I’ve been promising for a long time to write a new book, framed as a reply to a free-market tract Economics in One Lesson by Henry Hazlitt, published in 1946, but still in print and popular among free market advocates. Its popularity reflects the fact that it’s a reworking of Bastiat’s “What is Seen and What is Not Seen”, still one of the best statements of the case for free markets.

Bastiat’s argument is implicitly based on the concept of opportunity cost but, since the term wasn’t coined until 1914, he doesn’t use it. Neither, more surprisingly, does Hazlitt. Once this is made explicit, Hazlitt’s rather ponderous, and misleading statement of his “One Lesson”

The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.

can be boiled down to the much simpler statement “Market prices reflect opportunity cost”. In important respects, this is true, particularly when we consider the problem from the perspective of choices about how to allocate an individual, family or government budget. With fixed aggregate levels of public expenditure, for example, more money for the military means less for schools, and vice versa.

There are plenty of other questions about private and public decisions for which Hazlitt’s One Lesson is useful. Another example is the well-supported finding that the best way to fight poverty is to give money to poor people. This is unsurprising given that poor people themselves will usually have a much better idea of the opportunity costs they face than will those seeking to help them.

But as a general statement, Hazlitt’s One Lesson is false, which is why my working title is Economics in Two Lessons”. Lesson Two is “Market prices do not reflect all the opportunity costs we face as a society”

To someone trained in mainstream economics, as I have been, the immediate examples of this Lesson are “market failures”, such as externality, monopoly and information asymmetries. I originally planned my book to focus on these market failures, making it a somewhat idiosyncratic take on what is usually called public economics. But I kept feeling that I was missing out too much that was important: unemployment, income distribution and many other issues.

After struggling with this for a long while, I reached the conclusion that a framing in terms of opportunity cost worked to deal with the issues with which I was most concerned, and allowed for a more fundamental critique of the free market position. My central point is that, before we even consider whether a set of market prices is subject to market failures in the usual sense), it is necessary to consider

* The allocation of property rights, broadly defined to include rights to pensions and social security, obligations to pay tax and so on, and the opportunity costs associated with alternative allocations

* Whether the market outcome is a full employment equilibrium or a recession/depression. In the second case (very common, as I will argue), markets don’t properly match supply and demand, so that prices and particularly wages do not determine opportunity costs in general.

My recent posts about the nature of property reflect some of my thinking on the first point, and I’ll soon be posting about the second also. As with Zombie Economics, though less systematically, I’m planning to put up draft extracts from the book for comment and criticism.

Working on my Economics in Two Lessons book, I’ve had to address the concept of Pareto optimality, which naturally raises the question of how it fits into Pareto’s larger body of anti-democratic and anti-egalitarian thought, which culminated, at the end of his life, in his embrace of Mussolini’s fascism. This led me to an article (paywalled, sorry) published by Renato Cirillo, in 1983, defending Pareto against the charge of being a precursor of fascism. Cirillo asserts that, far from being a fascist, Pareto

“manifested consistently a strong attachment to a type of liberalism not dissimilar to the one later attributed to Mises and Hayek”

These are rather unfortunate examples, in view Mises writings in praise of fascism and work for the Dollfuss regime, and (even more), Hayek’s embrace of Pinochet, at the very time Cirillo was writing [^1].

This, along with my discovery that Locke was actively involved in the expropriation of the native American population, justified by his theory of property, led me (back) to the question of the relationship between the writings of political theorists (broadly defined to include economists, sociologists and philosophers engaged with these issues) and their personal political activity and commitments. I’ve come to two conclusions about this.

First, for serious writers on political theory, political engagement is and ought to be the rule rather than the exception. I don’t mean that philosophers should (necessarily) run for office. Rather someone whose political theory doesn’t lead them to have and express views on the great political issues of their day probably doesn’t much of interest to say about theory either (unless of course, their theory leads them to some form of quietism). That’s true of the writers whose commitments were creditable (for example, John Stuart Mill and Bertrand Russell) as well as the discreditable cases I’ve mentioned.

Second, it makes no sense to look at the theoretical writings and ignore the political commitments with which they are associated. For example, it is easy to construct readings of Pareto, Mises and Hayek in ways that make them appear either as friends or as enemies of political liberalism. Their (remarkably similar) actions make it clear which reading is correct. Eventually, of course, ideas outgrow their creators to the point where original intentions, and the texts in which they were expressed, cease to be relevant. But, as the Locke example shows, that’s a very slow process. As long as a writer is regarded as having any personal authority, the weight of that auhtority must be assessed in the light of their actions as well as their words.

[^1]: To be sure, none of these writers can properly be described as fascists – they aren’t interested in nationalism or in the display of power for its own sake. Rather, their brand of liberalism is hostile to democracy and indifferent to political liberty, making them natural allies of any fascist regime which adheres to free market orthodoxy in economics.

After a couple of preliminary posts, here goes with my first draft excerpt from my planned book on Economics in Two Lessons. They won’t be in any particular order, just tossed up for comment when I think I have something that might interest readers here. I’ll update as I go, in response to comments and criticism; this may create some difficulties reading the comments thread, but hopefully the improvement in the final product will be worth it.

To remind you, the core idea of the book is that of discussing all of economic policy in terms of “opportunity cost”. My first snippet is about

Pareto optimality

The situation where there is no way to make some people better off without making anyone worse off is often referred to as “Pareto optimal” after the Italian economist and political theorist Vilfredo Pareto, who developed the underlying concept. “Pareto optimal” is arguably, the most misleading term in economics (and there are plenty of contenders). Before explaining this, it’s important to understand Pareto’s broader body of thought, one which led him in the end to embrace fascism.

Pareto and the libertarian path to dictatorship

Pareto sought to undermine the version of liberalism that dominated 19th century economics, according to which the optimal (most desirable) economic outcome was the one that contributed most to human happiness, often (if somewhat loosely) summed up as ‘the greatest good of the greatest number’. Particularly as developed by the great philosopher and economist John Stuart Mill, this is a naturally egalitarian doctrine.
The egalitarian implications of the classical framework reflect the fact that the needs of poor people are more urgent than those of the better off. So, the happiness of the community as a whole all be increased by policies that benefit the poorest members of the community, even if these benefits come at the expense of those who are better off. It follows that a substantial degree of income redistribution will be social desirable and that large accumulations of individual wealth, which contribute only marginally to the happiness of a small number of people are undesirable in themselves, though they may in some circumstances be a by-product of desirable policies.
Pareto’s big achievement, further developed by a large number 20th century economists, was to show that much of economic analysis could be undertaken without invoking the concept of utility. Hence, interpersonal comparisons of happiness, which invariably lead to the conclusion that redistributing wealth more equally is beneficial, could be dismissed as ‘unscientific’.
Pareto didn’t stop with an attack on the economic implications of Mill’s approach. Mill’s philosophical framework implied support for political democracy, including the enfranchisement of women. Since everyone’s welfare counts equally in the classical calculus, the political process should, as far as possible, give everyone equal weight.
Pareto reversed this reasoning, arguing that a highly unequal distribution of income was both inevitable and desirable; he proposed what he called a power law, described by a statistical distribution which also bears his name. Pareto’s “Law” may be summed up the 80-20 proposition, that 20 per cent of the population have 80 per cent of the wealth.
The supposed constancy of income distribution implies that any attempt at redistribution must be essentially futile. Even the aim is to benefit the poor at the expense of the rich, the effect will simply be to make some people newly rich at the expense of those who are currently rich. Pareto called this process ‘the circulation of elites’. (In his dystopian classic 1984, Orwell has the Trotsky-like character Emmanuel Goldstein present the same idea as the starting point of The Theory of Oligarchical Collectivism. Orwell almost certainly derived the idea from James Burnham, an admirer of Pareto whose work Orwell saw as the embodiment of ‘power worship))
All of this led Pareto to become one of the first advocates of a political position combining an extreme free-market position on economic issues with hostility to political liberalism and democracy. Pareto welcomed the rise of Mussolini’s fascist regime, and accepted and accepted a “royal” nomination to the Italian senate from Mussolini. However, he died in 1923, less than a year after
Pareto was not really a fascist however. Rather, he developed a version of liberalism similar to that of his more famous successors, Hayek and Mises, both of whom embraced and worked for murderous regimes that had come to power by suppressing democratic socialist parties. Like Pareto, neither Hayek nor Mises can properly be described as fascists – they weren’t interested in nationalism or in the display of power for its own sake. Rather, their brand of liberalism was hostile to democracy and indifferent to political liberty, making them natural allies of any authoritarian regime which adheres to free market orthodoxy in economics. (Fn Supporters of Hayek and Mises commonly describe themselves as “libertarians”, but their alliance with brutal dictators makes a travesty of the term – they have been derisively described as “shmibertarian”).

Pareto optimality

Now back to “Pareto optimality”, and why it is such a misleading term. Describing a situation as “optimal” implies that it is the unique best outcome. As we shall see this is not the case. Pareto, and followers like Hazlitt, seek to claim unique social desirability for market outcomes by definition rather than demonstration.

If that were true, then only the market outcome associated with the existing distribution of property rights would be Pareto optimal. Hazlitt, like many subsequent free market advocates, implicitly assumes that this is the case. In reality, though there are infinitely many possible allocations of property rights, and infinitely many allocations of goods and services that meet the definition of “Pareto optimality”. A highly egalitarian allocation can be Pareto optimal. So can any allocation where one person has all the wealth and everyone else is reduced to a bare subsistence.

Recognising the inappropriateness of describing radically unfair allocations as “optimal”, some economists have used the description “Pareto efficient” instead, but this is not much better. It corresponds neither to the ordinary meaning of “efficient” nor to the meaning with which the term is commonly used in economics, which is also misleading, but in a different way.

The concept of opportunity cost gives us a better way to think about the possibility of making some people better off while no one is worse off. If such possibilities exist, then there are potential benefits that have no opportunity costs. Conversely, if there is a positive opportunity cost for any benefit, then we can’t make anyone better off without making someone else worse off. So, a “Pareto optimal” situation may be described, more simply as one where all opportunity costs are positive.

Over the page, the draft preface for my book-in-progress, Economics in Two Lessons

I got some great comments first time round, but I can see it would be easier if I presented my drafts in a more orderly fashion, though not necessarily sequential. So, I’ll begin at the beginning. Comments, both critical and favorable, much appreciated.

As the name implies, this book is a response to Henry Hazlitt’s Economics in One Lesson, a defence of free-market economics first published in 1946. But why respond to a 70-year old book when new books on economics are published every day? And why two lessons instead of one?

The first question was one that naturally occurred to me when Seth Ditchik, my publisher at Princeton University Press suggested this project. It turns out that Economics in One Lesson has been in print continuously since its first publication and has now sold more than a million copies.

Both where he was right, and where he was wrong, Hazlitt’s arguments remain relevant today, and have not been substantially improved on by today’s advocates of the free market. Indeed, precisely because he was writing at a time when support for free markets was at a particularly low ebb, Hazlitt gave a simpler and sharper presentation of the case then many of his successors.

Hazlitt, as he makes clear, was simply reworking the classic defence of free markets by the French writer Frédéric Bastiat, whose 1850 pamphlets ‘The Law’ and ‘What is Seen and What is Unseen’ form the basis of much of Economics in One Lesson. However, Hazlitt extends Bastiat by including a critique of the Keynesian economic model developed in response to the Great Depression of the 1930s.

Hazlitt presented the core of the free-market case in simple terms that have not been improved upon by any subsequent writer. And despite impressive advances in mathematical sophistication and the advent of powerful computer models, the basic questions in economics have not changed much since Hazlitt wrote, nor have the key debates been resolved. So, he may be read just if he was writing today.

Some of the key questions addressed by Hazlitt are:

* Will Keynesian fiscal policies secure full employment?
* Should the government invest more in infrastructure ?
* Do minimum wages benefit workers?
* Can price controls stop inflation ?

Hazlitt answers ’No’ to all these questions. His One Lesson is:

The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.

As Hazlitt develops the argument, his meaning becomes clear. The direct benefits of more jobs and public works, higher wages and lower prices are obvious. But these benefits do not come without costs, often borne by groups far removed from the beneficiaries. The true measure of cost is not a money value, but the alternative use to which resources could have been put. In Hazlitt’s words:

Everything … is produced at the expense of foregoing something else.

Economists call this foregone value ‘opportunity cost’. The decision to provide some particular good or service makes us better off if, and only if, its value to us is greater than the opportunity cost involved in its production.
But how does Hazlitt get from the idea of opportunity cost, accepted by nearly all economists, to the conclusion that government intervention in the economy is hardly ever justified? The answer is simple.

Hazlitt assumes that the opportunity cost of any good or service is its market price. So, he infers, any government interference with markets , such as the provision of ‘free’ services, must involve hidden costs that outweigh the immediate benefits.

So we can restate Hazlitt’s Lesson as:

Assuming that market prices are equal to opportunity costs, government interventions that change the market allocation must have opportunity costs that exceed their benefits.

The simplicity of Hazlitt’s argument is his great strength. By tying many complex issues to a single principle, Hazlitt is able to ignore secondary details and go straight to the heart of the free market case against government action. His answer in every case flows from his ‘One Lesson’.

But Hazlitt’s strength is also his weakness. He never spells out the relationship between prices and opportunity costs. As a result, he implicitly assumes that there is a unique market allocation, in which prices equal opportunity costs, and that the two can only differ as a result of government interference. Although he does not say so explicitly, he implies that the existing distribution of income (or rather, the one that would emerge after the policies he dislikes are scrapped) is the only one that is consistent with his One Lesson.

While markets are exceptionally powerful social institutions, they cannot work unless governments establish the necessary framework in which they can operate. The core of the economic framework in a market economy, and a central role of government, is the allocation and legal enforcement of property rights.

The market outcome depends on the system of property rights from which it is derived. In fact (as we will see later) when markets work in the way Hazlitt assumes, any distribution of goods and resources where prices equal opportunity costs can be derived from some system of property rights. So Hazlitt’s Lesson tells us nothing useful about the distribution of income or about government policies that may change that distribution.

An equally important problem is that, despite the then-recent experience of the Great Depression, Hazlitt implicitly assumed that the economy is always at full employment, or would be if not for government and trade union interference. Experience shows that the economy frequently remains in a depression or recession state for years on end. In such a situation, markets don’t properly match supply and demand. This means that prices, and particularly wages, do not, in general, determine opportunity costs.

Finally, there is what economists call ‘market failure’. Even within a market system, and accepting the initial allocation of property rights, a variety of possible problems, such as monopoly, may result in market prices that do not reflect all the relevant opportunity costs for society as a whole.

To understand the central issues in economic policy debates, we need not one lesson, but two. The first lesson, implicit in Hazlitt’s One Lesson is:

Lesson 1: Market prices reflect and determine opportunity costs faced by consumers and producers.

The second lesson is the product of more than two centuries of study of the way markets work, and the reasons that they often fail to work as they should:

Lesson 2: Market prices don’t reflect all the opportunity costs we face as a society.

Two lessons are harder than one. And thinking in terms of two lessons comes at a cost: we can sustain neither the dogmatic certainty of Hazlitt’s free-market policies nor the reflexive assumption that any economic problem can be solved by government action. In many cases, the right answer will remain elusive, involving a complex mixture of market forces and government policy.

The problem of how markets work and why they fail is at the core of most of the economic policy issues that drive political and social debate. I hope this book, and the two lessons it contains will help to clarify these issues.

As part of the research for Economics in Two Lessons, I’m looking in to the history of some of the ideas I’m talking about, including Pareto optimality, externalities and of course opportunity cost. I’m undecided as to whether I’ll include this material, perhaps as starred (skip if you feel like it) sections, or in an Appendix. Suggestions on this point are welcome.

My research on the intellectual history of opportunity cost has so far gone no further than Wikipedia, which attributes the term to Friedrich von Wieser, an Austrian economist in both the national (he was Minister for Finance there in 1917) and theoretical senses. Turning to the article on von Wieser, I was surprised to read that he put forward an argument very similar to mine regarding the relationship between opportunity cost and the distribution of wealth

Instead of the things that would be more useful, there are things that pay better. The greater the difference in wealth, the more striking are the anomalies of production. The economy provides luxury to the capricious and greedy, while it is deaf to the needs of the miserable and poor. It is therefore the distribution of wealth that decides what will be produced, and leads to a consumer of a more anti-economic variety: a consumer wastes on unnecessary, guilty enjoyment that which could have served to heal the wounds of poverty. —Friedrich von Wieser, Der Wert Natürliche (The Natural Value), 1914.

It turns out, even more surprisingly to me, that von Wieser was linked to a Viennese group of Fabians.

I’m still trying to digest this, and work out where to go next with it. Can anyone point to useful information about von Wieser?

I’m still redrafting the opening section of my book, on the concept of opportunity cost. Some applications to specific problems coming soon, I promise. In the meantime, comments and criticism, including editorial corrections and nitpicks, much appreciated.

Opportunity cost

What is opportunity cost?

Remember that Time is Money. He that can earn Ten Shillings a Day by his Labour, and goes abroad, or sits idle one half of that Day, tho’ he spends but Sixpence during his Diversion or Idleness, ought not to reckon That the only Expence; he has really spent or rather thrown away Five Shillings besides.



Benjamin Franklin, From his Advice to a Young Tradesman from an Old One” (1746)

Two roads diverged in a wood, and I—
I took the one less traveled by,
And that has made all the difference.

Robert Frost, The Road Not Taken, 1916

Economists are famous for disagreeing among themselves. Keynesians argue with monetarists about fiscal policy. Members of the Chicago School, including a string of Nobel Memorial Prizewinners1, advocates unfettered free markets, while the case for government intervention in the economy is championed by economists such as Paul Krugman, Amartya Sen and Joseph Stiglitz, all of whom have also been awarded the Prize. As George Bernard Shaw is supposed to have observed, ‘If all the economists in the world were laid end to end, they still wouldn’t reach a conclusion.’

And yet, there is an economic way of thinking that separates any serious economist, regardless of their views on policy, from just about anyone who has not studied economics. The centrepiece of this way of thinking is the concept of opportunity cost. This key idea comes up in the first few weeks of any Economics 101 course, and the definition is easy enough to memorise and restate. Learning to think in terms of opportunity cost takes a lot longer, and many students (including some who go on to become professional economists) never do so.

On the other hand, some people, such as Benjamin Franklin get the idea without any formal training. Franklin’s observation, cited above, that ‘time is money’ has become such a truism that it is often taken to be a traditional proverb rather than the acute observation it was when he made it. Franklin’s explanation points to a far broader point, which forms the basis of the central idea in economics: opportunity cost.

The idea of opportunity cost is inseparably bound up with choice. When we make a choice between alternatives choosing one implies forgoing the other. To paraphrase Robert Frost, the opportunity cost of walking down one road is whatever would have been found on the road not taken. It is this road not travelled, and not any monetary measure, that is most properly regarded as the cost of our choice.

To sum up:
The opportunity cost of anything of value is what you must give up to get it.

This is an idea that seems simple enough when it is first presented, but turns out to be unexpectedly subtle.  The lesson of opportunity cost is easy to state, but hard to learn. A large part of any good course in introductory economics consists of attempts to lead students to an understanding of the idea. 

Let’s consider some examples, starting with some simple (in fact, simplistic) textbook cases. For people who are largely self-sufficient producers, or who trade mainly through barter, opportunity cost can be described in simple terms. This is why introductory economics courses spend so much time worrying about Robinson Crusoe, alone on his island, or engaged in barter transactions with Friday.

If Crusoe spends a day fishing, when the best alternative was to pick coconuts, the opportunity cost of the fish he eats for dinner is the coconut he might have enjoyed if he had spent the day foraging on land instead.

Alternatively, perhaps, Crusoe might have traded his fish to Friday in return for, say, some roast goat. If the trade goes ahead, then Crusoe’s opportunity cost for his goat dinner is the fish he traded. For Friday, the reverse is true. He gets fish for dinner, and the opportunity cost is the goat.

Of course, these examples are oversimplified, and conceal a range of complexities. A couple are worth mentioning straight away. First, Crusoe can’t know for sure what will happen if he goes foraging for coconuts instead of fishing. The problem of uncertainty is inescapable and, often, intractable. Second, in discussing barter, we haven’t said how Crusoe comes to have the fish, and Friday the goat. We’ll look at both of these issues, and the complexities they raise, later on.

Introducing money complicates the problem even more, and provides plenty of opportunities for fallacious reasoning. The lesson of opportunity cost is that, contrary to the popular view, economics is not ‘all about money’. In fact, the lesson of opportunity cost is harder to learn, the more accustomed you are to thinking about costs and benefits in monetary terms. The principle of opportunity cost is relevant to decisions of all kinds, whether or not there is any monetary cost associated with those decisions.

Sometimes, as we will see, the money price of a good or service is a good measure of its opportunity cost. But very often, as Franklin points out, it is not. The sixpence spent on idle diversion is only part of the opportunity cost of a day off. And even adding the foregone earnings of five shillings may not capture the entire cost. Perhaps the hard working tradesman might have built up goodwill, leading to future demand for his services; this is also part of the opportunity cost.

Opportunity cost is equally relevant to public policy. This is obvious in relation to decisions to provide some particular good or service to the public.  In making such a decision, governments forgo opportunities, including alternative expenditure items, cuts in taxation or reductions in public debt (allowing for higher spending in the future).  The opportunity cost of a particular item of public expenditure is the value of the best available alternative.

Sometimes, the way in which choices are presented makes it appear that an attractive good can be obtained at no cost. However, a careful consideration of the alternatives usually shows that there is an opportunity cost involved.  As we go on, we will see numerous examples of this.

1 The Economics Prize is not one of the original Nobel Prizes, and its full name is The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel.  Philip Mirowski has some interesting remarks on how the prize came into existence http://ineteconomics.org/video/30-ways-be-economist/philip-mirowski-why-there-nobel-memorial-prize-economics
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The idea of opportunity cost*

(Skippable section)
The idea of opportunity cost is a natural consequence of modernity. In a traditional society, most economic decisions are made on the basis of custom, or of fixed obligations (what Marx called ‘motley feudal ties’). The central idea of tradition is to do whatever has been done before. In a modern society, we are faced with new choices all the time, regarding how to spend our household income, how to manage the business of production and how to determine public policy.

We have already seen what may be the first presentation of the idea of opportunity cost, due to Benjamin Franklin. Franklin presented the idea as a piece of practical wisdom, naturally applicable in a modern commercial society, and particularly for the ‘tradesman’ (the term then encompassed shopkeepers as well as self-employed craftsmen) to whom his advice was addressed. But it is equally applicable to anyone making the complex choices entailed by modern life.

The first economic theorist to use the idea of opportunity cost (though not the name) was David Ricardo. Ricardo’s theory of comparative advantage in trade (discussed in more detail later) marked a substantial advance on the assumption that trade was determined by differences in the labor time required for the production of goods in different countries. As Ricardo observed, what mattered was the opportunity cost of producing one good, expressed in terms of the other.

Frederic Bastiat was the first to deploy the idea of opportunity cost (though not the name) as a polemical weapon. Bastiat demolished spurious arguments for a variety of proposals to assist particular industry by pointing out that the proponents had focused on the benefits of the path they proposed without taking account of the opportunity costs of the (unseen) path not taken.

Both Ricardo and Bastiat are well-known names in the history of economic thought. The same cannot be said of Friedrich von Wieser, the Austrian economist who coined the term ‘opportunity cost’, (German Opportunitätskosten) along with the equally notable term ‘marginal utility’. Along with Carl Menger, and Eugen Bohm von Bawerk, Wieser was one of the founders of the ‘Austrian School’ of economics.

For Wieser, the concept of opportunity cost was applicable, not only to decisions made in markets but also to the distribution of wealth and resources for the community as a whole. A highly unequal distribution of wealth means that the luxury consumption of the rich takes precedence over the basic needs of the poor. As Wieser sharply observes

It is therefore the distribution of wealth that decides what will be produced, and leads to a consumer of a more anti-economic variety: a consumer wastes on unnecessary, guilty enjoyment that which could have served to heal the wounds of poverty.

Wieser used this idea to justify a progressive income tax.
The idea of opportunity cost was brought into the mainstream of economics by Austrian and Austrian-influenced economists, most notably FA Hayek, Ludwig von Mises and Lionel Robbins. Unfortunately, all three were dogmatic advocates of the free market, who stripped Wieser’s idea of its egalitarian implications

Mainstream economists largely accepted Robbins’ dictum that interpersonal comparisons of wellbeing should be rejected as ‘unscientific’, and sought to rebuild welfare economics without reference to such concepts as marginal utility (another term coined by Wieser). By the time theorists such as Peter Diamond and James Mirrlees returned to the problem of optimal tax in the 1970s, the link to Wieser’s work and to the concept of opportunity cost was lost.

Meanwhile, rather than applying the opportunity cost concept to the actual problems of economics, Wieser’s students Hayek and Mises pursued a far less fruitful aspect of his work: the sterile 19th century controversy over the “theory of value”. By subordinating economic analysis to dogmatic ‘market fundamentalism’, Hayek and Mises drove the Austrian school of economics into a blind alley from which it has never escaped.2






1 The Economics Prize is not one of the original Nobel Prizes, and its full name is The Bank of Sweden Prize in in Economic Sciences in Memory of Alfred Nobel. Philip Mirowski has some interesting remarks on how the prize came into existence http://ineteconomics.org/video/30-ways-be-economist/philip-mirowski-why-there-nobel-memorial-prize-economics
2 As I observed in my book Zombie Economics, the same is true of another innovation of the Austrian School, their business cycle theory, based on bubbles and busts in investment. The model implied that governments could potentially stabilise the cycle with beneficial effects, but Hayek and Mises were unwilling to accept the implications of their own theory. Instead, they advocated a contractionist response to the Great Depression, which had disastrous results wherever it was implemented.

Here’s another draft excerpt from my book in progress, Economics in Two Lessons. To recap, the idea of the book is to begin with the idea that market prices represent opportunity costs for the households and business who face them (Lesson 1), and then go on to explain why market prices won’t in general equal opportunity costs for society as whole (Lesson 2). A lot of the book will be applications of the two lessons, and this section is an application of Lesson 1.

As before, all kinds of comment and criticism, from editorial points to critiques of the entire strategy are welcome.

To help poor people, give them money

The problem of poverty is huge, in rich and poor countries alike. Around the world, nearly a billion people live in extreme poverty, living on less than $US1.50 a day. Even in the United States, on many measures the wealthiest country in the world, the Dept of Agriculture estimates that 14.5 per cent of the population experience food insecurity, defined as being ‘uncertain of having, or unable to acquire, enough food to meet the needs of all their members because they had insufficient money or other resources for food.’

Faced with images of the hunger and suffering caused by famines and extreme poverty, a natural and intuitive reaction is to send food. This reaction is often politically appealing in countries that happen to have large stockpiles of food, either because of unforeseen declines in market demand, or because of government policies such as price supports for farmers.

On the other hand, many advocates of development aid dismiss food aid as a short-term ‘band-aid’, and argue that the aim of aid should be to provide the ‘right’ kind of assistance, as measured by subsequent economic growth. Advocates of aid initially focused on economic infrastructure and industrial development, and have more recently turned their attention to health and education.

Similar debates have played out in the United States. The Supplemental Nutrition Assistance Program (SNAP), better known as food stamps, has played a central role in US programs to assist low-income households since it was introduced in 1964. With cuts in other welfare programs, its importance has increased over time.

On the other hand, as with international food aid, the SNAP program is regularly derided as a bandaid approach. Liberals frequently point to education as the way to provide real opportunities for the poor.

Which of these approaches is right? Much of the time, neither. While support for health and education has a better track record than food aid, there is a growing body of evidence to say that, in both poor countries and rich ones, the best way to help people is to give them money.

To see why this should be so, ask: What would a desperately poor family do with some extra money? They might use to stave off immediate disaster, buying urgently needed food or medical attention for sick children. On they other hand, they could put the towards school fees for the children, or save up a piece of capital like a sewing machine or mobile phone that would increase the family’s earning power.

So, the poor family is faced with the reality of opportunity cost. Improved living standards in the future come at the cost of present suffering, perhaps even starvation and death. Whether or not their judgements are the same as we would make, they are in the best possible position to make them.

This is a straightforward application of Lesson 1. Market prices reflect (and determine) the opportunity costs faced by consumers and producers.

Exactly the same points apply in rich countries. Giving poor people assistance in kind, such as food stamps and subsidized housing, has a lot of political appeal. Not only does it meet an apparent need, but it appears to reduce the chance that the recipients will waste their extra income on luxuries, or on alcohol and tobacco. In addition, as in the case of the US food stamps program, it may also be possible to form a political coalition with producer interests, represented by the farm lobby.

Thinking in terms of opportunity cost, however, we can see that aid in kind almost inevitably results in waste. The opportunity cost of subsidized housing is the low rent paid for the house, while the opportunity cost of moving usually includes going to the back of the line. So having secured subsidized housing, people will stay there even if the house no longer suits their needs, because it is too big, too small, or too far away from a new job.

The same kinds of problems come up with food stamps. Families poor enough to get food stamps face all kinds of problems. They might, for example, need urgent medical or dental care, or be faced with eviction if they don’t make a rent payment.

Most of the time food stamps cover only part of a family’s food budget, so they are really just like cash. Families can meet some of their food bills with stamps, then use the money they save to meet other needs The opportunity cost of spending more on food is the alternative that can’t be afforded.

But it’s precisely when people need money most, to the point where they are prepared to live on a restricted diet, that the limits of food stamps start to bite. If poor families were given money, they could choose to pay the rent bill even if it meant living on rice and beans. That’s a hard choice, but it might be the best one available.

Unsurprisingly, then, poor people often try to change some of their food stamps for money. This is denounced as ‘fraud’ and used as a reason for cutting food stamps even further.

It is market prices that determine the opportunity costs of goods and services for individuals and families. So, when people choose how to spend additional money, the opportunity cost of one choice is the alternative that could be bought for the same amount.

The idea that poor people don’t understand this is patronizing and wrong. The tighter are the constraints on your budget, the more important it is to pay attention to them. Poor people often have less access to markets of all kinds, including supermarkets basic financial markets such as bank accounts and face complex and variable prices as a result. Nevertheless, many of them manage to find highly creative ways of stretching a limited budget to meet their needs. Additional constraints, in the form of payments that can only be spent in particular places and on particular goods, are the last thing they need.

These arguments have been going on for many years, but resolving them has proved difficult, since there are usually many different factors that determine good or bad outcomes for poor families. In recent years, however, a combination of improved statistical techniques and careful studies of experimental program pilots have allowed an assessment of the evidence to emerge. Overwhelmingly, it supports the view that giving people money is more effective than most, if not all, forms of tied assistance in improving wellbeing and life outcomes.

http://www.thebaffler.com/blog/blaming-parents/

http://www.nytimes.com/2013/08/18/magazine/is-it-nuts-to-give-to-the-poor-without-strings-attached.html?_r=0

If the best way to help the poor is to give them money, what is the best way of doing that? In a market economy there are two possible answers. The one that has been discussed most is redistribution; that is, using the taxation and welfare systems to transfer some market income from the rich to the poor. More difficult, but arguably more effective is to change the structure of markets and property rights to produce a less unequal distribution of market income — this is sometimes called ‘predistribution’. We will come back to this issue later.

Another excerpt from my book-in-progress, Economics in Two Lessons. To recap, the Two Lessons are

Lesson 1: Market prices reflect and determine opportunity costs faced by consumers and producers.
Lesson 2: Market prices don’t reflect all the opportunity costs we face as a society.

In this section, I’m working on Lesson 1, leading up to the point (my restatement of what’s usually called the First Fundamental Theorem of Welfare Economics) that an ideal competitive equilibrium is one in which there are no unexploited potential gains from technical improvements or mutually beneficial exchange. For reasons I’ve spelt out already I don’t want to use the term “Pareto-optimal” to talk about this. I also want to confine “efficient” to its normal meaning of “technically efficient” and avoid the common economist practice of extending this to cover various definitions of “market efficiency”. So, I’m talking about “free lunches” or, more formally, benefits with no opportunity cost.

In Lesson 2, I’ll be looking, among other things, at the Second Welfare Theorem, which says any outcome with no free lunches corresponds to a particular initial allocation of property rights, broadly defined to include taxation obligations and entitlements of all kinds.

Now please comment, criticise and hopefully enjoy

The acronymic adage TANSTAAFL (There Ain’t No Such Thing As A Free Lunch). The saying was popularized, particularly in libertarian circles, by Milton Friedman’s book of that name and, a little earlier by by Robert Heinlein’s science fiction classic, The Moon is A Harsh Mistress. The acronym is derived from a marketing ploy used in 19th century saloons, whereby a ‘free’ lunch was offered to customers, on the assumption that they would wash it down with beer or other drinks. Naturally, the cost of the lunch was incorporated in the price of the drinks.

The key idea may therefore be restated in terms of the broader point that it is opportunity cost, rather than just monetary cost, that matters when making economic decisions. Although there is no explicit charge for the lunch, patrons can only consume it at the opportunity cost of forgoing cheaper beer.

Libertarians commonly use the TANSTAAFL adage to point out that services provided ‘free’ by governments will, in general, have an opportunity cost. ‘Free’ provision of some service must be funded either by higher taxes or by reductions in other areas of public expenditure. The more general point, that it’s necessary to look at the full opportunity cost of any good or service, and not just the immediate price, is yet another version of Lesson 1.

But there is a contradiction here. Most economists think that improved economic policy could yield better outcomes for everyone, even though they may disagree about which policies would yield this result. Libertarians, who extol the benefits of rolling back the state and giving markets free rein, are no exception to this rule. The same is true of technological advances that allow us to do more with less, for example, by producing goods and services with smaller inputs of labor, energy and capital.

A free lunch is ‘something for nothing’, that is a benefit obtained with no opportunity cost. The TANSTAAFL adage embodies an important truth applicable to many apparent ‘free lunches’, in which the true opportunity cost is carefully hidden.

If TANSTAAFL were literally true, however, humanity could never have risen above a subsistence level of existence. Every technological advance since people first learned how to make flint tools and control fire has provided a potential free lunch, literally and metaphorically, for humanity as a whole. The same is true of improvements in social and economic organization that have allowed larger and larger groups to co-operate in mutually beneficial ways.

TANSTAAFL holds if and only if there are no free lunches left on the table, which in turn will only happen if all options for technological progress have been exhausted and, in addition, the economic system is functioning perfectly1. So, if outcomes can be improved for everyone, the correct statement is TISATAAFL, that is, There Is Such A Thing As A Free Lunch’.

Economists have understood this point ever since Adam Smith wrote The Wealth of Nations, the first serious study of economic growth, in the 18th century. Even the poorest person in a modern developed economy enjoys a range of goods and services that were unavailable to our ancestors, with less effort and toil and, at least potentially, with less use of resources and damage to the environment.

The improvements in living standards generated by a modern economy are, for us, a free lunch. In fact, economics tells us about two kinds of free lunch, technological innovations and improved allocation of resources.

Technological innovations are the most obvious kind of free lunch. Technological innovations that allow us to produce a given output with less of every kind of input, including labour, provide us with the classic example of free lunch. Adopting the new technology allows us to increase output without using any additional resources. So, the opportunity cost of the additional output is zero. To put this point the other way around, additional production entails opportunity costs only if it is technically efficient.

The second kind of free lunch, the core concern of economics, arises from improved allocation of resources. Lesson 1 leads us to think about improvements that can be generated by allowing markets to work. Lesson 2 shows how public policy can yield improved resource allocation when markets fail to match prices and social opportunity costs.

In this section we will look at Lesson 1, and the gains from exchange discussed earlier. Exchange through trade and markets can generate benefits for everyone, compared to a situation where everyone relies on themselves. When Crusoe trades fish for Friday’s goat, each obtains a meal that would have had a higher opportunity cost in the absence of trade. The improvement is a (partly) free lunch, or maybe a free dinner.

By contrast, the saloon story underlying TANSTAAFL, in which an apparent bargain turns out to be nothing of the kind, stands in stark opposition to the economic idea of exchange as a bargain in which both parties benefit. It is in line with the pre-modern view of trade as a zero-sum game, in which any gain to one part is a loss for the other.

With the correct economic analysis, the saloon story illustrates TISATAAFL. Suppose that the customer would be willing to pay the saloon’s price for the beer alone. Then the price must less than the opportunity cost of obtaining the beer some other way, for example, through home brewing. On the other hand, assuming the saloon is not operating at a loss, its price must cover the saloon’s opportunity cost of providing both the beer and the lunch. In these circumstances, compared to the situation in the absence of exchange, the lunch really is free.

Under ideal conditions, the market outcome will ensure that there are no free lunches left on the table. More precisely, there are no potential benefits that can be obtained unless an opportunity cost is borne by someone. These are the conditions of perfect competitive equilibrium, the subject of our next section.

—-
1 More precisely, ‘functioning perfectly, given the initial allocation of wealth’. We will look at this point later in the book.

I’m now coming up to (what I hope will be) the most challenging part of my book-in-progress, Economics in Two Lessons. The core theoretical point the first part of the book (Lesson 1) is that, under a set of ideal assumptions, competitive equilibrium prices both reflect and determine the opportunity costs faced by consumers and produces. This means that there is no way to rearrange consumption to make someone better off unless someone else is made worse off. (I’ve already mentioned my reasons for avoiding the term “Pareto-optimal” in this context.

What I’m trying to do here is to spell out the logic underlying these results in a way that foreshadows the discussion of market failure and income distribution, in Lesson 2, but still shows the power of market mechanisms. I’ll probably need a few goes at this, and this is my first try. Critical comments on everything from the underlying theory to editorial nitpicks are welcome. Sincere praise is also welcome of course, but constructive criticism is best of all.

Competitive equilibrium

Let’s restate Lesson 1:

Market prices reflect and determine the opportunity costs faced by consumers and producers.

We’ve seen how market prices determine the opportunity costs we face in making economic decisions as consumers, workers and producers of goods and services. We can’t as individuals, change the market prices we face for goods and services in general, so we must take them as given in looking at the opportunity cost of different choices.

But Lesson 1 says something more, namely that market prices also reflect opportunity costs. That is, just as the opportunity costs of our choices are determined by market prices, those market prices are determined by our choices. Under ideal conditions, those choices, aggregated over all the members of a society, will reflect the opportunity costs for that society as a whole.

There is a large branch of economic theory devoted to proving results of this kind using formal mathematics. But the core of the idea may be approached using the idea of ‘no free lunches’ or, more precisely, ‘no benefits without equal opportunity costs’, discussed in the previous section.

As we saw then, this condition requires that all production be technologically efficient. If not, there is always a free lunch to be had by making production more efficient, producing more with the same inputs.

The second requirement ‘no free lunch’ requirement is that there should be no gains from mutually beneficial exchange remaining to be realised. It’s easy to see that this requirement is closely related to market prices.

Example 2: lets suppose that you own a new jacket that you would be willing to trade for tickets to tonight’s baseball game, while I have tickets and would be willing to trade them for your jacket.

Now lets look at market prices. If the market price of the jacket is greater than the price of the tickets, there is no need for you to trade with me. You can (assumption A) sell the jacket at the market price (which is unaffected by assumption C), use the proceeds to buy the tickets and have money left over. Since you make the best possible choices (assumption D) that’s what you will do. If I want to complete the trade, by selling my tickets and buying the jacket, I will have to make up the price difference. By assumption (E), no one else is affected.

On the other hand, if the market price of the jacket is less than that of the tickets, the fact that this price prevails indicates that there must be someone else willing to sell jackets, and buy tickets at those prices. So, I can sell my tickets and use the proceeds to buy a jacket, making an exchange that benefits both me and the other parties involved. You, on the other hand, am out of luck. At the prevailing prices, no one is willing to trade tickets for a jacket, and there are no remaining exchanges to be made.

This simple examples give a flavor of the argument that leads to Lesson 1. Intuitively, it suggests the conclusion that trade at market prices will capture all the potential gains from mutually beneficial exchanges, so that no free lunches will be left on the table. In other words, in market equilibrium, TANSTAAFL holds.

This is where casual presentations of Lesson 1 commonly stop. But the simple story above embodies a lot of assumptions about the way markets work:

The most important are:

(A) Everyone faces the same market-determined prices herefor all goods and services, including labor of any given quality, and everyone can buy or sell as much as they want to at the prevailing prices

(B) Everyone is fully aware of the prices they face for all goods and services, including how relevant uncertain events might affect those prices

(C) No one can influence the prices they face

(D) Everyone makes the best possible choices given their preferences and the technology available to them

(E) Sellers bear the full opportunity cost of producing the good, and buyers receive the full benefit of consuming it, no more and no less. That is, no one can shift costs associated with production or consumption to anyone else without compensation (for example, by dumping waste products into the environment) and no one else receives benefits for which they do not pay.

We can go back to the example to see where each of these conditions fits in

If the market price of the jacket is greater than the price of the tickets, there is no need for you to trade with me. You can (assumption A) sell the jacket at the market price (which is unaffected by assumption C), use the proceeds to buy the tickets and have money left over. Since you make the best possible choices (assumption D) that’s what you will do. If I want to complete the trade, by selling my tickets and buying the jacket, I will have to make up the price difference. By assumption (E), no one else is affected.

This more complicated version of the story can be formulated in mathematical terms to show that, under the stated conditions (and some additional technical requirements), a competitive equilibrium will arise in which there are no free lunches; that is, any potential benefit entails an opportunity cost that is at least as great.

In this ‘perfectly competitive equilibrium, the price of any particular good good is equal, for everyone who consumes that good, to the opportunity cost of a change in consumption, expressed in terms of the alternative possible expenditures. Similarly, firms can maximise profits only if the prices of the goods they produce are equal to the opportunity cost of the resources that could be saved by producing less of those goods.

This point is the core of Lesson 1. In a perfect competitive equilibrium prices exactly match opportunity cost. So, there are no ‘free lunches’ left. More precisely, any additional benefit that can be generated for anyone in the economy must be matched by an equal or greater opportunity cost, where opportunity cost is measured by the goods and services foregone, valued at the equilibrium prices. This opportunity cost may be borne by those who benefit from the change or by others.

Hazlitt, and many subsequent writers, implicitly assume something much stronger: that if prices reflect opportunity costs, there is no room for improvement in public policy. In particular, he assumes that any policy that benefits one group at the expense of others is undesirable. To put it more strongly, the distribution of income associated with competitive market equilibrium, based on existing private property rights, is assumed to be optimal.[^1]

This idea is false: as we will see there are a vast number (in the usual mathematical formulation, infinitely many) possible outcomes in which there are no free lunches, each corresponding to a different allocation of rights and a different market equilibrium.

We will discuss the issue of income distribution when we come to Lesson 2. Before doing this, we will consider a variety of examples to illustrate Lesson 1.

[^1]: Hazlitt’s reasoning is reinforced, in many economics texts, by the description of the competitive market equilibrium as “Pareto-optimal” or “efficient”. These misleading terms are discussed here.

fn1: Hazlitt’s reasoning is reinforced, in many economics texts, by the description of the competitive market equilibrium as “Pareto-optimal” or “efficient”. These misleading terms are discussed here.

Yes. This has been the latest in our series “Short Answers to Misconceived Questions”.

Actually, there’s a longer answer over the fold, another extract from my book-in-progress Economics in Two Lessons. You can find a draft of the opening sections here.

This extract is a subsection of Part 2, in which I explore the implications of Lesson 1:
Market prices reflect and determine opportunity costs faced by consumers and producers.
The conclusion is

if the damage bill measures the cost of restoring assets to their pre-disaster condition, it is also equal to the opportunity cost of the disaster, namely the goods and services that would otherwise have been produced.

I’ll be interested to see whether readers’ reaction is “That’s obvious” or “That’s obviously wrong”, assuming of course that you have any reaction at all. As always, civil comments of all kinds are welcome, particularly constructive criticism.

Natural disasters like floods, earthquakes and hurricanes come seemingly out of nowhere, wreak intense havoc in a short period, and move on, leaving vast, and largely random, destruction in their wake. Reports of such events commonly provide estimates of the associated damage bill. [1] The cost is partially covered by insurance claims and government disaster assistance, but inevitably much of it falls on the residents of the area hit by the disaster.

It is only natural for people, faced with such disasters, to seek to find some consolatory ‘silver lining’, and one such consolation is the idea that natural disasters will create work, and thereby stimulate the economy. Disasters certainly create work for emergency services of all kinds when they occur and for all the many kinds of workers needed to rebuild damaged houses and infrastructure.

The wages earned by these workers might be seen as an offset against the damage from the disaster. That would be true if they had nothing else to do. But, most of the time, such workers are not to be found sitting idle and waiting for a disaster to happen.

Government budgets are chronically tight, so emergency services are routinely overstretched. Providing additional services to respond to a disaster comes with an opportunity cost, that of the more routine services that would ordinarily be provided.

Similarly, unless the disaster happens to coincide with a slump in the construction industry, rebuilding damaged houses comes at the expense of the new houses that would otherwise have been built.
Lesson 1 tells us that, when markets are working well, the opportunity cost of the resources used in disaster recovery and rebuilding can be measured by their market value, that is the price paid for materials and the wages paid to workers. So, if the damage bill measures the cost of restoring assets to their pre-disaster condition, it is also equal to the opportunity cost of the disaster, namely the goods and services that would otherwise have been produced.

Much of Hazlitt’s Economics in One Lesson consists simply of restating this application of Lesson 1 in a variety of contexts, from the broken window in the glazier story to the massive destruction wrought by World War II. In all these cases, assuming that markets are initially working well, the effect of unexpected destruction is simply to divert resources from new production to damage repair.

Lesson 2 shows that the proviso ‘when markets are working well’ is critical, and that Hazlitt’s argument must be heavily qualified as a result. In the presence (all too frequent in market economies) of mass unemployment, wages are not a good measure of opportunity cost. In these situations, events that create work may yield positive benefits. But natural disasters strike at random, and most of the time do not coincide with any requirement to create jobs in the construction sector. Moreover, there are many more useful ways of creating jobs. So, in economic terms, disasters are, in most cases, just as bad as they appear at first sight.


[1] Footnote These measures usually don’t take account of injury and loss of life, which may often be more significant. We will be discussing this issue later.

What is true of natural disasters is even more true of the disasters we inflict on ourselves and others. Of these human-made calamities, the greatest is war. The wars engaged in by the US, Australian and other governments come at the opportunity cost of domestic programs that could save thousands of lives every year. The cost of war, in terms of American (and Australian) lives, is many times greater than battlefield casualty counts would suggest.

That’s the theme of this extract from my book-in-progress, Economics in Two Lessons. You can find a draft of the opening sections here.

Dwight Eisenhower, Supreme Commander of the Allied Forces in Europe during World War II was arguably America’s greatest military commander, and served as President of the United States at the height of the Cold War with the Soviet Union. It is striking, then, that more than any US political leader before or since, Eisenhower showed an acute understanding of the limitations of military power and of the economic costs of military expenditure. He is, perhaps, best remembered for warning of the dangers of the ‘military-industrial complex’ as a standing lobby for armaments spending.

Even more penetrating was his observation that

Every gun that is made, every warship launched, every rocket fired, signifies in the final sense a theft from those who hunger and are not fed, those who are cold and are not clothed

The logic of opportunity cost has rarely been put more simply or sharply, particularly as it applies to military expenditure.

Nearly 50 years after Eisenhower’s death, the lesson he stated so simply and forcefully has not been learned. Every crisis in the world brings forward a call for military intervention, often from people who regard ‘foreign aid’ as a proven failure.

The failure rate for these interventions is far higher than for ordinary foreign aid projects. Of the major US military interventions in the past 20 years (Kosovo, Somalia, Gulf War I, Afghanistan, Gulf War II, Libya and Iraq/Syria) only Kosovo could be regarded as a success, and even there the outcome is a bitterly divided between two hostile communities, kept apart by armed peacekeepers.

But even when military action works as planned, it is hard to justify in terms of opportunity cost. The total figures are staggering. The Afghan and Iraq wars between them are estimated to have cost the US between $4 trillion and $6 trillion dollars in wartime expenditures and future medical bills for veterans (Bilmes). That’s ten times the total amount of aid received by the whole of Africa since 1945, an amount regularly cited to show the futility of foreign aid.

Rather than attempt to apply opportunity cost calculations to such stupendous numbers, let’s look at the opportunity cost of maintaining a single additional soldier in Afghanistan. The direct cost has been estimated at $2.1 million per soldier per year. Support costs and the need to provide for future medical care would almost certainly double this.

We could look at the opportunity cost in terms of alternative ways of providing aid to Afghanistan. The US development agency USAid provides around $70 million a year in aid to Afghanistan, a sum which is claimed to enable one million additional children to enrol in school.

Obviously there is plenty of room for more expenditure of this kind, in Afghanistan or elsewhere. So, the opportunity cost of keeping 35 soldiers in the field is school education for a million young people.
Most advocates of the war, faced with this kind of calculation would say that the object of the war is not (primarily) to promote the welfare of Afghans but to protect Americans from the threat of terrorist attack. It might seem to be impossible to place a monetary value on such protection. However, it is at least possible to identify the opportunity cost, and the US government does so explicitly. As we will see later, US government interventions aimed at protecting Americans from threats to their life and safety are typically approved only if the cost per life saved is less than the ‘Value of Statistical Life’ for the agency concerned.

In particular, this procedure applies to policies aimed at protecting Americans from terror attacks within the United States. In a September 2007 Department of Homeland Security proposal to expand air travel security, the U.S. Customs and Border Patrol estimated life-saving benefits using two separate life values: $3 million and $6 million.

However, no such analysis is applied to overseas military action. Nevertheless, the logic of opportunity cost applies, whether or not it is taken into account by planners. Each additional soldier deployed in Afghanistan comes at the cost of the alternative use that could be made of the required funding. Taking the high end $6 million VSL range for the Department of Homeland Security the opportunity cost of the $6.3 million spent to deploy three additional soldiers is the funding of a domestic security program that would save one American life per year.

If the casualty rate for soldiers in the field were anything like one in three, the war would have ended long ago. Yet the same cost in lives, in the form of foregone opportunities to protect Americans at home, has been accepted with bipartisan support, because it is invisible, unless viewed through the lens of opportunity cost.

Bastiat’s contrast between “that which is seen” and “that which is not seen” has never been more apposite.

One of the big benefits of blogging for me is the chance to try out my ideas on an audience I couldn’t easily reach (or at least hear back from) in any other way. That’s particularly true when I’m writing a book, which is always a difficult process for me. My last post, on the opportunity cost of war produced a great comments thread. Particularly useful was a discussion, started by Chris Bertram at Crooked Timber, of the oft-heard claim that war stimulates scientific and technological progress. I’ve used my response, along with points appropriated from commenters to draft a new section for the book, pointing out how this claim ignores the problem of opportunity cost.

As always, comments of (nearly) all kinds are appreciated, and useful ones may be recycled.

Despite, or perhaps because of, the obvious waste and destruction of war, it’s often claimed that war has economic benefits, and even that it’s necessary to the successful functioning of the economy. One version of this argument, based on the idea of ‘military Keynesianism’ will be discussed later.

In this section, we’ll look at another popular argument, that war is a spur to research and development (R &D), and therefore to peacetime prosperity. This idea has some superficial appeal. Penicillin, nuclear energy, computers and jet aircraft are examples of technologies that were developed, or advanced rapidly, during World War II, and played a major role in postwar prosperity.

In all of these cases, the underlying research had been undertaken in the 1920s and 1930s. The outbreak of war led to a massive push to apply this research on an industrial scale, producing millions of doses of penicillin, hundreds of thousands of jet airplanes, and of course the atomic bomb. ENIAC, the first electronic general-purpose computer was commissioned to compute artillery tables, but did not appear until 1946, when it was used in computations to produce the first hydrogen bomb.

Opportunity cost reasoning leads us to ask what was foregone to release the resources. In large part, the answer is ‘research of the kind that made these developments possible’. War gives great urgency to the “D” part of R&D, at the expense of R. This can produce some impressive short run payoffs.

To be counted against that is the loss arising when scientists are shifted from fundamental research to activities more directly relevant to the war effort, much of it with very little value beyond the immediate needs of the military. The there are the vast numbers of young scientists whose careers were interrupted because of military service, and older scientists.

For quite a few scientists war service has been more than a career interruption. Harry Moseley, widely regarded as the greatest experimental physicist of the twentieth century, was killed at Gallipoli in 1915. [Bohr (I think) said that even if no one else had died, the death of Harry Moseley alone was enough to make the First World War an unbearable tragedy.]

http://prospect.rsc.org/blogs/cw/2013/08/12/henry-moseley-single-most-costly-death-war/

The great theoretical physicist Karl Schwarzschild died the following year. Many more died before having any chance to contribute. one can think of the 50 fatality rate suffered by the class of 1914 at the École Normale Supérieure https://books.google.com.au/books?id=EjZHLXRKjtEC&pg=PA329&lpg=PA329&dq=ecole+nationale+superieure+casualties+world+war+i&source=bl&ots=asLFDx9V5p&sig=gr4l5-65JgNhXGRaCHkEz39xzmk&hl=en&sa=X&redir_esc=y#v=onepage&q=ecole%20nationale%20superieure%20casualties%20world%20war%20i&f=false.

A tragic and heroic story from World War II is that of the scientists of the Pavlovsk Experimental Station near Leningrad (now St Petersburg), twelve of whom starved to death while protecing the station’s seed bank during the siege of the city in 1941. Other losses include the mathematicians Jean Cavailles, shot by the Gestapo, and Wolfgang Doblin, one of thousands of Jewish scientists and doctors who perished in the Holocaust.

As this example shows, scientific projects themselves were not immune from the destruction. The first programmable computer to be built was not ENIAC, but the Z1 designed by German Konrad Zuse. This computer and its successors, the Z2 and Z3 were destroyed by Allied bombing raids, and Zuse’s work was not resumed for years.

Yet again, the idea of opportunity cost as ‘that which is not seen’ provides a corrective against any attempt to minimise the costs of destruction.

Here’s another excerpt from my book-in-progress, Economics in Two Lessons. Rather than work sequentially, I’m jumping between:

Lesson 1: Market prices reflect and determine opportunity costs faced by consumers and producers.

and

Lesson 2: Market prices don’t reflect all the opportunity costs we face as a society.

In the section over the fold, I’m looking at how opportunity cost reasoning applies to policies that change the distribution of income, wealth and other entitlements.

As usual, praise is welcome, useful criticism even more so. You can find a draft of the opening sections here.

Changes in the regulation of labor and capital markets and in taxation and expenditure policy since the 1970s have greatly enhanced the income and wealth of the best-off members of society (the so-called 1 per cent), and have yielded more modest, but still substantial, improvements in the position of those in the top 20 per cent of the income distribution (broadly speaking, professionals and business owners and managers).

On the other hand, incomes for the rest of the community have grown much more slowly than might have been expected based on the experience of the decades from 1945 to 1975. The substantial technological advances of recent decades have had little impact on the (inflation-adjusted) income of the median US household. For many below the median, incomes have actually fallen (real wages, welfare reform).

In the absence of the tax cuts of the 1980s, the associated cuts in public expenditure and financial and industrial relations policies that benefitted business, the incomes of the wealthy would not have increased as much as they have done. Those on median and lower incomes would have done substantially better[^1]. But how should we compare those gains and losses?

Economists and philosophers have been looking at this question for a long time and in many different ways. The answers most consistent with opportunity cost reasoning can be described by the following ‘thought’ experiment, developed explicitly by John Harsanyi and John Rawls in the mid-20th century, but implicit in the reasoning of earlier writers like Jeremy Bentham, John Stuart Mill and Friedrich von Wieser.

First consider yourself in the position of both the high income beneficiary and the low income loser from such a change. Next, imagine that you are setting rules for a society, of which you will be a member, without knowing which of these positions you might be in. One way to think of this is to imagine life as a lottery in which your life chances are determined by the ticket you draw.

Now consider a choice between increasing the income of the better off and the worse off person. Presumably, if the dollar increase were the same in both cases, you would prefer to receive it in the case where you are poor rather than in the case when you are rich.

The reasons for this preference are obvious enough. For a very poor person, an additional hundred dollars could mean the difference between eating and not eating. For someone slightly better off, it may mean the difference between paying the rent and being evicted. For a middle class family, it might allow an unexpected luxury purchase. For someone on a million dollars a year, it would barely be noticed.

Economists typically present this point in terms of the concept of marginal utility, a technical term for the benefits that are gained from additional income or consumption. As argued above, the marginal utility of additional income decreases as income rises. It follows that a policy that increases the income of the rich and decreases that of the poor by an equal amount will reduce the utility of the poor more than it increases the utility of the rich.

Few mainstream economists would reject this analysis outright[^2] . However, many prefer to duck the issue, relying on a distinction between ‘positive’ economics, concerned with factual predictions of the outcomes of particular economic policies and ‘normative’ economics, concerned with ‘value judgements’ like the one discussed above. The debate over the justifiability or otherwise of this distinction has been going on for decades and is unlikely to be resolved any time soon.

More importantly, constructs derived from economics are often used, implicitly or explicitly, in ways that imply that an additional dollar of income should be regarded as equally valuable, no matter to whom it accrues.

The most important of these constructs is GDP, the aggregate value of all production in the economy.GDP per person is the ordinary average (or arithmetic mean) income of the community. GDP per person treats additive changes in income equally no matter who receives them.

Used correctly, as a measure of economic activity, GDP can be a useful guide to the short-term management of the economy. In the short run, weak GDP growth is commonly an indicator of a recession, suggesting the need for expansionary monetary and fiscal policies.

Unfortunately, measures of GDP and GDP per person are commonly misused, as an indicator of living standards and economic welfare more generally. There are many reasons why this is inappropriate, but the failure to take account of the distribution of income is most important.
It is easy enough to see that, if the opportunity cost of a given increase the income of a better-off person is an equal increase in the income of a worse-off person, then the change is for the worse.

What about the case when we the choice is between a given increase for the worse off person and a larger increase for the better off person? How big does the opportunity cost have to be before it outweighs the benefit? This question, raising once again the thought experiment mentioned above, can be answered in many different ways

One answer, which seems close to the views typically elicited when people are asked questions of this kind, is to treat equal proportional increases in income as being equally desirable. That is, an increase of $1000 in the income of a person on $10 000 a year is seen as yielding a benefit comparable to that of an increase of $10 000 in the income of a person earning $100 000 a year. Conversely, if the opportunity cost of the $10 000 benefit to the high income earner is a loss to the low income earner of more than $1000, the cost exceeds the benefit.

It’s surprisingly easy to turn this way of looking things into a measure of living standards over time. If, instead, we want a measure that treats proportional changes equally, all that is needed is to replace arithmetic mean measures such as GDP per person with the geometric mean we all learned about in high school (and most of us promptly forgot).

The geometric mean has the property that, if all incomes increase by the same proportion, so does the geometric mean. So, it’s a better measure of the growth rate of incomes across the community than the usual arithmetic mean. It can also be justified mathematically, in terms of the theory of expected utility. For those interested, the details are spelt out in an optional section.

The geometric mean is equal to the arithmetic mean when incomes are distributed exactly equally. But the more unequal is the income distribution, the greater the gap between the arithmetic and geometric means. For this reason, the ratio of the arithmetic to the geometric mean is often used as a measure of income inequality.

We can look at the changes in these measures using data from the US Census Office, and some simple computations (details available on request). From 1967 to 2013, arithmetic mean income per household (in 2013 dollars) rose from $66 500 to $104 000, an increase of 56 per cent. But the geometric mean rose by only 34 per cent, from 50 000 to 67,500. The ratio between the two rose from 1.32 to 1.54, indicating a substantial increase in inequality.

The idea that equal proportional increases are equally valuable, and therefore that the geometric mean is a good measure of economic welfare or wellbeing is not the only answer to the question posed above. Another, leading to a strong version of egalitarianism, is always to prefer the increase to the worse off person[^3] . In this case, welfare is measured by the minimum income.

There’s no way of reaching a final resolution on questions like this. But it’s worth observing that a policy aimed at maximising the geometric mean of income would be substantially more egalitarian than anything that has ever been seen in a market economy.

For example, calculations by Peter Diamond and Emmanuel Saez, using a method equivalent to the geometric mean approach, suggest that the top marginal tax rate, after taking account of disincentive effects should be between 70 and 80 per cent.

These rates are far above those found in any country today. And while the top marginal rate was at or above this level in the 1950s, generous exemptions and other loopholes meant that the effective rate was much lower.

It’s not surprising that political outcomes are less egalitarian than an opportunity cost estimate would suggest. The thought experiment leading to the geometric mean gives everyone equal weight, as in an ideal democracy. In practice, however, the well off have more weight in democratic systems than do the poor; and of course the disparity is even greater in undemocratic and partly democratic systems. The disparity of political weight has increased with the growth of inequality over the past decades. So, while there are good arguments for more strongly egalitarian approaches, policies aimed at maximizing geometric mean income will inevitably be found well to the left of centre in any feasible political system.

[1^]: The claim that tax cuts for the rich will ultimately make people better off is discussed briefly in Section … and, at greater length, as one of the ‘zombie ideas’ in my book Zombie Economics
[2^]: The most notable exceptions, somewhat outside the mainstream, are members of the ‘Austrian School’, who have dismissed interpersonal comparisons as ‘unscientific’ and offered a variety of more or less spurious justifications for inequality. As discussed above, von Wieser, the originator of the opportunity cost analysis, was an exception to this exception.
[3^]: The ‘difference principle’ espoused by philosopher John Rawls is often interpreted to imply this view. However, scholars of Rawls work disagree on this, and much more.

Here’s another draft extract from my book-in-progress, Economics in Two Lessons, looking at income distribution. The entire draft section on this topic is available here. And the introduction, describing the general approach of the book is here.

Praise is welcome, and useful criticism even more so. As a reminder, this is an extract. If you think a crucial point has been missed, point it out, but bear in mind that it may be addressed elsewhere in the book.

If we are going to consider changes in the distribution of income and wealth, what should we take as our starting point? There are various possibilities, many of which are of theoretical interest, but not of much practical use.

Hazlitt doesn’t spell out the starting point for his analysis. However, his analysis is based on the implicit claim (spelt out in more detail by Bastiat) that there is a natural distribution of private property rights, that exists prior to any government activity such as taxation and the payment of welfare benefits.

This is nonsense. It is impossible to disentangle some subset of property rights and entitlements from the social and economic framework in which they are created and enforced.

The ordinary meaning of “property” refers to a specific kind of control over resources, most completely realised in freehold ownership of land. Freehold land can, with limited exceptions, be used as the owner sees fit, and freely sold, rented out or otherwise disposed of. In the idealised model which forms the basis of much thinking about property, all property is of this kind.

Most of the time, we take the existing allocation of property rights for granted. This is, however, an example of exactly the fallacy pointed out by Bastiat, that of focusing on what is seen and ignoring the unseen alternatives. All property rights began with a social decision to create and enforce someone’s right to use a particular good, asset or idea, and to regulate the way in which that right might, or might not, be transferred to others. [In societies without a formal state structure or legal system, these decisions may be made through custom or consensus. In modern societies they are made by governments and courts].

In some of the cases discussed in Section 2, such as those of telecommunications spectrum and fishing quotas, the rights were created relatively recently, and the process by which they were created is well documented. In somewhat older cases, such as that of the 19th century innovations which created limited liability corporations, the history has been forgotten by all but a few specialists. Going even further back, property rights in land and in ordinary goods (chattels, in legal parlance) are mostly taken for granted, even though they are all derived, in the final analysis, from a socially-created legal framework.

In any society, people have views about what property rights are legitimate and, in particular, what they themselves are entitled to. These views may or may not match the property rights that actually prevail in that society. For example, workers commonly regard of their job as belonging to them, in some sense. In some places, this perception is supported by laws prohibiting unfair dismissal. In the US, by contrast, the doctrine of employment at will means that the job is the property of the employer.

Propertarians like Hazlitt want to pare back government to the minimum necessary to protect the property rights of which they approve. These include rights over land and houses, private sector financial assets and personal possessions. Other rights, currently enforced by government, should, in their view, be abolished.

There are two main difficulties with this.

First, propertarians disagree among themselves as to which government functions should be retained, and which property rights should be maintained. For example, some support core government functions like police and fire services while others want these to provided, on a market basis, to those willing to pay for them. Similarly, some propertarians, support the idea that the creators of ideas should have unlimited ‘intellectual property’ in those ideas, while others believe that ‘information ought to be free’.

Moreover, while propertarians almost invariably oppose ‘welfare’ benefits paid out of tax revenue, such as social security, there is no clear dividing line between these benefits and contractually obligatory payments such as pensions for public and private workers.

The fine distinctions between Austrians, minarchists, objectivists, and anarcho-capitalists are too complex and tedious to be detailed here. The point is that any attempt to define, on the basis of logical first principles, a ‘natural’ set of property rights, independent of government, runs rapidly into quicksand.

The second problem is that any attempt to strip all rights and entitlements back to a minimal set corresponding to a naive notion of ‘private property’ would not produce anything like the existing distribution of private property rights. Some kinds of private property would become much more valuable, and others much less so. An example can be seen in the mass privatisations that followed the end of Communism in Russia and other countries in the former Soviet bloc., These processes greatly enriched a handful of oligarchs and greatly impoverished everyone else, leading to the loss of the little .

It is impossible to describe a proposed starting point based on such a radical change with any accuracy. So, we can’t really say what the opportunity cost of shifting property rights from one person to another might be in such a situation.

It makes sense, therefore, to start thinking about the initial allocation with reference to our actual position rather than to some or other theoretical ideal.

In most modern societies, governments collect a substantial proportion of national income in taxation revenue. Some of this revenue is spent on the provision of public services, and some on ‘transfer payments’ such as social security, unemployment and disability insurance, and assistance to poor families.

The starting point therefore includes both the existing set of property rights of workers, the employment position of worker and the rights and obligations of members of the community to receive government services and benefits and to pay the taxes necessary to finance those services and benefits.

1.1.3 The opportunity costs of redistribution

There are many policy changes that will improve the starting position for some members of the community. Examples include

(A) Reducing marginal rates of income tax above some income level, which will benefit those with taxable incomes above that level.

(B) Increasing the duration of intellectual property rights such as copyrights and patents, which will benefit the owners of those rights

(C) Increasing the number of publicly funded places in colleges and universities, which will benefit the young people who are enable to attend

(D) Increasing social security payments and unemployment insurance, which will benefit those who are unable to work because of age or inability to find a job

(E) Increasing the minimum wage

Over the past 40 years, we have seen substantial changes of types (A) and (B) in the United States and elsewhere around the world. The top marginal rate of income tax has been reduced from … to … . The maximum term of copyright protection has been extended from … Other measures, such as the use of ISDS provisions in trade agreements, have created a variety of new and expanded property rights for corporations.

By contrast, there have been few changes of types (C), (D) and (E). On the contrary, public funding of universities has been reduced, eligibility for social security has been tightened and the real value of the minimum wage has been reduced.

This outcome reflects the logic of opportunity cost. To finance increased expenditure on some goal or to reduce the taxes paid by one group, the government must find offsetting cuts in expenditure or increased taxes elsewhere, or else accept a larger deficit, incurring a debt that will have to be serviced in the future. The least unattractive of these options, as evidenced by the choices of policymakers, will constitute the opportunity cost of providing the benefit.

Creating new property rights or extending old ones provides the owner with control over resources, including ideas, that were previously accessible to all. Users other than the owner will either be excluded from the resource or will have to negotiate terms with the owner; the associated costs represent the opportunity cost.

Another excerpt from my book in progress, Economics in Two Lessons. There’s a partial draft here if you want to read it in context. I could spend a lot more time on the topic of advertising, but much of the ground has been covered in Akerlof & Shiller’s latest Phishing for Phools. As always, both praise and useful criticism are very welcome.

TANSTAAFL and advertising
We saw in earlier that the ‘free lunch’ provided by saloons wasn’t really free in terms of opportunity cost. Rather, consuming the lunch involves forgoing the opportunity of buying cheaper beer at a saloon where lunch is charged for separately

The same point applies to ‘free’ services provided by governments and financed by taxation revenue. The opportunity cost is the private expenditure forgone to pay taxes. This is the point being made by drivers with TANSTAAFL bumper stickers, even if many of them might be unhappy about paying to use ‘free’ public roads.

There are, however, lots of other examples of services provided free of charge by for-profit corporations. These include radio and TV broadcasts, Internet services like Google, Facebook and Twitter and sponsorship for sporting and cultural events.

Obviously, TV and radio stations, like Google and Facebook, are funded mainly by the sale of advertising. Corporate sponsorship is based on the perception that it will create a favourable impression of the company concerned, which is a kind of advertising. How does our analysis apply to advertising?

In thinking about advertising in TV and similar media, we can easily dispense with the claim sometimes put forward by industry advocates, that such advertising provides consumers with useful information. If this were true, firms would not need to pay TV networks or Internet companies to broadcast the ads.

As is shown by the sales of specialist magazines of all kinds, consumers are willing to pay for useful information about consumer products. But no one will willingly consume ordinary ads unless they are packaged with a program they want to watch, or a webpage they want to view.

In fact, the original free lunch provides a much better analogy. Eating a meal or snack, particularly a salty one, increases the desirability of a cold drink, and the bar is there to provide it.

Similarly, advertisements work because watching an ad increases the desirability of buying the associated product. This may be because the ad attaches desirable qualities (such as sophistication or sex appeal) to the product or because it engenders dissatisfaction with the alternatives we are currently consuming.

In terms of opportunity cost, it does not matter whether an ad works positively or negatively. Either way, the opportunity cost of alternative products is increased relative to the value of the product being advertised. In the standard terminology of economics, a successful ad is complementary (in consumption) with the product being advertised.

In terms of our happiness, though, there’s a big difference. The net effect of advertising is almost certainly to reduce our satisfaction with the things we buy, because most of the ads we see are designed to make us switch to something else. And of course, the things that are not advertised, such as quiet leisure time with family and friends, where no goods and services are required and no money is spent, are downgraded even further.

Market prices tell us about the opportunity costs we face, although the cost, like that of the original free lunch, is hidden. We can choose not to watch the ads (and the programs with which they are bundled), and buy the advertised ‘brand name’ products. Alternatively, we can avoid the ads and buy cheaper alternatives, which don’t include the cost of advertising.

The third possibility is that of watching the ads, but buying the cheaper products anyway. If ads work as they are supposed to, this should induce a similar feeling similar to that of eating salty bar snacks but not buying a drink to go with them. That is, we should feel less satisfied with our choice than if we had not viewed the ads for the brand name product, perhaps so much so that we change our minds and buy the advertised product instead.

Many readers will (like the author) probably judge that they are too strong-minded to be swayed by advertising, particularly the uninformative puffery that we get from mass media. But the continued market dominance of advertised name brands suggests that this is an illusion, similar to the one that leads around 80 per cent of us to believe we are better than average drivers.

Opportunity cost is as relevant to advertisers as it is to consumers. In particular, opportunity cost explains why some kinds of goods and services are commonly bundled with advertising, while others are not. The opportunity cost of producing a TV show or an attractive website can be substantial. But once a given program or website has been produced, the opportunity cost of allowing access to it is small (often less than the cost of restricting access).

In these circumstances, bundling the program with advertising may be the only way to cover the fixed costs of production. If so, the availability of the package as a whole makes us better off compared to the alternative, at least on the (strong) assumption that we carefully consider the hidden cost of the ‘free lunch’ we are being offered.

The problem is more complicated when there are alternatives, such as public funding for broadcasting, which might be financed (as it was for a long time in the UK and Australia) by a license fee for television sets. Choice is maximised when both methods of funding are available, but as a matter of political practice, advertising-funded commercial broadcasters will lobby to have publicly funded alternatives shut down or forced to take ads.

The Internet has shown the power, and the limitations, of a third alternative, that of voluntary provision by individuals (as with blogs) or by large co-operative groups (as with Wikipedia). We’ll discuss this more in Lesson 2.

Finally, it’s worth considering the case when we are forced to consume the advertising whether we want to or not, and without receiving any benefit. The most obvious example is that of highway billboard advertising [as distinct from informative signs regarding the services available at a given exit].

The case where the right to put up a billboard is controlled by (for example) a highway authority, and advertisers have to pay is essentially the same as that of ‘free’ TV and radio. Road users pay part of the cost of providing the highway by consuming ads.

By contrast, in the case where neighbouring property owners can display billboards, neither the road users nor the providers get any benefit. In effect, the owner of the billboard is imposing a cost without any intervening market transaction. In the technical jargon of economics, this is a ‘negative externality’ (we’ll look more at this in Section …).

I’m on to the macroeconomics section of my book in progress, Economics in Two Lessons. The key point of this section is that, whereas the academic economics profession has wasted most of the last thirty years on the project of founding macroeconomics on (some near approximation of) standard neoclassical microeconomics, the validity of the core results of neoclassical microeconomics depend on the assumption that the economy is operating at full employment[^1]. This observation isn’t original – it was why Keynes saw his theory as saving capitalism from itself. Even the title I used in this post on the macro foundations of microeconomics turns out to be a reinvention of the wheel.

Having noted the importance of the full employment assumption in the abstract, how relevant is it? If the economy is, with notably rare exceptions, at, or close enough to, full employment, then it seems safe enough for economists to continue, as the profession has for 40 years or so, to treat macroeconomics as a special subfield with little relevance to the rest of the discipline.

To put the question simply, are recessions abnormal?

Are recessions abnormal ?

Much economic discussion is based on the implicit assumption that the ‘normal’ state of the economic or business cycle is one of full employment, and that mass unemployment is a rare exception to this state. On this view of the world, recessions are temporary interruptions to a pattern of stable growth. The pattern of economic activity associated with a ‘typical’ recession is ‘V-shaped’, with two or three quarters of sharp contraction followed by an equally rapid expansion which restores the economy to something close to full employment. The widely-used informal definition of a recession as ‘two quarters of negative growth’ reflects this view.

There have, however, been lengthy periods when the economy has behaved quite differently. In deep depressions, however, such as those following the Wall Street Crash of 1929 and the Global Financial Crisis (GFC) of 2008, the contraction is sharper and the recovery, when it comes, is slow and fragile. Even after years of ‘recovery’ employment remains far below normal levels.

During the Great Depression the ratio of employment to population in the US fell from 55 per cent in 1929 to 42 per cent at the depths of the slump in 1933. Despite the expansionary effects of the New Deal, employment remained weak throughout the 1930s, with the ratio only reaching 47 per cent in 1940.

The same is true the ‘Lesser Depression’, which began with the Global Financial Crisis at the end of 2008 and has continued ever since. The ratio of employment to population in the US fell from 63 per cent to 58.5 per cent at the onset of the GFC. Despite years of ‘recovery’, the ratio has remained at or near that level ever since.

There have also been lengthy periods when recessions were consistently mild, so mild that many observers believed the business cycle to have ceased to operate. The longest such period began with the outbreak of World War II in 1939, and came to an end in the 1970s. This ‘long boom’ began when wartime economic planning mobilised all available economic resources. Most economists expected the economy to decline when the war ended, as had happened after World War I. However, under the influence of Keynesian economics, governments in the decades after World War II were committed to maintaining full employment and did so with substantial success.

The Keynesian system of economic policies ran into difficulties during the late 1960s. The 1970s was a chaotic period of high inflation and periodic high unemployment. In the mid-1980s, the economy began to recover, as the Federal Reserve developed new tools for economic management. Recessions continued to occur, as in 1990 and 2000, but they were relatively brief and mild. By the early 2000s, economists discerned a period of relative stability which was quickly christened ‘The Great Moderation’.

However, the Great Moderation turned out to be an illusion. Whereas the Keynesian long boom had lasted for decades, the Great Moderation was already over by the time it was ‘discovered’. The bursting of the Internet bubble in 2000 marked the end of strong employment growth in the US and much of the developed world. The GFC turned slow growth into sharp decline, followed by stagnation.

Taking these disparate periods into account, can we regard full employment as the normal state of the economy, subject to temporary interruptions associated with downturns in the business cycle? The evidence suggests that we can not.

Before looking at the business cycle, it’s important to observe that, even under the conditions normally described as representing full employment, around 5 per cent of the labour force is unemployed and actively looking for work at any given time. In addition, substantial numbers of workers would like to work longer hours while others would enter the labour force and seek work if they thought such a search would be successful.

In treating such a state as one of full employment, the underlying assumption is that, under these conditions, unemployment arises from difficulties in matching workers with jobs, rather than from a shortage of jobs in aggregate. (This will be addressed later on).

Turning to the cyclical data, the United States was the first country where systematic study of the business cycle was undertaken, and therefore yields a long series of data based on consistent criteria. The National Bureau of Economic Research was set up in the 1920s and has long been the source of official estimates of the start and end dates for recessions in the United States. According to NBER estimates, over the 100-year period since 1914, around 25 years have been spent in recession.

However, this classification is, in critical respects an underestimation. The NBER treats recessions as beginning when the economy starts contracting, and ending when economic growth resumes. This treatment works reasonably well for ‘typical’ ‘V-shaped’ recessions where the recovery phase restores full employment within a few quarters.

In deep Depressions, however, such as those following the Wall Street Crash of 1929 and the Global Financial Crisis (GFC) of 2008, economic weakness persists long after the end of the contraction phase. At least from the perspective of labor markets it would make more sense to treat the recession as continuing until the economy returns to its pre-crisis growth path. In particular, as long as the employment-population ratio is far below its pre-crisis level, implying the existence of large numbers of unemployed or discouraged workers, wages do not properly represent opportunity costs.

To see the implications of this, consider the NBER data separately for the periods before and after 1929. Before 1929, contractions and expansions were about equally long, so that the economy was in recession a little under half the time.

Now, in addition to the NBER data, treat the whole of the Great Depression 1929-39 and the years since the GFC as recessions. On that basis, the US economy has been in recession for about a third of the period since 1929, only a modest improvement on the period 1854-1929.

But even this is an underestimate. The post-1929 average is pulled up by World War II when the government actively worked to ensure that everyone capable of working towards the war effort did so, and by the period of Keynesian macroeconomic management from 1945 to 1970. If these periods are excluded, the proportion of time spent in recession is around 40 per cent.

To sum up, except when governments are actively working to maintain full employment, the economy is in recession almost as often as not. The idea of full employment as the natural state of a market economy is an illusion.

[^1]: Full employment doesn’t mean zero unemployment, since some people are always changing jobs, or are in the process of leaving the labor market. Roughly speaking, the employment is at full employment in the sense required here when any additional job creation in one sector of the economy is feasible only by attracting workers away from other sectors.

I’m currently working on a section of my Economics in Two Lessons book dealing with minimum wages in the context of predistribution policies, so I thought I would compare Australia with the US, where the idea of a $15/hour minimum wage is currently a hot topic. In Australia there are two kinds of minimum wage. The PPP exchange rate is estimated at $A$1.30 = $US, which is fairly close to the market exchange rate at present, so I’ll give both $A and estimated $US equivalents

The standard minimum wage for workers aged 21 and over is $A17.29 hour ($US13.30) applying to employees under standard award conditions. These include four weeks annual leave, sick leave, employer contributions to pension plans and so on.

More comparable to the situation of US minimum wage workers are “casual” workers, employed on an hourly basis. Casual workers get a loading of at least 25 per cent, bringing the wage up to at least $A21.60 an hour ($US16.60), to compensate for the absence of leave entitlements. In addition, they have entitlements including:

* “Penalty” rates for weekend and night work (usually a 50 per cent loading, 100 per cent on Sundays)
* For workers employed on a regular basis, protection against unfair dismissal.

The policy question is: what impact have these high minimum wages had on employment and unemployment. That’s too big a question to answer comprehensively, but we can look at the obvious data points: the official unemployment rates (5.7 for Oz, 5.5 per cent US) and the 15-64 employment population ratios (72 per cent for Oz, 67 per cent US). So, it certainly doesn’t look as if the Australian labor market has been crippled by minimum wages.

Note: I’ll respond in advance to the widespread misconception that Australia is a special case due to mineral resources. Mining accounts for about 2 per cent of employment in Australia, and (because most mines are owned by multinationals) its contribution to Australian national income is also so, probably around 5 per cent.

* Workers aged 18 get about 70 per cent of the adult minimum, equivalent to around $US11.50 for casuals. But the great majority of US minimum wage workers (about 80 per cent) are 20+.

In a recent post, I asserted that

activities like tax avoidance/evasion and regulatory arbitrage aren’t peripheral flaws in a financial system primarily concerned with the efficient global allocation of capital. They are the core business, without which the profits of the global financial sector would be a tiny fraction of the $1 trillion or so now reaped annually

As I’m working on income distribution issues my long-running book project, this seems like a good time to see if this claim can be backed up by hard numbers.

First up, here’s my source for the $1 trillion number (actually $920 billion). As a plausibility check, I’ve tried to estimate the total size of the global financial sector. Various sources, including Wikipedia estimate that the banking and insurance sector accounts for 7-8 per cent of US gross product. Extrapolating to world gross product of about $80 trillion that would give around $6 trillion for the total size of the sector. The US is almost certainly more financialised than the world as a whole. Still, the profit number looks about right. A trickier question is whether the rents accruing to managers and top professional in the sector should be counted as part of profits. I’d guess that these rents account for at least another $1 trillion, but I have no real idea how to test this – suggestions welcome.

Is tax avoidance/evasion and regulatory arbitrage a big enough activity to account for a substantial share of a trillion dollars a year? Gabriel Zucman estimates that there’s $7.5 trillion stashed in tax havens, of which around $6 trillion is untaxed. He estimates the tax avoided at $200 billion . I’ll estimate that half of that ($100 billion) is creamed off in financial sector, mostly as profits or rents. That implies a profit margin of a bit under 2 per cent, which seems reasonable.

Tax evasion by wealthy individuals is only a small part of the story. Legal tax avoidance is almost certainly more important. Most of that involves companies, but it’s important to distinguish between “close” corporations, which hide the activities of an individual or family and large global corporations. I don’t have any idea how to measure the cost of avoidance through close corporations. As regards global corporations, Zucman estimates that “a third of U.S. corporate profits, or $650 billion, are purportedly earned outside the country, with a cost to the US of $130 billion a year . Extrapolating to the world as a whole, that would be at least $500 billion. Again, assuming the financial sector creams off half of the sum, we get $250 billion (the fact that the finance sector itself accounts for around 40 per cent of all corporate profits means there’s a problem of recursion that I haven’t worked through)

Then there’s manipulation of exchange rate and bond markets. I have no idea how to measure this, but given that the notional volume of trade in some of the markets concerned is measured in the hundreds of trillions, it seems plausible that the profits and rents from market-rigging must be at least in the tens of billions.

These are probably the biggest scams, but there’s also regulatory arbitrage, privatization (a huge source of rent over recent decades), domestic tax avoidance and more.

Adding them up, I’d suggest that $500 billion a year is a low-end estimate for the profits and rents associated with various forms of anti-social financial sector activity.

There’s lots of potential error around these numbers, but the order of magnitude seems reasonable to me. As against the claim that the explosion in financial sector activity and profits over the past 40 years has been driven by the benefits of a more efficient allocation of capital by rational markets, the claim that it’s all about tax-dodging and socially unproductive arbitrage seems pretty plausible.

Obviously, the social cost of a financial system devoted to undermining tax and regulatory systems far exceeds the profits earned from the activity. That’s true of any kind of socially destructive, but privately profitable, activity. But the problem is greater in the case of financial sector activity because of the disastrous effects of financial crises.

Over the fold, another extract from my book-in-progress, Economics in Two Lessons. Encouraging comments appreciated, constructive criticism even more so.

Predistribution and profits

As we’ve seen in previous sections, the social constructions of property rights and institutions surrounding employment makes a big difference to the determination of wages and working conditions. These social constructions affect ‘predistribution’, the distribution of income and wealth that arises before the effects of taxes and public expenditure are taken into account.

Predistribution is equally relevant to the other big source of personal income: profit derived from private businesses and corporations. Without legal structures designed specifically to protect businesses from the risks of failure, profits would be far less secure, and the difficulty of establishing and running a business much greater. Corporate profits are not a natural outcome of a market society, but the product of specific structures of property rights introduced to promote corporate enterprise.

The risks of running a business in the 18th century, and well into the 19th, were substantial and personal. There was no such thing as bankruptcy: a business failure meant debtors prison, where debtors could be held until they had worked off their debt via labor or secured outside funds to pay the balance.

After a brief and disastrous experiment in the early years of the 18th century (the South Sea Bubble), joint stock companies were also viewed with grave suspicion.

The prevailing view was Quoted in John Poynder, Literary Extracts (1844), vol. 1, p. 268. [1]

Corporations have neither bodies to be punished, nor souls to be condemned; they therefore do as they like.

This is often misquoted as

“Did you ever expect a corporation to have a conscience, when it has no soul to be damned, and no body to be kicked?

Adam Smith was similarly scathing, though with more of a focus on the principal-agent problem

The directors of such [joint-stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own…. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.

Exceptions were made only for specially authorised quasi-governmental ventures like the East India Company, focused on foreign trade. In general, limited liability companies were not permitted in Britain or most other countries. The partners in a business were jointly liable for all its debts.

These same rules applied in Britain’s American colonies and continued to prevail in the United States until the middle of the 19th century. The introduction of personal bankruptcy laws put an end to debtors prison, greatly reducing the risks of running a business. The creation of the limited liability company was an even more radical change.

These changes faced vigorous resistance from advocates of the free market. David Moss, in When All Else Fails, his brilliant history of government as the ultimate risk manager, describes how the advocates of unlimited personal responsibility for debt were overwhelmed by the needs of business in an industrial economy. The introduction of bankruptcy and limited liability laws took much of the risk out of starting and operating a business.

By contrast, in Economics in One Lesson, Hazlitt doesn’t mention limited liability or personal bankruptcy and seems to assume (like most defenders of the market) that these are a natural feature of market societies. More theoretically inclined propertarians have continued to debate the legitimacy of bankruptcy and limited liability laws, without reaching a conclusion.

This debate over whether bankruptcy and corporation laws are consistent with freedom of contract is really beside the point. The distribution of income and wealth is radically changed both by the existence of these institutions and by the details of their design. In particular, the massive accumulations of personal wealth made possible by capital gains from share ownership would simply not exist. Perhaps there would be comparable accumulations of wealth derived in some other way, but the owners of that wealth would be different people.

A crucial policy question, therefore, is whether current laws and policies relating to corporate bankruptcy and limited liability have promoted the growth of inequality and contributed to the weak and crisis-ridden economy that has characterised the 20th 21st century. The combination of these factors has produced absolute stagnation or decline in living standards for much of the US population and relative decline for all but the top few per cent.

There can be little doubt that this is the case. As recently as the 1970s, a corporate bankruptcy was the last resort for insolvent companies, typically leading to the liquidation of the company in question. As well as being a financial disaster, and a source of shame for all those involved. For this reason, nearly all major companies sought to maintain an investment-grade credit rating, indicating a judgement by ratings agencies that bankruptcy was, at most, a fairly remote possibility.

Since that time, bankruptcy has become a routine financial operation, used to avoid inconvenient liabilities like pension obligations to workers and the costs of cleaning up mine sites, among many others. The crucial innovation was “Chapter 11”, introduced in the Bankruptcy Reform Act of 1978.

The intended effect of Chapter 11 was that companies could reorganise themselves while going through bankruptcy, and re-emerge as going concerns. The (presumably) unintended effect was that corporate managers ceased to be scared of bankruptcy. This was reflected in the spectacular growth of the market for ‘junk bonds’, that is, securities with a high rate of interest reflecting a substantial probability of default. Once the preserve of fly-by-night operations, junk bonds (more politely called ‘high-yield’) became a standard source of finance even for companies in the S&P 500.

At the same time, legislative changes and the growth of global capital markets greatly enhanced the benefits of corporate structures, while eliminating many of the associated costs and limitations. At the bottom end of the scale, the ‘close corporation’ with only a handful of shareholders, became the standard method of organising a small business. This process was aided by a long-series of pro-corporate legislative changes and court decisions (notably in Delaware, which has long led the way in this process, and where vast numbers of US companies are incorporated). At the top end, the rise of global financial markets from the 1970s onwards allowed the creation of corporate structures of vast complexity, headquartered in tax havens and organised to resist scrutiny of any kind.

At the behest of these corporations, governments have negotiated agreements supposedly designed to ensure that corporate profits are not taxed twice in different jurisdictions. In reality, using a combination of complex corporate structures and governments (notably including those of Ireland and Luxembourg) eager to facilitate tax avoidance in return for a small slice of the proceeds, the effect has been to ensure that most global corporate profits are not taxed even once in the countries where they are earned.

What can be done to redress the balance that has been tipped so blatantly in favor of corporations. The obvious starting point is transparency. Havens of corporate secrecy, from Caribbean islands to US states like Delaware must be made to reveal he true ownership of corporations, in the same way that tax havens like Switzerland, used mostly by wealthy individuals, have been forced to disclose the ownership of previously secret accounts.

The use of complex corporate structures to avoid tax is a much more difficult problem to tackle. Some measures are being taken to attack what is called “Base Erosion and Profit Shifting’, but past experience suggests that slow-moving processes of this kind will at best keep pace with the development of new forms of avoidance and evasion. It’s necessary to re-examine the whole structure of global taxation agreements. Instead of focusing on the need to avoid taxing corporate profits twice, the central objective should be to ensure that they are taxed at least once, in the place where they are actually generated.

More generally, though, the idea that corporations are a natural part of the economic order, with all the human rights of individuals, and none of the obligations needs to be challenged. Limited liability corporations are creations of public policy, useful to the extent that they promote the efficient use of capital but dangerous to the extent that they facilitate gross inequalities of income and opportunity.

A bit out of order, this is another draft extract from my book-in-progress, Economics in Two Lessons. It’s part of the chapter on income distribution, meant to follow the section on unions, and precede the Australia-US data point and the discussion of corporate profits [links to CT, but all published here also]. After this, I plan to conclude the “predistribution” part of the chapter with a discussion of intellectual “property”, then move on to “redistribution” through taxation and public expenditure.

As always, encouragement is welcome, constructive criticism even more so.

Minimum wages and predistribution

The most direct way for government to influence the distribution of market income is to set minimum wages.

The effects of minimum wages on the distribution of income has been the subject of a vast economic literature. Much of this literature starts from a simple (or simplistic) version of Lesson 1. The starting point is the assumption that the price of labor (that is the wage) is the product of a competitive market of the kind we discussed in Chapter 2.

If this is correct, then a minimum wage involves setting a price above the opportunity cost of labor. This means that some workers who would be willing to work at a wage below the minimum will remain unemployed, while potential jobs which yield less production than is needed to cover the cost of a minimum wage worker will remain unfilled or will not be created at all.

Even within this framework, workers may benefit from an increased minimum wage. Suppose for example that the minimum wage is increased by 10 per cent, and that employers respond by reducing the hours of work, for all minimum wage workers, by 5 per cent. In this case, workers would get 5 per cent more total pay, and work 5 per cent fewer hours, gaining both more income and more leisure.

Economists working in this framework point to a number of reasons to doubt this favorable projection. First, the gain to the workers here is associated with a larger increase in cost to the employer. Not only does the employer pay more and get less, but as shown in Lesson 1

Second, typical estimates of the change in hours of work associated with a given change in wages (referred to as the elasticity of demand for labour) are derived for small changes in the wage. Larger proportional effects might arise with a large and rapid increase in the wage.

Third, the idea of a uniform reduction in hours of work for all minimum wage employees is clearly unrealistic. More likely, many workers will experience no change in their hours (getting the full benefit of the increase) while others will lose their jobs, or fail to find jobs when they enter the market.

The third of these points is the most important. However, far from strengthening the case for an analysis based on Lesson 1, it undermines it. Hours of work are not a commodity that can be supplied and demanded so as to match prices and opportunity costs. Rather, each worker is typically matched with one job which largely determines their living standards. With the allocation of property rights to employers that normally prevails in the US, referred to as ‘employment at will’, the job is the property of the employer who can withdraw it at any time, for any reason, or none. Donald Trump’s catchphrase, ‘You’re Fired’ is the simple and brutal expression of this reality.

Because of this imbalance of power, Lesson 2 is just as relevant to the determination of wages as Lesson 1. In the absence of offsetting institutions like unions and minimum wages the imbalance of bargaining power will ensure that most of the benefits of the bargain go to the employer.

(except where they have to patch two or three jobs together, almost invariably ending up with worse terms)

Approaches based solely on Lesson 1 dominated the economics literature until the early 1990s. The central concern of this literature was to estimate the elasticity of demand for minimum wage workers. The elasticity of demand is the ratio of the percentage change in hours worked a given percentage change in the minimum wage. In the example above, where minimum wage is increased by 10 per cent, and that employers respond by reducing the hours of work, for all minimum wage workers, by 5 per cent, the elasticity would be 0.5 (that is, 5/10).

Economists working in this approach expected to find a moderately elastic demand for labor, and they did so. Econometric analysis undertaken in the 1970s and 1980s typically yielded estimated elasticities above 0 (no response) but below 0.5. However, over the course of the 1980s, the estimates tended to decline. Moreover, with the re-emergence of chronic high unemployment after the economic crises of the 1970s, the idea that wages could be regarded as prices emerging from a competitive equilibrium (for which full employment is a pre-requisite) became less and less plausible.

The debate changed radically in the 1990s. The biggest single event was the publication of research by two leading young economists, David Card and Alan Krueger. Card and Krueger examined differential changes in minimum wages in neighbouring states and found that they had no discernible effect on employment in the fast food industry. These estimates were subject to lots of reanalysis, the majority of which tended to confirm the original Card and Kreuger analysis.

More importantly perhaps, Card and Krueger shifted the terms of the debate to include the key point of Lesson 2, that market prices do not always reflect social opportunity costs. In particular they stressed the imbalance of bargaining power between employers and potential workers. This is reflected in what is called, in the jargon of economics, ‘monopsony power’. Monopsony is the other side of monopoly: literally interpreted it means that there is only a single buyer for the good or service in question, in this case labor hours. But more generally, monopoly and monopsony are relevant whenever one of the parties to a transaction has sufficient bargaining power to influence the price (in this case, the wage)

The central implication of the Card-Kreuger is that the primary effect of higher minimum wages will be to redistribute the benefits of the wage bargain from employers to workers, rather than to raise the opportunity cost of hiring to a level exceeding the private and social benefit.

Minimum wages are not a panacea. There must exist some level of minimum wages at which the wage is greater than both the opportunity cost of working and the social value of the output produced. At this point Lesson 1 would be more relevant than Lesson 2.

There is, however, no reason to believe that the current US national minimum wage of $7.25 an hour (far lower in real terms than the level prevailing 50 years ago) is high enough to produce such effects. A comparison with Australia, a country very similar in many respects to the US, suggests that an adult minimum wage of $15/hour could be achieved over time with few, if any, adverse effects on employment.