Of Risk and Profit

I seem to keep running into discussions of risk and profit lately, so I thought it might be interesting to spend a few minutes on the topic. What got me started was a post by Matt Bruenig entitled "Capitalism does not reward risk" wherein he says:

Capitalism does not reward risk-taking. This is easily shown. Suppose Noah and I each invest in ways that are identical in all regards with respect to risk. If capitalism rewarded risk-taking, then each of us would get an identical return. But we don’t necessarily. Suppose Noah’s investment leads to him receiving a large return, while mine leads to me receiving nothing and even losing what I put in. In that possible scenario, even though we behaved in a relevantly identical fashion, capitalism distributed us different amounts. Noah was rewarded for risk-taking. I was punished.

This is true as far as it goes. Risk taking, in the abstract, is not rewarded by capitalism. What I would argue that capitalism does do is allow you to achieve rewards by taking calculated risks, if those risks work out. Let's think this out via a couple of examples.

Jerome is a carpenter. He thinks that he's come up with a clever idea that will allow him to build a mechanical lathe and make beautiful table legs, bedposts and banisters very quickly, much more quickly than his hand lathe. However, it's going to take an investment of $200,000 dollars in equipment and several months of experimenting for Jerome to get it to work. He talks to various rich men in town and finds an investor who provides him with $250,000 so that he can but his materials and take half a year off work to get it all right.

At this point, the world splits in half.

In world A) Jerome's invention works out. He can produce beautiful woodwork in minutes instead of hours. He sells it for just a little less than a hand carved piece, but because they take so much less time he makes much, much more money. Last year Jerome made $100,000 but this year he makes $750,000. According to their agreement, Jerome gives half the profits to his investor, and keeps the other half for himself. He expands his shop and makes even more money the next year, but not another shop is building a similar set of machinery and soon he has more competition, the prices begin to fall, and he has to work hard and come up with more innovations or else see his profits fall.

In world B) Jerome's invention fails to pan out, his investor loses everything, and he has to go back to spinning wood on his hand lathe.

In both worlds Jerome takes a large risk. In one, he realizes large gains, in another he loses everything.

He was able to find an investor willing to provide him with that money because there was the possibility of large gains. Perhaps the investor thought there was a 1 in 4 chance the investment would work out. He loaned money in return for a share in the profits. In the world where this worked, he got all his money back in the first year and started making profits too. In the world where it didn't work out, he lost everything. If he had ten or twenty investment projects going at a time, some fail and some work, and the end result is that if he picks good risks he makes a profit by helping these aspiring business men.

Now how is it that we say that capitalism rewards risks? Well, the idea that Jerome's investor can invest in Jerome's business, and that they can form a contract whereby they will spit the profits that result, is a capitalistic idea. The money produced by the venture they have put money and work into belongs to them. If they didn't get to keep the profits produced, there would be no reason for them to take the risk in the first place. The investor would have no reason to lend money if there weren't a way to get a return on his money, and Jerome would not be able to secure the capital he needed to do his project if he weren't able to promise a return on that capital. Further, the fact that they can enter into a joint ownership agreement where the investor's capital entitles him to a return on the profits allows both of them to engage profitably in risks that would not make sense in terms of a loan. If the a capital investment was not possible, and Jerome instead had to get a loan, he would need to promise to pay 300%+ interest to compensate his investor for a risk of 1 in 4. Jerome would probably not want to take on a debt of $250,000 at 300% interest if there was a 3 in 4 chance that his invention wouldn't work out and he'd end up owing massive amounts of money with no way to pay it off. So the structure of investment and return makes Jerome's innovation possible.

Another key element that allows this investment and innovation is the concept of profits based on market pricing. Jerome makes his money back because he can charge only slightly less than a hand lathe carpenter and win lots of business at huge profits. But what if we don't accept the idea that Jerome can charge based on what people expect his product to cost?

This piece lays out an alternative concept of profit which it argues is the true Catholic understanding:

For modern man - that is, for post-Enlightenment, laissez-faire, neo-liberal capitalist man - profit is the difference between gross revenue and expenses. It is the result of a simple equation; simply subtract expenses from revenue and the difference is your profit. Thus, in order to maximize profit, the difference between revenue and expenses must be made as great as possible, and he is the most savvy, most astute businessman who can figure out how to enlarge that gap. For modern man, Profit = Revenue - Expenses.

But for pre-modern man - that is, for the man living under Christendom and working within the traditional understanding of economic relationships - profit is defined as a just recompense for some particular work. The amount of the recompense is relative to the work done.

We see in the traditional understanding, labor and profit are linked - the fact of the profit and its amount are related directly to the work performed. This is why my friend had a guilty conscience about taking 90% profit. He knew that, relative to the quick, inexpensive work performed, there is no way 90% profit could be considered "just recompense" for the work performed. There is a moral linkage between the work done and the recompense for that labor.

Notice, however, that in the modern definition, this linkage is not there. If profit is simply revenue minus expense, there is really no moral or logical connection between the work done and the amount of profit gathered. This is why those who subscribe to the modern definition have no moral scruples about pocketing 90% profit, for they see no necessary connection between the profit and the work done. Profit is simply whatever the businessman is able to pocket - though no doubt they would feel quite ripped off had they found someone took 90% profit at their expense. The pre-modern medieval definition, on the other hand, maintains a moral and logical connection between work and recompense, ensuring that financial actions remain situated on a spectrum of justice (another example of the superiority of the harmonious medieval mind over the fractured worldview of the moderns).

(For the record, let me just note that I really don't care what the profit margins of someone I buy from are, so long as I get what I want for a price I'm okay with -- unless that seller has made some false representation to me about his costs in order to justify the price he's charging. But I digress.)

Now, Jerome lived in a world with this other conception of profit and price, he might be in trouble. If the price he's allowed to charge for his woodwork is based only on the amount of work that he does, and not in the perceived value to the customer, then if he can produce a piece of woodwork in ten minutes that takes another carpenter two hours, he can only charge 1/12th the price -- a price based on the amount of time that he spent. Now, maybe he'd make some up on volume (while putting lots of other carpenters out of business) but unless he's going to get into the business of shipping woodwork all over the world there's not going to be enough demand for him to make back his investment if he has to sell his woodwork at 1/12th the going price. So one of the things that rewards the risk-taking of Jerome and his investor is an understanding of market pricing in which they are allowed to charge basically the same as the process they are replacing. This means that inventions that vastly increase productivity will have a large potential return, and so it's worth taking risks to see if you can invent such a thing. If you're not allowed to charge based on perceived value rather than time invested, then people like Jerome won't be able to afford to invest the time to develop productivity increasing inventions.

We Shouldn't Turn to the Church for Economic Analysis

Last week saw the publication of an apostolic exhortation written by Pope Francis, Evangelii Gaudium. The wide ranging document (over 200 pages long) is self described as "on the proclamation of the gospel in today's world" and opens:

The joy of the gospel fills the hearts and lives of all who encounter Jesus. Those who accept his offer of salvation are set free from sin, sorrow, inner emptiness and loneliness. With Christ joy is consistently born anew. In this Exhortation I wish to encourage Christian faithful to embark upon a new chapter of evangelization marked by this joy, while pointing out new paths for the Church's journey in years to come.

So, naturally, everyone decided it was about economics.

Yes, the document does touch on economics. Page forty-six has the section that generated headlines:

We have created a "throw away" culture which is now spreading. It is no longer simply about exploitation and oppression, but something new. Exclusion ultimately has to do with what it means to be a part of the society in which we live; those excluded are no longer society's underside or its fringes or its disenfranchised -- they are no longer even a part of it. The excluded are not the "exploited" but the outcast, the "leftovers".

In this context, some people continue to defend trickle-down theories which assume that economic growth, encouraged by a free market, will inevitably succeed in bringing about greater justice and inclusiveness in the world. This opinion, which has never been confirmed by the facts, expresses a crude and naïve trust in the goodness of those wielding economic power and I the sacralized workings of the prevailing economic system. Meanwhile, the excluded are still waiting.

There's something a bit frustrating about this one section out of a wide-ranging document which addressed everything from the need for a personal discipleship to Christ, to the importance of marriage to how homilies should be written to abortion and the sacredness of unborn life becoming the one passage which people reading news coverage of the exhortation hear about. It seems typical of the urge, both inside and outside the religious community, to reduce any complicated message to its most political application. "Pope Condemns Capitalism" is a headline which allows one side of the political spectrum to cudgel the other, while "Pope Calls Everyone To More Personal Relationship With Christ" just doesn't have that conflict-driving ring. Though, of course, it's the latter message that we arguably need to hear more. Given the way this reaction has developed I can't help but be reminded of the intro to the Hitchhiker's Guide to the Galaxy radio play:

This planet has — or rather had — a problem, which was this: most of the people living on it were unhappy for pretty much all of the time. Many solutions were suggested for this problem, but most of these were largely concerned with the movement of small green pieces of paper, which was odd because on the whole it wasn't the small green pieces of paper that were unhappy.

Francis, I think, gets this, and the focus of his exhortation is not primarily economic. Be that as it may, Pope Francis did certainly choose to include the controversial section, and so it's not unreasonable to address it, though I think people should be spending more time on the rest.

The Pope's comments have received attention even outside Catholic circles. For instance, Harvard economist and textbook author Greg Mankiw offered the pope's remarks a pretty skeptical reception. There have been a range of Catholic reactions as well, from politically left-leaning Catholics trumpeting "I told you so!" to politically right-leaning ones muttering that the pope does not know what he's talking about on economic matters.

Pascal-Emmanuel Gobry has provided a more thoughtful approach in First Things with a piece entitled "Let’s Listen to Pope Francis on Economics". Arguing that Catholics should allow their preconceptions to be challenged by the pope, Gobry writes:

I’ve long believed in free market economics and believed that the Church would do a lot of good in the world if it embraced it. And I still believe those things. But what the financial crisis has laid bare is that the most conventional version of free market economics was actually dead wrong.

It would have been a pastoral, doctrinal, and theological disaster if the Church had, over the past twenty years, blindly subscribed to what I’ll now refer to as the Washington Consensus. What in 2006 looked like the invisible hand of the market leading the financialization of the economy turned out to be a disastrous instance of crony-capitalist central planning. And when the Pope denounced it, I was among those condescendingly explaining to him that he didn't get it. What it turns out is that economists actually know very, very little, and that a lot of what we thought we knew turned out to be wrong. Given this hard-to-swallow fact, the prophetic voice of the Church that reminds us of what must be the ends of economic activity is very salutary.

I do think that free markets have allowed a great increase in economic growth throughout much of the world, and that this has been a great human good, but I don't think that the Church would "do a lot of good in the world" if it embraced capitalism. Indeed, I very explicitly think that the Church should not endorse capitalism.

Why not?

Because the Church is not on earth to conduct economic analysis any more than it is on earth to decide whether the sun is at the center of the solar system or the manner of the origin of species. Its job is not to figure out what sort of economic system will result in the highest growth or the greatest equality or any other such thing. Its job is to transmit God's graces to us through the sacraments, and to preserve and pass on to us His teachings. These teachings are not simply abstract, and throughout history (including the modern social encyclicals) the Church has sought to apply the teachings of Christ to the changing situations (the "new things" of Rerum Novarum) in which Catholics find themselves living out their lives.

However, while the application of moral principles to new situations most absolutely includes situations which we think of as "economic", and thus may have a certain appearance of being "economic teachings" they are not in fact economic analysis of the sort which we normally think of under the term. The Church's insight here is moral rather than economic. The Church teaches on how we ought to treat each other as people, not what actions will result in the greatest efficiency, the greatest growth, or the greatest profit. As such, the best response to Church teaching on economic interactions may not be "the state should require that everyone behave the way the Church says they should", since that may well not have the intended consequence. (For example, it may be far more beneficial for society to have need based programs which assist the working poor than to have a high one-size-fits-all minimum wage, in part because doing this would remove from employers the dilemma of either paying some workers more than the market value of their work because of their needs, or else being undercut by those employers who do.)

Reading Francis's exhortation with care (and in the light of some of the translation issues which have come up) I think it's fairly clear that Francis is not denying the efficacy of markets as functioning economic mechanisms, but rather condemning those who imagine that because markets allow for greater growth, and growth tends to help society as a whole, that by supporting markets we have now fulfilled the whole of our obligations to our fellow men. Far from it, the fact that on average people do better in a given situation does not mean that some people are not still doing very badly, and that we have a duty to help those people in every way we can.

Importantly, this critique applies no matter what one's economic preferences. Even after supporting what one imagines to be the right economic policies, one still must help those who find themselves in difficulties in whatever the prevailing situation may be. This applies to slacktivists on the left just as much to the misguided free enterprise fans who seem irresistibly drawn to writing defenses of Scrooge this time of year.

How World War Two Helped the Economy

There's a fairly common belief out there that World War II ended the great depression. Suddenly millions of men had jobs as soldiers and millions of men and women on the home front had jobs building war materials. What this line of thinking has a harder time with is why the economy didn't crash again when "the boys came home" and there was no longer a need for millions of soldiers and the bombs, airplanes, tanks and rifles they had used. There was a brief and sharp downturn in the GDP in 1945 as the war (and war spending) ended, but unemployment never really went up much (it peaked at 5%) and the economy quickly took off. Why?

One explanation points out that the US was the only major developed nation which hadn't been bombed to pieces during the war, and thus as the intact victor it was in an excellent position to become an export powerhouse. That seems like it definitely was a factor.

Another factor which may have contributed is one which Arnold Kling alludes to here:

After the second World War, the U.S. economy easily created new patterns of specialization and trade. I think that one reason is that the war increased mobility, as soldiers met others from different parts of the country. Instead of remaining in their communities of birth, men moved in order to take advantage of new opportunities.

It strikes me that the effect would go beyond shaking people up geographically. The war provided a distinct break in many people's lives, during which many went places and did things that they never would have otherwise. With the war over, there was a clear sense of starting over. It seems like this would have made both workers and employers more open to trying new things. Soldiers coming back from the war and workers who had been employed in war industries new that they needed to look for jobs wholly different than they had had during the war, and as such there was really no reason they needed to look for jobs the same as they'd had (or been looking for) before the war started. Employers knew that after four years during which everyone had been focused on the war, they were going to have to hire and train workers who might not have directly relevant experience.

In an economic sense, the war may have served in some ways as a giant "reset", clearing away structures, expectations, and "stickiness" in a host of ways which allowed things to head off in new directions.

The Minimum Wage and Race

Over at Cafe Hayek, Don Booudreaux posts an extended quote from David Henderson's book The Joy of Freedom dealing with the ulterior motives that were involved in raising the national minimum wage in the 50s and 60s:

“Forty years ago, the politicians who pushed for the increased minimum wage did not hide their motives. Nor, in an era of state-sanctioned segregation, did they feel the need to hide their knowledge of who the intended victims of minimum-wage legislation would be. In a 1957 Senate hearing, minimum-wage advocate Senator John F. Kennedy of Massachusetts, who just four years later would be President of the United States, stated,

Of course, having on the market a rather large source of cheap labor depresses wages outside of that group, too – the wages of the white worker who has to compete. And when an employer can substitute a colored worker at a lower wage – and there are, as you pointed out, these hundreds of thousands looking for decent work – it affects the whole wage structure of an area, doesn’t it?

“The witness he was addressing, Mr. Clarence Mitchell, then director of the Washington Bureau of the NAACP replied,

I certainly think that is why the Southern picture is as it is today on the wage matters, that there is a constant threat that if the white people don’t accept the low wages that are being paid to them, some Negroes will come in [to] work for a lower wage. Of course, you feel it then up in Connecticut and Massachusetts, because various enterprising people decide to take their plants out of your states and take them down to the areas of cheap labor.

(The quotations from Kennedy, Mitchell, and Javits are from U.S. Senate, Labor and Public Welfare Committee Proposals to Extend Coverage of Minimum Wage Protection, Hearings before the Subcommittee on Labor, 85th Congress, 1st session, March 20, 1957, p. 856)

One of the things which people often forget in discussing setting minimum wage levels is that when people are forbidden from using cost as a means of determining who to hire, they necessarily fall back on other reasons for choosing which in many cases may actually prove to be less savory: influence, preferment, race, etc.

How Pricing Fairness Can Hurt You

Megan McArdle has a great piece up dealing with one of the things that often bothers people about price discrimination: finding out that other people are consistently paying less than you. Since we live one of the wealthiest and largest countries in the world, and since many of the companies we buy products from do business internationally, this often means that US consumers find out that the products they pay a lot for here in the US are being sold for much less overseas.

Case in point, the US Supreme Court is considering the case of Kirtsaeng v John Wiley and Sons which deals with whether companies can get into the business of buying US-made textbooks overseas and shipping them back to the US. Why would this be advantageous? Textbooks are fairly expensive to produce (as in, to get all the content put together and ready to print) but the cost of producing additional textbooks is low (the cost of printing and binding.) The result is that publishers sell textbooks for far, far more than the cost of printing a book -- that is, far above the marginal cost (the cost of producing one more product.) This isn't because it allows the publishing executives and their investors to lie on beds of gold coin like dragons, publishing companies are not actually massively profitable. It's because the revenue produced by selling the textbooks needs to cover the cost of producing the book content as well as the cost of producing the book itself. So they sell textbooks for what the market will bear, which with something as expensive as college is a heck of a lot.

However, since publishing companies are also constantly on the lookout for more revenue (again, to cover their production costs, as well as to produce profits for their dragons to lie on) after pricing college textbooks in the US at what the US market will bear, they'll go into other countries and sell the same textbooks there for what that country's local market can bear, so that as that price is still above the marginal cost of producing more books. The result: US textbooks can often be bought for much less in other countries. Thus creating the opportunity for some enterprising company to buy the books abroad and ship them back, if only they can get around the legal restrictions thereon. But will that save everyone money? McArdle describes why not:

It is possible for a firm to make money with some of its customers paying less than the average cost (but more than the marginal cost of producing an additional unit). It is not, however, possible for a firm to stay in business with all of its customers paying less than the average cost.

But we want to believe that it is possible. Indeed, no matter how often it is explained that we cannot all be the marginal cost consumer, someone will insist quite loudly that it is possible; that only greedy companies, incompetent bureaucrats, or bad laws stand between us and the joys of marginal cost pricing.

She draws out an example of how this situation would equalize out to the higher price with lower overall unit sales, taking as her example a situation in which ordinary US consumers are the beneficiaries of price discrimination: air travel.

If you're skeptical that this is true, consider an area where you're probably the beneficiary of price discrimination: business travel. The first class and business passengers provide the bulk of the profit on airline tickets; they pay for the extra amenities, and the ability to make last-minute arrangements for short stays during the week. Restricted economy travelers often generate very little revenue over and above the cost of transporting them--but since the seat is a wasting asset, you might as well sell it even if you'll only make a few bucks on it.

Let's say that businesses who travel a lot got a law passed to eliminate this sort of price discrimination, forcing airlines to set a single price for a given route, no matter what date or time the flight was. Such a law might well pass, since people hate confusing airline prices.

The result would not be that everyone got the tourist class price, however. Imagine that you've got 10 business class passengers paying $100 apiece, and 100 tourist class passengers paying $5 apiece. Assume that the marginal cost of taking on an extra business passenger is $2 and the marginal cost of a tourist passenger is $1. Assume your fixed cost of getting the plane off the ground is $1300, so you've got a total cost of $1420 and revenue of $1500.

Now say someone comes along and mandates that everyone has to be charged the same ticket price. What happens? Well, you charge all 110 passengers $13.50 and keep your margins about the same . . .

But wait! The tourist class passengers are very price sensitive. They're on average only willing to pay $5-$8 for a ticket. When you raise the price to $13.50, half drop out. Now you've got 60 passengers, which gives you revenue of $810. But your cost has only dropped by $50. Now you're losing a big hunk of money. You'll have to raise prices. $23 should cover it.

Gee, $23 is more than 4 times what the tourists were paying. They don't want to see Grandma that much. Another half of the tourists drop out. Now you've got 35 passengers. But your costs have only dropped by $25. You'll need to raise prices again. Maybe $40 would cover it?

You can see where this is going; pretty soon almost all you have left is business passengers, paying what they were paying before. In fact, depending on how many tourist class passengers drop out, the business class passengers might end up paying more.

someone has to pay for all those planes, and airline profit margins are far from reliably spectacular (which is why they keep ending up in bankruptcy). No, the tickets for your next vacation would probably cost three or four times as much. Obviously, this is a made-up example, with numbers chosen more for ease of calculation than versimilitude--in the real world, most people would snap up a $38 plane ticket. But empirical research bears this out; ending price discrimination doesn't necessarily mean consumers get a better deal. It can easily mean they get a worse deal.

But there's something deep within us that resists that insight. We hate the feeling that someone else is paying less than us, even if it's not costing us anything. So while a decision for the textbook importer might not make consumers any better off in the pocket, it may make them feel better about the high prices they're paying.

The Clever Economics Behind Romney's Tax Plan

One of the things which the candidates sparred over repeatedly in the debates was Romney's tax plan, on which Obama has repeatedly charged "the math doesn't work".

Romney's plan, as it has been presented, is to reduce tax rates by 20%. Thus, for example, the top rate would go down from the current 35% to 28%. Deductions and credits would then be reduced such that while the middle class would experience a net tax decrease, those at the top would continue to pay the same amount in taxes as they do now. Romney suggested how this might be done in the first debate:

[W]hat are the various ways we could bring down deductions, for instance? One way, for instance, would be to have a single number. Make up a number, $25,000, $50,000. Anybody can have deductions up to that amount. And then that number disappears for high-income people. That's one way one could do it.

The idea here would be that for a family making, say 60k/yr that currently takes a total of $15k in deductions, the deductions would remain untouched while their rate would go down, resulting in lower net taxes. For a family making $400k/yr that currently takes $70k in deductions, their deductions would be capped at $25k but their tax rate would be lower, so they would pay about the same as they do now.

Democrats seem to want to suggest that some sort of secret poison pill would be slipped into the plan such that either the middle class would get a tax increase (while the rich would get a tax break) or such that the deficit would go up because fewer tax revenues would be collected. What this tends to miss is that the president does not get to unilaterally pass a tax plan. He has to ask Congress to pass one along the lines of what he would like. I think it's highly unlikely that Congress will pass anything that is a net tax increase on the middle class (or, indeed, anyone) if it's dominated by the GOP, as seems likely, especially if the election has gone well enough for the GOP to put Rommney in the White House. That Congress would pass a plan that increases the deficit is more likely (goodness knows they've done it before) but the president himself isn't exactly standing on a good record in that regard either so that argument seems something of a wash.

The thing about this tax plan which is actually interesting, and which isn't being discussed (probably because it takes more than one minute of shouting to convey) is how it's designed to increase the amount of income available to be taxed, and in a way much more clever than the somewhat stale "tax people less and they will make more money" argument. This supply side argument is true, and we've seen examples of it working in history, but although tax cuts do tend to result in pre-tax incomes going up as people seek to increase the income that they make more of, the effect is pretty mild when the existing tax rates aren't absolutely confiscatory. Thus, you might actually see total tax revenues go up cutting the top marginal rate 20% from 80% to 64%, because if 80% of your incremental earnings are being taken away you have little incentive to find ways to increase your earnings. You're better off finding ways to enjoy leisure with the earnings you already have. However, cutting the top rate 20% from 35% to 28%, it's a lot less clear that people would increase their incomes enough more to actually lift total tax revenues.

In a good post over at EconLog the other day, David Henderson digs into the different incentives that wage earners experience when their tax rates are cut:

When the government cuts a marginal tax rate, and that's all it does, that cut has two effects in opposite directions: a substitution effect and an income effect.

The substitution effect is to make leisure more expensive. If you're facing a 35% marginal tax rate (MTR), for example, and the rate is cut by 20% to 28%, your "price" of leisure rises by (72 - 65)/65, or 10.8%. When the price of a normal good rises (and leisure is a normal good), you buy less of it. So people work harder.

The income effect is to make you buy more leisure. The cut in marginal tax rates increases your real income and therefore you demand more leisure. That is, you work less.

Empirically, the substitution effect tends to outweigh the income effect slightly for men and strongly for married women. This means that cuts in MTRs alone will tend to increase income somewhat for men and a fair amount for married women. That was the effect of Reagan's cuts in MTRs in the early 1980s.

Now, I'm certainly not one to say that the government has a need to maximize the amount of total tax revenues it takes in. Maximizing the size of government is not an end unto itself, and it can actually cause all sorts of problems. So in the abstract, one might argue that if lowering marginal tax rates were to cause incomes to go up, we should simply do that and find a way for the government to get by with a little less. However, the fact is, right now the government is spending far, far more than it takes in. Even the most aggressive responsible budget cutters (emphasis on responsible here -- there are some silly plans out there that claim they can cut spending by huge percentages right off) need tax revenues to remain fairly stable in order to get the budget balanced.

Well, it turns out that by cutting marginal tax rates but also cutting deductions so that the who balance out, you can have the substitution effect that Henderson describes without having the income effect. The rate cuts and deduction cuts are perfectly balanced, so your income is exactly the same as it was before. You don't "feel richer", and so you don't have the incentive to rest on your laurels and enjoy your newfound wealth. However, the substitution effect does come into play. If you have the opportunity to make more, less of that incremental income will be taken away in the form of taxes, and you'll get to keep more of it. The reward for making more is higher, and so (all other things being equal) people will tend to do it more.

And, of course, if this does result in incremental total income for citizens, that incremental income will be taxed (at the new lower rates) and result in incremental tax revenue which can be used to close the deficit. Thus, a tax reform that was essentially revenue neutral (people pay the same taxes each year) but which decreased marginal tax rates and deductions would have the same stimulative effect on incomes that a tax cut would have, but wouldn't present the deficit risk of significantly decreasing tax revenues and counting on economic growth to make up for that gap.

The plan really is quite clever, which makes it a shame that no one is willing to talk about it except in tiresome soundbites.

The Reality Gap

We've reached the point in the election where the press decides to mostly report on how the election is being perceived rather than on any particular events, and since the president is doing well in the polls this results in a lot of "desperate Republicans do foolish things" stories. The flavor of the week seems to be the media's discovery that somewhere out there in the right-leaning internet, there are people who have made a hobby of "re-weighting" polls in order to reflect what the re-weighters think is a more likely partisan composition of the electorate come election day.

There is, yes, a certain sad desperation about this. Now that election reporting is often more about "the race" than about issues or events, being behind in the race is crippling and so people come up with way to try to explain it away. Those with long memories (eight years counts as long in our modern age) may recall that when Bush was so rude as to be ahead of Kerry in the 2004 race, Michael Moore and those like-minded rolled out a theory that all the polls were wrong because an army of voters who only used cell phones and not land lines (and thus couldn't be polled) were out there ready to vote against Bush.

However, just as everyone's getting ready to announce that Republicans, in their constant flight from the "reality based community" have decided they don't believe in polling, we find out that the left has its own reality problem: They're convinced that the economy has been getting better over the last couple months, despite the fact there's little reason to believe this. Gallup and the Pew Research Center both have data out showing that Democrats' opinions of the economy and the job market have suddenly started improving, despite almost universally bad news over the last several months.

As you can see, partisan affiliation wasn't much of a dividing factor in assessments of the economy a year ago, but now that a bad economy might mean President Obama not being re-elected, Democrats obediently come to the conclusion that the economy really isn't that bad. According to Pew, the same divide now exists on the job market, consumer prices, the financial market, real estate, and even gas prices. You would think that at least people could agree on what the level of gas prices is, but no, apparently not, though the gap is narrower there than elsewhere: 89% of Republicans say they hear mostly bad news about gas prices while 65% of Democrats do.

The trope goes that you are entitled to your own opinions, but not your own facts. However, as the political divide has become wider and more entrenched opposite sides increasingly do have their own facts, as reality become filtered through a partisan lens.

Will Money Make Everyone Virtuous?

One of the many divides among modern Catholics is between what we might call the "moralizers" and the "justice seekers". "Moralizers" are those who emphasize the importance of teaching people moral laws and urging them to abide by them. "Justice seekers" seek to mitigate various social evils (poverty, lack of access to health care, joblessness, etc.) and believe that if only these social evils are reduced, this will encourage people to behave better.

Moralizers tend to criticize the justice seekers by pointing out that following moral laws is apt to alleviate a lot of the social evils that worry the justice seekers, arguing, for example, that if one finishes high school, holds a job and gets married before having children, one is far less likely to be poor than if one violates these norms.

Justice seekers reply that the moralizers are not taking into account all the pressures there work upon the poor and disadvantaged, and argue that it's much more effective to better people's condition than to moralize at them (or try to pass laws to restrict their actions) because if only social forces weren't forcing people to make bad choices, they of course wouldn't do so.

(I'm more of a moralizer myself, but I think that we moralizers still need to take the justice seeker critique into account in understanding where people are coming from and what they're capable of.)

One area in which the justice seeker approach seems to come into particular prominence is the discussion of abortion. We often hear politically progressive Catholics argue that the best way to reduce abortions is not to attempt to ban or restrict them, but rather to reduce poverty and make sure that everyone has access to health care. There's an oft quoted sound bite from Cardinal Basil Hume (Archbishop of Westminster) to this effect:

“If that frightened, unemployed 19-year-old knows that she and her child will have access to medical care whenever it’s needed, she’s more likely to carry the baby to term. Isn’t it obvious?”

You'd think that it was obvious, but I'm suspicious of the idea that having more money or resources makes us better or less selfish people (an idea which strikes me as smacking of a certain spiritual Rousseauian quality that doesn't take fallen human nature into account) so I thought it would be interesting to see if there's any data on this.

I was not able to find data on the relationship of abortion to health insurance, but I was able to find data on the relation of abortion to poverty, and it turns out that the Cardinal, and conventional wisdom, are wrong.

It's often pointed out that a disproportionate number of abortions are procured by women living below 200% of the poverty line (that's about $22,000/yr for a single person). This causes people to conclude that poor women are more likely to abort because they can't afford a child. As it turns out, however, poor women are less likely to abortion an unwanted pregnancy than non-poor women.

The numbers I'm looking at are from this study by the Guttmacher Institute (the research arm of Planned Parenthood -- hardly an anti-abortion source) which looks at pregnancies and abortions for unmarried women aged 20-29 from 2001 to 2008.

The study looks at unmarried women in three economic groups: Those living below the poverty line (around $11,000 per year), those living between the poverty line and 200% of the poverty line ($11,000 to $22,000), and those making more than 200% of the poverty line. For convenience, I'm going to look at the two most extreme groups, those living below the poverty line and those who make more than 200% of the poverty line. The middle group falls pretty much in the middle on all statistics.

The first thing you see is that poor women get pregnant a lot more than better off women. The pregnancy rate for unmarried women living below the poverty line was 277 pregnancies per 1000 women in 2008. For unmarried women making more than 2x the poverty line, that rate was 56 per 1000 women. So poor women are five times more likely to get pregnant.

Now, the first thing that most people would guess is: Poor women must have a lot more unintended pregnancies. They can't afford birth control, or they hadn't had good sex education, or for some other social reason they're not able to control their pregnancies.

Well, it turns out that for unmarried women between 20 and 29 a majority of pregnancies are unintended, but poor unmarried women have a lower percentage of unintended pregnancies than better off unmarried women. 67% of pregnancies of 20-29 year old unmarried women living below the poverty line were unintended in 2008 while 73% of pregnancies of unmarried women making more than 200% of the poverty line were unintended.

Even so, surely a woman with more means is going to be more able to support an unplanned child than a truly poor women, right? Well, she may be more able, but that's not, on average, what she chooses to do. Unmarried women living below the poverty line aborted 48% of their unintended pregnancies in 2008. Unmarried women making more than 200% of the poverty line aborted 62% of their unintended pregnancies in 2008. So an unmarried woman living at more than 2x the poverty line is 30% more likely to decide to abort an unplanned pregnancy than an unmarried woman living below the poverty line.

Unmarried women are far more likely to abort unintended pregnancies (51% aborted) than married women (17% aborted), but unfortunately the Guttmacher report only provides income breakdowns of unmarried women, not married women. However, that does at least mean that the data we're looking at is not thrown off by the fact that a much greater proportion of poor women are unmarried than better off women.

So it turns out that the conventional wisdom is wrong on all fronts. A smaller percentage of pregnancies are unplanned for poor women than for better off women. And a smaller percentage of poor women who have unplanned pregnancies abortion than better off women. The only reason why a disproportionate number of abortions are obtained by poor women is that they get pregnant far more frequently than better off women.

What this underlines is something that should be fairly obvious to anyone with a Christian understanding of fallen human nature: Having more money and resources does not make us better people. Those who are better off are just as capable of doing wrong than those who are less well off. Indeed, in this case, it appears that people who are better off are more likely to do wrong than those who are less well off.

Does this mean that we shouldn't work to alleviate poverty or to make sure people are able to get the medical attention they need? Of course not. But this conventional wisdom that people only do wrong things because they're not well off is simply not the case.

UPDATE: Okay, I'm realizing that due to some odd formatting on the Guttmacher study, I hadn't realized that their data is split into two halves. First they provide overall rates of pregnancy, unintended pregnancy and abortion for all women 20-29 and break that data down into married and unmarried women. However, all of the demographic breakdowns which are provided in the lower section of each table are for unmarried women only. So the percentage of pregnancies which are unintended and the percentage of unintended pregnancies that end in abortion which I quote in the article are for unmarried women only. I've edited the article appropriately, but am leaving this update separately to make the changes clear.

Benefits of Trade

A quick economics education link for your Friday: Mark Bellemare of Duke University writes about an in-classroom exercise to demonstrate how trade "makes everyone better off".

The Trading Game is pretty simple. Before the start of every semester I have to teach principles of microeconomics, I look at the number of students enrolled in my class, and I head out to the nearest dollar store to buy an equal amounts of trinkets.
...
I go around allocating trinkets to students at random.

I then ask students to assign a value to the trinket they have just received ranging from 0 to 10, with higher values meaning cooler trinkets.

We then go around the room recording those values. Because students often bring their laptops to lecture, it is easy to find a volunteer to record those values, but you can have a teaching assistant do it. Once all values are recorded, total welfare (i.e., the sum total of the values students assign to their trinkets) is announced.

I then tell students that they have five minutes to trade voluntarily between themselves, insisting on the fact that trades must be voluntary (i.e., no stealing) and cannot involve dynamic aspects, or credit (i.e., no “I’ll give you my cool dinosaur if you give me your awful trinket and you buy drinks on Friday night.”)

Once students are done trading, we once again go around the room recording the values they assign to their trinkets. Once all values are recorded, total welfare is announced once again.

And that’s usually where the magic happens. When I ran the Trading Game last week, my class’ “aggregate welfare” went from 128 to about 180, if I recall correctly, and you could just see that it had become obvious to students that (in this context of well enforced property rights) trade not only left no one worse off, but it increased aggregate welfare.

This exercise has apparently been around for quote some time and been done, with variations, by lots of teachers. It seems like a very good classroom exercise. I find myself wondering if it would somehow be possible to do a version that would mirror the classic The Economic Organization of a P.O.W. Camp paper dealing with the benefits of middle men.

Initial Thoughts on College

I've caught up on reading Bearing's series on post-secondary education, and having done so I'm eager to start formulating some thoughts on the topic in general and on Mark's guest post "Why College Is a Bad Deal for America" in particular. I feel the need to sidle up to the topic and lay some groundwork, not just because I'm too short on time (trying to finish the novel, as I should be doing right now) to write a single exhaustive post, but also because I'm aware that this is a topic on which I have strong feelings influenced by my own history and the limited data set that personal experience provides.

Let me start by outlining my own personal background on the topic. I've written in the past about my own progress from a Classics degree to working in Marketing (and now, Finance -- pricing is one of those disciplines that can end up on either side of the divide.) What may or may not come through from that is the extent to which my personal pride ended up becoming wrapped up in proving that I could "make it" as a provider despite having a humanities rather than a technical degree. Many of the guys I hung out with socially in college were in business or computer science, and so I got a lot of "now you'll know how to say 'would you like fries with that?' in Latin!" ribbing. It was good natured enough, but I had (and have) more than my fair share of pride, and it tended to make me angry. Thus in addition to the need to provide for a family right out of college (MrsD and I married at 22, had our first child at 23 and our second at 24) I had a strong personal determination to prove that in the long run I could make as much or more than people who'd gone into fields like business, engineering and computer science.

So when I hear someone arguing that getting a college degree in general, or a non-career-oriented college degree in particular, is a bad investment, my first reaction is an entirely emotional competitive urge to respond, "Oh yeah? Can you match this?"

Secondly, my personal experience is very much formed around corporate office environments (in marketing and finance) where college degrees are almost a must. Yeah, sure, there are the famous college drop outs like Michael Dell and Bill Gates, but the companies those men founded employ almost exclusively college graduates when it comes to well paid salaried jobs. (If anything, I'm on the anti-credential side of the corporate spectrum, since I'm one of those who considers MBAs mostly useless degrees.) So when I look around me at the type of success that I'm most familiar with, purposely not going to college seems like a bad idea, because it mostly locks you out. (There are exceptions, but it's tough.)

Alright, so with those preliminaries out of the way, so that people will understand where I'm coming from and be able to contextualize what I'm saying accordingly, the approach I'd like to take is to lay out some thoughts in broad outline, and then delve into those points individually in further posts. Since these points are necessarily brief, I'll number them for easy reference in discussion. The ordering means nothing in particular.

1) I think that people are right to be concerned with the rapidly escalating cost of college education (undergraduate and graduate) and with the extent of student debt that people are getting into in order to finance their educations.

2) A great many people go to college believing that college guarantees them a job, or even a "good job". In our current economy, this is clearly not the case. Even people with degrees that are very job focused are having more difficulty getting jobs right now, and for those with less job focused degrees, things are even harder. That said, if things are hard for college graduates, they are even harder for people without college degrees and hardest of all for those without even high school degrees.

3) While one can argue that this maybe shouldn't be the case, a four year college degree is generally considered to be the minimum threshold for being a "well educated person" in our society at this time. As such, if you don't have a college degree, you're going to end up having to answer the question "why not?" to one extent or another (clearly, this will vary depending on your professional field and social milieu) and you will have to deal with people's unspoken assumptions based on your lack of degree.

3) All of that said: College is not a good deal for everyone. People who go to college but don't finish end up with debt and lost time, but don't have appreciably higher income or lower unemployment than those with only high school degrees. (Whether they learned and grew a lot is, of course, another matter, but I'd assume that dropping out isn't a great sign in that regard.) Further, some of the data out of the Academically Adrift studies suggests that among those who finish to college, unemployment is three times higher (and pretty similar to the rate for those with just a high school diploma) for those in the bottom 20% of academic ability as compared to those in the top 20% of academic ability.

4) On the other hand, we have a strong tendency to take a finding about society in general "college is a bad deal for some people" and apply it to each individual person regardless of circumstances. I'd argue that someone who has a lot of academic ability, and a strong desire to pursue a four year degree in some field, should not be dissuaded with the general observation, "College is a bad deal for some people." It's people who excel at and appreciate academic study who will get the most out of college both personally and professionally. Further, given that your children are more likely than the average member of the population to be like you (both as a matter of nature and nurture) while you shouldn't unduly pressure your children to follow your path, you probably also shouldn't assume that they should look like the general population. So if you and your spouse are both college graduates who did well in college and have gone on to successful careers, don't look at the overall population and say, "Well, 40% of people are graduating from college now, and many of them aren't doing so well, so probably most of my kids shouldn't go to college." If your kids are like you in ability and inclination, urging them to skip the college degree they want and get a certification in some skill like plumbing or welding instead is probably not a good a idea. (If they want to pursue one of those fields rather than college, that's a whole other situation.)

5) I think it's important to come to a broader understanding of the "liberal arts" as those arts and sciences appropriate to a free person. This means encouraging "liberal arts types" to study a bit of more hard-edged topics, and also making sure not to relegate more technical subjects strictly to training as opposed to education.

6) While I'm sympathetic to the search for "third ways", part of what made college such a valuable experience for me was living for four years with other people who where also studying academic subjects in depth, and the "community of scholars" feeling that creates. Goodness knows, it was imperfect, but I had a fairly intensive liberal arts education in high school and I've tried to do a fair amount of self teaching since, and I don't think either one is remotely comparable to the college experience.

7) While I'm a very big advocate of people getting an undergraduate college degree if they have the ability and inclination, I think people should very carefully weigh whether going to grad school is something really ought to do. It's often very expensive. If your hope is to get into academia professionally, it's an incredible career longshot. If you are doing it for more general professional advancement or benefit, I think you need to think hard whether the time and cost is going to have a sufficient return on investment. And if you're doing it because you don't know what else to do (or because it's just fun) I think you need to be very hesitant unless you can pull it off without incurring debt. Borrowing tens of thousands of dollars is a bad way to avoid making decisions.

So Who Did Build That?

Every so often a politician makes a statement which so well represents the partisan divide that the political chattering class settles down to mocking or defending the statement for a week or two. Such a case, it seems, is Obama's "you didn't build that" speech last Friday. Speaking to supporters in Virginia, Obama said:

There are a lot of wealthy, successful Americans who agree with me — because they want to give something back. They know they didn’t — look, if you’ve been successful, you didn’t get there on your own. You didn’t get there on your own. I’m always struck by people who think, well, it must be because I was just so smart. There are a lot of smart people out there. It must be because I worked harder than everybody else. Let me tell you something — there are a whole bunch of hardworking people out there.

If you were successful, somebody along the line gave you some help. There was a great teacher somewhere in your life. Somebody helped to create this unbelievable American system that we have that allowed you to thrive. Somebody invested in roads and bridges. If you’ve got a business — you didn’t build that. Somebody else made that happen. The Internet didn’t get invented on its own. Government research created the Internet so that all the companies could make money off the Internet.

My primary reaction to this is literary and intellectual snobbery. The pass to which political rhetoric has come in this really pretty sad. Compare Obama's whimpers of populism with the master, William Jennings Bryan:

Mr. Carlisle said in 1878 that this was a struggle between "the idle holders of idle capital" and "the struggling masses, who produce the wealth and pay the taxes of the country;" and, my friends, the question we are to decide is: Upon which side will the Democratic party fight; upon the side of "the idle holders of idle capital" or upon the side of "the struggling masses?" That is the question which the party must answer first, and then it must be answered by each individual hereafter. The sympathies of the Democratic party, as shown by the platform, are on the side of the struggling masses who have ever been the foundation of the Democratic party. There are two ideas of government. There are those who believe that, if you will only legislate to make the well-to-do prosperous, their prosperity will leak through on those below. The Democratic idea, however, has been that if you legislate to make the masses prosperous, their prosperity will find its way up through every class which rests upon them.

You come to us and tell us that the great cities are in favor of the gold standard; we reply that the great cities rest upon our broad and fertile prairies. Burn down your cities and leave our farms, and your cities will spring up again as if by magic; but destroy our farms and the grass will grow in the streets of every city in the country.

Bryan may have been wrong on a lot of things, but dang could he speak.

But aside from its poor prose, the surprising thing about Obama's speech is its poor thinking. Yes, it's certainly true that no one does anything "on his own" in that we are all live within society. And of course, successful businesses exist within the context of a civil society in which laws exist and are enforced, infrastructure is maintained, etc. It is entirely just, for that reason, that we pay taxes to maintain that law enforcement and that infrastructure, and that we charge taxes proportionally to people's earnings, so that those who make the most pay the most. Contrary to Obama's implication, no one is disputing this. Even the most radical of "flat tax" proposals would still result in the rich paying far more than the poor. The only truly regressive tax we pay in the US is the social security tax, to which Obama, Mitt Romney, Bill Gates and I all pay exactly the same tax bill every year.

However the claim "If you’ve got a business — you didn’t build that. Somebody else made that happen." doesn't merely suggest the obvious and inane point that "hey, we all exist in society", but rather that there's nothing particularly special about those who build huge businesses or otherwise become huge successes. "Let me tell you something," Obama offers, with his typical, hectoring, I'm-much-smarter-than-you tone, "There are a lot of smart people out there.... [T]here are a whole bunch of hardworking people out there."

But here's the thing: We all have roads and laws and the internet and teachers available to us. Bill Gates and Michael Dell aren't billionaires because they had roads and teachers and I didn't. They're billionaires because through some combination of vision, hard work, drive and luck they built companies that provide millions of people with things they want enough to pay for. I grew up with the same legal system, the same public infrastructure, and the same educational opportunities as them, and I didn't build a huge, successful company. I work a good job and earn a nice paycheck by providing services that my employer is willing to pay for, and as a result I pay my mortgage and buy things that we want. And I pay taxes -- though far less taxes then billionaire entrepreneurs (as is just, since they make more money.) However, despite having the same government provided services and infrastructure available to me as billionaire entrepreneurs (and smaller entrepreneurs), I haven't built a successful company that provides other people with jobs and many more with valuable goods or services. As such, the difference between my fortune and that of Michael Dell or Bill Gates is not due to the government providing them with infrastructure, it's due to them and their actions. They really did build it.

This doesn't mean that taxation is theft or that those who are highly successful shouldn't pay an equitable share of the cost of maintaining the civil infrastructure and services we all benefit from, but it does mean that the "you didn't build that" line of argument that the president is attempting isn't just bad rhetoric, it's just plain wrong.

The Ethics of Price Discrimination

To our modern ear the very term "discrimination" sounds bad. However, in the pricing discipline, "price discrimination" is not necessarily a bad thing. The term refers to creating a pricing and product structure which finds a way to charge customers with different willingness or ability to pay different amounts.

Examples include:

The price of clothes in a department store vs. in an "outlet" store.
The price of a newly released novel versus a backlist novel.
Name brands vs. store brands in grocery stores.

In most cases, price discrimination involves creating a situation in which customers can make a trade off between convenience and price or quality and price in order to get fairly similar products for very different prices. This ends up being good for both customers and companies. Companies are able to maximize their sales, allowing them to pay their employees, grow, and produce profits for their investors. They're able to do this by getting the most money from the customers most able to pay, and providing customers with the least ability to pay with the best deal.

However, some forms of price discrimination work more like an intelligence test. One of these I was reminded of recently when setting up travel arrangement for some upcoming trips. Most car rental companies now offer an option where the customer is offered the chance to pay for a tank of gas up front, usually at a rate $0.10 to $0.40 lower than the standard gas station price in the area. This seems like a great deal, until you remember that it only works out as a savings if you return the tank entirely empty. If you return the tank half full, you get no refund for that half tank, and you end up effectively giving the car rental company an extra $20 or so. By making money on the pre-sold tank of gas, the car rental companies are able to offer lower daily rates, allowing them to win more business, pushing other companies to lower their rates and make their money back in other less obvious ways like pre-paid gas, car rental insurance, etc.

This does offer customers who can think through all the offers they're given an opportunity to pay less, so it clearly benefits some customers. However, rather than doing so based on the willingness of customers to make small trade offs in convenience or quality, it does so based on their ability to problem solve. The pre-paid gas is particularly tricky, because at first pass the pre-pay at the lower price actually seems like a way to save money, but in most cases it will turn out to be an extra fee.

These kinds of price discrimination seem more ethically troubling, and yet it's very hard for companies to resist such approaches when they catch on, because "hiding" profits through this kind of pricing allows the companies that adopt such tactics to offer lower up-front prices.

Kidnapped by Pirates is... Economic?

One of the perverse joys of economics is taking some exciting topic like being kidnapped by pirates and analyzing it as a market transaction and game theory situation. Gabriel Rossman, one of Megan McArdle's guest bloggers, has a delightful post doing exactly this, and he gets extra points by framing it with the story of Julius Caesar's youthful kidnapping by pirates:

A couple years ago NPR's Planet Money podcast had an episode about Somali pirates. (The pirate part starts at 9:35). There was all sorts of interesting stuff about division of labor, allocation of shares, pirate venture capital, etc. Some of this paralleled early modern piracy (as given a scholarly analysis in Peter Leeson's work and a romantic perspective in innumerable books and movies since Treasure Island) but in other respects it's very different. In particular, whereas early modern piracy was mostly about seizing cargo and the crews were left alone if they surrendered promptly, Somali piracy is more similar to piracy in antiquity in that it's basically maritime kidnapping. The typical instance of Somali piracy isn't that different from what a young Julius Caesar experienced when he was kidnapped by pirates and held for ransom on his way home from political exile in Asia Minor. One interesting detail in Plutarch's report is that, "When these men at first demanded of him twenty talents for his ransom, he laughed at them for not understanding the value of their prisoner, and voluntarily engaged to give them fifty."

It's not entirely clear if we should take Plutarch's report at face value (he also tells us that Caesar constantly insulted his captors as being, for instance, too uncivilized to appreciate his poetry) but for the sake of argument let's accept that Caesar rather brashly gave away too much information in the game of price discovery. According to a hostage negotiator quoted by This American Life, giving away this information is apparently typical of hostages and is counter-productive to their release as it narrows the bid-ask spread. Economists would describe hostage negotiation as a bilateral monopoly price negotiation that is structurally just a special case of chicken. That is, unlike a barrel of oil or a freight car full of soybeans which can trade on an extremely liquid market with innumerable buyers and sellers, a hostage has exactly one seller (the kidnappers) and exactly one buyer (the employer and/or family of the hostage). When there is only one buyer, the opportunity cost for ransoming the hostage is zero. Likewise, the employer and/or family has no realistic alternative means to recover the hostage. In order for everybody to walk away happy, we need a cooperate-cooperate outcome: the kidnapper has to give up the hostage and the employer/family has to give up a ransom. This structure also characterizes art theft, which in practice is not a matter of fencing art on the black market but ransoming art to a museum's insurance company.

If we model a bilateral monopoly negotiation only two things should matter. The first is, as always in a game of chicken, the willingness to accept failure. The more willing you appear to walk away, the more bargaining power you have. In a more protracted game this can cash out as willingness to delay which we can treat as a defect-defect outcome on the installment plan. In fact in the Planet Money episode on Somali piracy, the hostage's party did balk and break off negotiations for weeks at a time until the pirates were willing to come down on price.

The other thing that should matter is the capacity to pay. If the pirate knows for an absolute fact that the hostage's people simply can't raise more than a million dollars then it would be pointless for them to demand two million dollars. Of course there is an issue of information asymmetry in that the hostage's party has much better information on its assets than do the pirates and so the pirates may be skeptical of the hostage's party pleading poverty (especially if the hostage has foolishly told them how much money they can get). We see this at work in the TAL story's point that kidnapping insurance holds the condition that you can't tell anyone you have kidnapping insurance.

Here's something that the econ model tells us shouldn't matter: the going rate. In normal markets the going rate matters, but only because it provides the opportunities for substitutes and this creates the "law of one price." For instance, when I go to a grocery store and see a loaf of bread for $4 I won't buy it. An economist would say I forgo this purchase because I know perfectly well that the going rate for a loaf of bread is about $2.25 and so I can go elsewhere and get bread cheaper. Similarly if I go to the Honda dealer to buy a Honda Accord, it is relevant for me to mention price quotes offered by other Honda dealers for an Accord or even how much Toyota dealers ask for a Camry because it is entirely credible that I'll walk off the lot and go to rival car dealers offering very close substitutes for this dealer's cars. However if my sister is locked in a basement in Ciudad Juarez and the kidnappers can credibly commit to not letting her go unless I raise $x, it is completely irrelevant that in the past kidnappers accepted ransoms of $x/2 since I don't have the relatively good fortune of dealing with a kidnapper who demands $x/2 but am stuck with one who demands $x. There are no other places where I can buy the freedom of my sister and so the only price that matters is the one being demanded by her particular kidnappers. (Note to any cartels reading this: I don't have a sister).

Read the rest for a discussion of how "fair market price" concepts may or may not creep into such negotiations, and for the conclusion of Julius Caesar's kidnapping story.

Income Inequality: 1945 Edition

I guess it's a sign that I'm a hopeless econ wonk that one of the things that I came away thinking about after watching The Best Years of Our Lives with MrsDarwin the other night (a good movie, which I'd strongly recommend) was how the income situations of the major characters would translate into modern terms.

Released in 1946, when it won the Academy Award for Best Picture, The Best Years of Our Lives follows the return to civilian life of three service men who all came from Boon City (a fictional Midwestern city) but didn't meet each other until they were hitching a ride on a B-17 back to their home town after the war.

Sailor Homer Parrish went straight into the Navy from high school, in which he had been an athlete, but he lost both his hands in a fire when his aircraft carrier was hit, and he now has a set of hooked metal prosthetics instead of hands and forearms. Before leaving he got engaged to his high school sweetheart, but he doesn't know how she'll react to his disability.

Capt. Fred Derry is slightly older. He comes from a fairly poor family and worked as a soda jerk before the war, but during the war he was the bombardier on a B-17. During training, he got married, but he and his wife had only a month together before he shipped out and he hasn't seen her since.

Sgt. Al Stephenson is in his 40s. Before the war he was a loan officer at a bank in town, and during the war he served as an infantry platoon sergeant in the Pacific. He's been married 20 years and has two children: a son just finishing high school and a daughter who graduated and has been working in a hospital for the last two years.

Much of the drama stems from the efforts of these three characters to integrate back into normal, civilian lives. However, a good portion of this conflict also relates to jobs and what place these characters will take in the post war economy.

Al comes back to a promotion: his bank puts him in charge of the small loan department, tasked with dealing with GI loans. He's given a salary of $12,000/yr. I wanted to get a feel for how large an income that was. Running it through a basic inflation calculator, 12,000 in 1945 translates to $143,792 in 2010 dollars. That's very good money now. Compared to how most people were doing, it was even better money then. I discovered that although many of the more detailed historical income tables on the Census.gov website only go back to 1967 (or in some cases even just 1991) it's possible to access scanned copies of the original Current Population Surveys dealing with income back to 1946. According to the 1946 report, the median income for a man engaged in full time civilian work in 1946 was $2600, which translates to $28,714 in 2010. By comparison, the median income for a full time, year round male worker in 2010 was $50,063. According to that 1946 report (page 15) only 2% of city-dwelling families in 1946 had incomes over $10,000 ($110,440 in 2010 dollars) putting Al very close to being in "the 1%" despite working for a very small bank by modern standards. Clearly, material want is not going to be among Al's problems. The conflict he deals with centers around the different experiences he's had over the last three years compared to the other managers at the bank -- and the personal difficulties of integrating back into family life.

If Al comes back to a cushy job, job woes are very much center stage for Fred. During the war, Fred was making $400/mo as a Air Corps bombardier. That's $57,517 in 2010 dollars. It also would have put him in the top 20% of incomes according to the 1946 income distribution tables. (By comparison, the threshold for the top 20% of incomes now is right around $100k.) Returning to civilian life, Fred is determined to find a good job, but in the post-war labor glut he finds that his status and pay from the Air Corps don't translate to many advantages in civilian life. At one point we see him in a job interview:

Manager: Did you do any work with supply or logistics in the Air Corps?
Fred: No.
Manager: Did you do any staff work? Did you lead men?
Fred: No.
Manager: Just what did you do, Captain?
Fred: My job was to sit behind the Norton Bomb Sight and get the bombs onto the target every time no matter what happened.
Manager: Well, we don't have much call for that here.

In the end, Fred finds himself back at the store where he had been a soda jerk, now working as an "assistant floor manager", a position more galling because the floor manager he is assistant to used to be his assistant at the soda fountain. This job pays $32/wk, which in turn works out to $1,664/yr. Run that through the inflation calculator and Fred is now making $19,939 in 2010 dollars. This now puts him in the bottom 33% of incomes in 1946. If we assume that the $32/wk rate is for the equivalent of 40 hours, Fred is making an hourly rate of $0.80, which makes an inflation adjusted $9.59/hr. I'm struck by the inflation adjusted hourly rate for Fred, since it's probably moderately close to what you'd make in retail now, though with his "assistant floor manager" title, perhaps he'd make closer to $12-$13/hr now (as compared to the $8-$9 which is common for basic retail). I was curious how other major expenses compared then to now. Table 7 of the 1946 census report shows median rents paid by income. For families making $1,500 to $1,999 per year, the median monthly rent was $25. That works out to $299/mo, a good deal less than you'd be able to find even a very cheap apartment for in most Midwestern cities now. Fred is making a little bit below the median for a man in Retail Trade, according to Table 17 of the 1946 census report, which gives the distribution of income by employment sector and lists the median income in retail at $1,927. I think it's probably arguable, at least from those few facts, that living on a retail job was significantly more possible then than now.

Homer, meanwhile, is trying to adjust to ordinary civilian life with his prosthetic hands (the actor playing Homer was a real veteran who had lost both hands in an explosives accident, he was one of only two non-professional actors ever to win an Oscar.) Income is not an immediate issue for him as he receives a disability payment from the government for his war injuries: $200/mo (which translates to $28,758/yr in 2010 dollars.) This actually puts Homer pretty much right at the median income for full time civilian workers. Given the sacrifices he'd made for his country, it's good to see that set of worries being taken care of.

Chart Of The Day: Whose Wages Are Stagnating?

I'd been fooling around with Census data a bit over the last week. Here's an interesting chart using Census Table P-36. Full-Time, Year-Round All Workers by Median Income and Sex: 1955 to 2010

Median income for full-time working men first hit 50,000 (in inflation adjusted 2010 dollars) in 1973, and it has been essentially flat ever since (breaking 50k for the second time in 2010.) However, the median income of full-time working women has gone up 35% since 1973. The percentage of full time workers who are women has also increased gradually throughout that time, from 30% in 1973 to 43% in 2010. (In absolute numbers, obviously both the number of male and female full time workers has increased significantly during the same period.)

Money Can Buy You Love

Paul Krugman has been putting up a number of posts over the last week expressing his annoyance with Charles Murray's new book Coming Apart and its emphasis on the social breakdown which underlies inequality in America. Broadly speaking, Krugman seems to think that Murray is obscuring the "real problem" that that top 1% of Americans make so much money by talking instead about the problems that the bottom 40% are suffering in relation to family breakup, illegitimacy and plummeting marriage rates.

In a post yesterday he says:

Lately inequality has re-entered the national conversation. Occupy Wall Street gave the issue visibility, while the Congressional Budget Office supplied hard data on the widening income gap. And the myth of a classless society has been exposed: Among rich countries, America stands out as the place where economic and social status is most likely to be inherited.

So you knew what was going to happen next. Suddenly, conservatives are telling us that it’s not really about money; it’s about morals. Never mind wage stagnation and all that, the real problem is the collapse of working-class family values, which is somehow the fault of liberals.

But is it really all about morals? No, it’s mainly about money.

To be fair, the new book at the heart of the conservative pushback, Charles Murray’s “Coming Apart: The State of White America, 1960-2010,” does highlight some striking trends. Among white Americans with a high school education or less, marriage rates and male labor force participation are down, while births out of wedlock are up. Clearly, white working-class society has changed in ways that don’t sound good.

But the first question one should ask is: Are things really that bad on the values front?
...
[T]he truth is that some indicators of social dysfunction have improved dramatically even as traditional families continue to lose ground. As far as I can tell, Mr. Murray never mentions either the plunge in teenage pregnancies among all racial groups since 1990 or the 60 percent decline in violent crime since the mid-90s. Could it be that traditional families aren’t as crucial to social cohesion as advertised?

The thinking here seems particularly tone-deaf: Confronted with the fact that among the least educated and lowest earning Americans, illegitimacy has skyrocketed, marriage has become far less common, attendance of religious services has dropped, etc. Krugman concludes that since crime and teen pregnancy are down, it must be that people aren't much bothered by those social trends. Rather, the big thing that's worrying them is that their wages in inflation adjusted terms have been flat for the last few decades.

If anything, he's sure that the causality must run the other way: since men with only a high school education are finding it increasingly hard to get good jobs, this must account for the collapse in marriage, rise in illegitimacy, etc. If we could just give those people more money, they'd be happy. That marriage stuff -- maybe it's just not so important to them.

Of course, causal systems among people are inherently complex. Doubtless, the economic difficulties of those at the lower end of the education spectrum lead to family breakdown. However, more importantly, family breakdown leads to economic and educational problems. Krugman's blithe "nothing to see here" waves away the far more human topic into order to get back more quickly to discussing the fiscal policy issues he'd rather discuss when it comes to inequality.

Catholicism and "Neoliberalism": Strawmen Are Often Contrary to Church Teaching

David Cloutier at the Catholic Moral Theology blog links approvingly to a post at dotCommonweal addressing Romney's political views which asks whether "neoliberalism" (the which is here used to mean something along the lines of free market capitalism) and Catholicism can ever be compatible. He says:

Superb exchange going on over at dotCommonweal over a post about how certain political conservatives, like Rick Santorum or Michael Gerson, try to reconcile their Catholicism with the neoliberal paradigm. For once, even the comment thread is worth reading!

I think this is an important – if not THE important – debate about Catholicism and politics in the current election. Often, the debate over particular policies dominates, but in fact, what we should be looking at are the basic principles of the economic order. If a candidate fundamentally contradicts the basic principles, Catholics should have reservations about supporting him. In the post referred to above, “neoliberalism” is cast in terms of a pure free-market conception, in which governments take a minimal role in economic activity, providing for enforcement of contracts, a stable currency, etc. – protection against “force and fraud.” Others claim that Gerson forthrightly support subsidiary actors – such as families, community organizations, and churches – and so is not in fact individualist.

The (frequently made) mistake here is one that goes back to Edmund Burke, that “father” of conservatism. Burke seeks to deal with nascent industrial capitalism by (Warning: blogging oversimplification ahead…) distinguishing between a sphere of “culture” (or “civil society”) that can be fostered, and refuses to attribute social problems to the mechanisms of the market itself. He defends the market as good, over against the landed establishment (the “nobles”) of the pre-industrial order, which is who he is opposing. But for him, the market is not all there is. (One sometimes sees a variant of this in defending Adam Smith by noting one must read both The Wealth of Nations and The Theory of Moral Sentiments.)

There are two fundamental problems with maintaining this thesis today, which never seem to be adequately explained. First, Burke (like Adam Smith, in this way) is writing prior to the advent of large, joint-stock corporations. They are imagining relatively small-scale market actors. This observation is important for the second reason: it is overwhelmingly clear that large-scale corporate capitalism is destructive of small-scale community organization. As Wendell Berry has written repeatedly, community does not “have a value” measurable in economic terms, and therefore is constantly undermined by the market for the sake of its expansion.
...
Ultimately, Benedict’s work continues the tradition of CST, which maintains a balanced approach, accepting markets if they are “circumscribed within a strong juridical framework” by sound government regulation (see Centesimus Annus, paragraph 42), and if they are respectful of the institutions of civil society (including the family), which are in some sense “prior” to both market and state. This approach tends to fit uncomfortably with the rights-based individualism that sometimes contaminates Democratic attempts to work for the common good, but it outright contradicts the anti-government rhetoric of “free enterprise” that is routine among Republicans.

It was the last paragraph that threw me and sent me back to re-read what came before a bit. Living, like most people, within a world that shapes and is shaped by my own beliefs and dispositions, it's not hard to forget that people can have such contrary assumptions. That someone would think that a Catholic worldview is a "sometimes" a difficult fit with the Democratic party worldview but clearly incompatible with being a Republican is a little eye-opening for me. It's not just that I and most of the other Catholics I know are fairly conservative, it's that my acquaintances who are mainstream progressives are quite eager to make it clear that people with my views on marriage, sexuality, abortion and childbearing are absolutely unwelcome on their side of the aisle. That other people can see the division between parties as not being primarily over these issues always seems surprising to me.

Still, the topic here is Catholicism and economic ideology, and I think there's some light to shed on what Cloutier claims here. I don't bring up the cultural divide between political alignments as a red herring, though, I think it's key. Part of the issue, I think, is that the ideological polarization of our society tends to lead people to thinking of the ideas of "the other side" in very broad stereotypes. There is some accuracy to them, but they also tend to obscure what people really think by taking a simplified form of a belief and building it into a strawman.

If we cast "neoliberalism" or "free market ideology" as the belief that only things that "have value" in measurable, market terms should be regarded, and that the market should be the determining factor in all things, then yes, these will be ideologies incompatible with Catholicism, with humanism, and with civilized life. On the other hand, the very untenability of this conception of what conservatives are talking about ought to be an indicator that perhaps some mistake is being made. We can imagine that conservatives are all as whacked out as Ayn Rand, but this involves both ignoring the criticism of Randian libertarianism that comes from many conservatives, and also assuming that a lot of what conservatives say stems from false consciousness. Try measuring it, for instance, against the following quote from Santorum (the person who is being accused by dotCommonweal of holding market beliefs incompatible with Catholicism):

This whole idea of personal autonomy, well I don’t think most conservatives hold that point of view. Some do. They have this idea that people should be left alone, be able to do whatever they want to do, government should keep our taxes down and keep our regulations low, that we shouldn’t get involved in the bedroom, we shouldn’t get involved in cultural issues. You know, people should do whatever they want. Well, that is not how traditional conservatives view the world and I think most conservatives understand that individuals can’t go it alone. [source]

Now, as the linked post shows, Santorum's comments here are enough to cause infighting among different conservative factions, but clearly this kind of thinking (which could fairly be described as subsidiary rather than individualistic) that is common enough in the conservative mainstream to attract more followers than the radical individualism of pure libertarianism.

In point of fact, supporting a free market approach to economics (and indeed, I probably have a more free market approach than Santorum, in that he seems to adhere to the idea that trying to prop up teetering rust-belt industries via subsidies will stave off the inevitable rather than prolonging the painful decline) does not mean assigning no value to things that are not easily quantifiable in monetary terms (contra Wendel Berry who at times cultivates an almost willful ignorance about matters economic and technological.) Indeed, one of the areas in which even economists have sought to capture this in recent decades is in looking at the ways in which information and relationships are essential parts of economic systems and economic growth, despite the fact that they are nearly impossible to quantify in purely monetary terms. This is why the kind of corporate restructuring which Romney is being criticized for participating in during his Bain days is so prone to failure: even if it's clear that a company needs to be reorganized in order to avoid bankruptcy, the process of restructuring often does so much knowledge to the networks of relationships and morale within the company that the company is sent into a tailspin for reasons that would not be immediately obvious from a business case.

Individualism is such a natural temptation it would be shocking if we found it only on one side of the political spectrum. If on the right it is found in the more libertarian side of conservatism, on the left it shows up in the idea that the state should provide each person with sufficient support to not have to rely on others for help, making each person's primary relationship be with the state rather than with other people and institutions. (This seems to work: through a mixture of cause and effect we find that the most splintered families are among those who require government aid while the greatest tendency to intact family and social structures is found at the higher end of the income scale.) This can come out in all sorts of unexpected ways. I recall being struck by it particularly a while back when talking with a relative (relatively progressive) who lives in Germany, and who maintained that the German outlawing of homeschooling (educating your children yourself in Germany rather than at a recognized school can be grounds for having your children taken away by the state) was just because it was the state's duty to protect the right of a child to a good education from any educational delusions the parents might be under.

Radical individualism is such an attractive error in modern affluent societies, it would be surprising if we found it only on one side of the political aisle. If we imagine that the other side is completely owned by it, while ours is only occasionally afflicted, we are probably failing to understand either side well.

Do Greeks Work Harder Than Germans?

Matt Yglasias has a piece in Slate attempting to counter the "if the Euro is going to work, Greeks are going to have to learn to work hard like Germans" line of thinking.

It’s true that Germans and Greeks work very different amounts, but not in the way you expect. According to the Organization for Economic Co-operation and Development, the average German worker put in 1,429 hours on the job in 2008. The average Greek worker put in 2,120 hours. In Spain, the average worker puts in 1,647 hours. In Italy, 1,802. The Dutch, by contrast, outdo even their Teutonic brethren in laziness, working a staggeringly low 1,389 hours per year.

If you recheck your anecdata after looking up the numbers, you’ll recall that on that last trip to Florence or Barcelona you were struck by the huge number of German (or maybe they were Dutch or Danish) tourists around everywhere.

The truth is that countries aren’t rich because their people work hard. When people are poor, that’s when they work hard. Platitudes aside, it takes considerably more “effort” to be a rice farmer or to move sofas for a living than to be a New York Times columnist. It’s true that all else being equal a person can often raise his income by raising his work rate, but it’s completely backward to suggest that extraordinary feats of effort are the way individuals or countries get to the top of the ladder. On the national level the reverse happens—the richer Germans get, the less they work.

Closer to the mark is the observation that Germans (like the Dutch and the Austrians) are thrifty, net savers who consume less than they produce and therefore export more than they import.

Even if there is some sense in which Germany’s trade surplus and attendant thrift is admirable, it simply isn’t possible for all countries to emulate Germany and export more than they import. Your exports are my imports. Your saving is my borrowing. Your assets are my debts. Living within one’s means certainly sounds like a good idea, but it’s not really advice that everyone can take. If every European country strives to reduce government and private borrowing simultaneously, a severe recession and steep decline in output is the only possible outcome.

The statistics Yglasias is referencing are from the OECD and can be found here. (Just select the country you want to view and scroll down about two thirds of the way.)

I think that, first off, he's probably engaging in a bit of statistical malpractice. The data being cited here is based on a household survey of all workers, both part time and full time, so this doesn't just tell you about how many hours the average full time worker works in a week, and how much vacation they take, but also how many people are working full time versus how many are working part time. By that point, I have to think it's a somewhat un-useful measure. And the survey produces some very odd results. For instance, this shows the only two countries in which people on average work more hours than Greece as being Chile and South Korea. While notoriously slacking Japan logs only 1772 hours per year and the US only 1792. Something here just doesn't smell right to me, given what I've read about standard full time work weeks and vacation hours in these various countries.

But leaving that aside, it strikes me that there are a couple of interesting lessons which can be drawn out of here -- though none of them are Yglasias' apparent conviction that Greece is somehow more economically deserving and Germany is exerting some sort of unfair advantage over them.

Being Poor Often Does Mean Working Harder
While the common place that working hard is a good way to improve your lot, this certainly doesn't mean that people who make less don't work hard. Many comparatively low paid jobs are absolutely back breaking. Here I am, after all, composing this post off and on during free scraps of time during my workday, while sitting comfortably at a desk with my cup of coffee and my MP3 player within reach. You can bet that someone who picks fruit all day or cleans toilets or frames houses is a lot more tired at the end of the work day than I am. Many of the world's poorest people in this day and age live by small plot subsistence farming, using tools that haven't changed much in hundreds of years. Unquestionably, that is a very hard life. So if those people are poor, it's certainly not because they aren't working hard.

Value Is Created By What You Get Done, Not How Long You Do It
Let's think about that farming example for a minute. Take a look at these two pictures:

The farmer in the first picture is doubtless working much harder. However, the farmers in the second picture are making a lot more money. Why? Because the technology and work methods they are using mean that at the end of a day's work, they will have far more grain to show for their work. Their productivity is higher. So assuming that grain is itself something which people value about the same no matter who they buy it from, the modern farmers are going to make far more money than the traditional farmers, even while doing less work.

Typically, the amount that someone is paid for doing some sort of work is measured by how much other people value the product of that work. This relates not only to questions of productivity, but of the relative value of the things being produced. If someone works ten hours a day selling tourist postcards for 0,20€ each, that person is likely to make less money than someone who spends seven hours a day assembling Volkswagens that will be sold for $30,000 each, even if the former is putting in more hours. It's not just a matter of how much effort someone puts in, but of how much other people are willing to pay for the product of that labor. The amount that people are willing to pay for the product of an hour's auto assembling is more than the amount they're willing to pay for an hour's postcard selling. It's not just a matter of how hard or skilled the work is, but also how much people need a car (and how much they value a good one over a bad one) compared to how much they need postcards.

There are a host of reasons why Germany is a wealthier country than Greece, but at root, one of the most basic is that Germany produces a total output of goods and services per capita which people value significantly above the per capita output of goods and services which Greece produces. "Germans work harder than Greeks" may not be the clearest way to express that, but it does come rather closer to the truth than implying that it is rather the result of Germans just happening to save a bit more and to have got to the export table first and gobbled up all the export surplus before Greece arrived on the scene.