A framework for normative economics

This is a post that Matt really should have written, but unfortunately he’s snowed under at work at the moment. Having said that, it’s not really much more than a plug for Steven Landsburg’s fascinating new paper entitled “The Methodology of Normative Economics”. Economists tend to shy away from making normative judgments: when constructing a social welfare function they claim to be maximising efficiency. Yet the form of that welfare function determines the form of the efficient solution. Moreover, people clearly have strong feelings about what constitutes an appropriate welfare function for a regulator to maximise.

Given that people feel strongly about what form this function takes it makes sense to model people as having preferences over different forms of the welfare function. For a welfare function to be ‘consistent’ it must predict that it is itself the optimal welfare function to use. Landsburg shows that, if rich people care about equity, there is only one such function that exists. Even if people are selfish and don’t care about equitable distribution of income, there are only a limited number of consistent welfare functions.

What I really like about Landsburg’s paper is that it forces economists to confront the normative judgments that they inevitably make when they talk about welfare. Yet it forces them to do so by using an analytical framework that they are comfortable with. Rather than forcing them to make value judgments, it allows them to talk about the normative framework of their model without having to resort to moral or philosophical discourse that they are ill-equipped to deal with.

Check out another of Landsburg’s methodology papers here if this stuff dings your bell.

An alternative ‘fat tax’

Matt’s talked in the past about fuel taxes to reduce emissions and reduce the time cost of congestion. This paper suggests that there may be further benefits to a fuel tax. Using US data the author estimates that

…a $1 increase in gasoline prices would reduce obesity by 15% in the U.S., saving 16,000 lives and $17 billion per year. These monetary savings would offset approximately 16% of the increased expenditures on gasoline. Additionally, …13% of the recent rise in obesity from 1979 to 2004 can be attributed to the decline in real gas prices.

He attributes this to both an increased time spent on incidental exercise and a reduction in eating at restaurants. It seems almost too good to be true, and perhaps it is, but it’s certainly an interesting alternative to taxing unhealthy foods.

Insiders vs outsiders

Government departments are constantly criticised for their lavish spending on outside consultants. Why, the newspapers ask, couldn’t they rely on the inside talent that taxpayers are already forking out for. This paper, mentioned by Eliezer Yudkowsky may give some clue. It turns out that people are not only incredibly bad at predicting how long it will take them to complete a task, they also get worse at predicting it as they know more about it.

A person who knows the ins and outs of a project will estimate the completion time of the project by taking in to account all of the things that they know need to be done for that particular project. In doing so they tend to disregard all of the unforseen stuff-ups that could happen along the way. An outsider will tend to estimate completion time by looking at how long similar projects have atken in the past. It turns out that the latter approach is not only far more accurate, but also estimates completion times far, far longer than ever predicted by insiders.

Could it be that, in some cases, ministries are actually saving us money by getting an outside perspective on a project? Quite conceivably, the money spent hiring the consultant improves project planning to the point that less money will be wasted on false expectations of the project’s success. We should also disregard the protestations of the ministry insiders that the hiring of the consultant was a waste of money because the consultants know very little about the project. It is precisely because they are not involved in the micro-management of the project that they can provide a realistic estimate of the project’s expected success and completion time. Of course, advocating more government spending on consultants is hardly an election winning strategy.

Has the Fed cut rates without telling anyone

Greg Mankiw noticed that the Fed target is still 5.25%, however the effective rate in August was only 5.02%.

This is interesting, in NZ you could not do this as the Bank is willing to release any amount of money for a given interest rate (that is what our OCR target implies), the constraint in this case is money demand. In American they have a Federal Funds rate, which acts as there target rate. However, they also target a certain money supply level and use open market operations to get there.

Now you can’t arbitrarily choose the combination of the price (interest rate) and quantity of money in the market place, it depends on money demand. As a result, the Fed can only truly control one of these variables, as if they want to hit their target rate there is only one level of money supply that will allow it (given a strictly downward sloping money demand curve).

According to Mankiw, the Fed is pretty good at choosing the right amount of money supply so as to achieve the Federal Funds rate. By deviating from this they are loosening monetary policy, even if they haven’t said they have. The fact that the Fed has control of money supply as well as money demand allows them to be loosen monetary policy quickly without making the market feel like they are. However, it makes them less transparent, which in the long run is not a good thing.

OCR stays at 8.25%

The RBNZ left the OCR at 8.25%, a move that was completely expected.

They also released a monetary policy statement this month, which is what the markets were keeping an eye out for. The executive summary was pretty neutral, mentioning both global credit market uncertainty and the need to keep rates high to combat inflation. As a result, this gave little information to the market on whether the Bank was thinking about easing in March, June or September.

However, I think that the current MPS points towards loosening in the OCR late in 2008. For one, there forecast 90 day bill rate track remains high, only easing slightly into 2009. Furthermore, they forecast economic growth to March 2008 of 2.9%, significantly above other analysts forecasts. Also, they expect inflation expectations to stay near the top of the target band up until at least 2009 (falling to a low of 2.7%!).

I’m not sure how to interpret this. Does this mean that the Bank is prepared to tighten again as they are pricing in strong inflationary pressures? Or does it mean that the Bank is estimating a high track for GDP growth, so that when growth comes in lower (as it invariably will, given the lack of TOT movement in June), the Bank has a consistent reason to cut rates.

Car safety choices

I’ve just read a great post about vehicle size and the probability of getting killed, go The Economist.  It says that, although you are less likely to die if you are in an accident and you are in an SUV, you are more likely to be in an accident if you are in an SUV, and therefore we can’t just say that having a bigger car will make us safer.  Now the reason I think SUV’s get into more accidents is that people feel safer in SUV’s and so drive more aggressively, especially after speaking with an insurance adjuster.

Let us now completely ignore this point and look at a slightly different issue.  Say you were certain that at some point you were going to be in an accident.  In this case, all other things equal, you want to choose a car that gives you a greater probability of living.  As a result, you choose an SUV.  Furthermore, if everyone in society felt the same sort of way, they would buy SUV’s as well.

However, your probability of living also depends on the type of car the person you crash into is driving.  If you have an SUV and they have a Honda Civic, you will destroy them, your probability of living will be high and they will be in trouble.  If they also have an SUV, then you are both likely to get munched as you both have big cars.  Now what happens in the hypothetical case when you and the other person have Honda Civics?  You will be worse off than if you were in an SUV, but you will be better off than if they were in an SUV.  The interesting question is, how does this compare to the case when you are both driving SUV’s?

If the probability of living is higher when you are both driving Honda Civics than in the case when you are both driving SUV’s we have a prisoner’s dilemma.  Both you and the other crash victim would be better off if you were both in Honda Civics than if you were both in SUV’s.  However, incentives convince the individual to buy an SUV.

If the probability of dieing in a Civic vs Civic crash are lower than an SUV vs SUV crash, then we have another reason (beyond the moral hazard aggressive driving reason and the environmental reason) for why the government should regulate the size of vehicles it imports.