Pur Autre Vie

I'm not wrong, I'm just an asshole

Sunday, March 01, 2015

Economics: Projects for Future Benefit

This is part of a series of posts on economics.  Unlike my typical posts, these posts are dynamic—I'm going to come back and edit them as my thoughts develop.  I am basically "thinking out loud."  I am trying to fit things together in a modular way, so that each piece stands on its own analytically.  But no promises.

We are not going to develop a very detailed model of the market for goods and services.  As we have noted, people get utility from consuming goods and services, which is reason enough to buy them.  But people can also buy goods and services for reasons that are less directly related to utility.  We've already briefly discussed this topic, but let's look at it in a little more depth.  There are various projects that can be undertaken with the following feature:  resources are spent at time t = 0 and then there is some benefit that accrues at time t = n (the benefit may also be spread out over several periods).  Examples include things like adding more machines to a factory to expand its production capacity, or buying a microwave so that you can easily heat food in your kitchen.  These examples are different in that one is an investment in capital, while the other is investment in a consumer item, but we are not going to make very much of this distinction.  In both cases you must spend money at time t = 0 in anticipation of benefiting in the future.  The main differences between the factory and the microwave that will interest us are when and for how long those future benefits will accrue, and what risks attach to the project (for instance, maybe the microwave has a 5% chance of breaking down each year, and its warranty lasts only a year).  There is not a sharp distinction between immediate consumption and a consumption project that lasts several time periods — there is a continuum from 100% of the utility being gained at t = 0 to 100% of the utility being derived far in the future.

We are not going to look very closely at these projects, except to note a few features that we will assume.  First, the anticipated value of a project is dependent on circumstances.  If you are going to build an ice cream factory, your expected profits depend on your view of the market for ice cream in the future, when the factory starts producing ice cream.  If there is a health craze, or if refrigeration becomes much more expensive, then the demand for ice cream may be depressed and your investment may prove unprofitable.  Or it may be that milk and sugar will be more expensive in the future, reducing profits even if demand remains steady.  Another important aspect (which we will examine more closely in a separate post) is the interest rate and the risk premium available in the market.  If the ice cream factory yields a return of 15% and the market interest rate is 20%, then the ice cream factory may be a bad investment even if it is profitable as an accounting matter.  In other words, the ice cream factory may earn enough profits to more than pay back the original investment, but the investor might still have done better by loaning the money to someone else.

Second, we are going to assume (somewhat unrealistically) that when someone spends money on consumption or on a project for future benefit (such as the ones we have been discussing), the expenditure involves using scarce resources.  So for instance, if I invest in machines for my factory, those machines will be unavailable for anyone else.  If they are custom-made, then the materials and labor that go into making them are unavailable for anyone else to use.  This is realistic for many goods and services, but it's not universally true.  When an individual buys software, or pays to stream a movie over the internet, there is no reduction in resources available for other people to use (or the reduction is minor, such as the use of bandwidth on the internet, which represents a small part of the price of the movie).  We are going to ignore these non-rival goods and services.

We are also going to ignore non-market use of resources.  Technically, if someone operates an orchard, she may be using carbon dioxide, without which she couldn't produce any fruit.  But there is no market for carbon dioxide, and realistically her use of carbon dioxide is trivial.  The same would be true of a facility that concentrates argon from the atmosphere and then sells it.  Technically, in addition to the market goods and services that are used (machines, electricity), the facility also removes argon from the atmosphere.  This is not what we mean when we talk about using up resources.  And we are going to ignore other cases in which people use up society's resources in a more material way without paying for them (as when a farmer removes water from an aquifer that extends beyond his land).  This may be economically significant, but it is not a project for future benefit for our purposes because the farmer doesn't spend anything for the water at time t = 0.  If she has to buy a pump to get the water, on the other hand, then that would count as a project for our purposes.

So in conclusion, projects for future benefit require spending at time t = 0, they use up scarce resources, and their profitability depends on external circumstances such as market demand for the particular good in question, as well as the market rate of interest and the risk premium that attaches to financial products.

Monday, February 23, 2015

Economics: The Logic of the Financial Markets

This is part of a series of posts on economics.  Unlike my typical posts, these posts are dynamic—I'm going to come back and edit them as my thoughts develop.  I am basically "thinking out loud."  I am trying to fit things together in a modular way, so that each piece stands on its own analytically.  But no promises.

Now I want to take a closer look at the logic behind the financial markets.  Remember that we have individuals who want to maximize their utility, which they achieve by consuming goods and services.  And recall that many (maybe all) people experience diminishing marginal utility from consumption, meaning that the first dollar the person spends in any time period is more valuable than the second dollar, and so on.  This has two implications:  first, it means that people can sometimes increase their utility by shifting their consumption over time, and second, it means that people have different levels of tolerance for risk.  People with sharply diminishing marginal utility are more risk-averse than others.

Moreover, people discount future consumption using their consumption discount rate, which varies from person to person.  Finally, let's assume that people's wages are not constant over time.  People are sometimes unemployed, and almost everyone wants to retire at some point.

Putting these things together, it's easy to see that there will be demand for at least three things that can be provided by the financial markets.  First, sometimes people will benefit by borrowing money at one point in time and repaying it at a later point in time with interest.  This could be done for many reasons.  Someone who anticipates higher wealth in the future might want to "shift consumption back in time" in order to take advantage of the higher marginal utility of consumption in the present.  Someone with a high consumption discount rate might want to do the same thing, but this time in order to take advantage of the lower discount applied to present consumption than the one applied to future consumption.  Finally, someone might have an investment opportunity—a good or service in the non-financial markets that will yield a rate of return more than sufficient to repay the interest on the loan.  (An example would be borrowing to buy equipment for your business, which will hopefully generate enough income in the future to repay the loan with money to spare.  Another example—hopefully!—would be a student loan.)

The second demand that can be satisfied by the financial markets is the desire to shift money in the other direction—to save money today in order to consume it (plus interest) tomorrow.  This is just the reverse of the situation in the previous paragraph.  Of course, when you shift consumption into the future, you are always pushing against the consumption discount rate (no one discounts present consumption more than future consumption).  But if the interest rate is higher than your discount rate, then you could shift consumption to the future to take advantage of the disparity.

It could also be advantageous to shift spending power to the future if the individual has enough to consume today and wants to make sure she will have enough to consume in the future.  This is especially true if she anticipates the possibility of unemployment or retirement.  Just note that this would not be true if the individual did not experience diminishing marginal utility of consumption—in that case, the inability to consume in the future would not matter, because the individual could obtain the same (or higher) aggregate utility by consuming today.

The third and final demand that can be satisfied by the financial markets is the demand to shift risk among individuals.  A risk-averse individual can improve her utility by entering into insurance-like contracts that are "statistically unfair."  To see how this works, imagine an individual who owns an asset that will, at time t = 1, be worth either $1,000 or $0, with equal probability.  Imagine that this individual has a marginal utility of consumption of 1/2, meaning that this person's utility from consumption follows this function:

U = C1/2

For the sake of simplicity, assume that this individual does not discount future income at all (this is just so that we can leave out some math).  And finally, assume that the individual's only source of wealth at time t = 1 will be the asset.  She will sell the asset (if it is worth anything) and consume the proceeds.

What is her expected utility?  It is:

U = (0.5)($0)1/2 + (0.5)($1,000)1/2

That is, there is a 1/2 probability that she will have a utility of 0 and a 1/2 probability that she will have a utility of (1,000)1/2 or ~31.62, for an expected utility of ~15.81.

Now what if someone offers to pay her $400 at time t = 1 in exchange for the proceeds of the asset (regardless of its value)?  (We will assume this is a credible promise—she can rely on receiving $400 if she takes the deal.  We might address counterparty risk later.)  This is a statistically unfair exchange because the expected monetary value of the asset is $500.  But should she take the offer?  Well, here is her expected utility:

U = ($400)1/2 = 20

So if she keeps the asset, her expected utility is about 15.81, but if she takes the $400 instead, her expected utility is 20.  Of course in reality she should try to get a higher price, but any price above $250 will increase her utility relative to no deal at all.

All right, so, if the financial markets are working properly, what should we observe?  We should see people with higher consumption discount rates borrowing from people with lower consumption discount rates.  We should see people with high current incomes saving money in anticipation of unemployment or retirement.  We should see anyone with a real-world (non-financial) investment opportunity borrowing money to finance it, as long as the interest rate is below the rate of return on the project.  On the other hand, we should not observe anyone investing in a project if a higher rate of return is available in the financial markets (taking risk into account).  We should see risk-averse people buying insurance (whether or not it is formally labeled "insurance") from people or institutions that are less risk-averse.

Sunday, February 22, 2015

Economics: Modeling Individuals

This is part of a series of posts on economics.  Unlike my typical posts, these posts are dynamic—I'm going to come back and edit them as my thoughts develop.  I am basically "thinking out loud."  I am trying to fit things together in a modular way, so that each piece stands on its own analytically.  But no promises.

We will model people as economic agents who engage in the following market activities:  working (selling labor in the labor market), consuming (buying goods and services), borrowing or saving (either buying or selling financial products), and investing (that is, spending money in anticipation of generating future wealth, but doing so outside the financial markets).  The difference between saving and investing can be illustrated with this example:  a saver might take $1,000 and put it in a bank account for future consumption, while an investor might take $1,000 and buy a solar panel so that he can enjoy cheaper electricity in the future.  Both are spending money to increase future consumption, but only one is doing so through the financial markets.  This is a non-standard use of the term "investing," and so I will try to be careful to make myself clear when using the term.

We are going to model people as though they are motivated to maximize their consumption over time.  However, we will be open to the possibility that people care more about present consumption than about future consumption, and more about near-future consumption than distant-future consumption.  We'll call this the consumption discount rate:  the rate at which future consumption is discounted in the individual's utility function.  We'll allow people to have different consumption discount rates.  We will also distinguish between the consumption discount rate and the effective discount rate, which may take into account other factors such as the market interest rate and the rate of inflation or deflation.  That will be a topic for another segment.  The consumption discount rate will vary between 0 and 1, with 0 indicating no preference for present spending, and 1 indicating no expected utility from future consumption.  You can determine the utility from a unit of consumption in the future by multiplying it by:

(1-d)n

where d is the consumption discount rate and n is the number of time periods between now and when the consumption occurs.  (For current consumption, n = 0 and so consumption is not discounted at all.)

We will also allow for the possibility that people experience diminishing marginal utility from consumption at any given time.  This is reflected in a variable that on the high end approaches 1 and on the low end asymptotically approaches 0, as in the following equation:

U = Cm

where U represents utility, C represents consumption, and m represents the marginal utility variable.

So for instance, imagine that a person has $1,000 at time 0 and no expectation of working in the future.  This person might seek to transmit some of her spending power to the future (by saving or investing), even though future consumption is (other things being equal) less valuable than present consumption.  This is because (for instance) two instances of $500 consumption are collectively worth more utility than one instance of $1,000 consumption (although you would have to discount the second $500 round of consumption if she has a nonzero consumption discount rate).

In the example I've just given, the diminishing marginal utility of consumption is pushing in one direction (saving rather than consuming, so as to shift consumption to a time when its level is lower and its marginal value is therefore higher), while the consumption discount rate is pushing in the other (consuming rather than saving because present consumption is more valuable than future consumption).  It is also possible that both factors will push in the same direction:  for instance, an individual might borrow money and spend it today in the anticipation that she will be wealthier in the future.  In that case the person is increasing utility by shifting consumption toward the present and by shifting consumption toward a time when its level is low and therefore its marginal utility is high.

We will assume that work is unpleasant and people experience disutility from working (or utility from leisure time), so that people have to be paid wages to induce them to work.

Finally we will assume (or really just note) that people will seek the most advantageous means of shifting consumption/spending power from time period to time period.  So when they shift spending power to the future, they will look for financial products or investment opportunities that offer a high expected rate of return, and when they borrow they will look for a low rate of interest.  People who have diminishing marginal utility from consumption are risk-averse and they will also seek a certain degree of safety when saving or investing.  (In other words, someone who gets diminishing marginal utility from consumption is not indifferent between a certain $500 and a 1/2 probability of $1,000, because the first $500 of consumption is more valuable than the second $500.  Someone with no diminishing marginal utility from consumption is risk-neutral and would not generally have a preference between a certain $500 and a 1/2 probability of $1,000.)  So in other words people maximize their utility from borrowing, saving, or investing taking into account both the rate of return (or rate of interest) and the level of riskiness.

Friday, February 06, 2015

Ein Klein Whining

Yesterday Elisa Gabbert tweeted:
I basically agree with this sentiment, but I also agree with the sentiment expressed by Catherine Nichols (e.g. here) that creepiness is a word used to describe unwanted male attention, and it's just a fact of life that male attention is more likely to be unwanted when it's coming from an unattractive man.

I want to take a step back and consider the way the sexual match-making process works.  In the U.S., at present, the general expectation is that men will be the agenda-setters.  In other words, men initiate things by indicating interest in some way.  This is obviously not an absolute rule, but in general a man must take affirmative steps to get the ball rolling, and by the same token can dial things down simply by not doing anything.  A woman generally must wait for expressions of interest, and then must take affirmative steps to shut things down.  Again, I do not mean to say that this is how things should be, or how they are in every case, but I think this is the norm.

The dynamic I've described above is not great for women, obviously, but it's also a very unfortunate dynamic for socially awkward men.  I think here is (very roughly) how things play out.  Men express their interest in women with varying degrees of adroitness.  When this attention is welcome, women are happy.  (They may not express their pleasure directly—they may play hard-to-get or feign disinterest or whatever—but they certainly don't often label men "creepy" when the attention is welcome.)

When the attention is unwelcome, it puts women in an awkward position (even if it is otherwise appropriate).  Sometimes, of course, the woman can simply communicate her disinterest, and that's that.  But the less perceptive the man, the more he is apt to ignore the "easy outs" that women may be trying to provide him.  "What is needed," he may be thinking, "is more persistence!  I just haven't gotten my message through with enough vigor."  When in fact the target of his affections is trying very hard to get him to stop.

Now the unfortunate thing here is that you can see how unpleasant this is for the woman (and therefore how she might be tempted to label the man "creepy"), and yet how unfair it is to pathologize the man's behavior (assuming, again, that the behavior is appropriate but for the fact that it is unwelcome).  Both the man and the woman in this scenario are behaving in a way that is rational given the context.  (The man is being oblivious, but he is behaving reasonably given his limitations.)  The culture expects him to be aggressive; he doesn't have the option of passivity.  Or at least, not if he wants to have a decent chance of finding a sexual partner through the normal channels.

The woman, meanwhile, really wants to dissuade this kind of behavior, because it puts her in a very uncomfortable position.  It would be different if there were clear, unmistakable ways to signal lack of interest.  But there aren't.  (Remember, it's not good enough to be reasonably clear to the average person.  It needs to be a signal that is clear to a less-perceptive-than-average person who is highly motivated to err on the side of aggressiveness.)  A woman can't extricate herself from the situation simply by dropping the matter.  That is (in general) the man's prerogative.  The woman may also want to signal to other people just how little interest she has in the man (to emphasize, in other words, that she has not encouraged the attention of this loser she has on her hands).  And so she labels him "creepy."

Where I think this leaves us is in an unfortunate equilibrium, one that is very disadvantageous to awkward/unperceptive men (something I'm keenly aware of).  The word "creepy" is used to encompass both truly problematic behavior and behavior that is merely awkward or tone-deaf.  Socially awkward men, who are understandably horrified at being lumped together with predators, respond by withdrawing from the market.  Or they adopt a much more tentative approach, which often amounts to the same thing, since women respond poorly to ambiguity or signals indicating lack of confidence.  (Some of this may be biological rather than social.  In Sheila Heti's How Should a Person Be?, the narrator is greatly aroused by what is essentially asshole behavior—what is, in fact, quite creepy behavior, except for the fact that it is welcome.  Hence my dismay, expressed in the comments section of Elisa's blog post on the book.  The narrator's reaction definitely seems to validate the idea that creepiness is almost entirely a function of attractiveness—when an attractive man says even the creepiest things, it's not creepy.)

And so a certain proportion of men are intimidated into passivity, while single women wonder where all the men are (or so I assume, what do I know?).  It's a frustrating situation all around, worsened I think by the weakening of old institutional forms of match-making.  And worsened also, I think, by the unfortunate (though understandable) tendency to use the same word to describe very different behavior.

As a kind of coda, here is another tweet from Elisa:

Indeed.  In the world we live in, the non-awkward man is king.

Monday, January 26, 2015

No True Technocrat

Today Paul Krugman wrote this (in the course of criticizing poor policy-making by EU officials):

This is one reason it irks me when the people who have been running Greece, or those in Brussels, are described as “technocrats.” Crat me no techno — real technocrats would (and did) warn about the downside of austerity, not seize eagerly on faddish research purporting to make a case for policies they probably wanted for other reasons.

Now, I recognize that Krugman is fighting about macroeconomics, not about the role of technocracy in society.  If he were actually debating the merits of technocracy vs. democracy or whatever, he would presumably express himself differently.

But - but! - I think this is a pretty good illustration of the way people often think about technocracy.  Technocrats are not just empowered bureaucrats, they are the good guys, the smart guys, the ones with white lab coats.  They are people like us.  So you see, there's nothing dangerous about technocracy at all.  When technocrats engineer a multi-year, staggeringly painful recession, then obviously they were never technocrats to begin with.  Because no true technocrat could do such a thing.

Wednesday, January 14, 2015

Taxes and Federalism

I'm not going to write a long post right now, but I just want to put down a marker that this article in the New York Times is exactly what you would expect:

States and localities have regressive systems because they tend to rely more on sales and excise taxes (fees tacked onto items like gas, liquor and cigarettes), which are the same rate for rich and poor alike. Even property taxes, which account for much of local tax revenue, hit working- and middle-class families harder than the wealthy because their homes often represent their largest asset.
The federal income tax system, by contrast, primarily taxes individuals at a graduated rate, and those who earn more pay a larger share. (The federal system also uses payroll taxes to raise large sums for Social Security and Medicare, dipping into the pockets of many low- and moderate-income Americans who pay little, if any, income tax.)
At the local level, if you tax rich people, you will drive them away, because you are in vicious competition with nearby (and not-so-nearby) jurisdictions.   The federal government, on the other hand, has much more leeway to impose progressive taxation.

One potential solution is to impose higher taxes at the federal level and then distribute them to local governments on a per capita basis.  This has the potential to counteract the race-to-the-bottom dynamic and allow local governments to do their job without imposing high taxes on the poor.

Interestingly, there is a good argument that it's important to lower marginal taxes at the low end of the income distribution, a result that conservatives in theory could get behind.  (In other words, in terms of incentive effects, taxes are more distortionary at the low end of the income spectrum, and so it is beneficial to trade away lower marginal tax rates at the low end for higher marginal tax rates at the high end.)  But because the conservative movement is so bound up with its rich constituency, I don't think you'll hear a lot of conservatives arguing for a systematically more progressive tax code.

Sunday, January 04, 2015

Beer and Public Policy

One phenomenon that is quite interesting to me is the huge increase in the number of breweries in the United States in the last few decades, which has occurred against a backdrop of declining beer consumption.  (I am too lazy to look up the data, but the increase in the number of breweries is beyond question.  I am not quite as confident about declining beer consumption, though that has definitely been reported in recent years.)

One way to think about it is this.  Imagine that each beer drinker has preferences that can be mapped in n-dimensional space.  For simplicity, let's pretend there are just 2 dimensions in beer preferences, since I'm pretty sure the results will generalize from there.  Just for concreteness, let's say the 2 dimensions are concentration of alcohol (ABV) and hoppiness (measured in international bitterness units, or IBUs).  And let's say that people's enjoyment of the beer diminishes as a function of the distance from their ideal point on the grid.  (So in other words, an individual's preferences are single-peaked.  I'm not sure this matters, but anyway I don't think the assumption does any harm.)

So you could generate a graph of people's preferences, with aggregate satisfaction on the z axis and ABV and IBUs on the x and y axes.  The result would be some kind of surface vaguely resembling a hill or mountain range.  There's no way to guess what this shape might be a priori (and remember, it's a highly simplified example to begin with), but if tastes are fairly stable, then there should be a peak on the graph where you can maximize the aggregate enjoyment of a brand of beer.  Of course there are other considerations - maybe hops are really expensive, maybe ABV is taxed or regulated in such a way that the brewers don't optimize that dimension purely in terms of consumer tastes.  And on top of that, it may be more profitable to brew an inoffensive beer (one that is acceptable to the highest percentage of drinkers) rather than a satisfaction-maximizing one.

But whatever considerations end up mattering, if there is only one brand of beer, it is going to be pretty far away from a lot of people's preferences (assuming there is much diversity of tastes).  And what happens as you add more brands of beer?  Well, this is a very complicated question, but one possibility is that the brands will cluster together for Hotelling's Law reasons.  So we might observe Budweiser, Miller, and Coors all brewing beers with similar characteristics, even though those beers are redundant in terms of preference-satisfaction.  And in fact, that's what we observed for years.  (This may be a good result for some beer drinkers, by the way.  If your tastes are well-served by weak lager with minimal hop character, then the intense competition around that point on the graph will keep prices low while giving you exactly the beer you want.  Other beer drinkers, though, are likely to regret that all of the major brands are focusing on a part of the graph far from their ideal style.)

Now, it's somewhat mysterious to me why that equilibrium persisted for as long as it did.  I'm no beer historian, but as far as I can tell, from the end of Prohibition (in 1933) to the advent of "microbreweries" in the early 1980s, there were very, very few brands of beer available in the United States that skewed very far from the light lager template.  Even imported beers were typically light lagers (think Heineken or Corona), with the notable exception of Guinness stout.

But then everything changed.  Brewers entered the market with beers that were very, very far from the existing cluster of mega-brands (a region of the graph in which no small brewer could hope to compete, I would think).  They brewed hoppy beers.  They brewed high-alcohol beers.  They brewed hoppy, high-alcohol beers.  And they experimented on dozens of other dimensions.  And in general they found a great deal of success, at least in the aggregate.  Individual breweries have failed, but "craft" breweries (which generally refers to small breweries making flavorful products) are commanding more and more of the beer market.  Certainly by the mid-90s the trend was noticeable, and in the last decade it has become utterly obvious.

And so if you think about our map of beer preferences, a much larger area of the map is being served by the U.S. brewing industry.  There is no plausible case that Hotelling's Law still applies on a large scale (though there may still be clustering within some regions of the graph).  There has been a profusion of styles readily available to U.S. beer drinkers.

It's fun to think about why things played out this way, and specifically why it took so long to shake off the old equilibrium.  One possibility is that beer drinkers had to be "educated" to enjoy certain styles of beer, which would explain the long gestation period and then (relatively) sudden explosion of interest in craft beer.  Another possibility is that Americans didn't have enough disposable income to pay the high prices commanded by craft beer.  (This is a little implausible as a full explanation, because plenty of European countries enjoyed a range of flavorful beer styles despite having less per-capita income than the U.S.  But it could be a partial explanation of the sticking power of the light lager equilibrium.)  Yet another possibility is that American brewers lacked the know-how to brew more interesting styles.  (In this account, Jimmy Carter's legalization of homebrewing in 1978 was the major turning point, because homebrewers learned to brew all kinds of styles as a hobby and then inevitably some of them went into business as microbrewers.  Certainly that fits the timeline, and I believe it's true that many of the early microbreweries were founded by homebrewers.)

Probably all of these things were factors.  I've kind of run out of steam, though, without building to any kind of coherent point.  I think what I was originally going to say was, whereas the marketplace can (in the right circumstances) allow for a kind of pluralism, in which a wide diversity of preferences are satisfied, the same is not true of public policy, where quite frequently you have to do the equivalent of brewing a single brand of beer for everyone.  And this means that you don't have the luxury of dismissing anyone's concerns, however idiosyncratic they might be.  So for instance, if someone complains to me that he only likes hoppy beers, then I will have no sympathy - his needs are abundantly satisfied by the market.  But if someone complains that he can't function in a society where gambling is legal, then I can't just tell him that he should stay out of casinos.  He knows that, but he can't control himself.  There may be a public policy that addresses his concerns while allowing other people to gamble (for instance, "pre-commitment," in which a gambler voluntarily puts his name on a list of people who aren't permitted to enter the casino).  But the point is that if you have to pick a single point on a graph, the choice becomes much more fraught and tragic than if you can simply allow a thousand flowers to bloom.