Friday, July 23, 2010

Market Perception

Over at Marginal Revolution Tyler Cowen poses and interesting question to his readers:

I have never heard a market-oriented economist argue that a rise in the minimum wage boosts the demand for labor...Market-oriented economists instead claim that entrepreneurs "see through" to the real marginal products of these laborers...So what happens when the Fed "sets" short-term interest rates or influences other prices? What is postulated by monetary misperceptions theories, including Austrian business cycle theory? Entrepreneurs no longer see through to the fundamentals...What is the difference between these two cases?

My economic insight is amateur at best, but I find the comparison somewhat tenuous. I'm not really sure if it matters if entrepreneurs "see through" the fundamentals or not. In the case of minimum wages, if a market actor takes into full account the actual marginal product of his laborers, he will choose to not hire additional workers or even try to get rid of a few current ones, resulting in rising unemployment. But even if he IS fooled by the government stamp of quality assurance, he still is forced to contend with the rising inequity of dispensed wages and the MRP of his laborers, and will probably eventually be forced to withdraw from new employment, etc., resulting in rising unemployment. A decree of increased minimum wage does not change the fundamentals of production or investment, no matter how much a given actor may or may not choose to believe it.

Similarly, I'm not sure if it matters that entrepreneurs see through the fundamentals in the second example either. In the case of mandated wages, the price of employment rises, creating a market incentive for unemployment. In the case of artificially deflated interest rates, the price of investment decreases, creating a market incentive for capital investment. Cowen seems to want to know why, if actors can see through the folly of the wage mandate, why they couldn't see through artificial interest manipulation. I think this is begging the wrong question. The real question is, "If market actors could see through interest manipulation, how would they have reacted any differently than they did?" I would contend that they wouldn't. And this is why it simply didn't matter if entrepreneurs had some kind of foresight into the issue or not.

In the case of the wage mandate, actors stand to lose on employment, regardless of their belief on the matter. In the case of altering nominal interest rates, actors stand to win on investment, regardless of their beliefs on the matter. The real productivity of labor hasn't risen when wages are artificially inflated, and the real productivity of investment hasn't risen when interest rates are artificially decreased. However, the nominal PRICE for labor and investment has changed (artificially) - which is exactly why individual actors act as they do. An employer sees that the price of employing labor has risen when the marginal product of labor has not; he stops employing. An investor sees that the price of investment has DECREASED when the marginal product of investment has not; he starts investing. If an employer ignores the relationship between price and productivity with regards to labor, and continues employing, he will lose money at the margin. If an investor ignores the relationship between price and productivity with regards to investment, he will lose money at the margin.

National unemployment or economic bubbles are largely irrelevant to the individual actor, even though they may ultimately affect his bottom line. Here we have a genuine market-failure; albeit one induced by government controls. If all actors choose to ignore individual incentives, there is a small failure as opposed to a larger one . If an actor chooses not to cooperate, he wins while other actors lose. It's a prisoner's dilemma of sorts. If all employers choose not to alter their employment trajectory, they all lose some profit but avoid mass unemployment. If all investors choose not to alter their investment trajectory, they all lose some would-be profit but avoid an investment bubble. The problem, of course, is that if they choose not to act in their self-interest, while other actors DO, they stand to lose even more.

This is, of course, analogous to the tragedy of the commons; if we all let our sheep use up common resources, we lose. If other shepherds' sheep use up the common resources, and I naively restrain my sheep from using those common resources as well, I lose relative to those who openly dismissed restraint. In the case of the Austrian Business Cycle Theory, in regards to the economic bubble, it didn't really matter if shepherds (investors) understood that we were over-using resources or not. What mattered is that there was an incentive to use those resources, because they were highly likely to, as individuals, lose more if they didn't do it at all.

And isn't this the case? In hindsight, we can all agree that if we could have stopped the investment from happening, we could have avoided catastrophe. Easy enough. But, as an individual actor, would you really have been better off simply disassociating yourself with that investment at the time? Were the people who flipped 2-3 houses in that period of time worse off (individually) than those who didn't? Sure, the aggregate result of choosing to invest was devastating. But, as in the case of the common pasture, those who let their sheep unabashedly consume the land were certainly in a better position when it all came crashing down in the end - and that outcome wasn't dependent upon whether they realized the aggregate result of their actions or not.

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