Economists Do It With Models

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:

• People report being less likely to purchase a replacement movie ticket than the original ticket, even though the two decisions are nearly identical (unless one is so cash constrained that the wealth difference between the two choices actually becomes a limiting factor). Sometimes people try to justify their choice by saying “Why would I pay twice to see the movie?” and I counter with “Why would you pay once to not see the movie?”
• People are less likely to attend concert events when they are randomly given a discount on their season tickets after they’ve decided to purchase the tickets.
• People often report being “pot committed”> in poker, when, rationally, whether the money in the pot is your or someone else’s should have no bearing on whether you raise or fold.
• If people were good at ignoring sunk costs, the phrase “throwing good money after bad” would have never been invented.

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]
adjective
moving or tending to a lower place or condition.

nominal nom·i·nal [nom-uh-nl]
adjective
(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.

wage [weyj]
noun
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]
adjective
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:

Or 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!

First, a friendly reminder on what price discrimination is:

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:

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:

• Unemployment and the Unemployment Rate
• A GDP Thought Experiment
• The EDIWM Macroeconomics Category

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:

• Economic Growth and the Rule of 70

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.

Happy New Year! I am celebrating by trying to stuff an entire exhibit booth of stuff into a convertible. As many of you know, this weekend is the annual meeting of the American Economic Association (which is, as the post’s title implies, part of the Allied Social Science Association). This year’s meeting is in Philadelphia, and it’s a great time to get your nerd on with about 10,000 or so economists.

If you’re reading this, you likely don’t need me to tell you what this site is all about, but if you want to stop by the exhibit hall I would be happy to remind you. Oh, and I have stickers and candy, but, sadly, no windowless van. BUT…more importantly, I have projects for you- one if you’re feeling ambitious, and one if you’re feeling bored. If you’re feeling ambitious, I want you to think of a fun example of an economic principle that you can describe in about 2 minutes or so. When you stop by the booth, my RA will use whatever videography skills she may possess to tape your segment, which we’ll then put together into a fun little series.

If you’re feeling bored, I’m working on an economics bingo card for you to take with you to talks to give you things to listen for. This is what I’ve got so far:

Suggestions welcome- I see lots of potential for turning econ bingo into a drinking game. Also, you should go to the humor session on Saturday.