Economists Do It With Models

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?

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.

I swear I know how to use the Internet in general, but I somehow managed to type my name in the wrong place when trying to access my Facebook page, which mysteriously lead to Googling myself. (I don’t care how completely that verb enters the popular lexicon, it will always sound dirty.) Anyway, those of you who have ever, well, Googled anything know that a few image search results show up near the top of the first page- I noticed one of the photos and was like “heh, I don’t remember taking that photo…” Luckily, that is because the photo was originally part of a video and not because I am ridiculously unaware of stalkers, given that I was looking at the camera in said photo:

Anyway, the video…I did a few videos a while back for a production company that was looking to put together subscription-based materials for introductory econ classes, and the company made the video on natural monopoly one of their free preview videos, which you can see here. (Hopefully, watching this video will help you understand why I am posing with a Verizon truck, if it wasn’t already obvious.)

Or, tl;dw (didn’t watch, get it?): Regular monopolies get to be monopolies because of some usually artificial barrier to entry such as intellectual property protection. Natural monopolies get to be the only game in town because their fixed costs have already been paid (and are therefore sunk) and their marginal costs are low, so they can lower price in order to make it unprofitable for others to enter. In related news, the cost structure of natural monopolies means that it makes economic sense for only one to exist in an industry at a time, but regulation is often a good idea, since natural monopolies left to themselves result in the same inflated prices and reduced supply that regular monopolies do.

Okay, so my last post mentioned my desire for an Economist political party, but I don’t think that this is what I had in mind:

(See here if you are feeling procrastinatory and want to watch the second part of the segment.)

First off, I can’t help but focus on the fact that Rate My Professors is apparently fair game for information sleuthing, so, in all probability, the student review that said I would make a good wife if only I learned how to cook will come to light if I ever become famous and/or infamous. (And yes, I’m still pissed that the little sh*t incorrectly assumed that I can’t cook.) More generally, this story is making the ambivalence center in my brain hurt. Let’s take a quick inventory:

• David Brat is in fact an economics professor at Randolph-Macon College, and he has a Ph.D. in economics from American University. (Yay!)
• David Brat also has a degree from the Princeton Theological Seminary. (a bit odd given the other facts, especially the Ayn Rand thing that we will get to, but neither here nor there)
• The above facts imply that the Tea Party isn’t entirely terrified of intelligent and/or educated people. (Yay!)
• None of the economists I talked to had any idea who David Brat was before this event. (technically not terrible, but potentially worrisome) I’ll let you all judge his CV for yourselves.
• Accoring to TPM, “Brat is also the director of the school’s BB&T Moral Foundations of Capitalism Program, a bank-branded program intended to give “free-market principles” — and Ayn Rand’s philosophy of Objectivism in particular — a leg up in the classroom.” (*facepalm* Am I the only one who finds it hilarious that anything having to do with the moral foundations of capitalism has a corporate sponsor? I am incredibly suspicious of these sorts of programs and centers because I feel pretty strongly that good scholarship can’t promise to give anything “a leg up.” In addition, Brat does realize that Ayn Rand was an atheist, right? I kind of want this to be a dealbreaker in my pro/con analysis, but most people gave Alan Greenspan the benefit of the doubt regarding his Ayn Rand obsession, so I will try to withhold overall judgment.)
• As the above article’s comments note, we can now look forward to the existence of a “Brat PAC.” (Yay! I like bad puns.)
• Regardless of how you feel about his policies, you have to admit that Eric Cantor is kind of an obnoxious twerp. (Yay!)
• It’s pretty appealing to root for the underdog (seriously, Cantor, more on steak than Brat spent on his whole campaign?), and, as one who studies incentives, it’s nice to see effort be rewarded and entitlement be punished. (This reminds me of the Coakley/Brown election for Ted Kennedy’s senate seat in Massachusetts where Democrat Martha Coakley made arrogant comments about how shaking hands with people outside Fenway Park was beneath her and subsequently lost to Republican Scott Brown in a very blue state.) (Yay!)
• Brat’s position is that Cantor is too liberal, specifically where immigration reform is concerned. I’m pretty sure I read somewhere that Brat wants to build a giant fence. (Yikes, especially since this suggests that Brat doesn’t fully appreciate the opportunity cost involved in resource utilization.)
• As Justin Wolfers notes, Brat is one of very few politicians who will actually admit when he doesn’t have an answer for something. (Yay!)

Overall, I don’t think I agree with Brat’s ideology (though I will admit that he does have his moments), but I do think that he’s better than the Tea Party label suggests. That said, I am frustrated that one side effect of this development is that everyone watching cable news is getting the phrases “Tea Party,” “economics professor,” and “Ayn Rand” in close proximity over and over, so I do understand and feel the desire to point out that this guy’s views don’t represent those of the typical economist. Especially as far as immigration is concerned.

The more I read about this, the more interested I become in how UNH’s Dan Innis will fare in his Congressional bid.

This is from a book on climate change, but the principle definitely holds more widely…(click for larger)

(thanks to EconLog for the images!)

This concept- that researchers don’t have the luxury of always running randomized controlled experiments (i.e. randomized controlled trials, or RCTs) to determine what affects what- is what leads a growing number of microeconomic researchers to search for good instrumental variables in order to, to a degree, simulate some form of randomization. In addition, researchers in microeconomics have been increasingly able to go out and perform field experiments in order to have a good deal of control over the data that they create and collect- just ask John List or Esther Duflo, for example.

In macroeconomics, however, it’s hard to even conceive of how experiments to answer most questions would be carried out. Say you want to analyze tax policy- do we tell people that if their social security number ends in an even number then they get a tax break (and that if it ends in an odd number they don’t) and then see what happens? In an immediate sense, I don’t need to do the experiment to tell you what’s going to happen- some combination of rioting and a deluge of of those petitions that the White House has to respond to if they get enough signatures, depending on how much initiative the nation is feeling at the time. Even in an economic sense, though, this experiment wouldn’t be very useful- after all, in order to get a clean result, we’d basically have to have the tax break consumers only interact with one another and the non-tax-break consumers to only interact with one another. (Just imagine the strife this would cause in households where one spouse has an even social security number and the other has an odd one.)

The experimental logistics problem only gets worse when we look to answer questions regarding economic growth- can we form an econ army and take over a country, divide it randomly in two, subject the two parts to different institutions or capital investment and observe what happens over time? Probably not, though the idea does dovetail nicely with my suggestion of an Economist political party. Luckily, we don’t have to, since countries like Korea have pretty much done this for us, in a way, and they provide interesting natural experiments to study.

If you don’t think that being limited to observational data is bad enough, just consider the fact that government economic policy is usually endogenous to the economic situation at hand- people think I’m crazy when I advocate for a government that conducts monetary and fiscal policy in an unpredictable manner, but that would actually be a big win, for research purposes at least. (Insert lame joke about the government seeming to want to help out researchers here.)

It’s no secret that many economists believe in the efficiency of markets- in fact, there’s a fairly well-known joke that goes something like the following:

Normal person: Hey look, somebody dropped $20 on the sidewalk.
Economist: Nonsense- that can’t be a real $20 bill, since, if it was, somebody would have picked it up already.

More generally, one feature of efficient markets is that all transactions that are profitable for all parties involved actually happen. This, however, doesn’t mean that no one can profit in an efficient market (which is why the economist in the joke’s logic is absurd), it just means that profit opportunities aren’t left on the table indefinitely in an efficient market.

The efficient-markets hypothesis puts a bit more structure on this concept, especially as it relates to financial markets (i.e. markets for stocks, bonds, etc.). The efficient-markets hypothesis, at its core, suggests that asset prices are “correct” in that they properly and rationally reflect all available information. This feature of efficient markets, according to economists, occurs precisely because market participants quickly take advantage of all of the ways to profit from asset mispricings, and these actions bring prices to their proper levels.

In another context, then, the efficient-markets hypothesis taken to the absurd extreme gets us this:

Full disclosure: I helped with this one, so you should probably blame me if you don’t like it. Also, my economist friends and I found a $10 bill on the ground at the zoo last week, and we actually picked it up- good thing I’m a behavioral economist, otherwise I might worry that my economist membership card would get taken away. (Then again, we did have a longer than reasonable conversation about how we should split the $10, so perhaps not.)

In related zoo news, economists understand the value of scarcity as it pertains to animals:

Also, I need this sign for my office…

…mainly because it would mean I get to research the economics of pandas.