How much should we save?

2015-07-11 PNRJ critique of neoclassical economics, macroeconomics, public policy Bridge to Nowhere, capital, consumption, credit constraint, crowding out, Golden Rule, Humane Genome Project, Hungary hyperinflation, interest, interest rate, investment, labor, life-cycle hypothesis, monetary base, monetary policy, money supply, open market operations, paradox of thrift, Paul Allen, Pirate Code, precautionary saving, quantitative easing, Save More Tomorrow, saving, saving-investment identity, self-control, Weimar Germany, zero lower bound, ZImbabwe

JDN 2457215 EDT 15:43.

One of the most basic questions in macroeconomics has oddly enough received very little attention: How much should we save? What is the optimal level of saving?

At the microeconomic level, how much you should save basically depends on what you think your income will be in the future. If you have more income now than you think you’ll have later, you should save now to spend later. If you have less income now than you think you’ll have later, you should spend now and dissave—save negatively, otherwise known as borrowing—and pay it back later. The life-cycle hypothesis says that people save when they are young in order to retire when they are old—in its strongest form, it says that we keep our level of spending constant across our lifetime at a value equal to our average income. The strongest form is utterly ridiculous and disproven by even the most basic empirical evidence, so usually the hypothesis is studied in a weaker form that basically just says that people save when they are young and spend when they are old—and even that runs into some serious problems.

The biggest problem, I think, is that the interest rate you receive on savings is always vastly less than the interest rate you pay on borrowing, which in turn is related to the fact that people are credit-constrained—they generally would like to borrow more than they actually can. It also has a lot to do with the fact that our financial system is an oligopoly; banks make more profits if they can pay savers less and charge borrowers more, and by colluding with each other they can control enough of the market that no major competitors can seriously undercut them. (There is some competition, however, particularly from credit unions—and if you compare these two credit card offers from University of Michigan Credit Union at 8.99%/12.99% and Bank of America at 12.99%/22.99% respectively, you can see the oligopoly in action as the tiny competitor charges you a much fairer price than the oligopoly beast. 9% means doubling in just under eight years, 13% means doubling in a little over five years, and 23% means doubling in three years.) Another very big problem with the life-cycle theory is that human beings are astonishingly bad at predicting the future, and thus our expectations about our future income can vary wildly from the actual future income we end up receiving. People who are wise enough to know that they do not know generally save more than they think they’ll need, which is called precautionary saving. Combine that with our limited capacity for self-control, and I’m honestly not sure the life-cycle hypothesis is doing any work for us at all.

But okay, let’s suppose we had a theory of optimal individual saving. That would still leave open a much larger question, namely optimal aggregate saving. The amount of saving that is best for each individual may not be best for society as a whole, and it becomes a difficult policy challenge to provide incentives to make people save the amount that is best for society.

Or it would be, if we had the faintest idea what the optimal amount of saving for society is. There’s a very simple rule-of-thumb that a lot of economists use, often called the golden rule (not to be confused with the actual Golden Rule, though I guess the idea is that a social optimum is a moral optimum), which is that we should save exactly the same amount as the share of capital in income. If capital receives one third of income (This figure of one third has been called a “law”, but as with most “laws” in economics it’s really more like the Pirate Code; labor’s share of income varies across countries and years. I doubt you’ll be surprised to learn that it is falling around the world, meaning more income is going to capital owners and less is going to workers.), then one third of income should be saved to make more capital for next year.

When you hear that, you should be thinking: “Wait. Saved to make more capital? You mean invested to make more capital.” And this is the great sleight of hand in the neoclassical theory of economic growth: Saving and investment are made to be the same by definition. It’s called the savings-investment identity. As I talked about in an earlier post, the model seems to be that there is only one kind of good in the world, and you either use it up or save it to make more.

But of course that’s not actually how the world works; there are different kinds of goods, and if people stop buying tennis shoes that doesn’t automatically lead to more factories built to make tennis shoes—indeed, quite the opposite.If people reduce their spending, the products they no longer buy will now accumulate on shelves and the businesses that make those products will start downsizing their production. If people increase their spending, the products they now buy will fly off the shelves and the businesses that make them will expand their production to keep up.

In order to make the savings-investment identity true by definition, the definition of investment has to be changed. Inventory accumulation, products building up on shelves, is counted as “investment” when of course it is nothing of the sort. Inventory accumulation is a bad sign for an economy; indeed the time when we see the most inventory accumulation is right at the beginning of a recession.

As a result of this bizarre definition of “investment” and its equation with saving, we get the famous Paradox of Thrift, which does indeed sound paradoxical in its usual formulation: “A global increase in marginal propensity to save can result in a reduction in aggregate saving.” But if you strip out the jargon, it makes a lot more sense: “If people suddenly stop spending money, companies will stop investing, and the economy will grind to a halt.” There’s still a bit of feeling of paradox from the fact that we tried to save more money and ended up with less money, but that isn’t too hard to understand once you consider that if everyone else stops spending, where are you going to get your money from?

So what if something like this happens, we all try to save more and end up having no money? The government could print a bunch of money and give it to people to spend, and then we’d have money, right? Right. Exactly right, in fact. You now understand monetary policy better than most policymakers. Like a basic income, for many people it seems too simple to be true; but in a nutshell, that is Keynesian monetary policy. When spending falls and the economy slows down as a result, the government should respond by expanding the money supply so that people start spending again. In practice they usually expand the money supply by a really bizarre roundabout way, buying and selling bonds in open market operations in order to change the interest rate that banks charge each other for loans of reserves, the Fed funds rate, in the hopes that banks will change their actual lending interest rates and more people will be able to borrow, thus, ultimately, increasing the money supply (because, remember, banks don’t have the money they lend you—they create it).

We could actually just print some money and give it to people (or rather, change a bunch of numbers in an IRS database), but this is very unpopular, particularly among people like Ron Paul and other gold-bug Republicans who don’t understand how monetary policy works. So instead we try to obscure the printing of money behind a bizarre chain of activities, opening many more opportunities for failure: Chiefly, we can hit the zero lower bound where interest rates are zero and can’t go any lower (or can they?), or banks can be too stingy and decide not to lend, or people can be too risk-averse and decide not to borrow; and that’s not even to mention the redistribution of wealth that happens when all the money you print is given to banks. When that happens we turn to “unconventional monetary policy”, which basically just means that we get a little bit more honest about the fact that we’re printing money. (Even then you get articles like this one insisting that quantitative easing isn’t really printing money.)

I don’t know, maybe there’s actually some legitimate reason to do it this way—I do have to admit that when governments start openly printing money it often doesn’t end well. But really the question is why you’re printing money, whom you’re giving it to, and above all how much you are printing. Weimar Germany printed money to pay off odious war debts (because it totally makes sense to force a newly-established democratic government to pay the debts incurred by belligerent actions of the monarchy they replaced; surely one must repay one’s debts). Hungary printed money to pay for rebuilding after the devastation of World War 2. Zimbabwe printed money to pay for a war (I’m sensing a pattern here) and compensate for failed land reform policies. In all three cases the amount of money they printed was literally billions of times their original money supply. Yes, billions. They found their inflation cascading out of control and instead of stopping the printing, they printed even more. The United States has so far printed only about three times our original monetary base, still only about a third of our total money supply. (Monetary base is the part that the Federal reserve controls; the rest is created by banks. Typically 90% of our money is not monetary base.) Moreover, we did it for the right reasons—in response to deflation and depression. That is why, as Matthew O’Brien of The Atlantic put it so well, the US can never be Weimar.

I was supposed to be talking about saving and investment; why am I talking about money supply? Because investment is driven by the money supply. It’s not driven by saving, it’s driven by lending.

Now, part of the underlying theory was that lending and saving are supposed to be tied together, with money lent coming out of money saved; this is true if you assume that things are in a nice tidy equilibrium. But we never are, and frankly I’m not sure we’d want to be. In order to reach that equilibrium, we’d either need to have full-reserve banking, or banks would have to otherwise have their lending constrained by insufficient reserves; either way, we’d need to have a constant money supply. Any dollar that could be lent, would have to be lent, and the whole debt market would have to be entirely constrained by the availability of savings. You wouldn’t get denied for a loan because your credit rating is too low; you’d get denied for a loan because the bank would literally not have enough money available to lend you. Banking would have to be perfectly competitive, so if one bank can’t do it, no bank can. Interest rates would have to precisely match the supply and demand of money in the same way that prices are supposed to precisely match the supply and demand of products (and I think we all know how well that works out). This is why it’s such a big problem that most macroeconomic models literally do not include a financial sector. They simply assume that the financial sector is operating at such perfect efficiency that money in equals money out always and everywhere.

So, recognizing that saving and investment are in fact not equal, we now have two separate questions: What is the optimal rate of saving, and what is the optimal rate of investment? For saving, I think the question is almost meaningless; individuals should save according to their future income (since they’re so bad at predicting it, we might want to encourage people to save extra, as in programs like Save More Tomorrow), but the aggregate level of saving isn’t an important question. The important question is the aggregate level of investment, and for that, I think there are two ways of looking at it.

The first way is to go back to that original neoclassical growth model and realize it makes a lot more sense when the s term we called “saving” actually is a funny way of writing “investment”; in that case, perhaps we should indeed invest the same proportion of income as the income that goes to capital. An interesting, if draconian, way to do so would be to actually require this—all and only capital income may be used for business investment. Labor income must be used for other things, and capital income can’t be used for anything else. The days of yachts bought on stock options would be over forever—though so would the days of striking it rich by putting your paycheck into a tech stock. Due to the extreme restrictions on individual freedom, I don’t think we should actually do such a thing; but it’s an interesting thought that might lead to an actual policy worth considering.

But a second way that might actually be better—since even though the model makes more sense this way, it still has a number of serious flaws—is to think about what we might actually do in order to increase or decrease investment, and then consider the costs and benefits of each of those policies. The simplest case to analyze is if the government invests directly—and since the most important investments like infrastructure, education, and basic research are usually done this way, it’s definitely a useful example. How is the government going to fund this investment in, say, a nuclear fusion project? They have four basic ways: Cut spending somewhere else, raise taxes, print money, or issue debt. If you cut spending, the question is whether the spending you cut is more or less important than the investment you’re making. If you raise taxes, the question is whether the harm done by the tax (which is generally of two flavors; first there’s the direct effect of taking someone’s money so they can’t use it now, and second there’s the distortions created in the market that may make it less efficient) is outweighed by the new project. If you print money or issue debt, it’s a subtler question, since you are no longer pulling from any individual person or project but rather from the economy as a whole. Actually, if your economy has unused capacity as in a depression, you aren’t pulling from anywhere—you’re simply adding new value basically from thin air, which is why deficit spending in depressions is such a good idea. (More precisely, you’re putting resources to use that were otherwise going to lay fallow—to go back to my earlier example, the tennis shoes will no longer rest on the shelves.) But if you do not have sufficient unused capacity, you will get crowding-out; new debt will raise interest rates and make other investments more expensive, while printing money will cause inflation and make everything more expensive. So you need to weigh that cost against the benefit of your new investment and decide whether it’s worth it.

This second way is of course a lot more complicated, a lot messier, a lot more controversial. It would be a lot easier if we could just say: “The target investment rate should be 33% of GDP.” But even then the question would remain as to which investments to fund, and which consumption to pull from. The abstraction of simply dividing the economy into “consumption” versus “investment” leaves out matters of the utmost importance; Paul Allen’s 400-foot yacht and food stamps for children are both “consumption”, but taxing the former to pay for the latter seems not only justified but outright obligatory. The Bridge to Nowhere and the Humane Genome Project are both “investment”, but I think we all know which one had a higher return for human society. The neoclassical model basically assumes that the optimal choices for consumption and investment are decided automatically (automagically?) by the inscrutable churnings of the free market, but clearly that simply isn’t true.

In fact, it’s not always clear what exactly constitutes “consumption” versus “investment”, and the particulars of answering that question may distract us from answering the questions that actually matter. Is a refrigerator investment because it’s a machine you buy that sticks around and does useful things for you? Or is it consumption because consumers buy it and you use it for food? Is a car an investment because it’s vital to getting a job? Or is it consumption because you enjoy driving it? Someone could probably argue that the appreciation on Paul Allen’s yacht makes it an investment, for instance. Feeding children really is an investment, in their so-called “human capital” that will make them more productive for the rest of their lives. Part of the money that went to the Humane Genome Project surely paid some graduate student who then spent part of his paycheck on a keg of beer, which would make it consumption. And so on. The important question really isn’t “is this consumption or investment?” but “Is this worth doing?” And thus, the best answer to the question, “How much should we save?” may be: “Who cares?”

What are we celebrating today?

2015-07-042015-07-04 PNRJ current events, public policy Adam Smith, Benjamin Franklin, constitution, democracy, Founding Fathers, George Washington, history, Independence Day, James Madison, Napoleon, nationalism, Obama, patriotism, public policy, Thomas Jefferson, Thomas Paine, tribal paradigm

JDN 2457208 EDT 13:35 (July 4, 2015)

As all my American readers will know (and unsurprisingly 79% of my reader trackbacks come from the United States), today is Independence Day. I’m curious how my British readers feel about this day (and the United Kingdom is my second-largest source of reader trackbacks); we are in a sense celebrating the fact that we’re no longer ruled by you.

Every nation has some notion of patriotism; in the simplest sense we could say that patriotism is simply nationalism, yet another reflection of our innate tribal nature. As Obama said when asked about American exceptionalism, the British also believe in British exceptionalism. If that is all we are dealing with, then there is no particular reason to celebrate; Saudi Arabia or China could celebrate just as well (and very likely does). Independence Day then becomes something parochial, something that is at best a reflection of local community and culture, and at worst a reaffirmation of nationalistic divisiveness.

But in fact I think we are celebrating something more than that. The United States of America is not just any country. It is not just a richer Brazil or a more militaristic United Kingdom. There really is something exceptional about the United States, and it really did begin on July 4, 1776.

In fact we should probably celebrate June 21, 1789 and December 15, 1791, the ratification of the Constitution and the Bill of Rights respectively. But neither of these would have been possible without that Declaration of Independence on July 4, 1776. (In fact, even that date isn’t as clear-cut as commonly imagined.)

What makes the United States unique?

From the dawn of civilization around 5000 BC up to the mid-18^th century AD, there were basically two ways to found a nation. The most common was to grow the nation organically, formulate an ethnic identity over untold generations and then make up an appealing backstory later. The second way, and not entirely mutually exclusive, was for a particular leader, usually a psychopathic king, to gather a superior army, conquer territory, and annex the people there, making them part of his nation whether they wanted it or not. Variations on these two themes were what happened in Rome, in Greece, in India, in China; they were done by the Sumerians, by the Egyptians, by the Aztecs, by the Maya. All the ancient civilizations have founding myths that are distorted so far from the real history that the real history has become basically unknowable. All the more recent powers were formed by warlords and usually ruled with iron fists.

The United States of America started with a war, make no mistake; and George Washington really was more a charismatic warlord than he ever was a competent statesman. But Washington was not a psychopath, and refused to rule with an iron fist. Instead he was instrumental in establishing a fundamentally new approach to the building of nations.
This is literally what happened—myths have grown around it, but it itself documented history. Washington and his compatriots gathered a group of some of the most intelligent and wise individuals they could find, sat them down in a room, and tasked them with answering the basic question: “What is the best possible country?” They argued and debated, considering absolutely the most cutting-edge economics (The Wealth of Nations was released in 1776) and political philosophy (Thomas Paine’s Common Sense also came out in 1776). And then, when they had reached some kind of consensus on what the best sort of country would be—they created that country. They were conscious of building a new tradition, of being the founders of the first nation built as part of the Enlightenment. Previously nations were built from immemorial tradition or the whims of warlords—the United States of America was the first nation in the world that was built on principle.

It would not be the last; in fact, with a terrible interlude that we call Napoleon, France would soon become the second nation of the Enlightenment. A slower process of reform would eventually bring the United Kingdom itself to a similar state (though the UK is still a monarchy and has no formal constitution, only an ever-growing mountain of common law). As the centuries passed and the United States became more and more powerful, its system of government attained global influence, with now almost every nation in the world nominally a “democracy” and about half actually recognizable as such. We now see it as unexceptional to have a democratically-elected government bound by a constitution, and even think of the United States as a relatively poor example compared to, say, Sweden or Norway (because #Scandinaviaisbetter), and this assessment is not entirely wrong; but it’s important to keep in mind that this was not always the case, and on July 4, 1776 the Founding Fathers truly were building something fundamentally new.

Of course, the Founding Fathers were not the demigods they are often imagined to be; Washington himself was a slaveholder, and not just any slaveholder, but in fact almost a billionaire in today’s terms—the wealthiest man in America by far and actually a rival to the King of England. Thomas Jefferson somehow managed to read Thomas Paine and write “all men are created equal” without thinking that this obligated him to release his own slaves. Benjamin Franklin was a misogynist and womanizer. James Madison’s concept of formalizing armed rebellion bordered on insanity (and ultimately resulted in our worst amendment, the Second). The system that they built disenfranchised women, enshrined the slavery of Black people into law, and consisted of dozens of awkward compromises (like the Senate) that would prove disastrous in the future. The Founding Fathers were human beings with human flaws and human hypocrisy, and they did many things wrong.

But they also did one thing very, very right: They created a new model for how nations should be built. In a very real sense they redefined what it means to be a nation. That is what we celebrate on Independence Day.

Externalities

2015-06-28 PNRJ core principles, public policy, Top 10 things to know about economics altruism, Bill Clinton, climate change, Coase, Coase theorem, democracy, externalities, government, Pareto-efficiency, pollution, rational, regulation, snowclone, social democracy, tragedy of the commons

JDN 2457202 EDT 17:52.

The 1992 Bill Clinton campaign had a slogan, “It’s the economy, stupid.”: A snowclone I’ve used on occasion is “it’s the externalities, stupid.” (Though I’m actually not all that fond of calling people ‘stupid’; though occasionally true is it never polite and rarely useful.) Externalities are one of the most important concepts in economics, and yet one that even all too many economists frequently neglect.

Fortunately for this one, I really don’t need much math; the concept isn’t even that complicated, which makes it all the more mysterious how frequently it is ignored. An externality is simply an effect that an action has upon those who were not involved in choosing to perform that action.

All sorts of actions have externalities; indeed, much rarer are actions that don’t. An obvious example is that punching someone in the face has the externality of injuring that person. Pollution is an important externality of many forms of production, because the people harmed by pollution are typically not the same people who were responsible for creating it. Traffic jams are created because every car on the road causes a congestion externality on all the other cars.

All the aforementioned are negative externalities, but there are also positive externalities. When one individual becomes educated, they tend to improve the overall economic viability of the place in which they live. Building infrastructure benefits whole communities. New scientific discoveries enhance the well-being of all humanity.

Externalities are a fundamental problem for the functioning of markets. In the absence of externalities—if each person’s actions only affected that one person and nobody else—then rational self-interest would be optimal and anything else would make no sense. In arguing that rationality is equivalent to self-interest, generations of economists have been, tacitly or explicitly, assuming that there are no such things as externalities.

This is a necessary assumption to show that self-interest would lead to something I discussed in an earlier post: Pareto-efficiency, in which the only way to make one person better off is to make someone else worse off. As I already talked about in that other post, Pareto-efficiency is wildly overrated; a wide variety of Pareto-efficient systems would be intolerable to actually live in. But in the presence of externalities, markets can’t even guarantee Pareto-efficiency, because it’s possible to have everyone acting in their rational self-interest cause harm to everyone at once.

This is called a tragedy of the commons; the basic idea is really quite simple. Suppose that when I burn a gallon of gasoline, that makes me gain 5 milliQALY by driving my car, but then makes everyone lose 1 milliQALY in increased pollution. On net, I gain 4 milliQALY, so if I am rational and self-interested I would do that. But now suppose that there are 10 people all given the same choice. If we all make that same choice, each of us will gain 1 milliQALY—and then lose 10 milliQALY. We would all have been better off if none of us had done it, even though it made sense to each of us at the time. Burning a gallon of gasoline to drive my car is beneficial to me, more so than the release of carbon dioxide into the atmosphere is harmful; but as a result of millions of people burning gasoline, the carbon dioxide in the atmosphere is destabilizing our planet’s climate. We’d all be better off if we could find some way to burn less gasoline.

In order for rational self-interest to be optimal, externalities have to somehow be removed from the system. Otherwise, there are actions we can take that benefit ourselves but harm other people—and thus, we would all be better off if we acted to some degree altruistically. (When I say things like this, most non-economists think I am saying something trivial and obvious, while most economists insist that I am making an assertion that is radical if not outright absurd.)

But of course a world without externalities is a world of complete isolation; it’s a world where everyone lives on their own deserted island and there is no way of communicating or interacting with any other human being in the world. The only reasonable question about this world is whether we would die first or go completely insane first; clearly those are the two things that would happen. Human beings are fundamentally social animals—I would argue that we are in fact more social even than eusocial animals like ants and bees. (Ants and bees are only altruistic toward their own kin; humans are altruistic to groups of millions of people we’ve never even met.) Humans without social interaction are like flowers without sunlight.

Indeed, externalities are so common that if markets only worked in their absence, markets would make no sense at all. Fortunately this isn’t true; there are some ways that markets can be adjusted to deal with at least some kinds of externalities.

One of the most well-known is the Coase theorem; this is odd because it is by far the worst solution. The Coase theorem basically says that if you can assign and enforce well-defined property rights and there is absolutely no cost in making any transaction, markets will automatically work out all externalities. The basic idea is that if someone is about to perform an action that would harm you, you can instead pay them not to do it. Then, the harm to you will be prevented and they will incur an additional benefit.

In the above example, we could all agree to pay $30 (which let’s say is worth 1 milliQALY) to each person who doesn’t burn a gallon of gasoline that would pollute our air. Then, if I were thinking about burning some gasoline, I wouldn’t want to do it, because I’d lose the $300 in payments, which costs me 10 milliQALY, while the benefits of burning the gasoline are only 5 milliQALY. We all reason the same way, and the result is that nobody burns gasoline and actually the money exchanged all balances out so we end up where we were before. The result is that we are all better off.

The first thought you probably have is: How do I pay everyone who doesn’t hurt me? How do I even find all those people? How do I ensure that they follow through and actually don’t hurt me? These are the problems of transaction costs and contract enforcement that are usually presented as the problem with the Coase theorem, and they certainly are very serious problems. You end up needing some sort of government simply to enforce all those contracts, and even then there’s the question of how we can possibly locate everyone who has ever polluted our air or our water.

But in fact there’s an even more fundamental problem: This is extortion. We are almost always in the condition of being able to harm other people, and a system in which the reason people don’t hurt each other is because they’re constantly paying each other not to is a system in which the most intimidating psychopath is the wealthiest person in the world. That system is in fact Pareto-efficient (the psychopath does quite well for himself indeed); but it’s exactly the sort of Pareto-efficient system that isn’t worth pursuing.

Another response to externalities is simply to accept them, which isn’t as awful as it sounds. There are many kinds of externalities that really aren’t that bad, and anything we might do to prevent them is likely to make the cure worse than the disease. Think about the externality of people standing in front of you in line, or the externality of people buying the last cereal box off the shelf before you can get there. The externality of taking the job you applied for may hurt at the time, but in the long run that’s how we maintain a thriving and competitive labor market. In fact, even the externality of ‘gentrifying’ your neighborhood so you can no longer afford it is not nearly as bad as most people seem to think—indeed, the much larger problem seems to be the poor neighborhoods that don’t have rising incomes , remaining poor for generations. (It also makes no sense to call this “gentrifying”; the only landed gentry we have in America is the landowners who claim a ludicrous proportion of our wealth, not the middle-class people who buy cheap homes and move in. If you really want to talk about a gentry, you should be thinking Waltons and Kochs—or Bushs and Clintons.) These sorts of minor externalities that are better left alone are sometimes characterized as pecuniary externalities because they usually are linked to prices, but I think that really misses the point; it’s quite possible for an externality to be entirely price-related and do enormous damage (read: the entire financial system) and to have little or nothing to do with prices and still be not that bad (like standing in line as I mentioned above).

But obviously we can’t leave all externalities alone in this way. We can’t just let people rob and murder one another arbitrarily, or ignore the destruction of the world’s climate that threatens hundreds of millions of lives. We can’t stand back and let forests burn and rivers run dry when we could easily have saved them.

The much more reasonable and realistic response to externalities is what we call government—there are rules you have to follow in society and punishments you face if you don’t. We can avoid most of the transaction problems involved in figuring out who polluted our water by simply making strict rules about polluting water in general. We can prevent people from stealing each other’s things or murdering each other by police who will investigate and punish such crimes.

This is why regulation—and a government strong enough to enforce that regulation—is necessary for the functioning of a society. This dichotomy we have been sold about “regulations versus the market” is totally nonsensical; the market depends upon regulations. This doesn’t justify any particular regulation—and indeed, an awful lot of regulations are astonshingly bad. But some sort of regulatory system is necessary for a market to function at all, and the question has never been whether we will have regulations but which regulations we will have. People who argue that all regulations must go and the market would somehow work on its own are either deeply ignorant of economics or operating from an ulterior motive; some truly horrendous policies have been made by arguing that “less government is always better” when the truth is nothing of the sort.

In fact, there is one real-world method I can think of that actually comes reasonably close to eliminating all externalities—and it is called social democracy. By involving everyone—democracy—in a system that regulates the economy—socialism—we can, in a sense, involve everyone in every transaction, and thus make it impossible to have externalities. In practice it’s never that simple, of course; but the basic concept of involving our whole society in making the rules that our society will follow is sound—and in fact I can think of no reasonable alternative.

We have to institute some sort of regulatory system, but then we need to decide what the regulations will be and who will control them. If we want to instead vest power in a technocratic elite, how do you decide whom to include in that elite? How do we ensure that the technocrats are actually better for the general population if there is no way for that general population to have a say in their election? By involving as many people as we can in the decision-making process, we make it much less likely that one person’s selfish action will harm many others. Indeed, this is probably why democracy prevents famine and genocide—which are, after all, rather extreme examples of negative externalities.

What does it mean to “own” an idea?

2015-06-21 PNRJ public policy copyleft, copyright, Free Software Foundation, gratis, Hollywood, intellectual property, J.K. Rowling, libre, Linux, monopoly, My Neighbor Totoro, patent, piracy, property, research, Thomas Pogge, trademark, TRIPS accord, winner takes all

JDN 2457195 EDT 11:29.

For a long time I’ve been suspicious of intellectual property as current formulated, but I’m never quite sure what to replace it with. I recently finished reading a surprisingly compelling little book called Against Intellectual Monopoly, which offered some more direct empirical support for many of my more philosophical concerns. (Fitting their opposition to copyright law, the authors, Michele Boldrin and David Levine, offer the full text of the book for free online.)

Boldrin and Levine argue that they are not in fact opposed to intellectual property, but intellectual monopoly. I think this is a bit of a silly distinction myself, and in fact muddles the issue a little because most of what we currently call “intellectual property” is in fact what they call “intellectual monopoly”.

The problems with intellectual property are well-documented within, but I think it’s worth repeating at least the basic form of the argument. Intellectual property is supposed to incentivize innovation by rewarding innovators for their investment, and thereby increase the total amount of innovation.

This requires three conditions to hold: First, the intellectual property must actually reward the innovators. Second, innovation must be increased when innovators seek rewards. And third, the costs of implementing the policy must be exceeded by the benefits provided by it.

As it turns out, none of those three conditions to hold. For intellectual property to make sense, they would all need to hold; and in fact none do.

First—and worst—of all, intellectual property does not actually reward innovators. It instead rewards those who manipulate the intellectual property system. Intellectual property is why Thomas Edison was wealthy and Nikola Tesla was poor. Intellectual property is why we keep getting new versions of the same pills for erectile dysfunction instead of an AIDS vaccine. Intellectual property is how we get patent troll corporations, submarine patents, and Samsung owing Apple $1 billion for making its smartphones the wrong shape. Intellectual property is how Worlds.com is proposing to sue an entire genre of video games.

Second, the best innovators are not motivated by individual rewards. This has always been true; the people who really contribute the most to the world in knowledge or creativity are those who do it out of an insatiable curiosity, or a direct desire to improve the world. People who are motivated primarily by profit only innovate as a last resort, instead preferring to manipulate laws, undermine competitors, or simply mass-produce safe, popular products.

I can think of no more vivid an example here than Hollywood. Why is it that every single new movie that comes out is basically a more expensive rehash of the exact same 5 movies that have been coming out for the last 50 years? Because big corporations don’t innovate. It’s too risky to try to make a movie that’s fundamentally new and different, because, odds are, that new movie would fail. It’s much safer to make an endless series of superhero movies and keep coming out with yet another movie about a heroic dog. It’s not even that these movies are bad—they’re often pretty good, and when done well (like Avengers) they can be quite enjoyable. But thousands of original screenplays are submitted to Hollywood every year, and virtually none of them are actually made into films. It’s impossible to know what great works of film we might have seen on the big screen if not for the stranglehold of media companies.

This is not how Hollywood began; it started out wildly innovative and new. But did you ever know why it started in Los Angeles and not somewhere else? It was to evade patent laws. Thomas Edison, the greatest patent troll in history, held a stranglehold on motion picture technology on the East Coast, so filmmakers fled to California to get as far away from there as possible, during a time when Federal enforcement was much more lax. The innovation that created Los Angeles as we know it not only was not incentivized by intellectual property protection—it was only possible in its absence.

And then of course there is the third condition, that the benefits be worth the costs—but it’s trivially obvious that this is not the case, since the benefits are in fact basically zero. We divert billions of dollars from consumers to huge corporations, monopolize the world’s ideas, create a system of surveillance and enforcement that makes basically everyone a criminal (I’ll admit it; I have pirated music, software, and most recently the film My Neighbor Totoro, and I often copy video games I own on CD or DVD to digital images so I don’t need the CD or DVD every time to play—which should be fair use but has been enforced as copyright violation). When everyone is a criminal, enforcement becomes capricious, a means of control that can be used and abused by those in power.

Intellectual property even allows corporations to undermine our more basic sense of property ownership—they can prevent us from making use of our own goods as we choose. They can punish us for modifying the software in our computers, our video game systems—or even our cars. They can install software on our computers that compromises our security in order to protect their copyright. This is a point that Boldrin and Levine repeat several times; in place of what we call “intellectual property” (and they call “intellectual monopoly”), they offer a system which would protect our ordinary property rights, our rights to do what we choose with the goods that we purchase—goods that include books, computers, and DVDs.

That brings me to where I think their argument is weakest—their policy proposal. Basically the policy they propose is that we eliminate all intellectual property rights (except trademarks, which they rightly point out are really more about honesty than they are about property—trademark violation typically amounts to fraudulently claiming that your product was made by someone it wasn’t), and then do nothing else. The only property rights would be ordinary property rights, which would know apply in full to products such as books and DVDs. When you buy a DVD, you would have the right to do whatever you please with it, up to and including copying it a hundred times and selling the copies. You bought the DVD, you bought the blank discs, you bought the burner; so (goes their argument), why shouldn’t you be able to do what you want with them?

For patents, I think their argument is basically correct. I’ve tried to make lists of the greatest innovations in science in technology, and virtually none of them were in any way supported by patents. We needn’t go as far back as fire, writing, and the wheel; think about penicillin, the smallpox vaccine, electricity, digital computing, superconductors, lasers, the Internet. Airplanes might seem like they were invented under patent, but in fact the Wright brothers made a relatively small contribution and most of the really important development in aircraft was done by the military. Important medicines are almost always funded by the NIH, while private pharmaceutical companies give us Viagra at best and Vioxx at worst. Private companies have an incentive to skew their trials in various ways, ranging from simply questionable (p-value hacking) to the outright fraudulent (tampering with data). We know they do, because meta-analyses have found clear biases in the literature. The NIH has much less incentive to bias results in this way, and as a result more of the drugs released will be safe and effective. Boldrin and Levine recommend that all drug trials be funded by the NIH instead of drug companies, and I couldn’t agree more. What basis would drug companies have for complaining? We’re giving them something they previously had to pay for. But of course they will complain, because now their drugs will be subject to unbiased scrutiny. Moreover, it undercuts much of the argument for their patent; without the initial cost of large-scale drug trials, it’s harder to see why they need patents to make a profit.

Major innovations have been the product of individuals working out of curiosity, or random chance, or university laboratories, or government research projects; but they are rarely motivated by patents and they are almost never created by corporations. Corporations do invent incremental advancements, but many of these they keep as trade secrets, or go ahead and share, knowing that reverse-engineering takes time and investment. The great innovations of the computer industry (like high-level programming languages, personal computers, Ethernet, USB ports, and windowed operating systems) were all invented before software could be patented—and since then, what have we really gotten? In fact, it can be reasonably argued that patents reduce innovation; most innovations are built on previous innovations, and patents hinder that process of assimilation and synthesis. Patent pools can mitigate this effect, but only for oligopolistic insiders, which almost by definition are less innovative than disruptive outsiders.

And of course, patents on software and biological systems should be invalidated yesterday. If we must have patents, they should be restricted only to entities that cannot self-replicate, which means no animals, no plants, no DNA, nothing alive, no software, and for good measure, no grey goo nanobots. (It also makes sense at a basic level: How can you stop people from copying it, when it can copy itself?)

It’s when we get to copyright that I’m not so convinced. I certainly agree that the current copyright system suffers from deep problems. When your photos can be taken without your permission and turned into works of art but you can’t make a copy of a video game onto your hard drive to play it more conveniently, clearly something is wrong with our copyright system. I also agree that there is something fundamentally problematic about saying that one “owns” a text in such a way that they can decide what others do with it. When you read my work, copies of the information I convey to you are stored inside your brain; do I now own a piece of your brain? If you print out my blog post on a piece of paper and then photocopy it, how can I own something you made with your paper on your printer?

I release all my blog posts under a “by-sa” copyleft, “attribution-share-alike”, which requires that my work be shared without copyright protection and properly attributed to me. You are however free to sell them, modify them, or use them however you like, given those constraints. I think that something like this may be the best system for protecting authors against plagiarism without unduly restricting the rights of readers to copy, modify, and otherwise use the content they buy. Applied to software, the Free Software Foundation basically agrees.

Boldrin and Levine do not, however; they think that even copyleft is too much, because it imposes restrictions upon buyers. They do agree that plagiarism should be illegal (because it is fraudulent), but they disagree with the “share-alike” part, the requirement that content be licensed according to what the author demands. As far as they are concerned, you bought the book, and you can do whatever you damn well please with it. In practice there probably isn’t a whole lot of difference between these two views, since in the absence of copyright there isn’t nearly as much need for copyleft. I don’t really need to require you to impose a free license if you can’t impose any license at all. (When I say “free” I mean libre, not gratis; free as in speech, not as in beer—Red Hat Linux is free software you pay for, and Zynga games are horrifically predatory proprietary software you get for free.)

One major difference is that under copyleft we could impose requirements to release information under certain circumstances—I have in mind particularly scientific research papers and associated data. To maximize the availability of knowledge and facilitate peer review, it could be a condition of publication for scientific research that the paper and data be made publicly available under a free license—already this is how research done directly for the government works (at least the stuff that isn’t classified). But under a strict system of physical property only this sort of licensing would be a violation of the publishers’ property rights to do as they please with their servers and hard drives.

But there are legitimate concerns to be had even about simply moving to a copyleft system. I am a fiction author, and I submit books for publication. (This is not hypothetical; I actually do this.) Under the current system, I own the copyright to those books, and if the publisher decides to use them (thus far, only JukePop Serials, a small online publisher, has ever done so), they must secure my permission, presumably by means of a royalty contract. They can’t simply take whatever manuscripts they like and publish them. But if I submitted under a copyleft, they absolutely could. As long as my name were on the cover, they wouldn’t have to pay me a dime. (Charles Darwin certainly didn’t get a dime from Ray Comfort’s edition of The Origin of Species—yes, that is a thing.)

Now the question becomes, would they? There might be a competitive equilbrium where publishers are honest and do in fact pay their authors. If they fail to do so, authors are likely to stop submitting to that publisher once it acquires its shady reputation. If we can reach the equilibrium where authors get paid, that’s almost certainly better than today; the only people I can see it hurting are major publishing houses like Pearson PLC and superstar authors like J.K. Rowling; and even then it wouldn’t hurt them all that much. (Rowling might only be a millionaire instead of a billionaire, and Pearson PLC might see its net income drop from over $500 million to say $10 million.) The average author would most likely benefit, because publishers would have more incentive to invest in their midlist when they can’t crank out hundreds of millions of dollars from their superstars. Books would proliferate at bargain prices, and we could all double the size of our libraries. The net effect on the book market would be to reduce the winner-takes-all effect, which can only be a good thing.

But that isn’t the only possibility. The incentive to steal authors’ work when they submit it could instead create an equilibrium where hardly anyone publishes fiction anymore; and that world is surely worse than the one we live in today. We would want to think about how we can ensure that authors are adequately paid for their work in a copyleft system. Maybe some can make their money from speaking tours and book signings, but I’m not confident that enough can.

I do have one idea, similar to what Thomas Pogge came up with in his “public goods system”, though he primarily intended that to apply to medicine. The basic concept is that there would be a fund, either gathered from donations or supported by taxes, that supports artists. (Actually we already have the National Endowment for the Arts, but it isn’t nearly big enough.) This support would be doled out based on some metric of the artists’ popularity or artistic importance. The details of that are quite tricky, but I think one could arrange some sort of voting system where people use range voting to decide how much to give to each author, musician, painter, or filmmaker. Potentially even research funding could be set this way, with people voting to decide how important they think a particular project is—though I fear that people may be too ignorant to accurately gauge the important of certain lines of research, as when Sarah Palin mocked studies of “fruit flies in Paris”, otherwise known as literally the foundation of modern genetics. Maybe we could vote instead on research goals like “eliminate cancer” and “achieve interstellar travel” and then the scientific community could decide how to allocate funds toward those goals? The details are definitely still fuzzy in my mind.

The general principle, however, would be that if we want to support investment in innovation, we do that—instead of devising this bizarre system of monopoly that gives corporations growing power over our lives. Subsidize investment by subsidizing investment. (I feel similarly about capital taxes; we could incentivize investment in this vague roundabout way by doing nothing to redistribute wealth and hoping that all the arbitrage and speculation somehow translates into real investment… or, you know, we could give tax credits to companies that build factories.) As Boldrin and Levine point out, intellectual property laws were not actually created to protect innovation; they were an outgrowth of the general power of kings and nobles to enforce monopolies on various products during the era of mercantilism. They were weakened to be turned into our current system, not strengthened. They are, in fact, fundamentally mercantilist—and nothing could make that clearer than the TRIPS accord, which literally allows millions of people to die from treatable diseases in order to increase the profits of pharmaceutical companies. Far from being this modern invention that brought upon the scientific revolution, intellectual property is an atavistic policy borne from the age of colonial kings. I think it’s time we try something new.
(Oh, and one last thing: “Piracy”? Really? I can’t believe the linguistic coup it was for copyright holders to declare that people who copy music might as well be slavers and murderers—somehow people went along with this ridiculous terminology. No, there is no such thing as “music piracy” or “software piracy”; there is music copyright violation and software copyright violation.)

What do we do about unemployment?

2015-06-14 PNRJ core principles, public policy basic income, Beveridge curve, employment, Hayek, inflation, macroeconomics, unemployment, work incentive

JDN 2457188 EDT 11:21.

Macroeconomics, particularly monetary policy, is primarily concerned with controlling two variables.

The first is inflation: We don’t want prices to rise too fast, or markets will become unstable. This is something we have managed fairly well; other than food and energy prices which are known to be more volatile, prices have grown at a rate between 1.5% and 2.5% per year for the last 10 years; even with food and energy included, inflation has stayed between -1.5% and +5.0%. After recovering from its peak near 15% in 1980, US inflation has stayed between -1.5% and +6.0% ever since. While the optimal rate of inflation is probably between 2.0% and 4.0%, anything above 0.0% and below 10.0% is probably fine, so the only significant failure of US inflation policy was the deflation in 2009.

The second is unemployment: We want enough jobs for everyone who wants to work, and preferably we also wouldn’t have underemployment (people who are only working part-time even though they’d prefer full-time or discouraged workers (people who give up looking for jobs because they can’t find any, and aren’t counted as unemployed because they’re no looking looking for work). There’s also a tendency among economists to want “work incentives” that maximize the number of people who want to work, but I think these are wildly overrated. Work isn’t an end in itself; work is supposed to be creating products and providing services that make human lives better. The benefits of production have to be weighed against the costs of stress, exhaustion, and lost leisure time from working. Given that stress-related illnesses are some of the leading causes of death and disability in the United States, I don’t think that our problem is insufficient work incentives.

Unemployment is a problem that we have definitely not solved. Unemployment has bounced up and down between peaks and valleys, dropping as low as 4.0% and rising as high as 11.0% over the last 60 years. If 2009’s -1.5% deflation concerns you, then its 9.9% unemployment should concern you far more. Indeed, I’m not convinced that 5.0% is an acceptable “natural” rate of unemployment—that’s still millions of people who want work and can’t find it—but most economists would say that it is.

In fact, matters are worse than most people realize. Our unemployment rate has fallen back to a relatively normal 5.5%, as you can see in this graph (the blue line is unemployment, the red line is underemployment):

However, our employment rate never recovered from the Second Depression. As you can see in this graph, it fell from 63% to 58%, and has now only risen back to 59%:

How can unemployment fall without employment rising? The key is understanding how unemployment is calculated: It only counts people in the labor force. If people leave the labor force entirely, by retiring, going back to school, or simply giving up on finding work, they will no longer be counted as unemployed. The unemployment rate only counts people who want work but don’t have it, so as far as I’m concerned that figure should always be nearly zero. (Not quite zero since it takes some time to find a good fit; but maybe 1% at most. Any more than that and there is something wrong with our economic system.)

The optimal employment rate is not as obvious; it certainly isn’t 100%, as some people are too young, too old, or too disabled to be spending their time working. As automation improves, the number of workers necessary to produce any given product decreases, and eventually we may decide as a society that we are making enough products and most of us should be spending more of our time on other things, like spending time with family, creating works of art, or simply having fun. Maybe only a handful of people, the most driven or the most brilliant, will actually decide to work—and they will do because they want to, not because they have to. Indeed, the truly optimal employment rate might well be zero; think of The Culture, where there is no such concept as a “job”; there are things you do because you want to do them, or because they seem worthwhile, but there is none of this “working for pay” nonsense. We are not yet at the level of automation where this would be possible, but we are much closer than I think most people realize. Think about all of the various administrative and bureaucratic tasks that most people do the majority of the time, all the reports, all the meetings; why do they do that? Is it actually because the work is necessary, that the many levels of bureaucracy actually increase efficiency through specialization? Or is it simply because we’ve become so accustomed to the idea that people have to be working all the time in order to justify their existence? Is David Graeber (I reviewed one of his books previously) right that most jobs are actually (and this is a technical term), “bullshit jobs”? Once again, the problem doesn’t seem to be too few work incentives, but if anything too many.

Indeed, there is a basic fact about unemployment that has been hidden from most people. I’d normally say that this is accidental, that it’s too technical or obscure for most people to understand, but no, I think it has been actively concealed, or, since I guess the information has been publicly available, at least discussion of it has been actively avoided. It’s really not at all difficult to understand, yet it will fundamentally change the way you think about our unemployment problem. Here goes:

Since at least 2000 and probably since 1980 there have been more people looking for jobs than there have been jobs available.

The entire narrative of “people are lazy and don’t want to work” or “we need more work incentives” is just totally, totally wrong; people are desperate to find work, and there hasn’t been enough work for them to find since longer than I’ve been alive.

You can see this on the following graph, which is of what’s called the “Beveridge curve”; the horizontal axis is the unemployment rate, while the vertical axis is the rate of job vacancies. The red line across the diagonal is the point at which the two are even, and there are as many people looking for jobs as there are jobs to fill. Notice how the graph is always below the line. There have always been more unemployed people than jobs for them to fill, and at the worst of the Second Depression the ratio was 5 to 1.

Personally I believe that we should be substantially above the line, and in a truly thriving economy there should be employers desperately trying to find employees and willing to pay them whatever it takes. You shouldn’t have to send out 20 job applications to get hired; 20 companies should have to send offers to you. For the economy does not exist to serve corporations; it exists to serve people.

I can see two basic ways to solve this problem: You can either create more jobs, or you can get people to stop looking for work. That may be sort of obvious, but I think people usually forget the second option.

We definitely do talk a lot about “job creation”, though usually in a totally nonsensical way—somehow “Job Creator” has come to be a euphemism for “rich person”. In fact the best way to create jobs is to put money into the hands of people who will spend it. The more people spend their money, the more it flows through the economy and the more wealth we end up with overall. High rates of spending—high marginal propensity to consume—can multiply the value of a dollar many times over.

But there’s also something to be said for getting people to stop looking for work—the key is do it in the right way. They shouldn’t stop looking because they give up; they should stop looking because they don’t need to work. People should have their basic needs met even if they aren’t working for an employer; human beings have rights and dignity beyond their productivity in the market. Employers should have to make you a better offer than “you’ll be homeless if you don’t do this”.

Both of these goals can be accomplished simultaneously by one simple policy: Basic income.

It’s really amazing how many problems can be solved by a basic income; it’s more or less the amazing wonder policy that solves all the world’s economic problems simultaneously. Poverty? Gone. Unemployment? Decimated. Inequality? Contained. (The pilot studies of basic income in India have been successful beyond all but the wildest dreams; they eliminate poverty, improve health, increase entrepreneurial activity, even reduce gender inequality.) The one major problem basic income doesn’t solve is government debt (indeed it likely increases it, at least in the short run), but as I’ve already talked about, that problem is not nearly as bad as most people fear.

And once again I think I should head off accusations that advocating a basic income makes me some sort of far-left Communist radical; Friedrich Hayek supported a basic income.

Basic income would help with unemployment in a third way as well; one of the major reasons unemployment is so harmful is that people who are unemployed can’t provide for themselves or their families. So a basic income would reduce the number of people looking for jobs, increase the number of jobs available, and also make being unemployed less painful, all in one fell swoop. I doubt it would solve the problem of unemployment entirely, but I think it would make an enormous difference.

Monopoly and Oligopoly

2015-06-06 PNRJ core principles, Top 10 things to know about economics Bertrand competition, collusion, competition, Cournot competition, game theory, monopolistic competition, monopoly, normal profit, oligopoly, perfect competition, prisoner's dilemma, tacit collusion, tit for tat

JDN 2457180 EDT 08:49

Welcome to the second installment in my series, “Top 10 Things to Know About Economics.” The first was not all that well-received, because it turns it out it was just too dense with equations (it didn’t help that the equation formatting was a pain.) Fortunately I think I can explain monopoly and oligopoly with far fewer equations—which I will represent as PNG for your convenience.

You probably already know at least in basic terms how a monopoly works: When there is only one seller of a product, that seller can charge higher prices. But did you ever stop and think about why they can charge higher prices—or why they’d want to?

The latter question is not as trivial as it sounds; higher prices don’t necessarily mean higher profits. By the Law of Demand (which, like the Pirate Code, is really more like a guideline), raising the price of a product will result in fewer being sold. There are two countervailing effects: Raising the price raises the profits from selling each item, but reduces the number of items sold. The optimal price, therefore, is the one that balances these two effects, maximizing price times quantity.

A monopoly can actually set this optimal price (provided that they can figure out what it is, of course; but let’s assume they can). They therefore solve this maximization problem for price P(Q) a function of quantity sold, quantity Q, and cost C(Q) a function of quantity produced (which at the optimum is equal to quantity sold; no sense making them if you won’t sell them!):

As you may remember if you’ve studied calculus, the maximum is achieved at the point where the derivative is zero. If you haven’t studied calculus, the basic intuition here is that you move along the curve seeing whether the profits go up or down with each small change, and when you reach the very top—the maximum—you’ll be at a point where you switch from going up to going down, and at that exact point a small change will move neither up nor down. The derivative is really just a fancy term for the slope of the curve at each point; at a maximum this slope changes from positive to negative, and at the exact point it is zero.

This is a general solution, but it’s easier to understand if we use something more specific. As usual, let’s make things simpler by assuming everything is linear; we’ll assume that demand starts at a maximum price of P₀ and then decreases at a rate 1/e. This is the demand curve.

Then, we’ll assume that the marginal cost of production C'(Q) is also linear, increasing at a rate 1/n. This is the supply curve.

Now we can graph the supply and demand curves from these equations. But the monopoly doesn’t simply set supply equal to demand; instead, they set supply equal to marginal revenue, which takes into account the fact that selling more items requires lowering the price on all of them. Marginal revenue is this term:

This is strictly less than the actual price, because increasing the quantity sold requires decreasing the price—which means that P'(Q) < 0. They set the quantity by setting marginal revenue equal to marginal cost. Then they set the price by substituting that quantity back into the demand equation.

Thus, the monopoly should set this quantity:

They would then charge this price (substitute back into the demand equation):

On a graph, there are the supply and demand curves, and then below the demand curve, the marginal revenue curve; it’s the intersection of that curve with the supply curve that the monopoly uses to set its quantity, and then it substitutes that quantity into the demand curve to get the price:

Now I’ll show that this is higher than the price in a perfectly competitive market. In a competitive market, competitive companies can’t do anything to change the price, so from their perspective P'(Q) = 0. They can only control the quantity they produce and sell; they keep producing more as long as they receive more money for each one than it cost to produce it. By the Law of Diminishing Returns (again more like a guideline) the cost will increase as they produce more, until finally the last one they sell cost just as much to make as they made from selling it. (Why bother selling that last one, you ask? You’re right; they’d actually sell one less than this, but if we assume that we’re talking about thousands of products sold, one shouldn’t make much difference.)

Price is simply equal to marginal cost:

In our specific linear case that comes out to this quantity:

Therefore, they charge this price (you can substitute into either the supply or demand equations, because in a competitive market supply equals demand):

Subtract the two, and you can see that monopoly price is higher than the competitive price by this amount:

Notice that the monopoly price will always be larger than the competitive price, so long as e > 0 and n > 0, meaning that increasing the quantity sold requires decreasing the price, but increasing the cost of production. A monopoly has an incentive to raise the price higher than the competitive price, but not too much higher—they still want to make sure they sell enough products.

Monopolies introduce deadweight loss, because in order to hold the price up they don’t produce as many products as people actually want. More precisely, each new product produced would add overall value to the economy, but the monopoly stops producing them anyway because it wouldn’t add to their own profits.

One “solution” to this problem is to let the monopoly actually take those profits; they can do this if they price-discriminate, charging a higher price for some customers than others. In the best-case scenario (for them), they charge each customer a price that they are just barely willing to pay, and thus produce until no customer is willing to pay more than the product costs to make. That final product sold also has price equal to marginal cost, so the total quantity sold is the same under competition. It is, in that sense, “efficient”.

What many neoclassical economists seem to forget about price-discriminating monopolies is that they appropriate the entire surplus value of the product—the customers are only just barely willing to buy; they get no surplus value from doing so.

In reality, very few monopolies can price-discriminate that precisely; instead, they put customers into broad categories and then try to optimize the price for each of those categories. Credit ratings, student discounts, veteran discounts, even happy hours are all forms of this categorical price discrimination. If the company cares even a little bit about what sort of customer you are rather than how much money you’re paying, they are price-discriminating.

It’s so ubiquitous I’m actually having trouble finding a good example of a product that doesn’t have categorical price discrimination. I was thinking maybe computers? Nope, student discounts. Cars? No, employee discounts and credit ratings. Refrigerators, maybe? Well, unless there are coupons (coupons price discriminate against people who don’t want to bother clipping them). Certainly not cocktails (happy hour) or haircuts (discrimination by sex, the audacity!); and don’t even get me started on software.

I introduced price-discrimination in the context of monopoly, which is usually how it’s done; but one thing you’ll notice about all the markets I just indicated is that they aren’t monopolies, yet they still exhibit price discrimination. Cars, computers, refrigerators, and software are made under oligopoly, a system in which a handful of companies control the majority of the market. As you might imagine, an oligopoly tends to act somewhere in between a monopoly and a competitive market—but there are some very interesting wrinkles I’ll get to in a moment.

Cocktails and haircuts are sold in a different but still quite interesting system called monopolistic competition; indeed, I’m not convinced that there is any other form of competition in the real world. True perfectly-competitive markets just don’t seem to actually exist. Under monopolistic competition, there are many companies that don’t have much control over price in the overall market, but the products they sell aren’t quite the same—they’re close, but not equivalent. Some barbers are just better at cutting hair, and some bars are more fun than others. More importantly, they aren’t the same for everyone. They have different customer bases, which may overlap but still aren’t the same. You don’t just want a barber who is good, you want one who works close to where you live. You don’t just want a bar that’s fun; you want one that you can stop by after work. Even if you are quite discerning and sensitive to price, you’re not going to drive from Ann Arbor to Cleveland to get your hair cut—it would cost more for the gasoline than the difference. And someone is Cleveland isn’t going to drive all the way to Ann Arbor, either! Hence, barbers in Ann Arbor have something like a monopoly (or oligopoly) over Ann Arbor haircuts, and barbers in Cleveland have something like a monopoly over Cleveland haircuts. That’s monopolistic competition.

Supposedly monopolistic competition drives profits to zero in the long run, but I’ve yet to see this happen in any real market. Maybe the problem is that conceit “the long run”; as Keynes said, “in the long run we are all dead.” Sometimes the argument is made that it has driven real economic profits to zero, because you’ve got to take into account the cost of entry, the normal profit. But of course, that’s extremely difficult to measure, so how do we know whether profits have been driven to normal profit? Moreover, the cost of entry isn’t the same for everyone, so people with lower cost of entry are still going to make real economic profits. This means that the majority of companies are going to still make some real economic profit, and only the ones that had the hardest time entering will actually see their profits driven to zero.

Monopolistic competition is relatively simple. Oligopoly, on the other hand, is fiercely complicated. Why? Because under oligopoly, you actually have to treat human beings as human beings.

What I mean by that is that under perfect competition or even monopolistic competition, the economic incentives are so powerful that people basically have to behave according to the neoclassical rational agent model, or they’re going to go out of business. There is very little room for errors or even altruistic acts, because your profit margin is so tight. In perfect competition, there is literally zero room; in monopolistic competition, the only room for individual behavior is provided by the degree of monopoly, which in most industries is fairly small. One person’s actions are unable to shift the direction of the overall market, so the market as a system has ultimate power.

Under oligopoly, on the other hand, there are a handful of companies, and people know their names. You as a CEO have a reputation with customers—and perhaps more importantly, a reputation with other companies. Individual decision-makers matter, and one person’s decision depends on their prediction of other people’s decision. That means we need game theory.

The simplest case is that of duopoly, where there are only two major companies. Not many industries are like this, but I can think of three: soft drinks (Coke and Pepsi), commercial airliners (Boeing and Airbus), and home-user operating systems (Microsoft and Apple). In all three cases, there is also some monopolistic element, because the products they sell are not exactly the same; but for now let’s ignore that and suppose they are close enough that nobody cares.

Imagine yourself in the position of, say, Boeing: How much should you charge for an airplane?

If Airbus didn’t exist, it’s simple; you’d charge the monopoly price. But since they do exist, the price you charge must depend not only on the conditions of the market, but also what you think Airbus is likely to do—and what they are likely to do depends in turn on what they think you are likely to do.

If you think Airbus is going to charge the monopoly price, what should you do? You could charge the monopoly price as well, which is called collusion. It’s illegal to actually sign a contract with Airbus to charge that price (though this doesn’t seem to stop cable companies or banks—probably has something to do with the fact that we never punish them for doing it), and let’s suppose you as the CEO of Boeing are an honest and law-abiding citizen (I know, it’s pretty fanciful; I’m having trouble keeping a straight face myself) and aren’t going to violate the antitrust laws. You can still engage in tacit collusion, in which you both charge the monopoly price and take your half of the very high monopoly profits.

There’s a temptation not to collude, however, which the airlines who buy your planes are very much hoping you’ll succumb to. Suppose Airbus is selling their A350-100 for $341 million. You could sell the comparable 777-300ER for $330 million and basically collude, or you could cut the price and draw in more buyers. Say you cut it to $250 million; it probably only costs $150 million to make, so you’re still making a profit on each one; but where you sold say 150 planes a year and profited $180 million on each (a total profit of $27 billion), you could instead capture the whole market and sell 300 planes a year and profit $100 million on each (a total profit of $30 billion). That’s a 10% higher profit and $3 billion a year for your shareholders; why wouldn’t you do that?

Well, think about what will happen when Airbus releases next year’s price list. You cut the price to $250 million, so they retaliate by cutting their price to $200 million. Next thing you know, you’re cutting your own price to $150.1 million just to stay in the market, and they’re doing the same. When the dust settles, you still only control half the market, but now you profit a mere $100,000 per airplane, making your total profits a measly $15 million instead of $27 billion—that’s $27,000 million. (I looked it up, and as it turns out, Boeing’s actual gross profit is about $14 billion, so I underestimated the real cost of each airplane—but they’re clearly still colluding.) For a gain of 10% in one year you’ve paid a loss of 99.95% indefinitely. The airlines will be thrilled, and they’ll likely pass on much of those savings to their customers, who will fly more often, engage in more tourism, and improve the economy in tourism-dependent countries like France and Greece, so the world may well be better off. But you as CEO of Boeing don’t care about the world; you care about the shareholders of Boeing—and the shareholders of Boeing just got hosed. Don’t expect to keep your seat in the next election.

But now, suppose you think that Airbus is planning on setting a price of $250 million next year anyway. They should know you’ll retaliate, but maybe their current CEO is retiring next year and doesn’t care what happens to the company after that or something. Or maybe they’re just stupid or reckless. In any case, your sources (which, as an upstanding citizen, obviously wouldn’t include any industrial espionage!) tell you that Airbus is going to charge $250 million next year.

Well, in that case there’s no point in you charging $330 million; you’ll lose the market and look like a sucker. You could drop to $250 million and try to set up a new, lower collusive equilibrium; but really what you want to do is punish them severely for backstabbing you. (After all, human beings are particularly quick to anger when we perceive betrayal. So maybe you’ll charge $200 million and beat them at their own conniving game.

The next year, Airbus has a choice. They could raise back to $341 million and give you another year of big profits to atone for their reckless actions, or they could cut down to $180 million and keep the price war going. You might think that they should continue the war, but that’s short-term thinking; in the long run their best strategy is to atone for their actions and work to restore the collusion. In response, Boeing’s best strategy is to punish them when they break the collusion, but not hold a grudge; if they go back to the high price, Boeing should as well. This very simple strategy is called tit-for-tat, and it is utterly dominant in every simulation we’ve ever tried of this situation, which is technically called an iterated prisoner’s dilemma.

What if there are more than two companies involved? Then things get even more complicated, because now we’re dealing with things like what A’s prediction of what B predicts that C will predict A will do. In general this is a situation we only barely understand, and I think it is a topic that needs considerably more research than it has received.

There is an interesting simple model that actually seems to capture a lot about how oligopolies work, but no one can quite figure out why it works. That model is called Cournot competition. It assumes that companies take prices and fixed and compete by selecting the quantity they produce at each cycle. That’s incredibly bizarre; it seems much more realistic to say that they compete by setting prices. But if you do that, you get Bertrand competition, which requires us to go through that whole game-theory analysis—but now with three, or four, or ten companies!

Under Cournot competition, you decide how much to produce Q₁ by monopolizing what’s left over after the other companies have produced their quantities Q₂, Q₃, and so on. If there are k companies, you optimize under the constraint that (k-1)Q₂ has already been produced.

Let’s use our linear models again. Here, the quantity that goes into figuring the price is the total quantity, which is Q₁+(k-1)Q₂; while the quantity you sell is just Q₁. But then, another weird part is that for the marginal cost function we use the whole market—maybe you’re limited by some natural resource, like oil or lithium?

It’s not as important for you to follow along with the algebra, though here you go if you want:

Then the key point is that the situation is symmetric, so Q₁ = Q₂ = Q₃ = Q. Then the total quantity produced, which is what consumers care about, is kQ. That’s what sets the actual price as well.

The two equations to focus on are these ones:

If you plug in k=1, you get a monopoly. If you take the limit as k approaches infinity, you get perfect competition. And in between, you actually get a fairly accurate representation of how the number of companies in an industry affects the price and quantity sold! From some really bizarre assumptions about how competition works! The best explanation I’ve seen of why this might happen is this 1983 paper showing that price competition can behave like Cournot competition if companies have to first commit to producing a certain quantit y before naming their prices.

But of course, it doesn’t always give an accurate representation of oligopoly, and for that we’ll probably need a much more sophisticated multiplayer game theory analysis which has yet to be done.

And that, dear readers, is how monopoly and oligopoly raise prices.

Drift-diffusion decision-making: The stock market in your brain

2015-05-302015-05-30 PNRJ cognitive science alternative, ambivalence, bias, confirmation bias, cutting-edge, decision, drift diffusion, indifference, neuroeconomics, random walk, trend

JDN 2456173 EDT 17:32.

Since I’ve been emphasizing the “economics” side of things a lot lately, I decided this week to focus more on the “cognitive” side. Today’s topic comes from cutting-edge research in cognitive science and neuroeconomics, so we still haven’t ironed out all the details.

The question we are trying to answer is an incredibly basic one: How do we make decisions? Given the vast space of possible behaviors human beings can engage in, how do we determine which ones we actually do?

There are actually two phases of decision-making.

The first phase is alternative generation, in which we come up with a set of choices. Some ideas occur to us, others do not; some are familiar and come to mind easily, others only appear after careful consideration. Techniques like brainstorming exist to help us with this task, but none of them are really very good; one of the most important bottlenecks in human cognition is the individual capacity to generate creative alternatives. The task is mind-bogglingly complex; the number of possible choices you could make at any given moment is already vast, and with each passing moment the number of possible behavioral sequences grows exponentially. Just think about all the possible sentences I could type write now, and then think about how incredibly narrow a space of possible behavioral options it is to assume that I’m typing sentences.

Most of the world’s innovation can ultimately be attributed to better alternative generation; particular with regard to social systems, but in many cases even with regard to technologies, the capability existed for decades or even centuries but the idea simply never occurred to anyone. (You can see this by looking at the work of Heron of Alexandria and Leonardo da Vinci; the capacity to build these machines existed, and a handful of individuals were creative enough to actually try it, but it never occurred to anyone that there could be enormous, world-changing benefits to expanding these technologies for mass production.)

Unfortunately, we basically don’t understand alternative generation at all. It’s an almost complete gap in our understanding of human cognition. It actually has a lot to do with some of the central unsolved problems of cognitive science and artificial intelligence; if we could create a computer that is capable of creative thought, we would basically make human beings obsolete once and for all. (Oddly enough, physical labor is probably where human beings would still be necessary the longest; robots aren’t yet very good at climbing stairs or lifting irregularly-shaped objects, much less giving haircuts or painting on canvas.)

The second part is what most “decision-making” research is actually about, and I’ll call it alternative selection. Once you have a list of two, three or four viable options—rarely more than this, as I’ll talk about more in a moment—how do you go about choosing the one you’ll actually do?

This is a topic that has undergone considerable research, and we’re beginning to make progress. The leading models right now are variants of drift-diffusion (hence the title of the post), and these models have the very appealing property that they are neurologically plausible, predictively accurate, and yet close to rationally optimal.

Drift-diffusion models basically are, as I said in the subtitle, a stock market in your brain. Picture the stereotype of the trading floor of the New York Stock Exchange, with hundreds of people bustling about, shouting “Buy!” “Sell!” “Buy!” with the price going up with every “Buy!” and down with every “Sell!”; in reality the NYSE isn’t much like that, and hasn’t been for decades, because everyone is staring at a screen and most of the trading is automated and occurs in microseconds. (It’s kind of like how if you draw a cartoon of a doctor, they will invariably be wearing a head mirror, but if you’ve actually been to a doctor lately, they don’t actually wear those anymore.)

Drift-diffusion, however, is like that. Let’s say we have a decision to make, “Yes” or “No”. Thousands of neurons devoted to that decision start firing, some saying “Yes”, exciting other “Yes” neurons and inhibiting “No” neurons, while others say “No”, exciting other “No” neurons and inhibiting other “Yes” neurons. New information feeds in, triggering some to “Yes” and others to “No”. The resulting process behaves like a random walk, specifically a trend random walk, where the intensity of the trend is determined by whatever criteria you are feeding into the decision. The decision will be made when a certain threshold is reached, say, 95% agreement among all neurons.

I wrote a little R program to demonstrate drift-diffusion models; the images I’ll be showing are R plots from that program. The graphs represent the aggregated “opinion” of all the deciding neurons; as you go from left to right, time passes, and the opinions “drift” toward one side or the other. For these graphs, the top of the graph represents the better choice.

It may actually be easiest to understand if you imagine that we are choosing a belief; new evidence accumulates that pushes us toward the correct answer (top) or the incorrect answer (bottom), because even a true belief will have some evidence that seems to be against it. You encounter this evidence more or less randomly (or do you?), and which belief you ultimately form will depend upon both how strong the evidence is and how thoughtful you are in forming your beliefs.

If the evidence is very strong (or in general, the two choices are very different), the trend will be very strong, and you’ll almost certainly come to a decision very quickly:

If the evidence is weaker (the two choices are very similar), the trend will be much weaker, and it will take much longer to make a decision:

One way to make a decision faster would be to have a weaker threshold, like 75% agreement instead of 95%; but this has the downside that it can result in making the wrong choice. Notice how some of the paths go down to the bottom, which in this case is the worse choice:

But if there is actually no difference between the two options, a low threshold is good, because you don’t spend time waffling over a pointless decision. (I know that I’ve had a problem with that in real life, spending too long making a decision that ultimately is of minor importance; my drift thresholds are too high!) With a low threshold, you get it over with:

With a high threshold, you can go on for ages:

This is the difference between indifferent about a decision and being ambivalent. If you are indifferent, you are dealing with two small amounts of utility and it doesn’t really matter which one you choose. If you are ambivalent, you are dealing with two large amounts of utility and it’s very important to get it right—but you aren’t sure which one to choose. If you are indifferent, you should use a low threshold and get it over with; but if you are ambivalent, it actually makes sense to keep your threshold high and spend a lot of time thinking about the problem in order to be sure you get it right.

It’s also possible to set a higher threshold for one option than the other; I think this is actually what we’re doing when we exhibit many cognitive biases like confirmation bias. If the decision you’re making is between keeping your current beliefs and changing them to something else, your diffusion space actually looks more like this:

You’ll only make the correct choice (top) if you set equal thresholds (meaning you reason fairly instead of exhibiting cognitive biases) and high thresholds (meaning you spend sufficient time thinking about the question). If I may change to a sports metaphor, people tend to move the goalposts—the team “change your mind” has to kick a lot further than the team “keep your current belief”.

We can also extend drift-diffusion models to changing your mind (or experiencing regret such as “buyer’s remorse“) if we assume that the system doesn’t actually cut off once it reaches a threshold; the threshold makes us take the action, but then our neurons keep on arguing it out in the background. We may hover near the threshold or soar off into absolute certainty—but on the other hand we may waffle all the way back to the other decision:

There are all sorts of generalizations and extensions of drift-diffusion models, but these basic ones should give you a sense of how useful they are. More importantly, they are accurate; drift-diffusion models produce very sharp mathematical predictions about human behavior, and in general these predictions are verified in experiments.

The main reason we started using drift-diffusion models is that they account very well for the fact that decisions become more accurate when we spend more time on them. The way they do that is quite elegant: Under harsher time pressure, we use lower thresholds, which speeds up the process but also introduces more errors. When we don’t have time pressure, we use high thresholds and take a long time, but almost always make the right decision.

Under certain (rather narrow) circumstances, drift-diffusion models can actually be equivalent to the optimal Bayesian model. These models can also be extended for use in purchasing choices, and one day we will hopefully have a stock-market-in-the-brain model of actual stock market decisions!

Drift-diffusion models are based on decisions between two alternatives with only one relevant attribute under consideration, but they are being expanded to decisions with multiple attributes and decisions with multiple alternatives; the fact that this is difficult is in my opinion not a bug but a feature—decisions with multiple alternatives and attributes are actually difficult for human beings to make. The fact that drift-diffusion models have difficulty with the very situations that human beings have difficulty with provides powerful evidence that drift-diffusion models are accurately representing the processes that go on inside a human brain. I’d be worried if it were too easy to extend the models to complex decisions—it would suggest that our model is describing a more flexible decision process than the one human beings actually use. Human decisions really do seem to be attempts to shoehorn two-choice single-attribute decision methods onto more complex problems, and a lot of mistakes we make are attributable to that.

In particular, the phenomena of analysis paralysis and the paradox of choice are easily explained this way. Why is it that when people are given more alternatives, they often spend far more time trying to decide and often end up less satisfied than they were before? This makes sense if, when faced with a large number of alternatives, we spend time trying to compare them pairwise on every attribute, and then get stuck with a whole bunch of incomparable pairwise comparisons that we then have to aggregate somehow. If we could simply assign a simple utility value to each attribute and sum them up, adding new alternatives should only increase the time required by a small amount and should never result in a reduction in final utility.

When I have an important decision to make, I actually assemble a formal utility model, as I did recently when deciding on a new computer to buy (it should be in the mail any day now!). The hardest part, however, is assigning values to the coefficients in the model; just how much am I willing to spend for an extra gigabyte of RAM, anyway? How exactly do those CPU benchmarks translate into dollar value for me? I can clearly tell that this is not the native process of my mental architecture.

No, alas, we seem to be stuck with drift-diffusion, which is nearly optimal for choices with two alternatives on a single attribute, but actually pretty awful for multiple-alternative multiple-attribute decisions. But perhaps by better understanding our suboptimal processes, we can rearrange our environment to bring us closer to optimal conditions—or perhaps, one day, change the processes themselves!

How to change the world

2015-05-23 PNRJ core principles, critique of neoclassical economics agronomy, altruism, anthropology, art, austerity, biology, Black-Scholes, CAPM, chemistry, cognitive science, earning to give, ecology, Einstein, engineering, forecasting, Hard Problem, Jonas Salk, Keynes, literature, mathematics, music, neuroscience, philosophy, physics, political science, psychology, sociology, Steve Jobs, Tomorrowland, Will Rogers

JDN 2457166 EDT 17:53.

I just got back from watching Tomorrowland, which is oddly appropriate since I had already planned this topic in advance. How do we, as they say in the film, “fix the world”?

I can’t find it at the moment, but I vaguely remember some radio segment on which a couple of neoclassical economists were interviewed and asked what sort of career can change the world, and they answered something like, “Go into finance, make a lot of money, and then donate it to charity.”

In a slightly more nuanced form this strategy is called earning to give, and frankly I think it’s pretty awful. Most of the damage that is done to the world is done in the name of maximizing profits, and basically what you end up doing is stealing people’s money and then claiming you are a great altruist for giving some of it back. I guess if you can make enormous amounts of money doing something that isn’t inherently bad and then donate that—like what Bill Gates did—it seems better. But realistically your potential income is probably not actually raised that much by working in finance, sales, or oil production; you could have made the same income as a college professor or a software engineer and not be actively stripping the world of its prosperity. If we actually had the sort of ideal policies that would internalize all externalities, this dilemma wouldn’t arise; but we’re nowhere near that, and if we did have that system, the only billionaires would be Nobel laureate scientists. Albert Einstein was a million times more productive than the average person. Steve Jobs was just a million times luckier. Even then, there is the very serious question of whether it makes sense to give all the fruits of genius to the geniuses themselves, who very quickly find they have all they need while others starve. It was certainly Jonas Salk’s view that his work should only profit him modestly and its benefits should be shared with as many people as possible. So really, in an ideal world there might be no billionaires at all.

Here I would like to present an alternative. If you are an intelligent, hard-working person with a lot of talent and the dream of changing the world, what should you be doing with your time? I’ve given this a great deal of thought in planning my own life, and here are the criteria I came up with:

You must be willing and able to commit to doing it despite great obstacles. This is another reason why earning to give doesn’t actually make sense; your heart (or rather, limbic system) won’t be in it. You’ll be miserable, you’ll become discouraged and demoralized by obstacles, and others will surpass you. In principle Wall Street quantitative analysts who make $10 million a year could donate 90% to UNICEF, but they don’t, and you know why? Because the kind of person who is willing and able to exploit and backstab their way to that position is the kind of person who doesn’t give money to UNICEF.
There must be important tasks to be achieved in that discipline. This one is relatively easy to satisfy; I’ll give you a list in a moment of things that could be contributed by a wide variety of fields. Still, it does place some limitations: For one, it rules out the simplest form of earning to give (a more nuanced form might cause you to choose quantum physics over social work because it pays better and is just as productive—but you’re not simply maximizing income to donate). For another, it rules out routine, ordinary jobs that the world needs but don’t make significant breakthroughs. The world needs truck drivers (until robot trucks take off), but there will never be a great world-changing truck driver, because even the world’s greatest truck driver can only carry so much stuff so fast. There are no world-famous secretaries or plumbers. People like to say that these sorts of jobs “change the world in their own way”, which is a nice sentiment, but ultimately it just doesn’t get things done. We didn’t lift ourselves into the Industrial Age by people being really fantastic blacksmiths; we did it by inventing machines that make blacksmiths obsolete. We didn’t rise to the Information Age by people being really good slide-rule calculators; we did it by inventing computers that work a million times as fast as any slide-rule. Maybe not everyone can have this kind of grand world-changing impact; and I certainly agree that you shouldn’t have to in order to live a good life in peace and happiness. But if that’s what you’re hoping to do with your life, there are certain professions that give you a chance of doing so—and certain professions that don’t.
The important tasks must be currently underinvested. There are a lot of very big problems that many people are already working on. If you work on the problems that are trendy, the ones everyone is talking about, your marginal contribution may be very small. On the other hand, you can’t just pick problems at random; many problems are not invested in precisely because they aren’t that important. You need to find problems people aren’t working on but should be—problems that should be the focus of our attention but for one reason or another get ignored. A good example here is to work on pancreatic cancer instead of breast cancer; breast cancer research is drowning in money and really doesn’t need any more; pancreatic cancer kills 2/3 as many people but receives less than 1/6 as much funding. If you want to do cancer research, you should probably be doing pancreatic cancer.
You must have something about you that gives you a comparative—and preferably, absolute—advantage in that field. This is the hardest one to achieve, and it is in fact the reason why most people can’t make world-changing breakthroughs. It is in fact so hard to achieve that it’s difficult to even say you have until you’ve already done something world-changing. You must have something special about you that lets you achieve what others have failed. You must be one of the best in the world. Even as you stand on the shoulders of giants, you must see further—for millions of others stand on those same shoulders and see nothing. If you believe that you have what it takes, you will be called arrogant and naïve; and in many cases you will be. But in a few cases—maybe 1 in 100, maybe even 1 in 1000, you’ll actually be right. Not everyone who believes they can change the world does so, but everyone who changes the world believed they could.

Now, what sort of careers might satisfy all these requirements?

Well, basically any kind of scientific research:

Mathematicians could work on network theory, or nonlinear dynamics (the first step: separating “nonlinear dynamics” into the dozen or so subfields it should actually comprise—as has been remarked, “nonlinear” is a bit like “non-elephant”), or data processing algorithms for our ever-growing morasses of unprocessed computer data.

Physicists could be working on fusion power, or ways to neutralize radioactive waste, or fundamental physics that could one day unlock technologies as exotic as teleportation and faster-than-light travel. They could work on quantum encryption and quantum computing. Or if those are still too applied for your taste, you could work in cosmology and seek to answer some of the deepest, most fundamental questions in human existence.

Chemists could be working on stronger or cheaper materials for infrastructure—the extreme example being space elevators—or technologies to clean up landfills and oceanic pollution. They could work on improved batteries for solar and wind power, or nanotechnology to revolutionize manufacturing.

Biologists could work on any number of diseases, from cancer and diabetes to malaria and antibiotic-resistant tuberculosis. They could work on stem-cell research and regenerative medicine, or genetic engineering and body enhancement, or on gerontology and age reversal. Biology is a field with so many important unsolved problems that if you have the stomach for it and the interest in some biological problem, you can’t really go wrong.

Electrical engineers can obviously work on improving the power and performance of computer systems, though I think over the last 20 years or so the marginal benefits of that kind of research have begun to wane. Efforts might be better spent in cybernetics, control systems, or network theory, where considerably more is left uncharted; or in artificial intelligence, where computing power is only the first step.

Mechanical engineers could work on making vehicles safer and cheaper, or building reusable spacecraft, or designing self-constructing or self-repairing infrastructure. They could work on 3D printing and just-in-time manufacturing, scaling it up for whole factories and down for home appliances.

Aerospace engineers could link the world with hypersonic travel, build satellites to provide Internet service to the farthest reaches of the globe, or create interplanetary rockets to colonize Mars and the moons of Jupiter and Saturn. They could mine asteroids and make previously rare metals ubiquitous. They could build aerial drones for delivery of goods and revolutionize logistics.

Agronomists could work on sustainable farming methods (hint: stop farming meat), invent new strains of crops that are hardier against pests, more nutritious, or higher-yielding; on the other hand a lot of this is already being done, so maybe it’s time to think outside the box and consider what we might do to make our food system more robust against climate change or other catastrophes.

Ecologists will obviously be working on predicting and mitigating the effects of global climate change, but there are a wide variety of ways of doing so. You could focus on ocean acidification, or on desertification, or on fishery depletion, or on carbon emissions. You could work on getting the climate models so precise that they become completely undeniable to anyone but the most dogmatically opposed. You could focus on endangered species and habitat disruption. Ecology is in general so underfunded and undersupported that basically anything you could do in ecology would be beneficial.

Neuroscientists have plenty of things to do as well: Understanding vision, memory, motor control, facial recognition, emotion, decision-making and so on. But one topic in particular is lacking in researchers, and that is the fundamental Hard Problem of consciousness. This one is going to be an uphill battle, and will require a special level of tenacity and perseverance. The problem is so poorly understood it’s difficult to even state clearly, let alone solve. But if you could do it—if you could even make a significant step toward it—it could literally be the greatest achievement in the history of humanity. It is one of the fundamental questions of our existence, the very thing that separates us from inanimate matter, the very thing that makes questions possible in the first place. Understand consciousness and you understand the very thing that makes us human. That achievement is so enormous that it seems almost petty to point out that the revolutionary effects of artificial intelligence would also fall into your lap.

The arts and humanities also have a great deal to contribute, and are woefully underappreciated.

Artists, authors, and musicians all have the potential to make us rethink our place in the world, reconsider and reimagine what we believe and strive for. If physics and engineering can make us better at winning wars, art and literature and remind us why we should never fight them in the first place. The greatest works of art can remind us of our shared humanity, link us all together in a grander civilization that transcends the petty boundaries of culture, geography, or religion. Art can also be timeless in a way nothing else can; most of Aristotle’s science is long-since refuted, but even the Great Pyramid thousands of years before him continues to awe us. (Aristotle is about equidistant chronologically between us and the Great Pyramid.)

Philosophers may not seem like they have much to add—and to be fair, a great deal of what goes on today in metaethics and epistemology doesn’t add much to civilization—but in fact it was Enlightenment philosophy that brought us democracy, the scientific method, and market economics. Today there are still major unsolved problems in ethics—particularly bioethics—that are in need of philosophical research. Technologies like nanotechnology and genetic engineering offer us the promise of enormous benefits, but also the risk of enormous harms; we need philosophers to help us decide how to use these technologies to make our lives better instead of worse. We need to know where to draw the lines between life and death, between justice and cruelty. Literally nothing could be more important than knowing right from wrong.

Now that I have sung the praises of the natural sciences and the humanities, let me now explain why I am a social scientist, and why you probably should be as well.

Psychologists and cognitive scientists obviously have a great deal to give us in the study of mental illness, but they may actually have more to contribute in the study of mental health—in understanding not just what makes us depressed or schizophrenic, but what makes us happy or intelligent. The 21^st century may not simply see the end of mental illness, but the rise of a new level of mental prosperity, where being happy, focused, and motivated are matters of course. The revolution that biology has brought to our lives may pale in comparison to the revolution that psychology will bring. On the more social side of things, psychology may allow us to understand nationalism, sectarianism, and the tribal instinct in general, and allow us to finally learn to undermine fanaticism, encourage critical thought, and make people more rational. The benefits of this are almost impossible to overstate: It is our own limited, broken, 90%-or-so heuristic rationality that has brought us from simians to Shakespeare, from gorillas to Godel. To raise that figure to 95% or 99% or 99.9% could be as revolutionary as was whatever evolutionary change first brought us out of the savannah as Australopithecus africanus.

Sociologists and anthropologists will also have a great deal to contribute to this process, as they approach the tribal instinct from the top down. They may be able to tell us how nations are formed and undermined, why some cultures assimilate and others collide. They can work to understand combat bigotry in all its forms, racism, sexism, ethnocentrism. These could be the fields that finally end war, by understanding and correcting the imbalances in human societies that give rise to violent conflict.

Political scientists and public policy researchers can allow us to understand and restructure governments, undermining corruption, reducing inequality, making voting systems more expressive and more transparent. They can search for the keystones of different political systems, finding the weaknesses in democracy to shore up and the weaknesses in autocracy to exploit. They can work toward a true international government, representative of all the world’s people and with the authority and capability to enforce global peace. If the sociologists don’t end war and genocide, perhaps the political scientists can—or more likely they can do it together.

And then, at last, we come to economists. While I certainly work with a lot of ideas from psychology, sociology, and political science, I primarily consider myself an economist. Why is that? Why do I think the most important problems for me—and perhaps everyone—to be working on are fundamentally economic?

Because, above all, economics is broken. The other social sciences are basically on the right track; their theories are still very limited, their models are not very precise, and there are decades of work left to be done, but the core principles upon which they operate are correct. Economics is the field to work in because of criterion 3: Almost all the important problems in economics are underinvested.

Macroeconomics is where we are doing relatively well, and yet the Keynesian models that allowed us to reduce the damage of the Second Depression nonetheless had no power to predict its arrival. While inflation has been at least somewhat tamed, the far worse problem of unemployment has not been resolved or even really understood.

When we get to microeconomics, the neoclassical models are totally defective. Their core assumptions of total rationality and total selfishness are embarrassingly wrong. We have no idea what controls assets prices, or decides credit constraints, or motivates investment decisions. Our models of how people respond to risk are all wrong. We have no formal account of altruism or its limitations. As manufacturing is increasingly automated and work shifts into services, most economic models make no distinction between the two sectors. While finance takes over more and more of our society’s wealth, most formal models of the economy don’t even include a financial sector.

Economic forecasting is no better than chance. The most widely-used asset-pricing model, CAPM, fails completely in empirical tests; its defenders concede this and then have the audacity to declare that it doesn’t matter because the mathematics works. The Black-Scholes derivative-pricing model that caused the Second Depression could easily have been predicted to do so, because it contains a term that assumes normal distributions when we know for a fact that financial markets are fat-tailed; simply put, it claims certain events will never happen that actually occur several times a year.

Worst of all, economics is the field that people listen to. When a psychologist or sociologist says something on television, people say that it sounds interesting and basically ignore it. When an economist says something on television, national policies are shifted accordingly. Austerity exists as national policy in part due to a spreadsheet error by two famous economists.

Keynes already knew this in 1936: “The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”

Meanwhile, the problems that economics deals with have a direct influence on the lives of millions of people. Bad economics gives us recessions and depressions; it cripples our industries and siphons off wealth to an increasingly corrupt elite. Bad economics literally starves people: It is because of bad economics that there is still such a thing as world hunger. We have enough food, we have the technology to distribute it—but we don’t have the economic policy to lift people out of poverty so that they can afford to buy it. Bad economics is why we don’t have the funding to cure diabetes or colonize Mars (but we have the funding for oil fracking and aircraft carriers, don’t we?). All of that other scientific research that needs done probably could be done, if the resources of our society were properly distributed and utilized.

This combination of both overwhelming influence, overwhelming importance and overwhelming error makes economics the low-hanging fruit; you don’t even have to be particularly brilliant to have better ideas than most economists (though no doubt it helps if you are). Economics is where we have a whole bunch of important questions that are unanswered—or the answers we have are wrong. (As Will Rogers said, “It isn’t what we don’t know that gives us trouble, it’s what we know that ain’t so.”)

Thus, rather than tell you go into finance and earn to give, those economists could simply have said: “You should become an economist. You could hardly do worse than we have.”

Why the Republican candidates like flat income tax—and we really, really don’t

2015-05-17 PNRJ critique of neoclassical economics, public policy basic income, Bernie Sanders, capital, Democrat, elections, flat tax, halo effect, Hillary Clinton, investment, IRS, just world, land tax, Miles Kimball, Mitt Romney, monetary policy, money, poverty, profit, progressive, Republican, saving, tax code, tax reform, taxation, taxes, wealth

JDN 2456160 EDT 13:55.

The Republican Party is scrambling to find viable Presidential candidates for next year’s election. The Democrats only have two major contenders: Hillary Clinton looks like the front-runner (and will obviously have the most funding), but Bernie Sanders is doing surprisingly well, and is particularly refreshing because he is running purely on his principles and ideas. He has no significant connections, no family dynasty (unlike Jeb Bush and, again, Hillary Clinton) and not a huge amount of wealth (Bernie’s net wealth is about $500,000, making him comfortably upper-middle class; compare to Hillary’s $21.5 million and her husband’s $80 million); but he has ideas that resonate with people. Bernie Sanders is what politics is supposed to be. Clinton’s campaign will certainly raise more than his; but he has already raised over $4 million, and if he makes it to about $10 million studies suggest that additional spending above that point is largely negligible. He actually has a decent chance of winning, and if he did it would be a very good sign for the future of America.

But the Republican field is a good deal more contentious, and the 19 candidates currently running have been scrambling to prove that they are the most right-wing in order to impress far-right primary voters. (When the general election comes around, whoever wins will of course pivot back toward the center, changing from, say, outright fascism to something more like reactionism or neo-feudalism. If you were hoping they’d pivot so far back as to actually be sensible center-right capitalists, think again; Hillary Clinton is the only one who will take that role, and they’ll go out of their way to disagree with her in every way they possibly can, much as they’ve done with Obama.) One of the ways that Republicans are hoping to prove their right-wing credentials is by proposing a flat income tax and eliminating the IRS.

Unlike most of their proposals, I can see why many people think this actually sounds like a good idea. It would certainly dramatically reduce bureaucracy, and that’s obviously worthwhile since excess bureaucracy is pure deadweight loss. (A surprising number of economists seem to forget that government does other things besides create excess bureaucracy, but I must admit it does in fact create excess bureaucracy.)

Though if they actually made the flat tax rate 20% or even—I can’t believe this is seriously being proposed—10%, there is no way the federal government would have enough revenue. The only options would be (1) massive increases in national debt (2) total collapse of government services—including their beloved military, mind you, or (3) directly linking the Federal Reserve quantitative easing program to fiscal policy and funding the deficit with printed money. Of these, 3 might not actually be that bad (it would probably trigger some inflation, but actually we could use that right now), but it’s extremely unlikely to happen, particularly under Republicans. In reality, after getting a taste of 2, we’d clearly end up with 1. And then they’d be complaining about the debt and clamor for more spending cuts, more spending cuts, ever more spending cuts, but there would simply be no way to run a functioning government on 10% of GDP in anything like our current system. Maybe you could do it on 20%—maybe—but we currently spend more like 35%, and that’s already a very low amount of spending for a First World country. The UK is more typical at 47%, while Germany is a bit low at 44%; Sweden spends 52% and France spends a whopping 57%. Anyone who suggests we cut government spending from 35% to 20% needs to explain which 3/7 of government services are going to immediately disappear—not to mention which 3/7 of government employees are going to be immediately laid off.

And then they want to add investment deductions; in general investment deductions are a good thing, as long as you tie them to actual investments in genuinely useful things like factories and computer servers. (Or better yet, schools, research labs, or maglev lines, but private companies almost never invest in that sort of thing, so the deduction wouldn’t apply.) The kernel of truth in the otherwise ridiculous argument that we should never tax capital is that taxing real investment would definitely be harmful in the long run. As I discussed with Miles Kimball (a cognitive economist at Michigan and fellow econ-blogger I hope to work with at some point), we could minimize the distortionary effects of corporate taxes by establishing a strong deduction for real investment, and this would allow us to redistribute some of this enormous wealth inequality without dramatically harming economic growth.

But if you deduct things that aren’t actually investments—like stock speculation and derivatives arbitrage—then you reduce your revenue dramatically and don’t actually incentivize genuinely useful investments. This is the problem with our current system, in which GE can pay no corporate income tax on $108 billion in annual profit—and you know they weren’t using all that for genuinely productive investment activities. But then, if you create a strong enforcement system for ensuring it is real investment, you need bureaucracy—which is exactly what the flat tax was claimed to remove. At the very least, the idea of eliminating the IRS remains ridiculous if you have any significant deductions.

Thus, the benefits of a flat income tax are minimal if not outright illusory; and the costs, oh, the costs are horrible. In order to have remotely reasonable amounts of revenue, you’d need to dramatically raise taxes on the majority of people, while significantly lowering them on the rich. You would create a direct transfer of wealth from the poor to the rich, increasing our already enormous income inequality and driving millions of people into poverty.

Thus, it would be difficult to more clearly demonstrate that you care only about the interests of the top 1% than to propose a flat income tax. I guess Mitt Romney’s 47% rant actually takes the cake on that one though (Yes, all those freeloading… soldiers… and children… and old people?).

Many Republicans are insisting that a flat tax would create a surge of economic growth, but that’s simply not how macroeconomics works. If you steeply raise taxes on the majority of people while cutting them on the rich, you’ll see consumer spending plummet and the entire economy will be driven into recession. Rich people simply don’t spend their money in the same way as the rest of us, and the functioning of the economy depends upon a continuous flow of spending. There is a standard neoclassical economic argument about how reducing spending and increasing saving would lead to increased investment and greater prosperity—but that model basically assumes that we have a fixed amount of stuff we’re either using up or making more stuff with, which is simply not how money works; as James Kroeger cogently explains on his blog “Nontrivial Pursuits”, money is created as it is needed; investment isn’t determined by people saving what they don’t spend. Indeed, increased consumption generally leads to increased investment, because our economy is currently limited by demand, not supply. We could build a lot more stuff, if only people could afford to buy it.

And that’s not even considering the labor incentives; as I already talked about in my previous post on progressive taxation, there are two incentives involved when you increase someone’s hourly wage. On the one hand, they get paid more for each hour, which is a reason to work; that’s the substitution effect. But on the other hand, they have more money in general, which is a reason they don’t need to work; that’s the income effect. Broadly speaking, the substitution effect dominates at low incomes (about $20,000 or less), the income effect dominates at high incomes (about $100,000 or more), and the two effects cancel out at moderate incomes. Since a tax on your income hits you in much the same way as a reduction in your wage, this means that raising taxes on the poor makes them work less, while raising taxes on the rich makes them work more. But if you go from our currently slightly-progressive system to a flat system, you raise taxes on the poor and cut them on the rich, which would mean that the poor would work less, and the rich would also work less! This would reduce economic output even further. If you want to maximize the incentive to work, you want progressive taxes, not flat taxes.

Flat taxes sound appealing because they are so simple; even the basic formula for our current tax rates is complicated, and we combine it with hundreds of pages of deductions and credits—not to mention tens of thousands of pages of case law!—making it a huge morass of bureaucracy that barely anyone really understands and corporate lawyers can easily exploit. I’m all in favor of getting rid of that; but you don’t need a flat tax to do that. You can fit the formula for a progressive tax on a single page—indeed, on a single line: r = 1 – I^-p

That’s it. It’s simple enough to be plugged into any calculator that is capable of exponents, not to mention efficiently implemented in Microsoft Excel (more efficiently than our current system in fact).

Combined with that simple formula, you could list all of the sensible deductions on a couple of additional pages (business investments and educational expenses, mostly—poverty should be addressed by a basic income, not by tax deductions on things like heating and housing, which are actually indirect corporate subsidies), along with a land tax (one line: $3000 per hectare), a basic income (one more line: $8,000 per adult and $4,000 per child), and some additional excise taxes on goods with negative externalities (like alcohol, tobacco, oil, coal, and lead), with a line for each; then you can provide a supplementary manual of maybe 50 pages explaining the detailed rules for applying each of those deductions in unusual cases. The entire tax code should be readable by an ordinary person in a single sitting no longer than a few hours. That means no more than 100 pages and no more than a 7th-grade reading level.

Why do I say this? Isn’t that a ridiculous standard? No, it is a Constitutional imperative. It is a fundamental violation of your liberty to tax you according to rules you cannot reasonably understand—indeed, bordering on Kafkaesque. While this isn’t taxation without representation—we do vote for representatives, after all—it is something very much like it; what good is the ability to change rules if you don’t even understand the rules in the first place? Nor would it be all that difficult: You first deduct these things from your income, then plug the result into this formula.

So yes, I absolutely agree with the basic principle of tax reform. The tax code should be scrapped and recreated from scratch, and the final product should be a primary form of only a few pages combined with a supplementary manual of no more than 100 pages. But you don’t need a flat tax to do that, and indeed for many other reasons a flat tax is a terrible idea, particularly if the suggested rate is 10% or 15%, less than half what we actually spend. The real question is why so many Republican candidates think that this will appeal to their voter base—and why they could actually be right about that.

Part of it is the entirely justified outrage at the complexity of our current tax system, and the appealing simplicity of a flat tax. Part of it is the long history of American hatred of taxes; we were founded upon resisting taxes, and we’ve been resisting taxes ever since. In some ways this is healthy; taxes per se are not a good thing, they are a bad thing, a necessary evil.

But those two things alone cannot explain why anyone would advocate raising taxes on the poorest half of the population while dramatically cutting them on the top 1%. If you are opposed to taxes in general, you’d cut them on everyone; and if you recognize the necessity of taxation, you’d be trying to find ways to minimize the harm while ensuring sufficient tax revenue, which in general means progressive taxation.

To understand why they would be pushing so hard for flat taxes, I think we need to say that many Republicans, particularly those in positions of power, honestly do think that rich people are better than poor people and we should always give more to the rich and less to the poor. (Maybe it’s partly halo effect, in which good begets good and bad begets bad? Or maybe just world theory, the ingrained belief that the world is as it ought to be?)

Romney’s 47% rant wasn’t an exception; it was what he honestly believes, what he says when he doesn’t know he’s on camera. He thinks that he earned every penny of his $250 million net wealth; yes, even the part he got from marrying his wife and the part he got from abusing tax laws, arbitraging assets and liquidating companies. He thinks that people who live on $4,000 or even $400 a year are simply lazy freeloaders, who could easily work harder, perhaps do some arbitrage and liquidation of their own (check out these alleged “rags to riches” stories including the line “tried his hand at mortgage brokering”), but choose not to, and as a result deserve what they get. (It’s important to realize just how bizarre this moral attitude truly is; even if I thought you were the laziest person on Earth, I wouldn’t let you starve to death.) He thinks that the social welfare programs which have reduced poverty but never managed to eliminate it are too generous—if he even thinks they should exist at all. And in thinking these things, he is not some bizarre aberration; he is representing an entire class of people, nearly all of whom vote Republican.

The good news is, these people are still in the minority. They hold significant sway over the Republican primary, but will not have nearly as much impact in the general election. And right now, the Republican candidates are so numerous and so awful that I have trouble seeing how the Democrats could possibly lose. (But please, don’t take that as a challenge, you guys.)

What you need to know about tax incidence

2015-05-092015-05-09 PNRJ core principles, public policy, Top 10 things to know about economics Adam Smith, consumer surplus, deadweight loss, economic surplus, elasticity, equations, land tax, LaTeX, producer surplus, rent, rent control, supply and demand, tax incidence, taxation, taxes

JDN 2457152 EDT 14:54.

I said in my previous post that I consider tax incidence to be one of the top ten things you should know about economics. If I actually try to make a top ten list, I think it goes something like this:

Supply and demand
Monopoly and oligopoly
Externalities
Tax incidence
Utility, especially marginal utility of wealth
Pareto-efficiency
Risk and loss aversion
Biases and heuristics, including sunk-cost fallacy, scope neglect, herd behavior, anchoring and representative heuristic
Asymmetric information
Winner-takes-all effect

So really tax incidence is in my top five things you should know about economics, and yet I still haven’t talked about it very much. Well, today I will. The basic principles of supply and demand I’m basically assuming you know, but I really should spend some more time on monopoly and externalities at some point.

Why is tax incidence so important? Because of one central fact: The person who pays the tax is not the person who writes the check.

It doesn’t matter whether a tax is paid by the buyer or the seller; it matters what the buyer and seller can do to avoid the tax. If you can change your behavior in order to avoid paying the tax—buy less stuff, or buy somewhere else, or deduct something—you will not bear the tax as much as someone else who can’t do anything to avoid the tax, even if you are the one who writes the check. If you can avoid it and they can’t, other parties in the transaction will adjust their prices in order to eat the tax on your behalf.

Thus, if you have a good that you absolutely must buy no matter what—like, say, table salt—and then we make everyone who sells that good pay an extra $5 per kilogram, I can guarantee you that you will pay an extra $5 per kilogram, and the suppliers will make just as much money as they did before. (A salt tax would be an excellent way to redistribute wealth from ordinary people to corporations, if you’re into that sort of thing. Not that we have any trouble doing that in America.)

On the other hand, if you have a good that you’ll only buy at a very specific price—like, say, fast food—then we can make you write the check for a tax of an extra $5 per kilogram you use, and in real terms you’ll pay hardly any tax at all, because the sellers will either eat the cost themselves by lowering the prices or stop selling the product entirely. (A fast food tax might actually be a good idea as a public health measure, because it would reduce production and consumption of fast food—remember, heart disease is one of the leading causes of death in the United States, making cheeseburgers a good deal more dangerous than terrorists—but it’s a bad idea as a revenue measure, because rather than pay it, people are just going to buy and sell less.)

In the limit in which supply and demand are both completely fixed (perfectly inelastic), you can tax however you want and it’s just free redistribution of wealth however you like. In the limit in which supply and demand are both locked into a single price (perfectly elastic), you literally cannot tax that good—you’ll just eliminate production entirely. There aren’t a lot of perfectly elastic goods in the real world, but the closest I can think of is cash. If you instituted a 2% tax on all cash withdrawn, most people would stop using cash basically overnight. If you want a simple way to make all transactions digital, find a way to enforce a cash tax. When you have a perfect substitute available, taxation eliminates production entirely.

To really make sense out of tax incidence, I’m going to need a lot of a neoclassical economists’ favorite thing: Supply and demand curves. These things pop up everywhere in economics; and they’re quite useful. I’m not so sure about their application to things like aggregate demand and the business cycle, for example, but today I’m going to use them for the sort of microeconomic small-market stuff that they were originally designed for; and what I say here is going to be basically completely orthodox, right out of what you’d find in an ECON 301 textbook.

Let’s assume that things are linear, just to make the math easier. You’d get basically the same answers with nonlinear demand and supply functions, but it would be a lot more work. Likewise, I’m going to assume a unit tax on goods—like $2890 per hectare—as opposed to a proportional tax on sales—like 6% property tax—again, for mathematical simplicity.

The next concept I’m going to have to talk about is elasticity—which is the proportional amount that quantity sold changes relative to price. If price increases 2% and you buy 4% less, you have a demand elasticity of -2. If price increases 2% and you buy 1% less, you have a demand elasticity of -1/2. If price increases 3% and you sell 6% more, you have a supply elasticity of 2. If price decreases 5% and you sell 1% less, you have a supply elasticity of 1/5.

Elasticity doesn’t have any units of measurement, it’s just a number—which is part of why we like to use it. It also has some very nice mathematical properties involving logarithms, but we won’t be needing those today.

The price that renters are willing and able to pay, the demand price P_Dwill start at their maximum price, the reserve price P_R, and then it will decrease linearly according to the quantity of land rented Q, according to a linear function (simply because we assumed that) which will vary according to a parameter e that represents the elasticity of demand (it isn’t strictly equal to it, but it’s sort of a linearization).

We’re interested in what is called the consumer surplus; it is equal to the total amount of value that buyers get from their purchases, converted into dollars, minus the amount they had to pay for those purchases. This we add to the producer surplus, which is the amount paid for those purchases minus the cost of producing them—which is basically just the same thing as profit. Togerther the consumer surplus and producer surplus make the total economic surplus, which economists generally try to maximize. Because different people have different marginal utility of wealth, this is actually a really terrible idea for deep and fundamental reasons—taking a house from Mitt Romney and giving it to a homeless person would most definitely reduce economic surplus, even though it would obviously make the world a better place. Indeed, I think that many of the problems in the world, particularly those related to inequality, can be traced to the fact that markets maximize economic surplus rather than actual utility. But for now I’m going to ignore all that, and pretend that maximizing economic surplus is what we want to do.

You can read off the economic surplus straight from the supply and demand curves; it’s the area between the lines. (Mathematically, it’s an integral; but that’s equivalent to the area under a curve, and with straight lines they’re just triangles.) I’m going to call the consumer surplus just “surplus”, and producer surplus I’ll call “profit”.

Below the demand curve and above the price is the surplus, and below the price and above the supply curve is the profit:

I’m going to be bold here and actually use equations! Hopefully this won’t turn off too many readers. I will give each equation in both a simple text format and in proper LaTeX. Remember, you can render LaTeX here.

P_D = P_R– 1/e * Q

P_D = P_R – \frac{1}{e} Q \\

The marginal cost that landlords have to pay, the supply price P_S, is a bit weirder, as I’ll talk about more in a moment. For now let’s say that it is a linear function, starting at zero cost for some quantity Q₀ and then increases linearly according to a parameter n that similarly represents the elasticity of supply.

P_S = 1/n * (Q – Q₀)

P_S = \frac{1}{n} \left( Q – Q_0 \right) \\

Now, if you introduce a tax, there will be a difference between the price that renters pay and the price that landlords receive—namely, the tax, which we’ll call T. I’m going to assume that, on paper, the landlord pays the whole tax. As I said above, this literally does not matter. I could assume that on paper the renter pays the whole tax, and the real effect on the distribution of wealth would be identical. All we’d have to do is set P_D = P and P_S = P – T; the consumer and producer surplus would end up exactly the same. Or we could do something in between, with P’_D = P + rT and P’_S = P – (1 – r) T.

Then, if the market is competitive, we just set the prices equal, taking the tax into account:

P = P_D – T = P_R – 1/e * Q – T = P_S = 1/n * (Q – Q₀)

P= P_D – T = P_R – \frac{1}{e} Q – T= P_S = \frac{1}{n} \left(Q – Q_0 \right) \\

P_R – 1/e * Q – T = 1/n * (Q – Q₀)

P_R – \frac{1}{e} Q – T = \frac{1}{n} \left(Q – Q_0 \right) \\

Notice the equivalency here; if we set P’_D = P + rT and P’_S = P – (1 – r) T, so that the consumer now pays a fraction of the tax r.

P = P’_D – rT = P_r – 1/e*Q = P’_S + (1 – r) T + 1/n * (Q – Q₀) + (1 – r) T

P^\prime_D – r T = P = P_R – \frac{1}{e} Q = P^\prime_S = \frac{1}{n} \left(Q – Q_0 \right) + (1 – r) T\\

The result is exactly the same:

P_R – 1/e * Q – T = 1/n * (Q – Q₀)

P_R – \frac{1}{e} Q – T = \frac{1}{n} \left(Q – Q_0 \right) \\

I’ll spare you the algebra, but this comes out to:

Q = (P_R – T)/(1/n + 1/e) + (Q₀)/(1 + n/e)

Q = \frac{P_R – T}{\frac{1}{n} + \frac{1}{e}} + \frac{Q_0}{1 + \frac{n}{e}}

P = (P_R – T)/(1+ n/e) – (Q₀)/(e + n)

P = \frac{P_R – T}}{1 + \frac{n}{e}} – \frac{Q_0}{e+n} \\

That’s if the market is competitive.

If the market is a monopoly, instead of setting the prices equal, we set the price the landlord receives equal to the marginal revenue—which takes into account the fact that increasing the amount they sell forces them to reduce the price they charge everyone else. Thus, the marginal revenue drops faster than the price as the quantity sold increases.

After a bunch of algebra (and just a dash of calculus), that comes out to these very similar, but not quite identical, equations:

Q = (P_R – T)/(1/n + 2/e) + (Q₀)/(1+ 2n/e)

Q = \frac{P_R – T}{\frac{1}{n} + \frac{2}{e}} + \frac{Q_0}{1 + \frac{2n}{e}} \\

P = (P_R – T)*((1/n + 1/e)/(1/n + 2/e) – (Q₀)/(e + 2n)

P = \left( P_R – T\right)\frac{\frac{1}{n} + \frac{1}{e}}{\frac{1}{n} + \frac{2}{e}} – \frac{Q_0}{e+2n} \\

Yes, it changes some 1s into 2s. That by itself accounts for the full effect of monopoly. That’s why I think it’s worthwhile to use the equations; they are deeply elegant and express in a compact form all of the different cases. They look really intimidating right now, but for most of the cases we’ll consider these general equations simplify quite dramatically.

There are several cases to consider.

Land has an extremely high cost to create—for practical purposes, we can consider its supply fixed, that is, perfectly inelastic. If the market is competitive, so that landlords have no market power, then they will simply rent out all the land they have at whatever price the market will bear:

This is like setting n = 0 and T = 0 in the above equations, the competitive ones.

Q = Q₀

Q = Q_0 \\

P = P_R – Q₀/e

P = P_R – \frac{Q_0}{e} \\

If we now introduce a tax, it will fall completely on the landlords, because they have little choice but to rent out all the land they have, and they can only rent it at a price—including tax—that the market will bear.

Now we still have n = 0 but not T = 0.

Q = Q₀

Q = Q_0 \\

P = P_R – T – Q₀/e

P = P_R – T – \frac{Q_0}{e} \\

The consumer surplus will be:

½ (Q)(P_R – P – T) = 1/(2e)* Q₀²

\frac{1}{2}Q(P_R – P – T) = \frac{1}{2e}Q_0^2 \\

Notice how T isn’t in the result. The consumer surplus is unaffected by the tax.

The producer surplus, on the other hand, will be reduced by the tax:

(Q)(P) = (P_R – T – Q₀/e) Q₀ = P_R Q₀ – 1/e Q₀² – TQ₀

(Q)(P) = (P_R – T – \frac{Q_0}{e})Q_0 = P_R Q_0 – \frac{1}{e} Q_0^2 – T Q_0 \\

T appears linearly as TQ₀, which is the same as the tax revenue. All the money goes directly from the landlord to the government, as we want if our goal is to redistribute wealth without raising rent.

But now suppose that the market is not competitive, and by tacit collusion or regulatory capture the landlords can exert some market power; this is quite likely the case in reality. Actually in reality we’re probably somewhere in between monopoly and competition, either oligopoly or monopolistic competition—which I will talk about a good deal more in a later post, I promise.

It could be that demand is still sufficiently high that even with their market power, landlords have an incentive to rent out all their available land, in which case the result will be the same as in the competitive market.

A tax will then fall completely on the landlords as before:

Indeed, in this case it doesn’t really matter that the market is monopolistic; everything is the same as it would be under a competitive market. Notice how if you set n = 0, the monopolistic equations and the competitive equations come out exactly the same. The good news is, this is quite likely our actual situation! So even in the presence of significant market power the land tax can redistribute wealth in just the way we want.

But there are a few other possibilities. One is that demand is not sufficiently high, so that the landlords’ market power causes them to actually hold back some land in order to raise the price:

This will create some of what we call deadweight loss, in which some economic value is wasted. By restricting the land they rent out, the landlords make more profit, but the harm they cause to tenant is created than the profit they gain, so there is value wasted.

Now instead of setting n = 0, we actually set n = infinity. Why? Because the reason that the landlords restrict the land they sell is that their marginal revenue is actually negative beyond that point—they would actually get less money in total if they sold more land. Instead of being bounded by their cost of production (because they have none, the land is there whether they sell it or not), they are bounded by zero. (Once again we’ve hit upon a fundamental concept in economics, particularly macroeconomics, that I don’t have time to talk about today: the zero lower bound.) Thus, they can change quantity all they want (within a certain range) without changing the price, which is equivalent to a supply elasticity of infinity.

Introducing a tax will then exacerbate this deadweight loss (adding DWL2 to the original DWL1), because it provides even more incentive for the landlords to restrict the supply of land:

Q = e/2*(P_R – T)

Q = \frac{e}{2} \left(P_R – T\right)\\

P = 1/2*(P_R – T)

P = \frac{1}{2} \left(P_R – T\right) \\

The quantity Q₀ completely drops out, because it doesn’t matter how much land is available (as long as it’s enough); it only matters how much land it is profitable to rent out.

We can then find the consumer and producer surplus, and see that they are both reduced by the tax. The consumer surplus is as follows:

½ (Q)(P_R – 1/2(P_R – T)) = e/4*(P_R² – T²)

\frac{1}{2}Q \left( P_R – \frac{1}{2}left( P – T \right) \right) = \frac{e}{4}\left( P_R^2 – T^2 \right) \\

This time, the tax does have an effect on reducing the consumer surplus.

The producer surplus, on the other hand, will be:

(Q)(P) = 1/2*(P_R – T)*e/2*(P_R – T) = e/4*(P_R – T)²

(Q)(P) = \frac{1}{2}\left(P_R – T \right) \frac{e}{2} \left(P_R – T\right) = \frac{e}{4} \left(P_R – T)^2 \\

Notice how it is also reduced by the tax—and no longer in a simple linear way.

The tax revenue is now a function of the demand:

TQ = e/2*T(P_R – T)

T Q = \frac{e}{2} T (P_R – T) \\

If you add all these up, you’ll find that the sum is this:

e/2 * (P_R^2 – T^2)

\frac{e}{2} \left(P_R^2 – T^2 \right) \\

The sum is actually reduced by an amount equal to e/2*T^2, which is the deadweight loss.

Finally there is an even worse scenario, in which the tax is so large that it actually creates an incentive to restrict land where none previously existed:

Notice, however, that because the supply of land is inelastic the deadweight loss is still relatively small compared to the huge amount of tax revenue.

But actually this isn’t the whole story, because a land tax provides an incentive to get rid of land that you’re not profiting from. If this incentive is strong enough, the monopolistic power of landlords will disappear, as the unused land gets sold to more landholders or to the government. This is a way of avoiding the tax, but it’s one that actually benefits society, so we don’t mind incentivizing it.

Now, let’s compare this to our current system of property taxes, which include the value of buildings. Buildings are expensive to create, but we build them all the time; the supply of buildings is strongly dependent upon the price at which those buildings will sell. This makes for a supply curve that is somewhat elastic.

If the market were competitive and we had no taxes, it would be optimally efficient:

Property taxes create an incentive to produce fewer buildings, and this creates deadweight loss. Notice that this happens even if the market is perfectly competitive:

Since both n and e are finite and nonzero, we’d need to use the whole equations: Since the algebra is such a mess, I don’t see any reason to subject you to it; but suffice it to say, the T does not drop out. Tenants do see their consumer surplus reduced, and the larger the tax the more this is so.

Now, suppose that the market for buildings is monopolistic, as it most likely is. This would create deadweight loss even in the absence of a tax:

But a tax will add even more deadweight loss:

Once again, we’d need the full equations, and once again it’s a mess; but the result is, as before, that the tax gets passed on to the tenants in the form of more restricted sales and therefore higher rents.

Because of the finite supply elasticity, there’s no way that the tax can avoid raising the rent. As long as landlords have to pay more taxes when they build more or better buildings, they are going to raise the rent in those buildings accordingly—whether the market is competitive or not.

If the market is indeed monopolistic, there may be ways to bring the rent down: suppose we know what the competitive market price of rent should be, and we can establish rent control to that effect. If we are truly correct about the price to set, this rent control can not only reduce rent, it can actually reduce the deadweight loss:

But if we set the rent control too low, or don’t properly account for the varying cost of different buildings, we can instead introduce a new kind of deadweight loss, by making it too expensive to make new buildings.

In fact, what actually seems to happen is more complicated than that—because otherwise the number of buildings is obviously far too small, rent control is usually set to affect some buildings and not others. So what seems to happen is that the rent market fragments into two markets: One, which is too small, but very good for those few who get the chance to use it; and the other, which is unaffected by the rent control but is more monopolistic and therefore raises prices even further. This is why almost all economists are opposed to rent control (PDF); it doesn’t solve the problem of high rent and simply causes a whole new set of problems.

A land tax with a basic income, on the other hand, would help poor people at least as much as rent control presently does—probably a good deal more—without discouraging the production and maintenance of new apartment buildings.

But now we come to a key point: The land tax must be uniform per hectare.

If it is instead based on the value of the land, then this acts like a finite elasticity of supply; it provides an incentive to reduce the value of your own land in order to avoid the tax. As I showed above, this is particularly pernicious if the market is monopolistic, but even if it is competitive the effect is still there.

One exception I can see is if there are different tiers based on broad classes of land that it’s difficult to switch between, such as “land in Manhattan” versus “land in Brooklyn” or “desert land” versus “forest land”. But even this policy would have to be done very carefully, because any opportunity to substitute can create an opportunity to pass on the tax to someone else—for instance if land taxes are lower in Brooklyn developers are going to move to Brooklyn. Maybe we want that, in which case that is a good policy; but we should be aware of these sorts of additional consequences. The simplest way to avoid all these problems is to simply make the land tax uniform. And given the quantities we’re talking about—less than $3000 per hectare per year—it should be affordable for anyone except the very large landholders we’re trying to distribute wealth from in the first place.

The good news is, most economists would probably be on board with this proposal. After all, the neoclassical models themselves say it would be more efficient than our current system of rent control and property taxes—and the idea is at least as old as Adam Smith. Perhaps we can finally change the fact that the rent is too damn high.

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Human Economics

Cognitive development economics: Understanding the mind in order to feed the world

Year: 2015