The Use of Models in Economics and Business History: An Appreciation of Maggie Levenstein

 

This post was prompted by some things I have seen on the internet lately (especially Twitter) about economic models. Specifically, I am referring to suggestions that economists shouldn’t teach the model of perfect competition, or should de-emphasize it, because markets in the real world are not competitive.

These suggestions reminded me of one of my favorite papers Margaret Levenstein’s presidential address to the Business History Conference "Escape from equilibrium: thinking historically about firm responses to competition." Enterprise & Society (2012): 710-728.  Levenstein understands what models are for. The point of economic models is not to copy reality or to create jars that we can sort different markets into: This market goes in perfect competition; that market goes in monopoly. The point of the models is to help us understand what matters.  

The model of perfect competition assumes:

1.       Firms maximize profits

2.       There are many buyers and sellers

3.       All the firms sell an identical product

4.       There are no barriers to entry or exit.

 

From these four assumptions we can derive at least two conclusions (if you are not familiar with the model there is brief explanation at the bottom of this post):

1.       The price will be equal to the marginal cost, which is the additional cost of the last unit produced.

2.       In the long run, firms will earn zero economic profit.

 

Maggie Levenstein pointed out these conclusions are not really what business students want to hear in their microeconomics course:

“The punch line of this course is that, in long run competitive equilibrium, free markets produce an efficient outcome in which firms earn zero profits. The answer to the final exam question, "What will an efficient economy look like?" is answered by finding where profits are equal to zero. This is often puzzling to students, especially the MBA students I teach most of the time. At some point I realized that it was important to clarify to them that equilibrium is not a goal, but a result, and that their job as managers and leaders was to escape from equilibrium. Long-run equilibrium is not the goal but the result of competition. It is what competitive pressure pushes firms toward, but from the point of view of the firm, it is to be avoided. Competition is not a state; it is a force, and it is a force that, left unchecked, will leave you earning zero profit.”

But this is precisely why the model is what business students (and business historians) need to hear. MBAs want economic profits. But how do you get them. The model tells you how. First, you have to convince people that your good is not exactly the same as everyone else’s. If you do that you can increase your price without having your customers run off to your competitors. If you can do that you can hang on to those higher prices. Second, you have to prevent people from copying you.

There are multiple ways to accomplish these goals. You might use marketing to convince people that other goods are not a substitute for yours and get a patent or trademark to keep people from copying you. You can also earn economic profits through innovation. When you introduce a new product, you are the only one selling it. You can charge a higher price without having to worry about people running off to your competitors. What if your competitors start to copy you? Then you have to do it again. One short little monopoly after another.

The point is that the model tells you what matters. In the example I have been using it provides some useful direction for thinking about strategy. Unless I want to compete purely on price, I need to differentiate my product from others. How am I going to do that? If I want to earn more than an ordinary accounting profit, I need to keep other firms from entering my market.

Levenstein also explains in her paper why the model is important for business historians when thinking about entry and exit and firm behavior. She also notes that these actions to escape from competitive equilibrium can be ones that benefits consumers (new, better, cheaper products) or negative (collusion or combination to reduce competition).

The model of competitive markets also provides a useful starting point for thinking about why prices are what they are. People often complain about prices being too high. The model suggests that if there are no barriers to entry prices will be driven down to the point that they just cover the costs, including a reasonable accounting profit. So, a useful place to begin thinking about high prices is to ask if there are barriers to entry. If you can’t identify any substantial barriers to entry you might want to consider the possibility that prices are high because the good is costly to produce.

The talk about whether to emphasize the competitive or the monopolistic models is misguided because it encourages people to think of the models as jars that they should sort real world markets into so that they can see which jar has the most in it and then emphasize it. Instead, models should be thought of as tools to understand the influence of important market features, such as number of sellers, product differentiation, and barriers to entry on the behavior and performance of firms. Models of monopolistic competition and monopoly don’t tell a different story than the model of perfect competition, they are all part of the same story. A lot of firms selling exactly the same thing implies that the firm is a price taker. Introduce product differentiation and the firm can increase its price without losing all of its customers. Barriers to entry imply zero economic profit. Allow one firm to keep competitors out of its market and you get not only the ability to raise price above marginal cost but the possibility (though certainly not the inevitability) of economic profits. In a model we can say products are differentiated or not. In reality, there are degrees of substitutability between goods. In a model we can say there are barriers to entry or there are not. In reality, there are no barriers there are no absolute barriers. The model of perfect competition is not useful because it perfectly mirrors reality but because it doesn’t.

Many models matter precisely because they do not provide a mirror of reality. For instance, Janet Yellen’s husband, who is also an economist, developed a model of the market for goods, like used cars, in which there is asymmetric information.  George A. Akerlof "The Market for Lemons: Quality Uncertainty and the Market Mechanism." The Quarterly Journal of Economics 84, no. 3 (1970): 488-500. In the model the market collapses. Are there in fact markets for used cars in the real world? Yes. Does that make the model stupid? No. The point of the model is to encourage people to think about the problem of asymmetric information. Akerlof provides several examples of ways that people have dealt with asymmetric information.  The fact that there ways of solving the problem does not mean that the problem does not exist or that it is not important.

The prisoners’ dilemma illustrates the problem of maintaining cooperation when people can benefit individually by departing from cooperation. The point of the model isn’t to suggest that people never cooperate. Obviously, they do. The point of the model is that we need to think about how people are able to overcome the problem: repeated interaction, legal enforcement, social norms, etc.

 

The bottom line is that models can be very useful if you use them to think about what matters. You will find them less useful useful if you think of them as providing jars that you can sort the world into.

 

 

P.S.

If you are not an economist and are wondering how the conclusions can be derived from the four assumptions, here is what I hope is a relatively easy to understand explanation

 

First conclusion: the price of the good is equal to the marginal cost of production.

Together assumptions 2 and 3 imply that the firm is a price taker; it has no influence over the price of the good. No matter how much or how little they produce it has no effect on the market price because there are a lot of other people selling at exactly the same thing as them. Because they are price takers, the additional revenue from selling another unit of the good will just be equal to the market price. If it is selling for $5, every time they sell another unit of the good, they get another $5. Economists call the additional revenue from selling an additional unit of the good marginal revenue. So we have concluded that because firms are price takers marginal revenue will be equal to the price (MR = P).

 

The first assumption, profit maximization, implies that the firm’s marginal revenue will be equal to its marginal cost. Profit is revenue minus costs. Every time I sell something that adds more to my revenue than it adds to my costs my profits will increase. If producing another unit of a good adds $10 to my revenue and $5 to my costs, my profits have to go up by $5. If I want to maximize my profits I keep producing as long as another unit adds more to my revenue than it adds to my price. If I were to produce another unit when it added more to my costs than it added to my revenue my profits would go down. Consequently, if I am maximizing profits I keep going right up to the point where the additional revenue of the last unit is just equal to the additional cost and I stop there. Therefore, the assumption of profit maximization implies that marginal revenue equals, (MR=MC).

 

Putting it all together, if P=MR because there are a lot of firms producing the same good and MR=MC because of profit maximization, it must be the case that P=MR=MC. Consequently, the price of the good will be equal to the marginal cost, P=MC

 

Second conclusion: In the long run, firms in a perfectly competitive market will earn zero economic profit.

The term zero economic profit is usually confusing to non-economists and possibly not the best choice of terminology. Most people think of profit as the money a businessperson has left over after they have paid their employees, their suppliers, their insurance, etc. Economists call that the accounting profit, but that there is another cost that it does not include: The businessperson must get something or they won’t be willing to stay in the business. Imagine you are running a busines and have to tell me the minimum accounting profit that would make you willing to stay in business. Imagine you tell me $60,000. That $60,000 is also a cost. Economists call it an implicit cost. If it is not paid the resources that you bring to the business will not continue to be directed to that business. If the accounting profit is greater than your implicit cost, we say you are making economic profits. If the accounting profit is less than your implicit cost, you are making economic losses. If the accounting profit is exactly equal to the minimum amount that would keep you in the business, you are making zero economic profit.

But what will if you are making economic profits? Will other people like you just ignore that or will they want to try to get some of those economic profits as well. In the model of perfect competition there is nothing to stop them from entering that market too. if you are making more than the minimum that would draw you into the business other people with similar skills and abilities to you will want to get in on that. As they enter the market, they increase the supply of the good and drive down the price. The opposite happens if the accounting profit is not large enough to make you want to stay in the business. As people leave the business the supply decreases pushing the price back up. Free entry and exit mean that the price of the good tends toward the price that will just provide a reasonable accounting profit, as much as people with similar skills and abilities are earning.

Thaler and Twitter on Auctions and Nudges

 

Richard Thaler has an essay in the New York Times about Covid shots in which he advocates a combination of auctions and “nudges.” As always there are interesting responses on Twitter. I saw several people suggesting that it was affine illustration of the evils of modern economics. I have a hard time seeing that.

 

First, lets start with the auction part. Thaler starts from the position that markets should not be used to allocate the shots. In the market solution, the shots would those who have the greatest willingness and ability to pay. He says that obviously that shouldn’t be done, but he notes that if market prices are not used to ration the limited number of shots then some other means of rationing must be found. He seems to want a distribution plan something like I have seen advocated elsewhere: those most at risk, elderly and health care workers, go first. After them others are generally prioritized in terms of their risk and their role in providing for public health and safety. So far, hard to see the evil. Its also hard to see the economics. The premise that markets should not be used to allocate the good is generally not one associated with economics. Economics does appear in the observation that with a price that is below the market equilibrium there will be shortage. The quantity of shots demanded will exceed the quantity of shots supplied. But it hardly seems controversial or evil to note that there is going to be a shortage of shots for the first few months.

 

The evil appears to arise from his suggestion that a small number of shots should be auctioned off to the highest bidder and the money used to benefit those who have been harmed by the virus. But what is Thaler’s argument for this plan. He suggests that the rich will find a way to obtain the shots, but if you auction them to the highest bidder that the money the rich are paying will go to the government and then to needy people in society. This argument is actually similar to one that has been made for elite colleges. Auction off places at Harvard, Yale, etc. to the highest bidder and use the money for scholarships to benefit low income students. The alternative seems to be that places are auctioned off to the highest bidder for the benefit of fencing, tennis, and crew coaches. You can, of course argue with multiple parts of his argument, but the claim that wealthy people are going to find a way to get the shots one or another doesn’t seem that controversial, and the suggestion that had might as well benefit from that hardly seems evil.

 

If there is a part that I do disagree with it is my usual complaint about Thaler: nudges are just old wine in new bottles.

What should we do to ensure that most people eventually get the shot?

Traditional economist: Lower the cost and increase the benefit of getting the shot.

Thaler: No. You should nudge them?

Traditional economist: Nudge them?

Thaler: Yes, make it easier for them to get the shot and give them some reward when they do.

Traditional economist: Isn’t that what I said?

The Green Books and American Economic History

 

I finally had a chance to read the NBER working paper by Lisa Cook, Maggie E.C. Jones, David Rosé, and  Trevon D. Logan on The Green Books and the Geography of Segregation in Public Accommodations. They identified the locations of businesses listed in the Green Books and then analyzed how they changed over time as well as how the locations were related to other characteristics of the areas where  they were located.  Their primary conclusions are described in the abstract:

Jim Crow segregated African Americans and whites by law and practice. The causes and implications of the associated de jure and de facto residential segregation have received substantial attention from scholars, but there has been little empirical research on racial discrimination in public accommodations during this time period. We digitize the Negro Motorist Green Books, important historical travel guides aimed at helping African Americans navigate segregation in the pre-Civil Rights Act United States. We create a novel panel dataset that contains precise geocoded locations of over 4,000 unique businesses that provided non-discriminatory service to African American patrons between 1938 and 1966. Our analysis reveals several new facts about discrimination in public accommodations that contribute to the broader literature on racial segregation. First, the largest number of Green Book establishments were found in the Northeast, while the lowest number were found in the West. The Midwest had the highest number of Green Book establishments per black resident and the South had the lowest. Second, we combine our Green Book estimates with newly digitized county-level estimates of hotels to generate the share of non-discriminatory formal accommodations. Again, the Northeast had the highest share of non-discriminatory accommodations, with the South following closely behind. Third, for Green Book establishments located in cities for which the Home Owner’s Loan Corporation (HOLC) drew residential security maps, the vast majority (nearly 70 percent) are located in the lowest-grade, redlined neighborhoods. Finally, Green Book presence tends to correlate positively with measures of material well-being and economic activity.

 

 

 The paper also made me wonder about the the Green Book in relation to places that I have lived. You can view digitized Green Books through the New York Public Library. I looked at the 1959 issue for Fredericksburg, Virginia and Nebraska, where I am originally from.

 

Here are some pictures of the Fredericksburg hotels listed in the Green Books: The Hotel McGuire and the Rappahannock Hotel. They were located across Princess Anne Street from each other near the corner of Princess Anne and Wolfe Street. It was an ideal location in several ways Princess Anne was part of the original Route 1. The Greyhound Bus Station was located on the same corner, and the train station was one block south.

 

 

 

 

Both Hotels were Black owned, and it was a predominately Black neighborhood. Shiloh Baptist Church (New Site) was next door to the McGuire and Mount Zion Baptist Church was less than a block away. Here is an article from the Free Lance Star with people reminiscing about growing up in the neighborhood.

 

 

I also looked at the locations for Nebraska. I was not surprised to see locations near Omaha. I was surprised to see locations in Chadron, Valentine and Ainsworth near the South Dakota border. These are pretty rural parts of Nebraska even now. 

 

According to the 1960 Census, the three counties that these towns were located in had a Black population of 19. I suspect the location of these hotels had to do with the fact that U.S. Route 20 goes through each of these towns. Route 20 goes from Newport Oregon and passes through Idaho, Wyoming, Nebraska, and Iowa before reaching Chicago and, ultimately, Boston. If you were anywhere in the Pacific Northwest and wanted to go to Chicago, Detroit or further east, Route 20 would likely have been your route. 

(The map is from the  Green Book working paper)

 

The Fredericksburg and Nebraska locations were both listed in the Green Book and both were located on what were, at the time, important highways, but that it pretty much where the similarities end. The Hotels in Fredericksburg were Black owned, located ina Black neighborhood, and catered to a Black clientele. I am not absolutely cetain, but I suspect that the motels in Valentine, Chadron and Ainsworth were not segregated. As best I can tell the Midwest Hotel in Ainsworth was white owned was listed in the American Hotel Associations Red Book. 

 (I'm not sure this is the hotel in the Green Book. Here it says the Three Oaks Auto  Court; in the Green Book there is an Oak Court. In any case its a cool old motel.)

It is less obvious why the rural Nebraska hotels were accommodating enough to be included in the Green Book. I grew up in small towns in Nebraska in the 1960s. I’m reluctant to believe that racism was just not an issue. I never saw any Black people but that didn’t keep people from being prejudiced against them.  My uncle lived in Valentine for awhile, its just across the border from the Rosebud Reservation and I suspect its residents would not tell you that racism is absent from the area. On the other hand, pressure to conform to norms or laws that enforced segregation were probably not as great as they were in places, like Fredericksburg, where there was actually more interaction with Black people. In addition, the profit margin on a small rural hotel may have made it difficult to turn anyone away.