The Filter^

The First Law of Demand

In Russell Roberts' excellent essay on why incentives matter, he repeats an important economic assumption that I think is often misunderstood: people are self-interested.

There's various equivilent ways to make this point:

• People respond to incentives
• People are self-interested
• People are purposeful
• People are rational
• Demand curves slope downwards

But note that people are selfish, and people only care about money are not on the list.

A decent micro course will make it clear that the first law of demand doesn't imply that people always respond to price changes, just that there is a possible price change that will create a change in behaviour. This point isn't controversial by-and-large, and pretty much everyone acknowledges that prices and quantity demanded are inversely related. But there are extreme conditions which people (typically anti-theorists) believe undermine this claim, and I think they can be put into three categories:

1. Is there a little whore in all of us? When Kerry Packer was bidding for the voting rights to screen ICC Cricket, he famously said "There's a little whore in all of us gentlemen, name your price". I do think that this is a valid assumption to make about human behaviour, and the typical criticism isn't that it's innacurate, it's that it is regrettable. Non-economists might accept that in practice people do respond to incentives, but such incentives illicit socially harmful outcomes. I don't see it this way, because the assumption is simply saying that people will be at the table and since this will always expand the menu of choices, it's a Pareto Gain. If someone inherits their mothers house, they might claim that it has infinite value to them. The self-interest assumption says that there is a price at which they'd sell it. Why? Because the consumer has many competing preferences, and in a world of scarcity we make trade offs. Hence selling the house - at the right price - might make enough money to pay for the kids to go to university. Suddenly it's not a choice between mum's old house vs. not mum's old house; it's the house vs. an education. Regardless of whether it's sold or not (quite possibly it's value is so very high there isn't an amount of alternative goods that can bid it away), surely it's selfish not to consider selling? If there's the slightest shred of altruisim within your own preferences, there must be a possible price that would get you to sell. If it's a choice between selling Grandma or a cure for cancer, who's the selfish person? The one who refuses to sell Grandma, or the one who sells her and invests the money into finding a cure for cancer? All we're saying is that people will come to the table: nothing is off limits, we're all open to negotiation. And therefore this is welfare-enhancing, by expaning our menu of choice.
2. Luxury Goods A common response is that if prices signal quality, a luxury brand would fear that a reduction in price would signal a reduction in quality, and therefore create a fall in quantity demanded. This seems intuitively plausible, but does it undermine the first law of demand? No, because it confuses a change in demand, with a change in quantity demanded. If a company drastically alters it's reputation, it's created a different product. The first law of demand (as represented on a demand curve) applies to the relationship between price and quantity demanded, for a given product. Therefore any other events (any non-price events) are exogenous, and represent a shift in the curve. Even if demand for Skodas has risen, and prices for Skodas has risen, both of these stem from a shift in the demand curve, and not a movement along it. It's possible that the quality of a Skoda has remained constant throughout (but it's worth considering whether this is likely, and if not why not) and the rise in demand is purely due to a price hike and it's corresponsing quality signal. But this is an abstract point, and rests on an assumption that price is used as an accurate indication of quality. If the consumer knows the quality of the product, there's no reason why a rise in price would lead to a rise in quantity demanded. For any given Skoda, if the price falls you're more likely to wish to buy one. For Skoda cars as a whole, an increase in price might alter the type of product it is, under certain conditions of asymmetric information. But this simply means that tastes have changed, and therefore the curve has shifted.
   
3. Giffen Goods It's easy to bat away charges of "Giffen goods" by appealing to (non-existent) evidence, but the theoretical point is straightforward. A "Giffen good" is, by definition, a good where the income effect dominates the substitution effect. In other words it constitutes so much of your shopping basket that price changes have a large effect on your real income. So if it's highly "inferior" (i.e. demand falls as income rises) a fall in price can induce a rise in quantity demanded. But again this violates the cetetris paribus condition, since changes in real income are an exogenous factor. If price changes occur simulatenously with a change in real income, the demand curve will shift. And if it shifts, the self-interest assumption hasn't been violated.

So all three of these theoretical objections to the law of demand fail to hold, and I think there are two reasons why students/professors remain confused:

1. A misunderstanding of the nature of theory A theoretical premise is not refutable by evidence - it can only be refuted by better theory. Therefore if we define a normal good as one where demand rises if income rises, and then label coffee a normal good, evidence (hypothetical or otherwise) that a rise in income leads to a fall in demand for coffee is irrelevent. In that case, coffee isn't a normal good. It doesn't mean that normal goods don't exist. Consider the three primary colours of red, blue and yellow. In real life we never see these three colours on their own, since we're always viewing some combination of them all. Evidence of a green object doesn't mean that blue and yellow don't exist, it just means they're not always observable and fixed.
2. Confusion between prices and revenues A firm isn't interested in charging as high a price as possible - revenues are what matters. A simple monopolist's cost structure will show that even if he had enough market power to triple his price, this would lead to an increase in costs and probably reduce profits. Therefore it's wrong to apply the laws of demand to firm behaviour, because the laws of demand focus on how consumers respond to prices. However firms don't care about prices, only revenue (and how revenue and cost correspond to generate profit). In fact, it's likely that a monopolist would increase profit by lowering prices (depending on the elasticity of the demand curves).
   

Fairtrade Update

The problem with Fairtrade is that it's nuanced - and at times hard to seperate the economic logic concerning cause-and-effect with the political intentions that underpin it. As I've said many times before, I'm suspicious of Fairtrade. I've just bought some "Good African Coffee", since I was enticed by their rhetoric and intrigued by their alternative model to Fairtrade. Reading through this Guardian article I can't decide whether the Fairtrade movement should see Good African as friends or foe. A recent Economist article points out the diversity of coffee underlining that Fairtrade vs. non-Fairtrade is an articficial, unhelpful distinction:

“It's a matter of finding the right market for each bean,” says Mr Pollock.

Throughout this more evidence on Fairtrade certification is emerging, as Colleen Berndt now has a few working papers based on her fieldwork (with Clark Durant), visit her research page and find out why the rise of Starbucks coincided with the end of Communism.

My biggest concern is that the Fairtrade movement will move onto a new policy proposal before the dust has settled on this issue. The emerging evidence does seem to corroborate the theoretical problems outlined by Fairtrade critics, but I fear that no-one is listening (where they ever?).

This might not ring any bells for British readers, but in 2004 the US media was obsessed with offshoring (recollect John Kerry's comments on "Benedict Arnold's"), making it one of the key Presidential issues. What's happened since? This Philadelphia Enquirier article takes a look...

Listen to Scott Kirwin, who made a return appearance in December to Wired magazine. Things have changed. He shut down his anti-offshoring Web site in 2006 and has since found himself a better job in the software business. "I don't view outsourcing as the big threat it was," he told the magazine. "In the end, America may be stronger for it."

For every worker who loses their job due to globalisation, a condition of their story being told should be a commitment to follow their attempts to find new work. The initial, short term effects are unfortunate but known - it is their lasting prosperity that matters, and our collective amnesia is telling. Similarly for every coffee farmer thrust into the media spotlight due to the advantages of Fairtrade, we should follow their story. I'm neither a journalist nor a specialist, so I won't be able to contribute, but I'd like to challenge those journalists and specialists on Fairtrade, and on the many other aspects of globalisation: follow the story. Give us case studies that aren't (literally) static snapshots, but evolving narratives. Only then can theory and evidence resolve these debates.

Direct Democracy

Chris Dillow has been interviewed by Never Trust a Hippy on the subject of Direct Democracy, here. It's an intelligent, fascinating conversation and Chris takes it as an opportunity to draw together and emphasise a broad swathe of his past articles on the topic. For the record, I'm very much looking forward to his upcoming book, and expect it to be as insightful and scholarly as any academic equivilent. I enjoy Chris' posts so much I tried to remember what - if anything - I disagree with him about. It has to come down to property and this post is all I can recollect on the matter.

Two points on DD

• Tullock's idea: tune into C-Span and vote with our remote
• Experts and the public converge even on trashy TV (i.e. Pop Idol might be the death of entertainment, but the best singer tends to win)

Update: Chris sensibly points out the difference between extremism and fanaticism.

Room To Let, SW1A

So Prince Harry's off to Iraq. Jolly good. You're not a real man - and certainly not a real royal - until you've had a pot shot at some natives in a desert somewhere. I wonder if the legendary boozer will be taking some of the hard stuff with him? I should jolly well hope so - how's a chap to endure that rotten country without a fine single malt for company (or in Harry's case, a juice-based King's Road cocktail)?

What's got me worried though is Hazza's pad. Now I'm not up with currrent royal living arrangements (which of the three major London palaces does Harry like to stay in when he's not in his barracks, and does he have an additional Chelsea pad to boot?), but I wouldn't mind betting our ginger-ninja will be leaving some significant real-estate vacant during his campaign.

One of the most blindingly stupid, indefatigably incongruous and unfailingly rage-inducing phrases used by the armed forces when describing the conflict in Iraq is 'the battle for hearts and minds'. It's a 'new labour' term for post-invasion supression and control. You can't imagine Hilter using it, can you? "Herr Goering, how's the old the battle for hearts and minds going?' 'Well, Herr Hitler, as soon as we finished the blitzkreig we tried to start a game of footy with some Warsaw jews in the burnt-out shell of their cultural centre, but they just didn't seem to warm to us...something about not playing fair'.

So now that Harry's left behind a few king-sized (or, rather, heir-sized) beds and the odd en-suite, what better way to ingratiate the hearts and minds of the Iraqi people than to initiate some sort of cultural exchange. There must be dozens of families made homeless by the conflict who would be happy to sleep in just one of Harry's bedrooms. And what's more, we can open a genuine dialogue and explore the cultural parallels between our two lands. 'A mad, self-deluded bunch, struggling for power in a crumbling country, fighting amongst each other, speaking out-of-turn on matters about which they know nothing, pouring inordinate amounts of money down the drain and living it up in gaudy, kitsch palaces', the Iraqi's would say to themselves, 'it's not that much different to home after all.' 

Policy: Windows and Doors

This weeks Economics Focus:

a careful reading of this report [the OECD's "Going for Growth"] would give an opportunistic reformer plenty of hints, tips and tricks. It offers a guide to the subtle art of making possible what is necessary.

But when are the appropriate moments for policy reform? It alludes to traditional Public Choice when it says that:

The report's most disheartening conclusion is that reform must often wait for the sting of a crisis.

In the second part of my dissertation I tie these situations into Bruce Ackerman's concept of "constitutional moments", but I point out the limitations of Public Choice. In the words of Mancur Olson (who originated the view that reform follows crisis),

"So it appears that a balance of power or stalemate among the organised interests can leave an opening for new ideas When the different organised powers or interests more or less offset one another, ideas may make a big difference” (Olson 1989:46).

In other words ideas can create policy windows, and I identify several possible ways (this is a hybrid of Ashford (1997) and Gamble (1989)):

1. ideas can create policy that switches people from one interest group to another. When Margaret Thatcher sold off council houses to residents, she was giving the relatively poor a stake in the economic prosperity she hoped to stimulate. As homeowners, a great number of voters suddenly had a stake in the monetary policy that the Conservatives were using. Privatization is a similar means to align people’s interests to liberal ideas, and reducing the barriers to entrepreneurship will also increase support for market reforms.
2. ideas can redefine an interest via education, “For instance, someone’s belief that it is in their interest to support any party that promises to preserve the NHS [National Health Service] may depend upon their belief that if there were not an NHS, they would be unable to afford medical care, that even if they could afford it, the quality of the care would be poor, and so on. But these beliefs reflect ideas, and if those ideas were changed the beliefs would be undermined and we would expect to observe a change in political allegiance” (Melnyk 1989:124). Consequently the art of persuasion is an important factor in defining interests and deciding the policies that people support. A strong intellectual argument is enough to switch policy if it convinces someone that a causal belief they’d held is incorrect.
3. policy entrepreneurs can identify new interests and pit them against entrenched ones. These may be existing groups that were not aware of particular policy, or those who’d gain from the new policy idea. This method explains why politicians like to leak legislation prior to crucial voting, to see how public opinion responds, and whether future beneficiaries emerge to support the bill.
4. any pressure group requires popular legitimacy and so attempts to undermine their claims can harm their efforts. The Common Agricultural Policy (CAP) rests on the popularity of self-sufficient farming, and the perceived importance of national agriculture. With the increase in globalization, and attention to farmers in developing countries who can’t compete with EU subsidies, this legitimacy becomes weakened and the moral case for free trade has potential to undermine the entrenched interests.
5. economic ideas can create new policy tools that restrict the power entrenched groups have over the legislature. According to Ashford (1997): “The pursuit of antiinflation strategy that depended on the money supply, which was within the control of the government, reduced that dependency relationship and thus the power of the unions"

"Constitutional Moments and Subjectivist Public Choice: From Chandeliers to Fireworks" download here.pdf

New Opera Productions 2006

I've uploaded my personal rankings for all the major new opera productions of 2006 on the review page - click here for the rundown. This doesn't include revivals - of which there were some spectacular examples last year - just new productions. As it is, many of these are bound to be revived themselves, or purchased by other companies.

The Oliviers

With a slightly sore head and a day's annual leave, I've made it to a computer to report on last night's gongfest at the Grosvenor House: the 2007 Laurence Olivier Awards. Some Filter^ readers might know that I managed to blag my way onto the opera panel for the 2007 awards, and last night was the culmination - for the opera panel - of a year of performances which we considered for Best New Opera Production, and thousands of creatives who were elegible for the Outstanding Achievement in Opera award.

In contrast to the frippery of this 'Saturday Supplement' style post, tomorrrow I hope to upload my personal ranking of every new opera production I saw last year on The Filter^ Review, starting with the best, and ending with the worst (and yes, there were some real turkeys in there!) As for the reality, English National Opera picked up Best New Opera Production for Janacek's Jenufa, with the Outstanding Achievement statuette going to Amanda Roocroft for her performance in the title role of the same opera. Deserved, yes, but the voting system dictates that these might not have been everyone's first chioce: around a table in January, the five panelists decided on four 'nominees' in each category without the aid of any system save the back of an envelope and a biro. But we then ranked each nominee first, second, third and fourth in secret according to personal preference, which results in something of a 'happy medium' winner.

An unexpected surprise last night was that the Society's [of London Theatre] Special Award went to an opera great, John Tomlinson, whom I had worked relatively hard to get nominated for Oustanding Achievement in Opera for his role as Hagen in the Royal Opera's Gotterdammerung (Wagner). This award can go to anyone in theatre, and that it went to such a talented opera singer was very gratifying. Other big winners were Sunday in the Park with George (Sondheim, Oustanding Musical Production and a confection of other awards), and the wonderful Tamsin Greig (Best Actress for Much Ado about Nothing, RSC).

All four nominees in each opera category were productions or people whom I considered to be of total class, because there were a lot of contrasting views amongst the panelists, most of whom were hugely more experienced than me. But if I'm honest, I'd have been delighted if ENO's Orfeo (Monteverdi) or Opera North's Peter Grimes (Britten) had pipped Jenufa - these were two performances that achieved something unspeakable from beginning to end, productions that make you forget where you live and what your name is (and suggest a lack of desire to remember such minor details).

I'll resist the temptation to thank lots of people for the experience of being a panelist (oh shut up, you weren't there as a performer and were probably the only person to walk out of the Grosvenor House and onto a nightbus back to Brixton...), but must just add that the experience of sharing a drink with the Green Wing cast and was pretty special. Well, not so much share a drink as a room...they were just a table away...OK maybe a couple of tables away...But I'm sure Tamsin Greig looked at me at one point...

So of you're interested stand by for the rundown on The Filter Review (button on the left), hopefully within 24 hours.

The Limitations of Home Bias

Last November I took a student to see Finn Kydland deliver a lecture on monetary theory and business cycles, and was highly impressed with Kydland's insights and delivery. The event was an excellent overview of his chief contributions (Real Business Cycle theory and time-inconsistency), as well as the current empirical evidence on both. One aspect that stuck with me was his claim that governments can only achieve credible monetary policy through either:

• Gold standard
• Currency board
• Independent central banks

He skirted around the first option, and the failure of Argentina's currency board (and continuing uncertainty about the Euro*) seem to have undermined their adoption. Pegging to the dollar is perhaps an option for poor, unstable countries, (assuming that there's IMF support), but the overwhelming consensus for developed countries is an independent central bank. An important point to make though, is that the jury is most definately still out: they haven't yet been tested, and we should reserve judgement until we see how Bernanke, King et al. do away from ideal conditions. Regardless, the triumverate above doesn't provide much hope for countries trying to establish credibility, and Kydland's conclusion is pessimistic:

Bad policies suck

It's surely true that if a fourth method is discovered - a method for weak governments to establish monetary credibility - then there'd be a massive boost in prosperity for their citizens, and a Nobel Prize for the economist who came up with it. Well Finn, I think there is another method - outsource government.

It sounds radical, but it's already true that some government's outsource particular functions to foreign, private companies. What I'm asking, however, is what's so unthinkable about hiring foreign-nationals as senior government officials? If Russia wants credible monetary policy, it should hire Alan Greenspan.

I noticed in this weeks Economist an article on William Amelio,

To win his board's backing for this deal, after some ill-fated attempts at growing organically abroad, Mr Yang [Chairman of Chinese computer firm Lenovo] agreed to hire an experienced American as chief executive.

If it can work in the private sector, it can work in the public one as well.

Finally, going back to Kydland's talk, and can anyone see the irony in the title?

The Dynamics of Business Cycles and Monetary Policy - Links and Drivers

Congestion Charging

Two interesting perspectives on road pricing, from two interesting thinkers. Firstly Tim Harford asks why climate change (a potential, future problem) receives far more attention than traffic congestion (a real, current problem):

If climate change ever begins to have the same impact on our lives that congestion does today, it will be a dark day indeed. Think about the delays; the uncertainties; think about the lengths big-city dwellers have to go to in an effort to avoid traffic. Then think about how severely the climate would need to change before it had the same effect on your daily routine.

Secondly John Adams (with a letter in The Guardian), says that road pricing is not the solution:

Congestion pricing is not the answer. It will simply disperse the problem into those parts of the country currently least congested, encouraging yet more sprawl and low-density, car-dependent land-use patterns.

Whilst I'm at it, I should update my original post on John by linking to a city-planning trial run to remove traffic lights. According to The Telegraph:

"We want small accidents, in order to prevent serious ones in which people get hurt,...It works well because it is dangerous, which is exactly what we want. But it shifts the emphasis away from the Government taking the risk, to the driver being responsible for his or her own risk."

Review Post

The Financial Times recently named its top-ten world orchestras, and there are no prizes for guessing that Amsterdam's Royal Concertgebouw Orchestra was included on the list. They were at the Barbican this weekend for their annual mini-residency in EC1. There's a review posted on The Filter Review - click on the button on the right.