The visible hand in economics

Archive for September 2007

On this blog we’ve talked a lot about how driving is undertaxed and overused. An aspect of this that we haven’t addressed yet is the funding mechanism for roads in New Zealand. At present, government spending on roading exceeds the revenue gained from road taxes. Essentially this means that road use is subsidised by all taxpayers. As a consequence, road use is inefficiently cheap for all road users even when congestion and carbon emissions are disregarded. Megan McArdle’s right when she says

We clearly need to institute comprehensive road tolls combined with a congestion pricing scheme. Plus, of course, a carbon tax to compensate for the negative externalities drivers are imposing on those of us who use primarily mass transit.

The road tolls she speaks of could be in the form of higher fuel prices, higher licensing costs for vehicles or toll booths on roads. If the government is serious about reducing congestion and decreasing our carbon emissions then ending the subsidy on road use might be a good place to start.

People are making a big deal about the fact that National wants to lift the cap on GP (general practitioner) rates. Now I know pretty much nothing about health policy, especially not New Zealand health policy, but I can see some of the merit in getting rid of the cap.

Now before you kill me let me make my case. I agree that in the short run the lift of rates will be painful in areas that do not have competition for GPs. GPs aren’t all going to rush into Otorohanga (small but beautiful country town ;) ) just because they hear that they can make some extra money there. Furthermore, there is a shortage of GPs, which means if we let them set prices they will have market power and they will set them above the market optimum. Beyond this people are also scared that if prices go up, poor people will not be able to afford health care, and in a society like NZ that is just not right. I agree that these points are highly relevant, but they are not the be all and end all of the argument.

We have a shortage of GPs. You increase the supply of GPs by increasing the return for people for getting trained and moving into that line of work. If we allow GPs to increase rates, then in the long run the supply of GPs will rise, and this is a good thing. Furthermore, if society is worried that poor people will not be able to afford doctors visits, why don’t we give them some sort of subsidy. If we subsidise the price for poor people, then poor people will be able to afford to see a GP, and GPs will still get their market rates.

Price controls are never a good policy. By keeping the price of visits to GPs artifically low we reduce the supply of GPs, by lowering the incentive of students to study and move into this type of work. By allowing market prices we can ensure efficiency. From there, subsidies and targeted assistance are the best ways to achieve our equity goals, not ad hoc price controls.

NZPA released a story about an Orchardist that tried to get out of paying some seasonal workers for a public holiday.  All well and good, the contractual obligations of an employer is a topic that is out of my league.  However, the final line of the article got my interest.

“When employers treat their workers well by paying their entitlements, their workforce is likely to be much more productive”.  This is the claim of the Department of Labour.  Now I think by itself this is a fair claim.  In the apple picking industry it can be difficult to quantify the amount of effort a worker is putting into picking.  The output of the worker depends on both the effort they put in, and the density of the fruit in the area they are picking (I did a little blueberry picking back in the day ;) ).  It is also impractical to constantly supervise workers (as they tend to work over a largish area).  As a result of these factors, efficiency wages can increase effort and thereby increase the workers productivity.

However,  the context that DOL made this statement in wasn’t purely descriptive.  They were trying to tell employers that they should be more generous with their wages, as they should want higher productivity.  In this sense I disagree with them.  The employer realises that the productivity of their workers depends on the way they treat their workers.  If they choose to pay their employees at a low rate, it is because the expected benefit from paying them more is less than the cost of paying them more.  Now in the case of the apple orchard this was illegal.  However, the employer obviously felt that the probability of getting caught was sufficiently low that the cost of paying his employees (which includes the productivity enhancement, and the loss from getting caught times the probability of being caught) was less than the benefit from paying.

If this is DOLs line on productivity, they are treating employers like they are stupid.  They believe that they understand the relationship between employers and employees better than the employers and employees themselves.  While I do not have a problem with the idea that higher wages leads to greater productivity, I do have a problem with the idea that firms are not doing what is in their own best interest.  If this is how the DOL feels, they need to realise that employers goal is not to maximise the productivity of their workforce, it is to maximise the profitability of their business.

Some people may feel that is would be a good idea to intervene and force firms to pay higher wages and increase labour productivity.  If we did this output could rise or fall (depending on the relative effect on productivity), the amount of labour hired would fall (as you would need less labour to produce the same quantity of output), and the effect on prices would depend on the change in output (as we are moving along the demand curve).  Ultimately, we assumed that the firm would not want to do this unless the benefit was greater than the cost, if this is the case output from each firm would fall and prices would rise.  In the apple industry we face a world price, and for the consumer, the loss of output would be made up by imported apples.  However, the leftward shift in the domestic supply curve implies that producer surplus would fall.  As consumer surplus hasn’t changed, total surplus from the industry would fall.

So by forcing firms to set higher wages, to force a higher level of productivity than they would have chosen in equilibrium, we get greater unemployment and lower profit in our apple industry.  Not an outcome that people on either side of the political spectrum would be particularly happy with.

Note:  I am only talking about setting higher wages to receive higher productivity and how that influences efficiency.  I am not talking about the equity reasons for higher wages, and I’m certainly not talking about the minimum wage.  You can talk about that stuff if you have a point you want to raise, but if anyone gets all ideological and angry about it I’m going to be very mean to you!

I was talking to a keen cyclist a few days ago who told me that he never fixes so much as a puncture on his gleaming pride and joy. “I’d rather leave it to a professional who knows what they’re doing than risk stuffing it up myself,” he told me. I was bemused at the time by his unwavering faith in ‘professionals’ to be able to do a better job than him. It’s not that I don’t think there are some great mechanics around, but there are likely to be far more who are not as wonderful as they think they are. Why is it that people believe that professionals are the best at what they do, even when they have no evidence and little means of evaluating performance?

Part of it might be a misunderstanding of comparative advantage. This sort of reasoning is commonly used to explain international trade, but is equally applicable to micro-level bargaining and job selection. Suppose a (rather unusual) lawyer is a better plumber than the guy he hires to fix the pipes. Yet, because it would be very costly to the lawyer to take a day off work to fix pipes he’s better off going to work and paying someone else to do his plumbing. The plumber doesn’t have an absolute advantage at plumbing but he does have a comparative advantage over the lawyer at plumbing. The opportunity cost to the plumber of working in his trade is far lower than it is for the lawyer. The lawyer has an absolute advantage over the plumber at both plumbing and legal work but has a comparative advantage in only the latter. Thus, it is not the case that a person doing a job is the best at it: they just have a comparative advantage at what they do.

Of course, once a person has chosen a profession they build up specific job skills that allow them to be more productive at that job than most others. So it may be that the heuristic of assuming a professional can do the job better than you is usually correct. At least, the cost of obtaining more precise information about their skills may be greater than the expected benefit of the extra information. In that case it would be best just to let professionals do their job and quit micro-managing stuff cos you think you know better.

Yesterday’s post on dress codes and signalling drew a comment pointing to Tyler Cowen’s reference to ‘counter-signalling’. TC refers to Steve Jobs dressing down as a counter-signal because he doesn’t need to dress up to show his seniority and importance. It’s a bit of a misleading term because a counter-signal isn’t really a signal at all: it doesn’t convey any information since it is not costly to fake. Anybody can dress down but for many people it’s not conducive to good career prospects. Essentially, Steve Jobs doesn’t need to signal his enthusiasm to his superiors because he has none, so he doesn’t signal at all. The fact that he doesn’t need to signal isn’t itself a signal because anybody can do nothing.

The original paper that this is drawn from goes a little further than pointing out that signalling is unnecessary for some people. It says that when a signal is easy to make – such as wearing a suit – then it is detrimental to high quality people to make the signal. The information conveyed by a signal that’s easy to make is that one is, at worst, mediocre. When you are, in fact, a high quality candidate then it can be damaging to you to be seen as feeling the need to prove yourself to be mediocre. Your optimal strategy is to avoid making the signal at all and look for a better signal of high quality. Thus, the people who end up making a signal are the worst of the people who are able to make that signal.

I guess the implication of this for dress-codes is that the people in nice suits are the lowest level employees who can afford to buy that quality of suit. Once you’re at a level where you can afford better suits you should cease wearing the lower quality suit at all. When you’re at the top and your subordinates wear top-drawer kit then you’re best off avoiding suits altogether and making no signal via your clothing.

I was just looking at an interesting post from Philosophy, et cetera. They are discussing value when we have ‘infinites’. Now if we are looking at points in time with infinite resources this would be pointless for economists, as economics is the study of scarcity. If there are infinite resources, consumption is infinite and value is infinite.

However, they also discuss infinite time. Now if we have a game which is played infinitely into the future how do we decide the optimal choice of an individual? In order to work out the optimal choice of an agent economists will often discount the agents future consumption decisions. This implies that, if the ordering of preferences is expected to stay constant over time, an agent will value a unit of consumption more now than they will at any given point in the future (Ultimately it means that the game provides a finite value even though we have infinite time, as a result these values can be ranked allowing us to choose an optimum). Now exactly how we discount is constantly discussed by economists, especially since the way we commonly discount doesn’t hold true in empirical tests.

Now, even though I have spent a lot of time discussing discounting, that is not what I want to talk about. I want to talk about why and infinite horizon game or choice problem is sensible. Now you might say that no game between agents will be played for an infinite amount of time because everything has an end. However, that is not the way I see it. Infinite time is the idea of unbounded time. If we do not have a definitive end-point then we can view our game going on into infinity.

Let me explain. Ultimately, agents in a game will associated some probability to the game ending during a certain period. In this case they will either believe that their is 100% probability that the game will have ended at some set point, which acts as a boundry and so makes the game finite, or they believe that there is a probability that the game will end at each point in time, but they never associate a 100% probability to the gaming ending at a set point. In the second case we need to look at a infinite horizon game.

The discussion of discount factors is important when we go to look at a person’s choice in this way. In a sense the discount factor represents the likelihood that the game or choice problem will still be going during future periods, as well as a general preference people may have for consumption now instead of consumption tomorrow. As a result, even if we think that saying the current value of a pie in a year is greater than the current value of a pie in 10 years is silly, the fact that I place a higher value on being dead in 10 years than in one means I will value the pie in a year more (as I may never consume the pie in 10 years). Now my consumption choice may still be bounded (as I associate 100% chance of being dead at 800 ;) ). However there are cases where there may be point where a 100% probability is implied, eg the survival of a firm such as the Warehouse.

All this teaches us, is that we have to be careful that the horizon we choose to look over things makes sense, and that infinite does not mean the game or choice problem will never end, just that we are completely uncertain when it will end.

I have always wondered why corporate offices require a dress code for employees, even when the employees never see the outside world. Tyler Cowen blogs about corporate dress and makes a couple of interesting points, but it doesn’t really address my particular curiosity. He’s inspired by a reader who points out not many people are as comfortable in business attire as they are in casual clothes. If a worker is most productive when they are most comfortable then why would you force them to wear a suit?

A common explanation of smart clothing is signaling to overcome adverse selection. People choose to bear the cost of wearing uncomfortable but smart clothes to show how dedicated they are to their job and to gaining a promotion. However, this seems like an argument against dress codes: if people can choose what to wear then it’s easier for the eager employees to signal their dedication to The Company through their choice of clothing. As Tyler mentions, it may even be worthwhile for companies to impose a maximum dress code in order to eliminate the signaling costs that allowing suits imposes upon employees.

Ultimately, I think the reason for dress codes is shrouded in the mists of corporate managerial lore, of which I know nothing. I can’t think of a good reason for it in standard micro theory, and since Tyler Cowen can’t either I’m in good company there. If anybody has a good explanation for this convention I’d love to hear it.


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