It's All Costs and Benefits

The way economists approach consumer choice theory (why do people buy what they buy at the prices and quantities they do) is really simple. Economic Man (or Woman) goes to a store or website. "What is the most I am willing to pay for this?" thinks Economic Man. "What is the price?" he asks himself. If the value exceeds the price, he buys it. If it doesn't, he doesn't. Simple. Rational.

Nobel Laureate in Economics Daniel McFadden recently argued that economists need to rethink how economists approach consumer choice. Psychology, neurobiology, and other disciplines find a host of things which put our stable, simple world into chaos.

To take one example, the “people” in economic models have fixed preferences, which are taken as given. Yet a large body of research from cognitive psychology shows that preferences are in fact rather fluid. People value mundane things much more highly when they think of them as somehow “their own”: they insist on a much higher price for a coffee cup they think of as theirs, for instance, than for an identical one that isn’t. This “endowment effect” means that people hold on to shares well past the point where it makes sense to sell them.

There are others as well: your loss of happiness is greater if you lose X than your gain of happiness if you acquire X. People prefer a free $10 gift card than to pay $1 for a $15 gift card. There is such as thing as too many choices. It's enough to make economists think people are irrational.

No doubt that people care for other things beyond what you see in our simple model, just like air resistances affects how fast a ball falls but it's so hard to incorporate that at the basic level, you assume it away in intro physics. It's a simplifying assumption. It doesn't require that we redo all of economics or change our fundamental approach.

And this is where these economists get it wrong because most stop there but they shouldn't. None of this demonstrates that people are actually irrational. Rationality is a very low bar in economics: do something when benefits exceed costs. That gets us very, very far. These studies that other disciplines tout are important, not because they undo what we know but because they add to what we know people care about. People derive inherent satisfaction from owning things or getting things for free, just as they value food, sex, and shelter.

Nothing really changes. I guarantee that if you change that $15 gift certificate to $20, $30, or $50, you'll see fewer people willing to indulge in their preference for "free" things. Demand slopes down.

This extends to all areas. Advertising works but it can never brainwash someone into buying something they don't want on some level. Advertising has limits and the fact that you don't buy everything you see advertised to you is a testament to that. I don't like tomatoes and I don't wear makeup. I know this about myself and no matter how many ads I see for either will not change my purchasing patterns. (I've seen thousands of ads for bras; I've never bought one.)

Ads work because they help us economize on other things we find valuable such as time and mental energy. On occasion, I find myself at the store wanting a general thing, like a cracker, but no strong preference on brand name. Then I remember a jingle or a funny commercial and so I buy Wheat Thins or Ritz. This is not irrational; I didn't have a strong preference and making a choice is costly both in time and mind. Costs exceed benefits to make up my own mind so I'll do what's easiest: I'll follow the ad.

That I am describing this everyday purchase in this way does not make me unusual. Quite the contrary, as an economist I'm trained to think like a typical strangers. Time is a real resource people care about. Thinking hurts. So we avoid it if it's cheap to do so. We are rational.

Unsustainable Pricing

A series of clicks today led me to this YouTube video of Senator Warren's March 2013 congressional hearings on the minimum wage.

At 2:53 she notes as a result of an increase in the minimum wage to $10.10/hour over three years, the price of a fast food meal would rise by four cents.

So instead of it being $7.19 it would be $7.23. Are you telling me that's unsustainable?

Given the context, "unsustainable" probably refers to the restaurant business itself. As in, "if you raise your price by four cents, are you really going to have issues?"

The answer is yes.

There is a nasty consumer habit to believe that the prices we see are given, as if they were determined randomly or granted to us from a deity. But they are the careful, careful decision of business owners and analysts with the sole aim at maximizing revenue. The $7.19 price came from a conversation like this (all prices are post tax):

"How about $7 for the meal?"
"$7 is a bit low; I bet we can up our revenue if we increase by two quarters."
"Our market research tells us our consumers are particular price sensitive, especially given the state of the economy. I wouldn't go higher than $7.05."
"Really? We can definitely go higher than $7.05. I was thinking $7.40."
"No way! Our competitors' are pricing lower than that. We gotta go much lower."
"Our competitors price there for a reason."
"A TV dinner only cost $5. This is our competition."
"It isn't nearly as easy, nearly as good. When we offered a coupon last year, people barely used it. We can afford to go higher. We have investments to pay off."
"How about $7.35?"
"Burger King's $7.25."
"It also's been hitting the airwaves harder than us. Let's drop a little below them and get our customers through price."
"$7.24?"
"A little bit more; something big enough that they just can't respond."
"$7.17? Has a nice ring to it"
"Maybe...or $7.20"
[Market research]
"$7.19 seems to be the sweet spot."

This is an abstraction, (void of uncertainty which is another factor they consider but I need to go to bed) but it's meant to remind us that firms do not grab numbers from nowhere, especially for firms who tend to sell very cheap food and where customers are very sensitive to price. Warren's thought process seems to be "Well, I'd pay 4 cents more while on my campaign trail" but she is a wealthy individual with very little time and not many alternatives: it's hard to get more insensitive than that.

Many customers, especially when times are tough (and thus when  increasing the minimum wage is most popular), are very price sensitive. This goes double after a lot of time has passed and they can adapt to the 4 extra cents (which, for a family of four and a biweekly meal out totals to $16.64 over the course of a year) in ways such as going to restaurants with fewer minimum wage workers (and thus less of a price increase so at least you get more for your money) to eating at home more to eating less when you do eat out.

At the heart of Warren's question is a puzzle: if an extra four cents is so sustainable, why isn't it already four cents more expensive?

It's because it is. That's the revenue maximizing price.

The Government Isn't a Household

I was recently told that the balancing the U.S. budget is like balancing a family budget. If you're spending too much, cutting out a lot of little things can make a big difference. In the conversation, cutting back on the EPA was a theme.

The EPA budget in 2011 was about $8.5 billion. The Federal government spent $3,630 billion that year and brought in $2,314 billion. This is a deficit of $1,316 billion. So if we to eliminate--not merely scale back but completely remove--the EPA, we are shaving off a little more than 0.6% of the deficit.

Let's put that in perspective. Suppose your household make $50,000 a year (after taxes) but you spend about $78,435 a year (this keeps our household income and expenses in proportion to the Federal government: here our deficit is $28,435). Our EPA equivalent is an expense of $170.61. You're spending more than $28,000 a year than you earn and some people are arguing you can solve your problem by three fewer video games.

Yes, yes, I know. The argument is that if we do enough of these little cuts (and keep in mind, I'm eliminating the EPA, not just cutting it back), it adds up into a significant effect. Forget the fact that there aren't enough little cuts to use until you run into the politically tough stuff (Medicare, Social Security, defense). The household analogy is fundamentally flawed beyond that.

Imagine you attempted the same strategy but you needed everyone's approval before you made changes. You can't cut your cellphone budget unless your talkative daughter approves. The video game budget adjustments need approval from your kids. Hell, even your dog has to approve adjustments to how many new toys he gets.

Now spending your time and effort taking away a few video games seems really dumb. In fact, it might be better to spend more on video games just so the kids won't complain when you dip into their college fund (which is a really big expense and can solve the problem by itself).

Like a household budget, our budget needs to be balanced. But there's where the analogy stops because to change the Federal budget, you have to get approval from folks who are about as forward thinking as teenagers and as thoughtful as a family dog.

The Scarce Resource of Political Capital

A couple of days ago I participated in a round table discussion on the state of the economy. It was organized by the office of Representative David McKinley and included local business leaders and political actors. Two of Bethany's best students were there as well, about 12 overall.

While the main purpose of the meeting was sequestration, the businessmen wanted to express concerns about the EPA, making sure the congressman was aware of the barriers it sets up. The EPA's smothering them and, by extension, job creation. I emphasized regime uncertainty: the only way we're going to get the investment needed to bring job growth back up is for Congress to strike some kind of deal. There's too much uncertainty in the market. Everyone agreed, but I don't think people really got it.

Everyone seemed to believe that McKinley could do both: help strike a budget deal and weaken the EPA (and do other things, too). But he can't. He only has so much political capital to spend and making these things happen requires getting a lot of people on board. McKinely's a Republican so reigning in the EPA will upset some Democrats which will make it harder to strike a deal. And since he's a member of the Tea Party Caucus, increasing taxes is politically tricky, too. A common Sophie's choice in politics: what the country wants or what the constituents want. (Oh wait, that's not a good analogy; they will side with their constituents almost every time.)

This is why I like pork. If you think of it solely as a project (e.g. a bridge to no where), then yes, it's wasteful. No one seemed to like pork at the round table discussion and I regret I didn't defend it because pork makes things easier. If EPA deregulation and politically stable is what you buy with political capital, pork is a way to earn it.

Pork is cheap. Giving every Representative a $5 million pet project would cost a little less than $2.2 billion dollars. If that gives us a budget deal, we get stability and economic growth: that's worth hundreds of billions of dollars. Yes, it might take more than $5 million to get cooperation from some, but others won't require any pork. It's a good deal.

Political capital's a scarce resource. Like the money Congress is fighting over, you can't have everything. But if you sleep with the pigs, you might get enough to make everyone satisfied.

James Buchanan (1919-2013)

Nobel laureate and Father of Public of Choice James Buchanan passed away at the age of 93. He was a titan of a thinker and a tireless defender of liberty. He will be missed.

Here is Tyler Cowen, Alex Tabarrok, Robert Higgs, Arnold Kling, Don Bordeaux, Russ Roberts, David Henderson, and additional remembrances compiled by Don Bordeaux.

Pete Boettke posts a video of a panel discussion with Buchanan from a conference held in his honor, Don Bordeaux discusses Buchanan's thoughts on public debt (in two parts), and here is Buchanan's Nobel lecture.

Two Krugmans Enter, One Krugman Leaves

Paul Krugman likes to contradict himself but never have I seen it happen within a single column. Writing on health care costs, he states:

But even as Republicans demand “entitlement reform”, they are dead set against anything like that. Bargaining over drug prices? Horrors!

I agree, being able to bargain over drug prices is a good thing. Makes sense: being able to bargain and not blindly accept forced prices is a hallmark of free-markets. But later he writes:

If they were serious about deficits, they’d be willing to consider policies that might actually work; instead, they cling to free-market fantasies that have failed repeatedly in practice.

Ah, but you might say that the goal is to allow the government more bargaining power and since the government increasingly has monopsony power (like a monopoly but there're few buyers rather than few sellers), it's not a free-market. In other words, Krugman tells us that monopsonies are actually desirable, which is endorsing a law which states only Microsoft gets to hire engineers. Even non-economists should understand why that's a bad idea.

That's not the only issue with today's column--the claim that private firms apparently have no incentive to reduce costs is equally strange and the point that an underfunded voucher system won't work is equally obvious (since it's underfunded!)--but those are for another post.

I'm Not a Grinch; I Just Don't Like Negative Externalities

I don't remember how it came up, but I couldn't help myself. And when it started, I couldn't stop. Today I told my managerial class that I don't like Christmas. Or, more accurately, the Christmas season. They were surprised, and so of course I had to tell them why. But my hatred for the season really stems for a hatred of any negative externality people blissfully ignore, things people don't think are externalities.

A negative externality is when something imposes a cost onto others. We are familiar with examples: pollution, cigarette smoke, screaming/crying babies, traffic. Basically anything someone does which makes people who had nothing to do with the transaction worse off. I buy power from the power company, but neither of us pay the cost of the pollution which poisons the water downstream from the power plant.

We're all well aware of these problems and there are attempts to correct for them. But what I find endless annoying are those negative externalties which so many refuse to acknowledge. And that brings me to the  Christmas season.

Christmas Season. For one month, everything becomes about Christmas. I must endure the decorations, the constant Christmas references in all media, the music on the radio, the Christmas theme in virtually every article, the extra traffic, and, most of all, the cheeriness of everyone who assumes you are as excited about the season as they are. Don't get me wrong: there are things I've found enjoyable. I like time with the family, I like my neighbor's Christmas cookies she bakes every year, I like the time off from work. But if we were to at least diversify the season for a month, I would welcome the change.

Sports. If you like sports, that's fine, but shut up about it. Don't be surprised when other people think slaying dragons is more interesting than watching football. Don't think me a fool because I don't know if the Raiders and the Cubs play the same game. Don't run around screaming and honking horns when the team you like wins. Or loses. (I really don't understand what motivates you.)

Dogs. Again, I don't hate dogs as much as the externalities they create. And really, I don't like how dog-lovers don't understand how inconsiderate they can be when they assume no one cares about these externalities. Dogs are not angels: they bark, they smell, their "kisses" are slobber. Dog poop, even when I see it to avoid it (which isn't always) stinks. Not to mention, they bite (and yes, they do bite; they of course don't bite you because you're the one who feeds them).

I am well aware that all of these things are better existing than not; the total annoyance they create is probably outweighed by the total joy they create. Benefits probably exceed costs, including the external, and in my book that's the thumbs up even if I'm not a fan.

But, for the love of all that is good and holy (religion: that's another one; not everyone's religious you know) stop assuming everyone's like you. I'm not excited that Christmas is coming, I don't want to pet your dog, and no, I didn't watch the #%$%^ game last night.

A Very Interesting Sentence

Within two or three decades the difference between automated driving and human driving will be so great you may not be legally allowed to drive your own car...

From The New Yorker

Let People Sell Kidneys!

In 2011, 35,031 people were added to the wait list for a kidney transplant. Only 31,626 were taken off the list that year, growing the waiting list by over 3,000 people.

Of those removed, 16,195 were taken off because they got a new kidney. However, 4,959 were taken off because they died and an additional 2,506 were taken off because they became too sick to either survive the surgery or have a new kidney make the difference (it's not clear from the source which one, or both, is the case).

About half of the individuals who are waiting for a new kidney are between the ages of 50 and 64. Their median wait time (between 2003 and 2004, the most recent years available) is 1,627 days or 4.45 years.

Dialysis cost about $75,000 per patient per year. That's $3,375,000 per patient.

Even if the market price for a kidney was $100,000, that would save not only millions of dollars per patient but, by getting kidneys faster, save thousands of lives. Every. Single. Year.

Data on kidney wait list found here.

Sweet Thoughts

Friend and economist Brian Hollar made a tongue and cheek reference to claims that eating chocolate helps you win the Nobel Prize. Per capita chocolate consumption correlates strongly with per capita Laureates. Yes, yes, yes, we're all aware of the "correlation is not causation" platitude--though I wonder if half the people who say truly understands it--and it probably applies here. But there's probably such a story here. Not that winning Nobels cause people eat chocolate but wealthier nations eat chocolate and have more Laureates. Wealthier countries, after all, have better nutrition and caloric intake (which helps the brain develop), are safer (so smart/driven people are less likely to die young), and allow greater specialization (so smart/driven people don't get stuck doing menial labor rather than expanding the boundaries of knowledge). Moreover, wealthier countries have the capital equipment that's so helpful when doing revolutionary work. Switzerland has the highest per-capita in Laureates. Switzerland also has CERN. The heteroskedastic nature of the best fit line supports this theory: chocolate-starved countries have few Nobels but chocolate-rich ones have either many or (relatively) few. When you're wealthy, there's a lot of different things you can spend your money on. (I assume if there was a Nobel for engineering, Germany would be higher.) This is all pretty straight forward; this post is largely a record so I can remember to use this example in class when I teach research methods next year. Still, it's a fun exercise.

Billionaires Per 10 Million

The US tops the list of countries with the most billionaires but who cares about the raw numbers? I'm much more interested in the number of billionaires per person. Or per ten million people in this case. That makes it easier (though some countries on this list don't have ten million people...but that just highlights how billionaire-friendly they are). Here's where I got my countries by population data. I removed Hong Kong's population from China's as I assume that their billionaires weren't included in China's billionaire count.

Country	Billionaires per 10m
Hong Kong	91.4
Switzerland	71.3
United Kingdom	22.6
Germany	16.8
United States	15.3
Canada	11.4
Russia	6.8
Brazil	2.5
China	1.1
India	0.9