The Fair Price

This has always been a low-volume blog, but I’ve been offline for a while as personal professional considerations have been eating into my blogging time.

Our journey will continue, however, and I’ve also started a sister blog, windy katabasis, that is more tech oriented.

For those wondering, an anabasis is a journey from the interior to the coast, but the context is Greek (made famous by Xenophon), and for that sea-faring culture, the implicit meaning is a journey from a low place to a high place, from chaos to order. That is how I think about macro-economics: the vicissitudes of personal decision-making are basically unknown and unknowable. Yes, there are some faith based models of utility optimization, but that is just handwaving, as there is no empirically or theoretically sound mechanism to convert the homunculus of “utility” into a coherent theory of individual consumer, worker, or firm behavior.  We care greatly about

  • being treated fairly
  • being around others who are treated fairly
  • not needing to worry about the future
  • not needing to optimize our consumption, but being able to expend mental resources on more enjoyable pursuits
  • professional fulfillment
  • living up to the expectations of our peers
  • smoothing consumption

…. it is not just a question of the marginal rate of substitution between a bag of rice and an hour of leisure. The decision as to which of these we focus on and which we ignore is religious — what goes into the utility function, and what costs do we impose an actors for optimizing (optimizing is not “free”, and most people prefer to not optimize — they would spend a lot of money to avoid optimizing).

From the depths of these ad hoc choices at the micro level, we try to form a coherent macro model. It seems the way forward is to trust the macro and tweak the micro underneath.

We know that there is such a thing as “aggregate demand”, we know there is such a thing as a risk premium — we have much more evidence of this than we do for something as ill-defined and problematic as risk aversion.

In this reign, I’m impressed by the recent excellent posts by J.W. Mason and S.R.W. Go read them here:

What they have in common is a refreshing inclusion of social/cultural institutions, that at least at the aggregate level,  constrain solutions to the optimization problem. In Waldman’s case, he is explicitly resurrecting the capitalist/labor cohort model, and Mason points out that capitalists do not actually want to be involved in the nasty business of running firms or allocating capital. History shows that this is correct. I.e. modern capitalism arose not because of economic freedom, but because of the opportunity to obtain economic rents.

In a closed or traditional economy, the existing rents are prescribed by social institutions, so you cannot compete to obtain them. You have to be born into the right class, become a member of the right temple, or have the king bestow a grant to you. But in a truly competitive economy, there is no profit in doing so. The reason why we never see such competitive economies is because no one ever bothers to drive economic rents to such a low level — there is no mechanism to force that much competition if investors don’t believe the cost of optimizing is a worthwhile endeavor — and remember, we are talking about very wealthy people here who are not concerned about consumption smoothing at all. They are purely in it for the chase, for aggrandizing power, for the enjoyment of creating new markets, or for the admiration of their peers/mates.

If suppliers of capital feel that they are entitled to 6% returns, even if their own rate of inter temporal substitution is 1%, they will still demand 6% returns and will re-price capital to meet those requirements, as consumption smoothing is not a binding constraint for them.

If the overnight rate is very low, then instead of having the rate of profit fall to the low level, you see a split between earnings and total return, with one high, reflecting earnings, and the other low, reflecting the influence of CB policy on the total return.   The result is that demand for labor is still low, even if the total return for holding stocks is negative and risk-free bond yields are zero. Shareholders keep re-pricing stocks downward according to their own discount rate, and the sum of declining share prices and constant earnings matches the declining interest rate environment as set by the central bank, even though the rate at which earnings are discounted remains high. Obviously labor demand is not going to increase in such an environment.

The Fair Price

In a new study, researchers had 15-month old babies watch movies of a person distributing crackers or milk to two others, either evenly or unevenly. Babies look at things longer when they’re surprised, so measuring looking time can be used to gain insight into what babies expect to happen. In the study, the infants looked longer when the person in the video distributed the foods unevenly, suggesting surprise, and perhaps even an early perception of fairness.

But the team also say they established a link between fairness and altruism. In a second part of the experiment, the babies chose between two toys, and were then asked to share one of the toys with an experimenter. About a third of the babies were “selfish sharers”: they shared the toy they hadn’t chosen. Another third were “altruistic sharers”: they shared their chosen toy. (The rest chose not to share. They may have been inhibited by the unfamiliarity of the experimenter, or maybe they just weren’t that into sharing.)

What’s interesting about the second half of the study was that by and large it was the babies who had previously been surprised by the unfair cracker and milk distribution who tended to share the preferred toy with the experimenter (the altruistic sharers). The babies who shared the rejected toy hadn’t expressed much surprise over unequal distribution. This led the researchers to suggest that there’s a fundamental link between altruism and a sense of equity.

Hat tip Bruce Schneier.

For the wealthy, the motivation of what they expect to get outstrips the motivation of maximizing consumption because they already have sufficient wealth so that they do not need to optimize their consumption; they can focus on the higher levels of Mazlow’s hierarchy and derive utility from that.

The birth of economic growth comes from the sweet spot — the opportunity to obtain rents via competition, with limits in place that do not allow those rents to be driven to a level below that deemed appropriate, so that there are always enough rents to encourage you to keep innovating.

The earliest capitalists were basically lenders who could demand monopolies and concessions in exchange for supplying funds to competing city states. Funds were only supplied if the monopolies were sufficiently lucrative.  This was possible because of trade — trade allowed for exploitation and for breaking the social barriers to selling goods for a “fair” price to your own community; you could screw someone over far away with trade whereas when conducting trade with your neighbor, you were answerable to the community, to the king, and to the priest. They all had a notion on what was a fair price. But this also provided an incentive for city-states to compete with each other. Competition therefore freed itself somewhat from social constraints.

The outcome of this arrangement was the spread of mercantilism and monopolies, together with industrial advancement that was funded by surplus profits. Each city state may have had a monopoly, but the city states themselves competed with each other. When barriers to entry were too low,  research and development — as well as living standards, began to stagnate. Suppliers of capital want rents, and when there are insufficient rents, the capital is not supplied and it goes away. Financial capital leads and real capital  follows. Money not lent is money not created. It disappears as the existing loans being repaid outstrip the new loans being taken out, and the tangible stock of capital declines as well, also disappearing due to being scrapped and/or depreciated as further investment does not occur. Society as a whole becomes less able to produce.

There has never been an example of an industrial economy that was not predicated on a steady flow of economic rents via some form of semi-permeable political and/or social barriers to competition that remain intact over sufficiently long time horizons to justify the initial investment. Ultimately you need a tricky balance, and this balance shifts with the social institutions and the general culture. It is very refreshing to see these concerns brought front and center.

The Fair Price

13 thoughts on “The Fair Price

  1. anon says:

    isn’t pretty much any new or improved product providing a “rent”?

    It takes time to duplicate products and processes, as the example of Apple tells us: Apple did (comparatively) very little litigation in the past 30 years, yet they managed to move the goalposts fast enough to be able to charge a premium.

    I.e. it might make sense to separate predatory rent seekers from self-fulfilling success – both can produce steady income.

    1. Anon — yes. Basically, the problem with the assumption of continuous market clearing is that it’s inconsistent with an economy in which new decisions are taken within time, which is why they want to model this as Arrow-Debreu markets in which all trade occurs in meta-time before the economic system is allowed to evolve. As soon as you allow trades to occur within time, you have the puzzle of why anyone would want to invest if all firms are already at their optimal size — the cheap-shot solution here of “population growth” is not convincing. People invest because firms are *not* at their optimal size. The process of optimization, as it occurs within time, is economic activity. And therefore you cannot model that activity by assuming it is the time path solution of an optimization problem.

      What I am advocating is to change this approach to say that optimization incurs a cost — costs of finding out what needs to be optimized, and costs of planning how to perform the optimization, and the costs of actually doing it. So at all times, nothing is optimal, and we take action to make things “more” optimal (e.g. invest) only when the acknowledged rents are sufficiently high to encourage us to act. This rent threshold, then, is not subject to market forces of supply and demand, it is subject to personal forces of what we think is a high enough return on optimizing in the first place. If that threshold is very high, then this imposes a higher level of non-optimality on all other markets, because no one bothers to put in a bid. As a result of that, you cannot argue that tangency conditions (e.g. marginal conditions) correspond to observed market equilibria at any point in time.

      1. You can think of this as a generalization of the concept of marginal adjustment costs. These are optimization costs — the costs of paying the auctioneer, the costs of paying the market participants to put in and revise bids when they could be working on production instead.

  2. beowulf says:

    Ha ha, when I left the comment, I thought the post ended with, “personal professional considerations have been eating into my blogging time.”

    Now that I see that there’s more to it than that… I would suggest that the only practical way to “optimize” the level or rent seeking is through the tax code. Since economic rent is a social ill, these Pigouvian taxes should be used to replace other forms of taxation.
    1. RSJ’s suggestion to control policy rate with a bank asset tax instead of the bond market and/or IOR (you could get to the same place, really, by amending FDIC Act so new asset-based premiums are marked up or down to set policy rate, rebate excess premiums to Tsy as misc. receipts to complete the tax circuit.).
    2. Instead of taxing corporate earnings, business entities (ex small business) regardless of corp structure, should be levied with a Lerner Index tax . You could impose (say) a 34% tax on gross profits exceeding firm’s industry sector average margin (both Census and IRS track that for every NAICS sector). Firms could still hit their earnings number without paying taxes by cutting prices and selling more volume, I believe that would both cut demand-push inflation and boost aggregate supply (if I’d ever studied Econ in school, I’d throw out something about “Ramsey Pricing” but I didn’t so I won’t).
    3. Michael Hudson is forever waiving the flag of the Georgist land value tax. A federal property tax is fraught with problems both political (the National Governors Association would go on the warpath to keep property taxes to themselves) and legal (the Constitutional restrictions on direct taxation are kind of a bear). There’s only one way to cut this Gordian knot, give a 100% federal tax credit for any state/local LAND taxes paid. It would take the governors about 15 seconds to realize that not dumping every dollar possible in tax burden onto land value would obligate their citizens to pay federal taxes they didn’t have to pay… and that would be sinful.

  3. Bruce Wilder says:

    wikipedia says, “The Greek term anabasis referred to an expedition from a coastline into the interior of a country. The term katabasis referred to a trip from the interior to the coast.”

    Xenophon is a bit confusing, since his adventure starts out as an anabasis with Cyrus the Younger, hence, I suppose his choice of title, but the story gets interesting, when their sponsor dies, and most of their leadership is killed, and they must organize an expedition in escape, a katabasis.

    At least I hope I’ve got that right — I’ve just cribbed wikipedia.

    I’ve been leisurely reading posts at random here over the past two or three months. Economic rents are the key to everything in economics. I look to forward to reading more.

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