Paul Samuelson: In Memoriam, Part 5

Samuelson was the Julia Child of economics, somehow teaching you the basics and giving you the feeling of becoming an insider in a complex culture all at the same time. I loved the Foundations. Like so many others in my cohort, I internalized its view that if I couldn’t formulate a problem in economic theory mathematically, I didn’t know what I was doing. I came to the position that mathematical analysis is not one of many ways of doing economic theory: It is the only way. Economic theory is mathematical analysis. Everything else is just pictures and talk.

-Robert Lucas, University of Chicago Professor and Nobel Prize Winner

Paul Samuelson was the FIRST American to win the Nobel Prize in Economics in 1970. He was born in 1915 and went to the University of Chicago for undergraduate studies and Harvard University for his Masters and Ph.D. He started teaching at MIT and worked there his entire career. When Samuelson first came to MIT there was no graduate program in economics, but he is one of the main reasons MIT got one in the 1960s and battles for he #1 graduate program each year. Samuelson, as Lucas hinted at, is essentially the person responsible for marrying economics with mathematics.

 

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After World War II, Samuelson was the main figurehead that wanted to apply economic theories to real-world problems by using math. He is famous in international trade theory with the factor-price equalization where he showed, mathematically, of course, that prices of inputs (labor and capital) will equalize amongst nations with free trade. Then, there was also the  Stolper-Samuelson theorem which stated that the prices of factors of production, (in economics there are 3: land, labor and capital), will rise in proportion to the price in output prices. So for example, if Nike t-shirts are made and the primary factor of production used to make them is labor than if Nike t-shirts rise in price to consumers ($10 to $12) the increase in output price is due to an increase in wages for workers. This assumes a few conditions, such as perfection competition. This theory along with factor-price equalization made waves within the international trade economics field and are the basis of many microeconomic theory classes.

However, his research extends beyond international trade into welfare analysis, price theory and financial economics, all of which I could elaborate pages and pages on (he has written 338 papers). Here is a highlight on some other notable topics you may be familiar with that are standard teachings in economic theory:

  • Revealed preference- by observing a consumer’s purchasing behavior you can determine their preferences for items or moreover, consumers maximize their happiness so by choosing one option out of the set, it must be the preferred option (developing this theory was a component of his dissertation)
  • Cost-push inflation- rising costs on the supply side of economics (by raw materials usually) will cause supply to decrease which could raise many prices and causes inflation
  • Efficient-market theory (he helped develop the theory before Fama eventually made it famous)- Asset prices vary randomly around an optimal path discerned mathematically

“The stock market has forecast nine of the last five recessions” Samuelson in Newsweek, 1966 

But, despite his numerous theoretical contributions, he is equally known for disliking the University of Chicago free-market thought. Instead, he believed in neoclassical synthesis, a slight off-shoot of Keynesian economics and neoclassical economics– government intervention is needed during economic instability, yet supply and demand models and prices do influence choice. Samuelson had a famous column in Newsweek for 15 years (1966-1981) that rebutted many of Friedman’s columns in Newsweek. Friedman was last week’s In Memoriam scholar.

In 1948, Samuelson’s arguably most famous written work, an undergraduate textbook, Economics, was published and is among the best-selling undergraduate textbooks ever. He also served as an adviser to President Kennedy. Samuelson died at the age of 94 in 2009 (he was actively publishing in the 2000s), but his influence on the profession will forever remain.

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His video below is a tad long but it starts off by him explaining his reaction when he was notified of winning the Nobel Prize and follows with a discussion about some of his work in financial economics.

Is “Fair Trade Coffee” Really Fair? A Lesson in Supply & Demand

At church a Sunday ago I was given a brochure to attend a community service event where “we can buy fair trade coffee to benefit those in Africa”. Immediately I shook my head and said there is a better way to increase welfare. This topic is really important to understand, because many organizations try pushing “fair trade” products yet it is not the most efficient way of increasing public welfare.

First , according to fairtradeusa.org, fair trade is,

“products…from farmers and workers who are justly compensated”.

To show that fair trade products are not an efficient means of redistribution, teaching a lesson about markets, particularly an Econ 101 lesson on supply and demand, will be helpful. In a free society, and by this I mean one in which people are not slaves and do not have to produce goods for an owner/dictator, workers can choose whether or not to sell their products to others in exchange for money to buy goods and services.  This is  best explained with an example. So for example, Mark has a coffee plant and processes the beans to make 36 bags of coffee each day. Now, he can choose to drink an insane amount of coffee each day or he can choose to sell it to others who may want coffee. In exchange for Mark selling coffee at $3/bag, Mark may buy beef or milk from someone else. Mark is not forced to sell coffee at $3/bag, but rather that is the price that the coffee market is in equilibrium.

Let’s look at the linear supply and demand graphs below to fully understand what is going on here. Mark chooses to supply coffee at the local farmer market in town. It may cost him $0.50 to make a bag of coffee, but Mark, like most normal-minded workers, would love to get the maximum amount of money in exchange for the bag of coffee. The supply curve represents Mark’s willingness to supply coffee at desired prices. At a price of $1, Mark is only willing to sell 6 bags of coffee; at a price of $2 Mark is willing to sell $12 bags of coffee and so on. At higher prices, Mark is more willing to sell his coffee beans and not save them or consume them himself.

 fairtrade

On the demand side of things, people who attend the local farmer’s market want to buy coffee, but would prefer to do so at the cheapest price possible. The cheaper they pay for coffee, the more money they have to spend on other products they want. The demand curve represents consumer’s willingness to pay at desired prices for bags of coffee. At a price of $5, consumers only want to buy 6 bags of coffee. At a price of $4, consumers want to buy 12 bags of coffee and so on. Consumers would really be happy to buy coffee at $1/bag, however Mark would not be happy to sell it for such a low price. The intersection of supply and demand gives us market equilibrium, which is the price that no one else has an incentive to alter the price or quantity. Equilibrium in this case is P*=$3/bag of coffee and Q*=18 bags of coffee are sold.

Now, let us say that there is an argument for “fair trade” and by this I mean pay farmers, like “poor” old Mark more money for coffee. Let’s say that a church group goes in and decides to pay Mark $4 for coffee, as opposed to the market price of $3. If this is the case then at $4, Mark is willing to supply 24 bags of coffee, but consumers are only willing to buy 12 bags of coffee. There is excess supply in the market (when supply > demand). What this means is that Mark is willing to supply more than what people want at $4/bag. To get rid of the extra bags of coffee on the shelves, consumers have to buy more coffee. Since we cannot force consumers to buy more coffee, the only way consumers are encouraged to buy the excess 12 bags of coffee (24 bags supplied, 12 demanded) is if the price drops. However, the price cannot drop to $2, because if it does than there is excess demand (demand > supply) in the market.   Consumers want to buy 24 bags of coffee, but Mark is only willing to put 12 bags on the shelf! In fact, at this price a line may start to form to buy coffee. If there are so many people willing to buy coffee, Mark will raise his price until some consumers drop out of line such that there is no more shortage of coffee. Exactly what is demanded is what is sold at the market-clearing price, or equilibrium price. A price other than equilibrium is not stable such that there will be pressure to alter the price up or down depending on excess supply or demand.

We measure welfare simply by a concept called consumer and producer surplus. At a price of $3 and 18 bags of coffee sold, consumer surplus is the triangle from $6 to $3 and 18 bags of coffee (represented by the red triangle, or triangle A). Consumer surplus is thus ($6-$3)*0.5*18= 27. Producer surplus is represented by the black triangle, or triangle B, and is ($3-$0)*0.5*18= 27. Now, if we go back to the fair trade example, where coffee is told to be sold at $4/bag, consumer surplus would be ($6-$4)*0.5*12= 12; while producer surplus would now be ($2-$0)*0.5*12+ ($4-$2)*12= 36. Here we can see that total surplus has gone down. Originally consumer surplus + producer surplus= $54, but now it only equals $48. This is because we have deadweight loss. Deadweight loss is the consumer surplus we lost out by setting a price higher than what market equilibrium in a free market would be, or $54-$48. Consumers are made “worse off” such that they get less surplus with a higher price and are unable to buy as much coffee beans, while Mark gains more surplus.

So, in reality “fair trade” is not really fair at all…at least for consumers. However, if the intent of fair trade coffee (or other products) is to make the farmer better off than perhaps it will and  in this case it did. But, it isn’t efficient! In the fair trade example above, Mark gains $9 while consumers lose $15 worth of surplus. $6 of surplus is deadweight loss and thus no one receives this money. If instead the price was at market equilibrium, then Mark receives $27 and consumers receive $27 of surplus. Consumers could then donate to give Mark the same extra $9 (thus leaving $36 for Mark and now $18 for consumers in surplus). In this example, Mark is just as well off as with fair trade coffee and consumers are better off! There is no deadweight loss, consumers can buy more bags of coffee and pay a lower price! This to me seems like a more efficient way to redistribute money than setting what is like a price floor via a fair trade platform.

To give a bit more background on the fair trade movement in recent year. The founding of Fairtrade International occurred in 1997 with a goal to give “producers in developing nations a minimum price—a safety net to cushion farmers and producers against market fluctuations—as well as a premium, a separate payment (for example, 20 cents per pound for coffee) that workers and farmers can invest in environmental, educational or infrastructure projects.”

This safety net, however, comes at a cost. Besides the, now obvious, decrease in consumer surplus and increased costs to consumers what else is the problem with fair trade?

  1.  Fair trade does not help out the world’s poorest countries. “We might think of sub-Saharan subsistence economies when we think of fair trade, but the biggest recipient of fair trade subsidy is actually Mexico. Mexico is the biggest producer of fair trade coffee with about 23% market share.” Roughly 200 of 300 fair trade coffee producers are located in South America or the Caribbean. 
  2. There is a question about how much of this extra price actually goes into the hands of farmers or whether there is an institutional cut before farmers see any increase. A George Mason policy series study shows that after paying a fair trade co-operate program and its employees, farmers may only seek to make an extra 5 cents.
  3. Farmers outside of fair trade product networks stand at a disadvantage or those who use the fair trade product as an intermediate good. Fair trade encourages producing more in one industry at the expense of another when there can be better uses of employee time than coffee production.

To be clear, economic inequality between third-world farmers and CEOS on Wall Street is large and concerning to many. However, demanding reallocation of resources by inefficient means is not the best or fairest solution.

A great quote by Gene Callahan at FEE sums this up great,

“The belief that any group with power – government officials, economic experts, or social activists – can establish a price that’s “fairer” or “more just” than the actual market price is a fallacy that bedeviled communism for decades and it’s bedeviling the fair-trade movement today.”