The Economic Way of Thinking

Economists think about things in ways that involve words like “Value”, “incentives” and “utilities”.  Such words are often used by other subjects, so here is an attempt to explain WIHIH (what in hell is happening).  Mostly it is, I think, using the same word for different ideas.

1.  Value

This is a source of endless confusion.  Here’s the Economist’s notion. 

a.       Think of a demand curve.   That curve traces out the willingness to pay for an additional item of the good.  If consumers are different, it’s the cumulative willingness to pay (WTP) starting with the person who values the good most, Nick, Harriet and Ali in the coffee example.  If consumers are the same, its the WTP arising from diminishing marginal utility of the good.

b.      Now suppose the price is set, by supply or law of something else: say £2.00.  At a price of £2 the Economist says, that gives the willingness to pay of the marginal consumers.  It does not give the WTP of the inframarginal consumers, indeed they earn some consumer surplus precisely because they are not marginal and it’s the marginal consumer’s WTP that the price reveals. 

c.       So what can we say about value in the marketplace?  To economists, all we can say is the value placed on the good by the marginal consumer, here £2.  All the  other consumers who are buying get consumer surplus.  We might, if we knew consumer surplus be able to work out the total WTP as well as the marginal WTP.  And if we wanted to call it that, we might be able to call total WTP total value.  But in Economics we tend not to do that; we reserve value for “value added” which is an accounting term (revenue less cost of intermediate goods used up in production).  Even if we did, economists don’t tend to talk about value in the market place since we would have to be able to count up consumer surplus to measure it.  At best, prices reveal the marginal customer’s WTP, which you might call how much the marginal customers’ values the good.  We need to know a lot more if we want to talk about every customer’s WTP or, if you so define it, their value.

d.      The emphasis on prices as revealing marginal values is, I think, helpful, since it avoids the endless debate on what is “value”.  Diamonds are very expensive and (in Western countries) water is very cheap.  But diamonds are useless baubles whereas water is vital for life.  We can then argue about whether diamond are more or less “valuable” than water, but the Economics approach cuts through this.  All we need realize is that if the price of Diamonds are high, that suggests the WTP, or “value” if you like, of an extra Diamond is by the marginal diamond buyer is very high.  Whereas with a lot of water around, the WTP, or “value” of an extra bottle of water is very low.  I think we can agree on marginal values and we can just avoid having to agree total values.

2.   Prices as incentives

Some object to prices being an incentive.  There are a number of objections.

a.       Consumers/firms don’t care about prices.   Economists: fine, that just says elasticities are low. 

A related notion is that you need, as a business, to emphasize quality, customer loyalty etc. and this somehow is more profitable.  The Economists' answer is that such things don’t come for free.  Getting loyal customers presumably means advertising, R&D etc. all of which costs.  It might shift out the demand curve, or make it less elastic, but its still not a guarantee that it will be profitable: that depends on the discounted benefits to incurring such costs.  Economists are, IMHO, good at looking at correlations between, say advertising spend and future revenue.  But the Black Box of just what neurones in the brain are activated by advertising is not well studied (for more on intrinsic motivation, see below).

b.      When Consumers/firms use prices to incentivise others, this might lead things that are not intended.  Example.  The firm rewards its workers for working quickly i.e. sets a good “price”, in this case a wage, for fast work.  But, then workers produce poor quality.  Economists’ answer.  But this certainly means that economic actors respond to prices! All that is happening here is that they have a menu of actions of dimension N, but the menu of prices they face is less than N, say M. 

c.       A more subtle criticism.  Consumers/firms/economic actors respond to “intrinsic motivation” e.g. fairness, responsibility.  If prices are then used, that will “crowd out” such responsibility.  Example: setting rewards for good performance at work is not a good idea because it offends people’s sense of responsibility and makes them perform worse (a reward for good performance improves behaviour due to extrinsic motivation, but worsens it since it weakens intrinsic motivation, perhaps because it signals that the employer does not trust the worker or if the worker tries due to a concern for social status which is undermined when it is paid for).  This is a key idea in Michael Sandel’s recent work and is discussed in a very interesting recent article by Gneezy, Meier, Rey-Biel, Journal of Economic Perspectives, Fall 2011.

The famous example is Titmuss (1970), “who argued that paying people to donate blood broke established social norms about voluntary contribution and could result in a reduction of established social norms about voluntary contribution and could result in a reduction of the fraction of people who wish to donate.the fraction of people who wish to donate”.

This is very controversial in education, with many programs now starting to pay High School students money to attend school, do exams, hand in work etc.

So what do we know about this area?  My take on the piece is that it is a bit horses for courses. In some contexts intrinsic incentives are so weak that financial rewards are very helpful.   “The current evidence on the effects of financial incentives in education The current evidence on the effects of financial incentives in education indicates moderate short-run positive effects on some subgroups of students, at indicates moderate short-run positive effects on some subgroups of students, at least while the incentives are in place.”

But the article also points out that incentive programmes must be clearly designed to be sure that such crowding out does not occur.  The conclusions are very interesting:

“When explicit incentives seek to change behavior in areas like education, contributions to public goods, and forming habits, a potential confl ict arises between the direct extrinsic effect of the incentives and how these incentives can crowd the intrinsic motivations in the short run and the long run. In education, such incentives seem to have moderate success when the incentives are well-specifi ed and well-targeted (“read these books” rather than “read books”)…

In encouraging contributions to public goods, one must be very careful when designing the incentives to prevent adverse changes in social norms, image concerns, or trust.  

Incentives to modify behavior can in some medial cases be cost effective. The medical and health economics literature intensely investigates whether, and when, prevention is cheaper than treatment (for example, Russell, 1986).  The question is economic rather than moral: certain prevention activities can cost more than than they save,  For example, cholesterol-reducing drugs can cost hundreds of dollars a month; simple exercising could, in some borderline cases, replace these drugs.

Our message is that when economists discuss incentives, they should broaden their focus.  the effects of incentives depend on how they are designed, the form in which they are (especially monetary or nonmonetary), how they interact with intrinsic motivations (especially monetary or nonmonetary), and what happens after they are withdrawn.”

Update on the UK recession, long and large, or short and long

The ONS released a new piece today on the UK Productivity Puzzle.  Some details:


1. current UK output per hour compared with other recessions is a disaster (output per worker does not look much better)








2.    That makes output per worker 10% lower than if it had continued on its pre-recession path:

3.   The international comparison for the UK is not good either:

Chart 6: International comparisons of output per hour productivity growth since 2008 Q1, seasonally adjusted

h

As the graph shows
1. everyone is worse than the US
2. the UK fell initially by less, but then fell back in the 2011 period, so that it is now at the bottom of the pile relative to 2008Q1 at least. 

As Peter Pattinson said at the seminar launching this document, the early productivity period is not so much of a puzzle, since barring the US, everyone seemed the same.  What is very mysterious is the post 2011 performance.

Could the GDP data be wrong?  Walton and Brown look at this.  Two crucial graphs:

1. mean revisions have got smaller since the 1960s and are negative in recent years (chart 3)
2. since 2005 the revision size is smaller than in the 1990s at 0.3% pa to growth.  So a revision, if upwards would add on average this.  Not enough to restore the 10% gap, but might be enough to restore the UK relative to other non-US in the chart just above.

US recessions and the current US recovery

I wrote about the recession here for the UK. In the US, Krugman and Taylor are having an argument:

1. Taylor says the US recovery is very weak relative to that from other financial crises, and blames policy.
2. Krugman says this is politics and the US recession is just what you would expect from a financial crisis.

Reinhardt and Rogoff have this graph:




There are two questions:
 
Q1.  is the US recovery, starting from the bottom of the cycle, currently slower than the 1930s?
Looking at the slope of the 2007 line starting from the bottom of the V, it grows slower than the wide dotted line, but about the same/faster as the small dotted line.   As Jim Hess has correctly pointed out to me, correcting an earlier mistake, the wide dotted line excludes the 1930s, and the narrow one includes it.  So the 1930s must have been slower recovery and hence current recovery is faster.  Score one for Krugman.

Q2.  are US recessions, starting from the peak, longer to get back to the peak, when they are financial crises?  Yes they are, according to Reinhardt/Rogoff  comparing different recessions according to type.  Score one for them and Krugman.

So its two different questions being compared.

Gettting the housing market going? Using simple economics for policy analysis

Ed Balls says let's use prospective 4G licence fees to fund a stamp duty holiday.  On this idea, we know what will happen since we have some evidence from when it was tried before: Chris Giles points us to the paper. from HMRC that evaluates the effect of a temporary relief on stamp duty for first time buyers March 2010-March 2012.

As my Imperial MBA students will know, the effect of a tax reduction in a Supply and Demand model depends on the elasticities of demand and supply.  Suppose as seems very likely due to planning, the supply curve is very inelastic.   Then tax falls have minimal impact on quantity.  If demand curves are quite elastic then any falls in taxes translate into minimal falls in prices for buyers, but rises in prices for sellers. Finally, falls in taxes are expensive for the state, since with little extra quantity the gain in revenue from the additional marginal quantity is small, but the loss from the inframarginal is large. 

So we can use some very simple economics to make some sharp predictions.  

And the findings in the real world from the study?  They show Economics right on the money.  Here's an extract from the summary.

The effect on quantity is tiny: 

The number of additional transactions is therefore estimated to be closer to 0‐1  per cent (1,000 additional transactions) 

The effect on buyer prices is tiny:

Considering the impact on prices, ... This implies that the majority of the 1 per cent tax  relief was capitalised in higher prices. It is equivalent to stating that the post‐tax
outlay for buying property is estimated to have decreased by 0.3‐0.5 percentage  points. The relief therefore appears to have had a small impact on reducing the
overall outlay of buying a first home. 

The costs to the state are huge:

The cost of the tax relief was around £150 million in 2010/11..[with].. 1,000 additional transactions across the 13‐month period April 2010‐April 2011, this represents an estimated cost to the Exchequer  of approximately £160,000 per additional transaction in tax relief.

Is Justin King a Bootlegger or a Baptist?

 The FT and Times report that Justin King, CEO of Sainsbury's, one of the largest UK retailers, has attacked George Osborne’s plans whereby new staff in small business can surrender their employment rights in exchange for shares.  He’s quoted as saying that this plan will reduce trust in business and that regulation should be maintained (he supports payroll tax cuts instead).

Is he a Bootlegger or a Baptist?

My students here at Imperial will know the story, set out by Bruce Yandle and discussed a lot on EconTalk.   The Baptist, acting through high-minded morals, wants to ban sales of alcohol on Sunday.  Politicians support him.  The Bootleggers realize that if liquor stores are closed on Sunday they can sell under the table.  So they support the policy as well.  Thus a coalition of unlikely bedfellows. 

Yandle has a nice example: The Northern Spotted Owl case.  Here, logging was banned in the Pacific Northwest of the US if there was evidence of the presence of Owls, in an attempt to protect their habitat.  This policy was promoted and supported by Nature campaigners.  Interestingly, it was also support by lumber companies.  But crucially, by lumber companies outside the conservation area.   Indeed, these companies even sent in ornithologists to try to spot Owls, but only in the Pacific Northwest areas owned by their rivals.   As a consequence, rival lumber supply fell and the price of lumber rose substantially.

Justin King talks in high minded terms.  But the Osborne proposal is for small firms.  An uncomfortable truth is that large firms typically rather like regulation: they can deal with it, whereas the burden falls on smaller firms.  That burden in turn stops entry and so blunts the threat to large firms.  So there’s a good bootlegger reason for his support. 

Fortunately for him, any organization who supports the Paralympics, before they were trendy, gets a big tick in my book.  So I’m going to call him a Baptist.  But it’s a powerful and insightful metaphor.

Various teaching links

1. Brad Jensen tells us about trade in services (via Tim Taylor). "Opportunities for U.S. Exports of Business Services"

2. Shane Greenstein: What is Google doing in KC?  Experimenting with superfast broadband.

3. What on earth is going on with EU Patent reform?  They have only been arguing over it for 40 years.  Here is my take on the latest:


The main sticking points are (a) the patent language and (b) location of Patent courts, (c) the ability of the European Court of Justice to have overall jurisdiction overruling member states.  In November 2011 the European Parliament reached agreement on location (Paris, London, Munich), language (English, German, French) and the jurisdiction of the Court.  However, at time of writing, the Spanish and Italians have refused to accept the language and the European Council have removed the agreement on the Court’s jurisdiction over member states.  Without such overall jurisdication, patent law goes back to being of national competence and hence one might win a patent case in member state A but lose it in member state B  (
See for example press release from the European Parliament, 10^th July 2012, “EU unitary patent: Council move wouldinfringe EU law, says EP rapporteur", ) 

Some quotes from EU MEPs

Raffaele Baldassarre (EPP, IT), “After 30 years of "national egoism (...), we need to find a solution that fully respects EU law and follows a transparent procedure with the Council".

Eva Lichtenberger (Greens, AT), who added "Council has acted irresponsibly in this area".

Cecila Wikström (ALDE, SE), the European Council's decision meant "national prestige won over the common good, which is a shame"

4. Vox EU has a very nice piece on financial innovation.  But it uses measures of R&D in finance, which is very badly measured in conventional data. Here is an alternative approach based on intangibles and here are some cross-country data.