Deadweight loss, debunking, and strawman micro

In a recent post, Paul Walker criticises the idea that “deadweight loss wouldn’t exist if we had a government monopoly”. He is right but in another idealistic sense the idea of no dead-weight loss is also correct right.

If the government acts as a monopoly we will still have dead weight loss, as it comes from the “loss of surplus” relative to the situation where “surplus” is as large as possible (given demand and the monopolies cost structure).

But if government blatantly sets price equal to the marginal cost of the last unit dead weight loss will melt away. This does not imply that profit is dead weight loss in any sense of the word, and it does not tell us that the solution will be “dynamically efficient” (where is the incentive to invest, to develop), but it does tell us that a government that is behaving this way could achieve the “perfectly competitive” price and quantity.

However, this is all 100 level stuff that I don’t particularly care about. My interest lies with the “debunking of microeconomics” that Steve tries to achieve on Paul Walker’s blog.

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Question on loss aversion

I have a question on loss aversion, as I am confused.  I keep seeing loss aversion defined like this:

our tendency to feel sadder about losing, say, $1,000 than feeling happy about gaining that same amount

But this sounds like diminishing marginal utility to me.  I mean, the $1,000 dollars I’m losing provides me with a greater level of satisfaction than an addition $1,000 would provide me with.

My feeling was that loss aversion was a situation where my satisfaction would be lower in a situation where I lost $10,000 and ended up with $40,000 than it would be in a situation where I gained $10,000 and ended up with $40,000 – even though in both situations my endowment was the same.

I thought loss aversion was about an additional payoff relevant factor (namely that the direction of the change in my outcomes is also payoff relevant, as well as the strict outcomes) not an arbitrary way of framing diminishing marginal utility.

If someone could explain where I am making a mistake it would be much appreciated 🙂

Hand waving, model making, and variable lags

I would suggest that anyone who is interested in economic models reads this post, namely because I agree with it wholeheartedly 🙂

While it might seem cool to run some regressions and get a result that you believe will tell you the future it is important to realise what your implicit assumptions are.  If you add a variable to you model and it is significant but you don’t know what it has to do with anything you should be careful.  This is how using a lag functions.

You need to ask yourself why is this lag significant? what is the process behind it? Data can only really be used when you can frame it with a model of how the world works.

Personally, I hate using too many lags unless I have an understanding of why the lag matters.  When you do an empirical model it isn’t just the “significance of the variables” that matters – it is the believability of the implicit model that it represents.

Arnold Kling on the economics profession

Arnold Kling from Econlog has an excellent post on the debates between economists. One of the best quote for me was:

There are economists making the case against the stimulus in ways that I find unpersuasive (Eugene Fama, for example). But the economists making the case for the stimulus are not doing a very good job, either.

There is no definitive answer. Those that are selling stimulus as the ONLY possibility are merely using a different set of value judgments than those selling the market as perfectly self-correcting. Ultimately, as Arnold says:

My advice to Will Wilkinson would be to distrust one-handed economists when it comes to macro

Economic models are incredibly useful for framing a situation like the one we are in now. However, don’t let the ideology of certain economists be more persuasive just because it is from economists.

I would add that by far the most balanced economic discussion on the crisis has come from Econlog and Marginal Revolution. And the reason that there description has seemed so balance is because they are TRANSPARENT with their value judgments – massively different to many of the other US economists on the blogsphere.

Institutions fail: What about it?

Over at Anti-Dismal, Paul Walker has replied to a comment I posted with a couple of posts. Now I thought I should repay the favour by writing something up 🙂

Update: Paul replies here.  I agree with absolutely everything he says, but ultimately I think our views on what constitutes “optimal” action still differ as a result of different value judgments.

You should definitely go read the posts, they are very good posts which cover the idea of government failure, and the limits to market failure through asymmetric information. I completely agree with all the objective parts of his posts. However, I still believe my response to “Now there may be something wrong with the price system, but there is a lot more wrong with the government system”:

That’s really your key value judgment isn’t it. I’m not sure I agree. I am not a fan of “multipliers” – but in the face of a large, sustained, market failure I find it hard to conclude that there is no role for government.

Here’s why:

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The Jedi, Economists, and public choice theory

In some of my most egotistical (although sometimes cynical) moments, I enjoy ranting about the similarities between economists and Jedi’s (at some point I might do a post – if I can actually be bothered trying to figure out what the similasrities are 😛 ).

In this context I found this old dialogue between Tyler Cowen and Bryan Caplan fascinating (ht Marginal Revolution).

On one side, Tyler argues against the Jedi order – effectively the existence of the order creates the very evil it means to prevent. Byran on the otherside believes that the Sith (the bad guys) would still exist in the absense of the Jedi – but would have no-one to truly counter them.

Both sides are right in part, and the ultimate result depends on an empirical relationship – does the Jedi order destroy more evil than it creates.

For fun, lets bring this back to an economics example. In this sense, if we heroically took economists to be Jedi’s my guess is that market failure would the Sith. Economists believe that their form of analysis helps to prevent, or improve outcomes in the face of, market failures. However, is it possible that the very act of economic analysis shifts peoples actions in a way that makes market failures MORE likely.

For an example we can go to “Freakonomics“. There is a story about how a daycare centre set a fee for “additional after hours care”. Once they set this fee, a the prior “tacit” agreement between the day care and its patron to avoid leaving children after the set hours collapsed. Even when the price was removed, this tacit agreement could not be restored.

As a result, the existence of economists and the need to set explicit prices destroy implicit institutional relationships that exist in society may thereby create the failures that economists are charged to prevent!