Here is the full text of my 68th Quartz column, "Economics is unemotional—and that’s why it could help bridge America’s partisan divide," now brought home to supplysideliberal.com. It was first published on May 15, 2017. Links to all my other columns can be found here.
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© May 15, 2017: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2020. All rights reserved.
In order to keep things tight, my editor for this column, Sarah Todd, suggested cutting two passages that might interest you: my original introduction, which defines the concept of "politicism," and a passage about the politics of financial stability. You can see those passages after the text of the column as it appears on Quartz.
As the 2016 US election showed, politics is dividing Americans more than ever before. How can we begin to bridge these ideological divides? A recent series of social psychology studies by Jarret Crawford, Mark Brandt, Yoel Inbar, John Chambers and Matt Motyl suggests one possible solution.
The studies, based on detailed surveys of 4,912 Americans, confirmed that liberals and conservatives look down on one another equally. But crucially, researchers also found that social issues were far more likely to spur conflict than economic issues. This is in part because—distressingly to an economist like me—a lot of people find economics boring. Academia even has an established rule of thumb regarding this point: “Inviting more than 25% of the guests for a university dinner party from the economics department ruins the conversation.” For the average person, it’s hard to get your hackles up about interest rates. And it’s precisely because economic policy is such an unemotional, esoteric subject that it could help narrow the gulf between the left and right.
When politicians do use economics to get a rise out of voters, the message is usually blunt and visceral: “You deserve more money, they deserve less.” Subtler dimensions of economic policies may not work in stump speeches—but they can be the kind of good governance that gets politicians reelected. Voters on both the left and right like policies that lead to healthier job markets and higher GDP. And so, for politicians who hope to garner bipartisan support, the key is to focus on economic policies that get results.
The stakes couldn’t be higher. For one thing, without serious reform to US monetary policy, the Fed will not be prepared to handle the next Great Recession. Meanwhile, aging Baby Boomers will soon put enormous strains on the federal budget, and the national debt is so large that it would take more than a year’s worth of everything our economy produces to pay it off. Since 2003, productivity growth has slowed down for reasons we don’t entirely understand. And in the midst of this critical situation, the Trump administration and Republican Congress are proposing policies that are not only untested, but have the potential to affect the economy in so many disparate ways that it’s impossible to predict what the overall impact would be.
For example, consider the plan proposed by Republican Congressional leaders to raise taxes on imports and cut taxes on exports—so-called “border adjustment.” They hope to kill two birds with one stone: (a) reduce the trade deficit and (b) raise revenue to make up for tax cuts they want to make elsewhere. But border adjustment could be largely self-defeating as a way to reduce the trade deficit because it would lead to a stronger dollar. The trouble is that border adjustment doesn’t do much to give the rest of the world access to the US dollars it would need to buy US goods. Border adjustment is like trying to sell cars by giving car buyers a discount but then failing to give them any financing.
Instead, as I discussed in another column here in Quartz, the best way to get more balanced trade is the much less obvious policy of raising the US saving rate so that Americans can lend to the rest of the world—and they can afford to buy our products—instead of Americans borrowing from the rest of the world. This could be achieved by requiring employers to automatically enroll their employees in 401(k)s. (In this plan, employees could opt out, but many wouldn’t.)
With Americans doing more saving, the US wouldn’t need to borrow as much from the rest of the world to build houses and factories—and the trade balance would improve. More exports and fewer imports would, in turn, lead to more of the types of jobs that many people want. In addition to lend abroad to finance US exports, extra saving would mean more funds for investments in the US that would also lead to better-paying jobs.
But instead of working to raise national saving, with all the good effects that would bring, Gary Cohn, head of Donald Trump’s National Economic Council, has been talking with members of the Senate Banking Committee about tinkering with retirement savings accounts in a way that’s actually likely to reduce national saving. Right now, a typical 401(k) allows people to contribute to their account with pre-tax dollars, with the understanding that people will pay taxes on those dollars when they withdraw money during retirement. Cohn’s idea is to tax people first, before the money goes into the retirement account. That means less tax revenue at some future date—but it would provide revenue now to make up for lost revenue from other big tax cuts the Republicans want to do.
This may help procedurally in ramming through a big tax cut. But the effect, while unpredictable, would be likely to reduce savings among middle- and upper-middle-class people (who would not want to pay the upfront taxes).
In this way, the danger of arcane economic policies becomes clear: they can often be used as a way to please the special interests who donate to political campaigns. But sooner or later, the chickens come home to roost. People may not know which policy led to a recession or to stagnant wages, but they do figure out that something is wrong.
The tricky thing about good economic policy is that, as things stand, it’s not so much something you talk about, but something you do. Nonetheless, it’s a worthy cause for politicians on both sides of the aisle to adopt. Given the number of highly politicized issues currently dividing Americans—from abortion to immigration to health care—the party that gets to stay in power the longest will be the one that does a good job handling economic policy when it gets its turn in the driver’s seat.
Meanwhile, it’s up to economists, teachers, and journalists to find more ways to awaken people’s curiosity about economics. It’s clear that American voters on both sides of the political divide are invested in topics like jobs, trade, retirement, and the plight of the working and middle classes. But often, hot-button issues such as immigration come to dominate the conversation about these subjects—perhaps because most people lack a solid grasp of the real forces that have created economic problems, or the mechanisms that might be able to address them.
So one of the best ways to turn the tide of the partisan US is to make economics a mainstay of the popular conversation—the better to enable Americans to elect officials capable of good governance, and reduce the intensity of the political divisions among us by making everyone happier with the circumstances of their lives.
Original Intro Defining 'Politicism':
Among friends considering where to live, I hear a concern these days I don’t remember hearing when I was younger: “I could never live there because people are too conservative there politically.” A series of social psychology studies by Jarret Crawford, Mark Brandt, Yoel Inbar, John Chambers and Matt Motyl back up the idea that this kind of distaste for those with different political beliefs is common. They have two main findings, based on detailed surveys of 4912 people. First, liberals look down on conservatives just as much as conservatives look down on liberals. Second, people look down on others more for discordant beliefs on social issues than they do for discordant beliefs on economic issues.
It is handy having a word for “looking down on a group of people because of their politics.” The word “politicism” seems available. The online Oxford Dictionary defines it as “A concern with or emphasis on the political,” which is close enough for me. The online Urban Dictionary defines it as “voting in a politic election simply based on religion, sex, or ethnicity.” In my definition I am turning that around: politics itself has become a quasi-ethnicity that many people have intense prejudices about. Using my definition of “politicism,” one can say liberals as well as conservatives show a great deal of politicism, and politicism is stronger for social issues than for economic issues.
Original Passage on the Politics of Financial Stability
For a political strategy in which rhetoric focuses on social issues and easy-to-understand economic issues, there is a role for hard-to-understand aspects of economic policy. Hard-to-understand aspects of economic policy are perfect for pleasing sophisticated special interests who understand—while others don’t—that some opaque bit of economic policy will enrich them at the expense of everyone else. A prime example is the hope of banks and other financial firms to get themselves in line for more bailouts in the future by gutting requirements that stockholders put up enough money for banks that stockholders take the hit in a crisis rather than taxpayers. Regular voters know they don’t like bailouts, but their eyes glaze over at discussions of the capital requirements needed to avoid bailouts. Even Elizabeth Warren, who is better at making this kind of thing interesting to the average voter than anyone else, often has to quickly shift the subject to the easier-to-understand issue of people being ripped off by deceptive consumer finance in order to keep her listeners awake.
I was pleased to be included in the list of "Anglophone Economic Leaders" on economicblogs.org. The top image is the aggregator page. The bottom image is the page they have for this blog specifically.
The "Key Posts" link at the top of my blog lists all important posts through the end of 2016. This is intended as a complement to that list, in two categories: popular new posts and popular older posts. (You can see other recent posts by clicking on the Archive link at the top of my blog.) The numbers shown are pageviews from January 1, 2017 through June 18, 2017 according to Google Analytics. My blog homepage had 15,149 pageviews in that period. Total pageviews were 96, 610.
New Posts in 2017
- There Is No Such Thing as Decreasing Returns to Scale 2062
- Economics Needs to Tackle All of the Big Questions in the Social Sciences 1208
- Border Adjustment vs. Dollar Depreciation 1102
- Defining Economics 1049
- Why I Am Now a Bear 1020
- My Objective Function 805
- Peter Conti-Brown's Takedown of Danielle DiMartino Booth's Book Fed Up: An Insider's Take on Why the Federal Reserve is Bad for America 723
- Breaking the Chains 647
- In Praise of Partial Equilibrium 556
- Returns to Scale and Imperfect Competition in Market Equilibrium 544
- Restoring American Growth: The Video 443
- Next Generation Monetary Policy 367
- How Strong is the Economics Guild? 360
- You, Too, Are a Math Person; When Race Comes Into the Picture, That Has to Be Reiterated 322
- Marriage 102 311
- Sugar as a Slow Poison 307
- Leaving a Legacy 292
- Thomas Sowell on How to Succeed as an Ethnic Minority 277
- Deregulation of Social Science as a Free Speech Issue 249
- Markus Brunnermeier and Yann Koby's "Reversal Interest Rate" 231
Older Posts with Continuing Popularity
- John Stuart Mill's Brief for Freedom of Speech 4075
- William Graham Sumner, Social Darwinist 1785
- How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide 1210
- How to Turn Every Child into a "Math Person" 1122
- John Stuart Mill’s Vigorous Advocacy of Education Vouchers 966
- The Complete Guide to Getting into an Economics PhD Program (with Noah Smith) 964
- Government Purchases vs. Government Spending 951
- The Medium-Run Natural Interest Rate and the Short-Run Natural Interest Rate 946
- Joshua Foer on Deliberate Practice 914
- Why I Write 877
- Why Taxes are Bad 868
- There's One Key Difference Between Kids Who Excel at Math and Those Who Don't (with Noah Smith) 780
- The Logarithmic Harmony of Percent Changes and Growth Rates 667
- Daniel Coyle on Deliberate Practice 639
- Robert Shiller: Against the Efficient Markets Theory 621
- Shane Parrish on Deliberate Practice 592
- What is the Effective Lower Bound on Interest Rates Made Of? 480
- John Stuart Mill's Brief for Individuality 455
- Inequality Is About the Poor, Not About the Rich 435
- How and Why to Expand the Nonprofit Sector as a Partial Alternative to Government: A Reader’s Guide 433
- Higher Inflation Is Not the Answer 415
- John Stuart Mill’s Defense of Freedom 413
- Sticky Prices vs. Sticky Wages: A Debate Between Miles Kimball and Matthew Rognlie 407
- Monetary vs. Fiscal Policy: Expansionary Monetary Policy Does Not Raise the Budget Deficit 388
- John Stuart Mill on Freedom from Religion 371
- How Increasing Retirement Saving Could Give America More Balanced Trade 325
- What If Jesus Was Really Resurrected? Musings of a Non-Supernaturalist 320
- Silvio Gesell's Plan for Negative Nominal Interest Rates 319
- David Dreyer Lassen, Claus Thustrup Kreiner and Søren Leth-Petersen—Stimulus Policy: Why Not Let People Spend Their Own Money? 310
- Bruce Greenwald: The Death of Manufacturing & the Global Deflation 264
- On Master's Programs in Economics 257
- Even Central Bankers Need Lessons on the Transmission Mechanism for Negative Interest Rates 233
- Cognitive Economics 230
- On Having a Thesis 230
- How Subordinating Paper Currency to Electronic Money Can End Recessions and End Inflation 224
Many of the popular older posts are posts that turn up easily in Google searches.
An excellent choice. I have been very impressed with Michael Barr during the time we overlapped at the University of Michigan. Michael did a lot to craft Dodd-Frank, which while imperfect is much better than alternatives being discussed now, and needs to be defended.
Section 21 of John Locke's 2d Treatise on Government: “On Civil Government” has remarkable resonances with the Chinese idea of the "Mandate of Heaven." This idea maintained that while the imperial Chinese government maintained the Mandate of Heaven by wise rule it was the legitimate judge over its subjects. But when the imperial Chinese government misbehaved, it lost the Mandate of Heaven; attempting to obtain justice then required war. the previous Section 20, which I discussed in "If the Justice System Does Not Try to Deliver Justice, We Are in a State of War," talks about a government misbehaving. Section 21 then contrasts society under a reasonably just government and a state of war in which one hopes for justice from military victory:
To avoid this state of war (wherein there is no appeal but to heaven, and wherein every the least difference is apt to end, where there is no authority to decide between the contenders) is one great reason of men’s putting themselves into society, and quitting the state of nature: for where there is an authority, a power on earth, from which relief can be had by appeal, there the continuance of the state of war is excluded, and the controversy is decided by that power. Had there been any such court, any superior jurisdiction on earth, to determine the right between Jephtha and the Ammonites, they had never come to a state of war: but we see he was forced to appeal to heaven. “The Lord the Judge (says he) be judge this day between the children of Israel and the children of Ammon,” Judg. xi. 27. and then prosecuting, and relying on his appeal, he leads out his army to battle: and therefore in such controversies, where the question is put, who shall be judge? It cannot be meant, who shall decide the controversy; every one knows what Jephtha here tells us, that the Lord the judge shall judge. Where there is no judge on earth, the appeal lies to God in heaven. That question then cannot mean, who shall judge, whether another hath put himself in a state of war with me, and whether I may, as Jephtha did, appeal to heaven in it? of that I myself can only be judge in my own conscience, as I will answer it, at the great day, to the supreme judge of all men.
Does Good Win in the End?
But let's take a look at the idea that military victory is positively correlated with justice. If a benevolent God does not yet exist, then this requires an argument.
Martin Luther King said, memorably,
The arc of the moral universe is long, but it bends toward justice.
Quote Investigator identifies antecedents of this saying. Unitarian minister and Transcendentalist Theodore Parker published an 1853 volume of sermons with this passage:
Look at the facts of the world. You see a continual and progressive triumph of the right. I do not pretend to understand the moral universe, the arc is a long one, my eye reaches but little ways. I cannot calculate the curve and complete the figure by the experience of sight; I can divine it by conscience. But from what I see I am sure it bends towards justice.
Things refuse to be mismanaged long. Jefferson trembled when he thought of slavery and remembered that God is just. Ere long all America will tremble.
and Morals and Dogma of the Ancient and Accepted Scottish Rite of Freemasonry, copyright 1871 had this passage:
We cannot understand the moral Universe. The arc is a long one, and our eyes reach but a little way; we cannot calculate the curve and complete the figure by the experience of sight; but we can divine it by conscience, and we surely know that it bends toward justice. Justice will not fail, though wickedness appears strong, and has on its side the armies and thrones of power, the riches and the glory of the world, and though poor men crouch down in despair. Justice will not fail and perish out from the world of men, nor will what is really wrong and contrary to God’s real law of justice continually endure.
In the absence of the supernatural there is still one reason that history is tilted toward victory of good over evil. Those who can cooperate with others who are unlike them can form larger coalitions than those who can only cooperate with others similar to them. The strategy of cooperating with others who are similar can be pushed a long way: each of us is built around a collection of genetically near-identical cells, with reproduction monopolized by a few germ-line cells much as beehives are built around collections of genetically closely related individuals with reproduction monopolized by the queen bee and the drones. But assuming that strategy of cooperating with similar individuals is pushed to the limit on both sides of a conflict, the side that can also manage cooperation among unlike individuals or unlike groups of individuals will have a big advantage. While not all the way there, the ability to cooperate with unlike individuals or groups of individuals is one step toward agape, the kind of love the early disciples of Jesus talked about.
But far short of reaching a high form of love, the victory of those with a greater ability to cooperate with unlike individuals can bring progress that merits being described as a victory of good against evil. I have in mind the decline in violence over the course of history that Steven Pinker writes about in The Better Angels of Our Nature—a book I highly recommend.
In any individual battle, evil (however defined) may win, but the dice are loaded in favor of goodness that is associated with an ability to cooperate with those who are different.
Conversely, the dice are loaded against those who cannot cooperate with those who are different from them. Hitler provides a good example. Because Hitler was not willing to cooperate with Jews, Nazi Germany lost access to scientific talent important for the war effort. Because Hitler could not cooperate with Stalin, he had to fight a two-front war. Because Hitler could not cooperate with Slavs whom his troops liberated from Stalin, he could not consolidate his hold on the Ukraine as well. If Hitler had not let ideology get in the way of the war effort he led, he would have been more likely to win. But if he had not been motivated by ideology, things might not have gotten to that point in the first place.
This may not be as much to hang one's hat on in hopes for the victory of good over evil as one might wish, but other than my unfounded native optimism, it is all I have.
Other commentators get close to the views I expressed in "Alexander Trentin Interviews Miles Kimball about Establishing an International Capital Flow Framework." In the first article above, Greg Ip interviewed Mervyn King, Fred Bergsten and Joseph Gagnon, writing this:
Protectionism can change the patterns of a country’s exports and imports, but not the overall balance.
Rather, deeper economic forces are at work. A trade surplus means a country consumes less than it produces and thus saves a lot. A deficit means the opposite. ... the persistence and magnitude of Chinese and German surpluses and U.S. deficits suggest actual policy decisions are at work.
This comes by interfering with currency markets. As Mr. King notes, a country with a weak economy and a trade deficit would expect its currency to fall to boost exports and restrain imports. That can’t happen if exchange rates can’t move, as is the case with China and Germany, though for different reasons. ...
Messrs. Bergsten and Gagnon suggest a new approach to prevent China from reverting to its old ways: When a country buys dollars to hold down its currency for competitive advantage, the U.S. should respond proportionately by purchasing that country’s currency. They also recommend the U.S. go beyond current law, which requires the U.S. to discourage currency manipulation in new trade pacts, by prohibiting it outright.
Notice that currency manipulation is often a matter of keeping an exchange rate the same when it should appreciate, rather than always being a matter of making one's currency depreciate. So currency manipulation cannot be defined by exchange rates. It needs to be defined by official purchases of foreign assets or other active policy to hold down an exchange rate.
The case of Germany is more complex:
Germany is a tougher challenge. Since adopting the euro in 1999, it hasn’t controlled its own currency. However, it did win competitive advantage over its neighbors in the currency union. Labor-market reforms restrained domestic wages. In 2007, a payroll tax cut, which made German labor more competitive, was financed with an increase in the value-added tax, which exempted exports.
I argued that Germany should in part return to having its own currency in "How the Electronic Deutsche Mark Can Save Europe." Short of that, Germany has a responsibility to manage its trade surpluses within the euro zone in other ways. As between the euro zone and the rest of the world, rules against purchase of non-euro-zone foreign assets without permission from other countries would go a long way.
I emphasize in "Alexander Trentin Interviews Miles Kimball about Establishing an International Capital Flow Framework" that monetary interest rate policy is not a problem and can be done by each currency area with only its own interests in mind since other countries can neutralize the main worrisome effects of other countries' interest rate policy with their own interest rate policy while leaving country that initially changed its interest rate policy with the stimulus or restraining effect it needs once all these interest rate movements have been scaled up appropriately. It is purchases of foreign assets that have big spillover effects for the rest of the world that cannot be neutralized without neutralizing the effect the initial purchaser of foreign assets desired.
In the second article shown above, Justin Fox discusses options for how Germany could spend more to reduce its trade surplus.
The last article above is about David Malpass, Trump's nominee for Treasury’s undersecretary for international affairs. David Malpass wants more stable exchange rates, but in many cases that would make things worse by perpetuating trade imbalances. As I mentioned above, currency manipulation often takes the form of countries' acting to keep their exchange rates the same when their currencies should move in order to better balance trade. Attacking official, unilaterally decided purchases of foreign assets is a more appropriate way to identify and combat currency manipulation.
Besides often perpetuating trade imbalances, a big problem with exchange rates that are too stable is that they make stabilization through monetary policy much more difficult. In effect, a country that maintains a fixed or nearly fixed exchange rate with some other country has used up many of its degrees of freedom stabilization policy to keep that exchange rate fixed.
If every country (or currency zone that is not too big) has full freedom in interest rate policy, while needing permission to purchase foreign assets, then each country can stabilize its own economy without artificial trade surpluses or deficits. There would still be a need to try to address the consequences different saving rates in different countries, but that is the next level up in improving the international trade architecture from the first step of banning official foreign asset purchases without permission.
Journalist Greg Ip makes a better case for economics in public policy than many economists themselves do. Here is an excellent passage from the article shown above, partly based on his interview of my classmate and coauthor Doug Elmendorf (whom I wrote about in my unsuccessful plea "The New Republican Majority Should Keep Doug Elmendorf as Director of the Congressional Budget Office"):
“Informed analysis will sometimes be wrong, but I’d rather bet on informed analysis than ignorant guesses,” says Douglas Elmendorf, who ran the CBO from 2009 to 2015 and oversaw its original estimates of the Affordable Care Act, known as Obamacare.
Economic analysis exposes the trade-offs inherent in all policy choices. Import tariffs protect some workers but hurt consumers; a higher minimum wage helps low-skilled workers who have jobs but makes it harder for others to find jobs; eliminating minimum required benefits for health insurance makes coverage cheaper for some consumers but more expensive for others. Identifying these effects “doesn’t mean everyone will agree. But at least people can make decisions with their eyes open,” says Mr. Elmendorf.
Unbiased analysis doesn’t guarantee good decisions, but it makes really bad ones less likely.
Four weeks ago I posted Part 1. And here are the other posts I have put up to honor my Dad since his death on November 21, 2016 (a little over six months ago):
- My Dad
- Christian Edward Kimball on Edward Lawrence Kimball
- Joseph Ellsworth Kimball on Edward Lawrence Kimball
- Paula Kimball Gardner, Mary Kimball Dollahite and Sarah Camilla Kimball Whisenant on Edward Lawrence Kimball
- Jordan Andrew Kimball on Edward Lawrence Kimball
- One for All: John Woodland "Jack" Welch on Edward Lawrence Kimball
You will learn a lot about Mormonism from watching this video and Part 1: particularly why someone who has thought deeply about many issues might be committed to Mormonism.
I am sad that my University of Michigan Survey Research Center colleague Eleanor Singer died on June 3.
In my post "There Is No Such Thing as Decreasing Returns to Scale" and my Storify stories "Is There Any Excuse for U-Shaped Average Cost Curves?" and "Up for Debate: There Is No Such Thing as Decreasing Returns to Scale," I criticize U-shaped average cost curves as a staple of intermediate microeconomics classes. But what should be taught in place of U-shaped average cost curves? This post is my answer to that question: returns to scale and imperfect competition in market equilibrium.
In order to talk about the degree of returns to scale and the degree of imperfect competition, we need a measure of each. The following notation is helpful:
The Degree of Returns to Scale
The degree of returns to scale can be measured by the percent change in output for a 1% change in inputs. I use the Greek letter gamma for the degree of returns to scale:
when there is only a single input in the amount x. (Note that throughout this post I use the percent change concepts and notation from "The Logarithmic Harmony of Percent Changes and Growth Rates" and write as equalities approximations that are very close when changes are small.)
According to the awkward, but traditional terminology, a degree of returns to scale equal to one is "constant returns to scale." A degree of returns to scale greater than one is "increasing returns to scale." As for a degree of returns to scale less than one, make sure to read "There Is No Such Thing as Decreasing Returns to Scale."
If more than one input is used to produce the firm's output, a convenient way to gauge the increase in inputs is to look at the change in total cost holding factor prices fixed. This gives an aggregate of all the different factors weighted by the initial factor prices. Notice that for the standard production technology notion of returns to scale it doesn't matter if factor prices are actually unchanging as the firm changes its level of output; holding factor prices fixed is simply a way to get an index for total factor quantities akin to the way real GDP is measured. Using the percent change in total cost with factor prices held fixed to gauge the percent change in inputs, the degree of returns to scale with multiple factors is:
Remember that this equation is about what happens when a firm changes the quantity of its output, always producing that output in a minimum cost way given those fixed factor prices. If factor prices or technology are changing, then this equation does not hold.
I argue that the degree of returns to scale will typically be declining in the quantity of output. I base this in part on the idea that a fixed cost coupled with a constant marginal cost is the base case we should start from as economists. Here is why the degree of returns to scale declines with the level of output when a firm has a fixed cost coupled with a constant marginal cost:
According to the derivation above, the degree of returns to scale gamma is equal to AC/MC. Thus, when a firm has a fixed cost coupled with a constant marginal cost for the product whose cost is depicted, the degree of returns to scale declines with the level of the output for that product. What is more, if marginal cost MC is constant, the degree of returns to scale gamma = AC/MC has the same shape as the average cost curve AC, though the vertical scale for the degree of returns to scale would have 1 in place of MC.
The Degree of Imperfect Competition
The degree of imperfect competition can be measured by how far above its marginal revenue a firm will want to set its price: the desired markup ratio p/MR. I use the Greek letter mu for the desired markup ratio. Since a firm tries to set its price so that marginal revenue equals marginal cost, this is also how far above its marginal cost a firm will want to set is price. This actual markup ratio p/MC can be different from the desired markup ratio p/MR over periods of time when the firm doesn't have full price flexibility, but in long-run equilibrium, the actual markup ratio P/MC should be equal to the desired markup ratio p/MR.
The desired markup ratio that measures the degree of imperfect competition is closely related to the price elasticity of demand a firm faces, but goes up when the price elasticity of demand the firm faces goes down. I use the Greek letter epsilon for the price elasticity of demand faced by a firm. The key identity can be derived as follows:
Here is a table giving the desired markup ratio for various values of the price elasticity of demand faced by a firm:
Price Elasticity of Demand Faced by a Firm epsilon Desired Markup Ratio mu
There are several noteworthy aspects about this table. First, if a firm has a marginal cost of zero, in long-run equilibrium it will seek out a price at which the price elasticity of demand it faces is equal to 1. The infinite markup ratio corresponds to a positive price divided by a zero marginal cost. I plan to talk about the market equilibrium for this case in a future post.
If a firm has any positive marginal cost, then in long-run equilibrium, regardless of what other firms do, it will keep raising its price until it reaches a price at which the price elasticity of demand it faces is greater than 1, unless it can get away with providing an infinitesimal quantity at an infinite price. (Being able to get away with providing an infinitesimal quantity at an infinite price is unlikely.) Therefore with a positive marginal cost, the desired markup ratio will be finite and greater than one.
A higher desired markup ratio corresponds a lower price elasticity of demand. And a higher desired markup ratio corresponds to more imperfect competition. The desired markup ratio is a very convenient way to measure the degree of imperfect competition.
The graph at the top of this post illustrates market equilibrium. I return to that graph below. For the logic behind market equilibrium, let me quote from my paper "Next Generation Monetary Policy":
Given free entry and exit of monopolistically competitive firms, in steady state average cost (AC) should equal price (P): if P > AC, there should be entry, while if P < AC there should be exit, leading to P=AC in steady state. Price adjustment makes marginal cost equal to marginal revenue in steady state. Thus, with free entry, in steady state,
where by a useful identity γ is equal to the degree of returns to scale and μ is a bit of notation for the desired markup ratio P/MR. The desired markup ratio is equal in turn to the price elasticity of demand epsilon divided by epsilon minus one:
Remarkably, in long-run equilibrium, after both price adjustment and entry and exit, the degree of returns to scale must be equal to the degree of imperfect competition as measured by the desired markup.
I am going to make four key simplifications to make it easier to understand market equilibrium. First, I will assume that the market equilibrium is symmetric so that each firm sells the same amount q. Second, I will assume, at least for the benchmark case that the elasticity of demand for the entire industry's output is zero. That is, customers are perfectly happy to shift from buying one firm's output to buying another firm's output at the elasticity epsilon if they can get a better deal, but they insist on a certain amount of the category of good provided by the industry. Using the letter Q for the total sales in the industry, that means
Third, I will assume that the price elasticity of demand a firm faces—and therefore its desired markup ratio—depends only on the number of firms in the industry. Fourth, I will assume that all fixed costs are flow fixed costs rather than being sunk. It is interesting to relax each of these assumptions, but it would be hard to understand those cases without first learning the simplified case I am presenting here. (The most difficult to relax is the symmetry assumption. Relaxing that assumption is least likely to meet the cost-benefit test in the tradeoff between tractability and realism.)
Let me reprise the graph at the top of this post to explain how it illustrates market equilibrium:
This graph is really two interlocking graphs. On the right, the degree of returns to scale and the degree of imperfect competition as measured by the desired markup ratio are shown in relation to the output of a typical firm. On the left, the degree of returns to scale and the degree of imperfect competition as measured by the desired markup ratio are shown in relation to the number n of firms in the industry.
The degree of returns to scale declines with output as explained above. For given total sales in the industry Q, that means that the degree of returns to scale increases with the number of firms in the industry.
The degree of imperfect competition as measured by the desired markup ratio decreases with the number n of firms in the industry. For given total sales in the industry Q, that means that the degree of imperfect competition as measured by the desired markup ratio increases with a typical firm's output q.
The assumption that—other things equal—the degree of imperfect competition declines with the number of firms is intuitive—and I believe correct in the real world. But I should note that there is a very popular model—the Dixit-Stiglitz model—that is popular in important measure because it makes the degree of imperfect competition as measured by the desired markup ratio constant, regardless of how many or few firms there are. The Salop model gives a degree of imperfect competition as measured by the desired markup ratio that declines with the number of firms. But the Salop model is less convenient technically than the Dixit-Stiglitz model. Innovation could be valuable here. A model that had an attractive story, was technically convenient and had a desired markup ratio declining in the number of firms should be able to attract a subsantial number of users. In any case, I stand by the claim that to model the real world, one should have the desired markup ratio declining in the number of firms in the industry.
The intersection on the right shows the long-run equilibrium output of a typical firm in this industry. The intersection on the left shows the long-run equilibrium number of firms in the industry.
When mu > gamma. Though this could be questioned, think of entry and exit happening at a slower pace than price adjustment. (I discuss the relationship between some other adjustment speeds in "The Neomonetarist Perspective.") Once prices have adjusted, MC = MR. So if the degree of imperfect competition mu = p/MR is greater than the degree of returns to scale gamma = AC/MC it means that p > AC and there will be entry. As n rises, AC and p will come closer together until they are equal at the intersection on the left side of the graph.
When mu < gamma. On the other hand, If the degree of imperfect competition mu = p/MR is less than the degree of returns to scale gamma = AC/MC, it means that p < AC and there will be exit. As n falls, AC and p will come closer together until they are equal at the intersection on the left side of the graph.
- If mu > gamma, firms enter.
- If gamma > mu, firms exit.
In either case, as n adjusts, the quantity of a typical firm's output also changes.
Let's consider four thought experiments. First, consider an increase in total sales Q by the industry. This shifts out both curves that are written in terms of Q:
The prediction is that both the number of firms and the output of a typical firm will increase, while both the degree of returns to scale and the degree of imperfect competition will fall. Because the curve showing the desired markup as a function of the number of firms does not shift, the reduction in the the desired markup only occurs as new firms actually enter. The degree of returns to scale overshoots: it drops most right after the increase in total industry sales Q, then gradually rises again as new firms enter and the quantity produced by each firm declines.
Second, consider reduction in the (flow) fixed cost. This cases the returns to scale (gamma) curves on both sides to shift downward:
The prediction is that the number of firms will increase, while the size of a typical firm decreases, and that both the degree of returns to scale and the degree of imperfect competition will fall. Because the desired markup curves does not shift, the desired markup only falls as new firms actually enter, which is likely to be gradual. As in the first experiment, the degree of returns to scale overshoots in the sense of dropping most at first.
With the marginal cost unchanged, the fall in the desired markup ratio leads to a reduction in price. That would expand the size of the industry if the elasticity of demand for the industry product category as a whole were nonzero. That in turn would require the results of the first experiment in order to analyze.
Third, consider a reduction in marginal cost. This causes the returns to scale curves on both sides to shift up, since returns to scale equals AC/MC, and because it includes average fixed cost, AC does not fall as much as MC. However, the effect of MC on AC means that the gamma = AC/MC curves do not rise vertically by as large a percentage as MC falls.
The prediction is that the output of a typical firm will rise, while the number of firms will decline. The degree of returns to scale and degree of imperfect competition rise in the long run. But note that this is because of improved performance of the industry in reducing costs. The equilibrium desired markup ratio rises less than the degree of returns to scale curve, which in turn rises by a smaller percentage than MC falls. The price will be lowest before firms have had a chance to exit—indeed it will initially fall by the full percentage of the decline in MC—but will remain lower in the new long-run equilibrium than in the old long-run equilibrium.
Again, if the elasticity of demand for industry output as a whole is nonzero, the decline in price would lead Q to increase (more at first, somewhat less later on), so the results of the first experiment would be necessary to fully analyze what would happen.
Fourth, consider an increase in the price elasticity of demand for any given number of firms. This might be described as the market becoming "more price-competitive." Both desired markup curves fall:
The prediction is that in the long run the number of firms falls, while the output of the typical firm rises. This might be called a "shakeout" of the industry. Because the industry has become more price-competitive, the number of firms falls. Someone coming from the ancient "Structure-Conduct-Performance" paradigm for Industrial Organization might be confused because the concentration of the industry goes up, yet the performance of the industry improves: the degree of imperfect competition as measured by the desired markup falls, as does the degree of returns to scale in long-run equilibrium.
With MC unchanged, the desired markup and therefore the price falls most right at first, before firms have had a chance to exit. Then the price comes up somewhat, but remains lower than in the initial long-run equilibrium. If the price elasticity of demand for the entire industry's output is nonzero, then Q will increase, especially at first, which will complicate the analysis in ways that the first experiment can help navigate.
In my view, the foregoing analysis is
- more on-target than U-shaped average cost curves in relation to the real world
- more interesting than U-shaped average cost curves
- no harder than U-shaped average cost curves, if one sticks to the simplifications I made. What I have laid out above is difficult, but U-shaped average cost curves are also difficult.
Therefore, it seems better to me to teach returns to scale and imperfect competition in market equilibrium than it is to teach U-shaped average cost curves. In any case, there are always tradeoffs. When it is impossible to teach both, what I have laid out in this post is the opportunity cost for teaching U-shaped average cost curves. I hope you will agree it represents a high opportunity cost, indeed.
Both of these are ungated. Ken Rogoff's abstract gives a good sense of the review and response:
Jeffrey Hummel provides an extremely thoughtful and detailed review, which is welcome, even if there are a number of places where I don’t quite agree with his interpretations, emphasis, and analysis. For example, the notion that central banks already can use helicopter money to solve the zero bound, and that there is little need for negative interest-rate policy in the next deep financial crisis, is dubious. It is also important to stress that the book is about the whole world and not just the United States; there are good reasons why many other advanced economies may find it attractive to move away from the status quo on cash much more quickly than the United States will. Importantly, deciding how to move to a less-cash society should be looked at as a question of calibration, not an all-or-nothing proposition, and not something that needs to be done quickly.