07 July 2014

What is Austrian Economics about?

"First they ignore you, then they laugh at you, then they fight you, then you win."

After Noath Smith's and Mike Munger's ridiculous attacks on Austrian economics can we can say that we have finally entered phase two? In case one is a neoclassical economist interested in moving to phase three, here's with what you have to deal with before anything else.

Take this quote from Knight and Johnson (2007) summarizing a basic point made by David Kreps in one of the most widely used microeconomics textbooks (emphasis added by me):
What economists offer is an analysis of the existence and qualities of equilibrium outcomes that does not explain how markets actually generate such nice equilibria. In other words this demonstration "doesn't provide... any sense of how markets operate. There is no model here of who sets prices, or what gets exchanged for what, when, and where" (Kreps 1990, 195-8). Instead, economists offer "a reduced form solution" that "describes what we imagine will be the outcome of some underlying and unmodeled process" (Kreps, 195, 187). Standard microeconomic analysis, in other words, offers little understanding of precisely how "market/exchange mechanisms" actually operate (Kreps, 195, 190). Thus the claim that economic agents will find their way to equilibrium in a decentralized process is a "rather heroic assertion" and, by implication, it "seems natural to think that we could increase (or decrease) our faith in the concept of Walrasian equilibrium if we had some sense of how markets really do operate." Progress on this task can be made "only if we are more specific about the institutional mechanisms involved" in mar ket interactions (Kreps, 187,190). 

In fact, Knight and Johnson and Kreps are somewhat uninformed. There are two major attempts to explain price adjustment. One is provided by Kenneth Arrow, and the other one by Israel Kirzner (his theory of entrepreneurship, which rests at the very foundation of Austrian economics). Here's a graph of their relative impact on the economic profession (numbers from Google Scholar):

Bottom line: (1) Austrian economics currently offers the most widely accepted model of how real markets actually operate. Austrian economics is alternatively referred to as "the theory of the market process" precisely because its main concern is with addressing Kreps' realism concern above, and deriving the consequences from it. (2) The importance of having such a realistic model is widely recognized by prominent authors like Kreps or Knight and Johnson. 

How about macroeconomics and the Austrian Business Cycle theory? After all, this is the focal point for scorn and ridicule. 
  1. First, it is absurd to identify Austrian economics solely with this theory, especially that prominent Austrians (e.g. Israel Kirzner or Richard Wagner) are actually critical of it for not being Austrian enough (ABCT is a highly aggregated theory with many idealized assumptions). (Here's an example.) And the idea that ABCT is supposed to be apriori correct and in no need of empirical testing is also absurd. The theory is hard to test because it requires disagregated data on the capital structure. Here's a list of empirical papers trying test it (e.g. by looking at the structure of the labor market).
  2. Second, I think that, properly understood, ABCT is an application to macroeconomics of the theory of entrepreneurship -- it is a theory of how entrepreneurial activity gets distorted. So, you cannot really criticize ABCT without getting into the deeper problem of explaining price adjustments. And to say it again: the neoclassical theory of price adjustment is not very well developed (Arrow's approach is interesting, and not necessarily contradictory to Kirzner's, but, in order to do the math, he is forced to make many highly unrealistic assumptions).
Addendum: For more details about various aspects of Austrian economics see my course at GMU.

19 March 2014

Why are costs subjective? And what is the subjective value of money?

A student asks me:

A classmate and I are having some trouble with the question in homework 2 about costs being subjective.  
One answer focuses on individual preferences as the source of costs:
"Costs are subjective because value is determined by the importance that individual players place on goods and services for the achievement of their desired ends. Everyone has different tastes and preferences and this can be reflected when determining how much they are willing to pay for a particular good or service." 
The other focuses on opportunity costs: 
"Costs are subjective because they are derived from marginal opportunity cost. The value of the next best alternative is a subjective value because it depends on the person who is considering a situations. Value is determined by the importance that individual players place on goods and services for the achievement of their desired ends. "

My answer:

The second answer is much better. Costs are subjective because they are opportunity costs - the cost is the value of the next best thing, and this value is subjective. Cost is not just how much you are paying for something, but it is what else you could have done with that money. (After all, the money itself is only valuable because of the things you can buy with it.)

The first answer is incorrect for the following reason:

Even if the two people value the item in the same way, the cost of acquiring the thing may still differ, because the value of the next best thing may differ. The first answer implies that if two people value something in the same way (say, they derive the same subjective pleasure from it), than they would be willing to pay the same amount for it. But this is incorrect. They may still differ in regard to how much they are willing to pay for it because the opportunity cost may differ.

By contrast, if the opportunity cost is the same, they are going to be willing to pay the same amount for the good, even if the subjective value of the good differs! For example, to simplify, suppose we have movie vouchers (we can only buy movies with these things). If I really like movie X, and you only kind of like it, but we both equally dislike the other movies playing, we are going to be wiling pay the same voucher amount to see X. The value of the voucher is given by our subjective valuation of the other movies, not by our subjective valuation of the movie we are buying.

11 February 2014

The Guaranteed Basic Income is Trickier than You Think

Not sure what to make of the recent interest in the idea of a Guaranteed Basic Income (GBI). Apparently, if the current spending on the US welfare state (~$1 trillion, according to this Boston Globe article) would be replaced by the GBI, everyone would get an annual handout of more than $30,000. To get some perspective, I currently have a relatively decent living in the most expensive US county with half that money. This highlights two things.

First, the staggering waste involved in the current welfare system. If the US government is throwing around more than $30,000 per person, how come there are still poor people in the US? Should I suggest firing everyone currently hired in the welfare state bureaucracy and giving them the GBI instead of their wage? But I'm sure many of them earn a lot more than just $30k, which should give you a glimpse at the political economy difficulties involved in any attempt to replace the current welfare system with a GBI.

Second, this highlights the size of the disincentive effect on work that the GBI would have. This is actually well known, but for some reason the concern for mobility is missing from the current discussions. E.g. Richard Wagner's To Promote the General Welfare (chapter 5, "Public Spending and Income Redistribution") discusses the effects of various GBI (or negative income tax) experiments in terms of lowering mobility. Spoiler alert: GBI is far worse than the current complicated system of various targeted welfare payments. This shouldn't be surprising. Giving more money with no strings attached has obviously bigger disincentive effects on work than giving less money with some strings attached. I think it's fair to say that most supporters of GBI have not looked carefully at the mobility side-effects. (Of course, one may also argue for replacing the welfare state with BGI and drastically cutting spending on social transfers, i.e. being in favor of a much smaller BGI, which would no longer have such large disincentive effects – but that sounds even more politically unrealistic.)

So, the real question GBI supporters should ask is how much income mobility are they willing to give up in order to get a lower level of poverty now? To put it differently, if you are concerned about equal opportunity, growing income inequality and a classless society (which is usually framed in terms of how many people succeed in getting out of their parents' income class), you should be against the GBI not in favor of it. The only ways in which to have some sort of safety net that doesn't dramatically affect income mobility are: (a) the current labyrinthic welfare state bureaucracy and waste; (b) a market-based social insurance system with plenty of unavoidable holes in it (occasional fraud, some people left behind, etc.).

There really is no way to have a safety net that is desirable on all margins (such as social mobility, efficiency, and risk aversion). If you want social mobility and are risk adverse, but don't really care about waste, people gaming the system and your occasional homeless person, you should favor the current welfare system, and be quite skeptical of GBI. If you want efficiency and don't care about mobility or growing income inequality, but are risk adverse, you should favor the GBI. If your priority is social mobility, are comfortable with risk, and enjoy your occasional conversations with homeless people, you should favor the market-based social insurance.

Social mobility
Efficient poverty reduction
Very small risk
Market-based insurance
Welfare system