Three Parables of Microeconomics
(Epistemic status: Satire.)
First Parable: Equilibrium Pricing
Highway Offramp 72 leads to the isolated town of Townton. Visitors are greeted by two fuel stations, Carbonaceous Fossils (CF) and Hydrogenated Chains (HC), on opposite sides of the main road. There are no other gas stations for many miles. Together, these two stations sell 1000 gallons per day. Since their products are indistinguishable, and they have prominently posted prices, every driver will choose the cheaper one; or if the prices are the same, they will split half and half. Both pay $1.50/gal for their stock and charge $2/gal to drivers, so half the drivers stop at each.
The owner of CF reasons as follows: If I keep my current price of $2, I will make 500*(2-1.5)=$250 of profit. But if I lower my price to $1.99, I will get twice as much business and make 1000*(1.99-1.5)=$490 of profit. The next morning, he updates his price.
Across the street, the owner of HC (who is having a bad day, due to the complete lack of customers), reasons the same way. The next morning HC has updated its price to $1.98; the morning after that CF lowers its price to $1.97; and so on.
Because CF and HC’s owners are law-abiding model citizens, they never talk to each other about prices. That would be collusion, which is illegal. Later that month, with CF’s price down to $1.52 and HC’s price at $1.51, the local community center holds Game Theory night, where both owners attend a local economist’s presentation on the Iterated Prisoner’s Dilemma.
The next morning, both stations charge $1.52. The morning after that, $1.53. The morning after that, $1.54, and so on. Later that year, CF reasons as follows: If I keep my current price of $20...
(Moral: Gas station attendants should study game theory.)
Second Parable: Comparative Advantage
Two farmers, Alex and Bertha, grow potatoes and carrots. In one year, Alex can either grow 4 barrels of potatoes or 10 barrels of carrots, or some linear combination of the two, such as 2 barrels of potatoes and 5 barrels of carrots. Bertha is better at farming, and can produce 15 barrels of potatoes or 20 barrels of carrots, or some combination of the two. Doctors agree that everyone should eat exactly equal numbers of potatoes and carrots—an excess of one over the other would be unacceptable. So in the first year, having just settled a new frontier and not having met their neighbors, Alex plants 2.9 barrels’ worth of each, and Bertha plants 8.6 barrels of each.
During the next year’s spring festival, Alex and Bertha meet, and Alex suggests arranging a trade: he will focus on carrots, and Bertha will focus on potatoes. At first, Bertha is skeptical; Alex is worse at farming, so how could trade be beneficial?
At that very moment, they are overhead by a passing economist, who explains the Principle of Comparative Advantage, which says that as long as their ability to produce crops comes in different ratios, they can profit from trade. With the help of a passing algebra teacher, they determine that Alex will plant 10 barrels’ worth of carrots, and Bertha will plant 2.9 barrels of carrots and 12.9 barrels of potatoes. That fall, they trade.
That winter, a travelling wizard casts a spell on Bertha, enchanting her voice, and explains that if she sings opera to her crops, they’ll grow twice as fast, doubling her yield. When Alex and Bertha meet and plan their trade, they agree that Alex will plant 10 barrels’ worth of carrots and Bertha will plant 12.9 barrels of carrots, 22.9 barrels of potatoes. Alex, unfortunately, missed the wizard because he had the flu, but thanks to comparative advantage and trade, he is nevertheless slightly better off than before.
The next year, the wizard returns, and casts another spell on Bertha, enchanting her hands. This, he explains, will cause any vegetable she plants with them, to taste slightly better. Bertha decides that she doesn’t want Alex’s less-tasty vegetables, and stops trading.
That winter, Alex starves to death.
(Moral: Don’t be a subsistence farmer.)
Third Parable: Regulatory Capture
Fleem production is a highly regulated industry. There are only three firms that make fleem, and prices are high. Investigation into the laws regarding fleem production reveals that, in order to make fleem, you must:
Not dump toxic waste into rivers
Have an outside accountant look at your books once in awhile
Fill out lots of paperwork
Do the secret regulator handshake, and
Perform the regulator dance
Buyers are complaining about prices, and producers are complaining about the burdensome regulations. The legislature decides that, in order to deal with the problem, they need to clean up and simplify the regulations. After extensively debating the issue and consulting with the fleem industry, they agree that, to be a fleem producer, you should:
Not dump toxic waste into rivers
Fill out lots of paperwork
Do the secret regulator handshake, and
Perform the regulator dance in under a minute
Several years later, one of the major fleem producers is caught defrauding its customers and contractors out of huge sums of money. The enraged public demands solutions to ensure that this never happens again. After extensively debating the issue and consulting with the fleem industry, the legislature decides to form a new agency, the Office of Fleem Scandal Prevention. The office contains dozens of workers, who spend their days:
Checking fleem producers’ paperwork for stray marks
Updating the secret regulator handshake, and
Issuing fines for missteps in the regulator dance
Several years later, there are two firms that make fleem.
(Moral: Learn to live without fleem.)
Subsistence farmers don’t trade for their sustenance, they farm what they subsist upon. So perhaps the moral is do be a subsistence farmer...
The second moral should be “I can only make comparative advantage look bad by assuming a magical wizard or by postulating a world in which a farmer has only one potential trading partner.”
(Note: I teach a course titled “The Magic of the Marketplace.”)
I believe you are missing the point of that story. I suspect that the magical wizard is actually technological development, and the actual message is to not be on the losing side of technological progression. Comparative advantage is just used to set the scene, as it were.
Of course, I could be missing the point of the story.
It’s hard to imagine technological development in the agricultural sector that causes farmers who own their own land and tools to starve.
His yearly income comes in during a short period of selling plants it took him most of the year to grow. If he doesn’t have enough savings, he may take a loan during the growing season. Then one failed or unsellable crop can wipe him out.
If the farmer invests in cash crops and than the price of said crops collapses.
Granted this is less of a problem for farmers then other industries where you may have a harder time changing what you produce quickly.
Edit: Also the example in the parable doesn’t work since Alex could produce enough food for himself on his farm during the first year. Thus it’s not clear why he couldn’t do so again.
One-generation seeds?
If you are not forced to used them, and if their existence doesn’t raise the price of other seed how would they cause you to starve?
You start using them in a year when they look like a good deal. Then the world market shifts and you wind up with an unmarketable crop—and no way to go back.
If the farmer is actually a subsistence farmer, they save their own seed, so they don’t care about the price of seed, nor would they buy single generation seed (say of a new crop or variety) knowingly. However, if someone nearby plants single generation seed, they can end up with genetic material in their variety of that crop, which cuts their germination (or seed baring) rates the following season.
Perhaps he died of deficiency diseases.
Right, he ate only carrots. But the point is that he didn’t have potatoes because he thought that he could trade the carrots when he planted them.
That’s pretty easy, the first thing that comes to mind is monoculture.
Charitably but precisely, the moral is ‘depending on trade exposes you to certain risks if the market changes.’ Notably lacking is any proof or argument that doing so is any riskier than trying to avoid depending on trade.
Yes a similar thought occurred to me today. I am a specialized professional worker in a big city. If the demand for my services went away, then I would have to either change jobs; depend on charity; or starve to death.
There is a subculture of people who worry about this kind of risk (among other things); they are known as “survivalists” or “preppers.”
He did label this as satire
Minor nitpick: You mean convex combinations or affine combinations; linear combinations would allow arbitrary numbers of carrots and potatoes.
The gas station story is quite real.
I suppose the meta-moral is that one should be wary of thought experiments based on idealized simplified scenarios.
As they say, in theory there is no difference between theory and practice. But in practice there is a big difference between theory and practice. Or, as the punchline goes in the old joke about the economist on a desert island: “Assume we have a can opener.”
Re: second parable
Yeah, anything that disrupts trade can be bad for you. Alex would have the same problem if the wizard destroyed the only bridge between his land and Bertha’s land.
Moral: Have a fallback plan?
Yes, and you can also drive yourself crazy worrying about trade disruptions. On survivalist blogs, you can read about people who spend countless hours and lots of money stocking up on canned goods; equipping mountain redoubts; and so on. I was reading about one guy who had a ranch with its own natural gas well so he could have heat and electricity after the big crash.
Perhaps this: Think about the risks you are facing in life and try to decide which are the biggest risks. Focus energy on preparing for and ameliorating the bigger risks.
Which is a bigger risk: (1) that you will develop cancer and die in the next 5 or 10 years? or (2) that you will be robbed and murdered by a band of nomadic savages after some great societal breakdown? So which should you put more energy into: Trying to exercise and watch what you eat; or surrounding your house with barbed wire and machine gun nests?
How long are years on Townton’s planet? Or is the Schelling price increase path nonlinear?
Three months into the process, the economist came back, and sold them both digital signs that update every hour.
Isn’t the moral of the story that the gas station owners colluded to form an illegal cartel to raise gasoline prices?
The moral, as I understood it, is that you don’t need illegal collusion to gain the effects of a cartel as long as you can use your pricing to play a reasonably pure iterated prisoner’s dilemma with the other members of your oligopoly.
Without communication it’s iterated prisoner’s dilemma (co-operate=raise prices, defect=lower prices), and so long as they’re not communicating there’s no actual cartel.
Are they really not communicating, though? They seem to be signalling to each other their willingness to cooperate in the prisoner’s dilemma.
I’d be very surprised if judges and regulators failed to classify this as a cartel.
They’re communicating in an information-theoretic sense, but probably not in a legal sense.
If something as simple as this can be considered a cartel, then the entire free market system is a cartel.
The whole point is that companies can only communicate with each other in this manner, and not directly, because that would be collusion.
When I have time, I’ll look up the specific legislation, though i suspect it varies by area.
My variant on number two: Instead of enchanting Bertha’s hands, the wizard tells her he’s going to curse Alex’s crops so that none of them will grow. He doesn’t, but Bertha grows equal amounts of carrots and potatoes and so has no incentive to trade, leaving Alex and his carrots to die of potato deficiency.
...life would be great, but what does that crowd of townies with torches and pitchforks is doing outside of my house?
I suppose the cycle of increasing prices could be broken in one of two ways in a purely economic way: 1) The increasing profits either increases the benefit for the the gas stations to break the truce and slightly lower prices again (or for a new competitor to do the same). 2) The vast majority of cars entering the town are not desperate for fuel (or at least not so desperate as to be extorted) but are merely considering getting fuel here. Without knowing it, the gas stations are actually in competition with the gas stations of neighbouring towns.
This was a toy example, there is no context to it and so little opportunity to speculate on how could this situation develop further. Implicit collusion is not unheard of in real life and could be broken in a variety of ways (including government agents showing up and asking questions).
The trick is to cooperate among a wide enough group that you can set your customers’ expectations.
It’s hard to do implicit collusion among a wide group, especially nowadays in a global environment.
Not really; there are plenty of real world business examples. This book examines some of them. There are a lot of cases where all the actors involved would be harmed by instigating a race to the bottom (they would gain a temporary profit, but their competitors would quickly follow suit leaving them worse off,) and barriers to entry into the business are high enough that it’s not possible for just any idiot to enter and break the equilibrium.
None of the examples in your link are prisoners’ dilemmas. If I had a copy of the book, how could I find relevant examples? And if I have an example that looks coordinated, how can I tell that it was not explicitly coordinated?
I don’t remember wherein the book you would find the relevant examples, since it’s been about a year since I returned it to the library.
If you have an example that looks coordinated, then it’s possible that it was explicitly coordinated, but in practical terms, explicit collusion that we can’t catch and prevent has largely the same effect as implicit collusion.
The book doesn’t look unbiased :-)
I’m sure implicit collusion exists in the real world, I’m not so convinced there are “plenty of real world business examples” which are purely implicit and, for example, do not involve regulatory capture. My impression is that industries which successfully build high barriers to entry and enjoy abnormal profit rates generally do so with the help of government agencies.
It doesn’t have to be, if the relevant issue is not whether the overall position of the author is correct, but whether the specific relevant examples are legitimate.
Regulatory capture is certainly a pervasive and significant problem. When given the option to pursue that kind of advantage, corporations would be foolish to pass it up; they’d only be outcompeted by other corporations which were not so reserved. But that doesn’t mean that in the absence of regulatory capture, implicit collusion (or even explicit, when the industries can get away with it) will not occur.