Economics in Two Lessons, Chapter 9

by John Q on April 19, 2018

Thanks to everyone who the first eight chapters of my book-in-progress, Economics in Two Lessons. I’ve found the comments on Chapter 8 valuable, but haven’t yet found time to edit in response to them. Soon, I hope!

In the meantime, I’ve posted a draft of Chapter 9: Market Failure. Comments, criticism and praise are welcome.

The book so far is available
Table of Contents
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
Chapter 8:Unemployment

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



Anarcho 04.19.18 at 9:31 am

For the labour market, I would add the evidence that before (approximately) 1980 wages rose with productivity, which after 1980 wages have stagnanted while productivity has continued to rise. This, I would suggest, show the flaws in “First Lesson” economics are regards the labour market, as I discuss here:

The neo-liberal medicine is still not working…

The notion that unions exploited other workers is nonsense — and proven to be by the acts of Thatcher and Reagan — and instead they provide a means of lifting up ALL workers wages.

(I suppose that the neo-classical position is that unions allow workers to exploit the master-class, although they never say that!)

Also, it is worth mentioning that as inequality soared, social mobility fell — unsurprisingly, as it is easy to climb a hill than a mountain.

Finally, as I wrote elsewhere:

Ironically, given economists usual role in society as defenders of big business and the elite in general, there is one conclusion of general equilibrium theory which does have some relevance to the real world. In 1956, two economists “demonstrated that serious problems exist for the model of competitive equilibrium if any of its assumptions are breached.” They were “not dealing with the fundamental problem of whether a competitive equilibrium exists,” rather they wanted to know what happens if the assumptions of the model were violated. Assuming that two violations existed, they worked out what would happen if only one of them were removed. The answer was a shock for economists — “If just one of many, or even just one of two [violations] is removed, it is not possible to prejudge the outcome. The economy as a whole can theoretically be worse off it just one violation exists than it is when two such violations exist.” In other words, any single move towards the economists’ ideal market may make the world worse off. [Ormerod, Op. Cit., pp. 82-4]

What Kelvin Lancaster and Richard Lipsey had shown in their paper “The General Theory of the Second Best” [Review of Economic Studies, December 1956] has one obvious implication, namely that neoclassical economics itself has shown that trade unions were essential to stop workers being exploited under capitalism. This is because the neoclassical model requires there to be a multitude of small firms and no unions. In the real world, most markets are dominated by a few big firms. Getting rid of unions in such a less than competitive market would result in the wage being less than the price for which the marginal worker’s output can be sold, i.e. workers are exploited by capital. In other words, economics has itself disproved the neoclassical case against trade unions. Not that you would know that from neoclassical economists, of course. In spite of knowing that, in their own terms, breaking union power while retaining big business would result, in the exploitation of labour, neoclassical economists lead the attack on “union power” in the 1970s and 1980s. The subsequent explosion in inequality as wealth flooded upwards provided empirical confirmation of this analysis.


Robert 04.19.18 at 12:34 pm

As usual, I am commenting without finishing my reading.

Economies of scale, as I understand them, are reversible, in some sense. The idea is that technology is known. If a firm goes back to decreased production, it will obtain the same costs as previously at that scale.

There is a whole line of literature about dynamic increasing returns or learning-by-doing that is more realistic. I might start with Marshall and mention Young, Arrow, and Kaldor. I think Smith’s pin factory falls into this, as well. I particularly like Kaldor’s 1970s articles on the failure of General Equilibrium.

Whether or not this complicates the argument too much, I leave to you.


Peter T 04.20.18 at 12:10 am

The economies of scale argument could, I think, do with a simpler example and a more forceful focus on the consequences. At its simplest, increasing volumes of production alter the ratio between fixed and recurrent costs. A key driver of this is that it becomes more advantageous to invest in capital machinery as volumes increase. If, for instance, I have to dig 10 post-holes, a crowbar will do; at 100 I will buy a post-hole digger; if I dig post-holes every day I will buy an auger for the tractor (note that using any of these needs only one person, and no more skill).

There are two important consequences. One you note: that the big get bigger, until they reach limits imposed by geography or the technology (this can be very big: there are only a handful of large-scale chip fabs in the world), and therefore can exert more leverage over prices (and politics).

The second consequence is, as you say, that marginal costs decline below average costs. This forces firms to look for ways to maintain prices above average costs, which is where cartels, intellectual property, tied supply etc come in. In other words, without government, complex production becomes impossible.


Peter T 04.20.18 at 4:33 am

Another area you might add a bit is the incentive for firms to create and maintain technical monopolies, and the role of non-market actors (governments, industry, academia) is setting standards that limit this. Examples in IT include Microsoft (Office) and its efforts to undermine open document standards, but note that Linux has pushed it out of the server market, where adherence to a non-proprietary standard is key. The ultimate standards are, of course, weights and measures – an area where governments have active for as long as they have existed.


H Horan 04.20.18 at 8:15 pm

1. on page 7 you try to distinguish between monopoly power developed from “good” reasons (lower prices) and “bad” reasons (physically blocking competitors). This falls into a trap set by Bork and others designed to short-circuit any antitrust discussion where there was evidence of “consumer welfare benefits” such as lower prices. The critical distinction should be between competitive pricing advantages that are “good” because they are based on legitimate, sustainable productive efficiency advantages, and pricing advantages that are “bad” because they reflect predatory actions, designed to drive more efficient competitors out of business so that the predator can then seize control of some (separate) source of market power. Uber is an obvious, simple example (using predation to pursue industry dominance where it has absolutely no competitive efficiency advantages). Amazon is a more typical case. It has legitimate cost advantages over traditional booksellers, but set prices even lower to establish impregnable dominance over broader aspects of ecommerce where it wasn’t more efficient. “Consumer welfare” rules need to be replaced with “economic welfare” rules. They are not the same thing.
2. Following One lesson/Chicago school approaches, the chapter focuses excessively on “monopoly” (in the Standard Oil sense) which is even more rare than a “perfectly competitive” market. It is useful to mention Standard Oil in order to explain than US antitrust law was designed to address simple/extreme 19th Century problems, and even before the onslaught of Chicago school attacks, was totally inadequate for dealing with actual real world 2oth Century market failures. The word “monopoly” implies using near 100% market share of a major industry to gouge consumers. Thus if those conditions don’t hold, there’s no basis for enforcing
3. One possible approach would be greater emphasis on “artificial market power” This allows that “legitimate, non-artificial” market power can exist (due to chemical industry scale economies or the ruinous costs of duplicating utility lines). Instead of crude size or market share or HHI criteria, it refocuses discussion of whether producers have sustainable supra-competitive profits, and whether those were created from legitimate (sustainable product/efficiency advantages) or artificial sources. In this context antitrust action focuses on stopping the exploitation of artificial power, while regulation limits the freedom of action of producers with legitimate, non-artificial power.


Mike Huben 04.21.18 at 4:10 pm

Ch. 9
This chapter, like many of the preceding chapters, suffers badly from a lack of clarity. Not so much a lack of clarity of prose, but clarity of moral purpose.

Just take a look at the first chapter of EIOL:

Every paragraph is making a judgment of good and bad. There is a moral clarity there which is electrifying. You could also have this same electrifying moral clarity about people who attend only the first lesson and ignore the second lesson. Instead, you tend to have very passive and technical prose.

As a matter of fact, his summary sentence works just as well for both your lessons. It does not rule out opportunity costs not borne by the market. That is a separate part of his propaganda. He writes: “The bad economist sees only what immediately strikes the eye; the good economist also looks beyond.” But that is exactly what he does by ignoring your second lesson! It would be easy to damn him with his own words.

Please pick a chapter of his and look at how the RHETORIC works. Note what he does: how many devices he uses. Then look at your prose and its rhetoric. At some point, you will have to make a decision: be rhetorical and be broadly read, or be passive and get read by very few.

Hazlitt probably honed his rhetoric over decades. I know you want to spend less time than that, but you can still do more. Make a checklist for EACH paragraph: does it start with a judgmental statement? Does it clearly relate to the moral point? Does it get bogged down with technical detail and terminology? Could part of it inspire quotation? Does it use enough rhetorical devices? Feel free to add more to the checklist. It wouldn’t hurt to check out some famous inspirational speeches to see if you could use their techniques.

need a small table to demonstrate the .6 power rule
“ Low traffic routes are often served by only a single carrier, whose prices are constrained mainly by the threat that some other airline might decide to enter the market. “ Need to be explicit that they charge more than opportunity costs, monopoly fares.
Point out Silicon Valley, Hollywood, Wall Street as well known examples of ‘external economies of scale’
“When economies of size are present, the (marginal) opportunity cost of producing an additional unit of a good or service is less than the average cost of the total quantity produced.” This could be expressed much more simply as “It is cheaper to manufacture more.” Use a footnote for the technical language.
State the conclusion first (higher prices), then explain in terms of opportunity costs. Nobody skimming will see the conclusion way at the end, and many people will want the gist, not the technical explanation.
“grow faster than your competitors, thereby securing economies of size. This can be a profitable strategy for the winning firm, even if it incurs losses in the short run. “ You can point out that this has been a major factor in the growth of Amazon, Google, Twitter, Facebook and other recent monopolists. And in the past, Microsoft, IBM, Xerox, etc.
“Starting in Cleveland, Standard Oil acquired its rivals or drove them out of business by a combination of fair means (lower prices) and foul “ It would be nice to see some references here: libertarians like to cite Standard Oil as an example of failure to create monopoly and good free market behavior.
“ IBM lost its dominance not to a rival manufacturer, but because the source of monopoly power shifted to the operating system, controlled by Microsoft.” Actually, the source of monopoly power shifted because IBM lost monopoly on the BIOS after the BIOS was successfully black-box reverse engineered. Once the BIOS replacement could be purchased, anybody could make an IBM compatible computer.
“It turned out that the crucial key to control of this market was the search function, and this market was quickly dominated by Google.5”
No, the crucial key was advertising sales and consumer data. That’s where Google makes its money. Google search is free to users: how does this relate to opportunity cost then?
‘But, with brief interruptions, the history of information technology has been one in which markets are dominated by a single firm, with a great deal of power over pricing. There is only a tenuous relationship between prices and opportunity costs”
As has been clearly shown by the Free Software Foundation and its descendents. LibreOffice, Opera, PGP, Linux, and a host of other foundational software. Somehow this has to be related to opportunity costs.
Ah: here is the mention of Apple, Exxon, Alphabet (Google), Microsoft, Amazon and Facebook. I’d move them up earlier.
“The market value of these firms depends more on the question of whether they can maintain that monopoly position than on whether the total return on their investments is greater than the social opportunity cost.” Don’t you mean their private opportunity cost? Since they can ignore social opportunity costs?
“ It’s arguable that Google’s monopoly in search is ‘natural’. There are obvious economies in having a single firm search and index the Internet, and no one has been willing to replicate Google’s vast engines.” Wow, this is so wrong. Google has an IP monopoly on its method of search weighting. Several other companies have indexed the entire web. It’s not that expensive: even the nonprofit internet archive does it.
“One Lesson economists are generally uncomfortable with the existence of monopoly, and tend to look for ways to dodge the issue” No, they flat-out deny it is an issue with bad arguments. You need to frame this in terms of “they are wrong, and here is why”.
“This claim can be, and is, made about any market failure, and has been generalized to a theory of ‘government failure’” You should point out that this is a propaganda term, and not nearly as formalized as “market failure”.
“Such firms will compete both on price and in terms of the quality of their offerings.” I’d say “supposedly compete”, to set up for the next paragraph.
“But this kind of competition is quite different from what economists refer to as ‘perfect competition’.” Why and how?
There is a constellation of “power” terminology that you are presuming readers are familiar with and can distinguish between. Market power, bargaining power, monopoly power, pricing power, monopsony power
I would split this into two sections: one on monopsony, and the other on labor and how that can have the characteristics of monopsony. I would put the labor one after 9.5.
“Crusoe has much more power” Yet another power to make clear. And wasn’t it essentially enslavement at first? And the disagreement point is quite arguable: it would be death at Crusoe’s hands because Friday could reveal his existence which would result in Friday’s death. While there is significant history of killing unwilling workers, perhaps you should find a less fictional example which has better clarity.
You might also point out that because of the costs of changing jobs, employers have yet another lever to reduce salaries when inflation is occurring. Employers also have efficiencies of scale and specialization in hiring and bargaining that employees lack. You could also mention non-compete agreements and other take-it-or-leave-it bargaining strategy that conceals opportunity costs by deferring them to the future or limiting bargaining flexibility.
“The Chicago critique has been widely accepted” What is this? Nobody will remember from earlier.
How can you relate this to opportunity costs right from the beginning? You lose focus.

Once again, the information here is invaluable. But it is only accessible to a tiny few readers (compared to EIOL) because it is not written for junior high school level would-be zealots. Take a look at my list of Fundamental Libertarian Books. Most of them, especially Atlas Shrugged, are written to ensnare young adults.

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