Tag Archives: economic theory

Economic and political cycles interlinked

Suppose the government’s policy determines the state of the economy with a lag that equals one term of the government. Also assume that voters re-elect the incumbent in a good economy, but choose the challenger in a bad economy. This voting pattern is empirically realistic and may be caused by voters not understanding the lag between the policy and the economy. Suppose there are two political parties: the good and the bad. The policy the good party enacts when in power puts the economy in a good state during the next term of government. The bad party’s policy creates a recession in the next term.

If the economy starts out doing well and the good party is initially in power, then the good party remains in power forever, because during each of its terms in government, it makes the economy do well the next term, so voters re-elect it the next term.

If the economy starts out in a recession with the good party in power, then the second government is the bad party. The economy does well during the second government’s term due to the policy of the good party in the first term. Then voters re-elect the bad party, but the economy does badly in the third term due to the bad party’s previous policy. The fourth government is then again the good party, with the economy in a recession. This situation is the same as during the first government, so cycles occur. The length of a cycle is three terms. In the first term, the good party is in power, with the other two terms governed by the bad party. In the first and third term, the economy is in recession, but in the second term, booming.

If the initial government is the bad party, with the economy in recession, then the three-term cycle again occurs, starting from the third term described above. Specifically, voters choose the good party next, but the economy does badly again because of the bad party’s current policy. Then voters change back to the bad party, but the economy booms due to the policy the good party enacted when it was in power. Re-election of the bad is followed by a recession, which is the same state of affairs as initially.

If the government starts out bad and the economy does well, then again the three-term cycle repeats: the next government is bad, with the economy in recession. After that, the good party rules, but the economy still does badly. Then again the bad party comes to power and benefits from the economic growth caused by the good party’s previous policy.

Overall, the bad party is in power two-thirds of the time and the economy in recession also two-thirds of the time. Recessions overlap with the bad party in only one-third of government terms.

Of course, reality is more complicated than the simple model described above – there are random shocks to the economy, policy lags are not exactly equal to one term of the government, the length of time a party stays in power is random, one party’s policy may be better in one situation but worse in another.

Golf as a cartel monitoring device for skilled services

Many explanations have been advanced for golf and similar costly, seemingly boring, low-effort group activities. One reason could be signalling one’s wealth and leisure by an expensive and time-consuming sport, another may be networking during a low-effort group activity that does not interfere with talking.

An additional explanation is monitoring others’ time use. A cartel agrees to restrict the quantity that its members provide, in order to raise price. In skilled services (doctors, lawyers, engineers, notaries, consultants) the quantity sold is work hours. Each member of a cartel has an incentive to secretly increase supply to obtain more profit. Monitoring is thus needed to sustain the cartel. One way to check that competitors are not selling more work hours is to observe their time use by being together. To reduce boredom, the time spent in mutual monitoring should be filled somehow, and the activity cannot be too strenuous, otherwise it could not be sustained for long enough to meaningfully decrease hours worked. Playing golf fulfills these requirements.

A prediction from this explanation for golf is that participation in time-consuming group activities would be greater in industries selling time-intensive products and services. By contrast, if supply is relatively insensitive to hours worked, for example in capital-intensive industries or standard software, then monitoring competitors’ time use is ineffective in restricting their output and sustaining a cartel. Other ways of checking quantity must then be found, such as price-matching guarantees, which incentivise customers to report a reduced price of a competitor.

Star job candidates benefit from appearing to be worse

Employers have a cost of making a job offer: filling out forms, getting approval, not being able to make other offers simultaneously in case too many job candidates accept, etc. A company who believes that it is not the top choice of candidates would want to avoid making an offer to a star applicant (one who is likely to receive better alternative offers from top employers, thus turn down the lower-ranked company’s offer).

If the star job-seeker is uncertain about the offers she or he will get, or wants a bargaining chip to use with the most preferred company, then (s)he prefers to obtain the lower-ranked employer’s offer, even when planning to reject it. A way to entice the company into offering a job is to pretend to be more attainable (have a worse outside option) by faking lower talent and potential when interviewing with lower-ranked employers. For this pretence to be (partly) credible, it must have a cost for the job-seeker, otherwise all the best candidates would pretend to be worse and increase their chance of obtaining offers from their backup employers. Then the next-best candidates would have to fake being less good to receive jobs, etc. This race to the bottom would only end once all candidates look like the worst possible, which does not seem realistic.

One potential cost is that faking lower talent has a random outcome, which may be so bad that the employer does not want to offer a job at all. This would temper the incentive to appear worse. Another cost is information leakage – if bad performance at a less desirable interview becomes known to higher-ranked employers, then the candidate may forfeit her or his most preferred interviews and jobs. It could also be that the top job-seekers cannot hide their quality, for example because their genius shines out despite their best effort, or employers base offers solely on recommendation letters, which the candidate cannot see or affect around the time of applying.

Social welfare functions derived from revealed preference

The social welfare functions used in policy evaluation typically put more weight on poorer people, justifying redistribution from the rich to the poor. The reasoning is that the marginal benefit of a unit of money is greater for the poor than the rich. However, people with a greater marginal value of money are more motivated to earn and save, other things equal, so more likely to become rich. In this case, the rich have on average a higher marginal benefit of money than the poor, or a lower marginal cost of accumulating it. If the justification for redistribution is an interpersonal utility comparison, then revealed preference suggests a greater Pareto weight for richer people, thus redistribution in the opposite direction to the usual.

If the marginal utility of money decreases in wealth or income, then people earn until the marginal benefit equals the marginal cost, so the comparison between the rich and the poor depends on their marginal cost of earning, evaluated at their current wealth and income. The cost and benefit of earning may both be higher or lower for richer people. In a one-shot model, whoever has a greater benefit should receive redistributive transfers to maximise a utilitarian welfare criterion. Dynamic indirect effects sometimes reverse this conclusion, because incentives for future work are reduced by taxation.

Those with a high marginal utility of money are more motivated to convince the public that their marginal utility is high and that they should receive a subsidy. The marginal utility is the difference between a benefit and a cost, which determine whether the poor or the rich have a greater incentive to lobby for redistributive transfers. The marginal cost of an hour of persuasion equals the person’s hourly wage, so depends on whether her income is derived mostly from capital or from labour. For example, both rentiers and low-wage workers have a low opportunity cost of time, so optimally lobby more than high-wage workers. If lobbying influences policy (which is empirically plausible), then the tax system resulting from the persuasion competition burdens the high-wage workers the heaviest and leaves loopholes and low rates for capital income and low wages. This seems to be the case in most countries.

A tax system based on lobbying is inefficient, because it is not the people with the greatest benefit that receive the subsidies (which equal the value of government services minus the taxes), but those with the largest difference between the benefit and the lobbying cost. However, the resulting taxation is constrained efficient under the restriction that the social planner cannot condition policy on people’s marginal costs of lobbying.

Equilibrium response to reduced material use for plastic bags

Probably to save material on the manufacture of the free plastic shopping bags in the US, these bags are small and thin compared to the ones in Estonia (which used to be free, but are now priced at significantly above production cost due to EU regulations on disposable plastic products). The equilibrium response of cashiers and customers to thin flimsy bags is to double-bag groceries, a practice unheard of in Estonia. After all, if one bag is sturdy enough, almost nobody will use two inside each other. I have successfully carried 10 kg in an Estonian plastic bag.

The equilibrium response to small bags is to distribute the groceries among many bags, especially the heavy or bulky items, for example to put each milk canister or large salad sack into a separate bag. Both double-bagging and the one-item-per-bag distribution lead to more bags being used in response to manufacturing each bag out of less material. It is an empirical question whether thinner, smaller bags result in less or more plastic waste overall. To incentivise reducing the one-time use of plastic bags and to encourage reuse, customers should have to pay for these, like in the EU.

One form of plastic bag reuse is as garbage bags (although it is only a one-time reuse, it is better than nothing). However, the flimsy free bags in the US come in bulk packs with the bottoms of the bags stuck together, so separating one from the stack often results in holes in its bottom an inch wide or more. The holes discourage many forms of reuse, including as trash bags, because small items (dust, crumbs, scraps) fall out. Partly the holes are due to the flimsiness of the material, partly to the way the bags are glued together to make a bulk pack.

Claims that tickets are running out

Both for paid and free events, the organisers often advertise that only a few tickets or places remain. The ad sometimes explicitly tells the viewer to register or buy now. Such advertising is costly, so there should be a benefit to the organiser. If the tickets have already sold out, then the benefit is zero, or at least smaller than if the event is not fully booked. The positive benefit from advertising a sold-out event is to build reputation for the future as an organiser of popular events, similarly to real estate agents putting a „Sold” sign in front of a house on which they closed the deal.

Given that the benefit of costly advertising is smaller when no tickets remain, some sellers should decide to advertise if and only if the event has not sold out. More generally, the probability of advertising should increase in the number of tickets remaining. In this case, rational buyers should treat advertisements saying that limited spaces remain as signals of the opposite – frequent ads show a desperate seller facing low demand. If most buyers think this way, then such advertising is counterproductive, because buyers want to delay their purchases when the probability of being able to buy in the future is large enough. The option value of waiting comes from the possibility that the buyer’s preferences change – a better event may become available, or some emergency may prevent the buyer from attending. Getting a refund for a ticket already bought is at least a hassle and may even be impossible.

The widespread claims of limited space remaining suggest that these ads boost purchases. One reason may be buyer attention – ads make them notice the opportunity to buy, which some of them wish to take advantage of. However, any ads draw attention to the event, so raising awareness cannot be the reason for the specific claim that tickets are running out.

For most events, buyers do not want to coordinate with the largest possible crowd, only with their friends, so do not prefer a fully booked event to a half-full one. Thus claims that the event is almost sold out are difficult to explain by the seller trying to coordinate buyer actions.

Some irrationality of buyers or the seller seems necessary to explain messages that demand is low. Either the buyers take the claim literally instead of using Bayes’ rule to infer the opposite, or the seller advertises despite ads decreasing demand.

It is an empirical question whether the target audience of ads saying that space is running out interprets these as signalling high or low demand, and whether these messages make people delay their purchase or speed it up.

Mugs, pens and USB sticks as advertisements

Several universities I have visited give free mugs to seminar speakers as advertisements for themselves. Similar branded objects (pens, USB sticks, T-shirts, baseball caps) are handed out by firms and political campaigns as part of their marketing.

The idea of giving people practical objects instead of flyers, junk mail or banners is to make the recipients use these objects (as opposed to throwing these away or storing them at the back of a closet), preferably in a public setting, and thus increase the visibility of the advertiser. For this, the more usable the handout, the better.

Unfortunately, the people ordering these objects in bulk and paying for the brand logo to be printed on these are busy administrators who do not connect the overall purpose the marketing campaign to the properties of the objects. Specifically, the mugs should have a large handle that lets more than two fingers hold it, the mug should be short with a wide mouth for easy filling and washing, and should not be too fragile.

Pens should write well and be ergonomical, not angular or too narrow. I have seen branded pens violating all these suggestions. For example, the Australian National University pens are of flimsy plastic, create ink splotches and the ink runs out quickly.

The USB sticks handed out by the University of Queensland had a metal cover which increased the USB drive’s bulk and scratchiness. Also, the USB was wide and thick, making it impossible to plug in side by side with another USB. The small capacity of the USB was also behind the times.

To advertise with an object, it would make sense to print the advertiser’s name and other relevant information in large readable font on the object. The logo is not useful unless it is already widely known by the target audience and associated with the advertiser. The readability suggestion is violated by the Singapore Management University’s mug, which has SMU written on it in complicated calligraphic script that is difficult to decipher even for someone who knows what the abbreviation SMU means.

For people to develop a positive view of the advertiser, the object should not seem too cheap or bad quality. By contrast, most free T-shirts are the cheapest ones that could be bought wholesale, made of the most threadbare and transparent cotton, which discourages their use.

Delivered food and restaurants are unhealthy due to moral hazard

Consumers observe the taste and cost of food directly, but checking the ingredients for healthiness takes extra effort and time. Rational inattention then implies that eaters are unlikely to verify the health claims. Thus food suppliers are subject to moral hazard: consumers buy based on the healthiness they expect, not the actual ingredients the seller chooses, so the seller has an incentive to improve taste, reduce the production cost and cut price even when this makes the food less healthy.

The standard solutions to moral hazard from economic theory are verification, repeated interaction and vertical integration (selling the firm). In the context of food, safety standards and truth-in-advertising laws restrict the substances manufacturers may add and claims they can make. Regulators verify claims made and punish for illegal additives or false advertising. Also, if a food supplier is found to use unhealthy ingredients (or amounts of sugar, salt and fat), then some consumers may switch to alternate providers, which is a repeated game punishment for the original seller.

The weakness of both verification and repeated interaction is imperfect monitoring: small increases in unhealthy substances are difficult to detect, because tests are noisy and food composition varies naturally. The variation sometimes makes the amount of an ingredient exceed the healthy limit, so honest suppliers would also be punished with positive probability. Incentives are created by the difference in payoffs, so reducing the payoff of the honest decreases their motive to stay honest. The imperfect monitoring allows unscrupulous sellers to outcompete the providers of healthy food on taste and price, for example by using various tricks to circumvent the legal requirements on labelling (https://sanderheinsalu.com/ajaveeb/?p=728).

The remaining solution to the moral hazard problem is vertical integration of the buyer and the supplier, i.e. home cooking. Of course, the ingredients bought to be cooked at home are subject to similar moral hazard – unhealthy substances can be added at any stage of the production process. The risk could in principle be even larger than for processed foods and restaurant meals, but in practice, it seems that simple and unprocessed ingredients are more difficult to manipulate than prepared meals, which are a mixture of many components. Adding sugar, salt, fat or monosodium glutamate to flour, rice or dry beans without mentioning it on the nutrition label is easier to detect than the same (amounts of) additives in shrimp fried rice, bread or a burrito. Raw meats and fish do have extra salt and food colouring added, but usually less than for ready-to-eat meals.

Relative prices are another reason why there may be less manipulation of ingredients than processed foods. There is a per-unit cost of adding unhealthy substances, as well as a fixed cost due to the risk of lawsuits and fines, especially if the additives are not declared on the label. Unprocessed ingredients are less differentiated, so the price competition is more intense. The increase in the price that customers are willing to pay if an ingredient tastes better than the competitors’ may be small if price is the main dimension of competition. The slightly higher price may not justify the per-unit cost of the additives. In contrast, for processed foods the margin may respond greatly to taste, motivating manipulation of the ingredients.

The taste of the final dish is likely to respond less to manipulating one ingredient than to altering the composition of the entire food, both because the ingredient may be only a small part of the final dish and because the taste of a dish is largely determined by the seasoning and the cooking method. In this case, additives to ingredients do not improve taste that much, reducing the profitability of manipulating these.

Intense price competition motivates cost-cutting, including by substituting cheaper ingredients or using additives (e.g. preservatives) that reduce the manufacturing cost. However, if the additives cost more than they save on production cost (such as preservatives for dry goods that already keep indefinitely), then they are unprofitable to include.

Demand for cooking ingredients may also respond less to price and taste than for restaurant meals or delivered food (raw ingredients may even be an inferior good, but eating out is more like a luxury good). In this case, there is a range of fixed costs of unhealthy substances for which adding these to ingredients is unprofitable, but to processed foods profitable.

Pill testing, placebos and illegal market efficiency

Testing illegal drugs for the active ingredient differs from testing for poisonous adulterants. Both tests have opposite effects on drug use before and after buying. After the pill has been purchased, testing reduces use, because sometimes the drug fails the test, whether correctly or not, and is discarded. Before purchase, the option to test for and avoid adulterated or inactive drugs reduces the buyer’s risk, thus increases use.

In the longer term, testing benefits the dealers of purer, more predictable and less toxic drugs, putting some suppliers of fakes out of business. Pill predictability reduces overdoses – a health effect similar to lower toxicity. If old drugs can be tested, but new ones not, then buyers experiment less and the incentive to invent new narcotics decreases.

The avoidance of poisonous adulterants is good for public health, but purer pills not necessarily so. Inactive drugs undermine consumer confidence in the illegal market, reducing use, prices and casual purchases. Trust then requires a long-running relationship with the seller, which has multiple benefits. It motivates dealers to care about the health of their loyal customers, simplifies policing and gives researchers and social workers better long-term access to the at-risk population.

One claimed benefit of party drugs is that they reduce anxiety, increase the user’s confidence and social interaction, thus improving mental health. Evidence from psychiatric medicines suggests that many such benefits are due to the placebo effect. Users are quite inaccurate in estimating the purity of ingested drugs, and factors like price and place of purchase strongly influence their perception of purity. The price per pure gram is negatively related to purity in some markets, further supporting the placebo interpretation. If inactive pills boost confidence similarly to illegal drugs, then there is a clear case for flooding the market with harmless placebos. The availability of pill tests for the active ingredient reduces this opportunity to make the illegal market inefficient. Tests for toxic adulterants, however, actually favour harmless placebos.

Spam deterrence by boycotting

The obvious reason for spam of any kind (emails, texts, phone calls, unsolicited mail) is that it is profitable. Thus spam must raise the probability that its target buys or otherwise complies with the spammer’s wishes, e.g. leaves a review. To deter spam, the incentive for it must be reversed – the targeted people should not give in to spammers, but do the opposite (not buy, not leave a review when receiving a „reminder”). I try to follow this strategy. If I remember that a business spammed me, then I try to boycott it, unless it is by far the best option (usually not, spammers are typically shady businesses and bottom-feeders).

Incentives are created by the difference in payoffs, not their level. Thus to deter spam, the buying probability should be lower for a spamming business than for a non-spamming competitor. To create this payoff difference for non-monetary actions, e.g. reviewinig, I leave a review with positive probability when not asked to do so, but certainly avoid reviewing when spammed with reminders.

If the whole society followed the strategy of boycotting spammers, then one possible concern is that spammers would start to use reverse psychology. They would spam in the name of their competitors to make them look like spammers. If customers start boycotting the competitors as a result, then demand shifts to the spammer, which is profitable.

The reverse psychology is unlikely to become a serious problem, because there are typically many competitors and the spammer would have to make most of them look bad to increase its demand significantly. Also, the law usually punishes the use of a fake name more harshly than unsolicited contacting. The competitors whose reputation is tarnished by spam under their name have a stronger incentive to sue its source than consumers just annoyed by the spam.