AI Can’t Cure a Flaccid Mind

Many of my classes consist of a large writing component. I’ve designed the courses so that most students write the best paper that they’ll ever write in their life. Recently, I had reason to believe that a student was using AI or a paid service to write their paper. I couldn’t find conclusive evidence that they didn’t write it, but it ended up not mattering much in the end.

Inflation, Information, & Logic

Most economists know that the CPI is overestimated and therefore prefer the PCE price index. However, monthly CPI data is consistently released before PCE data for a given month. One would think that they move in the same direction and be highly correlated. Indeed, in the past five years, the correlation is 0.96. Therefore, it stands to reason that the there is less new relevant information on the PCE release dates than on the CPI release dates. Yes, CPI is biased, but it still contains some information about prices and it is known well prior to the more accurate PCE numbers.

Supply and Demand react to new information. Sometimes the new information changes our expectations about the future, and other times we learn that our beliefs about goods and assets were previously not quite right. So, with new relevant information comes new prices as people update their beliefs and expectations.

Let’s get financial.

The Imperfection of Subgame Perfection

I’ve written previously about Pure Strategy Nash Equilibria (PSNE). They are the set of strategies that players can adopt in equilibrium – with no incentive to change their strategy. Students have an intuition that PSNE aren’t great because some outcomes that they identify depend on players making silly decisions in the past. In jargon, we can say that some PSNE depend on players choosing irrationally in a subgame while still reaching a PSNE.

See the extensive form game (below right). There are two players, each with two strategies per information set, and player two has two information sets. All PSNE will include a strategy for each information set. We can present the same game in normal form in order to make it easier to identify the PSNE (below left).

Player 1 (P1) can choose the row (B or C) and Player 2 (P2) can choose the column. Importantly, whether P1 might want to change his mind depends on P2’s strategy at the decision node in the alternative information set. Therefore, P2 must have two strategies, one per information set.

The four PSNE strategies and payoffs are underlined in the above table and they are noted in red on the below extensive form games. Again, the logic of PSNE states that no player can improve their payoff by changing only their own strategy, given the opposing player’s strategy. After all, a player can control their own strategy, but not that of their opponent. For example, note PSNE II. In the left subgame, P2 chooses M. His payoff would be unchanged if he changed his strategy, given the strategy of P1.

The Unimportance of Inflation: Stocks & Flows

One of my specializations in graduate school at George Mason University was monetary theory. It included two classes taught by Larry White who specializes in free-banking, Austrian macroeconomics, and monetary regimes. Separately, my dad was a libertarian and I’ve attended multiple Students for Liberty events. Right now, I’m writing from my hotel room at a Catholic/Crypto conference, where I learned that the deepest trench in Dante’s Inferno includes money debasers.

Everything about my pedigree suggests that I should have a disdain for the Federal Reserve and cast a wistful gaze toward the perpetually falling value of the US dollar. But I don’t. I certainly do have opinions about what the Fed should be doing and how our monetary system could work. But I’m not excited by the long-run depreciation of the dollar.

Let me tell you why.

Learning a little bit of theory is a dangerous thing. Monetary theory is especially hard because we examine the non-good side of the transaction: the medium of exchange. In frantic excitement, enthusiasts often point out that the value of the dollar has lost very much of its value in the past 100 years. They describe that loss by describing the lower quantity of something that a dollar can purchase now versus what it could have purchased historically. That information is incapsulated in the price of a good. The price of a good is the number of dollars that one must exchange in order to purchase the good. Similarly, the price of a dollar is the number of goods that one must give up in order to purchase the dollar.

We can consider a variety of goods. Below is a graph that describes the quantity price of the dollar where the quantities are CPI basket units, gold, and housing. In the 35 years following 1986, a single dollar purchases 60% less of the consumer basket, 74% fewer houses (not quality adjusted), and 76% less gold.

Market Concentration & Inflation

We are living in volatile times. With covid-19, big federal legislation packages, and the Ruso-Ukrainian conflict disruptions to grain, seed oils, and crude oil, relative prices are reflecting sudden drastic ebbs of supply and demand. I want to make a small but enlightening point that I’ve made in my classes, though I’m not sure that I’ve made it here.

Economists often get a bad rap for being heartless or unempathetic. Sometimes, they are painted as ideologues who just disguise their pre-existing opinions in painfully specific terminology and statistics. Let’s do a litmus test.

Consider two alternative markets. One is a perfect monopoly, the other has perfect competition. All details concerning marginal costs to firms and marginal benefits to consumers are the same. In an erratic world, which market structure will result in greater price volatility for consumers? Try to answer for yourself before you read below. More importantly, what’s your reasoning?

Extreme Market Power

A distinguishing difference between a competitive market and a monopoly concerns prices. While firms maximize profits in both cases, the price that consumers face in a competitive market is equal to the marginal cost that the firms face. There is no profit earned on that last unit produced. In the case of monopoly, the price is above the marginal cost. Profits can be positive or negative, but the consumer will pay a price that is greater than the cost of producing the last unit.

Below are two graphs. Given identical marginal costs of production and benefits that the consumers enjoy, we can see that:

1. The monopoly price is higher.
2. The monopoly quantity produced is lower.

But static models only go so far. What about when there is volatility in the world?

Volatile Costs

Oil and gasoline are important inputs for producing many (most?) physical goods. Not only that, they are short-lived, meaning that they disappear once they are used, making them intermediate goods. Therefore, changes in the price of oil constitutes a change in the marginal cost for many firms. If the price of oil rises, or is volatile otherwise, then which type of market will experience greater price and quantity volatility?

Below are two figures that illustrate the same change in the marginal cost. We can see that:

1. Monopoly price volatility is lower (in absolute terms and percent).
2. Monopoly quantity produced volatility is lower (in absolute terms, though no different as a percent).

The take-away: While monopoly does constrict supply and elevate prices, Monopoly also reduces price and output volatility when there are changes in the marginal cost.

Volatile Demand

That covers the costs. But what about volatile demand? A large part of the Covid-19 recession was the huge reallocation of demand away from in-person services and to remote services and goods. What is the effect of market power when people suddenly increase or decrease their demand for goods?

Below are two figures that illustrate the same change in demand. We can see that:

1. Monopoly price volatility is higher (in absolute terms, though no different as a percent).
2. Monopoly quantity produced volatility is lower (in absolute terms, though no different as a percent).

Monopolies Don’t Cause Inflation

Economists know that inflation can’t very well be blamed on greed (does less greed beget deflation?). Another problematic story is that market concentration contributes to inflation. But the above illustrations demonstrate that this narrative is also a bit silly. Monopolistic markets cause the price level to be higher, it’s true. But inflation is the change in prices. Changing market concentration might be a long term phenomenon, but can’t explain acute price growth. If demand suddenly rises, monopolies result in no more price growth than perfectly competitive markets. If the marginal cost of production suddenly rises, monopolies result in less price growth.

All of this analysis entirely ignores welfare. Also, no market is perfectly competitive or perfectly monopolistic. They are the extreme cases and particular markets lie somewhere in between.

Did you guess or reason correctly? Many econ students have a bias that monopolies are bad. So, in any side-by-side comparison, students think that “monopolies-bad, competition-good” is a safe mantra. But the above illustrations (which can be demonstrated mathematically) reveal that economic reasoning helps to reveal truths about the world. Economists are not simply a hearty band of kool-aid drinking academics.

Everyone’s an Expert: Easy Data Maps in Excel

I love data, I love maps, and I love data visualizations.

While we tend not to remember entire data sets, we often remember some patterns related to rank. Speaking for myself anyway, I usually remember a handful of values that are pertinent to me. If I have a list of data by state, then I might take special note of the relative ranking of Florida (where I live), the populous states, Kentucky (where my parents’ families live), and Virginia (where my wife’s family lives). I might also take special note of the top rank and the bottom rank. See the below table of liquor taxes by State. You can easily find any state that you care about because the states are listed alphabetically.

A ranking is useful. It helps the reader to organize the data in their mind. But rankings are ordinal. It’s cool that Florida has a lower liquor tax than Virginia and Kentucky, but I really care about the actual tax rates. Is the difference big or small? Like, should I be buying my liquor in one of the other states in the southeast instead of Florida? Without knowing the tax rates, I can’t make the economic calculation of whether the extra stop in Georgia is worth the time and hassle. So, the most useful small data sets will have both the ranking and the raw data. Maybe we’re more interested in the rankings, such as in the below table.

But, tables take time to consume. A reader might immediately take note of the bottom and top values. And given that the data is not in alphabetical order, they might be able to quickly pick out the state that they’re accustomed to seeing in print. But otherwise, it will be difficult to scan the list for particular values of interest.

Covid-19 Didn’t Break the Supply Chains. You Did.

This is my last post in a series that uses the AS-AD model to describe US consumption during and after the Covid-19 recession. I wrote about US consumption’s broad categories, services, and non-durables. This last one addresses durable consumption.

During the week of thanksgiving in 2020, our thirteen-year-old microwave bit the dust. NBD, I thought. Microwaves are cheap, and I’m willing to spend a little more in order to get one that I think will be of better quality (GE, *cough*-*cough*). So, I filtered through the models on multiple websites and found the right size, brand, and wattage. No matter the retailer, at checkout I learned that regardless of price, I’d be waiting a good two months before my new, entirely standard, and unexceptional microwave oven would arrive. I’d have to wait until the end of January of 2021.

¡Que Ridiculo!

The aggregate supply & aggregate demand model (AS-AD) is nice because it’s flexible and clear. Often professors will teach it in levels. That is, they teach it with the level of output on one axis, and the price level on the other axis. This presentation is convenient for the equation of exchange, which can be arranged to reflect that aggregate demand (AD) is a hyperbola in (Y, P) space. Graphed below is the AD curve in 2019Q4 and in 2020Q2 using real GDP, NGDP, and the GDP price deflator.

The textbook that I use for Principles of Macroeconomics, instead places inflation (π) on the vertical axis while keeping the level of output on the horizontal axis. The authors motivate the downward slope by asserting that there is a policy reaction function for the Federal Reserve. When people observe high rates of inflation, state the authors, they know that the Fed will increase interest rates and reduce output. Personally, I find this reasoning to be inadequate because it makes a fundamental feature of the AS-AD model – downward sloping demand – contingent on policy context.

At the same time, I do think that it can be useful to put inflation on the vertical axis. Afterall, individuals are forward looking. We expect positive inflation because that’s what has happened previously, and we tend to be correct. So, I tell my students that “for our purposes”, placing inflation on the vertical axis is fine. I tell them that, when they take intermediate macro, they’ll want to express both axes as rates of change. I usually say this, and then go about my business of teaching principles.

But, what does it look like when we do graph in percent-change space?

In Praise of the FRED Excel Add-in

Sometimes, large entities have enough money to throw at a problem that by sheer magnitude they produce something great (albeit at too high a cost). The iPhone app from the FRED is not that thing. But the Excel add-in is something that every macroeconomics professor should consider adding to their toolkit.

Personally, I include links to FRED content in the lecture notes that I provide to students. But FRED makes it easy to do so much more. They now have an add-in that makes accessing data *much* faster. With it, professors can demonstrate in excel their transformations that students can easily replicate. The advantage is that students can learn to access and transform their own data rather than relying on links that I provide them.

The tool is easy enough to find – FRED wants you to use it. After that, the installation is largely automatic.

Installed in excel you will see the below new ribbon option. It’s very user friendly.

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