July 19, 2008

The Weekly Blast From the Past #1: Political Economy

J. Laurence Laughlin. “The Study of Political Economy in the United States.” The Journal of Political Economy, Vol. 1, No. 1 (Dec., 1892), pp. 1-19

1892- the year that the Chicagoan “Journal of Political Economy” was first published. It is a chilling time for American economists, less than thirty years after the civil war, the field is slowly becoming dominated by the Marginalists.

Writing in the nineteenth century, James Laurence Laughlin contends that “the fact must be frankly acknowledged that the influence of scientific economic thinking in the United States has little or no authority with the masses of the people.” [How much that has changed can be debated. It is interesting to note that Laughlin would go on and found the Federal Reserve] However, there is sweep of political sentiment. “Persons of sensibility, refinement and intelligence have been touched as never before by a strong desire to do for the classes below them.”

Laughlin makes a strict attempt to separate normative and positive economic thinking and claims that the understanding of scientific ideas can only be understood by a few. He states that “the great working classes can be reached only by the literature which comes from within their own ranks.” Therefore, the journal was started as an attempt to clearly divide the schism between the two lines of analysis. It is an attempt to instigate underlying scientific ideals to the study of economics.

One interesting thing is a claim that the vitalization of economic thinking emerged due to newfound interest in money and finance. In many ways, it’s still true that welfare and public economics have been traditionally studied in a secondary nature.

In the time of the Marginalists, the author makes clear that “at first extreme views were ascribed to many writers; but more careful examination has made it clear that Adam Smith, Ricardo and Cairnes' had never adopted laissez -faire as a principle of action,” and at the same time tries to make clear that he does not fully support state intervention. How much of this line of thinking has changed in one hundred years? This marginalist sentiment has not changed over the years.

There is mention of the changing face of America due to advances in transportation, mention of Henry George’s proposal on single-tax on land, the growth of organised labour and concerns about poverty. It ends on the note “Inasmuch as existing scientific journals have a tendency largely towards discussions of theory, and as popular journals do not usually treat practical economic problems scientifically, the JOURNAL OF POLITICAL ECONOMY may, therefore, find for itself in the scientific study of this latter class a free field.”

Has economics changed at all in the past hundred years? It seems not. The underlying sentiment seems the same- all that has advanced is understanding in the field.



The Economics of Steaks

Steaks. I love steaks. Of course I never have steaks because of the price, but being at home I can afford such luxuries. So I had a minute steak for dinner tonight, and that made me wonder- why is there such a large spread in steak pricing. Working in a restaurant, I’ve learned the physical differences: fillet, rump, t-bones, and sirloins. I even know a cow’s anatomy, but I’ve never been driven to understand the real intuition behind the difference in steak pricing. Until now. Further research didn’t exactly answer that question, but I found some other interesting facts.

Everyone knows of the business cycle. But there is actually a cattle cycle, at least in the United States. There is a tendency for beef prices to start high at the start of a decade, move low, and then rise again. The nature of this is biological, profitable seasons means that producers hold back “heifers”, female cows. This means a greater capacity to produce more cows in the future due to anticipation of higher profits. However, all this does is create greater supply pushing down prices. In response producers liquidate their cattle stock to push prices upwards. The result, a cycle. This cycle is reflected in the price of beef. [There is actually an Econometric model for this. In fact, here is the model given to estimate cattle numbers.

So what factors affects beef pricing?. Overall- quality is the main factor. Individual cuts of beef can be considered inferior and normal goods, which is logical. When income rises you may switch from having hamburgers to having steaks. As for cuts of steak itself, one experiment found that “tenderness are among the highest ranked beef quality concerns” and found that “tender steak has value for consumers.” This would be the tenderloin, fillet mignot and T-bones. Another study found that rib-eye, top-round, and rump were the most price elastic because of cross-cut elasticity- individuals switch to different cuts of meat when the price of one rises.

Another thing to consider is how much beef prices has changed over the years. One journal article from 1905 has quality beef prices as being:

When you compare beef to today’s prices there have been massive changes. Once you calculate for volume, the difference in price for loins, ribs, and chuck isn't great in the past. The similarity in rib and loins is to be expected, but not the chuck. I would guess that the huge increase in living standards and income has completely transformed the beef market since 1905. A pound of tenderloin would cost $2.82 in today. A pound of hamburger would cost $1.95. So, what has caused such a dramatic shift over the years? That’s for another time, but one thing is certain- agricultural economics is a thriving discipline- more so than most branches of economics. Search for “Cattle Industry” on JSTOR and you’ll get 25,651 results.

References:

An Econometric Model of Cattle Inventories Randal R. Rucker, Oscar R. Burt and Jeffrey T. LaFrance American Journal of Agricultural Economics, Vol. 66, No. 2 (May, 1984), pp. 131-144

In-Store Valuation of Steak Tenderness Jayson L. Lusk, John A. Fox, Ted C. Schroeder, James Mintert and Mohammad Koohmaraie American Journal of Agricultural Economics, Vol. 83, No. 3 (Aug., 2001), pp. 539-550

Beef Prices Fred C. Croxton The Journal of Political Economy, Vol. 13, No. 2 (Mar., 1905), pp. 201-216

Effects of Retail Pricing and Advertising on Fresh Beef Sales T. F. Funk, Karl D. Meilke and H. B. Huff American Journal of Agricultural Economics, Vol. 59, No. 3 (Aug., 1977), pp. 533-537

For information on beef cuts:
http://ladssmokehouse.com/images/beef_cut_chart.jpg

Example of cattle cycle: http://www.beef.org.nz/breeds/mgrey/impr.asp


A Long winded Introduction to Arrow’s Impossibility Theorem

“It’s kind of fun to do the Impossible.” – Walt Disney

At least maybe that’s what drove Kenneth Arrow to create his famous Impossibility Theorem in 1951. The premise is that you can not create a voting system that is both stable and decisive. Either your system fails some simple fairness criteria, is instable in that it will produce “cycles” (intransitive outcomes) or it is dictatorial to reach a decision. You can’t satisfy all criteria. Not for every possible voting profile. The end result is that dictatorships are the only system that will bring a result for every possible situation and as an extension- any long-term stability.

The actual proof is monotonous, but the result is intriguing. It may be worth to note that the conditions are: Nondictatorship, Pareto Efficiency, Universal Domain, Independence from Irrelevant Alternatives and Transitivity. These are very basic conditions of fairness. The proof only applies to voting with more than two alternatives, Kenneth May proved in 1952 that simple majority voting satisfies all voting criteria with two alternatives. (Though any attempt to confine voting to two alternatives is a violation of fairness itself.)

There are political, economic, and philosophical ramifications. The economic consequence for welfare economics is that you can not fairly satisfy a social welfare function for economic planning. The political consequence is that if we use democratic institutions to decide how to allocate resources, then theoretically the fundamental institution is instable, and may produce intransitive results, cycles. The probability of cycles, may seem small- 5.6% when you have three cycles and three alternatives, but the irony of the situation is that the probability increases with either a greater number of alternatives or a greater number of voters [for more information read William Riker]. In essence, the more democratic an institution, the more fundamentally instable it is. As you keep adding more alternatives or voters, the likelihood of cycles converge to one hundred percent.

But, in reality how like is cycles? The principle assumption is that all voting profiles for every possible person are considered. The answer is, likely enough for us to have to worry about it. Consider three individuals. Each are told that they have to divide one dollar amongst themselves. Dividing the dollar equally may seem like the logical solution, but the other two individuals could confide in each other to divide it between them and leave a third individual with nothing. But then the individual left with nothing could approach one of the two individuals to make a better deal and the game continues. The result is a cycle. This happens all the time on issues concerning taxation. Moreover, William Riker contends that losing parties in elections should logically attempt to induce cycles. The result is a natural tendency towards political instability. (He claims that the cycle of the Republicans bringing up slavery started the American Civil War.)

The philosophical repercussions are important for the basis of rationality and morality. Rationality implies transitivity, but aggregate individual preferences produce an irrational result. So is that to say that democratic group thinking is irrational? Is a dictator a “rational” outcome? If that is the case, then the outcome “offends equity” and is immoral. Therefore, there is a trade-off between rationality and morality in democratic institutions, although individuals are acting in accordance to their own will. Thus, is the notion of liberty naturally politically instable? I wonder what Friedrich Hayek thought of Arrow's Impossibility Theorem. It poses a serious threat for Libertarianism.

References:

Grant M. Hayden Some Implications of Arrow's Theorem for Voting Rights Stanford Law Review, Vol. 47, No. 2 (Jan., 1995), pp. 295-317

Fred M. Frohock Rationality, Morality, and Impossibility Theorems The American Political Science Review, Vol. 74, No. 2 (Jun., 1980), pp. 373-384

William Riker. Liberalism Against Populism. San Francisco: W. H. Freeman, 1982.


The Economics of the Blogosphere

The Tipping Point can be seen in my subscription to various Economics blogs. Student or new blogs (ie: me) with no real theme or new information will have less than one hundred subscribers. Niche blogs or established blogs such as Game Theorist or Angry Bear have five hundred subscribers. As you move up to more serious Academic blogs, such as Crooked Timber or Greg Mankiw’s blog, you hit more than one thousand subscribers. And then there’s a massive gap until you reach MarginalRevolution’s blog where you have 127,494 subscribers. A one thousand percent increase.

That. Is the Tipping Point.

Why did the MarginalRevolution become popular? Google Trends shows a spike of activity sometime in 2007, but the data isn’t sufficient to draw a conclusion. It’s a good blog, but “The Economist Blog” has 170,000 subscribers. Maybe it’s safe to assume that popularity is not necessarily correlated with quality.

Perhaps blogging is simply a complex pyramid scheme. In Network Theory the popularity of blogs coincides with the emergence of “centers”. Hub blogs that smaller blogs link to. Indeed, the study concluded that both links and reporting influenced blog popularity. In the end what you have is an oligopoly in the Blogosphere. Computer Science actually predicts this. Maybe the latter is why the competitive Economic blogosphere won’t shut up about the sub-prime mortgage crisis. Moreover, in such a competitive environment it’s no wonder that there’s so much parasitic blogging, bloggers that engage in fisking which is essentially saying “My fellow blogger said this today. I agree.”

The Economics of blogging is complex. There are no direct entry costs for blogging- there’s simply an opportunity cost of time. However there are expected returns. Some of the most popular blogs earn up to $10,000 a month, but the vast majority of blogs- hardly earn anything at all. Therefore, what you have a system with only a few individuals earning from blogging on a specific topic. If you want to break into the system, you need to have your blog linked to. In order for that to happen, you need build up your own reputation by linking to other blogs yourself. However, all this does is firmly entrench the few blogs that earn money by making them more popular which simply exacerbates Harvey Liebenstein’s bandwagon effect making the blog even more popular.

It’s a competitive and difficult market to break into. What you need is a tipping point. Some event, some factor, that will shift your blog from four thousand to one hundred thousand subscribers. And this is where my theory comes in. Individuals choose which blog to read dependent on the its popularity. People will only read your blog if its popular, and the only way to make your own blog popular is to make popular blogs even more popular. It’s a vicious cycle.

Economics Bloggers must be the most depressed people in the world. The Dismal Science indeed.

More information: The Law and Economics of Blogging

http://www.blogcatalog.com/directory/economicblogs


The Economics behind the Tipping Point in Modelling Consumer Behaviour

I only learned recently that Thomas Schelling’s work was behind Malcolm Gladwell’s best-selling book the “Tipping Point.” Much of it was based on his paper concerning racial segregation in American suburbia. He observed that once enough black families moved into a white community, the there would be white flight. “There goes the neighborhood.” Literally. However, I remember seeing something related in his brilliantly titled work “Hockey helmets, concealed weapons, and daylight saving: A study of binary choices with externalities.” (I spent hours combing that paper to fully understand an n-person game of chicken for my public choice exam. It paid off in the end as I used it twice.)

Here the R-line represents my payoff by cooperating, and the L-line represents my payoff by defecting. There's a certain point, a tipping point in which if enough people cooperate, my payoff his higher by cooperate. This is when the L and R intersect. This made me wonder, do consumers make subconscious decisions based on the principles of the tipping point? I find that when deciding what software to download, or what books to buy, I sort by the total number of downloads and conform to popular opinion. So is this an isolated case of “irrational” behavior, or is it more universal in human nature? Could it be that demand for a specific product is related to the quantity consumed of that product in an increasing manner?

Other disciplines have studied this phenomenon. In sociology, Mark Granovetter considered a model for fads, and used the example of a hypothetical mob’s decision to riot. In many ways it was a type of game theory whereby I will riot if enough people riot riot, but I will not riot if too few people riot. In politics, the term has been coined the “bandwagon effect”- a situation whereby pre-election polls in favor of a candidate lead to greater support for said candidate. The direct model is that a poll forecast has a psychological effect on an individual voter which alters the final outcome in favor of that candidate.

Can the same be true for Economics? The economist Harvey Leibenstein seemed to think so in his 1950 paper “Bandwagon, Snob, and Veblen Effects in the Theory of Consumer Demand.” He explained that the situation in welfare economics would be where an individual’s utility function would depend on other people’s quantities consumed.

The graph above shows D(B), the actual demand curve which is a locus of expected demand at each quantity. The demand curve is more elastic, changes in price produce an additional increase in demand because more of the quantity of that good is consumed.

However, this isn’t necessarily the model I was hoping for. It is to some extent, but it doesn’t necessarily explain diagrammatically the “Tipping Point”. What is more interesting is his idea of “social taboos”. The amount of a good that is required for individuals to be induced to consume a good. However, I feel the model can be applied a bit more liberally to goods some people consider as normal goods.

Here, there’s a threshold, a clear “tipping point.” Expected demand for a good has to be at a certain quantity before people are induced to purchase a good. It would be interesting to see what markets apply to this model. A clear example would of course be technology- Schelling makes this point. There’s no point in buying a “video phone” if no one I know has a video phone. But, perhaps the model can be applied to best sellers and films. Look forward for a follow up post.


A Quick Primer in Public Choice

"A maze of conjectural variation" - Anthony Downs

In German, Public Choice is known as “Neue Politische Ökonomie” which translated means “New Political Economy.” That’s it in a nutshell. It takes what Politics tries to explain, applies Economic analysis, and produces material that requires a mix of normative and positive thought. The origins lay with Duncan Black’s “Median Voter Theory” and “The Theory of Committees and Elections” first published in 1958, though its foundations came much earlier, drawing from a number of sources such as Marquis de Condorcet and Jean-Charles, chevalier de Borda.

After Black was James Buchanan and Gordon Tullock who developed a theory of political rent-seeking- essentially a form of government corruption. Anthony Downs’ and his take on Democracy- an evolution of the median voter theory – and the paradox of Voting- why it’s mathematically irrational to vote. Kenneth Arrow and Arrow’s Impossibility Theorem which states that you can’t have a voting system that won’t be either dictatorial or indecisive. Mancur Olson and the Logic of Collective Action whereby he points the difficulty in the formation of large groups (For example, why is there no lobby for the unemployed?)

Public Choice is an attempt to scrutinize democracy. It tries to observe how rational individual actors in government or society conflict with the desires of the general public creating inefficiency. For example, taking a look at the rationality behind the supporting of pork barrel projects. It combines political science, the economic study of incentives, game theory and normative philosophical analysis in attempt to improve the working of democracy.

It asks such questions as, why is group participation so low? This stems from Macur Olson’s work. When we consider joining a group, we consider how many people are needed and the probability that your participation will make a difference. The majority of individuals think to themselves “let someone else do it.” And hidden in groups is an n-person prisoner’s dilemma. There are some other models for group action, like Assurance and Chicken and much work from Thomas Schelling, but that’s for another time.

It's a controversial field. William Riker tried to explain in his book "Liberalism Against Populism" that the American Civil War was caused by a voting cycle. The Republicans didn't really care much about slavery, they just wanted to beat the Democrats.

I want my Dennis Mueller book back.


Decisions, Opportunity Costs, and some Philosophy

Two Weeks. I have two weeks of summer. That's depressing.

Come August, I officially begin pure Economics at the "Fundacao Getulio Vargas" in Sao Paulo. Well, not quite. Even though it's pure Economics, there are still core modules in Philosophy, Politics, and History. In comparison, Economics at Warwick is extremely quantitative with only optional modules in the aforementioned subjects. It’s almost as though they’re trying to phase out the use of English language completely in teaching and replace everything with equations. Then again, Economics at Warwick prides itself in being the most quantitative in Europe. Maybe I should have known that beforehand.

In any case, since this year doesn’t count- I can do any module. Which means I can finally do the things I love, but I won’t. The things you hate are the ones that become the most useful; the most challenging modules are the ones where you learn the most. For example, I almost gave up on Econometrics and it ended up being my best mark. I almost gave up on Math and it got me into Economics. Maybe there’s a trend. Therefore, I’m making sure that my schedule is filled with difficult and challenging modules. No. Not really. Maybe one or two.

I’ve narrowed it down to eight modules (You do about four a term): The Formation of the Brazilian Economy, Microeconomic Theory III: Strategy, Evolution, and Complexities, Philosophy, Politics and Ethics, Monetary and Financial Economics, Financial Economics, Economics of the Public Sector, and Political Science.

On top of that, I’ve organized a motley reading list composed of random books in a heaped pile. “Quantitative Financial Economics” and some basic books on Finance, Rawls’ “Theory of Justice”, Shaw’s “Justice and Economic Distribution” and Nozick’s “Anarchy, State, and Utopia”. The former is for a career in finance, the latter to prepare for a final year course in political theory.

I’m not looking forward to Rawls. Philosophical trains of thought makes me nauseous. I think they make any Economist nauseous. Needs graphs.


The Economics of Federalism

To secure the public good and private rights against the danger of such a faction, and at the same time to preserve the spirit and the form of popular government, is then the great object to which our inquiries are directed. – James Madison

Perhaps one true aspect of PPE is the economics of political philosophies. Of great importance is the system of the United States and its historical context. American politicians love to use sound-bites like the “founding fathers”, “the constitution”, and the “separation of powers.” It’s a difficult subject, mostly due to the archaic nature of the document and times (For example, the constitution counts slaves as ¾ of a person). However, the defining aspect of US politics is the underlying federalist system although the system itself is overlooked in most literature.

Federalism is a political philosophy in which subgroups are bound together by a “federal” government in addition to local and state governments. Power is shared between the levels to government. The traditional historical, political, and philisophical justification for federalism dates back to the 16th and 17th century. They are the avoidance of tyranny by assuring that a government does not surpass its limits through checks and balances and the splitting of sovereignty. The political arguments and philosophical arguments are well known, but there are also economic justifications for the appropriate balance. In many ways the importance of economic calculations in federalism has become the subject of modern debate, as the philosophical and political arguments are sound or of lesser importance in modern society. These are one of topics that interlink public economics and political economy.

For example, fiscal federalism: the divvying of revenue and expenditure responsibilities amongst levels of governments. How to allocate these responsibilities becomes an economic problem! There are four compelling arguments: local information advantages, scale economies, spillovers, and making democracy meaningful. For example, a local government may possess more information about providing an amount of a public good than a federal government which would only result in a loss of efficiency: ie, schools or public transport. Thus, in areas in which information is key, its best that local government provides the public good. Another argument for local government is that it makes democracy meaningful. Change is greater at a local level, and placing greater emphasis and responsibility at a local level improves the democratic process as instead of pandering to a general electorate, politicians must focus on specific issues concerning local communities.

The arguments in favor of federal governments are fairly straightforward. There may be economies of scale from providing a public good. For example, national defense may be provided more efficiently on a national scale as opposed to randomly scattered militias or a national transport service may be provided more effeciently than a plethora of state services. There's also the concept of spillovers: situations in which a public good wouldn’t be provided (Another Prisoner’s Dilemma). The environment is a good example, if there is no federal government, local governments would be compelled to pollute and the result would be no clean air or toxic rivers, etc.. Another example would be states attempting to lower their tax rates to make immigration of firms and businesses attractive. The end result being that every states sets their tax rate very low to prevent capital flight.

What follows is a careful economic balancing act in a federalist state in which political and philosophical normative analysis is required. The question of how to balance the power of a central government so that it can provide the benefits from eliminating free-riding but systematically preventing itself from exercising too much power. Does the "sacrifice" of state soveirgnty outweigh the expected benefit? Or would the end result put some tyrannical planner in charge of the department of education.

To understand the complexity of the situation, consider the many “Departments” (ie. Department of Education, Health, Energy, etc.). Republicans and conservatives contend that federal government will always provide goods inefficiently due to local information advantages. However, in many ways, these departments should theoretically be useful if they allow for economies of scale and correct externalities. But doing so would theoretically intrude on a state's rights and wouldn't be allowed according to the US constitution. The argument is not as black and white as many perceive and the problems from fiscal federalism continue to be debated.


The Hotelling–Downs model of Two–Party Competition and the Median Voter Theory

My favourite topic from Public Choice is the Hotelling-Downs model of Two-Party Competition (Though it was never actually covered). First introduced in a paper by Harold Hotelling in 1929, the model still holds today. What’s impressive about the model is its simple, it’s realistic, and it’s something which one can observe in any pluralistic political process.

The intuition behind the model is as follows: Voters have single-peaked preferences. They hold a certain “bliss point” along a single dimension. For example, taxation. You would be okay with a 10% tax-rate. You find it reasonable, but anything greater or less you prefer less to your bliss point of 10%. The same can be applied to political ideologies among other things. In the US system, you have a bliss point along a Left-Right political system. You could be a ultra-liberal and be on the far left of the spectrum or be very conservative and be on the right. Or you could be moderate and be in the middle. What follows is that the median voter will always decide the election. In the median, you will have at least 50% of the vote.

What this means is that if a candidate wishes to win a two-party election, he must take the position of the median voter. He can not take any other position for fear of losing. In the United Kingdom, the labour party attempted to do so in 1983, and lost miserably. If you decide to go on the fringe, be prepared to lose if a country is made of moderates. This is the reason why you have career politicians, vigorous opinion polling, and intrusions into candidate’s personal lives. In a presidential election, the result will come down to a candidate’s personal charisma and not necessarily their policies.

For an example of the model in action, take the recent Democratic and Republic primaries. The two parties seem completely polarised, the Democrats talking about universal health care, liberal immigration, and ending the war. The Republicans talking about family values, closing borders, and abortion.

What happens first is that each candidate has to appeal to their base, and that means taking on positions many find radical. It’s easy to illustrate this point with the Republicans: just consider their stance on gun control. What happens after, once the party candidates are elected, is a dramatic shift from both candidates to the center. Instead of battling their ideological positions in the Democratic debates, it’s reduced to sound bites of “I also agree with the Senator” and “God bless America.” No candidate will risk taking his true position (This can be modelled as a Prisoner’s Dilemma, but that’s for another time). This is why the Hotelling-Downs model predicts that both candidates will converge to the position of the median voter.

However, the model rests on one major assumption. Single-peaked preferences. In a two-party system, it’s reasonable to suggest that preferences are single-peaked. If you’re a party Democrat, but believe that abortion should be illegal, unless you have a strong enough ideological belief in that single issue you won’t necessarily adopt a package of Republican policies for that single issue. I’ll leave it at that for now, but the truth is it’s even more complicated for a two-party system. However, once you get into parliamentary elections- the model falls apart completely. To consider why, look at the following diagram:

This might be a little complicated, but all it says is that no party can satisfy the median voter. A “cycle” can occur. Party X can beat Party Y which can beat Party Z which can beat Party X. That’s why parliamentary elections are a nightmare to model. You can only offer rough a priori predictions, but because there is no “core”, you can’t offer any certainty.


Weighing my Options

So I've been blogging using Blogger for the past week or so, but it seems like Warwick Blogs gives me more options. Anyone have any ideas which one I should use?


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