Economic Theory

Rod Carr is a leading New Zealand economist. In a recent article called Markets Have No Morals, he explained the benefits and the flaws of the standard economic theory that has prevailed for the past fifty years. In this post, I tease his comments out a bit to make them clearer. The words in italics are mine.

Benefits
The 1980s saw an explosion in enthusiasm for using markets to allocate scarce resources. That enthusiasm set off a period of rapid and comprehensive deregulation and privatisation.

• Taxes, tariffs, and subsidies were ‘inherently bad’ as they caused resources to be “misallocated”.

• The pursuit of profit was “inherently good” as resources would flow to their most valuable use.

• Least cost was assumed to create the most value for society (least cost alcohol or tobacco harms society).

• Markets are effective at efficiently allocating scarce resources.

• Markets allow producers and consumers to act in self-interest, leading to the best outcomes for society. (Pareto Optimal in the limited sense that no one can be made better off without making someone worse off, which is not really optimal at all).

• At the time, there was little doubt that markets could allocate financial capital more efficiently than politicians, technocrats, or corporate conglomerates (The global financial crisis showed that this is not true).

• The market acolytes were in control at the World Bank, the International Monetary Fund, the World Trade Organisation and most central banks and Treasury Departments in the world, taught, advised and acted to promote light-handed regulation, tariff-free trade, low taxes, private property rights and market-based solutions.

Assumptions
Markets are ruthlessly efficient at allocating privately-owned scarce resources with a price, provided:

• Price is determined in free market exchanges between many buyers and many sellers (most markets are not free).

• Complete information is available to all participants (rarely true)

• Search and transaction costs are trivial and .

• All the impacts, costs and benefits, are reflected in the prices buyers are willing to pay and

• Sellers are willing to incur (producers push many costs onto the community).

However, this set of ideal circumstances is rare (It probably never occurs). Economists build economic models based on their assumptions, so there models do not match reality.

Selfish, Myopic and Reckless
Markets are myopic, reckless and selfish. Markets are short-sighted:

• A direct result of discounting the future due to uncertainty

• Market participants face a constraint on their access to cash.

• Understate future benefits and exclude or understate future costs.

• Underinvestment in long-life infrastructure.

• Degradation of natural ecosystems and

• Underinvestment in public health and education (explains why our hospitals and schools are struggling).

Markets are reckless:

• They create an asymmetry that sees profits accrue to those with private property rights, while costs are left to lie with the general public.

• Limited liability companies limit downside risk and encourage risk-taking. (Limited liability is a hugely significant government intervention that business owners never admit, despite claiming to believe in free markets.)

• Children do not inherit their parents’ debts (but benefit from wealthy parents).

• Irreversible biodiversity loss is unpriced yet deprives future generations of options and choices while exposing them to unknown risks and costs.

• Decisions today without accountability have irreversible consequences, seriously reduce future choices, raise future costs, transfer risks to other members of our society and undermine social cohesion.

Markets are inherently selfish.

• Markets are indifferent as to the distribution of benefits and costs throughout society (This is a massive problem, because the rich get richer, and the poor stay poor).

• Market acolytes argue that the efficiency gains from market-determined resource allocation allow the winners to compensate the losers, leaving society better off (a rising tide lifts all boats), but political obstacles prevent this from happening.

• As it turns out, the winners attribute their winnings to personal attributes, such as hard work, thrift, ability, and are reluctant to pay enough tax or gifts to compensate the losers.

Rod Carr concludes that markets are a tool to achieve strategic, social, political and economic outcomes, not a result to be pursued for its own sake. Markets should be a tool to enable people and not a mantra to enslave us.

Maslow and Markets

Robert Reich writes in After-Shock (New York 2010 p. 86):

Much of what people want can’t be bought anyway. In 1943, behavioural scientist Abraham Maslow wrote “A Theory of Human Motivation,” a paper in which he posited a hierarchy of human needs. At the bottom are food, shelter, sex, and sleep (of which the first two are typically purchased, although markets also exist for the latter two). Next comes safety and security (which we normally purchase as well, typically though locks on the doors and taxes that pay for police officers and a system of criminal justice). If we lack any of these basics, we’re forced to spend most of our time trying to remedy what’s missing. But once these fundamental needs are met, according to Maslow, our higher needs cannot be satisfied in the market-indeed, they very act of trying to purchase them robs them of their emotional sustenance. They include “belonging needs, such as love, acceptance, and affiliation, and esteem needs”, by which he meant self-respect, social status, and he approval of others. At the top of Maslow’s pyramid are "self-actualisation” needs - our yearning to find meaning in our lives and to express ourselves.

The non-market sector is important. There are two sub-sectors. In the philanthropic part to non-market sector people give things away to people that need them, because they care or think that they are important. In the other part of the non-market sector people club together to provide goods and services for themselves. These are usually paid for with subscriptions or fees. Goods and services are only provided to those who are members.

Markets and Wages (7)

Here are some more problems with market wages that mean a righteous wage is still relevant in the modern world. Wages and salaries are often disconnected from supply and demand.

• In the labour market, adjustments takes place through a change in quantities rather than a change in price, as market theory suggests. Employers do not compete on price, because the long-term risks of that strategy outweigh the short-term benefits. When a profession is scarce, it is much safer to just pay what others are paying and not rock the boat. A few high performers will be paid extra, because they are critical to the business, but most staff others will still just get the going rate, or small increases.

• Neoclassical economics claims to have proved that in a market economy, every employee will be paid what they are worth. All differences in wages and salaries reflect differences in productivity. The problem with their proof is that their economic model depends on a serious of unrealistic assumptions that have no connection to the real world. That has not stopped employers from hiding behind the idea.

• The neoclassical market model assumes that every employer knows the marginal productivity of every employee and pays them accordingly. According to the model, an employer should keep employing additional employees until the marginal wage of the last employee equals the value of their marginal product. This is fine in theory, but the reality is that employers have no way of measuring what an individual employee has produced, so they no way for assessing what an extra employee is worth. A mix of capital and people contribute to every product, so the contribution of one person cannot be isolated. Employers cannot measure the contribution of a single employee or group of employees, so they most just fall back on paying what other businesses are paying.

• An employer has no way to compare the productivity of one class of employees with another. There is no economic model or accounting model that can show that the productive value of an accountant is five times greater than the productive value of a good receptionist. Decisions about their relative value depend on the subjective judgment of the employer, and they can easily be wrong.

These inadequacies with the standard economic model do not make much difference in most situations. Provided the employer has acted in good faith, and the employee has freely accepted the wage or salary offered, the situation is legitimate. However, the situation is different where the wage being offered is not enough for the employee to live on. This is where the righteous wage kicks in.

Markets and Wages (6)

There are several problems with market wages that mean a righteous wage is still relevant in the modern world. Wages and salaries are often disconnected from supply and demand. Market rates can be inadequate for people to live on.

• In every economy, a large proportion of employees are easy to replace. They often have useful skills and are doing work that is important for society, but other people can learn to do their work quite quickly, so employers can replace them if they request a better wage rate. These people cannot complete in a market, because they will always be at a disadvantage. They can often end up earning less it costs to live. The market rate will often be significantly less than a righteous wage rate.

• When low paid employees increase their skills by undertaking training, they are often not rewarded with an increase in wages. Market pressure means that they are not compensated, despite being worth more to their employer.

• Many employees do not have enough information to know what is the market rate for all their employees. Most will just pay what others pay. For low paid staff, they just pay the legal minimum wage.

• Some industries are more profitable than others. People working in these profitable industries are often paid more, even if their productivity is less than those in other industries. The finance industry is a recent example. Salary rates in this industry are disconnected from productivity, and supply and demand. This shift in income share penalises people on low wage rates.

• The price path over time for a good or service is often influenced more by the price in earlier periods than supply and demand in the current period. In labour markets, historical practice has a very strong influence on wage and salary rates. For example, economists are everywhere now (and often wrong), but they are still very well paid. Salary rates have more to do with what economic analysts were worth forty years ago, when they really were scarce.

• Salary and wage rates are slow to respond to changes in supply and demand. When there is a glut of a highly-paid profession, salaries do not drop to the low levels as the simple market model would suggest. Salaries just stay high, because they have always been relatively high. Others wages stay low, even when there is a shortage, because they have always been low.

Markets and Wages (5) Righteous Wage

Allowing the free market to determine wage rates works for many people. However, when employing people at the bottom of the heap, employers are required to pay a righteous wage. This will be sufficient for them to live on. Employers cannot hide behind the market if they have chosen to live righteous lives. God warns that those who ignore the requirement to pay a righteous wage will lose his blessing.

Otherwise they may cry to the LORD against you, and you will be guilty of sin (Deut 24:15).

The righteous rate is not a particular dollar amount. It will vary depending on the circumstances of the person being paid. The righteous rate will be less for a single person with no dependents and a higher for a person who provides for a family. Deciding the righteous rate is an issue between the employer and God. No one else can tell the employer what the righteous rate will be in a particular situation. God knows the employer’s heart and he also knows what is right.

Markets and Wages (4)

The other situation where the Instructions for Economic Life put constraints on the free markets was in the labour market. The employer is a neighbour of the employee. This gives the employer a moral obligation to ensure that their employee has sufficient to live on. Paying the wage or salary determined by the free market will be fine for most people. The situation is different with people who are poor and needy. The employer must not take advantage of their desperation.

Do not take advantage of a hired worker who is poor and needy, whether that worker is a fellow Israelite or a foreigner residing in one of your towns. Pay them their wages each day before sunset, because they are poor and are counting on it. Otherwise they may cry to the LORD against you, and you will be guilty of sin (Deut 24:14-15).

Most economies will have a large number of people who are poor and needy. This will push the market wage rate very low. An employer is not entitled advantage of the situation by paying the lowest wage rate that they can get away with. An employee who is desperate for work must be treated as a neighbour. They should be paid enough for them to live on.

Jesus confirmed and clarified this principle in the parable of the workers in the vineyard (Matt 20:1-16). The vineyard owner did not pay the market wage rate, he promised to pay the employees “what is right".

Go and work in my vineyard, and I will pay you whatever is right (Matt 20:4).

In every economy there will be a market rate for day labourers. Jesus confirms that there is a rate that is “right”. The Greek word is dikaios, which means righteous. The righteous wage rate may not be the same as the market rate. The employer who wants to do what is righteous cannot just pay the market wage rate. They must take into account what is righteous, as well.

For Jesus listeners, what is right referred back to what is specified by the law. The workers who were employed for the whole day were offered a denarius. That was the accepted rate for a day’s work at that time. The employees who only worked for part of the day were also paid a denarius.

He agreed to pay them a denarius for the day and sent them into his vineyard (Matt 20:2).

The workers who were hired about five in the afternoon came and each received a denarius. So when those came who were hired first, they expected to receive more. But each one of them also received a denarius (Matt 20:9-10).

The employer paid every worker a denarius, even though some had only worked for a few hours, while others had worked for a whole day. In those days, a person needed about a denarius to buy a day’s rations. These people were on the poverty line, living from one day to the next. The employer paid each person enough to buy food for the day, even if they had not worked enough to earn it. He was applying the requirements of the Instructions for Economic Life (Deut 24:15). An employer has an obligation to ensure that his employees have enough food that they will be strong enough to work the next day.

The employer in the parable paid all his employees a denarius, regardless of how long they had worked. This was the righteous wage rate, not the market rate. He knew at the end of the day that they would not be able to earn any more money until the next day. If they did not get sufficient income to buy food, they and their family would go hungry until the next day. The righteous thing was to pay the employees enough to live on to the next day, when they would have the opportunity to earn some more.

Markets and Wages (3) Poor

The Instructions for Economic Life put two other restrictions on free markets.

The Poor
Everyone with wealth has an obligation to care for the poor within their neighbourhood. Gleaning is an example of a transaction where the free market price did not apply (Deut 24:19-22). The landowner made grain available to poor person at a zero price. The gleaner had to pay with their labour, but the landowner received no return at all. The market price did not apply to these transactions.

Another example was loans to people in financial difficulty. The neighbour was required to make the loan for zero interest. The market interest rate would usually be well above zero, especially when an allowance for the risk of default was built in to the market rate. This is another situation where the free market was constrained, and a free market price was not legitimate. Charging the market rate of interest would be morally wrong.

Famine
Charging free market prices is not legitimate during a famine.

People curse the one who hoards grain,
but they pray God’s blessing on the one who is willing to sell (Prov 11:26).

Storing grain for tough times in the future is good and prices will always rise when food is scarce. This helps ration out scare supplies. But people who hold back grain and food during a famine just to force the price to excessive levels during a crisis, place themselves under a curse. People with surplus food should be careful about deciding what price they will charge. They must be careful not to just follow the market.

Markets and Wages (2) Fraud Forbidden

The first restriction on free markets is that fraud and deception are forbidden. They are considered to be theft, even if the transaction appeared to be free.

Do not have two differing weights in your bag—one heavy, one light. Do not have two differing measures in your house—one large, one small. You must have accurate and honest weights and measures, so that you may live long in the land the LORD your God is giving you. For the LORD your God detests anyone who does these things, anyone who deals dishonestly (Deut 25:13-16).

This instruction was given in a context where coins were not available for trade. Payments for purchases and sales were made by weighing out gold or silver. A clever way to defraud people was to use scales that weighed light when making payments and a different set of scales that weighed heavy when getting paid.

This type of fraud was an example of what economists call asymmetric information. The person who owned the scales had information that the other did not have. They assumed that they were getting full weight, whereas the person with the scales knew that they were not getting full weight. Even if the exchange occurred freely at an agreed price, the transaction was theft, because the person with the scales was taking something that belong to the other, without getting their permission. Dishonest buying and selling is theft.

The instruction applies to everyone selling goods or services. They must represent the stuff that they are selling accurately. Selling flawed goods as if they are good quality is wrong, because “God detests anyone who deals dishonestly”. This is not a totally free market, where people can take whatever price they can get, even if it is greater than they think the goods are worth. Nor are they entitled to pay the lowest price possible, especially if they think the goods are worth more. Two comments are common in business:

• Let the buyer beware.
• What the market will bear.

They have no place amongst God’s people.

The economic system that system that God gave Moses allows and supports free markets, but this is not freedom without constraint. Trade is free, but it must be honest. Dishonest trade if morally wrong, because it is theft.

Markets and Wages (1)

Free markets are good, and a great system for encouraging economic development. Prices are information carriers, that help producers and consumers make decisions. By studying prices, producers can decide which products are best to produce. Relative prices help producers decide how to combine together the various inputs to a production process in the most efficient way. Consumers use prices to compare the value of different products. Without the information carried by prices, many of these decisions could not be made effectively.

The problem with free markets and prices arises when they are applied to the labour market, because wages and salaries determine the ability of a person to live. Market wages and push some people into poverty.

The Instructions for Economic Life support operation of free markets, but they place limits on them to protect people.

“Do not steal” is one of the Ten Words given to Moses. The implications of this command are spelt out in the rest of Exodus and Deuteronomy. Stealing is a crime, and the penalty for theft is four or fivefold restitution to the person who property has been stolen.

By establishing crime as theft, the God’s law protects private property. If someone wants something that I have produced, they cannot take it without my permission. Taking something that belongs to someone else is theft. This protection is important for economic development. People will only invest in capital and develop efficient production processes, if they know they can sell their product. If someone powerful can steal everything that has been produced, they will not bother. They will produce what they can consume or hide, and do nothing more. This would make everyone in the economy worse off.

The law against theft means that there is only two ways that someone can get something that belongs to me.

1. If I am generous, I might decide to give it to them. This will happen sometimes, but it will not be that common, unless they are family or a friend.

2. They can swap what I have for something they have, including money. Free exchange for payment at the market price will be the most common way that people get access to goods and services for someone else.

The law against stealing encourages the development of free markets and free markets function effectively when stealing is prohibited. If people can just steal anything that they want, free markets will stop functioning and the economy will become productive, because anything that cannot be hidden will be lost.

The instructions for economic life endorse free markets, but they also place limits on them. Freedom to sell or buy at the market price, does not apply in every situation.

Specialisation and Exchange

I recently heard a radio interview with Matt Ridley, who wrote the book called The Rational Optimist. His comments about the nature of human progress are apt. After describing some of the great advances made over the last few centuries, he said,

That kind of progress has come about through the exchange of goods and services. That is what does it. Specialisation and exchange means that when we work for each other, we raise each other’s living standards, by doing what we are good at and swapping if for what other people are good at. That is the big theme of human history. When we do more of that, peoples living standards go up, when we do less of that, by cutting people off from trade and not letting them exchange, and not le them specialise, living standards go down.

This is clear. Prosperity is cutting the amount of time you have to take to fulfil your needs, and you do that by getting other people to do things for you and doing things for them in exchange. This is what happens in the commercial world.

God has created the world in a way that forces us to cooperate to improve our lives. Markets provide a way for us to do that without the need to know or trust the people we are cooperating with.

Scarcity (4) - Solutions

Societies have dealt with this problem of scarcity in different ways.

1. In traditional societies, the king or chief did most of the allocation of goods and services, and they did fairly well from it. The ordinary people usually lived a life of object poverty, but they were expected to provide the ruling group with everything they wanted whenever they wanted it.

2. During the Second World War, coupons were use to allocate a limited supply of consumption good. Essential goods like petrol and fabric could only be bought with a coupon. This limited the demand for scarce goods.

3. In the Soviet Union, the problem of scarcity was solved by queuing. The supply of bread and meat was hardly ever sufficient to meet people’s needs. Most of the time the shops were empty. When supplies came into the shops, people would queue to make their purchase. Those who were to slow to get into the queue would miss out.

4. In market economies, the problem of scarcity is solved by prices. The price of every product reflects the supply and demand for that product. If the demand for a good increases relative to the supply, the price will increase, which will reduce demand. If the supply of the product increases then the price will fall, encouraging more people to buy the product. Prices adjust up and down until the demand matches supply.

The first three options leaves one group of people dissatisfied. The market option, also leave some people dissatisfied, but it does help people to adjust their wants to what is available, because prices allow them to quantify the costs of their choices. If a person wants a high definition television, they can work out exactly how many hours they will have to work to pay for it. They can see in advance the cost of satisfying this need.

Prices have the affect of reducing the demand for goods to a more realistic level. For example, if high-powered sports cars were free, everyone would want one. Because the price is actually well beyond the reach of almost everyone, most of us just take sports cars off list of things we might want. The high price means that we rarely think about the possibility of owning a sports car. Prices enable us to focus on choices that are more realistic for our situation.

Market prices do not eliminate scarcity, but they help people make choices that match their consumption and saving to their earning capacity.