Thursday, March 21, 2013

Are there supply curves in a theory of return-seeking firms

In the theory of return-seeking firms there is no supply curve as such.  There are simply reactions by firms given their expectations about 1) the persistence of a demand shock, 2) their competitiveness.

Under normal conditions where demand increases in line with expectations, mark-up pricing that is set at a level to discourage competitor entry, can continue to be used.  However, there are many pricing options available to a firm to win market share (a discussion for a later post). 

The below model shows the case of three firms in a market.  The rate of return earned at the starting position is proportional to the market power/competitiveness of the industry.  The theory has nothing to say about whether three firms will result in reduced competition.  Competition, or lack thereof, is an artifact of local monopolies, regulatory frameworks, capital barriers and so forth. In a market with free entry and local competition, three firms can easily be very competitive. 

A shift in the demand curve in this model need not have any special impacts on prices under any period of analysis.  There are no assumptions about the slope of a supply curve.  What exists is an ability to interpret price changes as evidence of market/monopoly power.  For example, if demand for oil tankers increased over a short period, ship builders would have years to increase their mark-ups and returns before a competitor could become established.  However, they may choose not to take all the possible increase in returns to decrease the attractiveness for a new competitor, or to win market share from an existing competitor - no use making high return now, but being forced to accept very low returns in the future when new firms enter the market.  

The price setting during a short term demand shock is not at all the result of costs faced by firms, but of market power. 

To recap, an unexpected sudden shift in demand can provide temporary monopoly power for firms currently in the market (since the shift is beyond the planned capital investments in the market). In markets where new capital takes many years of investment, or there are regulatory barriers to investment, higher prices would be expected.  However in markets where production is highly competitive between established firms vying for market share,  sudden shifts in market demand may lead to falling prices. 

The below interactive graph the demand shock slider shifts the demand curve.  The market power slider sets the starting market power and shows that higher mark-ups / returns will be acheived with greater market power. The checkbox allows market power to be related to demand shocks to demonstrate the case that even in apparently competitive markets unexpected demand shocks might themselves create temporary market power. 

Saturday, March 16, 2013

How economists think of themselves

Tyler Cowen has an article in the New York Times about the egalitarian tradition of economics.  It appears to be a genuine effort to promote economic analysis and rationale as THE tool for social analysis, since it is the only value-free objective way to look at society.  My experience in the profession has given me strong reasons not to be easily convinced.  The very fact that most economists I know have linked to the article with ringing endorsements sheds some light on how economists perceive their role.  

In fact economics has a very distinct moral alignment, and even the basic notion of utility merely reflects an individual’s interpretation of contemporary morals. 

Cowen builds this backdrop of value-free objectivity as a foundation for his pro-immigration arguments. 

Let’s take it one point at a time.  
Economic analysis is itself value-free, but in practice it encourages a cosmopolitan interest in natural equality
What is “natural equality”? No seriously.  What is it?
Many economic models, of course, assume that all individuals are motivated by rational self-interest or some variant thereof; even the so-called behavioral theories tweak only the fringes of a basically common, rational understanding of people. The crucial implication is this: If you treat all individuals as fundamentally the same in your theoretical constructs, it would be odd to insist that the law should suddenly start treating them differently.
Behavioural theories that economists themselves accept could be considered minor tweaks - by definition the discipline won’t accept a rewrite of their fundamental belief structure. A genuinely objective, or value-free, observer of the behavioural tradition would reject the notion of rational self-interest, especially rationality as defined by consumer theory. 

Further, treating all individuals the same in theory is not what economists have set out to do, but what they are required to do to gain mathematical tractability of their core model.  It is equivalent to assuming a single person is the average of all.  Economic models can and do treat different people and groups differently.  For example the overlapping generations model.
 And the classical economists Jeremy Bentham and John Stuart Mill promoted equal legal and institutional rights for women long before such views were fashionable. Their utilitarian moral theories placed individuals on a par in the social calculus by asking about the greatest good for the greatest number.
Bentham and Mill didn’t support personal liberty in every instance — Mill was a proud imperialist when it came to India, and Bentham’s idea for a Panopticon prison was a model of state-sponsored surveillance. But they prepared the way for dissecting the prevailing defenses of hierarchy and injustice.
So basically if you look hard you can find instances where economists historically appeared to be value-free or egalitarian, but if you look even harder you realise that this is chance, and you are equally likely to find the opposite. 
Gary Becker, the Nobel laureate who is one of the founders of this approach, used the economic method to lay bare the selfish motives behind racial and ethnic discrimination. 
In my view Thomas Schelling was perhaps more influential in this area, but of course doesn’t identify as an economist, so his ideas can be dismissed.  Also, Becker’s model “often includes a variable of taste for discrimination in explaining behavior”.  So if people have a taste for it, they derive utility, the economic answer is that discrimination is good.

At this point Cowen turns to immigration an makes the point that we should include the benefits to immigrants in the cost-benefit analysis of immigration, rather than just the current citizens. 
The obvious but too-often-underemphasized reality is that immigration is a significant gain for most people who move to a new country.
In fact the key point of the whole article is in the following two paragraphs
In any case, there is an overriding moral issue. Imagine that it is your professional duty to report a cost-benefit analysis of liberalizing immigration policy. You wouldn’t dream of producing a study that counted “men only” or “whites only,” at least not without specific, clearly stated reasons for dividing the data.
So why report cost-benefit results only for United States citizens or residents, as is sometimes done in analyses of both international trade and migration? The nation-state is a good practical institution, but it does not provide the final moral delineation of which people count and which do not. So commentators on trade and immigration should stress the cosmopolitan perspective, knowing that the practical imperatives of the nation-state will not be underrepresented in the ensuing debate.

I can tell you a good answer of why to report costs and benefits only for the US when considering new laws, particularly with respect to trade and immigration.  Imagine you have the without immigration case.  You don’t draw the line at national borders so you need to include potential immigrants staying in their home country to understand the current situation.  But you don’t know who they are. So you have to take the whole origin country, and since you don’t know which countries they will all come from, you have to take all countries.  If you can’t draw the line as Cowen argues, you have to conduct a global analysis of every decision. 

If, as Cowen suggests, there are massive benefits from immigration at destination countries, then there may very well be massive costs to emigration from origin countries. Yet Cowen expressly ignores these in his supposedly value-free analysis, even though they may very well be higher in welfare terms because of wealth disparities - small benefits are valued more highly the lower your wealth.  

So much for value-free analysis then.  How about we actually consider these important issues like immigration from a moral standpoint instead - at least then we are debating our shared group values rather than using economic analysis to disguise one particular moral judgement.