Thursday, July 06, 2006

I really like this

Greg Mankiw has a reformulated take on the ages-old efficiency vs. equity problem:
The study of economics leaves a person with two strong impulses.

The Libertarian Impulse: Mutually advantageous acts between consenting adults should, absent externalities, be permitted. The ability to engage in such trades is how people in free-market economies achieve prosperity. When the government impedes voluntary exchange, it prevents the invisible hand of the market from working its magic.

The Egalitarian Impulse: The market economy rewards people according to supply and demand, not inherent worth. Markets often fail to provide people the ability to adequately insure themselves against the vicissitudes of life and accidents of birth. We should, therefore, look for ways to help those who end up at the bottom of the economic ladder.

Most economists feel both of these impulses to some degree. The difference between right-leaning and left-leaning economists is how strongly they feel each of them. Right-leaning economists have a stronger libertarian impulse, whereas left-leaning economists have a stronger egalitarian impulse.


Here is a conjecture: Whenever a policy appeals to both the libertarian impulse and the egalitarian impulse, economists will offer a relatively united view, as they do on the topic of immigration.

I personally have a strong libertarian impulse, but am also very much persuaded by egalitarian arguments regarding accidents of birth and alleviating market-based risk. Most things that happen are random, or at least unpredictable. In that way, the market is a lot like nature. When natural disasters happen, we don't blame the people hurt by them for their losses. In the same way, if free trade displaces textile workers, it is not really accurate to blame the textile workers for not having foreknowledge of what industries would be profitable in the future. It's random.

At the same time, of course, we do blame people for taking on too much risk. Like those who keep rebuilding Floridian beach houses. And there are clear problems of moral hazard with insuring unemployment. There's a very fine line that must be walked...

Sunday, July 02, 2006

Farm Subsidies Transfers

Greg Mankiw points out this Washington Post exposé on farm subsidies. But the particular program that the piece covers is not a subsidy at all. A subsidy is a negative tax on a good. If I pay you an extra $10 for every acre of corn that you grow, I've subsidized your corn-growing activities. This distorts your decision to grow corn because you'll grow more than you otherwise would. You may not even grow corn at all if I weren't subsidizing you. Since growing corn provides no positive externality and markets for agricultural goods are reasonably close to perfectly competitive, too much corn will be grown. What does that mean, exactly? "Too much corn" means that we could potentially improve everyone's well-being by moving some resources from corn-growing to other productive activities. You, the subsidized corn farmer, won't respond to price signals that tell you to abandon corn-growing for a profession that creates greater value. Moreover, the subsidy will squeeze out unsubsidized farmers, like those in third-world countries.

That's a farm subsidy. What the Post's story is really about is a program that was included as farm subsidy methadone in the Republicans' ultimately unsuccessful 1996 attempt to rid the U.S. of farm subsidies once and for all. Cutting farm subsidies is not a Pareto-improving action. Farmers are hurt (and so is Archer Daniels Midland.) They most likely have to find new work and a new home. They have to be trained to do a new job. They may never reach the same level of income that they once had because they've invested so much in farming-related human capital. But removing farm subsidies is a potential Pareto-improvement. It creates so much new wealth that the losers can (theoretically) be compensated for their lost income by the winners (everyone who benefits from lower produce prices, for example.) This program is an attempt to do that. (Though Republicans were not really interested in compensating anyone, they included the program simply to win Democratic votes.) It is not, as the Post makes it out to be, one of the truly pernicious farm subsidies that we should be most worried about.

However, this program is indeed a very bad way of compensating farmers. The program in a nutshell: if you own land that used to be farmed you get paid a per-acre transfer as long as that land is not developed and regardless of whether that land is still being farmed.

To see why this is a bad plan, consider what a good plan would look like. A non-distortionary compensation program would give everyone who was farming at the time subsidies were cut (or even better, a few months before subsidies were cut) a single payment or series of payments equal to the approximate amount lost through the removal of subsidies. This doesn't alter anyone's decision to farm (from the non-transfer, non-subsidy equilibrium) because it doesn't affect the cost or benefit of farming an additional acre of corn. If farming 500 acres of corn after subsidies were cut is profitable, farming 500 acres of corn would be no more or less as profitable after the transfer as it was before the transfer.

The plan as it was implemented has a number of problems. The biggest problem is that the transfer doesn't follow the people that were hurt, it follows the land. Why do we have an interest in whoever happens to own land that was farmed once upon a time? We don't; we have an interest in the people who were harmed by cutting farm subsidies. The transfer should be issued directly to the farmers, not to the land. This problem goes even deeper, however: it distorts the allocation of land. Suddenly, land that had been farmed had a fixed payment attached to it. Each acre of this land basically comes with an annuity and the price of this land is accordingly higher. Since farmers' property is now artificially worth more, this is in fact an incentive to sell land and stop farming. The plan actually creates an inefficiently low amount of farming. A related problem is the provision that land cannot be developed if you collect payments on it. This is simply silly, why prevent land from being used for more valuable purposes?

In this plan farmers are compensated in an extremely inefficient way: attaching an annuity to each acre of land inflates property values by the amount of the annuity. So, when farmers eventually sell their land, they are essentially paid the amount of the annuity by whoever purchases the land. And whoever purchases the land has a strong incentive to leave it undeveloped, even if it would be best to develop the land. But I wish that the Washington Post had pointed out that the basic idea is good. The losers from farm subsidy cuts are no different from the losers from free trade. Both should be compensated for their losses, not only because it is equitable to do so, but also because they will be more willing to support policies that increase the size of the economic pie.