Economics in Two Lessons, Chapter 8

by John Quiggin on April 8, 2018

Thanks to everyone who the first seven chapters of my book-in-progress, Economics in Two Lessons. I’ve tried to think about all of them and respond to as many as possible, but I’m seeking comments from quite a few sources and may have missed some. Feel free to remind me if you think you have a point that’s been overlooked.,

I’ve just posted a draft of Chapter 8:Unemployment. This is one of the most important chapters in the book where I confront a central error in both Hazlitt and Bastiat – the implicit assumption that full employment is the norm in a market economy. So,

The book so far is available
Table of Contents
Introduction.
Chapter 1: What is opportunity cost?
Chapter 2: Markets, opportunity cost and equilibrium
Chapter 3:Time, information and uncertainty
Chapter 4:Lesson 1: Applications.
Chapter 5: Lesson 1 and economic policy.
Chapter 6: The opportunity cost of destruction
Chapter 7: Property rights, and income distribution

Feel free to make further comments on these chapters if you wish.

{ 11 comments }

1

bruce wilder 04.08.18 at 5:51 pm

I find myself increasingly confused as I try to follow down JQ’s path of argument.

In the world of the 1st lesson, we confront the concept of opportunity cost and in the world of the 1st lesson, the opportunity cost is, impliedly I guess, fairly represented by price arrived at in a competitive market. (I say “impliedly” because I get this from the hint that the second lesson is to the effect that price may deviate from such a fair representation of opportunity cost.) Such a competitive market price reconciles the opportunity cost of consumers with the opportunity cost of producers — these two opportunity costs are equal and therefore also equal to the social opportunity cost.

In Lesson 2 territory, we have (at least) three opportunity costs: the opportunity cost of the producer/seller/employer, the opportunity cost of the consumer/buyer/worker, and the social opportunity cost and the possibility that these are not fairly represented/reconciled-at-the-margin by market price. Constructing opportunity cost from the choices and constraints facing the producing/selling firm seems fairly straightforward. Ditto, for constructing the opportunity cost facing the consuming/laboring household. I am not sure I have gotten any guidance in the narrative so far about how the social/public opportunity cost ought to be constructed. Are these public choices and constraints facing the state actor? Or, is the social opportunity cost to be constructed as a reconciliation of the opposing opportunity costs of firm and household? a reconciliation parallel to and presumably (morally?) superior to the market outcome?

This ambiguity seems to come to a head here, with the introduction of Keynesian macroeconomics.

OK, so we have a dynamic, capitalist market economy, with somewhat fluctuating levels of business activity: sometimes contracting (recession), sometimes expanding (expansion), sometimes passing points of inflection (trough, peak). And, “inside” the market system, resources are constantly being re-allocated in response to changes in opportunity costs as people discover new tastes, technologies, ways of living, etc. So, let’s say, there is a decline in demand for coal to fire electric generating plants. A whole bunch of miners are laid off. The unemployed miners would like to mine coal at the prevailing wage for coal miners, but there’s no need to mine that coal because no one wants to burn it. Coal mine operators see an opportunity: they propose to pay miners a lower wage, promising this will result in a lower price for coal, greater demand for coal, and more opportunities for miners to find work at the somewhat lower wage.

Are the coal mine operators wrong? Is there a macroeconomic remedy for unemployed coal miners?

Can we distinguish the plight of coal miners laid off because a decline in the general level of business activity has depressed the demand for coal and the plight of coal miners laid off because automation has displaced labor and the demand for coals is declining due to environmental concerns and the opportunity to use natural gas as a substitute?

2

Anarcho 04.09.18 at 9:47 am

I would have expected a short discussion of Keynes’ argument on cutting wages not being sufficient to solve the crisis — if wages are cut, then prices will fall so leaving real wages unaffected. In other words, the critique of the underlying model Hazlitt is using

http://anarchism.pageabode.com/afaq/secC9.html#secc91

It would also make sense to note that the evidence suggests that during recessions real wages fall, rather than rise. Also, it makes little actual sense to suggest (as Hazlitt implies) that unions have more power during periods of mass unemployment than during periods of low unemployment. Yet this is the implication of Hazlitt’s argument that unemployment is caused by wages being too high (thanks to unions).

It would also be sensible to mention the experience of Austria in the 1930s, when von Mises himself advised the government (including the fascist regime of Dollfuss). As I discuss here, it was not a success:

http://anarchism.pageabode.com/anarcho/talk-what-it-means-be-libertarian-london-28-oct-2017

(and, of course, it links in with the so-called “libertarians” being happy to support fascism)

Also, in terms of stimulus, it would be useful to mention uncertainty — for state spending has the advantage of being reliable, so reducing uncertainty. Unlike market based income, a company would be sure that funds would be steady and so would make them more likely to invest.

3

philip 04.09.18 at 10:29 am

Again, I like this chapter but maybe there is a bit too much that isn’t being made explicit for someone new to these economic concepts. Possibly a bit more explanation around micro and macro. You define micro as looking at individual markets but you could then think that the labour market is a market so in what sense is it macro and then what actually is a market anyway? You could use the example of Bruce above to show the difference between the employment rate in one industry and across the economy as a whole. For the coal miners there will be search costs and possible retraining to get new work (in conditions of full employment), also questions of scale and regional and national rates of employment. This could lead to the neoclassical view that unemployment will be a temporary response to a supply shock to the whole economy and the real business cycle view that all unemployment is voluntary but these fail to explain persistent involuntary unemployment. You make a good case arguing against this but it might help people to understand what you are arguing against.

For example in this passage you start of with an individual worker, then switch to workers, then mass unemployment and it seems to elide the micro macro distinction.

‘There can be no clearer case of this than that of an unemployed worker, willing to work for the prevailing market wage, but unable to find a job. Workers trade their labor for the goods they buy with their wages. Under conditions of high unemployment, workers would like to make this trade at current wages and prices, but are unable to do so. Yet when the economy recovers, the same workers regain employment and are sufficiently productive that employers can pay their wages and earn a profit margin. This is possible precisely because of the additional demand for goods and services of all kinds that arises when the labor force is fully employed.

Mass unemployment, then, is a clear illustration of Lesson 2. The prevailing wage does not reflect the opportunity cost faced by unemployed workers, who would willingly work at this wage and could, under full employment conditions, produce enough to justify their employment’

A libertarian counterargument to the above would be that the prevailing wage is not the market wage due to government interference in the labour market, minimum wage, benefits etc. Therefore, the correct response would be to stop government interference and let the wage reduce to he market clearing level for employment to rise. The problem with that being people won’t be earning enough to survive in the ‘adjustment process’. You could signpost something to the policy section here.

4

philip 04.09.18 at 11:31 am

I’m getting confused here. This section seems to be setting out what the social opportunity cost is but is referring to the situation of individuals and feels more micro to me.

‘Mass unemployment, then, is a clear illustration of Lesson 2. The prevailing wage does not reflect the opportunity cost faced by unemployed workers, who would willingly work at this wage and could, under full employment conditions, produce enough to justify their employment.’

I get that micro implications fail when macro conditions aren’t right so micro foundations in macro analysis only work in the right conditions. So here workers don’t have an alternative to unemployment so there is no opportunity cost for them i.e. micro assumptions aren’t holding but what is the opportunity cost as a society to mass unemployment i.e. what is the alternative? It seems to me that you answer that here:

‘Pulling all this together, we’ll see that the microeconomic analysis of Lesson 1 only makes sense if full employment can be sustained. This doesn’t happen automatically in market economies. It requires government action, through monetary and fiscal policy, to smooth out the business cycle.’ So is the actual opportunity cost to mass unemployment possible inflation and increased public spending in a recession and vice versa or am I just getting it all wrong?

I’ve just re-read this bit and am not sure why there would be a new window if the window wasn’t broken.

‘What if the window had not been broken? Under the assumptions made so far, the shopkeeper would buy a new suit for $50, the tailor would hoard the money and the glazier would remain unemployed. The shopkeeper is better off, since (before the window was broken) he preferred a new suit to a new window. On the other hand, the glazier is worse off, since he gets no work and no suit. For society as a whole, employment has increased: if the new window is better than the old one, output has also increased.’

5

philip 04.09.18 at 2:42 pm

Sorry if I am bombarding you but I’m just trying to work this through in my own head. It seems to me that your argument is:

1) Micro models include assumptions about macro conditions and these micro assumptions are not a good fit with actually existing macro conditions.
2) When macro conditions are not equal to micro assumptions then micro models fail to describe the choices faced by individuals (the market wage does not reflect the opportunity cost of employment so the unemployment is involuntary.)
3) Because the issue is located in macro conditions then it is not just a problem at the individual level but for society this is the social opportunity cost.
4) Micro models cannot explain involuntary unemployment, because they assume full employment, therefore micro models cannot be a foundation for macro analysis.
5) Therefore the solution would be either a) develop micro models that work under non-full employment or b) change the macro conditions to match the micro models’ assumptions. No one has come up with a feasible programme to develop sufficiently robust micro models but we have managed macro conditions successfully for a time under Keynesian policies.

Is this about right? If it is then I think I have been reading too much into the social part of social opportunity costs as here it is just an aggregate of choices made by individuals and I was thinking of choices faced by collectives. It is not just that lots of people who want to can’t get jobs at the market rate but people with jobs will have less choice in how to spend their income and will be reluctant about making large expenditures if they feel their job is at risk. The social cost of unemployment isn’t just situated in people e.g. losing relevant skills during the down turn but in relationships between people. There is the damage to communities, networks, social capital, local supply chains, pools of knowledge, emigration and ‘brain drain’ at regional and national levels etc. So when high unemployment has persisted for too long a time then even Keynesian policies might not be effective in producing sustainable growth. Especially at the regional level with some regions and countries recovering more slowly than others and others doing better but facing other issues such as inflation and affordable housing and living.

6

DCA 04.09.18 at 7:38 pm

Working from (perhaps inaccurate) memory: Kindleberger’s book on the Depression has Japan following successful policies (perhaps not by design) that reduced the impact. These may, of course, have been “let’s build a lot of weapons”, but stimulus is stimulus.

7

Robert 04.09.18 at 11:11 pm

I have barely started the chapter. This comment is provoked by Bruce Wilder.

Some economists can be classified into two camps. The first camp includes popularizers like Hazlitt who do not know what they are talking about. They think an utopia in which prices reflect opportunity costs approximate what actual capitalist economies could be, if only we would eliminate government interventions.

Then second group are imperfectionists, a label I take from Eatwell and Milgate. They think actual economies can be described by deviations from such an unrealizable utopia. And it is the role of government policy to try to make the actual economy approximate this utopia is closely as possible.

I find this framework silly, but it does provide an outline for teaching economics in two lessons. Some problems with the second approach include the allocation of property rights, the distribution of income, and the impossibility of eliminating fundamental uncertainty.

I do not have a good solution for addressing the contrast between the second group and the issues I raise. But maybe this is a source of difficulties for JQ as well.

Sometimes, when I have written stuff, I have found it useful to explicitly list some such problems or what approach I am adopting. This puts aside the problem of solving puzzling problems and lets me get on with writing what I can.

8

Robert 04.09.18 at 11:13 pm

This post is explicitly self-serving.

My name links to a post on international trade. The theory of comparative advantage is about opportunity costs. I illustrate issues with the theory.

Maybe this is too complicated to JQ’s target audience.

9

Peter T 04.10.18 at 5:53 am

Few points.

Does not the post assume that money costs=opportunity costs? The unemployment issue arises precisely because they are not the same. People have minimum survival needs (so many kilojoules, so much shelter and more) that may or may not be affordable in the market (money) economy – ie at the prevailing minimum wage. When they are not, the choices are to fall out of the market economy or die. The first highlights the mismatch between money and utility; the second leads to large losses, not least to the unemployed. Hazlitt does not just assume full employment, he assumes markets in everything.

You might point out after the destruction of the various church/guild/village social security systems and before the introduction of state schemes, around 10 per cent of the populations of the UK, France and similar countries were malnourished and ill-housed, to the point that dead bodies on doorsteps in winter were routine (Floud et al, The Changing Body is a good source on this).

Unrelatedly, can I recommend Adam Touze’s lecture slides on Prussia/Imperial Germany. The latest, on the Wilhelmine state, in particular:

https://www.adamtooze.com/2018/04/08/war-germany-lecture-12-wilhelmine-germany-militarism-weltpolitik/

10

Mike Huben 04.10.18 at 4:12 pm

At the beginning, you need to state that unemployment is a normal part of recession. Many people will not leap to that understanding.

You keep on saying “lesson 1” and “lesson 2”: readers ought to be reminded of the lessons in each chapter. And throughout, you need to keep relating each thing you mention to the lessons.

The third paragraph, 101’ers will reject government action, saying that they are purging the bad through the recession. You can say that government action can move us closer to full employment.

8.1
101ers will ask Why don’t workers just work for lower wages to re-establish full employment?

What is “ the social opportunity cost of labor”?

3rd paragraph takes a long time to not tell us that unemployment is an opportunity cost.

“To put it simply, Lesson 1, important as it is, holds true only in an economy that is working at full employment” BECAUSE unemployment is an opportunity cost. You really need to keep hammering that theme.

8.2
“Over the past century, the US economy has been in recession… almost as often as it has experienced ‘normal’ conditions of steady economic growth and full employment.” Considering that they alternate, of course. But you probably mean the amount of time in each, in which case equality is surprising.

8.3
This section and 8.2 need to present recessions as huge opportunity costs right up front. And Keynsianism as the solution to those opportunity costs. Austerity only worsens the opportunity costs. You are badly diverging from the lessons by presenting very interesting material without making clear how it is directly relevant to the lesson.

8.4
You need to come right out and say “mass unemployment represents an enormous opportunity cost.” A graph of GDP showing the gaps in expected production due to recession (as opposed to the growth path) might do a good job of illustrating opportunity costs.

“ around 5 per cent of the labor force is unemployed and actively looking for work at any given time.” Does this really make 101 theories not apply or be off by much from a state of full employment?

8.5
Aha! There it is. Mass unemployment and lesson 2. This needs to come BEFORE the recession parts. Because that is why you can say recessions are bad, to counter claims of purging the rot. And you can compare the opportunity costs of Keynsian solutions and Austrian solutions.

“Only when prices also fall to a level where they reflect opportunity costs does Lesson 1 become applicable again.” This needs clearer explanation. Textual handwaving is much less explanatory than a diagram here.

8.6
Maybe you should start with the point that microeconomics is a special case deriving from when macroeconomics is functioning correctly? Then, looking for microeconomic foundations for macroeconomics is foolish, since macroeconomics creates the conditions for microeconomics. And the macroeconomy is a government product due to a virtuous cycle that sometimes fails creating depressions.

8.7
Once again, textual handwaving does not llow us to make comparisons nearly as well as a table would. In addition, you seem to have forgotten that the tailor has $50 unspent. You might not be accounting properly for stocks and flows. I find it unconvincing.

11

John Quiggin 04.11.18 at 1:07 am

Thanks to everyne for these comments. I’m finding them very useful.

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