Wednesday, May 23, 2018

Which Economic Nutshell Is Better?

It seems like I'm forever endeavoring to stuff economics into a better nutshell.  Here are two recent nutshells... the first is bigger and more technical while the second is smaller and more accessible.  Which one is better?

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Nutshell #1 (shared here)

Here's Adam Smith's Invisible Hand...

It is thus that the private interests and passions of individuals naturally dispose them to turn their stocks towards the employments which in ordinary cases are most advantageous to the society. But if from this natural preference they should turn too much of it towards those employments, the fall of profit in them and the rise of it in all others immediately dispose them to alter this faulty distribution. Without any intervention of law, therefore, the private interests and passions of men naturally lead them to divide and distribute the stock of every society among all the different employments carried on in it as nearly as possible in the proportion which is most agreeable to the interest of the whole society.  — Adam Smith, Wealth of Nations

Contrary to popular belief, it's not about self-interest, it's about people using their money to communicate what their interests are.  The supply is regulated by the spending signals of countless consumers. 

In Friedrich Hayek's 1945 Nobel essay he reinforced the idea that markets are all about communication...

We must look at the price system as such a mechanism for communicating information if we want to understand its real function — a function which, of course, it fulfils less perfectly as prices grow more rigid. (Even when quoted prices have become quite rigid, however, the forces which would operate through changes in price still operate to a considerable extent through changes in the other terms of the contract.) The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action. In abbreviated form, by a kind of symbol, only the most essential information is passed on and passed on only to those concerned. It is more than a metaphor to describe the price system as a kind of machinery for registering change, or a system of telecommunications which enables individual producers to watch merely the movement of a few pointers, as an engineer might watch the hands of a few dials, in order to adjust their activities to changes of which they may never know more than is reflected in the price movement. — Friedrich Hayek, The Use of Knowledge in Society

Hayek argued that command economies fail because, in the absence of prices, they are unable to utilize all the relevant and necessary knowledge that is dispersed among all the consumers and producers.

In 1954 the Nobel economist Paul Samuelson, who was a liberal, critiqued Hayek's essay by pointing out that, because of the free-rider problem, prices don't work so well for public goods...

But, and this is the point sensed by Wicksell but perhaps not fully appreciated by Lindahl, now it is in the selfish interest of each person to give false signals, to pretend to have less interest in a given collective consumption activity than he really has, etc. —  Paul Samuelson, The Pure Theory of Public Expenditure

Samuelson's basic assumption was that the optimal supply of all goods is entirely dependent on honest signals.  The problem with a good like Linux is that you can benefit from it without having to pay for it.  Let's say that your true valuation of Linux is $40 bucks.  If you only donate $20 dollars to it, you still can fully benefit from it, but you can take the $20 bucks that you saved and use it to buy a nice steak.  The amount you spent on Linux would be a false signal because it would be less than your true valuation of it.  Your false signal on its own isn't so much of a problem... after all... you only cheated Linux out of $20 bucks.  The issue is when everybody else does the same thing.  When everybody's contribution to Linux is a lot less than their true valuation of it, then naturally it's going to be a lot lower quality than everybody truly wants it to be.  Also, there's going to be far fewer freely available alternatives to Linux than everybody truly wants. 

To be clear, the only reason that consumers have the incentive to be dishonest about their true valuation of Linux (a public good) is because they have the option to spend their money on steak (a private good) instead.  If this option was eliminated, then so too would be the incentive to be dishonest.  This was the point that the Nobel economist James Buchanan made in 1963...

Under most real-world taxing institutions, the tax price per unit at which collective goods are made available to the individual will depend, at least to some degree, on his own behavior. This element is not, however, important under the major tax institutions such as the personal income tax, the general sales tax, or the real property tax. With such structures, the individual may, by changing his private behavior, modify the tax base (and thus the tax price per unit of collective goods he utilizes), but he need not have any incentive to conceal his "true" preferences for public goods. - James M. Buchanan, The Economics of Earmarked Taxes

Let me hedge my bets by sharing how other people have explained the idea of individual earmarking...

One strand of this approach-initiated in Buchanan’s (1963) seminal paper-argues that the voter who might have approved a tax increase if it were earmarked for, say, environmental protection would oppose it under general fund financing because he or she may expect the increment to be allocated to an unfavored expenditure such as defense. Earmarked taxation then permits a more satisfactory expression of individual preferences. — Ranjit S. Teja, The Case for Earmarked Taxes

Individuals who have particularly negative feelings concerning a publicly provided good (e.g. Quakers on military expenditures, Prolifers on publicly funded abortions) have also at times suggested that they should be allowed to dissent by earmarking their taxes toward other public uses. — Marc Bilodeau, Tax-earmarking and separate school financing

Imagine if Netflix gave subscribers the opportunity to use their monthly fees to help rank the content.  Would subscribers have any incentive to be dishonest? Nope. This is simply because they would not have the option to spend their fees on things like food or clothes. Subscribers would not have the option to spend their fees outside of Netflix. Therefore, how subscribers earmarked their fees would honestly communicate their true valuations of the content.  The result would be the optimal supply of content. 

The expert economic discussion looks basically like this...

Adam Smith (1776): Consumers should have the freedom to spend their money to help rank goods.
Friedrich Hayek (1945): It's true, the market is the only way to utilize all the dispersed knowledge.
Paul Samuelson (1954): While the market does work for private goods, it fails for public goods.
James Buchanan (1963): Actually, earmarking would allow the market to also work for public goods.

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Nutshell #2 (shared here)


Right now, because of democracy, you assume that congress makes decisions that take my well-being into consideration. My well-being? In the private sector I have to spend so much time and energy going around using my money to inform producers what works for my well-being. I shop and shop and shop. For example, I go to the supermarket and buy some artichokes. In doing so I essentially tell Frank the farmer, "Hey buddy! Good job guy! You correctly guessed that my well-being depends on artichokes! Thanks! Good lookin' out! Here's some money! Keep up the good work!" His behavior benefits my well-being, so I have to use my cash to positively reinforce his beneficial behavior.

Now here you are with the assumption that congress somehow knows what works for my well-being despite the fact that I've never once in my life shopped in the public sector. I've never once decided to give any of my tax dollars to the EPA, NASA, the DMV or any other organization in the public sector. I've never once used my tax dollars to positively reinforce behavior that benefits my well-being. Yet, despite the fact that I've never once shopped in the public sector, congress knows what works for my well-being? Woah. This boggles my mind. It blows my mind. It puts my mind into a blender. Your assumption bears repeating with emphasis... congress knows what works for my well-being despite the fact that I've never once in my life shopped in the public sector. Your assumption is really that shopping is entirely unnecessary. If you truly believe that shopping is entirely unnecessary... then please... don't hide your insight under a bushel. Start a thread here, there and everywhere and say "Hey folks! Shopping is entirely unnecessary! It's a massive waste of everybody's limited time and energy to use our money to communicate what works for our well-being! All we need to do is infrequently vote! And occasionally write our representatives!"

Every democracy has been bundled together with a market. The market, not the democracy, is why these societies have been relatively successful. Societies always work better when we better understand each other's needs... and markets are far better at revealing our needs than democracies are. Our needs aren't simple things... they are incredible complex and dynamic. The idea that infrequently voting and occasionally writing our representatives can adequately reveal our needs is the most harmful idea that has ever existed. But it's not like I can show you all the additional prosperity we would currently be enjoying if it weren't for democracy.

However I can show you the difference between voting and spending. All we need to do is use voting and donating to rank prominent skeptics. Then you'll see the difference between voting and spending and decide for yourself which ranking better reflects your own need for skeptics.

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