Suppose that an acre of land in Iowa can yield either 50 bushels of wheat or 100 bushels of corn, while an acre of land in Oklahoma can yield either 20 bushels of wheat or 30 bushels of corn.

Which state has the comparative advantage in growing wheat? Which state has the comparative advantage in growing corn?

Suppose the residents of each state consume 200 bushels of wheat and 360 bushels of corn. If, instead of pursuing policies of self-sufficiency, each state specializes in its area of comparative advantage, how many acres of Iowa and Oklahoma farmland are freed up for other uses?

Quite a few people got this right in comments. In Iowa, the opportunity cost of a bushel of wheat is 2 bushels of corn. In Oklahoma, the opportunity cost of a bushel of wheat is 3/2 bushels of corn. Becauses 3/2 is less than 2, Oklahoma is the low-cost wheat producer, which is the same thing as saying that Oklahoma has the comparative advantage in wheat.

For a bushel of corn, the opportunity cost is 1/2 bushel of wheat in Iowa or 2/3 bushels of wheat in Oklahoma. Because 1/2 is less than 2/3, Iowa is the low-cost corn producer, which is the same thing as saying that Iowa has the comparative advantage in corn.

Knowing the comparative advantages tells us, without any further computation, that everyone can be richer if Oklahoma exports wheat and Iowa exports corn. But if we choose to do the extra computation, we see that with self-sufficiency, Iowa needs 7.6 acres to feed its people and Oklahoma needs 22 acres. whereas if Iowa grows enough corn for both states and Oklahoma grows enough wheat for both states, then Iowa needs only 7.2 acres and Oklahoma needs only 20 acres. The remaining acres are available to feed even more people, or to build NASCAR tracks.

(Edited to add: It was pointed out in comments that in the first couple paragraphs of this answer, I said “corn” when I meant wheat and vice versa. This is, I think, fixed now. Very sorry for not proofreading better.)

This example is ultra-simplistic in several ways of which here are two:

• It assumes that the yield in either state is a simple multiple of the number of acres under cultivation—in other words, we (unrealistically) assumed away diminishing returns.
• It assumes that food consumption in each state is fixed, as opposed to varying with price.

Econonerds might recognize that these assumptions are tantamount to assuming that all supply curves are horizontal and all demand curves are vertical.

But do not make the mistake of dismissing the example because of its simplicity. As I tell my students, you can’t understand the hard stuff till you’ve mastered the easy stuff. And as those students progress to more difficult and realistic exercises, they come to realize that the underlying logic remains pretty much inescapable—compute the comparative advantages, and you will discover an opportunity for everyone to gain from trade.

 Print

Share/Save

Hear hear. When someone says “I understand comparative advantage, but in this case it doesn’t apply”, or “I understand comparative advantage but in this case it is overridden by other considerations”, my experience tells me that you can be nearly sure you’re talking to someone who does not in fact understand comparative advantage.

If I were permitted to write a licensing exam for economic commentators, I would surely incorporate a standard textbook exercise or two on this subject. Being lazy, I’d probably lift them from an existing textbook. For example:

Suppose that an acre of land in Iowa can yield either 50 bushels of wheat or 100 bushels of corn, while an acre of land in Oklahoma can yield either 20 bushels of wheat or 30 bushels of corn.

Which state has the comparative advantage in growing wheat? Which state has the comparative advantage in growing corn?

Suppose the residents of each state consume 200 bushels of wheat and 360 bushels of corn. If, instead of pursuing policies of self-sufficiency, each state specializes in its area of comparative advantage, how many acres of Iowa and Oklahoma farmland are freed up for other uses?

Anybody? Bueller? Grove?

 Print

Share/Save

In experimental plays of this ultimatum game, responders tend to reject splits that are substantially worse than 50-50. This is offered as some kind of reproof to the principles of economics. After all, the responder is turning down free money.

But so what? People turn down free money all the time. Just this morning, I saw a $20 bill fall out of a guy’s pocket and I returned it to him. I did that because I don’t like taking things that aren’t mine—a sentiment that’s easy to incorporate into orthodox theory. Likewise, if you put me in the ultimatum game (at least as it’s usually run), I’ll turn down whatever I’m offered, whether it’s 50/50 or 20/80 or 80/20. That’s because I don’t feel any better about taking money from the taxpayers who are presumably funding this experiment than I am taking money from the guy in front of me in the checkout line.

Now, not everyone is as moralistic as I am on this point (as I am not as moralistic as some others on some other points), but most people are not psychopaths, so most people are going to feel at least a little squeamish about taking money nonconsensually from others. Some might be willing to overcome that squeamishness in exchange for a reasonable share of the bounty (but not for a smaller share). That doesn’t mean they’re irrational. Quite the contrary. It means everyone has his price. Just like your Principles of Economics teacher taught you.

 Print

Share/Save

A couple of bullet points from his latest:

• In response to the priorities of Senator John Kyl, Krugman writes: “So $30 billion in aid to the unemployed is unaffordable, but 20 times that much in tax cuts for the rich doesn’t count.” Oh, for goodness’s sake. $30 billion in aid to the unemployed might or might not be good policy and 20 times that much in tax cuts might or might not be good policy; that’s beside the point here. The point is that these are quite entirely separate issues and one’s position on the first need not dictate one’s position on the second. Aid to the unemployed is costly. Tax cuts are not. Didn’t I just say this?
• And Krugman goes on: “On paper, solving America’s long-run fiscal problems is eminently doable: stronger cost control for Medicare plus a moderate rise in taxes would get us most of the way there.” In the words of a certain Nobel laureate, this passage makes me want to stick a pencil in my eye. It’s like saying “Getting my family budget under control is eminently doable: fewer caramel macchiatos plus more trips to the ATM would get us most of the way there”. Yes, cutting spending will help. No, moving money around won’t.

  Like it or not, the government can always raise taxes and therefore always has a claim on your wealth. You are the government’s ATM. Making a withdrawal today (by raising your taxes) means there will be less available to withdraw tomorrow. Raising taxes does not make the government richer. Didn’t I say this already?

• Yes, I know, a bunch of silly Republicans (along with a bunch of silly Democrats) have gone around saying the deficit is all that matters, which implies that a tax increase can offset a spending increase. Yes, silly people are silly. But the existence of silly people is not enough to justify additional spending. For that, you’ve got to, you know, attempt to justify the additional spending.

Sometimes a caramel macchiato is worth the cost and sometimes it’s not. Sometimes an unemployment benefit is worth the cost and sometimes it’s not. We have useful ways of thinking about these things. Some people say: “You know, that macchiato is expensive but it’s worth it.” Others say: “I don’t think that’s a very wise expenditure right now.” Paul Krugman says: “AHA! So a caramel macchiato is unaffordable, but you still haven’t visited the ATM!” And I say: How’s that again?

Stay tuned for more Godel, more Darwin, and a little less Krugman.

 Print

Share/Save

The artwork above is courtesy of Jodi Beggs, proprietress of the lively Economists Do It With Models site, who graced us with a visit in yesterday’s comments and expanded on those comments on her own page. (That’s me kicking Paul Krugman in the gut.)

Jodi objects to the tone, and in part to the substance, of my response to Paul’s recent attacks on the “deficit hawks” who oppose various spending programs that Paul happens to favor. I’d summarized his rhetorical technique as follows:

• Identify an adversary who is concerned about the cost of some program Krugman likes.
• Label that adversary a “deficit hawk”.
• Belittle (perhaps reasonably) excessive concern about the deficit while ignoring legitimate concerns about the costs of spending and taxation, which is not at all the same thing.
• Omit any attempt at an honest reckoning of costs and benefits.
• Pretend you’ve said something relevant.
• Sneer.

I particularly objected to Paul’s labeling as “hypocrites” those who support both spending cuts and tax cuts. Paul thinks that’s hypocritical because spending cuts and tax cuts have opposite effects on the deficit. I think that’s completely ridiculous because the merit of a policy depends on many things other than its effect on the deficit. Here’s Jodi’s attempt to prove that we’re both right and both wrong:

If all people claim to care about is size of the deficit, then they are being hypocritical in advocating one method of reducing the deficit and eschewing another. If all people care about is economic efficiency, then they are by definition internally consistent if they advocate both benefits and tax cuts. The reality of the situation is that most reasonable people put some weight on both deficit reduction and economic efficiency, so people are not automatically hypocritical or consistent just because they are simultaneously in favor of cuts in unemployment aid and taxes.

I agree in principle, but I object in practice, because in practice nobody cares primarily about the size of the deficit.

Look. Any time the government spends money, there are two or three downsides (which might or might not be outweighed by the upsides). Call the downsides Thing One, Thing Two, and Thing Three. Thing One, the biggee, is that resources get consumed. Thing Two, which can also be pretty big, is that the program must be financed by (current or future) taxes, which discourage productive activity. And finally, there might or might not be a Thing Three, which is that any increase in the deficit could conceivably have some minor disadvantages that are, by any reckoning, eensy weensy compared to Things One and Two.

Because Things One and Two are so much bigger than Thing Three, it must be extremely rare for the prospect of Thing Three to sway anyone’s opinion about the overall desirability of any given spending program. So for Paul to pretend that most of the opposition to his favored programs is based on Thing Three still strikes me as, yes, pummelling a straw man.

Everyone agrees that the deficit is a relatively minor issue (though some of us have said so more consistently than others). Paul wants to pretend that his opponents believe otherwise so that he can prove them wrong. That’s easier, I suppose, than engaging the issues they might be right about.

 Print

Share/Save

In America, many self-described deficit hawks are hypocrites, pure and simple. They’re eager to slash benefits for those in need but their concerns about red ink vanish when it comes to tax breaks for the wealthy. Thus, Senator Ben Nelson, who sanctimoniously declared that we can’t afford $77 billion in aid to the unemployed, was instrumental in passing the first Bush tax cut, which cost a cool $1.3 trillion.

Where to begin?

First, no economist—let me repeat that—NO economist, not even Paul Krugman on the days when he’s being an economist—would count a tax cut as a cost for purposes of policy analysis. A cost is something that consumes resources, not something that changes the ownership of resources. My Principles of Economics students all understand this; so, presumably, does the Nobel-prize winning author of a prominent Principles textbook. (A possible exception: You could call a present-day tax cut costly if it necessitates a future tax increase which, for some reason, is costlier to collect than the present-day tax. I guarantee you this is not what Krugman has in mind. If it were,the $1.3 trillion number that he highlights would be totally irrelevant to the actual cost.)

Next, unemployment benefits are costly, both insofar as they discourage recipients from seeking work and insofar as they necessitate taxes that discourage productive activity. The cost of $77 billion worth of benefits is not $77 billion, but it’s not zero either.

So unemployment benefits are costly and tax cuts are not. Which doesn’t mean that all unemployment benefits are bad or that all tax cuts are good, but it’s plenty adequate to absolve the hypocrisy charge.

But Krugman, as is his wont lately, appears committed to the following flat-out dishonest rhetorical agenda:

• Identify an adversary who is concerned about the cost of some program Krugman likes.
• Label that adversary a “deficit hawk”.
• Belittle (perhaps reasonably) excessive concern about the deficit while ignoring legitimate concerns about the costs of spending and taxation, which is not at all the same thing.
• Omit any attempt at an honest reckoning of costs and benefits.
• Pretend you’ve said something relevant.
• Sneer.

In short: Keep on pummelling that straw man.

 Print

Share/Save

Now a new paper (well, new to me anyway; it’s a couple years old, but I’ve only just stumbled on it) by Yuri Gorodnichenko and Linda Tesar rains on the whole parade by arguing that all of these estimates are based on statistical illusions that arise when prices are more variable within one country than another—and there’s no clear way to correct for those illusions. The best Gorodnichenko and Tesar can conclude is that the border crossing between Seattle and Vancouver increases the economic distance by somewhere between 28 miles and 65,000,000 miles—and that we need a better way to approach this problem.

 Print

Share/Save

A.C. Pigou taught us that we get better outcomes when decisionmakers bear the costs of their actions. Ronald Coase taught us that Pigou’s lesson cuts two ways. The shrimp boats that are sitting idle today are sitting idle partly because BP decided to drill in the gulf, but also partly because the shrimpers chose to operate in the vicinity of an oil rig. In this case, making BP feel the costs of its own decisions entails insulating the shrimpers from the costs of theirs.

In this particular case, I’m inclined to believe that it’s a good thing for BP to pony up. But contrary to what I’ve been reading around the web, there’s absolutely nothing in economic theory to dictate that conclusion; instead the conclusion depends on the particulars of the case. Is it cheaper to deal with the problem of spills by encouraging oil companies to be more responsible, or by encouraging others to stay out of their way? That’s an empirical question. Theory can’t answer it.

The various commentators who think they can justify holding BP liable by crying the word “externality”—and stopping there—exhibit a commendable grasp of environmental economics circa 1930. But this is 2010.

 Print

Share/Save

Let me start with the budget arithmetic, borrowing an approach from Brad DeLong. Consider the long-run budget implications for the United States of spending $1 trillion on stimulus at a time when the economy is suffering from severe unemployment.

That sounds like a lot of money. But the US Treasury can currently issue long-term inflation-protected securities at an interest rate of 1.75%. So the long-term cost of servicing an extra trillion dollars of borrowing is $17.5 billion, or around 0.13 percent of GDP.

Yes. That’s the long-term cost of borrowing an extra trillion dollars. (Actually, the cost is even lower than Krugman says it is.) But the long term cost of spending an extra trillion dollars is somewhere in the vicinity, of, oh, about a trillion dollars, or about 7.4% of GDP.

Now you might argue that if some of that spending puts unemployed resources to work, then the true cost of spending a trillion is somewhat less than a trillion, but Krugman, at least here, does not attempt to make that argument. Nor do I expect that even Paul Krugman would dare to argue that an adjustment for unemployed resources could reduce the cost of government spending by roughly 98%.

Krugman is right when he says that borrowing is cheap. But the issue isn’t borrowing; it’s spending—and spending is expensive. It appears that like the President, Krugman wants to divert your attention from spending to borrowing so he can dismiss legitimate concerns without even acknowledging them. It’s a cheap trick. Don’t let either of them get away with it.

Edited to add: In fairness to Krugman, he appears to be imagining that the trillion is never paid back, so that the cost of spending it is simply the debt service of 17.5 billion per year forever. But his column makes it sound like the cost is a single one-time payment of 17.5 billion, which is absurd.

 Print

Share/Save

To be a Times contributor, you apparently have to write like Mara Gay, who penned these lines for a front page article last week:

New York may soon become the first state to offer employment protection for nannies.

The state Senate passed a bill of rights for domestic workers this week, a measure that would require employers to offer New York’s approximately 200,000 household workers paid holidays, overtime pay and sick days.

Supporters say the step will provide needed relief to thousands of women — and some men — who are helping to raise the children of wealthier New Yorkers without any legal workplace rights beyond the federal minimum wage.

Now, you see, if I had been writing this article, it might have opened more like this:

New York state may soon become the first state to restrict employment opportunities for nannies.

The state Senate passed a bill this week that would prohibit New York’s approximately 200,000 household workers from accepting any position that does not include paid holidays, overtime pay and sick days.

Opponents say the step will bring unnecessary hardship to thousands of women—and some men—who have found employment because of labor markets that operate freely, except for constraints imposed by the federal minimum wage.

A more neutral observer might have noted that this bill, if passed, will be good for some of those nannies who retain their jobs, bad for the many nannies who will be driven out of the business, and extremely good for people like Ai-jen Poo, director of the National Domestic Workers Alliance, who will represent the winners and can conveniently ignore the losers. Instead, Ms. Poo is quoted, without apparent irony, as calling the measure “a huge step forward in reversing the long history of exclusion that domestic workers face.”

Query: Are the editors at the Times genuinely oblivious to this kind of bias? Or do they just not care?

 Print

Share/Save