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Alexandria Ocasio-Cortez Misconstrues One of the Most Basic Principles of Economics

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New York Democratic Rep. Alexandria Ocasio-Cortez (AOC) is popular for many reasons, but perhaps the most meaningful source of her appeal is her intrepid advocacy for economic policies that energize progressives. She has buoyed progressive hopes with her unapologetically ambitious vision of a society with revitalized infrastructure and a Green New Deal in which everyone has a job with a living wage, health care, and the ability to get a college education. But “thinking big” carries an unwelcome degree of risk if policies are not grounded in a sound understanding of the basic principles of economics — like the problem of scarcity, at which she recently took aim in a town hall on education policy.

During the event, she talked about her father as a teenager living in the Bronx in the 1970s, leaving “his apartment at five o’clock in the morning every day to get on to the 6 train or to get onto the 4 train, and ride a very dangerous subway during the 1970s at 15 years old to go to Brooklyn Tech” — a “good school” that “was seen as his only opportunity to have a dignified life.” She asked: “why are there only five — or a handful — of schools in New York City that are seen to give us this life?,” and declared that every public school in the city should offer those opportunities.

After a member of the audience heckled her, AOC replied (once the member calmed down): “My concern is that this right here, where we’re fighting each other, is exactly what happens under a scarcity mindset.” Instead, she argues, people should join her to fight the moneyed interests corrupting the political establishment.

AOC’s Robin Hood oratory was all well and good, even laudable (besides the regrettable us-versus-them mentality). Economic inequality today reminds many of the Gilded Age. But if we are going to think seriously about these issues, we should begin, at least, by getting economic principles right.

Scarcity vs. Distribution

More than half a century ago, economist John Kenneth Galbraith wrote that America’s “affluent society” can afford to spend more on the public sector. But the problem to which Galbraith referred was distribution, not scarcity. Putting aside thorny questions about the pros and cons of elite schools, AOC misconstrued one of the most basic principles of economics — that resources are scarce and society faces opportunity costs when making decisions about how to allocate them.

In blaming what she calls a “scarcity mindset,” AOC conflated the problem of scarcity with the problem of distribution. Given scarce resources, the question for society is whether or not the economy is creating as much value as it can at the least possible cost (productive efficiency). The question then becomes how that value gets allocated to the most efficient uses, given the preferences of consumers and prices set by supply and demand in competitive markets (allocative efficiency). Efficiency is concerned with the optimal production and allocation of valuable goods and services derived from putting scarce resources to work. Distribution is concerned with how valuable goods and services are ultimately distributed among society’s members. America is the richest society the world has ever known, but resources are not limitless. There may be a lot more to go around, but abundance does not eliminate the question of whether the use of resources is optimal, both in terms of allocative efficiency and fair distribution.

The point is best illustrated by an Edgeworth box diagram, an elementary model of the economy that illustrates the problem of scarcity while making a distinction between allocative efficiency and distributional fairness. In the model, there are two consumers and two goods. Each consumer receives an “endowment” — i.e., inheritance — that makes some amount of both goods affordable. If the goods are wine and cheese, each consumer can afford some proportion of the total (not unlimited) amount of wine and cheese. If there are one hundred bottles of wine and one hundred blocks of cheese, and one consumer can afford seventy of each, the other consumer can afford thirty of each.

Given an endowment, each consumer prefers some affordable combination of the two goods. If prices change, he can buy more or less of wine relative to cheese by purchasing another bundle which is affordable at the new prices while yielding the same level of satisfaction. The set of bundles yielding the same satisfaction but corresponding to different prices all fall on what economists call an “indifference curve.” The curve is “convex” — a fancy way of saying it is shaped like (a sliver of) a crescent moon curving inward toward the origin on a standard Cartesian plane (a two-dimensional plane with y-axis and x-axis like we learn in high school). See here:

Though a consumer is indifferent among the bundles on his indifference curve, it is important to note that the satisfaction (“utility” in economic-speak) derived from consumption of one good increases at a diminishing rate as consumption of the good increases relative to consumption of the other good. This “law” of diminishing marginal “utility” means that, while overall satisfaction from any specific bundle from the set of bundles on the indifference curve remains the same, the marginal utility from specific amounts of each good in different bundles changes as the consumer considers how much of each good to trade as prices change (in economic-speak, the marginal rate of substitution changes as one moves from one bundle to another on the indifference curve).

In other words, consumers get sick of one good if they have too little of the other, and vice versa. If a consumer has a lot of wine and almost no cheese, he’ll probably be willing to trade a lot of wine to get a little more cheese. If he has a lot of cheese and almost no wine, he’ll probably be willing to trade a lot of cheese to get more wine. How does he choose? It depends on the prices. He might not care if he has a lot of wine and only a little bit of cheese, or equal amounts of both, at a certain level of consumption (i.e., for a given indifference curve), but he will probably purchase the bundle with a lot of wine and little cheese if wine is cheap and cheese is expensive. Similarly, he’ll probably choose the bundle with a lot of cheese and little wine if cheese is cheap and wine is expensive. The specific bundle he chooses will reflect what he can afford given the relative prices he faces. In economic-speak, he chooses the bundle at which the “budget line” (which illustrates the relative prices — i.e., the rate at which the consumer is able to trade wine for cheese given the prices that prevail in the market) is “tangent” to the indifference curve. See here:

At point “e”, the consumer has chosen the optimal bundle of wine and cheese — a combination of wine and cheese he is willing to buy at prices he is able to afford. Note that if he had more money to spend, he could buy more of each good at the same prices and end up, for example, on indifference curve I3, whereas if he had less money, he would be able to afford less of each good at the same prices and end up, for example, on indifference curve I1. Typically, economists assume that more is better.

The Edgeworth Box diagram combines this situation for both consumers in the economy. See here:

In this case, the economy consists of consumers A and B, who can purchase goods X and Y. Both consumers have indifference curves that show their preferences for different bundles of X and Y that are affordable at different prices while yielding the same satisfaction (or “utility” in economic-speak). Note that, in the case of consumer B, the Cartesian plane has been inverted and superimposed over the Cartesian plane depicting the indifference curve for consumer A. The point “w” indicates a bundle of X and Y that is affordable for consumers A and B given their endowments. Consumer A buys more of Y than X given his preferences and market prices, while consumer B buys more of X than Y given his preferences and market prices. In short, there is only so much of X and Y to go around (i.e., there is scarcity), and consumers spend what they can afford in accord with preferences and prices (i.e., competitive markets allocate resources efficiently).

If budgets lines were shown, they could be used to illustrate the optimal outcome for each consumer acting independently, as well as potential gains if they decide to trade. In isolation, consumers A and B may choose point “w,” representing an allocation of X and Y for each consumer (more of Y and less of X for consumer A, more of X and less of Y for consumer B) which is optimal if different prices prevail for each consumer (represented by budget lines tangent to each consumer’s indifference curve — Y is cheaper than X for consumer A, but more expensive than X for consumer B). But then, as summarized nicely here: “consumers can find prices at which they are willing to trade the two goods to achieve a ‘Pareto-improving’ reallocation of the two goods.” This means there is room for both consumers to improve their lot via trade. Suppose these relative prices are reflected in a budget line — perhaps announced in an “auction in which various price ratios are announced” — that runs through the point “w” without being tangent to either indifference curve.

Notice the space, in the graph below, between the two intersecting indifference curves. This is known as the “negotiation space” — i.e., consumer A can trade some of Y to get more of X, while consumer B can trade some of X to get more of Y. The amount of X consumer A can get by giving up some of Y is more than he can get with the budget allotted to him by his endowment (i.e., by trading Y for X along his indifference curve as prices change), and similarly for Y (i.e., trading X for Y along his indifference curve as prices change). If consumers A and B are allowed to trade with each other at some market price (e.g., a budget line which runs through point “w” and into the negotiation space) that makes more of X affordable for consumer A per unit of Y that he gives up to consumer B, and makes more of Y affordable for consumer B per unit of X that he gives up to consumer A, then both consumers to move to higher indifference curves (i.e., trade is “Pareto-efficient”). Both are made better off at point T, but because their indifference curves are tangent to each other, no further trade can make one consumer better off without making the other consumer worse off (i.e., the allocation resulting from trade is “Pareto-optimal”):

This diagram also illustrates the first and second welfare theorems of economics. The first welfare theorem of economics says that any equilibrium (i.e., any tangency points between the indifference curves of each consumer) in a competitive market (i.e., consumers are “price-takers”) is also a Pareto-efficient allocation. The second welfare theorem of economics states that any Pareto-efficient allocation can be achieved with appropriate transfers that change the initial endowments. In other words, under a set of assumptions (e.g., price-taking, zero transaction costs, and convex preferences), competitive markets give rise to efficient outcomes. If society deems any particular outcomes undesirable (e.g., one consumer has everything, while other consumer has nothing, so that point “w” is at the origin of one of the two consumers on the Cartesian plane), it can transfer some of the initial endowment of the rich consumer to the poor consumer, then let the consumers trade at the prices that arise in a competitive market. Efficient outcomes will result.

Public Schools: Scarcity or Distribution?

Coming back to AOC, consider education policy. Imagine a city with two neighborhoods: a rich neighborhood and a poor neighborhood. Both neighborhoods elect a political representative to negotiate legislation designed to determine how many schools are built, where they are built, and what type of school they will be. There are two types of schools: “elite” schools focused on preparing students to gain admission into a prestigious liberal arts university, and “trade” schools focused on training students to enter careers in practical vocations like carpentry, plumbing, or software coding. On their own, rich and poor families would build the number and types of schools that they prefer and that they can afford. But they can also elect representatives to a city council to see if a reallocation of resources can make at least one of the neighborhoods better off — in terms of the number, location, and types of schools — without making the other neighborhood worse off.

The rich and poor representatives may be able to negotiate a “Pareto-efficient” outcome in which the poor families get an extra school or two without making the rich families worse off, but the rich families will still build most of the schools. Suppose, however, there is a municipal government that imposes a tax on the rich families that can be used to increase the endowment of poor families. This tax redistributes the initial endowments that influence negotiation between the two political representatives over how to allocate resources for school construction in both neighborhoods. With or without the transfer, efficient outcomes can be achieved. But with a tax and transfer, the city government can achieve what it deems to be a “fairer” outcome that is also efficient.

AOC presumes a one-size-fits-all model of high-quality education. But “elite” schools may not be the best option for every rich or poor student. Different students respond in different ways to different educational environments. Elite schools may not be the best option for every rich kid, and trade schools may not be the best option for every poor kid — and vice versa. The political representatives for the rich and poor neighborhoods must decide on the optimal allocation of elite and vocational schools according to the preferences of their communities. Not all rich parents may want to send their kids to elite schools, and not all poor parents may want to send their kids to trade schools. With appropriate transfers to put both neighborhoods on an “equal” playing field, they can mutually decide on the optimal number and types of schools that are appropriate for each neighborhood.

Scarcity is still a problem, and competitive markets are still an effective, if not always perfect, mechanism for achieving allocative efficiency. Distribution is also still a problem — just a different problem. Fortunately, under certain conditions, competitive markets can achieve outcomes that are both allocatively efficient and distributionally desirable.

AOC has a point when imploring her constituents not to fight each other in a town hall or compete over their children’s admission to elite school, and that they focus their attention instead on beseeching their political representatives to develop legislation to provide every child an opportunity for a “good” education. But that’s about distribution, not scarcity. This might seem like much ado about nothing if we all agree on the goal of “fair” distribution, but if AOC misconstrues a basic principle of economics by conflating scarcity and distribution, one may be inclined to doubt whether any of her “big ideas” on economic policy are ultimately based in sound economic reasoning.

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