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Why is Supply and Demand so confusing?

In critique, popular economics, reblog on July 29, 2009 at 11:49 am

Scott Sumner, professor of economics at Bentley University, wrote an honest-to-goodness article about the general confusion that students, teachers and business journalists have in thinking about supply and demand. I found the article through the site of Greg Mankiw, the author of the textbook which Sumner refers to in this illuminating article. Consider this:

Question:  A survey shows that on average 100 people go to the movies when the price is $6 and 300 people go when the price is $9.  Does this violate the laws of supply and demand?

Very, very few can answer this question, especially if you ask for an explanation.  Even worse, I think there is a perception that there is something ‘tricky’ about this question, something unfair.  In fact, it is as easy a question as you could imagine.  It’s basic S&D.  It’s merely asking students what happens when the demand for movies shifts.  I cannot imagine a less tricky question, or a more straightforward application of the laws of supply and demand.  In the evening hours the demand for movies shifts right.  Price rises.  Quantity supplied responds.  What’s so hard about that?  And yet almost no student can get it right.  Our students enter EC101 knowing one of the two things they need to know about S&D, and they leave knowing one of the two things they need to know about S&D.  Maybe instead of having them memorize mind-numbing lists of “5 factors that shift supply,” and “5 factors that shift demand,” we should just tell them to read something that will explain what economics is all about, something that portrays economists as detectives trying to solve the identification problem, something like Freakonomics.

Scott Sumner articulates one of my personal concerns in studying economics. I felt that the general concepts, when you really think about them, really lack the empirical basis of the natural sciences. I thought that a more comprehensive education would make the philosophy of economics indispensable to clarify abstract concepts like value, exchange, utility, price and demand. These terms never fail to confuse me, though what I like in general is how the universe of economics can be postulated in the form of a labyrinth.

The author criticizes the manner with which reputed publications talk about the subject. “I feel like something is wrong.  What they are doing is about as closely related to economics as astrology is to astronomy.”

The full article can be found here.

Related posts:
Economics post archive

Vampires are good for the economy

In popular economics, reblog on July 25, 2009 at 4:46 pm

Just as I have thought. Vampires work wonders to the economy, if their population is managed effectively.

In Dennis Snower’s Macroeconomic Policy and the Optimal Destruction of Vampires (1982), the optimal production of stakes should make the supply sufficiently low to allow the regeneration of vampires (see my An economic policy on vampires post).

Michael Ian Black has some amateur arguments in My Custom Van. Ecocomics sums this up:

…vampires would be more likely to attack individuals of lower socioeconomic backgrounds, who have less adequate means of protecting against an attack. This, he argues, would serve to reduce spending on social welfare programs, such as Medicaid, since more lower-income individuals enroll in these programs.

The same blogger adds his own insights:

…there are other industries that have the potential to grow. One is, of course, the insurance industry. Much like with supernatural disaster insurance, people will want compensation in the event of vampires destroying their homes, their cars, and most of all, their pets. And what about insurance against actually becoming a vampire? Vampires have things to buy. They still live in homes, which means they have mortgages to pay, utilities bills, car insurance payments, etc. Unlike zombies, vampires do not just walk around lusting for brains and losing body parts. They are actually capable of blending in with humans, holding intelligent conversation, and engaging in rational thought. They are also capable of deriving enjoyment from television, music, books, clothing, and others. Therefore they are likely to make some purchases for entertainment and luxury in addition to necessity.

See the complete article here.

Related posts:
An economic policy on vampires

The market for prostitution

In popular economics on July 24, 2009 at 10:38 am

(This post is a continuation of More Sex is Safer Sex).

In this age of epidemic, “multiple partnerships save lives” (Steven Landsburg). How? Because it eliminates the market for prostitution, which is a venue for the spread of the epidemic.

Let’s imagine a community where women are required to sleep only with their husbands. But husbands are more likely to sleep with women other than their wives. The monogamous policy, however, prevents them from sleeping with the wives of other men. Hence, there emerges a prostitution market, which supplies more sex and satisfies the demand for more partners in a monogamous community.

For simplicity’s sake, let’s say the population of this community is 100. There are 50 men and 50 women. There are only 10 singles (5 males, 5 females), the rest are married. Let’s say monogamy is preached more strictly on wives, and culture has made a policy exemption on husbands due to their sexual instincts. Let us assume that the natural propensity of husbands to sleep with another woman is 1 extra partner per year. Given the number of single men, the number of husbands is 45. The number of wives is also 45. But if each husband, based on natural necessity, sleeps with 1 extra partner per year, and they’re not allowed to sleep with the wives of other husbands, they will resort to the 5 single females. Since there is very few and precious supply of extra sex, a market for prostitution arises because of the bargaining power of the single females. Assuming these 5 all engage in prostitution, they will have to meet the demand of 45 husbands and will need to sleep with multiple partners throughout the year. If all husbands must be satisfied, the average number of each prostitute’s customer is 9 husbands a year.

Now let’s say one husband (1% of the population) is HIV positive. He infects one prostitute, who in turn infects 8 more men. The 9 infected husbands will infect their 9 wives. If each husband tries the other prostitutes, then the other husbands and wives are also infected.

Now if we allow the 45 wives to have multiple partners and throw monogamy out of the equation, the husbands can sleep with other wives. Hence the total number of females in the population that are potential sexual partners becomes 50. If there are 50 women that can supply the demand of 45 husbands, then the bargaining power of females in providing sex is reduced, and hence no prostitution market will form, and no venue for the rapid spread of the epidemic.

Related posts:
More Sex is Safer Sex
Reincarnation Bank

Economics and Global Climate Change

More sex is safer sex

In popular economics on July 24, 2009 at 10:06 am

The key to reducing the risk of sexually transmitted diseases is not lesser sex, but more sex. This is according to Steven Landsburg, a professor of economics who writes columns at Slate in the tradition of Levitt and Dubner’s Freakonomics and Tim Harford’s The Undercover Economist. He is also the author of More Sex is Safer Sex. For him, the AIDS epidemic is not worsened by promiscuity, but rather by monogamy, chastity and sexual conservatism.

I like the thinking style of Landsburg because he shows that what we think as common sense is in fact irrational. His solutions to social problems, like urban congestion, are often the reverse of our assumptions of correctness. His rhetorical skills show this pattern: “X, which is thought to improve Y, actually worsens it”. Here are some of his claims in the past, backed by economic theory applied on everyday life:

1. Parking your car is more environmentally destructive than driving it.
2. We shouldn’t aid Katrina’s victims too much.
3. Pornography prevents rape.
4. It makes more sense to play the lottery than to vote during elections.

He talks about the economics of faking orgasms. He applies the marginal analysis in discussing why people stand still on escalators but not on normal stairs. Tim Harford praised Lansburg for his unconvential wisdom. The meaning of “unconvential” in his case is his ability to attack popular assumptions.

In More Sex is Safer Sex, he argues that conservatism, chastity and monogamy help spread epidemic, and claims that increased sexual activity can help reduce the risk of AIDS. The argument runs thus:

Identifying key players. One, we have a person who is looking for sex. Two, we have a set of potential partners. We divide this set into two groups: the promiscuous ones and the conservatives.

Quantifying the risk of getting HIV. Now let’s say you’re looking for sex in a party. You spot four (4) potential partners. Let’s say two (2) of them are promiscuous (engaging in casual sex, sleeping with strangers or with more than one partner or husband, etc.), and the rest are conservative (either  monogamous, virgins, or just cautious and picky).

Since the promiscuous group is more likely to be HIV positive, and the set is divided into two equal groups, there is 50% chance of getting an unsafe match. Supposing, however, that the conservative crowd in the general population doubles the frequency of their sexual activity (e.g. instead of getting sex just once a year with a partner met in a party, they now have sex twice), you will find that their number in the set increases. Hence, when you step into a party, you are more likely to add two (2) more conservatives in the set of potential partners. Now you have six (6) potential partners, four (4) of which are conservatives and only two (2) are promiscuous.

This means the risk of having unsafe sex is now just 2/6 or 33%, and the chance of sleeping with a safe partner is 4/6 or 67%. That is why we say that more sex reduces the risk of AIDS because the probability of having sex with an HIV-positive partner is reduced from 50% to 33% given that the conservative crowd in the general population becomes more sexually active.

Landsburg’s advice: let the sexual conservatives have more sex. It’s more doable than preaching sexual conservatism to the promiscuous crowd.

The solution isn’t that simple if we put monogamy into the equation. I’ll save this for my next post, The Market for Prostitution.

Related posts:
Reincarnation Bank
Economics and Global Climate Change

Reincarnation Bank, or How the Transmigration of Souls will change the Banking Industry

In popular economics on July 21, 2009 at 4:58 pm

There is a bank that can manage your assets to make sure you still own them in your next life. Tyler Cowen, co-author of the popular economics blog Marginal Revolution, found out that there is a Reincarnation Bank owned by a certain 2i Limited. Eccentric markets are interesting, even on the level of scholarship. We have here a hybrid of the theory of the transmigration of souls and the theory of banking. The process seems simple: you deposit now, then you can withdraw from the same bank in your next life. Too bad if you’re reborn as a duck or a horse. According to Jorge L. Borges’ knowledge of Buddhism, the probability of a person being reborn as a human being is the probability of a tortoise rising to the surface of the sea and finding a solitary ring, which can float anywhere in the world, around its head.

This bank’s theory of transmigration of souls has three assumptions before the transaction can be complete from deposit to withdrawal:

1. You do not attain Enlightenment (hence you are reborn);

2. You are reborn human; and,

3. You can remember your past lives.

A favorable condition must fulfill all these conditions. Granting metempsychosis fulfills these criteria, this is how Reincarnation Bank proposes to facilitate withdrawals:

As in this life, in the next you will have memories of previous lives. One of these recollections will be of your arrangement with Reincarnation Bank. Whatever version of the internet or data retrieval mechanisms in use at the time of your return, you will renew your contact with Reincarnation Bank and through regression you will recall the details/instructions that you left at the time of making your deposit. A custodian of Reincarnation Bank will open your letter privately in your presence and will ask you to repeat the details contained therein (whilst in regression). Once this has been satisfactorily achieved, funds/property will be handed back to you and the account closed.

Sounds like a passage from a Buddhist science fiction.

The universe of theories can be postulated in the format of a Tree. Each theory does not exist autonomously. The influential ones tend to coalesce and define what’s common sense, practical and enforceable. The whole arrangement sounds like the work of a lunatic, a prankster or a desperate fraudster, but maybe if we develop the theory of metempsychosis to the fullest until it is inscribed as common sense, a Reincarnation Bank wouldn’t sound so bad. The Catholics have done it with the selling of indulgences.

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Economics and Global Climate Change
Notes on the Film “Hero”
Arthur Waley and the Translators of the “Tao Te Ching”

Economics and Global Climate Change

In popular economics, reblog on July 15, 2009 at 11:53 am

Conor Clarke, correspondent for The Atlantic, lists the reason why it’s difficult to make sense of global climate change after his interview with Thomas Schelling, who won the 2005 Nobel Prize in Economics. Schelling has been recognized in the field of game theory, which is the study of strategic situations. A strategic situation, by layman’s definition, is simply a situation where the outcome of one’s decision is affected by the decision of another party.

The rationale for the interview is to contextualize the issue of global climate change in complicated bargaining agreements among nations. Part one of the interview can be found here. He summarizes the difficulty of making sense of the issue in the following:

1. Any solution to climate change must have a theory for what the present generation owes future generations. That’s hard. How do we weigh the interests of people that don’t yet exist?

2. Any global solution to climate change must take account the fact that the costs of warming will be borne unevenly around the world. Parts of the northwestern United States will actually benefit from a warmer climate. Bangladesh will not. But why should the U.S. care what happens in South Asia?

3. Any solution should account for the fact that the responsibility for global warming is also borne unevenly. The developing world will bear most of the costs, but the developed world bears most of the responsibility. (My understanding is that this will change at some point in the next 50 years.)

4. Related to #2, the world’s ability to adapt to a changing climate is distributed unevenly. It would surprise no one to learn that wealthy nations will have an easier time adapting than poorer ones. So should we allow poorer nations to pursue the most rapid growth possible, before the consequences become dire? Or should we pursue a solution that achieves the maximum possible reduction in global emissions?

5. There is a great deal of uncertainty about what will happen. To be sure: There is no (repeat, no) scientific uncertainty as to whether or not the climate is warming. It is. But the question is, By how much? And when? Will the temperature increase by two degrees Celsius over the next 100 years? Three degrees? Seven degrees? The differences matter.

6. Climate change has an incredibly long time horizon. Any small cost or small chance of a catastrophic outcome must to weighed across hundreds or thousands of years. There is also one-way ratchet here: It isn’t clear everything we change about the climate can be reversed.

7. Global warming asks us to weigh economic factors — growth, GDP — against non-economic ones, like the diversity of species and the amount of arable land on the planet. I have absolutely no clue how to do that.

Thomas Schelling

Related post:
Game Theory of Washing Dishes

The economics of brushing teeth

In academia, popular economics on June 6, 2009 at 12:40 pm

In The Economics of Brushing Teeth by Alan S. Blinder (1974), the author argues that economists have ignored a certain class of activities in the theory of human capital, such as brushing teeth. He says that the analysis can also be applied to equally important problems as “combing hair, washing hands, and cutting fingernails” (pg. 887).

Following from the human capital theory, each individual does whatever amount of toothbrushing to maximize his income (pg. 888). Blinder tells us that the “mother-told-me-so” explanation of toothbrushing rests on the fact that “offspring behave as if they maximize their income” since “the mother’s decisions are governed by income maximization for the child”.

The author then presents a theoretical model of toothbrushing by showing a wage maximization equation which involves the time spent brushing teeth as an independent variable:

Y=w(J,B)(T-B)+P, where Y=income, w=wage rate, J=index of job, B=time spent brushing teeth, T=time period available for working, and P=exogenously determined amount of unearned income.

Blinder puts the model into an empirical test and came up with a regression model for his data.

However, I must critique the article for relying on the value of the R-squared (i.e. “.79”) in concluding that the data confirm the prediction of the theoretical model. It is not, and never will be, the holy grail of econometrics.

An economic policy on vampires

In academia, mundane, popular economics on June 5, 2009 at 12:54 pm

What should be our economic policy on blood-sucking ghosts of dead homo sapiens, or vampires? In Macroeconomic Policy and the Optimal Destruction of Vampires (1982), Dennis J. Snower claims that vampires’ “most conspicuous macroeconomic impact arises from their detrimental effect on the labor force”.

One section of the paper presents a Model of Human-Vampire Dynamics, stating, “myopic humans, who maximize their welfare at every instant of time, may be expected to destroy a socially suboptimal number of vampires” (pg. 649).

Snower shows a number of analytic equations which include the variable p to represent a vampire’s blood coefficient requirement, S for the quantity of stakes produced, n for the constant human procreation rate, and the constant sigma for the rate of vampire attritition through sunlight.

He presents the theorem, “If the number of stakes per vampire remains below the critical level s^c=(p – sigma) – n, it is impossible for the human race to survive” (pg. 650).

Another section deals with optimal vampire destruction. He claims that, even though the annihilation of all vampires seems favorable, it is not socially optimal to do so. The author presents a set of graphs and equations I fail to understand, but I think the intuition behind the technicality is that the supply of stakes would become infinitely large if all vampires are destroyed (pg. 653).

He says that an optimal condition would be to have a production rate of stakes that reduces the vampire population, but is sufficiently low to allow their regeneration (pg. 653).

In his suggestion for future research, he claims that his work sets the stage for “an investigation whether humans and vampires grope their way toward a Cournot-Nash equilibrium”.

I think his assumption that only stakes are able to slay vampires is too simple to be of practical value. We should also consider the production rates of rosary necklaces, crucifixes, garlics, and scapulars.

The optimal Gift-giving Strategy

In popular economics on June 5, 2009 at 5:58 am

My roommate received a new copy of Twilight as a gift. I suggested to auction it on eBay. I checked Amazon and it was listed for a price of P700, which we will assume as the cost of the giver in buying the book from the bookstore. Then I surveyed the prices of the same book with slightly worse condition on eBay and estimated the average selling price to be around P500.

To compete with other similar items, P500 should be our price floor (the price before the first bid). Clear enough, this is economically inefficient. The situation is called deadweight loss. The giver bought the gift for P700, but it was only valued by the recipient for P500. The difference of P200 is called the deadweight loss. (Though the deadweight loss can decrease as more bids are offered, raising the initial price of P500, the price will never go beyond P650, which is the eBay buyer’s point of indifference, because of the added shipping cost of P50 that will increase the buyer’s total cost to P700, the bookstore price).

Joel Waldfogel, who wrote The Deadweight Loss of Christmas, is far from “condoning the healthy effect of [gift] spending on the macroeconomy” by focusing on the negative microeconomic impact of gift-giving. He estimates that Christmas gift-giving destroys 10% to 1/3 of the value of gifts. In our case, gift-giving erodes the value by almost 30% or P200, consistent with Waldfogel’s estimate.

Why is deadweight loss bad? Because it results from inefficient allocation. Gift-giving constrains consumer’s choices and does not maximize the utility of a good. Waldfogel points out that the size of a deadweight loss is determined by (1) the giver’s knowledge of the recipient’s preferences, and (2) the recipient’s knowledge of his own preferences.

The more a giver knows about the preferences of a recipient, gift-giving can create rather than destroy value. This is why parents and significant others give the almost “perfect” gifts. When you are in doubt about the recipient’s preferences, just give the gift in cash (which makes grandparents very efficient in gift-giving). The most inefficient gift-givers are the other relatives and friends.

The optimal gift-giving strategy must aim to reduce the deadweight loss. An economics blogger gives this funny but sound advice:

…if you give a gift valued at £40, but costing £50, the recipient can reduce the quantity that he buys for himself until the marginal value has risen back to £50. The solution is therefore to give gifts that the recipient purchases regularly. Things like cars and washing machines are bad – it’s hard to reduce your purchases if you only buy a new one every few years. Things like soap, toothpaste and bacofoil are good. [“But that’s so unromantic,” you protest. Tough. I’m trying to make you more efficient, not get you laid.]

How to read your own books

In academia, popular economics on June 3, 2009 at 5:02 pm

You love buying books, but once the titles are in your shelf, you just kind of stare at them and read books you do not own.

It makes sense. Books you lend are transient, while books you own are permanent. You just want to maximize limited privileges (library, friends, anyone?). That’s why a criterion I use in buying a book is that I shouldn’t want to read it right away. But ten years have passed and I still have dusty Austen, yellowing Twain and crispy Dickens, untouched like wrinkled virgins. How many of us are guilty of this cognitive bias?

Perhaps you should turn to economics. It’s time to get over what Richard Thaler calls the endowment effect, which makes us value the things we own more than what they were worth when we did not own them.

Thomas Schelling, whose work on conflict and cooperation through game-theory analysis won him the 2005 Nobel Prize, proposes an art of self-management he calls egonomics. He says each individual has a kind of split personality — for instance, one part wants to read the books in the shelves, while the other wants to play a simulation game instead.

You can force a cooperation between two conflicting parties through precommitment, which is a strategy that Schelling recommended in nation-state wars. The idea is for you to cut off your options to retreat or give up, hence making your threat credible. The credibility of the threat will deter the conflict, and the end result is avoidance of war (“you go to war to prevent it”).

Precommitment can cure the endowment effect. Simply threaten yourself to let go of your books, and see if you still won’t read them. The only catch is that the threat must be credible. Leave no option of retreating.

I did this by auctioning my books on eBay, where there’s a constant threat that a book will be sold. When someone bids for a book, I quickly pick it up from my shelf and read it before finally shipping it to the customer. I would feel sorry for myself if I did not read the books before letting them go.