Economists Do It With Models

You may recall that time when I taught Gizmo some economics for Cinco de Mayo. Greg Mankiw certainly does. Here’s a visual reminder:

Apparently the idea of canine economic education is catching on. For example, reader John posted the following on my Facebook page:

No, Fido, no it’s not. I wanted to insert something cute about dog economics here, but the closest thing I could think of was a paper that discusses whether people can distinguish pate from dog food. Short answer: no. I suppose that, along with the above picture, explains some of the decoration on my laptop:

Whenever I think about this topic, I am reminded of a line from Mean Girls:

Gretchen: That is so fetch!
Regina: Gretchen, stop trying to make fetch happen! It’s not going to happen!

Here’s my version:

Policitians, pundits, etc.: Blah, blah, blah, trickle-down economics, blah, blah…
Economists: Stop trying to make trickle-down economics happen! It’s not going to happen!

It vexes me more than a small degree that I read and hear enough about this notion of trickle-down economics that I start thinking “clearly people wouldn’t still be attributing this to economists if there weren’t a bunch of economists out there still advocating the validity of this theory.” Then I start entertaining the possibility that my education has failed me, since I did in face pass my general exam in macroeconomics with flying colors (admittedly, the colors being those of mediocrity and red ink) but can’t seem to remember having covered this concept. (I suppose I could say the same about the Austrian School, and that certainly exists, so I am hesitant to automatically dismiss everything that hasn’t specifically been covered in class.) So what gives? Even Stephen Colbert thinks that trickle-down theories are a thing among economists:

Hehe - “A tax bomb! Quick, rich people, to your tax shelters!” I suppose that statement isn’t altogether absurd, since higher taxes increase the incentive to, well, avoid taxes. Also, Stephen Colbert seems to be on Krugman’s side of the octagon. But I digress…

So is Colbert saying that the wealthy use tax cuts to piss on the rest of society? Now that I think about it, that’s at least as reasonable a theory as this original trickle-down economics thing. To quote Mr. Colbert: “Economists know tax cuts for wealthy Americans benefit everyone…it’s even got a name, it’s called the trickle-down theory.” Allow me to respond: *clears throat* NO, NO WE DON’T KNOW THAT, THANK YOU VERY MUCH. But, like I said above, I get paranoid when what the world thinks and what I think are very different, so I decided to do some research:

Step 1: Wikipedia, obviously. It’s article on trickle-down economics seems to be reasonably informative, and I direct you to the line “Thomas Sowell claimed that, despite its political prominence, no trickle-down theory has ever existed among economists.” So there.

Step 2: There really shouldn’t be a need for a step 2, since if Wikipedia says it then it must be right. But I had some time on my hands, so I decided to look further into the matter. I present as Exhibit B a quote from Robert Frank in the New York Times:

Trickle-down theorists are quick to object that higher taxes would cause top earners to work less and take fewer risks, thereby stifling economic growth. In their familiar rhetorical flourish, they insist that a more progressive tax system would kill the geese that lay the golden eggs. On close examination, however, this claim is supported neither by economic theory nor by empirical evidence.

Now, Frank is a professor at Cornell, which ain’t too shabby, so I’m willing to bet that he knows his stuff. However, it *is* the New York Times, so I can’t entirely eschew the possibility that Frank is putting a liberal-yuppie spin on the matter. So the research continues…

Step 3: Get information straight from the research horse’s mouth. There is an academic research database called EconLit that provides search functionality over nearly all journals that are even remotely relevant to economics. So I put in a text search for “trickle” to see what would come up. I got. Some relevant highlights:

• “A New Look at the Trickle-Down Effect in the United States Economy,” Lan, Yuexing; Hegji, Charles, Economics Bulletin, vol. 29, no. 3, 2009, pp. 1743-48: The results suggest that an increase in wage leads to a more equal income distribution. The findings also indicate that there is no trickle-down from proprietors income and corporate profits to lower income group.

  Translation: Trickle-down ain’t happenin’.

• “Financial Imperfections, Inequality and Capital Accumulation,” Nabi, Mahmoud Sami, Economics Bulletin, vol. 29, no. 3, 2009, pp. 2388-2403: Aghion and Bolton provide a model analyzing the effect of capital accumulation on income inequality. We integrate two additional features to a modified version of this model. The first one is a costly financial contract enforcement which represents the second type of credit market imperfection in addition to moral hazard. The second one is enabling wealthy agents to undertake larger investment projects relatively to other agents. I show that inequality increases in a first stage of development and, contrarily to Aghion and Bolton (1997), remains constant or increases in a second stage (depending on the deposit interest rate ceiling).

  Translation: Even though Aghion and Bolton can write down a theoretical model showing that a trickle-down effect could happen, I can just as easily change the assumptions of that model to show that trickle-down doesn’t happen. So there.

• “When Does Growth Trickle Down to the Poor? The Indian Case,” Basu, Santonu; Mallick, Sushanta, Cambridge Journal of Economics, vol. 32, no. 3, May 2008, pp. 461-77: A theoretical analysis and several econometric tests have been undertaken to examine whether the trickle down effect took place in rural India over a long time period. We found little evidence to suggest that the trickle down effect had occurred at all; our analysis suggests that the emergence of capital-labour substitution was primarily responsible for preventing growth from reducing poverty. The decline in poverty and a higher growth rate that took place during the late 1970s and 1980s were largely a result of government anti-poverty measures teamed with the more equitable distribution of credit and inputs to smaller and marginal farmers.

  Translation: You know how the trickle-down people say that their thing works because the rich people invest in businesses in ways that make employees more productive and thus able to get higher wages? Yeah, so, in India what happened was that the rich people invested in ways that replaced people with machines instead. Also, that reduction in poverty we saw was due to direct help and not trickle-down effects- just wanted to make sure that was clear.

• “Do Capital Income Tax Cuts Trickle Down?” Yang, Shu-Chun Susan, National Tax Journal, vol. 60, no. 3, September 2007, pp. 551-67: Reductions in the capital income tax rate generally stimulate investment and raise the marginal product of labor and the wage rate. Hence, it is often argued that cutting capital income taxes benefits capital owners and all workers. This result, however, depends on how government manages debt to maintain budget solvency. This paper analyzes the distributional effects of capital tax cuts, where endogenous adjustments in other tax rates are precluded. When productive public investment or transfers to liquidity-constrained workers are reduced, it finds that the trickle-down effect may not hold.

  Translation: Hey geniuses, giving rich people tax breaks doesn’t help poor people if you couple the tax breaks with a reduction in public programs aimed at low-income individuals in order to keep control over your precious deficit.

• “Endogenous Inequality,” Matsuyama, Kiminori, Review of Economic Studies, vol. 67, no. 4, October 2000, pp. 743-59: In a capitalistic society, do the rich maintain a high level of wealth at the expense of the poor? Or would an accumulation of the wealth by the rich eventually trickle down to the poor and pull the latter out of poverty? This paper presents a theoretical framework, in which one can address these questions in a systematic way. The model focuses on the role of the credit market, which determines the joint evolution of the distribution of wealth and the interest rate. A complete characterization of the steady states is provided. Under some configurations of the parameter values, the model predicts an endogenous and permanent separation of the population into the rich and the poor, where the rich maintains a high level of wealth partially due to the presence of the poor. Under others, the model predicts the Kuznets curve, i.e. the wealth eventually trickles down from the rich to the poor, eliminating inequality in the long run.

  Translation: I have a model that shows that trickle-down effects may or may not happen, depending on how I calibrate my model. Please give me tenure now.

• “Sectoral Productivity and the Distribution of Wages,” Nord, Stephen, Industrial Relations, vol. 38, no. 2, April 1999, pp. 215-30: Policy reports suggesting that productivity growth will raise the earnings of low-wage workers are based on the concept that gains from productivity will trickle down to raise the wages of workers at the lower end of the wage distribution. The compensation and employment systems of American industry do strongly link gains in industry productivity to wage increases for most workers. However, this analysis finds that the linkage of productivity change to wage change for the workers at the lower end of the distribution is virtually nonexistent. The empirical results of this study suggest that productivity increases have no effect on the wage change of workers at the lowest 10th percentile of the distribution and widen the dispersion in industry wages.

  Translation: So you know how that whole trickle-down effect is dependent on workers getting higher wages in return for being more productive? Yeah, that doesn’t happen for poor people. Just thought you would like to know.

• “A Theory of Trickle-Down Growth and Development,” Philippe Aghion and Patrick Bolton, The Review of Economic Studies, Vol. 64, No. 2 (Apr., 1997), pp. 151-172: Three main conclusions are obtained from this model. First, when the rate of capital accumulation is sufficiently high, the economy converges to a unique invariant wealth distribution. Second, even though the trickle-down mechanism can lead to a unique steady-state distribution under laissez-faire, there is room for government intervention: in particular, redistribution of wealth from rich lenders to poor and middle-class borrowers improves the production efficiency of the economy both because it brings about greater equality of opportunity and also because it accelerates the trickle-down process. Third, the process of capital accumulation initially has the effect of widening inequalities but in later stages it reduces them: in other words, this model can generate a Kuznets curve.

  Translation: What in the hell is a Kuznets curve? Oh, and even our theoretical model predicts that this whole trickle-down idea increases inequality before it reduces it, so we are going to specifically point out that government intervention to accelerate or replace the trickle-down process can be helpful.

Hopefully you get the idea…if nothing else, I find this screen shot to be telling:

It is worth noting that this trickle-down idea is subtly different from supply-side economics in general, since the idea that economic growth can be achieved by lowering barriers to supply doesn’t automatically mean that the benefits of economic growth spread to everyone in a society. It is also worth noting that I am not trying to make an argument for redistribution, socialism, whatever, but I am requesting that if you want to make an argument for or against various tax policies that you do so on the actual economics merits or morals of the policy and leave bogus economic ideas out of the discussion.

In summary: We economists get blamed for enough stuff that we actually put out there and support turning out to be wrong. Please don’t blame us for things that we don’t even support, since we really can’t take any more abuse. The closest thing to a trickle-down theory that economists have is the following, illustrated by yours truly:

(That diagram went over really well at the AEA meeting, given that a lot of people were there for job interviews. I have a talent for making friends wherever I go.)

I couldn’t resist:

Via: Medical Billing and Coding Salary

Now, these are just random statistics, which doesn’t, technically speaking, count as economics. Therefore, I present as a relevant follow up Hugo Mialon’s talk on the economics of faking ecstasy:

Well this just brings the concept of games in relationships to a whole other level. =P If you prefer to read rather than to watch, you can find the associated paper here. Steve Landsburg even chimes in on what faking orgasms has to do with the Fifth Amendment. You know you’re curious…

You can see the full Graphic Content archive here.

As I mentioned in my last post, one of my functions as econgirl is to go around to schools and companies and talk about economics, and I figured that I would share a bit of that with you here. This particular talk was about incentives- when they work, when they don’t, and how consumers and employees respond to incentives. It was also a bit about how to analyze causal effects and not get tripped up by that whole correlation vs. causation thing. The video quality’s not great, but I managed to get the whole thing up online:

You can also watch the (bigger) video directly on the Vimeo site here.

In general, I am available for academic events, corporate events, birthdays, bar mitzvahs, state fairs, whatever. I strive to provide a comprehensive learning experience, complete with follow up slides, video, sources, and so on. (You can see here for an example that goes with the above video.) In case you were curious, I also own a karaoke machine and know how to make balloon animals:

You can see more details on the hire me page. I am providing this more for informational than for sales purposes, but I figured I’d share since working on this has taken time away from writing as of late.

Bear with me as I take you on a pictorial journey through my day last Friday. (I swear there is a point to all of this.) I gave a talk to a marketing company in Minnesota, so much of my day consisted of schlepping halfway across the country and back on about 2 hours of sleep. My first observation was that Minnesota and Boston look very different, even from the air:

(I will leave it to the reader to determine which is which. Also, if I ever get banned from flying, you can be pretty confident that it’s because I didn’t heed the no electronics on takeoff and landing bit. But really, if my iPhone camera is enough to bring down a Boeing 747, then it is very statistically unlikely that it hasn’t happened yet, and I therefore reject the null hypothesis of “personal electronic devices cause airplane chaos.”)

Anyway, I had some time to kill after my talk and before my flight back to Boston, so my gracious host dropped me off at, where else, the Mall of America. I mean, how can I study behavioral economics and consumer behavior and not be entirely too curious about this shrine to consumerism? I mean look, even in photos it looks like it’s being blessed by some higher power:

The effect is just a coincidence, of course, since we all know that God prefers Wal-Mart. As it turns out, the actual stores in the mall aren’t particularly interesting, so I went in search of a late lunch instead. And by lunch I mean booze, obviously.

I generally take opportunities like this to do some reading, so I pulled up Dan Ariely’s Predictably Irrational. Now, much of what’s in these sorts of books isn’t new to me, since I’ve already seen most of the academic papers that these sorts of books draw from, but I still feel the need to read them in order to see what information is actually getting out to the non-academic world.

I just so happened to be reading the chapter about the power of a zero price, and I learned/was reminded of a few things:

• As a couple of you have pointed out, Dan does in fact use the specific example of Ben & Jerry’s free cone day to illustrate the appeal of free stuff. I had no idea that I was totally ripping off his example, so I am retroactively giving credit where credit is due.
• It really does appear that the notion of free has a pull on people that a very low but positive price does not. For example, Ariely shows that changing a tradeoff between a 15-cent item and a 1 cent item into a tradeoff between a 14-cent item and a free item can move consumption significantly toward the free item, even though the underlying tradeoff hasn’t changed much.
• Ariely and his colleagues were able to replicate his findings in various contexts, including one experiment that he performed on kids coming to his house on Halloween to trick-or-treat. While he learned that kids are also irrationally drawn to free stuff, I learned that it’s not necessarily a good idea to live next door to an economist. (For this reasons as well as others.)

An ungated version of the paper that the book chapter is based on can be found here. In his book, Ariely concludes the discussion on the power of a zero price with the following:

Zero is not just another discount. Zero is a different place. The difference between two cents and one cent is small. But the difference between one cent and zero is huge!

If you are in business, and understand that, you can do some marvelous things. Want to draw a crowd? Make something FREE! Want to sell more products? Make part of the purchase FREE!

That is probably why I was so amused to see, not more than 10 minutes later, the following sign as I was walking around the mall:

Sigh. If research falls in a forest and no one’s around to hear it, does it make a sound?

Dear Wet Seal: YOU’RE DOING IT WRONG. That is all. xoxo, econgirl