GDP and health: stocks, flows, output and outcomes

 Interesting discussion at Imperial today.  

1. The health of a nation can be thought of as an outcome (e.g. premature death) and/or a stock (the number of heavy smokers) and/or a flow (number of operations performed per year). 

2. GDP is a flow.  It is the flow of output via people purposefully employed in producing that output flow.  It isn't outcomes.  So a healthy society via social norms or parents helping their children produces an outcome but not an output.  The output of health is operations done, patients seen.  Which can of course be measured better.

3. Missing markets.  Well, people at home are producing things as well.   Not only with modern working from home, but reading to children, looking after family all of which produces a flow of services.  But, we don't typically have that included in GDP since we don't know what price to allocate to that activity, since it's not an activity that's sold in the market.  We could make some assumptions e.g. by taking the market price of a carer working for a care home but typically we don't do this. 

4.  So, GDP doesn't necessarily measure well-being.  

5. In our Indigo Prize essay we explain more on GDP as a flow, adding up the flow of iPads, pencils and 737s, and going beyond GDP.  And the ONS produces a dashboard of health outcome indicators. 

What is economics about, really?

Everybody knows the answer to this. Economics is about economic forecasting. Since much of economic forecasting is wrong, economics must be wrong. Or, economics is about the stock market and money. Since the stock market and money are by definition tasteless and immoral, economics must be tasteless and immoral too. Or, economics is about shifting a load of curves here and there in order to pass an exam, to be forgotten about once one is exited the exam room.

Getting a sound answer to this question is increasingly important as many other subjects touch on Economics. For example, much of human geography is concerned about economic questions: Cities, prosperity between countries, inequality. Much of management is also about economic questions, and if anything seems less abstract and more relevant: managing R&D projects, accounting, business strategy.

This is so ingrained there are now two famous jokes that everyone knows about economics.  The first is that a physicist, a chemist, and an economist are stranded on a desert island with a can of food but no can opener.  The physicist and the chemist devise a clever mechanism for opening the can: the economist says “assume we have a can opener".   The second is that a £50 note is lying on the street.  “Did you see that?” says the non-economist.  “No need to look” says the economist, “if it was really there someone would have picked it up”.

This is typically ignored when you start an economics course. You are told that the great benefit of economics is it helps you think about the big questions in the world. But many students , when they come out of an economics class, often jettison everything they've learned, regarding it as too abstract, and worth understanding just for the purpose of passing in the exam.  So it's worth asking again; what is economics about, really?

Let me suggest the study of economics can be summarised as asking a really good question: Is there a better alternative? That may not sound like something very profound, and economics is undoubtedly broader than this (the study of econometrics and associated statistical techniques for example), but as a pithy summary I think this carries the essence of economics and why it is actually very helpful in helping you think about the world.

Why is this a good question?  It’s worth stating first off that it’s a broad-based question.  That “better alternative” might be within the context of a market like a stock market for example. Or it might be in the context of a non-market transaction like a business hierarchy. Or a school or even a household.

Let’s take an example.  Geography has much to say about countries.  International business, a important subdivision of business studies and business strategy, has much to say about the arrangement and conduct of business across borders.  International relations, has much to say about the political and economic arrangements between nations.

In a 1997 article in the Quarterly Journal of Economics, the economists Alberto Alesina and Enrico Spolaore asked a different question: what’s the optimal number of countries?  Using an economic model, they argued the democracies would produce too many countries, that is, there would be too many nations, relative to a socially optimal benchmark.  Now whether you agree or disagree with their analysis is beside the point. My only point is that this is a nice example of the question that economists ask when they see a particular arrangement, in this case, a set of countries; is there a better alternative?

Likewise, the Canadian economist Robert Mundell asked in the 1960s how many nations should share currencies? This was viewed as an absurdity at the time but of course turned out to be an incredibly important question when it came to the design of the euro ( and indeed many have argued the design of the euro is flawed precisely because the designers ignored the principles that Mundell enunciated over half a century ago).

The next issue then is to ask whether economists have a comparative advantage in asking and answering this question? Surely other subjects have not only asked this question but perhaps answered it better? What do economists have to offer?

Herein I believe lies the true power of economics as a way of thinking relative to other subjects. I think that economists have two very important comparative advantages.

The first is that economics defines and understands very clearly the definition of “better”.  What are called, perhaps rather unapproachably, the fundamental theorems of welfare economics, describe the exact conditions under which a particular economic arrangement tends towards the most efficient allocation of resources. That is to say, that economics has a precise statement under which Adam Smith’s description of the “invisible hand”, namely interactions in markets , lead to the “best” outcome.  That means that in economics we are able to precisely compare a certain economic arrangement (the number of countries, the price of sugary food, the trade arrangements of a
country, your employment contract) with the “best” arrangement.  In turn, we can therefore answer precisely the question “Is there a better alternative?”. 

The second source of comparative advantage comes from the observation by Smith that the natural propensity of humans is “to truck and barter”.  Economists understand is that if there is a better alternative, unless there is some blockage, human beings are probably going to try to get towards it. Neither dogs nor human beings can fly naturally.  But human beings created a machine to help them fly because they saw a better alternative to walking.  The incentive to trade, means this is a good question to ask and an understanding that incentive makes economists in a good position to answer it.

Asking the question also provides a couple of helpful insights.  First, when presented with some fact of social interaction many subjects would explain it by social norms.  Where you shop, what newspapers you read, what phone you buy might be plausibly explained, at first pass, by what your parents did or peer groups do.  Economics tends to regard this as a last resort.  If there is a cheaper shop, a livelier newspaper, a zippier phone, the question of “is there a better alternative” and understand why people don’t get to that improvement is the first question to ask.

Of course, the relentless pursuit of even a very good question can get the Economist into hot water.  When presented with the public provision of a service (say health or education in many countries), the “is there a better alternative” question makes you ask if, for example, a private providers could do it much better.  Economists are, as said, well placed to ask this question because we have a strong theory about the optimality of a market economy.  But one has to remember that markets are in practice underpinned by a whole series of non-market factors such as trust.  Indeed there is a literature which suggests that financial incentives might drive out these non-market incentives.

Finally, the describing of economics in this way helps understand the two famous jokes set out above. The point of the “assume a can opener” story, is that economists start by thinking about the the best outcome, as a way of reasoning whether the current situation can be made better.  The point about the money on the street is to ask why human beings , with the Smithian propensity to track and barter, would not reach a better outcome. It does not say they would reach a better outcome, but it forces the analyst to set out exactly why not.

The information content of prices

We spend a lot of time in class looking at prices as a discovery mechanism and as an information indicator of unknown consumer attributes.  Here's a summary on their use from p.5 of

https://laweconcenter.org/wp-content/uploads/2019/07/Concluding-Comments-The-Weaknesses-of-Interventionist-Claims-FTC-Hearings-ICLE-Comment-11.pdf

Price and output are metrics (and relatively easily identifiable ones, at that) that aggregate the decisions of countless individuals who are performing their own hedonic calculations, using all their own subjective values, with respect to the conduct of firms in the economy. The price and level of output that arise from those individual calculations necessarily takes account of the various preferences—albeit relatively imprecisely—of all those subjective, multidimensional calculations. Importantly, price and output offer the best means available to evaluate the effects of many non-price factors, including innovation. In other words, although imperfect, measurements of market price and market output are (generally) reliably informative, at the very least of the direction of likely changes in consumer welfare along all dimensions in response to changes in firm conduct

BTW, later in the report they say

Many ...voiced concerns about the potential for data to enable more price discrimination. Perplexingly, this issue was largely discussed as a presumptively harmful outcome. On the contrary, in industries with high fixed costs, price discrimination can increase total output and produce benefits for previously unserved segments of the market. 

We shall cover this last point in class next week.

Economics and Biology

With COVID modelling in the news the relation between the two is interesting.  in this post, Peter Klein, argues

    "To understand why people shoot guns, on purpose or accidentally, we need to focus on their preferences, beliefs, and actions."

He further links to Edith Penrose warned more than sixty years ago about the limits of biological analogies in understanding social issues. “The chief danger of carrying sweeping analogies very far is that the problems they are designed to illuminate become framed in such a special way that significant matters are frequently inadvertently obscured. Biological analogies contribute little either to the theory of price or to the theory of growth and development of firms and in general tend to confuse the nature of the important issues."

And the Penrose article is interesting.  What is the relation between market competition and natural selection?  Penrose discusses Alchian:

" To survive firms must make positive profits. Hence positive profits can be treated as the criterion of natural selection-the firms that make profits are selected or "adopted" by the environment, others are rejected and disappear. "  Thus he argues also that even non-profit maximising firms will be forced to profit maximise.


I suspect this is an argument that a lot of economists will recognize and would relate to biology.  But Penrose has read Darwin. 

" Darwin deduced the struggle for existence from two empirical propositions:
    a. all organisms tend to increase in a geometrical ratio, and
    b. the numbers of any species remain more or less constant.
From this it follows that a struggle for existence must take place"

She relates that to economics

" Translated into economic terminology, the explanation of competition in nature is found in the rate of entry. The "excessive entry" is due to the nature of biological reproduction."

That is, in biology, the assumption of geometric increase means the entry of new "competitors".   She continues:


" But how shall we explain competition in economic affairs where there is no biological reproduction? The psychological assumption of the traditional economic theory that businessmen like to make money and strive to make as much as is practicable performs a function in economic analysis similar to that of the physiological assumption in the biological theory of natural selection that the reproduction of organisms is of a geometric type-it provides the explanation of competition (and in economics, incidentally, also of monopoly). To be sure, the two assumptions rest on vastly different factual foundations and should not be treated as analogous. We can only say that there is some evidence that such a psychological motivation is widely prevalent and that we have found we can obtain useful results by assuming it. If we abandon this assumption, and particularly if we assume that men act randomly, we cannot explain competition, for there is nothing in the reproductive processes of firms that would ensure that more firms would constantly be created than can survive; and certainly from observations of the real world we can hardly assume that competition is so intense that zero profits will result in the long run or that only the best adapted firms can survive."

asks Is Terrorism a Disease?

Various teaching links

1. Opponents of capitalism tell you that the market system promotes greed. selfishness and rapacious behaviour by firms.  Proponents say no: its the opposite as firms have to understand what consumers want. A view from Tim Harford's great book Fifty Things that Made the Modern Economy" http://amzn.eu/aWaeGcn. about the founder of Selfridges, Mr. Selfridge

"He saw that female customers offered profitable opportunities that other retailers were bungling, and made a point of trying to understand what they wanted. One of his quietly revolutionary moves: Selfridge’s featured a ladies’ lavatory. Strange as it may sound to modern ears, this was a facility London’s shopkeepers had hitherto neglected to provide. Selfridge saw, as other men apparently had not, that women might want to stay in town all day, without having to use an insalubrious public convenience or retreat to a respectable hotel for tea whenever they wanted to relieve themselves. "

File as well under innovation.

2.  Via Tim Taylor, this is a very good review:§ "Immigrants, Productivity, and Labor Markets," by Giovanni Peri

3.  Do our banks still need fixing? yes they very much do says Martin Sandbu. 

 Some points

"

A rather worrying consensus emerged in a recent conference held by the Centre for Economic Policy Research, in which top names from the economics profession (their presentation materials are available on the conference web page) assessed the state of the financial system 10 years after the crisis.

The consensus was that we still fall far short from what would be a safe financial system."

For as John Vickers pointed out, “the general . . . opinion among economists outside the financial sector is that banks should be required to have at least twice as much equity capital . . . as the prevailing regulatory settlement”, but “regulators, not just banks, [think] that reform since 2008 has got us to about the right place”.

Martin Wolf sums up the economists’ consensus in a recent op-ed, where he advocates equity requirements four to five times higher than today’s rules.

..... Vickers has strongly criticised the Bank of England for its judgment that the required push for more equity funding in banks is largely completed. (To be fair, the BoE is also adding requirements for non-equity funding that can be “bailed in” to bear losses in a crisis.) Across the Atlantic, the US Treasury has plans under way to weaken rather than strengthen capital requirements — plans that, in William Cline’s analysis, could cost the US economy $2.7tn in increased risks over 10 years

 Vickers and Tucker are critical of equity measures (something for intangible reserachers to bear in mind) 

Second, the way it [equity] is constructed means the inherent instability of measured bank equity is unstable in just the wrong way. Paul Tucker, the former BoE deputy governor, has explained this in a rather chilling, if technical, speech. Before the crisis, he says, “‘common equity’ was measured without adjustments for items recorded by accountants as assets but which don’t — can’t — help in a crisis”, such as “goodwill” (the assumed extra value acquired when assets are taken over for more than their prior accounting value) or future tax credits.

That means improvements in regulations made to sound impressive — Vickers highlights BoE governor Mark Carney’s point that equity requirements are 10 times higher than before the crisis — are true only because of how absurdly low the requirements were then.

Here's a key calculation: 

In Tucker’s calculation, “when tangible common equity is measured in a way that is more fit for purpose, the minimum risk-asset ratio requirement was about 1 per cent” and even less when not discounting supposedly safe assets with low risk-weights (which has its own problems). Consequently, the ability of banks today to have assets 25-30 times as large as the equity intended to absorb losses on them is only 10 times stricter than before the crisis because they could then get away with gearing up their own (their shareholders’) money by three-digit multiples. Vickers is surely right that “10 times better than hopelessly lax is not a useful measure”.

 4. Related, here is Catherine Mann on how the wrong type of lending distorts growth.
Catherine L. Mann (OECD) Slides