WorldSys: Austrian Home Study Course, week 21

READINGS: Chapter 9 of Robert Higgs’s Against Leviathan, ‘Private Law’ chapter of Bob Murphy’s Chaos Theory

1 Is it reasonable to require that a medical product be completely safe?

No, all any certifying agency can hope to do is ensure that medical products are as safe as possible and that the manufacturer is not making bold, erroneous claims about its efficacy.

2 Describe the history of the FDA.

The FDA was established by the Food, Drug, and Cosmetic act of 1938 for the purpose of certifying that food and drugs weren’t dangerous, a mandate which was extended in 1962 to include requirements for proving a drug’s efficacy. In 1976 the agency gained regulatory powers over medical devices in addition to drugs.

3 What are some of the typical activities of the FDA

They approve or deny the performance of clinical trials for new drugs and devices, regulate product information, monitor manufacturing practices, and enforce requirements that companies monitor and report on products after their introduction to the marketplace.

4 Describe the incentives of the FDA when it comes to approving a new drug.

Suppose a new drug is either safe and effective (SE) or isn’t (NSE) and that an FDA reviewer can either approve (A) a drug or not (NA). The only two scenarios in which a problem will arise is NSE/A, in which an unsafe drug is sent to market, or SE/NA, in which a safe drug is restricted from the market.

As far as incentives go the reviewer is much more likely to be nailed to the wall for NSE/A than for SE/NA, because in the former case there will actually be a drug on the market which people can recognize and point to. In the latter case the drug simply never appeared, and it’s much less likely that someone will pore over FDA data and notice that a good product failed review and the public was therefore deprived of its use.

The official, therefore, is better off being very, very cautious about handing out approvals. Rather than using common sense and his best judgement he will instead refuse to approve a product unless there is damn-near no chance at all he can later be blamed for its failure.

5 How does Higgs evaluate the success of the FDA in providing safety?

Very poorly. While no one is sure how many lives have been lost because the FDA held up development of life-saving drugs there is reason to believe it’s a solid order of magnitude greater than the number of lives saved by preventing dangerous drugs entering the market.

An unsafe drug would almost certainly be pulled from the market as soon as it became widely known that it was unsafe. But no one ever knows about the absence of a drug held up in the FDA’s Byzantine regulatory proceedings. Every year that the safe drug is not allowed to come to market the death toll rises and goes on rising.

And this doesn’t account for the fact that human beings are wildly divergent in their appetite for risk. Many people would be fine taking an experimental drug with little or no knowledge of its likely side effects, while others will be reticent until a comprehensive decade-long study on the matter has been published. Every bit of this heterogeneity is simply ground under by the FDA’s blanket protocols.

6 Why does Higgs say that “more than health is at stake” on this issue?

Because the existence of the FDA and the scope its breathtaking powers is tantamount to declaring American consumers to be children not capable of weighing risks and making their own decisions. The moral arrogance of this stance can scarcely be exaggerated.

7 How does name brand recognition allow for safer products?

There will be serious consequences to a company’s reputation if it allows one of its products to kill people. Even if it winds up somehow not being the company’s fault it might never again recover its standing among consumers.

8 Describe the function of intermediaries in providing consumer protection.

Over and above the FDA there are now a number of entities intervening betwixt consumer and drug company, including “…prescribing doctors, health-maintenance organizations, and hospital formularies…” which add extra layers of protection to the consumer.

9 In the present system, how do unions and government licensing restrict service and raise prices? In a free society, how might trade associations offer consumer protection?

Unions are notorious for subdividing tasks in ridiculous spread-work schemes, such as those cases in which plumbers aren’t allowed to remove the tiles around a toilet because that is the province of tile layers. It probably doesn’t take much to see how these redundancies and inefficiencies raise prices. Licensing requirements, while perhaps sensible at first glance, wind up involving vastly more schooling and training than is often necessary.

10 Describe the role of insurance in medical malpractice in the current system.

Insurance in the current system is badly distorted by decades of government meddling and mandating. Insurance companies have to pay for things like routine check ups which would otherwise be more sensibly paid for out-of-pocket after services are rendered, and it is often difficult to get an accurate itemized list breaking down the costs. This means both that people are more careless in their consumption of medical services (because they aren’t paying for them) and also unable to shop around for the best deal (because the prices aren’t easily attainable).

Contrast this with auto body work. If you want an oil change, you walk into an establishment and ask for an oil change, which will usually run something like $40. If you ask the price, you’ll be told, and if it isn’t to your satisfaction you can go elsewhere. This puts a cap on how expensive an oil change can be.

If auto repair were treated like medical care then oil changes would be routed through insurance companies and cost $400 dollars because there’s neither incentive nor mechanism for cost control.

11 Describe the possible role of insurance in air travel in a hypothetical libertarian society.

Passengers, wanting some hedge against the possibility of their plane crashing or malfunctioning in some way, will require their airlines to sign a contract to the effect that if there is a problem the airline will pay some pre-determined amount of money to the claimant.

12 Wouldn’t private safety inspectors be susceptible to bribes by big corporations.

That’s not inconceivable, but the damage to reputation that would ensue should anyone get wise to these maneuvers should suffice to dis-incentivize bribery. It wouldn’t take long for contractors to realize that the inspectors of x agency are being bribed by Big Cement before they’d refuse to use inspectors of that agency.

Worse: bribes are a constant fact of life in the prevailing public-sector system, so this can hardly count as points against the hypothetical system being described.

13 If the entire world became a bastion of private property and free enterprise, would consumer protection standards necessarily be uniform in every area?

No, they would likely vary by region.

14 In the interview, Murphy erroneously referred to “Underwriters Association” and their symbol, “UA”. Which certification organization did he actually have in mind?

Underwriter’s Laboratory.

WorldSys: Austrian Home Study Course, Week 20

READINGS: Chapter 4 of Gene Callahan’s Economics for Real People; Chapter 5 of Holcombe et al.’s Fifteen Great Austrians (a chapter on French economist Frederic Bastiat)

1 What is the law of association?

It was the term given by Mises to the broader application of the ‘law of comparative advantage’ to all human cooperation, on which more below.

2 What is the law of comparative advantage?

David Ricardo’s famous ‘law of comparative advantage’ states that it is still in the best interest of two people to divide labor even if one of them proves better at everything than the other. The superior person should specialize in whatever they are most best at and allow the inferior person to specialize in something else, then trade their effort.

3 If U.S. workers are more productive than Mexican workers in every good and service, will the U.S. be hurt by trade with Mexico?

No, for the reasons detailed above. Even if Americans proved better at manufacturing everything they still can’t actually manufacture everything, so it is in everyone’s best interest to let Mexico handle some of the manufacturing.

4 Suppose U.S. workers can make either 2 TVs or 10 radios per hour, while Mexican workers can make either 1 TV or 7 radios per hour. Which nation has the comparative advantage in radio production?

Mexico. Their comparative advantage lies in whatever they are comparatively best at producing, not absolutely best at producing. In this example U.S. workers are better at making both TVs and radios, but they are comparatively better at making 2 TVs — that is, they are most better at making TVs.

So let the Mexicans make radios and trade with them!

5 Continuing with this example, if we only consider unfettered trade between U.S. and Mexico, describe the likely flow of goods (I.e, describe the pattern of exports and imports for each country with respect to these two goods.)

I imagine that firms in the U.S. would make vastly more TVs than they needed and send them to Mexico in exchange for Mexican-made radios.

6 Should the U.S. government lower tariff barriers only if other governments agree to do likewise?

No, the advantages accrue to freer economies regardless.

7 What was the subject of Bastiat’s The Law?

The proper and necessary role of government in upholding worthy laws. The last adjective is imperative — senseless or outrageous laws cannot be upheld indefinitely without bad consequences. The state should therefore restrict itself to the essential function of defining and enforcing only those laws that prevent force and fraud.

8 What was the subject of Bastiat’s Economic Sophisms?

This work has been described as “…the most complete case for free trade ever constructed up to that time…”, wherein Bastiat applied concepts like the law of comparative advantage to argue forcefully for trade between nations. Drawing a historical connection between barriers to this practice and war Bastiat admonished his readers that one of the best ways to stop armed conflict is to ensure trade is ongoing.

9 What was the subject of Bastiat’s Economic Harmonies?

It was an answer to the claims made by Marx in Das Kapital to the effect that the profits of the capitalists necessarily come at the expense of the workers.

10 Describe Bastiat’s famous essay, “The Candlemaker’s Petition.”

Bastiat ridicules state-mandated protection of domestic industries by describing a fictional account of a Candlemaker’s guild petitioning to have all cracks and windows sealed off to prevent the interference of a ruinous competitor: the sun.

11 Why did Bastiat (satirically) recommend that French ships dump their goods after leaving port?

It would guarantee a ‘favorable balance of trade’ for France because it would prevent the vessel from selling its goods at a profit, buying other goods for the return trip, and then importing them. By sinking the vessel immediately after its left it has frozen the whole economic picture at a rosy frame containing only exports.

WorldSys: Austrian Home Study Course, Week 19

READINGS: Sections from Murray Rothbard’s What Has Government Done to Our Money, Henry Hazlitt’s Economics in One Lesson, and Lew Rockwell’s The Economics of Liberty.

1 What are the functions of a bank?

In Rothbard’s vision banks act as warehouses storing big piles of gold on behalf of depositors. The banks might issue gold-substitute certificates so that large transactions don’t require physically moving gold around, but otherwise they would do little in the way of investing or speculating (except, one assumes, in those cases when the bank makes clear upfront that they intend to do so and gets advance consent from depositors)

2 How does the existence of banks encourage saving and investment?

With banks around you have a safe place to store money long term. If you have to keep piles of gold in your house or buried in your yard, you’ll be less incentivized to accrue large amounts of it because it’s a hassle to guard and organize and also takes up a lot of space. Not so with banks.

By analogy, we can say that banks encourage saving and investment in the way that gyms encourage exercise. There’s nothing stopping people from doing push-ups or even building an entire workout facility in their home basement, but that places hurdles in your way which don’t appear if you just go somewhere else to workout.

3 What is fractional reserve banking?

Fractional reserve banking occurs when banks only retain a small fraction of total deposits in reserve. So if bank A has $1,000,000 in deposits and keeps all $1,000,000 in its vault, it’s just a money warehouse, but if bank B has $1,000,000 in deposits and loans out all but $10,000 of it, it is engage in fractional reserve banking.

The latter approach has all sorts of potential dangers, most obviously being the possibility of many depositors asking for their money simultaneously and precipitating a ‘bank run’.

4 What is central banking?

A system in which an often nominally private bank will be closely intertwined with the government and enjoy state-backed monopoly on issuing currency. In the United States the system of central banking began with the Federal Reserve Act of 1917, which established our central bank and set up various provisions. Among these, for example, is the fact that all banks must keep a fraction of their reserves in deposit at the Federal Reserve — they can’t just keep gold reserves in their own vaults.

Central (and sometimes even private) banks are afforded the privilege of suspending specie payments; that is, they can refuse to redeem bank notes when their depositors come demanding their deposits back. This is a big part of why there were economic crises even prior to the instantiation of the Federal Reserve.

5 Is government oversight necessary to ensure sound banking?

If anything, government involvement in the banking sector just introduces more problems and distortions in the incentive structure. In a truly free banking system each bank would be constrained by a handful of factors: the narrowness of its own clientele, the narrowness of the clientele of the whole banking industry, and the overall confidence of the clients in their banks.

So if a single bank begins drastic inflation it will lose the supports of its patrons, who will then move on to another bank. As with any other business banks would be compelled to provide the product and service most demanded by the public.

Now let’s examine how government oversight has changed this picture. By gradually pulling society away from using gold and silver and toward using paper money the government has made inflation possible at a scale inconceivable before; by allowing for the suspension of specie payments the U.S. government made it possible for a nominally private banking sector to precipitate numerous economic crises throughout the 20th century. Of course the establishment of the Federal Reserve in 1913 was meant to head off these swings, and it has accomplished nothing but to profoundly exacerbate them.

All in all it looks to me as though banking, like most things, should be left to the private sector.

6 Why is the government interested in controlling the banking system?

Such control affords the government a fair bit of power in the form of being able to manipulate both the money supply and the over all level of inflation in the economy. And If a government has enough control over the central banking system it can go off the gold standard, effectively removing the last check on its power.

7 In what sense can banks “create money” by making loans?

They can simply write checks for assets against their reserves. If there isn’t a gold standard this is relatively straightforward — a central bank can buy a $1000 asset by writing a cheque for $1000. Obviously if this is taken too far too fast then the resulting inflation could cause the economy to spiral into depression, but if used judiciously then why shouldn’t a bank simply declare itself to have more of the baseless green pieces of paper floating around?

8 Wouldn’t banks lose money if they held 100 percent reserves?

No, they would charge fees for handling and storing money like any other warehousing operation. It’s conceivable that such banks in the free market might work out some sort of investment vehicle to be funded with depositor money with the depositor’s consent, in which case you’d have <100% reserves without the nightmare of ultra-leveraged fractional-reserve banks.

9 Don’t high interest rates slow economic growth?

In some ways and in some circumstances. The Austrian view of interest rates is that they are a kind of price, an exchange rate between current and future dollars. This price might be prohibitively high and thereby discourage investment in a manner similar to the way in which high startup and overhead costs might discourage someone from opening a capital-intensive business on credit. But the point isn’t simply economic growth at all costs, it’s sound, sensible, sustainable growth which steadily enlarges the pie for everyone.

That having been said it’s hard to know whether or not a high interest rate set by the free market would actually slow economic growth because other things like regulatory burden and regime uncertainty would be less of a problem in the absence of state meddling.

10 Should the government give (or guarantee) low-interest loans to farmers and other important groups?

Look at it this way: almost by definition the government only lends to those whom individuals that had to risk their own funds didn’t think were safe bets. Armed with this insight alone we can probably conclude that the government shouldn’t be providing loans to such people with taxpayer money.

But we can expand this analysis and ponder the consequences of taking from one group of people to loan to another; just as we have to avoid the broken window fallacy, we must avoid the isomorphic ‘awesome government loans to poor farmers whom other people considered an unsafe bet’ fallacy (for which we really need a better title).

When taxpayer funds are diverted to beet farmers to buy tractors they are not loaned to another group, used on public works projects, or (preferably) returned to private individuals with a little note that says ‘sorry I robbed you.’ While we may never see the gap created by these non-ventures, it still exists, and we cannot ignore it for the sake of focusing on the spike in capital-goods ownership in the beet industry.

We needn’t stop at funds, though: the number of tractors is finite, and if the government is taking finite money and loaning it to farmers to buy one of the finite number of tractors no one else can buy that tractor. And government lenders needn’t pass the same rigorous tests as private lenders. A successful private lender must repeatedly exercise his judgement and risk his own funds with each transaction; a civil servant does not.

The distortions keep piling up.

11 Does saving cause business depressions?

No, it is only by saving that one can gain the funds required to invest, and only investments of this sort are what allow businesses to expand their stock of capital goods. It might conceivably be argued that if a large enough fraction of people simply buried their cash in their yards a depression might ensue. But the burden of proof is on them to demonstrate such conditions exist, because as far as I know no one ever saves money in this fashion.

As Hazlitt points out ‘active saving’ — putting your money in a bank, or investing it — is really just another, longer-term form of spending.

12 How does saving lead to capital accumulation?

People saving money and loaning it to businesses so that the businesses can buy capital goods.

WorldSys: Austrian Home Study Course, Week 18

READINGS: Sections two and three of Murray Rothbard’s What Has Government Done to Our Money?, Chapters five and nine of Gene Callahan’s Economics for Real People.

1 What are the disadvantages of barter?

The two biggest are ‘indivisibility’ and ‘lack of coincidence of wants’. If my most valuable possession is a plow and I want to exchange it for several different things I can’t break it into pieces to facilitate the exchanges. I can’t give one handle to a farmer for some eggs, the blade to a tailor for a shirt. The plow is only value in whole, and either I find someone who wants to trade one plow for the five or six things I want, or I go without.

Which leads to the next problem. What if no one wants what I currently have? If I possess more eggs than I need and want to barter some away for oranges, shoes, etc., I have to find someone who has those things and wants eggs. If no such person exists, I am out of luck.

2 What is the definition of money?

A medium of exchange chosen for its marketability. In a direct-exchange economy people will eventually find something which is valuable not just for its actual use but because most everyone will accept it in exchange.

3 Is it possible that a wise king invented money?

No, money as such can only develop out of the free market because the ‘price’ of money (i.e. the demand for some commodity as a medium of exchange) must grow out of people’s attempts to engage in ever-more-complex economic activity. It won’t work to simply have a king suddenly declare something money, unless it already had value as a medium of exchange on the open market.

4 What are some qualities that characterize a good money?

First, it gets rid of two big issues of indivisibility and lack of coincidence of wants discussed above. This allows for a far more complicated structure of specialization and production to emerge, which has wide-ranging benefits.

Perhaps greater still, the presence of objective, (relatively) stable, and widely-agreed-upon prices allows businesspeople to perform economic calculations, which enables all sorts of profitable speculation and entrepreneurship.

The coins themselves are durable, portable, fungible, etc.

5 Do money prices measure subjective value?

No, values are expressed in money prices, not measured by it.

6 Can increases in the supply of money make everyone richer?

Of course not. If we gave everyone on Earth $100, then consequently $100 would not go as far and everyone would be in about the same situation.

7 Can increases in the supply of money be completely neutral?

It’s conceivable — if everyone’s holdings increase by the exact same amount and no-one begins hoarding or panic-selling or anything similar.

8 What is the optimum quantity of money?

Whatever is determined by the typical market forces of supply and demand. There is no static ‘optimum’ that an economist can discover at his computer.

9 Why do people give up valuable goods and services for money?

Because everyone else values money as a medium of exchange, which means that money comes in handy no matter what you want to accomplish.

10 In a free society how would money be measured?

I take this question to mean, ‘how would we know how much money there is in a free society?’. Such a society would be on something like a gold standard, and its total volume of money would be equal to the sum of all its cash balances. That is: the amount of money can be learned by adding up the amount that everyone has available to them.

If I’m purchasing apples then we imagine subtracting $3 from my cash balances and adding it to the cash balances of someone else. This quantity would increase slowly because printing physical coins is a good deal more difficult than printing paper dollars.

11 What is counterfeiting?

Manufacturing something that looks enough like money to be mistaken for it.

12 What is inflation? Why is it harmful?

Inflation is an artificial increase in the supply of money, undertaken for example when a government prints money to stimulate demand and end a recession. It is harmful because it dilutes the purchasing power of each dollar.

13 Should government try to stabilize the price level?

No. It’s true that the purchasing power of money would change as demand for it increased or decreased, but this does not mean that governments should have a hand in stabilizing it. To begin with this sort of meddling reliably has unfavorable consequences, and in the system of fiat money under which we currently live we can see that ‘quantitative easing’ and ‘stimulus packages’, if anything, de-stabilize the money supply more than the free market alternatives.

Moreover the fall of prices is a natural consequence of productivity-boosting investments in capital goods. If the government doesn’t let those prices fall then the benefits of such investment cannot accrue to society at large.

14 Would an ideal money have a constant purchasing power?

No, on a free market the price of money would fluctuate freely in response to demand for it.

15 What is Gresham’s Law?

That ‘bad’ (i.e. artificially over-valued) money drives out ‘good’ (artificially under-value) money. Rothbard illustrates this principle with the following example:

Imagine a set of 1-ounce coins is minted and used for several years, resulting in a bit of wear and tear that means they are only .9 ounces now. Everyone recognizes this and trades them at .9 ounces until the government decrees that all coins trade at 1 ounce.

Seeing this state of affairs people realize that it makes sense to use the .9-ounce coins as full 1-ounce coins because they are essentially getting a .1-ounce bonus, and they simultaneously hoard the full coins to be used later.

The result is that the bad money has chased the good money out of circulation.

WorldSys: Austrian Home Study Course, Week 17

READINGS: Chapters 7, 8, 19, 20, 21 of Henry Hazlitt’s Economics in One Lesson, Chapter 7 of Gene Callahan’s Economics for Real People.

1 What is the definition of a laborer?

A person selling his labor on the open market to achieve some end. Put another way: anyone who is not entirely supported by other people is a laborer.

2 What is the difference between rents and wages?

Rent is a typically-fixed amount paid to the owner of a property or a good for its use. Wages are just the price paid to people for their labor.

3 Won’t workers be paid starvation wages without government regulation?

No. If there were some force inexorably pushing wages down then why isn’t everyone paid the minimum wage now? As it happens a relatively small fraction of people are paid the legal minimum, which suggests that things like investment in capital, rises in productivity, and more options in other sectors consistently pushes wages up without government interference.

If this is true then there is no reason to suspect that workers would be paid starvation wages in an unfettered market.

4 What is marginal productivity?

The additional unit of production gained by hiring one more worker (or the unit lost by firing one worker).

5 How can a worker increase his or her marginal productivity?

Learning new skills, earning new accreditations, exploring and mastering the responsibilities of the position to which she aspires?

6 What are the effects of capital accumulation on wages?

Wages will rise, on average and over time. Capital accumulation means that someone (probably an investor-capitalist) is investing in more and better machines, equipment, etc. — this is what is usually meant by ‘capital goods’. It is exactly this kind of investment that leads to increases in productivity, which leads to rising wages. Giving a worker a better machine which allows him or her to work at 120% their previous rate makes paying them more economically justifiable.

7 Do workers benefit from high prices?

It depends. If the product they’re making increases in price it probably means more profits for their firm, more investment in capital goods, more marginal productivity on their part, and eventually higher wages. Of course other workers paying higher prices for the product in question may or may not benefit, depending on their relative situations.

8 Why do professional athletes earn higher salaries than teachers or nurses?

There is vastly more demand for the athlete’s services. There is only one Lebron James, but even so he would have to be a welder if no one were willing to buy tickets to see him play. Sports franchises are willing to pay so much money to have him play because he wins games, which draws crowds, which makes the team money, which makes paying him millions of dollars possible.

9 Do “labor-saving” inventions destroy jobs?

No, more often than not they result in the expansion of an industry which then employs more people or they temporarily free up workers who move to other industries.

10 What is the cause of unemployment?

There are myriad causes of unemployment, but in Hazlitt’s book voluntary unemployment results from machinery increasing production so much that people can afford to work less.

11 Is the value of a good proportional to the amount of labor required to make it?

Of course not; this is the good ‘ol labor theory of value, refuted in an earlier set of answers.

12 Without unions, how would workers bargain with employers?

They could bargain individually, of course, but we must also ask ‘what is meant by a union?’ In the present conversation I think it’s fair to say that a union is considered to be a collective bargaining entity with a spate of legislation behind it giving it privileges it wouldn’t otherwise have. I don’t get the sense that Hazlitt has an issue with the first part of the definition, only the second part. A libertarian would see nothing wrong with employees forming associations to collectively bargain as long as they don’t, say, physically assault employees who abstain from the union and continue to work.

13 Can unions raise wages for union members?

Perhaps, artificially and through political means. But this will not be a “real”, “organic” increase in wages. Wages are a price for labor, and they increase on their own when labor becomes more productive. The way to achieve this is to investment in management, equipment, and training and make each worker more productive. This approach is what made wages among American workers much higher than those paid out to English and German workers during the period in which the strength of labor movements was waxing in those countries.

14 Can unions raise wages for all workers in society?

No. Hazlitt walks us through a fictional example in which six groups of workers form unions and attempt to achieve wage raises. There is no way an economy can sustain the simultaneous increase in hourly earnings for every single group, and in any case it is exceedingly unlikely that all six unions will end up in exactly the same strategic position. So this means that some unions will get wage hikes and others will stay where there are.

Because wages are a price for labor an increase in wages has to be result in an increase somewhere else, probably in the cost of living. Let us imagine that the unions manage to get a raise of 25% on average. Some raises are higher, some are lower, and this is what it works out to on average.

Well, any member of a union that didn’t get a wage raise of this amount or higher now must get by in a more expensive world.

And this isn’t factoring in various secondary effects. Increases in unemployment almost always accompany increase in wage rates, often in the industries that gain the most. This is because workers on the margin — those just barely able to produce $12/hr of value — simply aren’t worth employing any more. Perhaps we could ameliorate this effect somewhat by setting up government relief plans. But where do you suppose the money for that comes from? From the wages of those still employed in the industries that fought so hard for a wage raise. If members of the unsuccessful unions are taxed at a higher rate, they’re now in pretty bad shape, and if members of the successful unions are taxed at a higher rate their wages are reduced, so it’s not clear what all the striking and picketing was for.

Nor can we blithely assume that it will merely be employers and investors who are getting screwed. If a capitalist realizes that the rate of return on her investments is shrinking rapidly and permanently it won’t take long to conclude that her money is best invested elsewhere, or not at all.

15 In a recession, should we raise wages so that consumers can have more money to spend?

There isn’t any way to do this that wouldn’t also raise production costs and eventually raise prices. If we pay toothpaste manufacturers 30% more then it is only a matter of time before toothpaste costs more, ultimately helping no one.

WorldSys: Austrian Home Study Course, Week 16

1 Why does [Peter] Klein characterize the traditional theory of the firm as “a calculus problem”?

Standard economics treats firms as single-agent black boxes obeying the outputs of a ‘production function’, an approach which is appealing because it can be analyzed with the tools of calculus.

2 In neoclassical theory, what is a production function?

It’s simply an equation capturing a relationship between physical output and factors of production (such as capital goods and labor). The production function be used to do things like establish an upper bound on productive capacity given constrains on some input.

3 Mainstream economists have grown dissatisfied with certain aspects of the orthodox approach, but (according to [Peter] Klein) what is the “more serious problem” that they generally overlook?

The more serious issue is that the story of business firms is almost always told from the manager’s viewpoint, even when the manager isn’t the owner. But in cases in which someone owns the business and puts up investment capital they must decide how much authority to delegate to the manager. In an important way, therefore, the owner is the one calling the shots, even if they aren’t much involved in the day-to-day running of the business.

The fact that the mainstream approach completely overlooks the role and function of the owner is a serious problem.

4 What are the “two alternative perspectives” on the firm?

The entrepreneur-promoter perspective sees the firm as an entrepreneur in the Misesian sense; that is, as an entity that purchases factors of production at today’s prices for the promise of an unknown and uncertain reward in the future.

The capitalist perspective sees the owner as a kind of ‘decision-making capital’ and ‘residual claimant’ with the firm’s objective as the maximization of the owner’s profit.

5 What is the Coasian explanation for the sizes of different firms?

Coase realized that the boundaries of a firm were determined in large part by transaction costs. A firm operating in the open market can choose to outsource the production of a certain good, or hire a marketing team, or hire people to do market research, or it can choose to do these (and other) things internally. The are obvious costs associated with taking the former route, but it’s important to not overlook the costs of taking the latter route: people must be hired and fired, performance must be monitored and critiqued, etc.

So, the process of determining at the margin whether a given task is worth doing externally or internally is a decisive driver of firm size.

6 Beginning with the Coasian framework, what two elements does Klein add for an Austrian theory of the firm?

The idea that firms have an entrepreneurial function insofar as they bear uncertainty, and they utilize economic calculation to evaluate the decisions they make. The owners and managers of a business firm fit the Misesian definition of an entrepreneur as an uncertainty-bearing entity that takes risks by acting on a vision which could end in total failure.

7 According to Rothbard, what provides an upper limit to the size of a firm?

To contextualize this question we first note that there is a blind spot in the economics literature around the costs of internally governing a firm. Much effort has been put into analyzing inter-firm transaction costs but much less into analyzing intra-firm transaction costs.

Put another way: why does a given entrepreneur not take one less or one more action in the governance of his enterprise? What marginal calculations are driving firms towards being a certain size?

Rothbard believed that it was the socialist calculation problem rearing its head. We all know that any centralized authority attempting to plan an economy faces a hopeless computational thicket. There just is no way to organize and act upon the information distributed throughout a market without so badly distorting price signals as to make them meaningless. From that point it becomes impossible to make even basic economic decisions.

At a certain size similar issues begin to plague large firms. Rationally allocating resources to different divisions within a company requires an external market generating prices so that meaningful counterfactual comparisons can be made. The size of the firm, therefore, is constrained by the need for external markets for all its goods, allowing for sensible prices between its subdivisions and efficient use of resources.

8 What is the “principal-agent problem”?

The problem of analyzing the relationship between the owner of an enterprise and its manager, roles often occupied by different people. How is it that owners decide on the correct amount of authority to delegate to the manager, how do they monitor managerial performance, etc.

9 How do capital markets, and in particular takeovers, allow shareholders to rein in management?

Incentivizing managers can be a tricky issue because they often wield enormous discretionary power while monitoring and   be tricky. As with other things one of the best ways to ensure managerial discipline is to have an external market for corporate control. That is, allow mergers and takeovers. If a manager underperforms badly enough often enough, eventually someone will buy his enterprise and replace him.

10 What are the four areas that Klein believes an Austrian theory of corporate governance should address?

Looking at the ways in which firms constitute an investment, examining how internal and external capital markets are related, comparing various corporate governance strategies, expanding upon the notion that financiers are entrepreneurs.

WorldSys: Austrian Home Study Course, Week 15

1 In mainstream theory, what is a “perfectly competitive” market?

A purely competitive market is one in which all the sellers of a good are so small that they individually cannot move prices, distribution, or any other feature of the market around. This becomes a perfectly competitive market when perfect information is introduced.

2 In mainstream theory, what is the definition of a monopoly?

An intolerable situation in which there is either one seller of a good or several sellers collude to act as a single agent. Such an entity, it is assumed, has quite a lot of power in the marketplace.

3 What is allocative inefficiency?

Allocative inefficiency is one consequence of allowing monopolies to exist: namely, that any firm in a monopoly position can boost profits by restricting supply. If you are a soap-manufacturing monopoly and people simply must get their soap from you you can maximize profits by producing just so much soap, which prevents the per-unit price from dropping.

4 What is technical inefficiency?

Technical inefficiency is the other dire consequence of allowing monopolies to exist: because the firm has no competition from direct sellers and is thus not incentivized to be as efficient as possible. Over time all sorts of suboptimal configurations creep into the production, distribution, and marketing processes because there is no reason to control costs.

5 Why does uncertainty upset the orthodox benchmark of competitive equilibrium?

Because none of the assumptions we make in attempting to understand competitive equilibrium hold at all. The competitive equilibrium model assumes homogeneous consumer preference and perfect information, when in real markets consumer tastes change moment-by-moment and no one has a crystal ball. It’s hard to see why a model with assumptions this fantastic should be taken seriously at all.

6 What is the Austrian approach to competition?

Austrianism makes no assumptions about perfect information or intransigent consumer tastes. It takes dynamism, change, and limited information as its starting points, and never runs into the absurdities of the textbook model of pure/perfect competition.

7 Name some problems with orthodox monopoly theory.

It draws dubious conclusions from specious comparisons to a model of competitive equilibrium that bears no relationship to the real world. Orthodox monopoly theory does little to justify anti-trust regulation because it gives us no reason to suspect that collusion among firms will be stable or that a single firm could capture monopoly profits by engaging in monopoly prices indefinitely.

8 Couldn’t a monopolist cut prices to discourage rival entrants into his industry?

Sure, but this practice would either be economically unsustainable or the result of a profound increase in productive efficiency. If it’s the former then eventually prices will rise and other firms will enter the market, if it’s the latter then the entire marketplace is getting a good deal and therefore should lighten up a little bit.

9 What is the relevance of economies of scale to mergers among firms?

Mergers needn’t signal anything nefarious, there are perfectly wholesome reasons for multiple firms wanting to integrate. One of these is ‘economies of scale’. An economy of scale is any situation in which a given process becomes easier as productive output increases. Beyond a certain point it might make economic sense to expand into a bigger factor, invest in better equipment, and acquire automation. All of this means savings can be passed on to consumers.

What might not be feasible for one firm might be feasible for three, if they merged.

10 What is the conventional account of the Standard Oil case?

That Standard ruthlessly expanded its business holdings with ethically dubious maneuvering before finally being smashed by the almighty hammer of the State at the height of its monopolistic tyranny.

11 What were the managerial innovations of Standard Oil?

Quoting from Dominick T. Armentano: “[The success of Standard] was the result of shrewd bargaining for crude oil, intelligent investments in research and development, rebates from railroads, strict financial accounting, vertical and horizontal integration to realize specific efficiencies, investments in tank cars and pipelines to more effectively control the transportation of crude oil and refined product…”

12 How did the price of kerosene move following Standard Oil’s rise to dominance?

The prices fell from 30 cents/gallon to a little under 6 cents/gallon over the course of three decades.

13 How many competitors did Standard Oil have in 1911?

At least 147.

14 Why do some empirical studies use profit as a measure of “monopoly power”?

Mainstream theory is that extremely high profits are evidence of restricted competition and monopoly practices.

15 What are some problems with these studies?

They conflate ‘accounting profit’ with ‘economic profit’ (I do not understand the distinction at present and it is not elaborated in the book), the presence oft tariffs, occupational licensing, and other barriers to entry might force a connection between legal and market monopolies that needn’t necessarily hold, and most of these studies are comparing existing profits against a ‘competitive equilibrium’ benchmark which, as we’ve seen, is problematic.

WorldSys: Austrian Home Study Course, Week 14

1 What is the problem with all government efforts to improve on the market?

The only thing which permits a rational analysis of the costs and benefits of a given program or piece of legislation is a market price. Any public institution which wants to intervene in the market must necessarily use made-up numbers in their diagnostics. The longer the government intervenes the less accurate its numbers will become, and the more distorted that segment of the economy will be.

2 How does a mainstream economist use “efficiency” as a  criterion for settling disputes?

In short: if we think of dollars as votes then we declare an ‘efficient’ solution to have been reached when the people who are willing to pay more for one outcome than another actually achieve that outcome.

If I’m willing to pay $100 to set your house on fire and you are only willing to pay $80 to stop me, then the efficient solution is to put your home to the torch.

3 What is the efficiency objection to the free market?

That under a variety of circumstances the market doesn’t lead to efficient outcomes and the state is required to step in with interventions that provide corrections.

4 Why are secure property rights important to society?

For myriad reasons, but within the context of mainstream efficiency analysis we must note that there is a penalty for not vigorously defending property rights. If I know that the only thing stopping my neighbors from burning down my house is my having more funds immediately available than they do, all sorts of otherwise inefficient behaviors become sensible.

I might horde huge amounts of cash instead of keeping it in a savings account (where it can accrue interest) or investing it in a business (where it can move the economy forward), for example. Or I might react to a neighbor’s house party with consternation — is he plotting to have all of his guests donate money to the cause of burning down my house? The more popular he is and the more friends he has over, the more likely it is that he’ll finally have enough to outbid me!

5 What is the relevance of [Gene] Callahan’s example of swimmers reaching the Olympics?

That it is easy to say something has a lot of value to us, but we won’t know until we have to actually pay for it. A lot of children may claim to want to make it to the Olympics, but no one, including them, can know if they’re serious until they consistently make the sacrifices required.

This is yet another problem with ‘efficiency analysis’, because people can claim that something is worth an arbitrarily large amount of money to them, but this doesn’t mean much until they have the option to buy it at that price on the open market and then do.

6 What is a problem with the Pareto criterion?

The Pareto criterion is that a policy should be adopted if it makes at least one person better off while making no one worse off. There are several problems with this. First: in actual society it is virtually never the case that no one is made worse off by a policy. Second, it still isn’t possible to determine how much something is worth to a person unless they have to pay for it. We can’t determine the Pareto-optimum policy simply by asking people what they’d like, because people may not understand how costly a policy will be until they feel it’s effects. But it is precisely this process of paying for what you want at a fair price that is distorted by the government’s interventions into the market.

7 If there were at least one person in society who despised all government interventions, could the State ever effect a Pareto improvement?

Not if the person were serious enough to pay some amount to stop the interventions from being enacted.

8 If at least one person will always object to any change from the status quo, is society always or never at a Pareto optimum?

You could never achieve a Pareto optimum because any move away would make this one person worse off.

WorldSys – Austrian Home Study Course, Week 13

The World Systems Project is going to begin with a thorough examination of Austrian economics, starting with Robert P. Murphy’s outstanding “Austrian Economics Home Study Course“. The plan is to blog my answers to the weekly questions, with posts and book reviews tossed in as I go along. 

It should go without saying that the following contains ‘spoilers’, and if you intend on doing the home study course on your own you might not want to read further.

READINGS: Chapter 15 of Gene Callahan’s Economics for Real People

1 What is welfare economics?

Welfare economics attempts to study the impact of various policies on total, aggregate social welfare.

As you can imagine, Austrians consider this approach to be problematic.

2 What is a positive (negative) externality? Give an example of each.

When a person does something that has an effect on other people we call this effect an externality. If I burn tires in my backyard the smoke and the acrid stench will waft onto my neighbor’s property, creating a negative externality. If, feeling remorseful, I design and build a bleeding-edge air purify which scrubs the atmosphere of the entire neighborhood free of allergens and irritants, that is a positive externality.

From an economics standpoint a problem arises if these positive/negative externalities aren’t baked into the prices of the relevant goods and services. If my shirt factory is polluting a river and I don’t suffer a penalty then I’m producing more than the ‘correct’ amount of shirts. The price of making each shirt is a little bit of pollution, but if I bear no pecuniary responsibility for this pollution than I will make more shirts than is warranted, just as I would if I got the fabric for free.

An inverse problem occurs with positive externalities. If I put up the funds to clean the polluted river then there likely isn’t a good way for me to ‘charge’ people for this service. They receive the benefits of a cleaner river without having to pay for them. What this means is that services of this kind, where costs are centralized and benefits are diffuse, are less likely to be provided because it is so difficult to capture the value created.

3 What was Pigou’s policy recommendation in the case of a positive externality?

A state mandate or subsidy.

4 What was Pigous policy recommendation in the case of a negative externality?

Regulations or taxes.

5 Explain Lionel Robbins’s critique of the Pigovian analysis.

Robbins noted that we cannot simply compare utility between people, as Pigou’s analysis requires. There’s no way for me to determine the correct tax rate for a negative externality by saying ‘everyone everywhere suffers -5 utility from +1% air pollution, so we must tax the local factory at .08%’.

6 What is the Pareto criterion of an improvement in social welfare?

Instead, Robbins advocated for using ‘Pareto improvement’ as a criterion for welfare economics. A given policy is a Pareto improvement if it makes at least one person better off while making no one worse off.

7 According to Rothbard, how can the observer draw conclusions about another’s preferences?

In his 1956 paper “Toward a Reconstruction of Utility and Welfare Economics” Rothbard argue that the only way to deduce another’s preferences is by watching him in action. We cannot do it from our armchairs or with fancy mathematical tools, which means the project of determining the correct tax/subsidy for a negative/positive externality is doomed.

8 What is Ronald Coase’s famous treatment of this issue?

Case noted that externalities can be internalized when transaction costs are low and property rights are clearly defined. In the case of river pollution, if the people living along the river have some sort of property right pertaining to it, then the factory doing the polluting will have to compensate them for their suffering, purchase the right to dump pollutants into the river, shut down, pay people to move, or something else.

Coase demonstrated that developing market solutions to externalities problems isn’t a hopeless, intractable problem.

9 If transaction costs are high, is government intervention justified?

No, the solution is still to have the most crisp notion of property rights possible. It might be hard to negotiate settlements for air pollution, given how diffuse the externality is, but if we have worked out exactly what rights people have to the air on their property we can almost certainly have a third party arbitrate the issue and arrive at a fair payout.

10 What is a (so-called) “public good”? Give some examples.

In the standard analysis a public good is a good whose positive externalities are such that there is no way for the free market to provide them, and instead public action through the intermediary of the state is required to furnish them.

Examples include postal delivery, parts, garbage pickup, museums, airports, roads.

11 What is a free rider? How does it relate to public goods?

A free rider is anyone who enjoys the use of a good while letting other people pay for it. Many believe that free riders are the root cause of the impossibility of provisioning public goods by any means except the state. If I build an enormous air purifier I can’t force people to reimburse me for its use; I can’t cut off the oxygen supply if they refuse to pay me. The State, on the other hand, can simply levy a tax and be assured in advance that they’ll be paid for the equipment.

12 What are some problems with these objections to free markets?

To begin with these objections show an astonishing lack of imagination. On more than one occasion economists who have troubled to look they have found that markets develop robust mechanisms for incorporating externalities into their transactions. Once upon a time a standard example of market failures was the fact that beekeepers and fruit tree growers didn’t have a way to avail of each other’s valuable services. Peach trees could be pollinated and bees could eat if only the State intervened to coordinate things. Of course when Steven Cheung actually examined the relevant markets he discovered that these groups had done perfectly well on their own; in fact, by simply looking in the Yellow Pages one can find multiple ‘pollination services’ provided by beekeepers.

Further, the distinction between public and private goods is rather fraught because most goods have some externality. As Walter Block has argued, we are all spared great discomfort when everyone wears socks. So should we subsidize or mandate socks?

13 How could a free market provide public goods? Give an example from the real world.

Because the public roadways in Britain at the beginning of the 18th century could not handle the increased traffic of the Industrial Revolution the National Turnpike Company undertook to build a private roadway financed by tolls. It didn’t take long for factory owners and other sorts to see that their interests were served by linking into this network, and soon a private transportation system sprung up that was the envy of the world.

14 Does mainstream welfare economics smuggle value judgments into (what should be) value-free economic science?

It does. The idea of subsidizing clean energy, for example, is not based on sound economics but on the value judgment that the world should be moving away from fossil fuels and toward solar, wind, etc.

15 Even if the market provided too little of a particular public good, should we expect government to know better?

No. First, the government faces no real incentive to contain costs and stay on schedule. Second, even if they did want to do these things the mere presence of interventionism begins to distort market prices, making economic calculation harder and harder to undertake.

WorldSys – Austrian Home Study Course, Week 12

The World Systems Project is going to begin with a thorough examination of Austrian economics, starting with Robert P. Murphy’s outstanding “Austrian Economics Home Study Course“. The plan is to blog my answers to the weekly questions, with posts and book reviews tossed in as I go along. 

It should go without saying that the following contains ‘spoilers’, and if you intend on doing the home study course on your own you might not want to read further.

READINGS: “Liberty and Property” in Two Essays by Ludwig Von Mises

1 What was liberty in the eyes of ancient Greek and Roman writers?

A privilege granted to an elite few who would rule as an oligarchy.

2 What was a second notion of liberty, held by European princes?

Similarly, the liberty conceived of by European princes was an oligarchic freedom granted solely to a landed aristocracy.

3 What does Mises consider the “characteristic feature of capitalism that distinguishes it from pre-capitalistic methods of production?

Under capitalism it is not enough simply to make products, you must make products with an eye toward satisfying needs. You become wealthy by better serving your fellow human beings. Under most other regimes, including feudalism, monarchy, etc., the road to power is conquest, not production.

Importantly, a capitalist could make a fortune catering to the impoverished masses, whereas most artisans and craftsmen in pre-capitalist eras focused on high-class or aristocratic clientele.

4 In what sense are capitalists, entrepreneurs, and landowners ‘mandataries’ of the consumers?

If you refuse to make things people want they will vote with their dollars to go elsewhere and you will likely go out of business. The factors of production are allocated according to the mandate of the consumer, not a mandate from gods or kings. To continue to be successful you must continue to anticipate, understand, and satisfy consumer needs; it is not enough to have once saved money and invested it.

5 Mises says that representative government may be viewed as an attempt to model political affairs after the market, but that this design can never be fully achieved. Why not?

First, because the market often does cater to ‘minority’ clientele — think of ‘big and wide’ men’s clothing stores that exclusively serve larger men. Second, in the public sphere there is no vehicle by which an individual can defy the will of the majority (except perhaps to simply break laws). In the market anyone who thinks the consensus is wrong is free to open a business and test his presumption.

6 What is the connection between “heretics” such as Kafka, Whitman, and Schopenhauer to private property?

A robust institution of private property made such people possible. If the government owns everything depriving heretics of the means of their survival would’ve been straightforward. As you can imagine, such an arrangement discourages non-conformity.

7 Why are terms such as “chocolate king” inappropriate?

It is literally a non sequitur. A person can only be a ‘chocolate king’ so long as he gives the buying public exactly what they want. He must work tirelessly to improve his production methods, to lower his costs, to expand his offerings, to conduct experiments to see if he can anticipate future demand. he must think about every aspect of his enterprise, from the soil in which coco trees grow, to the color of the wrappers for his confections.

How many kings lay awake at night thinking “would the peasantry prefer I wear a smaller crown? What kind of roads do they want? Have I truly thought of all the possible ways of reducing taxes?”

The answer might not be ‘zero’, but I’d be willing to bet it isn’t many.

8 Why does Mises think the socialist chiefs should have tried to earn a living selling hot dogs?

This alone might be enough to flatly refute their doctrines. Many socialist theorists speak of ‘exploitation’, as though the people in charge are the capitalists, the entrepreneurs, or the businessmen. A few weeks trying to dictate to people what they will buy should be enough to dispel this illusion.

I am inclined to agree with this point. I have met very few working-class socialists who take socialism seriously.

9 Why does Mises think the “one-party principle” is a misnomer?

There is no freedom in being able to choose one single thing. You don’t get a chance in whether or not to fall when you step off of a cliff, and you don’t get a chance to truly vote when there is only one party making every decision (especially when the party makes a habit of liquidating dissenters)

10 How does Mises evaluate the bargain by which Russians gave away their liberty in order to achieve prosperity?

In the communist revolution Russians bargained away liberty in the hope of getting prosperity because communist theory is blind to the connection between the two. In so doing the Russians ensured that they would have neither, as their standard of living under communism was far worse than it was under the freer countries of the west.

11 Why does Mises write, “Government is essentially the negation of liberty?”

Consider a contrast between the ‘chocolate king’ of question #7 and an actual king. The chocolate king, operating in a free market with no barriers to entry, must relentlessly anticipate and serve the needs of his costumers in order to maintain his success as a purveyor of confection. The same is almost never the case with a monarch, whose word is law and whose diktat’s must be obeyed on pain of death.

The chocolate king has no recourse if you choose to disregard him or take up with a competitor. An actual king can throw you in jail or have you killed. The chocolate king faces the ceaseless possibility of a superior competitor arising and better satisfying the market’s needs. Real kings are deposed, of course, but the crown then goes to whoever is better at violence or intrigue, not whoever is better at serving customers.

Government, then, imposes rules through force, and is the negation of liberty. If it subsidizes a school, pays a police officer, or builds a road, it does so with funds taken from someone involuntarily.

12 Does Mises think government is a necessary evil?

No, it is an institution required to prevent warlords or foreign powers from interfering with society. By arrogating the right to use force in a geographic area governments facilitate the smooth functioning of society.

13 Why can’t there be any freedom under a socialist system?

While Mises does not view the government as inherently evil he does see it as inherently an institution that limits freedom. People are free insofar as no one is coercing their decisions, and they are unfree to the extent that another person’s will is dictating their future. Private individuals do sometimes coerce one another, but only government is an institution designed to coerce.

Socialism, therefore, takes the entire sphere of free human choice and subsumes it under the will of the state. It literally permits no freedom at all.

14 Why does Mises say that private property in the material factors of production “is not a restriction of the freedom of all other people to choose what suits them best?”

Those people have a choice in how they use their own time, money, and property. Under a sensible definition of ‘freedom’ the fact that I own a factory or a piece of land does not infringe upon anyone else’s liberty. And if I use these resources to produce a new good or service, everyone else similarly has the right to avail themselves of the fruit of my efforts, or not.

What this means is that it is ultimately the consumer, not the producer, who has final say. An enterprise grows successful by virtue of better meeting a need.

15 What is the “distinctive principle of Western social philosophy,” and what is its connection to liberty and property?

Western social philosophy has had a greater emphasis on individualism than can be found anywhere else. A necessary corollary of endorsing spheres in which individuals are free to make their own choices is the idea of private property — after all, a freedom to speak one’s mind in a society that seizes the property of dissenters is a hollow freedom indeed.

This division of labor and reinvestment of profits in capital goods is what has given rise to the splendor and comfort of the modern world. Individualism and capitalism also gives everyone the greatest chance they have to rise in the world. It is true that some people are born to vastly more favorable circumstances than others, but by and large you’re best bet of making a fortune from scratch is to be born in the freest possible society.