Incentves matter: hidden information file

This example is from Donald E. Campbell's book Incentives: Motivation and the Economics of Information, 2nd Edition:

I was driving home one day, correcting the manuscript for this section, trying to think of a good example of private information in this context. Then I realized that my practice of correcting manuscripts while driving is the perfect illustration. My insurance company would love to know about this dangerous habit. [p.304]

Policy for the Next President: Fair Trade or Free Trade

Over at the Council on Foreign Relations website Jonathan Jacoby, associate director of international economic policy at the Center for American Progress and Robert Lane Greene, an international correspondent for the Economist, have an online debate on the shape of trade policy for the next U.S. administration and whether new trade deals should come with strings attached.

Pure inflation v. relative price changes.

One thing that seems odd about much discussion of inflation is the failure to make a distinction between changes "pure inflation" and "relative price changes". Changes in relative prices are important because it is relative prices that direct resource allocation. These are the price signals that are important for the smooth functioning of the economy, they provide the incentives for people to change their behaviour. As Cowen and Crampton (2002: 5) put it [t]he Canadian plumber's knowledge of substitutes for copper piping influences the French electrician's choice of home wiring through its effect on the market price of copper. "Pure inflation", on the other hand, is signal jamming noise which can result in the misallocation of resources. One of the major problems with inflation is the fact that people can't tell the difference between changes in relative prices and pure inflation. This is, in part, because the standard measures of inflation, eg changes in the CPI, contain both components: relative price changes and "pure inflation". Sorting these two factors out however is far from easy.

But what exactly is meant when we talk about "pure inflation"? Imagine an economy in which every price exogenously doubled. What used to cost $1 now costs $2, those who were paid $10 per hour now are paid $20, and what was worth $100 now is worth $200 and so on. Note that there has been no relative prices changes here. Thus, because people care about trade-offs when making choices, no one will behave any differently in the new "high price" world than they did previously. We would say, there is no "money illusion" in that changes in the unit of account don’t change anything real at all. (In microeconomic theory you learn this when you are told that demand functions are homogeneous of degree zero in prices and income.) Such an equiproportional price level increase, in the example just given the price level has doubled, is what can be called pure inflation.

In a recent paper - Relative Goods' Prices and Pure Inflation by Ricardo Reis and Mark Watson, CEPR 6593, December 2007 - it is pointed out that central to the story told above is a measure of inflation which is defined by two properties:

1. all prices increase in exactly the same proportion, and
2. the change is unrelated to any relative-price movements.

Reis and Watson argue that the extent to which (2) holds is an inflation measure's "purity." A measure of inflation is purer the more it has been stripped from relative-price changes and so it is closer to the thought experiment carried out above. How then to purify a measure of inflation?

Reis and Watson note that,

[i]n our own work, we noticed that factor analysis also gave a natural way to purify the measure of inflation. Factor analysis produces a set of components (or factors) that explain why prices move together. One of these factors is the equiproportional change in prices that Bryan and Cecchetti emphasised. But the other factors are just as interesting. These factors are measures of relative-price changes due to some common source (say productivity, fiscal, or monetary shocks), and it turns out that a few of these alone account for a great deal of the variability of price changes. Therefore, we can use them to statistically purify our measure of inflation from these main sources of relative price movements.

Using US data Reis and Watson found that

... most of the movements in conventional measures of inflation like the Consumer Price Index (CPI), its core version, or the GDP deflator are due to relative-price changes. Only around 15-20% of the movements in these measures of inflation correspond to pure inflation.

Given that they had measures of relative price changes and pure inflation Reis and Watson could look for evidence of money illusion in their data. They found that once they controlled for relative price changes, the correlation between (pure) inflation and real activity is essentially zero. So,

... when we see that high inflation typically comes with low unemployment or high output, this is indeed driven by the change in relative prices hidden within the inflation measure. When there is pure inflation, that is when all prices increase in the same proportion independently from any relative price changes, nothing happens to quantities.

Can pay regulation kill?

Here is a discussion, by Carol Propper and John Van Reenenof, of a new paper that argues pay regulations can kill. Economists have long warned of the unintended consequences of market regulation, including regulation of the labour market. What seems "fair" on the face of it – like paying people the same wage for doing the same job regardless of where they work – may turn out in practice to be foul. While economists often worry about the minimum wage pricing people out of jobs, a regulation that can impose a maximum wage and price people out of jobs has received little attention. Propper and Van Reenenof point out that an example of such a pay regulation is centralised wage-setting, where pay is mandated to be (almost) the same across different labour markets, effectively imposing a maximum wage on people living in areas where labour markets outside the regulated sector are strong.

This kind of centralised pay-setting happens in many public sector labour markets like health, teaching and the police. Nowhere is centralised pay-setting more important than in the UK National Health Service (NHS). More than a quarter million nurses in England have their pay set by a single pay review body. The process allows some local flexibility, but in practice the gap between the wages paid to a nurse in a low outside wage area – such as Newcastle in the North East – and a high wage area –such as London –is small compared to the pay gap between women who are not nurses. In recent research, we examine in detail how centralised pay-setting for nurses in the NHS affects hospital performance by tracking changes in the outside wage and changes in performance in over 100 English hospitals over a six-year period. (Hall et al. 2008)

The outcomes of the centralised pay system can be fatal. The pay regulation means that hospitals which are in high wage areas treat fewer patients and these patients have poorer health outcomes. And these effects are far from minor. Results from the Hall et al. (2008) study point to that fact that a 10% increase in the gap between the wages paid to NHS nurses and those paid to women working in the private sector locally raises the fatality rate among people admitted with a heart attack by 5%. To put this into perspective the size of this effect is not dissimilar to the reductions in heart attack fatalities brought about by the greater use of aspirin and other clot-busting drugs in recent years.

What Hall et al. (2008) did was look at the quality and productivity of nursing across the UK, this being measured by the percentage of those admitted to hospital after a heart attack who died in the subsequent 30 days. What was found was that the richer the area surrounding the hospital the worse the survival rate. This is in contrary to what we would expect given the often discussed connection between poverty and bad health. We would expect the death rates to be higher in poor areas. The reason for this "rich area effect" is the centralised pay-setting which results in wages being the same right across the country, with little responsiveness to local labour market conditions. But it isn't that nurses wages are too high in low wage areas, but that they are too low in high wage areas. In high wage areas this leads to both a shortage of people willing to do the job itself and hospitals relying upon agency staff who are not constrained by the national pay scale. The problem with this is that the agency staff are, by the very nature of their shift by shift employment, unlikely to know the systems and hospitals as well as permanent staff. Local and tacit knowledge gained via experience in that particular situation is important and unknown to the agency staff. This lowers the quality of care and people die.

The answer, at least as far as the Adam Smith Institute see it,

is to abolish such national pay rates and allow local employers to pay what they need to attract the staff they desire.

This makes sense, and may save lives.

Assessing the recent labour market agreement in France

Gilles Saint‑Paul, Professor at the Toulouse School of Economics, takes a look at the labour market reforms agreed to recently in France. He sees a positive side in that flexibility increases for firms, in particular the reduction in the non-wage costs firms' face when deciding to get rid of a worker, but a negative side-effect is that the incentive to remain unemployed has somewhat increased. Saint-Paul notes that the risk of opportunistic behaviour by firms and workers with respect to the unemployment benefit system has not been taken into account and this needs to be addressed.

Marginal Revolution book forum 3

In the third of the Marginal Revolution book forums Fabio Rojas looks at chapter 3 of the Logic of Life: Is Divorce is Underrated?

This is the chapter with the pin factory error in it.

Jason Furman vs Steven Landsburg 5

In the concluding part of their debate Furman and Landsburg ask, Say the stimulus package doesn't work; then what? Another stimulus package, or does the U.S. just wait out the slump?

Economic Communication Prize

Here is a contest you may wish to enter if you think you are a great communicator of economic ideas.

(HT: Bryan Caplan, EconLog)

Tim Harford interviews

At Bloggingheads.tv Will Wilkinson interviews Tim Harford.

Tim Harford on Colbert Report

(HT: The Bayesian Heresy)

Harford is also on Authors@Google.

(HT: Tyler Cowen, Marginal Revolution)

Jason Furman vs Steven Landsburg 3 and 4

In the third of the Los Angeles Times "DUST-UPs", Jason Furman and Steven E. Landsburg continue their debate with the question Why should Freddie Mac and Fannie Mae guarantee home loans bigger than $600,000? Does this increase the likelihood that public money will be used to bail out lenders?

The fourth "DUST-UP" considers the possible causes of the current slump in the US.

What more needs to be said? (updated x6)

According to Paul Bloom, a professor of psychology at Yale, "The problem is not that economists are unreasonable people, it’s that they’re evil people".

(HT: Greg Mankiw)

Update: Phil Miller, on the Market Power blog, comments here: The Evil Economist and the Market for Organs.

Update 2: Stephen J. Dubner blogs on this quote on Freakonomics. His message contains the following addendum which is an email from Paul Bloom:

Hi Stephen,

I just read your entry on the Freakonomics blog, and thought I should send a quick reply.

Yes, my remark about evil economists was a joke. This was perfectly clear at the talk and it’s clear if you watch the video, but not from the NYTimes article, unfortunately. After I make the remark and people laugh, I then say “To put it more fairly …,” and go on to make the point that economists tend to reason consequentially, and are less sensitive to other considerations such as taboo, disgust status quo bias, and so on. I actually think that economists are right to do so in general, and I’ve argued in particular that disgust is useless as a guide for moral behavior. So, no, I don’t think you’re evil!

Best,

–pb

Update 3: There are video and audio available from the recent American Enterprise Institute panel discussion on Repugnance as a Constraint on Markets: The Influence of Emotion and Reason on What We Buy and Sell during which the Bloom comment was made. The discussion interesting for more than just the joke.

Update 4: Edward J. Lopez comments on The Economics of Repugnance at Division of Labor.

Update 5: Paul Kedrosky comments, Be It Resolved: Economists Are Evil

Update 6: Ronald Bailey comments at Reason Magazine, Are Markets Repugnant?

Why do governments back losers? Two parts of an answer.

Tim Harford has a piece up at Forbes.com in which he tries to unravel why governments so unerringly back losers. Harford points out that "[i]f you want to dismay an economist, just mention the phrase "national champion."" On hearing such a phrase economists automatically think of "wheezing corporate behemoths protected from domestic competition, propped up with generous government subsidies and shielded behind trade barriers." Not a pretty picture, it has loser written all over it. So, asks Harford, if governments want to back winners, Why are they so good at backing losers?. He answers,

Partly, it's because picking the winners is inherently a difficult job. Left alone, the market does a great job of rewarding the very best and cutting the rest down to size. Any corporation that gets big and stays big in a competitive environment is likely to be very good at what it does. A corporation that stays big only because of government backing probably won't be.

He then goes on to explain that government favouritism may have a somewhat more sinister logic behind it,

Namely, firms in emerging, competitive industries have virtually no incentive to lobby for government hand-outs, while firms in aging, shrinking industries have the most to gain.

The reason for this is simple he says,

Firms in an open, competitive, growing young industry have little to gain from government support. More government funding for, say, biotechnology, is going to mean more biotechnology companies, more competition and (perhaps) more innovation. That might be good for America, but probably not much good for any single biotech company. Sure, they'll all enjoy the government help, but each must weigh that assistance against the swarm of new competitors attracted by the handouts. No one firm would choose to hire top lobbyists and send them to D.C. to bring back the pork.

By contrast, firms in aging, shrinking, capital-intensive industries have everything to gain from government support. Because the industry is shrinking and it's expensive to enter--think steel mills--the government subsidies and tax breaks are probably not going to attract new competitors. If there are no new competitors, the old guard gets to pocket all the money.

D R Myddelton looked at a related question in his recent book They Meant Well: Government Project Disasters. In this work, published by the Institute of Economic Affairs in London, Myddelton asks How is it that so many major, government-sponsored projects can lose so much money? He points out that the the answer to this question does not lie with malign intentions on behalf of their promoters in government. On the contrary the supporters within government of such projects only have the best of motives, so why do these projects go so wrong?

Myddelton considers six projects covering a period of 80 years to find answers. He looks at The R. 101 airship, the groundnut scheme, nuclear power, Concorde, the channel tunnel and the infamous Millennium Dome. A recurring rationale for these grandiose projects has been to boost "national prestige", but this concept has little real value.

Myddelton's explanation for the continual failure of such projects is that failure results from mismanagement, lack of clear lines of responsibility and lack of accountability. The point is made that

[n]one of the six projects was well managed and many of the failures were down to politicians: installing inadequate or over-complex organisations, appointing incompetent managers, or insisting on excessive secrecy.

These problems have their roots in the wider economic problems of undertaking quasi-commercial ventures in the public, rather than in the private, sector. This results, argues Myddelton, in well-meaning politicians and government officials wasting huge sums of taxpayers' money.

The arguments of both Harford and Myddelton should make us apprehensive when governments start talking of "national champions" and starting want to back these notions with our money. Odds are things will end badly.

Jason Furman vs Steven Landsburg 2

The Los Angeles Times has another "DUST-UP" between Jason Furman and Steven Landsburg. This time Landsburg and Furman discuss the stimulus package in the context of the government's deficit spending.

Tax burden

According to figures in the latest edition of the OECD’s annual Revenue Statistics publication the average tax burden in OECD countries is back up to the historic highs of 2000 after a brief reduction between 2001 and 2004. The tax burden is measured as the ratio of total tax revenue to gross domestic product (GDP). The average tax burden in the 30 OECD countries reached 36.2% of GDP in 2005, the latest year for which complete figures are available. The lowest burden appears to be Korea (South I would assume) with a ratio of 25.5%. The highest is Sweden at a whopping 50.7%!

In the case of New Zealand the ratio stands at 37.8 for 2005, so above the OECD average. For comparison, Australia's ratio is 30.9, Ireland's 30.6 and the US is 27.3. It is interesting to note that in 1975, the first year for which figures are given, New Zealand's ratio was 28.5 while Australia's was 25.8. So back in 1975 New Zealanders paid a bit less than 3% more of GDP in tax than Australians while by 2005 the gap had risen to about 7%. In 1975 the OECD average was 29.5%, so New Zealand was below the average back then. Over time the government in New Zealand is taking an ever increasing share of people's income.

Voting with your feet.

An article on the website CFR.org reports that

Some sixty thousand Zimbabweans were deported from Botswana in 2006, and over 23,000 were deported between April and November 2007. South Africa deported over 150,000 Zimbabweans in the first nine months of 2007, according to Refugees International.

The report goes on to point out that

... the primary reason Zimbabweans leave their country: the need for money.

These people are economic refugees who are simply fleeing Zimbabwe's economic collapse. The huge number of such people just goes to show how bad the situation in Zimbabwe has become.

There is little point in trying to bring about change by voting in an election in Zimbabwe, so people vote with their feet ... repeatedly,

"These repatriations are more or less a vicious cycle," says Moses M. Gaealafswe, Botswana's chief immigration officer told CFR.org. "You arrest them today, you repatriate them tomorrow, next week they are here."

Don't Cry for Free Trade

Or so says Jagdish N. Bhagwati, and who would know better? In an article on the website of the Council on Foreign Relations Bhagwati points out that if you

[t]urn to the leading American newspapers these days and you will read about the "loss of nerve", even "loss of faith", in free trade by economists.

Bhagwati tries to give some perspective on the current media stories about the economists' disappearing consensus on free trade by looking at three recent episodes where journalists have sounded similar false alarms on the topic. He writes,

... let me then turn to document different episodes in recent years when false notes of alarm were sounded over free trade, similar in hype to those of the motley crew that I have just cited as the latest journalists writing in a similar vein. I will assess and dismiss the "heretical" arguments that were advanced against free trade in each episode; in fact, I was cast by the media in the role of the defender of free trade in all these episodes.

The episodes Bhagwati deals with are

• Episode 1. The Rise of Japan: Krugman and Tyson
• Episode 2. The Rise of India and China: Paul Samuelson
• Episode 3. India and China and Fear of Outsourcing: Alan Blinder

Bhagwati's basic aim is to point out the obvious, that

[t]he truth of the matter is that free trade is alive and well among economists, their analytical arguments in favor of it, developed with great sophistication in the postwar theory of commercial policy, having hardly been dented by any original arguments by the few economists, including Alan Blinder in today's debate, arrayed against it.

It is an article well worth reading.

Jason Furman vs Steven Landsburg

The Los Angeles Times has a "DUST-UP" between Jason Furman and Steven Landsburg on the usefulness, or otherwise, of the recent stimulus package in the US.

(HT: Greg Mankiw)

Collier on EconTalk

Russ Robert's guest on EconTalk this week is Oxford University Economics Professor Paul Collier, author of the recent book The Bottom Billion. This book is analysis of why the poorest countries in the world fail to grow. Collier talks with Roberts about conflict, natural resources, being landlocked, and bad governance; four factors Collier identifies as causes of the desperate poverty and stagnation in the countries where 1/6 of the world's poorest peoples live.

A point worth noting is that William Easterly is scheduled to appear on EconTalk in two weeks. He'll provide a different perspective on some of the same issues, as is demonstrated by his review (pdf) of Collier's book.

Marginal Revolution book forum 2

The second instalment of the Marginal Revolution book forum on Tim Harford's book, The Logic of Life is available. The reviewer is Fabio Rojas and he's looking at chapter 2.

Coalition against fiscal stimulus (updated)

Greg Mankiw has a "coalition against fiscal stimulus" here.

Update: The Bayesian Heresy has links to a number of views on the merits of fiscal stimulus.