Markets, Incentives and a Krugman (et al.) Fail

Pity the poor teenager taking an AP Economics course whose father is an economist. Especially when the local school district has adopted a text that is based on Paul Krugman’s Economics (3rd ed., coauthored with Robin Wells). Even more especially when the father-economist has a fundamental disagreement with much of what Mr. Krugman has become since surrendering his academic credentials for political punditry. Yeah, that’s my lucky kid.

So of course, I had to thumb through the text. I suppose I shouldn’t have been too surprised to find on only the third page of Module 1 a gross error in explaining the trouble with command economies. After explaining the failed history of command economies, the text asserts (p. 3):

At the root cause of the problem with command economies is a lack of incentives, which are rewards or punishments that motivate particular choices.

Where to start? How about with the simple fact that incentives always exist, no matter the type of economy. And there were plenty of incentives in the former Soviet Union (the textbook example of a command economy–literally in this case). I remember the late Nobel Prize-winning economist James Buchanan sharing the story of his visit to Moscow shortly after the fall of the Soviet empire during which he was surprised to learn of a market for burned out light bulbs — because people could use them to steal working light bulbs from their workplaces when they couldn’t get light bulbs in the stores. People responding to incentives. It’s The Basics 101. The problem with command economies is not a lack of incentives–but a lack of incentives that are based on the wants of consumers themselves and a lack of incentives for innovation or efficiency. In short–the absence of the incentives created by a free market economy.

More importantly, the focus on incentives misses the point in a way that has significant implications for what the text goes on to say about economic policy. At the root of the problem with command economies was the lack of information available to decision-makers about the wants and desires of an entire population of individual consumers with different tastes and preferences and about the conditions of scarcity and desires in dispersed local markets across the society’s economy. As F.A. Hayek (another Nobel Prize winner) explained, the fundamental role of markets is to discover and reveal information based on the complex interactions of individuals across product types and geographic space.These interactions result in prices that reflect the relative scarcity and value of goods across society. Those prices create incentives, and those incentives are fundamentally important in guiding individuals to use their resources in ways that innovate, create value, and serve consumers. But the incentives are secondary–derived from the information discovery role of the market that cannot be replicated in a command economy.

Why is this such an important distinction? Because of the way the text goes on to describe the objective of policy making. After (fairly accurately) explaining how prices create incentives, the authors state (p. 3):

In fact, economists tend to be skeptical of any attempt to change people’s behavior that doesn’t change their incentives. For example, a plan that calls on manufacturers to reduce pollution voluntarily probably won’t be effective; a plan that gives them a financial incentive to do so is more likely to succeed.

The implication? All we need to do is create incentives (implicitly, in the form of taxes, fines or subsidies) to create financial incentives for manufacturers (or people) to do what we want them to do. But this line of argument ignores the more fundamental question of determining whether the plan makes social or economic sense in the first place. What is the economic basis for whether we uses fines or subsidies and how large they should be? At what point, if any, would doing nothing be economically more efficient than doing something? By taking away the fundamental information function of the market and jumping immediately to incentives, we skip the whole messy discussion of the information requirements by legislators, bureaucrats and policy makers in coming up with “the plan” to begin with. All we need to do is trust the omniscience and beneficence of policy makers to know what the “right price” is–and to set arbitrarily the incentives to get the outcomes we want. But that’s exactly why command economies fail.

The root problem of a command economy is not that there are no incentives, but that there are socially inefficient incentives. The incentives are socially inefficient because it is impossible for a central authority to know the value individual citizens place not only on existing goods and services, but on the latent value of potential goods and services that can only be discovered by innovation and experimentation–and a central planner cannot think beyond her own imagination in the realm of possibilities. And it’s not only true of Soviet-style planned economies, but of any central decision-making authority–including the US federal government–even in the context of a heavily market-dominated economy.

Note: AP Economics students (and teachers), remember….the correct answer on the test may not be the right answer in reality. Answer the questions from the textbook based on the information in the textbook. But in your real life as a consumer of information and participant in the market place of ideas and politics, be sure to get to the fundamentals rather than the superficial.

Incentives and the SCOTUS Surprise on Same-Sex Marriage

The Supreme Court of the United States (SCOTUS) surprised even veteran court watchers this week by refusing to hear a set of cases involving state-level bans (and reversals of those bans) of same-sex marriage. One lawyer offers a pretty convincing argument on why the Court decided not to weigh in on an issue that has such important consequences for large groups of people (and employers). At its heart, it’s all about individual justices’ incentives and the cost-benefit calculation justices had to make in the face of an uncertain outcome:

So why is the Roberts Court, not normally shy in jumping into controversial issues such as affirmative action or campaign finance law, ducking this one?

The answer may lie in the incentives facing the individual Justices rather than the approach of the Court as a whole. When you look at the choices available from the three different perspectives on this issue – liberals, swing votes, and conservatives – it becomes much easier to see why there weren’t the four votes required (out of the nine Justices) to hear this issue now. With no camp assured of victory if the court decided to hear the cases, the uncertainty may hold the key to the Justices’ thinking.

You can read the full blog post with the details of the explanation here. Regardless your position on the issue, this analysis of the justices’ likely reasoning in passing on the opportunity to settle the issue (at least for a period of time) illustrates how understanding individuals’ incentives helps to explain the expected–and not-so-expected–outcomes that shape the laws and institutions that help structure society at-large.

 

The “Laws” of Economics

Economics has few “laws”. The most notable is the Law of Demand, which simply states that there is an inverse relationship between the price of a thing and how many units people are willing to buy (i.e., when the price goes down (up), people buy more (less)). The Law of Demand is basically just the culmination of the most basic observations of human behavior; specifically, The Basics with which I started this blog.

There are a few other things that sometimes get labelled as “laws” in economics textbooks. The “law of supply” only applies to things still actively produced, for which the necessary inputs are available; but in general, the more people are willing to pay for something, the more of it producers will try to produce. The “law of diminishing returns”–typically applied in the context of production–assumes there is at least one fixed input that constrains the marginal productivity of the rest. It’s more a rule of thumb than a “law.” But it is also analogous to Rule #3 in The Basics: More more is less better.

Whether we consider them “laws” or not, one thing is for certain: when we ignore these basic principles, we do so at our own peril. And that brings me to the motivation for this post; namely a recent blog post by “The Edgy Optimist” (aka Zachary Karabell) at Reuters.com titled “The ‘laws of economics’ don’t exist.” Continue reading The “Laws” of Economics

Paid To Be ‘Stuck’?

Words matter. So when a recent article in the Wall Street Journal Online proclaims “Workers Stuck in Disability Stunt Economic Recovery,” it sets off the incentive alarms. What do you mean by “stuck in disability” and what role do incentives play in that “stuck”-ness? I mean, if you choose to stay in a sticky situation, are you really stuck?

The quick background:
A very large number of people were disabled by the recent recession (i.e., the number of people who were placed on federal disability jumped dramatically, even by historical standards). The preponderance of this increase in “disability” came from people who were no more disabled than they had been previously. Rather, they are people who lost jobs that they were previously able to endure but jobs they were not able to replace. In short, the new “disability” was really the inability to find new jobs given whatever physical limitations individuals claimed to have, not the physical limitations themselves. This was compounded by States that were able to reduce their welfare and Medicaid costs by shifting people to Social Security disability (SSDI) and Medicare.

Now people are not getting off of disability as rapidly as they have after recessions past. While the official unemployment has been falling of late, it has more reflected a decrease in the labor participation rate than an increase in the number of jobs. The percentage of working-age adults who are in the labor market has decreased, and almost half of that decrease is a result of people moving into “disability” status. Fewer people in the labor market not only makes unemployment look better than it really is, but it also puts a drag on the economy as fewer workers are available to take jobs (supply of labor decreases) and make “stuff”. And “stuff” is what makes the market economy go ’round. If that wasn’t bad enough news, the high disability rate is now predicted to bankrupt the current SSDI system in the next three years.

So, are people really “stuck in disability”? Continue reading Paid To Be ‘Stuck’?

Beginning With The Basics

The purpose More Is Better Than Less (MIBTL…I may have to think about that acronym) is to have a venue for sharing information and for sharing my perspective on various economic issues. So I figured it would be good to start with the basics. And I think these basics are so important that I also have a page devoted to them so they’ll be easy to find as the blog grows. If you think economics is too complicated, too mathematical, or just plain stupid, I hope I can convince you otherwise—and that you, too, are capable of wielding the sword of economics to cut through much of the muck and mire that muddles public discourse.

Economics, at its foundation, is simply a framework for understanding how people choose to use the resources available to them; whether money, raw physical goods, knowledge, talents or time. Economists can make it very complicated–to the point of losing the economic intuition in the mathematics of the models they use. But at its foundation economics is based on some very simple premises that don’t take a PhD in economics–or mathematics–to understand and apply to real life. Sadly, too few people understand that–and fewer still use that understanding.

There are three basic assumptions I propose at the beginning of every course I teach. I believe they are sufficient to understand the vast majority of human behavior. And they involve no math: Continue reading Beginning With The Basics