Economists Do It With Models

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My Favorite Coase Theorem Illustration Is Taking Over The World…

August 29th, 2014 · 6 Comments
Behavioral Econ · Econ 101

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:

  • Property rights must be defined in some way- as stated earlier, it doesn’t matter how they are assigned, but they have to be assigned.
  • Bargaining must be costless, since otherwise transaction costs could prevent bargaining or drive a wedge between the valuations of the parties that prevents adjustment to the efficient outcome.
  • The decision makers in the bargaining must be economically “rational”- in this context, rationality implies thinking objectively about costs and benefits.

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:

  • Assignment of property rights: To me, it seems pretty clear that the property rights belong to the recliner, for two reasons. First, there is a functional recline button on the chair- when airlines don’t allow you to recline (in front of emergency exit rows, for example), they disable the functionality as opposed to just asking you to not recline. Second, the device used to prevent the seat from reclining is banned, and it’s only a small logical jump from “preventing an activity is banned” to “said activity is allowed.” That said, this scenario highlights the fact that it’s not only the assignment of property rights that is important, but also the recognition and respect for said property rights. (When multiple parties believe that they have the property rights, you get coexisting news headlines such as “Don’t Want Me to Recline My Airline Seat? You Can Pay Me” and “Don’t Want Me to Spit on You When You Recline Your Airline Seat? Pay Me.” as opposed to effective bargaining.)
  • Costless bargaining: In this type of situation in general, bargaining may not be costless for people who are averse to confrontation or if there is a fear of the other party, well, spitting rather than engaging in bargaining. Even I find bargaining to be perfectly reasonable but might think twice about trying to do so out of fear that the other party might think I’m insane. (For better or for worse, this hypothesis hasn’t even been tested because I’m short enough that this issue doesn’t play a large role in my existence.)
  • Rational actors: Intuitively, it seems pretty clear that the people in the story are acting pretty crazy, but, unless we decide that throwing water is a valid and productive bargaining strategy, we can conclude that they are acting in economically irrational ways as well. Irrationally can take far more mundane forms, however- behavioral economists, for example, would point out that a person who would pay a maximum of $15 to gain their legroom would likely demand far more than $15 in order to be willing to give it up. This “endowment effect” in and of itself can prevent the objectively efficient outcome from being reached, making the initial allocation of property rights more important than it would be otherwise.

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?

→ 6 CommentsTags: Behavioral Econ · Econ 101

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Follow Up: Stephen Colbert On Tax Inversions…

August 28th, 2014 · 7 Comments
Follow Ups · Policy

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.

→ 7 CommentsTags: Follow Ups · Policy

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Phrase Of The Moment: Tax Inversion…

August 27th, 2014 · 1 Comment
Policy

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.

→ 1 CommentTags: Policy

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What I Did Over My Summer Vacation, Film Shoot Edition…

August 21st, 2014 · 1 Comment
Administrative · Uncategorizable

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:


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!

→ 1 CommentTags: Administrative · Uncategorizable

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Fun With Related Goods, Broadway Edition…

June 28th, 2014 · 3 Comments
Econ 101 · Fun With Data

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:

  • Substitutes- roughly speaking, goods that are consumed instead of one another
  • Complements- roughly speaking, goods that are consumed together

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?

→ 3 CommentsTags: Econ 101 · Fun With Data

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Just Remember Kids, It’s Not You, It’s Your Data…

June 24th, 2014 · No Comments
Fun With Data · Just For Fun

Not in the grad school context per se, but this pretty much illustrates how I feel today…

I blame the Census County Business Patterns data.

→ No CommentsTags: Fun With Data · Just For Fun