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April 28, 2007

Climate Change Policy Needs a KISS (Updated)

With global warming all but established as fact, Martin Wolf is moving on to the next question, how to construct optimal policies to stem the rise in greenhouse gases:

Why emissions curbs must be simple, by Martin Wolf, Commentary, Financial Times: Man-made climate change may prove a disaster. No, I do not mean climate change itself. My concern here is rather over the policy responses. For ... recognition of the risks is generating a host of interventionist gimmickry, not least in the UK.

People I think of as my friends – pro-market liberals – are suspicious of what many of them consider the “man-made climate change hysteria”. They are surely right to note that it is a remarkably convenient banner for opponents of the market economy... This time, they fear, Malthusians and socialists may have a politically successful ... argument in favour of a long-standing desire to throttle the life out of the free-enterprise economy. ...

Yet even if one accepts the validity of concerns about man-made climate change, one should agree that market liberals also have a legitimate concern. Instead of policies that are minimally intrusive, well-targeted and efficient, we are depressingly likely to get the exact opposite. ...

Since climate change is likely to be a concern over decades, it is essential to get policy right. The big rule, as always, is: keep it simple, stupid.

A good example of what many (though not all) economists would consider a mistake has been the decision to go for tradeable emissions permits whose prices have proved disturbingly unstable. Predictably, the adoption of such permits is already leading to proposals to create a carbon emissions budget for every individual ... ([e.g. see] Mark Roodhouse). ... It is clear why an egalitarian with control-freak tendencies might welcome such a system of bureaucratic controls on most of humanity... But why should anybody else do so? And why should anybody believe it could be made workable?

Yet Mr Roodhouse is at least logical. He does also accept that his ration coupons should be tradeable. Meanwhile, Mr Cameron suggests that each individual might have some sort of “green air miles allowance”, with a sliding scale of taxation on those who travel most. The difficulty of monitoring such travel would prove immense: one can already foresee the host of business people taking their flights from Paris. ...[T]his is surely no more than a populist gimmick.

Then there is the government. In its new climate change bill, it proposes “a series of clear targets for reducing carbon dioxide emissions – including making the UK’s targets for a 60 per cent reduction by 2050 and a 26 to 32 per cent reduction by 2020 legally binding”. In this case, as I understand it, the government would be held legally liable for failing to compel the people of this country to behave as it desires over the next half century. I find that frightening.

Meanwhile, ... the chancellor proposed a raft of initiatives and incentives on light bulbs, efficiency standards, home insulation and micro-generation. It is impossible for the outsider to judge whether these would be cost-effective. Is the plan to make new homes “zero carbon” an efficient way to achieve emissions reductions? I have no idea. I suspect the government does not have any idea either.

Let us concentrate on the big issues: any workable policy system must be global; it must create stable incentives; it must be administratively simple; it must include investment in creation and dissemination of new technologies; and, not least, it must allow people to get on with their lives with as much freedom as possible. Uniform prices on emissions – ideally, through taxation – will do most of this job. Almost everything else is unnecessary or counterproductive.

Rob Metcalfe at Natural Capital is also unimpressed with the UK's proposal to create carbon targets, saying the targets for reducing carbon dioxide emissions, upon closer inspection are "not really binding at all."

I'll just repeat that, "it is essential to get policy right. The big rule, as always, is: keep it simple, stupid."

Update: Let me see if I can relate this to what Robert Frank is saying in the earlier post from today.

Economists prefer the most efficient taxes, the ones with the least distortions to the economy. The idea, in essence, is that we can use redistribution policy ex-post to make everyone better off or to address problems of equity. The more stuff you have to do that with - i.e. the more efficient the tax policy is - the better. Thus, first try to ensure that, after the policy and associated distortions are in place, there is as much GDP available as possible, then redistribute the gains in some optimal way.

Robert Frank's point is that the best policy may be blocked by politics, particularly the politics associated with redistributive policy (e.g., give someone 10 through a policy change, then take away 4 through taxes to make sure everyone gains, and there will be protests from the person who has 10 - they will argue hard for the policy, but oppose the subsequent redistribution). Because of that, we end up with suboptimal, convoluted policies that try to (a) please special interest groups so that it can pass the political hurdle, and (b) address equity and distributional issues up front in the policy itself rather than ex-post through redistributive policy.

Politics can be left out of our theoretical models, but it has to be considered when policies are actually put into place. Because holding out for the perfect policy according to idealized theoretical structures is an effective way to do your opponents a favor and block policy altogether, my view (perhaps without enough thought) is that we should use the simplest, most efficient policy that is also politically possible so long as the net benefits, including desired redistributions, are clear.

Advocates for Smaller Government Make Economic Efficiency Harder to Achieve

Robert Frank explains why antigovernment crusaders are often the biggest obstacle to achieving the goal they are after, increased economic efficiency:

When to Violate the Top Two Commandments of Antigovernment Crusaders, by Robert H. Frank, Economic Scene, NY Times: When asked to identify the two most important items from their list of 10 public policy commandments, most antigovernment crusaders pick (1) public spending shall be kept to an absolute minimum and (2) the state shall not transfer income from rich to poor.

No government heeds these admonitions in any literal sense. Yet they have had a profound impact on public policy decisions, especially in the United States. Often, however, their impact has been the opposite of what antigovernment crusaders intended.

The problem is that many compellingly advantageous public policies cannot be enacted without violating the two commandments. Every significant policy change benefits some people and harms others. If the gains to winners substantially outweigh the costs to losers, solutions can always be found that allow everyone to come out ahead. But those solutions often involve higher taxes and income transfers to the poor.

Regulations that limit auto emissions are a case in point. Because these regulations increase car prices, legislators in most jurisdictions exempt older vehicles to avoid imposing unacceptable costs on the mostly low-income motorists who drive them. Yet the cost to society of this exemption far outweighs its benefit for the poor. ...

For example, although fewer than 10 percent of the vehicles in Los Angeles are more than 15 years old, these cars account for more than half the smog. Exempting the old cars thus necessitates much stricter regulations for new ones..., [and] meeting air quality targets by further tightening new-car standards is several times as costly as ... eliminating the exemption for older vehicles.

By raising taxes on high-income motorists, the government could finance vouchers that would enable low-income motorists to scrap their older vehicles in favor of cleaner used cars of more recent vintage. The required taxes would be much smaller than the resulting savings from not having to adopt such costly standards for new vehicles. Both rich and poor motorists would win. The problem is that taking these steps would violate the two commandments.

Antigovernment crusaders have prevailed for now. ... In the process, however, they have made everyone poorer. Some believe that minimal government is synonymous with economic efficiency. But it is not. As the emissions example illustrates, economic efficiency sometimes requires that government play a larger role.

This example is part of a much broader pattern. In health care, for example, the private insurance system ... in the United States delivers worse outcomes at substantially higher cost than the single-payer system employed in virtually every other industrial country. But switching to the single-payer system would require higher taxes and increased benefits for low-income citizens, steps that would violate the two commandments. So for now, we remain saddled with a system that ... is dysfunctional.

In the realm of antipoverty policy, most economists agree that raising the earned-income tax credit would be the most efficient way of increasing the living standard of the working poor. ... Its compelling advantage is that unlike a higher minimum wage, it does not discourage hiring. But raising taxes to increase the earned-income tax credit would violate the two commandments.

Because the most efficient antipoverty policy is deemed politically unfeasible, many economists support current legislative proposals to raise the minimum wage... But ... an increase in the minimum wage not only limits job creation for the least- skilled workers, it also raises the prices of goods they produce. Over all, it would have been cheaper to raise the earned-income tax credit.

Antigovernment crusaders have also prevented the adoption of energy policies that would produce better outcomes for all. For example, economists of all political stripes have argued that a stiff tax on gasoline would relieve traffic congestion, reduce greenhouse gases, accelerate the development of energy-saving technologies and reduce dependence on foreign oil. But it would also impose significant economic hardship on low-income families, making it necessary to increase transfer payments to those families. Both the tax on gasoline and the transfers to low-income families would be clear violations of the two commandments. And so gasoline taxes continue to be far lower in the United States than in other industrial countries.

That democratic forces limit the economic hardship that government can impose on low-income families is a good thing. But sometimes imposing hardships on those families would create far larger gains for society as a whole. In such cases, we can always devise solutions that make everyone better off. But it is impossible to put these solutions into practice without violating the two commandments.

Is it better to solve a problem by spending two extra dollars in the private sector than by spending one additional dollar in the public sector? The two commandments insist, preposterously, that it is.

Economic efficiency is a worthy goal... Antigovernment crusaders deserve credit for emphasizing the importance of this goal. But as events of recent years have repeatedly demonstrated, they are often the biggest obstacles to its achievement.

Diminished Expectations

David Wessel of the Wall Street Journal says expectations of benefits from allowing financial capital to flow freely between countries are fading:

Advocates of Borderless Money Temper Outlook for Benefits, by David Wessel, WSJ: Ten years ago, with spectacularly bad timing, finance ministers and central bankers gathered in Hong Kong and declared that encouraging the free flow of capital across borders should become as much a part of the International Monetary Fund's mission as encouraging trade in goods and services.

That was in September 1997, in what turned out to be the opening act of the Asian financial crisis ... heightening fears that allowing money to slosh around the globe without restriction could be dangerous to economic health. In the end, the IMF's mission wasn't expanded.

A lot has happened in the past 10 years. Private money shied away from emerging markets for about five years but returned ... in 2004... Emerging markets, China in particular, have built huge war chests of foreign reserves in case they have to fight another 1997-style war against currency speculators. Talk of imposing controls on flows of short-term money in and out of emerging markets has faded.

But anxiety about unfettered flows of money could return if recent market turmoil persists, economies falter and politicians react to public suspicion ... that globalization means huge profits for Wall Street, hedge funds and private-equity investors and uncertain benefits for workers.

Amid all this, intellectual architects of the world financial order are rethinking the case for allowing money to move wherever it wants. ... The theory was that capital would flow from rich to poor countries because returns would be higher there, and that would spur growth in the poor countries. ...

But money is actually flowing heavily from poor nations (China) to rich countries (the U.S.), the reverse of what economists think should happen. And some countries that grew fastest between 1980 and 2005 (ranging from China to tiny Mauritius) weren't completely open to financial globalization. Some of the countries that were relatively open (Bolivia and pre-Chávez Venezuela) didn't grow at all.

The rationale for free flows of capital is undermined and the advantages are less than evident. So are the benefits worth the risks of ... financial crises? Stanley Fischer says they are. Mr. Fischer is ... convinced ... that "orderly" opening of an economy's financial markets to the rest of the world is wise -- but for different reasons.

It isn't clear, he says, that there are "massive, obvious benefits" from the money that flows into an economy when barriers to entry and exit are lowered. Instead, the benefits "have much more to do with your world view, how your people look at the world, and what they need to do to prosper." ...

In short, exposure to global capital markets ... forces financial markets and firms to be more efficient, offers businesses and consumers better terms for borrowing and lending, reduces openings for corruption and discourages short-sighted domestic economic policies. It isn't the money; it's the collateral benefits...

The case for erasing national borders to lift the fortunes of people in countries rich and poor isn't intuitive. That's why it has been so controversial for so long. There are obvious benefits: The world is richer today and has fewer poor people than it did 25 years ago. But there are obvious risks.

And in an admission that is striking coming from researchers at an institution that was ready to carve a new commandment into its charter a decade ago, Mr. Rogoff and his IMF colleagues conclude: "The more extreme polemic claims made about the effects of financial globalization on developing counties, both pro and con, are far less easy to substantiate than either side generally admits."

April 27, 2007

Income Inequality is Still Rising

Brad DeLong brings us the latest on inequality from Thomas Piketty and Emmanuel Saez:

Emmanuel Saez Writes in About American Income Inequality Rising Rapidly in 2005: He says:

The IRS has released yesterday the preliminary stats for year 2005 which I have used to extend my [and Thomas Piketty's] series [on the top income share by tax return unit] to 2005, posted at: http://elsa.berkeley.edu/~saez/TabFig2005prel.xls

2005 shows a very large increase in income concentration: the top 1% gains 14% in real terms from 2004 while the bottom 99% gains less than 1% (when including capital gains). The [previous] record peak of 2000 is surpassed even though 2005 is less of a high capital gains, high stock option year than 2000. By 2005, it looks like top incomes are showing strongly along all components: wages, business income, dividends, and capital gains.

The striking thing about 2003-2005 is the huge increase at the top with quasi-stagnation below the top 1%. In the late Clinton years, the top gained enormously but at least the bottom was also making progress (something you can see on Fig A2)...

Market income excluding capital gains

And in a second post, Brad adds:

Two Ways of Looking at Data on Income Inequality..., by Brad DeLong: A correspondent reminds me of this from Greg Mankiw, which at the time seemed to me to indicate that Greg was still high on the Bush administration koolaid he had drunk:

Greg Mankiw's Blog: New Data on Income Inequality: Paul Krugman calls attention to the update of the Piketty-Saez data on income inequality, although Paul describes the data differently than I would. Here is what I see: After rising substantially from 1986 to 2000, income inequality is essentially the same in 2004 (the most recent year of data) as it was in 2000.

Greg wrote this last year, before the IRS issued the data underlying the 2005 data point [shown in the graph above].

I expect the usual cast of characters will show up on the op-ed pages in predictable places with the same old tired attempts to rebut this evidence. But the question is not about whether inequality exists, or whether it is rising. The data are clear on this point - inequality is increasing. To me, the question is why inequality has been rising, i.e. the source of the increasing wealth accumulation and what, if anything, we ought to do about it.

Hal Varian: What Use is Economic Theory?

This article is suggested in a comment from Hal Varian to a post where I compared economics to physics. The article says it "is a mistake to compare economics to physics; a better comparison would be to engineering. Similarly, it is a mistake to compare economics to biology; a better comparison is to medicine." Having also made the comparison to medicine (when I wasn't comparing economics to physics and evolutionary biology), I'm in agreement with the perspective set forth in the paper.

The view adopted in the paper is that economics is inherently a "policy science" and thus the focus is on "how neoclassical economic theory is useful to the understanding of economic policy," and on describing "the role of economic theory in economics." It's a little bit longer than usual, but well worth it:

What Use is Economic Theory?. by Hal R. Varian, August, 1989: Why is economic theory a worthwhile thing to do? There can be many answers to this question. One obvious answer is that it is a challenging intellectual enterprise and interesting on its own merits. A well-constructed economic model has an aesthetic appeal well-captured by the following lines from Wordsworth:

Mighty is the charm
Of these abstractions to a mind beset
With images, and haunted by herself
And specially delightful unto me
Was that clear synthesis built up aloft
So gracefully.

No one complains about poetry, music, number theory, or astronomy as being ‘‘useless,’’ but one often hears complaints about economic theory as being overly esoteric. I think that one could argue a reasonable case for economic theory on purely aesthetic grounds. Indeed, when pressed, most economic theorists admit that they do economics because it is fun.

But I think purely aesthetic considerations would not provide a complete account of economic theory. For theory has a role in economics. It is not just an intellectual pursuit for its own sake, but it plays an essential part in economic research. The essential theme of this essay that economics is a policy science and, as such, the contribution of economic theory to economics should be measured on how well economic theory contributes to the understanding and conduct of economic policy.

1. Economics as a policy science

Part of the attraction and the promise of economics is that it claims to describe policies that will improve peoples’ lives. This is unlike most other physical and social sciences. Sociology and political science have a policy component, but for the most part they are concerned with understanding the functioning of their respective subject matters.

Physical science, of course, has the potential to improve peoples’ standards of living, but this is really a by-product of science as an intellectual activity.

In my view, many methodologists have missed this essential feature of economic science. It is a mistake to compare economics to physics; a better comparison would be to engineering. Similarly, it is a mistake to compare economics to biology; a better comparison is to medicine. I think that Keynes was only half joking when he said that economists should be more like dentists. Dentists claims that they can make make peoples’ lives better; so do economists. The methodological premise of dentistry and economics is similar: we value what is useful. None of the ‘‘policy subjects’’--- engineering, medicine, or dentistry---is much concerned about methodology, and economists, by and large, aren’t either.

When you think about it, it is quite surprising that there isn’t more work on the methodology of engineering or medicine. These subjects have exerted an enormous influence on twentieth century life, yet are almost totally ignored by philosophers of science. This neglect should be contrasted with with other social sciences where much time and energy is spent on methodological debate. Philosophy of science, as practiced in philosophy departments, seems to be basically concerned with physics, with a smattering of philosophers concerned with psychology, biology, and a few social sciences.

I think that many economists and philosopher who have written on economic methodology have not given sufficient emphasis to the policy orientation of most economic research. One reason for this is the lack of an adequate model to follow. There is no philosophy of engineering, philosophy of medicine or philosophy of dentistry---there is no model of methodology for a policy science on which we can build an analysis. The task of constructing such a theory falls to economists. This is, in my view, one of the most interesting problems for those concerned with methodological issues and the philosophy of the social sciences.

2. Role of theory in a policy science

Given my view that economics is a policy science, if I want to defend a practice in economics, then I must defend it from a policy perspective. So I need to argue about how economic theory is useful in policy. The remainder of the paper will consists of list of several such ways. The list is no doubt incomplete, and I would welcome additions. But perhaps it can help focus some discussion on why economists do what the do, and how theory helps them do it.

Theory as a substitute for data

In many cases we are forced to use theory because the data that we need are not available. Suppose, for example, we want to determine how a market price will respond to a tax. We could estimate this effect by running a regression of market price against tax rates, controlling for as many other variables as possible. This would give us an equation that we could use to predict how prices respond to changes in taxes.

We rarely have data like this; taxes just don’t change enough. But if people only care about the total price of a good, inclusive of tax---a theory---then we can use estimated price elasticities to forecast the response of price to the imposition of a tax.

This uses a theory about behavior---people will respond to the imposition of a tax in the same way that they respond to a price increase---in order to allow data on price responses to be useful. We can use the theory to forecast the outcome of an experiment that has never been done.

Here is another, slightly more esoteric example. Consider the assumption of transitivity of preferences mentioned briefly above. This theory asserts that if A chosen when {A,B} is available and B is chosen when {B,C} is available, then we can predict A will be chosen when {A,C} is available. This is certainly a theory about behavior; it may or may not be true.

If we had data on choices between all pairs of A, B, and C, then the theory wouldn’t be necessary. When we want to predict the choice out of the set {A,C} we would simply look at how the person chose previously---that is, we would just use brute induction. And we know why induction works---it has always worked in the past!

But we rarely observe all possible choices; typically we observe only a few of the possible choices. Theory allows us to interpolate from what we observe to what we don’t observe. In the case of the {A,B,C} example brute induction requires observing all choices the consumer could make from the various proper subsets available, which requires 3 choice experiments. But if the assumption of transitivity holds, then 2 choice experiments are all we need. The theory of consumer choice allows us to economize on the data.

Naive empiricism can only predict what has happened in the past. It is the theory---the underlying model---that allows us to extrapolate.

Theory tells what parameters are important and how we might measure them.

The Laffer curve depicts the relationship between tax rates and tax revenue. At some tax rates tax revenue decreases when the tax rate increases. It has been said that the popularity of the Laffer curve is due to the fact that you can explain it to a Congressman in six minutes and he can talk about it for six months.

The Laffer analysis demonstrates both good and bad economic theory. The bad theory is that inference that because the Laffer effect can occur it does occur. The good theory is that we can use simple supply and demand analysis to determine what magnitudes the elasticity parameters have to be for the Laffer effect to occur. We can then compare the magnitudes of estimated elasticities to estimated labor supply elasticities. In the simplest model a marginal tax rate of 50% requires a labor supply elasticity of 1 to get the Laffer effect. The theory tells us what the relevant parameters are; without the theory, one would have no idea of the relevant parameters are. Indeed, if one examines the rather sordid history of the use of the Laffer curve in public policy debates in the U.S. this becomes painfully clear.

For another example, consider the theory of investment in risky assets. I take it as given that risk is a ‘‘bad.’’ Therefore when wealth goes up, people may want to purchase less of it. On other hand, you can afford to bear more risk when you have more wealth. So an argument based on intuition alone shows that investment in a risky asset can go up or down when wealth increases. A systematic theoretical analysis shows what the comparative statics sign depends on: how risk aversion changes with wealth. So the risk aversion parameter is the one you want to estimate in order to predict how investment in risky assets changes with wealth. Conversely how investment changes with wealth tells you something about how risk aversion changes with wealth.

Theory helps keep track of benefits and costs

I indicated above that the sorts of optimizing models used by economists serve the purpose of providing guidance for policy choices. Indeed one of the important roles of economic theory is to keep track of benefits and costs. The idea of opportunity cost is a fundamental one in economics, and would be very difficult to use without a theoretical model of economic linkages.

This brings up the important point that the correct way to measure an economic benefit or cost can only be determined in light of a theoretical model of choice: a specification of what objectives and the constraints facing an economic agent.

Consider for example, the practice of computing present value or risk adjusted rates of return. These computations are only meaningful in light of a model of choice behavior. If the model of behavior does not apply, the policy prescription cannot apply either.

Benefit-cost analysis is only one small field of economics. But the idea behind benefit-cost analysis permeates all of economics. If economic agents are making choices to maximize something, then we can get an idea of what is being optimized by looking at agents’ choices. This objective function can then be used as an input to making policy decisions. In some cases, one may need a quantitative estimate of the objective function. In other cases, one may want to show that one kind of market structure, or tax structure, may do a better job of satisfying consumers’ objectives than another. But the basic framework of moving from individual objectives, to individual choice, to social objectives and social choice is common to many, many economic studies.

Theory helps relate seemingly disparate problems

If one describes a model in a purely mathematical way, it often happens that the underlying equations will describe a rich set of economic phenomena. The classic example of this phenomenon is the Arrow-Debreu general equilibrium model. The concept of ‘‘good’’ can be interpreted as a physical commodity available at different times, locations, or states of nature. One theoretical model can thereby provide a model of intertemporal trade, location, and uncertainty.

Another example from general equilibrium theory is the First Welfare Theorem. This result shows the intimate relationship between the apparently distinct problems of equilibrium and efficiency.

A third example is that a formal analysis of the problem of second-degree price discrimination shows that it is equivalent to the design of an auction or the determination of optimal provision of qualities. Quality discrimination, auction design, and nonlinear price discrimination are essentially the same sort of problem.

Each of these insights came from examining an abstract theory. Once the the ‘‘irrelevant’’ details are stripped away, its becomes apparent that the same essential choice problem is involved.

Theory can generate useful insights

Let me illustrate this role of economic theory with an example. In the U.S. most interest receipts are taxable income, but many kinds of interest payments are tax deductible. This policy has been criticized as ‘‘subsidizing borrowing.’’ Does it?

The answer depends on the tax brackets of the marginal borrowers and lenders. If the tax brackets are the same, for example, the policy has no effect at all on the equilibrium after-tax interest rate. The supply curve tilts up due to the tax on interest income, but the demand curve tilts up by the same amount due to the subsidy on interest payments. This is a simple insight, but it would be very difficult to understand without a model of the functioning of the market for loans.

A theory that is wrong can still yield insight

Pure competition is certainly a ‘‘wrong’’ theory many markets; pure monopoly is a wrong theory for other markets. But each of these theories can be very useful for yielding significant insights for how a particular market functions. No theory in economics is ever exactly true. The important question is not whether or not a theory is true but whether it offers a useful insight in explaining an economic phenomenon.

In my undergraduate textbook I examine a very simple model of conversion of apartments to condominiums. One result of the model is that converting an apartment to a condominium has no effect on the price of the remaining apartments---since demand and supply each contract by one apartment.

This result can hardly be thought of as literally ‘‘true.’’ There are a host of reasons why converting an apartment to a condominium might influence the rent of remaining apartments. Nevertheless, it focuses our attention on a crucial feature of such conversions: they affect both the supply and the demand for apartments. The simple supply-demand framework shows us how to start thinking about the impact of condominium conversion on apartment prices.

Theory provides a method for solving problems

I take the method of neoclassical microeconomics to be 1) examine an individual’s optimization problem; 2) look at the optimal equilibrium configuration of individual choices; 3) see how the equilibrium changes as policy variables change.

This methods doesn’t always work---the models of behavior or equilibrium may be wrong. Or it may be that the specific phenomenon under examination is not fruitfully viewed as an outcome of optimizing, and/or equilibrium behavior. But any method is better than none. In the words of Roger Bacon: ‘‘More truth arises through error than confusion.’’

Methodological individualism is a limited way of looking at the world, no question about it. It probably doesn’t do very well in describing phenomenon such as riots or class loyalty. Certainly this sort of individualistic methodology works better for describing some sorts of behavior than others. But it is likely to add insight to all problems.

Theory is an antidote to introspection

Most people get their economic beliefs from introspection and their personal experience- --the same place that they get their beliefs about most things. Economic theory---and indeed science in general, can serve as an antidote to this kind of introspection.

Consider, for example, the widely held belief that all demand curves are perfectly inelastic. If the price of gasoline increases by 25%, a layman will argue that no one will change their demand for gasoline. He bases this argument on the fact that he would not change his demand for gasoline.

Indeed, it is perfectly possible that most people wouldn’t change their demand for gasoline...but some would. There are always some people at the margin; these people would change their demand. At any one time, most people are infra-marginal in most of their economic decisions. The marginal decisions are the ones that you agonize over. If the price were a little higher or a little lower, the results of your agonizing might be different, and this is what causes the aggregate demand curve to slope downward.

Another nice example of this phenomenon is free trade. It’s hard to convince a layman of the advantages of free trade since it is easy to see where the dollars go, but difficult to see where they come from. People have personal experience with imports of foreign goods of foreign goods; but they rarely encounter their own country’s exports unless they travel abroad extensively. Only by abstracting from introspection can we see the total picture.

A third example is the bias in perceptions of inflation: price moves are perceived to be exogenous from the viewpoint of the individual, but wage movements are personalized. Even if prices and wages move up by the same amount, people may feel worse off since they think that they would have gotten the wage increases anyway.

Verifying that something is obvious may show that it isn’t

One of the criticisms that economists have to deal with is that they spend a lot of time belaboring the obvious. Isn’t it obvious that demand curves slope down and supply curves slope up? But many theories that seem to be obvious turn out not to be. It may be obvious that demand curves slope down---but as the theoretical analysis shows, it is possible to have demand curves that don’t.

Economic theory shows that a profit-maximizing firm will decrease its supply when the output price decreases. But farmers often claim that removing milk price supports will increase the supply of milk since farmers will have to increase output to maintain the same income. The second effect sounds like it might be possible---after all, farmers wouldn’t advance the claim unless it had some plausibility. However, theory shows us that this particular claim cannot be true if the farmers attempt to maximize profits.

Strategic interactions are a good source of counterintuitive results. A simple analysis of a two-person zero-sum game shows that improving your backhand in tennis may lead to your using it less often.

It would seem that a public offer to match any competitor’s price is a sign of a highly competitive market. But when you think about the problem facing a cartel it is not so obvious. The prime problem facing a cartel is how to detect cheating on the agreed-upon prices and quotas. Offering to match a competitor’s price is a cheap way to gain information about what your competitors are doing. What appears to be a highly competitive tactic can easily be viewed as a device to support collusion.

Theory allows for quantification and calculation

According to Lord Kelvin, ‘‘When you cannot measure it, when you cannot express it in numbers, your knowledge is of a meagre and unsatisfactory kind.’'[1]

Theoretical economics gives us a framework to calculate and quantify economic relations. Consider the Laffer curve mentioned above. Laffer gave the existence proof, but it took some theoretical calculations to see what magnitudes were important.

In fact, one of the major differences between economics and the other social sciences is that in economics you can compute. There is very little computation in sociology, political science, history or anthropology. But economics is filled with computation.

Economic theory is useful since you can use it to compute answers to problems. They aren’t always the right answers---that depends on whether the model you have is right. (Or, at least, whether it is good enough for the purposes at hand.) But a desideratum of a good model is that you can compute with it: the model can be solved to determine some variables as a function of other variables.

In my view, it is impossible to learn economic theory without solving lots of problems. Richard Hamming, a highly prolific electrical engineer, once gave me some excellent advice about how to write a textbook. He told me to assemble the exams and problem sets that you want the students to be able to solve by the time they had finished the course, and then write the book that would show them how to solve them. In general, I have tried to follow this advice, with, I think, some success.

Economics is amenable to experimental verification

Because neoclassical economic models enables one to compute answers to problems, it is possible to compare the answers you get with the outcomes of controlled experiments. In my view, experimental economics has been one of the great success stories of the last 20 years. We now have rigorous ways to test models of human behavior in the laboratory. Some standard models, such as supply and demand, have turned out to be much more robust than we would have thought 20 years ago. Other models, such as expected utility, have turned out to be less robust.

But this is to be expected---if there were no surprises from experiments, they wouldn’t be worth doing. The growth of experimental economics has led many theorists to construct theories that simple, concrete and testable, rather than theories that are complex, abstract, and general. And experience in observing human subjects in the laboratory has no doubt contributed to the current emphasis on investigating models of learning. Laboratory observations have also been instrumental in alerting us to theoretical dead ends, such as some of the more convoluted refinements of game-theoretic equilibrium concepts.

I expect that the interaction between theory and experimentation will continue to grow in the future. As economists become more comfortable with experimentation in the laboratory, they will also become better at identifying ‘‘natural experiments’’ in real-world data. Such developments can only lead to better models of economic behavior.

3. Summary

I have argued that in order to why economic theorists behave in the way they do one has to understand the role of economic theory’s contribution to policy analysis. The fact that economics is fundamentally a policy science allows one to explain many aspects of economic theory that are quite mysterious otherwise.
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1 However, the same poet whose praise for abstraction and synthesis I quoted in the introduction also once said: ‘‘...High Heaven rejects the lore of nicely calculated less or more.’’

Robert Reich: This is Not the Time to Deregulate

Robert Reich says to be wary of the push to deregulate Wall Street:

When the Bushies Meet with Wall Street, Watch Your Wallets, by Robert Reich: Top Bushies, including Cheney and Treasury Secretary Paulson, are talking with Wall Street honchos this week about how to make life easier for the securities industry by getting rid of some post-Enron regulations and shielding the industry from liability from shareholder lawsuits. The thinly-veiled rationale for this mutual kiss-up is that American securities markets are supposedly becoming less competitive in world markets.

As I've noted before, the idea that American capital markets are losing their competitiveness is complete and total nonsense. Returns to the financial sector in the U.S. continue to be higher than in any other sector of the economy – now higher than ever before. Investment bankers .... Top traders ... hedge fund managers ... Private-equity managers, the managers of large pension and mutual funds, and the rest, are raking in more money they know what to do with.

It’s true that the percent of big global initial public offerings listed on U S stock exchanges is declining while the percent of initial public offerings done through financial centers in London, Hong Kong, and elsewhere is rising. .. But this doesn’t mean Wall Street is becoming uncompetitive. Capital markets are now global. So of course other financial centers are going to gain a larger share of IPOs. Meanwhile, Wall Street is doing deals all over the world. Mergers and acquisitions in Europe, China, Latin America. Hedge funds taking in money from all over the globe.

American capital markets are fully competitive. America is still the world’s largest magnet for foreign capital. ... In fact, foreign companies that list both on a US and a foreign stock market typically trade at a premium over foreign firms that list only outside the US. Why are investors willing to pay more for listings in the US? Because the US capital market is more stable and transparent, and its tough accounting standards give investors better protection. In other words, because of the very regulations that the Bush Administration and its Wall Street cronies wants to get rid of.

The threat of another Enron or Worldcom hasn’t gone away. Executive suites are still reeling from the scandal of back-dating executive stock options. Small investors continue to be wary. Even if the Street weren’t doing better than ever, even if it weren’t already so competitive it doesn’t know what to do with all its money, this is not the time to deregulate.

Here's more on this topic, as well as Robert Reich's comments on the attorney firings and details of his date long ago with Hillary Rodham Clinton: Link to video.

Reducing Poverty: Direct Aid versus Institutional Reform

Jeffrey Sachs says the poor in developing countries are stuck in a bad equilibrium with low and stagnant income - a poverty trap - that can be overcome with an infusion of direct aid that provides the tools, infrastructure, and other support needed to spur "a dramatic surge of productivity that raises household incomes and initiates self-sustaining economic growth":

Rapid Victories against Extreme Poverty, by Jeffrey D. Sachs, Scientific American: Around one billion people live in extreme poverty... Extreme poverty is sometimes defined as living on under $1 a day, but more accurately it is the lack of reliable access to basic needs, including adequate food, basic health services, safe drinking water and connectivity with the wider world (via roads, power and telecommunications). Recent orthodoxy holds that extreme poverty results from corruption, mismanagement and weak institutions. A corollary is that institutional improvements take considerable time, so the escape from extreme poverty is likely to take decades.

Without denying the benefit of stronger institutions, I suggest that excessive focus on institutional reforms has gotten the policy sequencing more wrong than right. Often, more direct aid can dramatically reduce extreme poverty in just a few years.

The proximate cause of extreme poverty is that the poor lack basic tools to achieve adequate productivity. “Tools” should be interpreted broadly to include not only machinery and software for production but also agricultural inputs, clinics, medicines, schools and safe water. Even in poor countries with weak institutions, aid from rich countries can help the poor gain access to the needed tools in a very short time. The result can be a dramatic surge of productivity that raises household incomes and initiates self-sustaining economic growth.

Consider the case of agricultural output. Impoverished farmers in Africa grow around one ton of cereal grains per hectare, roughly a third of the average yield in other developing countries.

Their low yields reflect a lack of fertilizers, high-yield seeds and small-scale water management. The farmers are too poor to buy such inputs, and they lack the collateral to borrow. Thus, they plant with what is available, get insufficient yields and remain too poor to buy better inputs or diversify production.

Yet if poor farmers are subsidized for a few years to obtain improved inputs and thereby raise yields and diversify output, and if they reinvest the resulting boost to income on the farm and in the community, two things can happen. First, farm productivity can increase persistently, even after subsidies are removed. Second, the households can accumulate wealth, which can be used as collateral or to self-finance purchases of improved technologies. Temporary assistance can put the farmers on the path of long-term growth. It’s not a hunch. Asia’s Green Revolution worked that way.

In practice, it is a group of interacting technologies that matter, and that can be provided simultaneously. They include farm inputs, health services, safe water, latrines, computers and training, motor vehicles for village use, on-grid or off-grid electricity and all-weather roads. Because these interventions are low cost and high impact, they can be provided throughout the poorest regions of the world at a cost well within the ... (...unfulfilled) commitment by rich countries to donate 0.7 percent of their gross domestic product as aid. ...

Update: Kash at The Street Light has thoughts related to this topic.