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[Note for bibliographic reference: Melberg, Hans O. (1997), Five short ideas, http://www.oocities.org/hmelberg/papers/970609.htm]

 

Five short ideas
Nurses, Keynes, Hirschman, Popper and Akerlof

by Hans O. Melberg


Introduction
Time is scarce and my memory is imperfect. Hence, to save time, and to avoid forgetting some of these thoughts, I have decided to write down five ideas which I originally intended to write as five separate observations. I have to warn potential readers that these ideas are not scrutinised too closely. There are probably lots of background assumptions and variables that I have ignored. As before, criticism and comments are welcome.

1. Nurses
In the newspaper Vårt Land there was recently an article about the shortage of qualified nurses and pre-school teachers in Norway. The paradox, however, was that a survey revealed that several thousand people who were educated as nurses and pre-school teachers had decided not to work within their profession. Thus, the problem - it seems - was not the number of people trained, but the number of people who chose to work within their profession.

My first reflection was that this is what happens when the government sets the wage. If the laws of the free market were allowed to work, the wages of nurses would rise until the shortage was eliminated (assuming that the supply is not backward bending - in which case the system is unstable). However, a second reflection also hit my mind: The problem was not only the wage. In fact, there is an interesting vicious circle here: When there is a shortage of nurses, those who work as nurses are under constant pressure to work fast. This, in turn, makes it less attractive to be a nurse (at a given wage). In short, few nurses makes it even less attractive to work as a nurse. Some nurses may even decide to quit because of the stress (and some qualified nurses who would otherwise accept the given wage will not work since it is too stressful). But, when some nurses quit it becomes even more stressful for those who are left - leading to even more nurses to quit their work. In short, we have an bad circle.

I do not claim that this circle is the main factor behind the lack of qualified nurses in Norway. I do, however, believe it is one possible mechanism. The interesting point about this mechanism, is its potential for creating instability. We like to think about the free market as self-correcting and stable. This example shows a mechanism which leads to the opposite conclusion - the market mechanism left to itself would be "explosive" and unstable (For another example of the same, consider a Cob-Wed structure in a market in which the suppliers increase the supply when the price is low e.g. a family which makes more cogs in order to achieve their needed income when the price is lower). This may justify government intervention and some form of central planning. As an extreme example, imagine the government sent a letter to 3000 qualified nurses telling them to where to work. This could solve the co-ordination problem between the nurses which prevents them from working within their profession. But, of course, in a liberal society this kind of ordering mechanism is unacceptable). However, I do not want to stretch the conclusion too far. There are many other factors at work, and a single mechanism leading to instability does not make the whole aggregate market unstable. Nevertheless, knowledge of these mechanisms may be of use when we are analyzing a problem (such as the lack of nurses) and prescribing cures - e.g. try to reduce stress as opposed to increase the wage in order to attrach more nurses.

2. Was Keynes wrong?
In the book The Unemployment Crisis Layard, Nickell and Jackmann discuss the problem of why there is persistent rationing of jobs (unemployment). One answer to this is the so called dis-equilibrium models based on rationing in the goods market (the firms cannot sell as much as they want, thus they do not employ "enough" labour to clear the market). For example, Malinvaud, and Barro and Grossman have built models based on this. However, LNJ reject this approach because the models imply "an arbitrary rigid price which prevents perfect competitors from selling all they want to: we know of no mechanism that could sustain such a price" (p. 33). The argument seems valid. There is little reason to believe that the producers are rationed on the goods market since they are free to lower their price in order to sell more (true, there are some mechanisms, such as menu-costs, which create some degree of rigidity. However this is not enough to sustain a dis-equilibrium price over time).

Does this mean that Keynes was wrong - that there is no such think as Keynesian unemployment (unemployment caused by low aggregate demand)? I need to think more about this (especially about Clower's dual decision hypothesis, and the co-ordination problems which occur when all firms try to reduce costs (wages) in order to reduce price and sell more). However, there is an alternative interpretation of Keynes. To examine this we have to assume that we live in a world of uncertainty. Imagine a firm which decreases the price of its product in order to sell more. What if customers take this as a signal that the price is going to decrease even more in the future? If expectations are formed in this way, a price reduction may actually lead to a decrease in sales. Once again we have a mechanism which leads to instability - an adjustment away from equilibrium after a shock. However, once again I think there are many other factors at play, and the mechanism described above need not dominate.

3. Was Hirschman wrong?
I recently wrote an article in the student journal Observator in which I argued that Hirschman's analysis of exist and voice may serve as a justification for a monopoly. The argument was that in a monopoly the customer was forced to complain (use voice) when something was wrong, while in a market with many firms the customer could simply stop buying the product (exit). The reason this may justify a monopoly, is that voice may be a better communicator of information than a decrease in profit, since the firm will know exactly what the customers are dissatisfied about. Hence, a monopoly may be best because it forces people to use voice, not exit. However, Ole J. Røgeberg pointed out to me that this argument is flawed.

The argument is flawed because profit maximizing firms would seek the information communicated by voice as long as it was profitable. Film-producers test their movies on small audiences before they release the film; Ice-cream producers test their products before they are released; Most companies try to encourage feedback from customers by rewarding those who respond - you get chocolate if you complain to the chocolate producer! Hence, the voice I thought could be gained by having a monopoly, is already exploited in the free-market. There might, of course, be imperfections in this mechanism (if people have high discount rates they will not be motivated by the reward, or of the ability to use voice effectively is unevenly distributed such as among parents of children in a school), but the pro-monopoly argument also has many flaws. For example, why would a monopoly care about voice (the complaints)? Hence, I think Hirschman's analysis represents a weak case for monopolies.

4. Unfalsifiable theories, Popper
In a previous observation I argued that even unfalsifiable theories might be assigned a probability of being true and hence should not be discarded (see Why unfalsifiable theories are also worth considering). I still think there is some value to this argument, but my interpretation of Popper may be incorrect - or at least incomplete. To understand why, consider the following arguments (from The Economist, 31. May, 1997, p. 31):

The Monopolies and Merger Commission in Britain has recommended to ban recommended retail prices across a wide range of electrical goods. The reason was that the firms used these recommended prices to discourage price competition between retailers. One piece of evidence used by the commission, was that the price of many products did not vary much between retailers. Typically the prices of 90%, 80% and 75% of (respectively) the washing machine Hotpoint WM22, the tumble-dryer Zanussi TD520, and Bosh's dishwasher SMS 4452 were within a narrow 5% band. This indicates a small degree of price competition. However, the producers complained and argued that "the similarity in prices is evidence not of collusion but of fierce competition" (p. 31). This is interesting: We have one piece of evidence (the similarity of prices) and two radically different interpretations.

I guess it is this kind of problem that Popper (and Kolstø - see the previous observation) was worried about. I also think they were right to worry about this, but I still believe one might find evidence to discriminate between the plausibility of the two theories (although one might not be able to falsify one completely). For example, if the firms are correct that it is the fierce competition which is producing the uniform prices, they should not be afraid of the ban on recommended retail prices. Thus, their resistance against this move makes me believe that RRPs actually do hinder competition - and the interpretation of the uniform prices as evidence of collusive behaviour is more plausible than the "fierce-competition" argument.

5. Prices as signals
In economics one often speaks about prices as signals. The standard theory is that prices are good conveyers of information i.e. good signals. A higher price signals an increased demand - and investors will expand the capacity in that sector. In this way the price signals make sure that the structure of the economy is adjusted to the preferences of the population. However, the theory isn't as easy as it may appear.

One exception is presented by Akerlof in his article on adverse selection and lemonds. In this article he shows how the price signal does not fulfil its function. The problem occurs when there is asymmetric information and the price is taken as a sign of quality. For example, in the market for second-hand cars the seller knows the quality of the car, while the buyer has less information. The price demanded for a second-hand car may then become a signal of the quality of the car (the seller will demand more for good quality cars). However, when the price is a signal of quality the seller of a bad car may try to bluff: To charge a high price in order to fool the buyer into believing that this is a good second hand car. Now, to make a long story short, the buyer knows he might be bluffed so he will never pay as much as the seller of good quality cars demand for their cars. The end result is a market failure (caused by asymmetric information): There is no market for good quality second-hand cars.

There are many more examples of signals in economics. Spencer's model of education as a signal; signalling in game-theory (to signal your type e.g. by drinking beer to signal that you are tough even if you really want Fanta!); Veblen argues that we buy expensive products to signal that we are rich. All of these exemplify the complexities of signalling in economics. Prices are not always perfect signals leading to market equilibrium. In fact, I mentioned another possible exception to the question about Keynesian unemployment. A decrease in price may be taken as a signal not to buy more, but to wait in order for the price to fall even more!

I now want to discuss a more general frame for signals in economics, and I want to give an example of market failure which may be original (!). The first question concerns this: What do we want our signals to achieve? The price mechanism serves at least two functions. First, it allocates goods at any point in time (those who pay most get the goods). Second, it directs investments since goods in high demand will fetch a high price which, in turn, will lead to more investment in that sector. One might call this the static and the dynamic function of prices. The interesting questions are now: First, do the static and the dynamic function of prices conflict. Second, are price signals a good way to allocate resources? Third, is the price mechanism a good way to co-ordinate the adjustment of size of the various sectors in the economy?

The first question is quite well explored. From Tinnbergen we know that the same mechanism cannot be expected to maximize two objective functions at the same time i.e. there is probably a conflict between static and dynamic efficiency. For example, Schumpeter has argued that monopolies are dynamically efficient, but statically inefficient. The precise mechanism is that monopolies earn enough profit to invest in research and development, while firms in a perfectly competitive market do not have the same resources to invest and improve efficiency (This argument has many weaknesses, but I will not discuss these here).

As for whether the price mechanism is a good way to allocate resources, this is a normative question. Consider, for example, an economy with individuals who have different abilities. Assume person A earns $5000 a month, while person B gets $2500. Assume also that a certain good - say a ticket to a football game - would increase A's utility by 10 units, while it would increase B's utility by 15 units. It is fully possible in this economy that A gets the ticket, even though B would benefit more in terms of utility from the ticket. The ticked does not go to the one with the highest utility valuation because income is unevenly distributed. There are, of course, many hidden assumptions in this example. For example, there are problems of interpersonal comparison (and there is an incentive problem if we start compensating lack of ability since this would make it less profitable to work in order to acquire skills). Moreover, the example is not a general proof that a market economy in general does not tend to give goods to the people who will gain the most utility from the good. In short, there are many more factors at work than can be discussed in a single paragraph!

Third, dynamic efficiency. In the example of nurses (question 1) I argued that the free market would solve the problem of a shortage of nurses by increasing the salary of nurses. I now want to examine this mechanism a bit closer in order to see if this mechanism is efficient. The key is this: While it seems necessary to increase the salary to attract new nurses, it is not necessary to increase the salary of the nurses who are already working on order to make the "nurse" sector bigger. However, the free market does both: A lack of nurses drives the wages of all nurses up. I wonder whether this represents an inefficiency which could be avoided. Then again, it does not really represent a dynamic inefficiency (a rise in wages will lead to more nurses - unless the supply curve is backward bending). The problem is more that the cost is too high compared to what it could have been in an imaginary ideal (?) world in which we could target the signals more precisely.

[Note for bibliographic reference: Melberg, Hans O. (1997), Five short ideas, http://www.oocities.org/hmelberg/papers/970609.htm]