Economics for Krugman

Last week, Paul Krugman wrote a column on how economists got things so wrong. He got a few things wrong himself.

First there is the ketchup quote:

Larry Summers, now the top economic adviser in the Obama administration, once mocked finance professors with a parable about "ketchup economists" who "have shown that two-quart bottles of ketchup invariably sell for exactly twice as much as one-quart bottles of ketchup," and conclude from this that the ketchup market is perfectly efficient.

I'm not sure if the original problem here is with Summers or Krugman but Krugman quotes it more than once in his article. There are several problems with this example of market economics.

First, a two-quart bottle of ketchup invariably sells for less than two one-quart bottles. This reflects economies of scale and per-unit costs. As portions become smaller, the cost of packaging, transportation, and shelf space take up a larger proportion of the cost.

Second, supermarkets have been investing heavily in marketing research for decades. What ever price a bottle of ketchup has, it reflects a lot of calculation and experience on the most profitable point. Supermarket prices don't just happen. Krugman thinks that market-based prices arrive at the wrong prince. While they can, and did with the housing bubble, the vast majority of the time they are correct.

Krugman's second problematic example is with a babysitter co-op:

I like to explain the essence of Keynesian economics with a true story that also serves as a parable, a small-scale version of the messes that can afflict entire economies. Consider the travails of the Capitol Hill Baby-Sitting Co-op.

This co-op, whose problems were recounted in a 1977 article in The Journal of Money, Credit and Banking, was an association of about 150 young couples who agreed to help one another by baby-sitting for one another's children when parents wanted a night out. To ensure that every couple did its fair share of baby-sitting, the co-op introduced a form of scrip: coupons made out of heavy pieces of paper, each entitling the bearer to one half-hour of sitting time. Initially, members received 20 coupons on joining and were required to return the same amount on departing the group.

Unfortunately, it turned out that the co-op's members, on average, wanted to hold a reserve of more than 20 coupons, perhaps, in case they should want to go out several times in a row. As a result, relatively few people wanted to spend their scrip and go out, while many wanted to baby-sit so they could add to their hoard. But since baby-sitting opportunities arise only when someone goes out for the night, this meant that baby-sitting jobs were hard to find, which made members of the co-op even more reluctant to go out, making baby-sitting jobs even scarcer. . . .

In short, the co-op fell into a recession.

The analysis that Krugman gives is flawed at every level.

First there is the reason that people hold a reserve of 20 coupons. He says that it is so that they can splurge at a future date. I suspect that it is so that they can quit at any time. The rules of the co-op almost mandate a 20-coupon reserve. You are given 20 coupons when you join and you have to return 20 when you leave. Anyone who allows their reserve to fall below 20 is in debt and will have to earn the difference in order to quit. A different way of looking at this is that you start with a balance of zero but a credit limit of 20 which have to be repaid when you quit.

But that's only part of the problem. The other problem is that this is being presented as a closed system when there are external factors.

Any parent can tell you that it isn't much trouble to watch someone else's child along with your own. It does not double your work, especially if the child that you are sitting is close enough in age to play with your own children (remember that everyone in the co-op has children by definition).

On the other hand, going out represents an additional expense. Dinner and a movie will cost at least $40. So, in order for you to get babysitting work from me, I have to spend an additional sum.

Most people do not send their kids to the sitter every night or even every other night and go out. On the other hand, any parent who is not going out is available to babysit. Since the co-op was established with the expectation that the demand for coupons would balance the demand for sitters, it was doomed from the start.

Also, the prices (coupons) were fixed from the start by the co-op so this example has no place in a discussion of market-based economics. There is no market here. If anything, this is an example of why having prices set by an external authority does not work. Also, if it is hard to find work as a sitter then that makes it harder to repay the 20 coupons when you leave.

This should be obvious to a Nobel-Prize-winning economist but Krugman missed it. He just dismisses it as a recession. He goes on to say:

Freshwater economists are, essentially, neoclassical purists. They believe that all worthwhile economic analysis starts from the premise that people are rational and markets work, a premise violated by the story of the baby-sitting co-op. As they see it, a general lack of sufficient demand isn't possible, because prices always move to match supply with demand. If people want more baby-sitting coupons, the value of those coupons will rise, so that they're worth, say, 40 minutes of baby-sitting rather than half an hour — or, equivalently, the cost of an hours' baby-sitting would fall from 2 coupons to 1.5. And that would solve the problem: the purchasing power of the coupons in circulation would have risen, so that people would feel no need to hoard more, and there would be no recession.

Since the demand for babysitting has an external element, price adjustment will only have a marginal impact. Worse, it would encourage hoarding, at least above the 20-coupon level, since it might take you two evenings of sitting to make up for one night out.

In a normal market, only a subset of the population provides babysitting and they do it for real money instead of hours. The idea of the co-op was to remove the expense of babysitting from the cost of going out. The system that was set up did that admirably. Anyone who needed a sitter would find a large pool of people available. If you stop there then it was a success. It only becomes a failure if you expect an equal number of people to need a sitter and to want to sit. In a population where there was a high demand for sitters and low cost for needed them then this would work. Among a normal population it will always fail.

One final note - any attempt to fix this "recession" is likely to make it worse. There is no way to adjust the co-op rules so that the demand for sitters will match the demand for children to sit. So much for "government" intervention.