George Stigler: Information is Power

It is July 4th weekend coming up. Woo hoo! Some of you will be traveling and doing some mini vacations somewhere. I don’t know about my plans for the 4th just yet, but I know that I am going to try and head out somewhere. As long as I escape the nation’s capital on the nation’s birthday, I’m game. One of the largest costs for any getaway is lodging, and hotels are really darn expensive! I also have to have a budget for my beer, my bathing suit, and some sunscreen since I will roast in the sun. Of course, I can’t leave without stopping by the local barbershop for a fresh cut. All of this is adding up to a lot of costs for a simple summer trip. So there has to be an alternative right?

Lucky for me, home sharing platforms like Airbnb and Homeaway are available, where I can rent out an entire home or apartment for a fraction of the cost of a hotel. Not only that, but I get a home experience as opposed to the hotel life. I’m only needing a pad to get some z’s anyway.

These home sharing platforms have been under fire lately, though. They are facing stiff regulations already in major markets like New York, Santa Monica, and New Orleans. In Washington D.C., a new battle is brewing over how to regulate home sharing. But, why? What’s more is why do we have regulations at all?

George Stigler, a masterful economist took a stab at answering that question and his insights have left a lasting impact on how we view this question to this day.

Businesses have so many different things that they have to take into consideration! Photo take from Sageworks.

The Winner

George Stigler won the Nobel prize in economics in 1982 for “for his seminal studies of industrial structures, functioning of markets and causes and effects of public regulation.”

Initially, he looked at monopolies in the movie industry by looking at block booking of movies. Block booking is where a studio would sell a bundle of films to a theater but the theater could not pick and choose among the movies in the package. Theaters would be forced to take on films that were probably not all that good along with the hits, supposedly paying higher prices. This led the Supreme Court to intervene and end this practice on the grounds that the movie companies were compounding a monopoly by using the popularity of the winning movies to compel exhibitors to purchase the losers. Stigler thought otherwise.

So, he wrote a paper displaying how a theatre would not be forced into a situation where they were paying a higher price. Theaters would not purchase these bundles unless they thought the best movie would bring in enough profit to account for the shitty movies that were in the bundle.

Another topic that Stigler popularized was “information economics” and how it pertains to monopolies and cartels. To Stigler, “information” has a critical role in how markets work. He theorized on how information, or the lack thereof, can create problems for firms that are trying to collude (or compete) when pricing out their goods and services. They do not know whether their competitors are secretly undercutting them. However, that uncertainty could be reduced by spending resources to gather more information. By applying some of these theoretical insights, he could show that collusion is virtually impossible the more firms are in a market. His preliminary dive into information economics paved the way for future Nobel laureates to make some substantial contributions in this arena.

Littlefinger has been able to navigate his way through the political climate of HBO’s Game Of Thrones because of his ability to acquire information.

Stigler Was A Stickler

He wrote a lot about the role of the regulator and the origins of regulations. He believed that regulations were brought on, not by the government, but by the industries themselves. Stigler called this “capture theory”. Capture theory was a fear that the producers in an industry would “capture” the regulating agency, using regulation as a tool to keep their competitors out. This theory and skepticism of regulators put Stigler at odds with the mainstream economists of his time.

Stigler argued that economists needed to study the effects of regulation rather than assume them. He criticized the great economists of the past who had spoken out for and against government regulation without ever trying to study its effects. In trying to promote this kind of discussion, he held a talk with Paul Samuelson to discuss the role of the state in the economic life of the nation.

Economist George Stigler, photo taken from the University of Chicago.

When Stigler challenged economists, they rose to the challenge. Economists, using powerful tools of empirical analysis, have found that government regulation of industries harms consumers, often giving monopoly power to producers.

To illustrate, let’s look at the barbershop I want to hit before going on my vacation. Barbers are partially regulated by mandating them to get a license. The story of occupational licensing has two sides, though. On one side, it can be argued that the purpose of the license is to be able to signal who is qualified to cut my hair. Another argument could be easily made that it is a method to restrict competition, forcing people to spend an inordinate amount of time and money to get permission to enter a field. Think about how crazy this sounds: In Florida, you need 1200 hours of training and 230 bucks to get a barber license. In the same state, it only takes 250 hours of training and 100 bucks to become an emergency medical technician. This is a case scenario where you can see how regulation by licensing can end up actually hurting people.

In a day and age where search costs are low and reputation effects are a huge factor in how people consume goods, licensing does very little to “protect the consumer” or signal quality. Using occupational licensing in fields such as locksmiths, hair braiding, and animal control officers, is rather unnecessary. Illinois, by the way, requires each of these occupations to have a license.

Perhaps the biggest impact was that he forced people both in the profession of economics as well as in the public service arena to think about the costs and benefits of regulation. On top of that, he was a great communicator that wrote and spoke in such a way that was down to earth. He was a model economist, capable of explaining his ideas in a way that could be understood by all.

Sir Arthur Lewis: Progress Always Beats Nostalgia

Donald Trump, the 45th President of these United States, has spoken emphatically about the factories that are running away from the United States and into the arms of Mexico and China. He said “I have visited cities and towns across this country where one-third or even half of manufacturing jobs have been wiped out in the last 20 years.” He believes that the politicians we have elected are responsible for allowing this “disaster” to happen. Factories shut down, leaving cities is a state of disrepair, and utterly destroying the middle class.

While there may be some merit to his claims, there is a different aspect to this story; one the President has slyly left off his angry speeches to the masses.

Sir Arthur Lewis, a development economist, would say that politicians are not the sole reason that factories are closing shop in the United States. Rather, that the factories are no longer necessary as the country is experiencing a turning point.

Sir Arthur Lewis and Theodore Shultz won the Nobel Prize in Economics in 1979. They won the award for their “pioneering research into economic development research with particular consideration of the problems of developing countries.”

Sir Arthur Lewis put his name on the map when he published an article in 1954 entitled, Economic Development with Unlimited Supplies of Labor. It was from this article that he developed what came to be known as the Lewis model. In this model, Lewis combines an analysis of developed countries with the core principles of economics to produce a picture of how countries develop and flourish.

His Work

In his theory there are two sectors; The first sector, the “capitalist” sector, is developed by using up labor from the second sector, the “subsistence” sector. According to Lewis, this second sector is governed by informal institutions and social norms, where producers are not maximizing their profits and workers aren’t being paid their appropriate wages. He develops the model, explaining that in the early stages of development, the “unlimited” supply of labor from the subsistence sector allows the capitalist sector to expand for some time without having to raise wages. Think of how plantation owners made their killings off the backs of slaves.

As a result, the capitalist sector experiences higher returns to capital, which they are then able to reinvest in order to make even more money. With the extra stacks of cheddar that they have accumulated, or the capital stock, the capitalists are able to hire more workers from the subsistence sector. As long as the profits are reinvested and the build up of money does not replace workers, the country modernizes and grows! When the labor from the subsistence sector gets fully absorbed into the modern sector, with increased wages and all, this is known as the…wait for it, the Lewisian turning point.

Has This Happened Before?

Have we seen cases where countries experienced these turning points? Definitely! We need not look any further than the good ole US of A to see this happening. Think back to both of the Industrial Revolutions that took place in our country. In both cases, we saw people moving from agrarian type jobs to manufacturing jobs, which resulted in higher wages for the people that moved into the city to take those industrial based jobs. The graph below shows the time period before and after the industrial revolution. The industrial revolution also occurred in Europe, and it shows in both cases where the people of those countries experienced increased levels of wealth after these Lewisian turning points.

The graph above is often referred to as the “hockey stick of growth.”

The most recent case has to be China (Trump’s favorite country). China has experienced an incredible rate of growth over the past 35 years.

A lot of this growth has to do with the country going through one of these Lewisian turning points, where the country has experienced a shift from an agrarian society to a more industrial one. The result has been increased GDP per capita, or standard of living, for the people of China.

The New American Lewisian Turning Point?

While Lewis’ model was meant to look at the development of poor countries, we can also use it to look at advanced countries as well, because they also continue to develop even when they are at a state of prosperity. So when we look at Trump’s statements about manufacturing jobs, it is only partially true. For over 30 years, manufacturing jobs have, indeed, disappeared from the United States.

The data provided by FRED shows that the percent of US jobs in manufacturing have taken a nose dive, going from almost 22.5 percent to just over 10 percent. If this was all there was to the story, perhaps there would be more merit to the president’s words.

However, I would argue that the United States is in another Lewisian turning point. Here is why: The United States has the service industry — including finance, insurance, and healthcare — which is more lucrative than manufacturing. The criss-cross is a clear and telling depiction of this transition.

The data above shows how the services sector has taken an increasing share of representation of the US economy. While manufacturing represents a smaller portion of our economy, 12 percent of the GDP in 2016 is still a multi-trillion dollar industry. It’s foolish for President Trump to assume that the path we’re on will end with no factories or manufacturing jobs. We will always have more manufacturing jobs than none due to the fact that we have a comparative advantage in producing some goods over other countries. In other words, it’s still cheaper to produce some goods here than overseas.

Another way of looking at the disappearing jobs is by looking at how productive our workers have become.

Output per worker has been steadily growing over the years, and that is a good thing.

Similar to how service sector jobs replaced many of the manufacturing gigs, the disappearing workers have been replaced by highly productive manufacturing workers. If one worker can now produce the same amount 400 workers produced 15 years ago, it makes no sense to keep the same amount of workers. You’d get rid of some, right?

The End Result

We’ve largely transitioned from an economy based on farmers to one that was based on manufacturing. From there, the service sector has overtaken manufacturing. Now, we are in the midst of transitioning into a “knowledge economy” with the slew of technological advances and global connectivity. Trump’s dismal view of the manufacturing sector and his attempt to “save” it ignores the idea that we may be transitioning into something better. He’s ignoring the Lewis model and the turning points that come with it.

This is exciting! But, no one said these Lewisian turning points don’t have some aspects that hurt. These are just growing pains of a transitioning economy, championed and brought to light by Sir Arthur Lewis.

Sir Arthur Lewis: Photo was taken from Wikipedia

Gunnar Myrdal: The Moral Economist

The rise of the camera phone has allowed us to capture the world in the form of candid videos more than ever before. We get front row seating to the tensions of racial disparity here in the United States. We also get to watch the Middle East and other regions in the world crash and burn as people die due to warfare, diseases, and hunger. All the while, the clash between globalism and nationalism only seem to make things worse. Continue reading “Gunnar Myrdal: The Moral Economist”

Ragnar Frisch: A Love Affair Between Economics and Statistics

On March 24, 2017, the American Health Care Act (AHCA) was pulled from the floor of the House because it lacked the necessary votes to get it passed. Many have claimed to know the reasons for this failure: from Paul Ryan’s inability to handle Congress, to the Freedom Caucus’ avid opposition to the bill. Though, much of the blame is laid at the feet of the Congressional Budget Office’s analysis of the bill. The CBO examined the lasting impact the bill would have on Americans, if passed, such as the number of insured people, the higher cost of premiums, and the negative effect on the federal budget.

How were they able to determine those relationships? They had an advanced econometric model that owes in part it’s existence to Dr. Ragnar Frisch.

Ragnar Frisch surrounded by research. Taken from University of Oslo website

Although Ragnar Frisch was a doctor in mathematical statistics, he changed the game in economics. A list of his accolades: the father of econometrics, the father of the current methods of macroeconomic studies, and one of the first two Nobel Prize winners in Economics. He and Jan Tinbergen won the first year the Economics Nobel in 1969 “for having developed and applied dynamic models for the analysis for economic processes.”

So that’s a little vague. What they’re referring to here is Frisch’s contributions to both econometrics and macroeconomics. Frisch essentially founded econometrics, even coining the term “econometrics” itself. We can all thank him for making statisticians out of economists. He also helped found the contemporary ideas of macroeconomics and studying the movement of the economy as a whole. This was most popular in his discussion of the business cycle.

Picture from RomEconomics: “How economists like Frisch see the economy.”

When Frisch was writing his famous paper, contemporary business cycle theory had explanatory variables for the booms and busts of our economy such as consumption, savings, and production. Frisch saw these variables in his time, but there weren’t enough equations in the model to calculate the business cycle. So, Frisch brought his mathematics background to bear and created a model that could better predict the ups and downs of business cycles.

Though he made some big moves in the field of economics, he was overshadowed by one of the more famous economists, John Maynard Keynes. Keynes came out with his macroeconomic model at around the same time, and grasped the public imagination much more effectively than Frisch. Frisch had dense mathematical models that spoke on relationships between variables and factors that could inhibit or grow the size of the economy’s booms and busts. Keynes, on the other hand, was a much better writer whose ideas were easier to grasp. In the end, ideas from both of these economists were terribly rough around the edges, but it’s all about selling them. Keynes won the economist popularity contest because he was into “probing what men believe they ought to believe, rather than proving what is true according to abstract methods.”

“Shoot for the moon. If you miss, you’re still in fucking space.” That’s the quote that came to mind after reading through Ragnar Frisch’s ambitions and work. Frisch began his writings in the 1930s as a strong proponent for free markets as the solution to all allocation problems. However, as a result of witnessing the Great Depression and the subsequent rise of the Soviet Union, he became increasingly disillusioned with unregulated markets. The hands free approach in the U.S. brought the economy to it’s knees while the Soviet’s hands-on method helped it become the acclaimed economic superpower in the mid-20th century.

These events, and his support for the Soviet Union, spurred his lifelong ambition of finding every single relationship and variable in the economy to reach the holiest of grails in economics: economic calculation. In his eyes, if we could just perfect the math of economic calculation we could bring markets out of their undesigned, dog-eat-dog, hellscape that constantly fail. Or, as he called it “planlessness.” Even when governments would fail, he would stand true to economic calculation by claiming that the government was practicing “a thoroughly naive and unimaginative form of economic planning.” Or in other words, it’s not that economic planning doesn’t work, it’s just that you didn’t do it right!

Frisch’s contribution to the field of economics was so revolutionary and pervasive that we simply see it today as part of the everyday fabric of economic study. We use econometrics and mathematical modeling in the AHCA, but we also use it in practically every subdiscipline of economics. This plays a major role in regulatory analysis, stock exchange analysis, and nearly all empirical work. Although Frisch pursued the pipe dream of economic calculation, his ideas are still with us today. And, though the saying goes, “We are all Keynesians,” it’s safe to say we are also all Frischians.

Ragnar Frisch. Taken from University of Oslo website

What Will the Future Economy Look Like? Welcome to 2040.

Previously posted on GenFKD.

Our series on the modern economy ends with what lies ahead: the future economy.

Continue reading “What Will the Future Economy Look Like? Welcome to 2040.”