DRI-183 for week of 12-7-14: Immigration and Economic Principles

An Access Advertising EconBrief:

Immigration and Economic Principles

1776 marked the founding of a new nation and a new intellectual discipline. The Declaration of Independence announced the creation of a United States of America and proclaimed the individual’s right to life, liberty and the pursuit of happiness. The Founders – specifically, the Declaration’s author – relied heavily on Adam Smith for the intellectual underpinnings of their document.

Smith’s Wealth of Nations, published in 1776, identified the purpose of all economic activity as consumption. Today, economists view consumption as the source of happiness. But in 1776, that notion was radical indeed. The reigning philosophy of government was mercantilism, which taught that government should accumulate gold (or specie generally) as a store of wealth by promoting the export of goods and discouraging imports. The resulting net inflow of gold would enrich the nation. Of course, even mercantilists knew that food was necessary to human survival – they coexisted with a primitive school of economists known as the physiocrats, who believed that land was the only source of economic value and agriculture the only productive economic activity.

Smith’s work began the tradition of modern economics by overturning both his fallacious predecessors. The mercantilists were wrong on two counts: they were wrong to stress exports at the expense of imports and wrong to imply that a “favorable” export surplus was a stable outcome. Imports are the beneficial part of international trade because they enhance consumption; exports are the cost of international trade because they connote a sacrifice of goods sent abroad to obtain imported goods for consumption. Even if an export surplus were to prevail temporarily, it could not persist. Building on the work of his contemporary David Hume, who developed the famous “price-specie flow model,” Smith pointed out that the net inflow of money (either gold or silver) resulting from the export surplus would raise domestic prices, causing exports to become less desirable to domestic residents and foreign imports to become more desirable.

Smith also pointed out that human labor created goods for consumption not only by working the land but in factories as well. His discussion of a pin factory is still studied today as a pioneering analysis of productivity.

Thus did the modern study of economics and international trade begin life together. International economics has stayed in the spotlight ever since. Currently immigration occupies center stage; President Obama has seized the political initiative from the Republicans by proposing to temporarily suspend enforcement of immigration laws against large numbers of undocumented immigrants.

Unfortunately, the accidental historical precedence given to international economics has contributed to the misapprehension that this field of economics is sui generis. The truth is that international economics is subordinate to general economic theory. The truths of basic economics apply internationally as well as intranationally. In fact, most international issues would be clearer if they were reconfigured in intranational form. This applies just as strongly to immigration as it does to every other aspect of international economic theory.

Migration and Marginal Productivity

When students take their first economics course, the principle of marginal productivity is one of the first lessons they learn. But first things first. In the beginning, there is scarcity – and it is pervasive. The “economic problem” is the outgrowth of scarce resources and infinite wants. There is no end to the number of good things that the human imagination can dream up. Unfortunately, virtually all of those good things are created using “inputs” – human labor, natural resources and produced goods. Inputs are available in limited quantities; they are “scarce.” Consequently, the good things – “output” – are also scarce. The science of economics has devised a pure logic of choice enabling us to make the best use of scarce inputs in producing scarce output to satisfy unlimited human wants.

The principle of marginal productivity deals with input allocation. It says to allocate inputs so that all marginal productivities are equal. That sounds mind-blowingly simple, and it is. In practice, what it boils down to is that business managers – indeed, all of us, if you want to view each individual as their own manufacturer of happiness – are on the lookout for situations in which some inputs are highly productive. For example, we are all looking for jobs in which our own labor specialties are highly valued. If we are teachers, we keep a weather eye peeled for highly paid teaching vacancies. Movie actors flock to auditions for desirable parts. Computer programmers look for programming jobs that offer the highest salaries.

Input prices, such as the wages paid for human labor, reflect the productivity of the input at the margin. The more productive the input, the greater the demand by managers and the higher the price they are willing to pay it. The more people supply the input, the more sellers compete to offer input services and the lower the price will be, all other things equal.

Input supply and demand determine the market prices for all inputs, from human labor to land to capital goods. The principle of marginal productivity governs the productive allocation of inputs – it tells us whether it makes sense to use more or less of each input in producing the various outputs. It also tells us whether it is efficient to shift inputs between different outputs by using more labor to produce one good and less labor to produce another one.

When we talk about changing input amounts and shifting inputs, we are talking not just about one particular place and one particular point in time. We are also talking about different places at the same time and about different points in time as well. That is, it may also make sense to shift labor from one place to a different place. The same is true of natural resources and capital goods. We also shift input use from today into the future and vice-versa. Differences in input prices and productivities are the keys to these shifts, too.

Migration is one of the most fundamental examples of all economic adaptive response. Differences in input price and productivity between geographic regions create an opportunity for gain by input reallocation. Let us assume that low-skilled human labor is more productive in Kansas than in Missouri. This will tend to make wages for unskilled labor in Kansas above those in Missouri. The most practical response to this discrepancy is for unskilled labor to migrate from Missouri to Kansas. This will tend to lower wages of unskilled labor in Kansas and raise them in Missouri, thereby reducing the wage discrepancy in the two states. The migration will also tend to reduce the marginal productivity discrepancy in the two states by lowering marginal productivity for unskilled labor in Kansas and raising it in Missouri.

Migrations of this kind happen throughout the U.S. on a daily basis. Nobody thinks much about them, let alone takes measures to prevent them. But if I were to replace the word “Kansas” with the word “Texas” and the word “Missouri” with the word “Mexico,” the whole passage would suddenly become controversial and subject to debate. While intranational migration has occurred throughout American history without attracting unfavorable comment, international immigration has been heatedly debated since at least the 1920s.

Our discussion is the tipoff to the falsity of most of the debate. There is little economic difference between intranational migration and international immigration. The mere fact that the migratory movement crosses an international boundary does not invalidate it. It does not rob it of its economic value. Of course, it does change its superficial character. But that is all; the change is superficial only. The gain from immigration is the same as that from migration – more efficient use of scarce resources. It is one of the most basic, bedrock principles in economics.

Opportunity Cost and Comparative Advantage

The very first subject undertaken in the very first course in economics taken by college students is the subject of economic cost. What is special about economic cost, as opposed to (say) accounting cost? Economists view cost in a special way. Because all of us live our lives exchanging goods for money and vice versa, we are completely habituated to denominating prices and costs in monetary units. And that’s good, because it gives us a common denominator for valuing thousands of things whose heterogeneity would otherwise make comparative valuation a nightmare. Can you imagine a life in which we had to trade goods and services directly for other goods and services, without a medium of exchange to intermediate each transaction?

The thought sends shivers up and down your spine. But economists conceptually do just that when they explain microeconomic theory or, as it is sometimes called, price theory. That theory treats money prices only in relative or real form. A relative price reveals the implied sacrifice of one good involved in the purchase of one unit of another. For example, if the Px = $10 and the Py = $5, then the relative price of X (its real price) is the ratio of X’s price to Y’s price. That is, the purchase of one unit of good X implies the sacrifice of 2Y. While the money price of X is $10, its real price is 2Y. In a two-good world, this relative price is the opportunity cost of consuming X.

Why do economists go to all the trouble of jolting students out of their comfortable familiarity with monetary valuation and into the retrograde world of direct barter exchange? Not because barter trade has much practical application, certainly, although it does arise occasionally in special contexts. No, the purpose is expressed in an aphorism by the great 19th-century English economist John Stuart Mill, who characterized money as a veil that obscures but does not completely hide the underlying reality. That reality is that indirect monetary exchange substitutes for direct barter exchange, and this accounts for the concept of a relative or “real” price. When we pay money for goods we are really trading alternative consumption – specifically, the highest-valued alternative consumption purchase equal in monetary amount. This is a tipoff to the fact that the real value we derive from goods and services is the happiness they bring; money is merely a placeholder (or unit of account) that facilitates comparison and exchange.

We penetrate the monetary veil because it’s the only way to learn the underlying truths about opportunity cost and comparative advantage. In 1815, an English stockbroker named David Ricardo assumed Adam Smith’s mantel as the world’s leading economist by developing a revolutionary model of international trade. Ricardo’s model stipulated two hypothetical countries. He could just as well have called them “A” and “B,” but with an eye to the headlines of his day he called them “England” and “Portugal.” He specified two produced goods, wine and cloth, both produced using human labor. (He treated all labor hours as equivalent.) No chauvinist, he assumed that Portugal was capable of producing both goods using fewer labor hours than was England. He began by assuming a condition of autarky; that is, no international trade between the two countries. He also stipulated (arbitrary) price and production levels for both goods in each country.

Up to this point, Ricardo had done nothing remarkable by contemporary standards. But now he hit his audience with a thunderbolt. He asserted that opening up the two countries to international trade would benefit both of them by allowing them to consume more than each country could produce and consume in the absence of international trade.

First, Ricardo pointed out that the true economic cost of production for wine and cloth in each country was not the (unspecified) monetary cost of employing labor. It was not even the amount of labor hours used to produce each good. (Up to this point, classical economists such as Adam Smith had favored a ‘labor theory of value”; the value of any good was determined by the amount of labor required to produce it.) No, the true economic cost was the opportunity cost of production – except that Ricardo called it the “comparative cost.” Based on the labor coefficients of each good in each country, Ricardo calculated the opportunity cost of one unit of wine and cloth production in both England and Portugal.

And lo! The results shocked the world. In fact, they still do. Even though Portugal appeared to be the more efficient producer of both goods, it had a lower opportunity-cost of production for one good only – wine. Portugal was the more efficient wine producer because its opportunity-cost of production was lower than England’s.

The implications of this finding were – and are – world-shaking. England should specialize in its most efficient good, cloth, by producing more cloth than it did under autarky. Portugal should produce more wine than it did under autarky. (Actually, Ricardo’s model prescribed complete production specialization by each country, an artifact of the super-simplified assumptions built into his model.) Then the two countries should trade internationally – England should export cloth to Portugal in exchange for wine produced by Portugal, thus allowing both countries to consume both goods. The terms of trade should represent a ratio of prices intermediate to that existing under autarky.

Sure enough – Ricardo’s model generated a result in which both England and Portugal achieved consumption levels for wine and cloth that exceeded the possibilities open to them under autarky. At the time, this seemed to the general public like a magic trick. To some people today, it still does. Some people have never learned it and others refuse to believe what they learned. Then there are those who insist that Ricardo’s conclusions apply only in textbooks and not in reality, for a host of reasons.

There are two key insights behind Ricardo’s theory. The first is his notion of comparative cost. Modern economists have broken this term in two. They have modified the term “comparative cost” to “opportunity cost” in order to stress its alternative element. To bring out the comparative or relative element, they have devised the term “comparative advantage” to encompass situations like England’s in Ricardo’s theory. Despite being less productively efficient in both goods in the absolute sense, England nevertheless had a comparative production advantage in cloth because its opportunity-cost of production was lower.

But merely identifying the locus of comparative advantage is purely academic unless we act on it by specializing in production, which creates the extra output that allows us all to consume more by engaging in international trade. Thus, specialization and trade is the second key element in Ricardo’s theory.

Thus far in this section, we have said nothing whatever about immigration. But immigration is the proverbial elephant in the room. For thousands of years, civilization has been following this principle of specialization and trade according to comparative advantage. That is what we do when we grow up, go to school, get a job, work and earn money – then use the money to support our lifestyles. We did it for millennia without realizing what we were doing or why, like the character in Moliere’s play who had been speaking prose all his life without realizing it.

David Ricardo developed his theory in terms of international trade for the same reason that Adam Smith began the modern study of economics by focusing on international trade: that was where the action was in terms of money, public interest and government activity.

It is only very recently that economic textbooks have tentatively begun to point out that the same insight they have been flogging for centuries while teaching the theory of international trade is valid in intranational trade. In fact, this is exactly the insight that has accounted for human productivity since the days when human beings left their hunter-gatherer bands and formed individual families residing in villages, towns and cities.

And how does immigration fit into this implicit theory of everyday production, you ask? The answer would be too mundane to need mention were it not for the fact that so many people ferociously resist it even now. In order for specialization and trade according to comparative advantage and trade to work, people have to specialize in their comparative-advantage line of production, just as England and Portugal had to specialize in Ricardo’s model for those countries to realize the gains from international trade.

And they can’t very well specialize when they aren’t allowed to work at what they do best, can they? Yet Mexicans who are five times more productive working in Texas than in Mexico are nevertheless barred from working legally in the U.S.! The basic fundamental principles of markets are designed to achieve maximum productivity by assigning all of us to our highest-valued uses, where our marginal productivity is highest. And U.S. immigration laws allow people to move across international borders only according to their national origin, which has as much to do with their marginal productivity as the color of their eyes does.

Is this any way to run a railroad? Is it any wonder that the greatest economists, like Milton Friedman, constantly stress fundamental principles rather than niggling about esoteric mathematics or econometric models?

Cost Minimization

The standard microeconomic theory taught in college courses is divided into three subject areas: the theory of consumer demand, the theory of cost and production and the theory of marginal input productivity. The theory of cost and production is sometimes called “the theory of the firm” because its usual application is to business firms. That theory explains the optimal logic behind the production and sale of output to consumers by businesses.

A key principle of this theory is cost minimization. The theory of the firm assumes that the firm’s goal is profit maximization. (“Profit” might be viewed in instantaneous terms as the residual of total revenue from the sale of output minus all costs of production, including the opportunity cost of capital and/or the owner’s labor time, or it might be viewed intertemporally as the discounted present value of expected future net revenue.) The firm’s manager(s) will choose the rate of output that maximizes profit and will select the combination of inputs that minimizes the cost of producing that rate of output.

It goes without saying that the firm will purchase any quantity of (homogeneous) input at the lowest possible price. Alternatively, the firm will purchase the highest quality of any heterogeneous input at a given price.

Well, it’s supposed to go without saying, anyway. But when it comes to immigration, suddenly it’s a crime even to say it out loud. When employers want to hire foreign workers because they can pay lower wages than they are paying to domestic workers for the same work, that turns out to be illegal, or immoral, or fattening or otherwise verboten. But if this is not only allowable but even downright de rigeur in an intranational context, why should it be unthinkable in an international context?

Of course, the answer is that it shouldn’t. It is just as beneficial to minimize costs by hiring cheap foreign labor as it is to hire cheap domestic labor. It is just as beneficial to hire cheap labor from any source as it is to purchase cheap raw materials or cheap land or cheap machinery.

Did a reader respond by inquiring “beneficial for whom?” Well, the answer is “beneficial in the first instance for business owners, but beneficial in the long run for everybody, because lower costs ultimately are reflected in lower prices and everybody is a consumer – including all the owners of inputs who are paid the lowest prices.” We can’t always guarantee that every single person benefits from every efficient economic activity – such as immigration – more than they suffer from it. But that has to be true for most people – otherwise, how did civilization advance as it has over the millennia? How did the U.S. become the U.S.?

What About “Fiscal Cost” or “Net Job Creation” or …

We now know that the concept of free and open migration – whether inside the boundaries of a nation or across national boundaries – is fundamental to the efficiency of markets. It is inextricably interwoven into the fabric of our everyday lives, so much so that we take it completely for granted. Thus, when we protest against immigration by foreigners into our country we are engaging in the most blatant contradiction.

How many times have readers of this EconBrief previously seen this issue framed in these clear, straightforward terms? Chances are, the answer is: Zero. Instead, we are presented with a variety of alternative arguments against immigration.

For example, a fairly recent anti-immigration tactic is the “fiscal cost” scam. We are urged to restrict immigration – or ban it altogether – because it is unaffordable. Supposedly, immigrants cost the government more in various forms of transfer payments (welfare, Social Security, emergency medical and more) than they generate in receipts (various tax payments). Thus, on net balance they flunk the criterion of “fiscal cost.”

The non-economist might suppose that this is a key test of economic worthiness, perhaps tabulated quarterly or annually on every American by a government bureau and kept on file. What a laugh. Fiscal cost is a term made up by anti-immigrationists in order to discredit immigrants. The easiest way to appreciate this is to recall that half of the American population now pays no income tax. It has recently come to light that most Americans stack up even worse by the fiscal cost standard than do immigrants! This is hardly surprising; immigrants are not eligible for most forms of welfare and tend to be younger than the average American, so get less medical treatment than average as well. They are more entrepreneurial and tend to work harder, so are more productive as well. This follows because, far from being the tired, dispossessed, tempest-tossed, ragged poor of the Emma Lazarus poem, immigrants tend to have more initiative and smarts than the average person. They have to be better than average in order to contemplate traveling to another land, speaking a foreign language, coping with another culture and starting another life. The anti-immigration stereotype of a lazy bum who somehow runs the border gauntlet in order to live off the fat of the U.S. welfare state is a particularly egregious myth.

Calculating fiscal cost is no easy task. Why would a researcher engage in laborious calculations to produce estimates of aggregate effects whose meaning is so obscure? Actually, complexity and obscurity are what make concepts like fiscal cost attractive to anti-immigrationists. The last thing they want to do is join a debate on fundamental economic principles, where the issues are so straightforward and clear-cut. Why start a fight they are destined to lose? Instead, they want to pick a fight they can pretend to win because the public will not know how to judge it. We are so used to hearing economic issues outlined in complicated terms, so accustomed to watching with glazed eyes and hearing without comprehending that we fall back on our emotions rather than our reason.

Now the anti-immigrationists have us where they want us. The immigration debate takes us back to the days of pre-history, when mankind first began to break up the ancient bands and form families. Outsiders were looked upon with suspicion. Trade and specialization were forbidden; economic activity was geared to benefit the band, not the individual household. Today, the nation state has taken the place of the ancient hunter-gatherer band as the extended family. The state dispenses welfare benefits and rules over us with an iron fist. It wants to control economic activity for its benefit and the benefit of its acolytes. It inflames those ancient, instinctive antagonisms toward outsiders that still reside within the citizenry.

We can revert to the savage, instinctive atavism of mankind’s primitive past. Or we can embrace the reasoned productivity of freedom and free markets. The choice should be easy, for the record of history shows that markets have lifted mankind out of the muck and mire to the prosperity of today.

The last thing we should do is judge immigration by perusing the latest pseudo-study by a think-tank dedicating to obfuscating clear thought. The simplest, clearest, most basic of all economic principles tell us that immigration is vital to freedom and prosperity.