Month: April 2023

Socioeconomic Engineering

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April 30, 2023

by Stephen Stofka

Last week’s letter was about marginal loss and marginal value. This week I’ll continue exploring another topic in marginal thinking – the marginal disutility of labor. I will touch on the influence of John Stuart Mill, Karl Marx and Thorstein Veblen and revisit John Bates Clark from last week. I will finish up with Keynes, a seminal figure who voiced disapproval of some earlier economic ideas but incorporated portions of that thought into his General Theory.

What is the marginal disutility of labor? Disutility is a synonym for harm. There are two choices in each period of time: work and leisure. Leisure should be understood as non-work, not an activity like resting in a lounge chair on the beach. If the next period of work causes harm we will choose leisure, a rest from work. This idea became popular in the late 19th century as neoclassical economists adopted utilitarian ideas contained in John Stuart Mill’s Principles of Political Economics. Mill claimed that values were subjective, based on scarcity and the costs of production (Heilbroner, 1997). Mill rejected the claim by classical economists like Ricardo and Smith that there was some natural law of distribution of the gains from production. Mill wrote that distribution of gains was based on customs and morals peculiar to each society.

That was a bit too arbitrary and subjective for some neoclassical economists like Jevons and Menger. The neoclassical economists wanted to divorce politics from economics, to cut out the “Political” in the title of Mills book. They developed the concept of a marginal productivity of labor idea to accompany the marginal disutility of labor. Under this schema, every worker was paid their marginal product, their contribution to production. Neoclassical economists became preoccupied with equilibrium in a static world.

I wrote about John Bates Clark last week and I will mention him again. A neoclassical economist himself, his book The Distribution of Wealth reminded readers that most neoclassical ideas only made sense in a fictional world where labor and capital were free to go wherever they would earn the most return. It is a world without friction or gravity like Newton’s mechanical world of motion. The simplification helped Newton identify the interplay of forces on an object in motion.

Clark went down the rabbit hole himself and he defined and reconciled two sets of laws, the static and dynamic. In his theory, there were static laws of equilibrium between scarcity and wants. This was a system seeking rest like the swing of a pendulum as it gradually comes to rest at the lowest point of an arc. He identified five forces that disrupted the static laws. These were population, capital, technological improvements, the types of businesses and the wants of consumers. Each of these were increasing, a dynamism that interfered with any resolution.

At this point in the story, I will return to The Worldly Philosophers by Robert Heilbroner (1997).  One of Clark’s pupils was Thorstein Veblen, a Norwegian who would become one of the leading voices of what is called American Institutionalism. That school of economists proposed a class of socio-economic engineers who would optimize the institutions that dictated the distribution of property to make production more efficient. Marx had also insisted that production and distribution could not be separated. Veblen’s ideas were a rational system implemented by a trained intellectual elite. Marx envisioned a reactionary movement like the upheavals that swept Europe in the 1840s. Despite the stark differences between Veblen and Marx, the neoclassicals depicted Veblen as another Marxist philosopher and marginalized that school of thought.

John Maynard Keynes rejected the notion of the marginal disutility of labor because it failed to explain how millions of workers were idle regardless of their asking wage. Employers were not hiring because the expectation of sales was so low. Sales remained low because workers were not employed, a problem that Henry Ford had solved two decades earlier. Ford needed more people to buy his cars but even his own workers could not afford the cars. So he paid them more money. That solution was more difficult to deploy throughout an entire economy, however. Only a government had enough fiscal power to put a large number of people back to work, to increase what Keynes called effective demand.

In his General Theory Keynes introduced the same idea of the economist engineer but did not mention Veblen. Heilbroner thought it was because the neoclassicals had successfully stereotyped Veblen as a Marxist, a socialist without respect for private property. Keynes was essentially a conservative in the camp of Edmund Burke, someone who wanted to preserve the capitalist system based on private property. Despite the difference in intentions, Keynes introduced top down economic engineering at a time when people were desperate for solutions that would preserve existing institutions.

Our society today is based on these ideas and the institutional norms those ideas spawned. As the debate over raising the debt nears a critical standoff sometime this June, we will be able to see the clash of ideas tangled with the posturing and struggle for political dominance.     

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Photo by Mykola Makhlai on Unsplash

Heilbroner, R. L. (1997). Teachings from the worldly philosophy. New York, NY: Norton & Company.

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Marginal Losses

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April 23, 2023

by Stephen Stofka

Today’s letter is about marginal loss and marginal value. We are going to take a rollercoaster ride from Einstein to relationships to the Bible to the marginalist revolution in late 19th century economics. Buckle in.

Einstein’s formula equating mass and energy confused me for a time. With all the mass in the universe, it seemed that it would blow itself up. At some point I read that the m in E = mc2 represented the mass lost and a light bulb turned on in my young head. A grain of sugar lost from a sugar cube weighed almost nothing but when multiplied by c2 – well, no wonder the atom bomb was so powerful.

We understand the value of a partner when we lose them. The worst part of breaking up with someone is thinking that they experience the loss far less than we do. We think back and wonder if we valued them more than they valued us throughout the relationship. The pain of loss becomes the yardstick that we measure the parts of the relationship. After the death of a dog, we remember them licking us awake in the morning with far more fondness than we actually felt when we just wanted a few more minutes of sleep rather than a walk in the cold morning air.

In the Parable of the Workers in the Vineyard, the workers hired early in the day get the same daily pay as those hired later in the day. Those who worked least, i.e. the last workers hired in the day, became the standard by which all the workers’ pay was evaluated. That became their standard of value. By this measure, the landowner had cheated the workers hired earlier in the day. In the landowners valuation, the workers were indistinguishable. To each worker, they distinguished themselves by the amount of time spent working and discomfort endured.

In a market stall in a developing country, the produce sold by each vendor may be largely indistinguishable. The value of what each vendor sells is mostly determined by what would happen if they weren’t there, not by the amount of effort they put into growing and harvesting what they offer for sale. Is that fair?

John Bates Clark was a leading economist of the late 19th and early 20th century who asked that very question. In Chapter 7 of The Distribution of Wealth he noted that the price of all the wheat grown by farmers in the northwest United States was determined by the price of whatever surplus wheat there might be when all the wheat reached the marketplace. This price was fixed on a London exchange thousands of miles away. Why should the marginal surplus determine the price of an entire crop?

A pound of ground beef might sell for $5. Add 10 cents worth of spices, 20 cents of packaging, 50 cents of labor and that same product now sells for $8 as Italian meatballs. Why do the marginal ingredients determine the price of the entire pound of ground beef?

In Chapter 8, Clark noted that a worker’s value to an employer is not their marginal product – not directly. It’s the loss to the employer if a worker left, or the marginal loss. Clark called it a zone of indifference. Within that zone are the expendable workers. Should those expendable workers become the standard of value just as in the parable of the vineyard? These are uncomfortable conversations. Workers have families. They contribute more to the community than their marginal worth to an employer. They take their kids to soccer games and coach Little League games. They volunteer at food banks, animal shelters and museums. How should society pay for that worth?

Clark published his book The Distribution of Wealth in 1899 when employers provided few benefits or protections for workers and factories were crowded with child workers. There was no income tax. In the U.S. today, employers are required to pay some part of society’s share of a worker’s worth to the community. The employer then includes those societal costs in the price of their product and the burden is shared among the employer’s customers (note below).

This is an indirect or hidden tax, a more politically feasible type of taxation. We judge our taxes at the margin – the amount that we have to give to the government on the last dollar we earn. The press cites marginal tax rates, the rate on the last dollar, and not the effective tax rate, the total amount of tax divided by our total income. We might be in the “25% tax bracket” when our effective rate is only 11%. We are guided by marginal loss thinking.

Repeated experiments have demonstrated that we assign a greater value to marginal losses than we do marginal gains. Consider this, a variation of Einstein’s thought experiment with moving trains. Consider two observers – John is on a moving train and Mary is an omniscient observer on a train platform. In this case, the moving train is time. John has a $100, which becomes his standard of value. Then some event happens before the next stop and John has $105, which becomes his new standard of value. Like the rest of us, John forms expectations of the future based on his current motion. He expects a gain of about $5 before the subsequent stop. But something happens and John loses $5. From Mary’s point of view, John has the same amount of money he started with. But John feels like he has lost $10, the initial gain and the expected gain that he did not receive.

No one has to teach us marginal loss thinking. It seems to be instinctual because we live at the margin, breathing in and out every minute of our lives. The very act of breathing creates a loss of pressure in our lungs. Sometimes marginal thinking is appropriate and sometimes thinking at the average is more appropriate. As investors, not traders, we must think at the average, not the margin, to survive.

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Photo by Roman Fox on Unsplash

*These societal costs are not the Marginal Social Costs (MSC) referred to in Environmental Economics texts. Those are costs that an employer imposes on society.

Public Goods and Private Values

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April 16, 2023

by Stephen Stofka

This week’s letter is about the funding for public goods. More than sixty years ago economist Charles Tiebout predicted that we would splinter into different communities based on our use of and desire for public goods like schools, highways, public transportation and other facilities. Let’s dig in!

In his 1948 textbook Economics: An Introductory Analysis, Paul Samuelson introduced the definition of a public good as non-rival and non-excludable. Non-rival means that one person’s consumption of a good does not lessen another’s consumption. National defense is an example. It is difficult to exclude people from a public park or a radio broadcast so these are considered public goods. Samuelson introduced these two characteristics to distinguish public goods from common or pooled goods like a public lake. When there is a plentiful stock of fish, no one notices that when one person catches a fish, someone else cannot catch that particular fish. Overfishing results when people catch fish faster than they can replenish their stocks.

In his eager efforts to systematize and mathematize economic concepts, Samuelson sometimes introduced provocative simplifications. In two separate articles published in 1955, economists Stephen Enke and Julius Margolis gave examples of public goods that were rivalrous. A crowded public highway or school does lessen other people’s consumption. Charles Tiebout (1956) pointed out that one of Samuelson’s simplifying assumptions was that public goods were provided by one source, the federal government.  In 1954, state and local spending was actually twice that of federal spending, excluding national defense. In the chart below, the orange bars are state and local spending, which does include police protection. While it is a public expenditure, a police response to one incident means that they are not available for another call so the police are rivalrous.

A few years after the Johnson administration ushered in the social reforms collectively termed the Great Society in 1964-65, federal spending overtook state and local spending. These programs included Medicare, Medicaid and what were called Food Stamps and Welfare at the time. Today the spending roles are reversed. Without including spending on national defense, federal government spending and investment is almost twice that of state and local.

Samuelson pointed out that there is no market mechanism to price public goods. What is the appropriate price for defense, highways, schools and other public goods? Charles Tiebout (1956) argued that the price for these goods is determined in the voting booth by a public that desires to keep its taxes low. Voters will support those public goods which they consider valuable and will use. Tiebout predicted that voters would migrate to communities where they were among taxpayers who shared similar preferences for a particular set of public goods. If a couple had young children, they would vote for more school funding. Their children would get the benefit while the community as a whole bore the expense. People who liked to golf would favor communities with a like-minded interest who would vote for a public golf course. Tiebout wrote, “The greater the number of communities and the greater the variance among them, the closer the consumer will come to fully realizing his preference position.”

Writing in 1956, Tiebout’s prediction ran counter to the predominant social theory of the American melting pot – that people were becoming gradually harmonized into a single American monoculture. In 2008, Bill Bishop’s book The Big Sort confirmed Tiebout’s prediction. For decades, Americans had been sorting themselves into communities of like-minded preferences and values. Today, few would argue that we live in an increasingly differentiated society of insular interests and values. On social media, we establish community by voicing outrage at those others – what one of them said or did. We form interest clubs with a unique vocabulary, inside references, remarks and jokes that those outside the club don’t get because they don’t understand the context.

In spite of this cacophony of interests and values, there is a clamor for more public goods. More health care, more schools, more public spaces. How are we ever going to agree on the funding for these public goods? The successful ballot initiatives supporting public goods have a common characteristic. They spread the cost evenly by exacting a very small increase in a sales tax rate. People will vote for a public good if it will cost all households a small amount like $20 extra sales tax. This tax, known as a Tiebout equilibrium, acts more like a user fee than a tax.

Each year federal spending less national defense grows a bit more than state and local spending. If local voters cannot agree on spending priorities, this divide will get larger, throwing more of the spending burden on the federal purse and increasing the federal debt. Officials in local districts, frustrated by a lack of voter consensus, will increasingly look to Washington for school funding, children’s lunch programs, health care, public transportation, support of libraries and museums. Where does this end?

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As an aside, defense spending has a unique characteristic. Most government services increase as the population increases. It may not be in proportion but that is the general case. Increases in defense expenditures respond more to the perception of outside threats, not the size of the population. Here is a chart of per capita spending in nominal dollars, spending that has not been adjusted for inflation.

When spending is adjusted for inflation, it is clear that defense spending responds primarily to  perceived threats, not population growth.

After 9-11, real per capita spending on national defense increased by 33%, from $2100 to $2800 per person. In June 2009, President Obama began withdrawing troops to meet a campaign pledge. By the end of his second term in 2016, real per capita defense spending had returned to a level that existed before 9-11. Despite his isolationist rhetoric the Trump administration increased defense spending. This was largely due to pressure from a Republican Senate and House. In the less populous areas of the south, central and mountain west, more defense spending means more government jobs that promise stability and benefits. Republicans may preach small government but the communities they represent value government jobs and the economic benefits that ripples through local communities from military spending.

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Photo by Amy-Leigh Barnard on Unsplash

Tiebout, C. M. (1956). A pure theory of local expenditures. Journal of Political Economy, 64(5), 416–424. https://doi.org/10.1086/257839

Healthcare Inflation

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April 9, 2023

by Stephen Stofka

This week’s letter is about health care spending and its effect on inflation. Economists construct a composite price index number out of many components of the economy. While that construction may have a rigorous methodology we struggle to make causal inferences from the data because price movements in an economy are complex.

In 1965 President Johnson signed the law creating the Medicare and Medicaid programs. At that time, health care spending was 6% of total consumer spending. The radical reformers of that age wildly underestimated Medicare’s costs, particularly for inpatient hospital costs. Since the government now paid for the first 90 days of a hospital stay, doctors were encouraged to take a cautious approach and keep a patient in the hospital if there was a chance of infection or accident at home. The deep pockets of the federal government incentivized medical and pharmaceutical companies to develop new drugs and equipment. Hospitals expanded their surgery and rehabilitation units. Doctors increasingly turned to specialization and their numbers tripled from near 90,000 in 1965 to 284,000 in 1990, according to the National Center for Health Workforce Analysis. In 25 years, healthcare spending (https://fred.stlouisfed.org/graph/?g=12f9k) more than doubled as a percent of consumer spending, coming close to 15% of the total. It has risen to 17% in the past decade and now is 16%. Here’s a chart showing the growing contribution of healthcare spending to total consumer spending (blue line) and healthcare inflation’s impact on overall inflation (red line).

Healthcare spending has a large effect on inflation through two channels: first, during recessions healthcare spending does not decline as much as overall consumer spending; second, prices for health care services have grown faster than the prices of many other goods because the demand for healthcare services remains strong and constant. Since 1990 the prices for all goods and services have increased 81%, far less than the 131% of healthcare prices.

During recessions, total consumer spending falls and that puts downward pressure on inflation. But the healthcare component resists that downward pressure. The Federal Reserve, whose job it is to keep prices stable, might delay lowering interest rates because healthcare spending is keeping the price index elevated above the level of all other goods and services. This in turn could prolong the after effects of a recession: less lending and slower gains in employment. This is what happened after the 1990 and 2001 recessions. During the 1990 recession, inflation (the annual change in price) actually rose a bit before falling, spurred on by an 8.5% increase in healthcare prices. By the first quarter of 1991, healthcare was contributing 40% to overall inflation, rising up from 13% in 1989. The same pattern repeated in the 2000-2002 period.

Even though both recessions lasted less than a year, job recovery was slow. The lingering effect of a recession surely cost President George H.W. Bush a chance at a second term. In 1992, both Bill Clinton and Independent candidate Ross Perot reminded voters that the economy was sluggish and it was time for a change of direction. In the 2000s, Bush’s son, George, learned from his father’s misfortune. He urged the passage of tax cut packages and the Medicare Drug program, which helped secure his victory in the 2004 election despite disapproval of the conduct of the war in Iraq.

The ACA, or Obamacare, capped the growth of inpatient Medicare payments at 2% and this helped keep healthcare inflation (https://fred.stlouisfed.org/graph/?g=12f9b)  at or below 2%. Medicaid expansion doubled the contribution level of healthcare prices to overall inflation, but because healthcare inflation was restrained, that helped to contain overall inflation.

The pandemic showed the enduring influence healthcare has on the general price level. When consumer spending had a sharp decline, healthcare prices remained strong. During the 3rd quarter of 2020, healthcare inflation was 2.9% and was responsible for nearly all of the general inflation rate of 1.1%. But here, the paths diverged. As the economy reopened and the general rate of inflation rose during 2021 and 2022, healthcare inflation decreased. That divergence describes the nature of the current overall inflation. It is procyclical, driven by short-to-medium term events, not a fundamental change in the economy.

In a 2017 Federal Reserve Economic Letter, Tim Mahedy and Adam Shapiro (2017) assigned spending categories into two buckets, procyclical and acyclical. Procyclical components that make up 42% of spending are those whose demand and prices vary with the business cycle and changes in employment. These include housing, recreation, food services and some nondurable goods. Acyclical components account for 58% of spending and include healthcare, financial services, many durable goods and transportation. The authors don’t mention energy specifically but I presume that it is an acyclical component of both housing and transportation services.

The pandemic caused shifts within and between these two buckets. During the pandemic demand soared for housing services, but declined for recreation and food services – an example of a shift within the procyclical bucket. We used a lot less energy in our cars but a lot more electricity and gas at home – a shift within the acyclical bucket. We bought a lot of durable goods – a shift between buckets.

I think it is the between  shifts that had the most disruption. Supply chains for acyclical goods and services function on a less flexible timeline that does not anticipate sudden changes. Global shipping rates soared, ports were clogged with traffic, parts inventories were depleted, leading to manufacturing delays and an opportunity for companies to raise prices to make up for decreased profits due to shrinking volumes. With long delays from overseas suppliers, big retailers like Wal-Mart and Target increased their orders. As pandemic restrictions lifted, people shifted their spending again from acyclical durable goods to procyclical recreation and food services.  

Each of us constructs an instinctive index based on our individual buying habits and circumstances. An American who lives for a while over in Europe has to learn to convert Centigrade temperatures to Fahrenheit. Like the CPI price index, there is methodology for making that conversion. However, it is much easier to remember that 0°C is cold, 10°C is cool, 20°C is comfortable,  30° is hot, and 40° is hell. Much of the time we navigate our daily lives without precision, relying on professionals when we do need exactness. Sometimes the professionals can tell us why something is the way it is but sometimes even they can only guess. Complexity is the result of an interlocking causality that is harder to solve than a Rubik’s cube.

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Photo by John Barkiple on Unsplash

Mahedy, T., & Shapiro, A. (2017, November 27). What’s down with inflation? San Francisco Fed. Retrieved April 6, 2023, from https://www.frbsf.org/economic-research/publications/economic-letter/2017/november/contribution-to-low-pce-inflation-from-healthcare/

The Price Box

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April 2, 2023

by Stephen Stofka

This week’s letter is about prices. If you’ve have ever been a business owner – even a micro business like delivering papers – you are aware that price is a label on a box. My wife and I have a cat, Ellie, and we keep all of her toys in a cardboard box in the living room. The price of one product – $24.99 – is like a label on all the objects in that box.

Inside that price are supply factors, the costs of making and distributing the product and the vendor’s costs in selling the product. To a kid delivering papers on a bicycle those costs include broken chains and flat tires and brake repair. There are opportunity costs – what else a kid could be doing when they are out delivering newspapers.[i] The supply of a product entails legal costs and taxes and the institutional costs of maintaining property rights. The court system and the police force are in that price box. Is the market for that product a monopoly or competitive? Trade restrictions and tariffs, supplier subsidies, weather and seasonal factors – It’s in the box.

There are demand components in that box as well. How responsive are customers to changes in price and the trend in income growth. Consumer expectations of price increases or supply shortages for that product and competition from other vendors and goods. Substitutes or complements for the product. Consumer subsidies like low interest loans, mortgage loan government guarantees, bankruptcy laws and favorable tax laws. Time itself is in the box. Our tastes and desires change with the years and that’s in the box.

There is a calculation procedure in linear algebra where a bunch of numbers get multiplied and added together to give just one number. That’s what a price is. It is a piece of information that unfolds into an origami of the structure of our society, government and economy. If uncovers our moral values and the relationships of power within our society.

Economists of the Austrian School of Economics stress that prices help organize production and consumption decisions. They reject the emphasis on regulation as a director of resources. They sometimes refer to Adam Smith’s “invisible hand,” the idea that people seeking their own well-being can act for the benefit of everyone. Prices work in that world. The drive to seek our own well-being has a darker side that Smith explored throughout his book, The Wealth of Nations. In that world, isn’t there a need for regulations to curb individual appetites? Those who craft and enforce the regulations are themselves seeking their own well-being.  

We often say that “no one is above the law.” However, everyone wants to “get around the price,” and the politically powerful are able to do so. Smith advocated a free market only as a last resort after documenting the many instances where policymakers – “magistrates” and “council members” – wrote laws that favored the rich and influential. He was in favor of a well-regulated economy that ensured fair and equitable rules for everyone but there is no one capable of that. Smith found relationships of power corrupted most rule-making.

In Part 1, Chapter 7, he explains the price advantage enjoyed by those who secured a monopoly for their product or service. They were then able to charge the highest price. In Chapter 8, capitalists had contrived to have laws written that permitted the combining of capital but did not permit workers to form unions to increase their bargaining power. Business owners regularly colluded with each other to keep wages low. Smith writes “whoever imagines … that masters [employers] rarely combine, is as ignorant of the world as of the subject.” This from a man who studied the wages and prices in Europe and the colonies. Chapter 10, he notes the Statute of Apprenticeship laws that restricted the free movement of labor from one town to another and from one company to another. The weaving of plain linen and plain silk were similar skills but linen weavers were not allowed to transfer to another company to weave silk. In Chapter 11, he documents how French vineyard owners got a law passed that prevented any new vineyards. This preserved the vineyard owners pricing power. There were money policies and trade rules that preserved the power of the politically powerful in Britain at the expense of the American colonists. The American colonists were allowed to harvest raw materials but were required to ship them to British manufacturers to make the final products from those inputs. The book was published in 1776, the same year that the colonists finally got fed up and declared their independence.

Because prices direct production and consumption, so many of us want to alter that direction for own benefit. In the past weeks I have written that social, political and economic behavior is better understood as a recursive function where the output from the function becomes the input to the next call of the function. As some parties in the free market successfully alter the rules that govern the costs that are in the price box, that raises the call for regulation from those who are disadvantaged by that alteration. So policymakers and regulators write rules that rearrange the costs as a corrective to the distortions committed by the people and companies that they regulate.

Economic purists may envision a market of prices that work like an Antikythera mechanism, directing resources for the general well-being. Economic students are taught the ideal of the perfectly competitive market even though it rarely exists. Aircraft wing designs are tested in a wind tunnel without an engine powering the wing. This eliminates distortions in the interaction between wind and wing. Isaac Newton envisioned a universe without gravity and friction – both of them “unbalanced forces” – to derive the first law of motion. Too much deductive economic theory is founded on the assumption that a social science like economics can be tested with the same methods used in the physical sciences.

Socialist purists clamor for ever more regulation to fix an endless supply of injustice in the market. They open up the price box and see all the dark forces that Smith wrote about – monopoly and collusion and greed and bigotry that harms the general well-being. They claim that regulators and lawmakers are able to overcome their self-centered impulses and act in accordance with democratically created law. To paraphrase Smith, whoever imagines that to be the case is as “ignorant of the world as of the subject.” He did not have a cynical view of human nature but a realistic view of the natural contradictions of human nature.  

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Photo by Katrin Friedl on Unsplash

Keywords: supply costs, demand factors, Austrian Economics, price theory, regulations

[i] Conventional economic theory too often assigns little or no value to leisure. Tate & Fegley (2020) argue that leisure is a complementary good to labor the way that mustard is a complementary good to a hot dog. They countered the neo-classical assumption that people would work all of their waking hours if they were paid enough.  

Fegley, T., & Israel, K.-F. (2020). The disutility of Labor. Quarterly Journal of Austrian Economics, 23(2), 171–179. https://doi.org/10.35297/qjae.010064