Fish kill

"Overfishing" has been blamed for the decimation of wild fish populations worldwide. When we say "over" it should be with respect to some criterion. The popular norm is maximum sustainable yield (MSY), the maximum harvest per period that can be consistently obtained from a fishery. (Economists have an even more conservative norm, but MSY is sufficient for the following.) The typical fishery is harvested at levels way in excess of even just MSY; that means "less" is literally "more", i.e. at the industry level, reduced fishing increases catch.

The reason for this is the well-known "tragedy of the commons": nobody owns the wild fish stock. Nobody can stop another fisher from fishing. Hence nobody has any incentive to keep the fish stock from being overexploited. Keeping the stock higher may increase everybody's catch now and in the future - but if just a few fishers refrain from fishing, they catch less.

Overfishing implies either of two scenarios:

1. Catch can be maintained, but it can be higher.
2. Catch is declining.

Scenario 2 can be further subdivided into two:
2.1. Catch will continue declining at a gradual to moderate pace.
2.2. The decline in catch will accelerate into a full-blown "collapse".

World marine fisheries peaked in the early 90s, and seemed to hold steady since then. So it seems that scenario 1 is happening. Not so, warns many marine biologists. At least three trends are cause for worry:

a. Wherever they are measured, marine fish is much less abundant than they used to be. Large predatory fish populations are down to just one-tenth of pre-industrial fishing levels.

b. Fishing is moving "down the food web". Predator fish are being taken out first, followed by their prey, and their prey, and so on. Biodiversity is rapidly vanishing.

c. Actually fish catch worldwide is declining when we take into account estimated overfishing in China, which accounts for a big share of world marine catch.

At the global level therefore we have observed the start of a gradual decline in catch. I don't know yet whether Scenario 2.1 or 2.2. will materialize. Some biologists are convinced though that the latter is inevitable. They just don't know how soon. Preventing this requires a massive reduction in fishing activity.

If fish stocks could be held privately (just like farmlands), the problem could be solved. Sounds strange? It does, but recall that ownership permits the owner to restrict fishing activity. Then the owner can maintain the stock at commercially appropriate levels, not for environmental reasons, but for the sake of current and future profit. As argued earlier, the way the fisheries are being depleted now does not make commercial sense.

This solution though is moot as it is infeasible. The alternative is state regulation - licensing, catch limits, limits on the fishing equipment used, etc. This too has failed, obviously. Unless alternatives are found soon, we are headed for that bio-simplified fish menu of carp-tilapia. With a few jellyfish on the side.

The future fish menu

If you're a young person, your grandchildren will probably sample marine fish and shrimp as a rare delicacy (like venison). The common fish will be carp, tilapia, and a few other freshwater fish. Marine fish will all go the way of other animals we humans have hunted to extinction. Contrary to popular opinion, this is not a recent development - even in prehistoric times hunter-scavenger societies have wiped out delectable species, especially the bigger ones. Diamond's Guns,Germs, and Steel argues that the big animals of Australia and North America - the giant kangaroo, cow-size marsupials, the mammoth -were annihilated by humans. That makes Homo sapiens the unsurpassed predator ever. We'd have made dinner out of the dinosaurs had we evolved at the same time.

(Why the big animals? Plain economics - they provide the most food per unit of hunting effort. Rats, say, are abundant because they're too costly to hunt for food.)

Nowadays the last frontier of hunting is the sea and inland water bodies. Clearly we are repeating the pattern of terrestrial destruction, a fact that has been known for years. We are reminded of this by a NY times article, and picked up by the Environmental Economics blog.

So: looks like the we're turning our oceans, lakes, and rivers, into a haven for plankton and other inedibles. (That list doesn't even include jellyfish anymore - just check out a Chinese restaurant menu.) What about tuna, roundscad (galunggong), mackarel (alumahan), sardines (tunsoy), anchovy (dilis)? Gone from the dinner table. Maybe available in a pricey restaurant, or a five-star hotel. (Imagine, the galunggong ...)

Don't worry. There's still going to be fish - only they are all going to be farmed. And not the tasty marine fish and crustaceans either, like salmon and prawn - they need to eat smaller fish. It's going to be omnivores and herbivores - good old trusty carp (not familiar in the Philippines, but very popular worldwide), tilapia, etc. All freshwater species, by the way - I know of no farmed herbivorous marine fish.

It turns out that farming fish - like farming any other animal - is hard work, and has been successful with only few species. Domesticating animals (land or water) is a tough job, involving lots of research and selective breeding. "Closing the life cycle" - i.e. figuring out how to rear and reproduce an animal entirely in the farm - is tougher still. For example, the Tiger prawn (the most common farmed shrimp for export) has so far defied efforts of determined researchers to breed it in commercial quantities in captivity.

Freakonomics has also picked up the NYT article, if only to cite this BBC report on a method of extrapolating back to past fish stocks using old restaurant menus. Pretty freaky. We'll I've just shown you the future fish menu. Care to order?

A new study out on the brain drain

Hat tip to the PSDBlog of the World Bank posts about new studies on international migration. I did however find the following statement odd:

Two new books (both free online) look at the impact of ‘brain drain’ on development, and agree that the loss of skilled workers may be trapping the least developed countries in poverty.

All I read is that it is possible for so-and-so negative effect to happen - especially in Kapur and McHale's brief. They mention possible negative channels, highlighting the loss of "institution-builders". Combine that with findings that institutions are an important part of economic growth, and you get the negative conclusion. Plug in the family institution (not mentioned in the brief), and the picture is even worse, with lots of families effectively reduced to single parenting due to migration.

However the evidence (reported in the book edited by Ozden and Schiff) point to mainly positive effects of remittances on wealth, human capital formation (kids get better educated), incomes, and poverty reduction among the origin households. (Evidence on inequality is mixed).

Migration choices are made voluntarily by the households, trading off proximity for income. While a lot may made of a hypothetical scenario of rapid domestic wage growth for skilled workers, thus promoting brain retention, the reality is persistently large and stable wage margins between developed and developing economies, which (in the household's calculation) more than offset the psychic and other costs of migration. Moreover, it is difficult to imagine that institutions in developing countries would be appreciably better had they not gone through the recent wave of migration. If for example institutions are built by few key individuals who would likely not migrate anyway, then the instituion-building argument fails. Keeping talent home may just be leaving lots of money on the table (abroad, that is.)

My personal view is that migration has so far been welfare-improving and promotes economic growth in the origin country - especially for the Philippines. It is not the solution to slow growth (nothing is), but it can certainly help. And as the sending economy grows and local incomes rise, the incentive to migrate diminishes.

Failure of WTO talks will make some people happy

To keep up to date with the latest WTO talks, I just turn to Ben Muse and Peter Gallagher. (BTW: I entitled one of my posts "Do or Die", referring to the Doha Round - inadvertently plagiarizing one of Ben Muse's post titles. I regret the coincidence!)

I finally got around to the browsing the World Bank publication on Agricultural Trade Reform and the Doha Round (HT: again, Ben Muse.) The article by Anderson, Martin, and van der Mensbrugghe reports a simulation analysis from removing trade distortions in agriculture and manufacturing by WTO members. (The summary is already in Ben's post, so no need to reiterate it here.) I can think of no better evidence of the ineffectualness of the academic economist than the impending failure of the Doha round, and the complete neglect of impact studies like this in the negotiation process.

Instead, this is getting more support: Anti-globalists continue to call for halting all trade liberalization. Why they find studies like this unbelievable?

Sheer ignorance and misunderstanding could be the explanation. As I've written before, it all starts with Ricardo. His model is a simple one, with two goods, and fixed ratios of factors to outputs, fixed technology, and no explicit model of consumption. The models found in Anderson and Kym are basically elaborations - many goods, and ratios of factors to outputs may vary (given a general specification of the input to output relationship), explicit consumption. And in the World Bank's LINKAGE model, equilibrium is dynamic, hence technological progress is built-in. As a sign that Ricardo's doctrine is fundamentally correct, despite this enormous added complexity, free trade turns out to still be welfare-increasing. Countries specialize in goods for which they have the lower comparative cost. Period. If you don't get Ricardo right, all of this elaborated analysis is going to fly over your head.

Anti-globalist groups style themselves as advocates of development and poverty reduction. So why their uncompromising stance? Is the ignorance hypothesis correct, or is it something deeper?

The notorious input VAT cap

A reader has requested me to discuss the notorious EVAT provision capping the input VAT credit:

Could you help explain the dissenting opinion of SC Justice D. Tinga regarding the 70%/90% cap. He quotes people like Monsod, Wallace, and the PWC head in his dissent. While I am all for VAT, I just want to understand what the dissent was all about so that I get the whole picture. A copy of the dissent is in the Inq7.com website (as well as a copy of the decision).

Remember my discussion on how the VAT works? All sales transactions - including sales between businesses - gets slapped a VAT rate, say 10% (unless there are exemptions). Every quarter the business needs to pay government the VAT on its sales, or the output VAT. However, what makes the VAT a "value added" tax is that it can subtract that VAT it has paid on its inputs. So what it pays for is VAT for the difference between its sales, and the cost of inputs, which is the "value added".

Sometimes (depending on timing of input purchase and output sales) the input VAT can exceed the output VAT. This excess can be carried over to the next quarter's net VAT calculation - and so on. (But if net VAT is positive, no carryover - pay at once! Nothing so sure as death and...)

The new law contains a provision: the input VAT + carryover (if any) that you can subtract from the output VAT, every quarter, in computing for that quarter's net VAT, cannot exceed 70% of the output VAT per quarter.

Let's give an example: Suppose the law is not yet effective. In year1-quarter4 you incur 1,000,000 output VAT, but you paid 1,200,000 input VAT. You have an excess of 200,000. You carry that over to year2-quarter1, when the new law is in effect. For that quarter you owe 1,000,000 in output VAT, but paid 600,000 input VAT. Of course, government owes you 200,000 from the previous quarter. You add that in - so total subtraction from current output VAT is 600,000 + 200,000 = 800,000. Sorry! Since you paid 1,000,000 output VAT, you can only subtract a maximum of 700,000; so you end up paying 300,000. You're entitled to a refund of 300,000 - 200,000 = 100,000; just carry that over to the next quarter. And so on.

If you're a business that is often claiming input VAT below 70% of output VAT, the excess refund owed to you eventually disappears. But if your input VAT is consistently higher than that, you have a big problem. The carryover continues indefinitely, as long as the business exists. The carryover is a fiction!

The VAT therefore excessively penalizes businesses with low margin (small value-added); because of the cap, effectively they are slapped a higher rate on their value-added. This is distortionary and reduces economic efficiency. The VAT should be implemented in its original form; any cap (to curb cheating) should be set close to 100%.

Benefit-cost-wise, the EVAT still puts us ahead. If there is any room for amending the law, this is it- take out the stupid 70% VAT cap. Not re-exempting power and fuel. Now that's piling one stupidity after another.

Go signal for expanded VAT

The Supreme Court of the Philippines has finally resolved all legal challenges to the Expanded Value Added Tax law (EVAT). The Executive can now start implementing it.

Wikipedia has an informative (but badly written) article on VAT here. Think of a product going through stages of production, from raw material to final pick-up by the consumer. At each stage value is added to the product. Government slaps an VAT rate on all sales (whether business-to-business or business-to-consumer). The business is able to subtract the VAT it has paid for its inputs (input VAT), from its output VAT, so that it only pays the net VAT, i.e. effectively the tax is levied only on value-added.

In the Philippines there was a lengthy debate a few years back about shifting from sales tax to the VAT. That hubbub has died down, as everybody realized that the VAT - which is the norm in EU and many other countries - is superior to the sales tax from the administrative viewpoint. (An excellent discussion of VAT is found here.) Since a tax is slapped at multiple stages of production, the scope for tax evasion shrinks (whereas under the sales tax, if a retailer evades payment, the entire product goes untaxed.) However unlike the simple turnover tax, there is no "cascading effect", i.e. tax upon a tax.

The debate is actually about the VAT rates. In the Philippines the standard rate was 10%, with some key sectors being "zero-rated" (i.e. zero output tax, but able to claim input VAT.) The new law enacts a new standard rate of 12% (under certain conditions) effective next year, and removes zero rating of key sectors such as power and fuel.

Of course, there will be some short-term repercussions on prices (due to the increase in tax rate, and consequent increases in energy prices). Well, what do you expect, silly, if government collects 70 billion additional revenues from VAT, then of course households need to fork over that 70 billion in the form of higher prices. Duh. Moreover, VAT rates around the world (from the Wikipedia entry) are worse: 12.5% for India and New Zealand, 15% for Mexico, 17% for China, 18% for Russia and Turkey, to a whopping 24.5% for Iceland. So there is no clear-cut prognosis of economic disaster from raising VAT rates.

In fact, as the expanded VAT is the only significant revenue measure that has been enacted while the country's public debt balloons (now at 70% of GDP), economic disaster - on the scale of financial debacles of our neighbors in 1997, and Argentina recently - would have been a sure thing had the High Court voided the law.

As usual, we've escaped by the skin of our teeth.

On power

The way the WTO negotiations are playing out (update here), you would think that a country benefits only if it able to gain market access into another country's market, or if competing exporters don't get those dang subsidies from their governments. Hence negotiations are based on "reciprocity" - I'll widen your market access, if you'll widen mine.

Just goes to show how powerless consumers are. If the consumers were all represented on the table, with influence commensurate to their numbers, then there would be no negotiations. End of story. A country would unilaterally drop its trade barriers to give its consumers access to the widest variety of goods at the widest range of prices. If another country decides to shoot itself in the foot by imposing barriers to trade, all another country would do is to try to persuade it to mend its ways. Not impose "retaliatory" trade sanctions. That would be like shooting its own foot in return! And if a foreign government opts to subsidize its exports, the importing country would yell, "Dump it all on us, please!"

The most formidable potential advocate of unilitaral trade liberalization is the consumer block. Nowhere are they represented. This goes to show that they are absolutely powerless. Yet they are obviously the most numerous. Why the absence of clout? Mancur Olson, in The Logic of Collective Action, explains this paradoxical outcome by pointing out that a group, to be influential on public policy, needs to get organized. Organization entails transaction costs (time, effort, communication, ancillary expenses). But lobbying is a public good to the entire group - once organized every member gets represented by the lobby, even if they didn't contribute (much) to the transaction cost investment. In large groups therefore we would expect tremendous free riding problems. Hence we don't see big consumer lobbies. We do get big farm lobbies, big labor union lobbies, and other industry lobbies, where the benefits are shared by few enough members to overcome the free rider problem associated with lobying and organization.

Who's left? Why, the lonely free trade economists. We're a small band, so we can get organized. Alas, our clout is nil and we are way too highbrow to have any popular appeal (who wants to hear about comparative advantage anyway?) Hey, that's why I love to read anti-globalist stuff, it's the technocrats who rule the world (minor detail: they happen to be the villains). It's as great a fantasy as any comic book, equally fun, and equally escapist.

The Nobel and game theory skeptics

Most of the econ blogs have lauded the Nobel Prize to Thomas Schelling and Robert Aumann, who won for their work on game theory and its applications. However Business Week's Mandel has called it a letdown; and the Austrian economists are in principle opposed to applying mathematical reasoning to human behavior - a critique particularly directed against the work of Aumann.

Mandel's though represents a more mainstream complaint - that the empirical accomplishments of game theory have been disappointing. And according to this article there are zero applications of game theory to practical business.

One wonders though whether this type of criticism is fair; after all the presumption is that the sub-discpline aims at generating practical techniques and empirically testable statements. Consider general equilibrium theory; nobody (least of all its theorists) pretend that an empirical test can be made about the existence of equilibrium. Rather the theory is intended to close a gaping hole in the internal logic of the partial equilibrium model (if other market prices determine how to draw a pair of supply and demand curves, where do those prices come from?) It provides an coherent, benchmark idealization for understanding how markets work. Of course, the idealization itself cannot represent how markets really work.

As I understand it, game theory offers another benchmark, this time of how strategic behavior works. Incidentally, later theorists may develop some practical techniques and applications (as was the case with the computable general equilibrium models). However this is not the standard by which to judge current work, which is predicated on formally working out the implications of complete rationality in game-like settings.

Chess and tic-tac-toe provide a good analogy. Tic-tac-toe is completely computable, because it is so simple. Chess on the other hand is extremely complex, and appears to be beyond a computational solution for a long time to come. Game theory basically analyzes tic-tac-toe type of games. I don't mean that to be disparaging - what I mean is that games are reduced to a set of rules and strategies as to be amenable to a computational solution.

Real world strategic behavior is more like chess than tic-tac-toe: moves are guided by intuition, rules-of-thumb ("seize the center", "don't bring out the Queen too early", "bishops of opposite color endgames are drawish"), subject to exceptions that only the experienced can detect in specific positions.

Game theory skeptics want models that tell us, in a manner of speaking, how chess is played. Unfortunately for that you don't need a mathematician or an economist - you need a chess expert! Similarly within practical business settings, the people you would ask about business games would be - well, the players themselves.

Here we see the benefit of the game theorist's approach: reducing games to a simple structure permits generalization to a wide variety of settings. The "Prisoner's Dilemma" for example arises over and over and over in many settings (war, business, resource maangement, and - law enforcement?). But as for not bringing out your queen to early - that principle makes sense only to chess (unless you happen to suffer an overdose of imagination.) The cost of course, is that one must be contented with analyzing tic-tac-toe types of games.

As in everything else, game theoretic approaches have a trade-off. My intuition is that within the hyper-complex endeavor which is the advancement of economic science, the Nobel prize has nudged us closer to the optimum.

Comparative advantage ain't for dummies

If you haven't understood the doctrine of comparative advantage, you're in good company. It turns out a lot of the world's intellectuals - particularly those versed in anti-trade rhetoric - fail to understand it too.

In an old classic essay, Paul Krugman explains why. He draws a parallel between Ricardo's idea and Darwin's idea: both are simple, but profound; both run counter to everyday intuition.

In the case of evolution, it seems obvious that some rational Mind must be responsible for designing living organisms. Well, biology has no comment on the idea of a supernatural Mind; however it takes strong exception to the "must" of the foregoing sentence. Purely natural processes are sufficient to account for the forms and actions of living things. The main insight is that organisms reproduce; combined with natural selection, generations of organisms undergo successive modification (which also gets reproduced) to arrive at their current forms.

In the case of foreign trade, the intuition is that the amount of resources used to produce something ought to figure in its cost, and therefore in its price. Hence a country that needs more of every resource to produce a good, will not be able to sell that good in the foreign market. Nothing can be more obvious, it seems. In fact if every commodity requires more of everything - land labor, capital - than other goods produced abroad, then the country will not be able to sell anything at all in the world market.

The common sense view turns out to rely on a subtle misconception about the true nature of cost. Ricardo's insight is that cost is measured by what is given up to produce something, i.e. its opportunity cost. The normal way of reckoning cost (resources used x price of resources) is a reasonable enough approximation within a price system of a single economy; however when comparing two or more economies, the normal method breaks down and one must proceed directly to a comparison of opportunity costs.

As Krugman points out:

To a trained economist, the basic Ricardian model seems almost trivial. Two goods, two countries, one productive factor, perfect competition: what could be simpler? Indeed, one of the fierce joys of being an international trade economist is that so many seemingly sophisticated tracts can be revealed as nonsense, so many self-important men unmasked as poseurs, using such a minimalist framework.

And yet if one tries to explain the basic model to a non-economist, it soon becomes clear that it really isn't that simple after all. Teaching the model, to docile students, is one thing: they get the model in the course of a broader study of economics, and in any case they are obliged to pay attention and learn it the way you teach it if they want to pass the exam. But try to explain the model to an adult, especially one who already has opinions about the subject, and you continually find yourself obliged to backtrack, realizing that yet another proposition you thought was obvious actually isn't.

Furthermore:

In sum, while the concept of comparative advantage may seem utterly simple to economists, in order to achieve that simplicity one must invoke a number of principles and useful simplifying assumptions that seem natural and reasonable only to someone familiar with economic analysis in general. ("What do you mean, objects fall at the same rate regardless of how heavy they are -- if I drop a cannonball and a feather ... you're assuming away air resistance? Why would you do that?") Those principles and simplifying assumptions are indeed reasonable, but they are not obvious.

The reliance on simplifying assumptions to lay bare the essentially formal, quantitative relations is the essence of mathematical reasoning. However many intellectuals are deeply hostile to this type of reasoning, preferring to attribute trade to the shadowy designs of neo-colonialist conspirators. (Similarly anti-evolutionists prefer to trace life to a divine Designer.)

Krugman concludes with the following advice for the economist:

(i) Take ignorance seriously: I am convinced that many economists, when they try to argue in favor of free trade, make the mistake of overestimating both their opponents and their audience. They cannot believe that famous intellectuals who write and speak often about world trade could be entirely ignorant of the most basic ideas. But they are -- and so are their readers. This makes the task of explaining the benefits of trade harder -- but it also means that it is remarkably easy to make fools of your opponents, catching them in elementary errors of logic and fact. This is playing dirty, and I advocate it strongly.

(ii) Adopt the stance of rebel: There is nothing that plays worse in our culture than seeming to be the stodgy defender of old ideas, no matter how true those ideas may be. Luckily, at this point the orthodoxy of the academic economists is very much a minority position among intellectuals in general; one can seem to be a courageous maverick, boldly challenging the powers that be, by reciting the contents of a standard textbook. It has worked for me!

(iii) Don't take simple things for granted: It is crucial, when trying to communicate Ricardo's idea to a broader audience, to stop and try to put yourself in the position of someone who does not know economics. Arguments must be built from the ground up -- don't assume that people understand why it is reasonable to assume constant employment, or a self-correcting trade balance, or even that similar workers tend to be paid similar wages in different industries.

(iv) Justify modeling: Do not presume, as I did, that people accept and understand the idea that models facilitate understanding. Most intellectuals don't accept that idea, and must be persuaded or at least put on notice that it is an issue. It is particularly useful to have some clear examples of how "common sense" can be misleading, and a simple model can clarify matters immensely. (My recent favorite involves the "dollarization" of Russia. It is not easy to convince a non-economist that when gangsters hoard $100 bills in Vladivostock, this is a capital outflow from Russia's point of view -- and that it has the same effects on the US economy as if that money was put in a New York bank. But if you can get the point across, you have also taught an object lesson in why economists who think in terms of models have an advantage over people who do economics by catch-phrase). None of this is going to be easy. Ricardo's idea is truly, madly, deeply difficult. But it is also utterly true, immensely sophisticated -- and extremely relevant to the modern world.

Do or die

There is a sense of a turning point in the upcoming Ministerial Conference of the WTO, to be held in Hong Kong this December. The Doha Conference of 2003 provided a mandate and framework for negotiations on critical trade issues, such as agricultural trade, trade in services, intellectual property, and the environment. However the preceding conference in Cancun failed to build a consensus on making progress on the Doha round. The Hong Kong conference seems to be the last chance to restart the stalled trade talks.

Anti-globalists warn that this may be their last chance to throw a monkey wrench into the system:

We are entering the most dangerous period of the negotiations, when a deal will either be struck or killed. The next four months will determine whether the WTO gets consolidated as the engine of global trade liberalization and we enter a Brave New World of even greater liberalization, or the process of reversing trade liberalization gains momentum and the WTO is crippled as a mechanism of globalization.

All types of trade restrictions (tariffs, quotas, discriminatory product standards, and so forth) are obstacles to countries specializing in their comparative advantage (discussed in yesterday's post). In short, products are not going to be produced where their opportunity cost is lowest. This is to the detriment, not only of the global economy as a whole, but also of individual countries.

Of course when I say "country" I mean the citizenry as a whole, consumers and producers taken together. For sure there are vested industrial interests which stand to lose from trade liberalization. Continuing Ricardo's example: in England the wine-makers stand to lose profit from the influx of Portuguese wine. So they would spin out all manner of ingenious fallacies to oppose international trade. All manner of power and influence is exerted upon the state regulators to restrict trade. The result? England as a whole, and Portugal as a whole forfeit gains from trade.

At least the wine-makers are happy. Will the "wine-makers" gain the upper hand (again) in Hong Kong? Or will states finally realize who they are really representing, and act accordingly?

What do countries trade? Why do countries trade?

If you read fairly typical antiglobalist propaganda (see here), you would think that foreign trade is somehow detrimental to an economy. An economy trades mainly because the foreigner wants to monopolize the domstic market. While the economy is ruined by imports, we also ruin ourselves by misallocating our scarce local resource to produce exports only to serve the foreigner.

Phobias have zero rational basis; xenophobia is no different. Fortunately many countries have, by joining the World Trade Organization, signalled their intention to liberate themselves from this obsolete way of thinking.

Consider the the first question in the title; of course I am not after opening some trade statistics book to find out what products are imported and exported. What I mean is, what is the reason those products are imported or exported? The answer was already given by Ricardo (quoted here). Without using the phrase, Ricardo was already elucidating an answer based on opportunity cost. Opportunity cost is a central concept in economics. When you produce cloth, the cost of doing it is not, I repeat not, determined by the amount of inputs (land, labor, machinery, materials) used up in the process. The cost is the vaue of the goods that are given up because resources have been shifted to produce the cloth. After all, these resources are means to an end, right? So the actual cost can be found only by examining the trade-offs between competing ends.

Once you get over that hump, the rest is (comparatively) easy. Suppose (as in Ricardo's example) 1 of cloth costs England 100 men, while 1 of wine costs 120 men. Portugal meanwhile can produce the same cloth with only 90 men, and the same wine with only 80 men. Laypersons (and most anti-globalists, I think) would say that it England will have to import both wine and cloth from Portugal, because it costs more (in terms of labor) in England. Wrong! Again, the labor does not matter; what matters is what you get out of the labor. So, with this in mind, consider: in Portugal 1 of wine costs 8/9 of cloth (= 80/90). Meanwhile in England, 1 of wine costs 1.2 of cloth (= 120/100). So wine has a lower opportunity cost in Portugal, than in England. However the reverse must be true: cloth must have a lower opportunity cost in England! By giving up one of wine, you can only get 8/9 of cloth in Portugal; however, in England, by giving up 1 of wine, you can get 1.2 of cloth. So:

What does England trade?
It exports cloth and imports wine.

What does Portugal trade?
It exports wine and imports cloth.

Why does England trade?
Because it is more beneficial for it to do so.

Why does Portugal trade?
Because it is more beneficial for it to do so.

Suppose say 1 of wine trades for 1 of cloth. Then by importing 1 of wine, it need only export 1 of cloth; to get the same wine without trade, the amount of cloth that needs to be given up is 1.2. Meanwhile Portugal gives up 1 of wine and gets 1 whole cloth; without trade, it will have to make do with only 8/9 of cloth.

Folks, you have just heard the simplest and most powerful argument for free trade. Everything else is gravy.

The genius of Ricardo

Who packed the densest amount of economic insight into the fewest paragraphs of prose? I would nominate David Ricardo, in his writing on foreign trade (bold emphasis mine):

If Portugal had no commercial connexion with other countries, instead of employing a great part of her capital and industry in the production of wines, with which she purchases for her own use the cloth and hardware of other countries, she would be obliged to devote a part of that capital to the manufacture of those commodities, which she would thus obtain probably inferior in quality as well as quantity.

The quantity of wine which she shall give in exchange for the cloth of England, is not determined by the respective quantities of labour devoted to the production of each, as it would be, if both commodities were manufactured in England, or both in Portugal.

England may be so circumstanced, that to produce the cloth may require the labour of 100 men for one year; and if she attempted to make the wine, it might require the labour of 120 men for the same time. England would therefore find it her interest to import wine, and to purchase it by the exportation of cloth.

To produce the wine in Portugal, might require only the labour of 80 men for one year, and to produce the cloth in the same country, might require the labour of 90 men for the same time. It would therefore be advantageous for her to export wine in exchange for cloth. This exchange might even take place, notwithstanding that the commodity imported by Portugal could be produced there with less labour than in England. Though she could make the cloth with the labour of 90 men, she would import it from a country where it required the labour of 100 men to produce it, because it would be advantageous to her rather to employ her capital in the production of wine, for which she would obtain more cloth from England, than she could produce by diverting a portion of her capital from the cultivation of vines to the manufacture of cloth.

This passage has been around since 1817. Yet people can pass their entire lifetime embroiled in trade issues, even militantly opposing foreign trade, without ever an inkling of comprehension about these few terse paragraphs.

Why not spend an hour or so puzzling out the above? It's great recreation, and is the foundational insight of international economics - nay, all of economics.

Energy use reduction scenario: A literary model

Back in the good old days, economists hardly used formal, mathematical models. They used what Alpha Chiang (of math econ fame) refers to as "literary models". Typically these are peppered with numerical examples. The work of the great classical economists like Smith and Ricardo were entirely of this mould. While sacrificing generality, such an approach is incomprable as a tool for understanding. Let me link you to a fine example of a modern application of literary logic:

Exhibit A: John Quiggin on the prospects for energy use reduction

Just as I thought: price increases are the lasting way to cut down on fossil fuel emissions. If the climate change scenarios are really that bad, then more expensive fuel now is just what we need.

Capping global consumption is not necessary. Getting prices right is.

Leaning left?

Some rich pickings from today's Manila Times:

The editorial points to the apparent "leftward glance" made by the World Bank in its recent World Development Report. However as I've pointed out, there's really nothing new here: economists have been identifying the links between equity and growth, links that run through even the institutional framework of the market economy.

In any case, the World Bank does not dare meddle in the political side of the equation. The Economist notes that this is not where the World Bank wants to go anyway; however their view takes an overly-monolithic perspective on the dominance of the "elites". In democratic societies especially, numerous elites and pressure groups are jockeying for power and influence; academic analysis such as this may assist those groups lobbying for shifts conducive to both equity and efficiency.

Another slightly-leftward proposal (if I may unjustly characterize it as such) is the debt-for-equity swap, which Edgardo Espiritu endorses. But finance and Central Bank officials are cold to the proposal. There are some good features of the swap, as I said before: in particular it will institutionalize incentives towards cost-recovery, income generation, and risk-sharing (between creditor and implementer) in anti-poverty projects.

What I sense however is a moral hazard problem: Congress may slacken efforts to pass needed tax bills to bridge the deficit, once some form of swap is in place. I think this is what the finance officials secretly fear. However this is an argument for inserting a deficit-reduction conditionality prior to and in the swap, not against the swap idea per se. The skeptics are right to point out though that any form of novel repayment scheme should be merely supplementary to a wider effort of enforcing a sustainable deficit policy.

Will smooth models win?

New Economist argues that the shift from "coarse" large-scale macroeconometric models to "smooth" general equilibrium type models is only justified if forecasting accuracy improves. He notes: "In my experience, more theoretically sophisticated, medium-term macro models typically produce markedly inferior forecasts for the usual forecasting horizon of 6-18 months."

This pragmatic stance is quite sensible. What matters is that forecasts improve planning for the future. Presumably forecasts that are more accurate (after the fact!) implies systematically better planning.

My own fearful forecast: the smooth approach will eventually yield more reliable forecasts. The inferior performance of smooth models now, arises from as yet a faulty understanding of the nature of sticky prices and adjustment costs in the short-run. It is not yet clear how to efficiently extract Keynes from Walras.

Eventually though we need to get to Walras, and that is why I am betting on this particular horse. I am optimistic about achieving, in the next 10-15 years, a markedly better understanding of market rigidities. For example, a model with a Phillips curve equation is essentially forcing a black-box relationship between inflation and unemployment. Inside that box is some kind sticky wage story. A smooth model though would attempt to open that box and plug in some kind of sticky wage story; one that has - crucially - a happy ending in full employment.

It's the punchline which grabs you.

Smooth and coarse modeling

Does supply equal demand in every market, all the time? Of course not. But in the long run, it is safe to assume that they do. The type of economic model most appropriate for this perspective is Computable or Applied General Equilibrium (AGE). Obviously the results churned out by this kind of model is not meant to be a predictive "forecast", but rather a representation of the underlying fundamentals determining economic structure and relations. We can call this type of model "smooth". Such models are so smooth, they don't even have money variables - only price ratios matter, not actual quoted prices.

Models like this are not useful for representing important phenomena such as the business cycle. This is because business cycle phenomena are mainly due to rigidities that interfere with the underlying tendency towards equilibrium. Macroeconomic models are filled with lots of relations that imply rigidities - for example, the so-called Phillips equation, which relates inflation with unemployment. These kinds of models are coarse; and they have every appearance of plugging in ad hoc conjectures. (In short, they're just plain ugly.) But the models do predict business cycles and monetary effects; we do get the rough-edge economic realities of the short-run.

The view that smooth models are unable to explain rough realities has been challenged by the "real business cycle" school (whose proponents won the Nobel prize last year). They showed that putting in stochastic elements in a "smooth" model generated time series that appeared to mimic macroeconomic trends.

As a gauge of the influence of this school, coarse models are slowly disappearing from the fashion scene. In come the smooth models, gradually expanding in scope - for example, money (or liquidity) can now be integrated as a time-saving device (Gavin and Kydland, 1998). Increasingly macroeconomic models of the business cycle and monetary aggregates are beginning to look more and more like the smooth, applied general equilibrium models.

Consider the shift by the International Monetary Fund from its Multi-mod model, which is coarse (with a parallel smooth model), to the Global Economic Model, which is semi-smooth (i.e. it's basically smooth, with coarse elements integrated here and there to improve realism). Unfortunately it is not yet a public access model (unlike the Multi-mod) as it remains under development (see the website ).

Was there anything wrong with the old-style models? In terms of short-term predictive ability, I don't see any advantage from the new-style models - hey, if you can average a 1 percent absolute error in one-year forecasts of GDP, you must be on to something! However the crucial advantage with the new-style models is the ability to link business cycle gyrations with micro-behavior that is better understood - behavior such as price adjustment to balance demand and supply, adjustment of quantity bought and sold in response to price, all based on the notions of maximization and equilibrium. A more coherent relationship can be drawn between the short-run and the long-run. In that broader view, perhaps we do have a hope of generating more reliable economic models out of this shift.

The killer application

I do modeling of the economy (micro and macro) for a living. I've been asked, how good are computer models? After all, a model, any model, requires simplifying assumptions. Lots of factors are omitted so that some clean equations can be written down in a way that a computer can process. Forecasts generated are prone to uncertainty (and, literally speaking, are always wrong!)

Outside of economics, let me present the following:

Exhibit A. Climate forecasting

The prediction of global warming could only come from simulations of computer models of the climate. Virtually a scientific consensus on the future trends of global tempertures has been reached, on the strength of computer models. How so given model uncertainty? A simple explanation is given by an economist article on climate change:

Individual models have their individual faults, of course. But unless all contain some huge, false underlying assumption that is invisible to the world's climatologists, the fact that all of them trend in the same direction reinforces the idea that it is the data which are spurious rather than the models' predictions.

Exhibit B. War forecasting

The techniques used in model-building cannot differ across disciplines. In the technique of "backcasting" we use the following: Hypothesize a theoretical relationship between variables; build a database; identify the numerical relationships using data; check if the data is replicated by the model; apply the model to forecast future trends. That is precisely what the state-of-the art commercial war forecasting software does - though with the advantage of an enormous database.

Some anecdotal evidence:

IN DECEMBER 1990, 35 days before the outbreak of the Gulf war, an unassuming retired colonel appeared before the Armed Services Committee of America's House of Representatives and made a startling prediction. The Pentagon's casualty projections—that 20,000 to 30,000 coalition soldiers would be killed in the first two weeks of combat against the Iraqi army—were, he declared, completely wrong. Casualties would, he said, still be less than 6,000 after a month of hostilities. Military officials had also projected that the war would take at least six months, including several months of fighting on the ground. That estimate was also wide of the mark, said the former colonel. The conflict would last less than two months, with the ground war taking just 10 to 14 days.
Operation Desert Storm began on January 17th with an aerial bombardment. President George Bush senior declared victory 43 days later. Fewer than 1,400 coalition troops had been killed or wounded, and the ground-war phase had lasted five days. The forecaster, a military historian called Trevor Dupuy, had been strikingly accurate.

Would that economists had such a killer app.

Indonesia bites the bullet

Still want to bring back oil industry regulation and cheap oil fuel by government subsidies?

How about a little dose of reality for a change?

From AFP (through the Philippine Daily Inquirer):

JAKARTA -- Indonesia more than doubled the average cost of fuel on Saturday despite angry protests before the larger than expected hike that Jakarta hopes will keep an economic crisis at bay. The second increase of the year, which will have immediate effect, comes after the government decided to cut fuel subsidies that were devouring one-fifth of Indonesia's annual budget.

"This is a difficult decision taken by the government after considering all other options," said Coordinating Minister for Economic Affairs Aburizal Bakrie. Earlier Friday, police in the capital fired tear-gas to disperse rock-throwing students protesting against the fuel-price rise, which was expected to be in the region of only 50 percent. At least three policemen were injured in clashes as students burned tires in front of the Indonesian Christian University's central Jakarta campus in an attempt to block traffic. Hours later the government confirmed the demonstrators worst fears, raising the cost of domestic fuels by an average of 125 percent.

Kerosene, widely used by the poor for cooking, went up from 700 rupiah to 2,000 rupiah (19.4 cents), an increase of 185.7 percent. The price for premium petrol was raised 87.5 percent from 2,400 rupiah to 4,500 rupiah, while diesel oil rose 104 percent from 2,100 rupiah to 4,300 rupiah.

Speaking ahead of the announcement, President Susilo Bambang Yudhoyono urged protesters to express their opposition peacefully, saying violence would deter foreign investors. "Don't act destructively. Don't create an image that our country is not safe. Never create a situation as if there were upheavals or riots," Yudhoyono said.

Former dictator Suharto was brought down in 1998 after raising fuel prices amid a crippling economic crisis. The first rise this year also brought mass protests.

With world oil prices near record highs, Indonesia has been forced to slash the budget-busting fuel subsidies, which parliament this week capped at 89.2 trillion rupiah (8.7 billion dollars) for the year.

Now wipe your nose, dig into your pocket, and be a good consumer.