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The fall academic semester is quickly approaching, so it’s a good time to remind readers that one of the goals of this site is to give economics instructors interesting examples and discussion topics for their classes. Those of you teaching Principles of Economics this term (as well as those of you teaching Environmental Economics and other related topics) will probably get to a discussion of externalities somewhere toward the middle of the semester, but here’s something for those of you who are inclined to plan ahead:
The Coase Theorem is a crucial topic in a discussion on externalities, since it shows that, under certain conditions, an efficient outcome will result via bargaining regardless of how property rights are initially assigned. This is an important concept because the policy implication is something along the lines of “just do something to define property rights and the rest will sort itself out.” I usually illustrate the Coase theorem via the following scenario:
Let’s suppose that there are two people on an airplane, one seated directly behind the other. The person in front, let’s call him Josh (you’ll wee why later), values the ability to recline his seat at $20. The person in back, let’s call him Hamilton, values the space in front of him at $15. These valuations imply that the efficient outcome for the system overall is for Josh to recline, since doing so confers larger benefits on Josh ($20) than it costs Hamilton ($15).
If the airline assigns property rights to Josh, there is no room to bargain since Hamilton doesn’t value his space enough to be willing to offer Josh enough money to get him to not recline (i.e. more than $20). In this case, the result will be that Josh reclines. If the airline assigns property rights to Hamilton, a logical Josh would be willing to offer Hamilton somewhere between $15 and $20 in return for Hamilton allowing josh to recline his seat. A logical Hamilton would accept this offer, since he is getting paid more than he values his space, and the outcome would once again be that Josh gets to recline. As the Coase theorem postulates, reclining is the outcome that transpires regardless of how property rights are assigned- the difference between the two scenarios is what the payment structure looks like. (It should be acknowledged that the payment structure will of course affect how good the different parties feel about the eventual outcome, so the initial allocation pf property rights is still relevant from a distributional perspective.)
I like this example because it highlights why the assumptions underlying the Coase theorem are necessary. There are three main assumptions that are, in practice, not always satisfied:
With all of this in mind, consider the following incident:
According to the Associated Press, a United Airlines flight from Newark to Denver was diverted to Chicago’s O’Hare International Airport after two passengers, both sitting in the “economy plus” section of the flight – which comes with extra legroom – began arguing because the man prevented the woman sitting in front of him from reclining her seat.
The man was allegedly using a $22 device, known as the Knee Defender, that locks onto the tray table on the back of the seat, making it impossible for the person in front to recline. The device is banned on United Airlines flights, but the Federal Aviation Administration leaves it up to individual airlines to set rules for the device.
According to law enforcement officials, the man used the device to stop the woman in front of him from reclining while he was using his laptop. When a flight attendant asked him to remove the device, he refused. The woman directly in front of him then allegedly stood up and threw a cup of water at him.
The flight crew determined the situation had escalated to the point that the flight needed to make an unscheduled stop at O’Hare.
I think we can all acknowledge that “grounding the plane and inconveniencing everyone on board” is not the efficient outcome, so let’s examine how the assumptions of the theorem were not satisfied:
Those of you who have ever flown on Virgin America may have noticed that their seat-back menus offer the option to send a drink or other item to another passenger- I would really like to see what would happen if the company added the functionality to bargain for space via touchscreen…and, let’s be honest, Richard Branson totally seems like the guy to get on that- after all, he’s the guy who thought that this was a good use of resources:
Who am I kidding, that video is worth every penny.
Update: IT HAPPENED AGAIN. Do people not watch the news? Or take basic economics classes?
Since we talked about Burger King and tax inversion yesterday, I figured it was only fair to point out that Stephen Colbert was ahead of the trend, since he did a couple of tax inversion segments (though he calls them “corporate inversion” segments) on his show on July 30:
(To further give credit where credit is due, I learned about this because my significant other was watching it he was on the Stairmaster and I was stuffing my face with Thai food.) I find the point that Obama makes about having a headquarters in a foreign country while most operations are in the U.S. to be less than satisfying for two reasons- first, are there really that many large companies whose businesses aren’t sufficiently international that it only makes intuitive sense for them to be based in the U.S.? Second, about three seconds of Thai-food-enabled pondering led me to the suspicion that most policies of a “your business is here so your taxes are here” nature is going to take the business away rather than bring the taxes in. Remember kids, a decent tax policy has got to work with the incentives of producers and consumers, not against them. OR…and I know this is totally out there, but perhaps the U.S. could work on providing institutional value to the companies that it houses such that the companies would find it worthwhile to pay the higher taxes and stay put. In this way, Allan Sloan seems to be going down a reasonable path in the second video when he suggests that the benefits that the U.S. can provide to companies be matched with the responsibility to pay U.S. taxes.
People seem to like analogies, so I’ve potentially got one for you- say my apartment is more expensive than the ones in the building next door. It would be absurd for me to be obligated to keep renting the more expensive apartment, but I might choose to do so if the more expensive apartment were also nicer. If it wasn’t, it’s completely reasonable for me to move…but most likely unreasonable for me to expect to keep using the roof deck, gym, etc. of the building that I moved out of. On a corporate level, however, we basically do have a system where residents and non-residents alike can use the facilities, so it’s not surprising that we are seeing the behaviors that we are seeing.
I was reminded earlier today by Ronan “I’ll be damned if Frank Sinatra isn’t your father” Farrow that the world is a little obsessed with Burger King’s potential acquisition of Tim Hortons. (In case you aren’t familiar, Tim Hortons is sort of like a Canadian Dunkin Donuts, assuming of course that all of the U.S. looks like New England in terms of having a Dunkin Donuts every 12 feet. Also, betcha didn’t know that Burger king was already itself owned by a Brazilian private-equity firm named 3G Capital.) I have to admit that I get both confused and intrigued when I hear new names for concepts that already have perfectly good names. Case in point: the term “tax inversion” has gotten thrown around in basically every article about the deal to refer to the fact that one of the terms of the deal is that Burger King will move its headquarters from Miami to Canada, thereby avoiding U.S. corporate tax liability as well as U.S. capital gains taxes in some cases. In my day, this was referred to as a form of the deadweight loss of taxation.
Deadweight loss can generally be thought of as an economic black hole, since it measures the economic value that is lost when a market deviates from what maximizes the economic value created for society. With taxation specifically, the deadweight loss comes about because the tax reduces economic activity (and, as a result value created for producers and consumers) but then shafts the government as well since it can’t collect tax revenue on transactions that don’t happen. This intuition suggests that taxes create less inefficiency when they don’t cause consumers and producers to change their behavior very much. (An exception to this, however, exists with taxes to correct for negative externalities, since in that case reducing the amount of economic activity is actually good for society.) Unfortunately, what we seem to be learning as of late is that companies are getting really good at changing their behavior for tax purposes- check out this chart from Goldman Sachs and Business Insider:
If this behavior is strong enough, it could even be possible that, in addition to keeping business activity in the country, the U.S. could even increase the amount of revenue it collects in corporate taxes by reducing the tax rate. (In other words, it’s possible that the U.S. corporate tax rate is on the bad side of the Laffer curve.)
It turns out that Greg Mankiw was somewhat prescient in his latest NYT column:
One Way to Fix the Corporate Tax: Repeal It
If tax inversions are a problem, as arguably they are, the blame lies not with business leaders who are doing their best to do their jobs, but rather with the lawmakers who have failed to do the same. The writers of the tax code have given us a system that is deeply flawed in many ways, especially as it applies to businesses.
The most obvious problem is that the corporate tax rate in the United States is about twice the average rate in Europe. National tax systems differ along many dimensions, making international comparisons difficult and controversial. Yet simply cutting the rate to be more in line with norms abroad would do a lot to stop inversions.
I’m not sure that I’m as gung-ho about a broad consumption tax as Greg is, but the rest of the piece is pretty spot on. I mean, it’d be nice to get companies to chant “U-S-A” while throwing money at the IRS, but it’d be nice to live in a world of unicorns and rainbows as well, and the sooner we acknowledge that publicly-traded firms do in fact have a fiduciary responsibility to maximize profit in addition to a general disposition to do so, the more we can focus on fixing the game rather than hating the player.
But wait- is it possible that the headquarters move is not actually tax driven? Burger King asserts that taxes are not the main consideration…and for context, I guess it’s helpful to know that there are far more Tim Hortons locations in Canada than there are Burger King locations in the U.S., so it’s more of a coming together of equals than the term “acquisition” would suggest. in any case, I hope that this discussion as at least convinced you that there are more productive things for policymakers to do than try to arrange a boycott of Burger King.
UPDATE: All this talk of tax inversion suspicions is distracting us from the real horror that Tim Hortons is unleashing on the world.
I probably say this every year, but how is the summer over already? I feel like I go in with the best of intentions and then feel like I never accomplish enough by the time the end of August rolls around. This time, though, I swear it’s not my fault. (Ok, I’ve probably said that before too.) I just had an opportunity that was too interesting to pass up:
See? I know that’s a bit cryptic, but, for now, you can see a bit more about what I am working on here. (Fun fact: I located that URL by googling “Vulcan economics,” and now I kind of want to go back and read some of the non-relevant search results. =P) Special thanks to James Tierney from Penn State and Matt Kahn from UCLA for contributing to the nerdiness of the film set- especially James, who got roped into being an extra for one of the videos! And who puts photos together better than I do:
— James Tierney (@James_Tierney) August 10, 2014
Overall, I am super excited to see how the project comes out, since it really highlights how hard it is to explain economic concepts by showing rather than just telling but how powerful it can be when done right. So stay tuned!
One of the first things we generally cover in intro microeconomics is the determinants of demand- i.e. the factors that influence how much of a good we are willing and able to purchase. The price of a good is obviously one of these determinants, but so are the prices of what economists call “related goods.” related goods are broken down into two categories:
More precisely, economists define substitutes and complements in terms of the relationship between the price of a related good and the demand for the good in question. By this definition, the demand for a good decreases when the price of a substitute decreases (and vice versa). Conversely, the demand for a good increases when the price of a complement decreases (and vice versa). While this definition isn’t wrong per se, I’m surprised that few (if any) textbooks address how this relationship applies when substitutes and complements enter the world in the first place. After all, it stands to reason that substitutes entering a market decreases demand for an item, and complements entering a market increases demand for an item. (Hence the existence of iTunes and the Apple app Store, for example.) In order to reconcile this with the textbook explanation, I usually have to dance around some story about how a price of an item is technically infinite if a product doesn’t exist, which then implies that a product entering the market at a finite price is a form of a price decrease (which makes the official definitions apply).
Ok, now I’m even boring myself, but I think about this more than is reasonable and therefore wanted to put it on the Internet. Now what was my actual point…oh, right- sometimes it’s not obvious whether goods are substitutes or complements, and I am often reminded of this when I make up exam questions that I think are obvious and then have students students complain when they lose points. (I actually had a student rather convincingly argue that lemons and limes are complements because lemon-lime soda is a thing.) Therefore, it’s often helpful to work backwards from the data to infer whether goods are substitutes or complements. Take Broadway musicals and movies made from them, for example- substitutes or complements? On one hand, they might be substitutes because people don’t want to watch the same story twice. On the other hand, however, they could be complements because the widespread release of the movie could make people more interested in going to New York to see the musical. Even though I didn’t know which way the relationship would go, I wasn’t expecting to see this from the data:
(You can see more on the topic here.) So I am to believe that Chicago and Chicago are complements but The Producers and The Producers are substitutes? (Yes, I realize that the chart shows revenue and not demand specifically, but revenue seems like a reasonable proxy in a way that quantity of tickets does not because revenue accounts for price changes.) The article that this chart comes from gives more detail and, at a rough level, rules out the possibility that the differences are attributable to how long the musical had been out prior to the movie or when during the year the movie came out.
I thought I would point this out not only because it could make for an interesting classroom discussion but also because we tend to make a lot of assumptions about how goods are related when we discuss intellectual property protection, and it’s important to remember that these relationships aren’t necessarily obvious or even consistent, as evidenced above. Or, put more simply, why assume when you can actually go to the data and find out for real?
I swear I know how to use the Internet in general, but I somehow managed to type my name in the wrong place when trying to access my Facebook page, which mysteriously lead to Googling myself. (I don’t care how completely that verb enters the popular lexicon, it will always sound dirty.) Anyway, those of you who have ever, well, Googled anything know that a few image search results show up near the top of the first page- I noticed one of the photos and was like “heh, I don’t remember taking that photo…” Luckily, that is because the photo was originally part of a video and not because I am ridiculously unaware of stalkers, given that I was looking at the camera in said photo:
Anyway, the video…I did a few videos a while back for a production company that was looking to put together subscription-based materials for introductory econ classes, and the company made the video on natural monopoly one of their free preview videos, which you can see here. (Hopefully, watching this video will help you understand why I am posing with a Verizon truck, if it wasn’t already obvious.)
Or, tl;dw (didn’t watch, get it?): Regular monopolies get to be monopolies because of some usually artificial barrier to entry such as intellectual property protection. Natural monopolies get to be the only game in town because their fixed costs have already been paid (and are therefore sunk) and their marginal costs are low, so they can lower price in order to make it unprofitable for others to enter. In related news, the cost structure of natural monopolies means that it makes economic sense for only one to exist in an industry at a time, but regulation is often a good idea, since natural monopolies left to themselves result in the same inflated prices and reduced supply that regular monopolies do.
Okay, so my last post mentioned my desire for an Economist political party, but I don’t think that this is what I had in mind:
(See here if you are feeling procrastinatory and want to watch the second part of the segment.)
First off, I can’t help but focus on the fact that Rate My Professors is apparently fair game for information sleuthing, so, in all probability, the student review that said I would make a good wife if only I learned how to cook will come to light if I ever become famous and/or infamous. (And yes, I’m still pissed that the little sh*t incorrectly assumed that I can’t cook.) More generally, this story is making the ambivalence center in my brain hurt. Let’s take a quick inventory:
Overall, I don’t think I agree with Brat’s ideology (though I will admit that he does have his moments), but I do think that he’s better than the Tea Party label suggests. That said, I am frustrated that one side effect of this development is that everyone watching cable news is getting the phrases “Tea Party,” “economics professor,” and “Ayn Rand” in close proximity over and over, so I do understand and feel the desire to point out that this guy’s views don’t represent those of the typical economist. Especially as far as immigration is concerned.
The more I read about this, the more interested I become in how UNH’s Dan Innis will fare in his Congressional bid.
This is from a book on climate change, but the principle definitely holds more widely…(click for larger)
(thanks to EconLog for the images!)
This concept- that researchers don’t have the luxury of always running randomized controlled experiments (i.e. randomized controlled trials, or RCTs) to determine what affects what- is what leads a growing number of microeconomic researchers to search for good instrumental variables in order to, to a degree, simulate some form of randomization. In addition, researchers in microeconomics have been increasingly able to go out and perform field experiments in order to have a good deal of control over the data that they create and collect- just ask John List or Esther Duflo, for example.
In macroeconomics, however, it’s hard to even conceive of how experiments to answer most questions would be carried out. Say you want to analyze tax policy- do we tell people that if their social security number ends in an even number then they get a tax break (and that if it ends in an odd number they don’t) and then see what happens? In an immediate sense, I don’t need to do the experiment to tell you what’s going to happen- some combination of rioting and a deluge of of those petitions that the White House has to respond to if they get enough signatures, depending on how much initiative the nation is feeling at the time. Even in an economic sense, though, this experiment wouldn’t be very useful- after all, in order to get a clean result, we’d basically have to have the tax break consumers only interact with one another and the non-tax-break consumers to only interact with one another. (Just imagine the strife this would cause in households where one spouse has an even social security number and the other has an odd one.)
The experimental logistics problem only gets worse when we look to answer questions regarding economic growth- can we form an econ army and take over a country, divide it randomly in two, subject the two parts to different institutions or capital investment and observe what happens over time? Probably not, though the idea does dovetail nicely with my suggestion of an Economist political party. Luckily, we don’t have to, since countries like Korea have pretty much done this for us, in a way, and they provide interesting natural experiments to study.
If you don’t think that being limited to observational data is bad enough, just consider the fact that government economic policy is usually endogenous to the economic situation at hand- people think I’m crazy when I advocate for a government that conducts monetary and fiscal policy in an unpredictable manner, but that would actually be a big win, for research purposes at least. (Insert lame joke about the government seeming to want to help out researchers here.)
It’s no secret that many economists believe in the efficiency of markets- in fact, there’s a fairly well-known joke that goes something like the following:
Normal person: Hey look, somebody dropped $20 on the sidewalk.
Economist: Nonsense- that can’t be a real $20 bill, since, if it was, somebody would have picked it up already.
More generally, one feature of efficient markets is that all transactions that are profitable for all parties involved actually happen. This, however, doesn’t mean that no one can profit in an efficient market (which is why the economist in the joke’s logic is absurd), it just means that profit opportunities aren’t left on the table indefinitely in an efficient market.
The efficient-markets hypothesis puts a bit more structure on this concept, especially as it relates to financial markets (i.e. markets for stocks, bonds, etc.). The efficient-markets hypothesis, at its core, suggests that asset prices are “correct” in that they properly and rationally reflect all available information. This feature of efficient markets, according to economists, occurs precisely because market participants quickly take advantage of all of the ways to profit from asset mispricings, and these actions bring prices to their proper levels.
In another context, then, the efficient-markets hypothesis taken to the absurd extreme gets us this:
Full disclosure: I helped with this one, so you should probably blame me if you don’t like it. Also, my economist friends and I found a $10 bill on the ground at the zoo last week, and we actually picked it up- good thing I’m a behavioral economist, otherwise I might worry that my economist membership card would get taken away. (Then again, we did have a longer than reasonable conversation about how we should split the $10, so perhaps not.)
In related zoo news, economists understand the value of scarcity as it pertains to animals:
Also, I need this sign for my office…
…mainly because it would mean I get to research the economics of pandas.
First off, I will be the proud owner of this in 4-5 business days:
In related news, Stephen Colbert offers up an explanation for the above item as it relates to Thomas Piketty’s Capital in the Twenty-First Century:
In case you haven’t been following along, allow me to get you up to speed: French economist Thomas Piketty wrote a book that is essentially 600 and some odd pages on wealth inequality in French, it got translated into English and became the number one seller on Amazon. (Not number one in economics, number one overall, as Colbert notes. Colbert made a Harry Potter joke, but you can basically think of of the book as 50 Shades of Economics, though better written than the original- not that I would know. This is actually a big deal if for no other reason than it follows a lot of discussion on how nobody pays attention to economic scholarship.) Various scholars and media outlets, most notably the Financial Times, have accused Piketty of errors reminiscent of the Reinhart-Rogoff austerity paper debacle, but Piketty responded with what basically amounts to an intellectual smackdown. (You can read a far more elegant summary here.)
The r and g, as Piketty uses them, refer to the return on property and investments and the rate of economic growth, respectively, and he argues that r being larger than g leads to increasing concentration of wealth. This is mostly reasonable but initially seemed a little odd to me from a notation perspective, since, if I remember my macro correctly, r generally represents the real interest rate and g generally represents the growth rate of technological progress. BUT…I suppose that the real interest rate if capital markets are competitive is equal to the return on capital (i.e. the marginal product of capital minus depreciation) and, along a steady state balanced growth path, the growth rate of the economy is in fact equal to the growth rate of technological progress. (Now who’s deathly boring, Colbert?)
Let’s go to Piketty directly, since he can obviously explain himself better than I can do so on his behalf:
Actually, the book is more interesting and nuanced than that interview suggests (at least the beginning of it), since Piketty certainly does a lot more than rehash the minimum-wage debate.
While watching the Colbert segments, I couldn’t help but giggle at Colbert’s choice to commiserate with Tony Stark, since Stark and the actor that plays him show up in a related work on the subject of income inequality:
Yes, the Wealthy Can Be Deserving
by N. Gregory Mankiw
In 2012, the actor Robert Downey Jr., played the role of Tony Stark, a.k.a. Iron Man, in “The Avengers.” For his work in that single film, Mr. Downey was paid an astounding $50 million.
Does that fact make you mad? Does his compensation strike you as a great injustice? Does it make you want to take to the streets in protest? These questions go to the heart of the debate over economic inequality, to which President Obama has recently been drawing attention.
I’m not sure whether I would rather think that the significance of the bit was a conscious choice or that the world just happens to come full circle when appropriate. (Who am I kidding- I absolutely want the Colbert writers to read as much of the econ interwebs as I do.)
Traditional economic models assume that the utility, or happiness, one gets from consuming an item depends only on how fundamentally useful the item is to the consumer. Under this model, an item’s utility must be independent from the price that the consumer paid for the item, since it’s hard to envision a scenario where the price paid for an item actually affects how useful it is (holding item quality and such constant, of course). Our own intuition, on the other hand, suggests that we get psychological warm fuzzies (or, conversely, cold…uh, slimies?) when we feel like we got a good deal on an item.
Behavioral economists recognize this phenomenon, and they even have a name for it- “transaction utility.” Under the behavioral model, the total utility that that an individual gets from an item is the sum of “acquisition utility” (roughly speaking, what traditional economists just call utility) and “transaction utility.” This model is interesting because it suggests that consumers can be convinced to buy stuff that they don’t rationally like enough to buy by making them feel like they are getting a good deal. (I think I’ve mentioned before how I am convinced that transaction utility is what keeps Christmas Tree Shops from going under.)
Economist Richard Thaler discusses the concept of transaction utility in his paper “Mental Accounting Matters”. In this paper, he gives the following anecdote to illustrate the irrational behavior that transaction utility can cause:
A friend of mine was once shopping for a quilted bedspread. She went to a department store and was pleased to find a model she liked on sale. The spreads came in three sizes: double, queen and king. The usual prices for these quilts were $200, $250 and $300 respectively, but during the sale they were all priced at only $150. My friend bought the king-size quilt and was quite pleased with her purchase, though the quilt did hang a bit over the sides of her double bed.
So let’s think about this- from what we know, we can probably infer that the double size quilt would give the friend the highest level of acquisition utility, since people generally like to have items that fit on the other items they are designed to go on. But the consumer is lured away from that choice by transaction utility, which is likely highest with the king-size quilt, since it had the biggest discount. (More specifically, the king-size quilt has the highest sum, or total utility, even though it probably doesn’t have the highest acquisition utility.)
Now that you are primed with this lesson, let me ask you a hypothetical question: What would you do if you got a coupon that would give you any drink at Starbucks for free? If you answered this, you’ve likely missed the point of the above discussion:
Apparently that is a sexagintuple vanilla bean mocha Frappuccino, and it has a regular price of $54.75. (The container for said drink, in case you were wondering, is a vase that the customer brought from home.) I am very tempted to think that this beverage is the equivalent of the king-size quilt, since what person in his right mind actually finds this beverage to be coincident with rational optimal consumption, even when taking cost out of the picture? That said, I am willing to reconsider my judgment, given the subsequent news that the customer actually drank the whole thing…eventually. In related news, let’s discuss how this beverage and gout medication are likely to be complementary goods.
It’s not often that something I’ve written gets put in the “brilliant and highbrow” quadrant, but here we are:
In related news, the Simpsons book is finally out!
And here I thought my thrilling yet nuanced take on the behavioral economics principles that Simpsons characters exhibit was never going to see the light of day. That said, I must humbly disagree with the New York Magazine editors when they suggest that you “forget Thomas Piketty,” and I will be following up on him shortly. I am told that Homer Economicus is number 13 on Amazon under Microeconomics- now if only we can get the likes of Mankiw and Krugman out of the way…
P.S. Apparently I/we also make house calls, so drop me an email at econgirl at economistsdoitwithmodels dot com if you are interested in arranging a Simpsons talk at your school, workplace, local bar I suppose, etc.
Many people think of money and wealth as fairly synonymous, whereas economists are careful to point out that money serves a number of specific functions in the economy. Most notably in the context of the discussion we’re about to have, money is the thing that we use to buy stuff. Therefore, people want to hold money, even though it doesn’t pay any interest and other assets do, since they need it to buy all of the cool stuff that they want.
We know that the amount of money in an economy, i.e. the money supply, is set by the Federal Reserve, so how does the supply of money relate to the amount of stuff bought and sold in an economy? Luckily, economists have a handy-dandy identity to describe this relationship:
So what does this mean? Let’s see…
If you think about it for a second, the relationship makes a lot of sense- let’s say, for the sake of argument, that an economy has $100 of money in it. (It’s a small economy, in case that wasn’t obvious.) If stuff in that economy costs $5 on average (i.e. P=5) and the economy makes 60 units of stuff (i.e. Y=60), then, in order to make the transactions happen to sell the stuff that was produced, it must be the case that a unit of currency changes hands 3 times on average (i.e. V=3), since the dollar value of the transactions totals $300 and there is only $100 of money to go around. (In case you’re curious, the velocity of money is thought to be pretty stable in the long run, so changes in the money supply eventually translate to corresponding changes in prices.)
The velocity of money is a very important concept in macroeconomics, even at the introductory level, but it’s a concept that is often less than intuitive for students. Luckily, I stumbled upon this comic that illustrates the concept quite adorably:
(Obviously you have to click to see it full size unless you have superhuman vision.) I get how electronic currency (I mean debit cards, not Bitcoin) is super convenient and efficient, but it’s just somehow not as cute. And this doesn’t even count the sheer hug-worthiness of the fact that my grandpa collected two sets of state quarters for me (apparently there are separate series for the Denver and Philadelphia mints or something) while he sorted change from his condo’s laundry machines and gave them to me as a holiday gift. You’ve gotta admit that a collection of debit or credit cards just doesn’t have the same warm and fuzzy factor, even when the cards look like this:
Sometimes I feel like the world is marketing directly to me.
In case you aren’t already convinced that Janet Yellen is the most powerful woman in the world (or, I suppose, that financial markets are at least approximately informationally efficent), take a look at this:
Okay, so maybe that requires a bit of explanation…today, the Federal Reserve released the statement coming out of its March meeting, and Janet Yellen held a press conference to discuss the Fed’s course of action and answer some questions. Judging by the above picture, I’m going to go ahead and infer that the whole statement/press conference thing started at 2pm. So why was the market unhappy? Let’s go to the statement and see what we can find:
For context, it’s helpful to know how this statement differs from the January statement and those from 2013 and such…luckily, the WSJ has been stealing my moves and developed a handy tool to track changes across FOMC meeting statements. (Spoiler alert: The Fed appears to be quite adept with cut and paste.) Upon reading the most recent statement, it’s mainly the change in asset purchases that really stood out, so the market’s reaction was likely due to the news of the further tapering. (Update: I had been told that the weak economic performance called the continued taper into question, but my banker friend assures me that the market still expected it, so the reaction was actually to the infamous interest rate “dot charts” that Yellen told everyone to not pay attention to. More on that in a second.) Why is this? Well, less expansionary policy generally means higher interest rates, which means it’s more expensive to invest, which makes businesses less profitable…yes, I know what you are thinking- but the Fed stressed its commitment to keeping interest rates low! Don’t worry, Twitter was a bit confused as well. For example:
Yellen says very clearly: The committee's views haven't changed. (The market hears it differently.)
— Justin Wolfers (@JustinWolfers) March 19, 2014
In other words, I’m guessing that the Federal Open Market Committee didn’t necessarily expect the world to interpret its statement as as “hawkish” (i.e. stingy with monetary expansion, in this context) as it did. This is probably because the world didn’t ignore the “dot chart” as instructed:
What the hell is that? (Yep, I can hear you asking that from here.) That, my friends, is a summary of where, under appropriate monetary policy, Federal Open Market Committee members and Federal Reserve branch presidents expect interest rates to be in the future. Okay, fine, that doesn’t mean a lot by itself, so let’s compare it to a similar chart from back in September:
Clear as mud, right? Apparently the takeaway is that interest rate expectations have moved up a bit, but why use a sentence when two incomprehensible pictures will do? =P I guess that’s why Yellen kept directing people to the statement rather than the dots, though one can’t help but notice that they contradict each other a bit. (Banker friend points out that the market did in fact notice and decided to believe the dots.)
But the real fun started during Yellen’s Q&A, which went from about 2:45 to 3:30pm. At around, oh, I dunno, 3:05 or so (mainly guessing from the graph above), a reporter asked Yellen to clarify the language in the statement that reads ” The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends…” Specifically, the reporter asked Yellen to define “considerable time,” since it would be nice to know for how much longer we can expect interest rates to stay near zero. Now, this is not the easiest thing, since it’s sort of like asking economists to put a time horizon on the short run versus the long run, but Yellen tried to be helpful and responded with 6 months as her time frame. Apparently the market had assumed that “considerable period” was something much longer than 6 months, since that is the point at which stock prices tanked.
Now, investors may be overreacting to this somewhat offhand comment of course, but at least we can tell from this that people are paying attention. Small victories, right?
Via a Twitter friend:
It’s funny because it’s true, and I’ve been trying to explain this to people for years. (In related news, economists don’t have a reputation for being particularly romantic.) In case you’re not familiar, sunk costs are costs that you’ve already paid and can’t recover- i.e. you can’t get your money back. Rationally, sunk costs shouldn’t factor into decision making because they are, since they’ve already been incurred, present in every possible outcome and therefore can’t affect the relative appeal of different options. For a Valentine’s themed illustration, consider the following: you purchase a box of chocolates, only to find that all of the chocolates are of the gross coconut-filled variety (seriously, who likes those?)- do you continue to eat the chocolate because, gosh darn it, you paid for it and you’re going to get your money’s worth, or do you chuck the heart-shaped box into the nearest trash can ASAP, saving yourself both empty calories and the pain of choking down substandard goodies? If you’re rational, you’d choose the latter option (or at least find that one person who is apparently keeping the coconut-filled Valentine’s chocolate industry alive and given them a nice gift), since “getting your money’s worth” is only going to make you less happy.
In practice, people are not always good at ignoring sunk costs, even though it would be reasonable to do so. Some empirical evidence:
If you’re curious, you can see more fun with sunk costs in Richard Thaler’s “Mental Accounting Matters.” Thaler even gives a potential explanation for why people tend to ignore sunk costs- in his mental accounting framework, people only explicitly evaluate transactions that are exceptions to the ordinary, so they fail to notice that, for example, they would be paying to not go to the movie and instead only focus on the potential of paying twice to go to the movie. Therefore, it’s not hard to see how ignoring sunk costs could lead to faulty reasoning along the lines of “well, I’ve put so much into this relationship already, I basically have to see this through.” (Like I said, we’re a romantic bunch.)
Isn’t it nice that you can get a valentine and a life lesson in one? I have to admit, however, that this is my favorite nerdy valentine thus far:
Or, if you prefer your valentines to be of the “real” sciences form instead, check these out. Personally, I’m giving this one to my students:
So, Paul Krugman wrote a blog post that generated the following comment:
Theoretically, it is possible you think about your intended audience. You owe it to the readership of your columns and blog posts (all of whom pay for the opportunity to read them) to identify your intended audience, if you have one. That you may very well have one, or an inchoate one that you do not define for yourself explicitly, is indicated by your use of the rubric “wonkish” for some posts.
Which brings us to today. What is the intended audience of your post which begins,
“David Glasner has a thoughtful post about wage stickiness, a favorite topic of mine. And he is partially right in suggesting that there has been a bit of a role reversal regarding the role of sticky wages in recessions: Keynes asserted that wage flexibility would not help, but Keynes’s self-proclaimed heirs ended up putting downward nominal wage rigidity at the core of their analysis,”?
The intended audience of this introduction must be a group of people who immediately understand what “wage stickiness” and “downward nominal wage rigidity” are. The intersection of that group and the readership of the Times I argue must be tiny.
On one hand, I do sympathize in general regarding the casual use of terminology- I mean, I was more than a little frustrated when I came into the first day of graduate macroeconomics and began supposedly exploring the question “Is money neutral?” and instead pondering what on earth it could possibly mean for money to be neutral…after all, it *does* appear that money really likes to be in Swiss bank accounts, but I at least knew enough to get that that is not the situation that my professor was referring to. (Spoiler alert: Money being neutral means that the amount of nominal currency in an economy doesn’t have an affect on real variables such as physical output, unemployment, etc.) On the other hand, at least some of the terms used above have definitions that can be inferred from just knowing the English meanings of the words, so come on.
Take “downward nominal wage rigidity,” for example. From dictionary.com:
downward down·ward [doun-werd]
moving or tending to a lower place or condition.
nominal nom·i·nal [nom-uh-nl]
(of money, income, or the like) measured in an amount rather than in real value: Nominal wages have risen 50 percent, but real wages are down because of inflation.
Often, wages. money that is paid or received for work or services, as by the hour, day, or week. Compare living wage, minimum wage.
rigid rig·id [rij-id]
firmly fixed or set.
From this, it’s really not a huge leap to infer that “downward nominal wage rigidity” refers to a situation where it’s difficult to adjust wages downwards in dollar terms. I suppose “sticky wages” is less clear as a phrase, but, in context, it’s specifically used to contrast with “flexible wages,” so it doesn’t take a genius to figure out that sticky wages are wages that are not flexible or adjustable, i.e. wages that exhibit (usually downward) nominal wage rigidity. Or, you could, you know, google “sticky wages” and get this. In picture form, sticky wages imply that it’s hard to do this:
Since a wage is just a price on labor, it’s probably not very surprising that prices can be sticky too…I think this sums up the sticky price situation nicely:
Now that we’ve got our nomenclature settled, let’s discuss for a bit why the possibility of (downwardly) sticky wages is relevant to the analysis of business cycles. As it turns out, prices, although somewhat sticky for various logistical reasons, tend to not be as sticky as wages, so prices of output in an economy tend to adjust faster than the prices of the inputs that make that output. Therefore, the typical textbook theory goes as follows: when prices go up due to an increase in aggregate demand in an economy, there is a period of time before the costs of production catch up where it becomes more profitable to produce and producers increase output. Conversely, when prices go down due to a decrease in aggregate demand in an economy, there is a period of time before the costs of production adjust in tandem where it becomes less profitable to produce and producers decrease output. This decrease in production leads to unemployment. If there is downward nominal wage rigidity, this unemployment can persist for a long time. Now, it seems somewhat intuitive that a reduction in nominal wages would solve this unemployment problem, but Krugman actually states that he doubts that such a change would be effective. He does, however, believe that sticky wages exist and have an effect on the economy, but more in this sort of way:
In other words, there must be some force that is preventing wages from adjusting to bring the supply (S) and demand (D) of labor into balance and relieve unemployment. In related news, there really is a meme for everything.
Let’s be honest- price discrimination is an important thing to talk about in class, but by the time it rolls around (in a principles course at least) you’re already rushing to cram in all of the material and too exhausted to bother coming up with clever/funny examples to use anymore. (Instructors, don’t even pretend that you don’t know what I’m talking about here.) This is unfortunate, both because knowing why price discrimination is a thing makes a lot of what consumers see in the marketplace make more sense and because price discrimination often gets an undeserved bad reputation, whereas it can actually be used to serve more customers without making anyone worse off. Luckily, I’m here to help!
On a general level, price discrimination refers to the practice of charging different prices to different consumers or groups of consumers without a corresponding difference in the cost of providing a good or service.
First-Degree Price Discrimination: First-degree price discrimination exists when a producer charges each individual his or her full willingness to pay for a good or service. First-degree price discrimination is also referred to as perfect price discrimination, and it can be difficult to implement because it’s generally not obvious what each individual’s willingness to pay is.
Second-Degree Price Discrimination: Second-degree price discrimination exists when a firm charges different prices per unit for different quantities of output. Second-degree price discrimination usually results in lower prices for customers buying larger quantities of a good and vice versa.
Third-Degree Price Discrimination: Third-degree price discrimination exists when a firm offers different prices to different identifiable groups of consumers. Examples of third-degree price discrimination include student discounts, senior-citizen discounts, and so on. In general, groups with higher price elasticity of demand are charged lower prices than other groups under third-degree price discrimination and vice versa.
Now, let’s think about this second-degree price discrimination situation…one thing you could do is ask your students whether the following scenario makes sense:
In general, firms price discriminate when price discrimination strategies increase their profits. (Shocking, I know.) Mathematically, this implies that price discrimination strategies will involve setting lower prices for consumers who are more price sensitive. But economists generally agree that consumers are more price sensitive (i.e. have higher price elasticity of demand) when the good they are buying comprises a higher share of their budget…and goods usually comprise a larger share of budget when they are purchased in higher quantities. This suggests that higher quantity consumers should be charged lower (per-unit) prices under price discrimination than lower-quantity consumers, right.
Even if you don’t buy this logic, you can always fall back on the observation that consumers can generally buy multiple individual units rather than the larger bundle, so they wouldn’t but the bundle at a higher per-unit price unless they realllllly liked the extra packaging. (And, in fact, if the packaging was actually significant, the scenario wouldn’t even really fit under the heading of price discrimination.) Now, armed with this new insight, consider a second similar scenario, which does in fact control for the packaging issue:
I dare you to devise a reason why an individual would pay $2 to not have 4 more batteries- the only thing I can come up with is that batteries don’t have the property of free disposal, since you aren’t supposed to just throw batteries in the trash and are instead supposed to…well, there’s a process that I’m not entirely familiar with. Therefore, if it takes effort to get rid of batteries, then maybe someone would pay money to not have them show up in the first place. Maybe.
Maybe third time’s a charm, so how about this one?
Is there such a thing as douchebag-degree price discrimination? Maybe I’m just bitter because I’m stuck on the waiting list for the event.
Reader Michael sent me the following yesterday:
@jodiecongirl What do you do on the first day of a principles of macro class? I'm looking to spice mine up.
— Michael Clark (@Hillsdalemc) January 12, 2014
I feel your pain, bro- I certainly wouldn’t self-identify as a macro person, so I think I struggle more to “sell” the concepts than I do in micro. Second, I’m not sure it’s a good idea ask me to spice anything up, since you might end up with something like this:
But at least it’s macro appropriate, and the expenditure categories of GDP never looked so sexy! But back to the problem at hand…I think that you could start your discussion by reviewing the distinction between microeconomics and macroeconomics and then point out that learning macro is really important because it’s what most non-economists intuitively think about when they think about economics. (In other words, people need to learn a bit of macro so that they don’t make granny think that she’s wasted her money helping pay for an education because one’s economics education can’t answer her seemingly basic question about recessions and interest rates. And no, rolling one’s eyes and explaining that you study microeconomics almost exclusively does not get the response one is hoping for. Trust me.)
From there, I might appeal to students’ desire for a good controversy by explaining that part of what macroeconomics interesting is that there are still a number of theories that are still up for debate. To explain why this is the case, you could start by asking the class a simple middle-school science project type question (my younger self, for example, examined such riveting topics as “which design of paper airplane flies the farthest?” and “Do ants prefer real or artificial sugar?”) and then discussing how one would answer the question using the scientific method (you know, control group and experimental group and all that). You can then conduct a thought exercise where students try to use the scientific method in order to, say, analyze the impact that a change in interest rates has on the economy- clearly, this goes haywire very quickly, since it’s hard to randomize U.S. citizens into a clean control and experimental group and so on and so forth. (I do, however, like the idea of randomizing based on the last digit of one’s social security number, especially since this is done a few times in the behavioral economics literature.) The point is that (most) macroeconomists aren’t stupid, they just can’t test all of their theories right away because they have to wait for appropriate data, and, thankfully, things like depressions and crashes don’t happen every day.
This may be a little advanced for your students, but I really like the history of economics slideshow that I found the other day (you saw this from the original Twitter conversation, but I figured it would be helpful for others):
The accompanying narrative in The Economist is also worth reading. Obviously, a principles course doesn’t cover everything mentioned here, but I think it’s still helpful for students to understand how what they are looking at fits into the bigger picture. Also, I think that Paul Krugman’s freshwater versus saltwater article helps students reconcile what they see in class with what they read in the news and such.
You could even introduce the suggested discussion above with this graphic:
Or you could show this at the end of the course and discuss whether the graph is accurate. (Fun fact: somebody in my department printed this out and wrote in a point for “Keynesian Macro” in the top right quadrant. Someone else from the department then wrote in “HA!” in big letters.)
One last thing: As your course progresses into different macro topics, I recommend the following items:
Hope this helps! Readers, if you have anything fun to add, contribute to an important public good and put your suggestions in the comments.
Since it’s now spring semester (my spring semester starts very early, so I am jealous of all of you who are still on break), I figured it would make sense to shift over to macroeconomics a bit rather than exclusively focusing on microeconomics. (It also doesn’t hurt that I’m teaching graduate macro this semester and want to give my students some review materials.) MY students are currently getting into economic growth models, so I figured it would make sense to write up a refresher on some growth math:
Gotta love that mathematical precision gives way to the fact that students giggle too much at a “rule of 69.” (And no, I can’t decide if I want to be the pot or the kettle.) See here for an overview of classroom-type materials available on the site.