To seek rent or not?

Rent-seeking has been a popular topic on this blog over the past week. In the comments of this post, Mike M asked if a company seeking to sell its products to government is rent-seeking.

I replied, yes and asked him what he thought.

Here are excerpts from Mike M’s well-thought out follow-up:

 I think there is a difference between “selling” your product (goods or services) to the government (just like an other consumer) and convincing them to buy your product (as opposed to others) and seeking to have the government (as a third party biased referee rather than as a consumer of your product) afford you some privilege that gives you an advantage (such as subsidizing your product or taxing or regulating the competitor’s product).

 In the first case, as long as the government representative is truly acting for the benefit of the government, he should be seeking to make a trade at FMV.

I agree.

A “rent” is essentially an excess return above the “normal” return in a competitive economic market.

Typically, we use the term to imply that one has lobbied the government to obtain some special privilege – something that’s been going on since governments and economies have existed and is not a unique occurrence in any economic system (although that does not mean that it is meant to be a part of that system). Rent-seeking differs from profit-seeking, in which two parties seek to extract value by engaging in mutually beneficial transactions.

What is important for us to realize is that the costs spent on lobbying for these privilege eliminates some of the beneficiary’s gains for the privileges and results in an economic inefficiency, i.e. less output results from the same inputs. The cost of obtaining the rent represents a use of real resources and is a loss to the economy as a whole.

I agree. Also, I think it’s worth highlighting that the cost of obtaining the rent is the rent-seeking.

The next excerpt, however, starts to get at one reason — after going through a similar thought process as Mike — I erred on the side of yes.

Of course, this goes out the window if he’s your cousin or you’ve offered him a bribe and he buys your product at an inflated price, but I think that’s a different “crime” than rent-seeking.

Unfortunately, so much of government spending, even if it initially starts out on the up-and-up, devolves into rent-seeking. That’s how we end up with $800 government hammers and toilet seats. That’s how education spending per student triples in a few decades with nothing but shiny buildings (and wealthy builders) to show for it.

While the bribe is a different crime than rent-seeking, it is also rent-seeking, because it is spending resources to gain something without creating value.

Next, government spending comes from taxes. Taxes are not value creating transactions. Rather, they are redistributive. So, government vendors are ultimately lobbying government officials for a slice of their redistributive taxing power.

How is that different from lobbying government for its other powers like enacting a tariff on sugar or restricting competition in a market?

One objection I can imagine to my case is that some of the money spent by government does create wealth.

This is true. But, to say these things create value isn’t enough. They have to create net value relative to opportunity costs.

Roads are great, for example. I’m eagerly awaiting a new road being built near my home. It will be profitable for me, because it will shave many minutes on my commutes.

When I think of that new road creating value for me, I think only of the benefit — how much time I will save. But, I never know the cost.  If the local, state and Federal government (all are pitching in) said I could have that road or $100,000, I might decide to take the $100,000 and continue to put up with the extra minutes on my commute.

So, even when I see government spending that appears to have created some wealth for society, I don’t really know if it did relative to the alternative that could have been if someone had spent the resources more carefully.

What do you think, Mike?  What am I missing?

Gas prices

A common quandary that perplexes many folks is fluctuating gas prices.  Whenever gas prices increase quickly, I typically hear something like the following:

  1. The cost of the current stock of gas in the underground tank at the gas station was bought at a lower price.
  2. Rising gas prices do not change what the gas station paid for that current stock.
  3. The gas station could keep the lower pump price and still have cleared a nice profit on that stock of gas.
  4. Why do they raise the price?  It must be greed.

I have something for folks who have not got past this quandary to think about.

Let’s say you bought a rookie baseball card for pennies.  Years later, that rookie develops into a future hall-of-fame player and is loved by a large fan base.

Ten years from when you bought that rookie card, you discover you have it and look up the market value and find that it is now worth $50.

You tell a friend that you have the card.  He wants it.  What do you consider to be a fair price?

You tell your friend the price is $50 since that’s the market value.  He might argue that it only cost you a few cents and even with inflation, the cost of the card to you in today’s dollars is $1.   He might offer to pay you a storage fee of $0.10 per year, which brings the total offer price to $2. Does he have a fair argument?  Are you motivated by greed for not agreeing to sell it for $2 and wanting $50 instead?

While you are negotiating a price with your friend, the player tragically dies in a car accident and you find out the next day that demand for his memorabilia has increased substantially.  You see his rookie card is now selling for $400 on eBay.

Remember, you only paid a few cents for the card and you have not agreed to a final price yet.  Do you accept your friend’s offer of $2?  Do you stick with your original asking price of $50?  Do you raise the price to $400?

If you choose the second or third option, you are behaving identically to the gas station owner and you are not being motivated by greed, but rather by your opportunity cost.

By selling the card to your friend for $2 you would give up the opportunity to sell it for $400 and you are giving your friend that opportunity. You recognize that what you paid has little bearing on the situation.  You also recognize that you would be giving your friend $398.

Now, let’s revisit the gas station.   The gas station owner fills his underground tank for $10,000 and sets a price that will earn him $11,000 once all that gas is sold – a tidy $1,000 profit.

A fire takes out a major refinery and the price of gas on the commodity market jumps.  The gas that cost the the owner $10,000 last night is now going for $15,000 on the commodity market.

Let’s say there’s a local law that requires the gas station owner to not change his price until he sells out of this batch.  He can sell the gas to his customers and make $11,000 or he can call his supplier and have them come pump the gas out of his tank and sell it back to them for $15,000.  Which would you do?

Trump ignores the opportunity costs of his foreign trade policy

In today’s column, Thomas Sowell proposes that one reason Trump is leading the Republican polls is his:

…ability and the willingness to articulate his positions clearly, forcefully and in plain English. Too many Republicans talk like the actor of whom a critic once said, “he played the king like he was afraid that someone else was going to play the ace.”

Sowell has a good point, but I think there are other characteristics that make Trump appealing to folks.

One, he isn’t a politician, yet.  Two, he is market tested.  His TV show attracts viewers. Three, he is a successful businessman, which appeals to folks who want jobs.

But, folks need to get over their crush on Trump.  His foreign trade policies stink and his views on government are no better than any other politician.

First, foreign policy.  With his protectionist approach, he wants to restrain imports to create jobs.

He doesn’t understand that is like me deciding not to buy food from grocery stores (imports to my home) so I can create the job of growing my own food.  While it’s true that restraining grocery imports to my home will create work for me, most people will deduce that I am not better off with my protectionist policy.

Instead of working an hour each day to buy those grocery imports (and an overabundance of calories), I will now need to work 10 to 12 hours plus weekends to produce just enough calories to sustain myself.

Which means I also need to give up whatever it was I was doing before to earn the wealth I used to buy the imports.  What I gave up to produce my own food is my opportunity cost.  It’s a steep cost that nearly everyone would advise me not to incur, wouldn’t you agree?

Yet it’s that very same opportunity cost that Trump, and all the folks who like what he says, ignores.  While he points out the work that is created, he misses the opportunity cost of creating that work by restraining imports.

My example is not much different when you expand it from the boundaries of my property to the boundaries of our country.

The big difference is that whomever is made busy with protectionist policies are easy to find and make great emotional anecdotes in Trump’s stump speeches, while the enormous opportunity costs (like going from one hour a day to earn an abundance of calories to 10-12 hours + weekends to produce a sustenance level of calories) are spread across millions and cannot easily be imagined or pointed out in a stump speech.

The other problem I have with Trump is that, like most politicians, he seems weak on the Constitution and the role of government.   I think he suffers from the same affliction as Obama.  He believes the President’s role is to run the country rather than defend liberty.  Unfortunately, many of the voters in the country have that affliction as well and vote accordingly.

Postive sum thinking

I came across this excellent insight from a commenter, kiwi dave, in response to this blog post on Marginal Revolution:

People often think zero-sum benefits are in fact positive sum (further education, tax credits to lure businesses, building gigantic stadia to lure professional sports team) and think that positive-sum transactions are actually zero sum (especially international trade, but more generally market transactions, especially those that make some people very rich). As bad as the former is, the latter is probably worse. And the political leadership — on both sides — openly encourage both fallacies (viz. “winning the future,” “our Sputnik moment” etc.)

As I think back, flipping my own view on this was key to moving me away from my ‘fiscal conservative, social liberal’ days of the past.

I took market trades for granted.  I had been buying stuff and working since I was young.  It’s so natural, I failed to recognize what was right under my nose — that we trade for mutual benefit, which is a positive-sum game.

Sometimes, those trades feel forced upon us and do not feel positive sum.  We probably complain about having to pay the electric bill more often than we consider what we gain from electricity.

On the other hand, arguments for “investing in education” or the economic benefits of luring a sports team seduced me with sophistication.  The rationale sounds smart, appears to be credible and are usually based on studies and projections by folks with college degrees in economics and finance.

Understanding the “full picture” of the positive sum economic argument in those cases grants you admission into a positively reinforcing echo chamber of self-congratulation (sorry about using that term twice in one day) for being able to comprehend such a seemingly sophisticated argument.  It also buys you acceptance with the special interest groups that will benefit from the spending regardless if it provides a positive overall benefit or not.

I started having doubts when I observed some of these projects miserably fail to meet projections.  As I learned more, I started seeing the holes.  Rarely did such studies consider or give proper weight to opportunity costs and they tended to treat all or nearly all activity as incremental.  They never seemed to have peers with opposing views test the assumptions, provide a critical review or identify potential unintended consequences. You shouldn’t trust a doctor that doesn’t encourage you to seek a second opinion.  Same goes for an economist.

I had long forgot about the time when I accepted such grand positive-sum arguments.  And I had been assuming that some folks just can’t see positive sum game.

Thanks to kiwi dave for reminding me of where I once stood and pointing out that it isn’t that they don’t see positive sum games, it’s just that they see them where they don’t exist and fail to recognize the positive sum games that do.

“Why do people go to restaurants if we can make food at home?”

I received this great question from a 5-year-old as we drove into the parking lot of Red Robin.

There are many reasons why restaurants exist alongside our kitchens, pantries and grocery stores.  Those reasons roll up to one economic concept: opportunity cost.

Opportunity cost naturally drives many of our economic choices, most of the time without us even realizing it.

In some cases, we value what we get by choosing a restaurant over fixing the meal at home.   That night the value of the convenience of being able to get a wide menu selection, reasonable quality food and entertainment for the kids outweighed the value of prepping the food at home.

Do No Harm

An interesting thread came up on this blog post on Cafe Hayek.

One commenter, JohnDewey, defended government agencies calling it unfair to say that government agencies do not add any value.  He admitted that agencies like the USDA may not operate as efficiently as a private solution, but it’s still better than nothing and therefore it adds value.

I disagreed.

Dewey used an example of an untilled field.  He said a man and horse-drawn-plow adds some value to the field.  Maybe not as much as a man and a powered tractor, but let’s not forget it adds some value.  In his example, government agencies were the man and horse-drawn-plow.

I disagreed as did others.  A commenter known as vikingvista pointed out that Dewey lacked the imagination to consider what Bastiat wrote about in the 1800s as the unseen, or how much different and potentially better things could be without government involvement.

I agreed.  But, this is a difficult point to grasp because it’s abstract.  It’s difficult to imagine how things might be different.  That’s because most good things are a result of accidental innovation.  None of us can really imagine the unseen because that would require us to be able to predict something we can’t predict — which accidental experiments will be successful.  If you could predict such things, you should do very well investing in the stock market or directly in business start ups.

But, I wanted to try to bring this abstract point home.

I wrote to JD that he was using the wrong reference point to determine if the horse and man add value.  He was using “nothing” or an untilled field as the reference point. Certainly, a horse and man can produce more crop than an untilled field.

But, the untilled field is not the correct reference point.  It ignores opportunity cost.  A better comparison is the powered tractor field because powered tractors are readily available an in use these days.  The horse and man will produce less per unit of input than the tractor and man.  Even if the man can’t afford to buy the tractor, he can afford to buy crops grown by other people with tractors.  So, it’s not worth his time to try to produce crops with his horse.

JohnDewey disagreed.  He still contended that man/horse added some value.

I used one more example.

I appointed myself his new manager at work and declared that I didn’t trust any technology that’s been developed in the last 40 years, so he and his co-workers must carry out their work with tools and methods that have been around longer than that.

I imagine when my superiors experience my team’s productivity sinking to a fraction of what it was before, they wouldn’t buy JohnDewey’s argument that “it’s better than nothing.”  Neither will shareholders.  They’ll correctly compare our new output to what it could be using modern tools and methods and fire me because they will have correctly viewed that I damaged, rather than helped, the team.

We Can Now Afford Gardens

This EconLog Everything’s Amazing, Nobody’s Happy post today from Arnold Kling ended with Kling observing:

Today, we take specialization and trade for granted. We get ticked off when the government “fails to create jobs.” Yet the unemployed do not revert to growing their own food, sewing their own clothes, and dipping their old candles.

That reminded me of recent Ellen show (yes, I’m a fan) where she showed off her new garden and expressed her delight in its bountiful, fresh produce.

While watching, it occurred to me that just how wealthy we really are.

We use to grow our own food out of necessity.  Then, through trade and specialization we became better off and didn’t have to grow our own food anymore.   Really what happened was that the opportunity cost of growing our own food became so great that we didn’t do it.  We could get more food by doing what we did best, whatever that may be.

Now, we are so well off that we can grow our own food again.  There’s nothing better for Ellen to do than to pay* someone to plant and tend a garden so she can enjoy fresh produce.  What use to be a necessity that was tended by our own hard labor is now a luxury item, like having a pool or hot tub.

It would actually be a sign that we are becoming less well off if people stopped tending (or have others tend to) to their gardens.

Come to think of it, Arnold Kling would make an interesting guest for Ellen Degeneres.

*I use the word pay loosely here.  The segment showed other people building her garden for her.  She may not have paid them directly with money (or she might have), but she did pay them with something – air time perhaps.

Easy to Understand Example of Opportunity Cost

My wife was talking to a friend about daycare.

Her friend works four days and is off one day a week.  She was disappointed she couldn’t find a daycare that would let them pay for four days a week.   They would have to pay for five, even though they would use the daycare only four days each week.

My wife explained that if they didn’t pay for five days a week, the daycare center could easily find another kid to fill the slot for five days a week so the day care center could maximize their sales, but it would be much harder to find parents needing to use the daycare just one day week, that happened to coincide with her day off.

I heard her say that and tried to explain to her that she understands the economics concept of opportunity cost.  The opportunity cost of the daycare would be forgone revenue of a five-day-a-week child, when they have the capacity for that, to accept the four-day-a-week child.

I went on to explain that if you could find a daycare that would take her money for four days a week, then she might want to consider taking that as a sign that daycare may not be very good, so paying more for the 5-day day care would be well worth it.