Economists Do It With Models

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An Economist Reads A Supreme Court Transcript, Energy Markets Edition…

November 2nd, 2015 · 2 Comments
Econ 101 · Policy

You know you’re a nerd if you get approached with questions regarding a “dry and technical” Supreme Court case and you’re all “Eeeeee, they’re talking about me!” Or at least what you study. Anyway, this actually happened recently:

JUSTICE KENNEDY: If there were a student in Economics I, it seems to me that he would conclude and his professor would conclude that wholesale affects retail, retail affects wholesale, they’re interlinked, which means you win the case, except that the statute makes a distinction. We have to make a distinction.

Oh Kennedy, does anywhere even offer “Economics I” anymore? I mean, there’s the classic Econ 101 of course, and Greg Mankiw’s Ec10, and I think the last principles course I taught had a course number of 1116 (nope, didn’t even try to make sense of that one), but this sounds a little outdated. Nonetheless, your reasoning seems correct. Given that the goods in wholesale markets are technically an input to production at the retail level, changes in wholesale prices should lead to changes in retail prices. In addition, though less obvious and straightforward, changes in retail prices due to either changes in retail demand or changes in retail supply (not caused by changes in the wholesale price, of course) should affect wholesale prices.

That’s technically the issue that I was asked to look at, but I noticed that things get way more economically interesting as the argument went on:

Second, what they have said is that this changes the effective rate. But what I would say in response to that, Your Honor, is that if I go out and buy a Ferrari for $100,000, everybody thinks that the price of the Ferrari is $100,000. Nobody thinks that the price of the Ferrari is actually $107,000 because I’m foregoing the $7,000 tax credit I can get if I bought an electric car.

I swear this was the only thing going through my mind when I read that:

Just replace “Kato” with “Solicitor General Donald Verrilli”…technically, I suppose this is true only if your best outside option was the electric car, but economists do certainly point out the importance of thinking about opportunity cost as the measure of true economic cost and, by extension, opportunity cost as the relevant measure of “price.” (Or, more simply, the price or cost of something is what you have to give up to get it!) So yeah, if you were going to buy the electric car and decide to buy the Ferrari instead, you not only have a $100,000 explicit cost but a $7,000 implicit cost of the forgone tax credit.

Chief Justice John Roberts does better both at coming up with relatable examples and at thinking like an economist later on:

It may be the same point as your Ferrari hypothetical, but if…if FERC is basically standing outside McDonald’s and saying, we’ll give you $5 not to go in, and the price of the hamburger is $3, somebody goes up there, their ­­ the price of a hamburger is actually, I think most economists would say, $8, because if they give up the $5, they’ve still got to pay the $3.

Dingdingding! Tell the man what he’s won, other than a Supreme Court judgeship. By now, I’m guessing that you are wondering what on earth is going on in this case. In a nutshell, the Federal Energy Regulatory Commission only has the authority to regulate prices in wholesale energy markets, but, in order to prevent wholesale price spikes, they are paying businesses to not use energy during peak demand times- essentially doing the equivalent of paying people to not go into the McDonald’s. The argument, then, is mainly over whether this behavior is within the boundaries of FERC’s authority or whether it falls under regulating retail prices, which is left to state authority. In other words, the case is pretty much squarely in the overlap in the Venn diagram of Econ 101 and Introduction to Semantics.

The person asking for insight on the case wanted to make it “fun,” so I obliged and put together a seriously Feynman-esque analogy involving apples:

Let’s say we have a wholesale and retail market for apples. As usual, companies buy apples in bulk on wholesale markets and then sell them in smaller quantities to consumers in retail markets (think Whole Foods). But let’s suppose that, for some reason, the price of apples is fixed in the retail markets, so I know that I will always pay 50 cents for an apple. (Sidenote: I just realized I have no idea how much apples cost.) Also, let’s assume that retailers are obligated to provide an many apples as consumers demand at 50 cents per apple. Not surprisingly, the popularity of apples fluctuates over the course of the year- for example, fall is great for apple cider, so demand is likely higher than normal right now (though not to a pumpkin spice level of hysteria). Because of this, the retailers are obligated to buy more apples than normal on wholesale markets, but getting additional apples is more costly than it was to get the original apples (note that I chose apples because the “low hanging fruit” principle applies literally). In order for suppliers in wholesale markets (i.e. apple pickers) to be willing to go and get the harder to reach apples, they need to be incentivized with a higher price, so the increase in retail demand results in an increase in wholesale price. Unfortunately, the cider maker buying apples at Whole Foods doesn’t get a signal that maybe she should think more carefully about her apple consumption, since the price of apples to her is still 50 cents, and a price spike in wholesale markets results. One way to avoid such price spikes would be to offer to pay some of the apple consumers not to buy apples in the fall, and this mechanism should be effective in regulating wholesale prices, which is what the federal apple regulators want to do. The question in the case is whether such incentivizing counts as messing with prices in retail markets, which the federal apple regulators are not supposed to do. One side of the argument is that the incentives don’t directly change the sticker price and therefore shouldn’t count as regulating retail price. The other side of the argument is that if you pay someone $1 to not buy a 50 cent apple, you’ve effectively changed the price of the apple to $1.50. (This latter definition of price is what most economists would view as a true economic price.) More generally, we’re usually good at seeing how fluctuations in wholesale or input markets affect retail prices (since at least some cost increases get passed on to the consumer), but it’s important to note that fluctuations in retail markets can also affect wholesale prices, which is partially why FERC is arguing that its actions are in scope, at least in spirit.

Or, of you prefer, you can just listen to the overall podcast here– it’s part of a series called “The World and Everything in It” by World News Group. I would point out that this is great example of how important it is to understand basic economics, except that I was asked the inevitable “so what would you decide” question and gave the typical “on the one hand” economist answer due to the semantic nature of the issue. So I guess what I’m saying is that we’re really not that helpful even when we know stuff. =P

Tags: Econ 101 · Policy

2 responses so far ↓

  • 1 Mario Bravo // Nov 2, 2015 at 4:11 pm

    Great reading! the apples explanation truly serve the purpose of clarifying a real regulative measure, cool stuff.

  • 2 Ivin Rhyne // Nov 2, 2015 at 4:56 pm

    The argument, when boiled down, is essentially whether FERCs “participation” in the retail market by providing incentives constitutes “regulation”. That is a fundamentally legal question I leave to the Supremes to figure out (how Diana Ross will weigh in is entirely up in the air –

    The economic question underneath the Solicitor General’s argument is more interesting. His Ferrari analogy is essentially the idea that the PERCEIVED price of a good can be fundamentally different than what we economists would label the TRUE cost of that same good. And in this, his Ferrari analogy is exactly correct. There is no reason to believe that buyers of internal combustion engine cars PERCEIVED the price of their cars as being higher than the sticker price because of any foregone subsidies except in one very specific situation.

    When buyers select the bundle of qualities they want in a car, and both an internal combustion and hybrid are both in the list of finalists, only THEN do most consumers make the explicit trade off of foregone subsidies. This behavior of looking at price LAST rather than first, is one of the reasons we economists are sometimes shocked to find out that our theories don’t hold up as broadly as we would like when describing consumer behavior.

    It would be illuminating to open new veins of research that look to put price-based behavior in its proper context behind other choice bases.

    Just my two cents.

    Ivin R

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