Methodology and the Young Economist

George Stigler, a man I am fond of reading and putting in goofy glasses on my banner, once said that economists should only do methodology once, when they are old and reflecting back on their career (at least I believe he said it: I cannot find the quote). Peter Boettke argues that Stigler was off by one. An economist should also do methodology early in his career when thinking of the type of economist he wants to become. I agree with Professor Boettke. Sorry, George.

In many ways, this year has been my full-fledged attempt at understanding and discovering the type of economics I want to do. In my coursework at Barcelona, I am experiencing a fairly typical introduction to Samuelsonian economics. Maximize, maximize, and then when done, maximize again. This is my first true exposure to this one particular method and the experience has highlighted some of the costs and benefits.

I am trying to conduct methodology outside of the classroom, too. Slowly, I am working my way through three different methods of basic economics with Rothbard, MWG, and Stigler- using the man’s book to go against his professional advice. I know that next year in my PhD it will be more difficult to take the time and think about these big picture questions. This year has clarified the type of work I want to do and the type of program I want to attend (more on this in the coming weeks). Continue reading

Well Put My Friend

From page 24 of Alchian and Demsetz’s 1973 article “The Property Right Paradigm”-

If private rights can be policed easily, it is practicable to resolve the problem by converting communal rights into private rights. Contrary to some popular notions, it can be seen that private rights can be socially useful precisely because they encourage persons to take account of social costs. The identification of private rights with anti-social behavior is a doctrine as mischievous as it is popular.

The instability inherent in a communal right system will become especially acute when changes in technology or demands make the resource which is owned communally more valuable than it has been. Such changes are likely to bring with them harmful and beneficial effects which can be measured and taken account of only by incurring large transaction costs under the existing property right structure. In such situations, we expect to observe modifications in the structure of rights which allow persons to respond more fully and appropriately to these new costs and benefits. The coming of the fur trade to the New Continent had two consequences. The value of furs to the Indians increased and so did the scale of hunting activities. Before the coming of the fur trade, the Indians could tolerate a social arrangement that allowed free hunting, for the scale of hunting activities must have been too small to seriously deplete the stock of animals. But after the fur trade, it became necessary to economize on the scale of hunting. The control system adopted by the Indians in the Northeastern part of the continent was to substitute private rights in land for free access to hunting lands.

Property rights and how they are defined have very different implications under certain situations. Sometimes social pressure can mitigate the problems of communal living. However, this is not likely to hold up well in times of drastic change or once social pressures fade.

Total Demand is a Forgotten Economic Tool

biden demands his money

Total demand is a useful tool for thinking through economic problems. Unfortunately, modern textbooks drop it completely. Searching through MWG, baby Varian, real Varian, Hirschleifer, David Friedman’s Price Theory, and McCloskey’s Applied Price Theory, I find no reference to this concept. It could be mentioned in passing in one of these books, but I did not find it today nor notice the idea when I have read through these books in the past.

When I say total demand, I do not mean the demand of all consumers added together. That would be total consumer demand. I mean TOTAL demand, the demand of all people and not just those economics define as “consumers.” Most authors do not see a difference, because they make the shortcut of dividing the population into producers and consumers. That division has many benefits, but it also has costs. The loss of total demand is one downside.

While I do not blame those authors for cutting the concept (book space is limited), I would like to elaborate on total demand here on the interwebs without space constrictions.

Producer Demand?

The difference between total demand and total consumer demand is the producer demand. Wait, I thought producers supply, not demand. Again, econ often works in this dichotomous world. Producer demand is obvious from a simple point, producers do not sell at any price. Continue reading

Human Capital Investment, Another Boom/Bust?

Austrian business cycle theory (ABCT) received a lot of press due to the recent economic realignment (I’m not sure what to call it since any title presupposes an explanation).

Austrians are different in their explanation of the business cycle. Clearly, Austrians emphasize words like malinvestment, boom, bust, or artificially lower interest rates. Unfortunately, most of these ideas are foreign to your average economist, at least in the way that Austrians use them.

This is because the underlying explanation of ABCT is Austrian capital theory. The Austrian emphasize the structure of production. Growth in capital investment cannot be easily reversed when these investments turn out to not be profitable. There is not blob of capital, K, and there is no instantaneous corrects.

The difficult correction explains the fluctuations in output. Always, capital is the underlying mechanism. This is the unique contribution of Austrian theory to macro, as I tried to show in an undergraduate project of mine on Austrian Business Cycle Theory and the Panic of 1907.

Unfortunately, most economists after Frank Knight assume away capital theory. Either capital does not matter or the changes come from outside of “the system.” Continue reading

Entrepreneur and the Firm from an Austrian Perspective

Girl Scouts (the firm) allow entrepreneurship from within. This girl was aware enough to camp outside of a marijuana dispensary.

Firm theory is an awkward field for economists. Firms are inextricably linked to markets but utterly unlike markets. Economists believe they are excellent at explaining how people react to incentives in markets. Economists are not as comfortable analyzing command structures. Firms represent an odd middle ground.

This is why firm structure is a relatively understudied field for economists. Economists can design the most complex auction system that satisfies X,Y,Z. Great, but when is the last time you participated in an auction? That is not to say auctions and auction theory is not important, but for the average person, firms are a huge part of their lives. One would think firms would be much more important to economists. Unfortunately, they are not.

For many economists, the firm is a black box. Inputs go in (duh, its in the name) and outputs come out. Markets take over from there. Anything more explicit than that is beyond the scope of economics and belongs in the realm of management or business theory. You know, that soft gushy stuff, not the hard science of economics. Continue reading

Welfare, Surplus, and Partial Equilibrium

I don’t get welfare analysis. I don’t. If you do, please let me know.

In posts on Stigler, MWG, Rothbard, and Buchanan, I have questioned the use of welfare analysis in economics. I can regurgitate the expressions that welfare economists use, but the supposed benefits of the model confuse me. That’s why I am appealing to the brighter minds online.

The standard picture is below. In any market with a market-clearing price, P, there are certain consumers who would pay more if they had to. How do we know they would pay more? Stop asking stupid questions. We know everything. Well, we assume we know everything about everything that the person wants, that’s how. OK. Let’s ignore that problem for now.

The most willing person is at point A. He would pay A dollars, but only pays P. Lucky him. Therefore, he receives a “surplus” of A minus P dollars.  This approach similarly holds for producers. There is someone who would be willing to sell at price E. Instead, he sells at P and gains P minus E. Big money.

The gap in dollars is some sort of “welfare”.  For this post, I’m not even worried about the comparison between dollars and utility here. I will act like a conversion between dollars and utils exists- we can’t reject all premises at once. Continue reading

Stigler Chapter 4: The Theory of Utility Part 2

Stigler spends a long time developing utility theory. He claims that abstract utility with its questionable foundation is a useful tool, because of its predictive power. Though the foundations are not great, the results justify it. Stigler spends the rest of chapter four showing off the power of utility theory.

Consumer Behavior

In order to test the predictive power, we obviously need to make some predictions from our model of utility maximization. Stigler sticks to mostly graphical predictions that involve reaching the highest indifference curve that is still within the consumer’s budget. The graphs allow economists to do comparative statics. If one aspect changes, how does that affect the consumer’s bundle?

One type of change is variations of income. On a graph, this corresponds to a shift of the budget, illustrated below. Normally, when people are richer they consumer more of a good, hence normal goods. Other times, when a consumer is richer, he consumes less of this good. The classic examples are ramen and potatoes. As college graduates start making money, ramen consumption declines. These are inferior goods.

While not a formal prediction, the outline of utility theory’s predictive power is starting to form. This model of normal and inferior goods suggests which types of goods will increase with wealth. Inferior goods convey the idea of “buying because it is cheap.” This is simply a definition, but it clarifies the thinking. Continue reading

The Role Of Political Economist

After solving problem sets, which require assuming the role of a ”social planner” for a society, it was refreshing to read this from Pete Boettke-

The task of the political economists is to assess alternative institutional arrangements with respect to their impact on the ability of free individuals to realize peaceful social cooperation and productive specialization.  This does require mastery of the technical principles of the discipline of economics, which not everyone can possess.  But with those tools in their possession, the economist still does not have any claim to privilege position in the democratic decision process that constitutes collective action.  All he can do is offer his proposed reforms as hypotheses to be tested in the public conversation.  He can try to persuade his fellow citizens of the value of his perspective, but he has no expert claim to impose his solutions on the body politic.  Buchanan’s work is both a counsel of humility while also being a cause for hope that reform can improve our situation.

We economists must stay humble in our role as observers of society. We are certainly not social engineers or social planners with any advanced understanding of how to manipulate people within an economy.

Why Are The Models Wrong?

It’s easy to say our economic models are wrong. It is even easier to say the other guy’s economic models are wrong. Nick Rowe is asking the more important question, “why are our models wrong?” We only learn through that question.

Nick writes:

The most important thing I have learned from the data over the last few years is that inflation targeting does not work as well as I thought it would. The most important thing I need to figure out is why inflation targeting doesn’t work as well as I thought it would. Inflation targeting does not separate real shocks from nominal shocks as well as I thought it would. But I don’t really know why inflation targeting failed to separate real from nominal shocks as well as I thought it would.

Economists have not fully disentangled the differences between nominal shocks, generally blamed on bad monetary policy, and real shocks, generally blamed on technology.

Real shocks are unlikely to stop. However, for a while, economists hoped that real shocks would not turn into nominal shocks by wise inflation targeting. Now wise NGDP or NGDPL targeting will prevent nominal shocks from becoming real.

My own impression is that the idea of separating the nominal from the real is doomed from the start. Money is too important in economic planning to be passive in an economy. Most economists would agree with me on this, although Ed Prescott remains strong. Money is also too complex to be managed by the Fed. Most economists would not agree with me on this.

However, until economists understand why our models and understanding of money are wrong, we are navigating blindly (or at least in the fog) and the Fed seems doomed to turn nominal into real and real into nominal for the foreseeable future.