I’ve noticed that a lot of people seem to view Halloween as pointless celebration that is used to help businesses sell candy. Now I don’t think is particularly fair on those who see it as a religious holiday, where this type of celebration can be compared to the way western society celebrates Christmas. However, according to Greg Mankiw, Halloween may be inefficient.
There seems to be a significant debate between the left and right wing blogs about whether Bloomfield Hills is over-taxed or not. However, there is one thing that both sides agree on, if taxes are cut by $1,000, this gives people $1,000 more to spend. This is the point I’m going to discuss.
Households receive a net wage, which is their gross wage – income tax. The household requires a certain net wage before it will enter the labour market (say the benefit + the opportunity cost of leisure time), and may also require a premium to choose one firm before another firm (when labour supply is restricted).
Now the gross wage + non-labour costs (which we will assume are exogenous, even though they aren’t really 🙂 ) is the cost to the firm of hiring that employee. If taxes fall, the net wage the household receives would be higher. However, the relationship between employers and employees determines the gross wage. If the employer knows that taxes will fall, they can reduce their employees gross wage and leave their net wage the same (I know that firms often can’t do this because of labour laws and wage stickiness, however in a dynamic sense they could just reduce the rate at which they increase an employees wage). Ultimately, the division of the tax depends on the relative bargaining power of the different agents.
If there were ‘many’ firms and ‘many’ employees, the incidence of tax would depend on the relative elasticities of demand and supply for labour. Often labour demand is assumed to be relatively elastic while labour supply is highly inelastic. In this case most of the tax is borne by the employee and so a cut in taxes will mainly benefit them.
However, if we have a high rate of unemployment, labour supply will become relatively more elastic, which implies that some of the burden shifts onto employers.
If we have a monopoly firm and many (homogeneous) low-skilled employees (flat labour supply curve) the tax burden will be fully taken up by the firm. This is because the monopoly will only want to pay enough to get the employees to work, and so the net wage will be set at the reservation level. If you cut taxes you cut the gross wage required to get this net wage. Note: This result would not hold with asymmetric information (worker effort) or heterogeneous agents (as a higher net wage would then be required to intice more workers – labour supply would be upward sloping).
Ultimately, where the burden of income tax falls is a difficult issue, and depends on the specifics of the labour and goods markets. However, it is not clear cut that if my taxes are cut I would end up with that much extra money. As a result, we have to realise that a cut in income taxes will result in a reduction in firm costs as well as an increase in consumers spending power.
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You all probably know by now that Eric Maskin was among the recipients of this year’s ‘Nobel prize’ in economics for his work on mechanism design. Browsing a few of his papers I came across one that reminded me of agnitio’s post on free software. Contrary to the obvious intuition, Bessen and Maskin propose that the software industry is an example of just the type of industry which could benefit from the removal of IP protections.
Software exhibits two characteristics that make this possible: sequential innovation and complementarities in technology. Since new software often builds on old software it is socially efficient to allow others to build on current platforms rather than have to reinvent the wheel. Of course, it means that rents that could be extracted through licencing are foregone. However, because software is complementary it is also in firms’ best interests to allow their ideas to be freely used. The complementarity means that others’ innovations increase the value of your future innovations. Thus, if you can speed the development of others’ software through letting them use your ideas then you can massively increase the expected value of your future developments. The conclusion they reach is that removal of patent protections would leave only the most innovative firms in the market and increase both their profitability and total surplus.
The paper discusses patents, not copyright, so it doesn’t directly pertain to open source software: Bessen and Maskin are talking about protection of ideas, not protection of actual written code. They don’t discuss allowing people to directly build on an existing code base but rather allowing ideas to be copied by others using their own code. Thus their proposal still provides significant barriers to entry in the form of an initial investment, but does not bar entry through the creation of monopolies over concepts. I wonder whether the removal of copyright protections would further enhance the incentive to innovate in the industry? Presumably the removal of barriers to entry would reduce profits and increase consumer surplus, but would it reduce or further enhance technological progress?
Some Canadian developers are making a computer game which simulates driving home drunk. They and police think it will be a great educational tool, showing teenagers how dangerous it is to drive while intoxicated. I’m not sure if I completely agree.
Assume that this game will realistically represent driving while drunk. As some people do get home when driving drunk, there must be some probability of getting home without crashing. According to this online keno article, teenagers can play this game over and over again, they can get better at not crashing in the game, which may make them think that they are less likely to crash when they actually drink and drive, experts from Hoyer Law Firm assure. Now it might do this, or it might just give teenagers a false belief of being good at drunk driving (given that the road and obstacles will be different on your home road). However, if our teenagers are rational this shouldn’t be the problem (as they will update their beliefs appropriately), the problem is that drunk driving is an experience good with negative externalities.
People who haven’t gone drunk driving don’t know how likely it would be that they would crash, they are uncertain (they don’t know the probability density function and so base probabilities on arbitrary beliefs). Once someone has consumed drunk driving, they gain information, and they know what the risks are when they drive. Now if current social advertising his mis-led teenagers, to believe that the risks are greater than they truly, a situation with no computer game may be preferable to a situation where kids have played the game.
Although full information is usually preferable, teenagers decision to drink drive has a negative externality which is the damage they cause when they crash. By showing kids the true probability of crashing, we increase their consumption of drink driving (assuming that their prior belief was that it was more likely they would crash) to the point where the social cost outweighs the social benefit of their driving activity.
However, there might still be scope for the game and full information. If we can ‘tax’ the negative externality, we can bring the quantity of drink driving down to the socially optimal level. This would require having police fining people when they catch them drink driving. The fine would have to equal [‘cost of outcomes’ x ‘probability of outcomes’]/[probability of being caught and fined]. In this case the driver takes on the full social cost of their drunken activity, and so will only consume the socially optimal amount. The problem with apply this rule come from quantifying the costs. If a drunk driver kills someone, what is the cost of that in monetary terms?
Ultimately, given the difficulty of quantifying outcomes, I think this may be the case where mis-information (at least a focus on the negatives) may be the best way to improve social outcomes. Check out https://floridaticketfirm.com/traffic-ticket-attorney/speeding-ticket-lawyer/ if you are looking for a speeding ticket lawyer.
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Matt posted earlier today about someone who gains utility from thinking about buying something even if they never actually buy it. There’s actually quite a lot of work that’s been done on utility gained from anticipation. George Loewenstein’s 1987 paper reports a study in which people were willing to pay more for a kiss they received in three days than they would be willing to pay for the same kiss today. They gained pleasure simply from thinking about the kiss and anticipating how good it would be. I don’t think the students in the study ever actually got the kiss so he doesn’t mention whether it lived up to expectations. Interestingly, this idea of utility from anticipation only seems to hold over non-monetary items. Nobody values receiving $1000 in three days more than $1000 today: monetary gains are discounted as one would normally expect.
Of course, if you get benefits from anticipation then that might affect your consumption of ‘real’ items. Botond Koszegi has a working paper in which he models a ‘personal equilibrium’ which describes the interaction between anticipated and actual consumption. Two phenomena which he identifies as arising from his model are self-fulfilling expectations and behaviours which depends upon unchosen alternatives. Both of these are commonly observed: the second in particular is often referred to by psychologists as a criticism of the standard economic model of consumer choice. We value consumption differently depending upon the proximate reference points: for instance, if you go on a fantastic holiday then even if the next holiday is good it is a disappointment. If incorporation of anticipation into our models of behaviour can make them that much more representative of reality then it’s certainly worth thinking about.
So according to a recent study, Chimpanzees play the ultimatum game more ‘rationally’ than humans (hat tip Marginal Revolution).
For those who don’t know, the ultimatum game goes like this. There are two players, and a sum of money that can be split between them (say $1). The first player gives decides on how this dollar should be divided between the two of them. Given this division the second player decides whether to accept this division or reject it. If the second player accepts they divide the dollar, if the second player rejects the offer they both get nothing.
If both players only value the amount of money they get then the first player will set up the division so they give player two only an infinitesimally small amount. However, when humans play the game we find that they divide the dollar up quite evenly. Furthermore, we find that when people divide the dollar up very unevenly, the offer is rejected, even though that means player two misses out on some money.
When they say that Chimps play a more rational game than humans, they mean that chimps behave in the way closer to what we would expect if the agents involved only valued money. All this really tells us is that humans value concepts like fairness at a higher rate than chimps do. Hardly a surprising result.
However, this does make a good point for economists to take on board. Humans obviously do value fairness,. Part of this is instinct, and part of this is institutional. By institutional, I mean that it is a preference we have developed as a result of the society we live in. Although economists are happy to abstract from ideas like this, when we apply economic theory it is important not to forget about the social norms that people also value.
But more importantly, the social norms that are created through the application of economic ideas may eventually change the preferences of the individuals in society. Fairness is useful as it helps reinforce co-operation in situations where a prisoners dilemma occurs. If analysts introduce policy that undermines fairness, or in some way degrades the social norm of fairness, then the socially optimal co-operative result becomes more difficult to achieve. Even more fundamentally, how does the change in preferences influence the way individuals value things, could the loss of fairness as a social norm leave people feeling more upset ceteris paribus? I think this is what sociologists have been telling economists for a while.
Ultimately, I accept the idea that social norms are important in determining preferences, but academic economists have good reason for not looking at them. Academic economists want to focus on thing they feel that they can objectively measure, so that their work does not become value laden. Defining preferences is not value neutral, and so is steered away from in academic work (except maybe in Evolutionary game theory? Not that I would know 😉 ). However, economists that want to apply their ideas to reality must realise that societies affect on preferences is non-trival. This makes the questions of how a given policy will impact on preferences more difficult.