An Excellent Diagram to Explain Behavioral Economics

A while back I got involved in a rather long discussion regarding limiting soda sizes. The basics are that how a good is presented can shape behavior, often to the benefit of the producer and detriment of the customer, partially as a result of power relationships (try going into a gas station and wanting to treat yourself to a small soda, it's rare a 12 oz. size is available). People often make choices in the short term that they dislike in the long term as a result of framing and limiting choices.

A very good graph of how this works is up at Worthwhile Canadian Initiative, which I suggest taking a look at.

I do want to quibble with one point. At the end of the post it reads:

While I am sympathetic to behavioural economics, I worry about the consequences of viewing all policies through the lens of health. Some of the best things in life are also somewhat dangerous - like swimming across a lake with only the moon and stars for company. At the same time, I want to live in a world where I'm nudged towards healthy choices - where it's easy to get around by bicycle, for example, and the university cafeteria serves reasonably nutritious meals.

Welfare economics teaches us to respect people's choices. Behavioural economics urges us to protect people from making dumb choices that they'll regret later. I don't know of any way of resolving these two views.

I have a few thoughts based on this. First of all, it makes it rather stark that standard economics is taking the revealed preference as ideal. While this makes a lot of sense for methodological concerns, it is rather philosophically weak. If you are trying to investigate whether or not the market, as currently instituted, does deliver ideal outcomes you won't get very far in that investigation if you simply take revealed preferences as your ideal starting point. It is important when thinking about economics to remember that revealed preferences are used primarily because it eases methodological investigations, philosophically, defenses of revealed preferences look a lot more like justifications than they do valid starting premises. For methodological purposes it is an ideal place to start from, and it makes optimizing choices clear. However, in the quest for the ideal it is rather limited since it creates a self-confirming loop.

Second, I do see a way of resolving the two views. Both serve as different ways of informing policy. But to decide which to use, it is necessary to recognize the importance of having different decision rules. Ultimately, this is why market economies and democracy works so well together. The market provides a space for optimizing behavior; democracy provides a different decision rule that allows other considerations to rule. Behavioral economics provides an explanation for why other considerations may influence people differently than welfare economics. Economic assumptions can simply only take you so far, after that it becomes necessary to pick up concerns that are not expressed at the moment of decision by a consumer through the price signal. The tension between the two is very healthy, it provides opposing viewpoints that can be resolved through the democratic system, rather than an elitist, optimizing and technocratic process. It is better that this tension exists to be negotiated through this means than it is to try to choose one or the other as the better view for decision making.

Alternatives to Socialism and Capitalism, the 3 Ideal Type Model

Something that I believe I have remarked on before is that I am rather dissatisfied with the crude portrayal of the choice between socialism and capitalism given by politicians, sometimes by the media, and that is expressed rather often on comment boards and by the public generally. I personally don't believe that socialism and capitalism accurately capture the choices we face in modern society or the factors that impact society, whether growth, social mores, or politics.

Of course, denigrating a perspective isn't worth much unless an alternative can be suggested. Personally, I prefer a model used frequently by economic historians, the 3 ideal type model.* Rather than a simple line between socialism and capitalism, this model separates economic organization into three ideal types, customary, market economies, and command economies. All three types are visible throughout history and all societies have elements of all three.

The first type, customary or traditional economies, are those dominated by role and custom. This can mean guild organizations, functional age groups (in some very primitive economies), gender roles, household economies, castes, and many other variants. At its most basic, these economies are organized on the notion of reciprocal obligations, each actor has a defined role to play and gets some sort of compensation in return, without the need for money or barter (though more complex, mixed interactions are possible, with either culturally proscribed fair prices or defined occupational roles but with money exchange occurring for the actual production). In the modern economy, the household is the primary example, I cook and my girlfriend cleans house. It would also involve other family obligations, or something as simple as rotating who hosts dinner parties among a group of friends.

On Interpreting Data

The Economist recently had a couple of blog posts about using data to support political arguments.  In the comments there were at least a few allusions to the common notion that data can be used to prove just about anything.

This is true in only the most trivial sense.  It is true that just about anything can be "proven"* by sufficiently restricting the data and by choosing exactly the right level of abstraction to use while discussing it.  But doing this is just silly, human beings are pattern finding animals, we see shapes in clouds and Jesus on our toast for chrissake.  Carefully cherry picking your data and choosing an arbitrary level of abstraction is equivalent to saying that you can see a face in a rock if you stand on your hands, angle your head just right, and squint with one eye.  While this may perhaps give the appearance of a face, it compares poorly to a statue where you can tell that the rock is a face by sight, by touch, by measurements, and by many other approaches to the available evidence.  The image produced by one particular method is likely random chance, the image that can be detected by multiple methods is far more likely to have been produced by intent and to be what it is said to be.

This basic approach is what is meant when it is said that an idea or theory is well supported.  It is true that if data is carefully selected and an argument is carefully enough made you can make the data look like just about anything.  This is the intellectual equivalent to needing to squint just right.  However, it is almost impossible that a false image can be generated through multiple distinct approaches.  An idea that is supported by comparative evidence, by modeling, that is independently arrived at by multiple fields (like economics, sociology, and political science all agreeing), that remains true under multiple different levels of abstraction, that remains visible under multiple different sets of assumptions, that has survived testing by multiple independent teams, etc. is like the face in a statue that can be detected by sight, touch, measurements, etc..  Multiple lines of evidence mean that something is likely true, and the more independent lines of evidence the more likely it is to be true.  If an idea is instead only asserted by one group, uses an extremely restrictive set of assumptions, lacks agreement with other fields, uses a high level of abstraction, lacks independent confirmation, etc. it is almost always going to be BS.

Now, the contrast in the social sciences is rarely as clear as my above example.  We're dealing with worn statues here, not perfectly preserved pieces.  But keeping this in mind does give a rough and ready approach to the validity of various arguments.  Generally, the better argument will be the one that is adding data to the discussion rather than trying to reject it,** the one that suggests new approaches, the one that uses less restrictive assumptions, the one that is less abstract, etc.  Approached in this way it becomes fairly easy to assess the validity of various arguments being made with only a fairly cursory knowledge of the subject.  Someone that has the confidence to suggest reading widely and deep and that can point you towards multiple fields to gather evidence is fairly likely right.  Someone that denigrates other approaches and tries to tell you to use their interpretation or you're doing it wrong is probably wrong themselves.

Now, a separate issue is what we should do with the data once we've agreed on a rough and ready way of interpreting it and moved past the idea that all data is equal.  But that is for another post.

Modelling Taxation

I just came across a reference to taxing capital as double taxation in a book I'm reading (specifically Lindert's Growing Public which is an excellent book I'll have more to say about later, opening up the taxation assumptions like Batina and Ihori do would only reinforce his points) which proved to me this isn't simply an idea floating around the internet and is something that needs to be addressed.  I'm by no means an expert on taxation, though I do find it a fascinating topic, so I thought I'd get to it while my recent reading on taxation is still fresh (I've currently moved on to public spending).

The basics are that it was a common view that taxation on capital would be double taxation on saving leading to lower capital formation as well as being inequitable.  This is true enough when one is thinking about the economy in the form of a simple two goods model with choices between consumption and investment where investment amounts to little more than deferred consumption.  If there is also a present value discount of future consumption, this effect is even stronger.  In this view, people largely save now because they believe they will be able to consume more later by doing so.

However, more recent literature is skeptical of the strong case in favor of consumption over capital taxation (though I am not aware of it bothering to give a critique of this simple accounting identity regarding taxing saving as double taxing income, nor should it really, economics is a study of human behavior not natural law so if behavior does not match the accounting identity it's the accounting identity that is wrong, not human behavior).  To quote Batina and Ihori's Consumption Tax Policy and the Taxation of Capital Income:

It may be suboptimal to exempt capital from taxation if any of the following conditions hold: government spending is strictly proportional to output; precautionary saving arising from incomplete insurance markets exists; there is productive public spending that enhances private investment; there are liquidity constraints; and negative externalities associated with production exist.  The general case for the consumption tax is very weak in the presence of any of these phenomena.

That's a lot of caveats, all of them realistic.  There are other problems with the idea of exempting capital income from taxation.  For instance, while under the assumption that savings today is the result of expected higher, time discounted consumption tomorrow a capital tax will reduce investment, investment will be increased if I assume savings today is the result of a desired income level tomorrow (such as under a lifetime income hypothesis).  With this assumption, if I want to save $1 million for my retirement I will have to save more today if there is a capital tax than if there is not, the capital tax now has the opposite impact that it did under a separate set of assumptions (though it is potentially still distortionary regarding utility measures).  This is probably closer to how most savers in an economy behave. 

Other assumptions create similar complications.  If we add a human capital term so that an individual has a choice between standard capital investment and human capital investment taxing the income derived from human capital in the form of increased wage income and not capital income derived from capital gains and dividends distorts this choice as well.  Enter in bequest terms and the various bequest strategies that have been found in empirical studies of this behavior and things get even more complex.

Stepping outside of more formal economics and just thinking about savings behavior that we encounter as individuals throws more complications up.  Many people just save excess income, if I have plenty of books on the shelf that I haven't read yet my savings account just gradually increases (assuming my girlfriend doesn't have some more exciting ways to spend money, I tend to be kinda boring).  I only consider the return if enough money is sitting there that I think it would be wasteful not to invest, taxes don't even occur to me.  Saving in case of a rainy day is rather common, things happen and we want money just in case.  Also, it should be noted that studies of this find that alternatives to capital taxation, such as wage and consumption taxes, distort labor leisure trade-offs creating another source of distortions not always mentioned when capital taxes are discussed.  There are strong hints that it is labor supply elasticities and not savings elasticities that are of more importance to capital taxation.

I could go on, but I think the general point is clear enough.  The idea that taxing capital is double taxation is largely the product of the assumptions of certain models used to analyze this topic, use different assumptions and there are different results.  This is something that I think should be emphasized more in undergraduate courses (or perhaps in economics generally, I know I heard this much more in my graduate poli-sci courses than I did in my undergrad economics).  Models are excellent tools for thinking about relationships between the concepts under study.  However, they are also prone to simply spitting your assumptions back out at you, if a simple two good economy involving consumption and investment is assumed then there will be one set of results, if instead human capital vs. physical capital is being modeled or labor market dynamics, different sets of results and policy recommendations will be the product of the model. 

From a policy standpoint however, it is most likely the case that all assumptions are valid to one degree or another, some people will face decisions between human capital and physical capital others will follow a strict lifetime income model while others will make consumption decisions that conform more closely with consumption maximizing behavior.  Which model to use then becomes primarily an empirical question, given current starting conditions which set of behaviors is most accurate for the polity under study.  It is also likely that the answer will vary depending on both location and time, one polity may be capital short and need policies to maximize capital investment even at the expense of human capital another may have labor market problems and need a focus on human capital development.  Dealing with the problems of each of these will require different conceptualizations of how income, savings, and capital are treated.  There is no "right" way to think about these subjects, they are contingent on the situation and on what is being studied.  Optimal policy requires the ability to approach a problem from multiple angles, otherwise disaster awaits.

An Example of How the Media's Focus on Balance Warps Perceptions

Nate Silver deserves a drubbing for this one.  The important thing to note about the debt ceiling debate is that it has been from the start about how fully the Republican's agenda would be fulfilled in return for raising it.  So when I see something like this:

Perhaps, on a 100-point scale where 0 represents a total victory for Democrats (say a debt ceiling increase with no strings attached) and 100 represents a total victory for Republicans (perhaps the passage of “cut, cap and balance”), Mr. Boehner’s original bill would be scored at about a 70 and Mr. Reid’s at a 50.

I get angry.

Let's be honest about what a truly neutral scale would look like.  0 should be a bill that fulfills a number of Democratic priorities (say an increase on taxes on the wealthy to help close the debt and a hefty dose of fiscal stimulus to raise GDP growth thus cutting the deficit long term) and 100 should be a bill like that mentioned by Mr. Silver.  In this case, 50 would be raising the debt ceiling with no strings attached, no one gets their priorities met, which is more or less what usually happens.

Putting a scale where 0 is defined solely in non-ideological technocratic terms, raising the debt ceiling, and 100 is full partisan terms (with full Democratic ideological priorities apparently at -100) seems to me completely deceptive, since the -100 definition isn't even mentioned.  The framing here makes it look like simply raising the debt ceiling is an extreme partisan position and the current compromise fairly centrist, which it isn't at all.  This defines politics in completely relativistic terms, whatever one sides position on an issue, even if it involves substantial compromise and a complete abandonment of that side's ideological priorities, is defined as the extremist partisan position.  This is downright silly.  A scale of 0 to 100 can't be defined by wherever the parties are on any particular issue, it has to be defined in terms of each party's ideological priorities.  To do otherwise is to substantially distort partisan issues.

On the broader issue about whether this will help/hurt Republicans/Democrats, I'm agnostic.  I just think we should talk about these things in consistent terms rather than letting political opportunists move the goal posts whenever they want to.

Krugman on Reading CBO Reports

This is a great post on basic analytical reading (this one specific to a CBO report) for the casual reader.  Ignore the ideological axe he's grinding here, this shows the basic methodology you should be following when reading anything to show the proper scepticism.  I'm sure many people know this already but methodology barely gets mentioned in the news so I'm a little bit overjoyed just to see it mentioned somewhere.