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.

I generally enjoy The Economist’s blog, but I think they’ve taken their free-market philosophy a little far with their post on the “de facto monopoly of the American Medical Association in the distribution of licences to practice medicine.” Their claim is that the AMA extracts large rents from their monopoly and unfairly prevents other from practicing medicine. I don’t know what sort of rents doctors get from their education so I can’t comment on that. A more interesting question is whether it would be efficient to allow a deregulated market in medical practice.

Every time you go to the doctor you are, effectively, contracting for medical services. A well-known problem in contracting theory is lack of verifiability. The problem is that it is very costly to you to find out whether the doctor is providing you with high quality medical services. If you are not yourself trained as a doctor then you have to seek the opinion of someone who is in order to verify the quality of service you received. Even then, there is a question mark over the third party’s credibility: they may want to either protect the reputation of medical practitioners or, alternatively, destroy the reputation of competitors. Even the knowledge that you recovered from illness is not enough since this is a very noisy signal of medical quality. Without specialist knowledge it is impossible to know what the outcome would have been in the absence of treatment. The suggestion that consumers ought to have “choices over traditions of training and styles of care” suffers from the same problem. In the absence of highly specialised knowledge there is no way for consumers to verify the quality of each style of care.

There are two possible remedies to the problem of verifiability: information and regulation. Consumers can be informed by the AMA about the choices they face in a deregulated market or the market can be regulated. Unfortunately, it is simply not possible to become an expert on medical care by reading a couple of pamphlets. Placing the burden on consumers to choose wisely is unlikely to result in an efficient health care outcome. By contrast, regulation puts the burden of choice on experts in the field for whom it is far less costly to evaluate performance. It is quite possible that the rents that the AMA extracts from consumers are far lower than the costs to society of deregulation.

I was reading the Dilbert blog the other day, and Scott Adams was trying to talk about a Dilbert movie. Before starting to ask the blogging community whether they thought it would be a hit, he linked to this article, and asked why movie producers keep making so many R rated films, when G rated films gave larger returns. He puts it down to the directors incentives not being aligned with those of the investors. So instead of making a film that will maximise profit, directors make films that maximise the chance of winning awards. This is all very good, and I’m sure that there is an agency problem in film making. However, the agency problem will be ex-post the decision on what type of film to make. It seems to me that if investors felt they would make the most money of G-rated films, they would make contracts with directors to force them to make G-rated film, thereby solving (most) of the agency problem.

Scott Adams has an extremely good understanding of economics (he did do a degree in it), however, in this case I feel that he has confused average and marginal revenue. Now the article states that the average revenue from a G-rated film is greater than the average revenue from a R-rated film. However, when an investor puts money into a film being made, they are interested in the marginal revenue of that film type that is available from the market. The investor is putting money into a project that creates 1 more of that type of film in the market place. In that case the marginal revenue of a film type is what the investor is after.

Now it is possible that the average revenue of R-rated films may be lower, while the marginal revenue of an R-rated film is the same as a G-rated film. All we need for this to happen is the initial returns from the first G-rated film on the market to be higher than the R-rated film, but for marginal revenue to then fall much faster for the G-rated film type than the R-rated film type. I think this is a good description of demand for movies. Families have a high value for taking their kids along to the first great animated film of the year, however once we get to the 3rd animated film for the month the family will stop going. However, R-rated films tend to get a specific crowd that is interested in that type of film. This crowd is willing to pay to see more movies, but may not be as large as the crowd that goes to the first animated film. Furthermore if there is more range among R-rated films than G-rated films, the set of products we are discussing is catering to a differentiated market. If this is the case, the release of an R-rated film would have less of an impact on the marginal revenue of another R-rated film than would be the case with G-rated films.

However, there are a number of other explanations for the difference in average revenue:

  1. R-rated films are less prone to failure (so the marginal profit can be lower)
  2. R-rated films are cheaper to make (so although marginal revenue is lower, marginal profits are equal)
  3. There is some bias among investors towards R-rated films
  4. There are too few directors and too many investors, and so directors they have some market power. As a result, directors can change the composition of movies

Personally, I think all these things come into play in some way. However, I’m confident that movie investors are often trying to maximise their profit, just like people who invest in companies or houses.

I’ve been thinking about the fact that AirNZ is going to shut down Freedom Air in March 2008. With Freedom Air, Air NZ was able to serve the budget end of the market and the higher quality end by selling a differentiated product. However, the company could have simply offered different services in different compartments of the plane, it seems a touch over the top to create a whole separate brand just to get the advantage of price discrimination (at least in this case).

The true purpose of Freedom air was to prevent competition. By paying a whole lot of money to run a cut price airline, Air NZ was able to make it uneconomical for other potential entrants from coming into the market, as their marginal cost was greater than the price they could set when competing with Freedom. The investment in Freedom air acted as a form of commitment. As the investment in capital, goodwill etc for Freedom air was costly to reverse, Air NZ could credibly commit to fighting a new competitor on the Trans-Tasman route through the low prices Freedom charged, rather than just allowing them entry.

However, Air NZ has dropped Freedom right when Virgin was getting in on the act. I expect this is because the costly commitment to fight the new competitor was not sufficient to prevent the new competitor entering. As a result, Air NZ has decided to dump Freedom Air and just accept that there is a new competitor. I guess this is fair enough, as Virgin has some very deep pockets, and if Air NZ decided to fight them they may well be on the losing end. As a result, Freedom Air was a useful mechanism to reduce small scale competition in the market place, but it was not effective at preventing the arrival of one of the big boys.

In the future, I’m sure the case of Freedom Air will be a useful case study in how an incumbent can use costly commitment to prevent the entry of a new competitor. How do you think the commitment game functions in this case?

This time instead of being lazy I’ve actually been a bit busy, so here are some numbers from the last fortnight.

  1. Net annual arrivals fell to 8,730 in August
  2. Tourist arrivals rose 5.8%pa in August
  3. CA deficit came in at 8.2% of GDP in June
  4. Electronic sales rose 9.2%pa in August
  5. Core retail sales rose 5.0%pa in July
  6. House sales fell 9.8% (SA) between July and August
  7. TOT rose 0.6%
  8. Manufacturing output rose 3.2% (seasonally adjusted) over the June quarter.
  9. RBNZ didn’t change the OCR
  10. The exchange rate went between 0.686US and 0.746US busy times.

Over at Cato Unbound the health care debate rages on. David Cutler and Dana Goldman reply to Robin Hanson’s original article by almost agreeing with him. They both begin by acknowledging that much of our current health care spending is wasted. The gist of their criticism is that when you reduce health care consumption then you reduce necessary as well as ‘wasted’ health care. Consequently they call for increases in the effectiveness of spending rather than cuts to it. Note that Hanson never claims that the spending that does happen shouldn’t be controlled by doctors to ensure that necessary procedures still get performed.

Moreover, the criticism really seems to be an attempt to avoid the problem by simply wishing it away. Nobody denies that it would be nice if no health spending were wasted and it were all highly effective for treatment purposes: the fact is that it’s not and it probably never has been. As Hanson asks in his reply, “why must this distant possibility [of better health care] stop us from publicizing and acting now on our consensus that we expect little net health harm from crude cuts?”

Ezra Klein claims that some of the spending might be justified in order to raise peoples’ quality of life showing that we care. This might be a valid point, but I question whether that money couldn’t have a greater impact on peoples’ quality of life if it were spent elsewhere in the government’s budget. I have never been one to call for slashing social spending indiscriminately, but I’m surprised by how weak the replies to Hanson’s rather radical essay have been. The overwhelming response seems to be a knee-jerk rejection of such extreme spending cuts without a real refutation of the reasoning behind them.

It looks like Matt’s not the only brilliant economist campaigning for Pigovian taxation of carbon emissions. Now Greg Mankiw’s weighed in on the side of taxation. To those who claim a carbon tax is regressive because poor people are forced to live in the suburbs and drive more than the wealthy, Mankiw says

Gilbert Metcalf, a professor of economics at Tufts, has shown how revenue from a carbon tax could be used to reduce payroll taxes in a way that would leave the distribution of total tax burden approximately unchanged.

In addition, the Economist points out that

…it’s possible that a carbon tax might sharply reduce carbon output without any fall in oil consumption, so long as consumers of other fuels affected by the tax reduce their use of such pollutants and their consequent emissions,

although this seems like a bit of a long shot.
In NZ, the government has preferred a cap-and-trade system to carbon taxes. Mankiw mentions that this is equivalent to a carbon tax only if the permits are auctioned off. If they are allocated for free based on previous emissions, as I believe the case will be in NZ (please correct me here if I’m completely mistaken), then “…the prices of energy products would rise as they would under a carbon tax, but the government would collect no revenue to reduce other taxes and compensate consumers.” In other words, a cap-and-trade with grandfathered permits IS regressive and it’s expensive to redress the burden on the poor.

I don’t have time to say much, but I will say that the Fed’s decision to cut rates 50 basis points was silly. They are pretty much telling the market that they will bail them out when the shit hits the fan from taking on overly risky investments. Although this decision may forestall a recession in the US, how many future recessions will be the result of the relatively new Fed governor Ben Bernanke showing that he will follow the whim of the asset market.

People are comparing this situation to 2000/2001 when Alan Greenspan cut rate significantly to stop a recession. If this was even true it would be an indictment of today’s decision, as in some ways the ease with which rates were cut in 2000/2001 lead to the asset bubble we are now facing.

However, todays decision is even worse than the 2000/2001 decision, as inflationary pressures are HIGHLY elevated. A good central bank should first and foremost control inflationary pressures. However, it seems that many central banks are starting to forget their primary goal.

Many writers have noted that colonisation contribute to the sad state of many African economies today. Now Nathan Nunn claims that the slave trade may also have had a long-term impact on economies. The author

…find[s] a robust negative relationship between the number of slaves exported from a country and current economic performance. To better understand if the relationship is causal, I examine the historical evidence on selection into the slave trades, and use instrumental variables.

This analysis indicates that “…it was actually the most developed areas of Africa that tended to select into the slave trades”, which points to a causal relationship running from slavery to poor economiic performance. The author suggests that the reason might be that “…procurement of slaves through internal warfare, raiding, and kidnapping resulted in subsequent state collapse and ethnic fractionalization.”

Yet another reason why the West is morally required to help African nations out of their current strife?


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