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April 09, 2010 – Comments (15)

Stop me if you heard this one before: an economic report is released and economists are suprised.  That only happens, oh, every week or so. This week it was rising jobless claims.  Economists are surprised.  This is a minor indescretion, like a meteorologist being off a few degrees on tomorrow's high temperature forecast.  Sadly, this is as good as it gets for modern economists.  All too often they miss Level 5 Hurricanes heading straight for the coastline. It makes us wonder whether we need an economics profession at all.

In this blog, I am going to attempt to explain that we need more economic inquiry while also showing why current mainstream economic thought is so dramatically flawed. 

I'll Trade You St. Charles Place for Marvin Gardens

We all played the Monopoly game as children and many of us still play.  It's a fun game of luck and strategy.  But it's just that - a game.  Unfortunately, for mainstream econ, Monopoly is representative of real life in all the wrong ways.  What do I mean by this?

Let's say you land on the Red properties (Illinois, Indiana, Kentucky.)  You purchase them, build them up with hotels, and start collecting rents.  Your rival lucks into the Green properties with higher initial costs, but higher rents.  All other things being equal, your chance of beating your rival is very low.  He has an unbeatable competitive advantage.

This situation, very common in a board game, does not in any way represent real life.  In real life, there are an infinite number of ways, limited only by your imagination, that you can reclaim a competitive advantage.  Your hotels on the board are homogeneous.  You can't do anything to make your Red property hotels more attractive to increase your rents.  In real life, the only thing stopping you from differentiating your product is YOU.

Competition is the dynamic rivalrous process of discovery that coordinates the actions of market participants.

The above definition of competition was the standard one up until the 1920's/1930's. 

First off, what does the definition say?  It says that entrepreneurs engage in a process of discovery.  That means they are going out and looking for ways to satisfy consumers.  It says that this process is crucial and essential because it coordinates market participation, i.e winners make money and are rewarded for satisfying consumer wants and losers lose money because they failed at this task. 

Notice that it doesn't say that entrepreneurs are always right.
It doesn't say that consumers know what they want or are omniscient.
It doesn't say that there is no luck involved.

The definition makes none of these assumptions.  There can be luck.  There can be genius.  There can be stupidity.  There can be any combination of the aforementioned attributes.  All of these things come together, but in the end the final verdict is whether or not consumer wants are satisfied.

Entrepreneurship is an essential element of economics.  Ignore it at your own peril, and that is exactly what modern econ has done, starting with the scientistic revolution that occured in the 1920's (circa).

We Can't Model Human Behavior So We Pretend It Doesn't Exist

So what happened?  The physical sciences had been extremely successful in explaining the physical realities of our world.  Their spectacular success made them somewhat the envy of the academic world.  Academics is a rather thankless job.  If your ideas do not translate into immediate, tangible results that common people can grasp, acclaim is rare.  Despite what romantics tell you, scientists and academics, just like every other human on this planet, find praise to be flattering.

The success of the physical sciences led many academic economists to break away from theoretical ideas and attempt to copy/mimic the physical sciences.  After 80 years, the results have been completely disastrous.  The theoretical schools saw this coming.  You can't model human behavior. Humans do not bounce around in jars like atoms, reacting exactly the same way to outside forces.  Humans react differently, they think differently, and they are unique entities with their own beliefs, goals, motivations, etc.

Nowhere is the failure of modern econ more striking than in the areas of entrepreneurship, competition, and monopoly. 

The Textbook Challenge

I want you to take up the following challenge: get a hold of a college level Econ textbook, flip to the index and look up the word entrepreneur.  I bet you will find nothing more than a quick reference to its existence, perhaps a page or two.  Some recent texts (mid 1990's and beyond) have started to reflect an inreased desire to understand entrepreneurship and may dedicate a whole subsection.

Modern scientistic econ modelers can not develop a model of entrepreneurship and so it was almost completely removed from modern economic thought.  Does this sound like a good idea to you?  To remove one of the most essential economic forces from the study of economics?  Do you see now why modern econ is challenged to come up with explanations for market phenomenon?

This willful ignorance had a terrible effect on modern econ's view of competition.  How does modern econ view competition?  Well, a lot like that basic Monopoly game described above.  Competition was replaced by Perfect Competition, a non-existent fairy tale that magically fits econ models. 

Perfect Competition has a few different forms, but the main elements are as follows: many market participants producing homogenous goods at pretty much the same amount of profit with no cost for entry/exit in the market.  If any of those elements are not present, competition is said to be monopolistic.  Yeah, ok. That's realistic!

I Have A Monopoly on Being Awesome

Can you think of a market, not just today but since the beginning of market economies, that has ever fit the description above?  There is none.  Even if two companies produce the identical product, it's still not the same product as there are many ways that two companies can differentiate the product - through superior service, for example.  If the customer's view of the two products differs in the slightest manner, then it's not the same product.

So Perfect Compeition is a ridiculous fantasy.  It's a child's game like Monopoly.  Yet, it is a foundation of modern econ, replacing the study of entrepreneurship and real market discovery.

What a shame.  What a waste.  This type of nonsense has been taught to college students for decades, most notably in Paul Samuelson's best selling econ textbook written in 1948 (Samuelson's book remained a best seller for over 30 years.) 

Fun Fact:  Samuelson was so enamored by the production numbers released in the USSR that he exclaimed one day they'd outproduce America!  Samuelson, like his student Krugman, does not differentiate between production that is useful and that which is wasteful.  With an economic model of perfect competition as his core theory of market participation, how could he?

Where Are We Going Next?  Straight to Jail.

I have to stop here for now.  This is the ground work for understanding an upcoming post on the folly of Antitrust regulation. 

People need to understand the basic precepts of economics as easily as they understand long division.  These concepts are not so difficult that they can't be taught to your children.  We would do our families and future generations a great deal of good if we come to understand these concepts and pass them on.  Failing to do so allows crackpots like Samuelson to infect entire generations of college students with nonsensical and worthless economic models built upon fallacies.

David in Qatar

15 Comments – Post Your Own

#1) On April 09, 2010 at 2:46 PM, whereaminow (20.23) wrote:

Also posted on FreedomChatter

David in Qatar

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#2) On April 09, 2010 at 3:46 PM, smartmuffin (< 20) wrote:

Sounds good so far!  I'm taking a Principles of Macroeconomics class right now, and I've been pleasantly surprised about how our assigned textbook has been very much in favor of free markets, continually emphasizes how the real world does not fit "perfect" models, and regularly seems to point out entrepreneurship as an essential and positive element of the economy.  Looking forward to the next post!

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#3) On April 09, 2010 at 3:52 PM, chk999 (99.97) wrote:

Nice writeup!

The textbook version of econ reminds me of the physics joke with the punchline "assume the horse is a sphere".

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#4) On April 09, 2010 at 5:10 PM, binve (< 20) wrote:

David, Fantastic post man!!

Also, chk999. Another physics cartoon, that applies more to Economics, is:

Two professors stand in front of 3 chalkboards. On the left chalkboard is written a mess of equations, on the right chalkboard is written a solution, on the middle chalkboard is written "then a miracle occurs"

The first professor says to the second professor, "I think you need to be more explicit in step 2"

... :)..

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#5) On April 09, 2010 at 5:49 PM, starbucks4ever (97.24) wrote:

A good post, but I still disagree.

My main objection is that you describe entrepreneurs as a class of hard-working, creative people who "engage in a process of discovery", as you aptly put it. Not a rentier class, but some mixture of an art cabaret and Silicon Valley. Only physical scientists in the USSR were once viewed that romantically, and even they did not really deserve it, for the most part, they just drew their paycheck and wrote boring, unimaginative articles titled "a few remarks in connection with the question of..." Realistically speaking, an entrepreneur is just someone with a million who grows it into two million by using simple, commonsense opportunities that don't involve any substantial work, require an IQ of 80, and the only reason why everyone is not doing it is because they don't have a million in the first place. Yes, there are a few creative entrepreneurs that fit your description to a tee. But the majority are just toll collectors.

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#6) On April 09, 2010 at 5:53 PM, DJDynamicNC (26.51) wrote:

Excellent post. Very educational. Thank you!

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#7) On April 09, 2010 at 5:59 PM, whereaminow (20.23) wrote:

zloj,

Realistically speaking, an entrepreneur is just someone with a million who grows it into two million by using simple, commonsense opportunities that don't involve any substantial work

If you are willing to look at research that disputes this, I would recommend The Millionaire Next Door, which showed that most millionaires in America were self-made (i.e. they didn't have a million to begin with), most were hard working, most lived very frugal lifestyles, only a few inherited their wealth (and most of those p*ssed it away), and most were entrepreneurs.

David in Qatar

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#8) On April 09, 2010 at 6:04 PM, whereaminow (20.23) wrote:

zloj,

Also, and I am glad you raised this point.  We are not trying to paint entrepreneurs in any idealized way.  We are merely saying that what they do - right or wrong - is very important.  If you ignore it, you are ignoring a crucial element of economics.

Entrepreneurs can be bad people.  There are bad dentists too.  Bad people exist in all walks of life.  There are entrepreneurs I find despicable - for example, the Wright Brothers - I am not a big fan.

But entrepreneurialship is extremely important to a functioning market economy.

David in Qatar

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#9) On April 09, 2010 at 6:06 PM, dbjella (< 20) wrote:

This is your best blog!  Very insightful.

Although some of the stuff you wrote during the bailout times was good as well.  I encourage others to review the Blog Archive.

Go Twins!!!!!! 

 

 

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#10) On April 09, 2010 at 6:30 PM, starbucks4ever (97.24) wrote:

#7,

I agree with that. But I think you are confusing two different things here. The first thing is the origin of the first million. Given that there are something like 3 million millionaires in America and 300 million ordinary citizens, it is not surprising that more than 50% of the millionaires would rise from the lower classes. After all, for every trust fund kid who gets his million with the probability of 100%, you have hundred people trying to earn that million. Out of that hundred, maybe 2 or 3 - the most brilliant or maybe the most lucky - will ultimately succeed. The entrance barriers must be extremely high to prevent that from happening. So this part is clear, and there is nothing surprising about it. And now this brings us to the next question. Let's say you earned your first million, so you now quit your job and become a professional entrepreneur. From that point on, is there any evidence that you are still working as a donkey and displaying your creativity, or is it simply a passive income from a $1M investment that keeps the snowball rolling?

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#11) On April 09, 2010 at 6:45 PM, whereaminow (20.23) wrote:

zloj,

I'm not going to lie to you and say that I have the answer because I don't.  Unfortunately, I'm not a millionaire so I can't speak for one.  I suppose that the range of behaviors of entrepreneurs that become very successful is quite wide.  Some may kick back, others may keep going until they keel over, others may get greedy/lazy and start gaming the system.  I would love to know first hand!

I will add that this is addressed by the disutility of labor, a concept that the classicals discussed.  They brought up how people that see their income levels rise tend to find new outlets for their energies that differ from their original purposes, i.e. working in their current capacity.  I have not spent a great deal of time analyzing this concept so I can't say it's spot on, dead wrong, or somewhere in between.

David in Qatar

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#12) On April 09, 2010 at 6:50 PM, ttboydxb (28.78) wrote:

Good job David!  +1 from me!  Keep up the good work!!!

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#13) On April 09, 2010 at 6:57 PM, starbucks4ever (97.24) wrote:

At least that's my experience with the stock market. Buy stock of a company that does something creative, useful, and brilliant, and earn a 0% return at best. Buy stock of a monopoly that does something dumb and probably harmful, and you can sleep well and enjoy your dividends. Case in point: Steve Jobs is probably 100 times brighter than Warren Buffett, but would you rather own AAPL or BRK-B?

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#14) On April 09, 2010 at 7:10 PM, whereaminow (20.23) wrote:

zloj,

LOL, well I don't know.  I have no track record of successful investing either.  I have said from the beginning that I came here to learn about investing, and only later after people found what I had to say interesting did I come to write about economics.  Investing is different because you are dealing with other people's perceptions of a company's worth, which might be wholly separate from the actual skill of the entrepreneur - especially in the short term.  And since the only "science" of investing I can comprehend is fundamental analysis I don't have a lot to add to the discussion that others here can't explain better.  If people ask me what I think about a company, I'll just tell them to ask UL or the TigerPack crew from now on :)

David in Qatar

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#15) On April 12, 2010 at 1:20 PM, nzsvz9 (< 20) wrote:

David,

Predictions by economists always begin with the phrase "surprise" ... different that what the analysts predicted. Brilliant!

And predicting that the USSR would beat the US in production was based on falsified claims and the inherent behavior of people: Consider Russian spike production taught to me by my college Latvian Professor of Macro-Economics:

Central Planners set about to cure the shortage of framing nails and carpetry nails (known as spikes in the bureaucrat's handbook) by central planning. Simple!

5 Year Plan #1 - Double spike production. Reaction? Plant turns out millions of carpet tacks.

After reviewing the results of the first 5-year plan and seeing his mistake, the central planner smartly comes up with a new assessment.

5 Year Plan #2 - Double mass of spikes produced. Reaction? Plant turns out millions of railroad spikes.

And still not a useful nail for framing homes or carpentry to be found 10 years after central planning "fixes" the problem. No problem the Central Planner has been promoted, and the new planner goes about devising a new plan.

The fallacy is that there is a "problem" which can be "defined" and then "fixed". A Tri-Fallacy (a.k.a. Jose-A, Jose-B and Jose-C :-)

Known as econo-humorist nzsvz9

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