Thursday, August 20, 2015

Freedom of Entry is Huge

The abstract:
The Fair Trade (FT) coffee initiative attempts to channel charity from consumers to poor producers via increased prices. We show that the rules of the FT system permit this rent to be eliminated due to free entry and costly excess certification of output. Using data from an association of coffee cooperatives in Central America, we verify that expected producer benefits are close to 0 when we take into account the output that is certified but not sold as FT. Our results illustrate how free entry undermines the attempt at extending charity via a price distortion in an otherwise competitive market.
In the realm of characteristics required for functional markets, it seems to me that freedom of entry is so important in scale compared to all other factors that it should be the cornerstone of all policy and market analysis.

Fair Trade coffee is a clear example of this point.  As Michael Munger points out, it is impossible to give away money.  More, specifically, if there are low barriers to access, there will be an arms race of expense and effort to exploit that access.  Even if the point of the transaction itself is to bundle charity with commerce, and everyone in the process is morally invested in that outcome, they will be powerless against the pressure of freedom of entry.

This is why individual ventures can earn persistent excess returns on investment (because their founders are especially skilled, or they picked a fortuitous location, or they have intellectual or organizational assets), but investors in equity markets generally do not have the same opportunity.  There may not have been unlimited access to the founders' skills, but once those skills have been capitalized, the price of the ensuing expected profits will leave nothing extra for the marginal investor, on average.

If Fair Trade wants to ensure positive returns to growers, on average, they will have to limit access.  Charity is not achievable here - only patronage or market-clearing incomes.  The difficulty with intuitions about progress is that patronage appears to be the charity that open access failed to achieve, but it is really just one edge of a double edged sword, the other of which is exclusion.  And, it fails in that it generally leads participants to expend effort toward gaining access instead of producing.

Fair Trade, as does all open access trade, induces its producers to more productive work.  If they utilized patronage to create income for their producers, the producers would cease to be induced to higher productivity, but they would be induced to ensure their access to the gains.  And, once they had access, their interests would be better served by complaining to Fair Trade buyers about the low price of the beans than by performing the difficult work of lowering costs.

This is an obvious sign of limited access regimes that create rents and underproduction.  The producers will focus much of their energy on complaining about prices.  Collect all of the stories you may have heard on NPR, for instance, where producers were complaining about prices (including wages) or funding, and note if any of them involved producers in a free access market.  (Some may be in a free access market that they are trying to close.)  To insiders, these complaints will seem reasonable, because those insiders will be working very hard within their institutions.  Productivity improvements don't come from working harder.  They come from innovations, large and small, and, if anything, result in easier workloads most of the time.  So, rent-seeking insiders naturally feel indignation when their complaints are met with skepticism.  This insight does not come naturally from their conscious experience.  Skepticism about their value seems to be a challenge to their sincerity or their commitment, when it is really about being vulnerable to competition.  (Though, for someone who attributes moral value to labor-captured rents, even this is an insult.)

All policies should be viewed through the lens of access.

Immigration and trade are issues about access limitations.  Some American workers may earn rents by keeping out Mexican workers. (This is probably the case in some specific industries, but in the aggregate, even for low wage workers, the benefits from open access mitigate this.)  But the other edge is the cost Mexicans are willing to endure to gain access.  It is a measure of the dysfunction of our national tendencies on this matter that there would be less deadweight loss if our border agents were corrupt and simply accepted bribes to allow Mexicans to enter instead of engaging in our policy of suffering and desperation in the deserts of the southwest.  (Of course, a system of fees and commitments would be better than bribes, but either would be better than our current policy.)

Our refusal to create a functional mechanism to accommodate some of the demand for entering U.S. labor markets, protects some rents for some groups of low-skill American workers, reduces real incomes for many others, and turns the price Mexican workers are willing to pay to gain access into waste.  This is likely a net loss for the U.S., and is almost certainly a net loss if we include the costs to the would-be Mexican immigrants.  That demand is there, whether any particular Americans want it to be or not.  The question is only whether that demand is met through a functional process of managed entry or through sweat, and occasionally blood, spilled in American deserts and the deterioration of the rule of law.  Politics at its worst is frequently the mirage that we can indulge our prejudices and discomforts with the threat of force.  Despite the pretense that there is some factional debate here, there is really a national consensus for continued dysfunction on this issue because we have lost the communal understanding that civilization is the manifestation of universal access.  This would be an ideal that would be difficult to realize even without so much confusion about the relationship between rents and shared abundance.

That confusion causes many immigrant advocates who decry deportations and other indignities, nonetheless to call for prosecution of those who would employ those immigrants.  Generally the people I know in Arizona who are exorcised enough on these issues to march and do public advocacy are against NAFTA and other trade liberalization policies.  They generally don't accept the notion that access limits economic profits.  They would dismissively say that is "trickle down" economics.  And, maddeningly, this leads them to support economic exclusion.

Are you concerned about food deserts in American urban communities?  If 90% of your effort isn't directed at removing barriers for firms to locate in those areas, then are you engaged in the topic to make utilitarian improvements?

Are you concerned about education?  Remove barriers to entry for schools and for teachers.  Every other remedy in the world will not add up to the weight of that factor.  Pleas for funding and higher wages are a sign of the problem, not the solution.  Very poor families in Kenya use their cell phones to make payments to private schools.  Neither the schools nor the cell phones were made available to them because education entrepreneurs and cell phone manufacturers went on Kenyan airwaves pleading for funding.  Those schools appeared, in spite of all the seeming obstacles, because costs were (quietly) lowered, not because funding was (loudly) increased.  The difference in process between competition and patronage is massive - orders of magnitude over time.

If you think the sharing economy is damned by the lower incomes its producers make, please turn the sword over.  You've missed something.

Firms asking for protectionism explicitly claim it is to raise their profits (for the sake of their workers, of course).  If you think the wages of current taxi drivers will fall because of new competition, think of the value of taxi medallions.  Think about the idea of negotiating power with regard to that issue.  If ride-sharing becomes ubiquitous, would you rather have been a taxi driver or a taxi medallion owner?  Is it even close?  In the absence of barriers, firms are practically powerless.  If you think our society is bedeviled by the power of corporations, then surely all of your work is directed toward the easier creation of more corporations.  Surely, the elimination of rents for taxi firms is something to celebrate.  Surely the encroachment of Mexican and Chinese firms into American markets is something to celebrate.  Surely simplified regulations would be something to celebrate.

If this seems wrong to you - if you approve of all of those limited access regulations - because those limits produce rents for American workers and raise their wages, then you must believe that labor has significant power to claim producer surplus - even for taxi drivers.  They do capture much of those rents, but not all.  But, limited access only raises profit and wages relative to other incomes - allowing some to capture a larger portion of a smaller pie.

First and foremost, freedom of entry is important and useful for everyone, today and in the future.  But, if you agree that limited access raises the wages of the protected industry, and that it is worth the cost to everyone, then you have to believe that corporate power to claim excess profits is a minor force in American labor markets.  [One way to overcome this cognitive dissonance is to conjure up the belief that rents captured by labor instead of capital actually create economic growth.  As far as I can tell, this requires the following chain of logic: (1) the affected firms have sustainable rents, (2) owners will invest marginal profits, (3) there is no marginal benefit from additional investment, (4) laborers will consume instead of investing, (5) the consumption will allow firms to retain profits (presumably equal to more than the original transfer?), and (6) those profits will be invested (now to the benefit of new workers?).  If a reader knows of an academic defense of the economic benefits of rent transfers to labor, please post a link in the comments.]

The oddity here is that to achieve the political goal of pushing wages above the levels created by open markets, economic rents must be created for wage earners to claim.  In some areas, labor advocates achieve this through public monopoly - as with primary education.  But, short of public ownership, step 2 (above-market wages) is not possible without step 1 (economic rents from limited access).  Unions can capture higher wages for their members, but there has to be some source of protected profits for the unions to capture.  In areas like the U.S. auto industry in Michigan, this was sustainable until globalized competition reduced the excess profits those firms could claim from their geographic advantages.  But, without those rents, unionization became an impairment.

As the paper I pointed to the other day from Hsieh and Moretti discussed, cities can develop natural sources of productivity, and wages in those cities can rise if there is limited access to housing.  Similarly, this recent paper from Song, Price, Guvenen, and Bloom at the LSE, which attributes essentially all the increase in measured income inequality since 1978 to inequality between firms.  In other words, wages across income levels rise within successful firms.  Some set of complex processes appear to distribute producer surplus broadly.  (Maybe even the issue of firm-based income inequality is related to these high-cost, limited access metropolitan housing policies.  Those rents move through laborers, but tend to flow to real estate owners.)

So, advocates for higher wages fight open access economic regimes.  This frequently means fighting for corporate favoritism.  Those who disfavor ride-sharing firms because their wages are lower than taxi firms are an example of this.  Calls for protectionism in order to protect workers are an example of this.  Just about all calls for licensing, regulation, and public spending on projects that will create "good jobs" fall in this category.

The implication of closed access policies is that wage earners will claim some of the producer surplus.  The error is in seeing the world in terms of favored groups (labor) and disfavored groups (capital), missing the unmeasurable outcomes of these policies, and selectively measuring the visible outcomes.  Open access markets create higher incomes for consumers while limited access markets create a transfer from consumers to producers.  Limited access policies miss the forest for the trees.

So, ironically, wage advocates tend to be the most vocal supporters of crony capitalism, even if it is inadvertent. Money illusion helps to hide the problem here, because these policies tend to lower real incomes through higher costs.  In the aggregate, labor captures much more of the value added in open access markets than it does in closed access markets.  The evidence for this is overwhelming in international experience.  But, Bastiat has his work cut out for him here, because all of the gains are unseen while the targeted gains of limited access are seen.  Elizabeth Warren may be the premier representative of this problem.  In one speech, she can bravely demand and defend thousand-page regulations while decrying the revolving door of lobbyists and regulators - to fawning applause.  I think one way to think of labor compensation above the subsistence level is as human capital - an idiosyncratic and illiquid form of capital - so that most wages, themselves, are a form of economic rents.  And, helping firms claim limited access profits from the complex regulation you helped write may be the most effective form of wage-rent-seeking ever devised.  In this case, with, say, some financial firms dealing with Dodd-Frank regulations, there is frequently relatively free access, so excess profits beyond the extra cost of compliance may be difficult to retain.  In these cases, most of the rents may go to the regulatory compliance officials who are using those revolving doors.  Those revolving doors may be the apex of the limited access wage project - such a successful version of the policy that the downside can be seen, kind of like what we might have found with the $15 minimum wage.  So, we have recognition of the beast at the high end of labor rent seeking.  I suspect that these over-reaches of the minimum wage will help us rediscover it at the low end.  Can the unseen ever be seen in the big, muddy middle?


  1. One of the best statements on political economy I have ever read.

  2. I read the study which you link - the link is broken, it should be: The basic points which they make are that the coffee market is highly competitive, and in this situation, it is not possible for people to "do good" through artificial raising of (some) prices, because the rent would simply be dissipated by excess supply. Demand for fair trade coffee is high, but supply is even higher, so only a fraction gets sold in FairTrade markets, just enough to recoup the cost of certification.

    I tried to come up with some objections, but didn't succeed:

    a) Will this problem go away if one reduces the cost of certification. Perhaps, but since this is already a big market, the past experience does not inspire confidence in this remedy.
    b) There is a countervailing competitive market, which basically swamps this one in size. That is true, but then this means that for FairTrade to matter, it will basically have to dominate the market. That seems unlikely.
    c) The third "solution" is given in the paper: give money directly to the producer. But this will likely go through non-commercial channels, and difficult to scale.

    Ironically, this can feed into both "neoliberal" and "far-leftist" viewpoints. The neoliberal viewpoint because it says that the best you can do is the market price. The far-leftist viewpoint because the market system is the "enemy" here: you cannot hope to do good in the system which exists, unless this FairTrade system dominates the whole market. That is a very tall order, but that has not stopped people (either neoliberal or far-leftists) from trying. (For instance, open borders is a rather tall order).

    By the way, I wonder if you know about efforts to control the commodity (like coffee) markets, which can be very volatile, and punishing for smallish farmers. As far as I read, UNCTAD, a lot of years back tried to do something, but it was killed by the major powers. Here is a report on this:

    (As background: I read some of your comments on Scott Sumner's blog, and I occasionally browse your blog as well. I generally find Scott persuasive on monetary policy, less on wider political matters, though often interesting. This is probably partly because I know more about wider political matters than monetary policy. The more one knows, the less one is sure.

    I come from India, and generally am influenced by the leftist thinking, so I try to seek out different views. India is generally favourable towards WTO, and criticizes the agricultural subsidies by the rich nations. While leftist thinking in the US is quite critical towards WTO. I generally like the comments by Jagdish Bhagwati on this matter. )

    1. Thanks for your input, Anand. Glad to have you as a reader. Thanks for the heads up on the link. There are few things more valuable and difficult to maintain than generous and curious disagreement.

      On your comments about volatility, it seems that the best development would be a functional and accessible financial market that could provide hedging access to farmers.