Heterogeneity matters: Why remembering people are different is important for thinking about outcomes

When I was a student a lecturer said to us “When analysing trade, does it make sense for us to assume everyone is the same?  If everyone was the same why would they trade with each other?“.  This is simultaneous a bit of a silly question and a useful one.

He answered that they wouldn’t, and went on about something – but in truth it is because of his definition of “same” with regards to the model he was describing.  He was looking at a GE model with people with the “same” endowments and preferences – and yeah sure in that model there is no trade.  But this ignores the idea of production entirely – even if we have the same preferences and same “characteristics” (in terms of the hours we are endowed with and our ability to turn those into leisure or output), the existence of a production process with specialisation implies that there is benefit from specialising and then trading.  This division of labour is pretty central to our understanding of trade, so we shouldn’t really look past it.

But it raises something important as well.  We need to describe why people are trading, and what exactly is driving that process, before we can evaluate anything.  Let’s make a quick framework that will help us do that!

Why are we trading then?

Ok, we trade for one reason – someone who has something values it less than someone who buys it [Note:  Those explanations of value in the Wikipedia article are atrocious – the description at the top is what I’m linking to].  This says nothing of the process that leads to these relative values, or the harm or benefit that trade may have on other people uninvolved in the transaction.  All it tells us is that these differences in value give the reason for trade.

If there are three of us sitting around, there are 9 chocolate bars (3 Moros, 3 Mars bars, and 3 Snickers), and we all value varying chocolate bars the same way (a Moro, Mars bar, and Snickers each give us the same level of utility, but we also have the same type of diminishing marginal utility from either) then we can think about trade.  If we are each endowed with 1 of each bar we will not trade.  If we are each endowed with 3 of one bar, then there are gains from trade – and a trade with equal bargaining power will see us go from an endowment of 3 of 1 chocolate bar to having 1 of each of the 3 chocolate bars!

Now if there is production, the existence of the division of labour suggests we can make more by focusing on only making one thing – or one element of one thing.  Given this we are paid money incomes which we can use to trade with other people specialising.  Our decision to work gives us money incomes, we then trade these money incomes for products from the firms that organised us blah blah blah.  The key thing is NOTHING here requires that people are different – instead people are doing different things because of the institutional structure of the economy alone.

How can we be different in ways that may cause trade without specialisation though?  There are three ways:

  1. We have different preferences over things (goods and services, leisure, chocolate bars) – we differ in how we turn the observed products, and the endowment of hours we have which we spend on “leisure/home production”, into utility.
  2. We have varying abilities to turn our time into goods and services, both in a relative sense (what am I good at making?) and an absolute sense – we differ in terms of how we turn our endowment of hours that are spent on remunerated work into products. [Note:  I state products rather than incomes, as the income we are remunerated with for producing may in turn vary from our contribution to output due to institutional structure.]
  3. We vary in terms of our non-income generating and non-utility from consumption generating characteristics – what we commonly think of as “endowments”, even though our preferences and ability to work are also endowments in a sense.  Think here the wealth we start off with when we are born, or start off in a society where there is a safety net so we don’t face the risk of starvation.  However, to get that trade the endowment must vary from the set of things that the individual values … that is the example of clustered chocolate bars before.

Ok that is nice, we have extra reasons why we may observe trade.  But are patterns of trade fair?

Are patterns of trade fair?

So here we can try another framework.  Why might we get different outcomes?

  1. If everyone is exactly the same and we have different outcomes, then this appears unjust.
  2. If peoples preferences differ and we have different outcomes then we don’t know – if we have equal outcomes this is unjust.
  3. If some people are better at making things then others and we have different outcomes then we don’t know – if we have equal outcomes then we don’t know either.

We can start to see some threads coming through if we can agree with the above statements.  Horizontal equity appears as, since everyone is exactly the same varying outcomes solely imply differential treatment by society.

With the second one things are difficult.  People actually enjoy different things and make different choices.  Some people like to work and consume, some people despise working and don’t value consumption much – these people are allowed to make different choices.  Forcing people who want to do different things to do the same thing is unjust.

The last one is where things get difficult.  We need to ask “why are some people better at making some things than others”?  Are they endowed with natural talents?  If so, they are endowed with something by luck that is giving them higher life satisfaction – is that fair?  If not is it the responsibility of government to make it fair?  If so what will happen to the behaviour of this person if we reduce the income they receive from doing that production – will they decide to work less or take more leisure?

What happens if, instead of natural talents we are talking about someone who undertook extra training, or someone who has been in the labour force longer … how do our answers change as the REASON for the difference changes!

In this last example we get a lot of the trade-offs that we argue about when discussing policy all the time – is redistribution just?  Even if it is just in terms of distribution, what about if it leads to less being produced overall?

This can lead to the argument regarding deserving vs undeserving poor – someone with a lifetime disability as compared to someone who could work but sits around playing Fifa 19.

Importantly, how do our answers change once we shift the question to why people may make a higher income from their role – is that solely the response of them creating more, or is there something to do with the institutional structure.  What happens if, as a white man, I am just paid more than a different group?

As soon as we introduce heterogeneity we find that some inequality is actually good, but we also find that types of injustices differ greatly based on the differences between people – something that is incredibly important and gets ignored when some loud mouth like me makes a statement like “replace the minimum wage with a minimum income“.  Policies have different ethical principles embedded in them, and we should be trying to ask about those when we decide what types of policies we support in a society like New Zealand.

This is why I’m an incrementalist – instead of trying to grab a measure of wellbeing and maximising it, I’d prefer we try to figure out what equity/fairness principles are relevant to people in society, and to ask what the policy trade-offs would be when trying to correct for observed injustices.  My unpopular opinion among many economists is that a lot of New Zealand’s policy settings are actually pretty good when we ask these sorts of questions … hence why incremental change rather than some type of Big Kahuna is appropriate where we are at the moment.

Although if you want to disagree with me in comments, and provide some arguments why, I’d enjoy it 😉