What exactly is “gentrification”? How should we deal with it?

Nov 26, JDN 2458083

“Gentrification” is a word that is used in a variety of mutually-inconsistent ways. If you compare the way social scientists use it to the way journalists use it, for example, they are almost completely orthogonal.

The word “gentrification” is meant to invoke the concept of a feudal gentry—a hereditary landed class that extracts rents from the rest of the population while contributing little or nothing themselves.

If indeed that is what we are talking about, then obviously this is bad. Moreover, it’s not an entirely unfounded fear; there are some remarkably strong vestiges of feudalism in the developed world, even in the United States where we never formally had a tradition of feudal titles. There really is a significant portion of the world’s wealth held by a handful of billionaire landowner families.

But usually when people say “gentrification” they mean something much broader. Almost any kind of increase in urban real estate prices gets characterized as “gentrification” by at least somebody, and herein lies the problem.

In fact, the kind of change that is most likely to get characterized as “gentrification” isn’t even the rising real estate prices we should be most worried about. People aren’t concerned when the prices of suburban homes double in 20 years. You might think that things that are already too expensive getting more expensive would be the main concern, but on the contrary, people are most likely to cry “gentrification” when housing prices rise in poor areas where housing is cheap.

One of the most common fears about gentrification is that it will displace local residents. In fact, the best quasi-experimental studies show little or no displacement effect. It’s actually mainly middle-class urbanites who get displaced by rising rents. Poor people typically own their homes, and actually benefit from rising housing prices. Young upwardly-mobile middle-class people move to cities to rent apartments near where they work, and tend to assume that’s how everyone lives, but it’s not. Rising rents in a city are far more likely to push out its grad students than they are poor families that have lived there for generations. Part of why displacement does not occur may be because of policies specifically implemented to fight it, such as subsidized housing and rent control. If that’s so, let’s keep on subsidizing housing (though rent control will always be a bad idea).

Nor is gentrification actually a very widespread phenomenon. The majority of poor neighborhoods remain poor indefinitely. In most studies, only about 30% of neighborhoods classified as “gentrifiable” actually end up “gentrifying”. Less than 10% of the neighborhoods that had high poverty rates in 1970 had low poverty rates in 2010.

Most people think gentrification reduces crime, but in the short run the opposite is the case. Robbery and larceny are higher in gentrifying neighborhoods. Criminals are already there, and suddenly they get much more valuable targets to steal from, so they do.

There is also a general perception that gentrification involves White people pushing Black people out, but this is also an overly simplistic view. First of all, a lot of gentrification is led by upwardly-mobile Black and Latino people. Black people who live in gentrified neighborhoods seem to be better off than Black people who live in non-gentrified neighborhoods; though selection bias may contribute to this effect, it can’t be all that strong, or we’d observe a much stronger displacement effect. Moreover, some studies have found that gentrification actually tends to increase the racial diversity of neighborhoods, and may actually help fight urban self-segregation, though it does also tend to increase racial polarization by forcing racial mixing.

What should we conclude from all this? I think the right conclusion is we are asking the wrong question.

Rising housing prices in poor areas aren’t inherently good or inherently bad, and policies designed specifically to increase or decrease housing prices are likely to have harmful side effects. What we need to be focusing on is not houses or neighborhoods but people. Poverty is definitely a problem, for sure. Therefore we should be fighting poverty, not “gentrification”. Directly transfer wealth from the rich to the poor, and then let the housing market fall where it may.

There is still some role for government in urban planning more generally, regarding things like disaster preparedness, infrastructure development, and transit systems. It may even be worthwhile to design regulations or incentives that directly combat racial segregation at the neighborhood level, for, as the Schelling Segregation Model shows, it doesn’t take a large amount of discriminatory preference to have a large impact on socioeconomic outcomes. But don’t waste effort fighting “gentrification”; directly design policies that will incentivize desegregation.

Rising rent as a proportion of housing prices is still bad, and the fundamental distortions in our mortgage system that prevent people from buying houses are a huge problem. But rising housing prices are most likely to be harmful in rich neighborhoods, where housing is already overpriced; in poor neighborhoods where housing is cheap, rising prices might well be a good thing.
In fact, I have a proposal to rapidly raise homeownership across the United States, which is almost guaranteed to work, directly corrects an enormous distortion in financial markets, and would cost about as much as the mortgage interest deduction (which should probably be eliminated, as most economists agree). Give each US adult a one-time grant voucher which gives them $40,000 that can only be spent as a down payment on purchasing a home. Each time someone turns 18, they get a voucher. You only get one over your lifetime, so use it wisely (otherwise the policy could become extremely expensive); but this is an immediate direct transfer of wealth that also reduces your credit constraint. I know I for one would be house-hunting right now if I were offered such a voucher. The mortgage interest deduction means nothing to me, because I can’t afford a down payment. Where the mortgage interest deduction is regressive, benefiting the rich more than the poor, this policy gives everyone the same amount, like a basic income.

In the short run, this policy would probably be expensive, as we’d have to pay out a large number of vouchers at once; but with our current long-run demographic trends, the amortized cost is basically the same as the mortgage interest deduction. And the US government especially should care about the long-run amortized cost, as it is an institution that has lasted over 200 years without ever missing a payment and can currently borrow at negative real interest rates.

How rich are we, really?

Oct 29, JDN 2458056

The most commonly-used measure of a nation’s wealth is its per-capita GDP, which is simply a total of all spending in a country divided by its population. More recently we adjust for purchasing power, giving us GDP per capita at purchasing power parity (PPP).

By this measure, the United States always does well. At most a dozen countries are above us, most of them by a small amount, and all of them are quite small countries. (For fundamental statistical reasons, we should expect both the highest and lowest average incomes to be in the smallest countries.)

But this is only half the story: It tells us how much income a country has, but not how that income is distributed. We should adjust for inequality.

How can we do this? I have devised a method that uses the marginal utility of wealth plus a measure of inequality called the Gini coefficient to work out an estimate of the average utility, instead of the average income.

I then convert back into a dollar figure. This figure is the income everyone would need to have under perfect equality, in order to give the same real welfare as the current system. That is, if we could redistribute wealth in such a way to raise everyone above this value up to it, and lower everyone above this value down to it, the total welfare of the country would not change. This provides a well-founded ranking of which country’s people are actually better off overall, accounting for both overall income and the distribution of that income.

The estimate is sensitive to the precise form I use for marginal utility, so I’ll show you comparisons for three different cases.

The “conservative” estimate uses a risk aversion parameter of 1, which means that utility is logarithmic in income. The real value of a dollar is inversely proportional to the number of dollars you already have.

The medium estimate uses a risk aversion parameter of 2, which means that the real value of a dollar is inversely proportional to the square of the number of dollars you already have.

And then the “liberal” estimate uses a risk aversion parameter of 3, which means that the real value of a dollar is inversely proportional to the cube of the number of dollars you already have.

I’ll compare ten countries, which I think are broadly representative of classes of countries in the world today.

The United States, the world hegemon which needs no introduction.

China, rising world superpower and world’s most populous country.

India, world’s largest democracy and developing economy with a long way to go.

Norway, as representative of the Scandinavian social democracies.

Germany, as representative of continental Europe.

Russia, as representative of the Soviet Union and the Second World bloc.

Saudi Arabia, as representative of the Middle East petrostates.

Botswana, as representative of African developing economies.

Zimbabwe, as representative of failed Sub-Saharan African states.

Brazil, as representative of Latin American developing economies.
The ordering of these countries by GDP per-capita PPP is probably not too surprising:

  1. Norway 69,249
  2. United States 57,436
  3. Saudi Arabia 55,158
  4. Germany 48,111
  5. Russia 26,490
  6. Botswana 17,042
  7. China 15,399
  8. Brazil 15,242
  9. India 6,616
  10. Zimbabwe 1,970

Norway is clearly the richest, the US, Saudi Arabia, and Germany are quite close, Russia is toward the upper end, Botswana, China, and Brazil are close together in the middle, and then India and especially Zimbabwe are extremely poor.

But now let’s take a look at the inequality in each country, as measured by the Gini coefficient (which ranges from 0, perfect equality, to 1, total inequality).

  1. Botswana 0.605
  2. Zimbabwe 0.501
  3. Brazil 0.484
  4. United States 0.461
  5. Saudi Arabia 0.459
  6. China 0.422
  7. Russia 0.416
  8. India 0.351
  9. Germany 0.301
  10. Norway 0.259

The US remains (alarmingly) close to Saudi Arabia by this measure. Most of the countries are between 40 and 50. But Botswana is astonishingly unequal, while Germany and Norway are much more equal.

With that in mind, let’s take a look at the inequality-adjusted per-capita GDP. First, the conservative estimate, with a parameter of 1:

  1. Norway 58700
  2. United States 42246
  3. Saudi Arabia 40632
  4. Germany 39653
  5. Russia 20488
  6. China 11660
  7. Botswana 11138
  8. Brazil 11015
  9. India 5269
  10. Zimbabwe 1405

So far, ordering of nations is almost the same compared to what we got with just per-capita GDP. But notice how Germany has moved up closer to the US and Botswana actually fallen behind China.

Now let’s try a parameter of 2, which I think is the closest to the truth:

  1. Norway 49758
  2. Germany 32683
  3. United States 31073
  4. Saudi Arabia 29931
  5. Russia 15581
  6. China 8829
  7. Brazil 7961
  8. Botswana 7280
  9. India 4197
  10. Zimbabwe 1002

Now we have seen some movement. Norway remains solidly on top, but Germany has overtaken the United States and Botswana has fallen behind not only China, but also Brazil. Russia remains in the middle, and India and Zimbawbe remain on the bottom.

Finally, let’s try a parameter of 3.

  1. Norway 42179
  2. Germany 26937
  3. United States 22855
  4. Saudi Arabia 22049
  5. Russia 11849
  6. China 6685
  7. Brazil 5753
  8. Botswana 4758
  9. India 3343
  10. Zimbabwe 715

Norway has now pulled far and away ahead of everyone else. Germany is substantially above the United States. China has pulled away from Brazil, and Botswana has fallen almost all the way to the level of India. Zimbabwe, as always, is at the very bottom.

Let’s compare this to another measure of national well-being, the Inequality-Adjusted Human Development Index (which goes from 0, the worst, to 1 the best). This index combines education, public health, and income, and adjusts for inequality. It seems to be a fairly good measure of well-being, but it’s very difficult to compile data for, so a lot of countries are missing (including Saudi Arabia); plus the precise weightings on everything are very ad hoc.

  1. Norway 0.898
  2. Germany 0.859
  3. United States 0.796
  4. Russia 0.725
  5. China 0.543
  6. Brazil 0.531
  7. India 0.435
  8. Botswana 0.433
  9. Zimbabwe 0.371

Other than putting India above Botswana, this ordering is the same as what we get from my (much easier to calculate and theoretically more well-founded) index with either a parameter of 2 or 3.

What’s more, my index can be directly interpreted: The average standard of living in the US is as if everyone were making $31,073 per year. What exactly is an IHDI index of 0.796 supposed to mean? We’re… 79.6% of the way to the best possible country?

In any case, there’s a straightforward (if not terribly surprising) policy implication here: Inequality is a big problem.

In particular, inequality in the US is clearly too high. Despite an overall income that is very high, almost 18 log points higher than Germany, our overall standard of living is actually about 5 log points lower due to our higher level of inequality. While our average income is only 19 log points lower than Norway, our actual standard of living is 47 log points lower.

Inequality in Botswana also means that their recent astonishing economic growth is not quite as impressive as it at first appeared. Many people are being left behind. While in raw income they appear to be 10 log points ahead of China and only 121 log points behind the US, once you adjust for their very high inequality they are 19 log points behind China, and 145 log points behind the US.

Of course, some things don’t change. Norway is still on top, and Zimbabwe is still on the bottom.

This is one of the worst wildfire seasons in American history. But it won’t be for long.

Oct 22, JDN 2458049

At least 38 people have now been killed by the wildfires that are still ongoing in California; in addition, 5700 buildings have been destroyed and 190,000 acres of land burned. The State of California keeps an updated map of all the fires that are ongoing and how well-controlled they are; it’s not a pretty sight.

While the particular details are extreme, this is not an isolated incident. This year alone, wildfires have destroyed over 8 million acres of land in the US. In 2015, that figure was 10 million acres.

Property damage for this year’s wildfires in California is estimated at over $65 billion. That’s more than what Trump recently added to the military budget, and getting close to our total spending on food stamps.

There is a very clear upward trend in the scale and intensity of wildfires just over the last 50 years, and the obvious explanation is climate change. As climate change gets worse, these numbers are projected to increase between 30% and 50% by the 2040s. We still haven’t broken the record of fire damage in 1910, but as the upward trend continues we might soon enough.

It’s important to keep the death tolls in perspective; much as with hurricanes, our evacuation protocols and first-response agencies do their jobs very well, and as a result we’ve been averaging only about 10 wildfire deaths per year over the whole United States for the last century. In a country of over 300 million people, that’s really an impressively small number. That number has also been trending upward, however, so we shouldn’t get complacent.

Climate change isn’t the only reason these fires are especially damaging. It also matters where you build houses. We have been expanding our urban sprawl into fire-prone zones, and that is putting a lot of people in danger. Since 1990, over 60% of new homes were built in “wildland-urban interface areas” that are at higher risk.

Why are we doing this? Because housing prices in urban centers are too expensive for people to live there, but that is where most of the jobs are. So people have little choice but to live in exurbs and suburbs closer to the areas where fires are worst. That’s right: The fires are destroying homes and killing people because the rent is too damn high.

We need to find a solution to this problem of soaring housing prices. And since housing is such a huge proportion of our total expenditure—we spend more on housing than we do on all government spending combined—this would have an enormous impact on our entire economy. If you compare the income of a typical American today to most of the world’s population, or even to a typical American a century ago, we should feel extremely rich, but we don’t—largely because we spend so much of it just on keeping a roof over our heads.

Real estate is also a major driver of economic inequality. Wealth inequality is highest in urban centers where homeownership is rare. The large wealth gaps between White and non-White Americans can be in large part attributed to policies that made homeownership much more difficult for non-White people. Housing value inequality and overall wealth inequality are very strongly correlated. The high inequality in housing prices is making it far more difficult for people to move from poor regions to rich regions, holding back one of the best means we had for achieving more equal incomes.

Moreover, the rise in capital income share since the 1970s is driven almost entirely by real estate, rather than actual physical capital. The top 10% richest housing communities constitute over 52% of the total housing wealth in the US.

There is a lot of debate about what exactly causes these rising housing prices. No doubt, there are many factors contributing, from migration patterns to zoning regulations to income inequality in general. In a later post, I’ll get into why I think many of the people who think they are fighting the problem are actually making it worse, and suggest some ideas for what they should be doing instead.

What we lose by aggregating

Jun 25, JDN 2457930

One of the central premises of current neoclassical macroeconomics is the representative agent: Rather than trying to keep track of all the thousands of firms, millions of people, and billions of goods and in a national economy, we aggregate everything up into a single worker/consumer and a single firm producing and consuming a single commodity.

This sometimes goes under the baffling misnomer of microfoundations, which would seem to suggest that it carries detailed information about the microeconomic behavior underlying it; in fact what this means is that the large-scale behavior is determined by some sort of (perfectly) rational optimization process as if there were just one person running the entire economy optimally.

First of all, let me say that some degree of aggregation is obviously necessary. Literally keeping track of every single transaction by every single person in an entire economy would require absurd amounts of data and calculation. We might have enough computing power to theoretically try this nowadays, but then again we might not—and in any case such a model would very rapidly lose sight of the forest for the trees.

But it is also clearly possible to aggregate too much, and most economists don’t seem to appreciate this. They cite a couple of famous theorems (like the Gorman Aggregation Theorem) involving perfectly-competitive firms and perfectly-rational identical consumers that offer a thin veneer of justification for aggregating everything into one, and then go on with their work as if this meant everything were fine.

What’s wrong with such an approach?

Well, first of all, a representative agent model can’t talk about inequality at all. It’s not even that a representative agent model says inequality is good, or not a problem; it lacks the capacity to even formulate the concept. Trying to talk about income or wealth inequality in a representative agent model would be like trying to decide whether your left hand is richer than your right hand.

It’s also nearly impossible to talk about poverty in a representative agent model; the best you can do is talk about a country’s overall level of development, and assume (not without reason) that a country with a per-capita GDP of $1,000 probably has a lot more poverty than a country with a per-capita GDP of $50,000. But two countries with the same per-capita GDP can have very different poverty rates—and indeed, the cynic in me wonders if the reason we’re reluctant to use inequality-adjusted measures of development is precisely that many American economists fear where this might put the US in the rankings. The Human Development Index was a step in the right direction because it includes things other than money (and as a result Saudi Arabia looks much worse and Cuba much better), but it still aggregates and averages everything, so as long as your rich people are doing well enough they can compensate for how badly your poor people are doing.

Nor can you talk about oligopoly in a representative agent model, as there is always only one firm, which for some reason chooses to act as if it were facing competition instead of rationally behaving as a monopoly. (This is not quite as nonsensical as it sounds, as the aggregation actually does kind of work if there truly are so many firms that they are all forced down to zero profit by fierce competition—but then again, what market is actually like that?) There is no market share, no market power; all are at the mercy of the One True Price.

You can still talk about externalities, sort of; but in order to do so you have to set up this weird doublethink phenomenon where the representative consumer keeps polluting their backyard and then can’t figure out why their backyard is so darn polluted. (I suppose humans do seem to behave like that sometimes; but wait, I thought you believed people were rational?) I think this probably confuses many an undergrad, in fact; the models we teach them about externalities generally use this baffling assumption that people consider one set of costs when making their decisions and then bear a different set of costs from the outcome. If you can conceptualize the idea that we’re aggregating across people and thinking “as if” there were a representative agent, you can ultimately make sense of this; but I think a lot of students get really confused by it.

Indeed, what can you talk about with a representative agent model? Economic growth and business cycles. That’s… about it. These are not minor issues, of course; indeed, as Robert Lucas famously said:

The consequences for human welfare involved in questions like these [on economic growth] are simply staggering: once one starts to think about them, it is hard to think about anything else.

I certainly do think that studying economic growth and business cycles should be among the top priorities of macroeconomics. But then, I also think that poverty and inequality should be among the top priorities, and they haven’t been—perhaps because the obsession with representative agent models make that basically impossible.

I want to be constructive here; I appreciate that aggregating makes things much easier. So what could we do to include some heterogeneity without too much cost in complexity?

Here’s one: How about we have p firms, making q types of goods, sold to n consumers? If you want you can start by setting all these numbers equal to 2; simply going from 1 to 2 has an enormous effect, as it allows you to at least say something about inequality. Getting them as high as 100 or even 1000 still shouldn’t be a problem for computing the model on an ordinary laptop. (There are “econophysicists” who like to use these sorts of agent-based models, but so far very few economists take them seriously. Partly that is justified by their lack of foundational knowledge in economics—the arrogance of physicists taking on a new field is legendary—but partly it is also interdepartmental turf war, as economists don’t like the idea of physicists treading on their sacred ground.) One thing that really baffles me about this is that economists routinely use computers to solve models that can’t be calculated by hand, but it never seems to occur to them that they could have started at the beginning planning to make the model solvable only by computer, and that would spare them from making the sort of heroic assumptions they are accustomed to making—assumptions that only made sense when they were used to make a model solvable that otherwise wouldn’t be.

You could also assign a probability distribution over incomes; that can get messy quickly, but we actually are fortunate that the constant relative risk aversion utility function and the Pareto distribution over incomes seem to fit the data quite well—as the product of those two things is integrable by hand. As long as you can model how your policy affects this distribution without making that integral impossible (which is surprisingly tricky), you can aggregate over utility instead of over income, which is a lot more reasonable as a measure of welfare.

And really I’m only scratching the surface here. There are a vast array of possible new approaches that would allow us to extend macroeconomic models to cover heterogeneity; the real problem is an apparent lack of will in the community to make such an attempt. Most economists still seem very happy with representative agent models, and reluctant to consider anything else—often arguing, in fact, that anything else would make the model less microfounded when plainly the opposite is the case.

 

Why “marginal productivity” is no excuse for inequality

May 28, JDN 2457902

In most neoclassical models, workers are paid according to their marginal productivity—the additional (market) value of goods that a firm is able to produce by hiring that worker. This is often used as an excuse for inequality: If someone can produce more, why shouldn’t they be paid more?

The most extreme example of this is people like Maura Pennington writing for Forbes about how poor people just need to get off their butts and “do something”; but there is a whole literature in mainstream economics, particularly “optimal tax theory”, arguing based on marginal productivity that we should tax the very richest people the least and never tax capital income. The Chamley-Judd Theorem famously “shows” (by making heroic assumptions) that taxing capital just makes everyone worse off because it reduces everyone’s productivity.

The biggest reason this is wrong is that there are many, many reasons why someone would have a higher income without being any more productive. They could inherit wealth from their ancestors and get a return on that wealth; they could have a monopoly or some other form of market power; they could use bribery and corruption to tilt government policy in their favor. Indeed, most of the top 0.01% do literally all of these things.

But even if you assume that pay is related to productivity in competitive markets, the argument is not nearly as strong as it may at first appear. Here I have a simple little model to illustrate this.

Suppose there are 10 firms and 10 workers. Suppose that firm 1 has 1 unit of effective capital (capital adjusted for productivity), firm 2 has 2 units, and so on up to firm 10 which has 10 units. And suppose that worker 1 has 1 unit of so-called “human capital”, representing their overall level of skills and education, worker 2 has 2 units, and so on up to worker 10 with 10 units. Suppose each firm only needs one worker, so this is a matching problem.

Furthermore, suppose that productivity is equal to capital times human capital: That is, if firm 2 hired worker 7, they would make 2*7 = $14 of output.

What will happen in this market if it converges to equilibrium?

Well, first of all, the most productive firm is going to hire the most productive worker—so firm 10 will hire worker 10 and produce $100 of output. What wage will they pay? Well, they need a wage that is high enough to keep worker 10 from trying to go elsewhere. They should therefore pay a wage of $90—the next-highest firm productivity times the worker’s productivity. That’s the highest wage any other firm could credibly offer; so if they pay this wage, worker 10 will not have any reason to leave.

Now the problem has been reduced to matching 9 firms to 9 workers. Firm 9 will hire worker 9, making $81 of output, and paying $72 in wages.

And so on, until worker 1 at firm 1 produces $1 and receives… $0. Because there is no way for worker 1 to threaten to leave, in this model they actually get nothing. If I assume there’s some sort of social welfare system providing say $0.50, then at least worker 1 can get that $0.50 by threatening to leave and go on welfare. (This, by the way, is probably the real reason firms hate social welfare spending; it gives their workers more bargaining power and raises wages.) Or maybe they have to pay that $0.50 just to keep the worker from starving to death.

What does inequality look like in this society?
Well, the most-productive firm only has 10 times as much capital as the least-productive firm, and the most-educated worker only has 10 times as much skill as the least-educated worker, so we might think that incomes would vary only by a factor of 10.

But in fact they vary by a factor of over 100.

The richest worker makes $90, while the poorest worker makes $0.50. That’s a ratio of 180. (Still lower than the ratio of the average CEO to their average employee in the US, by the way.) The worker is 10 times as productive, but they receive 180 times as much income.

The firm profits vary along a more reasonable scale in this case; firm 1 makes a profit of $0.50 while firm 10 makes a profit of $10. Indeed, except for firm 1, firm n always makes a profit of $n. So that’s very nearly a linear scaling in productivity.

Where did this result come from? Why is it so different from the usual assumptions? All I did was change one thing: I allowed for increasing returns to scale.

If you make the usual assumption of constant returns to scale, this result can’t happen. Multiplying all the inputs by 10 should just multiply the output by 10, by assumption—since that is the definition of constant returns to scale.

But if you look at the structure of real-world incomes, it’s pretty obvious that we don’t have constant returns to scale.

If we had constant returns to scale, we should expect that wages for the same person should only vary slightly if that person were to work in different places. In particular, to have a 2-fold increase in wage for the same worker you’d need more than a 2-fold increase in capital.

This is a bit counter-intuitive, so let me explain a bit further. If a 2-fold increase in capital results in a 2-fold increase in wage for a given worker, that’s increasing returns to scale—indeed, it’s precisely the production function I assumed above.
If you had constant returns to scale, a 2-fold increase in wage would require something like an 8-fold increase in capital. This is because you should get a 2-fold increase in total production by doubling everything—capital, labor, human capital, whatever else. So doubling capital by itself should produce a much weaker effect. For technical reasons I’d rather not get into at the moment, usually it’s assumed that production is approximately proportional to capital to the one-third power—so to double production you need to multiply capital by 2^3 = 8.

I wasn’t able to quickly find really good data on wages for the same workers across different countries, but this should at least give a rough idea. In Mumbai, the minimum monthly wage for a full-time worker is about $80. In Shanghai, it is about $250. If you multiply out the US federal minimum wage of $7.25 per hour by 40 hours by 4 weeks, that comes to $1160 per month.

Of course, these are not the same workers. Even an “unskilled” worker in the US has a lot more education and training than a minimum-wage worker in India or China. But it’s not that much more. Maybe if we normalize India to 1, China is 3 and the US is 10.

Likewise, these are not the same jobs. Even a minimum wage job in the US is much more capital-intensive and uses much higher technology than most jobs in India or China. But it’s not that much more. Again let’s say India is 1, China is 3 and the US is 10.

If we had constant returns to scale, what should the wages be? Well, for India at productivity 1, the wage is $80. So for China at productivity 3, the wage should be $240—it’s actually $250, close enough for this rough approximation. But the US wage should be $800—and it is in fact $1160, 45% larger than we would expect by constant returns to scale.

Let’s try comparing within a particular industry, where the differences in skill and technology should be far smaller. The median salary for a software engineer in India is about 430,000 INR, which comes to about $6,700. If that sounds rather low for a software engineer, you’re probably more accustomed to the figure for US software engineers, which is $74,000. That is a factor of 11 to 1. For the same job. Maybe US software engineers are better than Indian software engineers—but are they that much better? Yes, you can adjust for purchasing power and shrink the gap: Prices in the US are about 4 times as high as those in India, so the real gap might be 3 to 1. But these huge price differences themselves need to be explained somehow, and even 3 to 1 for the same job in the same industry is still probably too large to explain by differences in either capital or education, unless you allow for increasing returns to scale.

In most industries, we probably don’t have quite as much increasing returns to scale as I assumed in my simple model. Workers in the US don’t make 100 times as much as workers in India, despite plausibly having both 10 times as much physical capital and 10 times as much human capital.

But in some industries, this model might not even be enough! The most successful authors and filmmakers, for example, make literally thousands of times as much money as the average author or filmmaker in their own country. J.K. Rowling has almost $1 billion from writing the Harry Potter series; this is despite having literally the same amount of physical capital and probably not much more human capital than the average author in the UK who makes only about 11,000 GBP—which is about $14,000. Harry Potter and the Philosopher’s Stone is now almost exactly 20 years old, which means that Rowling made an average of $50 million per year, some 3500 times as much as the average British author. Is she better than the average British author? Sure. Is she three thousand times better? I don’t think so. And we can’t even make the argument that she has more capital and technology to work with, because she doesn’t! They’re typing on the same laptops and using the same printing presses. Either the return on human capital for British authors is astronomical, or something other than marginal productivity is at work here—and either way, we don’t have anything close to constant returns to scale.

What can we take away from this? Well, if we don’t have constant returns to scale, then even if wage rates are proportional to marginal productivity, they aren’t proportional to the component of marginal productivity that you yourself bring. The same software developer makes more at Microsoft than at some Indian software company, the same doctor makes more at a US hospital than a hospital in China, the same college professor makes more at Harvard than at a community college, and J.K. Rowling makes three thousand times as much as the average British author—therefore we can’t speak of marginal productivity as inhering in you as an individual. It is an emergent property of a production process that includes you as a part. So even if you’re entirely being paid according to “your” productivity, it’s not really your productivity—it’s the productivity of the production process you’re involved in. A myriad of other factors had to snap into place to make your productivity what it is, most of which you had no control over. So in what sense, then, can we say you earned your higher pay?

Moreover, this problem becomes most acute precisely when incomes diverge the most. The differential in wages between two welders at the same auto plant may well be largely due to their relative skill at welding. But there’s absolutely no way that the top athletes, authors, filmmakers, CEOs, or hedge fund managers could possibly make the incomes they do by being individually that much more productive.

Markets value rich people more

Feb 26, JDN 2457811

Competitive markets are optimal at maximizing utility, as long as you value rich people more.

That is literally a theorem in neoclassical economics. I had previously thought that this was something most economists didn’t realize; I had delusions of grandeur that maybe I could finally convince them that this is the case. But no, it turns out this is actually a well-known finding; it’s just that somehow nobody seems to care. Or if they do care, they never talk about it. For all the thousands of papers and articles about the distortions created by minimum wage and capital gains tax, you’d think someone could spare the time to talk about the vastly larger fundamental distortions created by the structure of the market itself.

It’s not as if this is something completely hopeless we could never deal with. A basic income would go a long way toward correcting this distortion, especially if coupled with highly progressive taxes. By creating a hard floor and a soft ceiling on income, you can reduce the inequality that makes these distortions so large.

The basics of the theorem are quite straightforward, so I think it’s worth explaining them here. It’s extremely general; it applies anywhere that goods are allocated by market prices and different individuals have wildly different amounts of wealth.

Suppose that each person has a certain amount of wealth W to spend. Person 1 has W1, person 2 has W2, and so on. They all have some amount of happiness, defined by a utility function, which I’ll assume is only dependent on wealth; this is a massive oversimplification of course, but it wouldn’t substantially change my conclusions to include other factors—it would just make everything more complicated. (In fact, including altruistic motives would make the whole argument stronger, not weaker.) Thus I can write each person’s utility as a function U(W). The rate of change of this utility as wealth increases, the marginal utility of wealth, is denoted U'(W).

By the law of diminishing marginal utility, the marginal utility of wealth U'(W) is decreasing. That is, the more wealth you have, the less each new dollar is worth to you.

Now suppose people are buying goods. Each good C provides some amount of marginal utility U'(C) to the person who buys it. This can vary across individuals; some people like Pepsi, others Coke. This marginal utility is also decreasing; a house is worth a lot more to you if you are living in the street than if you already have a mansion. Ideally we would want the goods to go to the people who want them the most—but as you’ll see in a moment, markets systematically fail to do this.

If people are making their purchases rationally, each person’s willingness-to-pay P for a given good C will be equal to their marginal utility of that good, divided by their marginal utility of wealth:

P = U'(C)/U'(W)

Now consider this from the perspective of society as a whole. If you wanted to maximize utility, you’d equalize marginal utility across individuals (by the Extreme Value Theorem). The idea is that if marginal utility is higher for one person, you should give that person more, because the benefit of what you give them will be larger that way; and if marginal utility is lower for another person, you should give that person less, because the benefit of what you give them will be smaller. When everyone is equal, you are at the maximum.

But market prices don’t actually do this. Instead they equalize over willingness-to-pay. So if you’ve got two individuals 1 and 2, instead of having this:

U'(C1) = U'(C2)

you have this:

P1 = P2

which translates to:

U'(C1)/U'(W1) = U'(C2)/U'(W2)

If the marginal utilities were the same, U'(W1) = U'(W2), we’d be fine; these would give the same results. But that would only happen if W1 = W2, that is, if the two individuals had the same amount of wealth.

Now suppose we were instead maximizing weighted utility, where each person gets a weighting factor A based on how “important” they are or something. If your A is higher, your utility matters more. If we maximized this new weighted utility, we would end up like this:

A1*U'(C1) = A2*U'(C2)

Because person 1’s utility counts for more, their marginal utility also counts for more. This seems very strange; why are we valuing some people more than others? On what grounds?

Yet this is effectively what we’ve already done by using market prices.
Just set:
A = 1/U'(W)

Since marginal utility of wealth is decreasing, 1/U'(W) is higher precisely when W is higher.

How much higher? Well, that depends on the utility function. The two utility functions I find most plausible are logarithmic and harmonic. (Actually I think both apply, one to other-directed spending and the other to self-directed spending.)

If utility is logarithmic:

U = ln(W)

Then marginal utility is inversely proportional:

U'(W) = 1/W

In that case, your value as a human being, as spoken by the One True Market, is precisely equal to your wealth:

A = 1/U'(W) = W

If utility is harmonic, matters are even more severe.

U(W) = 1-1/W

Marginal utility goes as the inverse square of wealth:

U'(W) = 1/W^2

And thus your value, according to the market, is equal to the square of your wealth:

A = 1/U'(W) = W^2

What are we really saying here? Hopefully no one actually believes that Bill Gates is really morally worth 400 trillion times as much as a starving child in Malawi, as the calculation from harmonic utility would imply. (Bill Gates himself certainly doesn’t!) Even the logarithmic utility estimate saying that he’s worth 20 million times as much is pretty hard to believe.

But implicitly, the market “believes” that, because when it decides how to allocate resources, something that is worth 1 microQALY to Bill Gates (about the value a nickel dropped on the floor to you or I) but worth 20 QALY (twenty years of life!) to the Malawian child, will in either case be priced at $8,000, and since the child doesn’t have $8,000, it will probably go to Mr. Gates. Perhaps a middle-class American could purchase it, provided it was worth some 0.3 QALY to them.

Now consider that this is happening in every transaction, for every good, in every market. Goods are not being sold to the people who get the most value out of them; they are being sold to the people who have the most money.

And suddenly, the entire edifice of “market efficiency” comes crashing down like a house of cards. A global market that quite efficiently maximizes willingness-to-pay is so thoroughly out of whack when it comes to actually maximizing utility that massive redistribution of wealth could enormously increase human welfare, even if it turned out to cut our total output in half—if utility is harmonic, even if it cut our total output to one-tenth its current value.

The only way to escape this is to argue that marginal utility of wealth is not decreasing, or at least decreasing very, very slowly. Suppose for instance that utility goes as the 0.9 power of wealth:

U(W) = W^0.9

Then marginal utility goes as the -0.1 power of wealth:

U'(W) = 0.9 W^(-0.1)

On this scale, Bill Gates is only worth about 5 times as much as the Malawian child, which in his particular case might actually be too small—if a trolley is about to kill either Bill Gates or 5 Malawian children, I think I save Bill Gates, because he’ll go on to save many more than 5 Malawian children. (Of course, substitute Donald Trump or Charles Koch and I’d let the trolley run over him without a second thought if even a single child is at stake, so it’s not actually a function of wealth.) In any case, a 5 to 1 range across the whole range of human wealth is really not that big a deal. It would introduce some distortions, but not enough to justify any redistribution that would meaningfully reduce overall output.

Of course, that commits you to saying that $1 to a Malawian child is only worth about $1.50 to you or I and $5 to Bill Gates. If you can truly believe this, then perhaps you can sleep at night accepting the outcomes of neoclassical economics. But can you, really, believe that? If you had the choice between an intervention that would give $100 to each of 10,000 children in Malawi, and another that would give $50,000 to each of 100 billionaires, would you really choose the billionaires? Do you really think that the world would be better off if you did?

We don’t have precise measurements of marginal utility of wealth, unfortunately. At the moment, I think logarithmic utility is the safest assumption; it’s about the slowest decrease that is consistent with the data we have and it is very intuitive and mathematically tractable. Perhaps I’m wrong and the decrease is even slower than that, say W^(-0.5) (then the market only values billionaires as worth thousands of times as much as starving children). But there’s no way you can go as far as it would take to justify our current distribution of wealth. W^(-0.1) is simply not a plausible value.

And this means that free markets, left to their own devices, will systematically fail to maximize human welfare. We need redistribution—a lot of redistribution. Don’t take my word for it; the math says so.

Bigotry is more powerful than the market

Nov 20, JDN 2457683

If there’s one message we can take from the election of Donald Trump, it is that bigotry remains a powerful force in our society. A lot of autoflagellating liberals have been trying to explain how this election result really reflects our failure to help people displaced by technology and globalization (despite the fact that personal income and local unemployment had negligible correlation with voting for Trump), or Hillary Clinton’s “bad campaign” that nonetheless managed the same proportion of Democrat turnout that re-elected her husband in 1996.

No, overwhelmingly, the strongest predictor of voting for Trump was being White, and living in an area where most people are White. (Well, actually, that’s if you exclude authoritarianism as an explanatory variable—but really I think that’s part of what we’re trying to explain.) Trump voters were actually concentrated in areas less affected by immigration and globalization. Indeed, there is evidence that these people aren’t racist because they have anxiety about the economy—they are anxious about the economy because they are racist. How does that work? Obama. They can’t believe that the economy is doing well when a Black man is in charge. So all the statistics and even personal experiences mean nothing to them. They know in their hearts that unemployment is rising, even as the BLS data clearly shows it’s falling.

The wide prevalence and enormous power of bigotry should be obvious. But economists rarely talk about it, and I think I know why: Their models say it shouldn’t exist. The free market is supposed to automatically eliminate all forms of bigotry, because they are inefficient.

The argument for why this is supposed to happen actually makes a great deal of sense: If a company has the choice of hiring a White man or a Black woman to do the same job, but they know that the market wage for Black women is lower than the market wage for White men (which it most certainly is), and they will do the same quality and quantity of work, why wouldn’t they hire the Black woman? And indeed, if human beings were rational profit-maximizers, this is probably how they would think.

More recently some neoclassical models have been developed to try to “explain” this behavior, but always without daring to give up the precious assumption of perfect rationality. So instead we get the two leading neoclassical theories of discrimination, which are statistical discrimination and taste-based discrimination.

Statistical discrimination is the idea that under asymmetric information (and we surely have that), features such as race and gender can act as signals of quality because they are correlated with actual quality for various reasons (usually left unspecified), so it is not irrational after all to choose based upon them, since they’re the best you have.

Taste-based discrimination is the idea that people are rationally maximizing preferences that simply aren’t oriented toward maximizing profit or well-being. Instead, they have this extra term in their utility function that says they should also treat White men better than women or Black people. It’s just this extra thing they have.

A small number of studies have been done trying to discern which of these is at work.
The correct answer, of course, is neither.

Statistical discrimination, at least, could be part of what’s going on. Knowing that Black people are less likely to be highly educated than Asians (as they definitely are) might actually be useful information in some circumstances… then again, you list your degree on your resume, don’t you? Knowing that women are more likely to drop out of the workforce after having a child could rationally (if coldly) affect your assessment of future productivity. But shouldn’t the fact that women CEOs outperform men CEOs be incentivizing shareholders to elect women CEOs? Yet that doesn’t seem to happen. Also, in general, people seem to be pretty bad at statistics.

The bigger problem with statistical discrimination as a theory is that it’s really only part of a theory. It explains why not all of the discrimination has to be irrational, but some of it still does. You need to explain why there are these huge disparities between groups in the first place, and statistical discrimination is unable to do that. In order for the statistics to differ this much, you need a past history of discrimination that wasn’t purely statistical.

Taste-based discrimination, on the other hand, is not a theory at all. It’s special pleading. Rather than admit that people are failing to rationally maximize their utility, we just redefine their utility so that whatever they happen to be doing now “maximizes” it.

This is really what makes the Axiom of Revealed Preference so insidious; if you really take it seriously, it says that whatever you do, must by definition be what you preferred. You can’t possibly be irrational, you can’t possibly be making mistakes of judgment, because by definition whatever you did must be what you wanted. Maybe you enjoy bashing your head into a wall, who am I to judge?

I mean, on some level taste-based discrimination is what’s happening; people think that the world is a better place if they put women and Black people in their place. So in that sense, they are trying to “maximize” some “utility function”. (By the way, most human beings behave in ways that are provably inconsistent with maximizing any well-defined utility function—the Allais Paradox is a classic example.) But the whole framework of calling it “taste-based” is a way of running away from the real explanation. If it’s just “taste”, well, it’s an unexplainable brute fact of the universe, and we just need to accept it. If people are happier being racist, what can you do, eh?

So I think it’s high time to start calling it what it is. This is not a question of taste. This is a question of tribal instinct. This is the product of millions of years of evolution optimizing the human brain to act in the perceived interest of whatever it defines as its “tribe”. It could be yourself, your family, your village, your town, your religion, your nation, your race, your gender, or even the whole of humanity or beyond into all sentient beings. But whatever it is, the fundamental tribe is the one thing you care most about. It is what you would sacrifice anything else for.

And what we learned on November 9 this year is that an awful lot of Americans define their tribe in very narrow terms. Nationalistic and xenophobic at best, racist and misogynistic at worst.

But I suppose this really isn’t so surprising, if you look at the history of our nation and the world. Segregation was not outlawed in US schools until 1955, and there are women who voted in this election who were born before American women got the right to vote in 1920. The nationalistic backlash against sending jobs to China (which was one of the chief ways that we reduced global poverty to its lowest level ever, by the way) really shouldn’t seem so strange when we remember that over 100,000 Japanese-Americans were literally forcibly relocated into camps as recently as 1942. The fact that so many White Americans seem all right with the biases against Black people in our justice system may not seem so strange when we recall that systemic lynching of Black people in the US didn’t end until the 1960s.

The wonder, in fact, is that we have made as much progress as we have. Tribal instinct is not a strange aberration of human behavior; it is our evolutionary default setting.

Indeed, perhaps it is unreasonable of me to ask humanity to change its ways so fast! We had millions of years to learn how to live the wrong way, and I’m giving you only a few centuries to learn the right way?

The problem, of course, is that the pace of technological change leaves us with no choice. It might be better if we could wait a thousand years for people to gradually adjust to globalization and become cosmopolitan; but climate change won’t wait a hundred, and nuclear weapons won’t wait at all. We are thrust into a world that is changing very fast indeed, and I understand that it is hard to keep up; but there is no way to turn back that tide of change.

Yet “turn back the tide” does seem to be part of the core message of the Trump voter, once you get past the racial slurs and sexist slogans. People are afraid of what the world is becoming. They feel that it is leaving them behind. Coal miners fret that we are leaving them behind by cutting coal consumption. Factory workers fear that we are leaving them behind by moving the factory to China or inventing robots to do the work in half the time for half the price.

And truth be told, they are not wrong about this. We are leaving them behind. Because we have to. Because coal is polluting our air and destroying our climate, we must stop using it. Moving the factories to China has raised them out of the most dire poverty, and given us a fighting chance toward ending world hunger. Inventing the robots is only the next logical step in the process that has carried humanity forward from the squalor and suffering of primitive life to the security and prosperity of modern society—and it is a step we must take, for the progress of civilization is not yet complete.

They wouldn’t have to let themselves be left behind, if they were willing to accept our help and learn to adapt. That carbon tax that closes your coal mine could also pay for your basic income and your job-matching program. The increased efficiency from the automated factories could provide an abundance of wealth that we could redistribute and share with you.

But this would require them to rethink their view of the world. They would have to accept that climate change is a real threat, and not a hoax created by… uh… never was clear on that point actually… the Chinese maybe? But 45% of Trump supporters don’t believe in climate change (and that’s actually not as bad as I’d have thought). They would have to accept that what they call “socialism” (which really is more precisely described as social democracy, or tax-and-transfer redistribution of wealth) is actually something they themselves need, and will need even more in the future. But despite rising inequality, redistribution of wealth remains fairly unpopular in the US, especially among Republicans.

Above all, it would require them to redefine their tribe, and start listening to—and valuing the lives of—people that they currently do not.

Perhaps we need to redefine our tribe as well; many liberals have argued that we mistakenly—and dangerously—did not include people like Trump voters in our tribe. But to be honest, that rings a little hollow to me: We aren’t the ones threatening to deport people or ban them from entering our borders. We aren’t the ones who want to build a wall (though some have in fact joked about building a wall to separate the West Coast from the rest of the country, I don’t think many people really want to do that). Perhaps we live in a bubble of liberal media? But I make a point of reading outlets like The American Conservative and The National Review for other perspectives (I usually disagree, but I do at least read them); how many Trump voters do you think have ever read the New York Times, let alone Huffington Post? Cosmopolitans almost by definition have the more inclusive tribe, the more open perspective on the world (in fact, do I even need the “almost”?).

Nor do I think we are actually ignoring their interests. We want to help them. We offer to help them. In fact, I want to give these people free money—that’s what a basic income would do, it would take money from people like me and give it to people like them—and they won’t let us, because that’s “socialism”! Rather, we are simply refusing to accept their offered solutions, because those so-called “solutions” are beyond unworkable; they are absurd, immoral and insane. We can’t bring back the coal mining jobs, unless we want Florida underwater in 50 years. We can’t reinstate the trade tariffs, unless we want millions of people in China to starve. We can’t tear down all the robots and force factories to use manual labor, unless we want to trigger a national—and then global—economic collapse. We can’t do it their way. So we’re trying to offer them another way, a better way, and they’re refusing to take it. So who here is ignoring the concerns of whom?

Of course, the fact that it’s really their fault doesn’t solve the problem. We do need to take it upon ourselves to do whatever we can, because, regardless of whose fault it is, the world will still suffer if we fail. And that presents us with our most difficult task of all, a task that I fully expect to spend a career trying to do and yet still probably failing: We must understand the human tribal instinct well enough that we can finally begin to change it. We must know enough about how human beings form their mental tribes that we can actually begin to shift those parameters. We must, in other words, cure bigotry—and we must do it now, for we are running out of time.