Marginal Utility

by Ken Houghton

They are heavily discussed at EoB. (Most recently here.) Now, Zombies have made it into The Economists' [sic] Voice:

The problem with this assumption is that there is a significant amount of spam that is currently being sent via "zombie" computers...Should the owners of these zombie bots then be made liable for their contribution to the worldwide spam problem?

Sounds like a good idea. But YOU may be (running) a Zombie:

Perhaps, the responsibility of maintaining a sound firewall lies on the owner of the machine. But, even if we do make the owner legally liable, what good would it do? The subtleties of security technology lie beyond the average user of the Internet.[emphasis mine]

I think I prefer Steve's version.

Lim, Jamus Jerome (2008) "Letter: Zombies May Mean Attention Bonds Will Not Cure Spam," The Economists' Voice: Vol. 5 : Iss. 2, Article 5. Available at: http://www.bepress.com/ev/vol5/iss2/art5

Labels: Eat Our Brains, Economics, technology

by Ken Houghton

As per the desires of the world, she attacks McCain without mentioning Obama:

"I believe saying no to the farm bill is saying no to rural America."

Bush and McCain both say the bill, which boosts farm subsidies and includes more money for food stamps, is fiscally irresponsible and too generous to wealthy corporate farmers.

"When Bear Stearns needed assistance, we stepped in with a $30 billion package. But when our farmers need help, all they get from Senator McCain and President Bush is a veto threat," Clinton said.

The $30 billion didn't help Bear Stearns (ask most of my former coworkers); it guarantees that the market remains stable while the Great Sucking Sound that is Bear fades.

And this is over the farm bill? The "Disgraceful" farm bill?

The bill includes the usual favors like the tax break for racehorse breeders pushed by Mitch McConnell of Kentucky, the Senate minority leader. But the greater and more embarrassing defect is that the bill perpetuates the old subsidies for agriculture at a time when the prices that farmers are getting for big row crops like corn, soybeans and wheat have never been better. Net farm income is up 50 percent [56% in the past two years, per the WSJ&,mdash;though it is on the Editorial page, and therefore needs a to be taken with a five-pound bag of salt].

The legislation preserves an indefensible program of direct payments amounting to about $5 billion a year that flow in good times and bad. It raises support levels for wheat and soybeans, while adding several new crops to the list in a way that will make it easier for farmers to raid the federal Treasury even when prices go up.

And this is, to be certain, a farm bill that targets the richest of the rich. From the WSJ:

A bigger scam is the new income limit to qualify for subsidies. Mr. Bush sought a $200,000 annual income cap, but Congress can't bring itself to go below $750,000. Even that is a farce, because it doesn't include loan programs and disaster payments, and it allows spouses to qualify for payments too. The White House and liberal reformers calculate that farm owners with clever accountants can have incomes of up to $2.5 million and still get a taxpayer handout.

I know Senior Managing Directors at Bear Stearns who didn't make $750K a year, let alone $2.5 million.

It's a good thing we have Barack Obama to speak against the bill, and for the "little people" who have financed his "grass roots" campaign.

Huh? Oh, wait.

"I applaud the Senate's passage today of the Farm Bill, which will provide America's hard-working farmers and ranchers with more support and more predictability."

"The bill places greater resources into renewable energy and conservation. And, during this time of rising food prices, the Farm Bill provides an additional $10 billion for critical nutrition programs. I am also pleased that the bill includes my proposal to help thousands of African-American farmers get their discrimination claims reviewed under the Pigford settlement."

(in best Emily Litella voice) Never mind.

Labels: 2008, Economics, Politics

by Ken Houghton

Is Zubin Jelveh one of the economists advising Hillary Clinton, or was Tyler Cowen just giving him a pass?

If you're a married woman living in the New York City area, there's a better than 50 percent chance that you don't work, according to a recent analysis of Census data by economists affiliated with the St. Louis Federal Reserve Bank.

More specifically, only 49 percent of white high school-educated married women in their prime working ages were holding down jobs in the New York area as of the 2000 Census.

It was not until 6:04p.m.—eleven hours later—that "Cardinal Fang" noted:

What, so now only white women count as women?

Posted by: Cardinal Fang at May 9, 2008 6:04:19 PM

while Andrew Samwick perpetuates the meme.

I would have hoped that Felix would apologize that one of Portfolio's reporters swallowed this one whole, but it's been three days.

Labels: Economics, Statistics

by Ken Houghton

Thank you, Kathy G, guesting at Crooked Timber.

Now, if only she would point out the spillover effects of rent control.

Labels: Economics, minimum wage

by Ken Houghton

Dear Mark,

Please read him, since anne and I haven't been able to get through on this one.

best,

Ken

Labels: Economics, Economists View, Paul Krugman

by Tom Bozzo

The Capital e-Times has a remarkably wrong-headed editorial trying to take Rep. Paul Ryan, the GOPipsqueak whose district includes GM's Janesville assembly plant, to task over Ryan's support for various "free trade" agreements. The Janesville plant, which assembles GM's full-size SUVs, is losing a shift and 756 hourly manufacturing jobs thanks to free-falling sales of its output. Shouldn't Ryan get a clue on trade, the editorialist wonders?

(A clue might be a lot to ask of Ryan, whose greatest hits include a Social Security privatization plan which would have put the government on the hook for investment losses in the would-have-been private accounts.)

The obvious reply is that GM's Janesville employees wouldn't likely have been building full-size SUVs but for policies that allow petroleum to enter the U.S. freely and which have declined to establish serious tax incentives for conserving it.

One of the editorial's more curious claims is that Janesville's woes can be attributed in part to "[t]he federal government's conscious neglect of the basic tenets of industrial policy." What tenets might those be? If you ignore that destabilizing-the-Persian-Gulf business, the Bush Administration has been as openly friendly to motoring by gargantuan SUV as is imaginable.

However, the CT may be on to a meta-truth on the industrial policy front. Economics tends to describe production and consumption in highly abstracted terms ('Amalgamated Widgets' etc.), and it seems that's led to an indifference to if not maybe a touch of elite contempt for actually making things. You can see that when Chickenshit John McCain gallantly tells Rust Belt audiences that good jobs are gone forever, or in the more sophisticated version you get out of someone like McKinsey's Diana Farrell (here, from an NYT roundable with Stephen Roach and Josh Bivens):

MS. FARRELL -- This is a big deal in the sense that we see something structural happening. But I would react to the notion that it is a big deal we should try to stop or recognize as anything other than the economic process of change. I think the bigger deal is the fact that we are going to have very serious curtailment of the working age population.

[...]

MS. FARRELL -- There is an assumption by protectionists that these jobs are going somewhere else, and all this money has been pocketed by C.E.O.'s who take it home. A little more sophisticated version is: It's being pocketed by companies in the form of profits. [Which is to say, knowing what we do about the distribution of the ownership of the means of production, it largely goes to the CEOs or the CEOs' country club buddies. -- TB] One step further and you say those profits are either going to go as returns to the investors in those companies, or they're going to go into new investment by those companies. Those savings enable me, if I am an investor, to consume more and therefore contribute to job recreation, and if I am a company, to re-invest and create jobs. That's important because I agree that we are migrating jobs away, some of which will never return, nor should they.

This is pretty typical of the 'can't fight Mother Nature' neo-laissez-faire view of the economy, where outsourcing to China in search of a 20 percent unit cost decrease is treated as a matter of universal gravitation rather than human agency. I can also imagine a McKinseyite thinking that the knowledge work we're theoretically specializing in has brains and electrons as inputs, and money as outputs, and who wouldn't want that instead of dirty and tedious manufacturing work. Of course, it doesn't sound quite so good in the Krugman formulation of "selling each other houses... with money borrowed from the Chinese," and when talk turns to offshoring the knowledge work, the narrative would seem to have run away from its tellers.

One thing I'd noticed scanning the notice of proposed rulemaking on U.S. automobile fuel economy standards is that Congress did stick an industrial policy provision in the enabling law: domestic passenger cars are required to have an average fuel economy that's at 92% of the manufacturer's fleet average. So there's an allowance for larger (and hence less fuel-efficient) cars to be built domestically, but perhaps not so much that manufacturers could meet the standards simply by importing the more fuel-efficient ends of their product lines. We'll see how this works out in practice, but at this point the Detroit Three's manufacturing workers' biggest problem is less the outright collapse of the U.S. car market than that they're not screwing together the more marketable end of it.

Labels: Economics, free trade, Trains Planes and Automobiles

by Tom Bozzo

Rant time!

I write not to bury Hillary Clinton for joining Chickenshit [*] John McCain's Gas Tax Pandering Express [**], even though she's full of it and Barack Obama is on the side of the angels. Nor do I intend to put my Dean Baker hat on in saying that even this Washington Post debunking fails to note that Obama is right that the hypothetical maximum "gift" [***] to someone who drove 3,500 miles over three months at 20 MPG would be on the order of $30. The Economists for Obama have a nice graph showing why even this is wildly optimistic. Moreover, $30 is all but rounding error in the chickenshit 'economic stimulus' payments [****], which as bright a light as George W. Bush says is in part intended as compensation for high fuel prices. I'm also inclined to deny Hillary's grab for an additional populist point for being willing to tax oil companies to pay for the gas tax holiday, since we all know what the chance such a provision would have of passing a Republican filibuster in the Senate is.

Returning to yesterday's QOTD, a question for gas-tax repeal advocates would be whether they think gas prices are "too high" by only 18.4 cents. Even rolling prices back by $1 would only be to slow the rate with which particularly auto-exposed exurbanites are getting boiled in oil. I imagine that an enterprising reporter who asked Chickenshit John or HRC why we shouldn't be subsidizing gasoline would be told (correctly) that such a thing would be madness, but you can't derive that from the fuel-affordability rhetoric.

Also largely absent from the discussion, and highlighting its essential bogusness, is any mention of structural changes to the U.S. transportation system. The Obama campaign at least devotes a paragraph to the proposition that our transportation needs go beyond greener automobiles; that's one more than HRC. Chickenshit John, who you may recall recently gained plaudits from the press for ditching his wife's jet for the Acela Express, is a famous campaigner against operating subsidies for passenger rail — subsidies which, thanks to the external costs of the alternatives, actually can make more than a little economic sense.

Substantially rebuilding the transportation system requires a lot of time and money (plus maybe some NIMBY arm-twisting), putting the project in need of early and strong political support. (The money, at least, could be obtained largely by ending the most useless parts of the DAMN WAR.) Trying to counteract the price signal that's telling us that we should reconsider the easy motoring lifestyle is worse than doing nothing.


[*] Certain elements of the left blogiverse have taken to calling McCain "Saint John" after the candidate's inability to do wrong in the eyes of the Washington press corps. Irony is dead, people! Gail Collins, who's been pretty good on the subject of late, writes:

[McCain] is fearless when it comes to delivering unpleasant news to people who are probably not going to vote for him anyway.

No reason not to say what we really think, eh?

[**] Making members of the Pigovian Tax Club cry since April, 2008!

[***] I.e., assuming the full incidence of the gas tax is on consumers and not, at least in part,
on producers and/or distributors.

[****] As Grampa Simpson might say, I didn't ask for it, don't need it, but gimme gimme gimme!

Labels: Economics, Energy, Vituperation

by Tom Bozzo

Michael O'Hare:

The ease with which politicians say "gas prices are too high" combines their cowardice (or cynicism and irresponsibility, or maybe just ignorance) with a widespread confusion of price with cost in the public mind... The distinction is no piece of technical arcana, but one of the most fundamental keys to getting policy right, and in this case, a very big batch of policy with enormous consequences. If you don't understand the difference, you do what Hugo Sanchez Chavez does and suppress the price by enormous public subsidies. Unfortunately, the cost of anything is quite independent of what we want it to be, or the price at which it is offered, because cost a reality sort of thing, the value of the economic resources consumed in providing it... If you lie about the cost of gasoline, or anything, by offering it for sale at an arbitrary price, the cost doesn't change, but the behavior of everyone gets crazy with very bad consequences.

(A related rant may be forthcoming, assuming I have time to write it later.)

Labels: Economics, Energy

by Ken Houghton

I'm buried right now, even without working for direct pay, but want to make certain this gets mentioned.

Mark Duggan and Fiona Scott Morton have an NBER paper (#13917; gated link here*) examining the results of the first year of Medicare Part D. To no one's great surprise, they find that it wastes a lot of money compared to direct government purchases that it works well for the most common drugs,* not well at all for the "protected" class of drugs (basically expensive cancer/AIDS treatment that have few rivals and are therefore all required to be carried by Part D providers), whose prices may have increased by their inclusion.

But what is most (generally) interesting is the list of most common drugs prescribed under Part D:

Lipitor, Zocor, Prevacid, Nexium, Zoloft, Epogen, Celebrex, Zyprexa, Neurontin, Procrit, Effexor, Advair, Paxil, Norvasc, Pravachol, Plavix, Allegra, Wellbutrin, Oxycontin, Fosamax, Vioxx, Singulair, Protonix, Actos, Ortho, Aciphex

That's right; "hillbilly heroin" is #19 on the IMS Health list of prescribed drugs under Part D.

*If anyone finds a non-gated version, feel free to ref it in comments and I'll add it. (Tom, just edit appropriately if you find one.)

**Duggan and Scott Morton do note that "If a price is suboptimally high, there can be over-utilization of the treatment, with physicians and other health care providers potentially inducing the demand of consumers," but appear to assume that is not the case here.

Labels: Bushonomics, Economics, Health Care

by Ken Houghton

Note the progression here:

The essential story there was one of hard-science arrogance: Forrester, an eminent professor of engineering, decided to try his hand at economics, and basically said, “I’m going to do economics with equations! And run them on a computer! I’m sure those stupid economists have never thought of that!” And he didn’t walk over to the east side of campus to ask whether, in fact, any economists ever had thought of that, and what they had learned. (Economists tend to do the same thing to sociologists and political scientists. The general rule to remember is that if some discipline seems less developed than your own, it’s probably not because the researchers aren’t as smart as you are, it’s because the subject is harder.) [italic his; emphasis mine]

Labels: Economics, Social Science

by Ken Houghton

My favorite paper from this year's AEA is now available from NBER (gated; non-gated copy available here).

Also noted, the prepared text for the most interesting presentation (most interesting, to some extent, from the non-prepared text at the beginning) was the lead article in the current issue of Post-Autistic Real World Economics Review (not clearly available on the website; PDF available here; AEA version here).

More later, which probably means the middle of next week.

Labels: Bushonomics, Economic Development, Economics

by Tom Bozzo

Were it not for D-squared, I'd have to wonder how Xavier Gabaix and Augustin Landier managed to get published in the QJE and not the American Enterprise Institute working paper series. So it's maybe more a matter of a disappointing reminder that the peer-review system is the worst one apart from all the rest than a call to the barricades to see the NYT maintain its death spiral in part by telling me that Gabaix is shilling his and Landier's dubious little result on executive pay in the AEI house organ (without notifying me that it is the AEI house organ we're talking about).

The verdict from two years ago was that they derived some mildly interesting results from fantasy premises, starting with the idea that the CEO labor market is frictionless and neoclassical. From some perspectives on economics research methods — and sometimes to the annoyance of economics critics — that can be a feature and not a bug; it's a common research method to characterize how far reality departs from such flights of fancy. The problem here is that even The American's Laura Vanderkam can't help but recount a variety of gross features of executive pay (the heads-I-win, tails-you-lose arrangements, the divergence in compensation between the executive ranks and everyone else, the non-observability of talent, the factoid that investor willingness to pay more money for a dollar of earnings is a major driver of recent market cap increases) that are puzzles for if not grossly inconsistent with a model of a frictionless CEO labor market.

Anyway, the Davies model seems to me to be a rounder peg for this particular hole: economists of a couple generations ago did their duty by providing a plausible explanation why corporate executives were underpaid, certain frictions in the system did their bit, and belatedly-discovered holes in the theory have been non-neoclassically slow to be plugged.

Labels: Economics, The New Gilded Age

by Tom Bozzo

Peak Oil goes to Russia. Hey, and I was pretty close to $2/day in fuel savings from the bike commute as things stood.

As a microeconomist, I'm perhaps less inclined than some you'll read to wring my hands over the Fed's possible softness on commodity-price inflation. We occasionally get the notion that increasing prices for some goods should be interpreted as a signal to consume substitutes in greater quantities. You might indeed wonder if trying to reduce the price of oil through means that involve throwing millions of people out of work is a worthwhile Fed initiative.

Labels: Economics, Energy

by Tom Bozzo

If someone wanted to make the argument to me that the CES Net Birth/Death Model is more trouble than it's worth, today would be a good day to do so.

The U.S. employment report for March, as most of you probably know, stank. But it would have stank more but for this model, which estimated that there were an additional 28,000 jobs in the construction sector, 7,000 in manufacturing, and 6,000 in financial activities jobs. I don't think so.

One of the things that keeps applied economists busy is figuring out whether Sophistimacated Methods are better than simpler ones. In this case the model seems to perform worst exactly at the turns in the business cycle when you'd think policy-makers would want the most accurate reading on employment changes, which is not a great recommendation.

Labels: Economics, labor

by Ken Houghton

UPDATE: Well, that was quick. A Bailout is a Bailout, No Matter How Small.

UPDATE II (via Dr. Black): There is a reason to renegotiate the contract from the JPMC side, but it should hardly be worth 4x the price of the firm, unless the stuff really is pure shite. Which would make this a true textbook case of Moral Hazard. Anyone taking bets whether Mankiw or Varian or any of the other intro or intermediate texts ever cites it? UPDATE V: John Carney gives the lie to that claim.

UPDATE III: The pity party thrown last week by the WSJ for Bear's senior, er, management appears to have omitted some data:

Insiders at Bear sold a total of 715,000 shares last year worth more than $75 million, up from 2006 but down considerably from 2004, when sales of more than 1.5 million shares worth $147.9 million took place, the data show.
Since 2000, Cayne has sold 2.37 million shares worth about $182.7 million, while Schwartz has sold more than one million shares for roughly $67.2 million.

UPDATE IV: And it becomes official:

JPMorgan Chase & Co. (NYSE: JPM) and The Bear Stearns Companies Inc. (NYSE: BSC) announced an amended merger agreement regarding JPMorgan Chase's acquisition of Bear Stearns.



Under the revised terms, each share of Bear Stearns common stock would be exchanged for 0.21753 shares of JPMorgan Chase common stock (up from 0.05473 shares), reflecting an implied value of approximately $10 per share of Bear Stearns common stock based on the closing price of JPMorgan Chase common stock on the New York Stock Exchange on March 20, 2008.

The Old Firm is projected to open trading today between 9.87 and 9.88 per share. Since its current takeover offer is slightly over $2/share ($2.41 last I looked, based on the then-current JPMChase price), and it was around $6.39 Thursday night, there is clearly a different type of Resurrection on the market's mind.

If the market turns out to be correct, then[It was; see Updates above] I will change my mind and agree with Tom and Cactus that the actions last weekend were a bail-out, even if the Fed didn't intend them to be.

Until then, the severance offer* alone strongly suggests that most of the employees will vote their shares in favor of the takeover.

*Three weeks per year of service for the first five years, two weeks for each year after that, and last year's bonus paid for this year. This is only slightly worse** than what the people who were severed in November got.

**November was three weeks per year, regardless of service time.

Labels: Economics, FRBOperations, Moral Hazard, teaching, The Old Firm

by Ken Houghton

First she caught Tyler Cowen (and, through him, Brad DeLong's) attention with this paper (NBER; gated).

Today, Ben Muse looks two papers earlier and finds "The Economic Value of Teeth."

I haven't seen anyone go four papers forward to discuss this one yet, but I haven't hit the Health Care blogs yet today.

Labels: Economics, education, Health Care

by Ken Houghton

A marvelous post from Andrew at Statistical Modeling etc. which evolves in the comments into a discussion of Willingness to Pay (WTP) vs. QALYs.

For some reason, economists seems to prefer the former to the latter. Which is strange, because it is intuitively easier to build a realistic Health Economics model using QALYs and treating insurance premia as an investment than the current standard of treating insurance premia as a "sunk cost" and declaring Moral Hazard at all turns.

Labels: Economics, Health Care, QALYs, Statistics

by Ken Houghton

In comments at DeLongville, save_the_rustbelt notes:

The University of California at Berkeley has accumulated a $1.1-billion “war chest” to fend off Ivy League poachers, the Bloomberg news service reported today.

Berkeley administrators hope the money, which will go toward endowed chairs for 100 professors, will dissuade faculty members from defecting to wealthier competitors like Harvard and Yale, where salary offers are significantly higher.

For the 2006 fiscal year, full professors at Berkeley earned an average of $134,672 and associate professors $88,576 — about 15 percent less than peers at private institutions. And, since 2003, the California university has lost at least 30 faculty members to its eight main competitors, chief among them Harvard.

This appears to be in reaction to rumors summarized concisely by David Warsh a few weeks ago:

Private universities raise tuitions at will and keep enrollments small while public universities, constrained by legislatures, must keep fees down while increasing their enrollments.

Something of a test of the balance of power may come this spring at the University of California at Berkeley, where professors in the economics department, one of the top half-dozen in the nation, are targets of ten outside offers. Every spring departments all over the country seek to improve their standing by hiring from their rivals, a little like free agent season in big league sports. Bids are always out. But the suspense at Berkeley this year is unusually intense.

Development economist Chang-Tai Hsieh already has preferred an offer from the Graduate School of Business at the University of Chicago to one from Stanford. Other targets of multiple offers include applied microeconomist David Card, a [John Bates] Clark medalist who is a department unto himself; husband-and-wife macroeconomists Christina and David Romer; growth economist Charles Jones; public finance specialist Raj Chetty; not to mention several members of Berkeley’s remarkable junior faculty, led by wunderkind theorist Yuliy Sannikoff and international economist Pierre-Olivier Gourinchas. Meanwhile, star information economist Hal Varian has gone off to be chief economist for Google (to whom he consulted for many years, growing wealthy from his options grants), and Nobel laureate George Akerlof, a youthful presence in Evans Hall, is retiring.

Akerlof turns 68 this year. Varian got a once-in-a-lifetime opportunity (and got rich from the options he had received before; maybe not Mankiw-rich, but rich enough). Card (Class of 1950) and Christina Romer (Class of 1957) already have endowed chairs, as does David Romer (Herman Royer Professor of Political Economy).

On the other hand, Chetty is an Associate Professor and is on leave, as are Professor Jones and Assistant Professor Sannikov. Gournichas is an Assistant Professor, a rung lower than Chetty.

And the institution will still have a host of riches:

Its behavioral economists are led by Nobel laureate Daniel McFadden, Oliver Williamson and Clark Medalist Matthew Rabin. The presence of Joseph Farrell, Michael Katz, Enrico Moretti, Daniel Rubinfeld and Carl Shapiro give it a lock on a certain kind of applied industrial organization. Maurice Obstfeld, Alan Auerbach, J. Bradford DeLong and Emmanuel Saez assure that Berkeley macroeconomics won’t wink out altogether.

Only after bemoaning all of this does Warsh note that UC-Berkeley isn't exactly just being taken in this roundelay:

The department has its own offers out, too, naturally, including one to James Hines of the University of Michigan. What Berkeley economics desperately needs is a faculty entrepreneur to serve as department chair, someone to wheel and deal for it the way John Dunlop did for Harvard economics in the 1960s. But the next chair has yet to be chosen.

There are some things Warsh seems to get wrong. His overall frame suggests that UCLA, not the obvious choice, would [have] supplant[ed] Berkeley before that $1.1 Billion came in. And the mere fact that Cal can raise a $1.1B "war chest" strongly suggests that its not exactly going to be the loser in these battles.

The losers are going to be the "land-grant schools," such as Minnesota, and the other schools whose budgets are being slashed and that don't have access to the type of war chest that Cal does.

But David Warsh won't write about those, and they'll only raise large sums of money if it's for a new football stadium.

Maybe I should change the title of this post.

Labels: Economics, education, Rutgers

by Tom Bozzo

Yves Smith finds Wolfgang Münchau of Eurointelligence wondering if U.S. official statistics massively understate inflation. Münchau buries his lede:

There is a website called Shadow Government Statistics, for whose accuracy I cannot vouch, which claims that the pre-Clinton era inflation index shows current inflation at close to 8%, while opposed official CPI inflation is only half that level. [link in original]

Let's forget for the moment about the accuracy of SGS. (Münchau is suspicious that the alternative inflation series is just an upward shift of the official series.) What of their methodology?

SGS's primer on CPI focuses on the supposed evils of accounting for substitution of goods in CPI, versus the supposedly "simple and straightforward concept" of measuring price changes using a fixed basket of goods, and to a lesser extent quality adjustments of price changes, or "hedonics." This is not promising. Why takes some explanation, so bear with me (I'd have installed a jump, but that's bloggered for the moment).

To set some bounds here, I'm not going to discuss the tendencies of policymakers to (sometimes) over-focus on "core" CPI (stripping out major expenditure categories) versus headline CPI. I sometimes sympathize with the inflation-ex-inflation crowd and sometimes don't. Nor will I get much into actual or incipient injustices in how CPI statistics are applied in the real world; count me as opposed, for instance, to indexing Social Security initial benefit levels to prices instead of wages.

With that out of the way, it has to be recognized that there is a fair amount of sausage-making in the compilation of statistics like CPI, but a great deal of it occurs because the "simple and straightforward" is not so easy in practice.

Take the idea of measuring price changes with the same basket of goods over long periods of time. This would be fine up to a point if all people consumed were commodities that are marketed in essentially the same form over long periods of time, but that just ain't so. If I were to make a comparison of prices between now and, say, 1980, how do I account for things in my field of vision (MacBook Pro, iPhone, organic blue corn tortilla chips, no-iron dress shirts, Gillette Fusion Power razor) that weren't marketed back then? How do you deal with existence of products called the "Chevrolet Monte Carlo" (our family car in 1980) existing in both periods but not being the same thing? The unavailabilty now of gasoline with added tetraethyl lead? Not so simple now, eh?

Yves picks up the substitution theme and puts the objection more succinctly than SGS:

What did the Boskin Commission think was out of line? According to Wikipedia:

The report highlighted four sources of possible bias:

Substitution bias occurs because a fixed market basket fails to reflect the fact that consumers substitute relatively less for more expensive goods when relative prices change.

Outlet substitution bias occurs when shifts to lower price outlets are not properly handled.

Quality change bias occurs when improvements in the quality of products, such as greater energy efficiency or less need for repair, are measured inaccurately or not at all.

New product bias occurs when new products are not introduced in the market basket, or included only with a long lag.

So the Boskin report would have us believe that if I switch from steak to hamburger because beef prices are up, we should only capture the change in how I consume (ie, inflation is new hamburger/old steak price, not new steak/old steak). That is patently bogus. Similarly, the outlet substitution seems rife for abuse ("Ooh, the number is going to be really bad this month! Can we find anywhere selling X cheaper so we can put that in the model instead?").

To give Yves some credit, we could have a deep philosophical discussion of what constitutes inflation. Some simple macroeconomic models avoid the question by positing a composite consumption good whose price change is trivially inflation. In reality, there is an enormous menu of goods whose prices change in different directions and magnitudes, and not all of those changes represent macro inflation (or deflation) phenomena. Otherwise, she's on shaky ground at best.

I'm an economist, so my inclination is to consider inflation in terms of the price of maintaining a level of welfare. This is not the same as maintaining consumption of any given set of goods. One thing people should get from such economics training as they may have (but often don't) is that no pattern of consumption is uniquely privileged. Usually, failures to recognize that (e.g., "Americans will never get out of their hulking SUVs") confuse preferences ("more of everything!") with the realities of choices under expenditure constraints, or the inability to remember that demand curves for consumer goods generally do slope downwards.

Yves and SGS both commit a foul by blaming the substitution bias concept on Boskin (and, at SGS, Greenspan) and implying that taking into account substitutions necessarily ratifies a lower standard of living. In fact, the substitution falls out of elementary economics of consumer choice and there's no reason why CPI changes incorporating substituion need imply a reduction in living standards.

Suppose there are only two goods in the economy, let's say chicken and beef, and a representative utility-maximizing consumer chooses to buy two pounds of each given today's prices and budget B0, giving the consumer utility of U0. Then the price of beef increases, while the price of chicken and the budget stay the same. The consumer can no longer afford to buy two pounds of each; instead, consumption of beef will fall, consmption of chicken will rise relative to beef (maybe, or maybe not, in absolute terms), and the consumer will get a lower level of utility U1.

Now let's say that we want to calculate an inflation index for this situation. One approach — my preference, from above — is to figure out by how much the consumer's budget would need to be expanded (to B1) to get back to utility U0. This amount, by definition, could not be said to make the consumer worse off. The candidate inflation measure here is (B1/B0)-1. What we can say about this amount of money is that (1) with it, the consumer still will buy more chicken relative to beef, and (2) the consumer will not be able to afford the original two pounds of each. In accord with my welfare-centric concept from above, this preserves the original welfare level here, not the consumption levels. As far as calculating a hypothetical CPI consistent with this concept, to get an equivalent of (B1/B0)-1 from the price changes, we have to change the weights on chicken and beef.

(Added in response to Ken's comment.) This is shown graphically below — this is cut-and-pasted from Deaton and Muellbauer's Economics and Consumer Behavior (Cambridge, 1980).

The original equilibrium is at point A (on indifference curve U0), then moves to B when the price of beef (q1) increases. The new equilibrium with compensation to return to U0 is at point C; note that A is outside the associated budget constraint leading to C (dashed line). The graphical representation of pushing the new-price budget constraint back through A is left as an exercise for the reader.

It follows that we'd need to add even more money (to B2>B1) to the previous scenario for the consumer to again be able to afford the original two pounds of both chicken and beef. Obviously, (B2/B0)-1 will give a higher "inflation" measure. What would happen if the consumer had B2 to spend? Put simply, the consumer wouldn't choose the original mix of two pounds each of chicken and beef. At the higher price of beef, the last bites don't provide marginal utility (!) in excess of the price, and the consumer still will consume relatively more chicken. The consumer will also get more utility, U2, than U0 from the re-optimized choice.

I'm not opposed in principle to making people better off, but if the goal of an inflation measure is to tell us what people need to be made whole given some set of price changes, then this measure overshoots its goal. In any case, far from being "patently bogus," reweighting of the price changes is necessary to properly capture the welfare consequences of price changes for h. economicus. I grant that H. sapiens may think that change is bad per se and thus be made (at least temporarily) unhappy, but whether (let alone how much) to compensate people for that is no simple matter.

Outlet substitution is more straightforward. Partly there's a technical issue regarding how changes in points of purchase are incorporated in CPI, the upshot of which is that to the extent consumers do switch to lower-price outlets, CPI doesn't reflect the savings (see here). Unreality can't be claimed here, since real consumers actually search for low-price outlets for the goods they purchase, at least to some extent. But "hey, let's look for a low-priced outlet to deliver sufficiently low CPI" isn't how the measurement is done.

SGS takes on the quality bias issue, misrepresenting how the "hedonic" quality adjustments work:

Hedonics adjusts the prices of goods for the increased pleasure the consumer derives from them. That new washing machine you bought did not cost you 20% more than it would have cost you last year, because you got an offsetting 20% increase in the pleasure you derive from pushing its new electronic control buttons instead of turning that old noisy dial, according to the BLS.

The notion that the quality improvements directly offset — or, in the case of goods like computers with rapidly improving quantitative specs, even proportionally offset — price increases is simply wrong. If anything, some of the adjustments could be said to be conservative.

For instance, as I'd noted back in '05, my then-new computer's specs were in the ballpark of 20x or more better than those of one of its predecessors, while the corresponding deflation factor over roughly a decade was only 10x. A remaining objection is that someone who bought a $3,000 computer 10 years ago isn't buying a $300 computer now. But, conversely, the $3000 computer of 10 years ago probably isn't marketable for $300 now, even in mint condition.

A better objection, to which there may even be some substance, is that quality adjustments are unevenly applied, and in particular are less likely to be applied to areas of quality deterioration (say, air travel). I don't happen to think that an outbreak of quality deterioration fairly characterizes personal consumption as a whole, though.

In summary, then, there's no reason to think that bringing CPI methods back to the dark ages would conceptually improve CPI as an inflation measure. Nostalgia for those methods is misplaced.

Labels: Economics, Inflation

by Ken Houghton

Paul Krugman expands the, er, Foundation of economics with an analysis of trade between Earth and Trantor.

Labels: Economics, free trade, sf