It’s hard for me to give a better example for the 300 students than Hayek talking about tin. This is from the 1945 AER piece, “The Use of Knowledge in Society“:
It is worth contemplating for a moment a very simple and commonplace instance of the action of the price system to see what precisely it accomplishes. Assume that somewhere in the world a new opportunity for the use of some raw material, say, tin, has arisen, or that one of the sources of supply of tin has been eliminated. It does not matter for our purpose—and it is very significant that it does not matter—which of these two causes has made tin more scarce. All that the users of tin need to know is that some of the tin they used to consume is now more profitably employed elsewhere and that, in consequence, they must economize tin. There is no need for the great majority of them even to know where the more urgent need has arisen, or in favor of what other needs they ought to husband the supply. If only some of them know directly of the new demand, and switch resources over to it, and if the people who are aware of the new gap thus created in turn fill it from still other sources, the effect will rapidly spread throughout the whole economic system and influence not only all the uses of tin but also those of its substitutes and the substitutes of these substitutes, the supply of all the things made of tin, and their substitutes, and so on; and all this without the great majority of those instrumental in bringing about these substitutions knowing anything at all about the original cause of these changes. The whole acts as one market, not because any of its members survey the whole field, but because their limited individual fields of vision sufficiently overlap so that through many intermediaries the relevant information is communicated to all. The mere fact that there is one price for any commodity—or rather that local prices are connected in a manner determined by the cost of transport, etc.—brings about the solution which (it is just conceptually possible) might have been arrived at by one single mind possessing all the information which is in fact dispersed among all the people involved in the process.
Professor Gerard has treated us again to some good, clean microeconomic fun. I think he is correct, and the bottom line is: if beer is a Giffen good, its consumption can fall as its price rises. His elaboration (and correction) of Yglesias is very nice, as is his translation of Yglesias’s argument into the neat graphical device of the iso-alcohol constraint. Yglesias’s original statement, however, that “…another possibility is that people hold total spending and total alcohol consumption [constant]…” strikes me as pretty sloppy, by Briggs 2nd floor standards. Why would one keep alcohol consumption constant, in the face of a price change? Changing circumstances leading to no change in a choice variable (alcohol consumption) is always suspicious, especially in a continuous model like this.
Yglesias seems to be groping (in the dark) for a characteristics model—in other words, a model where people care about characteristics (alcohol and taste) of goods, not the goods directly. This sort of model was thoroughly worked out in the 1970s, mainly by one famous Kelvin Lancaster. In this example, there are two goods, beer and bourbon, and they both have two characteristics (to various degrees), viz. alcohol and taste. The utility function is defined on alcohol and taste, and the quantities of characteristics consumed depend linearly on the quantities of beer and bourbon purchased. So, I thought, perhaps there is something interesting going on here. Maybe, just maybe, we could have a Giffen good even if the utility function (on characteristics) is perfectly normal, i.e., not Giffen. Luckily, before I got too absorbed in linear transformations, I took Google Scholar for a spin, and soon got to “A Contribution to the New Theory of Demand: A Rehabilitation of the Giffen Good” by Richard G. Lipsey and Gideon Rosenbluth, published in The Canadian Journal of Economics in 1971. Here is a taste from the Introduction:
Three of the most commonly used illustrations of possible Giffen effects are: Bread and meat, beer and whiskey, and Marshall’s account of transportation. There is a common feature of these three examples which “common sense” suggests is an essential requirement for a Giffen good and indeed for an inferior good, of which the Giffen good is a special case: there must be a “superior” good which shares one or more of the characteristics of the inferior good. If, for example, meat is substituted for bread as income rises, this implies that there is a want-satisfying characteristic shared by the two goods, in respect of which the substitution takes place. Bread must be a cheaper source of supply of this characteristic than meat, else the substitution would not depend on a rise in income. The reader can satisfy himself that similar reasoning applies to the other two examples.
They then go on to explain very neatly how Giffen goods could easily arise even if we assume that the utility function (on characteristics) excludes the possibility of a Giffen characteristic. Basically, if the income elasticity for characteristic 1 is very high compared to the income elasticity for characteristic 2, then an increase in real income will push the consumer to want so much more of characteristic 1, that just consuming more of the good that is more characteristic 1 intensive won’t do—he will have to cut back consumption of the other good to consumer even more of the good that is more characteristic 1 intensive. In our example, the income elasticity for taste is so much higher, that an increase in real income will push the consumer to want so much more taste that just buying more bourbon won’t do—he’ll have to cut back on beer and buy even more bourbon. However, as he does so, total alcohol consumption will still increase! (Remember, we assumed that there are no Giffen characteristics.)
I must say that I am pretty satisfied with the Lipsey–Rosenbluth explanation of why beer might be a Giffen good in this case. If the name Lipsey sounds familiar, that’s probably because of his association with The Theory of the Second Best, which probably requires a post of its own. (See also here.) And I would be remiss if I did not mention that Lipsey was a recipient of the 2006 Schumpeter award for the book Economic Transformations (co-written with two of his students).
I hereby propose that Griff’s Grill be renamed “Griffin Good” for a week in honor of economic science.
The clever graphic is one of Art Carden’s economic “memes” that has been circulating around in cybersphere for a day or two. The lesson, of course, is the law of demand — price goes up, people buy less; price goes down, people buy more.
Imagine a world with two goods—beer and bourbon—such that beer is cheaper per unit of alcohol than bourbon, but bourbon is tastier. Drinkers arrive at some kind of beer/bourbon mix based on their desires to (a) get drunk, (b) drink something tasty, and (c) have money left over for other activities. Now the price of beer falls…
The first thing to notice is that this is not a two-good world, as assumption (c) places us squarely in a three-good world: beer, bourbon, and other activities. More on that in a minute. Yglesias runs through a couple possibilities where people indeed drink more beer when the price decreases, as one would expect, but then he finishes with this zinger:
Yet another possibility is that people hold total spending and total alcohol consumption (constant) and use the budgetary headroom opened up by cheaper beer to buy less beer and extra bourbon.
So, let’s break this down. First off, total spending here is simply another way of saying the consumer has an income constraint. Second, the “budgetary headroom opened up” is the income effect from the price of a good in the consumption set decreasing. In other words, when the price of a good in a consumer’s consumption set falls, he effectively becomes richer because he can continue to buy his current consumption set, but now he has money left over to buy more beer, more bourbon, or more other activities.
If we go ahead and assume that our consumer has convex preferences, our standard assumption, then we know that holding utility constant that when the price of beer falls, the substitution effect will indeed induce more beer consumption.
But what about the income effect from the budgetary headroom? It’s possible that greater income leads to lower consumption of some goods (Ramen Noodles, bus rides, World Series viewings), and we call such goods inferior goods. Anyone who has taken price theory knows that I don’t need three goods to get people to buy more bourbon and less beer — I simply need beer to be an inferior good that is subject to a really big income effect. That is, the price of beer falls, the substitution effect leads our consumer to buy more beer, but the income effect from greater budgetary headroom overwhelms the substitution effect. Beer is a Giffen good and we call it a day.
Of course, economists have been looking for Giffen goods for a very long time, and there isn’t a long list, so maybe that isn’t the best route to go.
Instead of this, Yglesias provides this additional “iso-alcohol” constraint, where consumers want to keep overall alcohol consumption constant. If the standard two-good model, if you hand someone $1000, the beneficiary buys more beer and less bourbon (if bourbon is inferior), more bourbon and less beer (if beer is inferior), or more of both (if both are normal). With the iso-alcohol constraint, however, the third case is off the table and additional money will go to some other activity. Hence, for Yglesias’ case of less beer with more “budgetary headroom” to hold, we know that we would have to be in the second case with beer being an inferior good. At the same time, though, if I hand someone $1000, it’s possible that they buy more bourbon and less beer, which is Yglesias’ point to begin with: “use the budgetary headroom opened up by cheaper beer to buy less beer and extra bourbon.”
So, let’s collapse this back down to a world where we have two goods: (1) beer and (2) bourbon and everything else, where the consumer is subject to both the income and the iso-alcohol constraint (linear combinations of beer and bourbon that lead to an equivalent level of insobriety). For visual simplicity, assume that initial income constraint is the same as the initial iso-alcohol constraint. That is, the relative price of beer and bourbon is the same as the relative weights needed to achieve some level of insobriety. Also for simplicity, assume that the consumer initially spends all his income on beer and bourbon. The optimal consumption set denoted by the circle with the 1 with bourbon consumption of Brb 1, where Brb 1 constitutes all spending on goods other than beer.
Now along comes the decrease in the price of beer and all of a sudden we have a new budget constraint, one that pivots outward with the same Y intercept but a new X intercept. The potential consumption set has expanded. Clearly, the consumer can buy more than he bought before, and a new optimum consistent with less beer consumption is illustrated by the smiley.
Because the consumer wants to maintain the same level of alcohol consumption, the amount spent on bourbon has to be on the original budget constraint — in this case the distance Brb 2 represents the amount spent on bourbon and the amount necessary to maintain that level of alcohol consumption. The distance between Brb 2 and the smiley is the amount spent on other stuff. As you can see, Yglesias’ possibility collapses to the observation that “beer could be a Giffin good.” In other words, not likely at all.
It’s probably worth noting that the iso-alcohol constraint is problematic in its own right, as it implies a minimum level of consumption that might not be viable in a world where the price of beer and bourbon go up, or income decreases. In our example if the consumer is initially exhausting his income on beer and bourbon, any price increase or income decrease has the unhappy result that the iso-alcohol constraint cannot be satisfied.
In a piece dear to the hearts of all my Econ 300 students, Master of rhetoric Deidre McCloskey lays out the case for teaching old school, Chicago economics. Although I certainly beat the maximize! drum, the central intuition is certainly that profits drive economic activity in the long run. McCloskey traces the historical context back to Adam Smith:
The core of Smithian economics, further, is not Max U. It is entry and exit, and is Smith’s distinctive contribution to social science… He was the first to ask what happens in the long run when people respond to desired opportunities. Smith for example argues in detail that wage-plus-conditions will equalize among occupations, in the long run, by entry and exit. At any rate they will equalize unless schemes such as the English Laws of Settlement, or excessive apprenticeships, intervene. Capital, too, will find its own level, and its returns will be thereby equalized, he said at length, unless imperial protections intervene.
The essay is interesting throughout, and I certainly approve of her message on this point.
If you like the rhetoric of this piece, you might consider checking out some of McCloskey’s other works, as she is indeed a prolific writer. One recent add to my summer reading list is her update of The Rhetoric of Economics. In it, she argues that “economics is literary,” and that making a persuasive case is “done by human arguments, not godlike Proof.”
This is one of McCloskey’s continuing projects. This one began with her work in the 1980s, and continues to be discussed today. The preface to the second edition, in fact, begins with a discussion of why more people didn’t read past chapter 3 in the first edition.
L.W. Burdeshaw, an insurance agent in Chipley, told the St. Petersburg Times in 1982 that his list of policyholders included the following: a man who sawed off his left hand at work, a man who shot off his foot while protecting chickens, a man who lost his hand while trying to shoot a hawk, a man who somehow lost two limbs in an accident involving a rifle and a tractor, and a man who bought a policy and then, less than 12 hours later, shot off his foot while aiming at a squirrel.
“There was another man who took out insurance with 28 or 38 companies,” said Murray Armstrong, an insurance official for Liberty National. “He was a farmer and ordinarily drove around the farm in his stick shift pickup. This day – the day of the accident – he drove his wife’s automatic transmission car and he lost his left foot. If he’d been driving his pickup, he’d have had to use that foot for the clutch. He also had a tourniquet in his pocket. We asked why he had it and he said, ‘Snakes. In case of snake bite.’ He’d taken out so much insurance he was paying premiums that cost more than his income. He wasn’t poor, either. Middle class. He collected more than $1-million from all the companies. It was hard to make a jury believe a man would shoot off his foot.”
It’s not often that I come across source material like this that I will use every single time a topic comes up in class. I tested it out on Econ 300 today and I daresay the image is a lasting one.
After yesterday’s spirited discussion of the nature of the long-run supply curve, tomorrow we will kick off with the classic brownie problem:
Brownies sell for $12 a dozen and are available only in packs of a dozen. You choose to buy two packs a month. If sellers begin offering brownies at $1 each, what can you say about the quantity you will buy?
PART 1: Audrey shops at Wegman’s supermarket, where she spends $20 a week to buy 10 apples and 5 bananas. IF she bought the same 10 apples and 5 bananas at Top’s supermarket, she’d pay $30. True or False: Audrey is wise to continue shopping at Wegman’s. (Hint: This is easy).
PART 2: You earn $100. You can use your $100 to buy 100 current apples, 200 future apples, or any combination in between.
Consider a 50% tax on wages versus a 40% tax on all income (that is, wages and interest income) and assume both taxes raise the same amount of revenue.
Which tax do you prefer? Under which tax do you consume more (and save less) today? (Hint: I’m not sure if this is easy or not).
Does knowing what your peers make matter to how happy you are? Certainly, the utility functions that I sketch in Econ 300 say no. As Ray Fisman puts it in a recent piece at Slate, “Why do we care what those around us make? It doesn’t affect the real estate or furniture or sushi dinners we can afford.”
On the other hand, of course it matters. And Fisman continues:
[I]n recent years, economics has become both more social and behavioral, borrowing evidence and ideas from elsewhere in the social sciences. Economists now acknowledge that we constantly judge our own accomplishments in comparison to others, and salaries serve as one ready benchmark. People (and perhaps monkeys, too) are also averse to inequality—unequal pay for equal work just isn’t fair (especially if you’re the one who drew the short straw).
Fisman talks about an ingenious study by group of economists, including David Card and MacArthur genius grant winner Emmanuel Saez, that investigated how differences in pay affect variables like job satisfaction. If you are interested in how economists think about these things and how they evaluate them empirically, this paper is worth checking out. The abstract is below the fold: Continue reading Interdependent Utility Functions
First, emphasizing efficiency forces us to concentrate on the most important problems. Second, emphasizing efficiency forces us to be honest about our goals.
He then runs through some nice examples (that Econ 300 students will be looking at when we get to Chapter 9), and concludes with this:
The advantage of an efficiency analysis (along, say, the lines suggested here) is that it would force Professor Reinhardt’s colleague to be clear about his priorities. Is he, for example, concerned primarily about increasing current output or about redistributing current output? Either might be a worthy goal, but we can’t have a useful debate with someone who won’t tell us what his goals are.
Wow, I’m getting excited just thinking about this.
In today’s New York Times Economix Blog, Uwe Reinhardt poses the central question: “Is ‘More Efficient” Always Better?” In answer to the question he provides the basic definitions one would confront in an introductory economics course – including appropriate references to Pareto – and proceeds to point out that some efficient points, such as R and U, are not necessarily better than some inefficient ones (any in the region bounded by X, Y, and Z).
He then proceeds to link efficiency with optimality, which becomes his point of contention.
“One suspects that the term optimal came into widespread use among economists as a marketing device to promote their normative propositions based on efficiency. But as Professor Arrow warns his colleagues on this point:
A definition is just a definition, but when the definiendum is a word already in common use with highly favorable connotations, it is clear that we are really trying to be persuasive; we are implicitly recommending the achievement of optimal states.
Alas, it gets worse. Astute readers will have figured out by now that literally every point falling on the entire solid curve in the graph must be “Pareto optimal” by the economist’s definition of that term, not only those falling on line segment Y-Z. That circumstance makes the economist’s use of the word optimal even more dubious.”
In my view, Reinhardt stops in the wrong place. Rather than “dis” the term efficiency, he could differentiate between Pareto efficient (all points on the concave curve bounded by the two axes and called in this case the Happiness Possibility Frontier or HPF) and Pareto optimality (which employs Pareto’s notion that, at these points, to make someone better off, another person must be made worse off.) So what’s the point? Actually, there are two points to be made.
1. For any point (or allocation) below the HPF, that is any Pareto inefficient allocation, there exist Pareto improvement possibilities, and economists should encourage taking advantage of such.
2. Once on the HPF, Pareto optimal allocations depend upon social preferences, about which economists have no unique judgment to contribute; however, each such social choice judgment does yield consequences with opportunity costs (foregone choices) that can be identified. Stated differently, all Pareto efficient points are candidate points to be Pareto optimal under some set (of sometimes very curious) social preferences.
To conclude, the notion of efficiency is not a vague term, and it does reflect a value free standard. In my view, one can claim that for any Pareto inefficient allocation, Pareto improvements exist. Efficiency, however, says nothing about the optimal choice until preferences – in this case comparison of A’s vs. B’s happiness – is made. Furthermore, economists should encourage those making such social preferences to be transparent rather than hide them in 2000 pages of legislation.
I’m a big fan of Steven Landsburg’s approach to micro theory, and hence I have adopted Price Theory and Applications the times I have taught the course (HT: Charles Steele). The 8th edition is about to come out, meaning that there is no viable used market to purchase the 8th edition. This also calls into question paying full price for a new version of the 7th edition (currently north of $160).
Since most Econ 300 students are majors (the ones that survive, at least), I am not worried about the resale market, because I think someone walking around calling themselves “an economist” should have a solid micro theory book on the shelf.
So, with all of that said, I recommend that you either pony up for the 8th edition (which I have yet to get a desk copy of), or start scouring your used options now. Amazon doesn’t seem to be much help, but a quick search of Valore Books and Big Words (< $40), eBay, and Chegg.com, indicates that you should be able to locate a copy at a pretty reasonable price.
Worth every penny. But there’s no sense squandering the surplus.
Girl Scout cookies sell for different prices in different areas. The going price is either $3.50 or $4.00 depending on where you live. Local Girl Scout councils are actually allowed to set any price they want…
Well, perhaps not ruthless. The author incorrectly titles it “price gouging,” when in fact it is simply a form of third-degree price discrimination, I suppose. I would be interested in seeing data on different prices across different markets. Do you think the different elasticities of demand stem from differences in income? Differences in tastes? Differences in close substitutes? Why isn’t there entry to wipe away the excess profits? I could spend the rest of the day thinking about this (and probably will).
For you 450 readers, perhaps there is an arbitrage opportunity out there for a would-be (Kirznerian) entrepreneur.
I am definitely going to check the price before I commit to Girl Scout cookies for the Economics TeaBA.
This question came up in class the other day — are you peeling your bananas wrong? As usual, the Armchair Economist Steven Landsburg has something to say about the matter:
My friend Petal peels her bananas from the bottom. Well, it’s the top, actually, since bananas grow upside down. Come to think of it, that’s not quite right either—bananas grow the way they grow, which should be right-side up by definition, even if we think of them as upside down. So let me start over. Petal peels her bananas from the end without the stem.
Petal’s method is counterintuitive and thus instantly appealing to economists, who love nothing more than to overturn conventional wisdom. Multiple experiments (well, two experiments, actually, since we only had two bananas) quickly convinced a majority of the department that Petal’s way is—surprisingly—easier than the traditional method, though the econometricians thought you’d need to test at least 30 bananas to report that result with confidence. The labor economists immediately resolved to apply for a grant.
Still not convinced? Well, you aren’t alone. But the peel-from-the-bottom case is a compelling one:
In the anti-Petal camp, we have the theorists who argue that peeling from the stem end must be optimal because that’s what people do. But Petal counters—and indeed this is her clincher argument—that monkeys do it her way (though I think it would be more accurate to say that she does it the monkeys’ way) and monkeys are the real experts.
If such knotty problems interest you, you should consider taking Econ 300 with me this fall. In fact, you should consider it anyway.
While dredging through Steven Landsburg’s excellent, yet interminable, chapter on perfect competition, we took a brief break to contemplate the Austrian critique paused to think about some of the Austrian critiques of the competitive model. To wit:
The trouble with the concept from the Austrian point of view… is that it describes an equilibrium situation but says nothing about the competitive process which led to that equilibrium. Indeed, it robs the firm of all business activities which might reasonably be associated with the verb ‘to compete’ (Hayek, 1948). Thus, firms in the perfectly competitive model do not raise or lower prices, differentiate their products, advertise, try to change their cost structures relative to their competitors, or do any of the other things done by business firms in a dynamic economic system. This was precisely the reason why Schumpeter insisted on the irrelevance of the concept of perfect competition to an understanding of the capitalist process.
The dust is settling on the, well, the dust up between Amazon and Macmillian over eBook prices. There are some excellent posts from Virginia Postrel, Lynne Kiesling, and Megan McCardle. Some great Industrial Organization topics here, like price discrimination, resale price maintenance, and why entry by Apple here is leading to higher retail prices. (Did he just say entry is leading to higher prices? Yes, he did).
Well, as we try to sort that out, it appears the dust is on the rise again, as a third publisher is demanding the “agency model” in the pricing of e-Books.
The future of the $9.99 e-book is in danger. A third major publisher, Hachette, is going for Apple’s agency model in order to sell e-books for up to $14.99 apiece, the company revealed in a memo to agents.
Following Amazon’s public dispute over e-book prices with Macmillan early this week, Hachette is also seeking a shift to the agency model, which allows the publisher to set the price for the e-book, while the retailer keeps 30 percent of the sales.
I wonder if that “agency model” bears any relationship to the “principal-agent” problem we will be covering in 450 after the break?
Macmillan, one of the “big six” publishers, has clearly communicated to us that, regardless of our viewpoint, they are committed to switching to an agency model and charging $12.99 to $14.99 for e-book versions of bestsellers and most hardcover releases.
We have expressed our strong disagreement and the seriousness of our disagreement by temporarily ceasing the sale of all Macmillan titles. We want you to know that ultimately, however, we will have to capitulate and accept Macmillan’s terms because Macmillan has a monopoly over their own titles, and we will want to offer them to you even at prices we believe are needlessly high for e-books. Amazon customers will at that point decide for themselves whether they believe it’s reasonable to pay $14.99 for a bestselling e-book. We don’t believe that all of the major publishers will take the same route as Macmillan. And we know for sure that many independent presses and self-published authors will see this as an opportunity to provide attractively priced e-books as an alternative.
Kindle is a business for Amazon, and it is also a mission. We never expected it to be easy!
Greed, no doubt, exists on both sides, living as we do under capitalism, but greed alone doesn’t explain the dispute. Yes, Amazon wants to sell e-books for $9.99 or less, and Macmillan wants Amazon to sell them for $15 or less. But as Macmillan’s CEO John Sargent explains, in a statement released today as an advertisement to the book-industry newsletter Publisher’s Lunch, Amazon and Macmillan aren’t at the moment fighting to see who can make more money on a book sale. They’re fighting to see who can lose more money. This is a very peculiar battle.
Most publishers have until now sold their e-books to Amazon for the same wholesale price that they sell their hardcovers–roughly half the hardcover’s list price. It is up to a retailer like Amazon whether to sell the book to consumers at its list price, as printed on the inside front flap, or at a discount. With e-books, Amazon has usually offered a discount so low that it actually loses money. That is, Amazon buys for $12 an e-book whose hardcover list price is $24.95, and then Amazon sells the e-book to its customers for $9.95.
Macmillan has probably been selling its e-books to Amazon at the wholesale price of about $12, and Amazon has been selling them retail for about $10. Macmillan says that it would like to sell its e-books at the wholesale price of about $10.45, and have Amazon sell them for the retail price of $14.95. In other words, Macmillan was offering to earn $2 less per e-book. Amazon, however, insisted that it would prefer to take a $2 loss on each e-book, instead, and became so indignant over the matter that it has now ceased selling any Macmillan titles, print or electronic. Macmillan’s proposal is known as the “agency model” for e-book pricing, and the company probably only dared attempt it because Apple has promised that it will sell e-books for its new tablet on exactly those terms. (Amazon has said that they’re willing to accept the agency model, starting in June, but only if an e-book’s list price does not exceed $9.99.)