02 Jan 2018

There’s Nothing More Complicated Than First Principles

Economics 16 Comments

I am not kidding, it is ridiculously hard to express basic economic principles to non-economists. I always felt much more comfortable teaching upper level econ courses to majors.

Case in point: In my latest EconLib, when writing the initial draft, I actually had pangs of doubt that my discussion was so elementary, people would wonder why I wasted their time with truisms.

And yet, the people chiming in at EconLog said my two principles contradicted each other, while the guy chiming in here on Free Advice said my two principles are the same thing.

(BTW, “Transformer” here at the blog is very familiar with economic theory, so that actually might help explain his different reaction.)

Anyway, this is for the professional economists: People objected that it was confusing for me to talk about the gains from specialization, and then to offer a numerical example where the marginal productivity of workers started dropping from the 2nd worker. I.e., I had diminishing marginal returns kicking in right away, so it looked like adding more people always reduced per capita income.

There is actually a lot going on with these examples that is swept under the rug. But, on its own terms, for future reference does it hurt anything if I use numerical examples where the marginal physical product goes up with the first few workers, before maxing out and then falling?

16 Responses to “There’s Nothing More Complicated Than First Principles”

  1. Nick Rowe says:

    Bob: this First Principles stuff is important, because a lot of people don’t get it, until it is explained very carefully.

    My guess: explicitly introduce a second factor. And I would make that second factor land (because “capital’ always confuses people). And I would start out with Constant Returns to Scale, with diminishing returns everywhere.

    And if you have Increasing Returns to Scale, at least locally, then the sum of the Marginal Products add up to more than total output. (And it’s incompatible with perfect competition, of course). So some (or all) of us must get paid less than our Marginal Products. And IIRC the theory of the CORE, the core does not exist. (In a CRS economy, the core shrinks to the competitive equilibrium, in the limit as the economy gets large and the number of players infinite.)

  2. RPLong says:

    I’m not a professional economist, so take my comment with a grain of salt.

    I thought it was a good article, and I enjoyed reading it. As I read it, though, I wondered if too much of it hinged on the principle of comparative advantage and production possibilities frontiers. You allude to this in your article, but you never state it outright.

    I realize it’s hard to touch on yet another basic principle in an article that already covers so much, but in this case I thought it might have helped. But that’s just my opinion.

    • RPLong says:

      To clarify a little, what I think would drive these concepts home is a brief discussion of what makes gains from trade possible in a two-person island economy (you cover most of this already), followed by a brief discussion of how three people would be able to collect even more coconuts at the same tree, and four even more, etc., but each additional person yields fewer coconuts on the margin, until the tree is exhausted and they have to find other trees. But when they do, the margins get bigger again.

      This might help set the reader up for the subsequent discussion about employees in a chewing gum factory. One guy in a factory has to do a lot of work. Two guys get to split the work. Maybe five employees gives us one employee per machine in the factory, but after that it should be obvious that having an i-th person pouring batter into the vats produces a lower marginal yield than when there were just two of them taking turns pouring.

    • Anonymous says:

      I’m not a professional economist, so take my comment with a grain of salt.

      Given how much incompetence and outright dishonesty, such as Bob Murphy, comes from so many professional economists, your lack of professionalism can hardly be considered a disadvantage.

      Considering your bubble gum factory, consider two scenarios: In the first, the factory owner was the architect and designer of the factory and the equipment obtained therein, and paid others to help him build it at wages they found acceptable. While there was a farm there before, he paid the farmer for the land at a price the farmer found acceptable.

      At the second bubble gum factory, the factory owner used eminent domain to take the land from the farmer who was there before, forcing him out. While the second factory owner did hire voluntary workers to build the machinery, he saved on bricks to build the factory by using slave labor for those.

      Both factory owners claim ownership of bubble gum produced in the factory. That is to say, any worker taking bubble gum out of the factory to sell to whomever they want is considered a thief. Workers are only allowed to work for the wages offered by the factory owner, not sell the bubble gum on their own.

      However, the second factory owner is engaging in a clear case of exploitation. He has no legitimate claim of ownership over the factory. The land rightfully belongs to the farmer who was there before, and the bricks to the slaves who built them. As for the factory equipment, since it was placed on stolen land and shielded from the elements with bricks made by slaves, we can consider that forfeit as well. He has no legitimate claim over the right to prevent workers from selling the bubble gum to whomever they wish.

      The workers themselves don’t really have a right to be there either, using stolen land and sheltered by slave-made bricks. However, their culpability is at least less direct, and it is possible they would have preferred the land not be stolen and the slaves not have been forced to make the bricks. Especially if they can’t afford the bubble gum and have want of food, they might prefer the farmer were still there for them to do business with instead of the bubble gum factory owner. Likewise, they might have preferred the brickmakers were free to conduct other transactions instead of being enslaved. Thus, the factory workers are both beneficiaries of exploitation, in the sense that they likely wouldn’t have their current job were it not for the theft and enslavement, and also possibly indirect victims, in the sense that they might have had better opportunities had the theft and enslavement not occurred.

      While it would be best for some form of reparations to occur to the enslaved brickmakers and the robbed farmer, in the event these people cannot be found, the workers still have no moral obligation to hand over the bubble gum to the factory owner. Indeed, it would be better if they didn’t, since when they do, they are rewarding his bad behavior. So, if they wanted to seize ownership of the factory and sell the bubble gum to customers on their own, this would be an improvement in terms of justice. If they couldn’t find the farmer and enslaved brickmakers to offer reparations to, they could instead make a donation to a reputable anti-slavery NGO.

      The first factory owner could still be argued to be exploiting the workers, as it is possible they might do better for themselves if they were allowed to sell the bubble gum directly to customers. However, he at least as a legitimate claim of ownership, and if the factory workers were allowed to sell bubble gum directly to customers, the question would arise of how he could be fairly compensated for his contribution in designing the factory and paying people to build it.

      • Anonymous says:

        Additionally, when the second factory owner is able to undercut the first factory owner, since he did not pay a proper price to the farmer for the land or proper wages to the brickmakers (whereas the first factory owner did pay for these things), it makes the first factory owner an indirect victim of the second factory owner’s immoral acts. When the first factory owner has to reduce wages to compete, it makes his employees indirect victims of the second factory owner. The bubble gum customers benefit from this exploitation, even if they buy from the first factory owner, since he had to reduce wages in order to compete against the second.

        • Tel says:

          Let me get this straight… in North Korea nearly the entire population are slaves. Other than a small handful at the very top, everyone else is subject to largely arbitrary retribution for stepping out of the line, or any minor slight against the boss. They run special punishment camps where they take entire families and subject them to brutal treatment as a way of terrorizing everyone else.

          Thus, by your theory, North Korean factories should be in a position to undercut every manufacturer in the whole world, thanks to their massive slave labour force. Yet, if you ask the average Western factory owner what they are worried about they are unlikely to put competition from North Korea at the top of their list… but why is that?

          Think is the North Korean slave society can barely feed itself, let alone achieve any significant competition on an international basis. Capitalist societies are simply more productive. Vastly more productive.

  3. Transformer says:

    I had no problems with the example where the marginal productivity of workers started dropping from the 2nd worker. This is demonstrating a situation where one factor is kept fixed , and not the general issue of gains from specialization where all inputs can be varied.

    My objection is rather that I do not believe infra marginal units will exist in equilibrium (and the Econ Lib article expressly talks about equilibrium conditions).

    In equilibrium (in an Austrian-type model) all prices will tend towards a level where prices reflect input costs (with rent on capital set to reflect societal time preference) . If specific prices are above that level then new entrants will be attracted and prices will fall back to their equilibrium levels . The existence of infra marginal units as in Bob’s gum model will be case where price is above cost – and the equilibriating process would kick in. I think that in equilibrium marginal product will be equal to average product and in this situation no worker will add more to total output than he receives in income

    • Transformer says:

      “This is demonstrating a situation where one factor is kept fixed” = “This is demonstrating a situation where ALL BUT one factor is kept fixed “

    • Anonymous says:

      The “Austrian model” seems to be to spread propaganda pretending all transactions are voluntary even when people are literally being forced to work at gunpoint, as in the Congo.

      Prices will never reflect input costs under slavery. The suffering of the slave will always exceed the price paid by the consumer. And slaves generate positive output (at least from the perspective of the enslaver), but receive negative income (violence or at least the threat of violence, generating pain and/or fear), and thus always generate more output than they receive in income.

  4. Bitter Clinger says:

    But, on its own terms, for future reference does it hurt anything if I use numerical examples where the marginal physical product goes up with the first few workers, before maxing out and then falling? Your table does not make any sense. Why would five workers working cooperatively making 252 units NOT work independently where they could make 500 units? The whole chart is bogus (or is it “fake news”). No one (OK maybe education or government) would add a worker if that worker would not add at least what one person working alone produces, they would just put him in a new room and have him work alone. What am I missing? Where did I go wrong? That being said, wouldn’t the lowest marginal physical product be the product of one person working alone? The search for the optimum workgroup size has been a continuous process since Frederick Taylor falsified his experiments and I don’t see that changing. In the corporate world; at any time the workgroup size is such that the incremental addition of a worker reduces the workgroup per person productivity; I will assure you firing, demotion, layoffs, poor performance reviews, and transfers will result.

    • Bob Murphy says:

      I think you’re missing that there is a factory? I agree, if factories were free to build, then you would make bubble gum in separate, one-person operations.

    • Bitter Clinger says:

      Let me try again. Let us say that variable costs are $.50 a pack, fixed costs for the “factory” is $10 per hour and marketing wants 500 packs per hour. We have a choice. We can get the production by five one-person lines or else by two four-person lines. The cost of five one-person lines is $300 while the costs of two four-person lines is $270. But if we have profit sharing the five employees would much rather split the $200 ($40 each) than the eight employees splitting $230 ($28.75 each). But management says “NO PROFIT SHARING” and that Dr. Murphy, after a long and arduous analysis informed us the proper payment to the workers was $9 per hour. Then the cost of production is $345 for the one-person lines and $342 for the four-person ones. Management, of course, gets paid millions of dollars a year to consider and think (this is called ‘executive time’) and they might think, “What if Dr. Murphy is wrong and the workers demand $12 per hour.” Then the one-person lines are the better choice. Plus there is the consideration that the workers on the four-person lines are going to be beating the equipment like rented mules and it may drive up the fixed costs. I have always believed that labor was a commodity and the rates were set by supply and demand where they were not set by law or union negotiations. That is why companies with labor intensive products would move to low labor cost countries. But your argument that it is set by marginal productivity has opened my eyes. I assume that is also what sets the price being paid for the gum, sugar, and flavors that go into the bubble gum? And more generally it also must be what sets the price for gasoline, diesel, steel, aluminum, plastics, groceries, cars, trucks, etc. etc.

      • Bob Murphy says:

        Hey BC,

        You’re definitely right that the supply schedule of the workers is relevant. E.g. if I had extended the table until the point at which the marginal product were 1 penny, then we wouldn’t conclude, “All the workers get paid 1 penny per hour,” because that wouldn’t be worth giving up their leisure. (Plus it would be illegal if we assume binding minimum wage laws.)

        So yes, if that was the only thing tripping you up, sorry that I breezed through the example too quickly.

        You’re right, the default view among economists is that if we have reasonably competitive markets, then all factors of production get paid in this fashion.

        That’s also why we can’t conclude that the management is ripping off the workers due to the inframarginal surplus, because they have to pay the owners of the other factors of production too. You need more than raw labor power to make bubble gum.

        • Tel says:

          Here’s what I come up with after thinking this one over:

          We start with physical productivity and let’s look at the case of Henry Ford’s assembly line. Begin the story with simple craftsmen — these guys work individually and everyone thinks that’s the best you can do. For a given sized workshop (usually small) adding more craftsmen rapidly hits a diminishing return, but if you are willing to allow that each craftsman is general purpose enough to also build themselves a workshop then it scales linearly. The industry will grow until supply meets demand.

          But along comes the assembly line. Now you have capital investment in the form of factories, oriented around more specialized workers… suppose you try and run a production line on just one worker; it will not be physically productive at all! The craft model just does not fit assembly line infrastructure.

          Then try two workers on the assembly line, and you find it’s a little bit better, but still not much good… you need more workers.

          Thus, once we are looking at the type of tech-level where assembly lines are coming onto the scene, we have a situation where adding more workers to the assembly line makes it more physically productive but only up to a point. Eventually if you just keep stuffing more and more workers into the same factory you will go over the optimum and back down into diminishing returns again. So it scales non-linearly and there’s some sort of curve that goes up for a while, but down again.

          The factory manager presumably is not stupid, so she will keep adding workers and push that up perhaps a little bit past the optimum but not too far down into diminishing returns territory, because by doing so all the workers become less productive … and as Bitter Clinger points out, why would anyone do that?

          This means I agree that your curve is wrong: it should ramp up for a while, reach a peak (in terms of productivity per worker) and then ramp down again.

          Now, I remind you, that’s physical productivity which does not couple directly to market profitability because there’s this important thing in the middle — price!

          In a competitive market, the existence of a single factory drives the entire industry into diminishing returns because the market price of that particular type of goods is driven down, to the point where those individual craft workshops are now making much smaller profits (their physical productivity has not changed, but the market price of their output has fallen). Thus, the competitive industry forces all production to shift into that type of tech which is the highest physical productivity known in the industry at the time (in this example they all switch over to the assembly line).

          If any single factory manager pushes the number of workers significantly past the optimum, that factory goes into diminishing returns and thus the marginal productivity is below what is typical for that market. However, the sell-price gets determined by the market as a whole, so profitability is weaker in that particular factory and therefore either wages fall or the factory goes out of business. Seeing wages fall, the best workers leave and move to competitor factories and it all balances out again. What you get is every factory attempting to hover just past the optimum point, but not too far past.

          There will also come a point where it is not worth building another factory, because the market price of those particular goods has fallen to the point where the return on investment is too low. At that point the whole industry is stable (until the next tech-shock comes along and they move to machine tools, robots, etc).

  5. Tel says:

    … at any time the workgroup size is such that the incremental addition of a worker reduces the workgroup per person productivity; I will assure you firing, demotion, layoffs, poor performance reviews, and transfers will result.

    You don’t spend much time in the software industry, do you?

    I will say this much: software projects are notoriously difficult to manage; and the strategies deployed shift around from week to week, so perhaps we are not looking at an equilibrium situation.

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