Category Archives: Economics

Economics and coffee shops – The myth of ‘predatory pricing’

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My local

“That’s the Starbucks cluster marketing model. It doesn’t matter if each of the individual stores makes a profit, they run them at a loss so as to distort the market so the independents go out of business”

So said a neighbour of mine about the supposedly high number of Costa coffee shops in the postcode we live in. This is a new outing for the old argument of ‘predatory pricing’. Happily, ‘predatory pricing’ is a myth.

The theory behind ‘predatory pricing’ is that the largest company in a market can reduce its prices to below cost of production and corner the market. To attract business, its competitors will have to match it for price. If their pockets are not as deep, they will go bust. Then, the big company, now a monopoly, can raise prices to whatever it likes, and make good the losses it ran up driving the competition to the wall.

This is a high risk strategy. If a big company, such as Costa, runs at a loss so as to drive the competition out of business, who is to say they will succeed? It might be that even with the low prices people just don’t like their coffee and keep on frequenting the independents in which case Costa will be running losses indefinitely and it will go bust.

In addition to the uncertainty over whether there will be a return at all to an investment in a firm engaged in ‘predatory pricing’, there is no knowing how long it will take to see one.

Then, think what happens when the big company achieves its goal, becomes a monopoly, and raises its prices way above cost of production to enjoy its profits. With a margin of price over cost of production it is now possible for an independent to enter the market and compete. The process repeats itself with the big company slashing prices again to below cost of production in an effort to drive the newcomer out of the market. Indeed, the theory of ‘predatory pricing’ means that, where barriers to entry are low (and there is a guy near my local tube station who sells coffee out of the back of a van), the big company will have to run at a loss permanently. This is clearly unsustainable.

So ‘predatory pricing’ is as much myth as theory and that, in fact, is what we see. Simply put, there aren’t examples of it. It doesn’t happen.

To see this, consider that one of the predictions of ‘predatory pricing’ theory is that the big players in a market will drive the smaller ones out. But in the UK the number of branches of Costa, for example, rose from 658 in 2010 to over 1,500 in December 2015. Over the same period however, the number of independent cafes in Britain rose from 7,000 to 19,000. If major coffee retailers are running their branches at a loss so as to drive independents out of business, the strategy is failing dismally and they are doomed.

There is a second prediction of ‘predatory pricing’ theory, that where a producer secures a monopoly it raises its prices. Again, we don’t see this happening in real life. Indeed, Costa’s prices are set centrally so a latte in a town with lots of independent competition will cost you the same as a latte in a town with none.*

The example of coffee shops is true more widely as well. ‘Predatory pricing’ doesn’t stack up in theory and, in consequence, it isn’t seen in real life. Stop worrying and have a coffee.

* There is a point to be made about Costa specifically here. The Starbucks ‘cluster model’ was based on the fact that each shop was owned by Starbucks. As a result, it could use the profits from one local shop to offset the losses of another, what is known as ‘cross-subsidisation’. That is not the case for Costa which operates a franchise model. The guy who owns the Costa by the train station might not be the same person who owns the Costa by the tube station and it might be a third person yet who owns the Costa in the Mall. In a business sense, these Costa owners are, in effect, as ‘independent’ as most coffee shops commonly described as such. There is no room between franchisees for cross-subsidisation so the ‘cluster’ argument does not apply.

Whoever won the debate, economics lost

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You lose

I try to avoid politics on this blog and keep it focused on economics but sometimes politics and politicians just won’t leave economics alone. When that happens you have a right and possibly a duty to check what they are saying. After watching last Monday night’s presidential debate between Hillary Clinton and Donald Trump, one thing we can say with depressing near certainty is that the next president of the United States will be almost totally clueless about economics.

Hillary Clinton

Investment vs spending

Hillary Clinton seems to have discovered Gordon Brown’s old trick of referring to every penny piece of government spending as ‘investment’. She would not be spending money on this, that, or the other, rather she would be investing money in this, that, or the other. “I want us to invest in you. I want us to invest in your future.”

But investment isn’t just another, cuddlier term for spending. It actually means something. When you invest you are spending money in such a way as to increase your future income. If a driving licence will enable you to get a high paying job then paying for driving lessons is investment. If you spend money on food and clothes, necessary as that me to keep you going in the here and now, it is consumption spending, it is not investment. There are greyish areas. A suit bought for a job interview is clothing and also an investment.

Government can invest but it often doesn’t do it very well. Look, for example, at the histories of Britain’s coal and steel industries. Both had vast sums of money lavished on them by government with the aid of dragging them into the late twentieth century. Almost all of that money was wasted, going on higher wages – consumption – rather than actual investment. But that’s politics. Miners and steelworkers vote. Modern machine tools don’t.

Simply put, an enterprise which, via the government, has access to taxpayer funding has no bottom line to worry about. They can be as inefficient as they like, they will be bailed out. And, yes, many banks are an example of this these days. Competitive businesses however, with access to no funds other than those which people will give them willingly (either as loans, investment, or payment for goods and services) have to worry about their bottom lines. They have an incentive to invest profitably, not in whichever direction is most expedient over the election cycle. And if they get it wrong, they carry the can, not the taxpayer, ie, you.

As an illustration, Clinton gave the politically popular area of renewable energy as an example of somewhere she’d invest: “Take clean energy. Some country is going to be the clean- energy superpower of the 21st century”. The experience of Solyndra – a politically well connected solar panel producer which took took $535 million of taxpayers money and went bust without producing a single solar panel – doesn’t bode well.

Tax the rich

Clinton claimed that she would be able to pay for all this ‘investment’ by taxing the rich. “Because what I have proposed…would not add a penny to the debt…What I have proposed would be paid for by raising taxes on the wealthy, because they have made all the gains in the economy. And I think it’s time that the wealthy and corporations paid their fair share to support this country.”

I’ve written before about the futility of British governments trying to wring a greater share of the national income out of the public in tax revenue: “Whether the top rate of income tax is 83%, as it was in the 1970s, or 40%, as it was in the years before 2010, the British people seem to have decided in some mysterious way that 35% of their income is all the government is going to get.”

Something similar applies in the United States. As you see in Figure 1, in the ten years 1972 to 1981 inclusive, the top rate of Federal income tax was 70%. Over those years the share of national income taken in by the Federal government in tax averaged 11.67%. Over the ten years from 2003 to 2012 inclusive the top rate of Federal income tax was half that level, 35%. And, over those years the share of national income taken in by the Federal government in tax averaged 9.83%: a difference of 1.84 percentage points.

Figure 1

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Source: World Bank and the Tax Foundation

You can take any message you like out of Figure 1 depending on which bit you choose. The steep rate cut in 1982 was accompanied by a decline in the share of national income taken by the federal government, but the even steeper cuts of 1987 and 1988 were followed by no such decline. Rises in the top rate of federal income tax from 1991 to 1993 might have started the rise in the federal government’s share of national income beginning in 1993, but this rise continued until 2000, seven years after the rate stopped rising. Indeed, since then, if anything, it looks as though it is changes in the federal government’s share of national income which have led changes in tax rates.

Indeed, as Figure 2 shows, the share of the US national income taken by the federal government in tax seem more closely correlated, in recent years at least, with economic growth.

Figure 2

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Source: World Bank and the Tax Foundation

The policy lesson would seem to be that if you want the government’s share of national income to rise you’re better off working to get the economy growing rather than tinkering with tax rates.

Clinton also blamed the housing boom and bust of the 2000s on the Bush tax cuts. “Well, let’s stop for a second and remember where we were eight years ago”, she said, “We had the worst financial crisis, the Great Recession, the worst since the 1930s. That was in large part because of tax policies that slashed taxes on the wealthy, failed to invest in the middle class, took their eyes off of Wall Street, and created a perfect storm.”

In am not aware of a serious economist, in their serious work at least, who thinks that tax cuts were even in part behind the housing bubble and its bursting. Indeed, there is a surprising amount of consensus that the causes were monetary, not fiscal.

Joseph Stiglitz has written that following the burst of the dot com boom in 2000

“…Greenspan lowered interest rates, flooding the market with liquidity…[the lower interest rates] worked – but only by replacing the tech bubble with a housing bubble, which supported a consumption and real estate boom”

Nouriel Roubini wrote

“The bubble eventually burst in 2000, and Greenspan’s Fed responded by slashing interest rates by 5.5 percentage points – from 6.5 percent to 1 percent – between 2001 and 2004. The rising tide of easy money helped cushion the bursting of the tech bubble, but it fed another bigger bubble in housing”

Thomas E Woods writes

“That year [June 2003 to June 2004] saw eleven rate cuts. The unsustainable dot-com boom could not, in the end, be reignited…But the Fed’s easy money and refusal to allow the recession of 2000 to take its course led to an even more perilous bubble elsewhere”

The gender wage gap and the minimum wage 

Beyond this, Clinton showed that she is interested in solving problems that aren’t problems and using solutions that aren’t solutions. Paradoxically, she claimed that, while cutting regulations for small businesses, “We also have to make the economy fairer. That starts with raising the national minimum wage and also guarantee, finally, equal pay for women’s work.”

As has been pointed out time and time again, the gender pay gap is a myth. The oft repeated charge that “the typical woman who works full-time earns 79 cents for every dollar that a typical man makes” is completely bogus. It is derived simply by taking a ratio of the difference between women’s median earnings and men’s median earnings: 21 cents. It takes absolutely no account whatsoever of the different types of work men and women do. When factors like that begin to be figured in the gap disappears.

Indeed, Clinton herself might not actually believe it. At one point in the debate she said “(Trump) doesn’t think women deserve equal pay unless they do as good a job as men”, leaving me asking “Well, what’s wrong with that?”

Clinton also said she would raise the federal minimum wage as part of an effort to help the middle class (a policy Trump also supports). It will do no such thing. Put briefly, if an employer estimates that a worker will add $8ph to their revenue, they will hire that worker at any wage up to $8ph as they will be adding more to their income (the revenue) than their costs (the wages) by doing so. If the minimum wage is raised so that that worker cannot now be hired at any wage less than $10ph, the employer will not hire them. Doing so will add more to costs (the wages) than to income (the revenue). No company that increases costs more than income will be around for very long.

All a raise in the minimum wage from the current $7.25ph to $10ph would do is lock out of the labour market workers whose contributions to turnover employers estimated at less than $10ph. These will be the lower skilled workers Clinton presumably seeks to help. As I wrote recently, one way to help these workers is to help them acquire the skills to raise employers expectations of what revenue they might generate. This is somewhere where genuine government investment could play a part.

Donald Trump

Corporate Tax

Indeed, the first bit of economic sense came from Donald Trump. “So what (companies are) doing is they’re leaving our country, and they’re, believe it or not, leaving because taxes are too high and because some of them have lots of money outside of our country.” He went on to argue that one way to bring them back is to lower the tax on corporate profits.

This makes sense. The United States has the third highest rate of corporate tax in the world. You can’t really blame companies which increasingly do business in multiple political jurisdictions for choosing to domicile in one that doesn’t take nearly four in every ten dollars profit they make.

Indeed, the tax should be abolished completely. Just because a tax is called a ‘corporate tax’ does not mean that corporations pay it. The incidence of the tax, ie, who the burden of paying for it actually falls on, is a different thing altogether. In reality, corporation tax is paid by either consumers, shareholders, or workers.

When tax on cigarettes are put up the cost is not paid by the tobacco companies in lower profits but by the addicted smokers in higher prices. The price elasticity of demand for the product is low so the producer can pass the full cost of the tax on to the consumer.

If the price elasticity of demand for a product is high, ie, an increase in its price will see consumers buying less of it, then the tax will be paid by either shareholders or workers. How the burden is split between these two categories depends on how many of each there are relative to the other. If there are lots of workers around, they will accept wages low enough to offset the burden of the corporate tax. By one estimate, the average share of the corporate tax burden borne by workers is 57.6% of the amount raised by the tax.

Monetary policy

Trump was also onto a winner with his comments about Federal Reserve monetary policy.

“Now, look, we have the worst revival of an economy since the Great Depression. And believe me: We’re in a bubble right now. And the only thing that looks good is the stock market, but if you raise interest rates even a little bit, that’s going to come crashing down.”

“We are in a big, fat, ugly bubble. And we better be awfully careful. And we have a Fed that’s doing political things. This Janet Yellen of the Fed. The Fed is doing political — by keeping the interest rates at this level. And believe me: The day Obama goes off, and he leaves, and goes out to the golf course for the rest of his life to play golf, when they raise interest rates, you’re going to see some very bad things happen, because the Fed is not doing their job. The Fed is being more political than Secretary Clinton.”

This echoes something I wrote three years ago

“As interest rates are lowered in response to an adverse shock investment, calculations change, especially when, like Alan Greenspan, those behind the policy publicly promise its continuance. To the extent that this fosters a wealth effect, consumption, as well as investment, may be stimulated. And this, in fact, is exactly the way the policy is supposed to work.

But the rates cannot stay that low indefinitely, nor, despite the jawboning by monetary policymakers, are they intended to. At some point they will rise. Again, this actually is the way the policy is supposed to work.

And when those rates do rise what happens to those marginal investors who made their decision when rates were at their lowest? What happened to the NINJAs who bought condos in Michigan when interest rates were 1 percent when the rates went up in 2006? They were scuppered. And what will happen to all the enterprises which are currently dependent on interest rates remaining at their historic lows when those rates start to rise? It is because more people are now asking that question that markets have turned skittish recently, since Ben Bernanke even began to discuss a possible future ‘tapering’ of Quantitative Easing.

Those rates will have to rise at some point. But, when they do, whichever bubble we have now will burst. Our monetary authorities have printed themselves into a corner.”

Shortly afterwards I wrote

“On Aug. 15, the London Telegraph reported that British retail sales had risen unexpectedly sharply and that American unemployment had fallen to a six-year low. This would usually be promising macroeconomic news, but that day major indexes—the Dow Jones Industrial Index, the S&P 500, the CAC 40, among others—tumbled. Markets, hooked on the Fed’s cheap liquidity cocktail, were terrified that an improving U.S. economy might see the punch bowl removed with a Fed “taper” of quantitative easing.

A day later, when the results of a U.S. consumer confidence survey came in “far worse than expected,” stock markets rallied. Markets are supposed to be driven by the expectations of a stock’s perceived profitability, not the pursuit of speculative gains caused by the manipulations of central bankers. Now the economy appears to be in a position where the interests of financial markets are precisely at odds with the interests of the rest of the economy.”

International trade

And then he went and blew it. “You look at what China is doing to our country in terms of making our product” he said, “They’re devaluing their currency, and there’s nobody in our government to fight them. And we have a very good fight. And we have a winning fight. Because they’re using our country as a piggy bank to rebuild China, and many other countries are doing the same thing.”

I recently wrote

Indeed, it is true that policymakers in Beijing have tried to keep the yuan weaker against the dollar that market forces might allow…But…this has not been a costless exercise for the Chinese.

By holding down the value of the yuan the Chinese government has held down the purchasing power of Chinese producers. This has effectively worked as a subsidy from Chinese producers, with an average GDP per capita of $14,100, to US consumers, with an average GDP per head of $56,000. If anyone should be angry about this arrangement, it should be Chinese producers.

Indeed, the argument that the Chinese have been using the US as a piggy bank to fund investment in China is exactly the wrong way round. Instead, the US has been using China as a piggy bank to fund American consumption.

Trump often talks of international trade as a struggle with winners and losers. But trade is not a zero sum game in which the benefits for one are offset exactly by losses for another. This fallacy, the root of much modern misguided economic rhetoric, is based, essentially, on the ancient misunderstanding that for two things to exchange for each other these things must have an equal value.

But logically that must be wrong. If I hand over £1.10 for a tuna sandwich I do so because I value the tuna sandwich at more than the £1.10. Conversely, the unnamed supermarket where I buy my lunch values the £1.10 more than the tuna sandwich. If I valued the tuna sandwich as much as I valued the £1.10, why would I exchange the latter for the former? I wouldn’t and the supermarket wouldn’t either. In fact, trade can only take place because people value things differently. ‘Value’ is not a property inherent in a product, it is entirely a function of the human mind and these value different things differently at different times and in different places. Value is entirely subjective.

It follows from this that people trade less valued things for more valued things. They accumulate value through trade. Both parties gain. Trade is a positive sum game.

The verdict

The United States has been woefully governed by both parties for a long time. On the strength of this debate, that won’t be changing for at least another four years.

Kate, Allie, and the Fight for Fifteen

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If only it was that simple

“I’ve been at Burger King since I was 14, now I’m 19 and still making $9.75,” said Alexis Collins at a protest outside the north Minneapolis fast-food restaurant where she works on Monday. This was another battle in the long running battle to have the minimum wage raised to $15 per hour.

The problem with this view is that a worker’s wage is not a simple function of how long they have worked at a company. Nor should it be. Neither is it a function, at all, of the cost of living or what other people are earning. Nor should it be.

To see the truth of this put yourself in the shoes of an employer named Kate for a second. Kate has the opportunity to hire Allie and thinks that Allie’s work will add $9.75 per hour to her company’s turnover (its income). Assuming for simplicity that Allie’s wage (the businesses’s expenditure) is the only cost that Kate faces, it will make sense for her to employ Allie at any wage up to $9.74 per hour. That is because at any wage up to that, hiring Allie adds more to Kate’s company’s income than it adds to its expenditures.

So what happens if the wage is suddenly raised by government edict to $15 per hour. That means that the cost of hiring Allie has risen by nearly 54%. So, if Kate still thinks that Allie’s work will add $9.75 per hour to her company’s turnover, she will be faced with a choice of adding $9.75 per hour to her income and $15 per hour to her expenditure.

What business would take a decision expecting it to add more to costs than to income? What would happen to a business that did so? Businesses that spend more money than they take in go bust. Knowing this, Kate just won’t hire Allie.

This is why the Fight for Fifteen’s argumentation is composed of irrelevancies and its demands actually counterproductive.

A protester in Minneapolis on Monday said “It’s hard for mothers, single mothers, two parent homes, single fathers, families period to live off the wages we’re making now”. Quite possibly, but, as we can see, Allie’s (the employee’s) cost of living is no part of Kate’s (the employer’s) calculation whatsoever.

Let’s say that initially Allie can get by on the $9.75 per hour Kate pays her. Now imagine that, for some reason – kids or a rent increase – Allie needs $10 per hour to get by and asks for a raise. If Kate still thinks that Allie’s work will add $9.75 per hour to her company’s turnover, she will be faced with a choice of adding $9.75 per hour to her income and $10 per hour to her expenditure. As before, Kate wouldn’t do it. She couldn’t.

What matters for Allie’s wage is Kate’s estimation of the amount of turnover she will generate. No government order will make Kate pay Allie a wage above what Kate thinks Allie will add to her turnover. That is the real iron law of wages. If government arbitrarily raises the minimum wage to $15 per hour, all that will do is exclude those workers whom employers deem to have low (sub $15 per hour) levels of productivity from the legal labour market.

If activists are really concerned about raising wages they need to raise the estimates that the Kates of this world make of the productivity of the Allies. This requires that Allie have better skills which needs better education and on the job training. It requires that she have more and better tools to work with which means more capital investment. And it means that Allie’s labour and Kate’s capital should be brought together as efficiently as possible, which demands better entrepreneurship.

This a longer shopping list of actions than simply jacking the minimum wage up by government diktat. It doesn’t fit into a tweet like #FightFor15. But it does take economic reality into account and it has more chance of helping Allie make $15 per hour.

Economic history in two (and a bit) charts

My MSc was in economic history. That probably sounds more straightforward than it actually is. Let me explain.

Adam Smith deployed episodes from history to illustrate the laws of economics he claimed to be outlining in The Wealth of Nations. These laws, like those Newton had just laid down for physics when Smith wrote, were held to be good at all times in all places. Just as Newton’s law of gravity dictated that the apple would always fall from the tree wherever it was in the universe, so did Smithian economists believe that the law of demand would hold anywhere at any time.

In the nineteenth century a group of economists in Germany challenged this. To them, economic theory was not something apart from the varied experiences of economic life. Instead, it grew from them. To these economists, it was ludicrous to argue that the lives of African tribesmen were dictated by the same economic laws as those of the industrial proletariat then emerging in European and North American cities. These economists thought, then, that economics should not be the study of a priori theories, but of the particular historical circumstances of economic life which varied from time to time and place to place. They set out to collect data on economic life, earning the nickname the Historicists and pretty much founding the field of economic history.

In recent decades theory has pushed back. The tools of econometrics were applied to historical data to create the field of cliometrics. Econometrics, essentially, is the application of statistical analysis to data to test economic theories. This appealed to economic historians as it gave their discipline the extra veneer of credibility that pages of impenetrable mathematical equations always bestows. But they needed theories to test. Thus were economics and economic history reunited. That is largely where the discipline stands today, at least at the LSE.

That is a brief history of economic history, what of economic history itself? The two big subjects can be laid out in the two and a bit graphs below.

First, the graph below shows GDP per capita from the year 0 to 2000. Two things are striking and worthy of study. First, why is the line so flat for so long? Second, why did the line take off like a rocket around 1800?

Image result for gdp per capita history

This chart doesn’t quite show everything though, so take a look at the ‘and a bit’ chart below.* This zeros in on the inflexion point of the line in the graph above. What we see is that the rocket didn’t take off for everyone around 1900. Some countries, with levels of GDP per capita previously comparable to the fast growers of the nineteenth century like Britain and France, stayed stuck on the launch pad, namely India and China.

This, then, gives rise to some further questions. Why did Britain’s economic growth take off? Why did China’s stagnate? Why did Japan’s catch up, both in the late nineteenth century and again after the Second World War? To carry on from above, the third question is in essence why did that GDP per capita line in the first chart diverge from country to country?

But even for those countries whose GDP per capita line did take off it did not proceed smoothly. At times the line has gone upwards very fast, at other times not so fast, and at still others it has even gone down. This is known, erroneously I think, as the business cycle and is illustrated by the chart below.

We see a steadily rising trend for GDP per capita but we also see fluctuations around that trend. We see, for example, the Roaring Twenties and the Great Depression which followed them. We see the sharp contractions in the US and UK in the late 1970s and early 1980s and the prolonged expansions which came afterwards.

If the first set of questions relates to why economies grow – or don’t, as it was for most of human history – the second set relate to why that growth fluctuates. Why do economies sometimes stop growing? What, if anything, can be done to get them growing again? These questions are the stuff of macroeconomics.

But that is another topic, macroeconomics, funnily enough. The rest, in a nutshell, is economic history as it is practiced today.

* These graphs are sometimes merged and that would have helped here. However, I couldn’t find such a graph at present and my graph drawing skills are such that I thought it best not to try.

Wages, immigration (again), and economic methodology

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A while ago I wrote about a Bank of England paper investigating the effect of immigration on wages in Britain which found that “the immigrant to native ratio has a small negative impact on average British wages”. Then, some time after, I came across a paper by Julie L. Hotchkiss in the Southern Economic Journal which finds that “illegal immigrants actually raise wages for documented/native workers”. How to explain this contradiction in the economic evidence?

The first thing to note is that the Bank’s researchers, Stephen Nickell and Jumana Saleheen, are looking at slightly different question to Hotchkiss. Nickell and Saleheen are looking at immigration in general, Hotchkiss only at that part of it which is illegal.

Second, they are also looking at different data. Nickell and Saleheen are looking at data from Britain, Hotchkiss from the US state of Georgia.

But should this matter? Should not an economic theory which predicts that, ceteris paribus, an increase in immigration will raise/lower wages in Britain also predict the same for Georgia? In his excellent History of Economic Thought, Lewis H. Haney called the belief that the answer to this question is Yes ‘cosmopolitanism’ and the belief that the answer will be Yes at any point in time ‘perpetualism’.

That seems to depend on which theory you mean. As I wrote of Nickell and Saleheen’s paper, “In the short run at least, this is what economic theory would lead you to expect. If you increase the supply of anything relative to the demand for it, ceteris paribus, the price of that thing, whether it is shoes or labour, will fall.” But Hotchkiss applies a different bit of economic theory, that of comparative advantage, and finds the opposite. So which theory to apply?

The theory of comparative advantage is one of the old workhorses of economics. It states that Country A should specialise in the production of the good or service A that it produces most efficiently, even if it also produces good or service B more efficiently than Country B. This will lead to more efficient production and, via trade, make both countries better off. The more countries there are, the more they can specialise, the more productive they become, and the better off everyone is, so the theory goes.

Hotchkiss applies this to illegal immigration. Illegal immigrants “with limited English skills” (I’m quoting Art Carden’s write up here) coming into Georgia and finding jobs   “frees up low-skill American workers who can then specialize in tasks that require better English”.

That makes theoretical sense, but it isn’t happening in Britain, according to Nickell and Saleheen. Perhaps this is because the premium on speaking English particularly well isn’t all that high lower down the value chain in the UK. Consider Mike Ashley’s Sports Direct warehouse where the signs are posted in English and Polish. There would seem to be little advantage accruing to a native English speaking employee over his or her Polish immigrant colleague from their greater language skills.

It is interesting to speculate on the microeconomic differences between the British and Georgian labour market that allow for so much more specialisation in linguistic ability lower down the value chain in Georgia than there would seem to be in Britain. After all, these differences would seem to determine whether we apply standard supply and demand analysis to the question of immigration’s impact on wages, or the theory of comparative advantage.

But how much of this is fitting theory to the facts? When I read Nickell and Saleheen’s paper I thought “Well, that’s what standard supply and demand analysis would predict”. Did Hotchkiss, I wonder, see her results and think “Well, that’s what the theory of comparative advantage would predict”? Imagine if the British results had also shown a positive impact on wages from immigration. Would I then have thought to myself “Well, that’s what the theory of comparative advantage would predict”? If so, whither economic theory?

Prior to conducting the analysis on British and Georgian data, we would not have known which theory to apply and, hence, could have made no predictions. If, for example, you assumed that comparative advantage applied to the British labour market you would have predicted that immigration would cause wages to rise, as in Georgia. When confronted with the result, that immigration actually causes wages to fall in Britain, you would conclude that your prediction was wrong and that your theory had been falsified. But if you had gone through the same process in Georgia, your prediction would have been borne out and your theory would stand.

These are fundamental questions of economic methodology. Economists generate theories which make predictions such as ‘if X then Y‘.Governments spend large sums of money according to these predictions based on these theories. Is it the case, however, that the appropriate economic theory is entirely contingent on the particular circumstance in which it is applied?

I generally consider myself a cosmopolitan perpetualist in economic methodology. This can lead to situations where, when data contradicts theory, I assume that the data is faulty, that it must be failing to take some relevant factor or magnitude into account. But if there is even a question over which theory to apply in the first place, whither economic methodology?

The economics of sympathy

belgium

A common response to the horrible events in Brussels two days ago has been to condemn people in the UK or US, for example, who share their sympathy. People ask where was this sympathy when Baghdad or Ankara were bombed earlier this month? Is this, as I have seen argued often in the last two days, racism, stemming from the belief that these attacks only bother us when white people are killed?*

Perhaps economics can provide an answer.

Consider Lionel Robbins’ famous definition of economics: “Economics is the science which studies human behavior as a relationship between given ends and scarce means which have alternative uses” This is economics as a study of resource allocation.

Now think of sympathy, such as that demonstrated by candlelit vigils in London for attacks in Paris or people changing their Facebook profile pictures. We only have a fixed amount of sympathy to allocate, a ‘sympathy budget’, if you will, which we can spend. Perhaps we are constrained by the costs of feeling bad, perhaps we are willing to incur this cost but we only have so many hours in the day to do it. Time, after all, is the budget constraint which we all face.

And there are, sadly, many tragic events to which we could allocate this sympathy budget. Natural disasters, horrific terrorist atrocities, ‘collateral damage’ casualties in attacks carried out by western governments…How do we allocate our budget of sympathy between so many competing, perfectly deserving ends?

This is to state the problem. All I’ve done so far is put what I think is a familiar problem into some economic terms. But how to answer it? This is perhaps more controversial.

One of the things driving empathy would seem to be the magnitude of the disaster. Or, rather, the magnitude of the disaster relative to some baseline of peril which the victims face constantly. Thus, the Tsunami of 2004 can draw a great response by its sheer size, even compared to the relatively higher mortality rates than in the west in many of the countries affected.

Another possibility might be the novelty of the event. I saw Amanda Palmer read a deeply moving poem about the Germanwings plane crash. But would she have written the poem if the plane had splashed into the sea owing to engine trouble rather than getting flown into a mountainside by a deranged pilot? Again, this could be measured against some baseline of peril which the victims normally face. Bombs attacks are, sadly, much more common in Iraq and Syria than they are in Brussels, so we discount their victims.

But another factor, possibly more controversial, seems to be how similar the people affected are to you. Take the bombing of the Brussels Metro as an example. I travel by tube in London everyday. Indeed, I was travelling on the tube on July 7th 2005. When I see the film of that blood drenched toddler crying over her dead mother in Brussels, I can picture it very vividly.

By contrast, the effect of a bunker buster on a block of flats in Syria I find harder to picture. To try and imagine it I find myself drawing, unconsciously to an extent, on Hollywood movies. That might sound trite or ridiculous, but to picture such an event and its consequences my brain searches for a comparable image stored away somewhere. With next to no actual experience myself of such things, it settles on the fictional representations I have seen.

I’m sure many of you will have seen something like the image below

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Ask yourself what a Tragic World Map for, say, Africa might look like. We would probably see Africa shaded in red with the United States coloured green or blue. As different people in different circumstances have different subjective preferences when it comes to spending their budget of money, the same applies, if economic reasoning is appropriate here, when people spend their budget of sympathy.

Indeed, if you wanted to be really economicsy about it, you could say that S=f(MαNβY) where sympathy (S) is a function of the magnitude of the disaster (M), the novelty (N), and the similarities with the people to be sympathised with(Y). αand β represent the relations of the magnitudes to the baseline.

So a disproportionate concentration by the western media or westerners generally on western casualties is probably not a sign of widespread racism, though in a few cases it surely is. Rather, it is the result of people with a constrained budget of sympathy selecting via certain criteria (and feel free to suggest your own) how to allocate that budget. In short, don’t feel bad about who who you feel bad for.

* This argument is curious given that many non-whites were killed in Brussels as in Paris last November.

Wages and immigration in the short run

The Bank of England has a new paper out titled The impact of immigration on occupational wages: evidence from Britain. Its key finding is that “the immigrant to native ratio has a small negative impact on average British wages…Our results also reveal that the biggest impact of immigration on wages is within the semi/unskilled services occupational group.”

Why, then, does the Bank of England correctly state that “There seems to be a broad consensus among academics that the share of immigrants in the workforce has little or no effect on native wages”? The reason is that “These studies typically have not refined their analysis by breaking it down into different occupational groups”, which the Bank’s paper does.

To de-jargon this, studies which find no effect of immigration on wages make no distinction between the wages and workers they are examining; they lump the falling wages of nine road sweepers in with the rising wage of one City banker and say that, on averages, the ten workers wages haven’t fallen. A paper from Oxford University which also dug down into the averages found similar results to the Bank of England; immigration disproportionately reduces wages at the bottom end of the labour market.

In the short run at least, this is what economic theory would lead you to expect. If you increase the supply of anything relative to the demand for it, ceteris paribus, the price of that thing, whether it is shoes or labour, will fall.

But that, too, is to fall into the trap of looking at ‘the average’. There is no labour market in which we are all willing sellers of homogeneous labour. I am not offering the same skills on the job market as Sergio Aguero or Stephen Hawking. The market for the labour of economists and the market for the labour of footballers are different markets, they are not part of ‘the’ labour market. Labour, like capital, is heterogeneous.

To simplify, consider an economy with two types of worker, highly skilled and lower skilled. The markets for each are shown below, for highly skilled labour in chart a and lower skilled labour in chart b.

wages

Immigration of  lower skilled workers increases the supply of lower skilled labour – the rightward shift of the supply curve on chart b from S1 to S2. Ceteris paribus, this pushes wages for lower skilled workers down from P1 to P2. But, and this is the point the Bank of England paper makes empirically, this has no effect on the wages of highly skilled workers, as shown on chart a.

If the immigrants were skilled then the opposite would be the case. The wages of highly skilled workers would fall and those of lower skilled workers would be unaffected. It is doubtful, however, that this is currently the case, at least in Britain.

This debate over the effects of immigration on wages, in the short run it should be stressed, is another example of the difficulties economists can find themselves in when thinking of lumpy, homogeneous aggregates. Lumping all labour together for anayltical purposes makes no more sense than, for example, lumping all capital goods together. The Bank of England’s new paper is a welcome step towards greater acknowledgment of the heterogeneity of economic variables.

The price mechanism in healthcare

The poster above, produced by the National Health Service, popped up in my Facebook feed recently. Just last week, a friend posted this

“Horrified by the ‘if it’s free why shouldn’t I take it’ attitude with regards to the minor ailments scheme. If everyone takes free plasters and calpol from the NHS then there is less money in the pot to pay nurses, treat brain tumours, strokes and dementia – ya know, the things that will kill you. Ultra liberal lefty that I am, I’m sick of seeing people grasping for freebies without thinking about the consequences. Here’s a good rule of thumb – if you’ve treated yourself to a packet of fags or a glass of wine this month, you can buy your own sodding calpol.”

One of the laws of economics is that, ceteris paribus, the lower the price of something the greater the demand for it will be, even if it might not be the demand the supplier intends to meet. If you offered me, for free, a DVD of Sheffield Wednesday winning the League Cup in 1991 I’d take it and enjoy smashing the thing. Several thousand Sheffield United fans, like me, would do the same.

But if I had to pay even 1p for the pleasure of smashing that DVD, I’d say ‘No thanks’. And the higher you raised that price the more people would say ‘No thanks’. At some price, even people who would actually want to watch the DVD would say ‘No thanks’. That’s how you get your downward sloping demand curve, shown below.

lt is doubtful that enough of something could be supplied to everyone with even the slightest demand for it. The resources that produce one thing cannot, after all, be used to produce another thing. Supply is constrained. What is needed is some way of matching these various states of demand with the actual supply – of making sure the League Cup final DVDs go to nostalgic Wednesday fans and not grumpy United fans like me. In a given period supply can be considered fixed, as represented by the vertical supply curve on the chart below.

sc

If, on the chart below, we hold the price below the market clearing price, p1, where quantity demanded meets quantity supplied (the curves above cross – the NHS effectively holds the price of British healthcare at zero), the quantity demanded rises, from q1 to q2

Untitled drawingBut, as the NHS and my friend are finding out, even though q2 of healthcare is being demanded, there is still only q1 of healthcare being supplied. How to match this supply to this demand?

Queuing is the most common answer. The person with severe chest pain in the NHS poster ought not to be in a queue, but with a price of healthcare set at effectively zero, that is exactly where he will be. Alternatively you can try and rely on people to ration themselves, as the the NHS and my friend are trying to encourage. And maybe it will work.

The essential point is that in a world of limited means with competing ends scarcity is real and cannot be wished or voted away. The laws of economics are a little more stubborn than that.

Greece and the euro crisis

drachma

Welcome back

Below is something I wrote for a now defunct website in July 2011. There’s finessing I’d add here and there if I wrote it now, but its exhumation seemed timely.

Greek town squares and streets have erupted in violence. A Socialist government has incurred the wrath of the left by forcing through a package of fiscal retrenchment which would have made Margaret Thatcher blush. Greek interest rates are skyrocketing yet borrowing still grows. Even so, many commentators from both right and left doubt it will be enough. Greece will almost certainly default on its debt. It’s a good bet that it may even be forced to leave the euro.

 How did we reach this state? What will happen next?    

The project for European integration has always been steeped in unreality. One of the great political trends of the last 200 or so years has been nationalism, the breaking down of people into political units with shared characteristics of language, history and culture. This has been seen on bloody fields from Lombardy to Rwanda. The lesson of the First World War was that the other great trend, the basing of society on class lines à la Marx, was a dud. A Sheffield steelworker would rather shoot his fellow proletarian from Essen than his capitalist boss.

The mission to integrate Europe politically runs counter to this. For a combination of reasons ranging from the noble through the potty to the plain sinister the ‘European project’ has always been an exercise in denial, in seeking to bend what is into what its makers would like. The creation of the euro, the single currency, viewed as another step on the road to the “ever closer union” the projects’ leaders alone seem to desire, was born in this atmosphere of denial.

Back in 1961 the Nobel Prize winning economist Robert Mundell wrote “A Theory of Optimum Currency Areas” a paper in which he analysed the characteristics an area must have to be suitable for a single currency. Mundell put forward five criteria; labour mobility across the region, capital mobility across the region, price and wage flexibility across the region, similar business cycles across the region and a risk sharing mechanism across the region.

The euro zone clearly has a high degree of capital mobility though in the globalised world it is not much easier to shift funds between London and Rome as it is London and Hong Kong. In theory the EU should have almost perfect labour mobility so that unemployed people in a depressed area can move to a booming area and the profusion of ‘Polski Skleps’ around the country suggests this is true. But in fact, when compared to another currency area, the United States with the dollar, linguistic and cultural factors are far more of an obstacle in a move from Madrid to Copenhagen than they are from Minneapolis to Seattle. Labour mobility in the EU is far lower than in the US as demonstrated by the shortage of unemployed Greeks and Irish decamping to booming Berlin.

The euro zone scores even worse on the other measures. On price and wage flexibility the euro zone has one of the most rigid labour markets on the planet and the apparent synchronisation of business cycles prior to its launch in 1999 was aided by more than a little creative accounting which the project’s leaders, ever averse to reality, turned their blind eye to.

It is the fifth criteria however, the risk sharing mechanism, or lack of, which is of central importance now. By risk sharing mechanism we mean a way by which, in downturns, fiscal resources can be redistributed from better off areas to less well off areas. This can mean welfare payments to or government projects in depressed areas. In the current set up it has meant a chaotic series of bailouts.

So the theory goes that a single currency means a single central bank and a single central bank means a single government. Simply put, the area covered by the body with the fiscal authority, the government, has to match the area covered by the monetary authority, the new European Central Bank. But though, in the European Union (née European Coal and Steel Community, European Economic Community, European Community), Europe had a political structure which, with only occasional consultation of its subject peoples had, like Topsy, “just growed”, it still didn’t have the necessary fiscal authority to match the monetary authority of the ECB.

The Germans, for whom the old deutschmark run by the Bundesbank has worked so well, were worried by this. They were concerned that countries with less creditworthy borrowing histories, like Greece which has been in default for large chunks of its history, would use the new interest rates, held low by the German reputation for good financial behaviour, to go on a borrowing binge and demand a German bailout when it all went wrong. So the Germans got the Stability & Growth Pact which limited the borrowing of euro members to 3% of GDP. But the still fiscally autonomous Greeks ignored the pact, lied about the figures, and borrowed like mad anyway. And why not? When Germany and France broke the Stability & Growth Pact rules in 2003 neither were fined.

The Irish situation was slightly different. When it gave up some of the independence it had fought Britain for so long for and joined the euro its economy was booming, it needed higher interest rates to cool the boom. However, Germany was in a prolonged period of economic stagnation and needed low interest rates to get a boom boiling. There was no question of the tiny Irish tail wagging the ECB dog and, obeying its German paymasters, it kept euro interest rates low. This was great for Germany but in Ireland, already doing well, this flood of cheap credit stoked a wild property boom. Irish banks borrowed, lent to people to buy houses, and then collapsed when people realised that County Leitrim didn’t need three houses for every resident. The property investments of banks were worthless overnight.

But Ireland’s politicians, a particularly craven bunch, moved to save Ireland’s bloated banks by extending a taxpayer guarantee not only to all depositors, as the British government did, but also, staggeringly, to all holders of the bonds of Irish banks. In other words, the Irish people would be made liable for loans taken out by Irish banks, often from other eurozone banks, to lend on to the Irish people. The cost of this insanity was staggering; about €100,000 for everyone in Ireland. Ireland’s deficit soared above its Stability & Growth Pact limit and, like Greece, drastic fiscal consolidation followed.

So where do we go from here? It is clear that one of the major flaws of the euro, baked in from inception, was the attempt to create a central monetary authority without a central fiscal authority. In the current crisis this has changed. Many of the spending cuts and tax rises which have driven Greeks to riot and Irishmen to grumble more loudly than usual into their Guinness were forced upon them as much by European bodies trying to protect the euro as by lenders concerned about their increasingly apparent status as basket cases. So one possible outcome is that this will continue; we will see the upward evolution of fiscal power to a European body to match the monetary power the ECB already has.

But there is another possibility, one which a growing number of observers predict. The fiscal retrenchment in Greece, Portugal or Ireland could be so unpopular that no government can enact it. In that case the country would default on its debts (or write down or reschedule which amounts to the same thing) and it would be difficult to see how it could continue in the euro zone. In this case, with the country exiting the euro zone, we would see the other possible outcome; the downward devolution of monetary power to a national body to match the fiscal power the national government already has. In other words, the break-up of the euro.

Which of these is more likely? Economics dictates the break-up of the euro which would more likely mean its retreat to the core of ECSC countries. Euro bailouts are at ever higher interest rates. Economic growth when it is positive at all is sluggish and if the rate of interest is higher than the rate of growth you will see the debt burden grow ever heavier. But as we’ve seen the European project is about the active denial of realities. Adam Smith once observed that there is a “great deal of ruin in a nation” and there may be even more ruin in a supra national entity like the EU.  But, as the Soviet Union eventually found, the laws of economics have a way of being enforced with the doggedness of Inspector Javert and the merciless brutality of Dirty Harry. Bet on them being enforced again.