The visible hand in economics

Archive for October 2007

According to a number of religious people, there is a Jesus economics. Now I don’t agree with their idea of the sort of economics Jesus presented at all, that may be because I’m not a religious academic, or it could be that these people just didn’t understand what economics actually is (for example they complain that we study scarcity, when Jesus economics is about abundance. That is silly, economics is the study of scarcity. Just because its Jesus economics doesn’t mean it can break literal definitions.)

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Time is tight so I can’t do a real blog post just now. However, I thought I could mention oil shocks and the difference between their impact in the 1970’s and now.

Oil prices have gone through the roof in recent times as a result of high world prices. In 2006, New Zealand was also suffering from its own oil shock, with world prices high and our dollar falling. However, we haven’t really seen much of an impact on the domestic economy, other than a slight fall off in domestic consumption. Compare this to the 1970’s, when oil shocks caused periods of massive inflation, forcing economists to see that the Phillips curve idea didn’t hold up in a dynamic setting.

Greg Mankiw goes on to discuss three reasons why oil shocks haven’t lead to massive inflation (note that the current oil shock will be severe in the USA, as their dollar has fallen strongly and world prices have risen):

  1. The economy is more energy-efficient
  2. Labour markets are more flexible, monetary policy has been designed better
  3. The inflationary impact of an oil price shock is different when it is the result of greater demand for oil (as it is currently) compared to the 1970’s when their was a cut in the supply of oil.

If I find time, I might try to talk about these issues, and how I think oil price shocks influence the NZ economy, but don’t count on it 🙂 . So, does anyone have anything to say about oil price shocks (preferably not about peak oil, but if you really have to 🙂 )

Update: There was a fourth reason in the Mankiw article. 4) The increase in oil prices was not as sudden, giving economic variables the chance to adjust (this concept comes from his New Keynesian belief in sticky wages and prices).

Update 2: Even NZPA has something to say about Oil prices and inflation, it might be a hot topic.

Update 3: Looks like the topic of Oil prices is making its rounds on the blogsphere. With US economic growth at 3.9% (this is an annualised rate, it is equivalent to have just under 1.0% quarterly growth in terms of how we measure GDP in NZ) with these high oil prices, it looks like this will be an important and interesting issue.

There seems to be a significant debate between the left and right wing blogs about whether New Zealand is over-taxed or not. However, there is one thing that both sides agree on, if taxes are cut by $1,000, this gives people $1,000 more to spend. This is the point I’m going to discuss.

Households receive a net wage, which is their gross wage – income tax. The household requires a certain net wage before it will enter the labour market (say the benefit + the opportunity cost of leisure time), and may also require a premium to choose one firm before another firm (when labour supply is restricted).

Now the gross wage + non-labour costs (which we will assume are exogenous, even though they aren’t really 🙂 ) is the cost to the firm of hiring that employee. If taxes fall, the net wage the household receives would be higher. However, the relationship between employers and employees determines the gross wage. If the employer knows that taxes will fall, they can reduce their employees gross wage and leave their net wage the same (I know that firms often can’t do this because of labour laws and wage stickiness, however in a dynamic sense they could just reduce the rate at which they increase an employees wage). Ultimately, the division of the tax depends on the relative bargaining power of the different agents.

If there were ‘many’ firms and ‘many’ employees, the incidence of tax would depend on the relative elasticities of demand and supply for labour. Often labour demand is assumed to be relatively elastic while labour supply is highly inelastic. In this case most of the tax is borne by the employee and so a cut in taxes will mainly benefit them.

However, if we have a high rate of unemployment, labour supply will become relatively more elastic, which implies that some of the burden shifts onto employers.

If we have a monopoly firm and many (homogeneous) low-skilled employees (flat labour supply curve) the tax burden will be fully taken up by the firm. This is because the monopoly will only want to pay enough to get the employees to work, and so the net wage will be set at the reservation level. If you cut taxes you cut the gross wage required to get this net wage. Note: This result would not hold with asymmetric information (worker effort) or heterogeneous agents (as a higher net wage would then be required to intice more workers – labour supply would be upward sloping).

Ultimately, where the burden of income tax falls is a difficult issue, and depends on the specifics of the labour and goods markets. However, it is not clear cut that if my taxes are cut I would end up with that much extra money. As a result, we have to realise that a cut in income taxes will result in a reduction in firm costs as well as an increase in consumers spending power.

The OCR was left unchanged at 8.25%.

It seems that the RBNZ took a relatively neutral tone, stating that it was happy that without any external shocks the current rate should be sufficient to keep inflation in the target band of 1-3%.

However, looking at the set of external shocks the Bank provided seems to indicate that there is still some prospect of rate increases in the near future.  Specifically, the Bank indicated that any increase in government spending would be taken as an upward shock.  As we are entering an election year where the parties will base policy on the fundamentals of lollynomics rather than fiscal restraint, the balance of probabilities seems to suggest further hikes may be on there way.

We mentioned a while back that the way politicians’ reputations are besmirched by allegations of misconduct coudl be due to the mistaken recollections of their constituents. Of course, there are rational reasons to mistrust politicians who are investigated for misconduct too, as Stuart Armstrong points out:

more guilty people get tried and acquitted than the average of the population. So … the trial is evidence of guilt – noisy evidence, but evidence none the less.

So, barring a complete exoneration (rather than a mere acquittal) perhaps I am silly to have faith in people who’ve been tried for crimes or misconduct. Our justice system is designed to prevent the conviction of the innocent, rather than preventing the acquittal of the guilty. As such we should expect that far fewer people are wrongly convicted than are wrongly acquitted. Given that there are a reasonable number of convictions overturned in light of later evidence, it must be that plenty of those acquitted are guilty of what they are accused of. They can’ t be punished but that doesn’t make them innocent, and our beliefs should rationally reflect that.

You all probably know by now that Eric Maskin was among the recipients of this year’s ‘Nobel prize’ in economics for his work on mechanism design. Browsing a few of his papers I came across one that reminded me of Will’s post on free software. Contrary to the obvious intuition, Bessen and Maskin propose that the software industry is an example of just the type of industry which could benefit from the removal of IP protections.

Software exhibits two characteristics that make this possible: sequential innovation and complementarities in technology. Since new software often builds on old software it is socially efficient to allow others to build on current platforms rather than have to reinvent the wheel. Of course, it means that rents that could be extracted through licencing are foregone. However, because software is complementary it is also in firms’ best interests to allow their ideas to be freely used. The complementarity means that others’ innovations increase the value of your future innovations. Thus, if you can speed the development of others’ software through letting them use your ideas then you can massively increase the expected value of your future developments. The conclusion they reach is that removal of patent protections would leave only the most innovative firms in the market and increase both their profitability and total surplus.

The paper discusses patents, not copyright, so it doesn’t directly pertain to open source software: Bessen and Maskin are talking about protection of ideas, not protection of actual written code. They don’t discuss allowing people to directly build on an existing code base but rather allowing ideas to be copied by others using their own code. Thus their proposal still provides significant barriers to entry in the form of an initial investment, but does not bar entry through the creation of monopolies over concepts. I wonder whether the removal of copyright protections would further enhance the incentive to innovate in the industry? Presumably the removal of barriers to entry would reduce profits and increase consumer surplus, but would it reduce or further enhance technological progress?

Some Canadian developers are making a computer game which simulates driving home drunk. They and police think it will be a great educational tool, showing teenagers how dangerous it is to drive while intoxicated. I’m not sure if I completely agree.

Assume that this game will realistically represent driving while drunk. As some people do get home when driving drunk, there must be some probability of getting home without crashing. Since teenagers can play this game over and over again, they can get better at not crashing in the game, which may make them think that they are less likely to crash when they actually drink and drive. Now it might do this, or it might just give teenagers a false belief of being good at drunk driving (given that the road and obstacles will be different on your home road). However, if our teenagers are rational this shouldn’t be the problem (as they will update their beliefs appropriately), the problem is that drunk driving is an experience good with negative externalities.

People who haven’t gone drunk driving don’t know how likely it would be that they would crash, they are uncertain (they don’t know the probability density function and so base probabilities on arbitrary beliefs). Once someone has consumed drunk driving, they gain information, and they know what the risks are when they drive. Now if current social advertising his mis-led teenagers, to believe that the risks are greater than they truly, a situation with no computer game may be preferable to a situation where kids have played the game.

Although full information is usually preferable, teenagers decision to drink drive has a negative externality which is the damage they cause when they crash. By showing kids the true probability of crashing, we increase their consumption of drink driving (assuming that their prior belief was that it was more likely they would crash) to the point where the social cost outweighs the social benefit of their driving activity.

However, there might still be scope for the game and full information. If we can ‘tax’ the negative externality, we can bring the quantity of drink driving down to the socially optimal level. This would require having police fining people when they catch them drink driving. The fine would have to equal [‘cost of outcomes’ x ‘probability of outcomes’]/[probability of being caught and fined]. In this case the driver takes on the full social cost of their drunken activity, and so will only consume the socially optimal amount. The problem with apply this rule come from quantifying the costs. If a drunk driver kills someone, what is the cost of that in monetary terms?

Ultimately, given the difficulty of quantifying outcomes, I think this may be the case where mis-information (at least a focus on the negatives) may be the best way to improve social outcomes. Discuss 🙂

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