Fences, Schools, Dryer Lint, & Shower Levers

In game theory, coordination games reflects the benefits of everyone settling on the same rules. Settling on the same rules can avoid a conflict and destructive competition. For example, some rules may be arbitrary, such as on which side of the road we’ll all drive. It doesn’t much matter whether a country’s vehicles drive along the right or left side of the street. As long as everyone is in the same lane, we overwhelmingly benefit from our coordination. The matrix below describes the game.

The above game reflects that whether we agree to drive on the left or on the right is trivial and that the important detail is that we agree on what the rule is. Rules like this are arbitrary. No amount of cost benefit analysis changes the answer. Other coordination rules are seemingly arbitrary, but do have different welfare implications. For example, according to English common law, a farmer was entitled to prohibit a herdsman’s flock from trampling his crops even if the farmland had no fence. Herdsmen were responsible for corralling their flocks or paying damages if they grazed on the farm. With lots of nearby farms, total welfare was higher with a rule of cultivation rights rather than grazing rights.

But the property rights could have been assigned to the herdsman instead. The law could have said that the sheep were free to graze with impunity and that the onus was on the farmer to build fences in order to keep the sheep at bay. In a world where there are a lot of farmers who are very nearby to one another, a small flock of sheep can do a lot of damage. And so, the cost-benefit analysis prescribes that herdsmen bear the cost of restricting the flock rather than the farmer. The matrix that describes this circumstance is below.

The above matrix reflects that agreeing on any rule is better than no rule at all. And, the rule that is selected has societal welfare implications. Choosing the ‘wrong’ rule means that we could get stuck in a rut of lower payoffs because coordinating a change in the rules is hard.

Schools

Another way in which the specific rule can be important is by whether it instantiates or works contrary to pre-existing incentives. Before compulsory schooling laws were passed, US states already had very high school attendance rates. Most parents sent their kids to school because it was a good investment. The ages at which children should be required to attend is largely, though not entirely, arbitrary. And wouldn’t you know it, most states applied their compulsory schooling legislation to the age groups for which the vast majority of children were already attending school. Enforcing a law against the natural incentives of human capital investment would have been more costly. The particular ages of compulsory schooling had different welfare implications due to the differing costs of enforcement.

Dryer Lint

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Car Prices and Quality

Inflation is on everyone’s mind. Everybody freaks out. You cannot do anything about it. As such, lets talk about something mildly related: how price indexes (those that we use to talk about inflation) deal with quality changes.

One big problem when we try to measure the cost of living is that the price information we collect does not reflect the same thing we consume. I know that sentence seems weird. After all, 1$ for a pound of bread is 1$ for a pound a bread. And if prices go up 10%, then the price per pound of bread is 1.10$!

If you think that, you’re wrong. Think about the following example from my native province of Quebec. In the 1990s, Quebec deregulated opening hours for grocery stores. The result was … higher prices at large superstores. Why? Before the reform, stores had shorter hours especially on sundays. This meant that stores were competing with each other on a smaller quality dimension which meant more price-based competition. With deregulation, some consumers were willing to pay slightly higher prices to shop at ungodly hours. What were these consumers consuming? Were they consuming only the breadloafs they bought or were they consuming those loafs and the flexible schedule of the grocery stores? The answer is the latter! Ergo, the change from 1$ per pound to 1.10$ per pound does not mean that the price of bread alone increased — it may have even fallen all else being equal!

So how do you adjust for that? There are many papers on how to do hedonic adjustments (hedonic is the fancy words we use to say “quality-adjusted”) and they are all a pain to read unless you are very familiar with real analysis, set theory and advanced calculus (and even there, its still a pain). Fortunately, I recently found a neat little application from an old econometrics graduate text from the 1960s (see image below) that allows me to teach this to my students (and now, you too!) in an easy-to-get format.

A neat book

The book has a neat chapter by one of the most famous econometricians of the 20th century, Zvi Griliches, titled “Hedonic Price Indexes for Automobiles: An Econometric Analysis of Quality Change”. In the chapter, Griliches points out that from 1954 to 1960, car prices went up some 20% — well above the overall price index. From 1937 to 1950, prices for cars went up in line with inflation. Taken together, these two facts suggest that the real price of cars stayed constant from 1937 to 1950 and increased to 1960. But that suggestion is wrong Griliches points out because of our aforementioned quality issues. Up until 1960, there were considerable improvement in vehicle quality: better gears, better brakes, more horsepower, safer settings, automatic transmission, hardtops, switching to V-8 engines rather than 6 cylinders engines etc.

How do you account for these quality changes? Griliches simply went about consulting guide books for autobuyers. He collected price data for the cars as well the details regarding quality. And he used this very simple specification where the log of the nominal price is set as a dependent variable.

Griliches’ specification

The vector X is all the quality dimensions he could find (horsepower, shipping weight, length, V-8 engine, hardtop, automatic transmission, power steering, power brakes, compact car). All of these dimensions were statistically significant determinants of the price of cars (with the exception of V-8 engines which was not significant). Then, Griliches assumed that all quality dimensions were “unchanged” from 1954 to 1960 in order to see how prices would have evolved without any changes in quality. The result is the figure below. The blue line depicts the actual prices he collected where you can see the 20% increase to 1960 (which is a 30%+ increase to 1959). The orange line depicts the price holding quality constant. That orange line is unambiguous: quality-constant car prices didn’t change much during the 1950s. Adjusting for inflation during the period suggests a drop in 10% in the real price of a quality-constant car.

Image

Isn’t that a fascinating way to understand what we are actually measuring when we collect prices to talk about inflation? I find this to be an utterly fascinating example (and a useful teaching tool). Okay, I am done, you can go back to freaking out about inflation and how bad the Fed, Bank of Canada, ECB are.

Inflation: Not Merely a Monetary Phenomenon

I’m a big fan of Milton Friedman. I’m also a big fan of easy-to-remember phrases that impart great wisdom. It honestly made me wince the first time I said the following:

Inflation is *not* everywhere and always a monetary phenomenon“.

The reasoning is as plain as day. Consider the quantity equation:

MV=PY

For the uninitiated, M is the money supply, V (velocity) is the average number of times dollars transacts during a period, P is the price level, and finally Y is real output during a period. This equation is often called the “equation of exchange” or “the quantity equation”. Strictly speaking, it is an identity. It is a truism that cannot be violated. All economists agree that the equation is true, though they may disagree on its usefulness.

Inflation is simply the percent change in price. We can rearrange the quantity equation, solving for price, in order to see the relationship between the price level and its determinants.

P= MV/Y

What does this mean? It means that more money results in more inflation, all else held constant. It means that higher velocity results in more inflation, all else held constant. It means that less output results in more inflation, all else held constant.

Why would Milton Friedman say that inflation is always caused by changes in the money supply if it is clear that there are two other causes of the price level? When Milton Friedman said his famous quote, output growth was relatively steady. Velocity growth was relatively steady. For his context, Milton Friedman was right. The majority of price and inflation volatility was found in changes in M. See below.

Strictly speaking however, Milton Friedman knew better and he knew that the statement was not strictly correct. Friedman was a public intellectual and he was a great simplifier. He taught many people many true things. At the time, people were blaming inflation on a great variety of things: taxes, fish catches, and unions, to name a few. Arguably, Friedman got them closer to the truth.

Now, there are economists that are pointing to total spending as the driver of inflation. After all, both sides of the equation of exchange describe NGDP (a.k.a. – Aggregate Demand or Aggregate Expenditure). Replacing M and V in the equation with NGDP yields:

P=NGDP/Y

What does this mean? It means that higher NGDP results in more inflation, all else held constant. It means that less output results in more inflation, all else held constant.

But economists dismissing M in lieu of AD are committing the same oversimplification. Y can also change! Maybe economists figure that our recent history is full of relatively stable Y growth and that we ought not pay attention to it. And indeed, unsurprisingly, RGDP growth has been less than NGDP growth.

But what is driving the current bought of inflation?

Pardon the crude image. The pink lines are eye-balled trend lines on natural logged data for AD, Y, and P. Prices are up. Is it because of exceptionally high NGDP? Nope. Total spending is back on pre-2020 trend. Does Y happen to be down? Yep, it sure is.

Right now, assuming the previous trend was anywhere close to potential output, inflation is not being driven by excess aggregate demand. It’s being driven by inadequate real output. The news tells the story. There have been supply-chain bottle-necks, difficulty employing, lockdowns, and fear of covid. Right now we have an output problem and higher prices are a symptom. We do not have an aggregate spending problem.

PS – In fact, it is my belief that the Fed successfully avoided a debt-deflation aggregate demand tumble that would have been catastrophic. Inflation is expected when supplies of goods decline.

A Canned-Beer Kind of Guy

An  ex-co-worker was once complaining to me that the prices of things that he liked kept going up.

He was an economics major. Of course he knew that wages also increase. He wasn’t simply cantankerous about inflation. He knew all about improving productivity, income, and price level changes. He was being more specific. The *particular* items that *he* liked were getting more expensive. He was complaining about what, to everyone else, were relative price changes.

Unrelatedly, I was floating around the bls.gov website and examining their Producer Price Index (PPI) FAQs (I learned a bunch). The content is extensive. CPI is broken up into some subcategories. But PPI, being used by multiple industries and trade groups for real-life costs and benefits, is excitingly granular.

You want to know what happened to the price of red, white, rose, and carbonated wines each in particular?  They’ve got you covered. It really is amazing.

Back to my co-worker. I tried to explain that relative price changes reflected underlying economic value and scarcities. We wasn’t having any of it. He just didn’t want his prices to go up. We economists are known for being kind of dispassionate. We see relative prices change and we shrug. Man-on-the-street sees a relative price change and, boy, does he care about it – if it’s the purchasing price that *he* faces.

See the below graph. What kind of consumer are you? Since the start of the pandemic, canned, bottled, and kegged beer have all changed in price. Or maybe you’re a teetotaler and you’ve noticed the increasing price of bottled water.  For interpretability, let’s consider what had cost $10 at the start of the year 2020. Bottled water has gone up to $10.50 and bottled beer has gone up to almost $10.30.  You may not blink at a 3% price increase – unless it’s for 6 bottles of your favorite craft beer.

The price of canned beer, on the other hand, hardly increased at all. And in the last couple of months, the price *fell*. I sure hope that my co-worker is a canned-beer kind of guy. Otherwise, someone is sure to hear a lot of belly-aching.

Steve Horwitz on “The Graduate Student Disease”

On Sunday the world lost a great teacher, economist, and all-around fantastic person in Steve Horwitz. If you don’t know about Steve, I recommend reading the tributes from Pete Boettke and Art Carden.

Pete and Art speak to Steve’s overall legacy and greatness. But I will tell you about a very specific piece of advice that Steve gave me about teaching undergrads.

Steve called it “the graduate student disease.” By this he meant the tendency of newly minted PhD economists to teach undergraduate courses as if they were mini versions of graduate courses. Steve insisted this was the wrong approach.

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Publications as Positional Goods, and the Division of Labor in Academia

My co-blogger Mike Makowsky has a thoughtful post this week about the academic publishing process. I wanted to offer a slightly different perspective on the same topic. But my perspective comes from someone who is not at a research university, and someone who has recently survived the tenure process.

A little background for those not completely familiar with the academic world: schools are usually considered either teaching or research schools. At first this seems confusing: both Clemson (where Makowksy is) and the University of Central Arkansas (where I am) require that faculty engage in both research and teaching. The difference is subtle, but the big hint is that Clemson is considered an “R1” school (the highest research designation) and has a PhD program with many graduate students. At a school like Clemson, research is valued more than teaching. At UCA, teaching is valued more than research. (Much more could be said about the differences, perhaps in a future post.)

We both engage in both teaching and research (as well as service!), but the emphasis is different. For me at UCA, the expectations of which journals I will publish in and how frequently I will publish are lower than at a school like Clemson. At Clemson, some of your publications should be in the Top 5 (or at least Top 10) journals from time-to-time. At UCA, if you published in one of the top journals, the assumption would be that you are probably leaving soon to go to an R1 school

I’m glad both types of schools exist, and my point here is not to disparage either type of school. But the difference is important for thinking about the academic publishing process.

For someone at an R1 school, publications in top journals are positional goods. Makowsky doesn’t say this exactly, but that’s my takeaway from his post. There are only so many spots available in these journals, and they have value because there is only a fixed number available. And since there has been, over the years, a lot more economists doing a lot more research not all of the great papers will end up being published in one of the top journals.

Upshot: there are a lot of great papers being published in Top 50 or even Top 100 journals! Let me pick on myself. As I said, I recently successfully survived the tenure process. My publication record was good enough. You can inspect my publications over at Google Scholar. I’m proud of these publications. I think some of them are really great. But I’m fairly confident that I would never earn tenure at Clemson with these publications. Instead, you need a publication record like Makowsky.

What’s interesting here is that Mike and I occasionally publish in some of the same journals. Public Choice and Constitutional Political Economy jump out to me. These are, in my view, very fine journals. Lots of interesting research is published in these journals. I’m especially proud of this paper in Public Choice. But if someone published only in these two journals and journals like them, they wouldn’t get tenure at an R1 university.

So what do we do with this information?

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Teaching Economics with COVID

In many of my blog posts I address either issues related to COVID or teaching economics. In this post, I want to combine the two. One thing economists of a certain age struggle to do is find examples to illustrate economic concepts which will actually connect with 18-22 year olds. The silver lining of the pandemic is that we now have an example that everyone is familiar with, and can be used to illustrate a host of economic concepts.

A great new book by Ryan Bourne, Economics in One Virus, really pushes this idea to the limit. He uses examples related to COVID to explain almost every single concept you would cover in a typical introductory economics course: cost-benefit analysis, thinking on the margin, the role of prices, market incentives, political incentives, externalities, moral hazard, public choice issues, and more.

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Bullfighting with cars and economic development

In Ecuador we bullfight with cars, literally. It’s not a game, its the name we give to the strategy we use when we cross the street. As in a bullfight, you stand on the edge of the curb, waiting for the car/bull to pass and then run behind the passing car to succesfully cross the street.

This is true no matter what the right of way legislation says (pedestrians have the right of way, de jure, in Ecuador as elsewhere), and as such is a very useful example to teach the difference between law and legistlation when talking about institutions. Although the actual phrase has fallen out of fashion lately, along with the falling popularity of bullfights (cue nostalgic music for dying traditions), the strategy remains as strong as ever.

Both pedestrians and drivers are familiar enough with the strategy that it is not uncommon to see pedestrians motioning angrily at the innocent driver that stops at a crosswalk, usually a foreigner, so that the car can pass and they can safely cross the street. Drivers speed up at crosswalks where people are waiting to cross, not in attempt to run them over, but as a courtesy, so as to get out of pedestrian’s way faster (at least many people I’ve talked to have shamefully confessed that is why they do this!). When a driver does stop at a crosswalk to give the people on the sidewalk the right of way there is a marked delay and drivers and pedestrians are incovenienced by the delay.

From conversations I have had with people from other developing nations, the strategy used by drivers and pedestrians to cross the street is nearly identical to bullfighting with cars we use in Ecuador. Although it’s not the best possible strategy for coordinating street crossing, it is an effective strategy that allows for social coordination since everyone knows that game that is being played. It is an institution of the developing world.

Moving to the US for my undergraduate degree, many years ago, I packed this institutional baggage along with me, which led me to be late for the first class of the semester. When I arrived at the crosswalk in front of a big red brick building in Boston’s suburbs, a car pulled up to the stop sign and stopped. My mind was lost thinking about what college in the US would be like, as I patiently waited at the edge of the curb for the car to pass so that I could bullfight the car to cross the street. A sudden honk of the horn startled me as I looked around to see an angry driver waving for me to cross the street. Partly because I was startled, but also because I was used to bullfighting with cars, instead of jumping out immediatly to cross, my feet began to do an akward one-step-forward one-step-back shuffle. It wasn’t until I made eye contact with the now exasperated driver, that I was confident enough I wouldn’t be run over to gathered my courage, break out of my developing-country meet developed-country shuffle, and finally cross the street.

Talking to a classmate from Central America later that day, he told me that he was all too familiar with what had happened to me, and with the one-step-forward one-step-back shuffle being discovered by tourists, immigrants, and foreing students all over the developing world. Many years later I have informally confirmed the shuffle still exists in conversations with students that have traveled abroad to the US and Europe.

When I tell this story in class, the question of how to switch to the obviously superior institutions of the US and Europe for street crossing, where pedestrians have the right of way, de jure and de facto always comes up. For institutional change to succeed without pedestrian bloodshed, the new institution would need to become common knowledge rather quickly. In more technical language, bullfighting with cars is the equilibrium now in the developing world, and we know a better equilibrium exists, but the path to the new equilibrium is difficult to traverse.

When I ask what students would do to change to this superior equilibrium, the most common first response is very economic in orientation. Increase monitoring and impose larger fines they say. But given the costs of these policies in an already poor and corrupt institutional environment, I doubt this is necesarily the path to superior institutions, for street crossing or anything else. This is especially true when we consider the relative cost effectiveness of changing this institution vs. other potential institutional investments in the developing world.

I also doubt that larger fines and increased monitoring are the main reasons that superior institutions for street crossing have emerged in the developed world. I have rarely seen police monitoring crosswalks (with the excpetion of school crossings) in the US and Europe, and while fear of punishment is definately an important influence, I don’t know how heavily the expectation of punishment weighs on the minds of drivers in developed countries.

Institutions are important for development but we know very little about how to change them. More thoughtfull students also suggest that a superior institutional arrangement could be reached by convincing people to change their perceived payoffs of playing different strategies. The hard and long process of social entrepreneurship, seems more effective and conducive to robust success.