Wednesday, May 16, 2007

The Argument against Gouging

In the wake of concerns about rapidly increasing gas prices and the resurgence of anti-gouging laws, I wanted to take a moment and think about whether there could be any economic justification for preventing price gouging. That is, is there any way of framing the problem so that economists would agree that anti-gouging laws are good for society as a whole.

To be clear, anti-gouging laws will help some people. Most economists, however, believe that when all is said and done such laws hurt more people than they help. I am skeptical. I am skeptical because I am always skeptical. I am particularly skeptical because the public reaction is so hardily in favor of such laws.

Collective ignorance is hard bullet for me to bite. That’s not to say that it doesn’t happen, just that it takes heavy doses of evidence to convince me that it’s true. I should say also that collective ignorance and mass ignorance are two different beasts. It is entirely possible for people acting in a society to arrive at the right conclusion even if each individual has no idea what’s going on. Call it social emergent intelligence.

The first culprit when trying to reconcile a difference in opinion between economists and the public is on distribution. Economics proper is largely silent on how wealth is distributed; the public cares a great deal.

So, what does price gouging do to the distribution of wealth. The most obvious answer is that it transfers it from costumers to sellers. This is true but for various reasons I find it unsatisfying. What interests me more is the transfer between customers.

When the price of something goes up people buy less of it. True enough. But, who are those people? Does everyone buy less of it? In particular, do the poor reduce their consumption more than the rich?

That depends in part on whether the good is a luxury or a necessity. When the price of luxuries go up, poor people stop buying them in droves but the rich only cut back a little. On the other hand, both the poor and the rich try to hold on to their necessities as long as the can.

Now let’s just say for the sake of pure argument that a person must have a few basics to survive including gasoline or some much more expensive alternative. The cost of the basic level is almost the entire budget of the poor but a small fraction of the budget of the rich.

Enter price gouging. The back drop is this: War destroys the US oil supply. There is a shortage of gasoline. Oil companies can respond one of two ways. The first is that they turn to the price system and keep increasing the price until demand falls. The second is some sort of non-price rationing like waiting in really long lines.

What happens if the oil companies choose the price system or gouging as the politicians call it. The price of gasoline keeps rising and rising and rising and doesn’t stop until demand falls to match supply. If the price rises to the point where the more expensive alternative is available then the wealthy will switch to it and all will be well.

However, what happens to the poor who could not afford that alternative to begin with? In this example they all die. They needed gasoline or the alternative to survive. They could only afford gasoline. Since the price of gasoline rises to the price of the new alternative they don’t survive.

What would happen if we used non-price rationing? In this example, the worst that could happen, even if you picked a rationing system at random, is that the poor still die. If the lives of any of the wealthy are threatened by the rationing system they will just turn to the more expensive alternative.

However, the lives of some of the poor could be saved. If the rationing system differs in anyway from the price system then more people will live. Said another way, price gouging is the worst possible thing that could happen.

For the nerds out there what is going on is that willingness-to-pay is not accurately measuring the utility gain because of budget constraints. The poor are forced into a corner solution. The poor would really like to trade consumption from states of nature without gouging to states of nature with gouging but cannot because of incomplete insurance markets. As a result relatively small utility gains for the rich are paid for with huge utility losses to the poor.

The death example is extreme but it is only for the purpose of clear illustration. No one disputes that death involves a large loss of utility. However, the poor could simply lose their jobs, not be able to take their kids to day care, or not be able to visit a dying relative. In any of these cases gouging could be worse than the alternative.

hat tip to mankiw

Tuesday, May 15, 2007

Summer Lull

Posting will be light for much of the academic summer. Thanks to all the regular visitors.

Thursday, May 10, 2007

The Evolution of Economic Psychology

Paul Rubin echoes an argument popular in economics and business circles these days. Most people fail to appreciate the gains from trade and immigration because they are trapped by Neolithic analysis. They see outsiders as threats to the tribe. They view competition as a zero sum game and they over-estimate the importance of anecdotes. What they really need is a good dose of economics education.

There is a part of me which is inclined to agree. Certainly impetuous young freshman, eager to change the world, often transfer models of small group interaction to the national stage. They forget the costs of information. They are unaware of the wide dispersion in preferences. They consistently overestimate the effectiveness of deliberate social pressure. They are also vulnerable to the Neolithic traps Rubin describes.

In my experience, however, the average person is more immune to those types of errors. Such analytical errors are most prevalent in white space thinking; the kind that passionate intelligent college students revel in.

Most people, however, rely on experience. Indeed, experience is so important in the modern world precisely because instinct is so ill suited to it. But that is another post. Trade and illegal immigration are so hated in the decaying cities of the Rustbelt, in the ghost like mill towns of Carolina, and in the crammed exurbs of Southern California because their experience with it is so horrific.

Some Americans see that and think, “That could be me” but more see and think “but for the Grace of God that would be.” The difference is subtle but important. The first involves a mistaken estimation of probability, the second a sympathetic heart. Both might be born out our evolutionary past, but the later is no less relevant today.

The real question is why so many economists are so quick to dismiss such objections as ill formed. The first question shouldn’t be why is this person wrong, but how can I understand what they are really complaining about. Is it truly a misestimation of the dangers of trade, or is it a cost that we have failed to pick up? Is sympathy an important externality? Is fear of change a real largely uninsurable cost? Do social spillovers induce a particular and non-linear pain when children have to leave home to find a job elsewhere?

These are the questions we should be asking, but perhaps the psychology of economics isn’t as evolved as we like to think.

Hat tips: Mankiw and Caplan

Tuesday, May 8, 2007

Signal to Noise Ratio

Will Wilkinson takes a walk on the dark side. He agrees with Bryan Caplan that education is mostly just a signal that you are already talented and suggests that there is “a huge entrepreneurial opportunity for whomever can come up with an alternative scheme of credible human capital certification”

My longstanding objection to the signaling hypothesis is two fold

1) The market abhors unclaimed profits. That is, it is hard to imagine that individuals in the economy are spending vast resources on something which is largely useless and that profit maximizing firms are rewarding them for doing so!

2) There is little to no evidence for the signaling hypothesis. The evidence shows that when we control for ability the return to college goes up, not down. For me this explains why nerds tend to find school useless. It was useless for them. That doesn’t mean that it’s useless for everyone.

My own theory is that the human capital formed in higher education is the ability to solve problems, manage time, work independently, seek out assistance, communicate your ideas, form and in some cases direct teams. These skills, not knowledge are what employers want.

Traditionally education focused on the classics for the same reason that athletes run hills. They’re hard. It’s not that your ability to run hills signals your ability as a football player or wrestler. It makes you a better football player or wrestler.

Now in athletics there was a revolution in “sport specific training.” That is, some people said “hey why don’t we have these kids train in ways that are actually related to the sport they are playing.”

It made a difference but not a huge one. The key factors of strength, speed, motivation, endurance, emotional self-discipline and tolerance for pain where sometimes better honed under conditions that had nothing to do with the actual sport.

Education, I believe, operates mostly the same way. The skills needed to direct an engineering project are sometimes best honed by slogging your way through purposefully near impossible homework assignments. The understanding of unintended consequences needed for white space thinking in big business may come best from analyzing why it is that none of your favorite economic policy proposals work out the way you thought. The communication skills needed to lead a company through restructuring my first come from writing and rewriting an essay that can persuade a stern professor that Hume is properly considered an atheist, not a deist.

In each case it is the skill set that is important. The knowledge is relatively unimportant.

hat tip to Kling

Technology and Trade

A reader asks where technological change fits into the analysis below. This question goes right to the heart of the matter. For trade to increase GDP without increasing factors trade must induce some type of technological change.

It seems pretty straight forward how this might happen with less developed countries. Technology transfer from the West pushes them closer to the frontier.

The argument gets a little more complex when you start thinking about developed countries. Anyway you slice it you are going to have to give up constant returns to scale to get technological growth from trade.

The options I see are:

1) The market for advanced technology grows which increases investments in R&D.

2) There are spillovers at the international level. That is, American firms learn techniques from foreign firms and vice versa. This is a little bit different than the first because a technique might be something like Total Quality Management which isn't quite the same as a new technological device.

3) Efficiency through dynamicism. I haven't seen this as a model but I think many economists believe that robust competition in and of itself can push the technological frontier. I think many observers would agree that AMD's competition with Intel was key in speeding up the development time in semi-conductors.

However, as I have said before once you open the door to these type of non-linear effects then the trade argument becomes much much more complex. For Example, it could be the case that increased trade gives the wealthier countries the opportunity to crush foreign competition early on. If you believe the dynamicism argument this might be bad in the long run.

Monday, May 7, 2007

What Happens to A Market Disturbed

There seems to be some confusion about the difference between welfare loss and GDP loss. Welfare loss (in partial equilibrium) is approximated by the Harberger Triangle. In the graph above C.

Partial equilibrium GDP loss is how much smaller the market is. In the graph above that is A - B. We measure the size of the market as quantity X price.1

It is entirely possible for the Harberger Triangle to be large and the GDP loss to be negative. That is, a tax could decrease welfare but increase GDP.

Moreover, in general equilibrium GDP loss can only come from decreased production. For most of our models that means that either there has to be less labor supply or less capital. Same labor, same capital implies same GDP.

Why is this important.

First, in most cases I believe GDP losses are significantly smaller than welfare losses. I may be able to prove this always true but I have to think about it.

Second, the standard answer that economists give when talking about the losses from taxation, tariffs, regulation, etc is a welfare measure. Yet, policy makers hear a GDP measure. In the back of policy makers minds they are already converting GDP to welfare. If you give them the wrong number they will convert twice and really overestimate the loss.

(1) Just as in Harberger case we assume that taxes are lumped summed back and spent on something else.

What's New About the New Offshoring

I am happy that economists like Alan Blinder are rethinking the consquences of free trade. It is too easy for most economists to conflate flawed reasoning with a flawed position. Even fools are right sometimes.

This, I believe is the case with free trade. The fact the anti-free trade crowd espouses a reasoning that does not hold up to scurnity does not imply that they are necessarily wrong.

Blinder's critque brings up the heart of the issue. There will be a transition process. That process will be difficult for some people. To the extent that we care about those people, we must be aware the consquences of globalization and be prepared to address them.

Moreover, it is in our naked self-interest to do so. A favorite quote of mine:

Why do we care about the poor? Because when they revolt, they always hang the elite.

Perhaps the new message should read:

Why do we care about the upper middle class? Because when their jobs are threatened they always vote out the current administration.

If there is anything new about the new offshoring then that's it. Its not how I would have prefered to gain allies, but I'll take it.

Saturday, May 5, 2007

Nothing New Under the Sun?

Interestingly, my background research on "cognitive capital" turns up some work by McFadden and others around 2000. The really cute thing is that they actually use the term "cognitive capital" and in roughly the same way I use it.

As far as I can tell the work seems to be mainly empirical in nature, primarily focusing on experiments. I have not yet seen a formal theory. If anyone has seen one let me know. I think there is some really cool work to be done here.

If you can model comprehesion as a produciton function of cognitive labor and cognitive capital then the Inada conditions should hold. If you combine that with non-linear depreciation my guess is that the importance of early childhood eduction/mental stimulation will fall right out.

Varian's Point Still Stands

So there has been a bit of a scuffle about what Ilia Dichev's paper really meant. Turns out I was wrong. The sole point is that the supply of stocks on the market changes as the market goes up and down.

Companies issue more stocks when the market is high, and they buyback more stock when the market is low.

So if you are buying into a rising market then you are buying into increasing supply. If you are selling in a falling market you are selling out of decreasing supply. That is, if you time the maket the way most people would try to then the basic forces of supply and demand are working against you.

Thus, you are better off buying and holding. Now that might also suggest that its better to take the Buffet strategy of buying against the market and then holding. But of course we know that seems to work. Its just that the opportunity cost is paid in stress.

Friday, May 4, 2007

A Theory of Cognitive Economics

One of the ideas that I have been kicking around is integrating some behavioral observations into a theory of cognitive economics.

It seems to me that many of the observations that come out of behavioral economics could be explained by two facts:

1) Thinking is hard.

2) People gain utility from imagining things that will never happen.

Both of these facts seem to be born out in everyday experience. Any professor knows that the first is true. Thinking must be hard. If it wasn’t then we wouldn’t have to offer students incentives to do it.

This fact can explain a lot of why people use rules of thumb and other short cuts when making choices. The cost of thinking simply outweighs the benefits. To explain why people who engage in relatively sophisticated thinking on a regular basis still use short cuts we simply need cognitive capital.

There are tools that we gain for thinking about certain types of issues that are not easily transferable to some others. Perhaps, mathematics can be seen as a particularly high return form of cognitive capital.

The second fact is perhaps less obvious but I think can explain a lot. Sometimes people purchase products which they do not use. Outside observers could easily predict that the person will not use them, so then why do they buy them?

Well, one reason might be simply cognitive consumption. The thought of myself going to the ballet all season long might be enough to get me to spring for season tickets, even if in reality chances are that I will miss most of the shows.

I am faced with two options. Option one, I buy season tickets and consume both the shows that I see and the thought of the seeing all of the shows. Option two, I buy the tickets individually and consume the shows I see and the thought only of the shows I see.

If the benefit of thinking about seeing the shows I actually missed is worth more than the additional cost of the season tickets I will buy the tickets. I will also be better off from having done so.

In a sense the tickets are a compliment to my imagining myself going to the show. The imagination is richer and fuller if I actually have the tickets.

I believe that an increasingly important part of our economy consists of cognitive capital and items which are complements to cognitive consumption. Understanding what these are and establishing the associated elasticities could enrich economists' ability to predict how individuals will actually behave. I hope this is true, but its hard to figure out. For all I know this could all be one exercise in my own cognitive consumption.

Paper Inspired By This Blog

A reader asks about the paper I promised a while back. I don't want to let the cat to far out of the bag until I have a working paper developed a little further. It will take a bit more work before I have clearly establish the concept as my own.

Here is the idea though. It is possible to constuct a policy that passes benefit-cost analysis but no single person in the economy wants the government to adopt.

This is a real problem for economists. When lean on benefit-cost analysis by saying "look we can't compare happiness between people. Thats a moral judgement. All we can do is maximize the material wealth of society"

But what if maximizing the material wealth lead to a policy that no one wanted. Surely that can't be right. The way I say it is that there is no social welfare function that would choose this policy.

It doesn't matter whose values you use because no one wants the policy.

The conditions that make this true are stringent. Most policies can probably find at least one person who is in favor of them. However, it does mean that benefit-cost analysis could loose it's intellectual safe haven. That would mean that we would have to engage in the messy business of figuring out who benefits and who looses.

Thursday, May 3, 2007

A Simple Objection To Greg's Height Tax

Greg is getting some press for his and Matthew Weinzierl's working paper on height taxation and its affront to standard notions of equity. Yet, I think the paper falls short when it fails to recognize the importance of the height-income effect mechanism.

Here is a simple example that shows why the mechanism is relevant. This is written in a tone familiar to economists. If there is enough interest among non-economists I can do a more thorough explanation.

Suppose that base income is drawn from a normal distribution. Then nature distributes a bonus to 50% of all tall people. This introduces a strong height-income effect.

Wanting to correct for this economists suggest that the social planner institute a tax on the tall and redistributes the income to the short.

However, she rejects the proposal because it fails her Rawlsian analysis.

The distribution of income for tall people conditional on not have received the bonus is the same as the distribution of income among the short. Therefore, the poorest tall person has roughly the same income as the poorest short person. Therefore, if she takes income from all tall persons the poorest tall person will likely become poorer than the currently poorest person.

Since her objective function is max min(all agents) the tax decreases social welfare.

Do Most Investors Underperform

Arnold gets in on one of my favorite topics. The question of what are “returns” and “capital gains” really.

So for a little background Arnold writes:

I rely a lot on intuition. I make up simple, numerical examples to illustrate problems, and sometimes I mess up. I get misled by my own examples, and then somebody needs to correct me. In this case, let us start with an example Varian uses.

To understand the difference between a stock’s return and an investor’s return, consider someone who buys 100 shares of a company at a price of $10 a share. A year later, the share price is up to $20, and the investor buys 100 more shares.
Alas, the investor’s luck has run out. By the end of the next year, the price has fallen back to $10 and the investor sells his 200 shares.
A buy-and-hold investor who bought at $10, held the stock for two years, and then sold at $10 would have had a zero return.
But our friend who tried to time the market did much worse: over the two years, he invested $3,000 in the stock and ended up with only $2,000.

Fair enough. But who did our friend trade with? If I sold to our friend 100 shares at $10, then sold another 100 at $20, then bought them all back at $10, then I made $1000. In the aggregate, our friend and I broke even, which is what the stock did.
My intuition tells me that for every buyer there is a seller. So I do not understand how trading profits and losses do not cancel out in the aggregate. If they do cancel out, then investors as a whole end up earning the market rate of return.
In this case, my intuition blocked me from understanding the paper. This is one of those cases where I need help straightening out my intuition.

Arnold is correct. Varian’s example misses the return to the guy who sold at twenty and presumably bought at some previously lower price.

Here is a better one. Suppose there are three investors Adam, Bill, and Chris

Adam and Bill buy on the IPO at $10 a piece for one share of stock.

One year later the price has doubled to $20 and Bill sells his stock his stock to Chris. Bill realized a 100% return.

The next year the price goes up to $30. Both Adam and Chris sell their shares for $30.

Adam gets an annualized return of 73%1. Chris gets a return of 50%.

At first blush it seems that Adam did about midway between Bill and Chris. So Adam is a good proxy for how well an investor can expect to do in the market. But, that’s not quite right. Chris invested as much money in the market as Adam and Bill combined. But, he made a smaller return than either of them.

In other words Chris’s 50% gain on $20 counts for more than Bill’s 100% gain on $10. The average dollar invested in the market behaved more like Chris’s money than like Bill’s money.

There is a big wrinkle in all of this though - an assumption that is not made explicit. I am going to think on it a bit more before I post.

1: (1 + 73%)*(1 + 73%) = 1 + 200%

Update: Greg offers some good advice on the matter.

Goldilocks After All?

Offline, I have been a persistent critic of what I considered Pollyannaish predictions coming from financial talking heads like Don Luskin or Larry Kudlow. The PermaBulls seemed to be completely ignoring the fact that the economy was heading into stagflation.

Moreover, if the modern FED was faced with choice of having to drag the economy into a bone crushing recession or tolerate a mild recession with persistently high inflation then you need to prepare yourself for some major fractures.

Memories of the Great Inflation are far more salient than the Great Depression. More importantly, no one doubts the ability of the FED to stop inflation. How well they can navigate the murky waters of exogenous supply shocks is less clear.

However, that all might, and I say might, be wrong. I am not quite ready to jump into the bull camp just yet but the latest economic data does induce a sigh of relief.

But then again if even I'm feeling bullish maybe this is the time to get out!

Wednesday, May 2, 2007

Why So Poor

Another great post by Rodrik.He points to a paper that looks at Total Factor Productivity (TFP) differences between the US, India and China.

For non-nerds TFP is a measure of how efficiently resources are combined. Different nations have different amounts of workers, factories, and natural resources. However, even when you account for all of that some countries like India and China are still poorer than the United States. Somehow, they are not able to combine there resources as effectively.

What the new study shows is that this is an industry by industry phenomenon. There are industries in China and India that are as efficient as those in the US but not all. The big question is why are Indians and Chinese still working and investing in the inefficient industries. Why don’t job move towards the industries that are more productive.

Perhaps, they are but we are just looking at a snap shot of the transition process. Give them a few decades and they will be there.

However, perhaps there is something more fundamental. Perhaps, dynamism is the critical component in strong economies. That is, there are barriers which prevent resources from flowing to where they are most efficient.

Here is what we know: People hate change. As an economist I usually make the nerdier quip that, “agents dislike uncertainty.” The underlying message, however, is the same. Safe economies are stagnant economies. Institutional and indeed preferences for stability will keep capital and labor locked into inefficient uses.

Here a real nut to crunch, too. Imagine that the poorer you are the more afraid of change you are. Now imagine that the world is changing in a way that slowly makes you poorer. We first see it happening it looks like its just a little loss so you don’t do anything. Why change.

Once it keeps happening you become aware that the potential losses are bigger than you realized. Yet, you’ve become poorer and thus even more afraid of change and so you still stay put, until you’ve become even poorer. The cycle continues until you are completely destitute.

Should I be thinking about a paper on The Vicious Cycle of Bayesian Updating and Rising Risk Premia or should I really be working on the papers I have already started. We both know the answer but alas hyperbolic discounting is a . . .

Tuesday, May 1, 2007

Aspie Nation

Vernon Smith talks about what its like to be an Aspie.

Perhaps I may be an Aspie Prider but I don't like curebie take. If the outside world wants to understand us that's fine, but I think of Asperger's not as a disorder but a difference.

Hat tip to Craig Newmark

Best Sentence I Read Today

From Mark Thoma

To say that ex-housing the economy is doing just fine is tantamount to claiming that, ex-Iraq, Bush's Middle-East policy is a rousing success

Though I don't think it's true. Our policy toward Iran and Syria leave much to be desired.

What Are We Paying These Professors For

A few days back Bryan posted on more evidence for the signaling hypothesis, that is the notion that the only reason to go to college is to prove to the world how smart you are. Exhibit A is the fact that you only have to pay for classes that you are getting a grade in. Sitting in the back and listening are free.

Well, first off sitting in the back and listening is not free. There are the usual opportunity cost arguments but I’ll bring up a more fundamental point. I have been kicked out of lectures that I didn’t pay for.

Being an Aspie and hence an economist since birth I realized I could get a free education early on. So long as I didn’t interact or say much I was fine. However, once the professor noticed that it was a little snot-nosed kid speaking up they were quick to ask me “Are you a student at this school??”

I think the reason that you can get a free education is that the monitoring costs are high compared to the number of people who want to steal education. Now, why is it that more people don't try.

Well, for one historically the actual cost of tuition is low compared to the opportunity cost. The cost of devoting enough time not only to the lectures but to homework and studying were much higher than tuition.

Two, the grading and advising process do serve a function. We can talk about hyperbolic discounting or constrained rationality but the bottom line is that self-control is a serious issue. The fact that you are faced with a grade motivates you to do the work.

As a side on this the best advice that I can give for young students is show up. Go to class. Go to see your professor. Your natural sense of shame will take care of the rest. As long as you can get yourself into that classroom on a regular basis you will be too embarrassed to slack off – that much.

Three, embarrassment is a serious cost to most people. I am amazed at the opportunities that people pass up because they are afraid of embarrassment. Even if there was no formal sanction, simply having someone point out that you are a free rider would mortify many people.

For these reasons most people pay for their education. The interesting question is whether or not the percentage of free riders has risen as the cost of education has gone up.

Rodrik on Trade

Dani has an excellent post on free trade. A recurring theme here is that economists are so eager to defend free trade against bad arguements that they forget about good ones.

For example whether or not we think there should be completely free trade between households, there is not. I can't sell you whatever I want, whenever I want. Why then would we automatically assume that free trade is always the best policy between nations.

Perhaps, we think households are capable of mistakes that nations are not. However, if we take public choice theory seriously we have to conclude that if anything nations are in more need to oversight. Moreover, not all nations are democratic.

For example, I think it is a rare economist that you will find advocating child labor. For one, it is not entirely clear what the power relationship is between parent and child. The child might prefer to invest in her own education but her parents may be coercing her into do otherwise.

Even when we don't think that parents might make their kids work there are still reasons to be skeptical about child labor. Can children make informed decisions about the risks and trade-offs? Is education a public good that needs to be encourged? Are people subject to hyperbolic discounting (read: lack of self control) that leads them to make choices they know they will regret?

Any of the above could be reasons why we don't think children should be allowed to sell their labor.

So then why would allow American consumers to buy child labor from abroad?

Environmental standards are even more justifiable at an international level. Even if we don't buy the concept of non-use value we all share the same air and in particular the same oceans. When Chinese factories pump mercury in the air this pollutes my cherished Alskan Salmon. I see no reason why a consumer should be able to escape the Pigouvian tax (or regulation if thats the best we have) just because the products she buys happen to be made in Asia.

As a general rule any restriction we are willing to place on trades within our borders are at least on the table when dealing with international trade.