Undergraduate Economist

Perspectives of an economics student

Towards an Objective Understanding of Scarcity

Posted by Alex M Thomas on November 26th, 2013

When Henry Holt & Co. sent me an advance edition of Sendhil Mullainathan and Eldar Shafir’s Scarcity: Why Having Too Little Means So Much to review, I had presumed it to be another book on the ubiquitous nature of scarcity. However, their book, while acknowledging the phenomenon of scarcity to be omnipresent, argues, in a novel manner, the adverse effects scarcity has on the cognitive resources of individuals. In other words, scarcity (of money, time, etc.) forces people into a scarcity-trap: the poor stays poor; the busy remain busy; and the lonely remain lonely. For, ‘[s]carcity creates a mind-set that perpetuates scarcity.’ The aim of their book, writes Mullainathan and Shafir, is ‘to unravel the scientific underpinnings of scarcity’ in order to make more sense of ‘social and behavioral phenomena’ and is targeted at a ‘wide audience’. Their book is an attempt to present ‘the logic and consequences of scarcity.’

‘Scarcity captures our mind. … It changes how we think. It imposes itself on our minds.’ And, ‘scarcity’s capture of attention affects not only what we see or how fast we see it but also how we interpret the world.’ Hence the authors argue that scarcity ‘is not just a physical constraint. It is also a mind-set.’ The consequence of scarcity, according to Mullainathan and Shafir, is that it makes ‘us less insightful, less forward-thinking, less controlled.’ It reduces our ‘bandwidth’ – our cognitive ability. There is however a positive outcome of scarcity, the ‘focus dividend,’ which makes us more effective in the immediate period but ‘scarcity eventually ends in failure.’ They label the mechanism which reduces our cognitive resources ‘tunneling’. ‘Sometimes when we tunnel, we neglect other things completely.’ ‘Focus dividend’ is a short-term positive outcome of scarcity whereas ‘tunneling’ is a long-term adverse consequence arising from the tax scarcity imposes on our bandwidth. They are, in fact, interdependent phenomena. Based on their experiments, they observe that poor people ‘tunnel’ and therefore do not purchase insurance which would have helped them in the future. For, ‘scarcity taxes bandwidth’ and ‘generates internal disruption’ by lowering ‘fluid intelligence and executive control’. The authors acknowledge the role ‘self-control’ could play in overcoming scarcity, but they note that ‘will-power’ is something which is not yet fully understood. To summarise: ‘[t]he problem is not the person but the context of scarcity.’

Opposite of scarcity is ‘slack’ or ‘abundance’. ‘Slack’, writes the authors, ‘is a consequence of not having the scarcity mind-set.’ Those who have an abundance of resources (money or time) have the luxury not to make trade-offs. Additionally, ‘[s]lack gives us room to fail.’ Scarcity therefore not only leads to ‘greater errors’ due to the bandwidth tax, but also implies that there is ‘less room to fail.’ Marginalist economics treats any unused or underutilised resource as wasteful and inefficient and the authors follow this logic. Although, in the later part of the book, they distinguish between useful and useful slack. Of course, what is useful or wasteful depends on the goals or aims of the individual, organisation or government. The subjective assessment of physical/objective scarcity is also dependent on the goals, and the process of tunneling depends on this subjective measurement of scarcity and the goals. Therefore, the experience of scarcity is in itself conditioned by the goals and they affect each other in a dynamic fashion – reasoning is not limited to the means to achieve the ends, but it also can modify the ends. In the initial chapters, the authors, using results from experiments, quite convincingly argue that the subjective feeling of scarcity generates an objective result – it taxes the bandwidth and lowers the cognitive ability. In fact, the entire book can be seen as an attempt to provide an objective understanding of scarcity (which can be real or imagined or both).

Scarcity leads to borrowing. Borrowing, according to the authors, is a ‘simple consequence of tunneling.’ Although, it is conceivable that scarcity can lead to borrowing, it certainly cannot be maintained that all borrowing is because of tunneling. The phenomenon of a debt-trap is nothing new. ‘Scarcity leads us to borrow and pushes us deeper into poverty.’ Scarcity, writes the authors, causes the poor to focus more on immediate (short-term) goals and they overlook long-term goals. The focus on several short-term goals is termed juggling, and is a ‘logical consequence of tunneling.’That is, the poor resort to ‘short-term fixes.’ Can one get out of scarcity? Without some external intervention, the authors argue, it is highly unlikely. For, getting out of the scarcity-trap requires a (long-term) plan but since the goal is not immediate, the scarcity mind-set does not accommodate it. ‘Planning requires stepping back, yet juggling keeps us locked into the current situation.’ Also, ‘future planning requires bandwidth, which scarcity taxes heavily.’ To state the obvious, the authors note that ‘[a]ll this is complicated by the lack of slack.’ Scarcity implies a lack of slack. Similarly, slack implies a lack of scarcity. Owing to the objective effects of scarcity on cognitive resources, getting out of a scarcity-trap is extremely difficult, be it those who lack money or time.

Chapters 7 and 8 are devoted to understanding (income) poverty and some suggestions are offered for improving the lives of the poor. The authors rightly argue that the extant explanation of poverty is largely ‘piecemeal.’ Their major contribution, I think, to studies on poverty is that the poor ‘lack not only money but also bandwidth’ as a consequence of their income poverty. As they ask: ‘Why not look at the structure of the programs rather than the failings of the clients?’ This bandwidth tax is something the designers of social programmes ignore. Therefore, ‘strong incentives’ do not often function well. The authors call for social programmes which are ‘fault tolerant’ given the already taxed bandwidth of the poor. A limit ‘penalises but fails to motivate’ the poor and according to the authors such limits/penalties on incentives are flawed because they do not take into account the cognitive effects of scarcity. ‘Limits create scarcity, the logic goes, which might lead to better management of how the resource is “used.” This almost relies on the psychology of scarcity. But it is flawed.’ A better solution, according to Mullainathan and Shafir, would be ‘to create smaller but more frequent limits.’

A greater focus on the creation of dependable jobs and stable incomes for the poor across the world could be psychologically transformative.

All this is a radical reconceptualization of poverty policy. … Now, rather than looking at education, health, finance, and child care as separate problems, we must recognize that they all form part of a person’s bandwidth capacity.

A powerful and political conclusion emerges from the authors: social engineering should be built on better foundations, in this case, that of the psychology of scarcity.

Chapter 9 is titled ‘Managing Scarcity in Organizations’ wherein the importance of slack is stressed, in contrast to the views espoused by the ‘efficiency experts.’ Organizations should ‘explicitly manage and ensure the availability of slack.’ In other words, the quality of the workplace must be improved – less surveillance, adequate leaves, reduced working hours, etc. For, as the authors note:

Increasing work hours, working people harder, foregoing vacations and so on are all tunneling responses, like borrowing at high interest. They ignore the long-term consequences.

In line with the optimizing story told by marginalist economics, Mullainathan and Shafir emphasise the need to ‘maximize our limited cognitive capacity.’ They call for a greater focus on the ‘cognitive side of the economy’ and even go as far as to suggest the creation of a ‘Gross National Bandwidth’ index!

Despite the authors adopting some static concepts employed in marginalist economics of a very subjective nature, their research points towards a very dynamic and objective understanding of scarcity. Moreover, the adverse consequences of scarcity on cognitive resources highlight the extreme importance of careful social engineering, especially in the reduction of poverty.

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Posted in Behavioral Economics, Book reviews, Economics, Marginalist economics | No Comments »

Two Fundamental Objections to Marginalist Economics

Posted by Alex M Thomas on October 31st, 2013

In the past, several posts on this blog have raised dissatisfactions and have expressed discontent with the prevalent orthodoxy in economics – neoclassical economics (more accurately, marginalist economics). This post is similar in intent as the previous posts, but it chooses to focus on, what I deem to be, the two most theoretically and empirically inadequate tenets of marginalist economics: (1) the marginal productivity theory of (income) distribution and (2) the supply-side growth theory.

Equilibrium prices and quantities of commodities and factors of production (such as labour and ‘capital’) are determined simultaneously in marginalist economics. Distribution is endogenously determined according to the relative scarcity of factors, i.e., based on the demand and supply of factors. Under conditions of perfect competition, in equilibrium, the wage rate equals the marginal product of labour and the profit rate equals the marginal product of ‘capital’. That is, there is no surplus in the marginalist theory of value and distribution. The origin of the marginal principle is to be found in Ricardo’s discussion of intensive rents. This principle has been illegitimately extended to labour and to ‘capital’. In marginalist production theory, labour is freely substitutable with ‘capital’. The famous Cobb-Douglas production function is based on the substitutability of the two factors of production. The use of the aggregate production function has been shown to be logically unsound (due to problems of not just measurement but also aggregation of ‘capital’) and therefore its applicability in empirical analysis is severely undermined. But, this logical critique, famously known as the Cambridge Capital Controversies, remains ignored.

Underlying the supply-side theory of growth is the marginal productivity theory of distribution. Relative scarcities of the factors induce changes in their prices such that the demand for factors equals their supply. This implies that, in equilibrium, all factors are employed. The real wages are assumed to be sufficiently sensitive to disequilibrium in the labour market such that they adjust in order to render the labour demand equal to its supply. And, the aggregate production function states that a growth in the factors will lead to a growth in output. In other words, if the labour and ‘capital’ endowments are increased, there will be higher growth. Aggregate demand adapts to aggregate supply and the possibility of an aggregate demand deficiency is ruled out. Slight modifications have been made to this theory in order to explain the presence of unemployment. These modifications take the form of rigidities of the real wage, which cause labour unemployment. In marginalist theory, one of the explanations for the presence of unemployment is labour market rigidities. If these rigidities are absent, labour will tend to be fully employed. Such theories have come under severe criticism and rightly so.

To conclude, marginalist economics is unsatisfactory on logical grounds. Moreover, it does not perceive the possibility of an aggregate demand deficiency. Lastly, unemployment is seen to be a consequence of imperfections or rigidities and not as permanent feature of competitive economies.

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Posted in Economic Growth, Economics, Marginalist economics, Neoclassical Economics | 1 Comment »

Robert Torrens: An Introduction

Posted by Alex M Thomas on September 30th, 2013

Robert Torrens’s An Essay on the Production of Wealth (1821) is an important contribution to economic theory, in particular, to classical economic theory. Torrens was involved in the founding of the London Political Economy Club along with James Mill, David Ricardo, Thomas Tooke and others. Torrens has written extensively on monetary issues, on colonisation and on price theory. He is also credited with having discovered the comparative costs principle independently of Ricardo. This blog post focuses on his contributions to the theory of value and the possibility of a general glut in his debate with Ricardo.

Torrens is one of the very few (to be precise, nine) economists mentioned by Piero Sraffa in his Production of Commodities by Means of Commodities; Sraffa approvingly cites him for his method of treating fixed capital. Fixed capital is conceptualised as a distinct commodity (a joint product) alongside new commodities which emerge from the production process. Torrens utilises a theory of value based on ‘capital’ as opposed to Ricardo’s labour theory of value. But, how is ‘capital’ to be measured without the knowledge of values/prices? Ricardo recognises that when labour-capital ratios are not uniform across sectors, value will not be proportional to the embodied labour. And, as Carlo Benetti writes in his entry on Torrens in The Elgar Companion to Classical Economics, when the rate of profit is zero, the labour theory of value holds; however, the existence of positive profits does not per se invalidate Ricardo’s labour theory of value. A satisfactory resolution of this problem in value theory is to be found in Sraffa’s simultaneous determination of profits and prices.

The macroeconomics of Torrens, built on his theory of value and distribution, suggests the possibility of a general glut in the economy. On general gluts, Torrens writes: ‘a glut of a particular commodity may occasion a general stagnation, and lead to a suspension of production, not merely of the commodity which first exists in excess, but of all other commodities brought to the market’ (Torrens 1821: 414; as quoted in the Benetti entry on page 473). The underlying reason for this is a disproportion between the different sectors of the economy. Owing to the structural interdependence prevalent in an economy, a disproportion can lead to a fall in ‘effectual demand’. This will lead to a glut in commodities in that particular sector and in other sectors as a consequence of a fall in sales and incomes in that sector. This, evidently, is in direct contrast with Say’s law, loosely understood as – supply creates its own demand.

Other notable commentators on Torrens include Giancarlo DeVivo and Lionel Robbins. The latter published his work in 1958 entitled Robert Torrens and the Evolution of Classical Economics. In 2000, DeVivo edited and put together the Collected Works of Robert Torrens. Studying Torrens will certainly prove invaluable in gaining a deeper understanding of classical economics, and especially his views on general gluts might have contemporary use in relation to the economics of Keynes and Kalecki.

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Posted in Classical Economics, Classical Political Economy, David Ricardo, Economic Thought, Economics, History of Economic Thought, Keynes, Macroeconomics, Michal Kalecki, Sraffa | No Comments »

Misunderstanding Economic Growth and Development

Posted by Alex M Thomas on August 25th, 2013

If two previous posts dealt with trying to understand how economic growth may or may not translate into development, this post goes a step behind and discusses what economic growth means. More importantly, this post examines what economic growth does not mean. The motivation for this blog post comes from Jagdish Bhagwati and Arvind Panagariya’s 2013 book titled Why Growth Matters: How Economic Growth in India Reduced Poverty and the Lessons for Other Developing Countries. Note that the following paragraphs are not intended to be a detailed review of the book; only their central premise – ‘the centrality of growth in reducing poverty’ (p. 4) – will be engaged with. The blog post, however, ends with a critical commentary on the authors’ methodology (focusing on authors’ engagement with opposing views, presentation of authors’ own arguments and referencing), as contained in the Preface, Introduction and the first three chapters. Also, no comments are offered on the data analysis present in their book.

A premise is ‘a statement or proposition from which another is inferred or follows as a conclusion.’ Bhagwati and Panagariya start with the premise that economic growth entails increase in employment opportunities and an improvement in income per person. This is also their conclusion, and forms the title of their book. They write:

Bhagwati argued nearly a quarter century ago that growth would create more jobs and opportunities for gainful improvement in income, directly pulling more of the poor above the poverty line and additionally would allow the government to pull in more revenues, which would enable the government to spend more on health-care, education, and other programs to further help the poor. Growth therefore would be a double-barrelled assault on poverty. (p. xix)

Further, they write: ‘growth helps by drawing the poor into gainful employment’ (p. 23). A simple question is sufficient to negate this view. Does the market create jobs after taking into account the abilities and skills of the poor? Of course not! If so, there would not be any unemployment or underemployment. A well-educated (and healthy) workforce is necessary so as to actually ‘gain’ from the newly created employment opportunities. [Not to forget the hardships involved in deskilling and reskilling.] And, it is not logically necessary for employment opportunities to increase when the economy grows. Jobless growth is a possibility where the surplus is not used to create further jobs; more often, it is a question of whether jobs are being created at the same pace as at which the economy grows.

By definition, economic growth entails a rise in income. But whose income? Economic growth can co-exist with the rich getting richer. Or, economic growth can give rise to stagnant wage shares amidst productivity rises. Growth can be export-led. It can be service-led. It might favour capital-intensive over that of labour-intensive technology. A rise in real GDP can happen because of a variety of reasons. It is these ‘reasons’ that one must investigate. For, it is here that we will find answers as to who the beneficiaries of economic growth are. It is to the mechanisms or processes which generate economic growth that we must attend to in order to comprehend which sector/classes/groups are losing out. For example, the nature and consequences of service-led growth will be very different from that of growth that is manufacturing-led. Bhagwati and Panagariya repeat the same fallacy, pointed out in the previous paragraph, in the following passage.

Conceptually, in an economy with widespread poverty, labor is cheap. Therefore, it has a comparative advantage in producing labor-intensive goods. Under pro-growth policies that include openness to trade (usually in tandem with other pro-growth policies), a growing economy will specialize in producing and exporting these goods and should create employment opportunities and (as growing demand for labor begins to cut into “surplus” or “underemployed” labor) higher wages for the masses, with a concomitant decline in poverty. (p. 23; see p. 43 as well)

Conceptually, in an economy with excess labour supply, labour is cheap. Bhagwati and Panagariya argue that a growing economy with cheap labour will adopt labour-intensive techniques. This reasoning assumes that an unemployed farmer or school teacher can easily and naturally be employed in a firm which exports computer parts. The authors’ views seem to indicate a gross misunderstanding of the actual economic dynamics of any society (see below as well). Moreover, one is not just concerned with mere employment, but with employment that provides good working conditions – including sick leave, maternity leave, overtime wages, etc.

‘The pie has to grow; growth is a necessity’ (p. xx). Yes, a larger surplus makes it feasible for each claimant to get a greater share, including the government. The contention is with respect to the feasibility and who these claimants are. According to Bhagwati and Panagariya, growth automatically and naturally generates higher incomes per person thereby ‘directly pulling more of the poor above the poverty line.’ Growth is not manna from heaven which everyone gets in equal amounts. It is based on definite political, economic and social institutions/processes – wage bargaining, possibilities of reskilling, mobility of labour, gender, caste, family structure, social security nets (family based or from the government) and so on. In this context, the authors rightly note the negative effects excessive licensing, government monopolies and protectionism can have on the growth of an economy (p. xii).

Given the authors’ belief in a strict one-way causation running from economic growth to development, they argue for carrying out growth-enhancing reforms first, which they refer to as Track I reforms. Subsequently, the surplus can be redistributed by the government to achieve development; this can be through transfer payments of various kinds. These are known as Track II reforms. They argue:

Track II reforms can only stand on the shoulders of Track I reforms; without the latter, the former cannot be financed. (p. xxi)

Of course, they can be financed through government borrowing and there is ample literature on the issues surrounding debt-sustainability in relation to achieving full employment. One wishes to see a more nuanced understanding of such matters.

This separation of growth from development is not just illogical and untrue, but also dangerous to public policy. Often, for purposes of economic theorising, in order to carefully study the causal relations between variables, some boundaries are drawn and certain assumptions are made. But, an import of this technique into the domain of public policy is methodologically flawed, where the abilities of individuals to seek jobs and actually work and earn (higher) incomes crucially depend on their social, cultural and economic backgrounds. In other words, while the distinction between economic growth and development might be reasonable for some purposes, in practical politics, they go together. Moreover, if the policy objective is to ensure good quality of life for all, then it must be the case that, to use the authors’ terminology, both Track I and II should be undertaken at the same time, with perhaps a greater emphasis on Track II reforms.

A fundamental error underlies the authors’ belief that ‘growth’ is an automatic process which takes place when the government lets the private players have a completely free hand, international trade is free, and capital can freely flow in and out of the country. It is this notion which makes the authors’ note that ‘Track II reforms involve social engineering…’ (p. xxi). That is, in their view, Track I reforms require no ‘social engineering’. Nothing could be farther from the truth! A ‘market’ is an engineered institution. The belief that ‘free markets’ will deliver both economic and social justice is quite easily discernible from their statements. Making commodity markets free (from both government and private monopolies) is certainly beneficial for economic growth as well as for wider socio-economic development. But, given the (historical or otherwise) arbitrariness (as opposed to ‘merit’) involved in the ownership of various forms of assets, and the tendency of markets to favour the powerful, there is always a crucial role for the government and civil society to intervene in order to ensure social justice (especially in the arenas of education and health). After all, is this not what we mean by participatory democracy?

The preceding commentary is based on a partial reading of Bhagwati and Panagariya’s book, as noted in the introductory paragraph. Their conception of growth, at best, seems superficial and at worst, they misunderstand the dynamics of economics growth as well as development. The view of ‘free markets’ generating growth with rising incomes per person is never an automatic process. It requires visible hands and is indeed social engineering. We end with a few observations on their methodology. For them, all that their critics say are myths; Part I of their book is titled ‘Debunking the myths.’ On one occasion, some of the critics, who are hardly ever named (and therefore not cited), are accused of being ‘intellectually lazy’ (p. 25; also see p. 32, p. 34, p. 35 for the unnamed critics). On the other hand, the following phrases are used for arguments in their own support: ‘state-of-the-art techniques’ (p. 31), ‘detailed state- and industry-level data’ (p. 31), ‘compelling nature of evidence on the decline of poverty under reforms and accelerated growth’ (p. 33), ‘irrefutable evidence’ (p. 37), ‘evidence…is unequivocal’ (p. 38) and ‘these authors’ superior methodology’ (p. 43). Out of the total number of references excluding data sources and reports (around 125 in number), about 37% (around 47 in number) are references to the authors’ work, either as a sole author, a co-author or as the editor of the volume. This is very striking. And, out of citations to Panagariya’s work (about 27 in number), 14 of them are newspaper articles published in the Times of India or Economic Times. It is indeed unfortunate to come across so many fundamental errors in a book like this, because growth does matter, although not at all in the way Bhagwati and Panagariya expound in their book!

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Posted in Book reviews, Development Economics, Economic Growth, Economics, Education, Employment, GDP, Government, India, Labour Economics, Macroeconomics, Markets, Neoclassical Economics, Poverty, Unemployment | No Comments »