Sunday, July 27, 2008

I'm moving!!!

Hi all- I just wanted to let you know that my blog is moving! I am taking most of the old posts over, and the new blog can be found at:

I am in the process of bringing the posts and comments over, so bear with me! I think the new, more customizable blog will make for a more enjoyable reading experience.


Saturday, July 19, 2008

Incentives Aren't Always About Compensation...

So, I am sitting at home on a beautiful Saturday afternoon watching a baseball game between the Boston Red Sox and the Los Angeles Angels of Anaheim. (I know, I have issues.) Unlike most games, this one is on FOX, and, while I love Jerry Remy and Don Orsillo, it's a nice change to hear what other anouncers have to say. One of the more interesting points that they brought up was how well-trained the Angels players are in terms of the overall spectrum of baseball skills (sacrifices, bunting, strategic running, etc.). They credited the Angels' minor league organization for this fact, saying that the minor league managers were somewhat unique in that they were more focused on developing players' skills than on specifically winning games. Put that way, the managers' goal makes perfect sense- I don't really think there is a large benefit for a team due to a winning minor league organization. Furthermore, the incentives for the players are such that they are much more willing to practice and experiment in the minor leagues than they would be when a whole bunch of people (fans, other teams, etc.) are watching and critiquing. So why doesn't this happen more often?

I am not overly familiar with the contracting structures for minor league managers, but I highly doubt that their compensation is directly dependent on the number of games that they win. (Players aren't allowed to contract on such things, so it would stand to reason that managers can't- or won't- either, especially since no one seems to care about the minor league records.) Therefore, an economist might argue that there are no perverse incentives at play since there is no direct compensation for wins, which would incentivize wins at the expense of drilling fundamentals. However, the FOX announcers are quick to point out that there are indirect incentives for wins because minor league managers use their records as a selling point when angling for a promotion.

How can this unintended incentive be corrected for? One solution would be for an organization to commit to not using win-loss records in promotion decisions. This would work well for internal promotions, and seems to be roughly what goes on with player promotion to the big leagues. (There isn't a particularly high correlation between minor league stats and getting called up.) But this would be ineffective overall, since an organization cannot prevent other teams from considering the records in external hiring decisions. A practical solution, then, would be to offer a competing incentive. Ideally, you would want to incentivize based on how well the manager drills the basic skills. Unfortunately, this is hard to measure, especially without distorting incentives in other ways, and there is a clear bias towards providing incentives for things that the easily measured. That said, the organization that can overcome that issue will end up with a very well-trained major league team, not to mention (theoretically) higher value for its minor league prospects.

Tuesday, July 15, 2008

The Office Understands Economics...

Angela: Gift baskets are... the essence of class and fanciness. They are the ultimate present that a person can receive.

Dwight: What about cash? With cash you can buy whatever you want, including a gift-basket, so... it's kind of the best gift ever.

Jim: What about a gift basket full of cash?

Andy: Yes! Cash-basket! Nice work, Tuna.

Monday, July 14, 2008

Bueller...Bueller...And the Disposition Effect...

Okay, I have to admit that I can't see Ben Stein's byline without thinking of his character (an economics teacher, of course) in Ferris Bueller's Day Off. As such, I am including a visual reminder for your viewing pleasure:

But I digress...Ben Stein has an article in today's NYT entitled "Lessons in Love, by Way of Economics". This article briefly describes the economic principles that, he argues, *should* guide our romantic choices. One part caught my interest in particular:

"When you have a winner, stick with your winner. Whether in love or in the stock market, winners are to be prized."

Now, consider the empirical finding in the stock market (called the disposition effect) that investors have a bias towards selling off winners (to realize gains) and holding on to losers (to avoid realizing losses). I am scared to think about how the disposition effect carries over to the relationship market. *shudders*

For way more disposition effect references than you would ever want, see here.

Wednesday, June 18, 2008

A Primer on Ricardian Equivalence (or "Why You Should Put Your Tax Rebate In A Savings Account")...

(Note: thanks to Tim Harford for reminding me that this issue was bugging me.)

Ok, I've seen two tax rebates in recent years (one back in 2001 and one this year), and I get that the political idea is to get cash back into the hands of citizens so that they can use it to buy stuff. In economic terms, spending the tax rebate stimulates aggregate demand and (temporarily) raises the nation's output and income. (If you don't see this, consider that people wanting to buy more stuff creates jobs, and those people working the new jobs get money, which they use at least some of to buy more stuff, which creates more jobs, and so on. Look up Keynes and the multiplier effect if you're still curious.)

In a way, the government is hoping that people don't stop to think where the "free" money comes from. Where *does* it come from? Generally speaking, the U.S. government is not a profitable enterprise, so if it wants to give out money, it has to get that money from somewhere. (Given that there is a national debt, the money isn't just sitting around in a government vault.) There are basically two options- the government can reduce spending and give the money that it would have spent back to people, or it can borrow money to give back to people. Given that reducing spending is likely to lower aggregate demand, take some jobs away, etc., that doesn't seem like the way to go to stimulate the economy. (Keynesian economists argue that FDR's increasing goverment spending went a long way to get the U.S. out of the Great Depression, for example.) Therefore, the funding of the tax rebate is through government borrowing.

Why does this matter? Well, there is the simple matter that borrowed money has to be paid back eventually, with interest even. (Macroeconomic models typically rule out the possibility of a Ponzi Scheme that would allow the government to keep borrowing more and more money without limit to pay the interest on the existing debt. This is most likely a realistic limitation, though it seems sometimes as though we are trending in that direction.) Where is the government going to get this money? From future taxes of course! Essentially what the government is doing is borrowing money on your behalf (albeit at a lower rate than you could borrow) and giving it to you as a "rebate", but there will come a time when it needs the money back (plus interest) to pay its creditors (hello China). When you think about it this way, are you going to spend or save your borrowed money? I might spend it if I thought I was old enough to not be likely to see the future tax increase, but that's about it. Even then, I should probably leave it to my (hypothetical) next of kin, since they are going to have to pay for the rebate that I got.

Economists like to put names to theories, and they like even more to name theories after themselves. The idea that debt-financed tax cuts or rebates are ineffectual in stimulating demand because people realize that the money will be paid back later in the form of higher taxes is a variant on Ricardian Equivalence. (Note that the theory of Ricardian Equivalence would also imply that increases in government spending via borrowing would also be demand neutral, in contrast to the multiplier effect described above.) Clearly Ricardian Equivalance can't hold in practice in the tax rebate case, since if it did the government (hopefully) wouldn't bother with the rebate.

Thinking from the consumer perspective, when might a household choose to spend the rebate? Maybe, as noted above, the household unit is old and doesn't really care about its children (or doesn't have any). Perhaps the household realizes the interest effect, but also realizes that the government's interest rate is pretty low and decides that consumption now is worth paying the interest later, even if it wouldn't have chosen to borrow on its own in order to finance consumption. It could even be the case that the household realizes that its tax position changes over time (due to expected income and policy changes) and it's not likely to bear the brunt of paying back the rebate. (Those nearing retirement or planning a career change to street performer could be in this category.) All of these explanations seem perfectly rational, even in the strict economic sense, and are thus not worrisome to me. That said, there are explanations for rebate consumption that are likely not utility-maximizing in the long run, and they are the ones that make me feel like the government is taking advantage of human behavior a little. My list so far is the following:

1. Households are impatient and tend to overvalue present consumption and immediate gratification. Furthermore, households are often time-inconsistent in this way, which means that there will be long-term regret regarding the present consumption, even if today it seems like the right thing to do. (Look up hyperbolic discounting for more detail.)

2. Households typically exhibit various forms of mental accounting and are thus likely to handle the tax rebate differently than it would handle an equivalent amount of earned income, for example. Specifically, there is evidence that households are likely to consume more and save less of what is considered a windfall, and the windfall is likely to be spent on more hedonic and frivolous items. In this way, the government is encouraging consumption of frivolous items- just what we need in this country.

3. Households have almost all retailers on the planet screaming "Spend your rebate here!" in their faces. It's unclear whether advertising aids in utlity-maximization or just clouds the process. I myself just bought a food dehydrator from an informercial, so who knows.

4. The households for whom the rebate is most attractive are the ones who are most liquidity constrained. The rebate at a low effective interest rate might be a boon to them, but it could also be the case that the liquidity constraint was an effective self-control device.

Update: Whatever the reason, consumers aren't as forward-looking as Ricardo's theory would imply. From Greg Mankiw's blog: "Total sales at U.S. retailers rose a full percentage point in May as many consumers had more spending cash in their wallets from government rebate checks."

Tuesday, June 17, 2008

Why I *Heart* Honest Tea...

Most people that know me know that I like dorky econ jokes. I think I also like products that feature dorky econ jokes on their labels. Behold the label from my beverage of choice:

I swear that this was not on purpose- this label is from Honest Tea's Green Dragon Tea, which is a lightly sweetened green tea with passion fruit flavor, and I picked it up without examining the text on the label. (The label is different on other flavors.) I do, however, appreciate the sugar optimization analogy, though the more picky among you will notice that their optimal point is technically not quite at the top of the curve. Maybe their sugar choice is the result of some sort of cost-benefit analysis that is not fully shown here. :) (Sugar isn't free, after all...)

If you are curious, the Barry of Seth and Barry is Barry Nalebuff, a professor at the Yale School of Management, and Seth was one of his MBA students.

Thursday, June 12, 2008

More From the Land of Unintended Consequences...

As of today, two airlines have decided to start charging customers for all checked luggage. Okay, I get it, sort of- the airlines need to cover the increased cost of fuel, customers are more sensitive to base ticket prices than they are to the later add on components, especially when the point of purchase is once they're already at the airport or on the plane, etc. BUT...hasn't anyone at the airlines thought of the incentives that this creates for passengers? For a while now, airlines seem to have been steering people towards checking baggage, presumably because it makes the security checkpoint process more efficient (3-1-1 rule, anyone?) and the airline doesn't run into the lovely situation where passengers are fighting for space in the overhead bins. (Not to mention the fact that it's probably easier to smuggle something onto a plane when everyone is bringing boatloads of stuff with them.) Why would they now want to push people in the other direction? I suppose part of the answer is that the airline doesn't bear the direct cost for the security checkpoint hassle. However, I would argue that if you are making your lines longer and slower than those at other terminals for other airlines, you're going to lose customers in the long run. People are already displeased enough with airline customer service as it is, is it really worth a few $15 pieces of checked baggage to make it worse?

You may ask how this is different from charging for a movie or snack on the plane, since this strategy has seemed to work out okay. That answer is simple- your decision whether to purchase a snack on the plane doesn't affect me, whereas your bag that previously would have been checked but is now being examined in line in front of me and pushed on top of my stuff in the overhead bin does. (And there will be some of these bags, since not everyone will pay the $15.) So the aitlines are potentially inconveniencing all passegers regardless of whether they choose to pay the $15 to check their bags.

Wednesday, May 28, 2008

Knowledge Isn't the Solution to Everything...

As a behavioral economist, I am curious as to the degree to which making people aware of their biases would make the biases go away. For example, would people stop procrastinating (or at least be sophisticated rather than naive, in economic terms) if they were told that they were doing so? Would they make better risky choices if they were aware of the concept of loss aversion?

My conjecture, based on my reading and casual observation, is "sometimes". Often times in economic experiments it is clear that subjects that have studied economics behave differently from those who have not. (It's also possible that people who choose to study economics are just intrinsically different from others.) That said, I present the following example:

Behold the concept of this context, once an individual has an anchor, she is unwilling or unhappy to pay a price higher than the anchor and feels like she is getting a good deal if the price is below the anchor, even if the anchor price was completely arbitrary. Clearly I am aware that this bias exists...but fast forward to me trying to buy a Wii Fit online- I was perfectly happy to pay a price of roughly $160 on Amazon Marketplace until I noticed that the list price was $89.99. This mostly irrelevant fact did in fact prevent me from making a purchase, which shows that biases such as the ones arising from the anchoring effect are not only intellectual curiosities but have real economic impact.

(Sidenote: one could argue that I am in fact rational, and that the list price should prevent me from purchasing simply because it tells me that I will eventually be able to get the item for that price. Personally, I don't think that that explanation jives with my impatience and/or desire for immediate gratification.)

Monday, January 14, 2008

The Huckabee Tax Plan...

I was explaining to a friend of mine that Mike Huckabee's tax plan is going to start haunting me in my dreams...I can't seem to stop thinking about it, since it's one of those things that makes so much sense for the first 5 seconds but upon further reflection is the worst idea ever.

Primer: Huckabee's tax plan is to abolish all existing taxes, both individual and corporate, and replace them with a flat consumption tax. Households would be reimbursed for tax paid on purchases up to the poverty line in order to avoid having the tax be too regressive.

So why would it make sense? The main appealing feature is that it would (theoretically) be easier to implement, since income taxes are a big pain in the ass for a lot of people. (Also, other countries have shown significant increases in compliance as the result of a simplified tax code, which would be a good thing.) It could be done automatically at point of sale, which seems great. BUT...upon closer reading, there are monthly tax rebates available based on cumulative purchasing. This means that some 200 million checks would have to go out each month and cumulative purchases would have to be reported just like income is reported now, which puts us back to where we started in terms of administrative hassle. (Besides, don't we already approximate the point-of-sale idea for income taxes with the whole concept of witholding? Just thought I'd ask.) Unlike Huckabee implies, the system can't just reimburse each household for purchases up to the poverty line automatically, since some households may be very low spenders and thus not entitled to the full rebate. Furthermore, reimbursing retroactively creates a problem for those with liquidity constraints, whereas the current income-tax witholding system at least partially accounts for this.

So why else is it a bad idea? Let me count the ways...I will even ignore the common ones that everyone is already complaining about and focus on the more subtle issues:

Issue 1: According to Mike Huckabee's web site, the FairTax (don't you love that name?) is "a simple tax based on wealth." Ummm...wrong. Wait, let me, still wrong. The only way that the FairTax, which is a consumption tax, is actually a tax based on wealth is if individuals' wealth levels and purchasing habits are always proportional. It's pretty easy to argue that this is not the case- I'm sure we all know a few $30,000 millionaires as well as the wealthy janitors and such who got that way by not buying anything and investing well.

Issue 2: Not unrelated to the issue above, a flat consumption tax is a huge boon for the super wealthy (and thus more of a burden on everone else), since they can't even begin to spend all of the money that they have- there are only so many Gulfstream G5's that Larry Page and Sergey Brin can buy, for example. (I think, in fact, that they have even chosen to share a used Boeing 767 rather than a new G5, and used goods aren't even subject to Huckabee's consumption tax!) One solution would be to place a higher tax rate on super-luxury items, but this is a) not addressed by Huckabee, and b) likely to upset/punish the producers of such items, who generally happen to employ many average or low-income individuals.

Issue 3: Huckabee's web site makes the following assertion: "Expert analyses have shown that the FairTax lowers the lifetime tax burden of all of us: single or married; working or retired; rich, poor or middle class." The page also says, in the sentence immediately before the above quote even, that the tax plan is revenue neutral. Um...if everyone is paying less over their lifetimes, this is mathematically impossible, no?

Issue 4: The rationale behind abolishing an income tax is that is seems inefficient to tax people for being productive and working more. I would argue that it might be a bit demoralizing, but not inefficient. After all, on a basic level, why do people work? They work so that they can buy things in order to improve their quality of life. A consumption tax reduces this purchasing power in largely the same way that an income tax does- who cares if you get to keep all of your $10 an hour if an after work beer now costs $12? (Obviously I am exaggerating, but you see the point.) This issue deserves a closer look as well as some economic background:

  • From an efficiency perspective, the best markets to tax are those where the parties involved are the least elastic in terms of changing behavior as a function of price (or wage). (This minimizes what is called deadweight loss, which is basically the amount of economic well-being that evaporates into thin air as a result of a tax or other market distortion.)
  • Taken in the tax context, how much do you really think that people change their work habits as a function of their take-home wage? I would argue that, because we are socially conditioned to the idea of the 40-hour work week if nothing else, the answer is likely to be "not much". To think about it another way, do you think that Bill Gates would have worked harder if his marginal tax rate were lower? The drive for innovation and success often has to do with much more than just monetary reward. (Either that or people aren't good at distinguishing LOTS AND LOTS of money from just LOTS of money.)
  • On the other hand, how much do you think that people change consumption behavior as a function of price? I point you to the overwhelming growth and success of Wal-Mart as an answer to that question. (Okay, fine, technically this argument requires that they would buy more stuff at Wal-Mart than they would otherwise, but I think that that is a small leap to make.) Furthermore, psychology would suggest that the behavior change would be greater with consumption than with income because the coupling of decision-making and payment is stronger with consumption than with labor.
  • Therefore, based on the above points, the income tax is likely to be more economically efficient. (I will concede that the consumption tax will encourage beneficial saving that perhaps individuals were too impatient to engage in otherwise, but that benefit doesn't outweigh the downside of the consumption tax and is way too paternalistic for my tastes.)
  • In terms of economic outcome, it doesn't matter whether you tax consumers or producers, and the tax burden is generally shared by consumers (in the form of higher after-tax prices) and producers (in the form of lower pre-tax prices). This is completely overlooked in Huckabee's argument, and it means both that a) workers wouldn't see the full dollar benefit of income-tax abolition, since wages would go down in equilbrium, and b) producers don't get a free ride, since the prices for the goods that they sell (at least to American consumers) will go down in equilibrium.
  • Consumption and production are economically two sides of the same coin- where is the incentive to innovate and produce when people aren't willing and/or able to buy your products? This is a factor that cannot be ignored when considering a consumption tax.

Issue 5: While it might lower landfill costs, encouraging trade in used goods (by not subjecting them to the tax) is not necessarily good for the economy, since there is not really any economic value added in pure resale. (The government statistics people must agree with me here since used goods sold are not included in the calculation of gross domestic product.) You would have to make a tenuous argument that knowledge of a good resale market would encourage people to purchase more new stuff, since they know that they can sell it later if they want to, in order to make a good case here.

Issue 6: Huckabee asserts that abolishing the corporate tax will make American products more competitive globally because it will lower prices on exports. I buy this, I really do. However, let's come back to this revenue neutral issue, i.e. the fact that tax dollars have got to come from somewhere. So if the corporate tax is at least partially baked into the price of goods produced by U.S. corporations, then other countries are helping to pay that tax when they buy our exports. Huckabee's plan implies that the consumption tax would not apply to exports (otherwise the price of exports would actually go up, not down, negating the increased competitiveness point), which means that the whole dollar amount of what used to be the corporate tax is now the reponsibility of the U.S. population. Also, the corporate tax is felt by shareholders of U.S. companies, some of which are not U.S. citizens. This amount would also shift solely to the U.S. population. Thus, there is a cost of this increased competitiveness in the form of higher taxes for American households. (If you want to think more about this concept, ponder why high-tourism states generally have high sales taxes but low property and income taxes.)

Issue 7: I actually started thinking about the tax issue in the context of Kahneman and Tversky's model of loss aversion. The general idea of loss aversion (which has been shown to exist empirically) is that losses are felt more strongly than equivalent gains. Calibration of this model suggests that losses are felt roughly twice as uch as gains. Why is this relevant here? Loss aversion predicts that a loss is felt less stongly when coupled with a gain than when coupled with another loss. In this context, the loss in question is the money that an individual is paying in taxes. With an income tax, the tax loss is coupled with a gain in the form of wages. With a consumption tax, the tax loss is coupled with a loss of money in the form of payment. Granted, there is a gain from getting the item purchased that could mitigate this effect, but the monetary loss is still present. This would also imply that the income tax would be more efficient in that it would result in less "pain" due to actually paying the tax.

Okay, I will get off my soapbox now. Go Hillary.

Sidenote: Steve Landsburg has an interesting Slate article on the Huckabee plan. Why is it that economists are so much more convincing than politicians? I do have to note, however, that the time element of consumption coming after (sometimes well after) income means that the tax rate has to be higher in order to be revenue neutral than if the time element was not an issue. Who would have ever thought that there would be a benefit to people spending money that they don't have yet?

In case you are curious: Apparently Bruce Bartlett agrees with me on a general level.

Thursday, January 10, 2008

On the Importance of General Equilibrium Analysis...

Okay, I have to admit it: I love the Fug Girls. They are hilariously mean, and I am always up for a good celebrity fashion train wreck. I never would have guessed, however, that they would stumble upon a real-world example of the importance of general equilibrium models to analyze economic welfare. They show pretty convincingly in their New York Magazine blog post that the Writers' Guild strike has far-reaching consequences that are both economic and non-economic in nature. For example, I'll bet no one took into consideration the loss of economic surplus by seamstresses who aren't getting paid because there are no Golden Globe gowns to sew. What did they ever do to the writers of America to deserve this?

What exactly is my point here? you may ask...well, my economics textbook tells me that, when externalities are present, the government can actually raise surplus by intervening in a market. In a way, there is a positive externality associated with showbiz writing, apparently, since it keeps other (non-showbiz) people in business. Neither the writers nor the producers seem to care about this, which isn't terribly surprising since they don't have an incentive to care. Historically, if the product at hand were cars rather than scripts, the government would likely be stepping in to bring an end to/mitigate the effects of this nonsense. At what point does that become justified in this case? If I have to go too long without new episodes of Gossip Girl I am going to be very cranky...

(Let it be known that I am not against the idea of collective bargaining in general, but I find it hard to believe that the current situation is profit-maximizing for anyone.)