Economists Do It With Models

I suppose an alternate title could be “A Lesson on Elasticity in Four Parts.” Elasticity is an important concept, since it’s used extensively throughout both microeconomics and macroeconomics, so I guess you can’t learn too much about it, right?

The first video introduces the concept of price elasticity of demand and shows how it’s calculated (hint: it’s NOT just the slope of the demand curve).

The second video continues on and gives some general rules about price elasticity of demand.

The third video compares two methods of calculating elasticity.

The fourth video briefly introduces other elasticities, such as price elasticity of supply, income elasticity of demand and cross-price elasticity.

See, you would think that this would complete the discussion on elasticity. But no, I have one more video coming on an application of elasticity. And also a funny one that I found while posting these, so stay tuned…

See here for the Micro 101 videos page, or here for econgirl’s YouTube channel.

Oh, The Simpsons…so a couple of months ago I was approached with the idea of writing about the economics to be found in the Simpsons…I figured that this would be fruitful, since if the Harvard stereotypes regarding the writers are true, it stands to reason that a number of the writers have taken the class that I (used to) teach.

This all started with a paper written by Joshua Hall at West Virginia University- the paper is, in fact, titled Homer Economicus: Using The Simpsons
to Teach Economics. As it turns out, I got much more than I bargained for. First of all, there are over 400 episodes of the show…and yes, I could have done the math to figure this out beforehand, given that the show has been on the air for 20 years. In addition, there are references to economic concepts in over 90 percent of the episodes I have gone through thus far (116 as of about a half hour ago). I have way more material than I need for the book chapter that this was supposed to be for, and I’m too much of an OCD researcher to stop partway through, so I’m probably going to turn my notes into a database of some sort so that people can look up references by topic and use them as teaching tools in their classes. But, as usual, I digress…

My chapter is supposed to be about behavioral economics, so I was very amused to see the following on the Nudge Blog:

(There is actually empirical evidence that this nudge would work. Brian Wansink shows in Mindless Eating that even something as simple as putting candy out of sight or a few steps away can have a big impact on consumption.)

If you are not familiar, Nudge: Improving Decisions About Health, Wealth, and Happiness describes how small changes in the way that choices are presented (choice architectures) can have big effects on the choices that people make. For example, authors Richard Thaler and Cass Sunstein talk about the effect of defaults on 401k savings behavior and give evidence that a simple opt-out versus opt-in scenario increases participation by a factor of four without actually limiting the underlying choices that people have available to them. (The concept is generally referred to as libertarian paternalism, which I have mentioned before.) Their stance is that it’s pretty much impossible to design a choice architecture that doesn’t nudge you in some sort of direction, so we might as well be smart about presenting options in ways that maximize people’s long term happiness (at least as best as outside observers can understand it).

I suppose in some way I am trying to nudge people into wanting to learn economics.

I enjoyed this video about the workings of the Federal Reserve, courtesy of the Federal Reserve Bank of Cleveland. (HT to Tim Schilling)

Cute. It’s also worth noting that it’s potentially just as important to understand what the Fed *doesn’t* do. More specifically…repeat it with me, people, THE FED DOES NOT PRINT MONEY. Trust me, this is true…unless of course Ben Bernanke has an underground counterfeiting operation that I don’t know about. In case you were wondering, the Treasury department prints money, either via the United States Mint (for coins) or the United States Bureau of Engraving and Printing (for paper money).

But, but…we hear all the time that the Fed controls the money supply. How is this possible if it doesn’t have the printing presses? Well, as stated briefly in the video, the Fed engages in what is called open market operations. This basically entails the buying and selling of government bonds.

You can picture the Fed as sitting on a pile of some combination of cash and bonds. If it were to sell some of the bonds, it would take in money and give out bonds. This would lead to less money in circulation, since it’s now in the Fed’s pile. Conversely, the Fed could buy bonds from people, in which case it would give out money and take in bonds. This leads to more money in circulation. Therefore, the Fed can increase or decrease the amount of money in the hands of the public by buying and selling government bonds. (Technically, it could buy and sell any number of non-perishable products, since the only logistical requirement is that the item can be easily kept on the pile. It just decided that bonds were the way to go.)

The Fed conducts open market operations because what it really wants is to control interest rates. (As you saw in the video, the Fed controls the discount rate directly, but direct control is not really an option for interest rates overall.) When the supply of money goes up, interest rates go down and vice versa. That seems random…so why does it work? The fact of the matter is that, like any other market, demand and supply are pushed to equalize. We just saw how the Fed controls the supply of money, but how do you get people to demand more or less money?

Note that money is just that- currency. (And checking account deposits, technically.) In other words, money is not synonymous with wealth. There are many ways to store wealth, and money is just one of them. The upside of money is that it can always be exchanged for goods and services- in contrast, I’d like to see someone walk into Bloomingdale’s with some gold bars and try to buy stuff with them. Given that people have a number of different ways to store their wealth- cash, gold bars, houses (though nowadays that seems a little funny), vintage beanie babies, whatever- they face a tradeoff between cash and non cash assets. If you hold cash, you can buy stuff with it directly, so cash is a very liquid asset. The downside of cash is that it doesn’t pay any interest, whereas other stores of wealth generally provide some (expected) positive rate of return. This rate of return moves with interest rates. If interest rates are high, there is a big opportunity cost to holding cash (or alternatively to spend rather than save), since I would be foregoing a big return if I were to stuff cash under my mattress as opposed to buy a treasury note or something. On the other hand, if interest rates were low, it might not be worth my while to fish the cash out from under the mattress and go to the bank. (Or you might start eyeing that big-screen TV, since it’s not like the money you used to buy it was going to grow in the bank anyway.) In this way, the demand for money is a function of the interest rate- higher interest rates go with less demand and vice versa, so the demand for money is downward-sloping like the demand curves for virtually all other goods and services.

I feel like I’m a donkey chasing a carrot on a stick with this argument, since now you’re just wondering why the Fed even cares about interest rates. The theory (note the use of that word) is that lower interest rates stimulate the economy by making it cheaper to borrow money in order to invest in business and also because it lowers the opportunity cost of consuming as opposed to saving. In other words, lower interest rates make people want to buy and produce stuff, at least in the short term. In the long run, increases in the money supply generally result in correspondingly higher prices for stuff rather than more stuff. So when the Fed tries to smooth out business cycles by stimulating the economy when it’s down and reining it in when it’s booming, it has to consider the long-run implications on prices and such.

Now that you understand what the Fed does, you are in a better position to evaluate what those “abolish the Fed” people are all about. From what I can tell, their argument is that monetary policy is harmful because it creates bubbles and results in inflation. (That and the fact that the Constitution doesn’t explicitly allow for the Fed in the first place.) I suppose I’ll have to follow up at some point with a lesson on whether inflation is an inherently bad thing. (Preview: not necessarily bad in theory, bad in practice.)

Ugh. Isn’t macroeconomics fun? But seriously, if you take one thing from this, let it be the fact that the Fed doesn’t control the money supply via a printing press. Please.

This has been going around the Internet for the past couple of days…(HT to Gizmodo and others…)

My first thought was “the guy on the right must be an economist.” Also, I’m surprised that no one popped up to offer $52. The comments on the sites that were running this, however, got me thinking a little more. Some observations:

• I initially thought that this was a very low reward offer, but then I noticed that it was for a lost iPod Touch rather than a lost iPhone. I would probably offer a reward higher than MSRP if I lost my iPhone, since I am terrible at backing up phone numbers and such. (Ah, the value of information. I also get confused when people offer rewards for lost dogs that are lower than what it would cost to buy a new dog. Aren’t you people willing to pay more to specifically get YOUR dog back???)
• This is a good example of what social scientists sometimes refer to as “sunspots” - why do people usually pick such round numbers? I mean, there’s little stopping someone from offering a reward of $68.24. The Internet has pointed out that, as such, people for the most part assume that the $50 offer is the real one, both because it’s a round number and it’s the lower of the two bids. But how do we know that the real person didn’t offer $51 and the imposter offered $50 to try to make it seem like she was the real iPod owner? (Note that if people were solely going for the reward rather than being nice people, this would be a non issue, since the highest bid would win and undercutting would be pointless.)
• I conjecture that the $50 reward is the real one because it has a name attached and the other does not.

For the record, this is my iPhone (and my living room rug):

It has been like this since last April- I ran the entire Boston Marathon without dropping the thing and then faceplanted it on Clarendon Street 10 minutes after I finished. Luckily, I was too tired to care. (And yes, it still works just fine.) As an economist, I point out to people that I am happy with this setup because it doesn’t bother me much and it greatly reduces the likelihood that anyone is going to try to steal my phone. Perhaps if the thieves understood more economics, they would realize that I would probably pay a decent amount to get the information back if nothing else. I think this is the first time I’ve ever been glad that some people don’t understand economics.

You know, I was previously worried that Goldman Sachs had Washington just a tad too much in its back pocket…good thing then, I suppose, that Greece has allowed me to take an “at least I’m not THAT guy” stance and feel much better.

If you’ve been paying attention to the news, you at the very least know that Greece is pretty much up a creek financially right now. If you aren’t familiar, here’s some background:

For the record, I do not get all of my news from Comedy Central…I’ll have you know that I also read The Onion. And I really want to be friends with Prof. Rehman. In addition to what you just saw, here’s what you need to know: In order to be able to join the European Union back in the early 2000’s, Greece had to agree to face fines if its yearly deficit ran more than 3 percent of the country’s Gross Domestic Product (read, value of output) or if its total amount of debt ran more than 60 percent of GDP. (I’m not sure how fining an entity for being in debt is productive, but I suppose there aren’t a whole lot of sanctioning options available. Maybe they’ll borrow the money to pay the fine.) Paying fines isn’t particularly appealing, but neither is only spending money that one actually has, so Greece entered into an agreement with Goldman Sachs to essentially put off some of its debt obligation via a product that was commonly used for other purposes. Because the type of agreement that they used looked like a transaction that a lot of other countries did just to logistically deal with the fact that there are multiple currencies in the world, people didn’t really notice that Greece was effectively borrowing from Goldman to make its deficit look smaller. (For more detail on this part of the matter, there is a decent article here.)

The bottom line here is that Goldman Sachs knows that Greece owes it money, and other parties don’t seem to be aware of this fact. As such, Goldman gets screwed if Greece does the governmental equivalent of declaring bankruptcy and doesn’t fulfill its obligation. So what does Goldman do? It enters into agreements with other, completely non-related entities that say Goldman gets a payout if Greece defaults on its debt. Because of this, the New York Times and other entities are really sniffing around in hopes of finding a scandal. Before we jump to conclusions, however, it’s helpful to actually understand what’s going on.

Allow me make an analogy…people generally like sports more than they like economics, so let’s talk about football. Let’s say, for the sake of good rivalry, that the New England Patriots are playing the Indianapolis Colts. I live in Cambridge, so it’s not surprising that I am happy if the Patriots win and sad if the Colts win. (I hate Peyton Manning. Eli sucks too. Or so the t-shirts sold in Kenmore Square after Red Sox games tell me.) It’s not uncommon for people to bet on the outcomes of football games, so I have the option of either putting my money on the Patriots to win or on the Colts to win. At first glance, it seems to make perfect sense for me to bet on the Patriots- they’re the team I like! (Just assume for the moment that the teams are evenly matched or that the bet is based on a spread or whatever.) But is that really the right thing to do? Consider the following outcomes with a $20 bet:

Granted, the happiness numbers are a tad contrived (though consistent with prospect theory in that I dislike losing $20 twice as much as I like winning $20), but they illustrate an important concept. If I bet on the Patriots, my happiness either goes up by 35 or down by 25. If the teams are evenly matched (or the underlying bet is even odds), my happiness goes up by 5 on average (read, in expected value terms). But, if I bet on the Colts, my happiness is guaranteed to go up by 5. If I am at all risk averse, I prefer the guaranteed bump of 5 units to the possibility of increasing by 5 units on average but at any given time being either 35 units happier or 25 units sadder.

This type of setup is called a hedging strategy- you are offsetting one swing of happiness (the game outcome) with a gamble that pays off when you are sad and costs you money when you are happy so that your overall result is more stable. (And yes, this is at least loosely related to what hedge funds do, but that is a conversation for another time.) Hopefully you feel that, in this context, the hedge that I described is a perfectly reasonable transaction. (You may have even entered into the bet with a Colts fan who was doing the same thing that you were!)

The above set of actions, taken back to the financial realm, is pretty much exactly what Goldman Sachs did. Yes, it was a little sketchy for Goldman to make agreements that would help hide Greece’s true debt level, I will acknowledge that. But once that is done, it makes perfect sense to want to take an opposing bet to avoid big losses. In the analogy, the side bet on the football game plays exactly the same role as the credit default swap that Goldman entered into, since this enables Goldman to get paid at least in part if Greece defaults on its original obligation (i.e. loses the game). It is important to note that the credit default swaps have nothing to do with Greece directly, and the swap contract is between two parties that are just watching the game of the Greek financial system to see how things play out. (Yes, these financial products actually exist.) So where is the problem?

Coming back to the football analogy, I really doubt that my bet on the game has any effect on the game’s outcome- I’m not exactly Pete Rose here. (There I go, mixing my sports…also, Pete Rose contends that he only ever bet for his team and not against it, so he was more of a speculator than a hedger.) However, I am not as important as Goldman Sachs. The claim by the media and some finance professionals is that people see Goldman buying what is essentially insurance against a Greek bust and they think “uh oh, what does Goldman know that I don’t?” and then they are more hesitant to lend to Greece. Then more people see the reluctance to lend to Greece and say the same thing. It then becomes very hard (or at least much more expensive) for Greece to borrow money, and the whole Greek bust thing becomes a self-fulfilling prophecy. This is an unfortunate scenario, but is it Goldman’s problem that the finance world really pays attention to the signals that it sends?

Like I said before, the media is sniffing around for a scandal. From the New York Times:

“It’s like buying fire insurance on your neighbor’s house — you create an incentive to burn down the house,” said Philip Gisdakis, head of credit strategy at UniCredit in Munich.

(I can only imagine what this guy says about people who take out life insurance policies on family members.) So people are now implying that Goldman Sachs is deliberately trying to crush the Greek financial system so it can profit? This reminds me of the scandal and lawsuits that broke out because Wal-Mart took out life insurance policies on its employees. The important question underlying this accusation is whether Goldman profits or loses overall (not just on the secondary bet) when Greece ends up in the toilet. If Goldman on net wins when Greece stays solvent, then there isn’t really incentive to try to crush an entire foreign country. (Though I have a suspicion the folks at Goldman could make it happen if they tried.) I did some digging (here, for example), and I couldn’t find anyone who was actually accusing Goldman of being “net short” on Greece, which would have meant that Goldman profits when Greece loses. Even if Goldman was net short on Greece, it has an incentive to not deliberately harm the country, since I’m guessing it wouldn’t get a lot of follow on business if it adopted a “here’s some money now, but we will probably use it to crush you later” strategy. Therefore, while it might be fair to criticize Goldman for the original deal it made with Greece, can you really blame it for covering its own behind?

For the record, the same is true for Wal-Mart- the life insurance policies partially covered the cost of training a new employee in the event that something bad (in or out of work) happened to an existing employee. So no, the policies didn’t actually give Wal-Mart the incentive to trample its employees with forklifts or whatever. As far as I know, Wal-Mart employees only get trampled by customers.