service is likely to be sold, all other things being equal”)?

  5. Gravatar of mbka mbka
    9. November 2013 at 20:04

    Scott,

    Historically and starting with Adam Smith you could claim that the rise of economics as a science was as much a defensive reaction against policy (mercantilism, protectionism, etc) as it was “about” policy.

    What came out of this, micro and macro, is now a deeply social science about the dynamics of human interaction related to exchange. The micro side looks at actual interactions, the macro side looks at the emergent properties of these interactions in the larger system. This study needs not be goal oriented. Policy is goal oriented because policy is about changing what the whole system does. But the study of such system does not need to want to change it.

    Ultimately it is probably fair to say that many economists studied economics in the hope to change public policy just as many biologists study biology because they have environmentalist leanings. So I can believe that most economists are interested in policy and especially macro-economists, because they believe it is their hope to be relevant in life. I just don’t think this pathway is necessary. As Tom pointed out, banks and large companies do employ economists too. And frankly, what is wrong with science for the sake of science, just for the sake of finding out what is happening and why?

  6. Gravatar of Integral Integral
    9. November 2013 at 21:50

    Tom,

    You may find this older article, here: https://www.themoneyillusion.com/?p=1993, interesting reading.

  7. Gravatar of Benjamin Cole Benjamin Cole
    10. November 2013 at 00:37

    Well, economics is about public policy? Or politics?

    Or, do people try to package their biases in a pretty box marked “Economics”?

    If suspect people are lazy, especially those not in my ethnic group, I am against any social welfare. But as an economist I speak of “work disincentives” etc. And that is what I study and write papers about, not the USDA money giveaways. Or that the military is a parasite.

    Or, I dislike rich people, so I speak of “progressive income taxes,” and write about incredible windfalls people get on Wall Street unrelated to anything except position and luck and perhaps bad-doings.

    Egads, no matter how complicated the model, how urbane the presenter, how sophisticated the reasoning..ain’t it funny how a conclusion of a paper always–always–supports the economist’s political views?

    Economics is just politics in drag, usually.

    This political animus is everywhere–why the resistance to Market Monetarism and QE from left-wingers and right-wingers? It is because MM does not fit their political biases?

  8. Gravatar of Bill Woolsey Bill Woolsey
    10. November 2013 at 03:50

    An entrepreneur innovates, introducing the new product corn flakes. Prediction: the price of leather gloves go up.

    The demand for corn rises. At the old price, that would cause a shortage. Sellers have an incentive to raise prices. The amount of corn buyers are able and willing to buy (quantity demanded) falls. This is a partial dampening or offset of the increase in corn used for cornflakes.

    That offset is partially ranchers purchasing less corn. Why? Because it is an input for producing cattle. The increase in the marginal cost of producing capital causes ranchers to find it profitable to produce less. (In this case, the decrease in profit is smaller if they produce less.) The supply of cattle falls. The lower supply of cattle creates a shortage. Ranchers make more money by raising prices.

    Cattle are an input for cattle skins. Cattle skins are an input for leather. Leather is an input for leather gloves.

    The market is a system of mutual adjustment. The wonderful benefit of eating cornflakes results in people using fewer leather gloves, allowing a reallocation of resources.

    None of this is directly related by public policy.

    Also, it shows how the law of demand is part of the account of how market forces adjust to changes in supply or demand.

    I can (and do) think about macro in much the same way.

    How does an increase in expected profit opportunities lead to a change in interest rates and the allocation of resources between the production of consumer goods and capital goods?

    How does an innovation improving bank clearing methods lead to a decrease in the purchasing power of money?

    How individual firms and households respond to price signals is part of the story.

    And the notion that if price goes up the quantity transacted goes down is just wrongheaded.

  9. Gravatar of W. Peden W. Peden
    10. November 2013 at 04:36

    My PhD is covering many of the topics discussed. One issue is this: though there are many uses for economics other than for policy choice (either by a government or a public) the focus and the funding has been for economics as a tool of the state. As Ronald Coase pointed out shortly before his death, this has had a significant impact on the course of economic research, and since methodologies need to be attuned to particular goals, on the predominant methodology of economics itself.

  10. Gravatar of Saturos Saturos
    10. November 2013 at 06:17

    The Economist Is Worried About Disinflation: http://www.economist.com/news/leaders/21589424-both-america-and-europe-central-bankers-should-be-pushing-prices-upwards-perils-falling

  11. Gravatar of W. Peden W. Peden
    10. November 2013 at 06:25

    Saturos,

    There are some problems with that article, but the general diagnosis (the problem is a lack of demand, not an excess of demand) is spot on, and opens up the floor to Market Monetarists offering an alternative solution to that of Keynesians’.

  12. Gravatar of Luis Pedro Coelho Luis Pedro Coelho
    10. November 2013 at 06:49

    Frost destroys 90% of oranges in Florida. Prices will rise to just the level necessary so that either (1) very few oranges will go unsold [no greater spoilage than usual] or (2) very few people will be willing to pay that price and find out that there are no oranges.

  13. Gravatar of mbka mbka
    10. November 2013 at 07:26

    “We [economists] still haven’t dispensed with models, because there are a few models we believe in pretty strongly, such as that when price goes up, people usually buy less of that good or service, all other things being held equal.” Unless the reason the price went up was actually stronger demand with limited supply. Or zero demand elasticity. Or monetary policy. Or it was a Veblen good. Or a lot of other things…

    Maybe it should be reworded thusly:

    We [economists] still haven’t agreed on models, because there are any number of models we can come up with at any time that allow us to prove anything we already believe in pretty strongly, such as that when price goes up, almost anything can happen to a good or service, or could have caused the rise in price, all other things being held equal. Because economics is highly complex and simple relations don’t exist.

  14. Gravatar of Jon Jon
    10. November 2013 at 09:12

    Plenty of economics students go into the private sector. Certainly most ug do. There they build market models businesses use to make decisions. Perhaps this is unseen to you because it is proprietary. Conversely public policy related economics is geared toward advocacy by persuasion. Naturally this is meant to be seen.

    I would also venture to say that five years of PhD makes a person less prepared for that work than five years of experience.

  15. Gravatar of ssumner ssumner
    10. November 2013 at 10:07

    Kevin, I’m not sure anyone would be surprised to learn that businessmen are unhappy when someone raises their rent.

    Ilya, Good point.

    Tom, I think you missed the point about reasoning from a price change.

    Lorenzo, No, that doesn’t really get around the problem, as you don’t expect less to be sold when prices rise.

    mbka, Good point.

    Ben, Unfortunately there is a lot of that.

    Bill, Good example.

    W. Peden, Good point.

    Jon, Good point.

    mbka, Way too pessimistic!! True, but way too pessimistic. 🙂

  16. Gravatar of josh josh
    10. November 2013 at 10:18

    Public policy debates often seem to conflate 2 related strands of analysis: a) policy effects (economics), and b) “valuation” of effects (values-laden cost/benefit analysis). I’d like to think economics can help clarify things by keeping those strands reasonably distinct.

    e.g. How likely is a burst of higher-than-expected inflation, vs. is such a burst such a (relatively) terrible thing that our priority must be minimizing the risk as close to 0 as possible.

  17. Gravatar of Morgan Warstler Morgan Warstler
    10. November 2013 at 10:25

    Scott, Kevin’s right you are too focused on macro.

    If you want to sell me shares of Twitter for $10 or BTC for $100 today, I’ll buy as many as you offer up, until you run out of your ability to supply, until you are in the poor house.

    I will buy 3 dozen Shipley donuts every Sunday at $2 a dz. Eat Torchy’s Tacos every morning at $1 a piece.

    So while there may be a limit of my personal demand for perishables…

    LIQUIDATION IS REAL. It involves someone hungry for cash to cover other wants, dropping price (hopefully at a loss!) to clear inventory.

    So, whatever else you want to talk about, there is a real rule most business men and their biographers the economists agree on about price affecting demand.

    Amazon is REAL. Skype and Pirate Bay are real. And they really exist for winning on price.

    Admitting micro is rock solid as a science improves your chances of proving macro is too.

  18. Gravatar of Lorenzo from Oz Lorenzo from Oz
    10. November 2013 at 10:39

    as you don’t expect less to be sold when prices rise. I am reminded of the story of a QC (Queens Counsel, a senior barrister) who said “I have too much work, I am going to have to raise my fees again”. But I take your point; the real model is that demand curves are downward sloping and that is not enough to tell you what will happen to quantity sold if prices rise, since the demand curve might have shifted rightwards. (Absolutely everything cannot have been equal, since otherwise prices wouldn’t rise.)

  19. Gravatar of Geoff Geoff
    10. November 2013 at 11:38

    “That’s true, but since it’s impossible to directly observe “quantity demanded,” it’s sort of a weak claim.”

    This is I believe why positivism in economics tends to lead to politics instead.

    The bias towards giving credence to observable data, and putting unobservable data on the sidelines, has the unintended consequence of leading the economist to conclude that economics is an empirical science of model testing, which of course means social engineering, and thus “public policy”.

    But if we don’t a priori reject unobservable concepts as invalid, then the economist is less prone to fall into this trap.

    Here is a model:

    The law of marginal utility follows from our indisputable knowledge of the fact that every actor always prefers what satisfies him more over what satisfies him less, plus the assumption that he is faced with an increase in the supply of a good (a scarce mean) whose units he regards as of equal serviceability by one additional unit. From this it follows with logical necessity that this additional unit can only be employed as a means for the removal of an uneasiness that is deemed less urgent than the least valuable goal previously satisfied by a unit of such a good. Provided there is no flaw in the process of deduction, the conclusions which economic theorizing yields must be valid a priori.

    – Hans-Hermann Hoppe.

    We cannot directly observe the law of marginal utility, because we can’t observe the counter-factual worlds where there is a difference of one unit of supply, and thus a different use being made of that different supply. This law, despite being unobservable, is nevertheless a cornerstone of economic science. It is what enables us to know why prices rise when there is an increase in the money supply, why there are opportunity costs, and more. We don’t have to arbitrarily inject amateurish aphorisms such as “the hot potato effect”. The entirety of economic science (NOT economic history) can be built sequentially and hierarchically using praxeology.

  20. Gravatar of Geoff Geoff
    10. November 2013 at 11:43

    “Perhaps Tyler saw me looking over his shoulder”

    It’s more likely he was just considering the possibility that the money supply and volume of spending might increase, and so a rise in the price of a good may not decrease that quantity of a good.

    I doubt very much he was thinking of market monetarism. Ceteris paribus arguments are fairly standard.

  21. Gravatar of Gordon Gordon
    10. November 2013 at 14:26

    It’s not just a problem in the area of economics. People tend to make statements they believe will be interesting to others. The impact economics has on public policy generates the greatest interest from non-economists. Also, when people in an area of expertise write about something, they have a tendency to leave out details or implications which are clear to them and others in that field. They fail to realize that their statements can lead to incorrect inferences by people outside of that field.

  22. Gravatar of Geoff Geoff
    10. November 2013 at 15:55

    We [economists] still haven’t dispensed with models, because there are a few models we believe in pretty strongly, such as that when price goes up, people usually buy less of that good or service, all other things being held equal.

    OK, am I happy now? No, I still think it’s wrong. Recall that every transaction is two-sided. When someone buys something, someone else sells something. So when you describe the quantity of something purchased changing, you are also describing the quantity of something sold changing. Let’s re-word Tyler’s claim into something exactly equivalent:

    We [economists] still haven’t dispensed with models, because there are a few models we believe in pretty strongly, such as that when price goes up, people usually sell less of that good or service, all other things being held equal.

    If Tyler had said this, I believe some eyebrows would have been raised. But Tyler did say this!

    Both statements are correct though. You haven’t disproved the first form of argument by rewording it to another, equivalent second form. It is indeed true that if the price of a good rises, then, ceteris paribus, people sell less of that good. There is nothing wrong with that statement. Perhaps you confused yourself into thinking that these statements are statements of personal desires in the idealist sense, instead of what they really are, which is economic necessity constrained to scarcity. If a buyer has $1000 to spend on goods X, then should the price of goods X rise, then, ceteris paribus, then he is economically incapable of getting the seller to give him the same quantity of goods X as before. The buyer must therefore accept fewer goods X from the seller.

    As such, the argument in the second form, from the seller’s perspective, is equally correct. If the seller has a supply of goods X to sell, then should the price of goods X rise, then, ceteris paribus, the seller is economically incapable of getting his buyer to give him the same quantity of money as before. The seller must therefore deliver fewer goods X to his buyer.

    One can reason from a price change, in cetaris paribus arguments. Cowen used cetaris paribus correctly, but your criticism of his argument misses the mark. You want us to believe that the second form of the argument is incorrect, and therefore the first form is incorrect. But both forms are correct, you just misunderstood the necessity basis of the argument in a ceteris paribus context.

  23. Gravatar of Geoff Geoff
    10. November 2013 at 18:00

    We [economists] still haven’t dispensed with models, because there are a few models we believe in pretty strongly, such as that when price goes up, people usually have a lower quantity demanded of that good or service, all other things being held equal.

    “That’s true, but since it’s impossible to directly observe “quantity demanded,” it’s sort of a weak claim.”

    Actually it is possible to observe quantity demanded. It is possible to observe how many cars are traded, how many computers are traded, and so on. These are “quantities of goods demanded.”

    Demand is an observable concept, not an idealist one. Desire is not demand. Demand is the ability, combined with the willingness, to purchase. We can’t know willingness than through exchanges, which are observable.

  24. Gravatar of Carl Carl
    10. November 2013 at 19:37

    Can’t we also make the public policy claim that Land Value Taxation is the “least bad” form of taxation, to quote Milton Friedman?

  25. Gravatar of Julian Silk Julian Silk
    11. November 2013 at 04:25

    I am coming to this from the opposite pole politically from that which is usually expressed here. I have no problem with the claims which are expressed as characteristic of economics, but do agree that they are overly policy-oriented. 2. about increased money supply depends on what the money is used for, and that’s an example of our disagreement. 6. isn’t “macro”, it’s the labor market. Minimum wages may go up or not in the District of Columbia, and it will have an effect on the labor market there, but it may have next to no effect on the U.S. at all, depending on what happens.

    But I do want to be clear that these propositions aren’t all of economics. There are propositions which economics teaches, which could in principle be tested by experiments that are run in the experimental economics fashion, which should be relatively neutral, and have little to do with public policy.

    1) “Don’t put all your eggs in 1 basket”, or diversification in investment pays. This is testable. Keynes argued you should invest in what you know about, and concentrate in things you have reason to believe in, while this claim would seem to apply to more or less complete uncertainty about all prospects.

    2) “The division of labor is limited by the extent of the market”. This claim, by Adam Smith, seems completely indisputable, but becomes very difficult to deal with when you try to consider either term as a measurable quantity. Exactly how do you measure division of labor? I have written up something, using the notion of economies of scope, which will hopefully soon be published. But it’s only a sufficient example, not a necessary one, and a lot more work could be done.

  26. Gravatar of ssumner ssumner
    11. November 2013 at 06:18

    Morgan, Micro is far from “rock solid.”

    Gordon, Good point.

    Carl, Yes, tax land. But by area not value. Otherwise you discourage improvements.

    Julian, Modern economics completely rejects Smith’s claim that the division of labor is limited by the extent of the market. So it’s far from indisputable, it’s not even theoretically valid.

  27. Gravatar of Roger Sparks Roger Sparks
    11. November 2013 at 10:25

    Scott, I link to this post in my new post found at http://mechanicalmoney.blogspot.com/2013/11/when-does-new-money-become-capital.html.

    My post is self-contained. Your post supplies additional concepts that serve to justify my ambivalent ending.

    Thanks for your post.

  28. Gravatar of Doug M Doug M
    11. November 2013 at 12:19

    “when price goes up, people usually buy less of that good or service.”

    If you ask “Why is the price of X up so much today”? The standard answer is “more buyers than sellers.”

    Or more precisely, “there were more buyer than sellers at the opening price and the price adjusted to a market clearing level.”

    re: #1 — Clearly false! It is never the case that all wages and prices move uniformly. If all prices moved in tandem, assets values would also move uniformly. If I am your lender, your debt it my asset. The value of that debt has a upper bound.

  29. Gravatar of Doug M Doug M
    11. November 2013 at 12:22

    Economics moves into a dangerous place when it becomes public-policy focused. It becomes political, and truth gets sacrificed to politics.

  30. Gravatar of Daniel R. Grayson Daniel R. Grayson
    12. November 2013 at 04:41

    I’m having trouble understanding what “the price goes up” means. Does it mean the price demanded by sellers for future transactions, the price offered by buyers for future transactions, or the price observed to have occurred in past transactions?

  31. Gravatar of ssumner ssumner
    12. November 2013 at 07:34

    Thanks Roger.

    Doug, Money is neutral in the long run, not the short run.

    Daniel, The prices at which goods transact.

  32. Gravatar of Kevin Dick Kevin Dick
    12. November 2013 at 09:52

    @Scott. You’re being too flip. The not liking the raised rent isn’t the surprise. As a guy who deals with entrepreneurs every day, I can tell you many are quite surprised that they can’t simply pass on changes in their production costs to customers.

  33. Gravatar of ssumner ssumner
    15. November 2013 at 12:39

    Kevin, Again, if they are surprised does that mean a higher rent doesn’t annoy them, because they assumed they could pass it on? I’m genuinely confused, but you seem to think I’m being sarcastic. I’m not.

    And have you ever asked them why they don’t simply pass on fake costs to consumers, if it’s so easy?

  34. Gravatar of Julian Silk Julian Silk
    14. January 2014 at 13:46

    Dear Scott,

    I am interested to learn that modern economics rejects Smith’s claim that the division of labor is limited by the extent of the market. I don’t have a particular problem with this, in that the extent of the market might in some sense provide an upper bound, which would be much greater than that which is effectively binding because of other factors. But since I will present my argument about it at the EEA meetings in Boston in a few weeks, it would be helpful to find out specific citations I could point to.

  35. Gravatar of ssumner ssumner
    14. January 2014 at 21:14

    Julian, Today economists assume that firms tend to produce at the lowest point of their long run average cost curve, unless they are a natural monopoly.

    So diseconomies of scale limit firm size, not the extent of the market.

  36. Gravatar of Julian Silk Julian Silk
    26. February 2014 at 16:44

    Scott, This is an assumption of firms being in a competitive market. If firms are in such a market, supposedly the market price is at this level of minimum LRAC, which has an effect on total output, and which still has an effect on division of labor. So that’s somewhat of a semantic distinction.

    What I am going to talk about at the EEA meetings in a week and 2 days is a situation where everything isn’t like a market for a million wheat farms. If we have a market where a firm can choose to divide labor or not, and everything isn’t made crystal clear by the furies of competition, the question still seems open to me. My particular case, most appropriate for me as a patient, is where a physical therapy firm can lease billing to a medical billing firm. I am making various guesses about when they would do this; not all such firms or similar firms do, and the extent of the market is certainly a possibility for a limit. What I am going to say is that the complexity of the task involved is the crucial determinant, and how that intersects the extent of the market is not clear.

    I do think the best and most non-ideological examination of how firms actually behave is John Baldwin and Guy Gellatly, “Innovation Strategies and Performance in Small Firms” )Northampton, MA: Edward Elgar, 2003). I can’t extend that in a full-fledged way for the U.S., but I think what I will say points to some things that might be relevant.

  37. Gravatar of Jim Glass Jim Glass
    26. February 2014 at 19:39

    Julian, Modern economics completely rejects Smith’s claim that the division of labor is limited by the extent of the market. So it’s far from indisputable, it’s not even theoretically valid.

    Huh? I missed the memo on this one.

    When I studied economics my profs started off with this concept by illustrating it very fundamentally: one person stranded on a desert island can’t divide his labor at all, two can divide their labor to do what each does best, a 747-full can establish a little community with many specialists, although they won’t be manufacturing any smart phones. Each extra degree of specialization with the rising number increases productivity and thus the group’s welfare. Then they went on to historical examples of societies that have had their economic development sharply handicapped by lack of market size (limited by geography, self-imposed policy, whatever) of which I’d say there are still many. (What happens when small closed markets are opened by free trade to the world market? Or for that matter with Mexico and NAFTA?)

    Back in Smith’s original example of the pin factory instead of having each worker make whole pins dividing up the labor so each specialized in a bit of the process greatly increased production — but that required a market sufficiently large to support the factory by buying its output.

    Now this “is not even theoretically true”?

    I can see making an argument that when a market reaches a sufficiently large size the effect diminishes, but that’s something entirely different.

    What am I missing?

    Julian, Today economists assume that firms tend to produce at the lowest point of their long run average cost curve, unless they are a natural monopoly. So diseconomies of scale limit firm size, not the extent of the market.

    That too seems to be something entirely different.

  38. Gravatar of Julian Silk Julian Silk
    25. April 2014 at 05:46

    Dear Jim,

    Let me try to make a neutral response,since I more or less agree with you, but can see what the contrary argument is. For one person, I agree entirely, and for one firm, I agree in essence. The distinction I see being made can best be illustrated by an example, which won’t be exact. Suppose we have Q, which is a tangible and fixed measure of output, market demand. We let q be the industry’s output that can vary, and yes, we can use agriculture, so this is being used broadly. Suppose for simplicity, we just consider 2 types of output, say corn and accounting data. So q, for our purposes will be output of corn. Q would then be market demand for corn, in a given time and place.

    We are interested in the output of accounting data, and are curious to see whether this is sufficient to create demand that will support employment of accounting firms. Call the measure of (variable) accounting output per farm a, and the total sum A. What I understand the argument to be is that the amount of accounting output would be strictly determined by Q and by the costs of production of corn. We produce corn at lowest cost, and the accounting output is just sort of a by-product for each individual farm, and the number of farms will be determined by long-run minimum average cost given Q, and this will determine whether there is a sufficient amount or not. None of the firms is really making a determined effort to optimize over accounting output, or it is so small individually that it doesn’t make any difference. In symbols, with AC as average cost and ~~ as approximately equal, and n the number of identical farms, LR as long run

    AC(q/n, a/n) ~~ AC(q/n)
    Q => n via min LRAC(q/n), so Q => A

    I am trying to consider a case where this is not so, where each farm is actively trying to minimize AC(q/n, a/n) and it does make a difference. It might be argued that this is an obvious problem, that the costs are (relatively) static, and if the added cost of doing the accounting yourself is greater than the cost of hiring out to accountants, the firms will hire out. What I saw with my own argument is that this not so simple at all. Things fluctuate a lot, and it is a real question whether you include fixed capital at all in your calculations if you are a farmer. It is a difficult thing to work out, at least for me. What seemed more likely was that the decision was not made by AC(q/n, a/n), but VAC(q/n, a/n), where V is variable, since the calculations involving capital didn’t seem relevant.

    So there do seem to be differing views in this, even in the case of the most purely competitive case possible, and it is a matter of specifying what we mean by the technology and market.

  39. Gravatar of Julian Silk Julian Silk
    25. April 2014 at 05:50

    P.S. I obviously meant to have the quantity supplied by the market for accounting to be a, and the (fixed) market supply for accounting be A, (given Q), so individual output per farm would be a/n.

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