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Breaking windows

Alex Tabarrok suggests that Krugman has taken the broken window fallacy to a whole new level. Krugman argues that we want more regulations when we’re in a liquidity trap–it forces firms to invest. Alex responds:

What is interesting about this argument is that Krugman has gone one derivative beyond the broken windows fallacy to create an argument requiring even stronger assumptions, let’s call it the breaking windows fallacy.

Bastiat’s assumption of a one-time, randomly broken window is more likely to be stimulative than an increase in the rate of window breaking. A one-time, window-breaking is a sunk cost that does not affect profit-maximization, at least not according to basic theory. (I say basic theory because once we introduce fixed costs, bankruptcy costs and liquidity constraints a one-time negative shock may cause a firm to shut down even when it would continue to produce without the shock, ala Krugman and Baldwin 1989). Thus a one-time window breaking may cause firms to increase spending. An increase in the rate of window-breaking, however, is a change in the marginal conditions for profit maximization that will cause some firms to exit the industry (reduce output) and thus the net effect on spending is more ambiguous.