microeconomics

An exchange economy

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Once upon a time there was a woman named Alicia. Alicia lived alone on the edges of a big forest. In fact, not only did she live alone, she didn’t even know if there was another person in the whole world. In her whole life she had never come across anyone else at all.

Alicia was unusually good at catching fish. Her skill and her intuition in fishing meant that she never went hungry. It was just a bit boring sometimes, that’s all, eating fish every day. Once in a while she scrounged up some berries from the forest, but other than that it was an awful lot of fish.

One day Alicia was walking home from the river, her basket full of fish, when, lost in thought, she wandered down a path she’d never traveled before. She came to a clearing in the woods. It was beautiful and cool, with sunlight dancing through the leaves, and it seemed like a lovely place. But that wasn’t the most important thing to Alicia. There was someone else in the clearing.

Will was unusually good at growing vegetables. His garden would have been the envy of the forest if he’d ever met anyone to show it to, but, like Alicia, he was all by himself. He ate well, but it wasn’t much fun eating nothing but vegetables every day. He caught a rabbit once, he remembered.

One day Will was taking a stroll in the forest, as he liked to do after gathering some vegetables from one of his many little gardens, when he arrived at a clearing in the woods. He thought he had a pretty good idea of the lay of the land, but this was a new place to him. But at that moment Will wasn’t thinking about maps. He was thinking about the person across the clearing.

Alicia and Will were wary at first, but they could each see that the other had something exotic and unusual to them. Happily, they both were peaceful folk and it would never have crossed their mind to try to swindle or wrestle away the other person’s bounty. Instead they realized that each of them could have a delicious dinner if they would only swap some of Alicia’s fish for some of Will’s vegetables. That night, back at their respective camps, ate more contentedly than either could ever remember. They’d go back to their clearing the next day, they thought, to enjoy another dinner like this again.

Alicia and Will quickly became at least allies, if not quite friends. Each day seemed a bit brighter and each dinner a bit tastier with new, exotic food to enjoy. And so it went, for a while, Alicia’s fish and Will’s vegetables on two plates, across the forest.

Then, one day, Alicia set off with her basket full of fish (she even had a tiny onion that she’d managed to grow, just to see what Will would say). She arrived at the clearing in the woods, the one she’d become so fond of, but she couldn’t see Will. All she could see was a vast, cold, gray wall as far as she could see.

The only interesting thing on the whole smooth surface of the wall was a little rectangular hole, with a screen in front that slid back and forth. She looked around, listened carefully, even knocked with the knuckles on the wall a few times (“clang”), but other than the birdsong there was no sign of anyone else at all.

And then, suddenly:

“Ahem,” came a voice, from everywhere around at once, “I say. I see that you have a lot of fish with you there.”

Alicia stood very still but she wasn’t scared. She waited to see what this voice had to say.

“Hm. What if, just to suggest something, I could give you some money for some of that stuff there? How would that be, hm?”

Now, money was a new thing to Alicia, so she didn’t quite follow at first. After some time, she and the big voice came to an understanding: if she put some fish into the little hole in the wall, the voice would give her numbers, one number for each fish. If she put her tiny little onion in, well, that would be worth a number too, a different number, but a number just the same. These numbers, she felt, were important somehow to the voice, and, perhaps, to her as well.

“So, the number,” said the voice, “there’s a point, you see. You can give me the number back, or some of it at least, and I could give you some vegetables in exchange. Of course, it’s the same amount of vegetables you’d have had to give me to get that number in the first place, that’s only fair.”

Alicia had to think about that one for a minute.

Now, as you might have guessed, Will was there too, on the other side of the wall. He couldn’t see Alicia and Alicia couldn’t see him, but there they were, curious and confused (not quite annoyed, since, after all, they both had nice, quiet lives and no particular place to be) on either side of the wall.

The voice had spoken to him to, just the same as Alicia, but with vegetables and fish precisely the other way around. It took him a minute or two, but he came to understand that he could put vegetables into the wall in exchange for numbers, and he could give those numbers back to get fish, if he wanted. He heard the numbers that the voice told him, and he thought about how many numbers his basket of vegetables was worth.

He wondered if Alicia was there on the other side of the wall.

But the sun was slipping across the sky and Will was getting hungry, so soon he made a decision. He marched up to the hole in the wall, lifted up the screen, and put in a big handful of vegetables from his basket. Schoop! Away they went, to who knows where.

“… Aha! Very well! Please, wait just one moment,” said the voice, “here it is! Your number, it’s… ten!”

Ten? Will had thought he understood, but it was still bizarre to hear the voice’s confident declaration. Ten? He remembered the number for fish that the voice had told him. He waited for what he felt was a polite amount of time, but the voice didn’t say a word.

“Um. I’d like some fish, please,” Will said, “with my number. Ten, was it?”

“Excellent!” said the voice, quicker this time (it was as if he’d expected such a thing all along), “… one moment, please.”

Alicia waited patiently. She had put her fish into the hole in the wall. She’d gotten her number, or at least the voice had told her so. And she’d asked for vegetables, which, as far as she’d come to understand things, was something she was quite entitled to do. Some minutes passed.

“… I don’t quite understand,” the voice said, quietly but unmistakably directed to Alicia, “but I don’t seem to have enough vegetables.”

“Whatever do you mean?” said Alicia.

“I was hoping to be able to take the number you gave me and give you those vegetables, just like I said, it’s just… I don’t have the vegetables after all. I’m sorry.”

The voice did sound sorry to Alicia.

“If it’s alright with you, maybe I could try again?” said the voice, and just then schoop! In the hole in the wall, Alicia’s fish were back, just as she’d left them. She took them back into her basket and decided to sit down to wait. Not much happened in the forest most days, so she was in no great hurry to get back home.

Eventually, and now the shadows were a little longer, the voice cleared its throat and Alicia looked up at the wall again.

“I have some new numbers!” the voice said, abruptly, “forget all about those old numbers! Wrong numbers!”

The voice said new, different numbers. The number for vegetables was bigger now. Alicia listened to the new numbers, and, since she knew the rules by now, thought for a moment. If she put a fish in the hole in the wall, what number would the voice tell her? If she gave the voice back that number, how many vegetables had it promised? She looked at her basket, pulled out a few fish, and walked towards the hole in the wall, as if it was the most normal thing in the world.

Well, this went on for some time. The voice was not impatient, exactly, but at least agitated, each time seeming a little more bemused not to have the amount of vegetables that Alicia wanted nor the amount of fish that Will wanted. Alicia and Will patiently picked from their basket each time an amount of fish and of vegetables to put in the hole in the wall in exchange for a number. Often it was a different amount from the last. They were patient, the two of them. and they were thoughtful, and so each time the voice called out its numbers they considered carefully how much to take from their basket to exchange for some numbers.

But each time when they tried to give the number back to get some vegetables and some fish, the voice had the same thing to say.

“Wrong numbers! Just one moment! Please!”

And so the afternoon passed, until, at last, after the voice had called out yet more numbers, and after Alicia had, yet again, put her fish into her hole in the wall and Will had, after so many times he’d quite lost count, put his vegetables into his hole in the wall, and after each of them had asked to swap their number for some different food, finally, after all of that, the voice said:

“… Yes! I mean, yes, of course! Here you are, as you asked!”

Alicia was shocked from a trance she hadn’t know she was in. It seemed to her that the voice was pleased or, at least, relieved after all this time. Schoop! In the hole in the wall was sitting there, precisely, to the tiniest fraction, exactly the amount of vegetables that her number had been worth. She slid open the hatch. It seemed to her that these might have been just the kind of vegetables that Will would have swapped her, on other days that seemed strangely far away now.

On the other side of the wall, Will looked at the fish that had appeared. He was happy, he supposed, to have a nice plate for dinner. He would have been sad to have had to go back to his boring old vegetables. He wondered where Alicia was. He took a good, long look at the wall, but it didn’t seem to mind, and the voice hadn’t said a word since it had proudly delivered his number’s worth of fish.

Will put the fish into his basket, alongside his remaining vegetables, and set off for home.

As Alicia prepared her dinner that evening, her mind drifted back to the clearing in the woods. She wondered if she would ever see Will again. She wondered what the numbers meant. At least, she thought, she had a nice plate of fish and vegetables to eat again tonight. She ate well and decided not to worry too much about the strange day she’d had. Soon, inevitably, it was time to sleep again.

But Alicia couldn’t sleep. There was a thought in her head that she couldn’t forget, even after a nice meal and a warm fire. She lay awake and looked at the stars and she thought to herself:

“Where did that voice come from?”

Profit maximization

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I read today David Colander’s article How to Market the Market: The Trouble with Profit Maximization and Aswath Damodaran‘s response in the most recent issue of the Eastern Economic Journal. By coincidence we’re also talking producer theory in my economics 101 class right now, so the timing is good. I favor Colander.

As the 101 story goes, profit maximization plus the assumptions of the perfectly competitive model generate maximal efficiency in the hypothetical economy. The Colander article establishes the historical context, entwined with the formal mathematical turn in economic theory and the methodological-ideological mashup of “free market” economics circa Friedman.

My feelings on the use and abuse of “efficiency” as a concept are well established. On top of this we have the evidence that learning about profit maximization induces students of economics and business to answer moral dilemmas involving hypothetical businesses differently than other people.

Something that bugs me is that I feel like “business” gets a pass on things that would never fly in other walks of life. I mean, sure United Airlines gets a justified backlash when a passenger is violently concussed on one of their flights, but the subtext is “well, yeah, they’re trying to make money.” Albert Burnenko was on to this at Deadspin after the United incident. The motives of the corporation are taken for granted to be inhuman.

In politics, behavior that would sink a typical politician a hundred times over rolls off the back of an “outsider” candidate from “the world of business”.

I struggle to think of examples from books, movies, or television in which firms, business, corporations—whatever you want to call them—are the good guys. Instead if you’re consuming the culture you’re getting a creeping collective paranoia about the callousness of the profit motive. This is what Angela Allan is getting at in this Atlantic article that I continue to assign regularly. I realize that the people who create art may have a particular perspective distinct from the average businessperson or person-on-the-street, but if culture creates and reflects itself then corporations are not the heroes of this story.

Damodaran concludes his response like so:

Implicit in that statement is the presumption that talking about private businesses making profits makes people feel queasy, a presumption which may be justified in the rarefied air of some parts of Vermont but it is not true in the rest of the world!

I don’t agree with this at all. Every semester I try to have my students think about what connotations they and their peers are carrying about “business”, “corporations”, “profit”. The connotations of “big business” are not positive. Economics is infected by association, and I know what the average person thinks of economists.

Or, more nuanced, the idea that a corporation is a callous automaton that is supposed to do whatever it can get away with to make as much profit as possible is so baked in that it doesn’t even seem like a bad thing anymore.”Of course” businesses are supposed to try to make as much money as possible, right?

On the other hand, Damodaran is quite right that there is nothing new in human suspicion of the pursuit of wealth just because economists came to adopt profit maximization into the canonical texts. It’s just another one of those aspects of our methodology that gives us a pedagogical PR problem.

I find profit maximization a lot riskier and more nefarious in econ 101 than utility maximization. It’s too real. It’s tricky enough to tease out the technical meaning of rational choice and preferences to sell utility maximization properly, but this ultimately lets profit maximization off very lightly since it doesn’t require the same technical ramping up. It just feels too obvious, and so I find myself having to work twice as hard to give it the interrogation it deserves. There’s no getting around either of them if you want to teach general equilibrium and the welfare theorems, and of course we do. I worry about the proportionality.

I also find it interesting the advent of behavioral economics has mobilized so much energy beating up on utility maximization, and the 20th century debates on profit maximization that Colander describes have given way to consensus. I think this is way out of proportion with the funkiness of the concepts. Utility maximization is abstract and flexible in way that profit maximization just is not. Profit is a real thing in the real world, very close to the model version of profit in its definition and spirit. Utility is not. Maybe we could pick the straw man of homo economicus up from under the bus, since I for one am much more relaxed about selling rationality than I am about selling profit maximization.

Microeconomics in six words

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This is certainly frivolous, but in the spirit of the addictive six word memoir (see here and here), I got to wondering about the six word memoir for the traditional undergraduate Intermediate Microeconomics course. My best effort is:

“Markets work, except when they don’t.”

Intermediate Microeconomics is a course I have both taken and lectured. It’s the gateway drug to economics electives, in a way that the Principles courses I hate so well are not: it is dry and musty with terminology, calculus and diagrams. Relating student to material is the difficult part, as with all of these positivist courses. When I took the course, it was split half and half between the dry stuff and policy debates that applied it, which was perhaps a good idea.

A six word syllabus for Micro?

“People, firms, markets: now with calculus!”

The technical parts of the course are about the foundations of all scientific theoretical economics: how we can model people, how we can model firms, how we can model interactions. It builds, in my opinion, towards the two monumental political economic results in our canon, our intellectual arguments for and against markets as a resource allocation mechanism. They are the first and second theorems of welfare economics. The first one sets out the conditions under which markets will give a Pareto efficient allocation of resources, and the second one sets out the conditions which would make lossless redistribution of resources possible.

First of all, these are tremendously elegant, in the mathematical sense. Second, they are utterly unrealistic. Together, this makes them a fascinating and infuriating jumping-off point for all debate about the appropriate way to allocate resources, in specific situations and in the wider sense. They don’t answer the questions. They beg us to ask when we can do better; they beg us to ask what better even means. All philosophical, moral and political debate on economic policy bursts fractal-like from these seeds, the painstaking culmination of the “how”, the layering of the interactions of all the actors in the economy.

That’s when technicalities can become interesting. It made me want to follow those paths where they led.